Antigua Brewers: Transfer Pricing, Ethics and Governance

It is April 2011 and you have used your newly acquired business degree to secure a management job as advisor to the Chief Financial Officer with Antigua Brewers Inc., located in Antigua in the Caribbean Sea.Antigua Brewers Inc. is a 75% owned subsidiary of Gera International, a conglomerate in the business of brewing and distributing beer.It is barely a week since you started your job and you already have major projects to deal with.

Gera International

"Gera" beer has been a well-established international brand of beer for over half a century, usually ranked among the top three selling brands of beer in the world.Up until 2005 Gera International, head-quartered in Munich, Germany, brewed Gera beer for the Antigua region at a brewery located in Jamaica.As transportation costs continued to increase the logistics of shipping from Jamaica, which is located in the Western Caribbean, to Islands in the Eastern Caribbean became problematic.In the early 2000s Gera International set out to find a suitable location for a plant in the Eastern Caribbean.After due diligence investigations on a number of locations Gera International decided on Antigua.

Antigua, with the population of 68,000 is the largest of the English-speaking Leeward Islands of the Eastern Caribbean.Antigua became Great Britain's most important Caribbean base when Admiral Horatio Nelson sailed there in 1784.Situated in the middle of the Eastern Caribbean chain of Islands Antigua often serves as a business and transportation hub between the Windward Islands of St. Lucia, Grenada, Dominica and St. Vincent and the Leeward Islands of St. Kitts, St. Martin, Montserrat and Anguilla.It is also in reasonable physical proximity to more populated islands of Puerto Rico and Dominican Republic to the north and Barbados and Trinidad to the south.

Antigua already had a successful brewery which produced "Tigua" beer, a popular brand in Antigua and throughout the Eastern Caribbean.In 2000 the Antiguan brewery had negotiated a fifteen year income tax holiday with the Government of Antigua on income earned from sales of Tigua beer.The combination of the central location of Antigua in the Eastern Caribbean, the success of the Tigua beer line, and the tax concession on Tigua beer made Antigua a good choice for Gera International; it purchased 75% of the Antiguan brewery, Antigua Brewers Inc. in 2005.The remaining 25% of the common shares of Antigua Brewers remained held by senior management and other employees.Antigua Brewers is one of the many subsidiaries of varying sizes under Gera International's control.

The production facilities of Antigua Brewers were expanded in 2008, thereby effectively doubling the productive capacity.This expansion was funded through a twenty-year amortized loan from Gera Caribbean Bermudaat a fixed interest rate of 10% (previous equipment loans from commercial banks were at fixed rates of 7%).All of the production of Gera beer for the Eastern Caribbean region was transferred to Antigua Brewers after the plant expansion.The resulting production figures for Antigua Brewers are provided in Figure 1.

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Recent Issues

Upon arrival in your new position you discover that all is not rosy at Antigua Brewers.On only your second day in the office the Production Manager Jason Joseph, affectionately known as JJ, comes into your office and shuts the door.JJ has been production manager for decades and has been heralded as a master brewer having won multiple awards for Tigua beer in the late 1990s and early 2000s.It is clear during the meeting that JJ is unhappy and distressed.He explains that prior to Gera International's involvement in the brewery things were better; JJ previously had a 25% ownership in Antigua Brewers which is now reduced to 8%.He had always received a salary of about $100,000 as the production manager but had also benefited by a bonus and an annual dividend.Since Gera International became the majority shareholder there have been no dividends.As well JJ's bonus which is based on a combination of controlling average total production costs and quality control has all but been eliminated since the plant expansion.With respect to production costs, JJ and other production personnel are eligible for a bonus provided that total production costs do not exceed 43% of sales.Figure 2 contains the format of the report that is used to assess production efficiency and bonus calculations.

JJ explains that the production process for brewing beer has been fundamentally the same for decades as outlined in Appendix 1.The first two steps, i.e., Milling and Mashturn, account for 50% of the total production overhead costs.Tigua beer has a longer and more time intensive production process up to the stage where the "wort" is created; this results in the Tigua beer consuming 100% more overhead resources up to this stage compared to Gera beer.After the creation of the "wort" the process and cost is the same regardless of the brand.

The direct costs of the beer are not all that significant; 98% of the beer is water and the cost of the raw materials is only about $3 per case of 24.The costs of the bottle cap and label are as much as raw materials, about $3 per case.The cost of the bottles is $8 per case of 24; however, this is not normally treated as a cost because a deposit of $8 per case of 24 is collected for all returnable markets, which include all domestic markets and export of Tigua.Contrary to this normal business practice no deposit is collected on the export market for Gera beer; as a result, the cost of the bottles pertaining to Gera beer exports are expensed.

