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Getting to know the Value Chain Analysis

IntroductionThere is much discussion these days about value chain analysis (VCA). The concept of a VCA has been around for decades, but only recently has its use in the tax world become more commonplace. Although the Organisation for Economic Co-operation and Development (OECD) has not explicitly referenced a VCA, the approach is proving itself useful in meeting requirements set forth in its Transfer Pricing Guidelines.

In fact, tax authorities around the globe to varying degrees have begun to look to a VCA as part of the process to understand “the big picture” of the whole value chain of a business. In many ways, it provides necessary insights beyond what one would get from mere functional analysis as a result of its enhanced focus on people and specific activities. Indeed, it has become a more commonplace part of transfer pricing documentation as well as in the area of advanced pricing agreements (APAs) and controversy.

Notwithstanding the VCA’s recently raised profile, many people don’t fully understand what a VCA is or the many ways it has been, and continues to be, useful to tax practitioners. In the next few pages, we consider what a VCA is, provide an overview as to how a VCA is performed, and discuss some practical use cases to demonstrate how VCAs are already being used by taxpayers.

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What is a value chain?To fully understand what a VCA is, you must first understand what a “value chain” is. Coined by Michael Porter in his 1985 best seller, Competitive Advantage: Creating and Sustaining Superior Performance, the concept of a value chain has evolved over the years to reflect the increasing complexity of global businesses. At its core, however, the term is meant to reflect how an organization creates value through the coordination of many discrete activities it performs in designing, producing, marketing, delivering and supporting its products and/or services.

As illustrated in Figure 1, below, Porter differentiates activities between “Primary Activities” and “Support Activities” as a logical way of illustrating the value chain of an organization, but that bifurcation alone is not indicative of the relative value a function within an activity grouping contributes.

As companies mature, certain activities are optimized to squeeze value through efficiency, while others focus on adding value based on their effectiveness. This mix between efficient and effective evolves over time as consumer and industry trends or competitive pressures for adaptation wax and wane. As such, a company’s value chain should be viewed as a continually evolving set of activities that change as new strategies are pursued, new business models are introduced, and new operating models are developed. Porter also recognized

the importance of engaging with a reliable network of third-party partners (i.e., suppliers, contract manufacturers, logistics providers, etc.) in what he termed as the larger value system. For many organizations, developing and maintaining these partner networks can be a big competitive differentiator in terms of cost, quality, and reliability. In a rapidly integrated, connected, and digitized world, many companies are finding that the value of formal and informal partner networks is the difference between success and failure.

Figure 1: Porter’s Value Chain

Primaryfunctions

Supportfunctions

5Services

Procurement

Human Resource (HR) management

Technology

Infrastructure

4Marketingand sales

3Inboundlogistics

2Operations

1Inboundlogistics


3Getting to know the Value Chain Analysis

How (and why) to conduct value chain analysis

Every firm is a collection of people performing activities aimed at driving certain outcomes. From purchasing, to operations, to sales and marketing, finance, and HR, firms have established sets of processes and procedures that, in many cases, have been developed over many years with little formal documentation and/or testing as to their efficiency or effectiveness.

Performing a VCA is a way for companies to better understand the structure of their own organization and how and where value is being created. Among other benefits, a VCA can help companies identify core competencies and distinguish those activities that drive competitive advantage or identify areas of less competency as potential risk areas or opportunities to acquire, enhance, or develop such competencies.

Conducting a VCA involves three steps:

Identify key business processes critical to the organization and related linkages

Overlay those processes in flow diagrams to understand how primary and support functions align and key roles are involved at different stages

Assign accountabilities/responsibilities within the process/specific activities. In identifying the key business processes, it’s critical to have a full understanding of the company’s strategy and key objectives to ensure the proper operational alignment of those processes/activities defined as key differentiators in steps 1 and 2.

1

2

3


Everyone has a different process of how to actually execute a VCA. For example, the KPMG VCA roadmap further segments these steps into seven bite-sized portions organized in three distinct stages (see Figure 2, below, showing a version used for transfer pricing use cases). A VCA starts with initial analysis that is based on going broad as well as deep. A proper VCA understands how value drivers within industry and peer groups exist and how they align with the subject company and how they differ. A VCA also goes deep as it needs to understand not only what is done by a company but also how and why each

activity is relatively important vis-à-vis the rest. Moreover, a VCA should help identify and include in its relative value assessment what Porter referred to as “linkages” and how they create value. At the end of the process, a VCA should identify the functions and business processes that are relevant to the particular VCA’s purpose or “use case,” described at the level of detail appropriate to such purpose and demonstrative of relative value. A best-in-class VCA also tags value drivers to people, assets (tangible and intangible), and geographic locations.

