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Legal agreements in transfer pricing: aligning form and fact in a post-BEPS world

Legal agreements in transfer pricing: aligning form...

In a post-BEPS world, the transfer pricing landscape has shifted to place much greater emphasis on economic ‘substance’. Does this mean intercompany legal agreements are irrelevant?


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A key aim of the OECD BEPS project was to counter arrangements where the “allocation of profits is not aligned with the economic activity that produced the profits”, a measure intended to help revenue authorities target artificial tax structures. On one hand, this poses a threat where group entities receive more profit than they deserve - despite what the intercompany legal agreements may purport. On the other hand, it also provides an opportunity to defend structures where ‘substance’ and reward are indeed aligned but the intercompany legal agreements are inaccurate. This however can be a difficult defence to apply in practice - even in jurisdictions like the UK which have embraced the updated OECD guidance. With the updated 2017 OECD Guidelines applicable in the UK for accounting periods beginning on or after 1 April 2018, it is an opportune time to review intercompany legal agreements and ensure they are accurate.

What is the transaction?

The concept of economic substance permeates throughout the BEPS Actions 8-10 Final Report and the updated 2017 OECD Guidelines, and should be used to accurately delineate a given transaction. One of the core principles is that the actual conduct of related parties will either supplement or potentially supersede intercompany legal agreements for transfer pricing purposes. The transfer pricing analysis would then be based upon this ‘truer’ or ‘more complete picture’ including the actual conduct of the related parties – that is, the economic or factual substance of the intercompany arrangement - rather than being solely based on the intercompany legal agreements.

For instance, the 2017 Guidelines state in Chapter 1 that “written contractual agreements… provide the starting point for delineating the transaction”.

They then go on to state that “the written contracts alone are unlikely to provide all the information necessary to perform a transfer pricing analysis”, and “if the characteristics of the transaction… are inconsistent with the written contract between the associated enterprises, the actual transaction should generally be delineated for purposes of the transfer pricing analysis in accordance with the characteristics of the transaction reflected in the conduct of the parties”.

Similar language is repeated and emphasised numerous times throughout the 2017 Guidelines.

The prior 2010 OECD Guidelines also acknowledged the above concept, albeit in a comparatively cursory manner. Under the 2017 Guidelines, there is now therefore much clearer and stronger technical grounds for contractual arrangements to be ignored if they are incomplete or inaccurate.

Does this mean intercompany legal agreements are irrelevant?

Despite the above, perhaps surprisingly, it is nonetheless vital to ensure that intercompany legal agreements exist and are accurate. This is because in practice, legal agreements are still the starting point for transfer pricing analysis. If a taxpayer argues that the substance differs to its intercompany legal agreements, the taxpayer will be arguing against its own documented position.

Two practical consequences that result from this include:

  • Arguing that the facts differ in substance to the legal agreements will require detailed factual evidence to be gathered to ascertain and document the extent of any difference. This can turn into a potentially time-consuming and difficult exercise, which at a minimum should be carried out by the time of filing the tax return; and
  • In the context of a dispute, if this fact-gathering exercise has not yet been done, this will become more difficult to carry out and prove as corporate memory fades over time, or relevant personnel leave the company. Furthermore, a taxpayer arguing against its own legal agreements naturally raises questions regarding its intentions at the time of putting the agreements in place, and the taxpayer’s credibility more generally. This can further complicate the ensuing dispute.

Where no intercompany legal agreements exist, similar types of issues can arise as there is no historical evidence of the planned arrangement between the parties. In other words, there is no ex-ante reference point to corroborate the taxpayer’s ex-post argument.

Therefore, in either case, the misalignment between the legal ‘form’ and the facts is likely to complicate the practical realities of taxpayers defending their transfer pricing.

Our recommendation

Taken together with the broader measures undertaken as part of the BEPS project, the priority for taxpayers should be to review their tax and transfer pricing arrangements to ensure that policies are appropriately rewarding group entities and are being correctly implemented. This should be documented as part of the yearly tax return process through the preparation of OECD-compliant transfer pricing documentation.

Equally, for the reasons outlined above, taxpayers should review their intercompany legal agreements to ensure that they reflect the factual substance. It is good practice for contractual arrangements to align to the behaviour of group entities. Despite the clear guidance in the 2017 OECD Guidelines, even if substance and reward are indeed aligned, successfully defending this in practice without accurate contractual arrangements being in place is another matter.

For further information please contact:

Onur Tekin

Karen Kwan


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