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How Does Transfer Pricing Risk Affect Premiums in Cross-Border Mergers and Acqu

How Does Transfer Pricing Risk Affect Premiums in Cross-Border Mergers and Acquisitions?* DEVAN MESCALL, University of Saskatchewan KENNETH J. KLASSEN, University of Waterloo† ABSTRACT This study investigates how transfer pricing risk affects the premiums in cross-border mergers and acquisitions (M&A). Differences in the rigor of transfer pricing enforcement and the severity and clarity of rules across countries create differential risk of material costs for multinationals as they expand globally. We use 448 country-level transfer pricing risk assessments by global transfer pricing partners and managers from two firms in 33 countries to develop a metric of country-year transfer pricing risks. The resulting measure of transfer pricing risk is used to analyze the premiums of 3,103 cross-border M&A from 2000 to 2012. We find that lower bid premiums are associated with higher transfer pricing risk in the target’s country. We find the relation is stronger when expected future transfer pricing benefits are larger. Our results, consistent with the views of experts in the field, provide the first archival evidence that acquirers consider synergies created by future tax planning when estimating the value of a target. Quelle est l’incidence du risque li e a l’ etablissement des prix de cession interne sur les primes dans les fusions et les acquisitions transfrontalie `res ? R ESUM E Les auteurs se demandent quelle est l’incidence du risque li e a l’ etablissement des prix de cession interne sur les primes dans les fusions et les acquisitions transfrontalie `res. Les diff erences entre pays dans la rigueur de l’application des principes d’ etablissement des prix de cession interne et dans la s ev erit e et la clart e des re `gles en la matie `re exposent les multinationales qui prennent de l’expansion a l’ echelle mondiale au risque diff erentiel de devoir assumer des co^ uts importants. Les auteurs utilisent 448 evaluations du risque li e a l’ etablissement des prix de cession interne au niveau national, evaluations provenant d’associ es et de directeurs de deux cabinets exerc ¸ant leurs activit es dans 33 pays, afin d’ elaborer un indicateur du risque li e a l’ etablissement des prix de cession interne, selon le pays et l’ann ee. Cet indicateur de risque est ensuite utilis e pour analyser les primes de 3 103 fusions et acquisitions transfrontalie `res entre 2000 et 2012. Les auteurs constatent que les primes des offres plus basses sont associ ees a un risque plus elev e dans le pays de la soci et e cibl ee. Ils notent que ce lien est * Accepted by Thomas Omer. The authors thank Patricia O’Brien, Tony Wirjanto, and Phelim Boyle; and Petro Lisowsky, Alan Macnaughton, Christy MacDonald, Jeff Pittman, Gordon Richardson, John Robinson, Richard Sans- ing, Tom Schneider, and Terry Shevlin for their comments. We also thank participants at the AAA and CAAA annual meetings; and the Universities of Hawaii, Waterloo, and Toronto. Additional thanks to the AAA selection committee of the 2008 Outstanding Dissertation in International Accounting for their review and selection of the dissertation from which this article is drawn. We would also like to thank the following tax professionals for their extremely generous assistance and insights: Marc Alms, Muris Dujic, Andrew Dunn, Greg Noble, Paige Hill, Paula Moore, Shawn Porter, and Lisa Rowe. † Corresponding author. Contemporary Accounting Research Vol. 00 No. 00 (Month) pp. 00–00 V C CAAA doi:10.1111/1911-3846.12397 plus fort lorsque les avantages futurs pr evus des prix de cession interne sont plus importants. Les r esultats de l’ etude, qui confirment le point de vue des experts dans le domaine, fournissent les premie `res preuves documentaires que les acqu ereurs tiennent compte de la synergie que permettra la planification fiscale ult erieure lorsqu’ils estiment la valeur d’une soci et e cibl ee. 1. Introduction In this study, we document that the uncertain tax costs created by transfer pricing tax planning affect the value placed on targets in cross-border mergers and acquisitions (M&A). We define “transfer pricing risk” as the risk of a decrease in future cash flows that result from tax authorities’ actions related to a corporation’s transfer pricing activi- ties. For multinational corporations, profit from internal transactions must be attributed to geographical locations for various purposes, including taxation. The arm’s-length principle currently underlies most transfer pricing tax regimes (United Nations Secretariat 2001). This principle requires that transactions with a related party should use intra-firm prices that are the same as would be charged for arm’s-length transactions (Brauner 2008; De Simone 2015). Although theoretically sound, identifying and measuring a comparable