Tax Strategies Practical Latin American Hub-and-Spoke Arrangements May Result in a Rough Ride—

. . . as appeared in . . .
Practical Latin American
Tax Strategies
WorldTrade Executive, Inc.
The International
Business Information
SourceTM
Report on Tax Planning for International Companies Operating in Latin America
June 2008
Volume 11, Number 6
Hub-and-Spoke Arrangements May Result
in a Rough Ride—
Tax Issues Facing Supply Arrangements in Latin America
By Victor Cabrera, Jose Leiman, and Marc Skaletsky (KPMG LLP)
Over the past decade, many large multinational corporations (MNCs) have been moving their European and Asian operations from a decentralized group of stand alone full-fledged
manufacturing and distribution (M&D) subsidiaries towards a
“hub-and-spoke” system. Under these arrangements, the hub
(the “Principal”) assumes functions and risks from the M&D
subsidiaries. This centralization of functions and risks in the
Principal hopefully brings a commensurate share of consolidated
profits.1 The conversion of full-fledged M&D subsidiaries to a
hub-and-spoke arrangement raises a series of non-tax and tax
considerations and associated issues that must be resolved in
order to implement the structure successfully.
Given the potential benefits of the hub-and-spoke structure,
many MNCs have sought to implement the structure for their
Latin American operations. However, when MNCs cast their
sights on Latin America, they are quite often faced with a diverse
and sprawling network of jurisdictions, each with its own rules
and views on the operation of structures within their borders.
Many MNCs doing business in Latin America learn that applying the European or Asian hub-and-spoke template to Latin
America does not always result in a natural fit. In particular,
MNCs that seek to implement a hub-and-spoke arrangement
in Latin America must deal with the regional issues described
below.
First, the determination of where to locate the Principal is
not as easy in Latin America as it is in Europe or Asia. The ideal
hub would be located in the region, have a low internal tax rate,
and enjoy a strong treaty network. Moreover, to the extent that
the MNC is U.S.-based, the potential to defer profits from U.S. tax
is preferred. Unfortunately, no country satisfies all these criteria;
therefore, MNCs need to optimize the location of the Principal
based on their specific facts.
Second, Latin America lacks the economic integration of the
European Union. As a result, MNCs operating in Latin America
are forced to deal with authorities that take a provincial perspective on revenue collection at the cost of market efficiencies. In
considering value-chain reorganizations in the region, MNCs
must take into account the peculiarities of each jurisdiction
and the current and evolving tax environment in the applicable
countries. As with structures throughout other regions, it is
important that an underlying business rationale drive the value
chain reorganization within Latin America.
Practical Latin American Tax Strategies
A third important factor is the ever increasing aggressiveness of the Latin American tax authorities. This aggressiveness
manifests itself in a variety of forms. For example, many tax
authorities in the region are attempting to assert “substance
over form” principles to challenge structures that they consider
“aggressive.” Even if they cannot successfully attack the overall
structure, the tax authorities may attempt to draw profits back
into their tax nets by asserting that the Principal has a local taxable presence or permanent establishment (PE). As electronic tax
filing requirements and information sharing among the authorities increase in the region, the tax authorities have greater tools
in their audit arsenals to press these arguments.
The foregoing factors require taxpayers to place their Latin
American supply chain structures on a solid footing from a tax
perspective. Mitigating unnecessary tax risks and unwelcome
local publicity are, needless to say, high on the agenda of every
MNC’s senior leadership team. With these considerations in
mind, the MNC should ensure that it incorporates the elements
described below into any supply chain conversion.
First and foremost, economic substance is an essential component of any supply chain conversion. As previously noted,
MNCs must be sensitive to a “substance over form” argument
by the Latin American taxing authorities. This means that any
restructuring of existing operations should produce substantial
operational changes and a corresponding adjustment to the parties’ potential for profits and risk of loss. A prudent MNC contemporaneously documents the business reasons for the restructuring
and its anticipated economic impact on the enterprise. Anticipated local tax savings is typically not a valid business reason for
local purposes. Moreover, savings generated by lower customs,
VAT and payroll taxes will often not be considered an adequate
business purpose absent a demonstration that the Principal has
assumed substantial business functions and risks. The business
reasons supporting the conversion ideally should include both
commercial and operational benefits. Contemporaneous documentation of the business reasons behind the restructuring of the
value chain is important for the MNC to maintain and will be
very important if and when the arrangement is ever challenged
by the taxing authorities on audit.
