The Role of Intercompany Contracts in the Transfer Pricing System
Michael C. Durst*
I.
Introduction
Today’s transfer pricing system, as set forth in both the US regulations and the OECD
Guidelines, generally requires that the acceptability of transfer prices within a commonly
controlled group be based on a case-by-case factual analysis of the functions performed and risks
borne by the different members of the group. The factually intensive nature of the analysis that
is required unavoidably raises the possibility of a high level of contentiousness. The factual
intensity also can give rise to a perception of unpredictability of result among the companies that
must establish and maintain transfer pricing policies on a year-by-year basis. Both the US
regulations and the OECD Guidelines provide scope, however, for multinational groups to
reduce uncertainty by reflecting their transfer pricing policies in binding intercompany contracts
and by conforming to those contracts on a consistent basis.
Practical experience is making it increasingly evident that such intercompany contracts
can be of great assistance to companies in both simplifying their transfer pricing compliance
tasks and achieving greater predictability of results. This predictability is desirable from the
standpoint not only of the companies themselves, but also from the perspective of the
*
Member, District of Columbia Bar; Partner, King & Spalding, Washington, D.C. This article was prepared as the
basis for remarks at the 13th Annual Institute on Current Issues in International Taxation, sponsored by the Internal
Revenue Service and the George Washington University on December 8, 2000. The author wishes to thank Richard
Barrett, Robert Culbertson, Karen Dayton, Frances Horner, Richard Hutchins, Bruce Kamins, Karl Kellar, Darrin
Litsky, Christopher Neligan, Jodi Schwartz, Bradley Shumaker and Siva Subramaniam for reading and commenting
on prior drafts. The opinions expressed in this article do not necessarily reflect the views of anyone other than the
author, who, of course, is responsible for any shortcomings herein.
Copyright 2000 Michael C. Durst
2
governments that must devote resources to transfer pricing examinations. Despite the general
desirability of reducing transfer pricing uncertainty through the use of intercompany agreements,
however, current practices impose impediments to their use. This article briefly describes the
role of intercompany agreements in transfer pricing compliance and suggests ways in which the
IRS and other tax authorities could facilitate their use.
II.
The Role of Intercompany Agreements in Transfer Pricing Today
Under the current global regulatory structure, in those situations in which closely
comparable uncontrolled prices and transactions cannot be found, transfer pricing planning for
the multinational group can often be described as a two-tiered process. First, pricing for the
relatively simple, peripheral operations of the group, such as distribution operations within
particular territories and, in many instances, manufacturing and assembly operations using
reasonably standardized processes, is determined using a one-sided transfer pricing methodology
such as either the cost-plus or resale price method or, if adequate comparables for application of
those methods are unavailable, the comparable profits method (CPM) or its OECD cousin, the
transactional net margin method (TNMM). These operations are assigned relatively stable,
limited rates of return, consistent with the limited risks that they are viewed as bearing. Any
income or loss remaining after the basic operations are assigned appropriate income is then
assigned to the entrepreneurial center of the group (that is, the entity that incurs R&D risks, other
risks of intangible development, and other fundamental business risks) if that center is located
within a single jurisdiction or, in the event the group maintains entrepreneurial centers in more
3
than one country, is divided among those centers using some form of profit split methodology.
Such a two-tiered approach seems plainly to be contemplated by both the US regulatory system
and the OECD Guidelines and generally should be accepted, at least in broad outline, by any
country that applies OECD principles.1
This basic two-tiered approach, while simple in concept, can result in serious disputes
and uncertainties upon examination. The US regulations and the OECD Guidelines, as well as
the growing body of transfer pricing guidelines in countries around the world, provide
exceedingly detailed lists of factual items to be considered in evaluating whether a particular
entity should qualify for limited-risk treatment, or whether a particular profit split methodology
used for core operations is appropriate.2 Each factual consideration listed in the governing
1
For a recent discussion of this underlying structure in today’s transfer pricing system, see Valerie Amerkhail,
Arm’s Length or Formulary Apportionment? Sometimes the Best Choice is Both, BNA Transfer Pricing Rep., June
2, 1999, at 94.
2
The US regulations, for example, contain the following lists of functions that should be examined in evaluating the
appropriateness of a transfer pricing methodology in a given instance:
(A) Research and development;
(B) Product design and engineering;
(C) Manufacturing, production and product engineering;
(D) Product fabrication, extraction and assembly;
(E) Purchasing and materials management;
(F) Marketing and distribution functions, including inventory management, warranty administration, and
advertising activities;
(G) Transportation and warehousing; and
(H) Managerial, legal, accounting and finance, credit and collection, training, and personnel management
services.
