Keep-well agreements are intercompany contracts that oblige the parties to make compensating adjustment payments, for example, year-end adjustments, if certain targets are missed. For instance, a low-risk distribution company and its principal may agree that the distributor should earn an arm's-length operating margin. If at year-end the actual operating margin deviates from the target, there will be a compensating adjustment payment.
This type of agreement enjoys increasing popularity among multinational groups as a way of reducing compliance costs. This cost reduction results from separating the management aspects of a transfer-pricing system from its tax aspects. The compensating adjustment that reconciles the actual profit level indicator with the target allows multinationals to structure their daily transfer-pricing independent from their tax needs as long as the taxable income is at arm's length. Therefore, with keep-well agreements taxpayers need be concerned only with whether their profit level is at arm's length and not with formal questions such as whether the underlying transfer pricing method was correctly applied.
Keep-well agreements and the transactional interpretation of the arm's-length principle
Transfer-pricing problems in tax audits often arise because tax inspectors take a formal approach either to the interpretation of transfer-pricing guidelines or to the existence of intercompany agreements. The Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD Guidelines) do not require companies to implement the methods identified by the OECD, but only suggest these methods to test compliance with the arm's-length standard. Nevertheless, many European tax authorities treat the OECD guidance as binding. For example, some European tax authorities deny taxpayer use of profit-based methods such as profit split, transactional net margin method (TNMM) or comparable profits. This reluctance is a consequence of the tax authorities' strong preference for the transactional approach to the arm's-length principle, as articulated in the OECD Guidelines. See for example, OECD Guidelines chapter II paragraph 2.5. However, this focus on transactional methods raises compliance costs for multinationals, as it often results in cherry-picking individual transactions, and often leads to challenges to global compensating adjustments that are intended to compensate negative margins on individual transactions.
Definition of a transaction
The OECD Guidelines and some European countries' rules state that transactional transfer pricing methods must be the first approach used by taxpayers in determining the arm's-length nature of their controlled transactions, and that profit-based methods should only be used "when traditional transactional methods cannot be reliably applied". See OECD Guidelines chapter III paragraph 3.1. The guidelines do not, however, define a transaction. A transaction may be defined as the transfer of one product, but it may also be defined as a product group or business line. There may be strong economic and commercial relationships between separate transactions so that only a combined analysis of separate transactions will be reliable.
In Europe, however, not all tax courts seem to accept this view. In two similar but distinct cases, a Dutch supreme tax court (Hoge Raad, June 28 2002, Nr 39542, regarding a car-importer) and the highest German tax court (Bundesfinanzhof (BFH) ruling from February 17 1993) came to different conclusions on the issue of aggregating profitable transactions with similar loss-making transactions. In the cases at hand, a local distribution company imported products from a foreign affiliate. Whereas most of the imports resulted in profits, the distribution company earned losses on some products. In both countries the tax inspectors argued that transfer prices set for the loss-making products did not correspond with the arm's-length principle.
While the Dutch tax court evaluated the arm's-length nature of the transactions by looking simultaneously at the entire product range, the highest German tax court denied such an approach and adopted a transaction-by-transaction approach. The court rejected arguments that it would be appropriate to offset the loss-making transactions with those transactions that resulted in a profit.
The two cases noted above are simple compared with many other relationships between affiliates. Often, local companies receive both products and services from foreign affiliates, including management support and marketing support. In some cases foreign and domestic companies are so intertwined that it seems inadequate to look at individual transactions and neglect their relationship with other transactions. In these cases tax inspectors seem to ignore that one transaction takes place only against the background of the other intercompany transactions, for example, products are imported only because the company also purchases certain related services at the same time.
Furthermore, to apply the arm's-length principle in a fair and adequate way, it is necessary to take into account the special relationships between many international affiliates that are not comparable to the relationships between unrelated parties. Thus, the arm's-length test has to rely on theoretical considerations instead of empirical observations.
The application of such a relational approach provides one potential solution to the problems presented by a rigid transaction-by-transaction approach. Such a view takes the complex relationships into account and tests the arm's-length principle on a global basis by bundling several, if not all, intercompany transactions. Thus, the relational arm's-length principle tests whether independent parties would enter into a similar arrangement. This is usually answered affirmatively, if the affiliates still earn an arm's-length return taking all the related-party transactions into account.
Tax authorities may assume that unrelated parties would never agree on an overall remuneration on the entity level and would always refer to individual transactions. However, the common use of commissionaire and contract manufacturer agreements suggest that this might not be completely accurate.
In commissionaire and contract manufacturer arrangements third parties follow the logic of keep-well agreements in structuring their transactions. Typically, they receive several types of commodities from a principal, very often accompanied by management, marketing, and logistics services. However, instead of determining a separate price for each individual transaction or category of transactions, both unrelated parties agree on an arm's-length gross or net profit, which typically depends on some performance measure such as costs or sales and a mark-up or a margin.
