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Business transformation

Corporate restructuring and changes influencing global trade and VAT processes


Your presenters

► Moderator: Kristine L. PriceErnst & Young LLP (US)

► Lynlee BrownErnst & Young LLP (US)

► Rocio MejiaMancera S.C. (MX)

► Lisa LimErnst & Young LLP (US)


Business transformation – introduction


Doing this in a fully integrated manner is key to success. The process is typically iterative.

What is operating model efficiency?

Operating model efficiency (OME) involves centralizing and co-locating assets, functions and risks to optimize business performance and profitability. To the extent value can be captured in a tax-effective jurisdiction, there may be a favorable tax impact of undertaking such change.

= Determine location

OME involves the development of a new operating model, which has business and tax benefits.

Design the operating

model

Identify operational

benefits

Develop the

tax/legal model


OME typically involves moving to a more centralized operational model to achieve operational and financial improvements

Decentralized (country based)

A “collection” of independent markets and operating units with duplicated functions and limited alignment

Centralized (regional or global)

An integrated business with a consistent set of operating policies and processes, strong local execution, competitive cost base and reduced effective tax rateTypical scope choices:• Global• Regional (e.g., Asia only)• BU (e.g., consumer products only)• Functional (e.g., sourcing only)

Centralization of business management can bring operational improvements► Speed and accuracy of operations

► Reduced duplication of business processes

► Improved service, with reduced working capital

► Improved handling of international customers

► Better decision making in “constraint” situations

► Central sourcing cost reduction opportunities

► Harmonization of processes and good basis for shared services

Using tax efficient supply chain principles will bring additional benefits► Increased management control

► Single performance management framework

► Simplified financial reporting

► Indirect tax efficiencies

► Stability/predictability of local tax burdens

► Leveraging operational improvements with lower tax


OME planning is scalableFocus of discussion are levels of “sourcing options” (as highlighted)

High

Low

Potential value

Low HighPotential business impact

Service Co.

Procurement Co.

Supply Chain Mgt. Co.

Sales & Marketing

Principal Co.

Transactional Principal with IP

Sourcing Co.Plus:►Supplier selection►Demand aggregation►Contracting/framework agreements►Supplier development►Quality assurance

Plus:►Logistics management►Buy/sell processing►Freight forwarding► Inventory ownership and

management

Plus:►Supply chain planning►Manufacturing strategy►Research and

development strategy

Plus:►Sales and

marketing strategy

►Pricing policies

Plus:►Brand and IP (Intellectual

property) management

Movement along the continuum can occur over time, consistent with the company’s business transformation initiatives and its readiness for change.

►Supplier identification/qualification►Develop/maintain supplier relations►Discuss product specs with supplier


Business transformation – international tax trends


International tax trends – evolution of procurement/ sourcing function in the value chain

► A variety of intangible rights and services can fall within the customs “additions to value” – particularly when considering the evolution of procurement companies in the supply chain.

► Traditional procurement is focused on demand aggregation and driving cost savings for the broader organization through volume discounts.

► New procurement function is focused on aligning with strategic suppliers. It’s increasingly more important to partner with suppliers that will be catalysts for future growth – e.g., suppliers with whom they can partner to co-develop innovation that translates into revenue growth for the organization.

► In the new procurement function, cost reductions are driven by optimizing supplier’s processes to drive cost out of the entire system, rather than relying on negotiation tactics. Cost optimization is generally driven by engineering changes to the process and investment from the company’s perspective.

► In certain industries, supplier management also involves risk management.


International tax trends – evolution of procurement/ sourcing function in the value chain

External partnership► Defines overall procurement/sourcing strategy for the

business

► Manages end-to-end supply chain for finished goods, including sales and operations planning process

► Partners with suppliers to develop cost improvement initiatives, including process know-how and innovation

► Responsible for product quality, including product liability risk

► Establishes and tracks key metrics for suppliers

► Assumes risks related to inventory (reliability of forecast), insurance and other economic risks

Functions and risks

Traditional sourcing company External partnership sourcing company

Sourcing and procurement► Develops and executes procurement/sourcing strategy

for raw materials (including commodity products)

► Aggregates demand and negotiates price reductions

► Negotiates contract terms based on cost improvement initiatives, e.g., investment by supplier in technology or processes to lower costs


Trends in services performed (Examples related to substantial contribution to manufacturing under US tax rules)

► Supply and demand planning (S&OP) ► Oversight of manufacturing and process controls ► Drive partner development to improve capabilities and performance

(quality, delivery, cost, risk-reduction)► Formulate policy to focus on strategic functions

Indicia of manufacturing Examples of activities

Activities that are considered in, but are insufficient to satisfy, the substantial transformation

Material selection, vendor selection, or control of raw materials, work-in-process, or finished goods

Management manufacturing costs or capacities

Control of manufacturing related logistics

Quality control

Developing, or directing the use or development of product design and design specifications, as well as trade secrets, technology, or other intellectual property for the purpose of manufacturing or producing the product

Oversight and direction of the activities or process under which the product is manufactured

► Qualify, select and manage contract manufacturers – participate in make/buy decision

► Manage supplier risk (capacity, obsolescence)► Determine supplier capacity and continuity

► Identify and manage cost improvement initiatives (i.e., lean manufacturing, six sigma)

► Manage cost initiatives (e.g., inventory reduction, price reduction)

