Amidst the current global crisis, disruptive trends and shifting value chains are impacting companies around the world. This brief discussion looks at challenges taxpayers are facing in these uncertain times and some issues to consider.
How does the current economic environment impact companies?
The economic and social impact of the Covid-19 pandemic has accelerated existing trends for evolving and new business models, particularly in the area of digitalization. At the same time, the crisis has put a strain on the flows of physical goods and tested the robustness of supply chains in many industries. Both effects call for a reassessment of key value drivers across companies’ existing value chains.
With the crisis, some companies faced disruption or even the collapse of their supply chains, while others had to downsize or close their operations during the shutdown periods or due to the decline in demand. In contrast, certain industries experienced an exponential increase in demand.
All of this illustrates that the world has become an uncertain place where disruptive events can no longer be considered an exception. To keep up in this ever-changing environment, companies must be able to adapt quickly. To do so, it is critical to reassess and possibly even redesign current business models.
How are businesses changing and what does it mean for tax?
Another option may be to localize or regionalize production. Decoupling from Asia and using local or regional alternatives heavily depends on the production capacity of these alternative locations. This trend is also fueled by the growing demand for sustainable and environmentally friendly consumption.
The uncertainty over the last 18 months has highlighted some phenomena that have a direct impact on the tax and transfer pricing landscape, including:
- Growth of centralized supply chain management: the crisis added fuel to the growing centralization of supply chain management in a central management hub (i.e. crises are typically managed centrally). This potentially means that value chain analyses, principal structures and profit splits may require revisiting and reassessing.
- Importance of procurement centers: in a world of short supply, larger volumes usually mean greater leverage and bargaining power vis-à-vis suppliers, and may increasingly be centralized in centers of excellence (“CoE”). The more strategic role of central purchasing functions may call for a redefinition of transfer pricing policies and remuneration schemes for said function.
- Virtualization of commercial flows: with the pandemic putting a damp on the physical flow of goods around the globe and the advent of technologies such as 3-D printing, in some industries, such as spare parts, it became possible to move away from a make-ship-sell model through, e.g., onsite 3-D printing. This will naturally call from a complete redefinition of transactions (i.e., buy-sell to a virtual licensing transaction) triggering an array of tax and transfer pricing consequences.
- Work-from-anywhere: as the workforce has moved to ‘telecommuting’, companies were prompted to invest in cloud services and cybersecurity measures. To avoid losing expertise when employees are (un)expectedly absent, automation and user-friendly tools are critical. These predictive analytics tools provide various stress testing scenarios that allow companies to prepare and ultimately mitigate or even avoid unfavorable outcomes The deployment of new technologies redefines the IT department and may require the recognition of new services being provided internally to group affiliates, with an appropriate transfer pricing policy. Another consequence of this phenomenon is the potential pressure on principal or central structures where key decision-making employees or executives have not been able to attend meetings or take decisions in the locations they were expected to.
- Store closures: with widespread lockdowns and store closures, distribution relationships will need reassessment with a view of determining who should absorb losses related to foregone sales and obsolete inventory. In the case higher-profile distributors who license-in brands and other marketing intangibles, it may be necessary to revaluate the relative weight of such intangibles to the business and the remuneration thereof (e.g., value and/or benefit of royalty fee).
- Boost of ecommerce and direct-to-consumer sales: another phenomenon was the boost of e-commerce, particularly in the (fast-moving) consumer goods sectors, where major players have been strategically investing in customer experience and direct-to-consumer sales channels. With a crisis that curbed the companies’ ability to move goods around the globe, there is a clear trend towards simplification (and reduction of) transactional flows, in addition to a complete revamp of marketing departments and growth in strategic importance of certain functions such as client relationship management (“CRM”).
- New offerings and service lines: the profound societal changes have created opportunities for expanded service offerings (e.g., “telemedicine”) which will require new tax and transfer pricing models in addition to the traditional offerings.
- Industry consolidation: another consequence of the changes is that while entire industry sectors collapsed, the crisis also saw the emergence of net winners, i.e., sectors that experienced multi-digit growth as a result of new ways of living and are now ripe for mergers & acquisitions (M&A). Interestingly, the TMT (Technology, Media and Telecommunications) sector saw the most activity in M&A transactions in the first half of 2021, followed by the industrial and pharmaceutical sectors1.
All in all, not only the supply chain but the entire value chain is shifting towards becoming more sustainable, globalized and digitalized. The importance of digital transformation and of a potentially digital business model has been underscored by the pandemic.
Tax is one of various areas impacted by these developments. Intragroup transactional models need to keep up as value chains shift and business models evolve. Understanding the continuous alignment of your tax model and value chain can be the difference between an optimal model and an inefficient setup that eventually will end up in tax authority scrutiny and potential challenges.
What can be done and where to start?
When business models evolve and new business lines or value chains are being created in an organization, tax is typically only a part of the puzzle – but certainly an important one.
One of the key questions is how existing business models and value chains have changed. Most taxpayers have tax and transfer pricing models that have been in place for a while. Has the pandemic shifted the value chain of a company by increasing the role of certain value creating factors (i.e. technology), with an implication for the companies’ transfer pricing? What changes in the value chain are only temporary and which ones will remain?
Assessing the company’s value chain is a first step to create a deep understanding of how the business operates and creates value. Having a good understanding of the value chain for the new business model is a crucial element to guide the transfer pricing model about how to allocate profits within different parts of the company.
Important decisions from a tax and transfer pricing perspective are typically made early when a new business model is designed. Such decisions will likely revolve around the specific role group companies play in the new global model and how the transactions between them need to be characterized.
Another important question when designing the new business model is whether to adopt a central or a decentralized operating model. Will developed intellectual property be owned in one location or held in multiple locations (for instance, through a cost-sharing mechanism)? Where will key decision-making functions be located?
The most important thing is for tax functions to walk in tandem with the business as things change. The continuous monitoring of the organizations’ strategic priorities and operating model priorities and possibilities is paramount for building and maintaining a best-in-class tax and transfer pricing function.
1 KPMG M&A – Semiannual Report