Acquisitions – are you ready for transfer pricing complexity?
We have seen a strong start to 2018 in terms of M&A activity, write Jon Vine and Greg Smith of Deloitte. Mergers and acquisitions invariably involve a range of complex tax issues. While these continue to include matters such as acquisition structuring, financing and structurally integrating the acquired business, the complexity and range of transfer pricing (TP) issues which arise in the M&A context should not be underestimated.
With revised OECD TP guidelines (including the application of the accurate delineation of the transaction as it relates to intangibles), greater TP documentation requirements, increasing transparency, and particular attention paid to TP by almost all tax authorities, it is increasingly important that sufficient focus and time is anticipated and ultimately given to TP in the M&A context.
This article explores a range of intangible and TP-related issues, which may need careful thought when a group makes an acquisition.
Value-based management fees
Management of the acquiring group may get heavily involved in setting strategies for, or controlling economically substantial risks of, the acquired group (or vice versa). These situations may arise, in particular, where the acquiring business has a centralised management structure or where management brings a unique set of skills in relation to the acquired business. Such involvement may be relatively short-term during an integration phase, or provide a benefit on a longer-term basis.
Where this is the case, the charging of a value-based management fee is becoming increasingly common, with the fee reflecting the substantial value delivered by management. For example, a fee based on a percentage of revenue or incremental revenue may be more appropriate than, perhaps, what is more typically seen for management charges (where a return on costs is commonly charged for more routine services such as back office functions including finance, IT, HR and so on).
The knowledge and services of management may be combined with the provision of certain intangible assets such as rights to use a trademark (for example, if the acquired group undertakes a rebranding exercise) or documented processes and know-how.
The pricing of such services (or bundle of services and provision of intangible assets) requires a detailed understanding of the value chain of the business and the extent to which the services play an important role within this value chain. Given the unique nature of such services, a sufficiently reliable comparable transaction may be difficult to identify and therefore other TP methods may be more reliably applied. That said, identifying similar third-party transactions can be helpful for supporting the overall arrangement (and potentially providing a corroborative pricing methodology).
It is also necessary to consider any existing arrangements within the group for such services to ensure that a consistent approach is taken.
Integration of intangible assets
In any integration of a business, it is necessary to consider how the functions (including control thereof) relating to the development, enhancement, maintenance, protection or exploitation (DEMPE) of intangible assets may be affected. This may happen in a number of different ways. For example, a business may:
Use intangible assets within the acquired group in combination with its own to create a new product (e.g. taking the best of both);
Combine the development groups to create a single centre of excellence;
Consolidate its sales structure to create a single go-to-market structure; or
Allow the respective parts of the group to sell the products of the other (i.e. upselling to existing customers).
Any such changes will require careful consideration from both a legal and a TP perspective and can result in a complex web of inter-company agreements and TP flows in order to appropriately reward both the DEMPE functions and the control of such activities. This is particularly important where, as a result of the acquisition, the DEMPE functions and/or the ownership of intangible assets are located in multiple jurisdictions.
Changes in the way groups operate often result in a mismatch between those entities that legally own intangible assets and those entities that, under TP principles, are entitled to profits (including residual profits after all other contributions have received an arm's-length consideration) associated with the assets. While this may not in itself be of immediate concern, aligning legal and 'tax' ownership can help simplify transaction flows and future business restructurings.
There may inevitably be a period of time until these challenges can be resolved through an appropriate reorganisation to simplify the intangible ownership structure. The extent of work undertaken to support the TP in this interim period needs to be carefully managed so as to appropriately mitigate the risk, while not incurring excessive costs for a relatively short-term benefit.
Simplifying the intangible ownership structure
There are a variety of commercial, tax and legal factors to take into account when considering the long-term structure of intangibles within a group. The tax issues commonly include:
Identification of the intangible assets – It is important to remember that the intangible assets of a business are likely to include more than what is already recognised on the balance sheet or what is legally protected (e.g. patents, copyrights, and trademarks) because of the expansive definition of an intangible asset for TP purposes;
Valuation of the intangible assets – It will be necessary to value any assets being transferred. This can often be a complex exercise, with a number of valuation techniques available. The acquisition will have resulted in a third-party price being paid for the acquired business; it can be useful to reconcile the value of the intangible assets to this value to ensure that any 'gap' in value can be explained to tax authorities. A valuation exercise is likely to have been undertaken for the purposes of a purchase price allocation (PPA) for the financial statements. Purchase price allocations are performed under fair market value concepts, which can be different in some cases from arm's-length value concepts. Therefore, valuation techniques used in such a PPA can differ from valuations performed for TP purposes;
Exit charges – The transfer of intangible assets can often result in substantial tax costs for the business. Careful consideration may be needed to manage these exposures from both a cash tax and accounting effective tax rate (ETR) perspective. Both the form of the transaction (e.g. sale vs licence) and the tax treatment of the intangibles in the purchaser's jurisdiction (e.g. amortisable tax basis), will impact the overall cash tax and ETR. Tax attributes may also be available to shelter any gains; and
To the extent that a centralised intangible ownership model is sought, determination of the appropriate jurisdiction for centralisation – Aside from the various commercial factors which may influence this decision, there are also a number of tax considerations, including (but certainly not limited to):
Location of teams contributing to the control of DEMPE functions in relation to the intangible assets;
The local tax rate and impact on group ETR;
Ease of profit repatriation, including withholding tax (WHT) cost;
Availability of tax attributes;
Local intangible tax regimes, including incentives;
Other rules such as 'controlled foreign company' or diverted profits or similar measures; and
Tax authority interaction and availability of rulings/advance pricing agreements (APAs).
