Tax efficient supply chain management in the chemical industry 

In general, the concept of TESCM entails the following aspects:

• the creation of much more centrally coordinated supply chain management processes, both from a strategic and tactical point of view;
• managing the international tax impact which results from the operational changes made in the supply chain, such as the flow of goods, the location of the tangible and intangible assets used when operating the supply chain, the allocation of risks assumed within the business supply chain as well as the underlying organizational structures and functions performed;
• reducing the effective direct (i.e. corporate) tax rate on income derived from the supply chain;
• optimizing the effect of indirect taxes triggered within the supply chain, such as value-added tax (VAT) and custom duties.

The underlying concept of TESCM is to model the various options that are available when considering the tax effects relevant to the development of a company's supply chain strategy.

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The fundamental principle supporting a business model which has gone through the entire TESCM optimization process is in fact quite simple: once the multinational company has centralized the functions which add the highest value and trigger the major risks within one separate legal entity, a significant amount of the income that it derives from the relevant supply chain can be attributed to that entity as well. Generally such centralized business model will be justified and supported by a commercial rationale for change. In fact there is a business case for change, where the centralized business model will enhance the efficiency and effectiveness of the value chain, reduce operating costs and transform operational processes. This may apply to the enterprise as a whole or just to a single business unit or division. It may even be that centralization of functions has occurred gradually without a specific restructuring plan. For this reason, creating awareness of what is driving the supply chain within the business is crucial.

In this respect, it should be noted that apart from shifting relevant functions, risks and associated tangible assets, often the ownership of the intangible assets which are used within the supply chain will be centralized as well. This may especially true for a knowledge intensive industry, such as specialty chemicals.

In TESCM terms, the legal entity that performs the high value-added functions and bears the most important economic risks within the supply chain, is often referred to as the 'principal' company, or alternatively as the supply chain management company or business entrepreneur. This is the entity which normally owns the relevant IP as well.

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To achieve the desired tax effects, the relevant entity should be located in a jurisdiction which offers favorable treatment from a tax perspective. However, from a business point of view, the principal company cannot be located in a country that is not equipped to host a firm for which the management of the supply chain is strategically important.

Taking into account these various viewpoints, jurisdictions such as the Netherlands and Switzerland are usually short-listed as suitable hosts for the TESCM principal company. Clearly, these countries are particularly suitable places to do business in Europe. Meanwhile, the Asian supply chain may prefer to be steered by a principal company resident in a local jurisdiction, such as Hong Kong or Singapore.

Key factors
Like any multinational that needs to determine the right location for its supply chain management entity in Europe and/or Asia, a chemical company (or any other company for that matter) will not just look at tax rates – although the effective tax rate is of course one of the driving factors in this process. Generally, companies may also consider factors such as direct access to R&D facilities and skilled labour, while a government that appreciates the wishes and needs of the business community will no doubt be looked upon favourably.

Many European governments actively support programs for the rapid commercialization of scientific advances. Typically, these government programs offer the opportunity to conduct advanced R&D at a relatively low cost. Often there are also a number of technology incentive programs, many of which are awarded on a project basis.

Indeed, certain countries have introduced beneficial regimes for IP income in recent years. For instance, as from 2010, the Netherlands has its 'innovation box' regime, providing for a 5% effective rate on profits derived from qualifying intangibles, in combination with a significant reduction of payroll taxes due by R&D workers. Other countries, such as the UK, consider introducing similar programs.

On the legal side, from an innovation perspective, it is very important that a jurisdiction has established a strong track record in securing patents to protect any IP rights resulting from R&D. At the end of the day, these legal aspects should weigh heavier than tax considerations, as the ability to effectively enforce intellectual property rights eventually determines the success of a business and the amount of profits to be generated.

Transfer pricing obstacles
Despite the many benefits TESCM potentially offers, there are still numerous multinationals, including chemical companies, that have not yet implemented such a strategy. One explanation for companies' reticence could be an aversion to getting caught up in tricky transfer pricing issues, the risk of which has been highlighted by recent disputes with tax authorities. The value for a particular product can be created at the very beginning of the supply chain (e.g. R&D carried out in country A leading to the granting of patents) and also at the very end (e.g. sales and marketing efforts in country B). Hence, a major challenge facing tax directors in knowledge intensive sectors of the economy, such as the chemical industry, is to avoid being taxed on the same profit in both countries. However, double taxation may occur if one nation considers a company's profits derived from a commercially successful product to be the result of the high-quality R&D conducted within its boundaries, while another government claims that success is down to the smart selling tactics employed in the local market.

In this respect, it is important to realize that in the cost structure of researchbased companies, a large part of costs may not be directly attributable to the products currently sold in a particular country. This is mainly due to the fact that expenditures may relate to long term R&D programs, which may or may not lead to a successful new product launch.

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The following European case study clearly shows the errors that are often made by multinational companies looking to achieve a short-term tax benefit without being prepared to make any meaningful changes to their existing supply chain through a proper business transformation. Although the case is about the introduction of a centralized purchasing entity, a similar case could be built around any supply chain restructuring that is wrongfully implemented.

The case concerns the tax position of an operating company which is part of a multinational group of companies. Previously, each operating company within that group purchased its own raw materials. However, following a change of strategy, one specific group company located in a low tax jurisdiction started to negotiate central purchasing contracts in the name of each operating entity. These contracts however still had to be signed by the operating entities, which also continued to perform all other purchasing activities as before.

