Tax Audit Implications of Operationally-Led Business Restructurings

By Yvonne Metcalfe, Esq., Steven C. Wrappe, Esq., and Diana Organista

Ernst & Young LLP, New York City and Washington, D.C.1

Today's companies are pursuing a wide array of business restructurings, streamlining, and supply chain reconfigurations due to various business drivers. For example, multinational enterprises (MNEs) are restructuring their businesses to maximize synergies and/or economies of scale, to address the need for specialization and the need to increase efficiency and lower costs, to provide more centralized control and management of manufacturing, research, and distribution functions, to be more responsive to customer needs, to expand in emerging markets, and, more recently, survive through the down economy.2 According to Ernst & Young's 2010 global transfer pricing survey ("EY 2010 Survey"), over 60% percent of 877 interviewed MNEs have engaged in post-merger integration of operations since 2006.3

Business restructuring has become an area of focus for tax authorities around the globe. Notwithstanding increased audit scrutiny, business restructuring should not represent a tax exposure for MNEs when business purposes are driving the change in their operating model. Although a company's restructurings will undoubtedly produce changes in revenues and profits, tax authorities should acknowledge the primary commercial purposes of most business restructurings.

Governments' Position

On July 22, 2010, the Organization for Economic Cooperation and Development (OECD) published a new Chapter IX for its Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations("the Guidelines"), addressing how transfer pricing principles and corresponding treaty rules should apply to a business restructuring.4 Although the Guidelines acknowledge that there can be legitimate business reasons for an MNE to restructure, the Guidelines point out that an independent party would only enter into a restructuring transaction if the transaction did not make that party worse off than its next best option. Accordingly, at arm's length, there are situations where an entity would have had options realistically available to it that would be more attractive than accepting the conditions of the restructuring and where an independent party may not have agreed to the conditions of the restructuring. Thus, the OECD Guidelines assert that the arm's-length principle requires an evaluation of the conditions made or imposed between group members at the level of each entity.5

For the most part, tax authorities are sensitized to business restructuring, and interest in the topic has been growing in a number of jurisdictions. To cite some examples, the Australian Taxation Office will now require a detailed explanation of any planned restructuring and transfer pricing impact,6 the U.K. tax authorities have been increasingly rigorous in addressing restructurings,7 Mexican tax auditors are paying special attention to local affiliates' risk when functions are relocated abroad,8 and the German Federal Ministry of Finance recently released a draft document outlining the principles for examination of income allocation between related parties in cases of the cross-border movement of functions.9 The United States recently codified the economic substance doctrine in §7701(o), which imposes a two-pronged test to determine whether to recognize a transaction: (1) the transaction must change in a meaningful way (apart from federal tax effects) the taxpayer's economic position; and (2) the taxpayer must have had a substantial purpose (apart from federal tax effects) for entering into such transaction. Also, tax authorities in many countries, including Brazil, Canada, the United States, Australia, Japan, New Zealand, Thailand, Vietnam, Austria, Belgium, the Czech Republic, Denmark, Finland, Germany, Israel, Italy, Kenya, Norway, Poland, Portugal, Slovenia, Spain, Sweden, the Netherlands, and Turkey, consider evidence of business restructuring as an audit trigger.10

Tax authorities are increasingly concerned about the impact of business restructurings when they result in changes in a local taxpayer's profits related to reduced local functions, assets, and risks, including potentially the movement of intangibles.  In this regard, the IRS is taking steps to recognize the common occurrence and impact of business model changes. Recently, IRS tax officials have suggested that taxpayers take a proactive approach to business restructuring controversy, by using Advance Pricing Agreements (APAs) to address underlying transactions before they are subject to the jurisdiction of the IRS audit team. Additionally, IRS officials have recognized the need in the APA context to inquire as to whether single transactions are part of a broader business restructuring arrangement.11 Given governments' focus on intangibles, taxpayers can expect continued examination, controversy, and litigation activity in this area in particular.12 Certainly, MNEs should be prepared to be audited and closely scrutinized in cases of business restructuring. Well-prepared supporting documentation, along with detailed business plans and pre-restructuring and post-restructuring analyses, will be beneficial to explain and defend corporate reorganizations in a tax audit.

Impetus for Business Restructuring

Business restructurings are a necessary reaction to business growth, the increasing level of global competition, and the need to improve business processes in order to stay competitive.  The OECD acknowledges that business restructuring has been a common occurrence during the few past years.13 Restructurings usually take place in pursuit of legitimate financial and operational goals that are not driven by tax savings, although tax savings may result from the restructuring. For example, corporate restructurings routinely take place after acquisitions, takeovers, or bankruptcy in order to realign similar businesses or create new business operating models. Reorganizations can also be driven by a need to improve profitability, efficiency, and/or to survive in an increasingly efficient and competitive market place or in emerging markets.

