after-tax: Boosting after-tax profits with supply chain management

The global financial crisis has led to significant cost cutting worldwide – look at the recent quarterly release of any multinational listed company and you will see a cost savings and restructuring plan. The impetus for controlling costs just to stay in business has led corporations to aggressively restructure, primarily by rationalizing their workforces and lowering all nonessential costs and, when possible, instituting price increases. The outlook may be myopic and inherently flawed in setting up a structure for sustained future profits, yet even for many global corporations it is critical for survival.

With profits down and many companies forecasting zero growth, cash is king and proactive tax planning has been pushed down the corporate agenda. However, for groups that can afford to take a long-term view, now may be the time for a strategic review of their worldwide operations.

Supply chain management is a global organizational planning strategy. While it makes sense from an operational perspective, multinationals can also achieve a sustainable boost to after-tax profits by integrating their tax planning with their supply chain operations. Global supply chain initiatives are a proven way to reduce operational costs and increase profits; however, without an adequate focus on taxation, these initiatives will fall short of their potential to drive shareholder value. A focus on pretax gains can lead to significant increased profits generated from supply chain management improvements that are normally lost to taxes.

Broadly speaking, in the absence of a supply chain strategy, companies tend to report and reward based on key performance indicators that promote the business unit, which actually encourages a silo mentality: institutionalizing costly competition and inefficiencies. The value chains of many global companies are therefore complex and country-focused, which means process is inconsistent, planning decisions are made locally and management is country-specific, each focused on their own profit and loss (P&L) accounts. The result is poor use of excess capacity and inability to achieve scale, ineffective distribution of working capital, inefficient processes and high supply chain cost structures. Ultimately, there is a loss of revenue and an inefficient tax structure.

Putting a supply chain vision into practice, however, is a formidable task, the success of which requires senior management to commit to an alliance between operations and tax that many find to be difficult to achieve internally. The tax focus also needs to be managed on a global level across corporate (including transfer pricing), indirect and state-based taxes.

The success of a supply chain strategy lies in leveraging expertise and economies of scale on an entity-wide basis. There is generally a shift required, which entails a change in mind-set and includes a corporate restructure that can transform a multinational into a globally operating entity, as well as enhance the efficient geographic distribution of profits and taxes.

The other aspect of supply chain and tax structuring decisions is that companies tend to focus on strategies aimed at reducing the current burden of taxes based on their current profit levels. Consequently, these strategies may not be scalable – as profits increase and the organization grows, the strategies will yield a proportionally smaller after-tax result for the company.

Supply chain optimization leads to reduced costs and increased profit before tax. By aligning tax planning with supply chain optimization, a company can achieve two significant advantages: a lower effective corporate income tax rate on incremental profits and tax related "above the line" cost reductions (e.g. lower unrecoverable VAT and lower customs and excise duty costs).


European experience

Several high-profile U.K. companies recently have moved their operations and tax residence to Ireland because significant tax benefits are available under the Irish tax system that are absent in the U.K. These benefits, which include a lower corporate tax rate and the availability of a participation exemption on dividends and capital gains, are offered to induce migratory behavior and thus stimulate employment, spending and the economy in general.

The imperative of listed companies generally is geared toward reducing the effective tax rate (ETR), which is directly linked to reported earnings and share price. The Irish experience, however, suggests that corporations are as interested in lowering their actual tax payable from cash balances at bank/on balance sheet to the relevant tax authorities (cash taxes) as compared to, and distinct from, tax expense in the P&L, rather than simply trying to reduce the ETR for purposes of reporting to the market. In a very simplified sense, a higher ETR translates to lower reported profits and, consequently, the risk of a lower share price. A strategic focus on supply chain optimization, however, can achieve the dual goals of lowering the ETR and generating cash tax savings.

The story in Europe is not limited to a simple reduction in cash taxes. Relocation to a new jurisdiction opens the door to significant opportunities to align the business globally. The EU has also assisted its member states by providing business with an overall regime of tax costs savings for transactions between member countries. Further, many EU Member States (e.g. Ireland, Luxembourg and the Netherlands) have been and are increasing the provision of particular incentives to serve as holding company jurisdictions as the point of entry into Europe.

