Limited Risk Models - Sept 4 2013

India Tax Forum 2013 Models for Limited Risk Structures
September 4, 2013
Agenda

Introduction Low Risk Structures

Direct Tax Implications Transfer Pricing Implications
2013 Deloitte Touche Tohmatsu India Private Limited
Introduction
Limited Risk structures
Traditional Business Models

Country-led Structure
Risk-based profit Value-added profit
Profit from in-country operations Country 1


Customer Relations Management (CRM)
Locally driven Multiple contact points for the customer Teams working in silos and in certain cases competing within selves Inefficient utilization of resources Increased Costs
Duplication of functions across Jurisdictions
Local Manufacturing
Manufacturing units cater only to local demand Inefficient use of Production lines
Enhanced Risk
Each entity in the supply chain functions as an entrepreneur, Each entity carries all the various types of entrepreneur risks
Tax Implications
4
Super Normal profits retained in local jurisdictions subject to high tax rates
Implications
Cash trapped in different jurisdictions
Inefficient usage of funds and assets
Higher worldwide effective tax rate (ETR)
Lower profitability
Increased Transfer Pricing Complexity

Business Models Whats Changing

Change in Business Models
Local businesses increasingly giving way to Globally integrated business models Increased involvement of Principal company in the decision making process of the local entities
Tax structures not in sync with cross-border business models
Globalization
Centralization of Support Services Procurement, HR, Accounting, Admin etc. Centralization of Management functions Sales organizations dispersed Co location of Manufacturing units with vendors and/or markets.
6 2013 Deloitte Touche Tohmatsu India Private Limited
Business Models Whats Changing

Evolving from a country-led model to a center-led model:
Transferring the management of functions, assets, and risks may allow the transfer of local profits to a jurisdiction suitable for regional/global management (and, if possible, complimentary tax efficiency).
Country-led Structure
Risk-based profit Value-added profit Profit from in-country operations Risk-based profit Value-added profit Profit from in-country operations Risk-based profit
Value-added profit Profit from in-country operations
Center-led Structure
Risk-based profit Value-added profit Risk-based profit Value-added profit Profit from In-Country Operations Profit from In-Country Operations Profit from in-country operations Profit from In-Country Operations Profit from In-Country Operations Profit from in-country operations Risk-based profit Value-added profit
Country 1
Country 2
Country 3
Country 3
Country 2 Country 1
Profit from In-Country Operations Profit from In-Country Operations Profit from in-country operations
Manufacturing
Sales and Distribution
Support Functions
Principal Operating Company
Traditional vs. Optimized Model

Traditional Supply chains
Complex supply chains - inefficient processes and use of fixed asset capacity, excessive working capital, inefficient tax structures and high costs Low control over Risk MNE profits trapped in various jurisdictions Repatriation Costs Focus on entity level profitability instead of Group profits
Supply Chain optimization

Optimisation of business model of the MNE by appropriate allocation of Value Adding Functions, Income Earning Assets and Commercial Risks (FAR). A fully-optimized supply chain with embedded tax solutions ensures alignment of remuneration model with the functions/risks of operations of the entity. Residual profit reflecting entrepreneurial remuneration Better and more focused control on risks
Consequence Fragmented and inefficient supply chain, resulting in higher exposure to risk and overall lowering of profits of the MNE
8
Consequence Integration of operational strategy with tax strategy. Centralisation of functions leading to centralization of profits.
Supply chain efficient centralized business model (with principal at the center)
Headquarters
Management Services
R&D Services Provider

R&D Services
Shared Services Centre

Admin Services
Processing Services
Limited Risk Distributor

Sell Goods and After-sales Service
Sell Goods
SUPPLIERS
Purchase Materials
Central Entrepreneur/ Hubco/Principal

Deliver Goods
CUSTOMERS
Deliver Materials
Manufacturing Services
Distribution and Logistics Services
Essence of TP position Toll Manufacturer

legal title physical flow services
Distribution Centre
Key profit drivers (risk, valuable IP) are placed with Principal, who receives entrepreneurial return Other entities perform routine functions (cost plus return)
Potential business and operational benefits