Even a structure with economic substance may, however,
have adverse tax consequences if the parties’ new arrangements
are not supported by a robust and geographically focused transfer
© WorldTrade Executive, Inc. 2008
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pricing study. For this reason, the migration of functions and risks
from local M&D subsidiaries to the Principal must be supported
by an analysis demonstrating that the parties’ post-conversion
potential for profit and loss is commensurate with their postconversion functions and risks. Moreover, the analysis should
demonstrate that the conversion does not result in a transfer of
value from M&D subsidiaries to the Principal. What this means
is that any reduction in the M&D subsidiaries potential for profit
must be balanced with a commensurate reduction in their risk
of loss.
In reducing the M&D subsidiaries’ risk of loss, the MNC
should be careful that it does not transform them into agents of
the Principal that are guaranteed a return for services, regardless of their performance. If the M&D subsidiaries are viewed
as agents of the Principal, the Latin American fiscal authorities
may assert that the Principal has created either a PE under the
provisions of a bilateral tax treaty, or an internal tax presence or
nexus in the absence of a tax treaty.
The following discussion explores the aspects of the typical
Principal M&D arrangement to its three primary classes of participants: the Principal, the Manufacturers, and the Distributors.
The Principal
The Principal is the key entrepreneurial risk taker for the
group in the region:
• It typically assumes risks associated with items such as
foreign exchange, inventory, long term pricing, accounts
receivable, and warranties.
• It typically assumes the economic burdens and responsibilities associated with coordinating business activities in the
region (e.g., long-term fiscal issues, research and development, strategic sourcing, manufacturing processes, demand
forecasting and production scheduling, marketing and
sales).
• It often holds rights to the use of intangible property (e.g.,
trademarks, patents, know how) necessary to conduct operations. The Principal sometimes assumes economic responsibility for the identification, development, and exploitation
of typically valuable intangibles.
The Principal’s responsibilities often include:
• Developing and implementing business, operational and
related administrative strategies (e.g., marketing, supply
chain, finance, HR, legal) associated with the business of
the Principal. These strategies may include product management, including the introduction of new products, and
regional marketing and advertising.
• Owning all finished product inventories.
• Overseeing the manufacturing process including management of the risk of loss and the making of payments to the
Manufacturers.
• Funding major company investments and carrying all related services costs.
As mentioned above, the ideal location for a Principal in a
hub-and-spoke structure is a country that provides a good location for centralizing regional management, has a low internal
tax rate, and enjoys a broad and favourable treaty network.
Unfortunately, unlike Europe and Asia, Latin America does not
currently have a country that generally satisfies all of these criteria. Thus, MNCs are often required to balance these factors based
© WorldTrade Executive, Inc. 2008
on their specific circumstances. For example, the United States
might be used as the Principal location for Mexican maquiladora
manufacturing, even though the use of a U.S. principal does not
permit the deferral of U.S. tax.
Manufacturing Arrangements
The Principal enters into contracts with regional Manufacturers for the production of goods. In this article, we will examine
two potential manufacturing arrangements: toll manufacturing
(e.g., maquiladoras in Mexico) and contract manufacturing.
Toll Manufacturing
Under a toll, or consignment, manufacturing arrangement,
the toll manufacturer (Toll Manufacturer) processes raw materials
owned by the Principal into finished products. The Toll Manufacturer follows the Principal’s orders and specifications relating to
its tolling services. The Toll Manufacturer is often related to the
Principal. Because the Toll Manufacturer does not own the raw
materials, work-in-process, or finished inventory, this alternative
does not involve an inter-company sale of finished goods.
