Next year, the European Union will expand to include 25 countries – and nearly 500 million people; goods, services, capital and labour will move freely in a single market covering most of Europe.
Throughout the EU, businesses will seek to reengineer their supply chains to take advantage of enlargement. They might aim to reduce Europe-wide stock levels, lead times and production costs, or to increase productivity and improve customer service. But in the process, they should not neglect tax issues. Supply chain initiatives may deliver far greater benefits if tax planning is added to the process.
Many EU businesses have already learned this lesson, and have adopted tax-effective supply chains. Enlargement might allow them to extend these initiatives eastwards.
On 1 May 2004, 10 new countries will become EU Member States – Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovak Republic and Slovenia (currently referred to as the ‘Accession Countries’).
This is the largest single expansion of the EU since it was founded. It is also the first time that former Soviet bloc countries have joined the EU club. The rules for investing in and trading with the Accession Countries will change overnight. As a result, many current wisdoms about European supply chain management, and about tax planning for these countries, must be revised.
Traditional supply chain management addresses the flow of materials and products, information, cash, and work from the point of first supply across the enterprise, to the customer, and back. Operational and financial efficiency – in terms of simplicity, consistency and cost effectiveness – usually takes the lead.
Tax effective supply chain management (or TESCM) integrates tax planning into the process. The results can be powerful. TESCM can more than double the benefits of corporate restructuring, measured in terms of after-tax income or free cash flows, compared with supply chain initiatives or tax planning solutions adopted in isolation.
In the TESCM approach, an optimal tax structure should be defensible, effective and simple. Tax planning should be based on the structure and strategy of the business. The starting points should be its business requirements, the existing substance and any restructuring plans. The revised tax and legal structures should be based on – and aligned with – business processes and should not simply be taxdriven.
The revised structure should also deliver sustainable tax deferrals or effective tax rate reductions. Significant tax savings are often available when major business change initiatives are undertaken, especially when multinationals move from nationally focused business units to a regional or global model. Tax savings of between six and 12 per cent of operating profit are not uncommon.
Typically, tax benefits may be achieved by reallocating functions, risks and assets with relatively high value contributions to a tax-favorable jurisdiction, in combination with other tax planning solutions.
Some typical features of a TESCM structure are outlined in the table opposite.
The TESCM approach may benefit any company that operates internationally and needs to improve its operating performance or to reduce its effective tax rate. Typical conditions where TESCM may add value include: where there is a high growth rate or a high effective tax rate relative to competitors; where losses in overseas subsidiaries are driving up the effective tax rate; where there is a high value of cross-border movements of goods and services; or where there are large numbers of cross-border transactions.
The TESCM approach may add value many ways. Integrating tax considerations into the business change processes allows management to optimise shareholder value and tax effective financing also ensures that cash flow is freely accessible within the group. Also, the effective management of indirect taxes may result in cost reductions and release significant cash flow.
Many businesses will want to streamline supply chains to reflect the new map of Europe. At the same time, the Accession Countries’ tax systems are undergoing enormous upheaval. Tax harmonisation is a cornerstone of the single market. As a result, in all Accession Countries, old domestic tax rules, protective tariffs, bilateral customs agreements and local tax incentives are being swept away. They are gradually being replaced by EU legislation and case law – as well as EU-approved tax benefits.
The main effects of this will be felt in indirect taxes – customs and Value Added Tax (VAT) – which are highly harmonised at the EU level. Each Accession Country must now adapt its domestic laws and practices to reflect the EU rules, both for international trade and for domestic transactions. For example, no border formalities or duties will apply to goods ‘imported’ from other EU countries and EU-wide customs procedures and rates will apply to goods imported from outside the European Union. The new rules will facilitate EU trade and speed up supply chains. However, they will also impose new VAT compliance requirements that may prove onerous, especially to corporate groups that operate in all 25 member states.
Changes will also apply to corporate taxation. Many current tax incentives and tax holidays for nonresidents will be abolished or phased out. At the same time, EU rules will apply to cross-border mergers and to intra-group transactions. Changes are also expected in the future for cross-border payments of interest and royalties.
