Executive Briefings

How to Benefit When the Supply Chain Meets Tax

Tax-effective supply chain management integrates tax planning into the overall management of your company's supply chain. TESCM must be considered when company officers are determining where to locate functions and assets.

Supply chain management is typically defined as the oversight of materials, information and finances as they move in a process from supplier to manufacturer to wholesaler to retailer to consumer.  As companies do business in a marketplace that transcends national borders, global competition and other mega trends change the nature and shape of supply chains. Allocating functions, assets and risks to different group companies will affect the level of profitability of those individual companies, and those profits will be subject to tax wherever the company is subject to tax.  So actively planning the location of functions, assets and risks - common features of business change and transformation initiatives - can alter the amount of tax paid by the group.

TESCM, or tax-effective supply chain management, is the process of integrating tax planning into the overall management of your company's supply chain, factoring in where to locate functions and assets of your business, centralized management and control over the risks, and which entity will legally and economically assume the risks.  It is an operationally driven approach to tax planning, putting in place a flexible international structure fully aligned with the new business processes and designed to deliver sustainable, long-term reductions in effective tax rate.

Sound like a panacea?  Well, yes and no.  On one hand, given the current economic climate, CFOs of multinational companies need to be aware of every risk that may affect or arise from their supply chains.  New U.S. contract manufacturing regulations, the OECD draft on Business Restructuring, and ever-increasing transfer pricing regulations are adding to your burden worldwide as you deal with tax authorities' renewed focus on supply chain structures as potential revenue sources.  That means any mechanism, approach or process that can help you get ahead of those efforts can be put to great use.

On the other hand, a TESCM structure is complex with a number of moving parts, a change in any one of which can affect its overall effectiveness.  The very nature of the structure is high profile in its ability to generate significant savings - likewise raising the visibility level for tax authorities worldwide.  Ernst & Young's 2008 survey on audits of limited risk structures indicated that levels of audit activity on TESCM structures have increased in the past four years.  So monitoring the TESCM structure to keep it "alive" and in sync with your business's conditions and circumstances at any given time is essential. 

Characteristics of TESCM Structure

Allocating functions, assets and risks to different group companies will affect the level of profitability of those companies; typically, that profit will be subject to tax where the company is resident for tax purposes.  So re-allocating functions, assets and risks - a common feature of business change and transformation initiatives - can alter the amount of tax.

TESCM can potentially benefit any group of companies doing business internationally which needs to improve operating performance or reduce the effective tax rate.  The structure can comprise the full scope of business processes or be limited to specific processes of specialized entities with a narrow range of functions and risks.  In any case, the structure is sure to contain many moving parts and a number of both independent and interconnected transactions - from people to IT systems, from the full complement of tax requirements to customs duty and performance measurement.  All have to work in sync in order to deliver benefits to the company, whether operational or tax.  And all have to be documented and aligned with substantive business purpose.

There are 10 essential characteristics inherent in the TESCM structure.  Some describe the organization of the structure itself.  Others relate more to impact and perception.

10 Characteristics of TESCM

1. Specialized entities with limited functions and risks
2. Principal company managing all economically significant risks
3. Arm's-length transfer pricing on related-party transactions
4. High visibility both within and external to the company
5. Simultaneous application of laws from multiple jurisdictions
6. Large accumulations of profits
7. Substantial financial statement benefits
8. Frequently representative of a new business model for the company
9. Evolving roles and responsibilities of employees
10. Economic assumptions about the model

Although each company has its own unique growth map, there are some "typical" activities that comprise a multinational supply chain.  For example, global growth may begin with a simple service company such as a shared service center.  As the company evolves and begins to ramp up non-headquarters activities, more functionality may be added through a sourcing or procurement company.

Adding functionality also adds risk, which in turn increases both overarching complexity and potential impact on the company.  As these processes are played out through more and more expansion efforts, the company may ultimately arrive at the full-scale principal model that encompasses all its business processes and its intellectual property.

