Deriving maximum cost efficiency from the supply chain is a critical issue for multinational enterprises (MNEs)—virtually all of our clients identify supply chain efficiency as a crucial operational issue in all or certain regions. Groups continuously seek to derive maximum cost efficiency from their design, production, distribution, servicing, administrative and other functions. Because taxation is typically one of a group’s largest costs, supply chain structuring and restructuring processes typically include tax savings as an essential element of the overall process.
Successful supply chain rationalizations inevitably involve a rationalization of the functions and risks performed by affiliates in the supply chain. They also involve an increase or decrease in such functions and risks performed in each country pertinent to the planning in question. When a function or risk is moved from one affiliate to another, questions are likely to arise regarding valuations of the transferred assets or functions. The specific issues depend upon the facts and circumstances of each situation.
While MNEs are concerned about minimizing the tax cost of their operations, tax authorities in each country impacted by a supply chain rationalization process must be equally vigilant to assure their domestic tax bases are protected from reduction in such. Specifically, tax authorities scrutinize transactions to determine whether the functions or risks of their domestic companies are restructured in a manner that is not consistent with the arm’s-length transfer pricing standard.
Whenever a supply chain rationalization is undertaken, valuation and transfer pricing issues need to be considered. These considerations are presented in the following illustration.
JCo is a Japanese parent of a group of companies engaged in the development, production, distribution and servicing of Unique Products. Its traditional supply chain process involves Unique Products being produced entirely in the Japanese factories of JCo, then sold to affiliates around the world for distribution and servicing. The competitive situation for Unique Products is intense, with JCo having many global competitors.
Because Japan is a high-cost and high-taxation country, JCo has sought to move as many functions as possible to lower-cost countries. In this process, JCo has been less concerned about tax costs than about actual production and related supply chain costs.
At the present time, the supply chain process of Unique Products is as follows, including an overall comparison to JCo’s competitors, which have already undertaken material steps to decentralize their supply chains to drive costs out of their systems and perform critical functions in low-tax countries:
|Function||Performed in||Effective Tax Rate (ETR)*||Problem/Opportunity|
|Design||Japan||40.69%||High op costs|
|Procurement/logistics||Japan||40.69%||High op costs|
|First production||China||25%||Increasing op costs|
|Final production||Japan||40.69%||High op costs|
|Sale to distributors||Japan||40.69%||High op costs|
|Distribution||Local countries||25% average||High op costs|
|Central services||Japan||40.69%||High op costs|
|Overall:||34%||High op costs, increasing unit cost: 100|
|*Source: KPMG Corporate and Indirect Tax Survey 2011|
|Overall:||-||22%||Low op costs and ETR unit cost: 60|
|Competitive disadvantage||-||12%||40 per unit|
|Design||Japan||40.69%||High op costs|
|Procurement/logistics||Singapore||17%||Fair op costs|
|Parts production||Indonesia||10%||Low op costs|
|Final production||China||25%||Increasing op costs|
|Sale to distributors||Singapore||17%||Fair op costs|
|Distribution||Local countries||15% average||Singapore is principal|
|Central services||Singapore||17%||Fair op costs|
|Overall:||26%||Lower op costs and ETR, more to do|
The supply chain restructuring, at a minimum, should reduce the unit cost disadvantage.
In the context of the illustration, the following functions or risks have been transferred:
|Procurement||Function/risk from Japan to Singapore|
|Parts production||Function/risk from China to Indonesia|
|Final production||Function/risk from Japan to China|
|Sales||Function/risk from Japan to Singapore|
|Distribution||Local country distributors converted to cost-plus "commissionaires" (risk moved to Singapore principal)|
|Central services||Function/risk from Japan to Singapore|
In each country from which functions or risks are moved, tax authorities will likely question whether the transfer of function/risk was achieved on arm’s-length terms. In preparation for such questions, and to comply with transferor country tax return filing obligations and transfer pricing documentation requirements, attention will need to be given to:
- Valuation of the assets, functions, risks or liabilities transferred, which will depend in part on the form of the restructuring transaction, e.g., sale, license, assignment, contribution or otherwise (the valuations may be important for tax and book purposes)
- Arm’s-length consideration to be received by the transferor entity, or the entity that loses the function/risk in question (the focus of tax authorities on these issues has been heightened by the recent Organisation for Economic Co-operation and Development (OECD) business restructuring additions to the OECD Model Income Tax Treaty and Transfer Pricing Guidelines)
- Preparation of transfer pricing documentation reflecting the pre- and post-restructuring arrangements
- Preparation for tax authority examination
In each country that takes over functions and risks, consideration is given to:
- The valuation issues noted above
- Arm’s-length consideration to be paid by the transferee entity, as noted above (the transferee’s country tax authority will be concerned about the amount of payment—is it in excess of arm’s-length terms?)
- Preparation of transfer pricing documentation reflecting the post-restructuring arrangements
This newsletter was developed with contributions from members of American Appraisal’s financial valuation practice: Gerald Mehm, senior managing director, Carlo Carpino, director, and Linda Sweet, director.