The Importance of a Relevant Indirect Tax Strategy
A well-implemented indirect tax strategy is essential for the effective functioning of a new business from the go-live stage, both from tax and commercial perspectives. This ensures smooth inventory movement, efficient sales and invoicing, reduced disputes with non-paying customers, ongoing tax compliance, and timely, on-budget business integration.
Indirect taxes play a vital role in the daily operations of a company, impacting various activities including invoicing, inventory management, supplier payments, and cash collection. As a result, the risks associated with indirect taxes can significantly affect an organization’s commercial viability, especially during mergers, acquisitions, or changes in the business model.
One critical aspect often overlooked in strategic planning for business model changes is indirect tax. Although tax considerations may not be the primary focus during financial transformations, neglecting them can lead to substantial and costly challenges—particularly concerning value-added tax (VAT), which influences multiple departments within the organization, including finance, procurement, IT, and HR.
Incomplete integration during transitions often leads to invoicing issues. For example, if many payable invoices are not correctly coded, this can cause delays in VAT deductions. Additionally, if a legacy system is only partially integrated with the new model, it may result in the issuance of incorrect sales invoices, leading to customer disputes, inaccurate tax reporting, and missed compliance obligations.
Using a Classic Principal Structure to Optimize Profits in Low-Tax Jurisdictions
Will employing a classic principal structure in the new entity help maximize profits in low-tax jurisdictions? If so, one entity would hold the title to the inventory across various locations, necessitating VAT registration in each jurisdiction where the inventory is stored. Addressing indirect tax issues during the design phase is crucial to ensuring the effective implementation of indirect tax planning, as any changes can significantly impact current processes, controls, and their overall effectiveness.
Effective tax planning is enhanced when the business model assigns profit drivers—such as value-added functions and associated risks—to low-tax jurisdictions.
Managing the Impact of Business Transactions
Changes in the business model, such as adopting a centralized operating structure, often lead to an increase in transactions and indirect tax obligations across multiple jurisdictions.
In many Asian and Latin American countries, centralized ownership of raw materials, work in progress, and finished inventory is not permitted. Additionally, in most countries outside Europe, registering for VAT, GST, or Consumption Tax typically establishes a full taxable presence, thereby creating a liability for corporate income tax.
Operational changes incur tax consequences due to shifts in transactional flows, as well as changes in the company’s assets, functions, and risk profile.
It is vital to ensure that the new operating model is not only implemented correctly from a corporate income tax perspective but is also aligned with indirect tax requirements. This alignment supports the business across various areas, including compliance, finance and accounting, legal, IT systems, and regulatory matters. Collaborative engagement with these work streams is essential during the design process.
Risks Associated with Changing a Business Model
Modifying a business model can introduce various risks, including VAT risks and commercial challenges. Potential issues may arise in logistics, such as customs delays that hinder the clearance of goods in certain countries, difficulties in importing products, and shipment delays. Such disruptions can adversely affect daily operations, leading to invoicing errors that necessitate the re-issuance of invoices and delays in cash collections. Misclassified transactions can complicate VAT compliance, resulting in payment and reporting errors that may incur penalties.
Common root causes of these challenges include failing to register for VAT or a lack of coordination between procurement teams and suppliers responsible for importation.
These issues can also damage the company's reputation, as stakeholders—including customers, suppliers, external auditors, senior management, tax authorities, and shareholders—are affected when problems arise.
A Comparative Analysis from a VAT Perspective
Tollers are manufacturers who produce goods on behalf of other parties, such as the principal, and they receive a tolling fee in return for their services.
Commissionaires function exclusively as intermediaries for customers, receiving a commission fee from the principal for facilitating transactions. In a strip-buy-sell model, this role is often filled by a reseller, known as a Limited Risk Distributor (LRD). The critical distinction here is that a reseller assumes ownership of the goods. From a VAT perspective, commissionaires are also viewed as owners; therefore, the VAT treatment for both commissionaires and LRDs is similar—they both engage in buying and selling activities—but they operate within different legal frameworks.
An LRD has the potential to maintain local inventory on its balance sheet, as long as all relevant legal and compliance considerations are properly addressed. In contrast, a commissionaire never assumes ownership of inventory, even temporarily. This distinction is significant, as an LRD momentarily holds ownership through a concept known as 'flash title.'
It is important to note that neither LRDs nor commissionaires have legal ownership of the inventory during periods of storage or transport, as ownership remains with the principal until the transfer is completed. Furthermore, different accounting rules apply to LRDs compared to commissionaires, highlighting the nuanced variations in their operational frameworks.