Example – A global manufacturing company that decides to implement a supply chain strategy is generally presented with four opportunities:

- Logistics – Adopt a model for the optimization of networks, such as a centralized global freight management center. The logistics center will generally be responsible for supplier selection, negotiation of supply agreements, contract administration, capacity planning, inventory management and distribution planning.
- Procurement – Establish a global sourcing center to obtain volume discounts and negotiating power. Procurement can be of finished or semi-finished goods or raw materials. The procurement center will generally be responsible for selecting suppliers, negotiating supply agreements and administering contracts. The center should have knowledge of suppliers and procedures and will generally bear some market risks.
- Manufacturing – Streamline processes to reduce inventory, overhead and carrying costs.
- Services – Create a global shared services center for treasury, finance and accounting, human resources, information technology and other functions.
When brought together, such strategies can drive the profits of a company on a worldwide basis. However, when the supply chain strategies are aligned with tax planning, the after-tax benefits are multiplied. For example:
- Set up a principal company, which assumes key entrepreneurial functions and risks and houses the global procurement function in a tax-advantaged jurisdiction;
- Convert manufacturing into a low-risk contract/toll manufacturer for the principal; and
- Set up the shared services center as a service provider.


By adding tax strategy to the supply chain, significant pre-tax income can be attributed to a low-tax jurisdiction and away from high-tax operational jurisdictions. This would have the effect of lowering not only cash taxes but also an ETR reduction globally, which is why the principal is typically based in a place like Ireland or Singapore.

More models – Companies that have the most to gain from tax-aligned strategies share one or more of these characteristics:
- Complex supply chain footprint spanning multiple countries;
- A high ETR and a need for sustainable tax planning options;
- Major changes on the horizon, e.g. merger, acquisition or restructuring;
- Pressure to reduce costs;
- New manufacturing, distribution or R&D facilities; and
- Need to upgrade supply chain technologies.

Once the imperative for implementing a supply chain solution has been identified and accepted, there are key nontax approaches critical to ensuring its success.

Under a best case scenario, key profit drivers (such as risk and IP) are moved to the principal, which is resident in a tax advantaged jurisdiction. Under this model, the principal will contract with suppliers for the purchase of materials that are delivered to a toll/consignment manufacturer. This manufacturer will simply be providing a service to the principal. A toll or consignment manufacturer processes goods belonging to the principal (without taking ownership). The contract/toll manufacturer assumes less risk and hence earns a lower return than a traditional manufacturer. The manufactured products are delivered to a distribution center, which provides distribution and logistics services to the principal.

Also split out of the principal are the internal functions with additional service centers performing services such as management services, research and development and shared services. The benefits offered here are similar to those already discussed – the centralization of these services allows for increased efficiencies and lower costs as well as centralizing tax deductions. Marketing and pre- and post-sales service functions could also be segregated into a separate company as a limited risk distributor. A further variation to this structure is the addition of a procurement center to contract with suppliers on behalf of the principal.

Variations to the distribution and marketing functions can also include:
- Instead of a toll manufacturer, the principal engages a manufacturer that produces goods to order for (and for the risk of) the principal. A contract manufacturer buys materials and sells finished goods to the principal. However, it has less risk and earns a lower profit than a traditional manufacturer.
- The principal contracts with a non-contract-concluding sales agent. In this regard, the sales agent would provide sales-related services to the principal but would not have the authority to conclude contracts that are binding on the principal; i.e. sales contracts are entered into directly between the principal and the customer.
- The principal operates under a commissionaire arrangement. Under this scenario, the commissionaire still provides sales-related services to the principal. However, the commissionaire enters into contracts with customers but not on behalf of the principal. Consequently, the sale is made by the principal and title passes from the principal to the customer.
- The principal contracts with a sales entity to make sales to customers. In this scenario, the sales are made by the principal to the sales company and then from the sales company to the customers. However, the sales company is a limited risk distributor such that although title passes from the principal to the sales company and then to the customer, the principal still bears the business risk.