A company's future does not need to be in jeopardy before a restructuring is considered. In order to maintain competitiveness, companies continually look for opportunities to develop efficiencies and benefit from cost savings. A business reorganization may allow a company to become more efficient, productive, and profitable. For example, corporations might decide to change their business approach in pursuit of increased profitability by downsizing a business line to concentrate on a core line of business, a more promising product, or a particular market niche.

Corporations also restructure for the operational and reporting benefits of centralized control and management of certain functions.14 Centralization involving co-location of functions and activities can result in a reduction in costs as well as leveraging best practices. Indeed, centralized business models have enabled several corporations to launch new products simultaneously and enjoy the benefits of advertising synergies.15 Companies also might want to commence a restructuring process where there are cost advantages that could be obtained due to economies of scale, or outsourcing of some activities.

Moreover, the economic downturn has forced MNEs to become more efficient; therefore, some level of business restructuring is inevitable.16 Many MNEs are suffering major operating losses,17 and when financial concerns are putting a company under stress, a timely restructuring to stabilize performance could represent the difference between liquidation and survival. As a matter of fact, a number of participants in the auto industry have recently restructured their operations due to economic pressures.18 Some companies in the communications sector have undergone restructuring as a response to the global financial crisis.19 The life sciences industry is undergoing a significant business transformation due to a shortened pipeline of new drugs, changes in the regulatory environment and reimbursement policies, and the need to expand into the emerging markets. For a troubled company, suffering cash flow issues and eroding profits, a well-planned business restructuring could be the sole alternative to filing for bankruptcy.


A business restructuring, like other types of transactions between related parties, should be conducted at arm's-length.  It is crucial, therefore, that the transition transaction and the post-restructuring organization properly allocate profits and losses according to the risks, functions, and assets of the parties involved in the process. Taxpayers who have undergone business restructurings should be prepared to be challenged by fiscal authorities, and should be ready to defend their transfer pricing models. As long as a restructuring has a genuine business purpose, the operating benefits are well-documented, and the results are consistent with the arm's-length principle, a taxpayer should not fear to embrace a business restructuring journey.

This commentary also will appear in the December 2011 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Maruca and Warner, 886 T.M., Transfer Pricing: The Code, the Regulations, and Selected Case Law, and Gleicher, 892 T.M., Transfer Pricing: Competent Authority Consideration,  and in Tax Practice Series, see ¶3600, Section 482 — Allocations of Income and Deductions Between Related Taxpayers, ¶7110, U.S. International Taxation — General Principles, and ¶7160, U.S. Income Tax Treaties.

1 The views expressed herein are those of the authors and do not necessarily reflect those of Ernst & Young LLP.

2 OECD, Report on the Transfer Pricing Aspects of Business Restructurings: Chapter IX of the Transfer Pricing Guidelines, ¶9.57. A copy is available at

3 Ernst & Young 2010 Global Transfer Pricing Survey, Addressing the Challenges of Globalization, Ernst & Young, January 2011,

4 See note 1, above.

5 Id., ¶¶9.59 – 9.63.

6 Tropin, "Australia: ATO Discussing How Much Information Must Be Provided to Defend Restructurings," 16 Tax Mgmt. Trans. Pricing Rpt. 111 (6/13/07).

7 Moses, "Restructuring: Practitioners Say Tax Authorities' Attacks on Restructurings May Lack Legal Support," 17 Tax Mgmt. Trans. Pricing Rpt. 326 (8/28/08).

  8 Tropin, "Mexico: Tax Officials Evaluating Assignment of Risks When Functions Are Shifted Out of Mexico," 15 Tax Mgmt. Trans. Pricing Rpt. 772 (3/7/07).

  9 The draft released on July 17, 2009, relates to the application of Section 1, subsection 3, of the Foreign Tax Code and the Order Decree Law on Transfer of Business Function.

  10 EY 2010 Survey.

  11 Wright, "IRS Official Speaks to Use of APAs In Business Restructuring Context" 19 Tax Mgmt. Trans. Pricing Rpt. 878 (12/16/10).

  12 See note 1, above.

  13 Transfer Pricing Aspects of Business Restructuring: Discussion Draft for Public Comment 19 September 2008 to 19 February 2009," OECD, available at

  14 See note 1, above, ¶9.57.

  15 Bell, "Company Official Says Worldwide Advertising Synergies Drive Procter & Gamble's Adoption of Centralized Business Model" 17 Tax Mgmt. Trans. Pricing Rpt. 926 (4/2/09).

  16 Wrappe, "Business Restructuring Dictates Transfer Pricing Planning," 81 Financier Worldwide (August 2009).

  17 Curtis, "Transfer Pricing in a Recession: What Taxpayers Should Consider," 17 Tax Mgmt. Trans. Pricing Rpt. 780 (2/19/09).

  18 "Dealerships Restructure Under Pressure From Economy, Automakers," The Seattle Times, (5/3/09).

  19 "Nortel Commences Comprehensive Business and Financial Restructuring,"Jan. 14, 2009, available online at See also Yousuf, "Simmons to Restructure Under New Owners," (9/25/09), available online at