What is the value creation story that lies behind the control premium?

When a buyer pays a control premium, they are essentially saying that they can create greater value in the company by gaining control over the decision-making process. The way they use the existing assets, and the plans they have for the company – an acquisition or divestment perhaps, or digital transformation – will generate value over and above what has been produced in the past. One of the most important questions, though, is how – and more importantly, where – will that value creation happen?

If the control premium is the result of the buyer believing that management will make decisions that generate specific value, does that mean that the value of the control premium should be allocated to where management is located? Or is the value being created by those who execute the plans of management, who may be located in a number of different places? Is it managements’ ideas that are creating value, or the execution of those ideas? Or a combination of the two?

These questions are absolutely vital for transfer pricing because of the need to determine how profits are allocated across the group, and where profit is taxed matters. The answer often depends on individual circumstances. If the value creation plan revolves around developing a digital platform, for example, there may be a strong argument that value is being created centrally, where the management team sits and is developing the digital platform strategy, creation and execution. But if the value creation plans involve regional management teams being empowered to make more decisions, value is likely being created more locally. But there are invariably complications.

One of the biggest challenges for us in this area is intellectual property such as brands. It’s not unusual for one legal entity within a group to own a brand, while elements of the strategic management that make a brand more valuable might sit within a different entity, in a different location. So where should profit be allocated? And what about cases where a multinational consumer product company has paid a lot for a brand because it can utilise its existing distribution network to bring a significant marginal benefit to the group, although individually the brand would not generate as much benefit? This has the potential to create a disconnect between the transfer pricing royalty rate and the external value of the brand. How much profit do you attribute to the brand, and how much to the distribution network?

This is a potential minefield for companies. Intangibles are recognised by tax authorities worldwide as a risk area for transfer pricing but, ironically, they add to the risk by adopting different approaches. HMRC, for instance, uses ‘key decision making’ or ‘DEMPE’ analysis (which determines which members of a multinational group should share in economic returns generated by intangibles based on the value they create through functions performed, assets used, and risks assumed in their Development, Enhancement, Maintenance, Protection and Exploitation, “DEMPE”). In practice this means that the lion’s share of profits tends to be allocated to where decisions are made. The US Internal Revenue Service, by contrast, takes a more straightforward asset ownership based approach. Interestingly, both approaches don’t find their foundation in economic theories, and they don’t try to explain why a Group would generate returns over and above the market average returns. Neither try to explain the role of “barriers to entry”, and where they can be located. In any case, the different perspectives of tax authorities can lead to a risk of double taxation, which is difficult and expensive to resolve.

As tax and valuation specialists, our role is to help management articulate the value creation story that lies behind the control premium – not just for the benefit of investors and management, but in persuading the tax authorities that your approach is the right one.