KPMG report: Transfer pricing in a deals context; risks and opportunities for value creation

The mergers and acquisitions (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 $5.8 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 article highlights the steps financial investors and multinationals need to consider to maximize value creation in a deal. An earlier report examined how companies can mitigate risks and enhance deal value from a transfer pricing perspective. Read TaxNewsFlash

The international tax landscape has changed significantly in the last 10 years. The OECD base erosion and profit shifting (BEPS) program led to a wave of substance-based transfer pricing rules and reporting requirements. Just as companies have adapted to these, BEPS 2.0 is here with a new framework for global taxation and even more complexity on the horizon.

Business models are also evolving as companies react to a variety of commercial and geopolitical issues, including climate change and the broader environment, social, and governmental (ESG) agenda, new technologies, remote working, and global trade tensions. With new and innovative ways of carrying out business, traditional approaches to transfer pricing may no longer be appropriate.

Additionally, multinationals are seeking increased flexibility on where senior management are located, and the pandemic has accelerated the trends towards remote working. BEPS placed more emphasis on how and where key business risks are controlled, and therefore increased flexibility in when key decision makers are located means it can be harder to manage transfer pricing outcomes.

Add to this the pressure on companies to maximize shareholder value as they emerge from the pandemic and the pressure on tax administrations to generate revenues to address rising public debt levels during the pandemic. As such, it has never been more important, and challenging, to effectively manage transfer pricing risk. Equally, as transfer pricing goes to the heart of the operating model, it plays an important role in preserving value in a deal. 

The key to unlocking the full potential of deals, both for sellers and buyers, is value creation. A backwards-looking view of company performance and initial projections into the future are not enough to gauge the full potential and value of a business. A holistic, end-to-end approach to value creation is required, whether the taxpayer is buying or selling.

Deals typically assume a synergy case—tax and transfer pricing can help deliver against this. From a buyer’s perspective, this could arise from the need to integrate the target’s business with its current operations, exploiting historic intangible property differently to how it was used pre-acquisition, and achieving cost reduction and operational efficiencies (e.g., driving synergies from integration, avoiding duplication of teams or functions). This would all have implications on both the buyer’s and target’s transfer pricing model, and without due consideration, pre-deal tax assumptions on the future operating model may quickly fade away.

For example, changes in important leadership positions post deal can undermine the substance of the transfer pricing model, potentially pushing more value to entities that were not envisaged to be critical when the model was set up. Equally, assumptions made on post deal funding structures, and the tax deductibility of interest, within an investor’s model can quickly fall away if a post deal transfer pricing analysis suggests a different interest rate or amount of shareholder debt that would be considered arm’s length.

As the business model evolves to realise the advantages from the deal, the transfer pricing model must equally align. It is common to find that profits anticipated when the deal was agreed differ materially from those which are realised, and it is necessary to consider which entity or entities within the multination group are to bear the upside or downside. The starting point is identifying which entity assumed the relevant risks, but it may be the case that other entities also contributed to the control of those risks and need to share in the upside or downside. This is an area that tax authorities are increasingly focused on since BEPS.  

Commercial, financial, legal, operational, and data science teams play a key role in providing the insight and expertise required to navigate what can be complex separations and integrations. However, it is critical that tax has a seat at the table when these decisions are made to mitigate significant tax leakages (such as VAT, corporation tax, customs duties, and even income tax for employees), and to determine that tax aligns with the strategy and growth ambitions for the business.

Transfer pricing goes to the heart of any business operating model (existing or new), posing challenging questions for both buyers and sellers such as:

• What is the deal value proposition including what synergies and other benefits are expected from the deal and what actions will be required to realise those benefits?
• What will the target group’s operating model and transfer pricing policies look like? Will the transfer pricing policies be flexible enough to adjust to the group’s strategy and people footprint over time?
• How will the transfer pricing policies align to the buyer’s existing business and potential integrations? If mismatches exist, can they be explained?
• Where will key IP be developed, is it valuable, and where do returns for this IP flow to? How will existing IP be adapted to create value?
• How will the acquisition be funded and what will the tax profile of the interest costs look like (i.e., how much is expected to be deductible, when, and at what rate)?
• What are the internal financial controls of the target group and how does this align to the acquirer? Can transfer pricing processes be documented, standardized, and implemented, and importantly who will take responsibility for this?
• Are tax rulings / advanced pricing arrangements (APAs) required for material / complex transactions to provide certainty?
• Have the transfer pricing policies been reviewed from a corporation tax and indirect tax perspective? Will potential changes to the international tax system (e.g., BEPS 2.0) shift the underlying assumptions?
• What does this all mean for the effective tax rate of the group? Can this be dynamically modelled?
• And, maybe crucially, what does the group’s transfer pricing strategy say about its ESG commitments and would it stand up to scrutiny in the public eye?
• Will all the above be documented to clearly communicate the strategy to all stakeholders (potential investors; internal tax, legal, finance and commercial teams and tax authorities)?

These are complex questions, for which the answers will depend on what side of the deal the taxpayer is on and will evolve over time during the deal life cycle. This can also seem a daunting exercise for tax departments already stretched dealing with business-as-usual. However, getting involved at the outset of the deal to formalize thinking and focus priorities can allow for a more manageable process.

For example, on the buy-side, beyond carrying out diligence on the target group’s historic liabilities, there is value in forming a view on the future state operating model of the target, and how the deal objectives align with both the buyer’s and target’s transfer pricing models, before the deal has completed. A significant amount of information is shared during the diligence process that combined with in-depth knowledge of the industry, can be used to maximise value creation opportunities, and embed transfer pricing in the 100-day and longer-term post deal plans.

Equally on the sell side, getting “transfer pricing ready” in advance of the sale is more than just remedying historic exposures. A carved-out group will have its own identity and unique value proposition that may be different to the seller’s wider business. This would extend to its operating model and therefore simply replicating existing transfer pricing policies may not be optimal. Identifying the options and putting in place a detailed plan for implementation in advance of the sale can result in a more attractive target from a tax perspective and potentially realise a higher premium from bidders.

As noted, there are a lot of tax and transfer pricing touchpoints on a deal. It is important to get the right people (tax and transfer pricing professionals) into the right room (e.g., deal governance and strategy meetings) at the right time (at the earliest opportunity!) This means that opportunities and workstreams are identified, scoped, and incorporated into the wider deal process so everyone is on the same page.

For sellers, it can help maximize value from the transaction by providing a blueprint for success. For buyers, they can imagine the possible from the outset, identify the opportunities and risks, and execute in a timely and cost-effective manner.

The role of transfer pricing in deals is becoming more and more important, less a one-off event, and more a continuous part of business planning. As a key driver of the group’s tax rate and a critical lever in value creation, businesses are realizing the importance of transfer pricing being part of broader strategic and operational deal discussions.

In conclusion, tax and transfer pricing is an important part of the deal lifecycle and can be the missing piece in the value creation story.

For more information, contact a professional with KPMG’s Global Transfer Pricing Services practice in the UK:

Erica Perry | erica.perry@kpmg.co.uk

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