Download pdf - Virtual Contract Manufacturing: The Last Frontier? · Virtual Contract Manufacturing: The Last Frontier? by William W. Chip W hen enterprises began to globalize in the middle of the

Virtual Contract Manufacturing:The Last Frontier?

by William W. Chip

Reprinted from Tax Notes Int’l, July 9, 2012, p. 169

Volume 67, Number 2 July 9, 2012

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Virtual Contract Manufacturing: The Last Frontier?by William W. Chip

When enterprises began to globalize in the middleof the 20th century, inefficiencies in interna-

tional communications and transportation forced theoperating subsidiaries in each country to perform forthemselves most of the functions related to purchasing,manufacturing, and sales. They also had to assume andmanage most of the risks arising from their perform-ance of those functions and their ownership of inputand output inventories. Modern risk managers classifythose business risks as market risk (also called pricerisk), credit risk (also called default risk), and opera-tional risk.

By the end of the 20th century, improvements intelecommunications and transportation made it pos-sible for global businesses to achieve important efficien-cies by centralizing both the performance of some busi-ness functions and the assumption and management ofsome business risks. Companies attentive to their globaleffective tax rates have taken advantage of those devel-opments and adopted tax-efficient transfer pricing strat-egies tied to the movement of materials and productsup the supply chain.

Those supply chain strategies are now well known,not just to tax professionals and their clients, but alsoto tax authorities nearly everywhere. At a Big Fourfirm’s tax conference two years ago, one panelist be-moaned the challenge of a client’s local commission-aire arrangement by a Latvian tax inspector! Althoughcommissionaire-like arrangements have survived strictscrutiny in France1 and Norway,2 they did not fare aswell in a more recent Spanish case.3

While the exposure of conventional supply chainstrategies to tax authority challenges has increasedsince they first became popular, the ‘‘price of admis-sion’’ has not diminished, because they involve exten-sive contractual documentation, transfer pricing studies,due diligence regarding exit taxes and other tax expo-sures, and management of the insurance, VAT, anddocumentation issues that result from changes in theownership of raw materials and product inventory.Also, the strategies are as unpopular as ever with localmanagers who are (fairly enough) concerned about theimpact on their bonuses of reducing locally reportedprofits and the distraction of their staffs during the in-vestigation and implementation of the strategy.

For international tax managers and advisers, conven-tional supply chain strategies are not just expensive andrisky; after the nth implementation, they are boring.One may ask in fairness whether the conventional ver-sions of supply chain tax planning have reached theend of a road. Are there any new frontiers to exploreand conquer?

This report explores the viability of entrepreneurstrategies that simulate the risk-shifting and income-mobilizing features of traditional supply chain planningunburdened by cross-border shifts of functions andother production factors. The use of an ‘‘entrepreneurswap’’ to fashion a ‘‘virtual contract manufacturing’’arrangement is explained.

1See Société Zimmer Ltd., Conseil D’Etat, Nos. 304715, 308525(Mar. 31, 2010).

2See Dell Products v. the State (Tax East), HR-2011-02245-A (No.2011/755) (Dec. 2, 2011).

3See DSM Nutritional Products Europe Ltd. v. Administración Gen-eral del Estado, Second Section of the Third Chamber of the Su-preme Court, No. STA/202/2012 (Jan. 12, 2012).

William W. Chip is an international tax partner in the Washington office of Covington & Burling LLP.

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Conventional Entrepreneur StrategiesThe conventional supply chain transfer pricing strat-

egy repositions inventory ownership and some operat-ing functions from high-taxed operating companies to alower-taxed management company (the entrepreneur)that assumes responsibility for the repositioned func-tions and risks. In locations where the enterprise en-gages in manufacturing, the entrepreneur purchasesand owns raw materials and contracts with the localsubsidiary (the contract manufacturer) to transformthem into products on a cost-plus basis. In locationswhere the enterprise engages in marketing, sales, anddistribution, the entrepreneur contracts with the localsubsidiary to sell products as a commissionaire (a civillaw sales agent of an undisclosed principal) or stripped-risk distributor (a buy-sell distributor that is protectedagainst price risk).

