Technical Transfer Pricing Tip
Transfer Pricing: How BEPS has increased the importance of Intercompany Legal Agreements
Transfer pricing has been a predominant focus within the OECD’s work of base erosion and profit shifting (BEPS) and the modernization of the international framework for taxing multinational companies. Multinational companies have more flexibility and control when establishing related-party intercompany legal agreements relative to third-party external legal agreements. The OECD Transfer Pricing Guidelines, paragraph 1.67, states that “contracts within an MNE could be quite easily altered, suspended, extended, or terminated according to the overall strategies of the MNE as a whole, and such alterations may be made retroactively.” As a result, it is not surprising that the OECD’s BEPS effort has placed a heightened importance on intercompany legal agreements. More specifically, the OECD identify four action items that either highlight, emphasize, or require transfer pricing intercompany legal agreements. These items are discussed below.
Intercompany Legal Agreements required under new OECD Transfer Pricing Documentation Standard
Action 13 of the OECD BEPS Project details the new OECD transfer pricing documentation standard and lists information to include in the Master file and in the Local file. One of the Master file items is a list of important related party agreements related to intangibles, including cost contribution arrangements, principal service agreements and license agreements. An item to include in the Local file is copies of all material intercompany agreements concluded by the local entity. Requiring the legal agreements in the annual documentation in the new OECD transfer pricing documentation standard will help to level the playing field between tax payers and tax authorities.
Documented contemporaneously, legal agreements serve as a reference point in time of the terms and conditions of related party cross border transactions and is highly recommended.
Intercompany Legal Agreement Required for OECD Proposed Safe Harbor
One of the recent OECD discussion drafts on services proposes a safe harbor rate in relation to low-value intra-group services. The approach has similarities to the treatment of specified intercompany services under Section 482 of the Internal Revenue Code. Action 10 of the OECD BEPS Project proposes these modifications to Chapter VII of the OECD Transfer Pricing Guidelines and according to the proposed paragraph 7.61, companies electing to apply the simplified method are required to prepare written contracts or agreements for the provision of those services.
Importance of Legal Agreements when Dealing with Intangibles
Action 8 of the OECD BEPS Project regarding changes to Chapter VI of the OECD Transfer Pricing Guidelines regarding intangibles contains multiple references to the expected scope and responsibilities that a legal owner of an intangible would possess. Arguably, the skepticism these OECD proposed guidelines have towards multinational companies on BEPS can be seen in the third step of the six step framework for analyzing transactions involving intangibles per paragraph 6.34. The first step is to identify the legal owner of the intangible. The second step is to identify the related parties that have functions, assets and risks related to the intangible through a functional analysis. The third step is to confirm the consistency of the first two steps. It is of note that this step exists and the six step framework is not a five step framework. That is, the third step could be considered redundant and that such a test for consistency would have been implied through the functional analysis required in step two. In any event, this underlying skepticism reinforces the importance of intercompany legal agreements that are consistent with the functions performed and risks held and assets possessed by the relevant related parties.
Applicability to proposed OECD “Nexus Approach”
Action 5 of the OECD BEPS Project currently favors the Nexus approach versus a transfer pricing approach for intellectual property regimes. The proposed Nexus approach makes the benefit of the preferential tax treatment of tangibles conditional on the extent of the research and development activities taking place in that same jurisdiction. The Nexus approach applies a proportionate analysis to income, under which the proportion of income that may benefit from an IP regime is the same proportion as that between qualifying expenditures and overall expenditures. Qualifying expenditures are defined in such a way that they effectively prevent capital contribution or expenditures for substantial research and development activity by parties other than the taxpayer from qualifying the subsequent income for benefits under an intellectual property regime. Only patents and other assets functionally equivalent to patents would qualify in this approach.
The Nexus approach requires detailed tracing of expenditures and income. An intercompany legal agreement that identifies the owner of the relevant patent or their functionally equivalent will greatly assist the administration and support for such preferential tax treatment. A framework to manage all intercompany legal agreements would also be of benefit to separate the remaining intellectual property that is not subject to the preferential tax regimes to be then addressed and supported according to transfer pricing principles.
There are many reasons to include the implementation and maintenance of intercompany legal agreements in a multinational company’s transfer pricing best practices. This article only mentions four of the most recent ones. It is anticipated the remaining OECD BEPS action items will include even more.