While this concept of having a systematic way of examining all of the activities an organization performs and how they interact has been a key concept used by management teams for analyzing sources of competitive advantage now for over three decades, it is only relatively recently that tax practitioners have started to utilize the approach in assessing how value can be attributed to such activities from an intercompany pricing perspective.

As noted above, the format of an output from a VCA will vary depending on the purpose for the VCA, the company, and the scope. For example, the primary and support functions and processes of an internet search and marketing company are different from that of a retail grocer, and such differences would reflect in a VCA.

Similarly, a limited-scope VCA of a purchasing function or an enterprise’s activities aimed at creating digital assets would be very different than an enterprise-wide VCA of a global diversified manufacturer. One of the more common output “views” of a VCA is a so-called “Level 2 enterprise-wide” view as shown in Figure 3. This output is considered enterprise-wide as it shows all important functions within the organization. It is referred to as level 2 because it includes the primary functions and processes (e.g., manufacturing, brand management, etc.) and a second level that shows more detail on the specific activities that occur in that function. It is a common output for many of the use cases described as follows.

Figure 2: Roadmap of how to do a VCA



Figure 3: Example of Level 2 VCA heat map output for industrial manufacturer

Strategy R&D and IPProcurement and supply

chain managementManufacturing Brand management Distribution Management services

1.1 Develop the long-term global strategic plans and initiatives

2.1 Identify products and service opportunities for innovation

3.1 Assessing business requirements

4.1 Product range selection

5.1 Brand marketing strategy

6.1 Define and develop distribution/sales and marketing channels

7.1 Finance and treasury services

1.2 Develop the medium- to short-term global strategic plans

2.2 Develop and manage the research and development (R&D) pipeline and strategy

3.2 Sourcing strategy

4.2 Sourcing of raw materials

5.2 Determine brand positioning and vision

6.2 Develop and manage global marketing strategy and budget

7.2 Human resources service

1.3 Develop the local/regional strategic plans

2.3 Manage the R&D budget

3.3 Supplier selection/negotiation and contacts

4.3 Overseeing the manufacturing function

5.3 Develop brand guidelines and best practice

6.3 Develop sales strategy local markets

7.3 Legal and tax services

1.4 Execution of strategic initiatives

2.4 Develop product and service designs

3.4 Postcontract and supplier relationship management

4.4 Production scheduling and managing production assets

5.4 Manage the legal and regulatory aspects of brand

6.4 Negotiate and execute sales contracts with customers

7.4 Information Technology services

1.5 Monitor the regional strategic initiatives being undertaken

2.5 IP protection (legal aspects)

3.5 Quality control and assurance

4.5 Quality control

5.5 Regional marketing framework

6.5 Manage after-sales service (global and regional)

7.5 General administrative services

2.6 Integrate R&D with existing product/service offerings

3.6 Logistics and delivery

4.6 Assembly and packaging

5.6 Develop and handle corporate communications

6.6 Manage client service experience

2.7 Monitor and manage governing regulations

3.7 Demand planning and forecasting

6.7 Develop and maintain relationships with customers

2.8 Manage IP related to technology

3.8 Warehouse stock

6.8 Develop framework for product pricing decisions

2.9 Train the staff on new product developments

3.9 Monitoring of stock

6.9 Perform customer insight and competitor analysis

3.10 Maintaining relationships with the suppliers

6.10 Maintain relationships with third-party distribution channels


Strategy R&D and IPProcurement and supply

chain managementManufacturing Brand management Distribution Management services

1.1 Develop the long-term global strategic plans and initiatives

2.1 Identify products and service opportunities for innovation

3.1 Assessing business requirements

4.1 Product range selection

5.1 Brand marketing strategy

6.1 Define and develop distribution/sales and marketing channels

7.1 Finance and treasury services

1.2 Develop the medium- to short-term global strategic plans

2.2 Develop and manage the research and development (R&D) pipeline and strategy

3.2 Sourcing strategy

4.2 Sourcing of raw materials

5.2 Determine brand positioning and vision

6.2 Develop and manage global marketing strategy and budget

7.2 Human resources service

1.3 Develop the local/regional strategic plans

2.3 Manage the R&D budget

3.3 Supplier selection/negotiation and contacts

4.3 Overseeing the manufacturing function

5.3 Develop brand guidelines and best practice

6.3 Develop sales strategy local markets

7.3 Legal and tax services

1.4 Execution of strategic initiatives

2.4 Develop product and service designs

3.4 Postcontract and supplier relationship management

4.4 Production scheduling and managing production assets

5.4 Manage the legal and regulatory aspects of brand

6.4 Negotiate and execute sales contracts with customers

