tax-efficient supply chain management (tescm) & transfer pricing ifa conference – 13 december...

Tax-efficient Supply Chain Management (TESCM) & Transfer Pricing

IFA Conference – 13 December 2008 Srinivasa RaoPartner, Ernst & Young, India

Tax-efficient Supply Chain Management & Transfer PricingIFA Conference – 13 December 2008

Contents

► TESCM

– Background

– The Concept

– Overall Structure Design

● Entity Characterization

● Alternative Structures

● Location of Principal Co

– Benefits & Key Tax Issues

– Recent Developments

● OECD Discussion Draft on Transfer Pricing Aspects of Business Restructuring

Tax-efficient Supply Chain Management


Background

► Discernible change in multinational business models

► “Local” business models giving way to regional and global supply chain structures

► Growing centralization of multinational decisions at a regional or international level

► Traditional tax structures impacted by the geographical blur in cross-border business models


Background

► MNEs have grown across the globe with some patterns:

– Manufacturing located near raw material sources, customer markets

– Sales organizations dispersed

– Management in the country of “origin”

► May be doing business in a number of “High Tax Jurisdictions” (“HTJs”)

► Tax base would correspond with the economic activity in the country

► Effective tax rate – cumulative weighted average tax rate


Traditional Supply Chain Model

Buysmaterials

Manufacturer

► Inventory risks►Warranty risk► Intangibles►Capital investment

Buysfinished goods

Distributor

► Inventory risk►Warranty risk► Intangibles►Pricing risk►Volume risk ►Credit risk

Sells finished goods

Customer

► Each entity in the supply chain assumes risks associated with respective functions

► Profit arising from the economic activities in the respective jurisdictions attributed to the jurisdiction


Issues with Traditional Supply Chain Models

► Customer relations

– Fragmented by country

– Multiple points of contact

– In some cases, “competition with ourselves”

► Duplicative functions across countries

– Increases costs

► Manufacturing managed by country

– Short production lines

► Possible results

– Higher worldwide effective tax rate

– Lower profitability


What is TESCM?

► Supply Chain Management (“SCM”) is defined as the management of material and products, information, cash and work flows from the point of first supply across the enterprise to the customer and back

► Tax-efficient Supply Chain Management (“TESCM”) is the process of integrating tax planning into SCM in two fundamental ways:

– Avoiding tax and legal obstacles to achieve business objectives

– Leveraging tax benefits from business change

Information flowsInformation flows

Intelligence flows - product, customer, market needsIntelligence flows - product, customer, market needs

Cash flowsCash flowsMaterial flowsMaterial flows

SuppliersSuppliers CustomersCustomersPlanning &forecastingPlanning &forecasting ProcurementProcurement ManufacturingManufacturing Distribution &

logisticsDistribution &logistics

CustomerserviceCustomerservice

PerformancemeasurementsPerformancemeasurements

Value Chain

Value Chain


Supply Chain Planning – First Principles

► Alignment and compatibility with business model

► Integration of tax planning into business changes

► Review of the allocation of the group’s:

– Value-adding functions

– Income-earning assets

– Commercial risks with a view to optimizing tax costs

► Aggregation of entrepreneurial risks at a Hub entity – Principal Co

► Overall profit of an enterprise:

– Remuneration for the normal functions/risks

– Residual profit – reflecting entrepreneurial remuneration


Supply Chain Planning – First Principles

► Allocation of profits:

– Operating entities entitled for normal profits

– Hub entity entitled for residual (entrepreneurial) profits

► Hub entity

– Located in Low Tax Jurisdiction (“LTJ”)

– Centralization of management, control & business risks

– Entitled for residual (entrepreneurial) profits

► Operating entities

– Location based on business & tax considerations

– Perform routine functions and bear subordinate risks

– Receive a stable and relatively low profit level

– Profit level can be controlled

Overall Structure Design


Supply Chain Design Overview

Factory

After SalesService

Headquarters

Purchase Materials

DeliverMaterials

DeliverGoods

ProcessingServices

Arrange Sales

Sale Of Finished Goods

ManagementServices

ResearchServices

AdminServices

Supplier

Shared Services Centre Commission Agent/LRDR&D Centre

Principal CompanyCustomer

Product Flow

Services

Title Flow

Legend


Key Triggers

Drivers Benefits

Business Drivers Profitable growth

GlobalizationBetter customer

serviceLower costs

Shareholder value

Tax DriversHigh domestic

effective tax ratesTransfer pricing

auditsTax Incentives

More aggressive tax authorities

Trapped tax losses

Alignment of tax & business structure

Improved cash flow

More stable effective tax rate

Less transfer pricing risk

Lower effective tax rate

Centralization of planning and mgmt

Shared services

Integrated supply chain management

Global/regional business units

Centralized Tax Structure

Higher earnings

Actions

Optimized supply chains


► Principal Co

- Hub entity and principal trading company

- Exercises direction, supervision & control over the supply chain

- Bears all significant risks of the supply chain

- Can either own Intellectual Property (“IP”) or license IP from an IP Holding Co

- Would need to have “substance” and some level of senior management/ decision-making functions

► IP Holding Co

- Can either be the Principal Co or a separate entity which owns IP and licenses to Principal Co

Entity Characterization – Principal Company


► Full-fledged Manufacturer

– Significant manufacturing functions risks and manufacturing/ process intangibles

► Contract Manufacturer

– Manufactures goods for Principal Co under a guaranteed sale arrangement, could bear some risks

► Toll Manufacturer/ Consignment Manufacturer

– Converts raw materials supplied by Principal Co into finished goods;

