A “group captive” is an entity or association owned or controlled by disparate unrelated members or owners. For simplicity we will refer to a “group captive” or “group purchasing organization” (“GPO”). In many industries such as agriculture, agricultural credit banking, credit unions, mutual savings banks, cooperative banking, insurance and commodity-purchasing industries, group captives serve a valuable role. Tax laws promote the establishment of group captives diverse purposes including pooled pension and retirement plan investments, supplemental unemployment compensation benefits, qualified group legal services of individual employers.
Group purchasing of commodity goods is a well established phenomenon. Group purchasing in IT-enabled managed services has begun and is likely to grow. The advent of group purchasing in outsourcing may follow from the historical evolution of outsourcing service providers as mini-aggregators of demand. Historically, service providers in outsourcing aggregated the demand of multiple companies in the target industries. Today, companies in various industries have the choice of developing a counterstrategy, of owning a piece of the service provider to satisfy ongoing needs for industry-generic managed services.
Group Captive as a Sourcing Model
By aggregating demand among unrelated members of a group, trade association, cooperative or affiliate program, individual enterprises can often negotiate better terms with a “group captive” than on the open market. The definition of a group is fluid. So long as the members of the group have a common interest, they can find an economic reason to create a GPO, so long as the structure and methods adopted do not violate applicable laws on competition, antitrust and fair dealing.
Legal Structure of Group Captives
Formation of a separate legal entity provides the members a legal structure for the internal governance of their group captive, as well as a means for limiting liability. Several legal formats are available for GPO’s of buyers of services and related technology for business process management.
Buyers can form cooperatives that enjoy special tax status. Some cooperatives provide services in regulated industries, such as in financial services, so the cooperative might be regulated, thereby incurring additional operating costs that reduce patronage dividends.
Trade Associations, Non-Profit Organizations and their Captives
As a corporation or other legal entity, a trade association (technically called a “business league, chamber of commerce, real-estate board, or a board of trade” under Section 501(c)(6) of the U.S. Internal Revenue Code), is the logical starting point for grouping together parties with common interests for purposes of advancing those common interests. A trade association might sponsor a buyers’ group captive, open to all members, which could be a separate subsidiary of the trade association. In addition, non-profit organizations may also form captives to service their members or their non-profit goals.
Example: A Captive of a Multiple Non-Profit Organizations
As an example, several scholarly and learned academic societies in a particular field (such as mathematics, physics or chemistry) could form a group captive to support the dissemination of published articles in journals on the academic subject. The group captive could either act as a shared services organization for the group, collecting the articles for all the member organizations of the group captive and investing in technology and personnel to publish the academic journals of each member.
Limited Liability Company, Limited Partnership or General Partnership of Special Purpose Entities
Group captives can take the form of a LLC, a limited partnership, a general partnership of special purpose entities. Such entities offer limited liability, governance structure, continuity of life and favorable tax status.
A group captive could take the form of a business trust under the laws of Delaware, Massachusetts or Illinois, among other states, or under common law. Under Delaware law, Title 12 Del. Stat. 3801, a “business trust” means “an unincorporated association which (i) is created by a governing instrument under which property is or will be held, managed, administered, controlled, invested, reinvested and/or operated, or business or professional activities for profit are carried on or will be carried on, by a trustee or trustees for the benefit of such person or persons as are or may become entitled to a beneficial interest in the trust property… and (ii) files a certificate of trust pursuant to Section 3810 of this Title. A business trust may be organized to carry on any lawful business or activity, whether or not conducted for profit. Business trusts can serve to take title to property (such as real estate or even intellectual property), either for active management or mere custody.
Regulatory Issues for Group Captives
Depending on what goods or services they purchase or broker, group captives can fall into the category of regulated industry. Such regulation might exist even in a tax haven. For example, in the insurance industry, group captives are common, with offshore entities, special exempt licensing in the onshore jurisdictions of the members and well-established uses for buying re-insurance for the members.
Tax Issues of Group Captives
Taxation of group captives can be complex, depending on the legal structure. Under local tax laws and applicable international income tax treaties, tax authorities retain the power to recharacterize business relationships to reflect their true economic character. So structuring and tax characterization of a group captive involves some forethought, analysis and planning.
Entities that are for-profit may avoid corporate level taxation by adopting partnership taxation, assuming they are eligible to do so. Such eligible entities include limited liability companies, limited partnerships and general partnerships (which may include separate special purpose entities of individual corporate entities).
Partnership format is generally considered ideal for GPO’s, though other formats may be better suited for certain functions. Partnerships do not generally incur taxes. Rather, the character of income and deductions of the enterprise is determined at the partnership level and apportioned to individual partners (who could be separately incorporated or established for this purpose). As a result, there is no double-taxation, and the “profits” from buying for resale to partners are not taxable.
Limited Liability Companies
Unless they elect to be taxable as a corporation, limited liability companies in the U.S. are not taxable on their income from sales of goods or services. Group captives might therefore be set up as LLC’s.
Trade associations and other non-profit organizations need to play within some key tax rules.
Risk incurring corporate income taxes for “unrelated business taxable income” that is not related to the non-profit purpose. If the non-profit devotes too much of its efforts to UBTI, its non-profit status might be put into question.
