value chain transformation in a globalized world (tax perspective)

Value Chain Transformation /Business Restructuring May.2015

www.pwc.com Miguel Tomé Medeiros Transfer Pricing Consultant Email: [email protected]

PwC

Agenda

maio 2015 VCT / Business Restructuring

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1. Value Chain Transformation (VCT)

2. Business Restructuring – Case studies

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1. Value Chain Transformation (VCT)


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Objectives of this session

Gain an understanding of:

• Value Chain Transformation (VCT) concept

• Potential benefits from VCT models

• Main VCT operating models

• Key triggers you should look out for

• What competencies are involved in an integrated VCT project


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What is Value Chain Transformation (“VCT”) and what does it mean?


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PwC Definition


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Value Chain Transformation (“VCT”) delivers an integrated and cross-border

portfolio of capabilities to support organisations to align their tax, legal and operating models to achieve sustainable

financial and operational benefits during business transformation.

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Basic principle of VCT: centralising the business model to improve financial performance


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Potential benefits of VCT models


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Operational simplifications / EBITDA improvement

• Reduction in cross-border and intra-group transactions

• Procurement and supply chain rationalisation and savings

• Improved clarity of information systems • More efficient cash/treasury management • Opportunity to simplify, reduce and standardise

processes (finance, procurement etc)

Organisational

• Simplification and clarification of management structure leading to quicker decision making process

• Refocus of management time towards commercial activities

• Symbolises one company, one way of working (in post-acquisition scenario)

• Possible headcount reduction

Tax/transfer pricing risk management

• Reduction in intra-group transactions • Simpler and standardised transfer pricing documentation process • More effective management of tax exposures • Cash tax reduction • Sustainable effective tax rate reduction

Customers/Supplies

• Improving customer relationships • Standard product quality and service regionally or

globally • Single point of contracting with customers and

supplies • Stronger bargaining position in negotiation with

suppliers

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For tax purposes, profit allocation is driven by Functions, Assets and Risks . . .

. . . therefore, taxable profits can be moved between territories by centralising and colocating value driving functions, assets and risks . Co-locating in a low tax environment will reduce the group’s ETR. However substance is key to achieve overall VCT benefits.


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What are the typical value drivers in a business?


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Therefore the more these can be centralised, the more benefit (operational and tax) can be realised…


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However there is no single model… In order to identify the right model there are 3 dimensions to consider:


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Risks/Assets

The more risk that the centre takes substance is increased to support more centralisation of profit.

Geography

Determining what countries or regions are in scope will have implications in terms of tax risk and implementation risk.

Functions

Centralisation does not need to be ‘big bang’ for all functions. A phased approach or a discrete functional scope are also options.

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What steps are typically involved in a VCT project

Identify what drives value within a business (what makes it successful)

• Design an operating model which focuses on these value drivers (higher degree of central control)

- Governance & organisation

- Process and metrics

- Systems

• Identify a location for the central team (operationally and tax advantageous)

• Move the value to the central location and align the transfer pricing and tax model (Profits follow functions, assets and risks)

The outcome is a more profitable business earning a greater degree of those profits in a more effective tax location.


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Main VCT Operating Models


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Tipos de produtor - Perfil funcional Funções Fully-Fledged

Manufacturer Contract

Manufacturer Toll

Manufacturer

Compra de matérias-primas X X

Consignação de matérias-primas X

Planeamento da produção X X X

Intangíveis Rotineiros X X X

Intangíveis de produção de valor específico X

I&D X

Produção X X X

Propriedade dos Produtos X X

Montagem e embalamento X X X

Armazenagem e logística X X (X)

Definição de preços X

Faturação e cobrança X X

Marketing e publicidade X

Controlo de qualidade X X X

Vendas e distribuição X

Suporte pós-venda X

Garantias e reparações X

Funções gerais administrativas X X X


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Tipos de produtor - Perfil de Risco


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Riscos Fully-Fledged Manufacturer

Contract Manufacturer

Toll Manufacturer

Risco I&D X

Risco de mercado X

Risco de inventário X X

Risco operacional X X X

Risco de taxa de câmbio X

Risco de produto (garantia) X (X)

