Thursday, September 1, 2011

Using Common Sense

In a post in one of the Linkedin groups about contracts an individual wanted to collect all the differences in laws between various countries. He was working in a foreign country only to find out that in that country his fixed price or lump sum agreement might not be really fixed under the laws of that country.

The problem is that no two legal systems in the 196 countries and their millions of geographic subdivisions that make up this world have exact that same laws. That may impact whether a specific clause or template will work within a country. More important it may impact whether specific points within that contract will be enforced. There are a number of differences between locations and I don’t think anyone knows them all simply because the laws in all the locations keep changing.

I’ve written about a number of topics about contracting and contract negotiation and have given examples of what might be included in a specific type of clause. On the Internet you will find a number of people offering to share clauses or standard templates. A common example of problems caused by the difference in laws is the issue of penalties. When I talk about penalties I mean an amount that is over and above your actual damages or agreed liquidated damages. Some jurisdictions allow penalties to be included in a contract. Those are mostly from countries that didn’t follow or evolve from British common law. Other jurisdictions clearly don’t allow the collection of penalties because of the inequity it creates. Under equity the concept is to make the other party whole for the damage caused, not to make a profit that the penalty would provide.

Where common sense comes in two-fold.

First, if you are going to be working in a different country or forced to agree that the laws of another country or location will apply to your contract, you need to take the time to understand what the differences will be so you manage those differences.Understand the rules of the game before you start playing, not after.

Second is when you see and want to potentially use something that you find here on my blog or anyplace else on the internet that wasn’t drafted specifically for your location, you should always run it by someone in your location that will know whether or not it will work, and be enforceable in your location, or what might need to tailored for it to work locally. It doesn't provide any value to put something into a contract that won't be enforced by the laws of that jurisdiction

Tax Issues In Negotiations

There are a number of different taxes. There are taxes on sales or use. There may be taxes on value added performed. All of these are usually charged based upon the specific point of sale.They may differ based upon the country, state, city, etc. There are taxes on inventories. Both the buyer and supplier may want to try to manage where the sale occurs to manage the cost of those taxes. Tax authorities are usually vigilant in managing or enforcing them or limit the quantities that may be transferred into that location. For example when you purchase something duty free, its also tax free and that’s why countries have limitations on the amounts of certain items you can import duty free. When you are purchasing something for resale many of these taxes aren’t a major issue as you may be exempt and have a statutory resale certificate that you can provide the supplier so they don’t charge the sales tax or there will be structure where you can apply for a rebate on the taxes paid for such purchases as occurs frequently where VAT is chanrged.

The bigger tax issue relating to procurement with suppliers is the point of sale. The point of is where a supplier makes their income that is taxed.Suppliers always wants to have the sale occur in the place that is best for them from a tax perspective. Income taxes have also created the need to the supplier to do tax management.Most major companies have both an organizational and selling structure that is designed to manage the tax rates they pay. Let’s talk about several of the ways this is done.

Organizationally a company will have a number of different subsidiaries that will be involved in making, delivering, selling and supporting a product or service. For example, a subsidiary in a lost or low tax country may make a product. They sell that to another subsidiary that provides more value added to compete the product. That subsidiary completes the product and then sells the completed product to sales subsidiaries at what is called transfer price. The initial subsidiary’s sale would have included a profit that is necessary to sustain the operation. The subsidiary that completes the product would normally be in a low tax cost location or tax haven and they will add substantial profit that the supplier intends to make and include that the transfer price they use to sell to the sales subsidiaries. Each selling subsidiary will then add overhead and profit onto the transfer price to establish the local selling price. The transfer price to that subsidiary is their cost which along with the cost of their operation establishes their costs and only the difference between their selling price and those costs is subject to taxation on those profits.

Companies also get creative in further managing their tax by doing things like selling the subsidiaries services that will be performed in low tax locations. The company then makes their profits on providing those services in the low tax location. For the Subsidiary that purchases those services,those purchases are just another cost that reduces their local profits. Examples of these type of things are leasing items to the subsidiary, providing the subsidiary with insurance or financial services, providing financial to the subsidiary.

When a buyer wants a sale to occur in a specific location or country for things like having hubs, stocking locations, or supplier managed inventory in locations close to the buyer, one of the first things that a supplier will consider is the tax impact of that. They will clearly want to avoid having the sales occur in locations where they will incur inventory taxes or increased income taxes. The second thing they will consider is the other impacts of selling in that location. You simply can't go anywhere and sell your product or service. First you must be legally authorized to conduct business in that location. Second, once you operate with that location you are now subject to the laws of that location. For example for a Supplier to set up their own hub in Shenzen, China, they would need to have a license from the government that allows them to operate there. By operating there they become subject to the laws and court system there. They would also need to pay all the applicable taxes on the operation and any profits made there.

The only exception to that would be if they managed the operation in a Free Trade Zone. A free trade zone is an area that exists prior to customs clearance. It is technically considered an international area. As an international area it doesn’t require the company to be registered to do business within that country. If the point of sale is in a free trade zone, it’s the Buyer responsibility import the product by clearing customs. Since the Supplier is not considered to be operating within the country, they are not subject to that country’s laws and courts. Lastly as they sale is occurring prior to customs clearance, the profit is not being made within the country and as such isn’t subject to local tax on the profits.

If a supplier is refusing to do something that would change the location of sale, you always should take the time to understand why. If its because it would be a bad idea for them to do from a tax perspective you should listen to them and work on an alternative solution. If it would impact their costs and net profit after taxes they will do one of two things. Either they do or they will pass the cost impact back to you in the price you pay. If they offer to have a third party stock the material locally where you can purchase it from that third party that isn't a good solution. Once you buy from that third party you lose your privity of contract for those purchases with the Supplier unless you modify your agreement with the supplier so they continue to be responsible..