external transaction is often difficult in practice. Consequently, the price, then, often relies on a number of assumptions and judgment, allowing the firm some flexibility in determin- ing the transaction price and therefore some ability to attribute profits to countries in manners that reduce tax costs. The assumptions necessary for transfer price determination also create uncertainty that leaves the company vulnerable to aggressive tax assessments by authorities (Willens 2009; KPMG 2009; Ernst & Young 2007–2008). For example, many countries’ transfer pricing rules around intangibles include “Something of Value” (SOV) clauses used to specify an implied intangible that also requires a transfer price; application of such clauses create sig- nificant risks. “From the trenches, I can say that SOV is used in opportunistic ways by tax authorities saying there’s something of value out there so we will tax it”: Isabelle Verlinden, PwC Transfer Pricing Leader, Belgium (Shaheen 2011, 1). “The term SOV scares the heck out of businesses because they’ve seen it defined in an opportunistic way by tax authorities”: Carol Dunahoo, Partner, Baker McKenzie (Shaheen 2011, 1). Transfer pricing rules and enforcement differ substantially in rigor and severity across countries and over time. Theoretical work by De Waegenaere et al. (2006) suggests that inconsistencies in transfer pricing regimes have the potential to either increase or decrease expected taxes for various firms. Transfer pricing audits have proven to be costly for tax- payers. GlaxoSmithKline’s transfer pricing dispute with the Internal Revenue Service (IRS) included $5.2 billion in additional tax, then the largest audit settlement in IRS history (IRS 2006). Because these risks are significant, transfer pricing was identified as the most impor- tant tax issue facing multinational entities in a survey of 850 tax directors (Ernst & Young 2008). In a 2012 survey of 384 senior executives from corporations that had previously undertaken cross-border acquisitions, 35 percent of participants responded that the “uncertain tax environment” was the main challenge they must overcome to ensure the success of cross-border acquisitions (Baker McKenzie 2013). While transfer pricing risk has been acknowledged as a significant source of risk for many companies, a specific firm’s risk is difficult to quantify and never disclosed publicly. For example, Towery (2015) identifies transfer pricing as the second-largest source of uncer- tain tax positions, as reported to the IRS; however, even these proprietary disclosures do not include quantifications. Cross-border M&A provide a strong setting to examine how the risk associated with transfer prices affect value. During M&A, the particular pairing of countries’ transfer pricing enforcement creates an opportunity to observe an exogenous shock to the 2 Contemporary Accounting Research CAR Vol. 00 No. 00 (Month) future transfer pricing risk of the firm.1 However, are these risks surrounding transfer pricing significant enough for a multinational firm to factor them into the price of an acquisition? We provide the first archival evidence relating the effect of uncertain tax costs associated with future transfer pricing to acquisition premiums in a cross-border setting. While there is no extant research on tax and transfer pricing in this setting, previous research has provided evidence that transactional tax costs are associated with domestic acquisition premiums (Chow et al. 2016; Erickson and Wang 2007; Dhaliwal et al. 2004; Ayers et al. 2003; Erickson and Wang 2000). A cross-border setting provides an opportunity to extend our understanding of the role of taxes in M&A acquisition premiums beyond the effect of transactional capital gains taxes. First, we hypothesize that, on average, there is a negative relation between the premium paid by the acquirer and the transfer pricing risk in the target’s country, reflecting the greater risk these transactions impose. Second, we hypoth- esize that the negative relation, if any, will be stronger in situations where potential tax ben- efits from transfer pricing post-acquisition are larger. That is, transfer pricing risk will have the highest impact where the benefits from tax-motivated transfer pricing are the highest. The value of cross-border M&A has grown substantially from under $0.1 trillion annu- ally in the first half of the 1990s to over $0.8 trillion in 2013.2 To investigate the role of transfer pricing risk in international M&A activities, we collect data on acquisitions over the period 2000–2012 that involve acquirers and targets from 32 to 39 countries each year. We develop a measure of transfer pricing risk using 448 country-level assessments by experi- enced transfer pricing practitioners.3 The assessments were gathered using a survey of 76 transfer pricing experts (45 partners uploads/Finance/ transfer-pricing.pdf