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Effective Tax Planning in the Post-BEPS Era

BEPS in the Current Tax Environment

Transfer pricing issues have become a significant political issue as the G-20 nations focus on ways to combat double non-taxation. Double non-taxation has increasingly been the subject of political agitation by non-governmental organizations ("NGOs"), resulting in reputational risk for MNEs that are the target of NGO actions, such as the "Lux Leaks" or "Panama Papers" leaks. In addition, the United States and other countries are demanding greater "transparency" in taxpayer disclosures.

Double non-taxation is the principal focus of a game-changing project at the Organization for Economic Cooperation and Development ("OECD"), referred to Base Erosion and Profit Shifting ("BEPS"). At the heart of the BEPS project are efforts to align profits from controlled transactions with "commercial reality" and economic substance- concepts that appear sound, but that are ultimately in the eye of the beholder. The BEPS project has resulted in a crescendo of action item papers recommending changes to existing international norms, model tax treaty provisions, or domestic tax rules. Transfer pricing issues that are at the heart of BEPS project include revisions to the rules regarding risk shifting within an MNE group, limitations on intercompany payments for interest, insurance or royalties, and revisions to the treatment of intangibles. The OECD BEPS project encompasses efforts to revise the rules for defining and valuing intangibles and for redefining the concept of a Permanent Establishment, especially with regard to companies engaged in digital commerce.

One general theme of the changes being enacted is that taxable (or non-taxable) profits should follow economic substance. In the case of risks, emphasis is being placed upon the actual management of the functions that give rise to the reward that is inherent in the risk being assumed. Current OECD BEPS recommendations emphasize that a rigorous functional analysis should be undertaken to justify returns to a controlled transaction and that the returns being allocated should reflect commercial reality. In an environment that abounds with uncertainty is tax planning possible to justify profits in tax-favored jurisdictions ?

Post BEPS Tax Planning and Tax Efficient Supply Chains

One often overlooked area of opportunity is tax efficient supply chain planning. For many companies, particularly in the consumer products industry, an efficient supply chain is a critical value driver. The efficient management of a company's supply chain allows it to bring to market innovative products of the right quality, at the right price, and at the right time. Failure to efficiently manage a supply chain can have drastic implications.

For many companies, the inability to meet a production schedule can lead to a brand missing a sales season. Inefficient management of a supply chain can even lead to the collapse of a brand. Conversely, an efficient supply chain enables the brand owner to market products in a timely manner, to increase number of product launches and offerings, to enhance the value of a brand through consistently high quality, to reduce costs, to better manage inventory levels, and to foster innovation. Efficient supply chains allow a company to react to consumers in a more agile way. In fact, fast-fashion brands such as H&M and Forever 21 have supply chains that enable them to bring trends to store shelves with unprecedented speed and efficiency, thereby driving less agile companies into bankruptcy or leading to sales declines for competitors.

Efficient supply chain management as a key value driver is not limited to fashion or similar consumer goods companies. For example, while technology companies are justly proud of having leading edge, technology-driven products, their technological innovations need to be incorporated into products that are produced efficiently, at the right time, and at the right price. The world's best leading-edge technology does not generate profits for the intangible property ("IP") owner until that technology is incorporated into a product that is made, delivered, and sold to the consumer. In short, turning leading-edge IP into globally realized profits requires a well-managed supply chain.

In the past, many consumer products companies have engaged in tax planning involving their supply chains. Typical, tax planning involved an intermediary entity located in a tax-efficient jurisdiction but without sufficient economic substance to withstand scrutiny from a BEPS-type inquiry. With the implementation of BEPS-type provisions, these structures are no longer viable.

Opportunities exist, however, for companies to structure or restructure their supply chains in a tax-efficient manner. The fact remains that for most companies, a well-managed supply chain is a significant value driver. Particularly in the consumer products industry, companies have generally employed companies ("buying agents") located close to the factory base producing the company's products. Historically, these agents were predominantly located in Hong Kong, close to production sites in China. However, as Chinese labor rates rise and companies increasingly look to other countries for sourcing, opportunities exist to restructure the supply chain in order to centralize management of the production functions and enable efficient expansion of the supply base.

Because production involves company employees performing labor-intensive activities, supply chain management through buying agents contains the economic substance necessary to support tax planning in a post-BEPS era. Buying agents generally earn a commission as compensation for the services that they provide. The industry practice is that buying agent commissions are expressed as a percentage of the free-on-board ("FOB") price of goods sourced through the buying agent. A buying agent's commission rate depends on a number of factors, including the variety of goods that the agent handles, the complexity of the manufacturing process, the functions provided by the agent, and the size of the territory that the agent covers.

Based on extensive industry experience, there is a direct relationship between the number, type, and intensity of functions performed by buying agents and the commission rates they earn, with agents that perform more specialized, high value-added functions earning higher commission rates.

According to U.S. Customs, there are standard activities that buying agents characteristically engage in when acting as an intermediary between manufacturers and principals. As compensation for providing these standard buying agent activities, agents generally earn average arm's-length buying agent commission rates in the range of 5.0 percent to 10.0 percent. High value-added services justifying higher or additional commissions include the following:

  • Product design and pre-production engineering services;
  • Artwork;
  • Additional quality control procedures; and
  • Certain product testing.

Because of income sourcing rules that exist in many jurisdictions, high value-added services can be performed in a tax efficient manner using arm's-length transactions to support the fees charged. These types of transactions are not the type for which the BEPS proposals are designed. Rather, these types of transactions reflect the economic substance-based tax planning that should be acceptable in a post-BEPS environment.

What can companies do now? Companies should review certain aspects of their supply chain, including the following:

1. Where are products sourced currently, and what are the plans for expansion of the supply base?

2. Are products sourced through company-owned facilities or unrelated manufacturers?

3. Which company employees are involved in performing supply chain activities close to the manufacturing source base, and where are these employees located?

4. Which headquarters employees are involved in performing supply chain activities?

5. Are internal or external buying agents utilized to assist with the sourcing of products?

This information can help determine whether opportunities exist to structure or restructure a the supply chain in a tax-efficient manner.