Businesses who restructure their supply chains can see significant tax saving opportunities and a reduction in the overall effective tax rate through two main avenues: the creation of a Principal in a lower tax jurisdiction, and that Principal earning a share of profits with lower relative profits across the remaining entities.
The Principal assumes entrepreneurial risks and business functions through a combination of a centralised procurement function, the assumption of quality control and assurance, full risk manufacturing, master distribution functions and ownership of intellectual property.
The existing entities are ‘stripped’ of critical functions and risks. Full risk distributors would become limited risk distributors or commissionaires and full risk manufacturers would become contract or toll manufacturers that, in future, will have only the Principal as their customer.
Unfortunately, in arriving at the new structure, many companies overlook the requirement to compensate the entities that transfer functions or risks and forgo future profits and there are many transfer pricing issues that should be considered, in particular:
– Was anything of value transferred?
– How is the value of the transferred functions, risks or assets determined?
– What are the costs related to the reorganisation and how do the agreements governing the existing operations and transactions address the issue of termination or indemnification?
– What other options would have been realistically available to the taxpayer pre-restructuring?
If the legacy taxpayer was performing key functions and incurring certain risks then some value exists. Tax regulations allow for the use of various specified and, in some instances, unspecified methods to assess the profit potential of functional characteristics, risks and assets. For instance, the value of forgone profits could be based on the present value of future profits adjusted for the costs of fixed assets and functions or risks remaining with the legacy taxpayer. This approach, commonly applied to intellectual property, is often overlooked when considering non-routine functions such as executive or strategic functions and/or supply contracts with customers.
Customer relationships are also a key area where arm’s length compensation is warranted, particularly if they are key to the business as a whole.
The tax rules in certain jurisdictions specify that where ‘functions’ are transferred, the transferee is required to pay an arm’s length compensation based on the profit potential of the transferred function – compensation could include the discounted cash flow attributable to the supply contract, for instance.
Arguably, if a restructuring occurs within the EU, there should not be an exit charge and the Attorney General of the European Court of Justice opined that exit charges are a violation of EU law and that a member state could not impose an exit charge that did not take account of either an option to postpone tax or any losses that materialised later on the hidden reserves within assets transferred. Although the particular case concerned the transfer of a company, the principles could apply equally to the transfer of a business. It is worth noting that Sweden allows for an exit charge to be postponed if certain conditions are met, whereas the Germans use their domestic shift of function rules and tend to ignore any European Court of Justice decisions.
If, through the use of transfer pricing analysis, suitable remuneration is achieved locally in future, tax authorities may accept a reduced, or nil, exit charge. It is imperative, therefore, that a full transfer pricing study is undertaken in any restructuring and adequate functional analysis is undertaken of the functions performed, the risks adopted and the assets employed by each entity within the supply chain, both pre and post-restructuring. n
For more information, call +44 (0)207 868 2431 or email les.secular@tpctax.co.uk