Understanding the Use of Intra-Group Agreements: Notes for Related Parties Transactions.

Marcos Rivera Montoya1

1. INTRODUCTION Agreements between related parties (hereinafter intra-group agreements) do not always gain the attention which they deserve. A common view is that there is no need to detail the obligations of group companies between them. The idea is that if issues arise, they will be sorted out; the companies belong to the same economic group, after all. Apart from the fact that belonging to the same economic group is not a safe guarantee for an easy dispute resolution and/or litigation, there are good reasons for documenting and specifying agreements within an economic group. This article will attempt to discuss the reasons to conclude detailed intragroup agreements and their use consequences. Our approach will include a general legal perspective and some transfer pricing issues related to such agreements. 2. MAIN REASONS FOR CONCLUDING INTRA-GROUP AGREEMENTS Intra-group agreements are important because offer proof of mutual rights and obligations. This statement however implies the question is such proof relevant for related economic groups and its members. We can outline some important reasons for intra-group agreements below. First, one reason concerns the other group company. Given that belonging to the same economic group is not always a guarantee for an easy dispute resolution, a proper review of the rights and obligations may help to avoid disputes among group companies and/or tax administrations of different jurisdictions. Second, another reason concerns the trustee of the group company. If a group company is granted a moratorium of payments or goes into bankruptcy process, it would start to act as a third party; and will no longer behave as a group member. The receiver or trustee, who should look after the interest of the creditors, may take a different approach to agreements with group companies and interpret them differently and could lead to the question of which party is the owner of the
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Transfer Pricing Manager at TP Consulting(Per) and PT Consultores (Chile).

intellectual property rights: if the contract is null in this matter, the rights will lie with the maker, if the contract does not clearly provide for the transfer of the intellectual property rights, a trustee looking for assets may contest such transfer. Third, another reason is given in the case of a group company leaves the group of companies, and becomes a third party. A company that has left the group will likely be guided by different interests and objectives than when it was still part of the economic group and hence it may seek different interpretations of existing agreements to take advantages in any sense. The future sale of the entire group of companies or an initial public offering (IPO) could also benefit from detailed intragroup agreements. Without such agreements, it could lead to difficulties for third parties to establish what the mutual legal obligations of the group companies are2. The clearest example of this is changing the conditions of an intra-group agreement in view of the sale to a third party. This action could be regarded as an indication that the original agreement was not concluded at arms length. The fourth reason concerns the tax authorities given that some tax administrations could require a written intragroup agreement as part of the documentation that should be made available in an agreement and/or to verify transfer pricing regulations.

3. CONTENTS OF INTRA-GROUP AGREEMENTS In drafting intra-group agreements, theres basic elements that deserve specific attention include classic agreement formalities and transfer pricing considerations: the legal relationship of the parties; specific conditions; exclusivity; duration and termination of the agreement; and

We might argue that always theres enough time to draft an agreement prior to the sale of a group company; or the agreement can be drafted or amended when the group company is about to be sold off. In such cases one should be careful because the drafting of the agreement could be more than putting the existing arrangements in writing, this could give rise to transfer pricing issues as truthfulness of services rendered or arms length compliance of terms.

3.1. Legal relationship of the parties. Setting the legal relationship of the parties becomes important given that the relationship may have consequences for dividing risks, functions and costs between the parties and hence, have an impact on transfer pricing. Sale and distribution of goods within an economic group is in particular sensitive to transfer pricing issues. Different models and schemes can be used for moving the product from the producer to the ultimate customer; therefore a group company can play the role of an agent, commission agent or a distributor. Each has different functions and the risks of the attendant business may vary significantly, which could have an impact on the validation of the profit margin of such group company and its members whereas is relevant if they deploy in different jurisdictions. So in drafting intra-group agreements, we should clearly distinguish between these concepts. A commercial agent acts in the name of its principal and for the risk and account of the principal. An exception is when the agent is made responsible for the payment obligations of the parties with whom the agent concluded the agreements on behalf of the principal. In this case, the risk of the business of the agent is limited. The risk of non-payment by the customers will rest with the principal. A commission agent acts in its own name but for the risk and account of the principal. The risk run by a commission agent is comparable with that of a regular agent as long as the principal fulfills its obligations towards the commission agent. If the commission agent cannot take recourse against the principal, the agent bears the risk of claims of such customers. On the other hand, a distributor acts in its own name and for its own risk and account. Compared with the other types, commercial agent and the commission agent, a distributor generally faces a higher risk profile. 3.2. Specific conditions in intra-group agreements. We also have to consider the specific conditions under which services are rendered or goods delivered between parties. The underlying contractual arrangement becomes in an essential element of transfer pricing and the risk assessment process of transfer pricing cannot performed if the conditions are unknown. Applicable price. Contracts that are concluded for a specific period of time should generally offer the possibility to renegotiate the prices and or conditions. If such clauses are not available, it could be very difficult to change the contractual