The fees that the entrepreneur pays to the operatingaffiliates are formulated to generate the routine operatingmargin that would be realized by an independent con-tract manufacturer or sales agent. In effect, the operatingaffiliates surrender to the entrepreneur a potentially vola-tile stream of profits and losses for a more stable streamof profits. The average expected profits of the volatilestream will exceed the average expected profits of thestable stream by an amount that represents compensa-tion to the entrepreneur for any functions it performsplus a ‘‘risk premium’’ to compensate the entrepreneurfor insuring the operating affiliate against losses.

Because supply chain transfer pricing strategies in-volve transactions between affiliated companies inhigh- and low-tax jurisdictions, their success dependson the availability of transfer pricing methods that allo-cate only routine profits to the high-tax locations andat the same time satisfy the arm’s-length standard asunderstood and applied by the local tax authorities.Because there are a plethora of independent commis-sion agents, distributors, and contract manufacturersthat may serve as comparables, the methods for deter-mining arm’s-length compensation to a contract manu-facturer, commissionaire, or stripped-risk distributor arefairly straightforward and defensible.

The desired outcome of the strategy is that profits ofthe global enterprise in excess of the routine profitsallocated to the manufacturing and distribution subsidi-aries should be taxable only in the entrepreneur’s low-tax jurisdiction. For the strategy to succeed, the entre-preneur must arrange its affairs so that it has notaxable presence in the manufacturing and distributionlocations and must have a means of transferring profitsto the ultimate parent without having to pay substantialdividend withholding taxes. For that reason, it is not suf-ficient that the country in which the entrepreneur is in-corporated have a low rate of tax; it must also have agood tax treaty network.

Switzerland is one of a few countries that meet allthe criteria for locating an entrepreneur, and a Swisssubsidiary is often the entrepreneur in the supply chain

strategies of U.S. and European multinationals. How-ever, more than a few U.S. Rust Belt giants make lotsof money abroad but have Himalayan net operatingloss carryovers negated by valuation allowances. Inthose cases, the U.S. parent can be a tax-efficient entre-preneur, with the benefit that foreign tax inspectors aregenerally less suspicious of dealings with a U.S. parentthan with a Swiss affiliate.

The Risky and the ClunkyThe conventional entrepreneur strategy is not with-

out risk. The subpart F rules provide for U.S. taxationof the profits of a controlled foreign corporation thatengages in specified transactions with foreign affiliates.4Because entrepreneurs must engage in exactly thosetransactions, U.S. parents and parents in countries withsimilar CFC regimes must structure their supply chaintransfer pricing strategies with special care.

U.S. parents of entrepreneur structures typically es-cape subpart F taxation by causing the CFCs that par-ticipate in the entrepreneur structure to elect to be clas-sified as disregarded subsidiaries of a common foreignholding company. (Although the IRS in 1998 tried toclose this escape hatch,5 it quickly retreated in the faceof a threat by Congress to reopen it.6)

Because the intercompany transfer pricing in con-ventional supply chain strategies has not been easy forlocal tax authorities to challenge, they have found alter-native grounds for attacking entrepreneur structures.Some tax authorities have argued that the entrepreneurhas a taxable presence in the manufacturing or distrib-uting location by virtue of its contracts with the localcontract manufacturer or commissionaire. That is onereason why it is beneficial to incorporate the entrepre-neur in a country with an extensive network of taxtreaties that generally provides that a foreign companyhas no local taxable presence unless the local affiliateexecutes contracts that bind the entrepreneur.

Although the OECD is reviewing those tax treatyrules7 and is under some pressure to make it easier tofind a permanent establishment for entrepreneurs, therules will likely not change in the near future.

Some tax authorities have argued that the conver-sion of a local manufacturer or distributor to a contractmanufacturer, commissionaire, or stripped-risk distribu-tor involves a constructive distribution of operatingintangibles to the shareholders. If so, the excess of thevalue of the intangibles over their local tax basis may

4Sections 951(a)(1)(A), 952(a)(2), and 954(a)(2).5See Notice 98-11, 1998-1 C.B. 433, Doc 98-2983, 98 TNT 12-8.6See Notice 98-35, 1998-2 C.B. 34, Doc 98-20115, 98 TNT

119-6.7See OECD Centre for Tax Policy and Administration, ‘‘In-

terpretation and Application of Article 5 (Permanent Establish-ment) of the OECD Model Tax Convention’’ (Oct. 12, 2011).