As a result of the decline in production efficiencies, as measured in Figure 2, JJ's bonus has suffered.JJ is adamant that the production facility is operating as efficiently, if not more efficiently than before the expansion, and is concerned that the cost allocations used in Figure 2 for production costs are penalizing his bonus."Prior to the expansion, I focused on production cost per case.Gera International now holds us accountable for production cost as a percentage of sales - this has taken away control from the production people.I also don't understand why the exported Gera beer bottle costs are charged to our plant," JJ exclaimed in sheer frustration.He also explained that Gera International has on occasion complained about the quality of Gera beer exported to other Caribbean countries, thereby refusing to pay Antigua Brewers for some shipments.JJ is adamant that the quality of the beer is consistent and desperately wants to be able to prove the allegations of poor quality as groundless.He is concerned that Gera International is making false allegations of the quality to justify not paying for some of the shipments."I do not understand how head office can say that our quality is poor; I have not heard any complaints

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from our local customers of Gera beer.I have been in the business long enough to know when quality is bad; I am able to and usually do take corrective actions during the process itself before things go out of hand."

Before leaving your office JJ explains that he is very frustrated and is seriously considering leaving the company to be the master brewer and production manager of a brewery in Trinidad, a major competitor of Antigua Brewers.This would be a major loss to the company.

Later the same day the head accountant provides you with a letter from the Inland Revenue Department ('IRD') of Antigua (equivalent to CRA in Canada) explaining that tax auditors will be coming out next month to review the tax filings for the years ending December 31, 2008, 2009 and 2010.You investigate and find that in order to benefit from the tax exemption of Tigua beer Antigua Brewers prepares profitability statements along taxable and non-taxable product lines when filing the annual tax return.This allocation between the two product lines is provided in Figure 3.

Antigua Brewers is a tax resident of Antigua and thus subject to taxes of 30% of profits.As you begin preparing for the tax audit you find out the following:

All export sales of Gera beer are made to Gera Caribbean, a wholly owned subsidiary of Gera International, which is located in Bermuda, a tax free jurisdiction (see Figure 4 for a chart of the transactions). For cost and logistical reasons the exports are shipped directly to the Island where the beer will be sold in the Eastern Caribbean while only the invoice is sent to Bermuda (see Figure 4). Domestically a case of 24 Gera beersells for $50 but the exported Gera beer is invoiced to Gera Caribbean for $25 per case. In addition to the $50/case Antigua Brewers collects a returnable deposit of $8/case on all domestic beer sales and on exported sales Tigua beer. Contrary to this normal business practice, no deposit is invoiced to Gera Antigua for exported Gera beer. Gera Antigua in turn invoices the other Islands in the Eastern Antigua for $50/case plus an $8/case deposit for the bottles.

You quickly research the Antigua Income Tax Act ('ITA') and come across a general tax anti-avoidance section (see Figure 5).

The Challenges Ahead (or The Road Ahead)

You ponder about everything that you have heard from JJ.You also reflect upon your new responsibilities, particularly with respect to new elaborate planning and budgeting processes that you will be spearheading.You have been told that these processes are extremely critical and will bring Antigua Brewers in line with the other segments in terms of using standard procedures for resource allocation, performance measurement, evaluation and reward."Is a corporate group standard approach the right way to go or should each subsidiary have some flexibility?" you wonder.

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There is a Board of Directors meeting scheduled for next week.Frederik Verstam, a long-time executive of Gera International has been parachuted in as the CEO and Chairman of the Board of Antigua Brewers. The other members of the Board of Directors of Antigua Brewers are Grandview Goerdler and Delores Garstad from head office who fly in for the quarterly meetings from Munich, Edward Woods a local politician and Byron Jackson a local businessman in Antigua with a 2% ownership interest in Antigua Brewers.

You receive an Agenda of the Board meeting and note that you are required to prepare the following reports:

1. Report addressing the rising costs of production as illustrated in Figure 2. 2. Report on the performance measurement system for production personnel with respect to both cost and quality control. 3. Report on any vulnerability or risks associated with the upcoming income tax audit.

In addition to the requested reports, you have some concerns over the transfer pricing policy in relation to exports of Gera Beer. How is this affecting the minority shareholders such as JJ? How will any presentation of adverse consequences to minority shareholders be received by the Board that is most heavily represented by the majority shareholder?

Based on the information provided you ponder as to what you can do to address the concerns of JJ and prepare for the Board meeting.As a new, responsible professional, you also wonder what management control and other issues you should bring up at the Board Meeting that relate to matters of governance.

