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Clear, well-defined intercompany contracts are necessary in light of new BEPS rules

Under new base erosion and profit shifting (BEPS) guidance from the Organization of Economic Cooperation and Development, the concept of "delineation of the transaction" involves understanding the parties' actual activities through a detailed functional and risk analysis. Contracts are the starting point that initially define the functions and risks undertaken by the parties. Without a clear contract, tax authorities may "complete" the contract as they believe it should be completed, allocating risk (and return) to the party in their own jurisdiction or another jurisdiction based on their subjective determinations. By identifying, allocating, and specifically addressing how each economically significant risk will be controlled and managed, and by which party, companies are in a better position to begin the discussion with tax authorities.

Although the contract is important, tax authorities will examine whether the commercial arrangement reflected in the contract substantially conforms to the conduct of the parties. Conduct will ultimately determine the commercial and financial relations.

In many cases, under the OECD guidance, the management, control, and funding of economically significant risks will be an important determinant of the arm's length returns allocable to an entity. To accurately delineate the actual transaction with respect to risks, the OECD guidance requires the following six-step process:

  • Identify economically significant risks with specificity;
  • Determine the contractual allocation of each of those risks;
  • Determine how the parties operate with respect to the assumption and management of each of those risks (including which party controls risk-mitigation functions);
  • Determine whether the contractual allocation of each of those risks is consistent with the previous determination ("control" and "financial capacity" test);
  • For risks that fail the previous test, apply guidance on allocating risks; and
  • Proceed with pricing the accurately delineated transaction.

Under this six-step process, tax authorities may find that the commercial and financial relations are broader than indicated by just the "four corners" of the legal document signed by the parties. However, when a transaction has been formalized by related parties through written contractual agreements, those agreements not only provide the starting point for delineating the transaction between them but also provide how the parties intended to divide the responsibilities, risks, and anticipated outcomes arising from their interaction at the time of entering into the contract.

In this six-step analysis, determining who is managing and controlling risk is essential. "Risk management" refers to the function of assessing and responding to risk associated with commercial activity. Risk management is comprised of three elements:

  • The capability to make decisions to take on, lay off, or decline a risk-bearing opportunity, together with the actual performance of that decision-making function;
  • The capability to make decisions on whether and how to respond to the risks associated with the opportunity, together with the actual performance of that decision-making function; and
  • The capability to mitigate risk, that is, the capability to take measures that affect risk outcomes, together with the actual performance of such risk mitigation. Contacts can provide evidence of who the parties intended to manage and control the significant risks.

In accordance with the OECD guidance, control over day-to-day risk mitigation activities may be outsourced. When the day-to-day mitigation activities are outsourced, control of the risk would require:

  • The capability to determine the objectives of the outsourced activities;
  • The ability to decide to hire the provider of the risk mitigation functions; and
  • The ability to assess whether the objectives are being adequately met (and, when necessary, to decide to adapt or terminate the contract with that provider, together with the performance of such assessment and decision-making).

In many intercompany transactions, day-to-day risk mitigation will be outsourced. A contract can provide evidence of which party controls the outsourced activity.

Examples

The following three examples present circumstances when a clearly defined contractual allocation of functions and risks can matter: one pertains to contract manufacturing, and the other two address research and development (R&D) services.

Example 1: Contract Manufacturing

Company A enters into a contract manufacturing contract with Company B. Under the contract, Company A provides product specifications and designs, and specifies objectives of quality control standards. Company B supplies products as per specifications and in accordance with the quality control standards. Company B invoices Company A on an agreed upon cost plus basis. Company A enters into a separate contract with Company C to perform regular quality control of the manufacturing process and the product specifications. Company C performs quality control of Company B's activities on behalf of Company A.

How do we analyze this fact pattern under the new BEPS guidance? First, what are the economically significant risks? The operationally significant risks are determined to be product recall risk and inventory risk. Second, who controls these risks? Company A controls its product recall and inventory risks by exercising its capability and authority to take on the risk and responding to the risks. Besides that, Company A has the capability to assess and make decisions relating to the risk-mitigation functions and actually performs those functions. These include determining the objectives of the outsourced activities, the decision to hire the particular manufacturer and the party performing the quality checks, the assessment of whether the objectives are adequately met, and, when necessary, to decide to adapt or terminate the contracts. These are all issues that would be defined in the contract between Company A and Company B and the contract between Company A and Company C to clarify that Company A is controlling all of these risks.

