SINCE inception, India’s transfer pricing regime has emerged as a key challenge for multinational enterprises in India. Over the past few years, Indian transfer pricing litigation environment has been continuously evolving with the intensity of scrutiny increasing year after year by the tax authorities. The taxpayers have been facing various challenges in justifying their transfer pricing arrangements before the tax authorities. One of such challenges is to maintain documentation related to the transfer pricing arrangement with related parties, since the taxpayer is required to maintain robust documents in support of arm’s length pricing.
The Transfer Pricing Documentation (‘TP Documentation’) is compilation of various section of information which inter alia includes details of organization structure, details of inter-company transaction, functional, assets and risk analysis and economic analysis etc. Amongst various documents, Inter-company agreement (‘ICA’) forms the very basis of TP Documentation and which in turn helps to explain and supporting the transfer pricing policy.
It is very important for any taxpayer to frame ICA in aligned with the actual business reality and the arm’s length principle. ICA has also gained importance in the final reports under Base Erosion Profit Shifting (‘BEPS’) Action plans released on October 5, 2015 by Organization for Economic Corporation and Development (‘OECD’). It requires taxpayers to include a list of “important agreements” pertaining to intangibles in the master file and copies of all “material inter company agreements” in the local transfer pricing documentation files of their worldwide affiliates.
Accordingly, one should be very careful while drafting ICA from a transfer pricing perspective. In this article, the author has addressed the key considerations/various aspects while drafting an ICA from a transfer pricing perspective.
Drafting of an agreement
As a starting point, ICA should be explicit, complete and properly informed i.e. taxpayer should avoid being unnecessary specific in various clauses which may otherwise not require.
Also, the taxpayer should take proper care that any provisions which violate or are otherwise inconsistent with local law, third-party contracts, or the taxpayer’s own rights should not form part of signed ICA.
ICA forms the key part of the TP Documentation required to be maintained by the taxpayer under their local laws. Hence, from a transfer pricing perspective, the following clauses amongst others need to be carefully drafted:
– Characterization of parties to ICA
– Terms and conditions governing the ICA
– Compensation/fee schedule
– Form of payment
– Terms of payment
– Specific clauses w.r.t to few services i.e. transfer of employees / secondment arrangement/royalty/intangibles
– Exit charges, wherever necessary
– Date of agreement
– Signature/validity of agreement
Characterization of parties to ICA
One of the crux of transfer pricing is basically involves examination of characterization of parties before determining the arm’s length price of controlled transaction.
The characterization in turn depends on the functional analysis i.e. functions performed, assets employed, risk assumed which provides an understanding of the controlled transactions and business operations.
For example, if a taxpayer is operating as captive service provider or as a Distributor (limited risk distributor or full-fledged) or manufacturer (full-fledged, licensed, contract or toll), then subjective provisions in the ICA should clearly highlight the respective functions/nature of services and respective risks (e.g., market, credit, inventory, foreign exchange, product liability, etc.) to be borne by the related parties to the agreement.
In the absence of correct characterization in ICA, it is often seen that tax authority may alter the characterization of parties/transaction while performing assessment. For example, tax authority may allege limited risk distributor as full fledge distributor and demand for the higher compensation.
OECD also provides some guidance where it may be appropriate to disregard the actual structure of a controlled transaction on the basis that the provision as structured would not have been made had the parties been unconnected.
Hence, it is very important for taxpayer to maintain documents in support of ICA because contractual terms of an agreement should be given due consideration as long as the terms are consistent with the economic substance of the transaction.
Since ICA sets out the basic inputs for a functional comparability analysis, it is also important that taxpayer should maintain alignment/consistency between ICA and actual conduct
To conclude, it is important that the intended substance of the arrangement is actually reflected in the contractual language while drafting ICA.
Compensation/fee
Once the test of characterization of parties is passed, the next scrutiny is on the part of compensation/fees charged by related parties for the activities performed as per ICA
Sometimes, it is often seen that the compensation clauses in the agreement is quite open and flexible for manipulations while defining the arm’s length price. For example, in case of provision of services, it is stated that related parties to agreement will pay such fees as may be agreed between them in writing from time to time or Compensation between related parties shall be determined in accordance with the “arm’s-length standard”.
