If you’re looking for more information on the implications of transfer pricing on Mergers and Acquisitions, you’ve come to the right place. It is absolutely important to consider transfer pricing before closing any M&A deal. This can help you to negotiate a better deal and/or avoid financial surprises after the deal is done!
Before we continue, it is important to understand that the main purpose of transfer pricing rules is to examine the ‘arm’s-length’ nature of ‘controlled transactions’. If these terms don’t ring a bell, we advise you to first read our article What is transfer pricing?
M&A – The First Step
In a merger or acquisition process full transparency is important. The parties involved need to understand what’s going on behind the financial scenes. This is usually done through a thorough analysis of the financial information of the target. This is known as a ‘financial due diligence’.
The due diligence provides important insights on the financial position and risks of the target. This affects the negotiations on the purchase price and the success of the deal. Sometimes, a deal has to be cancelled because of the conclusions of a due diligence.
Transfer Pricing and Tax Due Diligence
Tax is generally an integral part of the financial due diligence. A due diligence on tax at the target primarily focuses on risks and obligations in the area of direct taxation (corporate tax, withholding tax) and indirect taxation (VAT, wage tax etc.). However, transfer pricing rules are also part of corporate tax.
And as it turns out, there is often no in-depth analysis on transfer pricing in a due diligence on tax. Rather, the review is limited to a ‘check-the-box’ exercise. The presence of a policy, documentation and Advance Pricing Agreements is analysed. This is wrong. Transfer pricing is a key focus area for tax administrations in most countries and fines can get hefty. So, if the transfer pricing position of the target is not in order, this can have serious financial impact.
Let’s explain this with an example:
Joe Bananas is a company producing bananas. It wishes to expand its product portfolio with apples. In 2017, Joe Bananas approaches Andy Apples, a producer of apples, to seek their interest for an acquisition. Andy Apples is interested.
Andy Apples is willing to undergo a financial due diligence by Joe Bananas. It turns out that Andy Apples has been operating since 2007 through a Hong Kong legal entity (Andy Hong Kong) that owns all the shares in a company in Australia (Andy Australia). Andy Hong Kong buys the apples from Andy Australia and sells these to clients in Hong Kong. Andy Australia does not sell apples to external clients.
The financial administration of Andy Australia and Andy Hong Kong doesn’t reveal much of the controlled transactions among them. It does show that Andy Australia has been making a loss since 2007. The financial advisor, doing his ‘check-the-box’ exercise, asks if there is a transfer pricing policy and transfer pricing documentation. The answer is: ‘no’.
After conclusion of the due diligence, Joe Bananas decides to purchase Andy Apples for USD 1,000,000. This price equals 10 times the consolidated annual EBIT of Andy Hong Kong and Andy Australia of USD 100,000. No guarantees or indemnities are agreed for transfer pricing for internal transactions between Andy Hong Kong and Andy Australia. Joe Bananas is happy with this price and the new product line.
Shortly after closing the deal, the Australian tax authorities knock on the door. They request to review the transfer pricing policy and documentation of Andy Australia. Andy Australia cannot provide this. As mentioned, a transfer pricing has actually never been considered. The Australian tax authorities take the position that the transactions have not happened at Arm’s Length.
The authorities then rule that Andy Australia should have reported a cost+ remuneration on all years since incorporation. 10 years of losses are converted into 10 years of profits. In addition, penalties and interest for late tax payment are due. The total bill presented is USD 500,000. And Joe Bananas has to pay it. Joe Bananas is not happy any more. But with some basic knowledge on transfer pricing, this situation could have been prevented.
Important Transfer Pricing Attention Points
Now you know why it’s important to consider transfer pricing when doing a due diligence on tax. To better understand how to analyse the target, we list 3 important attention points below:
1. Internal transactions and documentation
The main thing to verify is whether the target has controlled transactions. These are transactions that happen inside the controlled environment of the group. Besides ‘visible’ transactions such as the supply of goods and provision of services, there can also be ‘invisible’ transactions such as a guarantee provided to a bank for a group credit facility.
If the target is involved in controlled transactions, the next step is to verify if they are in line with the applicable rules. The following three scenarios could be encountered:
- In the ideal scenario a full-fledged transfer pricing report is available. Then it would be enough to have a critical review of the documentation and assess the risks.
- In a lot of cases transfer pricing documentation is not available for (all) internal transactions. Then you would have to check whether there is other information that substantiates the transfer pricing and critically review it. For example, information that shows that internal clients (i.e. related parties) and external clients are charged the same fees for the same services.
- If there is no substantiation of the transfer pricing at all, the chance is quite high that transfer pricing has never been considered at all. This would require a more detailed transfer pricing analysis to assess the risks.
In the corporate world, ‘restructuring’ means the act of reorganizing the legal, ownership, operational, or other structures of a business. The purpose is to make it more profitable, or better organized for its present needs. Examples are:
- The integration of a new business into an existing business organization (like previous M&A events).
- The centralization of a procurement function.
- Outsourcing manufacturing activities to low-cost countries.
A restructuring generally involves the transfer of assets, functions and risks from one related entity to another related entity. Therefore, a restructuring can result in ‘visible’ or ‘invisible’ controlled transactions like we mentioned above. In those cases there can be a transfer pricing risk.
So, it is important to verify whether the target and related entities have recently been involved in a restructuring. If yes, it is recommended to get a clear picture of what happened. You can start by asking the following questions:
- Which changes have taken place in the last few years in the corporate structure?
- How did these changes affect the use and activities of the related entities involved?
- What were the business reasons for the restructuring?
- Were there other options available for the related entity instead of participating in a group restructuring?
In case a restructuring has taken place, you need to verify whether a remuneration should have been due for a transfer of activities from one related entity to another. This is in principle only the case if the transfer involved assets with excess value, such as a customer base.
3. Intangible assets
The last attention point is the presence of intangible assets at the target. It can be that the legal ownership of assets has been transferred to a related holding company. A common reason for doing this is to allocate revenues of the assets to an entity in a low-tax jurisdiction such as Barbados. This is something that tax administrations don’t like and the OECD recently has taken measures to combat it.
According to the OECD, legal ownership in itself is not sufficient to allocate revenues of intangible assets. In short, a legal owner of an intangible will only be entitled to all of the profits derived from the exploitation of that intangible if he in substance:
- performs and controls all of the functions related to the development, enhancement, maintenance, protection and exploitation of the intangible;
- provides all assets, including the funding necessary for the development, enhancement, maintenance, protection and exploitation of the intangible; and
- bears and controls all the risks related to the development, enhancement, maintenance, protection and exploitation of the intangible
In case the required functionality is not present, there can be transfer pricing corrections for the related entities involved. These corrections can be significant, especially when it concerns businesses where intangible assets are an important value driver. Like luxury fashion brands.
M&A and Transfer Pricing – Conclusions
As you now understand, a good command of transfer pricing rules is very important to assess the tax position of a target for a merger or acquisition.
In practice, a due diligence often doesn’t include an in-depth analysis on the transfer pricing position of the target. Considering the risks and potential financial impact, that is not recommended.
When doing a tax due diligence, specific attention should be given to:
- Internal transactions and documentation;
- Past and future group restructurings and
- Intangible assets.
Good luck with your Merger or Acquisition!
- OECD Transfer Pricing Guidelines (2017)
- Transfer pricing risico’s en overnames, Maandblad voor Ondernemingsrecht / Boom (2015)