An Intercompany Agreement (ICA) is a legal document that formalizes the terms of transactions between related entities within the same multinational enterprise (MNE). Its job is to lay out all aspects of the arrangement: not only the services, products, financial arrangements, or intangibles being transacted, but also the allocation of risk arising from the transaction. In other words, the genuine underlying business realities of all parties to the agreement.
There are as many flavors of ICA as there are types of transactions—IP licenses, loan arrangements, limited-risk or cost-sharing agreements, distribution deals, R&D, manufacturing, marketing, IT and back-office services, and much more. The specific type of ICA depends on the nature of the transaction and the roles of the entities involved. ICAs are legally binding documents, which, under the OECD’s Base Erosion and Profit Shifting (BEPS) guidance, must be integrated into the company’s local file and master file.
Given their importance in compliance, you’d think a top priority for MNEs would be ensuring ICAs are tightly aligned with transfer pricing policies. Unfortunately, many MNEs fall short—and costly errors are commonplace. Some confuse ICAs with larger third-party agreements (a surprisingly common occurrence). Or fail to update them when circumstances change. Or implement them at year-end (when risks have already become realities), rather than in advance, when allocating risk is the point. Or treat them as a formality that is hastily drafted (if at all), filed away, and forgotten.
In this article we look at the risks and benefits surrounding these oft-misunderstood contracts, with a focus on the tricky but strategically critical area of intangible transactions between related parties.
The Comparability Conundrum
Here’s the most important takeaway: in an audit situation, ICAs are often the low-hanging fruit—among the first documents tax authorities will demand, and no company, regardless of size, is immune. The consequences can be dire: Just ask BlackRock, which recently lost a multibillion-dollar judgment on appeal in the UK because an intragroup loan reflected in its ICA was shown to have no commercially viable purpose.
Beyond compliance, ICAs also have a beneficial role: they serve to protect taxpayers—especially in uncertain times, where disruptive factors like pandemics, supply-chain disruptions, or suddenly adverse macroeconomic conditions can shift the ground under both parties’ feet, and bring extra scrutiny from tax authorities.
At the core of the transfer pricing process, the comparability analysis requires MNEs to evaluate transactions between related entities, ensuring alignment with what would be expected between unrelated parties in similar circumstances. It is the intersection where legal, tax, and business priorities converge.
But comparability involves much more than pricing considerations, especially in high-risk domains like intangibles, financial arrangements, or cost-sharing agreements, where contractual terms outlining risks and responsibilities become paramount.
Consider a plausible Covid-era scenario, where the underlying business realities of two intragroup entities are disrupted. One party faces unanticipated losses due to a disrupted supply chain, while the other was guaranteed routine returns. Questions arise: Who bears the cost, and how does it impact the transaction’s tax reality? If these kinds of risks and responsibilities aren’t spelled out (in advance) in the ICA, the company’s transfer pricing can become vulnerable to disallowance or recharacterization by the tax authority, and possibly even to double taxation. In a limited-risk distributor agreement, few if any contemplate a situation such as this one, where no one makes money. Yet if a parent is guaranteeing a profit to a distributor, this could create a larger loss in the parent company: it could potentially put the entire organization at risk of bankruptcy.
The Intangible Angle
When it comes to assessing the comparability of transactions involving intangibles such as brands, patents, and other intellectual property, the task of accurately delineating the contributions and functions of each related party is especially tricky. With intangibles, legal ownership doesn’t always align with economic ownership, and determining which entity should bear the costs, risks, and benefits associated with these assets is challenging. What’s more, the value of these assets changes over time. OECD guidance calls for a DEMPE analysis—a methodology for determining which entities are responsible for the development, enhancement, maintenance, protection, and exploitation of the IP, and how to compare their relevant values across parties. The ICA should incorporate the result of this analysis (not the analysis itself).
The complexity of intangibles underscores why pricing alone is insufficient for a credible comparability analysis. Unique assets like patents or brands defy exact comparability. You have to look instead at licensing agreements—and in particular the supporting documentation behind the pricing—to assess the real market value of the transaction. Instead of relying solely on a large number of contracts, companies should identify the most relevant contracts from a database like RoyaltyStat and consider the unique factors—e.g., exclusivity, territorial rights, contract duration—that are vital for determining the arm’s length nature of the transactions.
One thing is clear. Regardless of the nature of the transaction, a clean, well-drafted ICA that delineates the full economic substance of the arrangement can greatly simplify the task of comparability, while serving as a major compliance asset should tax authorities come calling. In a transaction involving intangibles, a strong ICA can make your functional analysis stronger. And that becomes a significant asset for compliance.
Avoid These Common Mistakes
No matter how much a company invests in preparing its transfer pricing policies, if those policies aren’t followed in practice, or aligned with legally cogent agreements that accurately reflect the realities on the ground, the investment is wasted. With that in mind, here are some common practices to avoid when creating your intercompany agreements.
