Do your contracts comply with the new Transfer Pricing Guidelines?

Tax Alert - September 2017

By Bart de Gouw and Nandita Rao

The new Transfer Pricing Guidelines (2017) on the arm’s length principle will have a far-reaching impact on multinationals. Inland Revenue is more focussed than ever on the conduct of multinationals operating in New Zealand, and this pressure will only increase in the near to medium-term.

If your business has cross border arrangements and you don’t have intercompany contracts in place, now is the time to get them underway.  If you do, you need to consider whether they comply with the new guidelines.  It’s not enough to simply have intercompany contracts in place – they also need to adequately set out the functions and risk allocations of the parties and ensure that the contracts are aligned with the conduct of the parties.

As there are increased reporting requirements in the form of the master file and local file that require copies of the intercompany contracts, these will be scrutinised by tax authorities in ever more detail. 

However, there are practical steps that companies can undertake to ensure that their intercompany transactions are appropriately documented and supported.  The risk of not aligning contracts and conduct is the exposure of the transactions to challenge and potential reconstruction by tax authorities.

Why are contracts important?

Under OECD guidance, transactions are assessed by assessing the functions performed and the risks assumed by the parties to the transaction.

Contracts are the starting point that should ideally define in detail the functions and risks undertaken by the parties and the expected outcomes at the time of entering into a transaction.  Therefore the contract will be assessed first when analysing the appropriate allocation of profit between parties.

Consideration of risks

Under the new guidance issued by the OECD, companies will have to perform an expanded functional analysis of risks associated with each entity.

As risk is inherent in business activities, identifying risks is an integral part of a functional analysis.

In assessing and responding to risk associated with commercial activities, there must be consideration for the following three elements:

  1. Whether there has been a contractual allocation of economically significant risks;
  2. Whether the entity assuming the risk has control over the risks. There is updated and detailed guidance from the OECD on what “control” means in this context; and
  3. Whether the entity has financial capacity to bear the risks.

There is detail behind each of these three elements that must in turn be considered to ensure the functional analysis is correctly carried out. In an ideal scenario, there will be consistency, meaning the entity which has been allocated the risk in the contract has actual control over the risk and also the financial capacity to bear the risk.

If the conduct differs to what it is in the written contract tax authorities may seek to reallocate profit between the parties. Clearly such a situation produces a level of uncertainty that most taxpayers would seek to avoid.

Practical considerations

We have set out below steps for companies to follow in getting intercompany contracts “BEPS ready” in an efficient and cost-effective manner.

  1. Determine if there are any significant intercompany transactions for which there are no contracts in place.  These will be of greatest risk to challenge by tax authorities.  Implementing a contract that aligns with the conduct will remove uncertainty.
  2. Determine which existing contracts or transactions should be analysed.  The focus should be on higher risk contracts that allocate risks such as contract R&D or limited risk distributors.
  3. Identify the significant functions and risks (including the control and capacity to fund those risks, as discussed above).
  4. Compare the contractual allocation and the function and risk analysis to the intended characterisation of the entity.  For example, if the entity has been characterised as a limited risk distributor, the results of the function and risk analysis should support this characterisation.
  5. Determine if any changes to the contract or conduct are required to support the intended characterisation of the entity.

Disclosure requirements

The increased disclosure required under the OECD’s master file and local file requirements will highlight any discrepancy between contracts and conduct. There are a number of specific requirements of the master file and local file directly relating to the provision of contracts and the respective functional analysis.

Additionally, NZ Inland Revenue have released proposals that propose to shift the burden of proof from Inland Revenue to the taxpayer in a dispute.

It is important that companies have robust and aligned contracts in place as any discrepancy may be challenged.

If you need advice in considering whether you comply with the new Transfer Pricing Guidelines, or you need assistance in compiling or updating your intercompany contracts or master or local file, contact your usual Deloitte advisor. 


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