Time of change: blog

How much is the current structure of your business costing you?

Andrei Shpak
Director, Tax services
8 December 2008

One of my clients decided to increase his share of the market and buy a competitor’s company. He was happy with the financial results, negotiated a price quite quickly and in the due diligence we did not identify any significant risks. The negotiations were expected to culminate soon in the signing of an SPA.

As strange as it may seem, the legal structure of the company to be purchased turned out to be a stumbling block: it had more than ten legal entities, whereas my client operated a similar 9abd even a larger) business quite successfully with just two entities.

At the same time, it seemed to the seller that he had a number of “killer” arguments in his favour to support existence of more than ten legal entities: (a) it apparently allowed him to split and limit considerably the potential legal risks of the business; (b) it apparently made management control over the subdivisions easier as it allowed preparing Form No. 2 (the profit and loss statement) at the level of a separate legal entity’s statutory reporting; and (c) the managers of the subdivisions proudly carried the titles of “general directors”.

Things reached the stage where the seller was prepared to withdraw from the deal if the buyer refused to buy the existing structure “as is”.

So what was it that my client ended up with after the purchase? Well, he ended up with a structure that had at least seven substantial flaws; moreover, most of these flaws had a significant tax component:

• It was necessary to prepare several sets of Russian financial and tax accounting reports for each separate legal entity. This resulted in a huge number of additional support staff;
• It was hugely complicated to achieve consolidation; moreover, my client could simply wave goodbye to operational efficiency: instead of receiving sales figures on the fifth day, as he was used to, at first he had to wait two additional weeks, which seriously impaired market response efficiency;
• Cash flows in the internal structure required special structuring (loans, dividends etc.) and entailed significant tax expenses and risks, including a potential loss on dividend withholding taxes when making dividend distributions. In addition, the distribution of dividends was linked to the net profit in each legal entity, which may have been less than the amount of available cash;
• There was no consolidation for tax purposes: my client could not offset the losses of one entity against the profits of another, and this increased the group’s overall tax burden. It was a similar situation regarding VAT: the surplus of unrecovered VAT in one legal entity could not be offset against the VAT liabilities of another;
• Any transfer of assets or the provision of services within the structure required special documentation (invoices, contracts etc.), which increased administrative expenses exponentially, increased the risk of errors and gave the tax authorities additional opportunities to raise claims;
• Staff mobility within the group was a lot more difficult, as any movement of personnel between the legal entities required processing the associated labour documentation.
• Instead of having easier management control over the subdivisions, the complete opposite turned out to be the case – each general director exercised absolute control over his legal entity.

I have heard quite a number of times “killer” arguments that were similar to those listed above by the seller about the importance and absolute necessity of having a multitude of legal entities. It turned out every time that the person making the arguments in fact did not have the slightest clue about how much these benefits were actually costing him: starting from tax losses and ending with an overstaffed administrative function and gradual loss of control and competiveness.

In my experience, holding a relatively simple tax diagnostics of the existing structure usually proves to be a real revelation to managers and owners.

How operationally efficient is your company structure? Who evaluates the efficiency of the existing structure? Are the tax implications of decisions made taken into account? And how do these decisions influence the amount of paperwork? Do you know how much you lose in taxes as a result of not having an efficient structure? Have you thought about how you could eliminate these flaws? Have you thought about interim decisions, which would allow you to reduce the seriousness of the problems? (e.g., opening a centralised “back-office” at the initial stage to simplify administrative procedures and to improve overall control).

If you do not know the answers to these questions, now is the time to find them. A crisis usually highlights existing flaws, so the benefits of eliminating them become even more obvious. It is important not to waste such an opportunity.