Why Legal Entity Management Matters

Transcription

1 Q Why Legal Entity Management Matters Issue 1.0 Global businesses are coming under pressure to simplify their legal entity structures. Country-by-country reporting (CbC) update Please note that since this webcast took place several changes to CbC and especially to the CbC template have been proposed. These changes are highlighted on Pages 4 and 5. This paper captures the themes of discussion from EY s Why Legal Entity Management Matters webcast on 6 March The session was attended by over 150 participants from major corporates across a broad range of sectors. Why now? Keeping on top of an organization s legal entitiy structure is generally not considered by many as part of the day job. Companies have had other priorities in recent years: coping with an uncertain business environment, changing legislation and positioning for growth as markets recover. But global businesses are coming under pressure to address their structures. A growing regulatory burden and continued cost focus are driving the need to simplify compliance, improve transparency, reduce risk and find new ways to save costs. The financial crisis put corporate transparency at the top of the agenda for governments, regulators, stakeholders and the public. The result has been significant changes in legislation, regulation and compliance for boards to get to grips with a trend that seems set to continue given current Organization for Economic Cooperation & Development (OECD) reporting proposals. This is putting the effectiveness of companies legal entity structures under close scrutiny. Organizations are grappling with a number of complex questions: What will be the impact of regulatory change on our business? How can we structure the group to maximize efficiencies and reduce costs? What additional resource will we need to cope with a changing compliance landscape? Are our underlying accounting and management information systems fit for purpose?

2 The financial crisis also triggered a relentless focus on costs a pressure which has yet to ease. With operational costs already stripped to the minimum, firms are seeking new ways to trim budgets. Boards are therefore turning their attention to the cost of maintaining their existing structures and the back-office arrangements needed to support them. Eliminating redundant entities from a group offers a number of cost benefits. First and foremost, it removes the holding costs of entities that can be wound down. But simplified structures can create other cost efficiencies: Streamlined compliance and reporting requirements Greater tax efficiency Fewer internal transactions Reduced need for outsourced and shared services Lower headcount During our webcast we explored these benefits, and the factors driving the need for them. The session also featured advice on how legal entity management can address the challenges at hand, and achieve real value for complex organizations. Regulation Compliance and reporting Increasing regulation intensifies the compliance burden on businesses. Yet only 13.2% of webcast participants listed compliance and reporting as a driver of legal entity management at their firms (see fig. 1). This gives rise for some concern because overly complex structures can lead to significant risks, complications and burden for many groups. Particularly as we see many of those groups growing beyond borders and expanding into new markets. Fig. 1: For which of the following reasons does your organization review and manage its legal entity structure? 13.2% 26.5% 5.9% The challenges Two of the more serious risks are: Global complexity 27.9% 26.5% Source: webcast polling question data. Eliminating surplus entities Tax effectiveness Operational efficiency and alignment Statutory compliance and reporting None of the above In a global business environment, large organizations routinely operate across borders. In 2011, an EY survey of Fortune 500 and 2000 companies found that 40% had operations in more than 50 territories. This can be a problem when it comes to compliance and reporting. Different countries have different accounting and reporting regimes, which are continually evolving. It can be all too easy for a complex organization to misinterpret a change in local legislation or miss one entirely and incur a hefty penalty. Almost 20% of the Fortune firms we surveyed had encountered fiscal or financial reporting issues: that s nearly one in five of the world s largest and most sophisticated organizations. Complex global structures can lead to significant compliance and reporting risks. 2 Why Legal Entity Management Matters

