The Increasing Relevance of Transfer Pricing in M&A

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Transfer Pricing

TPA Global's Patrick Tijhuis and Marcel van den Heuvel of De Hoge Dennen Capital look at risks and opportunities related to transfer pricing and tax planning in mergers and acquisitions. The authors address the transformation of tax laws and regulations currently taking place under the OECD/G-20 initiative to combat tax avoidance, base erosion and profit shifting, and how it impacts the capital structure, strategic goals and priorities of an M&A transaction.

Marcel van den Heuvel

By Patrick Tijhuis and Marcel van den Heuvel

Patrick Tijhuis is a partner, Business Solutions, with TPA Global and Marcel van den Heuvel is a director, Private Equity, with De Hoge Dennen Capital. They can be contacted at and, respectively.

Common Tax, Transfer PricingPractices Under Scrutiny

The Organization for Economic Cooperation and Development and Group of 20 nations base erosion and profit shifting (BEPS) project is the result of public outcry over (perceived) questionable tax practices by corporations such as Starbucks Corp., Apple Inc. and Google Inc.

In October 2015 the OECD issued its final BEPS recommendations, stating it had found agreement among 62 participating countries for a minimum standard aimed at more transparency, curbing treaty shopping, eliminating hybrid mismatches and putting limitations on interest deductibility. Also, it announced changes to the transfer pricing guidelines, and the Model Tax Convention, and measures aimed at artificial avoidance of a permanent establishment and thus to aligning transfer pricing and profit allocation with the real value drivers of the business.

Since the publication of the final BEPS recommendations, a colorful patchwork of domestic tax law changes are being enacted and implemented, undoubtedly creating a rich source for even more tax conflicts. These developments will lead to a higher effective tax rate and detrimentally affect cash flows, funding costs and therefore company valuations, hence potentially killing an otherwise successful deal if not prudently managed.

Limitations on Deductible Interest
Nondeductible Interest Affects Funding Mix

Following the release of the BEPS recommendations, the European Union Jan. 28 published its Draft Anti-Tax Avoidance Directive, containing six measures of which in particular the limitation on deductible interest will have a significant impact for the M&A practice.

Basically, the directive proposes to restrict the deduction of interest on acquisition finance at the entity level to a maximum of 30 percent of earnings before interest, taxes, depreciation and amortization (EBITDA).

This may involve a double hit for the company in situations where EBITDA declines as a result of market conditions or poor performance. These considerations may eventually lead to a purchasing company having to put more equity in the funding mix, i.e. resulting in a higher weighted average cost of capital, or WACC (discount rate), and thus in a lower value of the acquisition target.

With respect to the limitation on deductible interest, the following reliefs are provided:

  •  a de minimis exemption for interest not exceeding 1 million euros ($1.1 million);
  •  a fallback to a groupwide debt-to-assets test demonstrating the debt-to-assets ratio of the entity involved is in line with or better than the ratio of the group;
  •  carryforward of excess or disallowed interest deductions to subsequent years; and
  •  regulated financial institutions, e.g., banks, insurance companies, pension funds and certain investment funds, are temporarily excluded from this rule.


Control of (Deductible) Interest Expenses

As far as optimization of the group's debt structuring is concerned, it may be beneficial to centralize the value chain—and EBITDA. The concept of a single business entity—also known as a principal-toller-agent model—provides for centralization of business processes, risk control and capital at the level of the principal, allowing local service providers to perform merely routine functions.

If properly structured, the lion's share of a group's EBITDA may then be allocated to the principal to safeguard optimization of available interest deductibility.

M&A; Phases and TP Impact
Phase 1: Due Diligence
Identification of Transfer Pricing Risks

Although the BEPS recommendations are being rapidly implemented around the globe, not all companies have been able or willing to adapt their tax and transfer pricing structures to this new reality. Therefore, in the due diligence process special attention should be given to the target's tax and transfer pricing practicalities.

Apart from complying with laws and regulations, nowadays a company is expected to be in control over all tax-related matters, and to be transparent about it. Therefore, tax and transfer pricing risks shouldn't only be identified from a tax technical perspective, but also from a reputational, brand management and corporate responsibility perspective, of which both the executive and supervisory board members have appropriate awareness.

