Companies may undertake business restructuring (or supply chain planning) for a number of commercial reasons. There may also be tax benefits and consequences of doing so. By changing the activities of companies within a multinational group, profits may be recognised in low tax countries. However, tax charges may arise as a result of the restructuring itself, and as a result of new intercompany transactions which are created. There is specific commentary in the OECD Transfer Pricing Guidelines on the treatment of business restructuring.
Multinational groups often carry out business restructuring for commercial reasons – for example to move manufacturing facilities closer to consumer markets, or to reduce costs by restricting the activities which are delegated to local sales teams.
However, the focus of this article is on the tax consequences and benefits which can arise from business restructuring. These tax benefits may not be sufficient by themselves to justify a business restructuring, but are frequently considered at the same time as a commercially motivated restructuring.
Transfer pricing rules in the UK and many other countries require that transactions between connected parties should be recognised on an arm’s-length basis for tax purposes. The arm’s-length principle is endorsed by the OECD (Organisation for Economic Co-operation and Development), and the OECD Transfer Pricing Guidelines form the basis of the transfer pricing rules in many countries. The UK transfer pricing legislation is set out in TIOPA 2010 Part 4, and TIOPA 2010 s 164 specifically incorporates the OECD Guidelines into UK law.
The arm’s-length profit earned by a company will depend on the functions it performs, the risks it holds, and the assets it owns. Companies undertaking activities which add little value, and carry no risk, will not usually earn significant profits.
From a tax perspective, business restructuring involves moving functions, assets and risks from high-tax countries to low-tax countries. For example, a full risk distributor may become a commissionaire, or a full risk manufacturer may become a contract or toll manufacturer. This is examined in more detail in the Example.
Under OECD transfer pricing principles, the arm’s length profit earned in the high-tax countries will then be reduced, and the profit earned in the low-tax countries will be increased.
Example: Tax benefits from supply chain planning
An Irish parent company has a number of subsidiaries, including in the UK. The UK subsidiary was previously a full risk distributor, carrying out the activities indicated in the first column of the table below.
Following a business restructuring, the UK subsidiary has transferred some functions, for example marketing and responsibility for warranty claims to the Irish parent company. It will continue to take customer orders in its own name, rather than on behalf of the Irish parent company. The subsidiary should therefore be characterised as a limited risk distributor, as it carries on the activities indicated in the second column of the table.
The UK subsidiary undertakes more limited functions than before the restructuring, and does not now hold certain risks such as warranty risk. Under the arm’s-length principle, it now recognises lower profits – in practice this would be as a result of increased charges from other group companies, and in particular the Irish parent.
As a result of the restructuring, the subsidiary has transferred intangible assets (the rights to local branding) to the Irish parent company. For UK tax purposes, this will be treated as a disposal for market value and any gain arising may be subject to corporation tax.
However, the subsidiary has retained customer lists and customer relationships and there is unlikely to be a disposal of goodwill.
Capital gains may arise as a result of restructuring, and this is confirmed by the OECD Guidelines. For instance, a UK company may transfer intellectual property or other intangible assets (such as customer lists, or goodwill) to another group company. As this is a disposal to a related party, the UK company will be treated as having disposed of these assets for their current market value.
Other capital gains may not be so obvious. Full risk manufacturers may become contract manufacturers, and will terminate existing contracts with other group companies under which they sell them finished goods, and instead enter into contract manufacturing agreements under which they will earn lower profits.
If these manufacturers were dealing with third parties on arm’s-length terms, they would be able to claim compensation for the termination/amendment of the contracts. Under OECD transfer pricing principles, they should therefore recognise an arm’s-length amount of compensation. Intercompany agreements should be carefully reviewed in advance of any restructuring, as standard termination clauses may allow the restructuring to take place without any compensation being recognised.
In other countries, such as the US and Germany, there are specific rules which deal with the transfer of assets and functions on a restructuring:
It is important to review the other tax consequences of a supply chain restructuring, and in particular:
Controlled foreign company
Following the restructuring, profits may be recognised in subsidiaries which are subject to a low (or nil) rate of tax. The UK controlled foreign company (CFC) rules may apply to these profits.
Subsidiaries which previously relied on exemptions from the CFC rules may have changed their activities such that these exemptions no longer apply. For example, a trading company may now receive non-trading income, or may no longer have the premises or employees which are required for certain exemptions.
Similar considerations may apply where the holding company is not in the UK.
Permanent establishment
Companies undertaking additional functions may have activities outside their country of residence. These activities should be reviewed to consider if they create a permanent establishment, and any appropriate registrations made.
Withholding taxes and VAT
New intercompany transactions may have been created by the restructuring, and the companies which are party to these transactions may need to obtain new withholding tax clearances.
The VAT and sales tax consequences of any new transactions should also be reviewed, and any appropriate registrations made.
Transfer pricing documentation
Transfer pricing documentation should be updated following a restructuring to reflect the new arrangements.
There are a significant number of practical issues to consider as part of a business restructuring. Two examples include:
Employee bonuses
Business restructuring can have a significant impact on where income and profits are recognised in a group of companies – and indeed this is what leads to many of the tax benefits. However, if employee bonuses or other incentives (such as share options) are based on the income and profits of a particular company in the group, the terms of these incentives may need to be amended.
Intercompany transactions
The nature of intercompany transactions, and the companies which are party to them, are likely to be changed following a restructuring. Accounting software and invoicing arrangements will need to be updated to reflect these new transactions, and staff notified about changes to internal procedures.
Robert Langston, Senior Tax Manager, Saffery Champness