In recent years, many European and US multinationals have restructured their European operations to achieve tax effective supply chains. However, the Accession Countries, especially in Central and Eastern Europe (CEE) were often left out of TESCM initiatives, or had to be treated separately. The reasons for this included legal or logistical barriers (for example, because of customs borders and tariffs), or the fact that the indirect tax systems in CEE were unfavorable to foreign non-resident companies. For example, VAT (at an average rate between 20 per cent and 25 per cent) was either a non-recoverable absolute cost or took a long time to recover.
CEE production also frequently had its own tax effectiveness based on local tax holidays and incentives.
Crucial tax changes
However, certain crucial tax changes and economic effects of EU enlargement may now change the impact of TESCM for CEE and it is the consideration of some of these factors that constitutes the last part of this article.
Many tariffs for EU imports and exports were already abolished during the 1990s; bringing down the last barriers will give impetus to finally creating seamless supply chains throughout the enlarged Union. Another important facilitator for increased cross-border product flows will be the standardisation of quality and labeling requirements.
Also, the Accession Countries will have to adopt the common EU tariffs for imports from outside the Union. Generally, tariffs for agricultural products will increase whereas tariffs for heavy industrial equipment may fall. In combination with several Accession Countries considering the implementation of relatively low general tax rates, following the Irish example, the reduction in tariffs may provide opportunities for European procurement for companies in the heavy industry sector.
With the adaptation of EU-applied VAT rules, the indirect tax cost of placing CEE operations in a TESCM structure will decrease significantly. For example, the non-recovery of VAT should largely stop (with the exception of businesses established in certain non-EU countries that do not have VAT reciprocity agreements with the Union). Also, the timeframe for obtaining such refunds should become far shorter. At the same time, certain legal concepts such as commissionaire should become easier to implement, since the EU’s VAT rules specifically discuss commissionaire arrangements.
While certain CEE tax holidays or incentives may be granted a grandfathering period of some years, the EU has made it clear that the new members must adopt the standards of the EU State Aid Rules and the EU Code of Conduct, and may not continue their current practices. Hence, multinationals will have to consider adopting the same measures in the CEE that they have already taken in the European Union. In many cases, extending existing structures (such as the use of consignment manufacturing for a Swiss principal company), to operations in the new EU member states would also have the benefit of standardising procedures within the multinational itself.
The expected increase in purchasing power in the new EU countries in the years following accession will probably require a beefed-up market presence beyond mere representative offices. As for manufacturing, concepts such as agency, commissionaire or limited risk distribution may be considered, as sales income will become subject to tax locally. And some of the new member states may actually become distribution stepping-stones for markets further east. For example, Poland and the Baltic States may be used to reach the Russian market, or Slovenia could provide access to Serbia-Montenegro, Croatia and Bosnia.
Services and know-how
Depending on the nature and speed of developments with respect to wage levels and education, changes may be expected in the nature of the CEE economies. It is expected that they will move from relying on low-cost manufacturing to being more driven by services and know-how. Some of the new EU members are, and will become even more, attractive locations for regional or pan-European shared services centers or R&D centers.
So, in conclusion, EU enlargement may not bring a wave of revolutionary change in the accession region, as much has already been achieved in adapting to EU norms during the past decade. However, all Accession Countries are expected to expand their economies substantially as a result of enlargement. Also, the tax, legal and business environments will change as each Accession Country becomes fully integrated. Multinationals in particular may be able to consider options to make the best of these opportunities in a tax effective way. Companies that have already adopted TESCM structures in the current European Union will be well positioned to leverage those structures into the new EU territory.
Owen Crassweller leads Ernst & Young’s UK Transfer Pricing and Tax Effective Supply Chain Management practice and is a member of the firm’s global transfer pricing leadership. For more information on EU enlargement look in the Issues and Perspectives section of the Ernst & Young website at www.ey.com