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Navigating Turbulent Times for Global Supply Chain Management

Executive summary

Many international companies are struggling with their supply chain management amid external factors playing out on the global stage.
To mitigate the challenges, you should be aware of the current trends in supply management as well as strategies to improve your resilience and flexibility.
Current trends include AI and automation, supply chain as a service, circular supply chains, risk management and stability, and sustainability.
Diversifying your supply chain and creating a backup plan can help you remain agile.
Know the tax implications of your supply chain.

The last two years have seen major disruption in supply chain management — and throughout 2023, that turbulence is expected to continue. The freight supply and demand equation was a common issue during the pandemic and recovery period. We’re now seeing how the Russian-Ukraine conflict is reshaping the global supply chain for many companies. And amid all the economic uncertainty, supply shortages, and rising costs, the U.S. and EU (European Union) have been heavily investing in infrastructure, putting even more pressure on China with the U.S.-imposed tariffs’ strenuous implications.

While managing your supply chain is currently a challenge, you’re not completely at the mercy of these external factors which are generally outside of your control. There are strategies to mitigate the impact to your supply chain: your goals should be to both improve your supply chain resilience and flexibility to allow you to better manage the disruptions — those foreseen and unforeseen.

Our International Tax team breaks down some of the current trends and strategies to be aware of.

Trends in supply chain management

Some of the main trends in supply chain management include artificial intelligence and automation, supply chain as a service, circular supply chains, risk management and stability, and an increased focus on sustainability. Now, more than ever, mid-market multinational companies must be strategic. These additional constraints cause strain on these companies that are being forced to pivot to address these issues among additional disruption.

Odds are, you’ve been rethinking the way you currently manage your supply chain — because the global situations aren’t changing. The China tariffs are unlikely to disband soon, and there seems to be no end in sight to the Russia-Ukraine conflict.

Diversifying your supply chain

Many agree that the global supply chain was too dependent on China, and now companies are considering breaking away from the Asia Pacific region to look at the Mexican maquiladora or IMMEX programs. Both these programs are, for all intents and purposes, synonymous, save for one detail: the IMMEX added shelter companies as a modality. Under this shelter program, companies may set up operations in Mexico without establishing a legal Mexican entity.

These programs have been in existence since the 1960s, so they’ve proven their worth — however, they don’t work for everyone, so it’s worth perusing other options. It’s important to remember that sourcing from vendors in only one location, regardless of where that location is geographically, is accompanied by elevated risk.

To mitigate this, you should not only diversify your supply chain but also create redundancies to avoid a single point of failure. In addition, bringing your sources of supply closer to where you operate also reduces the opportunity for risk. Engage with new suppliers and manufacturers in the Americas, for instance, and analyze your current suppliers to see if there is any one region you rely on more heavily already, then minimize the distance between your production and purchasing — without, of course, sacrificing quality, cost, control, and reputation. By optimizing your global footprint, you can maximize your production opportunities, minimize risk, and scout new vendors and locations for future efficiency.

Devising a backup plan for supply chain disruptions to address multiple contingencies

At the end of the day, we know that no matter how sophisticated or agile your supply chain backup plan is, external factors — which are never static — can affect things in unexpected ways. With rapidly and ceaselessly changing global conditions, there’s no way to account for everything you could encounter.

But there are ways to prepare. Plan for multiple contingencies, weighing their outcomes. Don’t forget to think broadly and for new opportunities — for example, if you’re looking at expanding into new markets or territories or want to add a new product line, you must assess their plausibleness under a variety of conditions (and not just logistical conditions, like lead times and delivery … but also tax liabilities and compliance, too).

Keep your supply chain planning agile and ready to evolve by reviewing its current model and updating it to ensure it reflects the restraints and vulnerabilities you’re presently dealing with. By making a step-by-step plan — for multiple scenarios — you can chart your path forward, regardless of what unfolds on the global stage in these uncertain times.

How MGO can help

Knowing the tax implications of your supply chain is crucial to your global success, and our experienced International Tax team can help you navigate the supply chain turmoil — no matter how turbulent. By reviewing your current supply chain model to determine where your processes can be strengthened and made more efficient, as well as pinpointing your vulnerabilities, we can help you hone your supply chain’s true potential while safeguarding it against whatever comes next.

