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The tax factor in global site selection
International site selection for manufacturing plants is a complex proposition. Companies that are seeking to build or lease manufacturing facilities across borders need to investigate many factors to ensure that they make location decisions with the appropriate level of rigor, accuracy, and, ultimately, confidence.
One of the most important site-selection factors—one that sometimes is not fully considered—is the foreign enterprise income tax. This is a corporate income tax that a company is required to pay to federal, state/provincial, and local governments based on the level of taxable income it has generated in a country.
[Figure 1] Before- and after-tax financial model output Enlarge this image
In our experience, it is important for international manufacturers to take a holistic approach that considers both before- and after-tax profit when assessing the merits of potential plant locations. There are good reasons to do so. For one thing, direct-investment projects by manufacturing companies, especially those that produce high-margin products, commonly result in a large amount of taxable income and a potentially significant tax liability in the country in which they establish operations. For another, the answer to the question of which is the best location for an investment can differ depending on tax factors.
Framing location trade-offs
Any company that is seeking to establish international manufacturing operations must carefully weigh the impact of operating-cost inputs that will affect the project's financial performance. Examples include labor, transportation, logistics, utility costs, land costs, taxes, and so forth. Performance measures vary depending on the organization, but they often include return on invested capital (ROIC), the project's impact on earnings per share, and pre- and post-tax cost per unit of production.
For many manufacturing companies, labor as well as transportation and logistics are the geographically variable considerations that exert the greatest influence on a project's financials. In high-margin industries that produce large amounts of taxable income, however, foreign enterprise income tax can have an even greater impact on project financials than either of those factors. In those types of industries, therefore, a location decision can be heavily influenced by in-country tax rates and the country's permitted investment structures. Examples of permitted investment structures, which vary from country to country, include wholly owned foreign enterprises and "toll manufacturing." The latter, in which a firm processes raw materials or semi-finished goods for another firm, is an arrangement that can reduce taxable income.
Although manufacturing companies must consider many factors when making site-selection decisions, they often find that a single geographically variable cost input most heavily influences the location decision. For the purposes of this discussion, we refer to this type of critical cost driver as an "investment optimization model." Three common examples include:
- Labor optimization model—This model is common to industries or products in which the most significant geographically variable cost input is labor. Such an operation is likely to be labor-intensive, with low levels of automation, low margins, and a shipping profile that typically is characterized by high-volume, low-weight products. Countries that might be favorable locations for a company with this type of profile include India, China, Thailand, and Vietnam, among others.
- Logistics optimization model—This type of model is common to industries or products in which the most significant geographically variable cost input is transportation. Such an operation is often characterized by heavy or bulky goods that are costly to transport, a more automated production process (which reduces labor content), low- to moderatemargin products, and a need for production to be proximate to the destination—that is, the revenueproducing—markets. Some examples of countries that currently align with this profile include Mexico (in support of the United States) and Central and Eastern Europe (in support of Western Europe).
- Tax optimization model—This model is common to industries in which the most significant geographically variable cost input is direct tax. Such an operation is likely to be a manufacturer with a highly automated manufacturing process producing high-margin products that are regulated in some form. Just two examples of products that fit this profile include onpatent drugs and medical devices. Countries that would be appropriate locations for companies with this operating profile are those that apply a low tax on foreign investors' net income. They include Ireland, with a tax rate of 12 percent, and Singapore, Switzerland, and Puerto Rico, all of which assess tax rates as low as 0 percent.
These are not the only models for manufacturing companies to consider when they are making international site-selection decisions. As noted earlier, in practice, optimizing a directinvestment decision requires companies to consider a complex set of factors. Moreover, some optimization considerations are specific to certain industries; one example is the cost of electricity for the solar manufacturing industry.
Taxes change the cost picture
The only way to capture the true impact of corporate income tax on a location decision is to develop a financial model that shows both the before- and aftertax implications of the proposed investment. One company's experience, outlined below, illustrates how the tax-cost factor can affect the overall cost of a high-margin, direct-investment manufacturing project. (The company cannot be identified, but the siteselection project and the results discussed here reflect its actual experience.)
The company, a manufacturer of medical devices, needed a new location for a manufacturing plant. The project's objective was to establish the operation in a location that would be globally cost-competitive over 10- and 15-year analysis periods. The project's leadership was charged with determining whether a taxadvantaged, low-operating-cost, or customer-proximate location represented the best option.
Figure 1 illustrates the influence of income tax on project financials and the extent to which it affected the relative attractiveness of the locations under consideration. This graphic clearly illustrates the potential risk in developing a location strategy without considering income tax.
The following key observations emerge from the before- and after-tax assessment:
- Location A (tax-advantaged location): This was the highest-cost option before tax. But when tax was incorporated into the financial analysis, Location A's low corporate income tax made it competitive.
- Location B (tax-incentivized location): Despite having higher before-tax costs, significant tax incentives— zero income tax for a period of 10 years, in this case—made Location B the most cost-competitive of the four locations.
- Location C (low-operating-cost location): The lowest-cost location before tax, Location C became less competitive due to its burdensome corporate income-tax structure.
- The United States: The United States was the second-lowest-cost location before tax, but it became the most expensive site candidate after taxes were factored in.
As you might imagine, modeling the tax impact of these sorts of international site-selection projects is not easy. Complicating matters is the fact that the modeling tools that many companies use to help them select facility locations commonly focus on pre-tax operating costs and do not consider the impact of direct taxes. To compensate for this shortcoming, companies can (and should) assemble an internal team of professionals from their supply chain, procurement, tax, finance, sales and marketing, engineering, real estate, and human resources organizations to provide the subject-matter expertise that will be needed to develop a complete view of an investment's financials.
Consider the cost consequences
For industries producing high-margin products, it is critical to incorporate corporate income tax into any financial assessment of potential manufacturing locations. Failure to do so can result in the selection of a financially disadvantaged location. But this advice is not limited to manufacturers of high-margin products. It is also prudent for industries producing lower-margin products to include tax analysis in their location strategies. This is because many countries offer incentives that have the potential to reduce investors' tax liability for an extended period and, as a result, could change the desirability of a candidate location for manufacturing.
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