There’s probably nothing more certain in mergers and acquisitions than taxes. At some level and in some form, structuring and engineering to escape or minimize a tax bite are inevitable features of a deal. And if even the simplest tax issue is no walk in the park, among the squiggliest are taxes linked to transfer pricing, which not only is hard to grasp but can trigger the heftiest of post-acquisition tax bills if a hassle develops with the IRS or overseas tax police. Because of its inherent complexities, transfer pricing, which involves what parent companies and their subsidiaries charge each other for goods, services, and technologies, seldom is discussed openly in an M&A context. But don’t let obscurity fool you, say tax and dealmaking experts. Merger partners not only are aware of the stakes but invariably dig hard to find problems, especially if the deal involves targets with foreign operations. Yet, they’re rarely sure that they’re off the hook even when everything seems to come up clean. The dealmaker’s dilemma was underscored in April when IT security software developer Symantec Corp. disclosed that the IRS was dunning it for $1 billion, most of it related to its $10.5 billion acquisition of Veritas Software Corp. last year. Based on audits for 2000 and 2001, the agency apparently is contending that Veritas undercharged an unidentified foreign subsidiary for a technology license in 2001 and rolled up a $900 million tax deficiency as a result. The remaining $100 million involves a licensing agreement between Symantec and a foreign sub in 2003 and 2004. Symantec says it will fight the assessment in the U.S. Tax Court. Dueling experts square off Regulatory rules and policies on transfer pricing allow no breaks for transactions between units in the same company. Basically, the buyers are to be charged prevailing market prices or the same as an outsider would pay. Simple in concept but very hard to execute because in many cases – technology and other IP being the prime examples – it’s very difficult to arrive at free-market values. That leaves intracompany pricing decisions vulnerable to challenge by tax authorities. “It becomes a question of dueling experts,” says Seth Green, a former Treasury Department official and a tax law expert at Caplin & Drysdale in Washington, and it’s mostly “quibbling about what they’re worth.” “The company hires someone who says it’s worth something and the IRS hires someone who says it’s worth something else, and you’re off and running.” Further complicating the matter is that common cases that could offer learning experiences are rare and each dispute is heavily dependent on an individual fact pattern. Paige Hunter, an economist and transfer pricing expert at PricewaterhouseCoopers, advises buyers with concerns about their targets’ transfer pricing practices to perform extensive tax due diligence with attention to specific arrangements between affiliates within the company. Costs discourage more challenges “The difficulty is that it’s incredibly fact-specific,” she warns. “It’s very dependent on how business operations are run. It’s not something you can evaluate simply by looking at tax returns or financial statements. You can get some clues from those materials but not enough to understand the real business arrangements.” Tax authorities have transfer pricing high on their radar screens because they believe that deviations from the marketplace offer room for manipulating company numbers. Underpricing can be used to depress earnings and shave tax bills while charging above-market prices can inflate results. Because the takes to regulators can be huge, tax and deal experts expect even more public tiffs to surface in the wake of acquisitions, particularly as increased numbers of deals involve technology targets and companies with overseas operations. And while the potential for big bucks has drawn tax authorities mostly to large transactions, more mid-market buyers can find themselves in a regulatory fix. Middle-market players, experts point out, are just getting their feet wet in cross-border deals, are less sophisticated about transfer pricing than big multinationals, and are more likely to roll over and pay the bill without putting up and an expensive, time-consuming fight. Robert Willens, a Managing Director and tax expert at Lehman Brothers, says that although transfer pricing disputes are common, the IRS limits its fights to the best prospects for big payoffs. “It’s a very labor-intensive and costly type of case for the IRS to pursue because they have to bring in experts. The idea is to establish what the arm’s-length charge should be for a particular product or service, and that tends to involve some serious cost accounting issues. So these cases are very difficult to prosecute because of the amount of time and labor required.” But no buyer should bank on a free pass if it has reason to believe its target does a lot of intracompany transactions. The across-the-board warning is to look hard but realize that there’s no magic bullet to guarantee a problem-free deal. Green says that many companies using transfer pricing obtain documentation of their practices under Section 6262e of the Internal Revenue Code when they file their tax returns. “If the target can’t supply one, that may be a red flag, but if the company has the documentation, that confirms that they’re not flying completely fast and loose and ignoring the issue,” he says. Buyers hunt for protection Green also advises probing for how much the target is showing in deferred profit and whether there is any disproportionate amount of profit attributed to overseas operations when most of the business is conducted in the United States. A buyer also can seek indemnities in the purchase contract that would force the seller to pay for any transfer price tax shortfall, Green says, while Willens notes that escrowing part of the purchase price might be the way to go. Hunter says that the buyer should seek the target’s transfer pricing studies, talk to its business representatives to understand actual practices, examine intracompany arrangements, look at all financial and tax data, and “identify significant transactions or flows from tax returns.” “Look for the hot-button issues – material transactions from certain [tax] jurisdictions, for example,” she advises. “License agreements for European rights could be tax-favorable arrangements, and you might want to investigate them further.” Hunter adds that she has even seen cases in which deal prices have been adjusted because due diligence surfaced transfer pricing issues. (c) 2006 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com

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