EU enlargement - a taxing problem

In four months time ten more countries will join the EU. Neil Byrne and Colm Halpin, of Ernst & Young, Dublin, consider the tax issues and their impact on the supply chain

On 1 May 2004, 10 new countries will become EU member states - Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovak Republic and Slovenia (currently referred to as the Accession Countries)- in the largest single expansion of the European Union since it was founded.After enlargement, goods, services, capital and labour will move freely within a vast single market of 25 countries and nearly 500 million people. The tax and legal framework for the Accession Countries will change to bring them into line with EU law, making it far easier for EU manufacturers in all industries to invest in and trade with the region.

Enlargement may present particular opportunities for EU manufacturers in the pharma sector. It may allow them to operate more efficiently and over a wider area, for example, by removing trade barriers and by reducing the costs of labour, European-wide distribution and imported raw materials. It will also increase market access, and not only in the Accession Countries themselves.

The admission of former Soviet bloc countries may open markets farther east. Poland and the Baltic states, for example, may be used to reach Russia, while Slovenia may provide access to Serbia-Montenegro, Croatia and Bosnia.

attractive locations

Changes may be expected in respect of wage levels and education in the Accession Countries after joining the EU. It is likely that their economies will move from relying on low-cost manufacturing to being more driven by specialist manufacturing, services and know-how. Some Accession Countries already are attractive locations for regional or pan-European shared services centres, centralised distribution centres and or r&d centres, and enlargement could boost this trend.

Many manufacturers will seek to re-engineer their supply chains to take advantage of these changes. They may aim, for example, to reduce European-wide stock levels, lead times and production costs, or to increase productivity and improve customer service. In the process, they should not neglect tax issues. Initiatives aimed at optimising supply chains may deliver far greater benefits if tax planning is included.

The results of tax-effective supply chain management can be powerful. Combining tax planning with supply chain management may more than double the benefits of corporate restructuring, measured in terms of after-tax income or free cash flows, compared with supply chain initiatives or tax planning solutions adopted in isolation.

Many pharmaceutical manufacturers have already adopted tax-effective supply chains in the EU, adopting structures such as toll manufacturing and assembly, outsourcing non-core processes, sub-contracting specialist functions and adopting centralised purchasing, either directly or indirectly through purchasing agents or commissionaires. However, the Accession Countries, which are key manufacturing centres for many industries, have often been left out of their plans.

This was due to a number of factors, such as their different legal systems, their different product specifications and their different tax treatment of transactions. The expansion of the single market may now allow EU manufacturers to extend the benefits of their tax-effective supply chains to include the new member states.

Significant tax savings are often available when major business change initiatives are undertaken, for example when multinationals move from nationally focused business units to a regional or global business model.

Effective tax planning should be based on the requirements of the business, the existing structure and any plans for business restructuring. While the revised structure should deliver sustainable tax deferrals or effective tax rate reductions, changes should not be tax driven.

Some typical features of a tax effective supply structure used by pharmaceutical manufacturers include: subcontracting for specialist processes, 'tolling' of raw materials owned by a principal company, sales made through limited risk distributors or commissionaires, centralisation of group functions such as r&d and shared administrative services.

tax harmonisation

The opportunity to adopt tax-effective supply chain improvements in the Accession Countries should be greatly helped by the tax harmonisation that is a cornerstone of the single market. In all Accession Countries, old domestic tax rules, high protective tariffs, bilateral customs agreements and local tax incentives are gradually being replaced by EU tax legislation and case law, as well as EU-approved tax benefits.

The most immediate effects will be felt in the area of indirect taxes, customs and VAT, which are highly harmonised at the EU level. Each Accession Country must now adapt its domestic laws and practices to reflect the EU rules, both for international trade and for domestic transactions, radically changing the cost and operating environment for companies in those countries.

No border controls, customs declarations or customs duties will apply to goods traded between any of the 25 countries in the enlarged EU. This will reduce the cost and time required for the movement of goods as well as eliminating the administrative requirements for proving 'origin' or claiming tariff preference under the current network of trade agreements between and among the EU and the 10 Accession Countries. These benefits will be offset somewhat by new and extended requirements to comply with EU VAT registration and reporting requirements potentially in up to 25 countries.

The Accession Countries must also adopt the common EU tariffs for importations from outside the EU and these may be significantly different from the existing national tariffs. Broadly, under the EU tariff finished pharmaceuticals and medical devices have zero rates of import duties while rates of typically 3-7%, apply to excipients and packaging materials imported from outside the EU.

Some manufacturers in Accession Countries will also face potentially significant changes in both import tariffs and domestic prices for materials, derived from agricultural commodities (such as sugar syrups) since they are affected by price levels determined by the EU Common Agricultural Policy. Companies should consider this when looking at alternative production locations, but keep in mind that they may be able to use special customs procedures to offset these costs or that they may be entitled to compensation under established EU schemes that provide refund payments for certain sugar and starch raw materials used in pharmaceutical manufacture within the EU.

Companies considering a significant capital investment in an Accession Country should consider whether the timing of imports around the accession date could materially affect the rate of customs import duty they will incur.

Many manufacturers operating in an Accession Country will already be using customs procedures, such as Inward Processing or Free Zones, which may become redundant or inappropriate after accession. Manufacturers should ensure they understand what impact this will have on their operations. Transition plans may be needed to dismantle or replace the current customs procedures to achieve the lowest customs duty cost.

Overall, the new indirect tax rules should facilitate EU trade, and speed up and lengthen supply chains. For example, the non-recovery of VAT by EU-established companies should largely become non-existent. Also, the timeframe for obtaining such refunds should become far shorter. At the same time, certain concepts such as toll manufacturing and commissionaire sales should become easier to implement, as their VAT and legal treatments are clarified.

However, the rules for cross border trade will impose new VAT compliance requirements that may prove onerous, especially to corporate groups that operate in all 25 member states.

corporate taxation

Changes will also apply to corporate taxation. After accession, EU rules will apply to cross-border mergers and to intra-group transactions. Changes are expected in the future for cross-border payments of interest and royalties. Several Accession Countries are considering the implementation of relatively low general tax rates, following the Irish example, to stimulate their economies.

At the same time, some tax benefits that were available to manufacturers in Eastern Europe are likely to disappear. The Accession Countries are being forced to review their systems of tax incentives and tax holidays that are considered to contravene the EU Code of Conduct and State Aid Rules. Although, measures may be allowed to run for some more years, the EU has made it clear that the new members may not continue their current practices indefinitely.

EU enlargement may not bring about a sweeping wave of revolutionary change in the accession region. A great deal has already been achieved to adapt to EU norms during the last decade. However, all Accession Countries are expected to expand their economies substantially as a result of enlargement.

Also, the tax, legal and business environments will change, as each Accession Country becomes fully integrated into the EU on all levels. Multinationals, in particular, may be able to consider different options to capture these opportunities in a tax effective way.

Manufacturers that have already adopted tax-effective supply chains may be well positioned to leverage those structures into the new EU territory.