Safeguarding & Sustaining Benefits - An Action Plans for CFOs

As effective as TESCM structures are, however, they may be less prevalent than you would think.  In a recent informal survey that Ernst & Young conducted in conjunction with a TESCM webcast, 58 percent of the 297 respondents (whose company configuration indicated they could have a TESCM) did not have such a structure in place.  Only about a quarter had any kind of formal program or process for safeguarding their tax or operational benefits.

Even companies that do have TESCM structures often work under the misconception of "once and done," thinking that all they need to do is put the structure in place.  Add to that the complexity of the structure and the potential for significant tax benefits in one country or another, and you have a situation that is vulnerable to internal and external threats.  Understanding where such threats come from and what to do to mitigate them is an ongoing process and one that is essential to protecting and sustaining the benefits your TESCM structure was designed to deliver.

Often the internal threat comes from an evolving business model - the structure becomes disconnected from its original TESCM design and no longer operates according to the initial documented plan.  Such disconnects can come from acquisitions that have not been well integrated or from other expansions not in keeping with the original TESCM design.  At the same time, companies can easily take the benefits of their structure for granted, assuming that they will continue in spite of any acquisitions or dispositions that may have been made or any other changes in their business that may have led services and products to expand or contract.

External threats may range from the effect of market volatility on underlying transfer pricing assumptions to changes in laws or regulations and the more aggressive approach that tax authorities subsequently take to examining TESCM structures.  Any of these threats, taken individually or together, can have a material impact on the structure, the presumed benefits and the company's risk, both tax and operational.

Neutralize the Threats

Focusing on three critical areas can help counteract such threats, mitigate risk and safeguard and sustain the benefits that your TESCM structure was designed - or should be designed - to deliver.  Simply put, you must:

• Create proper documentation
• Live the structure
• Maintain the structure

Create proper documentation.  Much has already been made in tax technical reviews, symposia and other communication outlets about the issue of contemporaneous documentation and how tax authorities the world over are stepping up their demands for a road map that walks them through the criteria your company uses for tax elections and other business decisions.  The first line of defense, then, is a robust and comprehensive documentation package.  Include tax technical support as well as the records substantiating internal processes and controls.  TESCM structures and the decisions that have driven them should be backstopped with as much documentation as possible.  There is virtually nothing too granular to be included in TESCM documentation, especially in the face of a challenge.

Live the structure.  A TESCM structure must be qualified with substantive business purpose.  Once you've determined what that structure will be, how your company actually operates with the risk-taking principal and the separate service entities must dovetail with what you've laid out in your plan.  Is the principal doing what you said it would?  Is the flow of information aligned with the design?  Are costs being charged out appropriately?  Have you developed key performance indicators that accurately reflect what the principal does and does not control?  Do job descriptions match actual job performance?

In a TESCM audit, it isn't uncommon for the reviewer to ask to see the detailed job descriptions originally outlined, then speak with the individuals who hold those jobs to find out what they actually do.  Disparities can put the TESCM benefits at risk and the overall structure in jeopardy.  So "living the structure" must be the daily modus operandi and not just something for the documentation files.

Maintain the structure.  Companies evolve.  Maybe not continuously, but enough so that an organization can outgrow its original TESCM structure and the documentation presented at the outset now falls short or is no longer applicable.  Beyond living the precepts of the original design, it is just as critical to keep the documentation up-to-date and accurately representative of any changes to the company structure or the way it does business.

Initial rulings on TESCM structures are generally applicable for a specified number of years.  As you make business decisions that affect the overall structure, you must take into account how the results of those decisions are aligned - or misaligned - with the ruling.  Where they fall and their implications for both tax and operations will determine what steps to take next and whether that will entail new dealings with authorities.