Special Purpose Subsidiary
Under Section 501(c)(2) of the U.S. Internal Revenue Code, a corporation “organized for the exclusive purpose of holding title to property, collecting income therefrom, and turning over the entire amount thereof, less expenses, to an organization which itself is [tax] exempt.” As to such group captives, special tax rules apply to the number of members, the rights of the shareholders in respect of corporate governance and the corporate purposes.
Unlike trade associations and other non-profit organizations, cooperatives enjoy a unique tax regime under the Sections 1381-1388 of the U.S. Internal Revenue Code. In general, they are corporations with a special-purpose corporate structure and the flexibility to distribute to members any operational cost savings from doing business with members (“patrons”) and non-members. The corporation is entitled to deduct payments of patronage dividends to members and other amounts paid or allocated during the taxable year. “Patronage dividends,” the term that describes the allocation to members of such cost savings, may be distributed in proportion to “the quantity or value of business done with or for such patron.” 26 USC 1388(a). This structure is particularly well suited to the purchase of commodity goods or fungible services necessary to run a particular type of business. Unless the corporate charter for the cooperative clearly contemplates all forms of distribution of assets, cooperatives might not be effective at tax savings, such as in respect of long-term capital gains from owning intellectual property or real estate that is used in the business operations.
International Tax Strategies
International tax strategies should be considered to minimize or avoid onshore taxation of the cost savings or other benefits of the group captive.
For example, a group purchasing organization established in a zero-tax jurisdiction can offer the same tax advantages as a partnership without the same regulatory environment as an onshore GPO. In both the planning and execution, processes should be adopted to avoid engaging in onshore activities that might defeat these benefits.
International Whipsaw: Conflicting Characterization of the Entity in Different Jurisdictions
Under income tax treaties, entities such as LLC’s (and their equivalents under foreign law, such as GmBH, SaRL and Limitadas) that might enjoy partnership income tax status in one country might not necessarily enjoy that status in another country. Whipsaw occurs in such cases. As a result, tax advantages may be lost. Whipsaw can be avoided by using classic legal entities that the tax treaty recognizes as having the same tax status in each country, with resultant benefits of avoiding double taxation or loss of tax advantages.
Antitrust Issues of Group Captives
Most international trading countries have adopted competition laws for the avoidance of collusive pricing or other collective actions that restrain trade in a material segment of the local market.
Lock-In Effect: Coercive Participation
Among the violations of antitrust and competition law, a GPO’s coercion of minority participants could serve as an important barrier to entry or exit. To avoid such lock-in effect, GPO’s need to carefully define the benefits and conditions of participation so that they can aggregate demand, without forcing GPO members to submit all their demand requirements to the GPO for an indefinite time.
Thus, spot-market commitments to purchase all one’s re-insurance requirements for a specific type of risk might pass muster and not violate competition law. Conversely, long-term commitments to purchase all supplies needed for general operations could run afoul of antitrust and competition law.
Operational Issues of Group Captives
Who will Manage the Operation?
Most group captives struggle with the question of control and protection of minority member. In traditional terms, it raises the specter of the “Tragedy of the Commons,” where in ancient times the “commons” (a field or park in the center of a city or town) would not be maintained, and would grow weeds. While all the townsfolk appreciated the benefits of access to the commons, no one took responsibility for maintenance. As a result, the tragedy of the weeds would occur, and the loss to the public would be irreversible without someone to take that responsibility.
How will “Profits” be Distributed
Distribution of profits, if any, need to be determined as part of the business plan.
How Open is Membership to New Participants?
Openness is an important factor in antitrust law but might be a hindrance under applicable tax law, securities regulations, accounting and corporate governance structures.
What Services are to Be Purchased?
Group purchases of services will be effective, compared to other models that solve the Sourcing Dilemma, only if the types of services that they aggregate share common characteristics. The critical characteristics are those that generate savings based on economies of scale. Those characteristics may change with advances in technologies, changes in regulations locally and across borders, and new impediments hindering or new incentives generating opportunities for scale.
How will Confidential Information about Purchasing Be Shared?
Confidential information includes the prices at which the group purchases third-party services or goods. Disclosure of that information to the public could damage the business of the service provider that discounts its prices to the GPO but not to others in the market.
Most Favored Customer Clauses
In BPO services categories where service providers regularly agree to “most favored customer” clauses, a GPO might be generating indirectly significant pricing benefits to businesses that are not GPO members. Service providers need to pay attention to this risk, and businesses that are not GPO members should negotiate appropriate market-focused pricing structures, to deal with this issue.
A Footnote: Sellers’ Cooperatives and Group Captives as Sellers to Their Members
Software developers and service providers in some countries such as Russia have organized sellers’ cooperatives to promote and market the individual and collective services of the group members. Under U.S. law, pooling arrangements of sellers may be legal for basic commodities or for sales of goods or services to the United States Government but are subject to antitrust regulation. See Internal Revenue Code, Section 1382(e), 26 USC 1382(e). Antitrust exemptions for sellers grouping their goods for sale for export are granted under the Webb-Pomerene” act on export associations and under the Export Trading Company Act of 1982. See 15 USC 61 et seq. Exemption from competition rules in an exporting country do not protect a selling group from competition rules in countries where their buyers are.
For this reason, group captives that engage in selling to group members should not be focused on exports but rather fit within applicable regulations in each country where there are any sales. For antitrust reasons, the group captive might therefore be structured to avoid the selling process altogether by adopting alternative legal structures and relationships.