The Toll Manufacturer’s local responsibilities usually are
limited to:
• Following principal’s instructions
• Owning, maintaining, and investing in plant and equipment
• Hiring and training its required labor
• Processing goods
• Managing product quality
• Planning production
• Acting as a purchasing agent in some cases
It is important that the transfer pricing analysis for the arrangement detail the functions undertaken, risks assumed, and
assets deployed by the Toll Manufacturer. Since a Toll Manufacturer does not assume the function and associated risk of purchasing raw materials or holding inventory, the Toll Manufacturer’s
expected income would generally be less than the expected
income of a contract manufacturer. A key reason for this lower
expected income is that a contract manufacturer, in contrast to a
Toll Manufacturer, assumes economic risks and investment associated with the raw materials and work-in-process inventory
and therefore should expect to earn a higher economic return.
Mexico is a primary example of a jurisdiction where toll
manufacturer arrangements are commonly used. Maquiladoras
are Mexican companies that can produce goods for Mexican and
non-Mexican companies pursuant to a toll manufacturing agreement. The Principal ensures that the maquiladora receives the raw
materials necessary for production and the maquiladora exports
the finished product pursuant to the Principal’s instructions.
In the case of Mexico, the raw material sourced outside of
Mexico for the maquiladora enters Mexico with no import duties
and no value-added taxes (VAT). Local purchases of raw materials
also should not be subject to Mexican VAT. The foreign Principal
engaging and contracting with the maquiladora is protected
under Mexican law from being deemed to have a permanent
establishment for regular income tax and flat tax (IETU) purposes
provided all the maquiladora’s production is for export.
Accordingly, a properly structured maquiladora arrangement should neither trigger Mexican regular income tax nor the
new flat tax to the Principal provided production is for export.
The earnings of the maquiladora itself, however, will remain
June 2008
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taxable to the higher of regular Mexican income tax or IETU.2
Toll manufacturing raises a number of issues in Latin American countries other than Mexico. For example, if the Principal
needs to import raw material into the Toll Manufacturer’s country, it may be required to obtain an import license. However, the
Principal may be deemed to have created a taxable presence (or
PE exposure) by virtue of holding the import license. In other
cases, the Principal may be considered to have created a taxable
presence (or PE) in a country merely by holding inventory in the
country. As a result, ideal jurisdictions for the toll manufacturing
structure will have legal provisions that contain a temporary
importation or a free trade zone regime.
VAT raises a second set of potential difficulties. Imports and
local purchases of raw materials (for toll manufacturing use) by
the Principal may trigger input VAT which may be unrecoverable without the Principal registering as a VAT taxpayer that
could trigger a tax presence (or PE exposure) by the Principal.
Depending on the jurisdiction, the Toll Manufacturer may need
to charge the Principal local VAT for services performed for the
Principal. Typically, the Principal cannot recover such VAT.
Contract Manufacturing
In the typical contract manufacturer (Contract Manufacturer)
arrangement, the Contract Manufacturer purchases (takes title to)
the raw material and then sells the finished goods to the Principal
for cost plus a small profit margin.
In the past, because of concerns about the Principal creating a
taxable presence or PE in the country of manufacturing, contract
manufacturing arrangements have generally been preferable to
toll manufacturing arrangements in Latin American countries
other than Mexico. However, the ability of U.S.-based MNCs to
mitigate foreign base company sales income using contract manufacturing arrangements was generally considered to require that
the Principal maintain the benefits and burdens of ownership of
raw materials and work-in-process inventory during the conversion practice.3 While this could be achieved through contractual
provisions, U.S. MNCs walked a tightrope between creating a
local taxable presence and achieving U.S. tax deferral.
Under the new contract manufacturing regulations proposed
by the IRS on February 27, 2008,4 a Principal would no longer
be required to be treated as the tax owner of raw materials and
work-in-process inventory in order to achieve tax deferral. Instead, the proposed regulations adopt a facts-and-circumstances
test under which a Principal can be treated as having manufactured personal property—and thus mitigate generating foreign
base company sales income—if it is considered to have made a
“substantial contribution” to the manufacture of the property.5
As a result, U.S.-based MNCs should review their current Latin
American contract manufacturing arrangements to see if some
modifications will be desirable once those regulations are finalized in order to reduce the risk of establishing a local taxable
presence.
