THIS ARTICLE FIRST APPEARED IN BNA'S INTERNATIONAL TAX PLANNING - TRANSFER PRICING (JANUARY 2001)

European, Asian and other non- U. S. multinational groups continue to acquire U. S. companies, including U. S. companies (" Targets") which are international companies in their own right. This has led to the consolidation of many industries and to a change in the number of related party transactions following an acquisition.

During the due diligence phase of a cross- border M& A transaction, in many cases there is an inadequate amount of attention paid to Target’s transfer pricing policies, planning and documentation. At times this information does not become available even from the most co- operative Targets. Not only does Acquirer need to deal with and potentially re- evaluate its existing inter- company transactions, but it must consider and evaluate a newset of issues with respect to Target’s policies on transfer pricing. The tax planning, strategies, methodologies and level of supporting documentation of Target and Acquirer may be compatible or entirely different.

The purpose of this checklist is to "highlight" some of the transfer pricing issues that should be raised and addressed during tax due diligence. It is designed to avoid surprises that may arise after the deal has closed and years after the inter- company transactions took place. It is not intended to cover every conceivable type of acquisition, related party transaction or issue.

Although the checklist is written from the viewpoint of a non- U. S. group acquiring a U. S. Target (either directly or indirectly), the issues are nearly the same for a U. S. company that is acquiring a non- U. S. Target. This checklist would also be relevant if a non- U. S. group is acquiring a non- U. S. Target. Merely substituting the name of Target’s country where "U. S." appears in this checklist will accomplish this goal.

It is assumed that the reader is familiar with the principle that related parties are to deal with one another at arm’s length and, if they do not do so, tax authorities have the right to reallocate income and deductions and to place taxpayers in the same (or nearly the same) position as they would be in if the transactions had been entered into with unrelated third parties. Although not a new concept, the level of enforcement and the proof required to support arm’s length transactions have spread way beyond the United States and many other OECD member countries.

This checklist applies to any industry: telecommunications, e- commerce, pharmaceutical, manufacturing and distribution, financial services, etc. and to companies that have in tangibles whether they are patents, trademarks or similar property. Also, these comments apply to all types of related party transactions including: the sale of tangible property (with and without so- called "imbedded intangibles") and the licensing of intellectual property and the rendering of inter- company services.

I. Acquisition Of A U. S. Target (Directly And Indirectly)

A. When Target Is A U. S. Company

This section deals with issues to consider when a non- U. S. parent company (" Forco") seeks to acquire the shares of a U. S. company (" Target") or assets in a case where a division or business unit is acquired. It is assumed that Forco has existing U. S. operations although, even if it does not, many of the points discussed herein will be applicable. The discussion includes both direct and indirect acquisitions – the latter involving the acquisition of Target’s non- U. S. parent company or other non– U. S. affiliate.

  • Will Forco acquire Target directly from its home country or another non– U. S. jurisdiction?
  • Alternatively, will Forco’s existing U. S. operations make the acquisition?
  • Will Target join the U. S. consolidated tax group of Forco’s existing U. S. operations – either as a subsidiary or division within one of the legal entities (as might be the case if an asset acquisition is involved or the acquisition of shares followed by a liquidation)?

Certain transactions may involve assets, shares or a combination thereof. Designing the legal structure during the acquisition phase and buying just the right legal entities and assets (especially intangibles) in the most tax- efficient manner is just as important as restructuring after the transaction has closed and may be less expensive. Not every objective that involves the structure can be accomplished beforehand and certain things may have to be accepted in order to close the deal. Nevertheless, to the extent that transfer pricing planning opportunities and exposures are identified during due diligence, this could have an impact on the legal structure which is used to make the acquisition and may play a role in negotiating the financial terms of the acquisition. For example, it may be one of many factors in determining whether Target is acquired from a non- U. S. jurisdiction or by Forco’s existing U. S. operations.

