FREE CHAPTER from ‘Intercompany Agreements for Transfer Pricing Compliance: A Practical Guide’ by Paul Sutton



Despite the title of this book, transfer pricing is not the decisive factor for the design and management of intercompany agreements. Corporate governance considerations are fundamental to the viability of any structure which involves legal entities and not merely natural persons. A system of intercompany agreements which is created ‘for tax’, and which does not respect the governance needs of the individual legal entities which comprise the group, is unlikely to withstand scrutiny, and may well create personal liability risks for directors. Issues of corporate and subsidiary governance affect matters such as:

  • The design of internal and external supply chains

  • The selection of transfer pricing policies

  • Which intercompany agreements are required, including parent company guarantees

  • The terms of those intercompany agreements as regards the allocation of functions and risks to each individual entity

  • The process for requesting subsidiary board approval of intercompany agreements, so that subsidiary directors have the opportunity to give informed consent

  • Processes for periodic review of intercompany agreements, to ensure that they remain appropriate, notwithstanding internal and external changes affecting individual legal entities

This chapter provides an overview of the fundamentals of corporate governance and subsidiary governance, and the supporting role which intercompany agreements play. It also offers some practical tools which company directors and their advisers can use when creating or assessing intragroup structures.

Legal entity perspective vs line of business and
functional management

Many corporate groups are managed by reference to business functions and lines of business, and their reporting structures therefore do not directly reflect the legal structure of the group. However, if the decision-making process is not consistent with the legal structure, this can create potential liability exposure for officers.

Ultimately, a ‘group’ has no legal existence, and the only way that a corporate group can interact with third parties is through legal entities and individuals which have the legal capacity to hold assets and to sue and be sued. The more a corporate group carries on its operations through subsidiary entities, the more significant subsidiary governance becomes.

What are corporate governance and subsidiary governance?

Corporate governance can be defined as the system by which a company is directed and controlled. Traditionally, the main focus of corporate governance has been aimed at parent company level, initially in relation to companies whose securities are listed on a stock exchange, and latterly also in relation to larger privately owned groups. Typical corporate governance mechanisms include bodies and functions such as audit committees, remuneration committees and non-executive directors; and principles such as separating the roles of chief executive and chairman, and disclosure of personal dealings in securities by directors.

At its simplest level, subsidiary governance respects the separate legal status of subsidiary entities, and (crucially) the legal duties of the directors or officers of those legal entities.

Why may multiple legal entities be required in a
multinational enterprise?

In theory, it would be possible to run an international business as a single corporate entity established in one country, with branches or ‘establishments’ in a number of other countries. In practice, it is often commercially and administratively convenient to operate through local subsidiaries which are separate legal entities. The reasons for this include:

  • A perception that local customers or suppliers may prefer to do business with a type and location of legal entity with which they are familiar

  • Ease of raising finance which is secured on specific assets

  • Ease of opening bank accounts

  • Ease of making other administrative arrangements locally, such as establishing pensions or benefits arrangements for members of staff

  • The desire to separate the commercial or financial risks of one part of the group’s business from other parts. This may apply, for example, to trading activities which are more volatile in nature than other business activities carried on by the group, or exposure to product liability risks in particular markets

  • The need to obtain regulatory permissions in order to carry on business in a particular country

  • The ability to offer equity participation to local staff or joint venture partners through minority shareholdings or share options in local entities

  • Convenience in effecting the sale of part of the business conducted by the group, by selling the shares of the relevant company or companies.

In addition, the growth strategy of many corporate groups involves acquiring other businesses, which may themselves operate through a corporate group structure. Therefore even if the acquiring group has a strategy of minimising the number of legal entities through which it operates, the process of integrating recently acquired businesses will include managing the relationships between new subsidiary entities and the rest of the group.

Corporate benefit vs group benefit

In general, the directors or officers of a legal entity are subject to personal duties to promote the interests of that specific legal entity. The interests of a particular legal entity are unlikely to be identical to those of the ultimate parent company or of other group companies.

There can be an assumption that whatever benefits the corporate group as a whole (or its parent entity) will also benefit each subsidiary company. This view can be linked to the assumption that a subsidiary company will always receive the support of the parent company. This assumption is clearly not justified, and failure to appreciate this is one of the root causes of intragroup arrangements which lack legal and commercial substance.

There can also be an assumption that arrangements which have been approved for tax purposes (such as intercompany transactions which are the subject of an Advance Pricing Arrangement (APA) which is approved by one or more tax authorities) are automatically appropriate from other perspectives. Again, this is simply incorrect. For example, an arrangement entered into pursuant to an APA may involve a particular company making losses in certain circumstances, and may result in that company becoming insolvent (either on a balance sheet basis, or a cashflow basis, or both). The approval of such an arrangement by the relevant company’s directors may create a risk of personal liability, notwithstanding the fact that the APA has been approved by the tax authority in the company’s jurisdiction.

Conflicts of interest of directors

One of the primary aims of corporate and subsidiary governance is to appropriately manage any conflicting duties or interests which key individuals may have – particularly directors and other officers. Those duties or interests may arise from multiple roles such as:

  • Directorships held in multiple group entities

  • Directorships held in joint venture entities

  • Positions held on governance committees at group level

  • Acting as employee or consultant to one or more group entities

  • Holding shares or share options in related entities

  • Acting as a trustee of pensions schemes, employee benefit trusts or similar structures

  • Membership of professional bodies

  • Compliance roles held, such as Senior Accounting Officer in the UK

  • Public offices held

  • Directorships or commercial interests held in unconnected undertakings

Personal liability risks for directors and office-holders

The specific duties and potential personal liabilities associated with particular directorships depend on the constitutional documents of, and laws applicable to, the relevant entities. However, there are some general principles which are helpful when designing and operating corporate groups. To a great extent, these general principles are also consistent with concepts of transfer pricing, including the arm’s length principle.