Although companies may choose to operate reactively, hoping to stay under the local radar and waiting to be asked the questions, experience tells us that a more proactive approach is better in the world of TESCM.  You can leverage a formalized strategy to assess, improve and monitor compliance with the structure's design on a regular basis, identify risks and controls, even drive process improvements and proactive risk management.

Top 10 Leading Practices

We've alluded to the complexity of TESCM structure a number of times in this article, so we don't suggest that we could cover all the issues in this context.  What we can do is give you a high-level look at some of the leading practices that apply to designing your TESCM structure, then protecting and sustaining its resident benefits.

1. Implement limited risk structures in parallel with, or following, a major business change.

2. Align the new tax and transfer pricing structure with the locus of strategic decision-making and control of business risks.

3. Adopt a strategic approach to managing controversy, focusing resources on the main risks and viewing Advance Pricing Agreements (APAs) and documentation as key tools for minimizing the impact of tax audits.

4. Document the business case for the restructuring contemporaneously, both from the perspective of the business as a whole and for specific entities, including the case for compensation or indemnification payments to restructured entities (apropos a specific provision in the OECD discussion draft).

5. Consider applying for an APA in one or more countries.

6. Prepare core transfer pricing documentation on the new structure, demonstrating its consistency with the business model, especially the defined and focused responsibility profile of the limited risk entities.

7. Undertake an annual review to ensure that implementation practice is consistent with the terms of the agreements and prepare a brief documentation report for the year.

8. Establish procedures for handling tax authority audits, including the level of disclosure at each stage.

9. Stay in touch with technical tax developments in the countries where the TESCM structure operates, especially where the principal company is located.

10. Talk to other companies that have a TESCM structure to understand better how they have leveraged it to make operational improvements. 

How you choose to move forward with your TESCM structure is up to you and the rest of your company leadership.  And though it may stop somewhat short of being a living, breathing organism, it is dynamic, requiring attention, input and follow-through - both within the organization and with external authorities - to maintain its viability and continue to deliver benefits.  

The views expressed herein are those of author Lee Oster, Tax Effective Supply Chain Management leader at Ernst & Young, and do not necessarily reflect the views of Ernst & Young LLP.

Supply chain management is typically defined as the oversight of materials, information and finances as they move in a process from supplier to manufacturer to wholesaler to retailer to consumer.  As companies do business in a marketplace that transcends national borders, global competition and other mega trends change the nature and shape of supply chains. Allocating functions, assets and risks to different group companies will affect the level of profitability of those individual companies, and those profits will be subject to tax wherever the company is subject to tax.  So actively planning the location of functions, assets and risks - common features of business change and transformation initiatives - can alter the amount of tax paid by the group.

TESCM, or tax-effective supply chain management, is the process of integrating tax planning into the overall management of your company's supply chain, factoring in where to locate functions and assets of your business, centralized management and control over the risks, and which entity will legally and economically assume the risks.  It is an operationally driven approach to tax planning, putting in place a flexible international structure fully aligned with the new business processes and designed to deliver sustainable, long-term reductions in effective tax rate.

Sound like a panacea?  Well, yes and no.  On one hand, given the current economic climate, CFOs of multinational companies need to be aware of every risk that may affect or arise from their supply chains.  New U.S. contract manufacturing regulations, the OECD draft on Business Restructuring, and ever-increasing transfer pricing regulations are adding to your burden worldwide as you deal with tax authorities' renewed focus on supply chain structures as potential revenue sources.  That means any mechanism, approach or process that can help you get ahead of those efforts can be put to great use.

On the other hand, a TESCM structure is complex with a number of moving parts, a change in any one of which can affect its overall effectiveness.  The very nature of the structure is high profile in its ability to generate significant savings - likewise raising the visibility level for tax authorities worldwide.  Ernst & Young's 2008 survey on audits of limited risk structures indicated that levels of audit activity on TESCM structures have increased in the past four years.  So monitoring the TESCM structure to keep it "alive" and in sync with your business's conditions and circumstances at any given time is essential. 