If Target is housed in the same U. S. consolidated tax group, upon an IRS audit both businesses stand a chance of being examined at the same time; however, this will depend on the objectives of the IRS team assigned to the audit, the location of the affiliates, the technical issues involved, the relative size of the businesses and a variety of other factors (e. g., high profile industry versus a routine business). On the other hand, if Target is established as a brother- sister U. S. group, it is possible that there will be a co- ordinated examination, although it is difficult to generalise. Even brother- sister groups that do not have a common non- U. S. parent may face a co- ordinated exam, as might be the case where Forco is established in one jurisdiction and an affiliate in another country makes the acquisition.

If the separate U. S. groups have (or will have) transactions among themselves, this event may trigger an inquiry – even though the transactions are entered into between two U. S. companies which (assuming both are profitable) are paying more or less the same effective rate of tax. For example, it is very common to see the sale of an asset or business from one U. S. group to the other for non- tax business reasons – to align and combine business operations and to develop synergies in order to reduce operating costs. Nevertheless, in designing the legal structure there are many more considerations – both operational and financial – which need to be considered long before one tries to assess the chances of an IRS audit on one or more businesses. For example, the ability to file consolidated U. S. tax returns (especially if one or more of the entities has losses) which can be used by the group on a current basis or against future earnings of the loss member, will be of great significance.

B. When Target Is A Non- U. S. Company

If Target is another non- U. S. entity (Forco 2) which itself owns U. S. operations, many additional issues should be considered:

  • Are Forco and 2 established in the same or different country?
  • Will Forco 2 merge or amalgamate in the foreign jurisdiction and/ or in other countries?
  • Will Forco 2 operations be integrated into Acquirer’s existing U. S. operations?
  • If there will be an integration of the U. S. operations, how will this be achieved? Sale of assets? Sale of shares? Reorganisation?

Many non- transfer pricing tax issues arise with such an integration. For example, great care needs to be given to address the risks of Internal Revenue Code Section 304 (redemptions through the use of related corporations) which, in very general terms, can result in deemed distributions in the case of a cross- chain sale of shares and, thus, the imposition of unwanted U. S. dividend withholding tax. Since this article is limited to transfer pricing, these topics are beyond the intended scope.

C. Different Methods And Types Of Transactions

  • Is the nature of the business of Target the same or similar to Forco’s existing U. S. operations? If the businesses are different are they "functionally" the same? For example, if the existing business is an importer/ distributor of Product X, is Target also a distributor of similar products or does the distributor have an entirely different function, such as that of a manufacturer? While the nature or the function of the business may be similar, perhaps the products compete in the marketplace with different names.
  • What are the types of related party transactions and have they been properly classified?

There may be cases where Forco’s existing U. S. operation is using a method of transfer pricing, for example the Comparable Profits Method (" CPM") (which uses objective measures of profitability by using profit- level indicators to determine arm’s length ranges of profitability) 1 and where Target is applying a different method. For example, Target may have been transacting business with an unrelated third party and have comparable uncontrolled transactions (which looks to amounts charged in similar third party transactions). 2 Alternatively, it may have applied the Cost Plus Method, 3 and in doing so, used the foreign parent as the "tested party" 4 for purposes of applying this method.

Rationalising the ongoing use of different methods or switching to another method needs to be analysed in great detail. Moreover, not only are the U. S. tax implications important, but the impact of any change in foreign jurisdictions must be considered.

With respect to the transactions themselves, in most cases they will fall neatly into one of the major categories: tangibles, intangibles and related party services. However, the issues should be considered in depth, for example:

  • In the case of tangibles, are services required to be rendered in connection with the sale? Thus, will it be necessary to consider the transfer pricing aspects of the tangible sale as well as the value of the services?
  • In the case of a sale of tangibles is there a trademark or other "imbedded intangible"? Is this a valuable intangible?
  • Does the related price include the intangible or is there a separate royalty for the intangible, which may, for example, include the right to distribute the product? Is this royalty to be included for purposes of determining import duties?
  • If there is a royalty will withholding tax be imposed and, if so, at what rate?
  • In the case of acquired intangibles which legal entity will own them? Will it be a non- U. S. company formed in a low- tax jurisdiction? Will such entity be entitled to the lower rate of withholding tax pursuant to a tax treaty with the United States?
  • For a Target or Acquirer that has substantial research activities, has "cost sharing" or "contract R& D" been considered in lieu of inter- company licensing? Did Forco or Target have one of these arrangements and, if so, how will it be incorporated into the new structure?