Given the importance of any reorganisation of intangible assets, groups commonly first undertake a feasibility analysis exploring possible options. This would include an assessment of the benefits and risks of those options (including maintaining the existing structure) and modelling the expected impact on cash tax and ETR.
The acquired group may have had TP structures in place that are no longer appropriate. This may be because the historic structures have not previously been updated by the vendor group to reflect the changes in the global TP environment, or because changes in the business mean that policies need to change.
Many of these risks may have been identified during the due diligence phase for the acquisition, and historic exposures may be dealt with through the terms of the sale and purchase agreement. However, work may be necessary to avoid a continuing exposure accruing to the business.
Many US groups have cost sharing arrangements in place whereby the intangible assets are legally owned in the US but the costs and risks of development, and the right to exploit those intangible assets (within a geographic region, e.g. EMEA) is shared with a cost share participant. These structures may have involved the cost share participant being located in a jurisdiction where there is limited control over economically substantial risks. The changes in the TP environment and the revised OECD TP guidelines in relation to cost contribution arrangements may put pressure on the future sustainability of such structures. Careful consideration and planning as to how these structures can be adapted may therefore be required.
In addition, a number of groups have historically operated a sales principal and commission agent structure, whereby the sales principal (and, potentially, intangible asset owner) is responsible for concluding all contracts with customers and the commission agent's role is that of marketing and demand generation. The way in which the field sales teams within the commission agents operate may have changed over time (i.e. before the acquisition) or may change because of an integration of the team into the new group's go-to-market organisation. Such changes may mean that the go-to-market structure is no longer sustainable without creating a substantial permanent establishment (PE) risk for the group (the work around PEs under the OECD's BEPS project is also a key consideration here).
It is not uncommon for short-term transitional service agreements to be put in place between the acquirer and vendor groups. These can be helpful in providing internal comparable transactions to support future intra-group arrangements, but may also present a risk of undermining existing pricing mechanisms within the group.
Operational transfer pricing
Acquisitions can result in a number of challenges from an operational TP perspective. It may well be the case that TP processes are managed in very different ways within the two groups, which can create inefficiencies and risk.
It will be important for the tax and finance function to quickly gain a detailed understanding of the various policies and procedures and consider whether any changes are required.
Different pricing policies and/or different teams operating those policies can create a weakness in the internal control environment, and additional checks may be required to ensure that each group company is earning the appropriate amount of profits. It may be advisable to align the way in which the policies are operated, which will require the various teams to either be consolidated or educated on the new processes.
Furthermore, the acquired group may use a different accounting system. Where this is the case, setting up intercompany accounts to allow transactions to take place and be booked between the legacy groups can cause complexities.
Acquisition and restructuring/integration costs can be substantial and involve a number of different work streams and many different advisors. It will be necessary to understand all the costs, what they relate to and where they have been booked. An exercise is then needed to determine to which company the costs should be charged from a TP perspective (i.e. which entity is benefitting from those costs, which can often be multiple entities) and the tax deductibility of those costs assessed.
The group's compliance responsibilities will also obviously increase. The master file is likely to need updating to reflect the acquisition, changes in the business, any additional supply chain structures and any restructuring of intangible assets. The process for collating the information required in the group's country-by-country report may need to be adapted, particularly where the enlarged group is operating multiple accounting systems. The local file for each group company will also need updating to the extent that there are any changes in the way in which the company operates and transacts with other group companies.
Mergers and acquisitions activity can often involve a number of different work streams and put strain on a business from both a commercial and a finance perspective. While the complexity of acquisition structuring, financing and the structural integration of the groups is often anticipated, the complexity from a TP perspective should not be underestimated.
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Jon Vine is a transfer pricing director, based in the UK. Jon has more than 17 years' of experience in advising on a wide range of international tax and transfer pricing issues. Jon now wholly focuses on the area of the taxation of intangibles and the associated transfer pricing in the post-BEPS environment, helping international groups implement sustainable transfer pricing models as they go through extensive changes within their business, whether this be as a result of M&A activity, IP centralisation or other business change.
Deloitte in the UK
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Greg Smith is an economist and a director with Deloitte in the UK, specialising in the transfer pricing of intangible assets. Greg has more than 20 years of experience with Deloitte, and extensive experience across a variety of industries.
Greg has worked exclusively on UK and pan-European transfer pricing issues, including planning and documentation studies, audit defence, and advance pricing agreements. He has managed the implementation of a number of complex transfer pricing analyses including the valuation of intellectual property, profit split policies, and transactional pricing methodologies. Greg also has experience working with clients to identify opportunities and to design centralised IP business models.
Greg focuses primarily on clients in the consumer product, TMT, and manufacturing sectors and on the valuation and pricing of intellectual property. He has advised a number of major FTSE 100 clients on transfer pricing issues relating to their brands, trademarks, patents, software, know-how, and other intangible assets.
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