Intercompany Agreements: What You Need to Know

When emerging companies expand outside of their home country, they’ll often create subsidiaries in the new jurisdictions for administrative, tax and legal purposes. Legal and tax advisors usually recommend putting in place written agreements between the parent and subsidiary to govern transfers of funds, intellectual property (IP) ownership and management of other assets. While companies may prefer informal relationships between related companies, formal intercompany agreements serve some important needs.

Here’s a high-level overview of intercompany agreements, including the purposes they serve and some common types of these agreements.

Why enter into intercompany agreements?

Parents and subsidiaries are separate legal entities, so they need to maintain separate accounting, tax and corporate records. This separation helps ensure that liabilities of one company are not extended to the other. Governments are more likely to respect this separate legal existence when each entity follows proper corporate formalities – rather than being treated by management as if they were a single entity. Formal intercompany agreements, rather than informal arrangements, help support this separate treatment. Intercompany agreements can also be important for tax compliance across jurisdictions and avoid multiple taxing authorities claiming that a portion of income from sales by the parent company, or even from a sale of the parent company, should be allocated to the local jurisdiction and subject to tax.

For purposes of the discussion below, we’ll assume that the existing company is the US parent company, and it has formed a sub to operate in a country outside the US. For groups with parent companies incorporated outside the US, similar structuring and intercompany arrangements will apply, also driven by the applicable tax and accounting regimes in the jurisdictions where the parent and subsidiary companies are incorporated.

Factors in structuring intercompany agreements

Here are some key factors to consider when structuring intercompany arrangements:

• Business role of the subsidiary – Subsidiaries can perform many different functions, such as research and development, sales, or support services. The nature of the subsidiary’s business will affect the legal arrangement between the parent and subsidiary.
• Tax position of the parent – The parent-subsidiary arrangement may be structured in a manner that might shift income to jurisdictions with lower tax rates while increasing deductions and losses in higher tax jurisdictions to minimize the overall tax burden on the business.
• IP ownership – Existing IP rights, such as those around the technology platform, products or services, typically are held by the parent at the outset. When development teams are engaged outside of the US in a new subsidiary, it is usually advisable for the resulting IP to be assigned up to the parent, so that all IP is held in one entity. The intercompany agreements help ensure that the IP belongs solely to the parent, so a foreign jurisdiction cannot claim that a portion of the IP belongs to the subsidiary due to its contribution to any development.

Types of intercompany agreements

Here’s a summary of the most common varieties of parent-sub arrangements that might be formalized by an intercompany agreement. The appropriate structure for any group of related companies will depend on a number of factors, including those discussed above, and should be discussed with the company’s legal, tax and accounting advisors.

1. Parent as holding company

This is the most commonly used structure for emerging companies. Under this arrangement, the parent obtains funding from venture capital or other sources, owns all technology and IP, and makes sales to customers. The parent funds the subsidiary through ”cost-plus” intercompany arrangements, under which the parent pays the employment and related operating costs of the subsidiary, and in return, the IP developed by the subsidiary employees and other personnel is assigned up to the parent. Under a “cost-plus” reimbursement structure, the subsidiary charges the parent for its costs together with a percentage markup on those costs (the “plus”), ensuring the subsidiary makes an arm’s length profit on the work it carries out for the parent. Accounting advice on the appropriate markup percentage is needed to ensure compliance with the transfer pricing rules of the US and the subsidiary’s jurisdiction. This will typically involve a “transfer pricing study,” under which accounting and/or tax advisors look at the appropriate profit margins of similarly situated companies.

2. Subsidiary as reseller or distributor

The parent, as owner of the underlying technology and IP, appoints the subsidiary as a reseller or distributor of the products or services in a single jurisdiction or a broader territory. The subsidiary contracts with customers, receives revenues and pays the parent either for the products or, by way of a license fee or royalty, for use of the technology and IP. This ensures the subsidiary receives a profit on the reseller/distributor services it performs for the parent. Again, accounting and/or tax advice is required to ensure compliance with applicable transfer pricing rules.

3. IP cost sharing

In this arrangement, the parent and subsidiary agree to split the cost of further developing the technology and IP. Each then has rights in the technology and IP, often based on geography. For example, the parent might own rights to sell in North America, and the subsidiary has rights to sell in the rest of the world. This is a more complicated structure, requiring significant tax planning and implementation. Recent changes in US tax law, as well as changes in tax policy led by the Organisation for Economic Co-operation and Development and numerous European countries, have made these arrangements less favorable. In addition, these setups are often not appropriate for early-stage companies.

4. Administration/management services

In this arrangement, one party provides management, financial, human resources and administration services to related companies, which is often paid for on an arm’s length basis by the recipient of the services, and documented in an intercompany administrative services agreement.

Some parent-subsidiary arrangements are more complex and beyond what we can cover here, such as “flips,” where a new parent company is formed to own the existing company, which thus becomes a subsidiary of the new parent. As an example, this Cooley GO article discusses flips and some of the common structuring alternatives available for Latin America-based companies.

Once you and your advisors have decided on and documented the appropriate intercompany agreement and, where necessary, a transfer pricing study, make sure to review and update it regularly to ensure compliance with the legal and tax regimes of the relevant countries.

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