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be subject to capital gains tax (an exit tax or severancepayment) or dividend withholding tax. That argumentmay have some merit if the local operating companyhas invested heavily in the development of manufactur-ing or distribution intangibles; any such history, includ-ing preexisting third-party contracts, must be accountedfor in the original transfer pricing analysis.

The profits retained by the local contract manufac-turers, commissionaires, and stripped-risk distributorsare low mainly because they are guaranteed. Thus,while the entrepreneur earns all the manufacturing anddistribution profits in excess of those margins, it mustin return absorb any net losses from manufacturing anddistribution activities. What seemed like a good idea atthe time can take on a different color if losses begin toaccumulate in the low-taxed entrepreneur — which hasoccurred from time to time.

Tipping the Mobility ScaleCross-border tax strategies based on transfer pricing

mobilize income by repositioning the factors that driveprofitability, which are typically categorized as assets,functions, and risks.8 On a scale of mobility, tangibleproperty and functions are the least mobile because theownership of tangible property and the location of em-ployees have many nontax implications. Intangibleproperty and risk are more mobile because they usuallycan be moved simply by signing a contract.

In industries where high-value intangibles are a fac-tor, income mobilization is typically premised on cost-sharing strategies that may be parallel to, but are dis-tinct from, supply chain management strategies.Consequently, the profit mobilization from supplychain entrepreneur strategies is more often attributableto repositioning risk than to repositioning intangibles.Although repositioning of risk may be the main supplychain profit driver, the classic techniques for reposition-ing supply chain risk have entailed the repositioning ofsome functions and ownership of raw materials andproducts. In effect, people and tangible property getstuck to the risk and are dragged along for the ride.

The stickiness of classical supply chain strategiesaccounts for their clunkiness; that is to say, the busi-ness headaches of the conventional entrepreneur strate-gies arise mainly from the transfer of business func-tions and supply/product ownership, not from thetransfer of business risk. A mere transfer of risk, suchas through an intercompany insurance contract or cur-rency swap, is usually unproblematic, provided that thetransfer pricing is defensible.

The riskiness and clunkiness of the conventionalentrepreneur strategy raises this question: Is there a

version of the strategy that moves risk and almostnothing else, thereby achieving a significant part of theconventional tax benefit without the conventional painand suffering? Twenty years ago, the answer was no.Today, I think the answer is yes.

Risk-Only Entrepreneur Strategies

Consider the oil and gas industry. Although oil ma-jors were among the first companies to globalize, theyseem not to have engaged in conventional supply chaintransfer pricing strategies to the same extent as otherindustrial companies. I have observed the same patternamong agribusiness clients. Several factors account forthat phenomenon,9 but I attribute it in part to the avail-ability in commodity-based industries of techniquesand tools for transferring risk and associated profitsamong affiliates that are more user-friendly and taxefficient than conventional supply chain structuring. Inthat regard, commodity-based industries are like thefinancial services industry, where price and credit riskare intensively and centrally managed, and where thoserisks are routinely transferred among business units andlegal entities through the use of derivative financialinstruments and other risk transfer agreements. Indeed,the most sophisticated risk management tools, includ-ing many adopted in the commodity-based industries,originated in the financial services sector.

Energy, agribusiness, and other commodity-basedindustries have from their inception been forced tocope with the business risks arising from extraordi-narily volatile prices for their raw materials and prod-ucts and long lead times between the extraction of rawmaterials and the sale of processed products. Becausemultinationals in the commodity-based industries areaccustomed to transferring risk (and therefore profits)through sophisticated risk management instruments,the use of those instruments (and of the associatedtransfer pricing methods) to shift taxable income fromhigh-tax to low-tax jurisdictions probably comes morenaturally than do conventional contract manufacturingand commissionaire arrangements.

Of equal importance, intercompany risk manage-ment transactions (futures, forwards, options, and soforth) can be structured as treasury transactions thatare less costly to implement, less likely to influencebonus-driving operating margins, and less intrusive inday-to-day operations than the intercompany contractsand transactions needed to initiate and operate a con-ventional supply chain structure.

