(Tax) Cost Efficient Multinationals Published January 2013 FIRM (Maastricht University) Dr. Arthur Pleijsier
1. Introduction In the current day and age, States need to look carefully at their budget and control their spending. Many politicians in Europe are obliged to keep their national deficit below the famous 3%. Multinational enterprises (MNE’s) are always looking at controlling cost. Certainly when the company is stock listed, cost control is a key element in the strategic planning. In this article I will first highlight a couple of cost items that are typically used by MNE’s to control cost short term. Then I will focus on the longer term planning when it comes to making the company more cost efficient. I am referring to implementing what we call a TESCM structure. TESCM stands for Tax Efficient Supply Chain Management. But please do not forget that it is really about making a company more efficient. We then need to focus on processes, people and information. If processes are handled more efficiently this automatically leads to a cost reduction. You need to have the right people with right capabilities and mindset in your organization. Incapable people make wrong decisions which always lead to additional cost. Finally, information relates to your IT systems. Having one global IT platform is the most efficient set-up for any MNE.
2. Short term cost reductions I have experienced multiple times, previously working for a US multinational that in the third quarter senior management gets nervous because the revenue forecast is below expectation and the year-end results are expected to show less increase in revenue then was communicated to – in my case - Wall Street before. A couple of immediate actions are taken: 1. Implement a hire freeze. This means no additional staff can be hired. Employee costs are always significant and this proposal has a short term positive result. 2. Implement a travel ban. Travel costs are generally speaking huge and all MNE’s spend a lot on travel. Many companies already sobered the travel policy over the last couple of years. Business class flights are generally only allowed for senior management and only for larger distances. 3. Sober the yearly merit increase and bonuses. This is a delicate issue. Employees are usually entitled to a yearly merit increase at least to keep up with the yearly inflation. Bonuses, obviously, are a different ballgame. Before a new fiscal year commences, it is communicated what the minimum targets for the upcoming fiscal year are, if a minimum bonus will be paid out. This target is kept on the radar screen the whole year, because a bonus needs to be paid out. Mind you, I am not talking about senior management at a CEO or CFO level. The layer below the executive committee regards the yearly bonus as part of their salary. In the US many mortgages © Arthur Pleijsier, Luxembourg 2013
are paid off by the bonuses, and many pension plans are funded by the bonus scheme. In Europe we usually regard bonuses as an extra. So that is a complete different perspective. 4. Reduce legal entity cost. Many MNE’s acquire other companies. This leads to an increase in legal entities which leads to additional cost. One legal entity on average will cost a US company $50k per year. These costs consist of: preparing financial accounts, statutory accounts, tax returns, VAT returns, board of director minutes and so forth. It is worth your while to carefully look at your legal entity org chart and determine which legal entities can be liquidated. This will save a lot of cost.
3. Long term cost reductions 3.1 Effective Tax Rate Tax is always one of or the biggest cost of a company. Look in any annual report and you’ll find proof of this. That is why the effective tax rate (ETR) is always carefully analyzed by the CFO and the tax team. A Head of Tax is yearly evaluated on the level of the ETR; the lower the better is usually the motto. So any strategy which can positively contribute to lowering the ETR is supported by the CFO and executive committee. One of the generally accepted strategies are TESCM strategies, optimizing the supply chain or manufacturing chain. These strategies are tax efficient, but above all these strategies will improve the performance of the company. There is often a clear and robust business case supporting these kinds of strategies. Key element in both strategies is setting up a principal company or also referred to as central entrepreneur. 3.2 Principal or central entrepreneur According to transfer pricing rules, taxable profits are based on the functions and risks that a legal entity assumes. It is therefore tax efficient to set-up one company, called a principal company or central entrepreneur, which is responsible for significant risks and functions. If that company is established in a low tax jurisdiction, a lowering of the effective tax rate will be accomplished. Locations like Switzerland and Ireland are favorite jurisdictions in Europe for setting up these kinds of companies. In Asia Singapore is often used for setting up such a company. The way to allocate risk to this principal company is relatively easy. First of all, place this entity in the center of your supply chain. This means that this entity will be the entity that purchases all finished goods from the manufacturers (intercompany or third party). This company will then on sell the goods to sales entities (intercompany or third party). A technical way to (re-)allocate risks is to adapt the distribution agreement between the principal company and the sales company. By means of this legal agreement both parties to the agreement can agree on who will pay for the – for example – shipping cost. The choice of currency also impacts the risks between these two parties. Risks relating to warranties/guarantees, marketing expenses and so forth can be allocated to one of the parties to this agreement. If the sales company is established in a high tax
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country, it would make sense – purely from a tax perspective – to allocate more risk to the principal company (located in a low tax jurisdiction) and more cost to the high taxed sales company. 3.3 Manufacturing vs. principal company The same principle explained in the previous paragraph can be applied between the manufacturing company and the principal company. If the manufacturing company assumes all manufacturing risk, the taxable base should be high. An option is to work on a contract manufacturing basis. This means that the manufacturing company can function as a kind of Service Company. The principal assumes legal title to the raw materials or semi-finished goods. The contract manufacturer manufactures the end product and legal title remains with the principal company during the whole manufacturing process. Implementing this structure in an existing MNE can be difficult if the global transfer pricing policy dictates that the intellectual property (IP) should reside at the manufacturers. Many MNE’s implemented this kind of policy. If you then want to change an in-house manufacturer which owns IP to a contract manufacturer you can be sure you will get the full attention of the tax authorities. You need to move the ownership of IP to another group company. This can trigger taxation because you need to transfer this IP generally at a fair market value. 3.4 Types of distribution The sales company of an MNE who is part of the group can - generally speaking – operate under four different models: 1. 2. 3. 4.
