Tax implications of transferring production from abroad
Our colleagues at BDO in the US have prepared an interesting study, in which they define seven factors that can significantly influence the success of large multinational enterprises, as well as the development of national economies in 2022. These factors include, among others, efforts to reduce dependence on China by moving production closer to the end customer in the domestic economy or so-called "nearshoring".
At a time when supply and procurement chains have been disrupted by the Covid-19 pandemic globally, it can be assumed that production will shift back to more than just the US.
Related to the shifting of production programmes is the issue of transfer pricing, referred to as "function shifting". This is a situation where there is a transfer not only of production machinery from abroad, but often also of entire production programmes, on terms that have been negotiated by an entity in the group other than the company that will continue the transferred production programme in the domestic tax jurisdiction.
In the Czech Republic, we have already encountered the transfer of functions in the past. However, the reason for the transfer of the production programme was not to reduce dependence on China, as is now the case in the US, but to achieve so-called relocation savings. This was the case, for example, when production programmes were transferred to the Czech subsidiary by the German parent company, which could no longer make the planned profit in Germany due to high production costs.
In such situations, the German tax authorities impose a so-called exit tax on the transferred profit potential. The amount of the tax was calculated based on the cash flow that the production company would have generated if the transfer had not taken place.
In practice, it was possible to encounter a situation where the German parent company transferred the obligation to pay the exit fee to the Czech subsidiary in the form of a royalty. The reason for this was that Czech tax legislation did not have a specific statutory regulation addressing how this fee should be taken into account in the tax base when it was part of the price for the transferred production programme.
For transfer pricing purposes, the company that will continue the production programme must be able to demonstrate that the prices at which it acquired the production facilities were negotiated at arm's length. In the case of royalties, it is necessary to demonstrate what the substance of the royalty is and what benefit it provides. Where the company merely continues its production programme without being able to change the prices agreed by the transferring parent company with the final customer for whom the products are produced, proving the benefit of the royalty paid may be problematic.
To resolve the situation, it is first necessary to correctly define the contractual relationship based on which the production programme is transferred. If this contractual relationship bears the hallmarks of a transfer of part of an enterprise, the Czech company involved in the transaction should follow the applicable Czech accounting and tax legislation.
In the case of a transfer of part of an enterprise, the current Czech accounting legislation gives a choice. The added value of the transferred part of the production plant, consisting of the transferred contracts, the value of which has not been recognised in the assets of the transferring company, may be quantified by the transferee company in the form of a valuation difference. The amount of this valuation difference will be determined as the difference between the price paid by the transferee company for the transferred production programme and the sum of the residual values of the transferred production facilities or other assets, as the case may be, recorded in the accounts of the foreign transferor company.
The second option is to use goodwill. This is the difference between the recipient's individual revaluation of the transferred production facilities and the price paid for the transferred production programme. If one assumes that the prices of the products of the transferred production programme are to remain unchanged because the gain from the relocation is to be achieved by reducing costs, then the use of goodwill may put the recipient of the production programme in a proof gap.
Imagine a manufacturing company that is wholly controlled by a parent company that has decided to transfer part of its business. Over the years that the recipient company will continue its production programme, energy or personnel costs will increase. To demonstrate that these costs, for which the market risk of negotiating the price is borne by the receiving company, were the reason why the location saving was not realised, it will be necessary to compare the costs before and after the relocation of the production programme. In a situation where goodwill is used, the depreciation of the transferred production facilities will be calculated differently than if the relocation of the production programme had not occurred. This will make the analysis of deviations from the planned cost savings less transparent.
The failure of the recipient of the production programme to demonstrate responsibility for the reasons for the losses generated by the transferred production programme may, in the event of a tax audit, lead to the conclusion that the loss-making entity should have been granted price compensation by the controlling company that decided to transfer the production programme, since its decision caused damage to the controlled company continuing production.
Companies to which a production programme is to be transferred from another country are advised to consult early with tax advisors and transfer pricing specialists in both tax jurisdictions concerned. This is the only way to avoid a situation where the amount paid as an exit fee in the country of the transferor of the production programme will be taxed a second time in the country of the recipient due to a failure to recognise the amount and manner in which it will be included in the tax-effective cost.
The implications of aligning corporate tax to 15% for multinational companies that are considered technical leaders so that these companies are incentivised to return their know-how to domestic jurisdictions will be discussed next in relation to transfer pricing in the future.