The supply chain improvement areas noted above can generate large incremental profits to the enterprise. However, unless proper tax planning is coordinated with these initiatives, a significant portion of the benefits will be unrealized because cost reductions may be achieved but the cash tax cost will not be minimized. Below are some key points to be considered regarding the above outlined areas.
- Procurement – Consolidation and scale benefits should only be a starting point. By setting up a procurement center as a separate entity, tax burdens can be reduced, particularly on cross-border transactions. Significant income tax efficiencies can be gained by the proper use of a low-tax jurisdiction and arm's-length transactions among business units. Companies can also mitigate transaction taxes.
- Product life cycle – The focus is on capturing returns attributable to intangibles developed in the course of a product lifecycle management initiative. For example, when one part of an enterprise performs R&D that benefits the entire organization, which legal entity within the enterprise owns the economic rights to exploit the new technology? Facilitating ownership in jurisdictions with a favorable tax rate can generate significant tax savings.
- Logistics – As companies undergo M&A activities, logistics creates opportunities to reduce the global structural tax rate by changing the flow of products and thus revenue from a high-tax jurisdiction to a low-tax one.
- Technology – Enterprise resource planning (ERP) systems with advanced supply chain functionality, planning systems and sophisticated warehouse management solutions are all examples of technology-based initiatives. Such initiatives can reduce time and costs associated with compliance and reporting, improve decision-making and efficiently identify credits and rebate opportunities.
- Intellectual property – There are broadly two key types of IP models: a decentralized model involving cost-sharing arrangements and a centralized ownership model involving a group IP company or IP held by the principal.

In a decentralized model, the IP ownership would be spread among multiple companies across the group as distinct from a single IP owner in the centralized model and companies within the group that are using IP would contribute to the costs of creating and maintaining it in proportion to the benefits they derive. In the centralized model, group companies would use the IP via license from the owner in exchange for a royalty. Centralized IP ownership generally leads to greater tax efficiency if it can be achieved without a significant tax cost to migrate existing IP. This ownership structure often provides commercial benefits through better control over IP, more effective investment in developing new IP and better deployment of new IP. However, centralized IP ownership requires a degree of centralized management of IP. It may nevertheless be possible to separate the development and ownership of IP by having the IP owner fund the costs of development that are incurred by other group companies.

Under the centralized model, the principal company in a group owns the IP and as such is entitled to the profits in the value chain attributable to that IP principal. However, if the existing IP ownership within a group is decentralized, this may prevent the effective migration of the IP to a centralized model without a significant tax cost (that is, triggering capital gains). It may be possible to structure the centralization of the ownership of new IP without disturbing the ownership of existing IP. In some cases, existing IP could potentially be migrated from existing owners to a new centralized owner by shifting responsibility for the costs of maintaining the value of the IP. Similarly, new products and technology developed from existing IP can be funded centrally and, over time, the value of the IP will, as a consequence, transfer.


Tax issues

The alignment of supply chain with taxation should bring about further cost reductions and cash savings. However, because of the revenue loss, it is likely that some tax authorities would consider such business reorganizations to be avoidance or evasion notwithstanding the commercial purpose and real substance behind the reorganization. This is especially important to deal with upfront and is typically dependent on the jurisdiction, so careful consideration is critical.

Broadly, the issues to be considered regarding the principal are securing a low ETR; avoiding controlled foreign company (CFC) attribution; achieving effective repatriation of low-taxed earnings; using cash generated by tax and other cost savings; and managing the tax structure over time (including exit strategies).

Regarding local operations, issues to consider include income tax or capital gains tax on the transfer of assets, the creation and taxation of permanent establishments (PEs) and preservation of tax losses.

Taxation of PEs is generally dependent on the application of an applicable tax treaty. For example, article 5(5) of the OECD model treaty provides that an agency PE may exist where a person ". . . is acting on behalf of an enterprise and has, and habitually exercises, in a Contracting State an authority to conclude contracts in the name of the enterprise." Article 5(5) generally applies to common law agents (i.e. authority to enter into a contract binding on the principal), but generally does not apply to civil law commissionaires (since the principal does not enter into a contractual relationship with the customer).