This process is driven by the fact that the sheer number and types of transactions between the principal and the commissionaire or contract manufacturer makes it simpler to determine an entity-based remuneration rather than transaction-based prices. Given that affiliates of an integrated organization are usually even more integrated than a principal and an unrelated commissionaire, this suggests that in such an integrated setting it is even more likely that hypothetical unrelated parties would agree to an arm's-length profit instead of tying results to individual transfer prices.
Finally some tax authorities have applied the relational arm's-length principle, at least in certain circumstances. For instance, where distribution companies earn losses, tax authorities typically reject evidence that the individual transfer prices comply with the arm's-length principle. In these cases the view is that comparable uncontrolled prices are irrelevant because an unrelated party would cede a business that earns only losses. In other cases tax authorities have challenged transfer-pricing regimes based on analyses of the profit position of the tested party and its related trading partners. Therefore, while some tax authorities might be harder to persuade than others, there may be a basis for arguing in favour of the relational approach as it applies to the acceptability of a keep-well agreement.
Compensating adjustments
Another situation where a transactional approach to transfer pricing raises compliance costs is compensating adjustments. For multinationals, compensating adjustments may considerably simplify the daily operation of a transfer-pricing system. Furthermore, the motivation for the compensating adjustments typically is to comply with the arm's-length principle. However, quite often such attempts result in the potential for double taxation.
For example, multinationals experiencing losses very often anticipate the problems of future tax audits by adjusting the losses through year-end lump sum payments. Such payments often take the form of marketing support, credit notes or retroactive transfer-pricing adjustments. However, under the transactional arm's-length principle, tax authorities often see these payments as evidence that the original pricing violated the arm's-length principle. They challenge the payments, particularly if there is no written intercompany agreement to support such payments, and/or if they do not refer to individual transactions. Furthermore, even tax inspectors auditing the receiving company sometimes challenge the lump-sum payments, because they believe that there are other transactions that should have also triggered compensating adjustments.
Tax authorities take the position that compensating adjustments violate the arm's-length principle because they eliminate the risk of losses, and because such agreements are not common between unrelated parties, each of whom normally assumes some risk of loss.
However, unrelated third parties often enter into contracts that provide a very explicit shift in risk that in effect provides significant protection to the financial results of one of the two parties. Such agreements include:
Contract manufacturing agreements in which prices are in effect set on a cost plus basis
Take or pay contracts in which the buyer agrees to either buy a minimum amount of product or, if they do not buy, to pay for it anyway
Price protection, in which the seller agrees to "protect" the buyer against any future reductions in prices
Right of return provisions in which unsold inventory can be returned to the seller
Pricing adjustment arrangements in which a distributor is charged in essence a "list" price that is adjusted after the distributor sells the product to a price that leaves the distributor with a pre-agreed gross margin
There may be other reasons, unrelated to transfer pricing, that would motivate affiliated companies to enter into keep-well agreements. For instance, affiliated companies frequently are more specialized than unaffiliated companies and manage narrower product portfolios. It is conceivable that an unrelated investor would be only willing to assume the resulting market risks from specialization, if there is some form of risk sharing. Thus, it seems that tax authorities' criticism of compensating adjustments is often the result of the application of the transactional instead of relational arm's-length principle.
Keep-well agreements assign a fixed margin or mark-up to international affiliates that perform standard functions such as distribution, routine production, or provision of services. Determination of the fixed margin usually makes reference to benchmarking studies. If the managerial transfer-pricing system misses the margin or mark-up, a compensating adjustment payment reconciles actual data with the predetermined goal. It is this simple mechanism that allows a clear separation between management and fiscal transfer pricing issues. Since the compensating adjustment payment often occurs in a year-end lump sum fashion based on targeted returns, there is no danger of tax issues interacting with daily operational issues or vice versa. Furthermore, it is simple enough that most tax departments of international corporations are able to handle it. To obtain tax authorities' acceptance of this system, however, the following processes and structures are suggested.
Form of agreements and supporting analyses
Many tax authorities are not inclined to accept keep-well agreements, often claiming that the fixed-margin approach is vulnerable to manipulations. To address these concerns, it is important to have written agreements signed in advance. Otherwise, tax authorities may challenge the agreements as violating the arm's-length principle on purely formal grounds. Furthermore, it is important to describe the process of determining the margin. This process can either refer to margins earned in transactions with unrelated parties or profit-level indicators of comparable organizations. Last but not least, it is important to specify the process of determining the compensating-adjustment payment. Therefore, to the extent possible, it is important to structure the agreement in such a way that it supports the arm's-length principle.
In some cases, such support will be based on economic analysis. Such an analysis may show, for example, why it is more logical to group different transactions into a single bundle than to evaluate them separately. In other cases, this support may be based on references to arm's-length transactions. In this regard, even if a distribution agreement between two third parties is not "comparable" for the purpose of establishing prices, it may nevertheless be an important piece of documentary evidence about pricing practices.