Whatever may have been the case when entrepre-neur structures first saw the light of day, it may be the

8See reg. section 1.482-1(d)(1), -5(c)(2)(ii); OECD TransferPricing Guidelines for Multinational Enterprises and Tax Ad-ministrations, Chap. I, para. 1.36.

9In the oil industry, for example, offshore subsidiaries wereset up long ago as per se corporations, which were often difficultor impossible to convert into the disregarded companies neededto avoid subpart F.

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case now that for many companies the more attractivesupply chain strategy is to reposition risk alone, leavingwhere they naturally fall the ownership of supplies andproducts and the location of functions.

Because risk-only arrangements can be implementedentirely by contract, they are less intrusive to manage-ment and less expensive to implement than arrange-ments that modify — even slightly — the holding oflegal title and the performance of business functions.While a conventional supply chain entrepreneur is buy-ing manufacturing and distribution services from high-taxed affiliates and interrupting the passage of title inthe supply chain, the entrepreneur in a risk-only struc-ture is selling risk assumption services to the manufac-turing and distributing affiliates, requiring no alterationin the chain of title passage and little or no change inthe daily conduct of business by its affiliates.

Narrowing our entrepreneur strategy focus to its risktransfer component actually widens our perspective onthe circumstances to which the strategy may apply. Forexample, many products are sold with a warranty, andit is no secret that for some products much of theprofit derives from the sale of extended warranty andservice contracts. A multinational group that has for-sworn full-blown supply chain planning may be willingat least to vest responsibility for issuing and fulfillingwarranty and service contracts in a low-taxed entrepre-neur, which in turn may subcontract replacement andmaintenance services to cost-plus affiliates in the cus-tomers’ countries. Risk, and little else, is thereby repo-sitioned in a tax-efficient way.

Hedge Funds as Comparables

As with conventional supply chain strategies, com-parables for risk management strategies are readilyavailable and provide a sound, defensible basis fortransfer pricing. To pick a single (if unconventional)example, hedge funds make a pure split of their profitsbetween experienced managers that perform all thefund’s business functions and investors that supply allthe fund’s risk capital and assume all the fund’s risk ofloss. With few exceptions, a hedge fund manager re-ceives a share of the fund’s profits; his share of anylosses may offset what would otherwise be his share offuture profits, but he has not invested any capital thatis directly impaired by the loss, nor is he required tocontribute any capital to cover losses.

The hedge fund model is attractive because it pro-vides a clean, arm’s-length split of profits between theparty that performs functions and the party that sup-plies risk capital. Whatever may be the risks of a tax-payer’s business, there are hedge funds that speculate inthat risk. Almost all of them will split their profits inthe same ratios, and those profit-split outcomes areavailable on databases that can be rented. Indeed,

hedge funds afford a rare opportunity for taxpayers toapply the comparable profit-split method.10

The hedge fund model has been under something ofa cloud since it was disparaged in the OECD’s 2010report on attribution of profit to PEs.11 In its discus-sion of global banking, the OECD concluded that themodel was not appropriate for allocating profits be-tween a bank’s home office and its PEs, because themodel ‘‘rests on the premise that capital can be as-signed to a particular part of the enterprise.’’12 How-ever, that argument has no bearing on arrangementsthat shift risk between two or more corporations. Infact, in its subsequent discussion of so-called globaltrading transactions, the report states that when thecapital to support the risks created by risk managementfunctions resides in a separate legal enterprise, ‘‘thereward for capital belongs with the enterprise in whichthe capital resides.’’13

The 2010 report’s discussion of global trading straysfrom the topic of PE attribution to consider the mostappropriate transfer pricing method for allocating profitsamong separate enterprises. It concludes that the hedgefund model may be appropriate for proprietary trading,which bears risks and infrastructure costs comparableto those borne by a typical hedge fund. However, whenthe enterprise is acting as a dealer rather than a trader,‘‘taking spreads from facilitating customer wishesrather than in taking gains from trade,’’ the reportquestions the reliability of the hedge fund model be-cause the dealer’s steady service fee income makes fora less risky business and the business demands a sub-stantial selling infrastructure not needed by a hedgefund.14

I do not share the OECD’s skepticism about usingthe hedge fund model for securities dealers, since thereis a considerable amount of risk-taking in many globaldealing books and a good economist can adjust for dif-ferences in infrastructure costs. Still, the model is onlyuseful when the conduct of a business exposes theowner’s capital to a substantial risk of loss based on avariable on which a reasonable number of hedge fundmanagers are inclined to speculate. Fortunately for thehandful of economists who understand the hedge fundmodel, examples of that exposure abound in most sup-ply chains, including the situation in which input andoutput prices are volatile and do not move in tandem.

