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India Tax Forum 2013 Models for Limited Risk Structures

September 4, 2013

Agenda

Introduction Low Risk Structures


Direct Tax Implications Transfer Pricing Implications

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Introduction

Limited Risk structures

Traditional Business Models


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

Risk-based profit Value-added profit


Profit from in-country operations Country 2

Risk-based profit Value-added profit


Profit from in-country operations Country 3

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
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Super Normal profits retained in local jurisdictions subject to high tax rates
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Implications
Cash trapped in different jurisdictions

Inefficient usage of funds and assets

Higher worldwide effective tax rate (ETR)

Lower profitability

Increased Transfer Pricing Complexity


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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.
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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

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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
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Consequence Integration of operational strategy with tax strategy. Centralisation of functions leading to centralization of profits.
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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)
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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

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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

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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

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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

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Toll / Contract Manufacturing Permanent Establishment implications


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
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Toll / Contract Manufacturing Permanent Establishment implications


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
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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
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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

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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

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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
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Limited Risk Distributor Permanent Establishment implications


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
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Limited Risk Distributor Permanent Establishment implications


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
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Dell AS (Norway)

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Limited Risk Distributor Permanent Establishment implications


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
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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.
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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

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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;

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Procurement Services Permanent Establishment implications


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
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Procurement Services Permanent Establishment implications


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

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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

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Integrated Franchisee Model

Integrated franchisee model


Global contracts Global Retailer

Principal

Business generated for India Outside India Franchisee fees


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IPR & Services

Legal Title of Goods

India

Legal Title of Goods Franchisee Mfg Exporter

Locally sourced materials

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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

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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.
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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

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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)?

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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)
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