Transfer Pricing in the M&A Process Transfer Pricing in the M&A Process

Transfer pricing is a tax topic that often does not get enough attention during the M&A due diligence, as well as afterwards when a deal is closed and the post-merger integration is in process. Buyers and sellers need to ensure that it is clear what the current and the future TP systems look like.

Transfer pricing (“TP”) is an often overlooked and lightly treated aspect of the tax due diligence (“TDD”) during the M&A process. However, given that the integration of the target company is often part of the post-merger proceedings, clarifying the TP system of both buyer and seller, and getting clarity on risks and opportunities should be considered a necessity as early as possible. 

From a pure tax perspective, TP can generally be considered to be one of the main risk factors. Tax authorities spend increasing amounts of time and resources on scrutinizing TP setups. Evaluating whether there is legacy risk in the target and getting appropriate coverage for it therefore makes sense. In addition, the target then will be integrated in many cases, which raises questions about the location of key value drivers within the target’s business model and synergy potential and redundancies. 

Potential TP risks can be broadly grouped into the following categories:

• Potentially non-arm’s length TP concepts
• Missing TP compliance
• Operational TP issues 

Each of these topics comes with its own impact and considerations that need to be made, and they should not be overlooked by the buyer.

A non-arm’s length TP concept comes with risks for the past, but also potentially poses challenges to a future integration of the target.

To identify issues, buyers can have a look at the following points:

• IP: is the IP located where it should be, i.e. are the returns from the IP aligned with the relevant DEMPE functions?
• TP methods: what remuneration methods are applied for the different intercompany transactions, and is it possible to defend/justify these as being at arm’s length? 
• Intercompany agreements: are there agreements in place for the major intercompany transactions, and do they correspond to actual behavior and arm’s length requirements?

Transparency and compliance requirements are increasing worldwide. Pure monetary penalties for missing compliance obligations are often not high enough to have a significant impact on the deal itself. However, the non-availability of compliance documentation or non-compliance with obligations such as country-by-country reports (“CbCR”) or TP returns can indicate that the topic is not well managed. In addition, non-availability of such information usually leads to limited transparency on potential issues during the due diligence process. It can also mean that there will be a more significant effort required to integrate the target into the buying entity once the deal closes.

Considering the increased scrutiny from tax and customs authorities globally, companies need to manage their TP system on a day-to-day basis accurately to avoid deviations from the intended TP policy. 

Generally, failure to manage the TP system properly on a day-to-day basis can lead to follow-on risks, because the actual margins deviate from the ones intended by the TP policy. 

Operational transfer pricing topics do not necessarily need to be considered as a red flag issue. However, if a company has this visibly under control, it can signal a high degree of maturity regarding TP aspects and may increase confidence in the target.

By implication, the seller should be aware of the aforementioned topics and their potential pitfalls. As such, providing information that signals that the various TP topics are under control is an important aspect in the tax due diligence process.

A proper process for the annual TP documentation report preparation can be a good starting point to do so. Whilst it requires a certain initial effort, it clearly shows that TP is taken seriously and compliance is properly dealt with.

Potentially, it may also make sense to prepare for the data room additional documents that – next to a transfer pricing documentation – give in an easy-to-understand manner a concise overview on important aspects of the transfer pricing system, the compliance status and the respective relevant processes.

Failure to providing structured information on TP topics may force the buyer to reflect this additional uncertainty in the purchase price offered.

For sellers, checking the status on the above-mentioned topics (transfer pricing system, compliance and operational processes) early on (if this is not already clearly known and understood) certainly makes sense, as the preparation of such documents and information for the due diligence process may take significant time.

For potential buyers, establishing an understanding of the target’s business and transfer pricing model as well as compliance status potentially saves time and money down the road in terms of post-merger integration efficiency and TP compliance e.g. in tax audits.