Benefit Description
Creation of an integrated operating company managing regional strategy and supply chain flows may result in potentially lower inventory levels and reduced working capital Reduced procurement spend Sustainable and scalable tax savings Co-location of regional leadership may result in improved communications, sharing of best practices, quicker decision making, and speed to market Business Process Efficiencies Harmonized and standardized processes may result in IT and business process synergies and more efficient personnel and training requirements Potential for business process improvements to create a more efficient and effective organization (e.g., supply chain optimization, product rationalization, shared services, price optimization, etc.) Improved visibility into local performance based on standardized key performance indicators Simplified functional and financial profile in local entities may result in potentially lower support function needs Tax and Financial Reporting Simplifies transfer pricing and reduces transfer pricing risk Efficiencies Creates a uniform transfer pricing model for all sales subsidiaries
Cost Savings
10
Limited Risk Manufacturing
Toll manufacturer
TM and Principal are related parties
Principal
$ (raw materials, packing materials) $ Service
TM and Principal enter into a longterm toll manufacturing contract, pursuant to which TM agrees to manufacture finished goods for the Principal for an agreed conversion fees Third party suppliers sell raw material and packing material to the Principal. However, the same is consigned to TM for manufacturing The finished goods are delivered pursuant to Principals instructions
Third Party Suppliers
Physical transfer (raw materials, packing materials)
Toll Manufacturer (TM)
Property in finished goods always vests with Principal
12
Contract manufacturing
CM and Principal are related parties
Principal
CM and Principal enter into a longterm sales contract, pursuant to which the Principal agrees to purchase finished goods from CM on an arms length basis party suppliers sell raw material and packing material to CM
Sale #2 (finished goods) Third Third Party Suppliers
$ Contract Manufacturer (CM)
Sale # 1 (raw materials, packing materials)
After manufacturing, the finished goods are stored by CM and are delivered pursuant to the Principals instructions Property in finished goods transferred from CM to Principal
13
Toll / Contract Manufacturing Permanent Establishment implications

No fixed place PE of principal in TM / CM jurisdiction
CMs / TMs premises are neither used by nor are at the disposal of principal No business of principal is carried on through CM / TM; manufacturing activity is the business of CM / TM and not of the principal
Amendment proposed by OECD WP 1 in Article 5 OECD MC Commentary

Where an enterprise does not have a right to be present at a location and, in fact, does not use that location itself, that location is clearly not at the disposal of the enterprise; thus, for instance, it cannot be considered that a plant that is owned and used exclusively by a supplier or contract-manufacturer is at the disposal of an enterprise that will receive the goods produced at that plant merely because all these goods will be used in the business of that enterprise
No agency PE of principal in TM / CM jurisdiction

CM / TM are acting on their own behalf and not on behalf of principal CM / TM do not exercise any authority to conclude contracts in the name of principal
14

Roche Vitamins Europe Ltd (Spanish Supreme Court) [2012]
Roche Vitamins Europe Ltd (RVEL) Sales Switzerland Spain
Contract manufacturing under instructions of RVEL (Cost plus 3.3%)

Renting of warehouse manufactured by RVSA to store products
Imports
Agent of RVEL to promote sale of specified products and to represent, protect and foster the interests of RVEL (Commission 2% of sales)
Roche Vitamins SA (RVSA) Goods contract manufactured Warehouse Sales
RVSA could not negotiate or fix prices though it was authorized to process purchase orders RVSA had no authority to bind RVEL qua customers
Customers

Roche
Contention / decision of tax authority / Spanish court:
RVEL has a fixed place of
Contradiction: RVSA had no contracting authority and also did not negotiate with customers However, the Court held that the sales promotion by itself did not create a DAPE but taken along with the manufacturing led to the PE conclusion
business because RVEL used the
premises to perform business

activities in Spain RVSA was a DAPE because RVEL exercised control over the manufacturing activity
Warehouse was held not to be the cause of PE
Decision appears to have been rendered based on incorrect interpretation of law especially the OECD MC Commentary
TP Implication for Toll manufacturer and Contract Manufacturer

Toll Manufacturers
Typical Remuneration Models Return on Value Added Expenses or conversion cost Return on operating assets
Contract Manufacturers
Typical Remuneration Models Return on total operating cost plus markup Return on operating assets
However, where the significant inventory functions and risks are undertaken by the Principal, the contract manufacturer acts akin to a toll manufacturer. The contract manufacturer maybe remunerated on its Value Added Expenses plus a return on its capital invested in the inventory
Limited Risk Selling Models
Sales Agent (SA)

SA and the Principal are related parties The Agent provides marketing support services and gets compensation on an arms length basis The Agent may or may not have authority to negotiate or conclude contracts which are binding on the Principal Title to goods transferred Principal to Customer
Customers
Principal $ Services
Sales Agent (the Agent) $ Sale
from
19
Limited risk distributor

