Tax Issues Facing Supply Arrangements in Latin America
08 Jul 2008 12:41 PM
Excerpt from Practical Latin American Tax Strategies by Victor Cabrera, Jose Leiman, And Marc Skaletsky (KPMG LLP).
Over the past decade, many large multinational corporations (MNCs) have been moving their European and Asian operations from a decentralized group of stand alone full-fledged manufacturing and distribution (M&D) subsidiaries towards a “hub-and-spoke” system. Under these arrangements, the hub (the “Principal”) assumes functions and risks from the M&D subsidiaries. This centralization of functions and risks in the Principal hopefully brings a commensurate share of consolidated profits. The conversion of full-fledged M&D subsidiaries to a hub-and-spoke arrangement raises a series of non-tax and tax considerations and associated issues that must be resolved in order to implement the structure successfully.
Given the potential benefits of the hub-and-spoke structure, many MNCs have sought to implement the structure for their Latin American operations. However, when MNCs cast their sights on Latin America, they are quite often faced with a diverse and sprawling network of jurisdictions, each with its own rules and views on the operation of structures within their borders. Many MNCs doing business in Latin America learn that applying the European or Asian hub-and-spoke template to Latin America does not always result in a natural fit. In particular, MNCs that seek to implement a hub-and-spoke arrangement in Latin America must deal with the regional issues described below.
First, the determination of where to locate the Principal is not as easy in Latin America as it is in Europe or Asia. The ideal hub would be located in the region, have a low internal tax rate, and enjoy a strong treaty network. Moreover, to the extent that the MNC is U.S.-based, the potential to defer profits from U.S. tax is preferred. Unfortunately, no country satisfies all these criteria; therefore, MNCs need to optimize the location of the Principal based on their specific facts.
Second, Latin America lacks the economic integration of the European Union. As a result, MNCs operating in Latin America are forced to deal with authorities that take a provincial perspective on revenue collection at the cost of market efficiencies. In considering value-chain reorganizations in the region, MNCs must take into account the peculiarities of each jurisdiction and the current and evolving tax environment in the applicable countries. As with structures throughout other regions, it is important that an underlying business rationale drive the value chain reorganization within Latin America.
A third important factor is the ever increasing aggressiveness of the Latin American tax authorities. This aggressiveness manifests itself in a variety of forms. For example, many tax authorities in the region are attempting to assert “substance over form” principles to challenge structures that they consider “aggressive.” Even if they cannot successfully attack the overall structure, the tax authorities may attempt to draw profits back into their tax nets by asserting that the Principal has a local taxable presence or permanent establishment (PE). As electronic tax filing requirements and information sharing among the authorities increase in the region, the tax authorities have greater tools in their audit arsenals to press these arguments.
The foregoing factors require taxpayers to place their Latin American supply chain structures on a solid footing from a tax perspective. Mitigating unnecessary tax risks and unwelcome local publicity are, needless to say, high on the agenda of every MNC’s senior leadership team. With these considerations in mind, the MNC should ensure that it incorporates the elements described below into any supply chain conversion.
First and foremost, economic substance is an essential component of any supply chain conversion. As previously noted, MNCs must be sensitive to a “substance over form” argument by the Latin American taxing authorities. This means that any restructuring of existing operations should produce substantial operational changes and a corresponding adjustment to the parties’ potential for profits and risk of loss. A prudent MNC contemporaneously documents the business reasons for the restructuring and its anticipated economic impact on the enterprise. Anticipated local tax savings is typically not a valid business reason for local purposes. Moreover, savings generated by lower customs, VAT and payroll taxes will often not be considered an adequate business purpose absent a demonstration that the Principal has assumed substantial business functions and risks. The business reasons supporting the conversion ideally should include both commercial and operational benefits. Contemporaneous documentation of the business reasons behind the restructuring of the value chain is important for the MNC to maintain and will be very important if and when the arrangement is ever challenged by the taxing authorities on audit.
Even a structure with economic substance may, however, have adverse tax consequences if the parties’ new arrangements are not supported by a robust and geographically focused transfer pricing study. For this reason, the migration of functions and risks from local M&D subsidiaries to the Principal must be supported by an analysis demonstrating that the parties’ post-conversion potential for profit and loss is commensurate with their post-conversion functions and risks. Moreover, the analysis should demonstrate that the conversion does not result in a transfer of value from M&D subsidiaries to the Principal. What this means is that any reduction in the M&D subsidiaries potential for profit must be balanced with a commensurate reduction in their risk of loss.
In reducing the M&D subsidiaries’ risk of loss, the MNC should be careful that it does not transform them into agents of the Principal that are guaranteed a return for services, regardless of their performance. If the M&D subsidiaries are viewed as agents of the Principal, the Latin American authorities may assert that the Principal has created either a PE under the provisions of a bilateral tax treaty, or an internal tax presence or nexus in the absence of a tax treaty.