Treas. Reg. § 1.482-1(d)(3)(i). In addition, the regulations specify that the following specific business risks should
be taken into account:
(1) Market risks, including fluctuations in cost, demand, pricing, and inventory levels;
(2) Risks associated with the success or failure of research and development activities;
(3) Financial risks, including fluctuations in foreign currency rates of exchange and interest rates;
(4) Credit and collection risks;
(5) Product liability risks; and
(6) General business risks related to the ownership of property, plant and equipment.
Treas. Reg. § 1.482-1(d)(3)(iii)(A).
The OECD Guidelines, and the recent national transfer pricing guidelines that seek to incorporate the
OECD Guidelines, contain equally daunting lists of considerations that are to be considered in transfer pricing
examinations. It takes little imagination to conceive of the difficult and time-consuming nature of the examination
4
guidance can become the source of disagreement during examination, and unpredictability of
result. It is thus easy for an examination even of a relatively straightforward transfer pricing
system used by a multinational group to become contentious, with extended arguments arising
over whether particular functions are or are not performed, or particular risks are or are not
borne, by particular entities. Indeed, the difficulty of transfer pricing examinations that was
encountered historically in the United States does not yet seem to be subsiding substantially
under the new regulations; some means of simplifying transfer pricing must be found if the
current system is to prove viable over the long term.
By entering into and complying with a system of comprehensive intercompany contracts,
however, specifying in advance the risks that different members of the group will bear and the
compensation that the group members will provide one another for bearing those risks,
multinational groups can eliminate much of the factual uncertainty that leads to difficult issues
on examination. Companies have, of course, been using intragroup contracts for many years to
achieve predictability in transfer pricing and for other reasons. Historically, such contracts have
been used most commonly to memorialize cost-plus arrangements for the provision of intragroup
services, as well as to memorialize licenses of intangible property within the group. The
frequent historical use of written contracts for those purposes undoubtedly reflects to some
extent the relatively prominent role that questions concerning compensation charged in cost-plus
service arrangements and royalties charged in intragroup licensing historically have played in
process that can arise from such regulatory guidance, unless somehow the fact-finding process can be simplified in
advance.
5
transfer pricing examinations around the world. 3 Indeed, those two issues often appear to have
dominated transfer pricing examinations in many countries in the past.
In addition, it has been common historically for supply contracts between affiliated
manufacturers and distributors to specify prices based on the anticipated gross margin of the
distributor. Such contracts, which have been intended to implement the resale price (resale
minus) method as it traditionally has been understood, typically have not attempted
comprehensively to apportion business risks between the manufacturer and the distributor, or to
establish the distributor’s net income within pre-determined ranges.
The recent global round of transfer pricing rulemaking, however, has changed the
environment in three ways that suggest a more powerful role for comprehensive systems of
intercompany contracts. First, the new rules typically focus more explicitly on the
apportionment of business risks in determining transfer prices. Second, the new rules generally
provide a wide scope for examination of factual issues in transfer pricing examinations. Third,
the recent round of rulemaking seems to be accompanied by more intensive enforcement of
transfer pricing rules in many countries. All three developments favor the wider use of
intercompany agreements that identify comprehensively the risks to be borne by particular
entities and the net compensation that those entities are to receive.
Intercompany contracts accomplishing overall characterizations of entities for transfer
pricing purposes already are increasingly common in practice; forms for such agreements are
3
The historical prevalence of written intragroup licenses for intangibles also reflects the usefulness of written
licenses in establishing the protectibility of patents and other intangible property in the international setting.
6
available commercially.4 Most commonly, such contracts are used to establish the
characterizations of particular entities as, for example, limited risk distributors or manufacturers.
In addition, contracts can be used to memorialize the respective functions and risks of different
entities engaged in the core intangibles-producing functions of a multinational group, and to
specify the manner in which each entity will be compensated under a profit split approach.
The increasing use of such contracts would seem to benefit both taxpayers seeking
greater predictability of result in transfer pricing, and governments desiring to simplify the
compliance process. Both the US regulations and the OECD Guidelines provide that tax
authorities should respect such contracts, provided that they are commercially reasonable and
that the parties follow them in practice.5
As a conceptual matter, the use of such contracts, in which the apportionment of risk
among related entities is established clearly in advance, conforms very well to a basic
“matching” principle that seems to underlie the arm’s length standard as it is understood today,
just as it underlies many other elements of income taxation as normally understood. Under this
matching principle, the entity that bears the deductible or capitalizable costs of developing an
income-producing activity also should, for income tax purposes, be considered as earning the
4
Forms can be found in 2 Cym H. Lowell, Marianne Burge & Peter L. Briger, U.S. International Transfer Pricing
5A-15 - 5A-61 (2d ed. 1998 & Supp. 2000).
