We recently began a new series of Transfer Pricing Masterclass Interviews. The first was with Adnan Begic, a hugely experienced and widely admired expert on the subject, who is Head of Transfer Pricing Asia-Pacific for the Michelin group.
The focus of the interview was how to manage the TP aspects of M&A integration, from the perspective of the in-house TP / tax function of the buyer group.
The following transcript has been lightly edited for clarity.
Paul Sutton: Hello and welcome to this Transfer Pricing Masterclass Interview. The focus of today’s conversation is how to manage the Transfer Pricing aspects of M&A integration. My name is Paul Sutton from LCN Legal. And I’m delighted to have as our special guest today Adnan Begic, who is the head of Transfer Pricing Asia Pacific for the Michelin group. So welcome Adnan. The focus of this session, as I mentioned, is really to get into the mind of someone like Adnan in terms of what do you do when you’re in the situation of being responsible for Transfer Pricing for a particular group, you’re being told about a particular acquisition coming up. What do you do to scope out the work involved? And what are the particular pain points that you might need to avoid here? So Adnan, please, can I ask you just to introduce yourself a little bit more and to set the scene as regards M&A activity?
Adnan Begic: Thank you, Paul. I’m very pleased to participate in this interview session, and in this new series that you introduced. As you rightly pointed out, I look after the Transfer Pricing affairs for the Michelin group across Asia Pacific, including all tax compliance, tax risk management, TP risk management, and of course, integration of newly acquired companies from a Transfer Pricing perspective.
Now, when we talk about M&A activity, from a TP perspective, if we just take a step back, we all know a lot of M&A activity happens for mainly two reasons: either for a company to grow through external acquisitions, and also to diversify the offering from its core offerings. And we talk throughout this session about the ‘Buying company’, which will be the main company that’s purchasing a target and ‘Target company’.
The typical starting point is always the due diligence report. So when I hear that there is a new acquisition where we are going to help with the TP integration, I know that there is a tax due diligence report that looks at the Target company. However, one of the issues that I always find with the tax due diligence reports, is that they are purely focused on the Target company. And they will ask some relevant questions, such as whether TP documentation is in place for the Target company, whether all transactions are covered in the TP documents, whether certain entities have sufficient substance – important points that you that you need to know, from a Buyer’s perspective, when you’re looking at a Target company, including whether certain percentages are within the interquartile range, etc.
However, what a due diligence report doesn’t typically cover is: how is the TP policy of the Target aligned with the TP policy of the Buyer. Are they somewhat similar? Are we going to integrate something that’s completely different into an ecosystem that that has fundamentally – or even slightly – different TP policies? That can cause some real pain points when you get into the integration process, because you will get pressure from the top management to demonstrate certain synergies at an early stage. So effective and efficient integration is really important. And if you can identify some of the pain points early on, we will talk about some of the questions that should be raised, once you hear that there is a new acquisition happening that will require a TP integration.
The differences between acquiring core and non-core businesses
PS: Okay, thank you. So you’ve mentioned broadly two scenarios. One is where the acquisition is core to the existing business of the acquiring group, and the other one where it is non-core, i.e. diversification. Maybe you can just talk us through your thought process, in each of those scenarios.
AB: Maybe we can just start with an easier scenario. If the Buyer is looking at a Target that’s not part of the Buyer’s core business. The TP integration can be relatively straightforward. You can almost leave that acquired company to run in parallel if you don’t have to integrate. Let’s just take a step back: when I say it’s not part of your core business, we’re talking about a situation where the Target’s products would not necessarily be distributed through the buyer’s existing distribution channels. So you’re not trying to buy a company to leverage your distribution channels to push it into certain markets. So you have basically, two companies running in parallel, maybe under a new business line that you manage separately. And even if the TP policies are not aligned, you can leave them as they are, and you can take more time to get some alignment over a period of a couple of years.
Now, where it gets tricky, is if the Buyer is buying a Target that’s core to their business. Let’s say, in a tyre company like Michelin, you’re buying a company that has certain tyres that we don’t have in our portfolio. So we want to add that into our portfolio. And ideally, utilise our distribution channels to add that tyre from the Target to our customers and identify new customers. If you take home appliances, for example, there may be a company manufacturing refrigerators, washing machines and dishwashers, and they buy a Target that’s an oven manufacturer. So it’s obvious that you will also try to push those ovens through your existing distribution channels. That’s where a lot of challenges can happen from a TP integration perspective.
