To what extent are a multinational enterprise's intra-group contracts respected for transfer pricing purposes?
While the arm's length principle is meant to be the guideline and reference of any intra-group contract, in order to spread as fairly as possible the income derived from a transaction, this may not always be the case in practice in a situation where parties are related and respective interest may not be divergent. In such cases, article 57 of the French Tax Code (FTC) enables the French tax authorities (FTA) to rectify the income statement declared if any profit has been shifted indirectly out of France, notably via non arm's length contractual terms.
By way of principle, the French tax law still very much relies on the contractual terms when analysing an intra-group transaction. The contract remains the starting point of any tax or transfer pricing analysis, just as outlined by the Organisation for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines recommendations (Chapter I, Part D.1.2.3 paragraph 1.52 and Chapter IX, Part I.B.1, paragraphs 9.11 and 9.13, for instance). In the field of the French Civil Law, intra-group contracts remain protected by the freedom of contracting, which means that generally the FTA, as any third party, are bound by the terms of the contract. Conversely, the French civil law does not regulate the level of prices to be determined between the parties or does not provide any form of principle to be complied with when setting up said prices, notably because it would contradict the very principle of contractual freedom mentioned above.
This was illustrated recently when the French Supreme Court (Conseil d'Etat - "CE") gave up the theory of the excessive risk, under which the French judge was able to challenge the deductibility of an expense generated under an operation which would "blatantly" put the concerned company in an excessive risk position: the CE judged that it does not belong to the judiciary body to characterize such a risk and take any consequence from it (CE, July 13, 2016, SA Monte Paschi Banque). More generally, the FTA are not allowed to challenge or discuss the acts of management of a company, notably the contractual terms of its relationships with other parties.
Despite the above, the FTA remains authorized, regardless the contractual position of the parties, to reassess the amount that had been unduly shifted from one party to another, based upon the economic reality, determined under a fair transfer pricing policy. This is the exception to the contractual freedom, set-out by article 57 of the FTC.
If an intra-group contract shows a contradiction with the economic reality of the group, or an abnormal act of management, a tax reassessment can be made to re-establish an arm's length price between the parties and the concerned transaction may eventually be recharacterized accordingly. This illustrates a form of autonomy of the French tax law vis a vis French civil law. However, the CE considers that such mismatch is subject to reassessment except if the concerned act of management can be justified by the reassessed company's own interest, notably when reviewing the terms of the concerned contract. This principle has been applied constantly (CE September 26, 2001, SA Rocadis), and notably in a recent case (CE November 21, 2012, MIN VS PWC), whereby the CE has reviewed a merger agreement and its protocol to identify certain advantages and corresponding obligations of joining a worldwide network, and to consider that certain contributions paid under these arrangements were justified and tax deductible. In another case (Appeal Court of Nancy, August 2, 2007, Clarins BV), the French taxpayer has been able to demonstrate such own interest in a situation whereby it was paying service fees under an intragroup contract which could not be subject to early termination. Such an early termination would have exposed the French paying party to the risk of an indemnification of the other related party, hence justifying the payment of the fees until the term of the contract (and being noted that invoices where documenting the content of the services provided as well). This analysis is actually very much in line with the recommendation of the OECD Transfer Pricing Guidelines (Chapter IX, Part I.E.2, paragraph 9.106, notably).
It should be noted that the FTA are not allowed to deem inapplicable the concerned contracts, but only to amend the economic consequences of said arrangements, when not aligned with the arm's length principle, and except if the abuse of law procedure is implemented. Indeed, in exceptional circumstances, the FTA can use the abuse of law procedure (article L 64 of the French Tax Procedure Code) to literally consider that a contract cannot be opposed, in all or in parts, when its terms are simply fictitious and do not disclose the reality of the operations between the parties. In such a case, the burden of the proof lies with the FTA, and the authorities will need to demonstrate how and why the contract is not aligned with the facts.
To sum up, while intra group contracts should be by way of principle respected by the FTA and used as the primary source of information to determine the respective rights and obligations between related parties, they are not always binding on the FTA, which can rely on economic terms and reality to rule out such agreement and proceed to a corresponding reassessment.