As part of a decision on whether to acquire assets or shares, it is important to consider the placement of intangible assets. Generally, income will flow to the entity that owns valuable intangible assets, and that entity will likely be taxed on the income in its home country. In many situations, intangible assets may be acquired by an entity in a low- tax jurisdiction. Such flexibility is often not possible or more difficult in a stock acquisition.

The ability to acquire intangibles in a low- tax jurisdiction is often easier in the case of a foreign acquirer purchasing intangibles of a U. S. group because of the U. S. Controlled Foreign Corporation / Subpart F legislation 5 which is designed to prevent the accumulation by U. S. companies of certain categories of income in low- tax jurisdictions. However, a foreign acquirer that purchases intangibles offshore and licenses them to a U. S. affiliate will have to deal with whether the company in the jurisdiction that owns the intangible will be eligible for lower withholding tax rates on royalties or will be subject to a 30 percent statutory rate because of restrictions contained in the "limitation on benefits" provision of a tax treaty.

D. Combining Operations

  • Will the businesses that are the same or similar be combined at some point?
  • Will they be managed together?
  • Will one manage the other?
  • Should there be an inter- company service fee paid for the management services?

If Target’s business is the same/ similar, eventually the corporate executives responsible for operations are likely to seek a combination or, alternatively, might seek to have one entity manage the other. It may be redundant to have two or more legal entities in the same jurisdiction operating similar businesses. Issues arise in terms of how those operations can be combined into one business unit. This art of combining will put additional pressure on unifying the transfer price methodologies. On the other hand, there may be circumstances where separate legal entities are necessary, for example, in a case where products with different trade names co- exist in the U. S. market.

E. Offshore Trading Companies

In the case of either Forco 1 or 2, the legal structure may include "trading" or other offshore companies through which the related party transactions occur.

  • Does Forco 1 produce products in its home country and sell them directly to its U. S. subsidiary?
  • What about Forco 2?
  • Does Forco 1 or 2 re- sell products manufactured in one country to another non- U. S. affiliate which, in turn, re- sells to the U. S. company?
  • If so, what functions and risks does the intermediary perform or assume?

In most cases foreign (non- U. S.) corporations that import products into the United States sell such products to their U. S. affiliates which, in turn, distribute the products in the United States and/ or North America through various distribution channels. There are exceptions; for example, where a foreign manufacturer produces a product in one country and then sells it to another foreign company which, in turn, re- sells it to a related U. S. company. The business purpose of the intermediary is important to the analysis as well as an assessment of the value added by the intermediary.

II. Documentation And Related Party Disclosures

It is important to consider the pre- acquisition transfer pricing practices and policies of Target or any affiliate

with which Target conducts business – whether or not the affiliates are also part of the current acquisition.

  • Has IRC Section 6662 documentation been requested during due diligence?
  • How extensive is the Section 6662 documentation?
  • Does it reflect all party transactions?
  • Was the documentation prepared with the assistance of a professional advisor?
  • How does Target retrieve related party information (particularly for U. S. Targets that are owned by foreign shareholders)?

Since 1996 when potentially onerous penalties were introduced for "substantial valuation misstatements" (Section 6662( e)), the practice of a vast number of multinational businesses has been to develop "contemporaneous documentation" setting forth the methodology by which related party’s prices have been determined. In general, it is only with such documentation that the penalties (which are in addition to the tax on a pricing adjustment) can be avoided.

It is extremely important to fully understand the transfer pricing policy of Target. Obtaining copies of the Section 6662 documentation will provide a good starting point in terms of the nature and the extent of such transactions and the methodology by which such transactions have been supported. This will identify areas in which there may be weaknesses in Target’s transfer pricing policy. In practice some taxpayers may make a business decision not to study all their related party transactions. Some may limit studies to high exposure transactions or to transactions with tax haven affiliates. It is important to try to develop and understand exactly what is and what is not covered by the documentation that has been furnished. Where documentation has not been developed, it is important to understand the reasons and to assess whether there is an area of exposure.

