What pharma supply chain transformation means for tax

New value drivers impact transfer pricing characterization and profit allocation

Operational shifts in the supply chain can impact transfer pricing characterization and profit allocation of existing entities, requiring the valuing of new functions and intangibles. Tax professionals should understand the full value chain and new value drivers of the supply chain evolution. The shift to an AI-driven supply chain will place greater emphasis on the commercial scale-up activities, particularly how data-driven supply chain analytics will likely inform decision-making going forward.

The importance of the procurement function became particularly apparent during 2020-21 when companies were affected by unforeseen shortages of basic raw materials (including ethanol and magnesium) and consumables (among others, single-use bio-reactor bags, known as biobags; glass vials; and sterile filters). To prevent future supply chain disruption, many pharmaceutical companies are investing in talent and technology to anticipate supply chain risk related to raw materials and building contingency plans (e.g., dual sourcing) to deploy should these risks materialize. With any change to the supply chain, tax professionals will have to revisit profit allocation among the future state entities involved based on their respective functions, risks, and assets and take into consideration any local legal or tax regulations, which may be more complex than the current model.

One example of a smart localization strategy takes advantage of a hub and spoke model, where certain manufacturing and supply chain activities are moved closer to the local market. Depending on which activities are localized, there could be direct tax impact related to value attribution. For instance, packaging operations are generally routine activities while API and formulation steps are generally attributed more value in the supply chain, and a principal company jurisdiction will often have a lower effective tax rate than the local market jurisdiction. In that case, limiting localization to more routine activities such as packaging and labeling could be advantageous.

For instance, consider a traditional large pharmaceutical company that currently has manufacturing and procurement relationships with a related-party licensed manufacturer in Puerto Rico. To make its supply chain more resilient and improve visibility, the company decides to expand beyond this exclusive relationship and implement a dual-sourcing model, shifting part of these operations to a new structure with a Swiss principal model that includes a procurement hub and European- and Asian-based contract manufacturers.

This change of manufacturing location creates operational benefits, including its proximity to the European and Asian markets, as well as a more stable and reliable infrastructure and a more business-friendly environment. It also has a variety of considerations for tax and transfer pricing professionals.

The current state supply chain and associated transfer pricing policy for the Puerto Rico-licensed manufacturer is relatively simple. Puerto Rico procures its own raw materials and semi-finished goods, uses its own workforce to manufacture finished goods, and sells finished goods to third-party and related-party distributors. After paying a royalty for use of patent and technology intellectual property (IP), Puerto Rico retains the residual income associated with the sale of the finished products. As the pharma company moves to a more dispersed supply chain, revisiting the profit allocation among entities will be particularly important as the manufacturing execution will now be separate from the supply chain and manufacturing leadership and procurement functions based in Switzerland.

Operational considerations for tax professionals

Establishing a principal entity in a new location requires the alignment of governance models with existing operating models. Tax professionals will need to consider the organizational structure, including the location of employees, their employing entities, and whether location transfers will be necessary to build robust substance to support the principal characterization. Tax professionals should connect with HR teams to get full visibility into how employees are geographically dispersed. Understanding from the business regarding what employees have significant functional contributions, including accountability and decision-making roles to manage risks and drive value creation.

If the principal will also have IP ownership, tax professionals should consider if legal entities have sufficient substance with respect to research and development or other functions that contribute to the development of IP, in line with the guidance provided in the Organisation for Economic Co-operation and Development’s (OECD’s) development, enhancement, maintenance, protection and exploitation of intangibles (DEMPE) concept, introduced in 2015. The team should also assess what corporate, payroll, or investment tax incentives or credits may change.

When evaluating and implementing potential changes to financial or physical supply chain flows, companies should also consider indirect tax and customs implications. Adjustments to financial flows, including rights licensed in changes to IP remuneration, can result in increases (or decreases) to customs value thus impacting both duty liability and import VAT/GST. Changes to physical flow and trade lanes will similarly impact both duty spend as well as potential planning opportunities, such as Free Trade Agreements and Foreign/Free Trade Zones. These additional costs or potential benefits should be appropriately considered in financial models to allow companies to understand the full supply chain impacts of tax and business decisions.

Many of the same considerations that are taken to enter a market need to be thought about as a company exits an existing market. Tax professionals should consider the BEPS 2.0 implications of exiting a market and understand the potential exit tax consequences of transferring functions, assets, such as intellectual property, or risks to a new structure.

What tax and transfer pricing professionals can do right now

Historically, statutory and effective tax rates have been part of the decision-making process in determining the location for a new entity. Yet, new guidance from the OECD’s anti-tax avoidance plan, BEPS 2.0, effectively sets a 15% global minimum tax for multinational corporations and minimizes the incentive to relocate in the jurisdiction with the lowest tax rate. Companies should consider selecting a principal location that best aligns with how the business intends to operate, with tax as only one of many considerations.

Other things for companies to evaluate when moving to a new location will be changes in accounting standards, shifts in legal entity structure, and the character of income on any new transaction flows.