Maintaining tax-sustainable value chains Maintaining tax-sustainable value chains

Many businesses face significant challenges to ensure their transfer pricing policies are still aligned with their business models, and that these fit for purpose going forwards. KPMG’s Value Chain Analysis can enable companies to assess these gaps & ensure an optimized and tax sustainable outcome.

Business models continually evolve as companies react to changes and reposition themselves to avoid emerging risks and to seize opportunities. Many companies have made use of new technologies, digitalizing their business operations, shifting towards more direct-to-customer models, where platform–based business models are eliminating distributors and intermediaries, and increasingly relying on software and data to provide customers with new and better solutions.

These drivers of change allow companies to pursue new economic opportunities in virtual markets, and to mix their product and service offerings, with the consequence that contributors to value creation are becoming increasingly blurred.

Over time, these accruing changes can transform everything about the business model – that is, how the business earns and distributes its profits, how it invests and how it deploys its capital.

Simultaneously, external factors are forcing companies to rethink their business operations, and among these the Covid-19 pandemic is at the forefront. The outbreak has accelerated the adoption of some of the trends seen above, while also creating new issues such as increasing trends towards flexible working that companies must monitor carefully.

The unprecedented impact of the pandemic has led to practical challenges for many companies. During this period, multinational enterprises (“MNEs”) have been forced to adapt their business models and have experienced significant changes in their organization. The dispersion of key personnel into different jurisdictions which occurred during the pandemic could also have led to reallocation of functions, resulting in increased risk of permanent establishments.

In the same vein, MNEs have had to re-think the allocation of the risks that materialized over the course of the pandemic across group entities (and the resulting costs, such as lockdown costs).

The importance of assessing the impact that these changes have on MNEs is further exacerbated by the confluence of existing and impending tax considerations such as BEPS 2.0, EU-style digital services taxes and unilateral tax reform in many jurisdictions. 

Whilst the driver for these changes are for taxes to be paid where value creation occurs, allowing the fair taxation of profits generated by businesses that do not have a physical presence in the market jurisdiction, they create complexity in terms of increased compliance and administration, and uncertainty on the potential impact for many businesses, at least in the short term. 

MNEs whose organizations are not compliant with these requirements face, in addition to potential tax inefficiencies, reputational and financial risks, which are magnified by the recent initiatives aimed at increasing tax transparency for taxpayers. 

Although these changes affect all companies with international operations, those which will be particularly impacted include:
 

• Companies with a high level of Intellectual Property (“IP”): these companies must be able to clearly define what the key activities are in order to create IP, what impact the IP has on business operations and how the IP is actually generating profits, what contributions other companies make to increase the value of this IP, and, most importantly, whether the allocation of IP-related profits between the group entities involved is aligned with their contribution.
• Companies undergoing a change in their business model: In this scenario, companies need to accurately map out how the changes are impacting their value chain (e.g. change in product offering or type of customer base, change in distribution channels). In practice, it must be clear what the new value drivers are, how these operate within the value chain, and what activities each entity is performing from a holistic point of view.
• Companies operating in industries subject to market disruption: The advent of new technologies has changed the way companies in many industries interact with customers and generate value (e.g. industries where services are provided to customers using platforms). 
• Companies with principal structures: Maintaining a principal structure allows companies to maintain a high degree of operational and tax efficiency. However, given increasing trends towards allocating value towards market jurisdictions, companies will need to ensure these structures can be defended and are tax sustainable going forwards.

• Rethink tax planning: Now more than ever, companies are required to integrate their tax planning into business operations to help them improve their growth, reduce expenses and risks, increase return on investments, and drive efficiencies across operations.
• Ensure tax efficiency: Alignment of the tax position with the business model is not sufficient to ensure tax efficiency. MNEs need to identify their current value drivers and confirm that sufficient substance via functions, assets, risks, personnel and processes are in the appropriate locations to be remunerated and taxed in an effective and sustainable way. 
• Assess specific risks: Monitoring the compliance with BEPS, and anticipating the impact of BEPS 2.0 and unilateral tax reform is essential. Tax transparency will define the coming years and it is necessary that MNEs present their value chain related information in a consistent manner within different jurisdictions.
• Adjust Transfer Pricing models: Determining which transfer pricing model is suitable for the specific business operations carried out is pivotal. Transfer pricing models, or the underlying operations, may be adjusted to provide substance where needed the most.

Value Chain Analysis (“VCA”) is an ideal methodology for quantifying risk levels and ensuring that tax planning is structured in a compliant and tax-efficient manner. VCA allows companies to:
 

• Assess the status quo and determine potential gaps between their transfer pricing policy and their business models. 
• Define the appropriate transfer pricing model and level of substance required in each location to ensure that profits are taxed effectively at a group level.
• Proactively assess BEPS risks and prevent/resolve disputes, by providing a clear, holistic view of how the MNE creates value, which can be used.

In order to maximize tax efficiencies, and reduce tax risks associated, it is important to follow VCA’s multi-step approach. More specifically, companies can focus on:
 

• Mapping their operating model, identifying the key value drivers of the business and allocating the contribution activities, roles and assets to each activity.
• Assessing the relative value of the activities from a holistic perspective and determining gaps and opportunities.
• Designing the targeted operating model or pricing realignment, considering operational efficiency, tax sustainability and conversion complexity, determining the impact, and implementing the most effective option.