Transfer Pricing in Mergers and Acquisitions: Due Diligence Considerations

Blog Article

In today’s dynamic business landscape, mergers and acquisitions (M&A) continue to be a critical strategic tool for companies looking to expand, diversify, or consolidate operations. However, the success of any M&A transaction hinges not only on strategic alignment and valuation but also on thorough due diligence. One often overlooked yet crucial element of this process is transfer pricing—a domain that plays a central role in evaluating the tax, compliance, and operational risks associated with a transaction. For businesses operating or acquiring in the United Arab Emirates (UAE), understanding transfer pricing in UAE within the context of M&A has become more significant than ever.

Transfer Pricing in UAE: Growing Importance in the M&A Landscape

The UAE, traditionally recognized as a tax-friendly jurisdiction, has seen substantial regulatory evolution in recent years. With the introduction of Economic Substance Regulations (ESR), Country-by-Country Reporting (CbCR), and most recently, the implementation of corporate tax in 2023, the country has aligned more closely with international tax frameworks such as the OECD’s Base Erosion and Profit Shifting (BEPS) action plan. Consequently, transfer pricing in UAE is no longer a peripheral concern but a core component of due diligence in any transaction involving multinational enterprises (MNEs) or cross-border elements.

In the context of M&A, transfer pricing becomes especially significant when the target company is part of a group that engages in intercompany transactions—be it goods, services, intangibles, or financing. Ensuring that these transactions have been priced in accordance with the arm’s length principle is vital to avoid future tax liabilities, penalties, or even disputes that can derail the success of a deal post-closing.

Transfer Pricing Risks in M&A: A Due Diligence Imperative

Transfer pricing risk in M&A primarily arises from non-compliance with tax regulations, incorrect pricing of related-party transactions, and lack of proper documentation. During the due diligence phase, buyers need to assess whether the target has followed appropriate transfer pricing policies and whether those policies align with local regulations and global best practices. This evaluation includes a review of transfer pricing documentation, intercompany agreements, functional analyses, and economic studies.

Key areas of concern include:

Accuracy of Transfer Pricing Policies: Are the intercompany transactions priced at arm’s length?

Consistency with Documentation: Is the transfer pricing documentation updated, comprehensive, and in line with the local regulatory requirements?

Tax Audit Exposure: Has the target undergone a tax audit recently? Were any transfer pricing issues raised?

Cross-Border Transactions: Are there any high-risk transactions such as royalty payments, management fees, or intercompany loans?

Given the increasing scrutiny on transfer pricing in UAE, these aspects are essential for avoiding costly post-acquisition surprises.

Role of Functional and Risk Analysis in M&A

An accurate functional and risk profile of the target company is fundamental to transfer pricing due diligence. This involves identifying the key functions performed, risks assumed, and assets employed by each entity involved in intercompany dealings. Such an analysis is critical to determine whether the profits are allocated appropriately among the related entities.

For example, if the target company acts as a limited-risk distributor in the UAE, its profit margins should reflect its limited functions and risks. However, if its profit margins are unusually high or if it assumes significant strategic risks, there might be a misalignment with the transfer pricing model. This misalignment could attract scrutiny from UAE tax authorities, particularly with the introduction of corporate tax.

In many cases, buyers engage tax advisors to perform a deep-dive into the functional and economic profiles of the group entities. These professionals can provide insights into whether the intercompany transactions are defensible under the arm’s length standard and whether any adjustments are needed prior to or after the transaction.

Tax Advisors and Their Role in Transfer Pricing Due Diligence

The expertise of tax advisors is invaluable in navigating the complexities of transfer pricing during an M&A deal. Their role includes evaluating current compliance, identifying potential risks, and structuring the transaction to optimize the tax outcome. This may involve revising intercompany agreements, recommending price adjustments, or even suggesting changes to the business model to reduce exposure.

In the UAE context, where the corporate tax regime is still relatively new, the role of experienced advisors becomes even more critical. They can help buyers understand how the target’s transfer pricing policies align with local requirements and advise on necessary remediation steps. Moreover, with the growing digitalization of the UAE Federal Tax Authority (FTA), transfer pricing documentation and data analytics are expected to be central to future audits. Ensuring that the target has systems in place for compliance is now a top priority.

Structuring Considerations: Post-Acquisition Transfer Pricing Adjustments

Post-acquisition, the acquiring company may wish to integrate the target into its existing business model. This can involve restructuring operations, shifting functions, or centralizing certain services. Such changes often lead to modifications in transfer pricing policies. However, any changes must be made with caution.

Modifying intercompany pricing post-deal could trigger tax consequences, especially if it leads to reduced taxable income in high-tax jurisdictions or increased income in favorable ones. This could raise red flags with tax authorities and lead to transfer pricing audits. In the UAE, where the FTA is rapidly enhancing its capabilities, these risks are particularly relevant.

Therefore, buyers should include transfer pricing considerations in their post-acquisition integration plans and seek to align transfer pricing strategies with operational realities and tax compliance needs.

Valuation and Transfer Pricing Alignment

Another important aspect is the alignment between the purchase price of the transaction and the transfer pricing valuations of intangible assets, such as trademarks, patents, or know-how. If the M&A transaction involves a significant component of intellectual property, there may be implications for future royalty payments and transfer pricing treatment of those intangibles.

Discrepancies between the price paid for an asset in an M&A transaction and its valuation for transfer pricing purposes can be a red flag. Tax authorities may question the rationale behind such differences, leading to potential disputes or recharacterization of transactions. Conducting a valuation analysis in tandem with transfer pricing due diligence can help mitigate this risk.

Documentation and Compliance Readiness

Documentation is the bedrock of transfer pricing compliance. In the due diligence phase, the buyer should verify whether the target has prepared and maintained adequate transfer pricing documentation in accordance with UAE guidelines. This includes:

Master file and local file as per OECD standards

Country-by-Country Report (if applicable)

Intercompany agreements

Economic analyses and benchmarking studies

The introduction of transfer pricing in UAE regulations necessitates a higher standard of documentation, particularly for companies with cross-border transactions. Failure to maintain proper documentation can lead to penalties and increased audit exposure, which can diminish the value of the acquisition.

Transfer pricing is no longer a niche tax topic in the UAE. With the maturation of the UAE’s tax ecosystem and its growing alignment with global standards, transfer pricing in UAE has become a central due diligence item in any M&A transaction. Ignoring it can lead to significant post-deal issues including tax liabilities, disputes, and reputational damage.

A proactive approach—one that involves early involvement of tax advisors, robust documentation review, and careful analysis of intercompany arrangements—can safeguard both buyer and seller interests. Whether structuring a deal, integrating a new business, or preparing for future audits, transfer pricing must be an integral part of the strategy. For companies operating in or entering the UAE market, understanding these dynamics will be key to successful and compliant growth through M&A.

TRANSFER PRICING IN MERGERS AND ACQUISITIONS: DUE DILIGENCE CONSIDERATIONS

Transfer Pricing in Mergers and Acquisitions: Due Diligence Considerations