7.4 Information Technology services

1.5 Monitor the regional strategic initiatives being undertaken

2.5 IP protection (legal aspects)

3.5 Quality control and assurance

4.5 Quality control

5.5 Regional marketing framework

6.5 Manage after-sales service (global and regional)

7.5 General administrative services

2.6 Integrate R&D with existing product/service offerings

3.6 Logistics and delivery

4.6 Assembly and packaging

5.6 Develop and handle corporate communications

6.6 Manage client service experience

2.7 Monitor and manage governing regulations

3.7 Demand planning and forecasting

6.7 Develop and maintain relationships with customers

2.8 Manage IP related to technology

3.8 Warehouse stock

6.8 Develop framework for product pricing decisions

2.9 Train the staff on new product developments

3.9 Monitoring of stock

6.9 Perform customer insight and competitor analysis

3.10 Maintaining relationships with the suppliers

6.10 Maintain relationships with third-party distribution channels

Key

High value

Medium value

Low value



VCA as applied to tax – Six use cases

Now that we understand the basic approach and components of a VCA, let us now explore some common use cases in the transfer pricing and tax realm, including how a VCA enhances and, therefore, should be the foundation of an entity’s transfer pricing (and where appropriate, tax) analysis.

Operating/Transfer pricing model design and reviewFirst, the foundation of transfer

pricing is that a well-developed and sustainable transfer pricing structure should follow directly from how a business is organized and operates. How does it make a profit? What are its critical assets or other resources, where are they located, and how are they developed and managed? Are there valuable linkages or synergies between functions? Where are its key people functions located, who are those individuals or teams, and how do they interact with the global organization? What are the economically significant risks facing the business and how are those risks managed and by whom? The answers to all of these questions and many more form the basis for evaluating the reasonableness of the transfer pricing methods and policies of a multinational enterprise (MNE). At the heart of this evaluation is the question—do the MNE’s transfer pricing policies align expected profit with where value is created? Understanding how and where value is created is at the core of a VCA. It is in this way that a rigorous VCA can be used to design a well-founded transfer pricing model to ensure that profit outcomes within a group align with the value creation.


DocumentationProperly documenting a MNE’s transfer pricing policies is more than simply generating a range

of so-called arm’s-length results (e.g., operating margins, cost-plus percentages, royalty rates, etc.) and commenting that a particular entity in the global group’s results fall into that range. Working backwards, a cohesive, convincing story has to be told as to why that range reflects outcomes that are reflected in arm’s-length dealings.

Stated differently, arm’s-length results reflect the value of the contributions that each of the parties is bringing to the transaction. In transfer pricing, we organize those contributions in terms of a functional analysis—a review of the functions performed, risks incurred, and assets or resources employed by the respective parties. A VCA supplements a traditional functional analysis by enabling the analyst to better articulate how the various functions, risks, and resources contribute value to the enterprise and, in so doing, answer questions such as: Why are the selected comparables truly comparable? Why are the factors selected to evaluate comparability-appropriate characteristics to gauge value-creating activities, significant business risks, and valuable resources? Why is the selected pricing method appropriate given how the companies operate? How does the company operate within its industry? The beginning of this story, which is told in the MNE’s documentation, is quite simply the VCA. Importantly, the output of a VCA—a description of the end-to-end value chain of a business—addresses these “why” and “how” questions and can drive consistency and depth of analysis across all elements of the MNE’s documentation—local file, master file, and country-by-country report.

BEPS risk assessmentOne of the outcomes of the BEPS program and, especially, the resultant evolving and developing

focus on development, enhancement, maintenance, protection, and exploitation (DEMPE), activities has been a re-examination by MNEs of the robustness of their transfer pricing methodologies. Can they demonstrate that the pricing methodologies result in an alignment of profits with value creation? Is there “sufficient” substance performing critical risk management and control activities in those critical operating companies to support the pricing outcomes? The undertaking of such BEPS risk assessments is another application of a VCA. It has elements of the MNE’s documentation efforts, but is more focused and tuned to answering specific DEMPE-related questions and assessing whether the extant transfer pricing structure continues to be fit-for-purpose or whether some changes need to be made in light of questions raised in the post-BEPS transfer pricing world.

