limited risk models - sept 4 2013

September 4, 2013

India Tax Forum 2013

Models for Limited Risk Structures

© 2013 Deloitte Touche Tohmatsu India Private Limited

■ Introduction

■ Low Risk Structures

‒ Direct Tax Implications

‒ Transfer Pricing Implications

Agenda

1

Introduction

Limited Risk structures


Traditional Business Models

4

Country 1 Country 3 Country 2

Profit from in-country operations

Value-added profit

Risk-based profit


Value-added profit

Risk-based profit


Value-added profit

Risk-based profit

Country-led Structure

• Locally driven • Multiple contact points for the customer • Teams working in silos and in certain cases competing within selves

Customer Relations Management (CRM)

• Inefficient utilization of resources

• Increased Costs Duplication of functions

across Jurisdictions

• Manufacturing units cater only to local demand

• Inefficient use of Production lines Local Manufacturing

• Each entity in the supply chain functions as an entrepreneur,

• Each entity carries all the various types of entrepreneur risks Enhanced Risk

• “Super Normal” profits retained in local jurisdictions subject to high tax rates

Tax Implications


Implications

Cash trapped in different jurisdictions

Inefficient usage of funds and assets

Higher worldwide effective tax rate (ETR)

Lower profitability

Increased Transfer Pricing Complexity

5


Business Models – What’s Changing

• “Local” businesses increasingly giving way to Globally integrated business models

• Increased involvement of Principal company in the decision making process of the local entities

• Tax structures not in sync with cross-border business models

Change in Business Models

• Centralization of Support Services Procurement, HR, Accounting, Admin etc.

• Centralization of Management functions

• Sales organizations dispersed

• Co location of Manufacturing units with vendors and/or markets.

Globalization

6


Business Models – What’s Changing

7

Evolving from a country-led model to a center-led model:

Transferring the management of functions,

assets, and risks may allow the transfer

of local profits to a jurisdiction suitable

for regional/global management

(and, if possible, complimentary tax efficiency).

Profit from In-Country Operations


Manufacturing Sales and

Distribution


Principal

Operating

Company

Value-added profit

Risk-based profit

Value-added profit

Risk-based profit

Value-added profit

Risk-based profit

Country 1

Country 2

Country 3

Center-led Structure




Support

Functions




Country 1 Country 3 Country 2


Value-added profit

Risk-based profit


Value-added profit

Risk-based profit


Value-added profit

Risk-based profit

Country-led Structure

© 2013 Deloitte Touche Tohmatsu India Private Limited 8

Traditional vs. Optimized Model

Traditional Supply chains

• Complex supply chains - inefficient processes and use of fixed asset capacity, excessive working capital, inefficient tax structures and high costs

• Low control over Risk

• MNE profits trapped in various jurisdictions

• Repatriation Costs

• Focus on entity level profitability instead of Group profits

Supply Chain optimization

• Optimisation of business model of the MNE by appropriate allocation of Value Adding Functions, Income Earning Assets and Commercial Risks (FAR).

• A fully-optimized supply chain with embedded tax solutions ensures alignment of remuneration model with the functions/risks of operations of the entity.

• Residual profit – reflecting entrepreneurial remuneration

• Better and more focused control on risks

Consequence – Fragmented

and inefficient supply chain,

resulting in higher exposure to

risk and overall lowering of

profits of the MNE

Consequence – Integration of

operational strategy with tax

strategy. Centralisation of functions

leading to centralization of profits.


Supply chain efficient centralized business model

(with principal at the center)

9

Admin

Services

Limited Risk

Distributor

Shared

Services

Centre

R&D Services

Provider Headquarters

legal title

physical flow

services

Purchase

Materials

Deliver

Materials

Deliver

Goods

Manufacturing

Services

Sell

Goods

Management

Services

Distribution and

Logistics Services

R&D Services

Processing

Services

Sell Goods and

After-sales Service

Central

Entrepreneur/

Hubco/Principal

CUSTOMERS SUPPLIERS

Distribution

Centre Toll

Manufacturer

Essence of TP position

• Key profit drivers (risk,

valuable IP) are placed with

Principal, who receives

entrepreneurial return

• Other entities perform routine

functions (cost plus return)


