Legal Entity Rationalization: What You Need to Know
By Kathryn Polak, Director, Advisory Services
US companies are expanding into international markets at unprecedented rates. Whether through acquisition, organic growth, or a combination of both, companies are attempting to capitalize on market opportunities as quickly as possible.
This desire for speed, however, can translate into overly aggressive large-scale expansion efforts that lack proper planning and ignore pertinent business risks and financial and administrative burdens. Over time, companies may become saddled with complex organizational structures that are inefficient, ineffective and costly to maintain. These needlessly complex legal entity structures can drain a company of much-needed cash, reduce profitability and introduce unnecessary risks.
While managing international operations has never been easy, overseeing a rapidly expanding global web of legal entities poses unique challenges that yesterday’s executives rarely had to address. A company’s overarching legal structure may include but not be limited to representative offices, branches and holding companies, each of which may have differing ownership structures. The related ongoing corporate governance, legal, accounting, audit, tax, human resources, regulatory reporting and compliance requirements can be daunting to say the least, especially when the company operates in a fast-paced multi-country, multi-currency environment.
Each country has its own set of rules and regulations related to legal entities that companies must follow, including but not limited to what types of activities may be carried out. Moreover, related laws can be difficult to interpret and apply; and they’re constantly changing. Just staying abreast of these evolving regulations can be an enormous challenge, and there is a real risk of missing a change that is not well publicized or communicated by local authorities. Countries typically issue penalties and fines for noncompliance, and these can be substantial. Companies also run the risk of reputational damage when running afoul of local laws. Noncompliance may even put their ability to operate in the country at risk.
Legal Entity Costs
The cost of supporting and maintaining legal structures continues to rise. Most companies with global operations use a combination of in-house and outsourced resources to support foreign activities. It is not unusual to see an overseas legal entity that’s in place to support just a handful of employees that costs $50,000 (or more) to maintain on an annual basis. One-time fees and recurring services such as accounting, payroll, tax and compliance account for much of this. Needless to say, there is constant pressure on executives to find ways to reduce these costs. Periodically, executives should step back and reevaluate the efficiency and effectiveness of the legal organizational structures they oversee.
Legal Entity Rationalization and Why It’s Important
Legal-entity rationalization is a process companies undertake — either on their own or in conjunction with an experienced third-party advisor — to review their legal structures. The purpose of the review is to: 1) determine whether their existing legal entities are all necessary; and 2) to identify and document what efficiencies or cost savings could be achieved by simplifying the structure of legal entities and/or eliminating some of them.
Through legal entity rationalization, companies may be able to build more efficient, sustainable operating structures, improve operational transparency, and significantly reduce risks and costs, as outlined below. It’s also a great opportunity to realign a company’s legal entity structure so that it’s consistent with the company’s current strategy, which may have evolved considerably since the structure was first created.
When done effectively, a legal entity rationalization may result in a number of tangible and intangible benefits. These include but are not limited to the following:
- Improved future profitability and financial results through better alignment with current business strategy.
- Reduced administrative costs and other costs related to accounting, auditing, financial reporting, tax-filing, compliance, HR, IT, cash management, headcount and overhead.
- Eliminated operational redundancies.
- Reduced intercompany transactions.
- Increased tax benefits and/or efficiencies.
- Improved statutory reporting and compliance.
- Increased transparency into operations and financial reporting.
- Clarified risk profile of your legal entities.
Step-by-Step Process for Legal Entity Rationalization
Companies should approach legal entity rationalization initiatives in a planned, well-organized manner. While the order may vary, the process should include the following steps:
Step 1: Obtain an accurate chart of the current structure, including all legal entities, types and locations. While this step sounds straightforward, many organizations do not have an updated chart, especially in the wake of a merger or new acquisition.
Step 2: Identify and document both the ownership structure and purpose of each legal entity. What role does each entity serve?
Step 3: Challenge the need for each entity. Is it essential? Does the purpose of the entity make sense? If not, target the entity for elimination or realignment.
Step 4: Create a mock legal entity chart for the newly proposed optimized structure. Does the new structure make sense? Is it aligned with the company’s business strategy? Should it be modified? What other options exist, such as changing an entity type rather than eliminating one? Can any additional entities be eliminated?
Step 5: Finalize the list of entities targeted for elimination or realignment. Establish a budget, timeline and project plan that minimizes business disruption. Factor in any policy-related and/or procedural changes that must occur before and after the realignment.
Step 6: Once the budget, timeline and plan are in place, obtain approval and execute according to plan so the expected benefits and cost savings can be realized.
Step 7: Create a process to evaluate your new legal structure on a regular basis. The frequency of this process will depend on company strategy, the number and type of entities involved, the number of acquisitions undertaken, and other factors.
We have just scratched the surface of legal entity rationalization. While questions will undoubtedly arise as you embark on your own initiative, having an understanding of the importance of conducting a legal entity review will help you get the process started.