The company convinced its suppliers that the discount resulting from its stronger negotiation position (because of the centralized purchasing of raw materials), would be paid directly to the group company located in the low tax jurisdiction. As such, the centralized purchasing entity was able to recognize a profit substantially exceeding its expenses, whilst the operating entities now received only a small cost plus margin for their function in the process.

The Dutch tax court decided that the centralized purchasing entity's extremely high profit could only stem from a shareholder relationship, resulting in an adjustment of the profitability of the operating company's profits. To this end, the court considered that the central purchasing activities were purely restricted to negotiating collective purchase prices, while such negotiation was still done in the name of the operating company, which still concluded and signed the contracts and, moreover, continued to perform all other relevant activities.

In addition, the court held that the central purchasing entity was exposed to limited risks (only with respect to its operating expenses), particularly as the agreements with the various operating companies did not contain any reference to the amounts or the method of remuneration. Moreover, since the co-ordination fee was a fixed percentage of the gross purchase price, the court held that the remuneration of the centralized purchasing entity did not so much depend on the discount percentage actually negotiated, but rather on the total volume of raw materials purchased. Thus, its profitability rate was not so much the result of its own efforts and achievements, but merely the consequence of the group's decision to centralize the purchasing of raw materials. Consequently, the central purchasing entity was only allowed to report a plus on its own costs as a profit.

This case clearly shows that it is often difficult to derive a sustainable tax benefit by shifting functions and risks without a true change of the underlying business model. This is why TESCM should entail a true change of the supply chain and related business processes, rather than a mere change of the applicable legal and financial arrangements.

In recent years, transfer pricing issues regarding supply chains have become increasingly complex and controversial. Part of this increase is business driven, as there is growing international specialization. While a typical supply chain might previously have included manufacturing, distribution and perhaps a centralized intangible holding company, today that supply chain may well have grown to add procurement companies, a centralized financing function, contract R&D centres and shared services centres. Managing the challenging transfer pricing implications of such complex supply chains has been further complicated by the growing focus of tax authorities on transfer pricing in an effort to make sure that they are able to tax an appropriate share of corporate income.

Case Study – Chemical Manufacturing

Source: KPMG analysis, 2011

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The growing influence of business developments in the field of business restructurings and TESCM projects have led developed countries, organised within the framework of the Organization for Economic Co-operation and Development (OECD), to set out their views on that practice. This has resulted in the recent issue of the OECD's Guidelines on business restructuring, formally incorporated in a new Chapter IX of its Transfer Pricing Guidelines for Multinational Enterprises.

The new OECD Guidelines broadly define business restructuring to include 'the cross-border re-deployment by a multinational enterprise of functions, assets and/or risks'. In essence, a business restructuring can involve almost any substantive change in a business relationship, including a change in the nature or scope of transactions among controlled entities, a shift in the allocation of risks, a change in responsibility for specific functions, as well as a termination of the existing contractual relationship.

Broadly, there is a consensus within the OECD that tax authorities are not in a position to judge how a multinational enterprise structures its business operations, and particularly where it decides to locate those operations. Moreover, the OECD accepts that tax savings may be one of the drivers for (intra-group) business restructurings. This attitude seems to be in contrast with the perception of tax authorities in certain jurisdictions, who still tend to perceive genuine business restructurings as purely tax driven operations. This may lead to controversy, as local authorities try to tax profits allocated to centralized risks and functions by challenging transfer pricing arrangements and/or taking the position that the principal company has a permanent establishment or representative in their jurisdiction to which those profits can be attributed. Nonetheless, tax authorities do reserve the right to judge whether there has been an efficient shift of functions, assets and risks and particularly how valuable these functions, assets and risks should be considered.

In addition to taxing payments for explicit transfers of intangibles, tax authorities may seek to impose 'exit charges' when local businesses either close down or downsize as a consequence of a transfer of assets, risks and functions to an affiliate. Such charges can be implemented by taxing a (deemed) payment from the legal entity that initiated and/or benefited from the restructuring or by disallowing deductions for closure costs locally. Therefore, any changes to the supply chain may trigger immediate revenue recognition in one jurisdiction ('exit tax'), not necessarily followed by a corresponding deduction in the other (low taxed) jurisdiction, with the inherent risk of double taxation.

Even though in today's reality, decision-making within many multinational enterprises is 'virtual' in that it reflects the input and decisions of a group that spans a number of legal entities and jurisdictions, the new Guidelines are essentially based on a model which attributes the decision-making process to (the perspective of) one specific legal entity.

The formal extension of transfer pricing to this broadly defined concept of business restructuring has important implications. Tax authorities will continue to measure whether the underlying agreements are consistent with economic substance and are adhered to in practice. Moreover, multinational enterprises may be expected to document a much broader range of changes in their business operations than before.

It follows from the above that the new OECD Guidelines on business restructuring no doubt have a bearing on TESCM projects. Nonetheless, since the Guidelines do respect a genuinely businessdriven forms of restructuring, TESCM is likely to continue to be a method of achieving tax reductions for multinational enterprises, even though tax authorities are likely to employ increasingly sophisticated investigation techniques to try to counter non-business driven changes of the supply chain.

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For multinational companies, the business driven and substance based form of tax planning known as TESCM continues to be an appropriate way to reduce or optimize the overall effective tax rate, while achieving efficiency gains in relation to the supply chain at the same time. Therefore, the tax and business aspects of a supply chain should be considered on an integrated basis, from both strategic and tactical perspectives. As transfer pricing disputes continue to impose a threat if the supply chain is not managed tax efficiently, companies should avoid the pitfall of trying to achieve short-term gains by changing legal arrangement without a genuine change of the underlying supply chain.

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