KPMG report: Common transfer pricing risks and opportunities of M&A transactions

The merger and acquisition (M&A) market is busier than ever. Pent-up energy and cheap financing have contributed to a resurgence in deal activity, with global M&A volumes surpassing $5 trillion in 2021.

Tax advisors continue to play a key role in M&A, helping investors protect against or price for historical and potential future tax exposures, while also helping to generate value once the deal has completed.

Transfer pricing is increasingly seen as one of the main tax risks and opportunities before, during and after the deal. This discussion looks at how companies can mitigate risks and enhance deal value from a transfer pricing perspective.

The international tax landscape has changed significantly in the last 10 years. The OECD base erosion and profit shifting (BEPS) project led to a wave of new substance-based transfer pricing rules and reporting requirements, as well as new focus on interest deductibility (among others).

While these have now been implemented in many countries, tax authorities have taken different approaches to interpreting them. This has led to an increase in cross-border disputes and challenges for companies. For example, tax authorities may have differing views on what constitutes “substance,” leading to direct challenges on the transfer pricing policies. Getting double tax relief through mutual agreement procedures can be a burdensome, expensive and lengthy process and does not always guarantee to have the desired outcome.

Additionally, new guidance was released by the OECD in 2020 on transfer pricing and financial transactions, with an important update being an increased focus on the lender’s perspective (i.e., substance of the lender and options realistically available to them). This guidance is still being digested but does open the door for tax authorities to challenge in the future on legacy related-party financing. This could lead to tax adjustments on the interest rate, quantum of debt, or more fundamental questions on whether the debt would have been issued in the first place and is more akin to equity (leading to potential full denial of corporate tax deductions and / or withholding tax leakages).

Finally, the compliance burden has increased significantly with the introduction of country-by-country reporting, Master files and Local files (“three tier transfer pricing documentation”). In some countries, there can be significant penalties for failing to prepare or file transfer pricing documentation. Additionally, a lack of contemporaneous documentation usually leads to skepticism by a tax authority on the robustness of a multinational group’s transfer pricing affairs, and the increased risk of scrutiny.

As such, it has never been more important, and challenging, to effectively manage transfer pricing risk.

There are several high-risk transfer pricing issues that typically are identified during a deal, including:

• Mismatches between legal ownership of intellectual property (IP) and the location where important risk control decisions are made in relation to that IP (so called “DEMPE risk control functions”)
• Centralised transfer pricing models not supported by an appropriate level of people substance
• Higher risk transactions, e.g., R&D services remunerated on a cost-plus basis / procurement hubs remunerated through a gain share
• Historical business restructurings undertaken without any consideration for exit charges / post restructuring transfer pricing policies
• High interest rates / quantum of related-party debt
• Insufficient / no appropriate attribution of profit to permanent establishments
• Financials of legal entities not aligning with transfer pricing policies
• Open transfer pricing disputes with tax authorities and / or material transfer pricing provisions
• Weak transfer pricing control environment, with little focus on transfer pricing from the head of tax or CFO
• Inconsistencies between the legal agreements and transfer pricing policies (or even a lack of agreements themselves)
• Lack of transfer pricing documentation (Master file / Local file) or even transfer pricing benchmarking

It is prudent to see that these risks are managed appropriately by involving transfer pricing specialists as and when they arise and well in advance of the deal. If not, they can build up significantly over time, leading to material tax exposures at the time of completing the deal.

If choosing an area of focus to uncover high-risk transfer pricing issues, it would be on the multinational’s operating model and how the transfer pricing policies being applied in practice align with this. The operating model goes to the heart of the tax profile of any group and can be a significant driver of their effective tax rate. Understanding the operating model allows sellers and buyers to understand when the biggest risks might be historically, but also when the areas of focus need to be post-deal.

For sellers, vendor assistance and vendor due diligence are critical for a smooth exit process. Issues like the ones highlighted above can be identified, remedied, explained, and even quantified in advance of any bidder process.

For buyers, a lack of investment in transfer pricing means these issues may not be picked up at the right stage, potentially missing out on appropriate tax protection being put in place (e.g., specific tax liability insurance).

Most importantly, a thorough transfer pricing analysis highlights not only the risks, but also the opportunities post-completion of the deal.

For more information, contact a tax professional with KPMG Global Transfer Pricing Services:

Malcolm Manekshaw | malcolm.manekshaw@kpmg.co.uk