InterCompany Agreements

How Do You Stay At Arm's Length To Avoid Tax Penalties?

Intercompany Agreements govern the transactions between related parties in different tax jurisdictions. As such they are critical when a tax authority seeks to evaluate the validity of the underlying transactions and should support the tax payer’s transfer pricing positions.

The general purpose of transfer pricing rules is to establish arm’s length terms for transactions between parties in different jurisdictions. In most cases, they apply particularly to transactions between related parties. However, in Australia, for example the new transfer pricing regulations need not apply just to transactions between related parties and the new rules do not specify any control requirements or ownership thresholds. . 

OECD Guidelines

The OECD (Organization for Economic Co-operation and Development) has issued various guidelines for transfer pricing for multinationals and tax administrations. While these guidelines have no legal status, they are widely accepted and the main methodologies recommended are briefly mentioned below.

Cost Plus Method

Arguably the most popular methodology because of its apparent simplicity! The method is based on providing a markup on the costs of the supplier (generally a subsidiary company or other related party) of goods or services. The costs are those incurred by the supplier in providing the goods or services to an associated company. Because of the relationship of the two parties and the ability to agree terms suitable to themselves, this is referred to as a "controlled" transaction.

The parties then agree an appropriate markup which is added to the costs to make an appropriate profit to cover the functions performed. The issue is, of course, what is "appropriate" and what would constitute "arm’s length" terms if the transactions were "uncontrolled" transactions i.e. were between independent parties.

The difficulty is to ensure that the mark up is the same as would have been earned by an independent provider in an "uncontrolled" transaction. To achieve this the mark up would need to be "bench marked" i.e. the mark up would have to be compared with the mark-up on costs from comparable "uncontrolled" transactions. This methodology is not considered suitable for a sales organization.

CUP: (Comparable Uncontrolled Price) Method

Briefly, the CUP method compares the price charged for goods or services provided in a "controlled" (see above) transaction to the price that would be charged for goods or services if they were transferred in an "uncontrolled" transaction in comparable circumstances.

If any difference can be found between the two, a tax authority may seek to substitute the prices of the "uncontrolled" transactions in place of the "controlled" transactions if that would increase the taxable profits.

The comparison is usually achieved by reference to accepted databases of profit and price information. The drawback of this method is the difficulty of applying it to any product with special features since that would impact an "uncontrolled" price compared with other products in the market.

Resale Price Method

The resale price method compares the gross margin achieved by purchasing a product from a related enterprise at the agreed price (A) to the price (B) at which it was resold to an independent enterprise. This gross margin is then compared to gross margins in comparable "uncontrolled" transactions. If the gross margin of the "controlled" transaction is higher, then this price (B - the “resale price”) is then reduced by an appropriate gross margin (the “resale price margin”), determined by comparing to gross margins in comparable "uncontrolled" transactions.

This adjusted gross margin would be the arm’s length amount out of which a reseller would seek to cover its selling and other expenses and make a profit based also on any other functions it may perform. This method is particularly applicable to sales and marketing operations especially, typically, distributorships.  

Transactional Net Margin Method (TNMM) 

This method (“TNMM”) examines a ratio of net profit relative to an appropriate chosen base such as costs, sales, assets, that a taxpayer achieves from a controlled transaction with the net profit which would be earned in comparable uncontrolled transactions. What the arm’s length net profit would be can be determined based on internal or external comparables.

  • The net profit achieved from the "controlled" transaction can be compared to the net profit achieved by the same tax payer in comparable "uncontrolled" transactions (referred to as internal comparables).
  • Alternatively, the net profit achieved from the "controlled" transaction can be compared to the net profit achieved in comparable transactions by an independent company (referred to as external comparables)

In general, when applying TNMM, the net profit is weighted to the costs of different functions i.e. to costs for manufacturing and service activities, to sales for sales activities and to assets for asset-intensive activities etc. The method is, therefore, useful when an organization has numerous functions and activities.

Transactional Profit Split Method (TPS)  

Where there are numerous controlled transactions between associated enterprises, the TPS method requires the combined profits arising from those controlled transactions to be identified.

The TPS method then splits these combined profits between the associated enterprises in a way that seeks to approximate the division of profits that would have been expected between independent enterprises. The split must of course be on a commercially sound basis. Ideally, the basis of the split should approximate the actual profits that would have arisen between independent third parties. Often, however, this is not possible and the split needs to be supported by internal data for arm’s length transactions such as sales to unrelated parties.

The main strength of the TPS method is that it can offer a methodology for highly varied and complex global operations for which a one-sided method would not be appropriate  

Other Methodologies

Brazil: does not follow OECD guidelines and instead sets its methodology based on the nature of the transaction: import or export. Brazil's version of the resale price method for imports sets statutory gross margins which are in a range set by the tax authorities. Other regulations apply to exports.

India: allows the 5 OECD model methods or such "other" method as may be appropriate. This "other" method can be used for selected, often one off transactions, e.g. intangibles or business transfers, sales of fixed assets, revenue allocation/splitting among others.

Italy: in addition to the methods listed above Italy also allows the invested capital profitability method, and the economic sector gross margin method.

The above are merely three examples of countries that use or allow other methods - it is not an exhaustive list of such other countries or methods.

These are general guidelines, for more information on your specific country or situation, please connect with us.

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