Business Model Optimisation (‘BMO’) is a process whereby value is created through business transformation. It is essentially a methodology which seeks to integrate both the operational and tax planning aspects of an organisation by identifying its various value drivers such as risks, functions and assets and by locating them in more efficient jurisdictions, both from an operational and a tax point of view. BMO can thus generate significant savings for an organisation, but for this benefit to be truly sustainable it is important that true substance is created in establishing an organisation’s presence in a new and more efficient location.
As already alluded to, a particular jurisdiction will generally be chosen by virtue of its ability to generate both operational and tax savings for an organisation. In practice, however, activities are often located in low tax jurisdictions with the aim of securing the latter benefit, and sometimes without justifying the existence of the former i.e. operational savings. This article discusses the level of substance that needs to be created in a tax efficient jurisdiction and also whether the South African Revenue Service (SARS) will regard this as being sufficient or whether further proof of operational efficiencies being created will need to be provided. In addition, the topic of potential exit charges usually associated with BMO is addressed.
In order to create a sustainable benefit for an organisation, merely shifting or relocating risks to another jurisdiction is unlikely to be sufficient. Instead, the functions and the people performing those functions must be relocated to a principal company (PC) in the tax efficient jurisdiction to manage the relevant assets, functions and risks of the organisation. Substance is therefore created by shifting “significant people functions” relevant to the management of risk and the ownership of the assets to tax-efficient jurisdictions. What remains in the local jurisdiction are typically limited risk manufacturing and / or distributing activities which should now be geared towards an execution role under the decisive guidance of the PC. The PC therefore assumes the role of a central entrepreneur for the organisation’s global business model.
For BMO to be successful, careful planning and subsequent monitoring must occur to determine that the PC has the appropriate level of substance to be recognised as the sole entity that manages all relevant strategic functions for the organisation’s global business model and, therefore, to be treated as the entrepreneur earning the residual return from a transfer pricing perspective.
A potential problem which organisations often face when implementing this type of structure, is where some of the “significant people functions” are still performed by the PC in the local jurisdiction where the manufacturing and / or distributing activities are undertaken. In so doing, a taxable presence is retained in the local jurisdiction in the form of a permanent establishment meaning that you would have partially defeated the purpose of the BMO exercise. Care should therefore be taken to ensure that all significant people functions are properly relocated to the jurisdiction of the PC and that no unwanted residual activity remains in the local jurisdiction.
Substance required by the tax authorities
The question that arises is whether BMO is acceptable from SARS’ point of view, especially where the structure delivers little operational benefit and is therefore mainly tax motivated. In the author’s view, it is acceptable that SARS, as an observer to the OECD, which has, via the OECD’s Model Convention on Income and Capital, adopted the “significant people functions” concept as a means of applying a more economic approach to profit attribution. Considering that the importance of this concept is limited not only to that of profit attribution in terms of Article 7, but also extends to Article 9 of the OECD Model Convention and therefore to the subject of business restructurings, it is likely that SARS will be content with a structure in which genuine substance is created through the relocation of “significant people functions” offshore even where the structure is mainly tax driven.
However, a risk may still exist that these types of transactions will fall foul of South African General Anti-Avoidance Rule (GAAR) as they are structured mainly for the purpose of obtaining a tax benefit. In this regard, it should be noted that, for an arrangement to be impermissible in terms of the GAAR, it also requires, amongst other important requirements, that the transaction lacks commercial substance. Therefore, it is contended that, provided SARS applies a similar approach as the OECD in determining whether an arrangement lacks commercial substance in terms of the GAAR, BMO can be considered as not only an acceptable alternative to creating tax and operational efficiencies within an organisation, but an excellent one.
This generally refers to a compensation payment which needs to be made for the removal of an asset belonging to an organisation whose business activity has been reduced or simplified. It follows naturally that “exit charges” are high on the agenda of tax authorities when organisations restructure their businesses using BMO.
However, proving that “exit charges” must be levied on an enterprise is not a simple matter because SARS will have to justify more than just a reduction in the organisation’s profits. There must be evidence that the party held an asset, including valuable contracts; that the party transferred it; and that between unrelated parties payment would have been made for that asset. A functional analysis must therefore be undertaken to understand what assets the organisation has before BMO takes place and what assets it has afterwards. A functional analysis is therefore an integral part of BMO and will need to be conducted by an organisation in order to justify to SARS the actual value that was transferred off-shore.
BMO is an excellent tool available to organisations to enhance their global value. However, in implementing a BMO type structure, it is essential that advice be obtained to ensure that genuine substance is created through the adequate reallocation of “significant people functions” to the PC jurisdiction. To this end, BMO requires a functional and risk profile analysis to be undertaken to justify to SARS that genuine substance has been created in the PC through the adequate migration of “significant people functions”. In addition, this will be required to justify the actual value of tangible and intangible assets transferred off-shore as part of the BMO process.