The Risks of Moving RiskThe conventional entrepreneur strategy entails spe-

cial tax risks that may be absent in a pure risk transfer

10Reg. section 1.482-6(c)(2).11OECD, ‘‘Report on the Attribution of Profits to Permanent

Establishments’’ (July 22, 2010).12Id. at para. 80.13Id. at para. 123.14Id. at para. 162.

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arrangement. There are not yet any widely acceptabletheories for imposing exit taxes or finding a PE on thebasis of risk transfer agreements, and there likely neverwill be. The tax treatment of insurance is a good ex-ample.

An insurance company may assume some businessrisks of a manufacturer or distributor for a fixed periodand an agreed premium. At the end of the term, thecustomer may enter into an identical or different ar-rangement with a different insurer. Apart from the pay-ment of premiums, the tax law does not recognize anytaxable transfer between the business and the insurancecompany or between the new and successor insurancecompany, either when the contract commences or ter-minates.

On the other hand, entrepreneur strategies that areconstructed around risk transfer agreements do posesome unique tax issues, two of which are describedhere.

The OECD transfer pricing guidelines specify that atax authority may disregard a purported intercompanyrisk transfer if the transferee is not financially capableof assuming or managing the risk,15 although they al-low that at least some of the risk management may beoutsourced.16 Accordingly, the entrepreneur must bewell capitalized, and someone at the entrepreneur orunder contract with the entrepreneur (not excludingemployees of the U.S. parent) must monitor the as-sumed risks and have the training and authority to de-cide whether they should be hedged.

Importantly for a U.S. company, subpart F corralsprofits attributable to financial and commodity transac-tions into the foreign personal holding company in-come basket.17 Fortunately, the election of disregardedstatus by the CFCs involved in the structure should bean effective safeguard against that classification, as it isfor conventional strategies.

Virtual Contract ManufacturingAlthough focusing on the risk-shifting component of

the entrepreneur strategy may open our eyes to applica-tions outside the traditional supply chain model, therisk-only approach can be, and has been, applied toordinary industrial supply chains to establish whatamounts to a virtual contract manufacturing arrange-ment.

Price risk is a key business risk of most manufactur-ing operations — the prices of inputs and outputs maybe volatile and may not move in tandem. Indeed, pricerisk is often the most important risk assumed by a con-ventional entrepreneur. A standard contract manufac-

turing arrangement typically protects the manufactureragainst price risks that it cannot control, such as ad-verse movements in the relative prices of its manufac-tured products and the raw materials or energy used toproduce those products (the manufacturer continues tobear operational risks over which it has some control,such as the costs of equipment failure and labor dis-ruptions). Likewise, the standard stripped-risk distribu-tion arrangement protects the distributor from theinput/output price risk that results from purchasinginventory before it is sold.

Manufacturers and distributors have sometimes beenable to protect themselves against uncontrollable pricerisks by hedging. Until recently, hedges almost alwaystook the form of a forward purchase of inputs, a for-ward sale of outputs, or both. Those hedges were ex-ecuted on a futures exchange if one existed, and other-wise through a forward contract with a dealer. Theability to enter into a fully effective hedge was limited,because there might be no futures or forward marketfor a given input or output, or a market might exist forthe inputs but not for the outputs, or vice versa.

In the last 20 years, dealers have developed evermore sophisticated risk-shifting contracts, ordinarily inthe form of swap agreements. Most swap agreementsare based on master agreements that have been pub-lished by the International Swap Dealers Association(ISDA).

The latest version is the 2002 ISDA Master Agree-ment, although many counterparties continue to usethe 1992 version. An ISDA swap agreement consists oftwo documents, a schedule that contains party-specificinformation such as addresses, and a general descrip-tion of the swaps that the parties intend to execute andone or more confirmations that confirm the applicationof the swap terms to specific transactions.

