In his 2016 budget plan, to be unveiled today, President Obama will propose that U.S. companies’ overseas profits be taxed to fund a major boost in infrastructure spending. These tax proposals could change the way the Tax Efficient Supply Chain (TESC) operates.
When highly profitable companies pay little in the way of taxes, negative press coverage can ensue. But CEOs are asked by financial analysts about their corporate wide effective tax rate (ETR) all the time. This can be a no win situation for a CEO. A company with a high effective tax rate is at a significant disadvantage to industry competitors with low tax rates, particularly in the company’s ability to grow the business. And ultimately a CEO’s tenure is often most strongly impacted by the financial community’s view of his company’s performance. Not surprisingly, many large companies have restructured to lower their tax burden; it is not unusual for these companies to lower their ETR by about five percent.
While supply chain cost savings fall to the pretax bottom line and improve a company’s Net Income position, corporate tax restructuring increases deferred revenues. Some large corporations are sitting on tens of billions in deferred earnings that can’t be used for stock owner dividends, without being taxed at US rates, but can be used to fund growth and thus future earnings, in a variety of ways.
This tax restructuring can be accomplished while leaving the physical supply chain flows untouched through the creation of a legal entity – an entrepreneurial hub company – that contains substantial intangible assets and the core regional supply chain executives. This type of realignment is based on the centralization of supply chain functions and risks in a regional headquarters located in a low tax country. That country might not, and frequently does not, contain any of the region’s plants or warehouses.
Unless there is a legitimate business reason behind the new Hub Company, this type of realignment will not withstand a challenge from tax authorities. Supply Chain centralization of risks and functions, to the extent that this realignment reduces the number of operational personnel or lowers supply chain costs, is a legitimate reason to engage in this type of realignment.
A key challenge is to combine a corporate structure that allows for a low effective tax rate with the optimal physical supply chain. These two goals are not mutually exclusive. Supply chain transformations often require regional centralization as a way of creating new synergies.
In order to understand the TESC, executives need to understand transfer pricing and intangible assets. Transfer pricing refers to the allocation of revenues between parts of a multinational corporate group. The core idea behind intangible assets is that the physical assets of a company often represent a very small proportion of a company’s overall financial valuation. The ability of a manufacturer to generate profits is more often linked to the specialized knowledge and processes at its disposal; the brand name and proprietary sales lists; and the technologies and patents it has created through Research and Development; rather than the mere physical assets under its control.
It is the structuring of where intangible assets reside, and what one entity in a corporation can charge other corporate entities for intangible assets that is the true driver a tax efficient strategy. A firm may transfer marketing and sales intangibles, for example, and charge other European entities for that intellectual property. However, shifting more significant amounts of corporate taxation to low tax locales, and having a more defensible position, often requires shifting supply chain expertise and risk to those locales as well.
The transfer pricing rules differ from country to country, as do interpretations of the rules, and enforcement policies. A manufacturer desiring to move to a more tax efficient supply chain would be crazy to attempt this without consulting advice from a respected tax accounting firm.
In general, the more supply chain functions, the more strategic those functions, and the more senior the executives that are located at the entrepreneurial hub company, the more defensible the company’s position is. Companies that have decided to centralize regional procurement and supply chain planning in a low taxation country are ideally situated to move toward TESC.
So what are Obama’s new proposals? Obama will call for a one-time, 14 percent tax on an estimated $2.1 trillion in deferred revenues that have piled up over the years. The President will also seek to impose a 19 percent tax on U.S. companies’ future foreign earnings.
The rhetoric surrounding this has been rather confusing. Republicans portray this as a tax increase that will hurt US competiveness. But the current US corporate tax rate is 35 percent, so this is really a tax cut on a portion of the company’s revenue.
Democrats say this is closing a tax loophole. But it might be more accurate to view the onetime 14 percent tax rate as a tax holiday that allows US firms to repatriate foreign earning into the US at a low tax rate. If the law passes, many multi-nationals will decide to repatriate a significant portion of their retained earnings in the form of a bonus dividend, a windfall for their stock holders.
No one expects much in the way of cooperation between Congress and the President. However, because of the number of big winners that would result from this legislation, I would not be surprised if it passes.