Dr. Avi Nov, Adv.
Under the Supply Chain Management tax strategy, a group of companies would centralize functions, risks and assets, as explained below, in a single entity (SCM). The SCM would manage foreign activity. To this end, the SCM would subcontract manufacturing, R&D and other functions, manage connections with foreign suppliers and undertake sales to the various distributors and clients in foreign jurisdictions.
Such allocation of functions risks and assets should allow for the allocation of a greater portion of the group’s profits to the SCM, since, from an economic perspective, the major portion of any sale transaction of the products lies with the entity bearing the economic risks, functions and assets. Thus, in effect, shifting profits from high tax jurisdictions within the group to a low tax jurisdiction, thereby reducing the overall tax rate for the group.
It is important to note that the profit attributable to the SCM in its country of residence must be determined and based upon economic principles and documented in a transfer pricing study. In this respect, we note that all inter-company transfer prices must be at arm’s length (i.e., the same terms that would have applied between unrelated parties under similar circumstances), since if this is not the case, the relevant tax authorities may attempt to adjust the remuneration determined by the parties, so that these reflect arm’s length remuneration.
The location of the SCM could be in a number of different locations, all enjoying favorable tax regimes (i.e. Singapore, Hong-Kong, Switzerland, etc.).
The SCM will be managed by a high level employee who has sufficient know how and expertise in the field of trading in the group’s products. Such an employee would have the necessary experience in order to freely and autonomously manage the SCM’s activity.
Below we list possible risks, functions and assets of the SCM which may be considered:
The SCM would manage all foreign activity – inter alia, these include:
1. Negotiations with suppliers. A key employee of the SCM will negotiate, determine, and approve the prices with the suppliers, which may allow for reduced prices for all the group companies as a whole.
2. Bookkeeping. The SCM will be responsible for its invoicing and general administrative management of the trading activity such as bookkeeping and similar functions. In this respect, we note that SCM will not only be responsible for its own invoicing, but it will also oversee the invoicing within the group under the proposed structure.
3. Process design/improvement – all major decisions regarding automation, new/replacement equipment, plant layout and significant process improvements should be approved by the SCM prior to implementation.
4. Training – Any training required for the manufacturer employees should be at the expense of the SCM.
5. Cost control – The SCM should be responsible for setting the standards for labor dollar/unit, defects, and days of inventory among other cost control measures.
6. Production scheduling – Production scheduling should generally be determined by the SCM, which should also be responsible for determining raw material requirements, and shipment. Once the raw materials are shipped to the facility, the manufacturer will manufacture the product according to specifications established by the SCM.
7. Logistics – The SCM should arrange for the transportation of incoming raw materials and outgoing finished goods. The cost of the freight should be borne by the SCM.
8. Quality control/assurance – The quality assurance processes utilized by the manufacture should be developed by the SCM. Thus, all significant quality assurance decisions made related to production should be made and/or reviewed and approved by the SCM.
9. Corporate strategy – The SCM should be responsible for the overall strategic decisions regarding production and sales.
10. R&D – The SCM should be responsible for the direction and conduct of R&D. The resulting technologies form the basis for new products, product improvements, distribution systems, and manufacturing processes, all of which are key to value creation for the company’s products and would be that of the SCM.
We note that in certain instances, the SCM may subcontract a related party or a third-party to perform specific technical services. These would be compensated on an arm’s length basis (e.g. cost-plus).
B. Assets owned and risks undertaken
As explained, the SCM would, in addition to its trading activities, own assets and undertake certain commercial risks as owner of the title to the inventory (until transfer to the end customer or the LRD / commissionaire). The assets and risks include:
· Know-how – Currently, the know-how is owned by the manufacturing companies and under the proposed model the know-how should be transferred to the SCM.
· Inventory Risk – Risks relating to inventory. The SCM will hold title in the inventory and consequently bear all inventory risk.
· Management Risk – LTD should strive to transfer the management, or certain activities and people within the management relating to the foreign activity to the SCM. This would strengthen the economic substance and allow for the justification of a higher margin. It is important to stress that the activity of such management must be conducted in the jurisdiction where the SCM will be incorporated, so that no permanent establishment is created for the SCM in any other jurisdictions.
· Foreign exchange risks – If the SCM purchases the raw materials in foreign currency, it should bear the risks associated with this activity. In addition, the payment made by the SCM to the manufacturer should be made in the currency used by the manufacturer, thus the SCM undertakes foreign exchange risks also in this respect.
· Customer credit risks – The SCM bears also customer credit and collection risks.
· Product liability/ warranty risks – The manufacturer should be free of risk for product liability. All warranty costs or costs resulting from defected products would be borne by the SCM.