How much emphasis is placed on related party agreements as part of a taxpayer's transfer pricing documentation, or as an important source of functional analysis information?
As a reminder, there are now many provisions under the French Tax law requiring transfer pricing documentation obligations to be complied with, namely article L 13AA (specific obligation beyond certain thresholds) and L13 B (general obligation if a transfer of income is deemed demonstrated by the FTA) of the French Tax Procedure Code and article 223 quinquies B (short form to be provided for companies under the article L 13 AA of the French Tax Procedure Code obligations) and finally article 223 quinquies C of the French Tax Code (new CBCR obligations).
It should be noted that none of these articles specifically requires the provision of the related party agreements as part of the documentation to be gathered and submitted. That being said, it is obvious that these agreements must be ready to be disclosed contemporaneously with any applicable TP documentation, and must match the content of such documentation in terms of functions and risks description, remuneration method and levels, nature of the operations and involved parties etc… .
In addition, if the procedure of article L 13 B of the French Tax Procedure Code is implemented, it is very likely that the FTA will directly require any related party agreement in addition to the TP documentation as such.
More generally, in the course of any tax audit or review of the TP documentation, the FTA will almost every time require such contractual elements to be provided, and sometimes even require such elements before any further TP documentation, notably for smaller audited companies.
What content is expected to be found in related party agreements?
The usual features of any contract are expected to be included: object of the contract, respective obligations and responsibilities of the parties, price and conditions, term etc… .
Obviously, for transfer pricing purposes, the price section is important and should include as many details as possible, including:
- The remuneration method
- The use of a budget costs method and/or an actual costs method, and how it applies and is updated from one year to another
- If based upon costs, the remuneration basis should be as precise as possible on the direct and indirect costs to be applied, and if multiple parties are involved, the allocation method of these costs should be also included (e.g. management services provided to multiple related parties)
- The documentation of the various components relied upon for the remuneration method
- The true-up mechanism if any, notably if a TNMM method is applied
- The notification mechanism in case prices derive during a given year from the norm as set-out by the contract, and how such solution is resolved
It should be noted that it became market practice to have the price section set-out as an appendix, to simplify the amendments over time, without impacting the remainder of the contract, or even amend it by way of exchange of consent over said appendix.
Attention should be also paid to the other clauses, depending on the nature of the operations involved in the agreement. The term of a contract and how early termination mechanisms work can be crucial, notably as the FTA may rely on said clauses to either request an indemnification of the terminated party, or request that the contract is maintained if improperly terminated. Similarly, it is key to have a contractual description of the operations, respective obligations and responsibilities that matches the parties' functions and risks for transfer pricing purposes.
To what extent can taxpayers be held to their related party agreements, even if they are not in line with normal commercial arrangements or economic reality?
There may be situations in which the FTA may use a contractual arrangement in place or formerly in place and oppose its conditions to the taxpayer, even if said conditions are not or no longer in line with the economic reality of what would be expected under normal commercial relationships. We have seen situations whereby the FTA would:
- Rely on mark-up rates in contracts which are in place, and despite the fact that the updated transfer pricing analysis showed that these rates are no longer appropriate. It is therefore key to update regularly the contracts which are enforced to avoid such situations.
- Make references to former contracts providing for a higher remuneration and challenge new ones providing for a lower one, notably in post-acquisition situations, where the acquired company sees its profitability decreasing. Here again, only a proper transfer pricing documentation can explain the change, due to changes in the functional profile of the acquired company or due to the fact that it may have been over-remunerated under the previous ownership. These justifications should ideally be included, in all or part, in the new contractual framework between the parties and tie-in with the new TP documentation.
- Request an indemnification for early termination, as provided formally or not by the intragroup contract, despite the provision of proper evidence of the mutual interest of the parties in cancelling said agreement. Again, documenting the termination and laying out contractually the mutual benefits of said operation is key.
These cases illustrate the need to match as much as possible and as regularly as possible the contractual and the economic framework of an intragroup relationship.
Is the situation different for certain transactions? For example, financial ones?
No, there is no specific treatment based upon the nature of certain transactions, being financial ones or not. They should all be reviewed under the same principles as the ones laid out above.