The global M&A boom of recent years slowed down in 2022, but activity is expected to rise again in 2023. This trend appears to be more pronounced in Poland, where even 2022 set a record for the number of M&A transactions.
The surge in M&A deals, combined with increasing scrutiny attached to transfer pricing by tax authorities, has awakened a growing interest in the transfer pricing aspects of M&A transactions. This area has been largely neglected in the past, despite its far-reaching tax implications.
In fact, transfer pricing issues affect various aspects of M&A processes; among them:
Due diligence;
Pre-closing preparation; and
Post-closing integration.
Due diligence
Quite often, transfer pricing issues do not receive sufficient attention during the tax due diligence process. The focus is usually on compliance with formal requirements. There is verification as to whether the target possesses the mandatory transfer pricing documentation and whether all the reporting obligations have been duly fulfilled.
Much less attention is directed towards verifying whether the target operated on an arm’s length basis with its affiliates, though this may have considerable implications for the past and future tax liability of the target. Post-merger tax settlements may be affected in various ways; for example:
Certain pre-merger arrangements made by the target, which turn out to be non-arm’s length, may be difficult to adjust afterwards (e.g., the basis value of fixed assets/intangibles, and tax depreciation rates);
The year-end transfer pricing adjustment of non-arm’s length pre-merger transfer prices may not be possible in certain cases, leading to an additional tax burden for the buyers;
Pre-merger allocation of development, enhancement, maintenance, protection and exploitation (DEMPE) functions between the targets may imply a certain post-merger allocation of profits from intangibles, which may not be conducive to the business of the buyers; and
The post-merger adjustment of existing intercompany agreements or the functional profile of the target may qualify as so-called business restructuring, implying the necessity of establishing an exit fee, which may be financially unfeasible for the buyers.
Therefore, it may be advisable to collect in the data room additional information/documents necessary for an accurate assessment of the transfer prices applied by the target, besides the standard transfer pricing documentation.
Pre-closing preparation
There is a broad range of transfer pricing topics that need to be covered before the transaction takes place. The sellers should review their transfer pricing policies and ensure that all the required documentation is available and the reporting obligations are fulfilled. The identified transfer pricing risks should be properly addressed to let the due diligence process run smoothly.
The way the information is presented to the buyers should persuade them that the transfer pricing processes are under proper control and give them reasonable confidence that the purchase price does not need to be discounted to account for unmitigated transfer pricing risks.
Such compliance steps do not exhaust the list of necessary preparations, however. The transfer pricing issues may also require some pre-merger restructuring actions from the sellers and the buyers. This may concern, in particular, the alignment of returns from intangibles with the division of DEMPE functions.
With regard to the concept of DEMPE, the mere legal ownership of intangibles does not justify any returns from their transfer, because so-called economic ownership should be decisive. It may turn out that the target, despite being the legal owner of the intangibles, has not sufficiently participated in their development.
In such case, the target’s remaining affiliates which performed the majority of the DEMPE functions, and are therefore deemed to be the economic owners of the intangibles, should also reap the benefits from their transfer outside the group. This, in turn, may necessitate a restructuring which would facilitate proper purchase price allocation within the group of sellers.
Similar considerations should be taken into account by the buyers. An appropriate business structure should be prepared in advance, because post-merger structuring may trigger unintended transfer pricing implications (such as an exit fee or accidental distribution of DEMPE functions not aligned with the legal ownership of the intangibles).
Some kinds of pre-merger restructurings may themselves qualify as controlled transactions subject to regular transfer pricing requirements and obligations. Therefore, transfer pricing documentation and benchmarking studies may need to support, for example, intra-group:
Mergers or divisions;
Capital injections or in-kind contributions; or
Share transfers or redemptions.
Proper awareness of these topics may greatly facilitate the whole M&A process and prevent potential tax risks and transactional pitfalls.
Post-closing integration
Once the deal is closed, the post-merger integration of the target often requires multiple adjustments to the existing transfer pricing policies. Given the multitude of business models and variety of transfer pricing methodologies, it is more likely than not that the transfer pricing policies of the sellers and buyers may vary substantially. Therefore, the first step should aim at integrating these policies and liquidating any inconsistencies.
Integration of the target will also most likely trigger a reallocation of commercial risks and have an impact on the other factors which originally determined the pre-merger transfer pricing methodologies. For example, the target may benefit from marketing intangibles of the acquiring group, such as a trade name or market recognition. There may also be a more direct impact on the target of the acquiring group’s strategies and centralised functions, such as management, central procurement, and other support services.
All these aspects combined may have a far-reaching effect on the functional profile of the target and other economically relevant characteristics of the controlled transactions, thereby requiring readjustment of the transfer pricing methodologies applied.
The effect of group membership may be even more pronounced as regards the financial transactions of the target. It may benefit from passive association arising from its status as a member of the acquiring group when dealing with financial institutions. With respect to intra-group transactions, the target may require integration with a central treasury function, cash pooling structures, and hedging arrangements. The potential use of the acquiring group credit rating and implicit support may significantly alter the creditworthiness of the target and the resulting arm’s length interest rate on intra-group loans and guarantees.
Acquisition of a target with intangibles (including marketing intangibles) – in particular, during the development stage – deserves careful consideration. The DEMPE concept would require from the buyers a determination of the entities within the group which are ultimately entitled to share in the returns derived by the group from exploiting the intangibles owned by the target, as well as bearing the costs, investments and other burdens associated with the development, enhancement, maintenance, protection, and exploitation of these intangibles. If the remaining group members are expected to contribute to the value of the intangibles owned by the target, they must be adequately compensated for their contributions under the arm’s length principle.
The post-merger actions will also include preparation of new or amended intercompany agreements, enabling legal implementation of the adjusted transfer pricing policies and integration of the target in the legal framework of the group. If the target has entered into arrangements with tax administrations related to transfer pricing (such as advance pricing agreements or mutual agreement procedures) or received tax rulings in this respect, they likewise may necessitate some revision.
Finally, the existing processes related to day-to-day operational transfer pricing issues and annual transfer pricing documentation preparation and reporting will need to be updated to accommodate the changes made to the transfer pricing policies.
