A relevant indirect tax strategy—correctly implemented—will allow the new business to function effectively from go-live, from both a tax and commercial perspective, so that it can move inventory, generate sales and invoices, face fewer disputes with non-paying customers, remain tax compliant, and integrate the business on time and on budget.

But do these taxes and tax planning opportunities get the attention they need, especially in light of increasingly complicated and globalized business models?

Indirect taxes are integral to the daily operations of a company, affecting various activities such as raising sales invoices, managing inventory, paying suppliers, and collecting cash. Consequently, the risk associated with indirect taxes can significantly influence an organization’s commercial viability, and this impact can escalate during mergers, acquisitions, or changes in the business model.

One crucial aspect often overlooked in the strategic planning of a business model change is indirect tax. While tax considerations might not be a primary focus of financial transformations, they can lead to significant and costly challenges. This is especially true for value-added tax (VAT), which affects various departments within the enterprise, including finance, procurement, IT, and HR.

A common issue that arises from incomplete integration during such transitions is related to invoicing. For instance, many payable invoices may not be correctly coded, leading to delays in VAT deductions. Additionally, suppose a legacy system is only partially integrated with the new model. In that case, it can result in the issuance of incorrect sales invoices, creating customer problems, inaccurate tax reporting, and missed compliance obligations.

Business operating models are evolving

From a Tax Control Framework perspective, for setting up risk-based controls, the more unusual the transactions, the greater the tax risks. An example of non-routine significant business transactions is the change of a company's business model.

Geographic footprint of a multinational

Suppose a business changes its model to optimize its effective tax rate (ETR), minimize cash tax impacts, reduce costs, or achieve overall efficiency. In that case, it is crucial to involve the indirect tax function when managing this change promptly.

Will using a classic principal structure in the new entity help keep maximum profits in low tax jurisdictions?

If that is the case, one entity will own the title to the inventory across various jurisdictions, and the principal will need to obtain VAT registration in each location where the inventory is held. Addressing indirect tax issues during the design phase is essential to ensuring proper implementation and execution of indirect tax planning, as any changes can impact current processes, controls, and their effectiveness.

Tax planning is improved when the business model ensures that profit drivers, such as 'value-added functions' and 'risk,' are assigned to low-tax jurisdictions.

Manage the impact of business transactions

Indirect tax obligations

A change in the business model, such as implementing a centralized operating structure, often leads to increased transactions and indirect tax obligations across various 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 complete taxable presence, creating a liability for Corporate Income Tax.

Involvement during design

Operational changes have a tax consequence due to the change in transactional flows and the change in a company’s assets, functions and risks profile.

Important is to ensure that the new operating model is not only implemented correctly from a corporate income tax perspective, but also ensures that business processes are indirect tax aligned realizing support of the business in the areas of compliance, finance & accounting, legal, IT systems and regulatory matters. That means teaming with these work streams is a necessity during design. 

Reputational risks

Changing a business model can lead to various risks, including VAT risks and commercial challenges. These may manifest as logistics issues, such as customs not allowing goods to clear in a country, difficulties importing goods, and shipment delays. Such disruptions can negatively impact daily operations, resulting in invoicing errors that require reissuing invoices and delaying cash collections. Incorrect tax treatment of transactions can also complicate VAT compliance, leading to payment and reporting errors and potential penalties.

Some common root causes of these issues include the company failing to register for VAT or procurement teams not coordinating with suppliers responsible for importing goods.

These problems can also harm the company's reputation, as stakeholders—including customers, suppliers, external auditors, senior management, tax authorities, and shareholders—may be affected when things go wrong.

A comparison from a VAT perspective

Explanation of the overviews presented in slides above

LRDs versus Commissionaires

For corporate tax purposes, principals often establish their residence in low-tax countries. From a business perspective, the principal bears the major risks associated with a contract. Generally, principals still own the goods when they are shipped to customers. However, having a sales principal located in a non-EU country can lead to more complex registration and trading issues (as discussed in the 'Implementation' section below).

Tollers are manufacturers that produce goods on behalf of other parties, such as the principal. In exchange for their services, tollers receive a tolling fee.

Commissionaires act solely as intermediaries for customers. The principal compensates them with a commission fee. In a strip-buy-sell model, instead of an agent, a reseller (Limited Risk Distributor, or LRD) is involved in the supply chain. The key difference is that a reseller becomes the owner of the goods. From a VAT perspective, commissionaires are considered owners. Thus, in terms of VAT treatment, commissionaires and LRDs are similar—they both buy and sell—but they operate under different legal frameworks.

