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International Corporate Tax case study 

A U.S. corporation has worldwide operations and manufacturing facilities. Nearly all of these foreign entities were historically held directly by one of the consolidated U.S. entities, creating a ‘flat’ corporate structure. The European headquarters is located in Western Europe, with the largest manufacturing facilities outside the U.S. in four European, Middle Eastern and African countries. What are the issues, and what approach has KPMG taken?

International Corporate Tax study

 

Over the past 10 years the company has made several business acquisitions in Europe. The funds for these acquisitions were sourced from the U.S. using cash reserves and/or debt.

Prior to 2004, approximately 70 percent of the company’s sales and income came from products manufactured in the U.S. Because of the location of the majority of third-party debt, there was tremendous pressure to keep the flow of cash to the U.S. high enough to service the interest on this debt. This practice resulted in additional U.S. taxes (to the extent the U.S. tax rate was higher than the foreign jurisdiction tax rate plus any withholding taxes) and the need to find a way to use foreign tax credits.

In 2004 the company acquired a major European business, increasing market share in a particular business line. The acquisition was designed to create corporate synergies; consolidate functions, leverage customer relationships across business lines, strengthen corporate controls and reduce costs.

The acquisition meant a significant increase in worldwide sales. It also saw 60 percent of global revenue and income coming from non-U.S. manufactured products. Most of the funds used to acquire the European business were financed with third party debt by the U.S. entities. As a result of this transaction, the misalignment of third party debt and income was further exacerbated.

In addition, the company faced a mounting problem of integrating their existing European management structure with the acquired, and larger, business. In order to achieve the synergies contemplated as part of the acquisition, integrate the acquired company’s back-office software and functions into the acquirers and significantly reduce the two companies’ total overhead, the U.S. Corporation contemplated a strategic realignment of functions and activities between the two companies.

Issues

Can the company create synergies between the older European, Middle Eastern and African (EMEA) companies and the new business?

Can the company source its debt in the jurisdiction(s) with the largest cash flows, eliminating the need to repatriate European earnings to the U.S.?

Can the company reduce its overall third party debt?

Can the company restructure its EMEA operations to take advantage of low-tax income to service newly-aligned third party debt?

Can the company manage the increased tax burden arising from its non-U.S. operations?


Approach
KPMG helped the company develop an appropriate structure to achieve its long term goals and address the issues described above.

The new structure created a principal European entity that assumed management responsibilities for nearly all of the EMEA manufacturing, development and distribution businesses thus eliminating the redundant functions performed by both the legacy entities and the acquired company. This principal entity owned all contracts, as well as accepting the risks associated with funding R&D activities in European and Asia.

The manufacturing entities received a fee based on costs incurred (‘contract manufacturing’ arrangement). Similar arrangements were concluded with entities providing R&D and other support services. The principal European entity also bought the existing intellectual property for an arm’s length amount. All these arrangements were supported by transfer pricing studies between the various foreign entities and according to local law.

Prior to converting to the new arrangement the company needed to address its third party debt issues. By taking advantage of IRC section 965 (which allowed for a one-year window for an 85 percent dividend received deduction on earnings repatriated from CFCs), the company was able to make significant distributions into the U.S., which were in turn used for corporate capital expenditures pursuant to a dividend reinvestment plan. In addition, as a result of the repatriated dividends, the U.S. company was in turn able to use its other available cash to repay third party debt. The remaining U.S. debt could then be serviced by the U.S. businesses income flow. Future funds needed in EMEA would be financed through the foreign entities directly.

The European operations were reorganized so they could raise debt without parental guarantees from the U.S. The reorganization was achieved by creating a partnership under European law. In turn, this partnership sold the relevant entities to the principal European entity in exchange for a note. The interest payable on this note created an interest deduction that significantly reduced the taxable income of the principal European entity.

The European partnership was set up so that any interest earned was not subject to tax in the jurisdiction of its formation, or in the U.S. unless repatriated. The earlier repayment of U.S. debt also meant it was no longer necessary to repatriate debt from Europe.

Outcome
The reorganization consolidates all of the European functions and risks. The new operating structure significantly decreases the amount of tax the company pays. By adopting a permanent reinvestment position under APB 23 the company also reduces its overall effective tax rate for financial statement purposes.

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