Foreign and Swiss multinationals have been establishing principal company structures (PCS) in Switzerland for more than three decades. In the majority of cases, these structures were focused on implementing a centralised business model for the European region to manage manufacturing and/or distribution activities. The implementation of these structures enabled multinational corporations (MNCs) to generate both operational savings and tax savings as a result of being located in a low tax jurisdiction such as Switzerland.
Since the PCS go-live date, its organisation (headcount and functions) is likely to have changed (increased or decreased) in response to various factors. Initially, the PCS may have been staffed with the minimum number of people and functions required to comply with the Swiss rulings, to run the business efficiently and to sustain the transfer pricing model in place. However over the years the PCS may have become larger than originally envisaged, attracting new, but not necessarily required, functions as a result of it having a force of attraction as the lynchpin of the organisation in the region. Alternatively, required functions may have evaporated and become located elsewhere as a result of people changes or cost pressure.
Cost pressure and risks
While growth in Europe was strong, the value of the PCS was rarely questioned, however today, MNCs are facing several issues related to their PCS in Switzerland:
- Pressure on costs: Recently the Swiss franc has strengthened and as a result the relative cost of operating a PCS based in Switzerland has significantly increased;
- The value that originally drove the transformation of the operating model may now be forgotten. A significant part of the value of a PCS is delivered by having key people in a single location working together to devise (and operate consistent with) a common and well-articulated strategy. The structure can, and probably did, promote economies of scale, help drive efficiencies, and improve competitive positioning. The PCS has the ability to better measure the effectiveness of manufacturing, distribution and better manage its procurement and manufacturing capacity across a region and expectations were probably built in regarding the overall effective tax rate (ETR) of the MNC; and
- The original economies of scale and other synergies may now be routine and taken as a given (whether fiscal or operational). The focus is now on maintaining margin and profitability, which in a recession probably means reducing costs. There is a danger that no one is making the link between the costs of the PCS and its generated savings (whether fiscal or operational). Costs are captured above the line in the profit and loss (P&L) while tax savings are below the line. Often these key metrics are not under the accountability of the same individual or organisation within an MNC.
As a reaction to this above the line cost pressure many MNCs are considering initiatives to downsize their PCS, potentially reducing its substance to address relatively short-term objectives. Such an initiative could result in some or all of these issues for a PCS:
- Potentially no longer fully complying with the rulings negotiated with Swiss or other tax authorities and/or not being aligned with the implemented transfer pricing model;
- Potentially jeopardising certain business processes, missing business opportunities or causing client dissatisfaction;
- Not being fully aligned with the supporting documentation collected during the implementation of the structure (that is, ignoring the original business case that was articulated for establishing the PCS);
- Sending an unintended and contradictory message to the remaining employees on the importance of the PCS and its role within the MNC for that region/market;
- Losing know-how accumulated by functions leaving the PCS,
- A gradual but inevitable move to a virtual PCS where key decision makers are no longer in a single location. These geographically scattered structures may not generate the same level of operational synergies or efficiencies and are unlikely to generate the same magnitude of fiscal savings. On the contrary, the virtual structures may often represent a bigger challenge for tax compliance and sustainability in the medium and long term.
The unintended and gradual erosion of the PCS key functions from Switzerland runs the risk of undermining and (arguably) jeopardising past benefits as it may result in questions as to whether anything really changed operationally upon the instigation of the PCS. However there is no doubt that the issue surrounding the cost pressure on the PCS needs to be addressed as this issue is unlikely to resolve itself in the short term.
How then does an MNC reconcile the focus on cost containment or reduction and maintain a PCS structure that is valuable to the organisation as a whole?
One part of the solution to the cost concern observed in many Swiss PCSs is to perform a holistic review that will determine which functions and headcount of a PCS are still required in Switzerland to operate the business efficiently, while remaining tax compliant and safeguarding the operational and fiscal benefits. This review should be able to answer these questions:
- What is the optimal cost (size and structure?) of my PCS to maximise its value?
- What is the relative value of my PCS in relation to other parts of my organisation (for example, measuring relative unit cost against contribution to overall earnings per share)
This review of a PCS is focused on sustainability as opposed to a pure compliance review that is undertaken in best practice organisations and its objectives should be to:
- Recognise the evolution in the business, the organisation or the legal environment;
- Assess proposed changes and their related impacts on the model;
- Identify any functions that have been collected by the PCS that could be located and undertaken outside of Switzerland (for example in a lower cost location) without significant effects on past and projected PCS benefits;
- Remind the organisation of the value delivered (including below the line value) by the PCS;
- Define, create and gather documentation that supports the rationale for any changes;
Based on our experience, the sustainability review should be performed by both business and tax representatives of the MNC with external advisers to ensure that any change is appropriate to the business, and in line with current and projected tax considerations.
Typically the review will last between six to eight weeks (depending upon the size and complexity of the organisation) and will address and conclude on these areas:
- Review the original designed Target Operating Model (TOM) including:
- The transfer pricing policy and the functional analysis;
- Critical risk areas and review points identified from the TOM and/or initial discussion with the chief financial officer or tax director of PCS; and
- Changes in legislation and practice in the territories where the model has been implemented.
For longer term
In our experience performing a sustainability review allows an MNC to take an objective and longer term perspective on the right size of the Swiss based part of the PCS which is based upon a larger selection of the facts, as opposed to a reaction focused on reducing the operational cost of the organisation and potentially ignoring the value that the PCS has and continues to deliver. When changes are identified they will have been assessed from both an operational and tax compliance perspective, allowing for necessary documentation and communication processes to be established to minimise misunderstanding internally and externally.
Tel: +41 58 792 81 29
Carl Bellingham is a partner with more than 20 years of experience in international tax. He leads the value chain transformation practice in Switzerland and has assisted numerous large and mid-sized corporations in designing, implementing and refining principal type structures both inside and outside Switzerland.
Tel: +41 58 792 83 22
Darioush Zirakzadeh is a director in the value chain transformation group. For more than 15 years he has worked in industry and has assisted large multinationals in implementing principal structures and led numerous VCT reviews of centralised business models in Europe.