Controversy—Engaging with tax authoritiesOne of the hallmarks of a successful controversy strategy is a clear and concise message. A strong

VCA can provide this message. Here are some examples from our Controversy practice where a VCA can be particularly helpful.

We have already had tax authorities, including the Internal Revenue Service, request a VCA during the early stages of an audit. These requests come despite there being no requirement in the U.S., most countries, or the OECD Transfer Pricing Guidelines that would oblige a taxpayer to have a VCA on file. In our experience, a company without a VCA can generally decline to provide a requested VCA—for now.

So, if MNEs are not currently required to prepare a VCA, why should they go the effort of conducting such an analysis? Going back to basics, the whole point of transfer pricing documentation is to explain to interested parties—most typically tax authorities but other external and internal audiences as well—how and why the MNE’s pricing policies comply with the arm’s-length standard. It invigorates the functional analysis and provides a holistic, as opposed to one-sided, view of value within the MNE. The enhanced quality of the documentation not only can inform more robust transfer pricing policies, but also better position the MNE to control the direction of the audit. A VCA draws a line in the proverbial sand about where the taxpayer believes relative value lies, and (where prepared with the right scope and level of detail) a VCA in many cases will account for the entirety of an enterprise’s global value on a geographic basis which could put pressure on inappropriate outsized adjustments by aggressive tax authorities. The VCA by its nature is a clear and concise summary of where profit should be attributed, and where it should not.

One practical point to note, in the middle of an audit where a company is struggling to keep abreast of tax authority information requests and then settlement negotiations, it may be impractical to find the time and resources to prepare a high-quality VCA. For this reason, the decision to undertake a VCA for audit defense may need to be part of the pre-audit defense file.

Another useful application of a VCA in our experience is for nontraditional or complex operating models that are often difficult to explain to tax authorities upon audit. An example might be a cloud computing MNE with a central R&D, marketing, and business development company with numerous affiliates holding server farm assets around the world. A traditional entity or transactional functions, assets, and risk analysis will often obscure the forest with the trees. Only by stepping back and analyzing the global value chain can the MNE’s true story emerge and be effectively communicated to the relevant authorities.

We have also found an interest in VCAs for APAs and MAPs. This application of the VCA is sparked in part by the tax authorities who during negotiations with treaty partners




are trying to convey complex and nuanced aspects of the business at issue. A well-crafted VCA, with its strong visual component, can cut through language barriers or even different levels of experience between tax authorities.

Finally, the VCA approach does not necessarily have to be fully global to be useful. In one recent example, we have found, for example, that a limited-scope VCA covering the manufacturing and sales functions from initial production through additional assembly and sales (across China, Japan, and the U.S.) and then to the end customer has been very helpful in addressing which entity should bear the impact of tariffs. The VCA will uncover how the various related and unrelated parties share the increased cost and can show the way to an appropriate transfer pricing result.

Substance-based tax positionsThe VCA has become an increasingly popular tool to assist a taxpayer in supporting various tax

positions based on facts-based substantiality tests that are related to operations. For example, many taxpayers use a VCA as part of the support for a position that a controlled foreign corporation (CFC) is treated as a manufacturer of property under the substantial contribution rules of Treasury regulation §1.954-3(a)(4)(iv). Under that rule, a CFC that does not physically manufacture a product may be treated as such product’s manufacturer so long as the CFC, through its owns employees, engages in activities that are considered a “substantial contribution” to the manufacturing process. There is limited guidance as to the threshold at which a quantum of activity is substantial, but it is commonly understood to incorporate both qualitative and quantitative views of substantiality. In order to substantiate the quantum of contribution, taxpayers use a form of VCA that is limited in scope to the manufacturing business process—typically including engineering, sourcing and procurement, production, quality, and transportation. The business activities included align with the types of activities considered contribution activities under the substantial contribution regulations. As a result, the limited- scope VCA provides insights on the relative value of each component of the end-to-end manufacture of a product with identification of what functions are performed by which parties. For example, a VCA might identify that the CFC’s employees were responsible for vendor selection, oversight of production planning and production process, and all aspects of quality control, but it would also inform on substantiality as it would assess the relative value of the entire manufacturing process by components. Put another way, the limited-scope VCA would assess the value of the CFC’s contribution activities compared to the total value of the end-to-end multientity manufacturing process.