An LRD has the opportunity to maintain local inventory on its books, provided all relevant aspects are properly addressed. In contrast, a commissionaire never owns any inventory, even temporarily. This is where the distinction lies; an LRD momentarily holds ownership through a concept known as 'flash title.'

However, both LRDs and commissionaires do not have legal ownership of the inventory during storage or transport, as the principal retains ownership at that stage. Additionally, different accounting rules apply to LRDs compared to commissionaires.

Note that commissionaires create a PE issue due to new legislation
see below and chapter BEPS

 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).

VAT automation of complex business models

Technology-related tax risk: understand and address the potential harms and benefits of (new) technology

ERP configuration takeaways In practice, ERP configuration - the amount depends - is needed when companies deal cross border and complex business models are set up. Why? It is often the case that the principal delivers the goods physically and directly to the final customer, a so-called drop shipment.

This creates only one physical departure of goods - goods issue' - in the ERP system. However, two invoices should be raised:

1. One from Principal to LRDs or Commissionaires and
2. One from the LRD/Commissionaire to the final customer

In the ERP system, the correct 'ship from' information at the LRD and Commissionaire level is missing so that the VAT treatment by the system is determined based on the 'ship from' and 'ship to' information present at the Principal level. For cross-border transactions that often results when SAP is used in an incorrect VAT treatment. Therefore, in practice, it is not easy to correctly configure the 'tax determination logic' set up.

See chapter: Data and Technology

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.

Fixed versus permanent establishmentThe 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

Click to enlarge

The objective is to bring commissionaire arrangements within the framework of dependent agency PE

Converting the sales middleman function from Commissionaire to LRD

The start point from an ERP perspective is to investigate how the commissionaire is set up from a current operational state.

Below, 2 different ways how a commissionaire could have been implemented in SAP:

1. Revenue of the commissionaire is directly booked by the principal.  The principal has set up all the master data. Manual corrections were made for VAT reporting. VAT is in that set up a real bottleneck and the root cause is that, for VAT purposes, a commissionaire is deemed to be a buy/sell.  VAT treatment for Commissionaires and LRDs in principle similar (buy and sell), but with different legal flows. That VAT qualification is, however, in conflict 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 Principal to the customer. This VAT bottleneck often results in many manual corrections have to be made to facilitate correct VAT reporting
2. Commissionaire is set up as a buy-sell and the master data of the commissionaire is used. VAT correct, but legally - as mentioned above - wrong as the revenue belongs to the Principal and the commissionaire receives a commission from the principal.

When option 1 has been implemented and the commissionaire model will now be converted to an LRD, the consequence is that the master data has to be transferred from the Principal to the local LRD and thus the VAT determination logic for the LRD's business transactions has to be designed and properly tested before the LRD can become fully operational.

As an LRD has revenue in its books, option 2 above might make conversion to an LRD a bit easier as in a business transaction the Principal to LRD and LRD to Customer will transfer legal title.

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

Financial data reflecting business model designed Not only finance, but also tax, needs access to data that shows how transactions are processed and how IT systems are set up. Data integrity is an operational risk factor when transactions are booked in any given country and are not properly evaluated for tax purposes.

It could be that the financial data in the system does not reflect the business model design or that change is not properly managed. Besides that, in the 'as is' it is often a challenge to get access to the relevant tax data that must be reported to regulators, investors and tax authorities in every business unit and country in which a company operates.

Cross-functional teams Likewise, the VAT work stream should be integrated with contingent technology and finance projects. This may prove challenging as a number of initiatives, particularly those that deal with systems development and technology enablers, are often not visible to the tax function — another point that underscores the need for transparency and upfront communications.

Failure to align with initiatives that can intersect with VAT can result in a VAT design that is inefficient from a process perspective and not a “best fit” for the business.

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?

Related GITM articles

• Examples of public Fiscal Transparency statements
• The Tax Transparency Benchmark, 2015
• BEPS 2015 Final Reports
• EU - Public consultation on further corporate tax transparency
• CbC reporting / tax transparency: Accounting Directive
• Improving large business compliance
• Tax administration: large business's transparency strategy
• Spreadsheets and Compliance
• Tax Strategic Plan
• Tax Control Framework
• Fraud

Written by Richard Cornelisse
 

Richard advises multinational businesses in improving the efficiency and effectiveness of their Indirect Tax Function and Tax Control Framework.

He started his career as a manager at Arthur Andersen and then became an EY partner where he led the indirect tax performance team for Netherlands and Belgium. Currently, he is a managing director of SAP Tax Consultancy Firm.

Richard has over 20 years of experience advising clients on international VAT issues. He is specialized in the tax aspects of financial transformations, shared service center migration, and post-merger integration work.