Over the years, I have attended a few seminars on M&A activity. One thing that has always struck me is the lack of transfer pricing analysis on the part of prospective purchasers of multinational enterprises (MNEs). In this sense, the term MNE does not necessarily imply large Fortune 500 type companies, but rather often refers to owner-managed small-to-medium sized enterprises (“SMEs”) with cross-border transfer pricing issues. In this article, I summarize some of the key issues that should be addressed as part of your due diligence process if you, or one of your clients, is considering purchasing an MNE.
Every M&A transaction involves both a potential acquiring company (“Acquisition Company”) and potential target company (“Target Company”). For the purposes of this article, I’ll assume the Target Company has at least a moderate level of transfer pricing risk.
Does the Target Company have up-to-date contemporaneous documentation?
A failure of the Target Company to have prepared contemporaneous documentation may likely expose the Acquisition Company to potential future tax liability in the form of transfer pricing adjustments not to mention possible penalties and interest. From the Acquisition Company’s standpoint, a lack of documentation is a cue to more deeply analyze potential exposures that may exist as well develop plans to mitigate risk on a post-acquisition basis. Lack of documentation is a red flag that the Target Company’s management never properly set up a transfer pricing system that is aligned with arm’s length principles. Given this, potential exposures may be significant enough to warrant adjustments to the offered purchase price. In addition, efforts will have to be made after the deal closes to incorporate the Target Company’s related party transactions into the newly combined company’s transfer pricing systems.
If the Target Company has prepared contemporaneous documentation, then management of the Acquisition Company, along with their advisors, should review it to ensure the following:
- Is the documentation up-to-date?
- Is it compliance with OECD principles and those of the local jurisdictions?
- Does it cover off all major related party transactions?
- Do your advisors agree with the general approach and conclusions of the report?
Any answer of “no” to the above may be cause to dig further to assess potential transfer pricing exposure in the Target Company. Even if all answers are in the affirmative, due to the complex nature of transfer pricing analysis, some exposure may still exist depending upon the complexity and aggressiveness of the positions filed by the Target Company management.
Does the Target Company have open tax years with transfer pricing exposure?
Even with contemporaneous documentation in place, transfer pricing exposure is not completely eliminated. For example, aggressive positions taken by the Target Company may still create exposures that should be accounted for in a tax provision, even if documentation has been prepared. In such cases, management should assess the potential exposure in all open tax years and consider the need to make the appropriate provisions for potential adverse tax adjustments..
Is the Target Company currently undergoing an international tax audit or transfer pricing audit?
An ongoing audit at the time of a potential acquisition may increase the risk of an adjustment to the Target Company that should be factored into any due diligence. Audits do not always move fast, and if a Notice of Reassessment has been issued at the time the due diligence is being performed, the matter might be tied up in Appeals for months or possibly years.
Has the Target Company had transfer pricing adjustments applied against it in the past?
Previous transfer pricing adjustments applied against the Target Company may indicate the CRA may apply a higher level of scrutiny to its transfer pricing in the future. This higher risk should be factored into any financial analysis. In addition, continuous acrimonious audit activity with the CRA may be a sign that an Advance Pricing Agreement should be considered in the future to minimize uncertainty.
How will post-acquisition transfer pricing systems differ from pre-acquisition transfer pricing systems? Will this create any additional tax exposure?
The transfer pricing systems in the Target Company may not necessarily align with those of the Acquisition Company. Reconciling these differences is an important first step as part of the due diligence process, followed up by developing a post-integration plan. In many cases, the following items may change once an acquisition closes:
- Transactional flows may change, and new related party entities may become involved;
- Ownership of tangible and intangible assets may shift;
- Key functions may shift from one location to another;
- The sharing of risk between all the members of the newly combined MNE may fundamentally be changed; and
- Key personnel may be relocated to different locations.
All these factors may intrinsically change the pre-acquisition transfer pricing systems and thus, require additional planning, analysis, and documentation.
Will this acquisition create tax planning opportunities through transfer pricing?
Sometimes acquisitions are made because there are perceived synergies between the two companies. If such synergies exist, there may also be opportunities for effective tax planning and streamlining of transfer pricing systems. This may include the movement of IP ownership, the establishment of contract R&D/manufacturing centres, the removal of redundant intercompany processes, and the shifting of key personnel to strategically advantageous locations. All of this provides opportunities to structure a transfer pricing system that produces a lower overall tax rate for the MNE.
Any company in the process of acquiring a company with an international legal structure has numerous considerations that must be made during both the due diligence phase and on a post-acquisition basis. These considerations may ultimately impact the purchase price of the Target Company along with providing opportunities in the future to streamline the newly consolidated company’s transfer pricing systems.