Transfer pricing issues are becoming increasingly high profile in the Asia Pacific region and around the world.
Global tax and transfer pricing driven developments such as the Base Erosion and Profit Shifting ("BEPS") project promulgated by the Organization for Economic Co-operation and Development ("OECD") are observed closely by Asian governments, and many Asia Pacific governments are members of the OECD’s “inclusive framework,” which aims to develop, align and support the enforcement of international tax and transfer pricing standards.
In this rapidly changing environment, existing policies will be subject to closer tax authority scrutiny, which requires multinational enterprises ("MNEs") to conduct robust risk assessment and planning to mitigate the potential for transfer pricing adjustments.
Given the predilection for tax authorities to scrutinize the policies of taxpayers involved in significant business change, MNEs engaging in mergers and acquisitions ("M&A") as well as business restructuring activities post M&A must now consider and be cognizant as to the sources of potential transfer pricing challenges by local tax authorities to best preempt and defend against them if needs be.
Part 1 of this Insight focuses on a few key issues that should be considered in the context of such restructuring projects post-closing.
Pre-deal Due Diligence
To mitigate potential tax authority challenges, or best defend against them, ideally, tax and transfer pricing matters would first be considered pre-closing through buyer due diligence and negotiation, to protect against historical tax and transfer pricing risks and to identify the tax risk mitigation potential.
This may result in certain representations and warranties being required of the seller, to protect the buyer against certain issues arising from a lack of compliance with transfer pricing principles and/or obligations. Such due diligence can also be used to develop a tax-efficient acquisition structure, and to consider the maximum bid price for the target.
In our experience, transfer pricing and tax teams (internally and with the support of advisers) are involved and add value throughout the deal process (see example).
Post-closing Restructuring and Risk Management
Post-closing, once further detailed information is available to better assess risks and opportunities to drive deal value, it is crucial to review and consider all of the relevant tax transfer pricing risks and implications in post M&A restructuring during the integration process to avoid potential pitfalls and the possible occurrence of double taxation.
On post-completion of an M&A deal, the acquirer needs to develop best strategies to ensure that the acquisition meets pre-deal expectations and delivers optimal value.
Preferably, a structured approach should be adopted, from assessing the facts through to implementing any desired or necessary changes.
First, and most importantly, the initial stages of review can be used to obtain detailed factual insight into the target’s business operations, identifying and evaluating transfer pricing vulnerabilities and opportunities and, from there, using the facts to develop an appropriate and tailored defense strategy for your historical and going-forward transfer pricing policies.
This should encompass a review of the arm’s length nature of the actual policies now and historically. Depending on the results of this factual analysis, recommended next steps could include desired (and minimally invasive) changes to the business to support the arm’s length nature of the model, or simply organizing your records to best defend against any future audit.
One commonality of the risk reviews we undertake is that previous transfer pricing policies that were implemented will not necessarily be representative of the realities of the business post-completion and of how things actually work, and so changes to policies and detailed consideration of the implications of this are necessary.
Further, upon integration of the buyer and seller operations, if there is a mismatch between the acquirer’s and target’s underlying operations and/or transfer pricing policies, the acquirer will need to make a decision on if and how to align them. Typically, it is preferable that there are integrated operations and a consistent transfer pricing policy approach across all entities, but in certain circumstances this may not be practical.
For example, on projects we have worked on, IT systems integration issues and regulatory concerns may impact the ability to align the respective models in the intended time frame, which restricts the ability to manage transfer pricing risks and achieve operational synergies.
To the extent feasible, the acquirer will need to implement the alignment of transfer pricing policies in a carefully considered manner to avoid challenges in dealing with tax authorities. For example, if the target and acquirer have similar operations in the same jurisdiction, there is a risk that a change to the transfer pricing policies will prompt an inquiry by the tax authority in that jurisdiction, triggering an audit.
So, in implementing a restructuring program, best practice is to understand the likely issues in advance so that they can properly be addressed contemporaneously.
In order to properly assess risks in relation to transfer pricing and to develop strategies to mitigate them, it is prudent for MNEs to review their global supply and value chain, operations, and fact pattern to ascertain the underlying substance of the transactions in conjunction with the actual and intended transfer pricing model. This would also entail a review of the actual conduct of parties.
MNEs should subsequently review the extent and nature of any contractual and operational changes necessary in order to achieve a target model, considering the commercial feasibility of such changes and their impact on the business.
If commercially feasible, and the model is implemented, contemporaneous documentation to show the extent and nature of the changes in business operations are helpful, as it is often the case that any tax authority scrutiny comes long after the restructuring takes place, and it is important to be able to factually substantiate the changes made.
In audit situations we observe that undertaking these steps can make a significant difference in substantiating the model. As the key focus of tax authorities in the context of business restructuring is to examine whether there is:
- a transfer of value functions from one jurisdiction to another, in particular from a high tax jurisdiction to a low or lower tax jurisdiction; or
- whether the post-restructuring transfer pricing model reflects underlying economic substance, directly addressing the issue through reasonable analysis, and retaining appropriate records to substantiate it can, for example, provide a solid factual basis to assert what the actual economic substance behind a transaction is, even significantly after the restructuring itself.
Many tax authorities strongly question whether form and substance of post-restructuring policies are aligned, particularly where there is legal entity integration.
Some add a legislative basis for querying such issues: for example, under Singapore’s transfer pricing legislation, the Inland Revenue Authority of Singapore (''IRAS’') can attempt to make adjustments and penalize taxpayers that do not comply with the arm’s length standard or documentation rules.
Should the IRAS conclude that they can disregard the form of a transaction if it is inconsistent with the substance of the transaction, and if a transfer pricing adjustment is made, a surcharge equal to 5 percent of the amount of the increase or reduction will apply.
Many other tax authorities in the region have similar rules in their own guidance or follow the OECD standards in this respect. For example, the China State Taxation Administration ("STA") would not hesitate to attempt to re-characterize a transaction if it perceives a form and substance deviation. This is where having a solid factual underpinning to support the corresponding transfer pricing analysis becomes so important.
If the transfer pricing risks are not addressed, the consequences can be significant.
For example, a post M&A due diligence may reveal that the target group has a Malaysian marketing company, which provides services to a U.S. principal, charging fees on a cost plus 5 percent basis.
Although the Malaysian Inland Revenue Board ("IRB") may not have requested the marketing company to provide appropriate transfer pricing documentation in the past, this may not be the case now. Malaysia does not have safe harbor transfer rules or a simplified approach for intragroup services. If the IRB conducts an audit on the marketing company and attempts to make a transfer pricing adjustment, increasing the income payable in Malaysia, this may result in double taxation as well as penalties.
There is no double tax agreement between the U.S. and Malaysia, which requires the U.S. to make a corresponding deduction adjustment. This underscores the need to prepare the analysis contemporaneously and focusing on the risks so that such adjustments can be avoided.
Part 2 of this two-part Insight continues to focus on the transfer pricing risks and BEPS issues in the context of post M&A transactions.
Michael Nixon is Principal, Economist at Baker McKenzie Wong & Leow; Krystal Ng is a Partner at Wong & Partners and Shanwu Yuan is International Tax Director, Baker McKenzie
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