The amount of due diligence that one can perform with respect to the acquisition of Target will vary according to each transaction. Generally speaking, the greater the demand for Target, the harder it may be to obtain information, since the seller may have a wide choice of buyers. With respect to the data room, it is necessary to obtain as much information as possible concerning the nature and extent of related party transactions. To the extent this information can be obtained over multiple years, it will demonstrate the trend of the business.

  • Have IRC Forms 5471 and 5472 been reviewed as part of the federal returns furnished by Target?

Generally, a foreign- owned U. S. corporation (a "reporting corporation") must report related party transactions on IRS Form 5472 (" Information Return of a 25 percent Foreign- Owned U. S. Corporation …"). A reporting corporation is any U. S. corporation that is 25 percent foreign- owned (Section 6038A). The reporting corporation must file Form 5472 with respect to each related party with which the reporting corporation has had a "reportable transaction" during the taxable year. Reportable transactions are initially divided into two categories: foreign related party transactions for which only monetary consideration is paid or received and foreign related party transactions involving non- monetary consideration or less than full consideration.

The reporting corporation is required to furnish or maintain information with respect to the following transactions with foreign related parties if the transactions involve solely monetary considerations:

  1. Sales and purchases of inventory made to and from related parties;
  2. Sales and purchases of tangible property (e. g., equipment) other than inventory made to and from related parties;
  3. Rents and royalties paid to and received from related parties;
  4. Sales, purchases and amounts paid to and received from related parties for the use of all intangible property, including (but not limited to) copyrights, designs, formulas, inventions, models, patents, processes, trademarks, and other similar intangible property rights;
  5. Consideration paid to and received from related parties for technical, managerial, engineering, construction, scientific, or similar services;
  6. Commissions paid and received;
  7. Amounts loaned to and received from related parties;
  8. Interest paid to and received from related parties;
  9. Premiums paid to and received from related parties for insurance and reinsurance; and
  10. Other amounts paid to or received from related parties with respect to transactions which are not specifically described in 1. through 9., above, to the extent that such amounts are taken into account for the determination and computation of the taxable income of the reporting corporation.

The transactions in 1.- 10. above are considered direct transactions. Indirect transactions are those which take place between parties related to the reporting corporation, but which do not directly involve the reporting corporation. An indirect transaction includes one between two related parties which ultimately affects the price of goods sold from a related party to the reporting corporation in the United States.

If a transaction was entered into and either non-monetary considerations or less than full consideration was received, such transaction must be reported and the disclosure must include: a description of all the property (including monetary consideration), rights, or obligations transferred from the reporting corporation to the foreign related party and from the foreign related party to the reporting corporation; a description of all services performed by the reporting corporation for the foreign related party and by the foreign related party for the reporting corporation; and a reasonable estimate of the fair market value of all properties and services exchanged, if possible, or some other reasonable indicator of value.

It is important to note that reporting corporations must be careful in determining which other corporations or persons are related to them; otherwise, penalties may be imposed. In many instances, a non- U. S. parent may wholly own multiple U. S. subsidiaries, along with multiple foreign wholly- or majority- owned subsidiaries. In such cases, the foreign parent is clearly a related party, as it passes the 25 percent foreign ownership test. Additionally, however, each of the foreign parent’s other U. S. and foreign subsidiaries are also related parties.

  • Does the U. S. Target itself own non- U. S. affiliates?

It is entirely possible that Forco will seek to acquire a U. S. target which itself has foreign (non- U. S.) operations whether they be controlled foreign corporations, for eign branches of the U. S. company, partnerships, joint ventures or so- called "check the box", which are entities where the tax characteristics "pass through" to the shareholders.

Although not discussed in detail, a U. S. person who meets the control requirements with respect to a foreign corporation for an uninterrupted period of 30 days during the foreign corporation’s annual accounting period must file a separate annual information return on Form 5471 (Information Return of U. S. Persons With Respect to Certain Foreign Corporations). As in the case of Form 5472, this form requires detailed information on related parties – not just on transactions that directly involve the U. S. company, but also foreign- to- foreign transactions.