LRD is a buy-sell distributor who distributes products in its own name and on its own account
Principal
Sales #1
Most of the risks are borne by the Principal (e.g., inventory and debtors) and only limited risks are borne by the LRD
Commissionaires in civil law
Limited Risk Distributor (LRD) $
Sale #2
Customers
20
Limited Risk Distributor Permanent Establishment implications

Zimmer SAS (French Supreme Court) [2010]
Background
Zimmer Ltd, UK Zimmer SAS used to be the full-fledged distributor in France for Zimmer Ltd (a UK Company) products and was later converted into a commissionaire
Sales Zimmer SAS, France PO Customer
Under the commissionaire arrangement, Zimmer SAS could accept orders, present estimates and documents within the framework of tender offers, conclude sales contracts for Zimmer Ltd without prior approval, and could negotiate prices, grant discounts and payment facilities to existing or new clients without prior approval of Zimmer Ltd. However, Zimmer SAS acted in its own name and could not legally conclude contracts in the name of Zimmer Ltd. Hence no privity of contract between Zimmer Ltd and customer
French tax authorities assessed Zimmer Ltd to French income tax on the ground that it had an agency PE in form of Zimmer SAS
21

Zimmer SAS
Held
French Supreme Court held that a company which acts normally under a commissionaire agreement may not be regarded as an agent having authority to bind its principal, and thus cannot constitute a permanent establishment of the foreign principal. The Supreme Court observed:
According to French civil and commercial law, the commissionaire had no legal authority to conclude contracts in the name of principal A commissionaire is described as "a person who acts in its own name on behalf of a principal." The principal is not legally bound by the contracts concluded by the commissionaire, whose
clients have no direct action against the principal; hence the requirement of agency PE under
OECD MC is absent
Held no agency PE since the commissionaire was not binding the principal qua third party customers, which according to Court was a prerequisite under OECD MC for constituting an agency PE

Dell Norway (Norway Supreme Court [2011]
Dell Products (Ireland)
Dell AS, a Norwegian company, was acting as a commissionaire agent on behalf of its Irish parent, Dell Products Dell AS sold computer products of Dell Products to companies in Norway under its own name. Dell AS could not conclude contracts on behalf of its parent Norwegian tax authorities argued that Dell AS constituted a PE of Dell Products in Norway Norways Supreme Court ruled that the activities of a Norwegian subsidiary do not create an agency PE in Norway of its Irish parent sales company The Court specifically held that a PE in accordance with article 5(5) of the OECD Model Treaty (agency PE article) can arise only in cases in which a dependent agent can legally bind its principal Referred to Zimmer French SC decision

Dell AS (Norway)
23

OECD WP1 has proposed following changes to Article 5 OECD MC:
Also, the phrase authority to conclude contracts in the name of the enterprise does not confine the
application of the paragraph to an agent who enters into contracts literally in the name of the enterprise; the paragraph applies equally to an agent who concludes contracts which are binding on the enterprise even if those contracts are not actually in the name of the enterprise. For example, in some countries an enterprise would be bound, in certain cases, by a contract concluded with a third party by a person acting on behalf of the enterprise even if the person did not formally disclose that it was acting for the enterprise and the name of the enterprise was not referred to in the contract.
Above amendment has been proposed to overrule the Zimmer and Dell decisions
Impact of above amendment on LRD models?

i. ii. iii. iv. v. vi. Amendment proposed specific to commissionaire arrangements The concept of commissionaire provided in both contract and commercial laws of European jurisdictions; India has no such concept Under Indian contract law, LRD does not act on behalf of the principal both contractually and legally Indian contract law requires a person to bind his principal qua third parties for him to be treated as an agent Setting up of LRD in India / conversion of full risk distributor into LRD should not fall in the substance over form category of the pre-ordained series of transactions (Vodafone) No complex web or smokes screen is put in place for defrauding the Revenue; risks / responsibilities vests with principal under a legally binding contractual arrangement
24
TP Implication for Sales Agent and Limited Risk Distributor

Sales Agent
Typical Remuneration Models Sales agent undertaking marketing support functions but not undertaking negotiations or concluding of
contracts maybe remunerated on a Cost Plus basis

Sales agent undertaking marketing functions alongwith negotiations and conclusion of contracts maybe remunerated on a Commission on Direct Sales
Limited Risk Distributors

