Introduction to Transfer Pricing and ICAs

This blog is based on the guest chapter written by Paul Sutton of LCN Legal in Athennian’s Best Practices in Corporate Subsidiary Management eBook.

Transfer Pricing

Transfer pricing, also known as TP, is a set of international tax laws that determine a company’s charges, such as royalties, service fees, and goods prices. These decide what is paid between connected entities within a multinational group and influence where profits are made and taxed. 

What is the Arms Length Principle?

The arms-length principle is an adopted international standard for determining transfer prices for tax purposes. According to LCN Legal, what this means is that “tax authorities review the transfer prices affecting a particular enterprise, and then tax that enterprise based on the profits it would have made had the prices been negotiated between independent third parties.”

This applies to ongoing and one-off transactions and to both legal entities and branches. However, this increases the risk of double taxation because the implication is that any tax change should apply to all jurisdictions. If this does not occur, the enterprise may be taxed twice. 

What are ICAs? 

Intercompany agreements, or ICAs are a fundamental component of transfer pricing compliance for multinational groups. According to Paul Sutton of LCN legal, intercompany agreements “define the legal terms under which transactions occur within a group of companies.” 

These transactions can look like:

• Head office and back-office services (e.g., finance, tax, legal, and HR services)
• Marketing services
• R&D services
• IT services and support
• Shared services arrangements
• Sale of goods
• Sales agency and commissionaire arrangements 
• Intellectual property licenses
• Revenue/profit sharing
• Cost-sharing
• Contract manufacturing
• Toll manufacturing
• Loan facilities (e.g., term loans, revolving credit, and overdraft facilities)
• Intercompany debt in security form (e.g., loan notes)
• Guarantees and other forms of security or financial support
• Cash pooling
• Secondment of staff and other mobility arrangements

ICAs play a critical part in implementing transfer pricing policies, including:

• Describing the transactions – (e.g., recording which services are provided or intellectual property is licensed.)
• Allocating contractual risk between parties – (e.g., risks include product liability claims, credit risks, or inventory risks.) 
• Specifying the fees to be paid by the correct parties – (e.g., royalties or license fees.)
• Specifying which party owns intellectual property rights used connection with the arrangement.

In a tax audit, ICAs are one of the first items that tax administrations will ask for. An ICA must match the group’s transfer pricing policy and tax filing; otherwise, the group is instantly disadvantaged. Not only will this extend the audit process, but it will also undermine the enterprise group’s credibility. 

What Makes an ICA Effective? 

To be successful, an ICA must be aligned with the allocation of functions, risks, and rewards described in transfer pricing policies. It must also be legally binding and correctly managed (i.e., signed and dated by all participating entities.) In addition, ICAs require regular maintenance so that they accurately reflect the group’s policies and structure. 

Without proper maintenance, a group could find itself with an excess of penalties. For more information on effective ICAs and their commonly occurring issues, you can download the Best Practices in Corporate Subsidiary Management eBook, which includes an entire chapter on ICAs and TPs.