By Craig A. Sharon, Esq.
Bingham McCutchen LLP, Washington, DC
As APA Director, I reviewed scores, if not hundreds, of intercompany agreements. Such agreements are critical in evaluating the facts and circumstances underlying a taxpayer's intercompany transactions, and they form the basis for much of the functional, legal, and economic analyses that support a taxpayer's transfer pricing positions. Notwithstanding the importance of these agreements, I was surprised as APA Director by the deficient quality of so many documents. Of the many lessons I learned while at the APA Program, surely one was that taxpayers should pay closer attention to the quality of their transfer-pricing-related documentation to ensure IRS respect for the taxpayer's transactions as structured and to avoid unnecessary controversy and the possible imposition of penalties. My experience in the private sector over the past 22 months has mostly confirmed that sentiment.
Below are my observations on the drafting of intercompany agreements from a transfer-pricing perspective. The discussion does not cover the quality of taxpayer transfer-pricing studies prepared for §6662 penalty purposes. That is an entirely different (and more woeful) subject beyond the scope of this commentary, albeit a topic that the IRS is likely to revisit as a regulatory project in the next few years.
By "deficient quality," I mean agreements that fail to cover key items, are excessively vague, and/or poorly thought-out. To illustrate, I have reviewed over the years many: (1) 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 sales base on which royalties are paid and 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; (2) sales and marketing agreements that purport to limit the risk of a distribution affiliate, but which lack any significant substantive provision effectuating such intent; and (3) compensation arrangements for all different kinds of related-party transactions that merely cross-reference the "arm's-length standard" or, in more adventurous cases, contemplate pricing adjustments, but only in circumstances that mimic the "80-120" periodic adjustment rules in the §482 regulations. In other cases, the agreements have created unforeseen and unexpected issues, e.g., where an agreement: (1) grants a taxpayer an authority that potentially creates a permanent establishment (PE) for the taxpayer or an affiliate (e.g., giving one party the authority to bind the other party or providing unlimited access by one party to the other party's premises); or (2) contains provisions that violate or are otherwise inconsistent with local law, third-party contracts, or the taxpayer's own rights.
So how should taxpayers approach their intercompany agreements?
My standard is to benchmark intercompany agreements against, but not to replicate the details of, third-party agreements, which tend to be longer and more complex than is necessary for intercompany arrangements. My approach contrasts with what appears to be the approach of many taxpayers, which start with barebones agreements and build up (more or less) from there. Either starting place - a barebones contract or a third-party imitation - may get a careful taxpayer to the same final agreement, but in my view the minimalist approach creates more uncertainty and poses greater risk that a tax authority will disregard the agreement or at least interpret it differently.
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. As a rule of thumb, a taxpayer should avoid being unnecessarily specific in provisions that do not relate to the taxpayer's tax positions. The drafting question should be "what is the tax result that the taxpayer is trying to support" in the countries for which the agreement is relevant, not "what would third parties specifically include in an agreement." Too much specificity in provisions not directly related to a tax position can needlessly create issues. For instance, an agreement could require an affiliate to produce certain documentation, records, and reports. Although this is what third parties would have in an agreement, the IRS could use the taxpayer's failure to receive the documentation, records, and reports to argue that the taxpayer has not been following the agreement. Similarly, confidentiality provisions can restrict a taxpayer's flexibility. Although it is important that the parties, in general, agree that proprietary and other important information be kept confidential, these provisions need not rise to the level of a third-party agreement. Mimicking typical third-party confidentiality terms sets up compliance issues. Have all the employees really signed a confidentiality agreement with those terms? What about contractors? Did someone transfer confidential information without receiving written consent? Did the affiliate really destroy all copies of any documents at the end of the term? In short, specificity that does not help a taxpayer's tax position can cause unexpected problems.
On the other hand, when provisions in an intercompany agreement affect a taxpayer's tax positions, the agreement should be explicit, complete, and properly informed. Consider the following drafting tips:
- Use recitals to your advantage. Although not technically part of the legal agreement, recitals can explain a taxpayer's position in straightforward terms. If a distribution arrangement is intended to be limited risk, say so in a recital. If some history is helpful to understanding the purpose of an agreement, provide the history in a recital.
- Make sure that the intended substance of the arrangement is actually reflected in the contractual language. If a taxpayer is trying to set up a limited-risk arrangement, the substantive provisions in the agreement should, in fact, reduce a party's risks, e.g., making clear which party bears certain risks (e.g., inventory, foreign exchange, product liability, etc.) or which costs are subject to reimbursement (e.g., advertising, pass-throughs, etc.). Simply providing for an adjusted, lower "arms-length" operating margin or using a cost-plus transfer pricing method to capture a limited-risk arrangement is not likely, without more, to carry the day.