About the authors

John Apuzzo is the leader of our International Tax Practice. He supports public and private companies, and high-net-worth individuals, as they conduct business on the global stage. His passion for developing optimal tax strategies helps his clients reinvest in their businesses and enjoy the wealth they have worked so hard to earn.

Mandy Li is a transfer pricing partner and provides strategic and tactical transfer pricing solutions to public and private multinational organizations. She supports highly complex global engagements, with an emphasis on transactions moving to and from the China region.

Using Transfer Pricing Strategies to Reduce 280E Tax Exposure

Executive summary

Companies face tax burden challenges related the classification of cannabis as a Schedule I controlled substance and IRC 280E.
To navigate this, companies may be able to utilize vertical integration strategies and incorporate transfer pricing best practices to minimize tax exposure.
A transfer pricing study will help identify and risks or opportunities for improvement.

As the cannabis market continues to grow, in the United States cannabis operators continue to face difficulties related to an excessive tax burden due to IRC 280E. One of the most effective strategies for mitigating tax exposure under 280E has been to leverage the benefits of vertical integration.

Since IRC 280E affects the various verticals differently, some cannabis companies are able to isolate activities within distinct business units and maximize Cost of Goods Sold (COGS) calculation to mitigate the impact of IRC 280E.

The potential downside is two-fold. First, IRS tax court cases have made it clear that isolating business units is not a universal solution. And secondly, if not optimally established and documented, transactions between the business units can be problematic and create issues with the IRS.

This article breaks down the impact of IRC 280E, demonstrates the potential benefits of vertical integration, and describes how a proactive transfer pricing strategy can help you maneuver the specific tax and regulatory considerations that affect the industry.

What IRC 280E means for your tax liability

Section 280E penalizes traffickers of Schedule I or II drugs by prohibiting the deduction of “ordinary and necessary” business expenses after reducing gross receipts by COGS, essentially resulting in your federal income tax liability being calculated based on gross income, not net income. For a cannabis operator, COGS typically consist of the cost of acquiring inventory by purchase or production.

Not only are these cannabis companies facing high federal taxes, but there is now an intense level of scrutiny in both federal and state tax audits on intercompany arrangements.

Impact of vertical integration on IRC 280E calculations

Many cannabis companies have become vertically integrated, i.e., combining production function (i.e., cultivation and manufacturing) of cannabis with retail or resale (i.e., distribution) or sometimes all three. Since Section 280E is directly related to selling or the “trafficking” of cannabis-related products, it has the biggest potential impact on retail operations. This means that if a producer can support a higher selling price to its retailer, the retailer will have more COGS from the producer, and the producer will have more costs to deduct because of the allowance of indirect costs.

The business motivation for vertical integration is to better control the supply chain and the end user’s experience. From a tax perspective, cannabis taxpayers want to dis-integrate activities subject to 280E from those for which a position can be argued that they are non-280E activities, such as management services. The Internal Revenue Service (IRS) uses transfer pricing to challenge such segregation and to make allocations between or among the members of a controlled group.

How a transfer pricing study can help your cannabis business

Whether its receives the recent budget infusion or not, the IRS is likely to conduct more transfer pricing audits of the cannabis industry, compared to other industries. These audits frequently result in much higher tax adjustments and significant penalties. In addition, since several states have had budgetary shortfalls due to COVID-19 and other factors, multistate businesses are more frequently being audited by individual states’ tax authorities. If your business has international or domestic intercompany transactions, you’re facing a difficult and uphill battle amid current local, state, and federal tax regulations. The best defense against an IRS transfer pricing audit is a comprehensive transfer pricing study.

A robust transfer pricing study provides the basis with which a company can refute and push back against federal and state claims that their intercompany transactions have no economic or operational substance. As part of a transfer pricing study we will work with you to identify key classes of intercompany transactions, document the pricing of such transactions and reference comparable benchmark data sets to support qualifying transactions. Where transactions fall outside norms, we will work with you to identify differentiating characteristics and seek other data if available, or recommend policy and pricing changes, along with an assessment of the potential exposure.

Taxpayers with inadequate or out of date transfer pricing policies risk an increased likelihood of controversy and transfer pricing adjustments. Thus, even if you have had a transfer pricing study performed in the past, it is important to have it reviewed and updated.

