Tax Efficient Supply Chain Model: Operational and Design considerations in SAP ERP
Summary and Objective
In today’s global economy with increased global trade, multinational corporations across various industries are rethinking and restructuring their supply chain models to distribute their products in a more efficient and agile way to reduce cost and achieve top and bottom-line growth. Inventory optimization, reducing material, labor and transportation are all well-known means of achieving reduction in cost of goods sold. In addition, tax incentives and contractual flexibility and openness provided by many countries, along with developments in technology and supply chain applications have provided opportunities for optimizing the financial flow of goods across international boundaries. Tax Efficient Supply Chain is such a model to reduce the overall effective tax rate of the corporation and provide significant financial and tax benefits. This has been a common practice in many industries, esp. Pharmaceutical/Life Sciences and High-Tech.
This blog article will explore operational and financial considerations for this supply chain model and some leading practices and methods to enable this model in SAP and S/4HANA ERP.
Tax Efficient Supply Chain: An Overview
Tax Efficient Supply Chain is a supply chain model that considers tax as an integral part of the overall operational supply chain processes to optimize global effective tax rates. It is designed to produce flexible tax planning that is operationally driven to achieve long-term reduction in effective tax rate as well as supply chain efficiency, cost reduction and inventory optimization while balancing customer service level. This requires corporations to undertake several strategic, operational, financial, Intellectual Property and systems design actions. The setup efforts and costs maybe substantial but are strategic investments to realize long term benefits and returns.
There are few key characteristics of a business that will benefit from this model:
- Business is multinational with revenues reported in multiple regions
- Multi geography cross-border transfer of goods volume is high
- High domestic effective tax rate
- Decentralized operations with complex global supply chain and distribution models
- Significant Research and Development spend and possession of Intellectual Property
- Manufacturing and Sourcing setup in low-cost geographies for cost optimization
The fundamental concept for such a supply chain design is to establish a “Principal” company -a legal entity in a lower tax jurisdiction/geography – a number of European jurisdictions e.g. Netherlands, Switzerland, Luxembourg etc. provide opportunities for low corporate taxation. The Principal company serves as the Logistics Hub entity and is responsible for purchasing goods from internal manufacturing plants or external manufacturing entities (contract or toll manufacturing) and then selling the goods to other Selling/Operating companies located in the various end customer markets through intercompany sales. The local operating companies then perform the final sale to the end customers.
The underlying mechanism is to shift appropriate amount of functions, assets and risks to the Principal to justify the allocation of taxable entrepreneurial profit and thus get tax advantage from low tax rate in that jurisdiction. The Principal company or the Hub entity should be allocated more management control and business risks (e.g. Inventory risk, Credit risk, Warranty risk, Pricing risk) to be entitled for the entrepreneurial profits while the local Selling/Operating entities should perform routine functions and have limited business risks to receive a relatively low profit level. Hence, the structuring and allocation of value adding functions and commercial risks between the Principal company and the local Selling/Operating companies are critical in the design of such a tax optimized model.
Business Process/Operational Design Considerations
The design and setup of the Tax Efficient Supply Chain model requires cross-functional collaboration across supply chain operations, tax, finance, sales and system integrators. It involves some fundamental restructuring of the overall supply chain or value chain of a global corporation. Hence it is imperative that a cross-section of business, finance and tax experts of the organization perform a complete business case including a cost-benefit analysis for some of the key considerations:
- Restructuring and reallocation of value adding functions, assets and commercial risks (e.g. Inventory risk, Credit risk, Warranty risk, Pricing risk, Volume risk etc.) between the Principal entity and local Selling /Operating entities
- Opportunity to optimize the overall supply efficiencies through centralizing key business functions while reallocating business functions and risks -e.g., Sourcing and Procurement, Demand and Supply planning, Inventory Management and optimization across the network, Customer service, Back-office operations and so on
- Legal entity structure, Transfer Pricing compliance for regulatory requirements with local government bodies
- Integrating 3PL companies to manage Principal owned DCs for physical distribution of goods can be complex due to both operational and systems integration perspectives of this supply chain model and need to be analyzed and designed thoroughly
- Returns and Warranties processes also can be complex due to the embedded intercompany transactions in the model that needs to be analyzed against the volume of such return transactions and designed for efficiency
Enabling a Tax Efficient Supply Chain model in SAP ERP
The setup of such a supply chain model in the system may not necessarily adhere to the standard SAP assumption that the financial flow of goods follows the physical flow of goods. In this case, the physical and financial flow can be different or will need to be designed to be different – the physical flow takes into account the optimization and efficiency of the supply chain distribution path to the end customer while the financial flow takes into account the tax optimization using the low tax jurisdiction setup.
Traditional Supply Chain Model
In a traditional supply chain flow, the physical flow of goods happens from manufacturing company (internal or external) to selling/distribution company to the end customer and the corresponding financial transactions of intercompany buy sell follow the physical flow. Here
- Each company/legal entity in the chain assumes risks associated with its respective functions
- Profits from the economic activities in each legal entity is assigned to the respective tax jurisdiction where it is located
- SAP system setup is standard – Each operating entity is under its own company code/legal entity: Manufacturing plant is under the Manufacturing company code/legal entity and Distribution plant and Sales Org are under the Selling /Operating company code/legal entity
The supply chain flow and a representative system setup is shown below
Tax-Efficient Supply Chain Model
In Tax-Efficient supply chain flow, the physical flow of goods from manufacturing company (internal or external) does not happen directly to the selling/distribution company but is routed through the Principal Company.