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Figure 1 Sales Volume (cases of 24)

Gera Tigua Domestic Export Domestic Export

2007 380,000 55,000 875,000 45,000 2008 389,000 59,000 868,000 48,000 2009 401,000 825,000 897,000 51,000 2010 411,000 1,190,000 911,000 53,000

Figure 2 Production Costs as a Percentage of Sales 2007 2008 2009 2010 Sales $66,375,000 $66,725,000 $88,075,000 $98,500,000

Production Costs: Variable Cost: raw materials $4,037,900 6.1% $4,078,360 6.1% $6,587,220 7.5% $7,874,550 8.0% bottles $440,000 0.7% $472,000 0.7% $6,600,000 7.5% $9,520,000 9.7% caps and labels $4,092,100 6.2% $4,146,560 6.2% $6,630,700 7.5% $7,823,250 7.9% Total Variable Costs: $8,570,000 12.9% $8,696,920 13.0% $19,817,920 22.5% $25,217,800 25.6% Overhead: utilities $4,539,250 6.8% $4,433,000 6.6% $6,739,400 7.7% $7,695,000 7.8% plant maintenance $1,084,000 1.6% $1,050,280 1.6% $1,521,800 1.7% $1,539,000 1.6% personnel $7,452,500 11.2% $7,229,200 10.8% $10,435,200 11.8% $11,286,000 11.5% depreciation $5,420,000 8.2% $5,456,000 8.2% $8,696,000 9.9% $10,260,000 10.4% Total Overhead: $18,495,750 27.9% $18,168,480 27.2% $27,392,400 31.1% $30,780,000 31.2%

Total Production Costs $27,065,750 40.8% $26,865,400 40.3% $47,210,320 53.6% $55,997,800 56.9% Note: For simplicity it is assumed that sales units are equal to production units.

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Figure 3 Allocation of Taxable and Non-taxable Streams

2008 Total Non-taxable - Tigua Taxable - Gera Volume in cases of 24 1,364,000 916,000 448,000

Sales $66,725,000 $45,800,000 $20,925,000

Production Costs $26,865,400 $18,041,574 $8,823,826 Sales Costs $4,670,750 $3,206,000 $1,464,750 Administrative Costs $4,003,500 $2,748,000 $1,255,500 Interest Costs $543,000 $372,715 $170,285

Net profit $30,642,350 $21,431,712 $9,210,638

2009 Total Non-taxable Tigua Taxable - Gera Volume in cases of 24 2,174,000 948,000 1,226,000

Sales $88,075,000 $47,400,000 $40,675,000

Production Costs $47,210,320 $20,586,653 $26,623,667 Sales Costs $5,284,500 $2,844,000 $2,440,500 Administrative Costs $4,844,125 $2,607,000 $2,237,125 Interest $3,257,000 $1,752,845 $1,504,155

Net profit $27,479,055 $19,609,502 $7,869,553

2010 Total Non-taxable Tigua Taxable - Gera Volume in cases of 24 2,565,000 964,000 1,601,000

Sales $98,500,000 $48,200,000 $50,300,000

Production Costs $55,997,800 $21,045,567 $34,952,233 Sales Costs $5,614,500 $2,747,400 $2,867,100 Administrative Costs $5,220,500 $2,554,600 $2,665,900 Interest $2,932,000 $1,434,745 $1,497,255

Net profit $28,735,200 $20,417,688 $8,317,512

Notes: Sales price of Gera Exported beer is $25 while all others are $50 Total production costs allocated on the basis of volume (# of cases). Sales and Administrative and Interest expense allocated on the basis of sales dollars.

Figure 4

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Corporate Transaction Flow Chart

Figure 5 Antigua ITA Section 23 Related Party Transactions Involving Liability to Tax

Where a resident corporation carries on business with a non-resident corporation and by reason of the relationship between such corporations the course of business between them has been so arranged that the business done by the resident produces less profits than those which could be expected to arise from that business if such relationship had not existed, Inland Revenue may determine in a reasonable fashion whether any additional profits should be deemed to be assessable income of the resident corporation.

Gera International Germany

Caribbean Brewers Antigua

Gera Caribbean Bermuda

Customers Other Caribbean islands

Owns 100% of Owns 75% of

Sale

Invoice

Delivery

Invoice

Management and Others

Own 25% of

of Gera Export

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Appendix 1

The Nine-Step Process of Beer Making

1. Milling - Beer brewing begins with polished barley grains called 'malt', which are passed through a milling machine to crack the dried kernels and grind them into a coarse powder 2. Mashturn - The milled grain is dropped into the mash turn with warm water of a certain temperature, depending on the brew recipe, the grain and water are mixed together to create mash - a thick, sweet liquid called wort. 3. Lautering - The wort is then drained off in a vessel called a lautertun (German for 'purification tank') where the husks are used like a giant sieve or filter bed for filtering out the 'spent grain'. 4. Boiling - The wort is boiled and spiced with hops, for up to 90 minutes in a large kettle, or Wort Copper. 5. Fermenting - After it is cooled, the wort is then transferred to a fermentation tank where the sugars are won from the malt juice and are metabolized into alcohol and carbon dioxide, and the resulting mixture is then called young beer.6. Conditioning - the beer is cooled to around freezing point, which encourages settling of the yeast and causes proteins to thicken; the beer becomes crisp and clean. 7. Filtering - In this stage the filtering removes excess yeast, protein and other insolubles as well as stabilizes the flavor so that the beer becomes bright and clear. 8. Pasteurizing - The beer is pasteurized to kill off any of the remaining yeast and any other microorganisms. 9. Packaging - The finished beer is then mechanically filled into bottles or kegs.

Issues?

Implication?

Recommendation?