Applying the Arm’s Length Principle to Business Restructuring in Multinational Enterprises

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Business Restructuring refers to the reorganisation of financial or commercial relations, including significant modifications or terminations in arrangements. This can involve centralising functions, intangibles, or risks within a group, often to enhance efficiency or streamline global operations. Examples include transforming full-fledged distributors into limited-risk distributors or sales agents, or converting full-fledged manufacturers into toll manufacturers for a central, controlling party.

MNEs restructure for diverse reasons, often with commercial justifications at the group level, which may not necessarily translate into arm’s length compliance for individual entities. Common drivers include economies of scale, management efficiency, technological advancements, and financial sustainability during economic downturns. 

While these restructurings can benefit the group as a whole, individual entities’ arm’s length conditions must be reviewed to avoid tax issues. For example, a group may consolidate its supply chain management within a single regional entity, lowering operational costs. For each member entity, the reallocation of functions must still meet arm’s length standards.

The FTA’s Transfer Pricing Guide provides details about the application of transfer pricing provisions to business restructuring transactions. 

Arm’s Length Compensation for Business Restructuring

1. Controlled Transactions

Applying the arm’s length principle to business restructuring begins with a precise definition of Controlled Transactions. This requires identifying the functions, assets, and risks before and after restructuring. Accurate identification of these elements through a functional analysis helps determine appropriate consideration between the restructured entities.

2. Evaluating Commercial Expediency

The economic justification for restructuring often hinges on achieving synergies and operational efficiencies. Taxable persons must document expected benefits, including any synergy-based assumptions, at the time of restructuring to support the group’s decision-making. This ensures transparency and supports compliance with tax regulations. For example, if an MNE restructures its operations to centralise procurement, expected synergies such as cost savings must be documented at the restructuring stage.

3. Assessing Realistic Alternatives for Related Parties

Restructuring decisions must reflect realistic options available to each entity, ensuring each would agree to the new terms independently. Arm’s length analysis involves examining whether other viable choices were realistically available to Related Parties or Connected Persons. This step helps to validate the economic rationale from each party's perspective. For example, if a restructuring limits an entity’s profit potential, the entity must have either realistically accepted the changes or received compensation to ensure Arm’s Length alignment.

4. Reallocation of Profit Potential

Profit potential, defined as the anticipated future profits or losses, shifts after business restructuring. This reallocation must reflect an arm’s length valuation, especially for intangibles or going concerns. The objective is to ensure that compensation aligns with the value of any transferred assets, changes in function, or renegotiated arrangements. In case when intellectual property (IP) is transferred to a central IP company, an income-based valuation, such as discounted cash flow (DCF), may help determine an arm’s length value.

5. Indemnification of Restructured Entities

When restructuring alters an entity’s risk or functional profile, indemnification may be necessary for incurred costs, such as asset write-offs, employment terminations, or adjustments to new operations. In determining appropriate indemnification, legal agreements (such as termination clauses) must be examined to confirm whether commercial law justifies compensation.

6. Valuation Techniques

Valuation becomes essential when reliable comparable uncontrolled transactions are unavailable. MNEs use valuation methods like discounted cash flows to estimate arm’s length pricing, particularly when transferring going concerns or significant assets. In some cases, where the valuation methods are not appropriate, the any other method (residual method) may be adopted. Regardless of the method adopted, it is important to maintain documentation for accepting a particular method and rejecting the others. Further, the assumptions underpinning valuations must be consistent with international standards. 

7. Post-Restructuring Controlled Transactions

Post-restructuring transactions must continue to comply with the arm’s length principle, aligning with controlled transactions from their initiation. Functional analysis must accurately capture the restructuring’s impact on each entity to reflect arm’s length terms in ongoing dealings.

Conclusion

In business restructuring, the commercial price of the transaction may be different than the arm’s length price. Yet, it is crucial to balance the commercial considerations with the regulatory requirements before the execution of the restructuring. 

Disclaimer: Content posted is for informational and knowledge sharing purposes only, and is not intended to be a substitute for professional advice related to tax, finance or accounting. The view/interpretation of the publisher is based on the available Law, guidelines and information. Each reader should take due professional care before you act after reading the contents of that article/post. No warranty whatsoever is made that any of the articles are accurate and is not intended to provide, and should not be relied on for tax or accounting advice