Agent Commissionaire Limited risk distributor Full-fletched buy/sell
An agent acts as an intermediary in the whole sales process. An agent typically performs marketing activities, solicits orders but is not party to the conclusion of the sales contract. They do not take title of the goods sold at any moment and they do not assume accounts receivable risk. The commissionaire acts in his own name; meaning concludes sales contracts in his own name, but for the account of the principal company. They do not assume legal title of the goods sold, the legal title is upon sale directly transferred from the principal company to the customer. So a commissionaire is not buying and selling. The limited risk distributor (LRD) is buying and selling in its own name. They do take legal of the goods sold but only in a flash. Because of this flash title transfer, the LRD would not run any economic risk relating to these goods, so no economic risk relating to inventory. The LRD does bear the accounts receivable risk. The full-fletched buy/sell is a straight forward buy/sell entity. They would sell in their own name, for their own risk and own account. On their books you will find inventory and accounts receivables. © Arthur Pleijsier, Luxembourg 2013
Typically if a company wants to enter new markets i.e. sell in new countries, third parties distributors are contracted to sell the goods. These third parties distributors are considered full-fletched distributors. Because they assume significant risk, from a commercial perspective, the MNE would earn less margin on these sales. 3.5 From sales office to commissionaire or limited risk distributor Converting a regular buy/sell entity into a commissionaire or LRD is a significant change management project. I will explain a couple in random order relating to a commissionaire conversion. Tax As explained in the previous paragraph, a commissionaire does not bear any inventory or accounts receivable risk. This will inevitably lead to a decrease in the taxable base. A change in business model should justify this. In some countries it would make sense to discuss this with tax authorities before the actual implementation. In France, for example, it is advisable to apply for an Advance Pricing Agreement (APA). This type of ruling provides certainty that the tax authorities accept the change in business model. Part of such an APA is agreement on the taxable base of the commissionaire. However, this whole APA process in France currently takes a couple of years to be finalized, a long and costly process. VAT Because in the case of a commissionaire, the principal company legally owns the entire inventory, in many cases this leads to VAT registrations of the principal company in many of the countries where sales are conducted via local commissionaires. Another important issue is the fact that the VAT legislation completely ignores the commissionaire set-up. This means that for VAT purposes the set-up in the IT system needs to reflect a buy/sell situation. So VAT invoicing deviates from the business model set-up. VAT is usually a neglected area within MNEâ€™s. It is important to have the right (meaning capable) internal VAT resources who can guide the company through this process of change. VAT will only become more complicated in these business models. Certainly implementing the new (changed) VAT invoice flows in the existing IT infrastructure is a very complex part of the whole process. Legal All of the intercompany agreements need to be reviewed and possibly adapted. The principal company concludes commissionaire agreements with all of the commissionaires. This agreement is crucial in the whole process. Tax authorities will look at this agreement carefully. If this agreement is not properly drafted, tax authorities will use this as an argument to reject the commissionaire set-up. This agreement will, for example, explain the duties and obligations of both contracting parties (principal vs. commissionaire). It will state details about the commission. The commissionaire will be paid a commission by the principal company usually based on a percentage of sales. The principal will also reimburse certain costs of the commissionaire related to the sales.
ÂŠ Arthur Pleijsier, Luxembourg 2013
Human resources Implementing a TESCM structure leads to an impact on human resources within the company. People could get different roles acquiring additional training. Certainly training on the revised IT set-up is important. Companies often use these kinds of structures to cut excess fat, in other words they “will let people go”. This will lead to job cuts which will put a lot of strain on the whole company and on the human resources department in particular. Accounting The commissionaire business model creates difficulties from an accounting perspective. The commissionaire – under the commissionaire agreement – receives a commission and has no inventory and accounts receivables on its books. In some countries, however, they do need to produce full financial statements showing inventory, accounts receivables and cost of goods sold (e.g. France). In other countries they are obliged to show accounts receivables on their financial statements (e.g. Belgium). Finally, there are countries which accept a financial statement fully in line with the commissionaire set-up, meaning only showing the commission income in the financial statements (e.g. Spain).This discrepancy between the financial statements and the tax return creates difficulties, as one can imagine.
4. Conclusion In the current economic times, companies will implement a lot of strategies to become more efficient in the way they do business which should lead to cutting cost across the board. Tax strategies, like TESCM structures, could provide this. But to be successful in implementation, companies should always have a solid business case. If a change in business model only leads to a decrease in taxation, non-acceptance of tax authorities is to be expected. If the change really leads to more efficiency within the company, like for example a more efficient supply chain process, the change should be accepted by tax authorities. In the commissionaire model all the inventory of the group is owned by one group company (principal) instead of multiple group companies (local sales offices). This set-up will help the supply chain organization to work more efficient. Because no inventory will sit on the local books of a commissionaire, no financing of inventory at a local level is needed. This will reduce the overall financing cost (like e.g. hedging cost of different currencies). All elements which should be part of the overall business case.
© Arthur Pleijsier, Luxembourg 2013