- Value added functions of Manufacturing, Sales and Marketing risks are shifted to Principal entity which is located in a low tax jurisdiction
- Selling/Operating companies perform limited functions of selling to the end customers with limited risks
- Logistics Hub plant is setup as the intermediary between Manufacturing plant and Selling /Distribution plant. The Logistics Hub plant is setup under the Principal legal entity separate from the Selling/Operating Company legal entity.
- Logistics Hub Plant (under Principal Company Code) purchases goods from manufacturing plant (under Manufacturing Company Code) and then sells the goods to Selling/Distribution plant (under Selling/Operating Company Code), which then does the final sale to the end customer in the respective country/legal entity. These transfers between Hub Plant to Selling/Operating plant are done using Intercompany stock transfers (Stock Transport Order). This sequence of intercompany and end customer sale transactions with Principal strategically located in a region with low tax rates reduces a company’s overall effective tax rate.
The basic system design is where the physical and financial flow of goods are the same. The goods ownership is transferred from Manufacturing entity plant to Principal Hub plant (assigned to low-cost tax jurisdiction Principal legal entity) to the Selling Distribution entity plant and then delivery to customer for a Sales Order to the Selling legal entity. This is done using standard SAP setup of Intercompany Stock Transfer Orders (STO) and predetermined Transfer prices setup between the Manufacturing to Principal entity and Principal to Selling entity.
There can be a few different ways of designing and configuring SAP system; the setup for different organizations will be different based on how it restructures its value chain, including the tax treaties and contracts to address the requirements of tax efficiency and supply chain agility; however, the basic design mechanism remains the same as discussed above.
Below are sample variations of the basic setup to automate and optimize the model.
Example Setup Variant 1
In this setup, the basic concept of an intermediary Logistics Hub plant assigned to a Principal company in a low-cost jurisdiction remains the same. The goods ownership is transferred from Manufacturing entity plant to Principal Hub plant (assigned to low-cost tax jurisdiction Principal legal entity). The sales order from the customer is placed on the Selling Distribution entity plant but the physical delivery is a dropship direct to the customer from the Principal Hub plant. An intercompany Flash title transfer takes place between the Principal entity to the Selling/Distribution entity using a predetermined transfer price process (ownership changes from Principal entity to Selling entity for an instant) – done using behind the scenes automation of goods issue and goods receipt process and triggering Intercompany invoicing between the Principal and Selling entity. For tax purposes, the valued inventory needs to appear as an asset of the selling company (even if only for an instant) which is performing the end sale to the customer and recognizing the customer revenue.
Example Setup Variant 2
In this setup also, the basic concept of an intermediary Logistics Hub plant assigned to a Principal company in a low-cost jurisdiction remains the same. But the physical path of goods is direct from the manufacturing plant to the Selling/Distribution plant while the Financial Intercompany invoicing is routed through the Logistics Hub plant. This is not a standard SAP supply chain flow and hence needs customization and automation of SAP design using custom tables and programs. The advantage of this customization is that it is reusable for many situations just by updating the custom table entries for the supply chain entities.
Solution Design and Execution Considerations
In addition to the operational considerations discussed above, some of the key solution considerations are critical to the successful design and implementation of such a supply chain model.
- Design of SAP Enterprise Structure aligned to the new Legal entity structuring of the organization and the physical vs. financial flow of goods to optimize the tax efficient supply chain and keep it scalable for future business changes e.g. M&A
- Transfer Pricing setup in SAP between the Principal entity and various local Selling/Operating entities that determines Intercompany profit allocation working with Transfer pricing specialists (critical for audit compliance)
- System configuration for various Intercompany flows, including custom tables design and custom programs are key to the success of execution of such supply chain model; need to design for flexibility and scalability for business process changes e.g. new/revised product portfolios, M&A etc.
- Automation of transactional flow e.g., Flash title transfer with auto outbound delivery/goods issue, inbound delivery/goods receipt, Intercompany invoicing are key to the efficiency and agility of such supply chain model
- Master Data setup and rigorous management is by far the most critical key success factor given that SAP is a data driven application (Material Master, Business Partners setup and extension, key master data fields for Procurement, Planning, Batch/Serial, Finance, Cost roll-ups, Tax, Transfer price tables). The majority points of failure for execution of this supply chain model typically point to one or more of master data error
- Interfaces for 3PL setup is another critical and complex area and multiple interfaces (order, batch/serial, ASN, receipt, delivery, confirmations, inventory reconciliation and so on) need to be designed and tested thoroughly, including batch and serial traceability that are key to some industries e.g., Pharma/Life Sciences and High-Tech
- Reverse Logistics path can be complex to manage due to the embedded Intercompany transaction reversals and compliance with the tax efficient supply chain flow that was used in the forward path
- Finally, it goes without saying that thorough and multiple cycles of end-to-end Integration testing of the entire supply chain setup with all possible scenario combinations for all products is a must for successful implementation of a Tax efficient supply chain model
Tax Efficient Supply Chain as a business model has been and will continue to be important for multinational organizations to keep pace with global competition, reduce costs and achieve bottom-line growth while enhancing operational excellence. The success of such a model depends on a cross-functional approach that includes strategic, operational, tax and systems integration initiatives.
Hope you find this blog useful in your journery of supply chain transformation and excellence. Looking forward to your feedback and comments.