conditions (at least if we consider a reasonable legally formal framework). Also, an extreme situation may consider the risk that the tax authorities might take the position that a party acting at arms length conditions would not have accepted the changes. Quality of services and/or products. Quality definitely has an impact on the acceptability of the transfer prices between related parties. In absence of any guarantees regarding quality and a limitation of liability will generally result in lower prices compared to goods or services delivered with a full guarantee and no limitation of liability3. On the other hand, the exclusion of liability could form part of the rationale behind a price that is lower than the average price of comparable products (e.g. low risk for the distributor and therefore liability of the principal-parent company) and the final objective to have the parent company with a minimum liability (or null) for the debts of its subsidiaries. 3.3. Exclusivity conditions. Intra-group agreements related to the distribution of products and/or the granting of specific commercial rights should always specify the territory will apply. If no territory clause is included, the tax authorities may take the position that the license or distribution agreement was concluded with no exceptions in the world. This may lead to the valuation of the license and/or distribution rights. Economic valuation of license rights may be relevant if this license is granted in return for the transfer of intellectual property rights (transfer and license-back agreements). The acceptability from a tax perspective of the intra-group transfer may depend on the rights that the licensee obtains in this agreement. Also not consideration of the territory clause in a distribution intra-group agreement could also lead to discussions with the tax authorities if it is decided that the distribution of goods in a specific country is to be undertaken by a local subsidiary. In this case theres the possibility that the first distributor will not be compensated for giving up its rights with respect to the territory of the latter group company. Hence, this situation will imply exclusivity too.

Electronic equipment economic groups consider intra-group schemes where one party produces equipment with the guarantee of one-year basis. Another related party provides the extended guarantee which considers an additional fee as insurance; this transaction actually may hide an underlying long term financing between related parties.

Regard to exclusivity, the value of an exclusive license will be -in in most of the caseshigher than a non-exclusive license. For example, if the agreement is null on exclusivity clause, the presumption is that rights granted under the agreement are therefore nonexclusive. Finally, long term relationship is important when considering exclusivity: if the licensor never granted rights to third parties and never exploited before the rights, one could argue that the license is exclusive. 3.4. Duration and termination of the agreement. The duration for an intra-group agreement is not always easy to determine given that from a transfer pricing approach, we have to define first what duration is appropriate for an intragroup license agreement. If we are thinking on duration, there is a one-year non-exclusive license that may more or less be terminated at any given moment. Such license may be appropriate for Marvel Worldwide Inc. licensing the merchandising of, let says Iron Mans character. The licensee will get a cash generating product without having to make substantial investments in product development (because is already developed and known). On the other hand, there is an exclusive license for the lifetime of a patent for 20 years; appropriate for the licensing of a patent that forms the active ingredient for the development of a new medicine which definitely will requires millions of dollars in order to turn it into a marketable product. Also we have to consider relationship between a long term contract and prices. This kind of agreement could provide lower prices than a short term one. Therefore the longer term of this relationship offers a benefit to the supplier in return for which the supplier offers lower prices. 4. Determining the intra-group service charge OECD Guidelines (Chapter VII) state that once it has been determined that an intra-group service has been rendered by a related party, it is necessary to determine whether the amount of the charge, if any, is in accordance with the arm's length principle. Therefore, similar to the treatment of the other related-party cross-border transactions, intra-group services also must be assessed with reference to third-party comparable dealing at arm's length. In other words, a charge for intra-group services between related parties should reflect the charge that would have been made and accepted between independent enterprises in comparable circumstances.

