For years, companies have developed global business models assuming they would operate in a relatively stable international tax and trade environment. Recent developments, however, have turned those assumptions on their head.
Sources of international tax policy and geo-political change include the passage of the U.S. Tax Cuts and Jobs Act of 2017 (TCJA) and the Organisation for Economic Co-operation and Development’s (OECD) Base Erosion and Profit Shifting (BEPS) action plan. Additionally, U.S. trade actions, expanded global imposition of tariffs stemming from U.S. trade policies, and Brexit all contribute to the vastly different tax and trade landscape through which multinational companies must navigate. As a result, companies will need to carefully consider how these changes will affect their plans to transform their global operations in the years ahead.
Volatile Tax and Trade Environment
Tax, trade and evolving business models may compel businesses to: (1) diversify sourcing and manufacturing locations to both mitigate potential tariff increases and locate closer to customer markets; and (2) explore how digital business models will impact sourcing and manufacturing of parts and finished products. To address potential risks and uncertainties driven by the new environment, companies with global footprints will need to revisit fundamental business decisions and the design of their existing supply chains.
Moreover, innovative, disruptive, and transformative technologies are already prompting global companies across all sectors to consider and adopt a comprehensive digital strategy to sustain and drive growth. For consumer products companies, digital trends influence both sales and supply channels as technology becomes ubiquitous and invisible, driven by sensors, data, and artificial intelligence. This compels companies to restructure operations through more consumer-centric and digital direct-to-consumer business models. In this new environment, many non-tech companies will transform their global footprint as they take on operating and tax features with respect to intellectual property (IP) and other assets that are more traditionally associated with technology companies.
Understanding the new paradigm this era of extreme volatility has caused is a necessary first step to address these challenges and opportunities and to maintain a competitive, predictable, sustainable effective tax rate. Going forward, companies should anticipate potential tax controversy and make efforts to address regulatory and tax risk.
To that end, many companies have already responded to these tax and trade trends by making changes to their supply chains. Examples include:
Fashion retailers are shifting manufacturing and sourcing to countries such as Vietnam and Cambodia as a viable alternative to the People’s Republic of China (PRC) to create more nimble supply chains in the event tariffs are expanded to include footwear and apparel.
Automotive companies are responding to the proposed United States Mexico Canada Agreement (USMCA) Rules of Origin requirements by reviewing their bills of material (i.e., product-specific data necessary for determining eligibility for trade benefits) and considering sourcing changes to either comply or assess the impact of losing the duty benefit afforded under the proposed free trade agreement.
Companies are reconsidering the United States as a location for manufacturing operations, owning IP or establishing a regional global hub for exports into Canada and the Americas. Factors driving this include the lower U.S. federal corporate income tax rate, which decreased from 35% to 21%; the foreign-derived intangible income (FDII) provision, which applies a minimum rate of 13.125% to certain export income; and the uncertainty of the global trade environment.
Overview of International Tax Developments and Implications for Global Supply Chains
The TCJA, generally effective after December 31, 2017, has introduced several international tax provisions that encourage the expansion and relocation of business functions, assets and intellectual property activities to the United States, while discouraging their location elsewhere. Among the key provisions are limitations on shifting income through IP transfers, the base erosion anti-abuse tax (BEAT), the global intangible low-taxed income (GILTI) provision, and the above-mentioned FDII deduction.
These provisions are expected to make it more attractive for many multinationals to deploy procurement or supply-chain hubs in the United States as they align their existing business and operational footprint with the functions that control and oversee the development and management of their global IP.
Companies also need to evaluate and reconsider their supply chains in light of the OECD BEPS action plan, as they seek to align income with value-creating activities. The BEPS action plan, in turn, has triggered developments at the global, OECD, European Union (EU), and individual-country levels that have a significant impact on most corporate supply chains. Among these developments:
The Anti-Tax Avoidance Directive that EU member states adopted for implementing the BEPS action items provides a comprehensive set of anti-abuse measures that impacts the mobility of operations and intangible property.
The Multilateral Instrument (MLI) updates existing bilateral tax treaties to implement the OECD’s tax treaty-related BEPS measures. The MLI limits treaty benefits and provides a lower threshold for creating a taxable presence (permanent establishment). This sets up the potential for double taxation, additional compliance obligations, or exposure to penalties.
Changes in transfer pricing guidance to align transfer pricing outcomes with value creation related to intangibles, risks and capital underscore the need to align business and tax outcomes.
Revised standards requiring more stringent transfer pricing documentation and allowing for greater information sharing and transparency provide effective tools for tax authorities that may increase scrutiny and the risk of multi-country tax controversy.
