1. Tax-efficient Supply Chain Management (TESCM) & Transfer Pricing
IFA Conference – 13 December 2008
Srinivasa Rao
Partner, Ernst & Young, India

2. Contents TESCM Background The Concept Overall Structure Design
Entity Characterization
Alternative Structures
Location of Principal Co
Benefits & Key Tax Issues
Recent Developments
OECD Discussion Draft on Transfer Pricing Aspects of Business Restructuring

3. Tax-efficient Supply Chain Management

4. Background Discernible change in multinational business models
“Local” business models giving way to regional and global supply chain structures
Growing centralization of multinational decisions at a regional or international level
Traditional tax structures impacted by the geographical blur in cross-border business models

5. Background MNEs have grown across the globe with some patterns:
Manufacturing located near raw material sources, customer markets
Sales organizations dispersed
Management in the country of “origin”
May be doing business in a number of “High Tax Jurisdictions” (“HTJs”)
Tax base would correspond with the economic activity in the country
Effective tax rate – cumulative weighted average tax rate

6. Traditional Supply Chain Model
Each entity in the supply chain assumes risks associated with respective functions
Profit arising from the economic activities in the respective jurisdictions attributed to the jurisdiction
Manufacturer
Distributor
Customer
Buys
materials
Buys
finished
goods
Sells
finished
goods
Inventory risks
Warranty risk
Intangibles
Capital investment
Inventory risk
Warranty risk
Intangibles
Pricing risk
Volume risk
Credit risk

7. Issues with Traditional Supply Chain Models
Customer relations
Fragmented by country
Multiple points of contact
In some cases, “competition with ourselves”
Duplicative functions across countries
Increases costs
Manufacturing managed by country
Short production lines
Possible results
Higher worldwide effective tax rate
Lower profitability

8. Intelligence flows - product, customer, market needs
What is TESCM?
Value Chain
Suppliers
Information flows
Customers
Intelligence flows - product, customer, market needs
Planning &
forecasting
Procurement
Manufacturing
Distribution &
logistics
Customer
service
Performance
measurements
Material flows
Cash flows
Value Chain
Supply Chain Management (“SCM”) is defined as the management of material and products, information, cash and work flows from the point of first supply across the enterprise to the customer and back
Tax-efficient Supply Chain Management (“TESCM”) is the process of integrating tax planning into SCM in two fundamental ways:
Avoiding tax and legal obstacles to achieve business objectives
Leveraging tax benefits from business change

9. Supply Chain Planning – First Principles
Alignment and compatibility with business model
Integration of tax planning into business changes
Review of the allocation of the group’s:
Value-adding functions
Income-earning assets
Commercial risks with a view to optimizing tax costs
Aggregation of entrepreneurial risks at a Hub entity – Principal Co
Overall profit of an enterprise:
Remuneration for the normal functions/risks
Residual profit – reflecting entrepreneurial remuneration

10. Supply Chain Planning – First Principles
Allocation of profits:
Operating entities entitled for normal profits
Hub entity entitled for residual (entrepreneurial) profits
Hub entity
Located in Low Tax Jurisdiction (“LTJ”)
Centralization of management, control & business risks
Entitled for residual (entrepreneurial) profits
Operating entities
Location based on business & tax considerations
Perform routine functions and bear subordinate risks
Receive a stable and relatively low profit level
Profit level can be controlled

11. Overall Structure Design

12. Supply Chain Design Overview
Shared Services Centre
Commission Agent/LRD
R&D Centre
Headquarters
Admin
Services
Research
Services
After Sales
Service
Arrange Sales
Management
Services
Purchase Materials
Sale Of Finished Goods
Supplier
Customer
Principal Company
Processing
Services
Deliver
Goods
Deliver
Materials
Legend
Product Flow
Services
Factory
Title Flow

13. Key Triggers Drivers Actions Benefits Lower effective tax rate
Business Drivers Profitable growth
Globalization
Better customer service
Lower costs
Shareholder value
Centralization of planning and mgmt
Lower effective tax rate
Less transfer pricing risk
Shared services
More stable effective tax rate
Integrated supply chain management
Higher earnings
Tax Drivers
High domestic effective tax rates
Transfer pricing audits
Tax Incentives
More aggressive tax authorities
Trapped tax losses
Global/regional business units
Improved cash flow
Centralized Tax Structure
Alignment of tax &
business structure
Optimized supply chains

14. Entity Characterization – Principal Company
Hub entity and principal trading company
Exercises direction, supervision & control over the supply chain
Bears all significant risks of the supply chain
Can either own Intellectual Property (“IP”) or license IP from an IP Holding Co
Would need to have “substance” and some level of senior management/ decision-making functions
IP Holding Co
Can either be the Principal Co or a separate entity which owns IP and licenses to Principal Co

15. Entity Characterization – Manufacturing
Full-fledged Manufacturer
Significant manufacturing functions risks and manufacturing/ process intangibles
Contract Manufacturer
Manufactures goods for Principal Co under a guaranteed sale arrangement, could bear some risks
Toll Manufacturer/ Consignment Manufacturer
Converts raw materials supplied by Principal Co into finished goods;
Does not take title to either the raw materials or finished goods
Bears insignificant risks and performs minimal functions

