Supply Chain Restructurings: Substance over Form
Due to the economic crisis and decreasing tax revenues supply chain structures have come under scrutiny of the Spanish tax authorities. On 11 January 2012 the Spanish Supreme Court gave its judgment on a supply chain case, encouraging Tax Inspectors to scrutinise tax driven restructurings on any grounds. Technical arguments and thorough legal analyses put on the table by taxpayers and their advisors to support these structures do not count for as much as the business case conveyed to the tax inspector or judge. It seems that for the Tax Agency, the end justifies the means - i.e., successfully combating what the Tax Agency and the Spanish Courts view as any kind aggressive tax planning. Taxand Spain investigates why multinationals with operations in Spain should be support supply chain restructurings with detailed documentation and carefully review, properly identify, measure and clearly state the business reasons for the restructuring, other than tax reasons, to show it has substance.
The Spanish Supreme Court issued a judgment on 11 January 2012 re a supply chain case which favours the Tax Agency's position. The underlying case is pretty standard: a multinational group with headquarters in Switzerland and operations in Spain undertook a supply chain restructuring in 1999. Before the restructuring, the Spanish subsidiary of the Swiss parent entity had been an "all-in-one" player (i.e. it manufactured and sold the products in the Spanish market). From 1 July 1999, however, the Spanish entity became a contract manufacturer and a promotional agent for the Swiss parent. The Spanish entity, until then a manufacturer, importer and seller of products, began to produce them for a single client, its Swiss parent, who then proceeded to introduce the products in the market. For that purpose, the Spanish subsidiary also leased a warehouse to the Swiss parent. The aim was to reduce costs, by centralising them in a single country: Switzerland.
The Tax Agency argued that the Swiss entity had a permanent establishment (PE) in Spain. The technical conclusions of the Spanish Supreme Court are summarised as follows:
i) The fact that the Swiss entity rents a warehouse from the Spanish subsidiary does not constitute a PE, based on Article 5.3 of the Spain-Switzerland Tax Treaty.
ii) As the Spanish entity has no authority to conclude contracts in the name of the principal, it cannot be regarded as a dependent agent in that respect.
iii) However, the Court took the view that the conjunction of three factors, such as a) the production-to-order, b) a price based on costs plus a remunerative percentage for financing the production, and c) the existence of one single client for the Spanish entity, supports the conclusion that the defining characteristics of a dependent agent permanent establishment are present in the case analysed.
iv) Lastly, the Supreme Court's judgment is based on their view that where an agent is also a manufacturer, it is a dependent agent.
The Court uses technical arguments based on a dynamic interpretation of tax treaties and delves into the concepts of permanent establishment and dependent agent. However, it transpires from the judgment that all those technical details and arguments could have been very well used, in a similar way, to defend the inexistence of a PE in the case at hand. A sign of this is that, even if a PE exists, adverse tax implications could be limited if the functions of the Spanish subsidiaries were appropriately remunerated. However, the Court dedicates less than one page to addressing the quantification of the profits attributed to the PE, computing as PE's profits all sales income from Spanish clients and disallowing the deduction of costs incurred by the Swiss parent except for a small percentage of the headquarters' general expenses.
i) arguing the existence of a PE of the foreign principal
ii) challenging the margins assigned to the Spanish agent or manufacturer (a fairly new approach, as tax inspectors begin to get more comfortable in transfer pricing disputes), or
iii) simply arguing that the parties did not respect their own inter-company agreements, thereby interpreting those agreements differently from the parties themselves (an odd and troubling trend, considering that the parties must know their own intentions when signing those agreements).
A disturbing conclusion is that supply chain restructurings in Spain should be as far removed as possible from the characteristic features of a "tax driven" restructuring in order to pass the test of a tax audit and subsequent litigation before the Spanish courts. Implementing a restructuring with those features and then trying to support it based on technicalities as regards the concept of PE, dependent agent, or the arm's length principle when remunerating functions of the parties involved, may be a naïve approach in the current tax climate. Rather, sound business reasons and proper quantification of the economic and financial savings (other than tax) achieved through the restructuring should be identified, and adequate contractual documentation put in place. Not only that, as always, care must be given, unfortunately, to "cosmetics" when drafting agreements and defining the role that each party will play. A proper review of the contractual documentation and of the factors supporting the restructuring, before the Tax Agency comes knocking on the door, can make the difference between a successful tax audit and a costly and lengthy litigation.
Your Taxand contact for further queries is:
Luís Manuel Viñuales
T. +34 91 514 52 00
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