Typical Remuneration Models Generally remunerated on a Return on Sales basis
Essentially the functions of an Agent and LRD are broadly similar. Accordingly, an agent maybe remunerated based on a return on Sales of an LRD with appropriate economic adjustments like working capital adjustment etc.
Limited Risk Procurement Services Centre
Procurement centre (services)

Agency Co. and the Principal are related parties Agency Co. acts as a sourcing support service provider to the Principal Goods are sold by the Suppliers directly to the Principal
$ Physical Transfer Sale
Principal $ Services Procurement Centre (Agency Co.)
Third Party Suppliers
27
Procurement Services Permanent Establishment implications

Exemption provided under the Income Tax Act, 1961:
In the case of a non-resident, no income shall be deemed to accrue or arise in India to him through or from operations which are confined to the purchase of goods in India for the purpose of export (Expln 1(b) to S. 9)
business connection" shall include any business activity carried out through a person who, acting on behalf of the non-resident, (a) has and habitually exercises in India, an authority to conclude contracts on behalf of the non-resident, unless his activities are limited to the purchase of goods or merchandise for the non-resident (Expln 2(a) to S. 9)
Exemption provided under DTAAs:
the term permanent establishment shall be deemed not to include:
d) the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise or of collecting information, for the enterprise;
28

Illustrative list of procurement services provided by procurement agents for the benefit of foreign buyers:
Pre-sourcing factory evaluations to determine vendors ability to manufacture products as per
buyers expectations
Vendor identification Review of costing data Vendor recommendation Quality control
Monitoring vendors for compliance with the policies, procedure and standards related quality,
delivery, pricing, labor practices and environmental laws

Coordination, monitoring and verification with vendors to develop the products in-line with the quality
and aesthetic requirements of the products

Laboratory testing Interaction with suppliers in relation to capacity utilization, quality assurance, on-time delivery
performance etc.
Negotiating competitive prices Providing training to selected vendor employees Ensuring usage of standard methods, tools, machinery and layouts

Many Indian decisions now supporting a no PE theory
Procurement services should normally not result in a PE. All activities inextricably linked to the procurement function should qualify for the exemption benefit
30
TP Implications for a Limited Risk Procurement Centre

Typical Remuneration Models
Agent undertaking routine procurement support functions maybe remunerated on a Cost Plus basis Agent undertaking significant value adding/ intangible creating functions such as product
design, preparing vendor databases, price and terms negotiation, etc. maybe remunerated
with a commission on goods purchased
31
Integrated Franchisee Model
Integrated franchisee model

Global contracts Global Retailer
Principal
Business generated for India Outside India Franchisee fees

Slide 33 33
IPR & Services
Legal Title of Goods
India
Legal Title of Goods Franchisee Mfg Exporter
Locally sourced materials
Integrated franchisee model

Principal enters into contracts & negotiates prices in overseas markets. It grants the Franchisee the right to use intangibles such as brands, technical know-how and commercial and supply chain related intangibles
Principal bears risks of bad debts & product-design liabilities

Franchisee uses IP provided in a manner authorised by the Principal for manufacturing and coordinates with customers for fulfilling global contracts. Raises invoices on customers and collects payments
Typical Remuneration Models

The functions undertaken by the Franchisee Manufacturer are akin to a contract
manufacturer. From the customer revenue it may retain an arms length return on total operating cost and pay the balance customer revenue to the Principal as Franchisee Fee
Slide 34 34
IP Migration
Transfer of Intellectual Property

Business Restructurings typically comprises of the following: Conversion of full-fledged distributors into limited-risk distributors or commissionaires Conversion of full-fledged manufacturers manufacturers or toll-manufacturers into contract-
Transfers of intangible property rights to a central entity (e.g. an IP company) within the group.
Para 9.80 of the OECD Transfer Pricing guidelines on Business Restructuring Relevant intangible assets might potentially include rights to use industrial assets such as patents, trademarks, trade names, designs or models, as well as copyrights of literary, artistic or scientific work (including software) and intellectual property such as knowhow and trade secrets. They may also include customer lists, distribution channels, unique names, symbols or pictures. An essential part of the analysis of a business restructuring is to identify the significant intangible assets that were transferred (if any), whether independent parties would have remunerated their transfer, and what their arms length value is.
Exit Charge an illustration