3 A structural disconnect There is often a structural disconnection between reporting at group and local level in multi-national organizations, especially listed companies. This can give rise to a series of potential risks and costs: Inefficient reporting: local reporting comes under multiple accounting frameworks, each with its own formatting and disclosure requirements. As such, the more entities in a group, the higher the cost of statutory reporting; and the greater the scope for inconsistent approaches and duplicated processes. Control issues: a lack of oversight of subsidiaries can mean problems with local filings being identified too late. This may result in tax exposures, penalties or advisory costs as groups take remedial action. Time lag: local reporting is generally done after group reporting, delaying the communication of local decisions to group level. This can lead to inconsistent approaches to financial reporting and more seriously, unreconciled or inconsistent balances between entities. Given these challenges, we asked webcast participants about their organizations local reporting systems (see fig. 2). Global warning Intricate global structures create complex reporting challenges. Take the example of a group with a significant presence in Nigeria, a country which recently adopted International Financial Reporting Standards (IFRS). Deadlines for applying IFRS in Nigeria depended on the public interest of a business local operations. On this basis, the group understood that it would need to use IFRS in the country from However, on submitting the 2013 financial reports, it emerged that IFRS should also have been applied to the previous year s statements. The sanctions for this in Nigeria go as far as revoking a firm s licence to operate. EY helped the group prepare retrospective filings for the previous year, while providing on-the-ground support by liaising with the Nigerian regulatory authorities. This helped to minimize the penalties incurred and ensured a continued positive relationship with the regulator. Fig. 2: Has your organization considered or implemented a standardized approach to local reporting? 28.6% 7.1% 19% 16.7% 28.6% Source: webcast polling question data. The benefits of entity management Simpler structures offer a range of compliance and reporting advantages: Streamlined requirements due to fewer entities Reduced reporting costs at group and local level Lower risk of breaching local regulation Less scope for inconsistencies in group reporting Greater transparency Better understanding of local issues Already implemented Currently planning or implementing Prefer a decentralized approach Not been considered None of the above Close to half (45.3%) are either operating or moving towards a standardized approach, while decentralized systems are in the minority. These results suggest that many groups in our audience are well placed to deal with statutory reporting requirements through a standardized approach. However, our experience also shows that organizations with decentralized structures may wish to look more closely at their operating models and processes to see if improvements could be made. Almost half of Fortune 2000 firms surveyed by EY were concerned that their local accounting and reporting lacks standardization. The consequences of failing to comply will not generally be so draconian. But the experience is a sober reminder of the risks local compliance issues can cause for global organizations. Why Legal Entity Management Matters 3

4 Simplifying your legal entity structure will deliver multiple compliance and reporting benefits. Local dynamics Rationalizing group structure to simplify local reporting should be a two-stage exercise: Stage one: Analyze your existing structure to identify vulnerabilities and costs from three points of view: Group and local dynamics: How aware are you of the differences between group and local reporting processes? How much visibility does group have over your local reporting activities? How straightforward is access to local financial controllers when issues arise? How effective are the links between the group finance function and shared service centers? Financial implications of local reporting: What is the total cost of your local reporting requirements? Are your local filings accurate and up to date? What penalties do you incur for late or substandard filings? Consistency of approach: How consistently are IFRS applied across your subsidiaries? How many statutory GAAPs does the firm have to use? Stage two: Identify opportunities to streamline local reporting by asking: How many more territories could use IFRS? Would consolidation and reporting be more efficient with fewer entities and a more consistent approach? Would more proactive legal entity management enhance distributable reserves and cash management? What is the right balance between centralized control and standardized processes on one hand, and devolved local responsibility on the other? Country-by-country reporting The compliance stakes are about to be raised further still, by OECD proposals on country-by-country (CbC) financial reporting. The initiative is part of the OECD s Action Plan on Addressing Base Erosion and Profit Shifting (BEPS). Profit shifting by multinationals has prompted concern in many countries, as it erodes the amount of corporate tax going into the public purse. The Action Plan is the international community s response, and has strong backing from the G8 nations. The plan is currently in consultation, with the finer details yet to be seen. But given the support behind it, companies need to be ready for its introduction in all countries where they have operations or investments. The proposals A key aspect of the Action Plan is a proposed new template for CbC reporting (see fig. 3). It s probably fair to say that this has caused a stir in the market. The template requires information for every entity and even every branch in every country of operation. CbC update Please note that since this webcast took place several changes to CbC and especially to the CbC template have been proposed. Some of these important changes include, but are not limited to: The removal of inter-company transactional data from the template (the last six columns of the template shown in fig 3 opposite). The proposal is to allow a degree of flexibility starting with either group accounting data or statutory accounts (effectively either a top down or bottom up approach), as long as this is applied consistently. Tentatively, there will be no exceptions provided on a materiality basis. This means companies would have to report activities in all jurisdictions. No decision has been made yet as to the provision of an exception for small and medium enterprises with respect to the reporting template. The reporting template will be populated based on aggregated country information, not on a separate entity basis. The only exception would be identification of business activity (which is to be designated through an expanded list of codes), which would be reported on an entity-by-entity basis. 4 Why Legal Entity Management Matters