4.1. Methods prescribed by the OECD Guidelines for intra-group services The OECD Guidelines indicate that the transfer pricing methods to be used to determine an arm's length transfer price for intra-group services include the comparable uncontrolled (CUP) method and the cost-plus method (chapter VII Para. 7.3.1 OECD Guidelines). 4.1.1. Comparable uncontrolled price method (CUP) The CUP method compares the price charged for services rendered in a controlled transaction with the price charged for similar services rendered in a comparable uncontrolled transaction under comparable circumstances. A transaction should be regarded as comparable only if both the services and circumstances surrounding the controlled transaction are substantially the same as those of the uncontrolled transaction. The most important factor in determining comparability under this method is services similarity. The uncontrolled transactions should reflect services of a similar type, quality and quantity as those between the related parties, and relate to transactions taking place at a similar time and stage in the production or distribution chain, with similar conditions applying. Similarity of contractual terms and economic conditions, geographic and the level of market are also important comparability factors under this method. In case those differences in products or terms exist, OECD Guidelines provide that adjustments would be appropriate to eliminate the effect of the differences on price. The OECD Guidelines state that a flexible approach should be adopted when examining the CUP method, and appropriate adjustments should be applied when reasonable. However, for intra-group dealings in services, the difficulty may arise is the absence of an open market price for similar services (pricing of services is very subjective and their true value as perceived by the receiver can differ to that perceived by others in the market place). Therefore, the CUP method requires a high degree of comparability in the services provided in the controlled and uncontrolled transactions. This standard of comparability is extremely difficult to meet in practice; this is mainly because of the very nature of intra-group services, in that they are in the nature of support services which the group service provider would render only to the entities within the group. Therefore, no internal comparable may be available in practice (even external comparable from the public domain). In the context of intra group services, as services rendered by the overseas parent are generally in the nature of support services, the CUP method would not be the most appropriate method. Consequently, in the absence of internal or external comparable, the CUP method generally

may not be the most appropriate method from a transfer pricing perspective for analyzing the arm's length nature of transactions involving intra-group services. 4.1.2. Cost plus method This method evaluates the arm's length nature of a transfer price in a controlled transaction by reference to the gross profit mark-up realized in a comparable uncontrolled transaction. The cost-plus method is typically used for evaluating the sale of services by service provider to service recipient, where the service recipient implies limited economic risk in the transaction. When applying the cost-plus method, the process typically begins with the identification of the costs that the manufacturer incurs in the controlled transactions. An appropriate markup is then added to these costs, based on the functions performed and the risks assumed, so that an appropriate profit level is generated. Under this method, comparability is primarily dependent upon the similarity of the functions and risks assumed by the controlled and uncontrolled service providers, and are less dependent on the similarity of the actual services being rendered. On the other hand, in the evaluation of external comparable companies, the cost-plus method can be applied in an internal capacity if such data are available: the gross profit mark-up of the service provider in the controlled transaction may be determined by reference to the gross profit margin that the same service provider earns on items produced in comparable uncontrolled transactions. As with other transactional methods such as the resale price method, the comparability requirements under the cost-plus method are less stringent than those under the CUP method. Therefore cost-plus method would in practice be the most appropriate method to benchmark intra-group service transactions. The calculation of any charges for intra-group services under the cost-plus method must be based on a cost accounting system which is developed according to generally accepted accounting principles. As noted above, the cost-plus method can be further classified into the direct charge method and the indirect charge method. 4.1.2.1. Direct charge method Under the direct charge method, related companies are charged for specific services. For example the overseas subsidiary may be directly charged for a week visit of a engineer who is on the payroll of the parent company and who may have visited the overseas subsidiary's site at latter's request to render certain consultancy or advisory services. In this case the parent company can charge the specific costs for these consulting services with or without a