As an example, conversion of full risk marketing distributor to LRD would require the following issues to be examined:
Any transfer of marketing intangibles i.e. customer list, distribution network, etc.
Any transfer/ surrender of a right i.e. early/ premature termination of exclusive rights of distribution under an agreement Any cessation of functions including movement/ transfer of workforce with or without bundling of intangibles with the work force Others The above in-depth analysis would be required to determine if an exit charge would be expected between independent parties
37
Exit Charge- India Tax Implications

Exit Charge refers to a payment made to compensate for removal of an asset belonging to an entity whose activity in the business is being simplified or reduced. For example, moving from full-fledged distributor to a LRD model Section 28(va), inserted by the FA 2002 provides that any sum received under an agreement for not carrying out any activity in relation to any business or not sharing any know-how or technique likely to assist in the manufacture or processing of goods or provision for services is taxable as business income Memorandum to the FA 2002 says that the new provision has been added for taxing receipts in the nature of non-compete fees and exclusivity rights
Does exit charge represent non-compete fee or does it represent consideration payable for stripping the subsidiary from certain rights previously held by it as a full risk distributor?
If not non-compete fee, capital receipt not taxable as business income (compensation for loss of revenue earning apparatus)?
38
Arguable that if charge represents compensation towards loss of revenue earning apparatus, not taxable as capital gains relying on B.C. Srinivasa Shetty (Supreme Court)
About Deloitte Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its network of member firms, each of which is a legally separate and independent entity. Please see www.deloitte.com/about for a detailed description of the legal structure of Deloitte Touche Tohmatsu Limited and its member firms. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Copyright 2012 Deloitte Development LLC. All rights reserved. Member of Deloitte Touche Tohmatsu Limited

Limited Risk Models - Sept 4 2013

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Limited Risk Models - Sept 4 2013

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India Tax Forum 2013 Models for Limited Risk Structures

Introduction Low Risk Structures

Direct Tax Implications Transfer Pricing Implications

2013 Deloitte Touche Tohmatsu India Private Limited

Limited Risk structures

Traditional Business Models

Risk-based profit Value-added profit

Risk-based profit Value-added profit

Customer Relations Management (CRM)

Duplication of functions across Jurisdictions

Inefficient usage of funds and assets

Higher worldwide effective tax rate (ETR)

Increased Transfer Pricing Complexity

Business Models Whats Changing

Tax structures not in sync with cross-border business models

Business Models Whats Changing

Value-added profit Profit from in-country operations

Sales and Distribution

Principal Operating Company

2013 Deloitte Touche Tohmatsu India Private Limited

Traditional vs. Optimized Model

Supply Chain optimization

R&D Services Provider

Shared Services Centre

Limited Risk Distributor

Central Entrepreneur/ Hubco/Principal

Distribution and Logistics Services

Essence of TP position Toll Manufacturer

Potential business and operational benefits

2013 Deloitte Touche Tohmatsu India Private Limited

Limited Risk Manufacturing

$ (raw materials, packing materials) $ Service

Third Party Suppliers

Physical transfer (raw materials, packing materials)

Toll Manufacturer (TM)

Property in finished goods always vests with Principal

2013 Deloitte Touche Tohmatsu India Private Limited

Sale #2 (finished goods) Third Third Party Suppliers

$ Contract Manufacturer (CM)

Sale # 1 (raw materials, packing materials)

2013 Deloitte Touche Tohmatsu India Private Limited

Toll / Contract Manufacturing Permanent Establishment implications

Amendment proposed by OECD WP 1 in Article 5 OECD MC Commentary

No agency PE of principal in TM / CM jurisdiction

2013 Deloitte Touche Tohmatsu India Private Limited

Toll / Contract Manufacturing Permanent Establishment implications

Roche Vitamins Europe Ltd (RVEL) Sales Switzerland Spain

Contract manufacturing under instructions of RVEL (Cost plus 3.3%)

Roche Vitamins SA (RVSA) Goods contract manufactured Warehouse Sales

Toll / Contract Manufacturing Permanent Establishment implications

business because RVEL used the

premises to perform business

Warehouse was held not to be the cause of PE

TP Implication for Toll manufacturer and Contract Manufacturer

Limited Risk Selling Models

Sales Agent (SA)

Sales Agent (the Agent) $ Sale

2013 Deloitte Touche Tohmatsu India Private Limited

Limited risk distributor

Limited Risk Distributor (LRD) $

2013 Deloitte Touche Tohmatsu India Private Limited

Limited Risk Distributor Permanent Establishment implications

Sales Zimmer SAS, France PO Customer

Limited Risk Distributor Permanent Establishment implications