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13 November 2010

Simplifying the Business Model

Tag(s): Business

      During my 35 years working in executive functions in multi-nationals I observed and often participated in excruciatingly complex legal structures that led to vast wastes of corporate time and money in seeking to manage the negotiations and relationships between all these arrangements. I was therefore fascinated to learn at a recent briefing for non-executive directors that significant regulatory progress has been made in helping organisations to align management and legal formations.

In the established arena of unnecessary complexity we see that the business has to operate in two very different spaces, the operational vs. the legal entity. There is often a maze of legal edifices as a result of financial structuring and legacy mergers and acquisitions. There is usually tension between global and regional management configurations and the country management. I used to call it triple matrix organisation because a matrix is normal as soon as you extend a company into more than one territory and/or more than one product category but when you also introduce functional management into the equation then you have three dimensions. For example a pricing decision will involve territory, product and financial dimensions. A hiring decision can involve territory, product and human resource management. This can lead to countless variations in process for governance of all these different divisions, entities, functions, locations, countries and/or regions. Often in an attempt to simplify these a large enterprise wide system has been overlaid on the whole organisation at huge cost and without the expected rewards. Meanwhile the outside world is moving fast bringing new challenges in economic, social and regulatory matters.

In response to this companies are restructuring their business models by rationalising the management and governance composition and consolidating key functions into centres of excellence. Some are organising regional shared service centres while others are outsourcing activities and disposing of fringe assets. What is also needed is single-minded process standardisation and if this is done in conjunction with the implementation of  an enterprise wide system the cost can only be justified if it is managed to achieve a single version of the truth. There is a growing trend to move the corporate head office to more sympathetic fiscal and regulatory regimes. This has become easier with greater flexibility in tax reporting.

Mario Monti, the EU Commissioner said “Would Bill Gates have had the same success if he had to create a subsidiary of Microsoft in each state where he operated rather than operating in the United States as a whole?” Traditionally multinationals have grown organically in Europe opening a sales company in every country and then setting up other companies to operate factories and other key functions like finance.  But, without a legacy legal fabric, many companies with a controlling corporate centre could do business in a region through a principal holding company and branch structure.  A simplified legal design would ideally consist of a single legal entity that would contract with all third parties, both suppliers and customers. Instead of the old world model of byzantine inter-company transfer pricing, profit would be allocated between the controlling centre and the local branches. Statutory reporting would only be required of the controlling centre and the need for local boards with their ability to introduce a bureaucratic muddle into decision making would disappear thus eliminating the risk factor for local directors.

But is this possible? Yes, because enabling legislation has been introduced in Europe that allows companies to use “single company models” as a result of two EU directives. In addition new OECD guidelines on profit attribution have further enabled such frameworks. The 10th Company Directive supports operating in Europe as a single national company and allows merger of companies across Europe more easily. EU Regulation and the SE Directive brings in the SE, no, not a Single Entity but the Societas Europaea. The legal form of the European Company, or Societas Europaea (SE), was created by the European Council on the 8 October 2001. It became subject to Community law in all EU member states on the 8 October 2004, over 30 years after negotiations for the creation of a European company were initiated.

According to the EU, the objective of the Statute for a European company is "to create a European company with its own legislative framework. This will allow companies incorporated in different Member States to merge or form a holding company or joint subsidiary, while avoiding the legal and practical constraints arising from the existence of twenty seven different legal systems. To arrange for the involvement of employees in the European company and recognise their place and role in the company."

This last issue of worker participation is one reason why the SE has not been implemented more widely but with the other changes this may now change.  In July 2010 the OECD Council approved the 2010 updates to the OECD’s Model Tax Convention, the 1995 Transfer Pricing Guidelines and the 2008 Report on the Attribution of Profits to Permanent Establishments. The updates are the result of several years of work to improve these core OECD instruments in the area of international taxation. The OECD say that these new guidelines will help both developed and developing countries ensure that multinational entities  do not use transfer pricing to shift profits into low-tax jurisdictions and, at the same time, that they will not be subject to double taxation. But the key change is that profit attribution can be based on the location of significant decision makers. During my time at Sony we often had to deal with extensive investigation by the Inland Revenue. We always succeeded in satisfying their requirements because so far from being involved in any dumping activity our upstream internal negotiations were at least as robust as our downstream third party ones and we could prove it. Nevertheless these investigations were a significant cost both to us and the taxpayer.

Over 500 SE’s are known to have been established in Europe of which about a quarter so far are in operation. Only about 20 have been established in the UK, well below our market share, possibly because of the need to include some form of worker participation.  This seems surprising when the benefits are taken into account. These would include greater freedom to shape and minimise tax risks, unification of management formations thus aligning more readily with global decision making, reduction of compliance risk and costs, and reduction of administrative costs as a result of fewer intercompany transactions and less statutory reporting.  Some of the cost saved can be released to support local management in better implementation, so, for example, financial staff that today spend a great deal of time in statutory reporting and audits can instead support their marketing colleagues in better management of the market. Of course, the local tax requirements will continue but with better planning of this at a regional level this work should also reduce.

There are several considerations to be taken into account before implementing such a change. It will cost and payback may not be for a few years. During the transition period complexity increases and there is the need for works council negotiations in some EU member states. The process may open up some issues relating to directors’ terms and conditions that were previously hidden and so some inflationary harmonisation may emerge. The tax and legal issues need to be properly assessed for their risks and consequences.  What is required is for the Board to ask itself if it can simplify its method of operation and is the SE model a way of doing that. It then needs to consider the business case including an assessment of one-time costs and recurring benefits. There needs to be thorough consideration of tax and legal issues including employment law.   How will the revised organisation actually be managed and governed. The potential risk of adverse publicity or cultural reaction in some countries where legal entities are to be dissolved needs to be considered. As is often the case simplicity is costly to achieve but almost certainly worth it.

As Albert Einstein said “Everything should be made as simple as possible, but not one bit simpler.”

Copyright David C Pearson 2010 All rights reserved

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