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TAX & LEGAL

TAX & LEGAL . Business Restructurings: Contract Manufacturers and Commissionaires Eugenio Graziani KStudio Associato - Verona. Introduction.

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TAX & LEGAL

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  1. TAX & LEGAL Business Restructurings: Contract Manufacturers and CommissionairesEugenio GrazianiKStudio Associato - Verona

  2. Introduction • There is no legal or universally accepted definition of business restructuring. Business restructuring be defined as the cross-border redeployment by a multinational enterprise of functions, assets and / or risks. A business restructuring may involve cross-border transfers of valuable intangibles • Since the mid-90’s, business restructurings have typically consisted of: • Conversion of full-fledged manufacturers into contract-manufacturers or toll-manufacturers for a related party that may operate as a principal • Conversion of full-fledged distributors into limited-risk distributors or commissionaires for a related party that may operate as a principal

  3. Contract Manufacturing

  4. Contract Manufacturing Base Case Shareholder PR bears economic risk of loss to raw materials, work-in-process and finished goods throughout manufacturing process; and it has requisite substance to oversee and control timing, quantity and quality of production 1 buy raw materials or components 4 sells finished goods (transfer price) PR Sales Company $ Y X 5sell finished goods 3cost-plus conversion fee $ $ 2 provide conversion services CM Customers Z X Drop Ship

  5. Contract ManufacturerOverview • Relationship between a principal (“PR”) that engages a contract manufacturer (“CM”) to provide manufacturing services • CM bears little economic risk associated with production: • Valued intangible property rights are held by PR • Plant and equipment are owned by CM (but PR compensates CM for their use) • Guaranteed sales (little market risk for CM) • Negligible obsolescence risk for CM • Little accounts receivable risk for CM • Little products defect risk for CM • CM transacts on a consignment or buy/sell basis with PR • CM generally compensated on a cost-plus basis

  6. Contract ManufacturerPrincipal • No employees, property, plant or equipment to manufacture products • Provides necessary knowledge to CM (technology, sourcing, planning, material procurements, financial management, sales management, etc.) • Assumes entrepreneurial risks such as economic risk of loss on raw materials, work-in-process and finished goods • Conducts itself in the manner expected of a third party

  7. Contract Manufacturing:Conversion Issues • Conversion issues will arise in areas such as transfer pricing, permanent establishment, Value Added Tax (VAT) & customs. Areas that could give rise to these issues include: • Research and Development (R&D) functions vs. cost-plus remuneration • Purchasing functions – cost savings can be achieved by centralization • Sales - migration to separate sales entity • Technology ownership / product specification / manufacturing and logistic / supervision • Product control – requires site visits • Quality control supervision – requires site inspections • Engineering/technical support • Export controls relating to release of design/development/ production technology

  8. Contract Manufacturing – Deemed Transfer of Existing IP or intangibles, or indemnity rights • Charge concerns/transfers of valued Intellectual Property (IP) or other intangibles from CM to PR, or right upon CM for an idemnity due to conversion of the business

  9. Contract Manufacturing:Transfer Pricing Issues • Issue where related party transactions are involved (provision of processing services). Concern that transfer pricing is used to reallocate profits from high tax to low tax countries • Preferred method - comparable uncontrolled price (CUP) • Likely to be most accurate but difficult to get good comparables • Alternative method - cost-plus • Endorsed by Organisation for Economic Co-operation and Development (OECD) • May also be difficult due to variables like functions performed, term of contract • Essentially an indirect way to determine an appropriate return on investment/assets

  10. Contract Manufacturing:Permanent Establishment Issues • Permanent Establishment (“PE”) = a taxable presence created by a fixed place of business • Includes substantial equipment, dependent agents • PE is an issue as PR will conduct itself as a third Party and thus, may perform: • On-site Inspection • Review of production and Quality Control (QC) reports • Approve/disapprove vendors lists • Some of these functions may require PR’s presence in CM’s country

  11. Contract Manufacturing:Permanent Establishment Issues (cont’d) • Exclusions • Auxiliary or preparatory type work • Comments: • PR should have no physical presence locally • CM sells products locally • CM has no authority to conclude contracts • CM to carry its own entrepreneurial risk • PR should not physically interfere in the manufacturing process

  12. Contract Manufacturing:Value Added Tax (VAT) Issues • European Union (EU) law is based on directives implemented in the domestic legislation of each member state • VAT is more complex for consignment CM • A consignment CM is supplying services • A buy-sell CM and a PR are liable to normal VAT rules based on the place of supply of goods • If the PR is not registered locally (VAT), CM can: • Act as importer; and • Recover import VAT paid on its VAT return