Characteristics of TESCM Structure

Allocating functions, assets and risks to different group companies will affect the level of profitability of those companies; typically, that profit will be subject to tax where the company is resident for tax purposes.  So re-allocating functions, assets and risks - a common feature of business change and transformation initiatives - can alter the amount of tax.

TESCM can potentially benefit any group of companies doing business internationally which needs to improve operating performance or reduce the effective tax rate.  The structure can comprise the full scope of business processes or be limited to specific processes of specialized entities with a narrow range of functions and risks.  In any case, the structure is sure to contain many moving parts and a number of both independent and interconnected transactions - from people to IT systems, from the full complement of tax requirements to customs duty and performance measurement.  All have to work in sync in order to deliver benefits to the company, whether operational or tax.  And all have to be documented and aligned with substantive business purpose.

There are 10 essential characteristics inherent in the TESCM structure.  Some describe the organization of the structure itself.  Others relate more to impact and perception.

10 Characteristics of TESCM

1. Specialized entities with limited functions and risks
2. Principal company managing all economically significant risks
3. Arm's-length transfer pricing on related-party transactions
4. High visibility both within and external to the company
5. Simultaneous application of laws from multiple jurisdictions
6. Large accumulations of profits
7. Substantial financial statement benefits
8. Frequently representative of a new business model for the company
9. Evolving roles and responsibilities of employees
10. Economic assumptions about the model

Although each company has its own unique growth map, there are some "typical" activities that comprise a multinational supply chain.  For example, global growth may begin with a simple service company such as a shared service center.  As the company evolves and begins to ramp up non-headquarters activities, more functionality may be added through a sourcing or procurement company.

Adding functionality also adds risk, which in turn increases both overarching complexity and potential impact on the company.  As these processes are played out through more and more expansion efforts, the company may ultimately arrive at the full-scale principal model that encompasses all its business processes and its intellectual property.

Safeguarding & Sustaining Benefits - An Action Plans for CFOs

As effective as TESCM structures are, however, they may be less prevalent than you would think.  In a recent informal survey that Ernst & Young conducted in conjunction with a TESCM webcast, 58 percent of the 297 respondents (whose company configuration indicated they could have a TESCM) did not have such a structure in place.  Only about a quarter had any kind of formal program or process for safeguarding their tax or operational benefits.

Even companies that do have TESCM structures often work under the misconception of "once and done," thinking that all they need to do is put the structure in place.  Add to that the complexity of the structure and the potential for significant tax benefits in one country or another, and you have a situation that is vulnerable to internal and external threats.  Understanding where such threats come from and what to do to mitigate them is an ongoing process and one that is essential to protecting and sustaining the benefits your TESCM structure was designed to deliver.

Often the internal threat comes from an evolving business model - the structure becomes disconnected from its original TESCM design and no longer operates according to the initial documented plan.  Such disconnects can come from acquisitions that have not been well integrated or from other expansions not in keeping with the original TESCM design.  At the same time, companies can easily take the benefits of their structure for granted, assuming that they will continue in spite of any acquisitions or dispositions that may have been made or any other changes in their business that may have led services and products to expand or contract.

External threats may range from the effect of market volatility on underlying transfer pricing assumptions to changes in laws or regulations and the more aggressive approach that tax authorities subsequently take to examining TESCM structures.  Any of these threats, taken individually or together, can have a material impact on the structure, the presumed benefits and the company's risk, both tax and operational.

Neutralize the Threats

Focusing on three critical areas can help counteract such threats, mitigate risk and safeguard and sustain the benefits that your TESCM structure was designed - or should be designed - to deliver.  Simply put, you must:

• Create proper documentation
• Live the structure
• Maintain the structure

Create proper documentation.  Much has already been made in tax technical reviews, symposia and other communication outlets about the issue of contemporaneous documentation and how tax authorities the world over are stepping up their demands for a road map that walks them through the criteria your company uses for tax elections and other business decisions.  The first line of defense, then, is a robust and comprehensive documentation package.  Include tax technical support as well as the records substantiating internal processes and controls.  TESCM structures and the decisions that have driven them should be backstopped with as much documentation as possible.  There is virtually nothing too granular to be included in TESCM documentation, especially in the face of a challenge.

