The "Principal International Company" Global Corporate Tax Reduction Opportunities

This article looks at the tax savings that might be available on a multi-jurisdictional basis to a manufacturer that is engaged in inter-company transactions internationally. Among other things, the author notes that to take advantage of these savings an enterprise must be willing to revamp the supply chain and legal structure supporting it.

Introduction

A manufacturer with operations in high-tax countries may have an opportunity to reduce its worldwide tax burden by establishing a "principal international company" (a "PIC"). A PIC can be useful in many industries when: (a) tangible personal property is involved, (b) the manufacturer controls the full lifecycle of a product (i.e., research, manufacturing and distribution), and (c) related party transactions come into play.

A PIC can be useful whether or not the tangible property involved has intangibles associated with it, such as a trade name. Further, the use of a PIC need not be limited to manufacturers. In some cases, it can be used by other businesses that buy and sell tangible property to and from unrelated parties. Also, it may be possible to "enhance" existing entities that have certain attributes of a PIC.

Nevertheless, this article focuses on manufacturers that engage in inter-company transactions on an international basis. It highlights some of the corporate tax savings that might be available on a multi-jurisdictional basis for a company that is willing to restructure the supply chain and legal framework supporting it.

The extent of restructuring and number of steps necessary to implement (or enhance) a PIC arrangement will vary and depend upon an enterprise's existing legal form and product flow. Therefore, the points discussed in this article should not be used as a road map for every situation, since each group's structure is different.

A PIC might increase global after-tax earnings and, at the same time, cause minimal changes in existing business operations. Nevertheless, to achieve maximum potential, it is quite possible that there will be changes to, among other things:

There may be customs risks and opportunities, as well, although they are not covered in this article.

Generally speaking, foreign (non-US) parent companies from countries that do not have controlled foreign corporation ("CFC") tax regimes in place might find the greatest number of opportunities in using the PIC structure. (In this regard, we are referring to tax regimes that make offshore "tax haven" type income currently taxable in the parent company's home country without the need for an actual cash distribution.) However, US parent companies also might find the PIC structure useful, provided that subpart F of the Internal Revenue Code (the US' CFC tax regime) does not impose any obstacles and/or the ultimate objective is to reduce foreign taxes.

To illustrate how the actual use of a PIC would work, certain basic assumptions need to be made. For example, consider the following:

1. We are looking at a global organization that develops, manufactures and distributes tangible property through related affiliates in major international markets and/or to unrelated parties in secondary markets. Alternatively, in certain cases, "trading companies" that deal with unrelated parties (i.e., suppliers and customers) may be able to use a PIC.
2. The research and development ("R&D") and manufacturing functions are conducted in a jurisdiction that imposes at least a 30-percent corporate tax rate on operating income. Further, it is assumed that this jurisdiction permits a current corporate tax deduction for R&D expenditures and/or requires that they be amortized over a period of years.
3. Related distributors or marketing affiliates are established in high-tax countries, which could be the case with a foreign-owned companies in the US, UK, France, Canada, Japan, Australia, Mexico, etc.
4. The PIC's parent company is established in a country that does not have a CFC tax regime. Alternatively, if the country has a CFC regime, as well as a foreign tax credit system, the PIC structure could be helpful
5. if the objective is to lower foreign taxes for purposes of calculating the parent's home country foreign tax credit.

The installation of a PIC structure for your international operations requires the formation of a legal entity in an appropriate low-tax jurisdiction. Further, as explained below, this entity should have the maximum possible degree of "substance and risk." While a global organization might already have an existing PIC in place, it will be necessary to assess whether this entity is the appropriate vehicle for conversion to (or further development as) a "fully-fledged" PIC. For purposes of the discussion in this article, we assume that "Country A" has been selected as the most suitable jurisdiction and that the corporate tax rate in Country A is below 10 percent. We do not discuss the "pros" and "cons" of any particular jurisdiction. However, as noted below, the existence of an income tax treaty for the prevention of double taxation could also be an issue.

In all likelihood the global organization will have the principal research, manufacturing and distribution entities already in place. Therefore, we assume that no changes in the legal structure of these entities are necessary. However, in reality, this step actually requires a country-by-country evaluation. In some cases, the ownership position within the group might require some reorganization as well.

