At the core of any M&A transaction is the fundamental scaling and growth of the integrated business unit at a macro level or tapping into and accessing the potential of the economies of scale of the target entity at a micro level.
As such, parties to the M&A transaction often spend a bulk of the transaction phase considering and negotiating the post-transaction integration of the transacting entities with respect to matters around optimising human resource, fine-tuning management and management functions, shareholder rights, exploitation of intangibles and a business growth strategy.
It is common that the acquiring parties to M&A transactions in Sub-Saharan Africa be entities controlled and managed from different jurisdictions. M&A transactions in Sub-Saharan Africa generally involve off-shore domiciled private equity funds or multinational entities as the acquirers and a local entity as the target. The outcome of these transactions bring the integrated unit or group within the purview of transfer pricing.
Transfer Pricing Basics
The concept of transfer pricing under Kenyan law is provided for under:
- the Income Tax Act (Cap 470) (the Income Tax Act);
- the Income Tax (Transfer Pricing) Rules, 2006; and
- the respective double tax treaties that Kenya is a party to.
In addition to these laws, the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations provide persuasive guidance on the application of transfer pricing principles in:
- the preparation of transfer pricing policies for taxpayers;
- which jurisdiction taxing rights lie; and
- dispute resolution between taxpayers and tax authorities.
At its most basic, transfer pricing may be defined as the concept whereby a fair price is determined for transactions amongst related entities of different tax residency. From a taxation context, the transfer price will affect the accounting profits of the respective entities and subsequently the taxable profits of each single entity. Section 18 of the Income Tax Act provides the basis for transfer pricing as follows:
“Where a non-resident person carries on business with a related resident person or through its permanent establishment and the course of that business is such that it produces to the resident person or through its permanent establishment either no profits or less than the ordinary profits which might be expected to accrue from that business if there had been no such relationship, then the gains or profits of that resident person or through its permanent establishment or from that business shall be deemed to be the amount that might have been expected to accrue if the course of that business had been conducted by independent persons dealing at arm’s length.”
For ease of explanation:
The transfer price set for the transfer of products from Entity 1 to Entity 2 will not affect the group’s overall/combined profit but will affect the taxable profit of Entity 1. Therefore, where Entity 1 is located in a relatively higher tax jurisdiction, there is incentive within the group to reduce the transfer price in order to decrease Entity 1’s taxable profit in that high tax jurisdiction.
Following an M&A transaction the following factors tend to materialise within the integrated entities:
- The adoption of minority rights by the acquirer. This typically occurs where an acquirer acquires a significant minority of the target entity and obtains control in the target business and is a common acquisition strategy adopted in private equity transactions.
- The integration of intangibles such as intellectual property rights and goodwill. Intellectual property rights of the integrated group may be farmed out from one jurisdiction to another or assigned over various jurisdictions.
- The post-transaction financing of the integrated group taking the form of shareholder loans spread across multiple jurisdictions.
- The integration of a new management group or the involvement of the acquiring entity’s management group in the affairs of the target entities and the centralisation of certain functions such as procurement.
Inter-company agreements from the legal and commercial foundations of these post-transaction matters and relationships. Consequently, there is the natural possibility of complex financial flows between these group entities which would affect the tax base in each respective jurisdiction.
A post-transaction transfer pricing analysis allows for the optimisation of the group’s tax strategy to achieve the most efficient and fair tax structure and is achievable by taking the following steps:
- Preparation of the inter-company agreements: being the core document establishing the legal and commercial relationship between related entities, it is vital that these agreements clearly define the roles of each party and delineate the respective group transactions.
- Internal restructuring: this involves the reallocation of group entity roles, the movement of real and intellectual property ownership and reorganisation of senior management.
- Reallocation of commercial risk: this involves the identification of economically significant risks and the contractual or transactional reallocation of these risks to group entities that are able to absorb the risk for the benefit of the integrated group.
Together, these steps would provide for a conclusive functional analysis of the group and subsequently provide an opportunity to adopt the most appropriate transfer pricing methods with a view towards tax optimisation of the entire group.
Whereas this write-up provides a brief overview of the salient issues to consider in your post M&A transfer pricing considerations, parties to M&A transactions ought to keep these factors as talking points at the negotiation stage of the M&A transaction on a specific and case-by-case basis.
This alert is for general use only and should not be relied upon without seeking specific legal or tax advice on any matter.