Risco de crédito X X

Fully fledged

• Full Risk

• Buys raw materials, makes finished goods and

develops and exploits market place for these

goods

• Owns Inventory

• Many own IP

• Stand-alone decisions

• Sale of Product

Contract Manufacturing

• Limited Risk

• Buys raw materials and converts these into

finished goods to Principal’s order and

specifications

• Owns Inventory

• May own manufacturing IP but not IP specific

to product

• Follows orders/no strategic control

• Sale of Product

Toller

• Minimal Risk

• Produces finished goods to Principal’s order and

specification using raw materials owned by the

Principal

• Does not own Inventory

• May own manufacturing IP but not IP specific to

the product

• Follows orders/no strategic control

• Charges Conversion Fee

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Panorama da legislação portuguesa Análise Funcional e de Riscos – Conclusão

Toll Manufacturer

Contract Manufacturer

Fully fledged Manufacturer

Risco

Pricing

Lucro

Serviços de produção

Volume

Qualidade

Custo matérias-primas

Contratos a longo termo

Custos de pessoal

I&D

Custos fixos

Produção

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Preços de transferência maio 2015

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Tipos de distribuidor - Perfil de Risco


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Funções e riscos típicos Commission Agent

Commissionaire Classic Buy-Sell distributor

Fully Fledged distributor

Propriedade dos bens X X

Armazenagem e logística (X) X

Planeamento de compras X

Marketing e publicidade X X (X) X

Controlo de qualidade X

Definição de preços X

Vendas e distribuição X X X X

Suporte pós-venda X

Garantias e reparações X

Faturação e cobrança X X X

Funções gerais administrativas X X X X

Risco de inventário X

Risco de mercado (X) X X X

Risco de crédito X X

Risco de produto (garantia) X X

Risco de taxa de câmbio X

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Panorama da legislação portuguesa Análise Funcional e de Riscos – Conclusão

Agente/ comissionista

Stripped buy/sell

Distribuidor

Risco

Volume

Lucro

Administração & Contabilidade

Product mix

Pricing

Câmbio

Obsolescência

Garantias

Risco de crédito

Quota de mercado

Custos de marketing

Distribuição

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Preços de transferência maio 2015

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Sales models

• Has full risk (e.g. bad debt,

inventory etc)

• Legal title from local sales co

to customer

• Local sales co invoices

distributor

• AR on local books of the sales

company

• Risks shared with Principal

• LRD invoices in own name

• LRD has “flash title” when

customer is invoiced

• AR on books of LRD

• LRD refers back to Principal for

acceptance (outside of pricing,

and terms & conditions

• Risks stripped out

• Commissionaire invoices

customer in name of Principal

• Commissionaire does not take

title to inventory, legal title

goes from Principal to

Customer,

• Commissionaire refers back to

Principal for acceptance

(outside of pricing, and terms

& conditions

• Still need local VAT

/accounting for buy-sell

• Risks in some countries

• Risks stripped out

• Agent identifies potential

customers for the Principal,

earning an arm’s length

commission

• Customer contracts with

Principal

• Agent typically has no powers

to sign contracts

• Principal invoices customer

• Two faces to the customer

(sales and invoice)

Limited Risk

Distributor

Tax b

enefit

opport

unity

Degree of accountability, management centralisation and organisational change

Full Local Risk

Commission agent

Marketing Agent

• Risks stripped out almost fully

• Marketing agent performs local

marketing activities and identifies

potential customers for the

Principal

• Agent typically has no powers to

sign contracts or agree pricing

• Rewarded on cost plus basis

1

2 Commissionaire

3

4

5 No Title Title

1 2 3 4 5

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The Traditional Model: Principal – Limited Risk Manufacturing / Distribution

Description

• Principal in tax efficient country buys raw materials from 3rd parties and sells finished goods to its distributors.

• Limited Risk manufacturers are rewarded for their services with a benchmarked cost plus return.

• Distributors control and bear limited risks– particularly where there is substantial “above market” control and direction, and are rewarded with a sales based return.

• Distributors can legally be Limited Risk Distributors (LRDs), as shown in this slide. Commissionaires, or Commission Agents, each having different activities and functions, but economically, all are “Limited Risk” with a similar level of reward.


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The “Centre Led” Principal Model:

Description

• Manufacturers act as Contract

manufacturers – buy raw materials from 3rd parties and sell to Limited Risk or Reduced Risk distributors for onward sale to 3rd parties.

• The Principal company carries out the Principal functions and risk and assets control and management for the buy and sell side but is NOT included in the transaction chain.

• The Principal issues a VALUE BASED service fee to the manufacturers and distributors for roles and responsibilities.


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Procurement Model (Buy/Sell Procurement Principal):

Description

• Procurement company purchases goods and

services for resale (typically with some inventory holding), negotiates and concludes contracts with vendors, takes certain commercial risks and is based in a low tax jurisdiction.