For example, the PIC in Country A will enter into a "contract R&D agreement" with a related party (in Country B) which performs R&D activities with regard to new products or the next generation of existing products. While it is conceivable that the organization's R&D center may be in a low-tax or no-tax jurisdiction, in most cases, this will not be the case.

Again, a country-by-country analysis will be necessary. The expenses incurred in researching a new product might be deductible on a current basis in the high-tax jurisdiction (Country B). However, once a new patent or other intellectual property is fully developed, registered and the product comes to market, the legal entity that houses the R&D center would probably become the "economic and legal" owner of that property -- assuming that steps are not taken to alter this consequence.

Therefore, the high-tax jurisdiction could assert (or require) the inclusion in taxable income of a substantial financial return if the product is a global success. This return might take the form of a royalty, for example, if other affiliates want to use the intellectual property in a manufacturing process. It could also be imbedded in the price of tangible products sold to affiliates that are handling the distribution function.

In most cases, the manufacturing affiliate (whether or not in the same jurisdiction as the R&D center), would need to pay a royalty to the entity that houses the R&D center. The deductibility of the royalty may or may not be an issue in the payor's country. Also, the amount of the royalty paid to the Country B affiliate might have to be "commensurate with income" from the product, which is the case under US tax law.

By entering into the contract R&D agreement, the PIC will assume the economic and legal risk of the research -- i.e., the potential successes and failures. In some cases, there might be variations in which a "cost sharing arrangement" is entered into between the PIC and the R&D center so that the ownership of the intangibles is split between jurisdictions. This would eliminate the need to cross-charge royalties and expose the payments to withholding tax.

The compensation that the R&D center receives from the PIC needs to take into account the transfer pricing rules and methods in Country B (the R&D center's location). Generally speaking, in the typical scenario, this might well take the form of a "cost plus" arrangement. Thus, in practice, the entity in the high-tax country that houses the research will have a modest amount of taxable income because it is guaranteed a profit and is not assuming the risks the PIC has assumed.

With respect to intellectual property that is currently being developed in a high-tax country, it may be more difficult to arrange for the completion (or funding) of that particular research project in the PIC jurisdiction (i.e., either a switch in form or substance). For example, if 80 percent of the product research has already been completed and the PIC enters into an agreement to assume the additional registration and finalization of the research efforts, this may be an issue in the high-tax jurisdiction.

Another approach might be to limit the R&D contract to new product launches or to product extensions. On the other hand, depending on how the R&D center's jurisdiction looks at the arrangement, it may become a question of whether the R&D center has the capability to finish the research.

A strong business case needs to be made for switching from a fully-fledged R&D center to a contract R&D center. Some jurisdictions may question whether a "reasonable business person" would make the switch and, thus, be willing to agree to a cost plus return.

After the new product or intangible is created and owned by the PIC, the PIC might enter into a contract manufacturing agreement with a manufacturer in a high-tax country (Country C). In many cases, this would be a related manufacturer. However, the concepts are equally applicable to unrelated parties.

Of course, a manufacturer might already be located in a low-tax jurisdiction. Therefore, the nature of the relationship will depend on the location of the existing manufacturing operation, as well as new manufacturing sites that might be created in the future.

When the manufacturer is a related party, similar issues arise as in the case of the R&D arrangement discussed above. For example, would a "reasonable" business manager of a fully-fledged company in Country C agree to switch to a cost plus arrangement from one that provided guaranteed (but lower) returns?

At this stage, the PIC enters into agreements with international affiliates that would sell or distribute products on a local country or regional basis (Countries D-Z). In one scenario, the PIC would hold title to the products that are produced under the contract manufacturing agreement. The distributors would be limited risk distributors ("LRDs") and would accept title from the PIC, rather than directly from the manufacturer (as in the past).

Depending on the jurisdiction, an LRD might use a transfer pricing method, such as the comparable profits method (discussed be-low) or transactional net margin method (the "TNMM"), which could limit the amount of its local taxable income. In most cases, the comparable uncontrolled prices (the "CUP") method will not be available and the resale price method (the "RPM") will not apply.

