For companies that are preparing for acquisition, or want to understand how transfer pricing affects their enterprise value
The Group’s transfer pricing model is wrong, leading to IllustrateCo earning too little profit.
“Surely I’m too small to have a tax inquiry.” - you may get lucky, but due diligence can also find this risk and use it to reduce your share price. A potential acquirer looks for off-balance sheet liabilities as part of due diligence. An incorrect transfer pricing model can create exactly this.
IllustrateCo’s transfer pricing model is wrong, and the new buyer’s shares will carry the risk of that error. It will also have to spend cash fixing the problem in future years.
This is how DD would typically approach it:
For 2023, IllustrateCo should have earned £200k if the transfer pricing model had been correct. This would mean that, at a 30% corporate tax rate, there is £60k underpaid tax for the year.
Once a risk is created, it remains a potential liability for five years. Assuming a similar mistake for all five years gives a total unpaid tax of £202k (assuming 30% headline corporate tax rate).
On top of this, the error can trigger additional penalties for IllustrateCo. A typical penalty in the UK for a Group that has been negligible by not setting an appropriate transfer pricing policy is 70% of unpaid tax. In this case, £141k (70% of £202k).
The price chip for the off-balance sheet liability could therefore be £343k.