Note that commissionaires create a PE issue due to new legislation
Globalization: 'Drop Shipments' and 'Flash Titles'
Many multinationals still use a traditional Principal structure to allocate profits to lower tax jurisdictions. In this structure, the Principal typically retains ownership of the goods when sent to customers. A Limited Risk Distributor (LRD) is part of the supply chain in a strip-buy-sell model.
An LRD, acting as a sales company, offers the advantage of maintaining local inventory on its books. However, the LRD only holds ownership of the goods for a brief period, referred to as "flash title." During storage and transport, the LRD does not have legal ownership of the inventory; the Principal remains the legal owner then.
Triangulation describes an ABC chain transaction involving three parties: Party A (the Principal), Party B (the LRD), and Party C (the Customer). In this scenario, the products are shipped directly from Party A to Party C, with Party B acting as an intermediary and never physically receiving them.
When multiple parties are involved in a supply chain, the VAT treatment of each transaction must comply with VAT regulations. For accurate VAT determination in a cross-border chain transaction, the VAT-relevant data between the involved company codes (A and B, in this instance) must be linked in real-time. This is necessary because Standard SAP typically only processes transactions within one specific company code (either A or B) .
Technology-Related Tax Risk: Understanding and Addressing the Potential Harms and Benefits of New Technology
When companies engage in cross-border transactions and establish complex business models, it is essential to properly configure their ERP systems—though the extent of this configuration may vary. One common scenario involves the principal physically delivering goods directly to the final customer, referred to as a drop shipment.
This process typically results in only one recorded physical movement of goods, or 'goods issue,' in the ERP system. However, it necessitates the issuance of two invoices:
- One invoice from the Principal to the LRD or Commissionaire.
- Another invoice from the LRD or Commissionaire to the final customer.
In these instances, the correct 'ship from' information for the LRD and Commissionaire levels may be lacking in the ERP system. Consequently, the VAT treatment of transactions is determined based on the 'ship from' and 'ship to' information associated with the Principal rather than the intermediary entities. This oversight can lead to inaccurate VAT treatment, particularly in cross-border transactions when using SAP.
As a result, properly configuring tax determination logic within the ERP system can be challenging and requires careful attention to ensure compliance with VAT regulations. Addressing these configuration issues is crucial for mitigating potential tax-related risks that may arise from new technology implementations.
Identification, assessment and implementation
There are all kinds of business reasons for setting up centralized models. The challenge from an implementation perspective is often indirect tax. Once a commercial and tax-efficient structure is determined— one that addresses both historical and potential risk - it is time to take the theory behind the structure into the realm of practice.
BEPS and Tax
Action 7 – prevent the artificial avoidance of PE status
The final BEPS report includes changes to the definition of PE for income taxes of Article 5 of the OECD Model Tax Convention. Action 7 broadens the threshold to determine when such PE status exists. Currently, such a PE status does not exist for commissionaire arrangements and the specific activity exemptions in treaties, such as warehousing, purchasing and “preparatory and auxiliary activities.
The indirect tax definition of a fixed establishment (FE) is different from a PE and has its foundation in EU VAT law, and should therefore not be affected by the BEPS initiative or OECD definition. Some countries, however, do (still) not accept the absence of a FE once a PE has been established.
Note that the amount of PEs will increase when "Action 7" is in force (e.g., commissionaire, overseas warehouses, toll manufacturing, marketing agents, consignment stock). For example, this risk of PE increases when an agent is actively involved in generating sales locally and that activity directly results in a binding contract.
Moving away from the commissionaire structure
As businesses are facing global challenges, it makes sense that the existing business model is reevaluated and amended when necessary to meet the new PE environment. That most likely means moving away from a commissionaire structure. The principal company sells to a master sales company (e.g., in the same country as the principal company) under an LRD agreement, and the master sales company resells through its local branches.
Adapt to change in time
Determine the impact of such changes on the company's supply chain and/or location of its tax functions. This could result in new set-up of ERP system and invoicing, new contracts, pricing procedures, processes and controls. Critical success factors are:
- Senior management support for change: 'Tax model should be based on business case and not vice versa'
- Existence of a solid and compelling integrated business case for the structure
- Sound, structured and proven design and implementation process driven by rigorous Project Management
- Complete understanding of the facts, objectives, transaction flows, business process and legal structure
- Early focus on integration with IT systems and operations
- Early buy-in to the “transformation” by management and those groups affected ('Change Management')
- Allocation of adequate resources by the company to manage and implement the project
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The objective is to bring commissionaire arrangements within the framework of dependent agency PE
Transitioning the Sales Middleman Role from Commissionaire to Limited Risk Distributor (LRD)
The starting point for converting from a Commissionaire to an LRD from an ERP perspective is to assess how the current Commissionaire model is configured in the operational state.