While a transfer pricing study directly reduces a company’s risk of tax assessments and liabilities resulting from tax audits, they also indirectly reduce execution risk when a company is considering an M&A transaction, a capital raise, or go public transaction.

How MGO can help you integrate transfer pricing for the cannabis industry

MGO’s transfer pricing practice has significant experience with the various transfer pricing concerns of the cannabis industry. We also work closely with our federal and state tax practices to assist many cannabis companies with their specific tax and regulatory considerations, which include:

Section 280E disallowance of ordinary business expense deductions;
Common supply chain concerns for operators, like state restrictions on inventory and separation of cannabis and industrial hemp;
Non-plant-touching structures that operate independently from the 280E-affected business lines; and
Sales and excise taxes specific to the cannabis industry.

To learn more about how we can help support establishing, optimizing, and documenting transfer pricing policies so your business can grow in this dynamic industry, contact us.

SALT Transfer Pricing Enforcement Is Increasing – How to Defend Your Transfer Pricing

Once primarily an international tax issue, transfer pricing has become increasingly important at the state and local tax (SALT) level. With states experiencing financial pressures from multiple sources, including the COVID-19 pandemic, businesses — especially multistate taxpayers with significant domestic intercompany transactions — should expect increased state tax authority scrutiny and audit activities. Many states that use both separate and combined filing methods recognize transfer pricing as a substantial potential source of revenue. State efforts in transfer pricing audits have also increased because of heightened awareness from the OECD’s base erosion and profit-shifting project and the recent global and domestic tax reforms related to intercompany transactions. Taxpayers with domestic intercompany transactions, who may have never needed to consider transfer pricing in the past, should proactively plan for these audits and seek out potential opportunities.

State and local enforcement is increasing and states are hiring

The number of state transfer pricing audits has significantly increased in the past few years, and state tax authorities are adding transfer pricing resources, including auditors and outside consultants, even throughout the COVID-19 pandemic.

As a result of the potential for increased revenue, there has been renewed interest in collaboration among state tax authorities on transfer pricing. The State Intercompany Transactions Advisory Service (SITAS) of Multistate Tax Commission (MTC) was established in 2014 to unite those states interested in transfer pricing, encourage information sharing among them, and train groups for transfer pricing audits. With little interest at the time, the group stopped convening in 2016, but in 2021, it has re-emerged with renewed state interest in information sharing when it comes to multi-state audits. MTC is working on multiple initiatives for transfer pricing collaboration among states. It promotes the exchange of taxpayer information, which permits the states to collaborate on audit, compliance, enforcement, and litigation activities. MTC is also drafting a proposed white paper on the taxation of digital products and processes.

Indiana, North Davidina, and Louisiana are among the states that are leading efforts in state transfer pricing dispute resolution. Indiana introduced an advance pricing agreement (APA) program in 2020 to offer taxpayers an avenue for resolving existing and potential transfer pricing disputes with the state directly. An Indiana APA covers two three-year audit cycles. The Indiana Department of Revenue (DOR) also goes to pre-audit years if net operating losses are involved — not to make assessments for those years but to adjust the NOL carryover deduction that comes into the audit years. In July 2021, Indiana DOR officially proposed bilateral APAs in separate-reporting states.

In 2020, North Davidina announced an amnesty program for taxpayers to voluntarily disclose state transfer pricing positions and reach agreements with the state on intercompany pricing without facing additional penalties. This effort resulted in roughly $100 million in tax revenue collected from more than 100 participating taxpayers through the program. Similarly, in October 2021, the Louisiana Department of Revenue invited eligible taxpayers to participate in a voluntary initiative, the Louisiana Transfer Pricing Managed Audit Program, which aims to resolve transfer pricing disputes. It is anticipated that other state tax authorities will also develop similar programs to those in Indiana, North Davidina, and Louisiana to boost their tax revenues.