16. Entity Characterization – Sales
Full-fledged Distributor
Significant sales and marketing functions, risks and marketing intangibles
Limited Risk Distributor (“LRD”)
Almost similar functions as a full-fledged distributor; assumes significantly lower risks
Commissionaire/ Commission Agent:
Sales and marketing services to Principal Co;
Enters into sales contracts on behalf of Principal Co and does not assume title to goods;
Does not bear any significant risks

17. Entity Characterization – Services
Management Services Co
Contract R&D Co
Shared Service Centers
Co-ordination Centers

18. Contract Manufacturing / LRD Model
Manufacturing, Sales and Marketing Intangibles/Risks Shifted to Low-taxed Principal Co;
Operating Cos perform their functions with limited risks
Supplier
Customer
Sale
Make
Sale
Manufacturer
Principal
LRD
Sales price
LRD agreement
Warranty risk
Intangibles
Inventory risks
Credit risk
Pricing risk (long-term)
Volume risk (long-term)
Pricing risk (short-term)
Volume risk (short-term)
Capital investment
Limited inventory risk

19. Toller / Commission Agent Model
Manufacturing, Sales and Marketing Intangibles / Risks Shifted to Low-taxed Principal Co;
Operating Cos perform their functions with limited risks
Supplier
Customer
Sale
Arranges
sale
Make
Commission
Manufacturer
Principal
Commission
Agent
Service Fee
Warranty risk
Intangibles
Inventory risks
Credit risk
Pricing risk
Volume risk
Agency
services
Capital investment

20. Location of Principal Co
Tax Factors
Low effective tax rate
Favorable tax regime for foreign source income
Favorable tax treaty network
Liberal advance ruling regime
Nil/ low withholding tax on outbound payments
Non-tax Factors
Good regulatory and legal framework
Conducive environment for expatriate personnel
Liberal exchange control regime
Minimal regulations on cross-border commerce
Political and economic stability

21. Structure Benefits & Key Tax Issues

22. Structure Benefits
Integration of tax planning into business change processes
Reduction in worldwide effective tax rate:
Principal Co located in a LTJ earns substantial profits
Operating Cos earn low and stable profits
Minimization in repatriation costs:
Low profit level of operating entities
Reduced repatriation tax costs
Consolidation of losses:
Aggregation of losses arising from global operations in a single entity
Avoids inefficiencies of dispersed losses
Ensures that cash flow is freely accessible within the group

23. Key Tax Issues Conversion/ Migration related issues
Starting point for tax authorities
“Gap” between current and future local profit levels
Points challenged by tax authorities
Lack of commercial purpose/ substance in business change
Conduct of parties not consistent with agreements/ documentation
Transfer of Intangibles (patents, know-how, brand names, trademarks, etc.) upon conversion and valuation
Deemed migration of “goodwill” upon conversion

24. Key Tax Issues Permanent Establishment (“PE”) Exposure
Appropriate structuring of arrangement (including movement of personnel) to shield from PE exposure
Potential PE risk under Toller/ Commissionaire structures in some countries
Transfer Pricing
Appropriate documentation of allocation of functions/ risks to support lower income allocation to operating entities
Intangible/ Buy-in payment valuation
Indirect Tax/ VAT
Not optimizing indirect taxes may reduce or negate corporate tax benefits

25. Recent Developments

26. OECD Discussion Draft on Business Restructuring
CTPA Roundtable in January 2005
Treaty, transfer pricing, and indirect tax issues
Business and governments
OECD and Non-OECD Economies
A Joint WP1 / WP6 Working Group set up
transfer pricing and treaty aspects
A small advisory group of business representatives and academics formed
Objective to release a discussion draft for public comment by the end of 2008
Discussion Draft on application of Transfer Pricing Guidelines released in Sept 2008

27. Recent OECD Discussion Draft
The OECD has recently released a discussion draft entitled “Transfer Pricing Aspects of Business Restructurings”
Consists of four issues notes:
General guidance on the allocation of risks
Arm’s-length compensation for the restructuring itself
Post-restructuring arrangements
Exceptional non-recognition of transactions
Recognition at an OECD level that these transactions are taking place
Practical guidance on treatment of transactions

28. Key Messages
Strong focus on business alignment in evaluating restructurings
Contractually defined relationships are the starting point but can be set aside in “exceptional” circumstances
Compensation payments to restructured entity to be evaluated and set on arm’s length principles by reference to realistic available alternatives
Restatement of bilateral approach to functional analysis including Principals as foundation for method selection
Economic framework for allocating location savings
Functions, assets and risks drive TP method – not the other way round

29. Key Implications
The OECD is clearly signalling a view that transfer pricing models should be driven by and aligned with the business model
Transfer pricing analysis now a central element in evaluating tax impacts of business restructuring
Evaluation of options available to the parties at arm’s length central to that analysis
Ensure alignment of transfer pricing and legal documentation with business substance
Need for continual and structured review of behaviour to ensure continuing conformity with transfer pricing model

30. Thank you