Defense For Transfer Pricing: Restructuring And Perceived Tax Haven
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1 FEATURED ARTICLES ISSUE 114 JANUARY 15, 2015 Defense For Transfer Pricing: Restructuring And Perceived Tax Haven by Dr Alexander Voegele and Philip de Homont, NERA Economic Consulting Contact: Tel ; Philip.de.Homont@nera.com, Tel Th is case study shows how robust economic analysis can be instrumental in defending the restructuring of a well-known consumer goods group (the "Group"), including the treatment of marketing intangibles as well as the transfer prices of goods from a Hong Kong procurement company in a European transfer pricing audit. The case was defended through an economic analysis and a residual profit split analysis. Background A European consumer goods company had purchased a number of global competitors. In the end, the Group included one of the most well-known US brands, a very well-known European brand, and several other European and American brands. Several of these brands had historically been in fierce competition with each other. Th e European company had been loss-making for several years, despite its strong brand. Simultaneously, another European company in the portfolio was producing very similar products, also with a strong brand. Th e European company had historically started as a national manufacturer and distributor of high quality consumer goods, but gradually grew its distribution networks worldwide, with an emphasis on distribution in Europe, the USA and Japan. As global presence grew, and the company increasingly focused on distribution activities, the manufacturing of certain goods was moved step-by-step to new subsidiaries in Eastern Europe and independent contract manufacturers in China. Since the 1990s, the Group has increasingly relied on the production of its core products in Eastern Europe. Nevertheless, several factories, the warehousing and logistics, and the research and development (R&D) activities remained in the European country. The factories were important employers in their regions. Due to the persistent losses, the Group reorganized the entire system. The core products were to be developed by the European sister company; in turn the primary European company would develop all other 33
2 products. The responsibility for a few prestigious core products with very low sales volume (but high visibility) remained in the European country. Most manufacturing entities in the European country and the other Western European countries were closed. Manufacturing in Eastern Europe was extended. In addition, the Group established a procurement unit in Hong Kong. This entity organizes the entire purchasing for the whole Group from South East Asia, and has several representative offices throughout East Asia. When the company was established, the tax authorities in Hong Kong granted a so-called "offshore ruling," which meant that effectively 90 percent of the income generated in Hong Kong was tax-free in Hong Kong. One condition of the ruling was that at least half of the business activities had to be performed outside Hong Kong, i.e., at representative offices predominantly in mainland China. Conversely, the tax authorities in mainland China taxed the representative offices on the basis of relatively low local costs plus a small profit margin. The European country and Hong Kong have a tax treaty. A European sales center was established in a European high-tax country. Th e business of the European company developed very well after the restructuring. Costs were reduced dramatically, the sales volume rose rapidly, and the firm reached a decent profitability. Effectively, the European marketing center and the distribution companies of the Group earned only relatively small profits, while the Hong Kong procurement unit earned a high percentage of the consolidated profit of the Group. The Audit Starts Th e closing of the factories and of the warehouses provoked a lot of rumors in the press and was observed closely by European politicians. Then, a field tax audit started. The tax authorities' audit team consisted of a high-ranking official and a younger tax inspector, both directly from the capital and assisted by economists in the central tax office. The tax audit procedures lasted a few months and covered the tax years of the restructuring. Besides a multitude of smaller issues from income tax to VAT, the auditors crucially focused on the restructuring costs, the transfer of marketing intangibles, and predictably the perceived high profits of the Hong Kong entity. The field tax auditors: Did not accept the sale of some company shares below book value during the restructuring; Did not accept the deduction of restructuring costs in the European country; Claimed a remuneration would be due for the transfer of intangibles and business out of the European country; and Treated the Hong Kong unit as a simple routine purchasing unit. They calculated its profit through a mixture of cost-plus on local expenses and a commission on purchase prices. 34