profit mark-up, directly to the foreign subsidiary. Its clear that even a third party would proceed in this way under similar conditions. The direct charge method is applicable primarily when services can be specifically identified for cost attribution. In those circumstances, the expenses of the specific support group responsible for the service rendered can be directly attributed to the services rendered (in terms of hours, travel and housing expenses, etc.). Therefore, the cost could relate to either a specific individual or individuals involved in providing the intra-group service or entire department responsible for the same. The only requisite for implementation of the direct charge method is that the services performed and the basis of payment must be clearly identifiable. Where the costs are directly related and identifiable to the recipient company, the cost should be allocated directly to that company. 4.1.2.2. Indirect charge method The indirect charge method is appropriate when the services provided and the costs attributable thereto relate to a number of different entities. For example there may be situations when an economic group cannot attribute direct costs either because the associated costs of a service rendered are not easily identifiable or the costs are incorporated into other transactions between the related entities. In those circumstances, a cost allocation or apportionment method is used which often imply some estimation or approximation. After revision above, direct charge method should be preferred over the indirect charge method in cases where the services rendered by the taxpayer to other group members: are the same or similar as those rendered to arm's length parties; or can be reasonably identified and quantified.

However, in cases where a particular service has been provided to a number of non-arm's length parties and the portion of the value of the service directly attributable to each of the parties cannot be determined; it is possible to use the indirect charge method. Thus, the applicability and acceptance of the direct cost method supersedes that of the indirect cost method and, in cases where the former can be used, the latter is generally not consider as an acceptable methodology by tax authorities. In general, the direct charge method is of practical convenience to tax authorities because of the clear correspondence between the resulting charge and the benefit provided to the payer party.

The use of an indirect charge method should contain safeguards against manipulation, especially on accounting principles, and be capable of producing charges or allocations of costs consistent with the actual or reasonably expected benefits to the recipient of the services. This is important, as charges for services which are structured in such an indirect way that the link between the payment for the services and their value is not established or lost, are more likely to be disallowed in the assessment of the foreign subsidiary and thereby result in double taxation. a) Identifying the cost base for the indirect charge method It becomes necessary to ascertain the chargeable cost base. It is necessary in this regard to take all costs directly or indirectly related to the services performed. Direct costs are those costs that are identified specifically with a particular service, including compensation, bonuses, travel expenses, materials and supplies. Indirect costs or deductions to be taken into account are those that are not specifically identified with or attributable to a particular activity, but which nevertheless relate to direct costs. These include utilities, occupancy, supervisory compensation, and other overhead costs of the department incurring direct costs or deductions. Indirect costs also include an appropriate share of costs or deductions relating to supporting departments and other general and administrative expenses, to the extent reasonably allocable to a particular service. Costs incurred by supporting departments can be apportioned to other departments on the basis of a reasonable overall estimate, or such costs may be reflected by means of application of reasonable departmental overhead rates. Having identified the cost base, the next issue to be addressed is that of apportioning the cost among various overseas subsidiaries. In general, cost allocations should be made on a reasonable basis, applying a comprehensive review of the centralized expenses incurred for the provision of intra-group services; have a relatively transparent basis of allocation; and result in costs being shared among the service recipients in proportion to the benefits received. There is no specific method or formula specified for allocating the centralized costs incurred. If the portion of the value of the service directly attributable to each of the service recipients cannot be determined (e.g. global insurance is intended to benefit all the related entities), an appropriate allocation key is used to allocate the costs. Charges for

services rendered are determined by allocating those costs across all potential beneficiaries using an appropriate allocation key. With respect to indirect cost allocations, the tax authorities are interested in assessing the arm's length nature of the allocation criterion. This is because, all said and done, the indirect allocation method is open to possible manipulation and is highly dependent on the nature and usage of the intra-group services. In consequence its imperative to select a proper allocation key (driver). The choice of the allocation key should be made by giving consideration to the nature of the service involved and the use to which it is put. Some of the examples of allocation keys have been noted below: allocation of department costs based on sales of the group; time spent by employees performing intra-group services; units produced or sold; number of employees; total expenses; space used; capital invested; any combination of previous elements.