Potential business and operational benefits

10

Benefit Description

Cost Savings

• Creation of an integrated operating company managing regional strategy and

supply chain flows may result in potentially lower inventory levels and reduced

working capital

• Reduced procurement spend

• Sustainable and scalable tax savings

Business

Process

Efficiencies

• Co-location of regional leadership may result in improved communications,

sharing of best practices, quicker decision making, and speed to market

• Harmonized and standardized processes may result in IT and business process

synergies and more efficient personnel and training requirements

• Potential for business process improvements to create a more efficient and

effective organization (e.g., supply chain optimization, product rationalization,

shared services, price optimization, etc.)

• Improved visibility into local performance based on standardized key performance

indicators

Tax and Financial

Reporting

Efficiencies

• Simplified functional and financial profile in local entities may result in potentially

lower support function needs

• Simplifies transfer pricing and reduces transfer pricing risk

• Creates a uniform transfer pricing model for all sales subsidiaries

Limited Risk Manufacturing


Principal

Third Party

Suppliers

Toll

Manufacturer

(TM)

Service

Physical transfer

(raw materials,

packing materials)

(raw materials,

packing materials)

Toll manufacturer

12

• TM and Principal are related parties

• TM and Principal enter into a long-

term toll manufacturing contract,

pursuant to which TM agrees to

manufacture finished goods for the

Principal for an agreed conversion

fees

• Third party suppliers sell raw

material and packing material to the

Principal. However, the same is

consigned to TM for manufacturing

• The finished goods are delivered

pursuant to Principal’s instructions

• Property in finished goods always

vests with Principal

$

$


Contract manufacturing

13

Principal

Third Party

Suppliers

Contract

Manufacturer

(CM)

Sale #2

(finished goods)

Sale # 1

(raw materials,

packing materials)

$

$

• CM and Principal are related parties

• CM and Principal enter into a long-

term sales contract, pursuant to

which the Principal agrees to

purchase finished goods from CM on

an arms’ length basis

• Third party suppliers sell raw

material and packing material to CM

• After manufacturing, the finished

goods are stored by CM and are

delivered pursuant to the Principal’s

instructions

• Property in finished goods

transferred from CM to Principal


Toll / Contract Manufacturing – Permanent Establishment

implications

• No fixed place PE of principal in TM / CM jurisdiction

– CM’s / TM’s premises are neither used by nor are at the disposal of principal

– No business of principal is carried on through CM / TM; manufacturing activity is the business of

CM / TM and not of the principal

• Amendment proposed by OECD WP 1 in Article 5 OECD MC Commentary

…… Where an enterprise does not have a right to be present at a location and, in fact, does not use that location itself, that location is clearly not at the disposal of the enterprise; thus, for instance, it cannot be considered that a plant that is owned and used exclusively by a supplier or contract-manufacturer is at the disposal of an enterprise that will receive the goods produced at that plant merely because all these goods will be used in the business of that enterprise……”

• No agency PE of principal in TM / CM jurisdiction

– CM / TM are acting on their own behalf and not on behalf of principal

– CM / TM do not exercise any authority to conclude contracts in the name of principal

14


• Contract manufacturing under instructions

of RVEL (Cost plus 3.3%)

− Renting of warehouse to store products

manufactured by RVSA

− Agent of RVEL to promote sale of specified

products and to “represent, protect and foster”

the interests of RVEL (Commission – 2% of

sales)

• RVSA could not negotiate or fix prices

though it was authorized to process

purchase orders

• RVSA had no authority to bind RVEL qua

customers

15

Roche Vitamins

Europe Ltd (RVEL)

Roche Vitamins

SA (RVSA)

Customers

Switzerland

Spain

Sales

Imports Sales

Warehouse

Goods contract

manufactured

Roche Vitamins Europe Ltd (Spanish Supreme Court) [2012]


implications


• Contradiction: RVSA had no contracting

authority and also did not negotiate with

customers

• However, the Court held that the sales

promotion by itself did not create a DAPE

but taken along with the manufacturing led

to the PE conclusion

16

• Contention / decision of tax authority

/ Spanish court:

• RVEL has a fixed place of

business because RVEL used the

premises to perform business

activities in Spain

• RVSA was a DAPE because

RVEL exercised control over the

manufacturing activity

• Warehouse was held not to be the

cause of PE

Roche


implications

Decision appears to have been rendered based on incorrect interpretation

of law especially the OECD MC Commentary


Typical Remuneration Models

Return on Value Added Expenses or conversion cost

Return on operating assets

TP Implication for Toll manufacturer and Contract

Manufacturer

17

Toll Manufacturers

Contract Manufacturers


Return on total operating cost plus markup

Return on operating assets

However, where the significant inventory functions and risks are undertaken by

the Principal, the contract manufacturer acts akin to a toll manufacturer. The

contract manufacturer maybe remunerated on its Value Added Expenses plus a

return on its capital invested in the inventory

Limited Risk Selling Models


Sales Agent (SA)

19

Principal

Customers

Sale

Sales Agent

(‘the Agent’)

Services

$

$

• SA and the Principal are related

parties

• The Agent provides marketing

support services and gets

compensation on an arm’s length

basis

• The Agent may or may not have

authority to negotiate or conclude

contracts which are binding on the

Principal

• Title to goods transferred from

Principal to Customer


Limited risk distributor

20

Principal

Customers

Sale #2 Limited Risk

Distributor

(‘LRD’)

Sales #1 $

$

• LRD is a buy-sell distributor who

distributes products in its own name

and on its own account

• Most of the risks are borne by the

Principal (e.g., inventory and

debtors) and only limited risks are

borne by the LRD

• Commissionaires in civil law


Zimmer SAS (French Supreme Court) [2010]

Background

• Zimmer SAS used to be the full-fledged distributor in

France for Zimmer Ltd (a UK Company) products and

was later converted into a commissionaire

• Under the commissionaire arrangement, Zimmer SAS

could accept orders, present estimates and

documents within the framework of tender offers,

conclude sales contracts for Zimmer Ltd without prior

approval, and could negotiate prices, grant discounts

and payment facilities to existing or new clients

without prior approval of Zimmer Ltd. However,

Zimmer SAS acted in its own name and could not

legally conclude contracts in the name of Zimmer

Ltd. Hence no privity of contract between Zimmer

Ltd and customer

• French tax authorities assessed Zimmer Ltd to French

income tax on the ground that it had an agency PE in

form of Zimmer SAS

21

Zimmer Ltd, UK

Zimmer SAS,

France Customer

PO

Sales

Limited Risk Distributor – Permanent Establishment

implications


Zimmer SAS

Held

• French Supreme Court held that a company which acts normally under a

commissionaire agreement may not be regarded as an agent having authority to bind

its principal, and thus cannot constitute a permanent establishment of the foreign

principal. The Supreme Court observed:

– According to French civil and commercial law, the commissionaire had no legal authority to

conclude contracts in the name of principal

– A commissionaire is described as "a person who acts in its own name on behalf of a principal."

– The principal is not legally bound by the contracts concluded by the commissionaire, whose

clients have no direct action against the principal; hence the requirement of agency PE under

OECD MC is absent

22


implications

Held no agency PE since the commissionaire was not binding the

principal qua third party customers, which according to Court was a

prerequisite under OECD MC for constituting an agency PE


Dell Norway (Norway Supreme Court [2011]

• Dell AS, a Norwegian company, was acting as a

“commissionaire” agent on behalf of its Irish parent, Dell

Products

• Dell AS sold computer products of Dell Products to

companies in Norway under its own name. Dell AS could

not conclude contracts on behalf of its parent

• Norwegian tax authorities argued that Dell AS constituted

a PE of Dell Products in Norway

• Norway’s Supreme Court ruled that the activities of a

Norwegian subsidiary do not create an agency PE in

Norway of its Irish parent sales company

• The Court specifically held that a PE in accordance with

article 5(5) of the OECD Model Treaty (agency PE article)

can arise only in cases in which a dependent agent can

legally bind its principal

• Referred to Zimmer French SC decision

23

Dell Products

(Ireland)

Dell AS (Norway)


implications


• OECD WP1 has proposed following changes to Article 5 OECD MC:

“Also, the phrase “authority to conclude contracts in the name of the enterprise” does not confine the application of the paragraph to an agent who enters into contracts literally in the name of the enterprise; the paragraph applies equally to an agent who concludes contracts which are binding on the enterprise even if those contracts are not actually in the name of the enterprise. For example, in some countries an enterprise would be bound, in certain cases, by a contract concluded with a third party by a person acting on behalf of the enterprise even if the person did not formally disclose that it was acting for the enterprise and the name of the enterprise was not referred to in the contract.”