5
See especially Treas. Reg. § 1.482-1(d)(3)(ii)(B)(1) (“The contractual terms, including the consequent allocation of
risks, that are agreed to in writing before … transactions are entered into will be respected if such terms are
consistent with the economic substance of the underlying transactions.”) and § 1.482-1(d)(3)(iii) (“[T]he allocation
of risks specified or implied by the taxpayer’s contractual terms will generally be respected if it is consistent with
the economic substance of the transaction.”); Organisation for Economic Co-operation and Development, Transfer
Pricing Guidelines for Multinational Enterprises and Tax Administrations (hereinafter “OECD Guidelines) (1995 &
Supp. 1996 – 98) ¶¶ 1.28 – 1.29 (Guidelines, while cautioning that parties’ actual compliance with intercompany
agreements is required if contracts are to be respected, indicate that “an analysis of contractual terms should be part
of the functional analysis ….”).
7
income (and bearing any loss) resulting from the activity. In today’s transfer pricing rules, this
matching principle is expressed most explicitly in the rules governing cost-sharing arrangements.
Implicitly, the principle can be seen operating throughout today’s transfer pricing systems.6
From a practical standpoint the key principle, again, is that if entities have clearly divided their
risks and functions in advance of engaging in economic activity, if they have done so in a
commercially reasonable manner, and if the entities have abided by their agreement, the fiscal
authorities should respect the allocation of risks on which the entities have agreed.
The potentially central role of such intercompany agreements in promoting a workable
transfer pricing regulatory regime should not be underestimated. Without the guidance provided
by comprehensive intercompany contracts, the transfer pricing compliance process in any given
instance can easily become a morass of overwhelming factual detail, intractable by taxpayers and
fiscal authorities alike. If, however, the current trend toward use of comprehensive
6
The matching principle is not, of course, without potential limitation in the context of international income
taxation. Recent litigation in the United States, for example, has focused on the question whether particular legal
entities or business operations are of sufficient substance to be recognized for tax purposes. If a business operation’s
substance is not to be recognized for tax purposes, then the matching principle will not apply to the operation. Such
arguments should arise, however, only in a limited class of cases. In the overwhelming majority of situations arising
in practice, there is no real question that business operations have sufficient substance to be recognized for tax
purposes. In such cases, the matching principle would seem to be a reasonable, and indeed necessary, guideline to
orderly income taxation.
It might also be argued that some kinds of activities are so portable that permitting income to be treated as earned by
the entity that pays the costs of the activity would permit excessively easy migration of the tax base to low-tax
jurisdictions. To the extent that a response to such concerns is needed, however, it would seem far preferable to
address the concerns through targeted remedies such as controlled foreign corporation rules, rather than by
impugning the matching principle as a basis for organizing analysis of transfer pricing issues. It would be
unfortunate if, because of concerns with migration of portable activities to tax havens, the tax system were to be
deprived of an organizing principle that can simplify the application of the arm’s length standard in a large range of
situations.
8
intercompany agreements continues, one can envision transfer pricing practice gradually
becoming more predictable and administrable.7
In many if not most situations, a multinational group’s system of intercompany contracts
could provide a clear guide to verifying the group’s transfer pricing compliance on examination
– and can also provide valuable guidance to the company’s own personnel in implementing the
group’s tax transfer pricing system and ensuring compliance. Large expenditures of resources on
compliance and enforcement generally could be reserved for novel or unusual situations, such as
when the structure of a growing industry initially makes it difficult to identify the particular risks
being borne, or when significant legal questions need to be resolved, as in current litigation in the
United States involving cost sharing agreements and buy-ins. In short, by facilitating the use of
comprehensive intercompany agreements related to transfer pricing, governments can provide
significant and needed assistance to multinational taxpayers, and can contribute significantly to
the development of a more workable transfer pricing system.
III. Ways in Which Fiscal Authorities Can Facilitate Use of Contracts
One problem that can interfere with the establishment of clear systems of intercompany
contracts is essentially procedural in nature. Companies sometimes fear that, when
7
Strictly speaking, intercompany contracts cannot be used in situations involving operations in particular countries
that are structured as branches rather than subsidiaries, as is often the case in the financial industry. Even in such
situations, however, comprehensive written guidelines governing the functions, risks and compensation of branches,
if followed consistently by the companies concerned, should remove much of the uncertainty from potential transfer
pricing examinations. Cf., e.g.,the “business profits” articles of typical income tax treaties (which, while at times
subject to conflicting interpretations by taxpayers and governments, generally apportion income to permanent
establishments by analogy to the treatment of separate entities); cf. also Notice of Proposed Rulemaking, Allocation
and Sourcing of Income and Deductions Among Taxpayers Engaged in a Global Dealing Operation, 1988-1C.B.