– Does not take title to either the raw materials or finished goods

– Bears insignificant risks and performs minimal functions

Entity Characterization – Manufacturing


► Full-fledged Distributor

– Significant sales and marketing functions, risks and marketing intangibles

► Limited Risk Distributor (“LRD”)

– Almost similar functions as a full-fledged distributor; assumes significantly lower risks

► Commissionaire/ Commission Agent:

– Sales and marketing services to Principal Co;

– Enters into sales contracts on behalf of Principal Co and does not assume title to goods;

– Does not bear any significant risks

Entity Characterization – Sales


► Management Services Co

► Contract R&D Co

► Shared Service Centers

► Co-ordination Centers

Entity Characterization – Services


Contract Manufacturing / LRD Model

► Manufacturing, Sales and Marketing Intangibles/Risks Shifted to Low-taxed Principal Co;

► Operating Cos perform their functions with limited risks

Manufacturer

►Capital investment►Limited inventory risk

Make

Sales price

Principal

Supplier

Sale

LRD agreement

LRD

►Pricing risk (short-term)►Volume risk (short-term)

Sale

Customer

►Warranty risk►Intangibles ►Inventory risks►Credit risk►Pricing risk (long-term)►Volume risk (long-term)


Customer

Arranges sale

►Warranty risk►Intangibles ►Inventory risks►Credit risk►Pricing risk►Volume risk

►Capital investment

CommissionAgentPrincipalManufacturer

Supplier

Service Fee

Make Commission

Agencyservices

Sale

Toller / Commission Agent Model

► Manufacturing, Sales and Marketing Intangibles / Risks Shifted to Low-taxed Principal Co;

► Operating Cos perform their functions with limited risks


Location of Principal Co

► Tax Factors

– Low effective tax rate

– Favorable tax regime for foreign source income

– Favorable tax treaty network

– Liberal advance ruling regime

– Nil/ low withholding tax on outbound payments

► Non-tax Factors

– Good regulatory and legal framework

– Conducive environment for expatriate personnel

– Liberal exchange control regime

– Minimal regulations on cross-border commerce

– Political and economic stability

Structure Benefits & Key Tax Issues


► Integration of tax planning into business change processes

► Reduction in worldwide effective tax rate:

– Principal Co located in a LTJ earns substantial profits

– Operating Cos earn low and stable profits

► Minimization in repatriation costs:

– Low profit level of operating entities

– Reduced repatriation tax costs

► Consolidation of losses:

- Aggregation of losses arising from global operations in a single entity

- Avoids inefficiencies of dispersed losses

► Ensures that cash flow is freely accessible within the group

Structure Benefits


Key Tax Issues

► Conversion/ Migration related issues

– Starting point for tax authorities

● “Gap” between current and future local profit levels

– Points challenged by tax authorities

● Lack of commercial purpose/ substance in business change

● Conduct of parties not consistent with agreements/ documentation

● Transfer of Intangibles (patents, know-how, brand names, trademarks, etc.) upon conversion and valuation

● Deemed migration of “goodwill” upon conversion


Key Tax Issues

► Permanent Establishment (“PE”) Exposure

– Appropriate structuring of arrangement (including movement of personnel) to shield from PE exposure

– Potential PE risk under Toller/ Commissionaire structures in some countries

► Transfer Pricing

– Appropriate documentation of allocation of functions/ risks to support lower income allocation to operating entities

– Intangible/ Buy-in payment valuation

► Indirect Tax/ VAT

– Not optimizing indirect taxes may reduce or negate corporate tax benefits

Recent Developments


OECD Discussion Draft on Business Restructuring

► CTPA Roundtable in January 2005

– Treaty, transfer pricing, and indirect tax issues

– Business and governments

– OECD and Non-OECD Economies

► A Joint WP1 / WP6 Working Group set up

– transfer pricing and treaty aspects

► A small advisory group of business representatives and academics formed

► Objective to release a discussion draft for public comment by the end of 2008

► Discussion Draft on application of Transfer Pricing Guidelines released in Sept 2008


Recent OECD Discussion Draft

► The OECD has recently released a discussion draft entitled “Transfer Pricing Aspects of Business Restructurings”

► Consists of four issues notes:

– General guidance on the allocation of risks

– Arm’s-length compensation for the restructuring itself

– Post-restructuring arrangements

– Exceptional non-recognition of transactions

► Recognition at an OECD level that these transactions are taking place

► Practical guidance on treatment of transactions


Key Messages

► Strong focus on business alignment in evaluating restructurings

► Contractually defined relationships are the starting point but can be set aside in “exceptional” circumstances

► Compensation payments to restructured entity to be evaluated and set on arm’s length principles by reference to realistic available alternatives

► Restatement of bilateral approach to functional analysis including Principals as foundation for method selection

► Economic framework for allocating location savings

► Functions, assets and risks drive TP method – not the other way round


Key Implications

► The OECD is clearly signalling a view that transfer pricing models should be driven by and aligned with the business model

– Transfer pricing analysis now a central element in evaluating tax impacts of business restructuring

– Evaluation of options available to the parties at arm’s length central to that analysis

– Ensure alignment of transfer pricing and legal documentation with business substance

– Need for continual and structured review of behaviour to ensure continuing conformity with transfer pricing model

Thank you

tax-efficient supply chain management (tescm) & transfer pricing ifa conference – 13 december...

Documents

tax planning

supply chain management

tax benefits

global supply chain

management of material

india slide

jurisdiction slide

business objectives