Keep-well agreements can also be flexible. While the general concept behind a keep-well agreement is to include contractual terms that: (i) define the set of transactions treated in common under the agreement and (ii) provide a mechanism for making a payment that protects the financial results of one of the two parties to the transaction, the agreement can provide for adjustments on a quarterly or monthly basis rather than an annual basis, and can define the entire legal entity results as the covered transactions or exclude some subset. For example, consulting services may be excluded from the keep-well agreement, and the agreement itself can be structured so as to mirror pricing adjustments that occur at arm's length, for example, as take or pay contracts.
Often, the contracting parties must provide some detail of internal budgeting processes. For instance, multinationals make reference to budget meetings in which contracting parties agree to the process of determining the target margin. It is helpful if summary notes of these meetings are available. For many companies the budgeting process is quite standardized and formalized. Quite often, detailed annual time-schedules are available. If so, it is helpful if the agreement can refer to these schedules.
The events that trigger compensating adjustment payments require clear identification. In the simplest form of the agreement any deviation between actual and targeted margins triggers a corresponding compensating adjustment payment. However, for some multinationals something more sophisticated than an automatic adjustment might be more appropriate. For example, it is not unusual for companies to agree upon compensating-adjustment payments that refer to deviations between budgeted and actual cost components or to identify corridors that must be left to trigger adjustment payments.
Refinement of the events that trigger adjustment payments may also be necessary from a different perspective. As adjustment payments effectively remove some of the risks of the company being targeted, they may trigger an agency permanent establishment (PE) to the extent that they remove all risks.
According to the OECD Model Tax Convention on Income and Capital, one of the features of an agency PE is the distinction between dependence and independence. To avoid an agency PE, the targeted company must be independent. One criterion to determine independence is the risk assumed by the agent. A common view has been that a company earning a fixed and guaranteed profit is not independent and therefore creates a PE for the company that effectively assumes these risks. However, a company earning a provision based on economic success, such as sales, assumes sufficient risks to characterize it as independent. This discussion shows that under normal circumstances it should be possible to avoid situations where keep-well agreements create a PE risk. In fact, under normal circumstances agreements targeting a margin, that is, relative profits instead of nominal profits should usually not create any risk of creating a PE.
Different demands
Multinationals may set management prices in many ways that deviate from OECD transfer pricing methods for reasons completely unrelated to taxes. This raises the important question whether it is possible to reconcile tax authorities' demands for compliance with OECD transfer pricing methods with the economic needs of multinationals. We have suggested one method, the keep-well agreement, which enjoys increasing popularity in the age of increasing documentation requirements and compliance costs. This approach relies on assigning fixed target margins to entities performing routine functions, which in turn allows the multinational to use whatever transfer-pricing methods fit best for day-to-day operations and transactions. If the statutory margin deviates at year-end from the target, the benchmarked entity either receives or pays an adjustment amount that reconciles the statutory margin with the target.
This approach has been defended as being at arm's length on the basis that unrelated parties in some situations also rely on gross or net profit targets as opposed to transaction-based transfer prices. Taking into consideration that economic integration between international affiliates is usually much deeper than between related parties, it seems much more appropriate to rely on a relational approach to the arm's-length principle instead of a transactional approach. Under such a relational approach the target margin approach seems defendable and economically reasonable.
Biographies |
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Henrik Lund is a transfer pricing and international corporate tax manager. He joined KPMG's Danish tax practice in 2001, but is seconded to the transfer-pricing group in KPMG Meijburg & Co, the Netherlands, to facilitate KPMG's international knowledge sharing. Lund's client relationships focus on multinationals with Dutch and Nordic operations across various industries, including industrial manufacturing, electronic equipment, chemicals and plastics, transportation, telecoms, consumer goods, and wholesale. His professional experience includes assisting numerous multinational groups on various multi-jurisdictional transfer pricing, tax and value-chain transformation projects. He carries out tax and transfer-pricing due diligences with respect to M&A transactions, has assisted several clients during transfer-pricing audits and helped clients negotiate advance pricing agreements. He holds a master's degree in commercial law and business administration combined with a BSc degree in commercial law and business economics and macroeconomics.
Before joining the transfer-pricing group of KPMG in Germany in 1999, Christian Scholz worked for the Kiel Institute of World Economics at the University of Kiel as a research fellow. He has extensive experience in transfer-pricing documentation, defence, and tax-driven transfer-pricing work. He has written a number of transfer-pricing articles in national and international journals. Scholz has assisted a number of clients in developing transfer-pricing systems in post-merger-integrations. In the last two years Scholz has assisted a range of well-known clients with significant intangible assets. In addition, he has assisted member firm clients in restructuring projects that involved transfer-pricing issues with cross-border shifting of functions and risks and helped implement cost sharing systems. He has particular experience in valuation and transfer pricing systems. Scholz holds a PhD in economics and works with healthcare, pharmaceuticals, software industry, consumer electronics, Japanese and US member firm clients. |