From a Latin American perspective, contract manufacturing
arrangements are attractive to Principals in many Latin American
jurisdictions for the following reasons:
• The arrangement should not generate any unrecoverable
VAT issue for the Principal since purchases of raw material
are by Contract Manufacturer for its VAT account. Caution
is advised where the Principal assumes the economic risks
associated with inventory ownership. Special care should
Practical Latin American Tax Strategies
be taken to make sure that the Contract Manufacturer can
recover input VAT when inventory is sold to the foreign
Principal and that the Principal is not subject to an input
VAT on purchases of finished product (inventory) from the
Contract Manufacturer.
• Provided the Principal does not assume inventory economic
risk, neither tax presence nor PE exposure issues should arise
for the Principal, since the Contract Manufacturer owns the
raw materials, work-in-process, and finished goods inventory.
The transfer pricing analysis for the Contract Manufacturer
should reflect the functions the Contract Manufacturer performs
and risks the Contract Manufacturer bears. Special care should
be taken to clearly define in the contract manufacturing agreement the allocation of risks between the Contract Manufacturer
and the Principal. Both the contractual allocation of risks and
the conduct of the parties should be consistent with the goal of
not creating a taxable presence for the Principal in the country of
manufacture. Unlike in the toll manufacturing case, the Contract
Manufacturer should earn a return for its investment in raw
material–inventory.
Distribution Arrangements
A Distributor is responsible for marketing and distributing
the Principal’s finished products to customers. The Distributor is
often related to the Principal. Below, we examine two potential
Distributor arrangements: commission agent arrangements and
limited risk buy-sell distributor arrangements.
Commission Agent Arrangements
A commission agent (Commission Agent) is a limited risk
commercial entity that acts essentially as sales and marketing
agent for the Principal. It sells finished goods on behalf of the
Principal and earns a commission. Typically, the Commission
Agent’s relationship with the Principal is disclosed to the customer. Under this distributor arrangement, the Principal owns the
inventory. The Commission Agent issues invoices in the name of
the Principal. The Principal transfers legal title to the customer at
time of sale. The Commission Agent’s responsibilities typically
include:
• Hiring and training sales staff
• Conducting local marketing and advertising within parameters established by the principal
• Developing and maintaining the local customer base
• Determining customer requirements
• Providing product and market information to the Principal
• Soliciting, negotiating, and closing sales based upon price
parameters set by the Principal
The Principal’s potential tax issues with using an in-country
Commission Agent as distributor are that the activities of the
Commission Agent may create a taxable presence (or PE) for the
Principal. Moreover, the commission the Principal pays to the
Commission Agent will often generate an unrecoverable input
VAT for the Principal.
Limited Risk Buy/Sell Distribution
Arrangement
Because of concerns related to creating a taxable presence
(or PE) for the Principal, a limited risk buy/sell distribution ar-
© WorldTrade Executive, Inc. 2008
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rangement with the Principal may be preferable to a commission
agent arrangement in most Latin America countries. Under this
arrangement, the Principal sells the finished goods to the local
country Distributor.
Generally, the key to mitigating unwanted tax exposure to
the Principal is that legal title to goods pass to Distributor from
the Principal.
Under this type of arrangement, the distribution agreement
typically provides that the Principal bears most commercial risks
(e.g., inventory, warranty, foreign exchange), and the Principal’s
mark-up on sale to the Distributor reflects these commercial risks.
The Distributor’s profit margins should be higher than for a
Commission Agent, since title is passed to the Distributor and the
Distributor bears an investment in both inventory and accounts
receivable. However, because the Distributor bears less risk than
under a full-risk distributorship, its expected profitability should
be lower and the Principal’s should be commensurately higher.
Although limited risk buy/sell distribution arrangements are
often preferable to commission agent arrangements, there will
be an increased level of tax scrutiny in countries where local
taxpayer’s taxable income declines materially. To mitigate tax
exposure, the transfer pricing report needs to analyze on a country-by-country basis the current types of activities undertaken
and risks borne.
The Principal’s key tax benefits from the use of a limited risk
buy/sell distribution arrangement should include:
• No unrecoverable import VAT issues for the Principal since
the Distributor bears import duties as well as input VAT
upon the acquisition of the goods from the Principal. The
Distributor should be able to recover input VAT upon the
sale of the goods to its customer.
• The activities of the Distributor should not trigger tax presence (or PE exposure) for Principal, provided the parties
respect the Distributor’s function and risks as a bona fide
buy-sell distributor. Both the distribution agreement and the
parties’ transfer pricing analysis should include a detailed
description of the risks the Principal and Distributor bear.