Under an ISDA swap agreement, a given volume ofan input or output at a fixed price is swapped for thesame volume at a floating price, or a given volume at afloating price according to one index is swapped forthe same volume at a floating price under another in-dex. A party that is concerned less about the absoluteprice of a given input or output than about the spreadbetween those prices may enter into two swap contracts— one that hedges the input price and one that hedgesthe output price. If a single counterparty is assumingboth price risks, the two hedges can be embodied in asingle contract that swaps a fixed margin against amargin measured by designated floating prices for theinputs and outputs (an entrepreneur swap, if you will).

Although ISDA swaps are typically tied to prices ofpublicly traded goods or commodities, or else to themargins between those prices, under a total returnswap a fixed margin can be swapped with the actualmargin earned by the customer, defined as precisely asthe parties may agree.

In principle, a manufacturing subsidiary can becomea virtual contract manufacturer by entering into an

15OECD transfer pricing guidelines, supra note 8, at Chap. I,para. 1.49.

16Id. at Chap. IX, para. 9.23.17Section 954(c)(1)(C) and (F).

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entrepreneur swap that guarantees a low but fixed mar-gin similar to what might have been earned had it be-come a contract manufacturer for the entrepreneur.Because the margin in the conventional arrangementmust account for the performance of some supply-chain functions by the entrepreneur, the virtual con-tract manufacturing arrangement may mobilize some-what less profit. Also, to avoid the deeming of apartnership for tax purposes, I recommend that an en-trepreneur swap be based on gross margins rather thanon margins net of operating costs.

Entrepreneur SwapsThe IRS, at least, has come to terms with the use of

entrepreneur swaps. In LTR 200829011,18 the subsidi-ary of a U.S. multinational engaged in research andowned product technology. Its income consisted ofproduct royalties from affiliates and third parties. Thesubsidiary wanted to stabilize its fluctuating stream ofroyalty income to prepare more realistic developmentbudgets. The U.S. parent caused another subsidiary toenter into an ISDA swap with the research subsidiarythat swapped the fluctuating royalty stream for an eco-nomically equivalent fixed stream of payments. Theswap effectively converted the research subsidiary froman entrepreneur whose income might not cover its bud-get into a contract researcher that earned a smaller butsteadier profit.

ISDA swap agreements are almost always cashsettled — that is, there is no delivery of the volumesbeing swapped. Because they are purely financial trans-actions, care must be taken to ensure they are exemptfrom withholding tax. Payments under an entrepreneurswap should be exempt from U.S. withholding tax ifthe swap qualifies as a notional principal contract.19

Generally, the tax treatment of a European counter-party will follow the international financial reportingstandards treatment of the swap as reported on thecounterparty’s financial statement. If the agreement isclassified as a derivative under IFRS, it should betreated as a derivative for tax purposes, which ordi-narily means that payments to a foreign counterpartyare not subject to withholding tax.

Periodic payments under an entrepreneur swap canbe structured to take account of timing differences be-tween the dates when inputs are purchased and outputsare sold. When the swap is cash settled, the mismatchin payments is resolved. The swap in that case hasserved as a de facto financing arrangement and pos-sibly an attractive alternative to lending into countriesthat impose withholding tax on interest.

One impediment to the introduction of ISDA swapsinto entrepreneur planning is that the ISDA-enforcedformat and terminology make them incomprehensible,not only to laypersons but also to lawyers who are notspecialized in drafting them. Consequently, the devisingof a schedule and confirmations that actually andtransparently achieve the desired tax results is an ardu-ous process that tests the IQ and patience of all whoare involved, but one that more than repays the effort.

Conclusion

By taking advantage of modern risk managementtechnology, today’s multinational enterprise canachieve many of the tax benefits of traditional supplychain planning with less tax risk and perhaps less re-sistance from business managers. Of course, once theclassic entrepreneur strategy has been stripped down toits risk transfer essentials, we may have reached theend of that particular tax planning road and will havenowhere else to go. In that respect, virtual contractmanufacturing may be the last frontier. ◆

18Doc 2008-15816, 2008 TNT 140-15.19Reg. section 1.863-7(b)(1).

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