Example 2: R&D Services Scenario 1

Company A has a contract development arrangement with Company B. Company A decides to perform part of the development work itself and decides to seek specialist input (Company B) for a part of the development process. Under the contract, Company A is entitled to decide what type of researcher(s) in Company B will work on the projects, the specific objectives of the research, as well as the budget allocated to Company B to perform the research. Company B is required under the contract to report back to Company A at predetermined milestones. These reports enable Company A to assess the progress of the development and decide whether its ongoing objectives are being met, and whether to continue investments in the project in light of that assessment. Company A has the financial capacity to assume the risk. Under these facts, it will likely be concluded that Company A controls the development risk. Because the rights and duties are clearly defined in the contract, the tax authorities are only required to test whether the parties' actions conformed to the defined terms. Without a contract, tax authorities could engage in a more extensive analysis of the parties' activities.

Example 3: R&D Services, Scenario 2

Company A and Company B have entered into a contract R&D arrangement in which Company A pays a service fee to Company B for R&D services to Company A on a project-by-project basis. Under the contract, Company A is required to perform the following activities with respect to these services: (1) design the R&D program; (2) develop and provide the budget for the projects; (3) decide the location of the R&D; (4) monitor the progress of Company B's performance of the R&D; and (5) register all patents, designs, and intangibles in its own name. Company B is required to perform the following activities with respect to the services: (1) work on the projects assigned by Company A; (2) suggest modifications – but need approval from Company A to implement such suggestions; (3) report on its progress every month to Company A; and (4) seek input on its annual budget and hiring from Company A.

Under the contract, the following important functions are performed by Company A: (1) management (establishing research program, monitoring progress, deciding to terminate or change course), (2) designing projects, and (3) budgeting and funding. Thus, under the new BEPS guidance, Company A will likely be determined to control all of the economically significant risks, and A will likely be entitled to all of the risk-adjusted returns associated with controlling these risks, if it follows the terms of the contract.

Action 13 Local File Requirements

OECD Action 13 guidance requires that a position be taken on the contractual terms of each transaction. The OECD local file requires: (1) a description of the contractual terms of the transaction; and (2) results of the analysis of the six-step procedure to accurately delineate the management, control, and funding of risk; and (3) copies of intercompany agreements. Thus, for purposes of Action 13 local file compliance, a comprehensive contract is recommended.

BEPS Contract Analysis Process

In conducting a BEPS contract review process, the following steps should be considered to identify and remedy any issues that arise as a result of the process:

  • Determine which contracts or transactions to review. These could include higher risk transactions, such as contract R&D, and transactions involving economically significant risks. If numerous entities are performing similar functions and risks, then the analysis can initially be done on a sampling basis or by looking at potentially high-risk countries.
  • Determine the functions and risks of the parties. In many cases, this will require an "enhanced functional analysis" or "super-functional analysis," such that all economically significant risks are identified and enough facts are ascertained to determine which entities are controlling these risks and how they are controlling these risks.
  • Determine what changes, if any, to functions and risks are necessary to conform to the intended characterization of the transaction. With respect to determining changes that can be made to the conduct to support the intended characterization of the entity, the following questions should be considered: Does the parties' actual conduct support the characterization? Can the conduct be changed consistent with the company's business model? Can the management and control of risk be changed consistent with the company's business model?
  • Determine functions and risk described and allocated in the contract.
  • Determine "gaps" in the contract (with respect to identifying, allocating, and addressing economically significant functions and risks).
  • Make changes to existing contracts or terms of a new contract to eliminate those gaps.

By working with transfer pricing advisors, tax advisors, and legal advisors to help complete these steps, companies will hopefully be able to reduce vulnerabilities in their structures that may come to light under the harsh glare of the new BEPS regime.

This communication contains general information only, and none of Deloitte Touche Tohmatsu Limited, its member firms, or their related entities (collectively, the "Deloitte network") is, by means of this communication, rendering professional advice or services. Before making any decision or taking any action that may affect your finances or your business, you should consult a qualified professional adviser. No entity in the Deloitte network shall be responsible for any loss whatsoever sustained by any person who relies on this communication.cussed some of the considerations companies are factoring into their preparation of their very first Master Files. Once the initial Master Files reach the hands of tax authorities and they start reviewing them, it will be interesting to see how the tax authorities use them.

This communication contains general information only, and none of Deloitte Touche Tohmatsu Limited, its member firms, or their related entities (collectively, the "Deloitte network") is, by means of this communication, rendering professional advice or services. Before making any decision or taking any action that may affect your finances or your business, you should consult a qualified professional adviser. No entity in the Deloitte network shall be responsible for any loss whatsoever sustained by any person who relies on this communication.

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