The CUP method evaluates whether the amount charged in a controlled transaction is an arm's length amount by reference to the amounts charged in comparable uncontrolled transactions. Product similarity is a key factor, as are contractual terms, economic conditions and whether an intangible (e.g., trademark) is used in one transaction, but not in another.

The RPM evaluates whether the amount charged in a controlled transaction is an arm's length amount by reference to the gross profit margins realized in comparable uncontrolled transactions. This method measures the value of the functions performed and is ordinarily used in cases involving the purchase and re-sale of tangible property in which the reseller has not added substantial value to the tangible goods by physically altering the goods before resale.

In practice, the RPM is difficult to apply unless the taxpayer has an "internal" comparable. An internal comparable is a comparable uncontrolled transaction to which the taxpayer is a party. For example, a controlled distributor of photocopiers may also distribute third party fax machines. Data on its fax resale margins may provide RPM comparable transactions for its controlled resale of photocopiers.

As mentioned above, a more prevalent transfer pricing method is the comparable profits method (the "CPM"). In essence, the CPM uses objective measures of profitability (i.e., profit level indicators or "PLIs") to determine arm's length consideration in a controlled transaction. PLIs are ratios that measure relationships between profits made and costs incurred or resources employed. With the CPM, an arm's length range of profitability is created.

Generally, if the financial results of the tax-payer in question (the "tested party") fall within the arm's length range of profitability, a transfer pricing adjustment should not need to be made. Although the CPM method originated in the US, the OECD has adopted the transactional margin method, which bears a close resemblance to the CPM.

As mentioned above, it is very important to maximize the amount of business activity in the PIC entity. This minimizes the risk that the high-tax jurisdiction will attempt to allocate a portion of the LRD earnings to the operating companies in the high-tax countries.

In this context, the "substance" in which the PIC is engaged can include many different business activities and investments. For example, it could include service and distribution functions, banking, cash pooling, management, treasury functions and strategic planning.

Also, in this regard, the ownership of intangibles by the PIC could be very beneficial. For example, if the supplier of the products also owns the trademarks imbedded in the goods, this could be a very positive factor.

For the PIC structure outlined above to work effectively, it is essential that there be contractual agreements between the related affiliates, which clearly spell out the relationships they have with one another. In the absence of these agreements, it is entirely possible that the tax authorities could look to the "behaviour" or "practice" of the parties and draw their own conclusions about their respective relationships.

Further, the nature of the relationships that the affiliates have to the PIC and to one another is a highly factual matter. Different interpretations can be made of the same set of facts. These different interpretations might generate tax-planning opportunities. However, on the other hand, they can also lead to misinterpretation and uncertain results. In many cases, taxpayers do not always pay as much attention to their contractual relationships with affiliates as they do to their contractual relationships with third parties.

Inter-company contracts can be very helpful to companies in terms of both simplifying their transfer pricing compliance obligations and obtaining more predictable results. This predictability is desirable for the companies themselves, as well as for the tax authorities that must devote resources to transfer pricing audits.

Virtually all income tax treaties include provisions designed to avoid double taxation, including the "competent authority" provision. Thus, if a transfer pricing adjustment is made by one country, there is the possibility of obtaining tax relief in the other jurisdiction in which the related transactions took place.

In the absence of a treaty, it would be up to the domestic law of one country to grant relief from double taxation resulting from a transfer pricing adjustment -- and the chances of this occurring are not great. Therefore, in selecting the country in which to locate a PIC, it would be a good idea to assess the significance of the absence of an income tax treaty. In very general terms, countries that have very low tax rates or no taxes do not usually have tax treaties.

The discussion and illustrations in this article do not provide a road map for using a PIC structure in your international tax-saving strategies. Naturally, specific opportunities for using this structure will vary for each multinational group and each PIC structure will need to be customized. Moreover, the structure will be appropriate and sustainable on in certain situations.

Finally, in selecting the best jurisdiction in which to form a PIC, it is necessary to be mindful of recent OECD initiatives with respect to certain harmful tax practices, which have been covered extensively in previous issues of Practical US/In-ternational Tax Strategies.