3 Th e field tax auditors presented detailed calculations, which resulted in extremely high proposed adjustments. Th ese adjustments would have led to a reduction of the loss carryforwards of the European company amounting to more than EUR200m, and a taxable profit plus withholding taxes (to be paid in cash) of approximately EUR50m (including interests). Furthermore, considerable deferred tax assets would fall away as a result of these adjustments. This would have a major book tax effect and thereby impact the net earnings of the entire Group. Our Defense Given the complexity of the case and the significant amounts at stake, the client's tax lawyers and other advisors welcomed the assistance from economic consultants for the defense of the case. Valuation Of Shares The tax auditors took issue that some shares were sold below book value during the restructuring. As a first step, we showed that the valuation of shares depends on the net present value of future cash flows and income, and therefore does not immediately correlate with the book value. However, this presented the challenge of showing the correct cash flows. These cash flows are determined by a number of factors, including different income streams from core products, other products, transfer prices of goods, other effects of the restructuring, as well as from changing market conditions. Last but not least, the value of shares had to include the remuneration of intellectual property. Th e determination of the future cash flows and income streams was therefore crucial. The European tax inspectors did not want to accept cash flows. Therefore, we used income streams. The critical question was the effect of the restructuring. To quantify this, we had to build a counterfactual case, i.e., show how the cash (or income) flow would have developed in the absence of the restructuring. We defended the original share valuation by recalculating the probable future cash flows. We used real options 1 for the determination of the probability of the future income streams. And we used game theory 2 for the simulation of the market behavior and the bargaining process that would arise over such income in an arm's length setting. The application of the real option pricing, as well as the game theory, necessitated the use of expert surveys. In the tax inspectors' view, it had been hard to accept that shares were sold below the book values of the net assets of the respective companies. However, due to the objective calculation of the future cash flows and of the bargaining process, the tax inspectors finally accepted our calculations in total. 35
4 Transfer Prices From Hong Kong The transfer prices of goods purchased by the Hong Kong unit had to consider a multitude of aspects: Th e Hong Kong company did not only purchase the goods from independent manufacturers, but also developed parts or elements of products in close coordination with the manufacturers. The Hong Kong company supervised the production, performed social audits, organized the logistics, but also used R&D and intellectual property of the European company. Th e contribution to the overall success by the Hong Kong company and its representative offices in mainland China and South East Asia were significant. In addition, the company enjoyed location savings, which had to be taken into account due to the wishes of the Chinese authorities. defense to a certain extent, but insisted on an additional check by using a bilateral profit split. We used a residual profit split methodology. 3 This split had to consider the prior, ongoing loss situation in the European country, the effects from the exchange of business activities with the European sister company, the location savings in China, and much more. The profit split had to separate the effects from different business lines: it necessitated cash flow projections for routine and non-routine functions; and the different bargaining situation with and without restructuring (see above). We used real options for (the probabilities of) the expected future cash flows and findings, and game theory for the effects from funding as well as for the bargaining procedure. Expert surveys provided the missing data for these methodologies. We determined what best economic argumentation would be suitable given the facts and circumstances of the case, and came to the conclusion that, in this case, an isolated defense of the Hong Kong company's profits (without considering the results of the European company) would have been much easier than a bilateral profit split between Hong Kong and the European country. Whereas a unilateral defense aims to defend the profit margins of Hong Kong only, a bilateral profit split would have considered the relative percentages of Hong Kong and the European country in the combined profits of the two companies. After lengthy negotiations, the tax authority accepted our argumentation of a unilateral Restructuring Costs Th e tax deduction of restructuring costs by the European company had been the most important issue for the tax auditors. Th e methodology for the valuation of shares, as well as for the transfer pricing between Hong Kong and the European country (see above), included the funding of restructuring costs by the European company. If the European tax inspector would not have accepted the funding of restructuring costs by the European company, the profit split would have resulted in lower European profits and a correspondingly lower valuation of shares. 36
5 In addition, the client's lawyers and NERA convinced the tax auditors that this issue would become a European arbitration case that might not end favorably for this European country. Finally, the field tax auditors accepted the deduction of restructuring costs fully. The Result After long discussions with the field tax auditors, a compromise was found. The final tax payment amounted only to the tax effect of the Chinese location saving, which was significantly less than originally anticipated. E NDNOTES Real option pricing determines prices according to an explicit modeling of management decisions under various scenarios. Game theory models the negotiation process of the various parties and their respective bargaining power. The residual profit split methodology identifies arm's length prices by first identifying routine profits for routine functions, and then attributes the remaining (residual) profit to the entities according to their relative respective non-routine contributions. 37
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