5 Fig. 3: Proposed OECD template on CbC reporting Country Consituent entities organized in the country Place of effective management Important business activity code (s) Revenues Earnings before income tax Income Tax paid (on Cash Basis) (a) To country of organization (b) To all other countries Total withholding tax paid Stated capital and accumulated earnings Number of employees Total employee expense Tangible assets other than cash and cash equivalents Royalties paid to constituent entities Royalties received from constituent entities Interest paid to constituent entities Interest received from constituent entities Service fees paid to constituent entities Service fees received from constituent entities Total: Total: Total: Total: Source: webcast polling question data. Why Legal Entity Management Matters 5

6 The challenges We asked participants for their views on the impact of the CbC template (see fig. 4) Fig. 4: Which is the most likely outcome of the OECD CbC reporting proposals? 47.5% 5% 30% 17.5% Source: webcast polling question data. Additional burden on resources (for companies and tax authorities) Changes to tax authorities audit approaches Fundamental changes to the transfer pricing framework All of the above At first glance many might expect an initial burden to fall on the resources of companies and tax authorities. However, when we examine the issue more closely we can identify the need for changes to tax authorities audit approaches, as well as the substantial changes required to the transfer pricing framework. Not surprisingly, all of the above was the clear favourite response among participants, reflecting the far-reaching challenges the new regime presents. Organizations face an enormous task to get to grips with the proposed template. Significant resources would be needed to collate the data required. Completing the template at entity and branch level would add up to thousands of entries for complex groups. In most cases, data for different territories would also need to reflect local accounting standards and currencies. What s more, companies rarely hold the information in the suggested form. Given the template s complexity, there is a real risk of misunderstanding or misinterpreting the provisions. And as proposed, the template would also present some serious practical hurdles: Obtaining data on stated capital and earnings by branch Placing a monetary value on certain elements, for example non-cash staff benefits (which is to be included under employee costs) Retrieving and aligning data from legacy databases, for instance following an acquisition or financial systems overhaul. In addition, the timetable for the introduction of the new rules is uncompromising. Having proposed the template in January this year, the OECD aims to release its approved version by September. A rapid rollout is then anticipated in many parts of the world. The benefits of entity management Whatever its final format, the CbC template will mean a considerable increase in the compliance and reporting burden. Assessing your legal entity structure could help minimize its impact. Removing unwanted entities would leave fewer subsidiaries to report on and less information to gather. It would also mean simpler taxation architectures and policies. However, rationalization cannot be done in a hurry. As we ll see, the process demands time and effort from stakeholders across the business (see Best Practice). With the new CbC regime imminent, it is something companies need to consider now. Rationalizing your legal entity structure has the potential to minimize the impact and cost of implementing the new CbC reporting rules. The OECD is proposing that groups report on every entity and every branch, in every country of operation. This has far-reaching implications. 6 Why Legal Entity Management Matters

7 Tax Simplifying structures can also be a valuable way to enhance an organization s tax position. Group structures can become ineffectual over time, as tax rules change and treaties are updated. In a climate of increased tax transparency, groups are also under pressure to reassess the use of tax haven jurisdictions. As a result, groups are reviewing their legal entity structures from a tax standpoint. In our experience, this is being driven by the need to: Identify opportunities to improve tax efficiency by streamlining group structure. Ensure that existing structures are aligned to current tax regulations and commercial objectives. Reduce the cost of tax administration in light of the new CbC reporting regulations outlined above. Simpler group structures can significantly enhance a business tax position. Cost As noted, efficient legal entity structures will have clear cost benefits. Before examining these, we asked webcast participants to estimate the average cost of carrying a legal entity. Fig. 5: What does your organization estimate the average cost of carrying a legal entity to be? 7.1% 4.8% 19% 23.8% 21.4% 23.8% Source: webcast polling question data. 10,000 or less 10,000 25,000 25,000 50,000 50,000 75,000 75,000 plus Don t know The benefits of entity management Depending on local tax rules, proactive entity management can unleash several tax advantages. Rationalization has the potential to: Manage effective tax rates: by removing multiple tiers of taxation, reducing tax leakage from inter-company transactions and optimizing the value of tax assets. Generate additional tax value: by releasing cash from inactive companies, and more effectively offsetting losses in one jurisdiction against profits in another. Almost half put the cost between 10,000 and 50,000 per entity and our experience shows the same. However, costs do vary between industries and are a good deal higher in closely regulated industries greater than 75,000 in financial services or oil and gas, for example. Legal entity rationalization typically removes a third of a group s subsidiaries. This represents a substantial cost saving. Release new value from existing tax assets: by generating capital losses when dissolving entities. Why Legal Entity Management Matters 7

