Multinational enterprises carrying out merger and acquisitions activity must assess the sustainability of their transfer pricing models post-integration, as they will likely be subject to tax authority review.
Taking appropriate actions, ranging from documenting any business changes to engaging in post-integration restructuring, in a timely manner is critical. Such actions should be both coordinated across jurisdictions, to ensure consistency, and focus sufficiently on local practice, which may differ between Asia’s complex and heterogeneous jurisdictions.
Local Challenges in Managing Transfer Pricing Risks
Turning to the practicalities of preparing your best defense, China, Hong Kong, Japan, Malaysia, Singapore, and many other Asia Pacific countries are members of the inclusive framework on base erosion and profit shifting (BEPS) implementation, and are enacting legislation and revising their administrative procedures to implement the BEPS minimum standards (i.e., countering harmful tax practices, transfer pricing documentation and Country-by-Country (CbC) reporting, and certain tax treaty-related BEPS measures).
In addition, they are adopting the OECD’s recommendations under BEPS Actions 8–10 or incorporating that into their regulations and practice, to ensure that the operational profits of multinational enterprises (MNEs) are aligned with the economic activities which generate them.
We expect to see more transfer pricing audits by Asian tax authorities, resulting in controversies involving intangible property, financing arrangements, goods and services, and other issues.
MNEs may encounter variations in the application of transfer pricing methods by Asian tax authorities. Asian tax authorities often have their own transfer pricing guidelines, which may diverge from the OECD standards. Further, technical standards are divergent in Asia, and sometimes these are incorporated into local laws. This may add a layer of complexity and uncertainty in how to manage transfer pricing risks.
In our experience, MNEs that engage in M&As must look ahead and proactively address the transfer pricing issues that may arise, taking into account local features and complexities and, when they do, it can be an effective way of mitigating potential disputes.
For example, a Chinese company within a MNE may pay royalties to a Singapore company, which holds intellectual property (IP) as its key asset. If so, the MNE must consider whether the risk of the China State Taxation Administration (STA) attempting to raise a challenge on the arm’s length nature of the royalties paid to the Singapore IP company is acceptable. Whether in China or elsewhere, local tax authority and market features should be considered.
For example, in March 2017, the STA issued the Bulletin on the Administrative Measures for Special Tax Investigation and Adjustments and Mutual Agreement Procedures (Bulletin 6), which contains concepts that may diverge from the BEPS Action Plans.
Bulletin 6 reflects the STA’s position that the whole value chain and local characteristics must be taken into account when determining the allocation of profits. Further, Bulletin 6 emphasizes promotion (or local marketing) as an additional value creation function, in cases involving the exploitation of intangibles. The STA may attempt to make a transfer pricing adjustment if the outbound royalty is paid for an intangible that does not benefit the payer of the royalty, or is paid to a legal owner that does not contribute to the value creation of the intangible. Therefore, sufficient work is required to substantiate the benefit, preferably in advance of any potential challenge.
As a further example, if the Singapore IP company pays services fees to a Hong Kong research and development (R&D) company, transfer pricing issues may also arise in Hong Kong. Under Hong Kong’s new transfer pricing legislation (see section 15F of the Inland Revenue Ordinance), it would be necessary to attribute sufficient value to the Hong Kong R&D company for the services it performs in the development, enhancement, maintenance, protection, and exploitation of intangibles (DEMPE).
It remains to be seen how in practice the Inland Revenue Department (IRD) will measure DEMPE value creation functions in Hong Kong. In any event, we expect that the IRD will scrutinize master files, local files, and CbC reports to identify the legal ownership of IP and DEMPE functions in Hong Kong. We regularly see challenges based on (asymmetrically interpreted) DEMPE-type characteristics of licensors and licensees of IP, and so some degree of analysis is necessary to substantiate that the licensor and/or its subcontractors have the necessary substance.
MNEs should further ensure that they coordinate the form and content of their transfer pricing documentation and present consistent transfer pricing positions to tax authorities, despite the local challenges they face in navigating divergences in documentation standards and rules.