• Above amendment has been proposed to overrule the Zimmer and Dell decisions

• Impact of above amendment on LRD models?

i. Amendment proposed specific to commissionaire arrangements

ii. The concept of commissionaire provided in both contract and commercial laws of European jurisdictions; India has no such concept

iii. Under Indian contract law, LRD does not act on behalf of the principal both contractually and legally

iv. Indian contract law requires a person to bind his principal qua third parties for him to be treated as an agent

v. Setting up of LRD in India / conversion of full risk distributor into LRD should not fall in the “substance over form” category of the “pre-ordained series of transactions” (Vodafone)

vi. No complex web or smokes screen is put in place for defrauding the Revenue; risks / responsibilities vests with principal under a legally binding contractual arrangement

24

Limited Risk Distributor – Permanent Establishment implications



Sales agent undertaking marketing support functions but not undertaking negotiations or concluding of

contracts maybe remunerated on a Cost Plus basis

Sales agent undertaking marketing functions alongwith negotiations and conclusion of contracts maybe

remunerated on a Commission on Direct Sales

TP Implication for Sales Agent and Limited Risk Distributor

25

Sales Agent

Limited Risk Distributors


Generally remunerated on a Return on Sales basis

Essentially the functions of an Agent and LRD are broadly similar. Accordingly,

an agent maybe remunerated based on a return on Sales of an LRD with

appropriate economic adjustments like working capital adjustment etc.

Limited Risk Procurement Services Centre


Procurement centre (services)

27

Principal

Third

Party Suppliers

Sale

Physical

Transfer

Procurement

Centre

(Agency Co.)

Services

$

$

• Agency Co. and the Principal are

related parties

• Agency Co. acts as a sourcing

support service provider to the

Principal

• Goods are sold by the Suppliers

directly to the Principal


Procurement Services – Permanent Establishment

implications

• Exemption provided under the Income Tax Act, 1961:

‒ In the case of a non-resident, no income shall be deemed to accrue or arise in India to him

through or from operations which are confined to the purchase of goods in India for the

purpose of export (Expln 1(b) to S. 9)

‒ business connection" shall include any business activity carried out through a person who,

acting on behalf of the non-resident,—

(a) has and habitually exercises in India, an authority to conclude contracts on behalf of the

non-resident, unless his activities are limited to the purchase of goods or merchandise for

the non-resident (Expln 2(a) to S. 9)

• Exemption provided under DTAAs:

‒ … the term “permanent establishment” shall be deemed not to include:

d) the maintenance of a fixed place of business solely for the purpose of purchasing goods or

merchandise or of collecting information, for the enterprise;”

28


• Illustrative list of procurement services provided by procurement agents for the benefit of foreign

buyers:

‒ Pre-sourcing factory evaluations to determine vendor’s ability to manufacture products as per

buyer’s expectations

‒ Vendor identification

‒ Review of costing data

‒ Vendor recommendation

‒ Quality control

‒ Monitoring vendors for compliance with the policies, procedure and standards related quality,

delivery, pricing, labor practices and environmental laws

‒ Coordination, monitoring and verification with vendors to develop the products in-line with the quality

and aesthetic requirements of the products

‒ Laboratory testing

‒ Interaction with suppliers in relation to capacity utilization, quality assurance, on-time delivery

performance etc.

