Operational Reality Invalidates Your Intercompany Agreements
In the world of Transfer Pricing, there is a golden rule set forth by the OECD Guidelines (Chapter I): economic reality always prevails over the letter of the law. Even if a legal contract is perfectly drafted, if the functions, assets, and risks (FAR) carried out in day-to-day operations do not align with what is stipulated, tax authorities have the power to disregard it and may recharacterize the transaction.
This “substance over form” principle is one of the pillars most closely scrutinized by SUNAT and other tax authorities to detect discrepancies aimed at artificially shifting profits.
Defining the reality of the transaction
The OECD establishes that, to determine whether a transaction complies with the arm’s length principle, one must first identify the “substance of the transaction.” This is not achieved solely by reading the contract, but by analyzing the conduct of the parties:
- Who makes the decisions? If the contract states that the parent company assumes the inventory risk, but it is the local manager who decides what and how much to purchase, then the actual risk is local.
- Who has the financial capacity? If an entity claims to assume financial risk but lacks the necessary capital to cover a potential loss, the tax authority will not recognize that allocation of risk.
- Who controls the risk? The entity that actually manages the risk and has the operational capacity to mitigate it is the one that should receive the associated profit.
The risk of “paper contracts”
It is common to find business groups whose intercompany contracts have not been updated for years. If the contract defines a subsidiary as a “low-risk service provider,” but in practice this entity develops market strategies, hires key personnel, and assumes credit risks, a material inconsistency arises.
In the event of an audit, the tax authority may disregard the contractual terms and require the subsidiary to receive a higher profit, in line with its true profile—for example, as a “full manufacturer” or “full-risk distributor”—resulting in retroactive tax adjustments, fines, and interest.
How to Mitigate the Risk of Reclassification
To protect the company, having a legal contract is not enough; ensuring operational consistency is essential:
- Periodic FAR Reviews: Conduct interviews with operational leaders to confirm they are following the guidelines and to verify that the reality of the operation aligns with what is stated in the contract.
- Real-time documentation: Meeting minutes, strategic emails, and job manuals must support the terms of the contract.
- Policy updates: If the business model changes, both the contract and the transfer pricing policy must be updated immediately.
Conclusion
In a tax audit, the contract is merely the starting point, but the conduct of the parties constitutes the definitive evidence. Alignment between economic substance and legal form is the only guarantee of legal certainty. A contract that does not reflect reality is not a protection, but rather an exposure to the tax authorities.
Do your contracts reflect your company’s operational reality?
At TPC Group, we specialize in assessing the consistency between economic reality and legal documentation. We help multinational groups shield their operations through in-depth functional analysis, ensuring that their intercompany contracts are a true reflection of value creation and withstand the most rigorous scrutiny by tax authorities.
Source: OECD – Chapter I