The parties must act in accordance with the distribution
agreement and the Principal should not take any action that
may result in it having a tax presence or PE in the country
of final sale.
Summary
Establishing a hub-and-spoke supply chain arrangement in
Latin America is much more challenging than has been the case
for MNCs doing business in the Europe or Asia, where such arrangements have been common for several years. MNCs entering
Latin America or considering the restructuring of established
operations there need to carefully structure their value-chain arrangement for the region in such a way that they do not generate
unnecessary tax risks or unwelcome local publicity. The business
reasons for any restructuring should be contemporaneously
documented in order to put the MNC in a position to defend the
arrangement in the event of scrutiny by the local tax authorities.
Moreover, MNCs that currently have contract manufacturing
arrangements in the region should review them in light of the
new U.S. proposed contract manufacturing regulations.
1. Because the Principal becomes the residual risk taker, it is not
guaranteed any profit. However, if the group is profitable in the
long run, the Principal should earn a profit commensurate with
© WorldTrade Executive, Inc. 2008
the risk it has assumed. Moreover, the centralization of risks in
the Principal, and the corresponding de-risking of the M&D subsidiaries, creates a “portfolio effect,” i.e., the centralization of risks
in the Principal both reduces the risk of individual M&D entities
suffering losses and increases the likelihood that the Principal
will be profitable on an overall portfolio basis.
2. It should be noted that special rules apply when part of the
production is for Mexican consumption.
3. Foreign base company sales income is a category of subpart
F income, which a U.S shareholder of a controlled foreign
corporation (CFC) must include in income currently. Foreign
base company sales income generally results where (1) a CFC
purchases personal property manufactured outside it country of
incorporation and re-sells it for use, consumption or disposition
outside its country of incorporation and (2) either the party from
which the CFC purchased the property or the party to which the
CFC sells the property is (or both are) “related” to the CFC. See
I.R.C. §954(d)(1). A CFC could mitigate foreign base company
sales income, however, if it was considered to have manufactured the property. Under former guidance, this was generally
considered possible only if the CFC had the benefits and burdens
of ownership of the property during the conversion process. See
Rev. Rul. 75-7, 1975-1 C.B. 244, revoked by Rev. Rul. 97-48, 1997-2
C.B. 89. See also Priv. Ltr. Rul. 87-49-060 (September 8, 1987); Priv.
Ltr. Rul. 87-39-003 (June 17, 1987).
4. The proposed contract manufacturing regulations are at 73 FR
10716-01 (Feb 28, 2008) and corrections have also recently been
published at 73 FR 20201-01 (Apr 15, 2008). A comprehensive
article discussing the impact of the proposed regulations titled
“Contract Manufacturing: Is the War Over?” written by Stephen
Bates and Derrick Kirkwood was published in the April 7th issue
of Tax Notes International.
5. Prop. Treas. Reg. §1.954-3(a)(4)(iv). In order to be considered
to have made a substantial contribution to the manufacturing
process, a CFC need not physically manufacture the property;
rather, it must perform substantial oversight functions through
the activities of its employees.
Victor Cabrera ([email protected]) is a senior manager with
KPMG LLP’s International Corporate Tax Services practice. Jose Leiman ([email protected]) is managing director and head of KPMG
LLP’s Americas Tax Center of Excellence. Marc Skaletsky ([email protected]
kpmg.com) is a partner and leader of KPMG LLP’s Tax Efficient Supply
Chain Management practice. The authors wish to thank the following
individuals for their contributions to this article: Murilo Mello and
Alexandre Guizardi of KPMG in Brazil and Felipe Burton of KPMG
in Mexico. KPMG LLP, the audit, tax and advisory firm (www.
us.kpmg.com), is the U.S. member firm of KPMG International. KPMG
International’s member firms have 123,000 professionals, including
more than 7,100 partners, in 145 countries. The views and opinions
are those of the authors and do not necessarily represent the views and
opinions of KPMG LLP. The information contained herein is general
in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation
with your tax adviser.
Reprinted from the June, 2008 issue of Practical Latin American
Tax Strategies
©2008 WorldTrade Executive, Inc.
June 2008
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