Intercompany operations and contractual terms

An in-depth consideration regarding substance

One of the procedures prior to confirming the arm’s length value of an intercompany transaction is the analysis of contractual terms in the operation. Contrary to what occurs among independent third parties, it is possible that among related parties the incentives to reflect contractual terms or negotiations that would have occurred among third parties do not exist. Or that once arm’s length terms have been established, in practice these are substituted by others.

Another possible scenario is that the transaction is misclassified and incorrect contractual terms are assigned to the operation, and even carry out functions that are not registered at the legal or accounting level in detriment to one of the parties.

It is for these reasons, and in consideration to the recommendations set in the BEPS plan in actions 8 – 10, it is necessary to review of contractual terms that govern  the intercompany operation and the consistency of said terms with the characteristics of the operation, functions performed, assets employed, and risks assumed by the parties participant in the transaction (not limited to risk assessment in regards to the transaction but also in relation to the economic capacity and control of the contracting parties over the risks assumed). The previous with the purpose to avoid a potential re-characterization of the operation, or eventually, the rejection of the agreed upon contractual terms, consequently impacting the taxable base of the participants.

 

Example (contractual terms that differ from the economic reality of the operation, from numeral 1.44 of the OECD Transfer Pricing Guidelines for 2017).

Company P is the parent company of an MNE group situated in Country P. Company S, situated in Country S, is a wholly-owned subsidiary of Company P and acts as an agent for Company P’s branded products in the Country S market. The agency contract between Company P and Company S is silent about any marketing and advertising activities in Country S that the parties should perform. Analysis of other economically relevant characteristics and in particular the functions performed, determines that Company S launched an intensive media campaign in Country S in order to develop brand awareness. This campaign represents a significant investment for Company S. Based on evidence provided by the conduct of the parties, it could be concluded that the written contract may not reflect the full extent of the commercial or financial relations between the parties. Accordingly, the analysis should not be limited by the terms recorded in the written contract, but further evidence should be sought as to the conduct of the parties, including as to the basis upon which Company S undertook the media campaign.