Transfer Pricing Best Practices with Effective Entity Management

For multinational companies, transfer pricing is often considered the number one risk affecting the group. Based on intercompany agreements that allocate a group's income and expenses among cross-border entities, transfer pricing affects how entities are taxed in their respective jurisdictions. When the intercompany agreements fall short of reflecting the nature of the transactions, the group becomes exposed to a number of adverse consequences.

At the same time, many compliance professionals admit that their companies "rarely or never" update or review their intercompany agreements, even in light of ongoing changes in their entity structures and evolving relationships and transactions among their entities. In practice, such approach leads to discrepancies between the intercompany agreements and the nature of cross-border operations, resulting in adverse tax adjustments, denial of tax deductions, penalties, and investors' claims.

Although there is no feasible way to make intercompany agreements future-proof and evergreen for years to come, there are multiple ways of making transfer pricing compliance easier by following best practices for entity management and transaction work. Below, we discuss common mistakes companies make in relation to their intercompany agreements, the best way to review such agreements and offer a 5-step plan for audit readiness.

Common Mistakes in Transfer Pricing Practices 

Many businesses overlook the importance of having accurate and updated intercompany agreements for their entities, considering it a right-pocket-left-pocket issue. As a result, companies expose themselves to various types of risks, including double taxation. 

There are multiple ways how companies fail to document the relationship among their cross-border entities. Some of the most common scenarios include:

• not having intercompany agreements at all,
• intercompany agreements that do not reflect the actual nature of the transactions,
• intercompany agreements that do not reflect the market pricing for goods, services or intangibles transferred among company entities,
• failure to reflect entity structure and right entities taking part in the transactions,
• backdated retrospective agreements.

Reviewing Intercompany Agreements 

The CFOs, legal, tax and compliance teams tasked with the review of intercompany agreements in multinational organizations face a set of challenges posed by the scale and complexity of their organizations. Fortunately, this task can be simplified by focusing on several key requirements for intercompany agreements:

First of all, the organization needs to make sure that the agreement describes the character of the transaction, whether it relates to transfer or intellectual property, supply of support services, or distribution of goods. The second important aspect of transfer pricing is always related to risk allocation within an organization, determining which entity covers which risks, pays compensations or is responsible for recalls. 

The third area of attention relates to the actual owner of pre-existing intellectual property rights which is entitled to respective royalty payments under existing agreements. Another critical aspect of intercompany agreement relates to the pricing model which should reflect the current level of pricing prevailing on the market.

Last but not least, intercompany agreements should be fit for purpose to reflect the nature of the relationships within the group. These requirements include:

• having correct legal entities as parties to the agreement,
• having an appropriate start date and validity period,
• an agreement written in simple terms to help tax authorities understand the relationship within the group without overcomplicating the text with procedural terms,
• having clear provisions about the choice of law.
• ability to stand a corporate benefit test.

A 5-Step Plan for Transfer Pricing Audit Readiness

If the intercompany agreements do not meet the above requirements, an organization is at serious risk related to corporate tax deductibility. Such companies need a clear roadmap of how to review and update their transfer pricing policies to ensure audit readiness at all times.

Whether an organization is in the process of updating the existing intercompany agreements or drafting one for the first time, the process is the same and includes five basic steps.

1. Determining the scope of the agreements. At this stage, organizations need to prioritize the transactions that should be included in the agreements based on such factors as the sensitivity of operations in particular countries, risks exposure for particular transactions, and jurisdiction particularly aggressive about enforcement of specific types of transfer pricing.

2. Review and validate. After determining the scope of the agreements, the group needs to review the proposed structure, validate legal entities that will be the parties of the agreements, and analyze respective regulations applicable to such entities.

3. Drafting stage. Companies need to prepare template agreements in collaboration with legal, compliance and finance teams and ensure these agreements reflect the nature of intercompany transactions.

4. Finalizing and localization. When a group operates in diverse jurisdictions with different treatment of transactions, the teams often need to localize the intercompany agreements based on economic circumstances in respective countries.

5. Implementation. At the implementation stage, companies need not only to have the agreements validated and signed by directors of respective legal entities, but also to explain to the board and directors what they are expected to sign to have informed consent.

Key Takeaways

While the absence of clear transfer pricing policies can make companies liable to penalties and double taxation, maintaining intercompany agreements can steer organizations clear of potential pitfalls and help them stay compliant. Companies that leverage an effective entity management system and have a single source of truth for all their entities are well-positioned for drafting and updating such agreements at all times, having all necessary information related to legal entities, stakeholders and transactions instantly available to all teams and entities.

First, organizations aiming to have audit-ready intercompany agreements need to identify all legal entities that participate in the transactions and include them in the agreements. They further need to establish accountability of stakeholders and teams that should have ownership of the process of maintaining and updating the portfolio of all the company's intercompany agreements. It is essential that these stakeholders and teams run regular reviews of the group's transfer pricing policies, especially if their organizations are active with M&A, deal-making or rationalizing company structure by acquiring or reorganizing their legal entities.

The above approaches were discussed during the webinar on Streamlining Legal Entities: Expert Q&A for CFOs on Transfer Pricing and Compliance,  hosted by the Athennian team. For more information about streamlining transfer pricing with intercompany agreements and effective entity management, please check the recording of the webinar or contact the Athennian team to request a free demo on entity management software.