Value chain managementOne of the earliest tax uses of a VCA has been in integrated tax and business planning in which

a company’s operating model is aligned by a holistic view of business imperatives and needs as well as related

components such as tax impact, operational reporting efficiency, and similar factors. Because such planning is essentially holistic business planning with respect to all or components of a company’s value chain, it is often referred to as value chain management (or VCM).

While tax and financial integration and benefits are a hallmark of VCM planning, it all begins with the business. Unlike other tax (or tax-related) planning that starts from a perspective of achieving some preconceived tax benefit, VCM planning starts by saying “let’s really understand the business” and develop an operating model driven by the reality of the business. And that reality is reflected in the VCA. At the highest level (level 1) of a VCA, many companies are very similar. They have strategy, design, sourcing, production, distribution, and back office. Even when you get into a more detailed inventory of the business processes of a company, many companies in a peer group may appear similar. It is when the lens of a VCA is applied to the functions that you can visualize the differentiation of each unique business. The VCA will help identify, for example, what functions are of most value for a specific company. Two companies may both have procurement that is an important value driver. However, Company 1’s excellence may be driven by best in class demand planning, vendor relationship, and business processes supporting buyers; Company 2’s excellence may be driven by its leading digital procurement analytic models and dashboards. Where a company wants to develop and build a strategic sourcing model, the VCA informs what that model looks like, the functions and assets that would be expected to be in and out of scope, and an initial view on the pieces that need to fit in the box. Using the VCA as its foundation, VCM planning is naturally aligned to value creation and, hence, a natural alignment to operational excellence and transfer pricing compatibility.

When done correctly, the VCA is the lifeblood of any VCM planning and is one of the core reasons that such planning stands apart from traditional tax supply chain planning as it starts with the reality of the business’s value drivers so that it leans towards inherent business purpose, alignment with operational strategy, and sustainability.

One unique feature of the VCM use case is the level of detail in the VCA. In a VCA, level 1 includes the highest and broadest categories of functions with each successive level—level 2, level 3, etc.—basically blowing out more detailed functions within the superior boxes. Because the use of a VCA in VCM planning is typically focused on architecting an operating model, the analysis often requires that one get to a lower level of granularity. For example, for many other purposes we only need a VCA to inform that pricing analytics is high value to a procurement function and performed by a team in Singapore; however, in a VCM use case we may need a VCA that informs specific functions Bob, Mary, and Sue individually perform within the pricing analytics function.


© 2020 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. The KPMG name and

logo are registered trademarks or trademarks of KPMG International. NDP094277

Conclusion

We are living in a new and ever-evolving world of transfer pricing. Tax authorities in the context of documentation, agreements, and controversy increasingly demand to know the “whole story” of a company’s end to end value chain.

Forward-looking companies who desire to align tax and transfer pricing need appropriate focus on the value drivers of enterprise (people functions, assets, risks, synergies). VCA use cases serve these purposes and so much more. Built on a business-first model, the VCA is a tool that can deliver insights on components and the entirety of an enterprise’s value in a way that is as unique as it is simple—what truly drives value in my business?

The authors hope that we have been able to provide some useful insights about VCA, eliminate some of the mystery, and help you see some of the great uses for a VCA. Hopefully, there will be many VCAs in your future!



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The following information is not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

Contact usBrian CodyPrincipal in charge, Economic & Valuation Services, Washington National TaxT: 314-422-2690 E: [email protected]

Sean FoleyPrincipal, Economic & Valuation Services, Washington National TaxT: 202-415-4395 E: [email protected]

Paul GluntPrincipal, International Tax, Value Chain ManagementT: 949-381-8434 E: [email protected]

Jerry ThompsonPrincipal, International Tax, Value Chain ManagementT: 714-721-3691 E: [email protected]

About the authors

Brian CodyBrian is the principal in charge of the Economic & Valuation Services group in the KPMG Washington National Tax practice. Brian provides national support to the KPMG Transfer Pricing practice, as well as serves as a senior technical adviser with respect to transfer pricing issues for the KPMG Global Transfer Pricing Services group.

Sean FoleySean is a principal in the Economic & Valuation Services group in our Washington National Tax practice. He has more than 20 years of experience working with multinational corporations to analyze their intercompany transactions and develop practical transfer pricing strategies.

Paul GluntPaul is an International Tax principal in our Value Chain Management practice. Paul has more than 23 years of experience serving multinational clients in a variety of industries building business operations solutions based on core value chain concepts.

Jerry ThompsonJerry is an International Tax principal and Technology & Innovation leader in our Value Chain Management practice. He plays a leadership role in integrating Tax into key Advisory solutions while also developing and deploying operational process and technology solutions.


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