Tradeoffs in Offshore Manufacturing
Often, companies desiring to expand into new international markets are at a competitive disadvantage due to tariffs on imported goods. Sometimes, producing your product in a trade area can provide access to regional markets with preferential tariffs, as well as, in some cases, local incentives. With incentives, however, often come obligations.
In many cases, managements must navigate the complex business, tax and currency restrictions that are an unavoidable feature of the new market. Many emerging economies insist on a technology transfer for any technology used in producing products in their jurisdiction.
LAFTA and loopholes
As an example, a US based telecommunications company wanted to enter into the expanding Latin American market. In order to do so, it found that in order to be competitive, it would need to participate in what was then called the Latin America Trade Association (LAFTA). Production in a participating country would enable sales to be made to customers in any country in the bloc at reduced tariff rates. After evaluating many alternatives, the Company determined that Brazil offered the most appropriate venue for production and sale of its products. Complications included the requirement that the manufacturer be more that 50% owned by Brazilian nationals, and the technology used in the processes had to be made available to the partner.
The company determined that there was a free trade zone in Manaus, one of the major cities in Brazil. The free trade zone allowed the import of components and sub-assemblies from the US tariff free. Incentives allowed the subsidized construction of a manufacturing facility in the trade zone. Production in the trade zone was exempt from the Federal and state value-added taxes making distribution of the product very cost effective within Brazil.
Since the product was produced within the trade association, sales to any customer within the member countries was subject to reduced tariffs. By producing in a free trade zone that was part of a trade bloc, the company’s products were able to be marketed at very competitive prices to end users.
Tripping up over technology transfers
Manufacturing in an offshore location can be advantageous competitively. However, where there are technology transfer requirements, care must be taken to protect the company’s intellectual property by negotiating the level of components and/or sub-assemblies to be produced at the offshore location and the use of proprietary technology that is transferred to local control.
Currency restrictions also must be considered in many emerging economies. The company wants to be assured that it can at least recoup its investment, along with a reasonable return. This can be accomplished through some combination of transfer pricing and management fees to be negotiated with local taxing authorities.
Other complex tax issues may arise. Typically, a start up organization will lose money in the early stage of operations. The parent corporation typically wants utilize these losses in its tax return. If, however, it has a minority position, it may not be able to easily utilize the losses. US tax planning has mitigated these problems in more recent years with the so called “check-the-box” rules. However, coordination with a competent US international tax advisor is essential to insuring the appropriate utilization of these losses.
Although the example cited is that of a Latin American trading bloc, there are many other- similar trade zones in Europe and Asia. As demonstrated above, expert financial, tax and legal advice at the parent and the local level are in order to optimizing the offshore investment.