III. History Of Target’s IRS Examinations And Indemnifications

  • Do you have a detailed explanation of Target’s IRS examination experience and the experience of affiliates in each jurisdiction in which there are significant transactions?
  • Was transfer pricing raised as an issue on prior examinations but then dropped or substituted for an IRS adjustment with respect to another tax issue? What was the other tax issue?
  • If a transfer price adjustment was sustained, was it treated as a deemed dividend on which U. S. withholding tax was imposed? Was the withholding tax applied at the lower treaty rate?
  • Will there be an indemnification with respect to any past liabilities that arise as a result of a transfer pricing adjustment?

Particular focus should be placed on Targets that have affiliates in low- or no- tax jurisdictions. Significant transfer pricing liabilities may exist in one or more jurisdictions. Even if the seller indemnifies Acquirer for tax liabilities (plus interest and penalties) arising out of transfer pricing adjustments, the time and cost of resolving disputes and achieving double tax relief (e. g., through the competent authority mechanism in a double tax treaty) could be a fine consuming burden on valuable corporate resources.

Consideration needs to be given to the Acquirer’s obligations in terms of taking over and defending the transfer pricing policy of Target. Will the seller continue to exist and handle the examinations at its expense? By acquiring Target will Acquirer be handling the audit? Where are the books and records?

IV. New And/ Or Combined Policies And APAs

  • If Forco plans to have a different policy or strategy with respect to the same type of transaction carried out by the affiliates of the newly acquired Target, will the policy trigger an examination of the old policy and practices?
  • Would it be better to keep the Target’s old policy in place?
  • Have the facts and functions changed to support a new policy? For example, will new transactions arise as, for example, where a U. S. Target is acquired that will export to the foreign acquirer?
  • In what way do related party agreements need to be updated to reflect transactions that will arise as a result of the acquisition?
  • Does Forco or Forco 2 have in place an Advanced Pricing Agreement (APA)? Is it bilateral?
  • If an APA exists will it cover the acquisition of Target? Should it? Is it appropriate to update the APA?

V. Acquiring Unrelated Parties

  • Is Target a company with which Forco or any of its affiliates did business prior to the acquisition?
  • If yes, was Target a U. S. distributor?
  • Was it a licensee or licensor?

Issues can arise where related party transactions did not exist before the acquisition, but do thereafter. For example, a non- U. S. manufacturer may acquire unrelated distributors located in the United States. If the distributor previously purchased inventory from the manufacturer and will continue to do so, is the group bound by its prior unrelated pricing arrangements? The issue arises as to whether the unrelated transactions that are close in time to the related transactions are comparable controlled transactions – among the highest quality arm’s length information and also the type of information most difficult to identify. The same point applies to the licensing of intangibles.

  • What if Acquirer wants to change the prices or royalties?

The issue here is whether there are new facts that can justify a change. Have the terms of the transaction changed or can they be changed to justify new pricing? For example, is the related party agreement now an exclusive licence for which a third party might be willing to pay a higher royalty?

VI. Related Party Agreements

The existence and development of related party agreements covering most (if not all) of the major relationships is essential to any international tax / transfer pricing plan. These documents reflect the intentions of the parties as, for example, which entity will bear certain business and financial risks. In the absence of agreements, companies can run the risk that certain of their practices can be questioned or misinterpreted. In addition, it is important that the actual practice of the parties follow the agreements and that there be periodic checkups to ensure this.

  • To what extent does Target have related party agreements that set forth the intentions of the parties and the different legal and economic roles that each one is willing to assume?
  • To what extent is the actual practice of the parties consistent with the terms of the agreement?
  • To what extent will Acquirer’s or Target’s existing agreements need to be amended?

VII. Summary

The above checklist is designed to highlight transfer pricing issues to consider during an acquisition. In many cases all of the information may not become available; however, this data may be so important that it can have an impact on how and what is acquired. It may also have an impact on the financial cost of the transaction.

Footnotes

  1. Treas. Reg. Section 1.482- 5
  2. Treas. Reg. Section 1.482- 3( b)
  3. Treas. Reg. Section 1.482- 3( d)
  4. Treas. Reg. Section1.482-
  5. ( b)( 2) 5 Internal Revenue Code Sections 951- 964

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.