Below are two different implementations of a Commissionaire setup in SAP:
- Revenue Accounting by the Principal: In this approach, the revenue generated by the Commissionaire is recorded directly by the Principal, with all relevant master data managed by the Principal. This setup has led to manual adjustments for VAT reporting, which has become a significant bottleneck. For VAT purposes, a Commissionaire is treated as a buy/sell entity. While the VAT treatment for Commissionaires and LRDs is fundamentally similar, the legal flows differ. The VAT classification conflicts with the legal reality, as the Commissionaire sells in its own name but on behalf of the Principal; legal title of the goods transfers directly from the Principal to the customer. Consequently, this bottleneck often necessitates multiple manual corrections to ensure accurate VAT reporting.
- Buy-Sell Configuration: In this scenario, the Commissionaire is configured as a buy-sell entity, utilizing the Commissionaire's master data. While VAT treatment may be accurate under this setup, the underlying legal framework is misaligned, as the revenue actually belongs to the Principal, and the Commissionaire merely receives a commission from the Principal.
If the first option has been implemented and there is a transition to an LRD model, it will be necessary to transfer master data from the Principal to the local LRD. Consequently, the VAT determination logic for the LRD’s business transactions must be designed and thoroughly tested before the LRD can operate effectively.
On the other hand, if the second option has been utilized, the transition to an LRD may be somewhat more straightforward. In this case, the business transactions between the Principal and the LRD, and then the LRD and the Customer, will involve the transfer of legal title, which simplifies the conversion process.
Key considerations
Below the relevant work streams and an example of each to consider:
- Corporate Income Tax - e.g. assess impact on local direct taxes
- Transfer Pricing - e.g. amend current TP documentation to reflect change of CMRs to LRDs
- VAT - e.g. different accounting rules for LRDs compared to Commissionaires may significantly impact current SAP logic
- Customs - e.g. need to investigate impact of adjusted transfer prices to Customs valuation
- Legal - e.g. terminate commissionaire agreement
- Technology - e.g. implement LRD in SAP and be aware that full VAT AP and AR automation for also the most complex transactions, real-time access to numbers / blueprint of business model (integrated in SAP: data analytics) and automated VAT controls are all possible
The Importance of Data Access for Finance and Tax Functions
Both finance and tax departments need access to comprehensive data that illustrates how transactions are processed and how IT systems are organized. Data integrity becomes a significant operational risk when transactions booked in a particular country are not adequately evaluated for tax purposes.
There are instances where the financial data within the system fails to accurately represent the business model design, or changes are not effectively managed. Additionally, current processes often make it challenging to access the relevant tax data necessary for reporting to regulators, investors, and tax authorities in each business unit and country where the company operates.
Furthermore, the VAT work stream should be seamlessly integrated with technology initiatives and finance projects. This integration may pose challenges, as many projects related to system development and technological advancements often remain opaque to the tax function. This highlights the critical need for transparency and proactive communication across departments.
If the tax function does not align with initiatives that may impact VAT processes, it risks creating a VAT design that is inefficient and not ideally suited for the business's needs. Implementing effective alignment measures is essential to ensure a streamlined VAT process that meets regulatory requirements and supports the overall business objectives.
Cross Border Movements in SAP
Some of the questions that can help you determine the impact of VAT before migration
- Do we have sufficient insight into current VAT processes including all manual adjustments, workarounds and internal quality assurances processes?
- Are the processes specific and well-documented, and are they adequate for the new environment?
- Do we understand the scope of personnel changes that may occur as we migrate?
- Have we captured all the relevant knowledge from personnel who may decide to leave the organization?
- Are we retaining access to and information about existing manual processes and procedures and offline solutions?
- To what extent do current processes depend on local VAT expertise and technology? How much will be lost in the event of a change or transfer?
- To what extent are different processes required from one jurisdiction to another?
- Who has final responsibility for the VAT compliance process at present, and who will own it upon transfer to the new model?
- Where are the essential process controls being carried out?
- How does the new model deal with local VAT risks in terms of internal communication and coordination?
