Pricing of acquisitions and reorganisations in the spotlight
December 2015 | SPOTLIGHT | CORPORATE TAX
Financier Worldwide Magazine
The Organisation for Economic Co-operation and Development (OECD) finalised its highly anticipated Action Plan on Base Erosion and Profit Shifting (BEPS) in October 2015. Contained within the report was a raft of recommendations designed to enable tax authorities worldwide to address the complex and increasingly politicised issue of tax avoidance.
The report consists of a number of Actions designed to address practical concerns in relation to cross-border transactions and the structuring of Multinational Enterprises (MNEs), and contains a detailed analysis of a number of continuing initiatives to standardise the approach being adopted by different authorities in relation to domestic and international taxation.
Several of the provisions focus on the highly contentious area of transfer pricing, the mechanism by which MNEs are required to value the internal transfers of assets, goods and services at a market-equivalent, arm’s length price. Of particular interest to any group undertaking an acquisition, merger or internal reorganisation are BEPS Actions eight, nine and 10, which deal with practical and commercial issues arising in relation to pricing and valuation of intangibles, risks and capital.
Increased audit risk
Many tax authorities, including the US and UK, undertake the ongoing risk profiling of MNEs to identify primary targets for transfer pricing audits, a particularly lucrative seam of tax revenue in recent years. Not surprisingly, any internal restructuring during a merger or reorganisation is red-flagged as potentially giving rise to a change in a MNE’s corporate tax position.
However, there are a number of opportunities that arise during a typical restructuring process that can ease any subsequent transfer pricing audit, pre-empting additional analysis that may be required under the new BEPS provisions.
MNEs often own IP that is unique and hard to value – a frequent area of contention between authorities and taxpayers. BEPS Action eight advocates a clear allocation of responsibility to the corporate to maintain its own comprehensive and contemporaneous valuations to support the internal pricing of transfer of intangibles or rights to those intangibles. In the absence of detailed analysis, ex-post pricing can be applied ex-ante (subject to certain exceptions listed in the OECD report, including ‘unforeseeable events’), which could potentially give rise to significant tax-cash costs. The OECD report allows for adjustment at tax audit to include a five year look back provision, allowing for a 20 percent variance in the original ex-ante projections.
A corporate acquisition is one of the infrequent occasions when commercial values are ascribed to individual assets and intangibles in more detail than might be found on an annual balance sheet. Contemporaneous documentation, such as purchase prices allocations and other financial reports relating to the deal, may contain valuations that are appropriate for transfer pricing purposes, and often the economic data supporting these valuations will, in turn, assist with determining internal pricing or licensing rates for ongoing use of the relevant intangible. For example, if the value of an intangible asset is based on a Net Present Value (NPV) of future revenue streams, this revenue may often be calculated using a royalty rate which could, in turn, be applied to subsequent internal transactions. Careful review of such documentation is therefore recommended for tax directors as the analysis can form an important part of the transfer pricing compliance process prescribed in the BEPS report.
Tax-efficient IP structuring
Structuring and ownership of business intangibles often forms a significant part of post-deal and operational restructuring, frequently involving centralised legal ownership of IP with R&D activity carried out by, or sub-contracted to, a group legal entity in another jurisdiction. The final OECD report discusses a number of key principles which have an impact on the attribution of long-term value and profits within an MNE when R&D is carried out in more than one country and consideration of these should now form an important part of the documentation supporting any IP funding structure.
Five key drivers have been determined to ensure that, to receive the full income attributable to the relevant IP, a legal entity needs to perform a number of key financial and operational functions, specifically, the development, enhancement, management, protection and exploitation of that IP (so-called DEMPE functions). To avoid potentially significant retrospective and ongoing adjustments to profit allocations within a group, it is critical to review operational activities as they relate to intangibles and any overarching IP initiatives, and to clearly document function and risk allocation between the group entities with reference to these DEMPE keys to substantiate the internal pricing.
Recharacterisation of transactions
For CFOs and legal and tax directors, there is a potentially nasty surprise in the OECD report concerning any disconnect between the terms and conditions of intercompany contracts, how these arrangements actually operate in practice, and the capacity for tax authorities to adjust income and profit allocations at audit.
Whilst a review of internal contracts remains the starting point for any tax authority review, the final OECD BEPS report unequivocally allows for recharacterisation of transactions where there is no genuine commercial rationale for the transaction should it have been negotiated between two unrelated third parties, regardless of any legal construct between the group parties concerned. In this instance the transaction in question does not need to be recognised per se by the tax authority, opening the door to convoluted and time-consuming audits. It is therefore highly recommended that multinationals do not wholly rely on often loosely worded intercompany agreements to substantiate their internal cashflows, but use the opportunity of any redrafting of internal agreements post deal to ensure that form follows operational function and tax authorities are not given easy ammunition to initiate tax adjustments on any post-deal structure.
In addressing the issues of financial transparency, the potential of unprecedented access to detailed financial analysis of the worldwide activities of MNEs will almost inevitably result in tax authorities attempting a greater ‘tax-grab’ of global profits, leading to companies experiencing more frequent and complex transfer pricing audits. The BEPS report provides a useful instruction manual for MNEs to protect and defend their internal pricing at tax audit, and warrant close attention and application in relation to existing and new business structuring. However, the significant risks for the unwary taxpayer are now even clearer.
Nick Foster-Taylor is head of transfer pricing at CMS Cameron McKenna. He can be contacted on +44 (0)20 7367 2123 or by email: email@example.com.
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CMS Cameron McKenna