Taxefficient Supply Chain Management TESCM

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Tax-efficient Supply Chain Management (TESCM)
Transfer Pricing

• IFA Conference 13 December 2008
• Srinivasa Rao
• Partner, Ernst Young, India

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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

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Tax-efficient Supply Chain Management
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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

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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

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Traditional Supply Chain Model

• 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

Manufacturer
Customer
Distributor
Buys finished goods
Sells finished goods
Buys materials

• Inventory risks
• Warranty risk
• Intangibles
• Capital investment

• Inventory risk
• Warranty risk
• Intangibles
• Pricing risk
• Volume risk
• Credit risk

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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

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What is TESCM?
Value Chain
Information flows
Intelligence flows - product, customer, market
needs
Procurement
Manufacturing
Planning forecasting
Distribution logistics
Customer service
Performance measurements
Cash flows
Value Chain

• 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

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Supply Chain Planning First Principles

• Alignment and compatibility with business model
• Integration of tax planning into business changes
• Review of the allocation of the groups
• 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

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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

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Overall Structure Design
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Supply Chain Design Overview
Commission Agent/LRD
Shared Services Centre
RD Centre
Headquarters
Admin Services
Research Services
After Sales Service
Arrange Sales
Management Services
Purchase Materials
Sale Of Finished Goods
Supplier
Customer
Principal Company
Processing Services
Deliver Goods
Deliver Materials
Legend
Product Flow
Services
Factory
Title Flow
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Key Triggers
Benefits
Drivers
Actions
Lower effective tax rate
Business Drivers Profitable growth Globalization
Better customer service Lower costs Shareholder
value
Centralization of planning and mgmt
Less transfer pricing risk
Shared services
More stable effective tax rate
Integrated supply chain management
Higher earnings
Global/regional business units
Tax Drivers High domesticeffective tax
rates Transfer pricing audits Tax
Incentives More aggressive tax
authorities Trapped tax losses
Improved cash flow
Alignment of tax business structure
Centralized Tax Structure
Optimized supply chains
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Entity Characterization Principal Company

• 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

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Entity Characterization Manufacturing

• 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

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Entity Characterization Sales

• 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

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Entity Characterization Services

• Management Services Co
• Contract RD Co
• Shared Service Centers
• Co-ordination Centers

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Contract Manufacturing / LRD Model

• Manufacturing, Sales and Marketing
  Intangibles/Risks Shifted to Low-taxed Principal
  Co
• Operating Cos perform their functions with
  limited risks

Supplier
Customer
Sale
Make
Sale
Manufacturer
Principal
LRD
Sales price
LRD agreement

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

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

• Capital investment
• Limited inventory risk

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Toller / Commission Agent Model

• Manufacturing, Sales and Marketing Intangibles /
  Risks Shifted to Low-taxed Principal Co
• Operating Cos perform their functions with
  limited risks

Customer
Supplier
Sale
Arranges sale
Commission
Make
Principal
Manufacturer
Commission Agent
Service Fee
Agency services

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

• Capital investment

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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

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Structure Benefits Key Tax Issues
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Structure Benefits

• 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

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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

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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

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Recent Developments
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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

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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
• Arms-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

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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 arms 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

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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
  arms 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

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Thank you