If you have TP policies which are fundamentally different, or even slightly different, this can cause problems. What I mean by that is if in one case, for example, the Buying company has manufacturers set up as fully fledged, full risk manufacturers, whereas the Target company may have contract manufacturers. On the downstream side maybe both Target and Buyer have limited risk distributors. But in the Buying entity, you may set your transfer prices operationally to get a certain target margin, whereas the Target may just set them to be within a certain range. So there can be differences in different types of the value chain, upstream, midstream, downstream. You may have regional headquarters or global headquarters that act as regional and global entrepreneurs, or just regional service providers getting a pure ‘cost plus’ remuneration.
If you want to have integration of TP policies under one common ecosystem, with these two companies, there is a lot of work that needs to happen before you can get an alignment across all of these elements.
The importance of aligned ERP systems in M&A
Another pain point is the level of detail of TP documentation. So what I mean by that is that sometimes you will have a Target company that may have global TP documentation, but they just try to keep it at a very high level and always use the base type of documentation for all countries. And they may only localise it if there was an audit in that specific country. Whereas the Buying company may prefer to have localised and detailed TP documents in all jurisdictions where they operate. That’s something that’s very easily fixed, so that’s not a big pain point. The big point in this entire thing, can sometimes be – I don’t want to call it ‘an integration killer’, but it can make the integration very difficult for the teams that are working on it – if the ERP systems are not aligned.
So if you have a Target company and a Buying company and their ERP systems cannot talk to each other, and you have the pressure to integrate and demonstrate synergies. Now, with ERP systems, we will talk about some potential workarounds that we have seen. But it doesn’t mean that the Buyer doesn’t want to invest in the ERP system. It just takes time to align the ERP system – that doesn’t happen overnight. These IT projects sometimes can take several years. But the pressure to demonstrate certain synergies and start utilising your distribution channels cannot wait until that integration happens.
PS: So if I can just check that I’ve understood so far. So what we’re saying is that traditional M&A due diligence or TP due diligence on the Target is very much focused on the Target as opposed to looking at it holistically with the acquirer in mind. So almost the first question you’re going to ask yourself is, in terms of the Target, can I just leave this to go along the same track from a TP perspective? Because it is a distinct business which is not being integrated heavily at that stage? Or can I not defer that decision, and if it is something which needs to be integrated then you’re looking at high level differences in TP policies, you’re looking at high level differences in the style of the TP documents, i.e. detailed versus specific.
And then you’re looking at ERP systems, and how much pain is that going to put you through in terms of actually being under pressure to demonstrate synergies? So, perhaps we can drill down onto the first pain point, which would, I guess, be where there are significant differences between the TP policies between the entities.
AB: So if you think about different TP policies, let’s assume your Buyer has different policies – we don’t have to go to extremes, let’s just use a scenario where there are slight differences. And again the differences could be, on the downstream side, targeting margins as opposed to specific margins. And maybe on the manufacturing side, it’s contract manufacturer versus fully fledged manufacturer. There may be certain management service charges in place that in the Buying company are charged to all legal entities be it manufacturer or distributor, whereas in the Target company, they may be only charged to the distributors, not the manufacturers. There may be a royalty in place for use of the technology and IP, the royalty arrangements may be different. And whether you want to or need to align those royalty arrangements is a question that’s further down the line.
They are not fundamentally different transfer pricing models, but there are certain differences that need to be aligned so that an internal operational TP process can function properly in a way that the right margin ends up in the right entity at the end of the year.
So why that’s important is for example, for downstream when you have specific margins versus targeted margin arrangements, it will have an impact on your price setting methodology, it will impact on your monthly or quarterly tracking of margins. And on understanding what price changes need to be done to achieve a certain margin. So if you have a process in place at a Buying company that manages that process for all entities, you want to align that process for the Target company as well, if you want them to go through the same distribution channels.
Now, let’s say that one of the Buying company’s commercial entities is in a country where the Target company doesn’t operate or hasn’t operated in the past. And it’s a great opportunity to demonstrate synergies: to say, now we will introduce the products of the Target company into this market, we will utilise our distribution channels, due diligence reports that there are no tax Transfer Pricing issues, so it should be a walk in the park, everything easy.