  13. Commissionaire

  14. Principal Principal PurchaseContract Agency Agreement Title Sales income Title Commission Sales Contract Commissionaire Buy/Sell Distributor Customer Customer SalesContract Invoice Title Invoice Conventional Distribution Structure vs. Commissionaire

  15. Commissionaire StructureObjectives • Business enhancement • Maintains local sales efforts • Retains existing client ties • Centralizes functions & risks • Conversion entails the centralization of many functions • Considerations must be taken into account: • Changes must be invisible to customers • Avoidance of perception of “downsizing” operations of the sales subsidiary

  16. Commissionaires in GeneralHow They Operate • Local distributor responsible only for product sales • Title passes directly from manufacturer to customer • Conversion from “buy/sell” distributor to commissionaire • Risks/functions change

  17. Commissionaire StructureIncome Shift

  18. Commissionaires in GeneralHow They Operate • Commissionaire • Acts in own name on behalf of principal • May or may not mention principal in contract with customer • May account gross or net

  19. Commissionaire:Conversion Issues

  20. CommissionaireConversion Issues Goodwill • Conversion from buy/sell to commissionaire may give rise to taxable sale of goodwill or other intangibles • Assumed transfer value may be treated as a constructive dividend subject to withholding tax • With proper planning, goodwill concerns can be reduced • Can taxable goodwill acquisition create amortizable asset?

  21. CommissionaireConversion Issues Net operating losses (NOLs) • In some countries conversion may constitute a change in business/trade so as to prevent the carry-over of NOLs

  22. CommissionaireConversion Issues Termination compensation • Existing distribution agreement and/or local laws may require compensation be paid for terminating or modifying long-term distribution contracts • Termination compensation depends on terms of the agreement and must be on an arm's length basis • If agreement is silent then distributor would have to show it had suffered a prejudice beyond its normal business and claim damages • Payment may also be due if contractual termination clause (notice period) is not properly observed • Compensation could also be due for expenses or investments made by the distributor at the request of the other party

  23. CommissionaireConversion Issues Economic substance in principal • Activities, economic risks and functions performed by the principal must reflect position as set out in agreements • Principal must have premises and personnel capable of fulfilling functions and managing the risks that are adopted • Location of place of management • Ownership of non-routine assets/risks/ functions

  24. Commissionaire: Maintenance and Management Issues

  25. Commissionaire Structure:Maintenance Issues • Transfer pricing • Accepted methodologies in country • Potential for advanced rulings • Relative differences from net profits on a stripped buy/sell • Permanent establishment • Background • Recent developments • Relative risk as compared to stripped buy/sell • VAT • Customs

  26. Commissionaire Maintenance:Transfer Pricing Considerations • Transfer pricing focus will now be on arm’s length nature of commission rate • Two most common methods • cost-plus • revenue based commission • Advanced ruling possible in some countries

  27. Commissionaire Maintenance:Permanent Establishment Issues • Principal could have a permanent establishment (PE) depending on • local tax law of distributor or commissionaire • terms of the tax treaty • Article 5 of Model OECD Treaty • PE avoided if • Independent agent • Dependant agent not empowered to bind principal

  28. Commissionaire Maintenance:Permanent Establishment Issues (cont’d) • Economic or legal independence at risk if commissionaire: • Is not free to organize his sales activities and negotiate • Receives a non-arm’s length commission • Does not support the risks of his own business • Carries on activities normally performed by the principal. • Risk mitigation requires principal to have true substance and carry out tasks previously performed by former buy/sell

  29. Commissionaire Maintenance:VAT Issues • Value Added Tax (VAT) • EU simplification adopted by all EU member states • VAT accounting procedures replicate buy/sell • Conversion from a buy/sell distributorship model should not have a significant VAT impact

  30. Commissionaire Maintenance:VAT Issues (cont’d) • Value Added Tax • Simplified VAT accounting model • Commissionaire is deemed to buy at a price excluding their commission charge and sell at a price including their commission charge • No VAT invoice for the commission charge should be issued by the commissionaire • European countries outside the EU may not operate a simplified structure

  31. Commissionaire Maintenance: Customs Issues • Customs Duties • Triggered by the movement of goods from one customs territory to another • EU is a single customs territory • There is no “deemed” intermediate sale from the principal to the commissionaire • This may result in the customs value (on which duties are calculated) being the full retail value

  32. Commissionaire:Customs Issues • Customs Duties • In the buy/sell model it may be possible for the customs value to be calculated on the value attributed to the sale by the principal to the buy/sell distributor • The commissionaire structure may increase the customs duties payable • The principal may need to address registration or other customs requirements for those transactions in which the principal bears responsibility for inbound customs clearance (e.g. a delivered duty paid sale)

  33. Presenter’s contact details Eugenio Graziani KStudio Associato Consulenza legale e tributaria +39 045 8114111 egraziani@kstudioassociato.it

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