Similarly while applying profit split methodology, it is often seen in the agreement that general statement should be there that profit will be split based on functional analysis of the related parties’ contributions. However, the agreement remains silent on the mechanism by which the value of those contributions is quantified.
This will lead to different interpretation of arm’s length price during the course of assessment and which in turn amounts to litigation or disregard of agreement itself.
Hence, the compensation clause should clearly specify an initial payment amount or details of profit margin/mark-up percentage depending on the characterization of parties to agreement. This will help the taxpayer to retain some pricing flexibility in the agreement without amending the full agreement.
Further, the taxpayer can include a “pricing adjustment” or “true up” clause in the agreement which should define when and how adjustments to the initial compensation is required to be made.
So, it is advisable that agreement should define “Arm’s length standard” in lieu of compensation in order to avoid any probable litigation.
Terms and conditions
The terms and conditions of a written agreement help the taxpayer to create certainty about the actual conduct of transaction or it also helps in determining the comparability analysis and examining the basis of payment forming part of ICA.
Hence, terms and conditions needs to be carefully drafted at the time of entering into an ICA because it is often seen that sometimes agreement fails to define key terms and conditions in the agreement for example in case of royalty agreement, the sales base on which royalties are paid and the terms and conditions relating thereto is not defined.
Also, it is often seen that taxpayer sometimes enters into two- or three-page license agreements of intellectual property (IP) that fail to define the IP properly, omit key terms and conditions (e.g., the owner of future-developed IP), and/or contain limited terms and/or short-term termination clauses wholly inconsistent with the long-term investment (and assumption of risk) required for a licensee to exploit the IP.
Also, if parties to agreement agree to change the terms of an agreement, it is advisable to execute a written amendment.
Form of payment
The form of payment in the agreement must be consistent with the facts and circumstances of the case, including the written contracts, the actual conduct of the parties and the ability of the parties to contract to bear and manage the relevant payment risks. Intangibles- Para 6.180 (BEPS- Action Plan 8-10)]
Terms of payment
The taxpayer needs to take utmost care while drafting clause relating to “terms of payment” especially in the light of recent transfer pricing scrutiny where transfer pricing adjustment being upheld when the collection terms of taxpayer with related party is different from that of what is stated in the agreement and not in line with terms agreed with third parties/industry practice.
On the other hand, if taxpayer believes that their terms of payment cannot be compared with that of third party/industry practices, in that case taxpayer should document the reason for the same while drafting an ICA in order to avoid any detailed scrutiny on this part.
Specific clauses in the agreement as relevant based on the type of transactions
In this Article, I have dealt with few of such transactions:
– Transfer of employees/secondment arrangement
It is important to be very careful while drafting an agreement for potential Permanent Establishment (‘PE’) issues, especially in inter company services arrangements.
The PE concept is vague and uncertain enough to create unexpected problems. So, terms of employment should be clearly defined in the agreement i.e. scope of work, who has ultimate authority and control over the seconded employee, payment of remuneration of seconded employee etc.so as to clearly identify the functions performed and risk assumed of each of the related parties to agreement.
The same also gained importance in the light of recent BEPS Action plan 7 relating to PE.
– Payment of Royalty/transfer of intellectual proprietary rights
In case of royalty agreement, it is often seen that the sales base on which royalties are paid and the terms and conditions relating thereto is not defined.
Further, in case of transfer of Intellectual proprietary rights, it is often seen that agreements contain limited terms and/or short-term termination clauses wholly inconsistent with the long-term investment (and assumption of risk) required for a licensee to exploit the IP.
The transfer pricing guidelines are also being modernized in relation to intangibles under BEPS Action Plan 8.