Transfer pricing issues can arise when there are transactions between two or more members of a unitary group. While most states require or permit “combined” reporting, under which affiliated entities conducting a unitary business file a group return that includes entities with out-of-state activities (and eliminates many intercompany transactions), seventeen states use “separate” reporting, which finds each entity filing its own return regardless of corporate affiliation. In both “combined” and “separate” reporting jurisdictions, transfer pricing can become an issue, but particularly in separate reporting states, the taxpayer’s separate-company taxable income can be directly affected by the pricing of transactions between the taxpayer and any domestic or foreign affiliates with out-of-state activities. And even in “combined” jurisdictions, state tax authorities may review the transfer price of transactions between related companies – both domestic and sometimes even foreign entities, depending on the state’s “water’s-edge” rules for including non-U.S. affiliates – to identify potential abuse of intercompany pricing (e.g., by overvaluing expense deductions or under-reporting income).

What the state and local tax authorities are looking at

At the federal level, transfer pricing is governed by the regulations promulgated under Internal Revenue Code (IRC) section 482 based on the rules of the arm’s length standard, which requires that the results of intercompany transactions be consistent with the results of comparable transactions between unrelated entities. Most states have adopted some form of the federal transfer pricing rules under IRC section 482. For example, Utah and Indiana have codified the language of IRC section 482 in the state statute.

State and local tax authorities are not bound solely to the arm’s length standard and are free to assert their own transfer pricing requirements. Intercompany transactions are often scrutinized at the SALT level in accordance with concepts like economic substance and business purpose, and in key focus areas such as royalties, debt, management or franchise fees, insurance, expense deductions, and allocations. The concepts are either derived from base erosion and profit shifting (BEPS) or incorporated into the state regulations.

The tools available to the state tax authorities to tackle transfer pricing issues include adopting IRC section 482, forced combination, alternative apportionment, related party expense addback, and asserting nexus with the out-of-state entities.

Under audit, states generally have the authority to require taxpayers to file on a combined basis on audit, or to use an alternative apportionment methodology. In addition, some states disallow certain deductions for expenses between related parties and require businesses to add back the deductions to their income.

When state tax authorities have deviated from IRC section 482, they have faced resistance to their transfer pricing approaches. Some recent court cases have sided with taxpayers and determined that state lacked sufficient support to claim that separate returns do not accurately reflect taxpayer income or that transactions lack economic substance. State revenue authorities have also been required to adhere to more standardized transfer pricing rules and practice when applying the state versions of IRC section 482. As a response, state tax authorities are actively engaging transfer pricing economists and professionals to boost their efforts against tax losses from intercompany pricing.

How to defend your transactions: taxpayer best practices

For transfer pricing among domestic affiliates, transfer pricing documentation is the best defense to support intercompany transactions. Companies anticipating significant intercompany transactions should prepare a transfer pricing study to document those transactions. The transfer pricing study should be completed contemporaneously with the completion of the tax return to provide penalty protection in case of transfer pricing adjustments.

Companies should closely examine their operations and determine the amount and details of all current and anticipated intercompany transactions, as well as try to avoid any single entity over- or under-paying taxes in any given state by valuing and compensating each affiliated entity for its relative contribution to the success of the business. Appropriate cost allocation analysis helps to ensure that revenue and expenses are allocated to the correct entities based on the contribution of each entity to the business.

Consistency is key for companies preparing a transfer pricing study and should ensure consistency across state revenue agencies. It is also crucial for taxpayers to ensure consistency in intercompany agreements, transfer pricing policies, and documentation to minimize audit risks. Businesses should have intercompany agreements in place and keep them up to date. It is important to incorporate transfer pricing as an integral part of the company’s business and tax planning process. Appropriate transfer pricing policies and documentation must be reviewed/updated periodically to reflect the new economic and business environment.

When facing state audits related to intercompany transactions, companies should work closely with their tax advisors to actively respond to requests from tax authorities to avoid prolonged audit processes and mitigate adjustment and penalties. Companies should also explore dispute resolutions such as state APA and voluntary disclosures for existing and future intercompany transactions to reduce tax uncertainties and associated costs.

How we can help

This area is complicated and filled with potential pitfalls. We are here to guide you – whether it’s to review your intercompany transactions and determine arm’s length pricing, help establish your transfer pricing policy, or represent you in an IRS audit. MGO’s SALT and Transfer Pricing teams are highly experienced and can guide you through best practices in these various areas. Reach out to our team of professionals to help protect your business.