Relying on third-party agreements as templates. Instead of creating a dedicated, fit-for-purpose ICA, some companies will duplicate a third-party agreement and call it a day. This is problematic, because the two are different animals, serving different purposes. Third-party agreements tend to be complex and long, often containing provisions that aren’t relevant to intercompany transactions. ICAs should be unambiguous, well structured, and narrowly focused on the specifics of those transactions in the context of the arm’s length principle—the better to get them understood by the non-lawyers who must sign them.
Set-it-and-forget-it. Transactions happen. Activities shift. Circumstances change. Do the terms of the ICA still apply? Have new entities been incorporated into the agreement? There’s little point in drafting ICAs if you’re just going to file them away somewhere, check a box, and forget about them. They are only as useful as they are current, relevant—and available. Inaccurate or missing ICAs can result in serious consequences, including tax adjustments, fines, and penalties.
Executing them at year-end. There’s a dangerous misconception that ICAs are implemented as part of the year-end transfer pricing documentation. That violates OECD’s guidelines, which stress that ICAs should be filed in advance, or ex ante. The whole point is setting out how you will allocate economically significant risk in the face of uncertainty. You can’t bet on a horse race after the winner has already been announced.
Blind spots and gaps. Intercompany agreements require two, very different skill sets—corporate law and transfer pricing expertise—which generally inhabit separate universes. Most lawyers aren’t familiar with the intricacies of the OECD’s transfer pricing guidelines, and tax experts don’t always understand the legal requirements and terminology needed for the contract to serve its purpose. Missing signatures, missing key terms, and poorly drafted agreements are “unforced errors” that can cost dearly. Another gap to be mindful of: Intercompany transactions that are not legally documented at all—a gaping hole of vulnerability.
Bottom line: If your intercompany agreements aren’t current or don’t align with your actual transfer pricing policies, tax authorities are likely to just disregard those agreements completely—and characterize the transactions in whatever way is most advantageous to themselves. They need only ask for copies of your ICAs, and carry out a desktop review against master files and local files.
Seven Best Practices
Setting up an ICA doesn’t have to be complicated, but it does require some discipline and organization. Here are 7 best practices to keep in mind.
- Make it tailored, clear, and concise. Crafting ICAs is the art of striking the right balance between conciseness and comprehensiveness. Don’t use third-party agreements as templates. Use clear, precise, and easily understandable language, facilitating stakeholder comprehension and eliminating ambiguities that could lead to disputes.
- Check your alignment. Your ICAs are a bridge between your transfer pricing policies and compliance: they must accurately reflect the economic substance of the transactions, including the functions and allocations of risk of each entity. Ensure that all the actual services or products provided are covered in the agreement, that the stated pricing methodology is still valid, and that all facts and potential circumstances (e.g., bad debt risk or foreign exchange risk) around the transactions are adequately reflected.
- Ensure every significant intercompany transaction is covered—especially high-risk ones such as licensing of IP, financial transactions, sales of assets, provision of management or back-office services, all of which are under growing scrutiny by tax authorities in many jurisdictions.
- Stay vigilant. Circumstances change. Changes in an MNE’s structure or business dynamics necessitate adjustments in ICAs to maintain their accuracy and compliance. ICAs are not static documents. Don’t file them away and forget about them, assuming you are covered.
- Support it with adequate documentation. Maintain thorough documentation supporting ICAs, including correspondence, transaction records, and related documents. Where appropriate, the agreement should specify what objective metrics (e.g., time spent, number of users, number of transactions) are to be used to measure any services. And, for applicable companies, ensure that these agreements are integrated into the company’s “local file” and “master file,” under BEPS guidance.
- Sign them in advance—before the start of your tax year. Rewriting history is not popular with tax authorities. And it bears repeating: The agreements must be signed and executed by all contracting parties—if at all possible, by different individuals (nothing is worse than seeing a multiparty agreement with only one officer signing on behalf of multiple companies)—or they are as good as invisible.
- Be audit-ready. Have a central policy for designing and updating agreements, a centrally managed archive, and someone in charge of monitoring your ICAs and keeping them up to date.
The Many Benefits of Doing It Right
Transfer pricing cases are won or lost based on facts.
Tax authorities are only too eager to find reasons to challenge intercompany transactions. Gaps in ICAs—or discrepancies between the agreements and your documentation—are relatively easy to detect, and will often become the focus of their investigations. The importance of maintaining a comprehensive suite of intercompany agreements, and keeping them up-to-date and accessible, cannot be overstated.
The benefits of well-constructed ICAs go far beyond protecting the taxpayer. Those agreements provide a “single source of truth” that is extremely useful across the organization. They can help strengthen corporate governance across the enterprise. They can support internal and external audits of its entities. They can help ensure your IP rights are enforced and appropriately monetized. They can even reduce personal liability risks for directors.
The path to sound transfer pricing and robust corporate governance starts with the strength of your intercompany agreements—ensuring they are not just documents on paper, but strategic assets that safeguard against risks and propel your enterprise forward. It’s safe to say that whatever resources you devote to the task of optimizing your ICAs will be 100% upside investments.