8 The benefits of entity management In our experience, an effective legal entity rationalization process might typically remove a third of a group s subsidiaries. This represents a substantial cost saving. Suppose a group operates 300 entities worldwide, each costing 15,000 30,000 per year to run. Eliminating 100 of these would drive 1.5m 3m of annual savings in administrative costs alone. And that s just the beginning. There other financial benefits to streamlining legal entity structures. More often than not, groups are able to: Release capital: one rationalization project liberated almost 2b of capital by eliminating around 80 entities. Release trapped dividends: another redesign generated reserves to fund dividend payments for the following five years. Enhance value: complexity can cause concerns for investors and bondholders. Simpler structures can reduce transaction costs when a business is carved out and divested, or reduce integration costs on acquisition. Rationalization will also free up the tax, finance and legal functions to focus on value-added activities like maximizing tax efficiency and preparing for new regulation. Best Practice The case is clear. Having fewer legal entities will streamline compliance, reporting and administration, reduce risk and cost, and release bankable financial value to the group. However, rationalizing entities can be a major undertaking. It involves a number of business functions, for whom simplifying group structure is not business as usual. With this in mind, setting up the project in the right way is vital to success. The process To overcome these barriers, legal entity rationalisation should follow a carefully planned process, also shown in fig 6, along the following lines: 1. Conduct a high-level review of your legal entity structure. Identifying and defining strategic opportunities to remove entities is key to ensuring an efficient process. 2. Identify quick wins that will rapidly show benefits. Then make them happen. This will help establish momentum, generate confidence among stakeholders and identify an effective approach to project management. 3. Create a blueprint for reorganization and removal. This manages disruption to the business and maximizes the efficiency of the process. Projects often falter because a clear plan is not in place from the outset. 4. Proactively manage your structure. Once rationalization is complete, legal entity management must remain a continual focus to achieve sustained results. This is especially important for businesses that make regular acquisitions. 5. Define a process for ongoing entity management. This should include policies on the creation of legal entities, and procedures for eliminating them once their purpose is served. 6. Revisit your legal structure regularly and at critical junctures. For example, following an acquisition, to determine the best structure moving forward and eliminate unwanted entities. Or in preparation for a divestment, to streamline the carve out business, enabling value to be maximized, as well as easing the due diligence process. As is stakeholder management. Stakeholder objections can be one of the greatest hurdles to effective legal entity rationalization. Projects often come up against challenges, concerns and objections from the various parties affected. Not everybody is willing or able to see the bigger picture, or dedicate the time and resource that rationalization requires. The upshot is that the pace of projects frequently stalls. Worse, value can be left on the table at the end of the exercise. 8 Why Legal Entity Management Matters

9 Fig. 6: The six steps to success: the legal entity management process 6 Revisit: rethink your structure at critical junctures 1 Review: conduct a high-level review of your existing legal entity structure 2 Isolate: identify quick wins and make them happen 5 Define: set out a process for ongoing legal entity management Six steps to success: The legal entity management process 3 Plan: create a blueprint for reorganization and entity removal Manage: proactively manage your structure on a continual basis 4 Next steps Legal entity management needs to be an integral part of everyday business operations, for important commercial, financial and risk management reasons. Maintaining efficient structures will ensure that firms are as cost and tax-efficient as possible. And it will reduce the costs, complexities and risks associated with compliance and reporting. With the regulatory burden mounting, groups urgently need to embrace entity rationalization. And they need to ensure that their structures are managed and optimized on an ongoing basis. Global businesses will ignore the benefits of managing their legal entities and the pitfalls of not doing so at their peril. Why Legal Entity Management Matters 9

10 EY Contacts Please contact one of our team if you have any questions: Samantha Keen Partner T: E: skeen@uk.ey.com Russell Payne Director T: E: rpayne@uk.ey.com Graham Roberts Director T: E: groberts1@uk.ey.com John Hinton Associate Director T: E: jhinton1@uk.ey.com Jelger Buitelaar Senior Manager T: E: jbuitelaar@uk.ey.com 10 Why Legal Entity Management Matters

11 Notes Why Legal Entity Management Matters 11

12 EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com EYGM Limited. All Rights Reserved. EYG No. DE indd (UK) 06/14. Artwork by Creative Services Group Design. ED None In line with EY s commitment to minimize its impact on the environment, this document has been printed on paper with a high recycled content. This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. ey.com