‒ Negotiating competitive prices

‒ Providing training to selected vendor employees

‒ Ensuring usage of standard methods, tools, machinery and layouts

29


implications



implications

• Many Indian decisions now supporting a no PE theory

30

Procurement services should normally not result in a PE. All activities

inextricably linked to the procurement function should qualify for the

exemption benefit


TP Implications for a Limited Risk Procurement Centre

31


• Agent undertaking routine procurement support functions maybe remunerated on a Cost

Plus basis

• Agent undertaking significant value adding/ intangible creating functions such as product

design, preparing vendor databases, price and terms negotiation, etc. maybe remunerated

with a commission on goods purchased

Integrated Franchisee Model

© 2013 Deloitte Touche Tohmatsu India Private Limited Slide

33

Integrated franchisee model

33

India

Principal

Franchisee Mfg Exporter

IPR & Services

Global contracts

Business generated for India

Locally sourced materials

Global Retailer

Fra

nch

isee

fee

s

Outside India

Legal Title of Goods

Legal Title of

Goods

© 2013 Deloitte Touche Tohmatsu India Private Limited Slide

34

• Principal enters into contracts & negotiates prices in overseas markets. It grants the

Franchisee the right to use intangibles such as brands, technical know-how and

commercial and supply chain related intangibles

• Principal bears risks of bad debts & product-design liabilities

• Franchisee uses IP provided in a manner authorised by the Principal for manufacturing

and coordinates with customers for fulfilling global contracts. Raises invoices on

customers and collects payments

Integrated franchisee model


• The functions undertaken by the Franchisee Manufacturer are akin to a contract

manufacturer. From the customer revenue it may retain an arm’s length return on total

operating cost and pay the balance customer revenue to the Principal as “Franchisee Fee”

34

IP Migration


Transfer of Intellectual Property

36

Para 9.80 of the OECD Transfer Pricing guidelines on Business Restructuring

“Relevant intangible assets might potentially include rights to use industrial assets such as

patents, trademarks, trade names, designs or models, as well as copyrights of literary, artistic or

scientific work (including software) and intellectual property such as knowhow and trade secrets.

They may also include customer lists, distribution channels, unique names, symbols or pictures.

An essential part of the analysis of a business restructuring is to identify the significant intangible assets

that were transferred (if any), whether independent parties would have remunerated their transfer, and

what their arm’s length value is.”

• Conversion of full-fledged distributors into limited-risk distributors or commissionaires

• Conversion of full-fledged manufacturers into contract-manufacturers or toll-manufacturers

• Transfers of intangible property rights to a central entity (e.g. an “IP company”) within the group.

Business Restructurings typically comprises of the following:-


Exit Charge – an illustration

37

As an example, conversion of full risk marketing distributor to LRD would require the

following issues to be examined:

• Any transfer of marketing intangibles i.e. customer list, distribution network, etc.

• Any transfer/ surrender of a right i.e. early/ premature termination of exclusive

rights of distribution under an agreement

• Any cessation of functions including movement/ transfer of workforce with or

without bundling of intangibles with the work force

• Others

The above in-depth analysis would be required to determine if an exit charge would

be expected between independent parties


Exit Charge- India Tax Implications

• “Exit Charge” refers to a payment made to compensate for removal of an asset belonging to an entity

whose activity in the business is being simplified or reduced. For example, moving from full-fledged

distributor to a LRD model

• Section 28(va), inserted by the FA 2002 provides that any sum received under an agreement for not

carrying out any activity in relation to any business or not sharing any know-how or technique likely to

assist in the manufacture or processing of goods or provision for services is taxable as business

income

• Memorandum to the FA 2002 says that the new provision has been added for taxing receipts in the

nature of “non-compete fees and exclusivity rights”

• Arguable that if charge represents compensation towards loss of revenue earning apparatus, not

taxable as capital gains relying on B.C. Srinivasa Shetty (Supreme Court)

38

Does exit charge represent non-compete fee or does it represent

consideration payable for stripping the subsidiary from certain rights

previously held by it as a full risk distributor?

If not non-compete fee, capital receipt not taxable as business income

(compensation for loss of revenue earning apparatus)?

About Deloitte Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its network of member firms, each of which is a legally separate and independent entity. Please see www.deloitte.com/about for a detailed description of the legal structure of Deloitte Touche Tohmatsu Limited and its member firms. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Copyright © 2012 Deloitte Development LLC. All rights reserved. Member of Deloitte Touche Tohmatsu Limited

http://www.deloitte.com/about

http://www.deloitte.com/us/about

limited risk models - sept 4 2013

Documents