Putting the Pieces Together: Legal Entity Challenges that Affect Pre-Tax and After-Tax Profitability
In today’s tumultuous economy, M&A transactions are being used more than ever to create shareholder value. Unfortunately, our experience has shown that as companies embark upon these transactions, they usually fail to realize the maximum benefit that can be attained through the creation of a properly planned and executed legal entity structure. This article describes ways you can minimize the loss that accompanies these common challenges:
- Compressed deal timelines : Management attempts to accommodate short timelines without fully developing a detailed strategy and plan.
- Underestimated complexities and dependencies : Management underestimates the cross-functional nature and magnitude of the changes required to align the underlying transactional systems.
- Slow regulatory responses : Management fails to recognize that dealing with jurisdictional requirements across the globe usually takes longer than expected.
Regardless of the deal type, the impact of the legal entity structure changes should not be taken lightly. You should consider the potential impact on all functions early in the deal life cycle. Where an entity is placed or the form it takes often has substantial long-term financial, operational, and regulatory consequences. While the transfer or creation of a new legal entity into your existing structure can be easily done, incorrect placement can take years to rectify with significant cost and potential risk.
Challenge 1: Compressed deal timelines
The process of completing an acquisition creates considerable pressure within extremely short timeframes, which seem to be getting shorter with every deal. Competitive pressures require acquisitions to be absorbed and synergies realized fast. In particular, troubled seller situations often require the buyer to act quickly, sometimes with little lead time to consider alternatives. In all situations, lack of analysis and planning can result in an inefficient structure that unnecessarily increases operating costs or tax costs and sometimes both.
The cost of doing nothing
In our experience, selecting the simple answer to ease short-term pressures usually compromises a longer-term strategy. And ignoring a complicated problem is not an option, as it will also have consequences.
One common mistake we see is leaving the acquired structure completely unchanged without investigating whether a more efficient and less complex overall structure is possible. This mistake is often compounded across multiple acquisitions, so that over time, there are many extra legal entities with overlapping purposes. In many cases, there can be scores, or even hundreds, of excess legal entities.
These excess legal entities have real costs. Some areas where you may be burdening your company with additional legal entity cost can be found in Table 1 (please refer to attachment). In today’s economy with a renewed cost reduction focus, this could be a ripe savings opportunity at your company.
Challenge 2: Underestimated complexities and dependencies
There are many transition processes that cannot begin until another process is complete; a typical transaction has many chains of dependencies. Until management begins to sketch out these activities to determine the critical path, it is hard to understand the true transaction timeline.
Hit your sweet spot through proper planning with a broad lens
The business strategy should drive the placement and form of a new legal entity. Priorities should be aligned to match the business strategy, not the needs of a few functions. Care should be taken so that the optimization of the entire corporation is not sacrificed for the benefit of a few functions. While obvious, this is often missed.
Tax considerations are important to all transactions, yet should not be the sole motivation. Transactions that are purely tax-motivated are at risk to fail; taxing authorities have successfully attacked these hollow arrangements and eliminated planned benefits. Conversely, transactions where tax considerations are overlooked can create horribly inefficient tax structures. There is a sweet spot that you should hit.
Moving too quickly without the proper analysis can have a significant impact. In one case involving a stock transaction, our client initially planned to quickly integrate the target into an existing legal entity and convert the operations to the acquirer’s ERP. Further analysis revealed that a phased integration approach was better. If they had moved the operation immediately, significant tax benefits would have been lost. Additionally, delaying the move allowed the acquirer to stage the conversion into an ongoing ERP implementation schedule. This had the added benefit of eliminating the need to establish an interim platform for the target and allowed a conversion to the new platform that met the needs of both the business and IT function. If management had not phased this integration, there also would have been duplicate implementation costs for the system set-up. This would have included significant activities by multiple functions of the ongoing company-wide effort to replace the ERP system.
As with any complex business problem, this example illustrates that the best solution can only be found through collaborative cross-functional analysis and planning. Also, implementation usually requires multiple interim states until the desired end-state is achieved. In most cases, the process will span multiple years. The considerations in Table 2 (please refer to attachment) are examples of the hundreds of decisions that will need to be addressed in your transaction.
