When considering the potential tax risks and opportunities arising from a cross-border or multi-jurisdictional M&A transaction, it is crucial to consider transfer pricing early in the process.

Most countries have transfer pricing laws requiring transactions between group companies to be priced on an arm’s length basis to prevent erosion of the tax base. An assessment of whether a related party transaction is arm’s length requires consideration of what pricing an independent entity would adopt in the same or similar circumstances. Where tax authorities find that a group company is not conducting transactions with related parties at arm’s length, they may adjust revenues or expenses, resulting in increased profit attribution and additional corporate tax. 

Failure to properly consider transfer pricing could result in transfer pricing adjustments impacting the buyer’s P&L and valuations. Equally, value can be unlocked as the target is integrated into the buyer’s business and synergies are realized with appropriate transfer pricing policies. 

Preparation for M&A

As a seller prepares for a potential sale, it should review its transfer pricing policies and ensure that all transfer pricing documentation and reporting obligations have been satisfied. 

Inconsistencies between transfer pricing policies and where value is created within the MNE may be identified, which could result in non-arm’s length allocation of profits within the group. This may require revisions to the transfer pricing policy or restructuring of transactions ahead of the deal. 

Due Diligence

The primary purpose of the tax due diligence process is to identify and manage any historic or future potential risks and liabilities in the target. 

The TP review would typically commence with a high-level understanding of the target’s business model and related party transactions, as well as TP policies, processes, and procedures, including whether the transfer pricing documentation and other reporting compliance obligations have been satisfied, and whether external advice has been sought from a reputable advisor. Depending on the results of this initial assessment, further detailed due diligence may be performed.

Some examples of potential transfer pricing risks that may be uncovered during detailed due diligence include:

• Misalignment between contract terms and conditions and actual conduct of the related parties. If the substance of the conduct between the parties is not consistent with the form of the contracts, then this may bring into question the characterization of the transaction and, potentially, the transfer pricing analysis. If, for example, a distribution agreement between the parent company and a related distributor indicates that the distributor acts as a limited risk distributor, but the actual conduct suggests that the distributor is bearing market risk, then this would bring the functional characterization of the distributor into question.
• The transfer pricing implemented may not be arm’s length given consideration of the functional profiles of the entities. An example: Whilst the functional analysis characterizes a manufacturer as a limited risk contract manufacturer, but the profitability of the entity fluctuates widely over recent years, this would not be consistent with expectations.
• The group may have performed some business restructuring that was not addressed appropriately from a transfer pricing viewpoint. For example, a distributor that had previously operated as a distributor bearing market and inventory risk may be converted to a limited risk distributor through transfer of functions and risks to the regional HQ. The distributor experienced a reduction in profitability following the conversion. However, there was no documentation or analysis of whether there should be any compensation for the conversion.
• IP compensation is wholly allocated to the legal owner whilst economic ownership as determined based on Development, Enhancement, Maintenance, Protection, Exploitation (“DEMPE”) functions is located in other entity(ies).

Where potential material transfer pricing risk exists, consideration should be given to whether the group has implemented operational transfer pricing (OTP) systems to proactively manage its transfer pricing policies. OTP involves taking the results of arm’s length transfer pricing analysis for a related party transaction through the record-to-report process and then ensuring ongoing monitoring, maintenance, and analysis of the resulting financial impacts. Whilst not implementing OTP is not necessarily a cause for concern, if it has been implemented, this suggests that the target has prioritized TP compliance and may give a higher level of comfort.

Valuation

Valuation of the target business requires understanding of the impact that TP policies have on the target’s financials. If the TP policies are not appropriate, then this may impact cash flow and tax inputs into the valuation model (e.g., DCF) and, ultimately, the valuation. This emphasizes the importance of the work performed during the due diligence in assessing whether the transfer pricing policies are supportable.

Sale and Purchase Agreement

The SPA should include TP-related warranties as confirmation from the seller that the target company’s related party transactions have been conducted in accordance with the relevant tax laws, including preparation of all required transfer pricing documentation (e.g., master file, local files and Country-by-Country Reporting (CbCR)) and arm’s length principle. If TP exposures are identified during the tax due diligence process, specific tailored indemnities may need to be included in the SPA. Such exposures may also be factored into the purchase price negotiation.

Post Transaction

Post-deal, any material TP risks identified should be revisited and corrected to the extent possible, both to protect the buyer against potential liabilities and to maximize value in case of a future business sale. 

As the target is integrated into the business operations, it will be necessary to consider whether the TP policies need to be revised, or new policies implemented to support new transactions. 

The target company may have implemented different transfer pricing policies or methods from the buyer for transactions, which have similar functional profiles for both the buyer and target. Failure to address these differences quickly after the deal can lead to increased scrutiny from the tax authorities and potential challenges.

Significant value may be created during the post-deal integration. This may come through a number of different mechanisms, including centralization of functions and/or IP, integration of key customer accounts, and consolidation of production volumes. As the acquired group is integrated there may be change in the functional profile of the businesses in the original and acquired entities, which may require a reassessment of the appropriate transfer pricing policies. 

In addition, where there is a transfer of assets or rights between the group entities as part of any post-deal restructuring, it may be necessary to determine an exit charge between the group companies for the restructuring. 

New or modified transactions between the group companies will also require that agreements be implemented or revised as necessary. It is essential that the agreements are consistent with the actual dealings of the parties following any restructuring to avoid potential challenges in the characterization of transactions.

In addition to addressing the pricing of any intercompany debt used to fund the acquisition, the preexisting debt funding of the group may need to be reviewed post-acquisition. For example, pricing of debt funding within the group may be impacted by a change in the applicable credit rating for the overall group.

Compliance and Systems

Increased compliance requirements may arise post-acquisition where new jurisdictions are included in the group. The MNE will need to acquaint itself with the relevant laws in these countries. Transfer pricing documentation and other transfer pricing compliance reporting will need to be updated to reflect the changes in the group structure and any restructuring that takes place.

Where the original and acquired group have different systems for managing and monitoring transfer pricing, these will need to be updated and aligned to ensure consistent practices and information availability.

How A&M Can Help

Whilst it has become commonplace for MNEs to have transfer pricing expertise at a global and regional level, M&A activity creates a temporary surge in the need for specialized transfer pricing expertise. Internal teams may not have sufficient breadth of expertise or the necessary bandwidth to navigate the complexities of a global M&A transaction effectively and efficiently. A&M is able to address the gap with our global network of transfer pricing professionals who regularly deal with complex M&A and cross-border transactions and have a deep understanding of global and local transfer pricing laws and practices. Our transfer pricing team can provide support with every step of the M&A transaction, from the initial preparation for M&A with seller due diligence to addressing the additional transfer pricing reporting requirements for the group.