Live the structure.  A TESCM structure must be qualified with substantive business purpose.  Once you've determined what that structure will be, how your company actually operates with the risk-taking principal and the separate service entities must dovetail with what you've laid out in your plan.  Is the principal doing what you said it would?  Is the flow of information aligned with the design?  Are costs being charged out appropriately?  Have you developed key performance indicators that accurately reflect what the principal does and does not control?  Do job descriptions match actual job performance?

In a TESCM audit, it isn't uncommon for the reviewer to ask to see the detailed job descriptions originally outlined, then speak with the individuals who hold those jobs to find out what they actually do.  Disparities can put the TESCM benefits at risk and the overall structure in jeopardy.  So "living the structure" must be the daily modus operandi and not just something for the documentation files.

Maintain the structure.  Companies evolve.  Maybe not continuously, but enough so that an organization can outgrow its original TESCM structure and the documentation presented at the outset now falls short or is no longer applicable.  Beyond living the precepts of the original design, it is just as critical to keep the documentation up-to-date and accurately representative of any changes to the company structure or the way it does business.

Initial rulings on TESCM structures are generally applicable for a specified number of years.  As you make business decisions that affect the overall structure, you must take into account how the results of those decisions are aligned - or misaligned - with the ruling.  Where they fall and their implications for both tax and operations will determine what steps to take next and whether that will entail new dealings with authorities.

Although companies may choose to operate reactively, hoping to stay under the local radar and waiting to be asked the questions, experience tells us that a more proactive approach is better in the world of TESCM.  You can leverage a formalized strategy to assess, improve and monitor compliance with the structure's design on a regular basis, identify risks and controls, even drive process improvements and proactive risk management.

Top 10 Leading Practices

We've alluded to the complexity of TESCM structure a number of times in this article, so we don't suggest that we could cover all the issues in this context.  What we can do is give you a high-level look at some of the leading practices that apply to designing your TESCM structure, then protecting and sustaining its resident benefits.

1. Implement limited risk structures in parallel with, or following, a major business change.

2. Align the new tax and transfer pricing structure with the locus of strategic decision-making and control of business risks.

3. Adopt a strategic approach to managing controversy, focusing resources on the main risks and viewing Advance Pricing Agreements (APAs) and documentation as key tools for minimizing the impact of tax audits.

4. Document the business case for the restructuring contemporaneously, both from the perspective of the business as a whole and for specific entities, including the case for compensation or indemnification payments to restructured entities (apropos a specific provision in the OECD discussion draft).

5. Consider applying for an APA in one or more countries.

6. Prepare core transfer pricing documentation on the new structure, demonstrating its consistency with the business model, especially the defined and focused responsibility profile of the limited risk entities.

7. Undertake an annual review to ensure that implementation practice is consistent with the terms of the agreements and prepare a brief documentation report for the year.

8. Establish procedures for handling tax authority audits, including the level of disclosure at each stage.

9. Stay in touch with technical tax developments in the countries where the TESCM structure operates, especially where the principal company is located.

10. Talk to other companies that have a TESCM structure to understand better how they have leveraged it to make operational improvements. 

How you choose to move forward with your TESCM structure is up to you and the rest of your company leadership.  And though it may stop somewhat short of being a living, breathing organism, it is dynamic, requiring attention, input and follow-through - both within the organization and with external authorities - to maintain its viability and continue to deliver benefits.  

The views expressed herein are those of author Lee Oster, Tax Effective Supply Chain Management leader at Ernst & Young, and do not necessarily reflect the views of Ernst & Young LLP.