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

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 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

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 3 Contract Manufacturing

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 4 Contract Manufacturing Base Case 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 PR CM Shareholder Z 1 buy raw materials or components 5 sell finished goods 2 provide conversion services $ 4 sells finished goods (transfer price) Sales Company X 3 cost-plus conversion fee $ Customers Y $ X Drop Ship

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 5 Contract Manufacturer Overview 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

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 6 Contract Manufacturer Principal 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

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 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

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 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

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 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

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 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

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 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

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 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

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 13 Commissionaire

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 14 Buy/Sell DistributorCommissionaire Country A Country B Conventional Distribution Structure vs. Commissionaire Principal Buy/Sell Distributor Title Sales Contract Customer Invoice Title Purchase Contract Commissionaire Commission Sales income Customer Title Agency Agreement Principal Sales Contract Invoice

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 15 Commissionaire Structure Objectives 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

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 16 Commissionaires in General How 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

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 17 Commissionaire Structure Income Shift Risk/Function Shift B U Y / S E L LC O M M I S S I O N A I R E DistributorPrincipalCommissionaire 1. Economic Risk (ER) 2. Inventory Risk 3. Receivable Risk 4. Currency Risk 5. Warranty Risk 6. Sales & Marketing 7. Distribution 8. Invoicing / Back Office 9. After Market Service 1. Increased ER 2. Inventory Risk 3. Receivable Risk 4. Currency Risk 5. Warranty Risk 6. Distribution 7. Invoicing / Back Office 1. Sales & Marketing 2. After Market Service (optional)

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 18 Commissionaires in General How 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

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 19 Commissionaire: Conversion Issues

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 20 Commissionaire Conversion 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?

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 21 Commissionaire Conversion 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

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 22 Commissionaire Conversion 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

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 23 Commissionaire Conversion 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

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 24 Commissionaire: Maintenance and Management Issues

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 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

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 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

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 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

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 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

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 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

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 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

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 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

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 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)

© 2008 Studio Associato Consulenza legale e tributaria, an Italian professional partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in Italy. 33 Presenter’s contact details Eugenio Graziani KStudio Associato Consulenza legale e tributaria