- The compensation provisions should either specify an initial payment amount or profit margin or incorporate by reference the payment or margin amounts set forth from time-to-time in a taxpayer's transfer pricing studies. It is not too helpful to simply state that the compensation shall be determined in accordance with the "arm's-length standard." If a taxpayer would like to retain some pricing flexibility without having to amend an agreement, it can include a pricing adjustment clause that defines when and how adjustments to the initial compensation will be handled. It may even be possible to include pricing terms that allow a taxpayer-favorable adjustment that would otherwise be prohibited under Regs. §1.482-1(a)(3), provided the mechanics of the adjustment are clearly set forth in the agreement and the provision pre-dates the conditions triggering the adjustment (i.e., adopted ex ante).1 Although the IRS's views on price adjustment clauses are still evolving, the new cost-sharing regulations and services regulations allow for contingent-payment arrangements.2
- Be especially careful with agreements dealing with intangible property. For example, it is important to make sure that a taxpayer has the capacity to grant the rights that it purports to grant. In a license arrangement where the licensor grants rights that it has only by virtue of a related-party sublicense or a third-party in-license, has the taxpayer taken the steps needed under its license to allow the intercompany arrangement? In cases where a basket of IP is being transferred, has the different IP been sufficiently identified and defined to forestall arguments about the identity of the economic owner of the IP for purposes of allocating future IP-related returns? More generally, when a taxpayer is dealing with IP, it is wise to consult with IP counsel to make sure that any overlapping IP and tax issues are understood and reconciled. What are the tax and legal effects of an exclusive vs. non-exclusive arrangement?3 What is the best way to transfer economic ownership of IP - a concept unique to tax - without changing the legal ownership of such IP?
For the above items, more specificity is better than less specificity, since each item directly affects a taxpayer's tax position.
A non-exhaustive list of other drafting tips includes:
- Make sure that key affected personnel (e.g., in finance, operations, IT, and legal) review, approve, and adhere to the terms of an agreement to ensure that a taxpayer's conduct and reporting, within and without the United States, are consistent with the terms of the contract. Otherwise, the IRS or the foreign tax authority can disregard the agreement and impute new terms based on the taxpayer's actual conduct.4
- When foreign law is implicated (whether tax or non-tax), consult with local counsel, or at least the taxpayer's in-house counsel. Given the real possibility of unexpected quirks in local law, such discussions should occur earlier rather than later in the process. If foreign law is selected as the governing law of an agreement, make sure that the taxpayer understands the potential consequences.
- Watch out for potential PE issues, especially in intercompany services arrangements. The PE concept is vague and uncertain enough to create unexpected problems. I would note further that even when the contract steers clear of the issue, it is still important to monitor a taxpayer's actual implementation of the agreement. Routines and operations that make eminent business sense may cause issues.
- If you include detailed administrative provisions in an agreement, follow them as much as possible. 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 be consistent from agreement to agreement on such provisions (and other boilerplate) to simplify the compliance process and to avoid foot faults on agreements with non-conforming provisions.
- If the parties agree to change the terms of an agreement, execute a written amendment.
- Last, but not least, keep track of all drafts and make sure that the final draft is signed by all the parties and filed so it can be retrieved if needed. Too often taxpayers are unable to produce signed agreements or even determine which draft of an agreement represents the final version.
I appreciate that tax department budgets are stretched thin and that the downside of preparing minimalist intercompany agreements may seem too speculative or remote to devote significant resources to preparing quality documents. Still, there are benefits to drafting quality documents because a taxpayer is allowed in the first instance to structure its intercompany arrangements as it sees fit and, in any event, the taxpayer will be held in a dispute to the terms of its contracts (unless the taxpayer has not complied with the terms and the tax authority sees a benefit in ignoring them). A poorly drafted (or lost) 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.
This commentary also will appear in the December 2012 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Maruca and Warner, 886 T.M., Transfer Pricing: The Code, the Regulations and Selected Case Law, and Stark and Blanchard, 893 T.M., Transfer Pricing: Litigation Strategy and Tactics, and in Tax Practice Series, see ¶3600, Section 482 - Allocations of Income and Deductions Between Related Taxpayers.
1 For example, it may be possible to incorporate a formula into an agreement that adjusts the "price" of transferred IP up or down depending on actual results that may span multiple years.
2 See Regs. §§1.482-7(h)(2)(iii)(B), -7(k)(l)(iv), and -9(i).
3 For additional background, see Valoir and Nijhof, "Tax-Speak for Intellectual Property Counsel," Intellectual Property Today (January 2010), p. 30.
4 See Regs. §1.482-1(d)(3)(ii)(B).