Weathering Economic Uncertainty with Intercompany Financial Agreements
Intercompany agreements (ICAs) have always been an important piece of transfer pricing compliance as they define the terms of intercompany transactions. However, in a volatile economic environment, when companies tend to inherit additional risk, these agreements become even more critical.
“Intercompany agreements provide a reference to show what has happened in the external world and how the group has adapted to it,” says U.K.-based corporate attorney and founder of LCN Legal, Paul Sutton. ICAs explain which entity was intended to bear risk and which entity is actually bearing that risk now.
In terms of transfer pricing, rising interest rates can significantly impact intercompany financial transactions, so it’s critical that ICAs surrounding intercompany loans and guarantees explain the arm’s-length nature of such arrangements. During a recent podcast, Exactera’ Chief Economist Mimi Song sat down with Sutton to discuss the essential elements of financial transaction ICAs. To hear the in-depth discussion, listen to the podcast.
In the meantime, here are a few takeaways from their conversation.
Key commercial terms must be outlined in intercompany agreements—and they may differ from third-party contracts
Outlining the terms of an intercompany transaction may seem like an obvious inclusion in an intercompany contract, it’s especially important when you’re dealing with financials. “When it comes to financial transactions, it’s not like you can observe the conduct of the parties and somehow impute what the overall terms are,” says Sutton. ICAs should include terms like the maturity or repayment date of the loan, the currency in which the transaction is taking place, and the interest rate: Is it fixed or floating? What are the interest-payment periods?
Third-party loan agreements may include extensive security packages. But that level of detail may not be necessary for transactions inside the group. “If you sign up for a third-party loan with a bank, that bank might require quarterly or annual reports. It’s not necessary to include them at least in as much detail with intercompany contracts,” says Sutton.
ICAs should align with the economic reality of the business
Consistency is key in all forms of transfer pricing documentation, and ICAs are no exception. “If you’ve got an agreement saying one thing, but the economic substance is completely different, then the mismatch means that whatever you try to create from a transfer pricing perspective will not withstand scrutiny,” says Sutton. “It’s all about alignment. It’s understanding what’s important from an economic perspective and then reflecting that in an agreement.”
Strong ICAs can help strengthen your transfer pricing documentation. “I always ask for intercompany agreements,” says Song. “I think that’s a fantastic place to start in terms of understanding facts and circumstances of the business and developing the narrative for your transfer pricing documentation.”
ICAs must reflect that the transaction makes sense for both sides involved in a financial transaction
HMRC vs Blackrock presents a cautionary tale as to why ICAs must illustrate that a transaction is logical for both the lender and the borrower. The case involved a $4 billion loan as part of an acquisition structure, and the ICAs came up short. The court sought collateral that would make it logical from a lender’s perspective to lend to the borrower but didn’t find it in the intercompany agreements linked to the loan notes. “The presence or absence of that security was at the heart of the lender to lend or not lend. The tribunal said no lender would have lent without that security so therefore, from a transfer pricing perspective the loan would not have been made and therefore, there would be no interest deduction,” says Sutton.
ICAs must show that transactions make sense from the start
The case of SingTel Telecom Australia Investments Pty Ltd vs the Commissioner of Taxation involved a $5.2 billion AUD intercompany loan that was originally repayable on demand—hardly something that a rational third-party borrower would have agreed to—and then changed to a 10-year term. The case examined whether you could change a loan during its duration and if so, by how much. “The lesson we take from SingTel is that you have to think about a transaction properly when you put it in place and apply those options available to both sides of the parties from a transfer pricing perspective and a legal perspective,” says Sutton, “The loan has to make sense.”
ICAs require maintenance
There’s little point of drafting ICAs if you’re going to file them away some place and then forget about them altogether. It’s best to keep a central archive of ICAs that is comprehensive and searchable by entity, by country, and by financial year. Has the group changed? Have you acquired new entities? Merged entities? Has there been a change in the activities an entity is performing? Spot-checking agreements will help keep transfer pricing policies in line with intercompany contracts—and therefore indicate to tax authorities that the group is operating at arm’s length and practicing diligent compliance. And as Song says, “Be sure to keep them up to date.”