In view of the above, taxpayer should take care of following basic points while drafting IC agreement for royalty
– option to sublicense;
– rights to share in improvements;
– when and how the royalty rate should be changed with the level of revenue, or be renegotiated, or waived
Further, ICA should be consistent among all group entities for particular transaction. However, if there is any variation in rates/terms and condition in any particular country, the reason of the same should be documented along with proper justification.
Exit charges
Recently, tax authority is very aggressive on transactions pertaining to Business restructuring and making enquiries for exit charges i.e. payment made by one related party to another to compensate for the business being simplified or reduced of one of the relate party. For example, moving from ‘full-fledged distributor’ to a ‘limited risk distributor’ or ‘undisclosed agent’.
In such cases, an ICA is being looked at very minutely by the tax authority as to whether the agreement or contract provides for compensation on termination of agreement, what was the form of business before such restructuring which important for determining whether exit charge will arise or not.
So, it is advisable that taxpayer should take care of this while drafting an agreement which helps in supporting future argument against re-characterization of transaction in few circumstances.
Date of agreement
The date of actual conduct of transaction should be correctly recorded in the ICA because it is seen that If pricing date specified in ICA between the related parties is inconsistent with the actual conduct of the parties or facts of the case, tax authority may determine a different pricing date consistent with those other factors of the case and what independent enterprises would have agreed in comparable circumstances (taking into consideration industry practices).
Signature/validity
Lastly, it is very important that agreement should be signed by all the related parties to an agreement before actual conduct of the transaction because it is often seen that sometimes agreement is not signed by one or few related parties to the agreement as the case may be and the same unsigned version forms part of TP Report and submitted as and when requested by tax authority during the assessment.
Also it is often seen that taxpayer sometimes does not enter into any new agreement or review or amend the original agreement in case of expiry of validity of original agreement.
The unsigned version/expired agreement will put the taxpayer in trouble as far legality/validity of the agreement is concerned.
Other points
In addition to above, the taxpayer should also give attention to following non-exhaustive list while drafting ICA:
– All administrative provisions in an agreement need to be followed properly without any exception. For example, if an agreement requires 30-days written notice to terminate the agreement, send out the written notice on a timely basis. It helps to avoid any non-compliance with respect to performing an agreement;
– Although not technically part of the legal agreement, recitals can explain a taxpayer’s position in straightforward terms;
– Consistent approach among the group entities for creating and maintaining inter company agreements especially in the light of BEPS; and
– It is advisable that all the provisions in the agreement needs to be vetted by respective teams for example tax and payment clause by finance team and on similar note respective clause relevant for other departments such as information technology (‘IT’), operations, Human Resource (‘HR’) and legal etc. to ensure smooth conduct of agreement.
Further, it is often seen that in few cases, no inter company agreements at all are put in place. Also, few agreements are heavily influenced by commercial contracts used with third parties.
I do not recommend simply duplicating third-party agreements, even if they are readily available, because detailed requirements in third-party agreements can result in significant compliance failures when applied to related parties, given the greater informality that typifies related-party relationships. The same has also been discussed in the BEPS final report.[Para 1.46 (BEPS- Action Plan 8-10)]
Conclusion and way forward
After taking the aforesaid discussion into consideration, now the question rises as to how the above mitigation can be avoided. To answer this, it depends on how taxpayers should approach their inter company agreements.
A poorly drafted agreement may deprive a taxpayer of the benefits of its planning and stands a good chance of generating avoidable controversies. A taxpayer can limit these risks, while managing its costs, by following the basic approach and practical tips described above.
A well-defined/exhaustive agreement helps the taxpayer in the first instance to structure its inter company arrangements as it sees fit as ICA sets out the form of a transaction and the obligations of the parties to agreement as for example, limited risk distributor or manufacturer or captive service entity. A well drafted agreement contains clauses that mirror the list of comparability factors and administrative guidance.
Also, with countries around the world signaling adoption of the OECD’s BEPS new documentation guidance and with the increased number of advance pricing in India, now is the time for multinational enterprises to assess the level of inter company agreement coverage for their international transactions globally and locally and to take action to remedy any identified gaps, if any
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