► Direct the planning and production schedules for external partners► Monitor production orders, schedules and output to ensure products

are manufactured and scheduled delivery dates are met

1

2

3

4

5

6

7

► Evaluate supplier quality systems and share best practices► Negotiate quality agreements► Undertake quality audits

► Develop technology transfer process for new product introductions► Transition design or process changes to external partners► Partner with suppliers on supply chain development initiatives

► Finish and fill


Business transformation – indirect tax impacts


Customs “base” – transaction value

Transaction value

Price paid or payable for the goods when sold for export

Plus certain required additions

Costs related to production, sales,

packaging, transport

Commissions and brokerage (except buying)

Packaging and transportation

Assists – certain goods/services supplied by buyer free or at reduced charge for use in production or sale for export► Tangible (e.g., materials, components, tools, molds)► Services undertaken outside import country

(engineering, design)

And other considerations…

Royalties and license fees

Proceeds of subsequent resale

The following, to the extent incurred by the buyer but not included in the price for the goods


Customs and trade challenges – increased duties ► Increased customs value and duties: OME projects are not always

customs advantageous and sometimes are a barrier to the overall structure ► For example, in the principal structure diagrammed below, when profit is

moved from a distributor to a principal, the sales price for finished goods to the distributor is often increased, resulting in increased duties paid by the distributor.

►

►

►

Current state

Flow of goods Invoice flow

Ownership

Importation

Manufacturer Distributor Raw materials Principal Raw materials

Distributor

Future state

Manufacturer


Sourcing Company

Customer

Case study involving intercompany payments for services and intangibles

Customer

(Licensor)

Unrelated manufacturers

HK Trading (HK)

Sourcing agent

License agreements

Royalty payment based on % net resale

(Product IP – know how, trademark, sales and marketing IP)

Buying agency agreement

Commission based on % FOB

(Qualify/select vendors, negotiation, procurement, QC, design)

Purchase agreements for Goods

Sales

A

Local country distributors

HK SourceCo (HK)

Service provider

Support services agreement

Service fee based on cost, plus (back‐office, raw material procurement, manufacturing support, transportation)

Purchase Agreements

Related manufacturers

Charges for molds, tools produced or acquired by manufacturers


Sourcing Company

Customer

Buy-sell model – case study involvingintercompany payments for services, intangibles

Customer

(Licensor)

License agreements

Royalty Payment based on % net resale

(Product IP – know how, trademark, sales and marketing IP) Sales

Local country distributors

Purchase agreements

Royalties – WTO Valuation Agreement Article 8.1(c) – royalty and license fees related to imported goods which must be paid as a condition of sale are dutiable

WCO Technical Committee on Customs Valuation – Commentary 25-1 (2011) –guidance where royalty paid to third-party licensor (even where unrelated to seller) –confirms broad concept that “control” over purchasing environment can create a practical condition of sale


Planning opportunity – exclusive distribution and demand creation rights US ruling HQ H242894 obtained by Ernst & Young LLP

US customs(using 2.5% vehicle rate)

Duty $125 million

Manufacturer US NSCProduct payment

$5 billion

$150million USD

US customs(using 2.5% vehicle rate)

Duty

Manufacturer US NSC$4.75 billion

Product payment

$118.75 million

$6.25 million annual savings in US duty

► Global application► WCO Technical Committee on Customs Valuation currently reviewing

Current model Model with EDR EDR fee(5% of value separated)


Other customs planning – free trade agreements (FTA)

►Continuity of FTA benefits ► Cost and profit aggregation in the Principal may strip the origin

content in the local country calculation.

► Invoicing via Principal – arises in some locations (e.g., denial of FTA benefits on account of invoicing through the Principal in a non-FTA member country) – has been alleviated to some extent.

► Computation and predictive modeling provides predictable cost impacts when sourcing is changed.


Customs operational changes

► Importer of record migration► Modification of commercial documentation► Broker/forwarder relationships and instructions► Intellectual property protection/registration► Securing, retaining, or migrating import or export quotas, licenses► Participation in trade related security and compliance programs


Customs and VAT – general challenges

► VAT registration for principal and/or sales entities► Long lead time► Potential risk to create corporate tax permanent establishment► Registration must be completed before go-live

► Non-recoverable conversion VAT► Restrictions to conduct business

► VAT documentation requirements► Invoice requirements differ per country► Delivery documents to be issued for the right legal entity► Proof of VAT exemption

► Principal company to fulfill VAT filing obligations in multiple jurisdictions

► Reversed supply chain► ERP systems


Circular 230 disclaimer

This presentation is provided solely for the purpose of enhancing knowledge on tax matters. It does not provide tax advice to any taxpayer because it does not take into account any specific taxpayer’s facts and circumstances.

These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting advice.


Disclaimer

► EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the U.S.

► This presentation is © 2014 Ernst & Young LLP. All rights reserved. No part of this document may be reproduced, transmitted or otherwise distributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, rekeying, or using any information storage and retrieval system, without written permission from Ernst & Young LLP. Any reproduction, transmission or distribution of this form or any of the material herein is prohibited and is in violation of U.S. and international law. Ernst & Young LLP expressly disclaims any liability in connection with use of this presentation or its contents by any third party.

► Views expressed in this presentation are those of the speakers and are not necessarily those of Ernst & Young LLP.

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