Personal liability risks for directors include the following:

  • Insolvency – if a company goes into insolvent liquidation, its directors may be held personally liable to contribute to the company’s assets in certain circumstances. Examples include a failure to take steps to protect creditors, starting from the point when the directors knew or ought to have known there was no reasonable prospect of avoiding insolvent liquidation

  • Health and safety regulation – in the event of a health and safety incident, relevant authorities may consider, in certain circumstances, the prosecution of directors personally, rather than merely the corporate prosecution of the legal entity responsible for the incident

  • Environmental matters – personal liability of directors may exist in cases where an offence is committed by a company with the ‘consent or connivance’ of a director or officer or is attributable to the neglect of the director. Offences may include:

    • those relating to environmental permitting, waste and water discharge

    • environmental damage offences

    • offences relating to the international transport of waste

  • Other forms of regulation, such as those relating to medical devices or food and drug safety

Subsidiary director perspective

From the perspective of the director of a subsidiary entity, disregarding the separate legal personality of that entity gives rise to personal liability risks. This can be demonstrated by the following fictional example.

A listed group is planning a substantial acquisition of a stake in an unconnected third party business. A new group subsidiary (Bidco) is established as the prospective purchasing entity. One of the existing members of the acquiring group acts as a finance company (Finco), and it is intended that Finco will lend the purchase funds to Bidco. One of the structuring questions is the possible role of the parent company (Parent) as guarantor in relation to that intra-group loan. In this particular case, the target company’s business is volatile, and the proposed stake is an illiquid asset.

The directors of Finco are being asked to approve the intra-group loan as lender. The size of the loan means that a default would be likely to affect Finco’s overall solvency. It is therefore doubtful whether those directors can properly approve the loan without an explicit, legally binding guarantee from the Parent company and, potentially, other members of the acquiring group.

From the perspective of the directors of Bidco as borrower, the existence of the guarantee may affect whether Bidco can obtain the loan (and its terms), but it would not affect whether Bidco should proceed with the loan. That is because a guarantee does not change the borrower’s liability – if the guarantee were to be called, the borrower would still owe the same amount, but its creditor would become the guarantor instead of the original lender. Therefore an explicit guarantee alone would not be sufficient. In order to be able to properly approve the arrangements, Bidco’s directors would also need to insist on a legally binding obligation from the Parent to contribute the funds by way of capital contribution, equity, subordinated/deferred loan or some other arrangement with similar effect.

Parent company board perspective

Issues of subsidiary governance do not just affect directors of subsidiary entities. Failure to have proper regard to the separate legal personality of subsidiary entities may result in liability risks for the parent company (and potentially its directors) in relation to unlawful conduct of a subsidiary. For example, under the laws of the United States of America, a subsidiary’s illegal conduct may be imputed to a parent company under principles of agency (if the parent company can be demonstrated to have authorised members of the subsidiary’s staff to act as the parent’s agent for the particular type of activity), or on the basis of the theory of ‘mere instrumentality’ or ‘unity of business’. This latter type of liability may arise, for example, if the parent company involves itself in the daily operations of the subsidiary, and is no longer acting as an investor in the subsidiary.

The role of intercompany agreements in subsidiary governance

Intercompany agreements define the legal allocation of duties, risks, rewards and ongoing benefit between associated entities. Those agreements provide an essential point of reference for directors of parent and subsidiary entities when they are considering whether or not to approve a particular arrangement. Without intercompany agreements and ideally supporting corporate resolutions to document the decision-making process, a director is unlikely to be able to show that they have complied with their personal duties to the relevant entities, because there is no clarity as to what they are approving.

The principle of informed consent, and questions for directors

The principle of informed consent requires that the directors of group entities who are being asked to approve specific arrangements be given the information which they need to make a decision. This should form part of the process for approving and reviewing intercompany arrangements. However, the onus is on those directors to obtain the information they need, and it is clearly not a defence for them to claim that they were provided with an incomplete picture. The following questions are intended to help parent and subsidiary directors who are asked to approve particular intragroup arrangements:

  • What roles do I hold which are relevant to these arrangements?

  • In particular, which individual legal entities am I a director or officer of?

  • What obligations is the company incurring under the arrangements, and what is the company agreeing to do or deliver?

  • What fixed cost commitments (if any) is the company incurring (e.g. staff costs, costs relating to premises and utilities, etc.) as a result of entering into and performing its obligations under the arrangements? What costs would the company incur if it had to exit from the arrangements? How long would this take?

  • How will this arrangement effect the company’s cash flow and operations? What capital or funding (if any) will the company require?

  • Who will the company be trading with? What potential claims from trading partners (if any) will the company be exposed to?

  • What other third party claims might the company be exposed to (e.g. public liability, product liability or other claims)? Is the company adequately insured against these claims or are these claims otherwise adequately mitigated?

  • What regulatory risks is the company taking on in entering into and performing its obligations under these arrangements?

  • What capacity does the company have to benefit from the arrangements, both while the arrangements continue and after they have ended?

  • What actual or implied guarantees, warranties and/or indemnities (if any) from related parties is the company relying on? What capacity do those other parties have to meet any liabilities if actually called on?