However, this should not be taken for granted and the particular articles of each treaty need to be carefully considered in each case. Also, in addition to contract/non-contract-concluding agents, there are other types of agency, such as a delivering agent, order-filling agent or order-securing agent. Consequently, structuring arrangements such as toll manufacturing, contract manufacturing and procurement activities may in some circumstances lead to the creation of a PE.

No amount of cross-border structuring would be complete without a consideration of the transfer pricing implications.

Critical to this process is the setting of prices that are defendable in the local jurisdictions. The principal should have the appropriate substance (by way of functions and personnel) to support the arrangement. Carrying out the functional analysis, benchmarking and economic analysis to support the transfer prices is key. Contemporaneous documentation should be in place to support the transfer pricing method, and post-implementation reviews should be conducted to maintain the alignment of the transfer pricing design and actual practice.

Although not discussed in detail in this article, the indirect tax issues should not be forgotten and indeed play an important part in determining the optimal tax-aligned structure. The VAT registration and reporting requirements and customs duty and transactional duty implications need to be considered as part of any structuring. Further, to get the tax-aligned supply chain model right for the long term, one must consider appropriate systems and process design upfront. In general, the VAT should not be a true cost to business as it is creditable and should be able to be passed on. However, there may be situations when VAT can become a net cost and therefore affect the P&L statement. In some cases, the registration of a principal for VAT in a foreign jurisdiction could even be taken to be evidence of a PE in that country. As noted, these issues require careful consideration upfront.

From an overall structuring perspective, it does no good to try to optimize the tax-aligned supply chain with entities and operations in low-tax jurisdictions only to end up with issues related to CFC income attribution back to the principal's country of residence or PEs subject to taxation in the country of operations. The subject of CFCs is contained in the domestic law of the principal countries and can depend on whether the CFC carries on an active business, whether any income is derived from tainted sales or services, and whether any income has been concessionally taxed.

Asia and Europe – Generally there are many differences between a tax-aligned supply chain model in Asia and one in Europe. First, the VAT laws are similar across EU Member States, so cross-border supplies are generally VAT creditable. VAT is more likely to be unrecoverable in Asia. There are customs duty benefits within the EU that provide relief from crossborder goods transactions between member states, but no such relief is available in Asia. There are also differences for income tax purposes. In civil law jurisdictions, generally the PE definition in tax treaties includes contract-concluding agents but would exclude commissionaires, while common law jurisdictions include commissionaires and may also include other types of agents. Last, to the extent of legal entity structuring, the EU offers the benefit of tax-free dividends under the Parent-Subsidiary Directive, and European countries may offer participation exemptions for dividends received offshore from, or capital gains arising on the disposal of, downstream entities.


Final considerations

A strategic tax vision is critical to successful planning. The leadership team must come together to put tax-aligned operations on the "C-suite" (i.e. CEO, CFO, CIO, etc.) agenda. An ongoing forum for cross-business unit collaboration between operations and tax is vital to ensure that the desired benefits are able to be realized. It is also important to learn what underlies the ETR of the corporation as a whole. What drives the ETR will determine the operational support or function necessary to implement the tax structuring consequences. The organization's management incentives should also be understood to determine whether they lead to tax-optimized decisions; if not, consideration may be given to whether these incentives can be aligned to achieve the supply chain solution. Experienced advice from either internal or external advisers is critical to ensuring that the intended outcomes are achieved from structural tax planning.

Focus on after-tax returns – As regards creating a focus on after-tax returns, an executive compensation scheme and incentives on after-tax performance are critical to the success of the supply chain vision. For example, this could involve changing management's mind set by instituting policies that even business cases developed for major projects use after-tax dollars. Additionally, successes can be evaluated on the basis of after-tax dollars rather than simply focusing on pre-tax results.

Plan for increased profits – The operations and tax divisions must be brought together before the beginning of any new initiative. Detailed planning at the outset will minimize the tax impact of expected performance improvement projects.

Focus on critical supply chain functions – The ETR is dependent on making decisions related to procurement, technology, logistics, and product lifecycle management. These are therefore the areas in which most of the key individuals' time and energy should be directed.

To bring about the full business and tax benefits of supply chain transformation, a holistic approach is critical to combine the supply chain and tax elements; the execution of the supply chain strategy will therefore continue to be business led and driven, but it will be tax aligned.