Difficulties when two ERP systems are not aligned
Then you realise that in order to set your operational transfer price, what you want to achieve is a process by which the right margin ends up in the right entity. Now, our commercial entity is, let’s say, getting a specific figure, not a range. The manufacturer on the other side is not getting the residual profit. If the manufacturer is the Target company operating as a contract manufacturer, they will get a cost plus. So there is already a misalignment: how do we set the price in order to achieve a smooth flow of the right margin into the right entities? Before that happens, teams have to take a step back and say, is there something that we can align without having a big change? Can we agree that going forward all entities are targeting a certain target margin? Can we agree that manufacturers may be contract manufacturers, but they will sell to a principal? Or if, historically, the Target company sold to the principal, can it change to sell directly to the commercial entities? If not, can our commercial entities buy from the new principal entity? And that’s where the ERP system comes into play.
Even if you identify a lot of workarounds to align the TP policies, and the commercial entity is ready to place a purchase order, that purchase order cannot flow into the right manufacturer, because the manufacturer of these new products has not aligned its ERP system with the Buying company’s ERP system. That’s where one of the biggest pain points for the integration team kicks in. And it’s one of the biggies around finding a solution before the ERP integration happens.
How it works is often, unfortunately, a manual process. You have a commercial entity, for example a distributor that needs a product from a manufacturer or from a Target company, and the ERP systems don’t talk to each other. Unfortunately, that process then needs to be handled manually, which means that the Finance teams, Operational Transfer Pricing teams, supply chain, Customs, the Treasury teams… they all have to be involved in a manual process. Typically all these processes would be automatically triggered once a purchase order is made in the system. But now everybody on both sides needs to be aligned and aware: what are the action points, once a manual purchase order comes through?
It works fine with one or two companies. Maybe two manufacturers, a handful of distributors, everybody’s aligned. But if it starts going into 20, 25, 30 different types of transactions, where you have manual purchase order management, and manual transaction management, monitoring margin tracking gets really complicated. Often, the teams would need to have a separate P&L for these manual transactions that are segregated from the normal traditional transactions that are done automatically. So you’re basically adding an entirely new manual operational TP process on top of the existing somewhat automated process. And traditionally, you wouldn’t get additional resources to perform all of these functions. And, you know, certain teams will give you some pushback, and yes, we understand that needs to be done, but we cannot handle 25 different entities.
So there is also a people part: a need to manage expectations and get a commitment by the group to say, yes, there is ERP integration coming, it’s a prioritised process, hang in there for another year or however long it takes. But it is very labour intensive, so of course the monitoring process needs to be more diligent because human errors can occur very easily.
Which M&A integration issues need to be tackled first?
PS: Okay, that’s really interesting. You mentioned the periods for ERP integration, and I’d just like to go slightly off piste and ask you about timescales generally. In terms of these issues that we’ve talked about, which of these issues would you want to nail down before the acquisition actually happens; which would be the absolutely critical things? And to what extent can those issues be managed after the event?
AB: ERP integration is for me the key. Because if you don’t have that, you need to co-ordinate with numerous teams on both ends of the value chain, upstream and downstream. If you have ERP integration, and you know about all of the other issues, the operational TP team can centrally manage that without too much involvement of other teams. Even if it’s not perfect, you at least know what the issues are, and you don’t have to explain to 50,000 other people. It’s more contained in the operational TP spectrum. So ERP integration is the absolute key that I would recommend to start very early on.
Ideally, the Target company and the Buying company have the same ERP system – let’s say both are on SAP or both are on Oracle. Even then, there is a certain level of integration that needs to happen. But a really painful one, is if it’s neither the one nor the other. And it’s completely two ERP systems in parallel. So you need to transform, let’s say, the Target company’s ERP system completely from ABC to Oracle or SAP.
Duplicate legal entities in M&A transactions
PS: And can I ask you about legal entity integration as well? Because obviously, in many cases, when you’re doing an acquisition, you end up with duplicate legal entities within each jurisdiction. And inevitably there is some kind of associated legal process to weed out the duplicates and physically integrate the assets and people into the right entities. How would you regard that? Would you say, well, let’s deal with that two years down the line; let’s focus on the operational TP integration first? What’s your initial view on this?