You should thoughtfully consider the needs of virtually every function in your company; this will result in a defensible position for your tax strategy. You can prioritize efforts and create a collaborative communication channel across functional areas by developing a systematic process to identify and prioritize decisions that may impact the legal entity structure. Ignoring these considerations will allow your strategy to be seen as a naked tax play and could result in the reversal of any benefits.
Challenge 3: Slow regulatory responses
It is easy to underestimate the enormous number of governmental entities that must approve many aspects of a transaction, especially a multinational transaction. Particularly outside the United States, explicit governmental approval may be required to conduct even routine business operations, such as opening a bank account, hiring an employee, or changing a sign.
The question of legal entity readiness
While it may seem obvious, do not overlook the legal readiness of your newly formed entity. On Day One after the transaction closes, you need to answer this question: Can the business legally sell products and services in the jurisdictions it operates? This includes the ability to legally hire and pay employees and to manufacture and ship products. If your entities are not legally formed, your business operations could grind to a halt.
Legal entity readiness is not always as simple as it seems due to the fact that in the United States it is usually possible to form a corporation and register it for business within a few days. If your new business has non-U.S. operations, the challenge quickly becomes complex. If your business is in a regulated industry, the complexity continues to grow; plan for a potentially multi-year legal entity readiness horizon. In most transactions, the lead time is so long that a work-around will have to be developed for many countries.
In one case, a large pharmaceutical company was separating one of its businesses. The intent was to quickly carve-out the new company in over 80 countries. The original plan in the deal model was to establish minimal short-term transition service agreements for various back-office functions. As a better understanding of the operations was gained, it became apparent that for some of the Asian countries, there would be significant lead times to meet the regulatory requirements. Rather than wait for regulatory approval, the carve-out management decided to establish distribution agreements with the seller. While not the optimal solution for the buyer and seller, this allowed the transaction to close as scheduled while providing a bridge until the carve-out operations could become compliant.
One advantage of asset purchases is that they generally limit the buyer’s liability exposure; however, one disadvantage is that they generally require the buyer to form new legal entities to conduct the business formerly performed by the seller. This is true even if the buyer already has legal entities in place. The existing legal entities may require some effort to make them ready to conduct the acquired operations.
Here’s an example: A company acquired a line of business (assets) in a dozen countries around the world. In Spain, there were a few employees, and the buyer planned to hire and pay those individuals as part of a soon-to-be-established branch of its United Kingdom (UK) operations. The transaction was set to close soon, and they obviously wanted to be able to pay those employees without interruption. To do this, they needed a Spanish bank account, but they couldn’t open an account without a valid Spanish tax identification number for the UK branch. They started to fill out the paperwork to obtain the Spanish tax identification number and realized they needed a copy of the UK entity’s charter. In addition, they were required to have the charter translated into Spanish by a certified (government-approved) translator. However, they couldn’t begin this translation process because the attorneys in the UK had not finished the formation of the UK entity, which was being held up while tax advisors were attempting to model the proper type of legal entity to be formed. When management realized how long the process was going to take, they made arrangements for the seller to continue to employ the individuals in Spain during the transition, with the buyer reimbursing the seller separately for this cost.
Even in unregulated businesses, it is common to have to wait for explicit approval from governmental agencies before new legal entities can conduct business. These approvals affect critical issues such as the ability to import raw materials, the legal right to hire employees and the right to sell goods at retail. For regulated industries, the delays can be even longer.
You cannot minimize the need for properly planning your legal entity readiness. Your business depends upon it.
Though the answer always changes, keep the promise
Companies regularly fail to take advantage of the benefits that can be obtained through proper legal entity alignment and selection during an M&A transaction. In many cases, companies introduce operational and regulatory risk as a result of incomplete analysis and poor planning for the sake of speed.
Sometimes we are asked for the quick answer. But in reality, there is no silver bullet; timelines will always be shorter than you want, complexity is an inherent business quality, and regulatory challenges will always be with us.
While there may be few instances where the answer is obvious, in most cases, finding the best solution will require thorough analysis to optimize the benefits across your entire company. When analyzed and chosen correctly, the benefits will almost always offer the quantitative and qualitative benefits that were promised with your deal. With proper planning, we believe that you can keep your promise to stakeholders, even within the short window of the deal life cycle.
Deloitte Consulting LLP
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