• Procurement company can share in the savings (by “gain share”) depending on risks assumed. Volume aggregation savings alone are not sufficient to leave material profits with the Procurement Principal.

• Manufacturers likely to have lower purchase prices as reward for compliance with new arrangements.

• Profit of Procurement Principal likely to fall over time as market prices decline.

• Procurement company acting as buy/sell entity with title is likely to have more gain share benefit than when acting as a Centre-Led “Strategy Principal” again depending upon risks assumed.

• Full Risk Distributors can own and manage local brands.


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The Services Principal Model:

Description

• The Principal enters into a Limited Risk

Service Company (“LRSC”) Agreement with each local service delivery company (“ServiceCo”). It is important to note that this contract will enable the ServiceCo to continue contracting with and servicing its customers on its own account as it does today.

• For illustration, and depending on the particular facts and circumstances, pursuantto the terms of the contract:

- The Principal grants ServiceCo access to its processes, policies and procedures, technical training, methods, manuals and technology and marketing rights as they relate to service solutions and sales.

- The Principal provides ServiceCo with management services (e.g., headquarters, stewardship, strategy, direction and control, etc.).


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The Services Principal Model (cont’d):

- The Principal manages and bears certain risks relating to ServiceCos‘ business (e.g., credit management risk, bad debt risk, delivery risk, foreign exchange risk, etc.).

- The Principal grants ServiceCo the right to use the IP without which ServiceCo cannot perform contracts it enters into with customers in its respective jurisdictions.

- ServiceCo remits the appropriate “Operating Fee” to the Principal (computed as specifically outlined in the LRSC Agreement). Exceptionally, Principal remits the fee to ServiceCo to maintain the arm’s length reward for ServiceCo.


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The Single Legal Entity Model

Description

• A Single Company with branches addresses

the complications that arise under the traditional structure.

• Primary benefits of a single company include:

- Reduction of internal transactions and associated recording and reconciliations costs – branches are usually allocated profit based on OECD principles.

- Single ownership of all assets and inventory

-Treasury simplification

-Regional decision making

-Improved corporate governance structure aligned with developing regional models

-Centralised management of risk

-Simplified and more cost-effective account filing and audit.

- Removal of local directors duties and non-value added activities.


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What are the triggers?


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Change is happening

The business environment is changing:

• Globalisation and Corporate simplification.

• Market pressure – not able to increase prices, so forced to look at managing costs to deliver bottom line growth/maintain profitability.

• Challenges to traditional tax planning/BEPS e.g. Debt pushdown – limited debt availability in the market, Political pressure – increased focus of governments on tax revenues during recession to “balance” the books.


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What you should look out for?


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The business issues that a large number of European companies face

Market Developments

• Adverse macroeconomic environment in mature markets • Pressure on sustained growth and margin/ROIC improvements • High costs or energy threating industrial production • Volatility of material costs • Intense competition


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Turmoil within European companies

• Highly layered organizations composed of national jewels

• Independent and loosely connected entities with cultural differences

• Product and/or region focused Business units

• Fragmented Product/Customer portfolio’s

• Supply base fragmentation • Excess manufacturing capacity

Strategies pursued to profitable growth

• Protect revenues & margins • Expansion into new markets • More efficient platform for product innovation & strategic acquisitions • Drive consistency in functional and operational excellence

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How is a VCT project aiming to fix these challenges? - establishing a single governance model


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Lead global – win local

• New targeted operating model Where possible, leverage scale by a having a single global identity Delivering breakthrough innovations to grow share and categories Reducing product complexity, optimizing distribution and increase employee productivity Develop/build repeatable models within specific functions

• IT enablement – one enterprise capability

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The PwC VCT approach


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Connecting business and tax substance in an unpredictable political climate


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Tax Impact business model Overview of transactional flows


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Tax Impact Business model Transfer Pricing TO BE


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Documentation requirements TP report new model Transfer Pricing Documentation consists of the following documents:

• Transfer Pricing Master file TO BE

Purpose: document the arm’s length nature of intercompany prices going forward/after Go-Live in line with OECD/local documentation requirements.

TO BE Master file includes:

Localized country template for MSUs and MUs to Transfer Pricing Master file TO BE;

Transfer pricing policy document;

Signed intercompany pricing agreements going forward (including audit trail on termination of existing intercompany pricing arrangements);

Intercompany invoices (examples).

• Local file (template to be completed), considering local country requirements.