AB: It is a process that happens in parallel. Of course, when you have, let’s say, jurisdictions were both the Buying and Target companies have a commercial presence. The big question is, should there be a merger? Or should one be eliminated? How should we deal with it? But if you have both legal entities in place, then you wouldn’t necessarily look for these synergies that we talked about before because the Buyer’s legal entity doesn’t necessarily buy the products of the Target entity. There is already an existing commercial entity. But it is a different question. And in many cases, it will result in merger, or basically ending up with one legal entity in a country.
So, again, it doesn’t happen overnight. There are different countries with different regulations and then different processes around that. But the target is not to have duplicate activities and the solution is typically a merger.
Then you get again to the same operational TP problems. Once you need to buy from somebody who doesn’t have your ERP system. Not to forget the importance of intercompany agreements in all of this. It starts from the review of the Target company and the existing TP policies.
Issues with intercompany agreements in M&A transactions
The legal team is always, in any M&A activity, heavily involved: we all know the importance of intercompany agreements, and know that when we anticipate a change in the TP policy, we need to anticipate also a change in the intercompany agreements. And when new transactions are introduced with M&A activities, there are hundreds, if not thousands, of new intercompany transactions between different Buyer and Target companies that would need to be substituted with an intercompany agreement.
Now, these often need to be re-written. You need to capture what is happening today, which is not a fully finished integration process. And you also need to remember, once everything is integrated, to re-look at your intercompany agreements, and see whether they still fit the purpose of the final picture. Often intercompany agreements are put in place very quickly to tick off a box. “We need to introduce this transaction, this management service fee, whatever, there is a royalty charge coming, but we don’t have an intercompany agreement. Quick, put one in place.” Once everything is done and settled, there needs to be a review process to see whether everything is still matching the reality.
PS: Yes, that’s something that we come across a lot. You know, it’s a classic risk point, everything gets done in a hurry at that time, and then it gets forgotten about and then two years later, you look at it, and actually, it hasn’t kept up at all with what the group is doing. So unfortunately, we’re running out of time in terms of this conversation. Could I ask you to leave viewers with one or two key points to remember when they’re faced with this kind of situation?
The most important issue for post-M&A TP integration
AB: Yes, so for me, the key takeaway or the key learning from a lot of M&A activities is: even if the tax due diligence report concludes that Transfer Pricing is low risk, TP documentation is in place, everything is fine at the Target company, it is important that the M&A team understands that it doesn’t mean that the TP integration is going to be smooth.
The M&A team needs to know early on whether there will be some pain points in the integration and, particularly, to secure funding and budget for ERP integration if needed. Or if TP policies need to be aligned, that often comes with an external advisors cost. Sometimes if you change a manufacturer from, let’s say, a contract manufacturer to fully fledged manufacturer or vice versa, it may come with an immediate tax audit, or potential exit charges.
So this is something that needs to be envisaged early on in the process. So for me, the first things that I think of when I hear that there is a new acquisition is, 1. Is going to be part of the core business or not. If it’s part of the core business, there are going to be some complications in integration, whatever the due diligence report says. 2. There is always an M&A team that does the pre-integration work. Are they aware that integration may not be a walk in the park as everybody thinks, and that the synergies will not just happen overnight? 3. Are the right teams in place to help with the integration? It needs to be formulated. We all have a day-to-day job, but every year you also have certain projects with certain targets that you need to achieve. So it needs to be captured as a team objective, so that everybody works towards it.
PS: Fantastic. Great. Well, all that remains is for me to say thank you very much indeed, Adnan, for sharing your thoughts on it. It’s a fascinating subject. It’s not one that is often written about or talked about. So hopefully this will open the floodgates of sharing thoughts and opinions, and we can collectively help to raise standards. And if you, the viewer, have any questions or issues that you’d like us to cover, please do reach out. You can reach us at firstname.lastname@example.org. I don’t know if Adnan will be able to assist in replying to every question, but certainly we will reach out to him and ask him if he can. So thank you very much indeed.
AB: Thank you, Paul. And I have a question for the viewers: if they can, in the comments, say whether their M&A activities are typically managed internally by the internal tax teams, or whether companies rely on external advisors to assist with the TP integration after the acquisition.
PS: Sure. Great question to end on. Thank you very much for watching. Thank you Adnan. And that concludes this video. Thank you.
AB: Thank you, Paul.