Interest Deduction Limitations
An emerging issue arising from the OECD’s BEPS initiative is the amount of interest and financial payments that can be deducted by businesses. The BEPS Action 4 final report recommended the application of a fixed ratio rule, which seeks to limit an entity’s deduction for interest expenses to a percentage of its earnings before interest, taxes, depreciation, and amortization.
A local tax authority may make adjustments based on domestic tax rules even if the financing arrangement approximates an arm’s length transaction.
For example, financing arrangements involving Malaysian entities should be reviewed to determine whether the borrowing costs will be deductible under the new earning stripping rules. The new section 140C of the Income Tax Act seeks to restrict deductions in respect of “any interest expense in connection with or on any financial assistance in a controlled transaction granted directly or indirectly.”
Under the new legislation, the term “financial assistance” is defined to include loans, interest bearing trade credit, advances, debt, or the provision of any security or guarantee. Interest expense means interest on all forms of debt or any payments economically equivalent to interest (excluding expenses incurred in connection with the raising of finance).
This issue may affect the funding of the deal; the acquirer may need to allocate more equity in the funding mix, affecting the weighted average cost of capital. In addition, there may be repercussions for existing highly leveraged and debt push down structures, which must be addressed post M&A during the integration process.
Given that financing arrangements are becoming a key focus of tax authorities in the APAC region, it is important that the acquirer review the target’s intercompany financing arrangement and policies. In Chevron Australia Holdings Pty Ltd v. Commissioner of Taxation  FCAFC 62, the Australian Full Federal Court dismissed Chevron Australia’s appeal in relation to the interest deductions that it had claimed. Chevron Australia had paid interest to its U.S. subsidiary at the rate of 9 percent; the loan was unsecured and no guarantee had been provided. However, the terms of the borrowing were inconsistent with the group’s usual commercial policy.
Allsop CJ stated that: “If the evidence reveals (as it did here) that the borrower is part of a group that has a policy to borrow externally at the lowest cost and that has a policy that the parent will generally provide a third party guarantee for a subsidiary that is borrowing externally, there is no reason to ignore those essential facts in order to assess the hypothetical consideration to be given.”
Post M&A Restructuring
It may be advisable for the acquirer to engage in post M&A restructuring. For example, if the target group has related party transactions involving tax advantaged jurisdictions, the acquirer will need to consider whether the level of risk is acceptable. If the target group has an Australian company that co-funds IP with a Cayman Islands IP company, and the Cayman Islands IP company engages R&D companies in China/Singapore to provide services, the acquirer may decide to “onshore” the IP in China/Singapore during the integration process in order to mitigate the tax risks.
In another example, the target group may have implemented a supply chain structure that involves an intermediary such as a Hong Kong principal, which:
- subcontracts related party manufacturing companies in China to produce goods; and
- pays service fees to marketing companies in China.
There is a risk that the STA may challenge the profit share of the intermediary in view of its value contributions.
Bulletin 6 requires location-specific advantages (LSAs) to be considered when substantiating the level of profits earned by the Chinese manufacturing companies.
The STA may attempt to make an adjustment if insufficient weight is given to location savings that are achieved through factors like low-cost skilled labor and infrastructure in China during the manufacturing process.
Further, MNEs are required to consider the market premium that is achievable in China, as the STA believes the huge Chinese population and their growing affluence allow MNEs to charge higher prices than they can in other jurisdictions. Depending on the circumstances, various options should be considered to mitigate potential risks while defending any arm’s length position taken, noting this additional layer of complexity.
Transfer pricing issues are a major concern in any M&A, affecting both the acquirer and target at all stages of the deal. Transfer pricing issues may affect valuations, representations, and indemnities. Opportunities may be identified at an early stage to optimize tax and transfer pricing positions, increasing value and utilizing synergies after the closing of the deal.
Although there may be transfer pricing risks inherent in the target group, or which may arise during the integration process, we believe that the risks may be managed effectively by strategically reviewing value chain structures and reconsidering transfer pricing policies and documentation, evaluating all points of weaknesses.
Local features and complexities in transfer pricing standards should be considered. Depending on the circumstances, it may be advisable for MNEs to engage in post M&A restructuring activities in order to arrive at transfer pricing positions that are more defensible.
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