Our chief economist, Mimi Song, is joined by Paul Sutton and Leiza Bladd-Symms of the U.K.-based LCN Legal, a company that specializes in ICAs. While ICAs are required as part of local transfer pricing documentation, Paul and Leiza discuss why ICAs’ purpose and format continue to cause confusion.

Mimi Song: How have MNCs use of ICAs evolved over the past few years?

Leiza Bladd-Symms: There has been a massive change in the way that multinational companies (MNCs) approach ICAs over the last three years. Previously, the sentiment was that ICAs were a “nice to have” but not essential. Now, there’s a global recognition by tax authorities that a review of transfer pricing tax compliance actually begins with an examination of ICAs and must be referenced in MNCs’ local and master files. As a result, not just large multinationals, but mid- and smaller-ones as well, are giving ICAs renewed focus.

Mimi Song: What exactly is an ICA and what does it typically cover?

Paul Sutton: An ICA in its most basic form is an agreement documenting a transaction, either a sale or a transfer of goods or services, entered into between two or more  associated entities, each of which are part of the same group of companies. IP license agreements, limited risk distribution agreements, loan arrangements, back office service agreements are a few examples of ICAs. ICAs are also developed to document agreements for R&D services, marketing services, cost sharing, cash pooling, IT services and support, among other transactions.

Mimi Song: How much detail should an ICA include?

Paul Sutton: As ICAs need to be reviewed and approved by multiple stakeholders, it’s important to keep the agreements as short and brief as possible and for it to accurately reflect the way the group operates in practice. So our approach is that you have to express the essence of the arrangement, but in a way that is, (1) consistent with the transfer pricing policies and the allocation of lists and functions, and (2) is consistent with the other legal needs of the groups including asset protection, IP protection and the legal governance of the structure as whole. As a result, there’s a really important balancing act between document length and functionality. On the latter point, it must have legal substance so that it’s an arrangement that can be properly approved by the directors of all the participating entities.

Mimi Song: What are the advantages of having an ICA beyond regulatory compliance?

Leiza Bladd-Symms: Bottom line is that in order to be tax audit ready, a MNC must have an ICA in place. However, stepping back from the transfer pricing requirements, there are a number of non-tax drivers for ICAs, including the ability to ring-fence assets and liabilities from risks. Also, strong corporate governance practices at the organizational level require that agreements are clear between companies and signed off by directors.

Mimi Song: What are the consequences of not having an ICA in place?

Leiza Bladd-Symms: The biggest risk of not having an appropriate ICA in place is that the transaction can be re-characterized by the relevant tax authorities, which may lead to the imposition of tax adjustments, fines and penalties. This occurs because an MNC has failed to present a clear position as to their entities’ arrangements and how risks are allocated between the groups. That gives tax authorities the opportunity to look at the circumstances and the facts as they see them, and to characterize the transactions in a way that is most advantageous to them. In certain jurisdictions, MNCs are fined for failing to produce the signed ICAs upon request.

Mimi Song: What specific transactions are the most confusing for MNCs when it comes to draft an ICA?

Paul Sutton: Limited risk distribution agreements are the ones we see the most where there is a discrepancy between what groups think the contracts is and what it actually says. It’s critical that in these types of agreements that you make sure that the contract really does reflect the substantive arrangements in place, for example, who bears the burden as it relates to inventory for unsold products, customer credit risk, etc. It’s critical that the ICA reflects an arrangement that you would agree to as a director of the distributor, but also as a director of the principal firm.

Mimi Song: What are the biggest mistakes when it comes to ICAs?

Paul Sutton: The main mistake is the complete contradiction between what the legal agreement says and what the transfer pricing policy states. It’s not unusual for even FTSE 100 and Fortune 500 companies we work with to make this mistake—oftentimes it’s because the MNC’s legal department is not well versed in the purpose and scope of ICAs.

Second, MNCs will put ICAs in the “too difficult” box and just not get around to them. Third is the adaptation of third party agreements—often 60 pages long—into ICAs when the former’s functionality is not relevant in an intergroup context. Fourth, is not having a central policy to create ICAs—they need to be developed from a holistic perspective. It’s not just about creating something for tax purposes, it’s about creating something that genuinely meets the needs of all the relevant stakeholders in the group. And that means having a central policy and system for designing and updating agreements.

Other common mistakes include agreements that miss signatures, making it non-binding. Key terms might also be missing, which lets the tax authorities make liability assessments.

Mimi Song: What are other best practices when it comes to ICAs?

Leiza Bladd-Symms: There needs to be a process in place to constantly monitor that the ICA documentation accurately reflects reality at all times. That process includes designating certain individuals to be responsible for ICA compliance. It’s then incumbent upon them to periodically revisit ICAs and confirm that it continues to adequately characterize the transaction in practice. IPAs should also be reviewed when there is a material alteration to the MNC’s structure or to the nature of their business, such as an acquisition.

Mimi Song: In what other circumstances is it mandatory to produce an ICA for tax authorities?

Paul Sutton: Currency or exchange controls and customer valuations are two scenarios. One scenario that trips up a lot of MNCS is that for some countries like China, if you want to remit payments from a subsidiary to the overseas parent, you need to produce an ICA as part of the overall documentation.

To learn more about ICAs, listen to this episode of The Fiona Show.