Organizations that do not adopt an integrated approach to address these new rules will be establishing operating models that create unintended discrepancies between tax, trade, legal, and operational realities, creating inefficiencies as well as commercial, regulatory, and tax risks. To avoid this outcome, many companies may need to consider changing their existing operating models, IP models, workforce locations and even information technology (IT) systems.
An integrated approach should also consider the potential financial impacts of the new rules. These could affect financial statements, effective tax rates and cash taxes, global liquidity and, perhaps most importantly, after-tax profit margins, earnings per share and shareholder returns. In addition, changes in reporting requirements could have an impact on public perception, governance, and compliance with control mechanisms.
SIDEBAR: How Companies Are Using FDII in the Current Disruptive Trade Environment
The TCJA included provisions that allow domestic C corporations to deduct foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI). For tax years beginning before December 31, 2025, the deduction equals 37.5% of a C corporation’s FDII, decreasing to 21.875% for tax years starting after December 31, 2025.
In light of these tax provisions, U.S. taxpayers are considering a range of supply-chain changes, which often complement initiatives considered in response to trade developments. For the short term, these changes include tactical modifications to existing transfer pricing protocols for the sale of goods, provision of services, and licensing of IP. Looking ahead, companies are weighing longer-term strategic options that leverage existing (or potentially new) substance in their U.S. supply chains to earn FDII credit by changing the role of the U.S. entity in invoicing, IP ownership and manufacturing.
For example, many U.S. taxpayers are considering expanding Mexico’s role in their global supply chains. Due to the close trading relationships established by the 1994 North American Free Trade Agreement (NAFTA), goods from Mexico already represent a strategic component in many corporate supply chains. Many U.S. companies that have historically used China as a manufacturing platform may now be considering diversifying into Mexico or expanding their existing operations there.
To further this goal, a U.S. company could manufacture various key sub-assemblies in China and then perform all final assembly, product testing and packaging in Mexico for export markets. In this scenario, the Chinese entity would typically charge cost plus a markup to the Mexican entity for its manufacturing activities. The Mexican entity would add its own final assembly, testing, and packaging costs to those of the Chinese components and charge a final market price to related distributors, giving those entities an appropriate operating margin based on global transfer pricing protocols. The U.S. company would then charge royalties and management services to the related distributors in return for its IP and management contributions.
This scenario would position many companies to manufacture assemblies or finished products in Mexico and sell them to the U.S. company. The U.S. taxpayer subsequently could export the goods from Mexico to non-U.S. related and unrelated distributors. Generally speaking, income the U.S. taxpayer earns from these transactions is eligible for the FDII deduction. As the FDII deduction eligibility requirements do not mandate physical U.S. manufacturing functions or U.S. warehousing, the U.S. company can play this role on a flash-title and drop-ship basis, leveraging its IP and management roles to increase FDII. Depending on the particulars of the situation, this could result in the U.S. company realizing an FDII deduction of 13.125%–21% in its global effective tax rate on the Mexico production and drop shipments.
Global Trade Disruption
Last year was pivotal for global trade. It is unlikely that anyone could have envisioned the extent to which global trade has been upended by events such as U.S. tax reform and other ongoing geopolitical trends.
Concepts that were once familiar only to seasoned trade professionals are now routinely in the headlines and a topic of daily conversations. The executive branch of the U.S. government can enact tariffs with the stroke of a pen. As a result, businesses need to be ready to react almost immediately or risk significant financial impact. Abroad, the uncertainty of Brexit continues to loom, with any change from the status quo holding the potential for a major shift in customs treatment between the U.K. and the 27 remaining EU member countries.
Adding to the disruption and the changing face of the global economy, the negotiation and renegotiation of free trade agreements (FTAs) such as the USMCA (also referred to as the “new NAFTA”), and the completion of the Trans-Pacific Partnership (TPP) without the United States, create a set of new regional trade blocs, both with and without U.S. participation.
Affected Products and Business Implications
Recent and proposed U.S. trade actions could have a profound impact on global supply chains. Taken together, these actions could affect all product categories within the global steel and aluminum industries, as well as the automotive industry and virtually any company that imports products from China. In addition, other industries that have historically been duty-free, such as the technology industry, now potentially face a sudden imposition of tariffs of up to 25%.
Companies must consider the impacts tariffs have on gross margins and, ultimately, on profitability and earnings per share. In the short term, passing these costs on to others, while not impossible, is not an ideal solution, given the competitive supply-chain landscape. This dilemma places a premium on having supply-chain options, such as multiple sources of production across separate regions or the potential for outsourcing production to global contract manufacturers that can shift production across jurisdictions as the rules of the game change.