9
intercompany contracts limit the financial risks of entities performing distribution and
manufacturing functions, fiscal authorities will view the entities as so subordinate to the parent
companies as to create permanent establishments of the parents under applicable treaties, or
otherwise to result in a taxable presence of the parents. Such claims, even if justified, generally
should be of limited substantive significance, because under typical treaty provisions as well as
other applicable laws, the taxable incomes of any resulting permanent establishments or other
taxable presence generally should be governed by the same arm’s length standard as governs the
taxation of separate legal entities. Moreover, at least in the author’s view, it is possible to draft
risk-limiting contracts that cannot fairly be said to result in the creation of permanent
establishments under the criteria typically set forth in income tax treaties, or otherwise to
establish a taxable presence of participants not operating in a given jurisdiction.
Nevertheless, the procedural implications of a finding of permanent establishment or
other taxable presence can be onerous in many countries, and in general only sparse guidance is
available around the world clarifying the substantive aspects of the law governing permanent
establishments and taxable presence. Fiscal authorities can perform a valuable public service by
issuing public guidance confirming that the standard kinds of risk-limiting contracts used in
transfer pricing practice today do not result in the creation of permanent establishments under
applicable income tax treaties, or otherwise create taxable presence with respect to operations
located abroad. Such guidance could be similar to language currently contained in both the US
897, corrected at 1998-1 C.B. 1047 (proposed regulations generally would apportion income of branches engaged in
global trading of financial instruments by applying principles applicable to transfer pricing among separate entities).
10
regulations and OECD Guidelines, indicating that the establishment of a cost-sharing
arrangement does not in itself result in the creation of tax jurisdiction over the participants.8
An additional – and typically more difficult – practical impediment to the establishment
of comprehensive intercompany agreements comes under the heading of “transitions.” When a
multinational group initially adopts a clear system of intercompany contracts, the group is setting
down in writing for the first time a set of relationships that probably were less clearly
memorialized in the past.9 Given the factually intensive nature of transfer pricing examinations,
especially with respect to periods that were not covered by clear intercompany contracts, it may
be possible for examiners to find reason for arguing that the establishment of intercompany
agreements results in a change from prior arrangements, with the result that a valuable intangible
asset of some kind is transferred from one entity to another in a taxable transaction.
Disputes over such issues do in fact arise, resulting in difficult examinations. Perhaps
even more importantly, fear of triggering such disputes often causes companies to refrain from
memorializing their transfer pricing policies in clear intercompany contracts. The potential for
conflict is magnified by the factually intensive and subjective nature of potential transitional
issues in transfer pricing. In the face of subjective issues, both sides to a controversy are prone at
least initially to stake out relatively extreme positions.
The history of each multinational group is different, and it is difficult to recommend
sweeping ways by which governments can reassure taxpayers against overly aggressive
8
Treas. Reg. § 1.482-7(a)(1); OECD Guidelines ¶ 8.3.
11
examinations when companies have adopted comprehensive intercompany contracts. What does
seem clear, however, is that providing such reassurance at this time would be an important step
toward a more administrable transfer pricing system. Fiscal authorities should make clear, both
publicly and in internal communications, that examiners will exercise appropriate flexibility in
circumstances in which taxpayers seek contractually to memorialize their transfer pricing
regimes, and the factual characterization of entities’ prior activities must to some extent be based
on subjective judgment. The policy underlying such flexibility is particularly compelling in the
context of avoiding unnecessary transitional challenges to companies that are seeking to move
toward a more predictable and administrable transfer pricing system by employing
comprehensive intercompany agreements. In addition, the advance pricing agreement process,
the use of which continues to grow around the world, can in some circumstances provide a good
vehicle for resolving difficult transitional issues in a moderate and consensual manner.
In summary, there is unlikely to be a one-size-fits-all, sweeping remedy to the fear of
transitional issues when companies are considering memorializing their transfer pricing systems
through systems of contracts. Fiscal authorities will need, however, to assist taxpayers in
remedying this concern in order for the transfer pricing system to achieve reasonable
predictability and administrability.
IV.
9
Conclusion
See generally 1 Lowell, Burge & Briger, supra note 4, at ¶ 6.05[3][i] (discussion, in supplement to treatise,
describes various transitional problems that arise in current transfer pricing practice).
12
As many multinational groups are finding, the use of clear intercompany contracts,
specifying the roles to be performed by particular legal entities, the risks that they are to bear,
and the compensation that they are to receive, can achieve much-needed predictability in their
transfer pricing arrangements. From the standpoint of governments, such predictability has the
promise of greatly simplifying transfer pricing enforcement efforts and avoiding unnecessary
conflicts. By facilitating the adoption of clear systems of intercompany contracts, governments
can promote the satisfactory operation, and indeed the long-term viability, of the current system
of transfer pricing regulation. Governments should take the steps necessary to promote the use
of such contractual systems, both by issuing specific guidance and by encouraging flexibility in
examination practices.