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Tax and transfer pricing issues of VCT models


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Core competencies

Advisory

• Target operating model/organisation design

• Business and operations architecture

• Integration

• Programme Management

• Technology

• Transformation and change management

• Finance

• Valuations

Tax

• International corporate tax

• Structuring and tax due diligence

• Transfer pricing

• Indirect taxes

• HRS

• Implementation management and review

• Tax dispute preparation and defence

Legal

• Legal workstream

management

• Intra group agreements

• IP /Commercial and Corporate law

• Corporate governance and compliance

• Legal feasibility

• Regulatory

• Policy review


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Tax and transfer pricing issues of VCT model

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Tax issues raised by the migration from one business model to another (e.g.):

• Goodwill

• Transfer of assets Intangible property (IP)

- Inventory

- Accounts receivable

• Termination of existing intercompany contracts

Tax issues raised by the operation of a tax- efficient business model:

• Permanent establishment: effective management and place of management must be in Entrepreneur territory

• Transfer pricing; acceptable margins for services providers (manufacturing, sales & marketing)

• Cash expatriation from the Entrepreneur

• VAT / Customs considerations

Portugal may not be the Entrepreneur location, but rather the location of a limited risk entity. The transition to and ongoing operation of such a model has local tax impacts:

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Key tax implications arising from implementing a new operating model are outlined below and increase with the greater the degree of centralisation.

1. Exit charges or conversion risk

2. Transfer pricing on ongoing operations

3. Economic substance

4. Permanent Establishment (‘PE’)

5. Indirect taxes (VAT and Customs)

6. Withholding taxes

7. Currency controls

8. Anti-avoidance measures / CFC rules

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Tax and transfer pricing issues of VCT models Key tax implications

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Tax and transfer pricing issues of VCT models OECD Transfer Pricing Guidelines on business restructurings

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A “business restructuring” or “conversion” refers to the “cross-border redeployment

by a multinational enterprise of entrepreneurial functions and risks. A

business restructuring may involve cross-border transfers of key

intangibles.”

• Full-fledges distributors conversions into commissionaires or limited-risk

distributors operating for the Principal

• Full-fledged manufacturers conversions into contract or toll manufacturers

operating for the Principal

• Rationalization or centralization of operations

• Transfers of IP to a Principal

• Migration of intangibles to tax effective companies

• Renegotiation of contracts

• Closing down of plants

• …

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Tax and transfer pricing issues of VCT models OECD Transfer Pricing Guidelines on business restructurings

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Key principle – the allocation of risk

• Risks are important factors within the context of business restructurings since local operations are often converted into low risk entities

• In the open market, the assumption of increased risk is also compensated by an increase in the expected return

• Contractual arrangements are the starting point for determining which party to a transaction bears the risk associated with it

• The contractual allocation of risk is respected only if it is underpinned with economic substance. Therefore, a review of contractual terms must be completed by an analysis of following matters:

Do related parties conduct and conform to the contractual terms

Do contractual terms provide for an arm’s length allocation of risk?

Which party has control over the risk and has financial means to bear the consequences of the risk? (capacity to take decisions to take on the risk, whether and how to manage the risk - Significant people functions needed: people that have the authority and competence to perform these control functions and effectively do so)

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Tax and transfer pricing issues of VCT models Main attention points

• Creating a PE (“PE risk”)

• Business rationale behind the conversion itself – is the nature of the decision arm’s length (“business case” & substance)?

• Functional analysis pre- and post- restructuring

- What functions / risks changed while stripping the profile of a local entity?

- Does the change in functional profile substantiates modifying / altering the pricing scheme?

• Methods used to set the TPs (post-restructuring pricing)

- Verifying comparable searches

- Possibility to apply Profit Split to test the outcomes

• Transfer of activity – compensated profit potential (“exit charges” )

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Tax and transfer pricing issues of VCT models Exit Charges – When? Key question – what is transferred?

• “Something of value” (rights or other assets)

• Termination or substantial renegotiations of existing contracts

• Reallocation of risks = transfer of profit potential

Does lower risk profile substantiate limited profits?

Additional compensation for transfer needed?

Post-restructuring

arrangement mispriced?

No additional compensation

required Yes

No

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Tax and transfer pricing issues of VCT models Exit Charges – What?

Considerations that may give rise to an exit charge:

• Transferring assets

• IP migration

• Existing contracts

• Renewal of contracts

• Loss of tax attributes and tax attributes becoming useless

• Reduction in profit

A commercial rationale must support the envisaged change

maio 2015

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Muito Obrigado pela Vossa atenção

Miguel Tomé Medeiros Transfer Pricing Consultant Email: [email protected]

value chain transformation in a globalized world (tax perspective)

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