Should you move supply chains away from China?
INSIGHT ARTICLE |
For decades, China has dominated global supply chains because of its infrastructure capabilities and sophisticated manufacturing ecosystem. Nevertheless, due to rising labor costs, the U.S.-China trade war and the outbreak of COVID-19, multinational companies are considering ways to ensure more resilience in their supply chains. Many U.S. companies have moved their supply chains away from China to other Asian countries such as Vietnam, Cambodia and India, as China’s advantage of cheap labor has increasingly been overshadowed by the advantages these alternative countries present.
Long before the United States imposed tariffs and other trade barriers on China, the Chinese government started to push for more value-added automation manufacturing processes and to shift out lower-end labor-intensive manufacturing processes. In response, many companies relocated sectors such as apparel or electronic products, which only require simple skills and are less capital-intensive than other industries. Relocating these types of lower-end manufacturing activities is a relatively easy strategy and can help multinational companies to better control their operating costs and manage their “origin of supply.”
Having said that, even if a company moves its manufacturing activities to other Asian countries, it may still be very dependent on China. For example, it may have to import raw materials from China such as fabrics and electronic parts for manufacturing. Alternatively, a company may primarily engage in midstream activities outside of China, playing the role of manufacturing and assembling products for exports. In these situations, some Asian countries have become China Plus One alternatives; this is a trend that will not go away anytime soon.
For higher-end manufacturing, reducing reliance on China is more complicated due to the following factors:
- Relocation of higher-end manufacturing is a very expensive process. It includes setting up new factories, moving production lines and rebuilding the entire ecosystem in a new country. New validation, approval and licensing from different authorities may also be required.
- Components are essential for higher-end manufacturing modules and finished goods assemblies. However, component manufacturing is difficult to move outside of China because of the country’s high-quality manufacturing, huge skilled labor force, sophisticated logistics infrastructure, and well-established and mature supply chain ecosystem.
- Sourcing raw materials and components for higher-end manufacturing requires extensive testing and validation. In addition, it takes time to build up confidence with new suppliers in a new country. In particular, most new vendors may not be capable of manufacturing at the same quality standards as the China vendors do.
- Even if production is moved out of China, if a company sources critical components from China or if certain critical processing is done in China, the finished products’ origin of supply may still be China, which would result in full tariff costs.
- In the case of higher-end products aimed for China’s fast-growing consumer market, moving supply chain activities out of China may not be a good idea. Manufacturing and trading in China are easier when an enterprise has operations locally. Goods manufactured outside of China but shipped back to China, will incur extra transportation costs and tariffs.
- Other factors to consider include the ease of access to second- and third-tier suppliers, the sustainability of supplies, the product life cycle, customer values and preferences, hiring and training of skilled workers, and the tax and regulatory regime.
While restructuring plans vary by industry, supply chain infrastructure takes time to establish. In the foreseeable future, China is still an optimal location for large-scale manufacturing. Because China is an attractive manufacturing location and boasts a large consumer market, many multinational companies may prefer maintaining some manufacturing in China, while at the same time bringing capacity closer to market demand.
Tax and transfer pricing considerations
Creating new foreign entities and transferring assets and activities from one foreign entity to another can have important group-wide tax implications. From a U.S. tax perspective, asset transfers can be structured in a taxable or tax-free manner. The implications of each structuring alternative must be modeled carefully, as different alternatives can result in markedly different tax consequences for the transferor, transferee, and U.S. shareholder.
Further, any significant changes to the global supply chain of a U.S.-based multinational will require analyzing a wide variety of U.S. tax provisions including those governing GILTI, Subpart F, indirect tax, and foreign tax credits among other provisions. Any prospective changes should quantify significant changes to the company’s effective tax rate in addition to potential improvements in the cost of labor, raw materials and other expenses.
Finally, transfer pricing considerations must also be reviewed for both complete and partial extraction from China. For complete extraction from China, it will be important to review transfer pricing guidelines for any new jurisdiction. For partial extraction, it will be important to ensure that there is compliance with Chinese as well as the new foreign jurisdiction transfer pricing guidelines.