b) Selecting an appropriate allocation key There are number of allocation keys that might be applied to allocate costs between members of an economic group. Some allocation keys that might be applied are analyzed below. Whether or not one of the keys, always might be appropriate a previous review of facts and circumstances. Global formula approach

One approach is to apportion costs on the basis of gross turnover of the worldwide group as follows: (Affiliate's gross sales / Worldwide group's gross sales) x Costs to be allocated Generally the global formulary approach does not always arrive at a reasonable or realistic result. The main deficiencies of this approach includes situations like startup costs of new subsidiaries; no consideration of costs relating to specific functions performed for, or product lines carried by, only certain related companies; and

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charges for services available to the entire economic group but not taken advantage of by all the affiliates in the region. We have also to consider situations where an affiliate of the group obtains its income from a number of sources, such as diverse product sales, providing services and leasing assets. However, the ratio of income to expenditure may not be uniform across all these income streams, with some types of income having higher inputs per dollar of output. Therefore, it may be appropriate to improve the formula and associate the income and expenditure with the relevant functions. Then, once the specific functions of the concerned overseas affiliate have been identified, the costs relating to functions that the concerned overseas affiliate performs could be allocated as follows: (Gross turnover for relevant functions of the overseas affiliate / Gross worldwide turnover for relevant functions of the concerned group) x Net central expenditure on relevant functions

Time expended

In the service industry, it is common to speak of units of time expended to perform a task or activity. When a central service provider performs functions for the group as a whole, hence it may be appropriate to allocate costs based on the amount of time expended on providing spaces to each member of the group. Again, if services are provided that has different varying degrees of value, an allocation based only on time spent may not be appropriate. Instead, the costs should be determined for each category of service provided by the central service provider. The final purpose of dividing costs between various categories of service is to ascertain an allocation of costs between group members that better reflects the benefits they derive. Income-producing units

Companies dedicated to leasing plant or equipment are generally able to identify the generation of income from the utilization of specific units. Expenditure incurred in producing the income can also be more readily identified. Once it is determined what assets the concerned affiliate is leasing out (as compared to the leasing of assets by the worldwide group), centralized costs in connection therewith might be allocated based on the number of units being utilized. Consider for example leasing of vessels;

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this kind of allocations do not recognize that different types of ships have different costs, support vessels for oil exploration and freighters vessels surely differs. The allocation could be drawn as follows: (Freighter vessels in Chile / Freighter vessels worldwide -working or not-) x Allocation expenditure

Gross profit allocation basis

There will be situations where allocating costs on the basis of gross revenue will not be appropriate. This problem arises when comparison of the turnover of the various companies of an economic group exhibit a mix of activities that are no consistent throughout the whole group and some activities may require greater support than others. E.g. one affiliates gross turnover may be distorted by a high turnover activity (that member generates little, if any, profit and requires relatively less assistance to administrative activities) respect the other affiliates. In this case, we have to explore the possibility of allocating costs on the basis of relative gross profits. 5. CONCLUSIONS Tax authorities have adopted an increasingly proactive and more sophisticated approach to examining transfer pricing policies in respect of intra-group services. Accordingly, many economic groups with subsidiaries abroad, are performing contemporaneously documentation of their intra-group arrangements and practices in respect of support services, so as to prepare in advance for an unavoidable transfer pricing examination. Given that intra-group services are regarded as one of the most likely areas to be audited by the transfer pricing authorities, economic groups that have not performed the necessary analysis and maintained adequate documentation run the definite risk of being audited (with a higher probability that their income will be reassessed by those authorities). There is no doubt that the best defense for an economic group with intra-group service transactions is thorough evaluation process. We observed that many companies fail to develop a coordinated and centrally managed intra-group support strategy (and moreover it has been observed that while formulating an intragroup transfer pricing strategy, many groups fail to work out the overall business strategy with various other relevant international tax planning considerations). Planning and performing a comprehensive transfer pricing strategy for intra-

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group service transactions also requires a deep understanding of various international tax planning principles, specially knowledge of applicable tax treaties, as well as an understanding of the laws and practices in different affiliates countries. The final message is assume the imperative of consider all these factors in the course of designing a proper intragroup arrangements policy.

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