Transfer pricing risks are manifest—and therefore significant transfer pricing liabilities may exist in one or more jurisdictions—if one of the following situations takes place:

  •  there is discrepancy between legal intercompany agreements and the conduct of the business;
  •  a discrepancy exists between the legal owner of intellectual property (IP) and the allocation of “people functions” managing the IP portfolio; or
  •  the non-intangible premium (synergies, established workforce and/or location savings) is allocated differently than where the benefits were contributed.


If one of the above situations is apparent, the magnitude of the risks identified should be determined as well as its potential effect on the projected cash flows. This can be determined by assessing future transfer pricing adjustments and thus additional tax payments, including interest for late payment and even potential penalties.

Even if the acquirer is indemnified for subsequent tax liabilities as a result of transfer pricing adjustments, the time and money spent on resolving disputes and dealing with the competent authorities may not be fully compensated for. Additionally it should be considered in advance which party bears the burden of proof and the associated expenses of defending the relevant transfer pricing policy during an audit.

Missing out on this may lead to a flawed valuation model, risk profile and subsequent funding issues, especially when actual cash flows of the combined company fall below the minimum requirement of the debt covenants or when the financing mix (debt/equity) needs to be reconsidered.

Understanding the transfer pricing policy of the target company is thus crucial. However, it may not always be possible to obtain a full picture of existing transfer pricing policies, advance pricing agreements (APAs) and audit outcomes, especially where many buyers are in the market. You may then consider limiting your due diligence on high-quantity transactions and those that involve intangibles and tax havens.

Structuring the Deal

If transfer pricing opportunities and risks have been correctly identified during due diligence, it will impact the legal and capital structure that is used to make the acquisition. It also helps to decide which companies and assets (especially the intangibles) should be part of the transaction and it may play a role in negotiating the appropriate financial terms of the acquisition.

Phase 2: Business Model Optimization

When it comes to business model and supply chain optimization, the goal should be more than reducing operating costs through synergies. It should also become the starting point for the development of a consistent integrated transfer pricing system of the combined enterprise, which will contribute to a maximization of after-tax cash flows and thus shareholder value.

This requires insight into the group's business operations, identifying important value drivers, head office functions, procurement, manufacturing and distribution, shared services, research and development, and IP ownership and deployment processes.

We recommend an integrated approach and creation of a “Center of Excellence” involving cross-departmental collaboration between the business, tax and transfer pricing section, accounting, finance and IT departments, which will support end-to-end process management. Representatives should join and contribute to strategic discussions on possible synergy benefits, process rationalization and choices regarding supply chain optimization.

Transfer pricing opportunities may ultimately be assigned to strategic goals such as increased efficiency (and thus increased shareholder value), vertical or horizontal integration, cash-pooling arrangements, international expansion, etc. These business restructurings may involve the cross-border redeployment of entrepreneurial functions and risks by the group, accordingly allowing another allocation of the group's total profit pool for transfer pricing purposes.

Phase 3: End State—Centralization, Standardization and Automation Of Transfer Pricing Compliance

The study of the value chain end state and the centralization, rationalization and standardization of transfer pricing compliance processes as provided for in Phase 2 gives an excellent opportunity to kick-start a technology-supported tax control framework and compliance solution. This enables the tax and transfer pricing function to allocate more time and budget to other key elements in their job description, i.e. risk control and communication with stakeholders.

When it comes to creating new transfer pricing documentation—master file, local file and country-by-country reporting—reflecting the combined new group's transfer pricing policy, its legacy of existing transfer pricing policies, APAs and audit outcomes should be taken into account. Besides, the group's intercompany agreements should be updated to reflect the additional transactions that will arise as a result of the acquisition.


Given the value-driving rationales behind an M&A deal and the subsequent strong efforts to secure a successful completion of the transaction, tax and transfer pricing risks are often marginalized and not properly managed.

With business models integrated globally and tax authorities increasing their efforts to collect their “fair share of tax” out of the global profit pool, the magnitude of tax and transfer pricing risks have increased significantly in recent years. Apart from lower after-tax earnings and cash flows, also WACC impact may be particularly substantial. This affects acquisition prices, vendor warranties, capital structure and may even lead to the collapse of a deal, e.g. the spectacular Pfizer Inc./Allergan Plc deal failure.

A structured approach to transfer pricing by the M&A lead manager comprises better tax and transfer pricing risk management, opportunities for more efficiency and results in an improved valuation model of the combined/acquired company.

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