Moreover, some of the tariffs are forcing companies to consider new low-cost manufacturing alternatives in Vietnam, Thailand, Korea, and Malaysia. Locations such as Mexico, Honduras, Costa Rica, Guatemala, Nicaragua, and Puerto Rico are also gaining favor as plausible manufacturing hubs based on their proximity to the U.S. market, competitive labor rates, and access to available labor pools.
As discussed previously, tax law changes affect the (after-tax) profitability of operations, while trade developments impact gross margins and above-the-line results. This creates an imperative to:
Align and integrate tax and trade into the overall business and supply-chain planning process to continuously evaluate the impacts of any changes and analyze the efficiency of initiatives or mitigate risks. Gaining a better understanding of (potential) impacts on trade, product costs, material, service and intangible flows can enable meaningful and timely supply-chain modifications that can help a business remain competitive.
Leverage economic modeling and analysis to assess potentially increased (tax or tariff) costs in relation to current and future business plans and any alternatives under consideration.
Consider implementing data-driven approaches to improve supply-chain efficiency and nimbleness. Companies that can successfully digitize their supply chains can deploy the data to improve the accuracy of their projections for supply-chain risks and disruptions. This, in turn, can enable adaptations to avoid cost increases and potentially stay one step ahead of competitors.
Work closely with operations functions to determine the potential impact of manufacturing alternatives on operationally driven factors such as:
- Labor, shipping, or capital expenses;
- Labor efficiency changes between jurisdictions;
- Product quality considerations from different supply chains;
- Inventory levels or safety stock requirements; and
- Supply-chain interruption risks associated with supply-chain modifications and transitions to new more diversified supply chains.
Consider the impact of manufacturing changes. If enacted, proposed U.S.-China tariffs will make origin planning increasingly important for companies exploring the overall business impact of shifting manufacturing and/or sourcing operations.
Explore and maintain alternatives to reduce the customs value on imports; because customs value is the basis for customs duties, any decrease in customs value results in a decrease in duties. Consequently, companies are exploring strategies such as duty reduction programs like First Sale for Export, as well as unbundling IP from product pricing.
Take a holistic approach to controversy management with global oversight of existing and potential tax audits that includes developing and maintaining robust documentation on tax and transfer pricing positions.
Historically, U.S. multinational companies across all industries have transferred most manufacturing operations offshore to other countries to achieve significant labor-cost savings and to be closer to growing markets. Over the years, however, many have experienced increased costs of doing business and have encountered other challenges, including safety and lower quality of manufactured goods. The reduction in the U.S. tax rate, coupled with the introduction of an export incentive and developments in other jurisdictions to increase the attractiveness of their tax systems, may present an opportunity to revisit those fundamental business decisions made years ago on the manufacturing footprint.
The Time is Ripe for Change
The scale, scope, and complexity of these developments should be a wake-up call for any global trade, finance, and tax executive. If not already doing so, companies should move quickly to understand the impacts of these developments and assess their risks within the overall context of the global supply chain. Now more than ever, the effective management of global tax, trade, and operating requirements are crucial in maintaining a competitive edge.
There is no one-size-fits-all solution. Performing a risk assessment, developing a roadmap, and assessing feasibility of alternatives now will allow corporate executives to note where reporting requirements will be onerous or where operational, IT, or other changes may be needed. Furthermore, every era of volatility, and the uncertainty and disruption it brings, can be leveraged to recognize and seize opportunities for advancing the overall business model, developing sustainable supply chain and trade strategies, and aligning tax and business models as much as possible.
The goal in developing a sustainable supply chain is to gain competitive advantage—one that makes a company’s products more attractive to customers in key markets. The priority should be to navigate current challenges, while also preparing for the next three to five years of change and uncertainty by deploying a nimble supply chain that can adapt as the long-term tax and trade agenda continues to evolve.
To navigate these challenges more effectively, affected companies should consider partnering with value-chain advisors that have the industry perspective, technical experience, assets, capabilities and global relationships to address today’s issues in the context of what tomorrow’s global tax and trade landscape may bring. A holistic process that connects the stakeholders with professionals in tax, trade, and operations who can help design an integrated supply-chain solution will help companies achieve sustainable strategic advantages in the marketplace.
For companies to remain competitive and win in the market, adopting a tax-aligned business model and sustainable supply chain that allows for efficient cross-border movement of goods, people, capital, IP and services will be an absolute imperative.
The views expressed are those of the authors and do not necessarily reflect the views of Ernst & Young LLP or any other member firm of the global Ernst & Young organization.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
By Lynlee Brown, Partner, Global Trade, Indirect Tax Services, Jay Camillo, Partner, Americas Operating Model Effectiveness Leader, Brant Miller, Partner, Operating Model Effectiveness, International Tax Services, and Kelly Stals, Senior Manager, Operating Model Effectiveness, International Tax Services, Ernst & Young LLP.