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Why Legal Entity Management Matters IVCollating and reporting legal entity information in today’s environment: are you prepared?Issue 4.0Q3 2015

Collating and reporting legal entity information in today’s environment: are you prepared?

This report summarizes the themes and discussion points arising from EY’s fourth Why Legal Entity Management Matters webcast held on 24 June 2015. The session was attended by participants from major corporates operating in a broad range of sectors.

The webcast addressed a number of key developments and drivers that are focusing the spotlight on the

need for the collation and reporting of information about legal entities. In particular, the panel discussed a number of the challenges and implications arising from the country-by-country reporting (CbCR) requirements of the Organisation for Economic Co-operation and Development’s (OECD) Base Erosion and Profit Shifting (BEPS) Action 13, intercompany transactions and dealing with information gaps, along with the steps companies will need to take in response.

As the answers to polling question one show, organizations already cite a number of different, and overlapping, motivations for collating and maintaining legal entity data. The introduction of Action 13 will certainly add to them.

2 | Why Legal Entity Management Matters IV

For which of the following reasons does your organization actively collate and maintain legal entity data across your footprint? Please select all that apply.

Polling question 1 BEPS and CbCR: are you ready?

The OECD’s BEPS initiative aims to address governments’ concerns about aggressive tax avoidance. In particular, Action 13 will increase transparency by providing tax authorities with information that will enable them to determine whether groups have used their international structures for either base eroding or artificially shifting profits from one entity to another via transfer pricing activities, with the express purpose of minimizing tax.

Action13 requires groups to use consistent templates for gathering information. There are three tiers of information: a master file, a local file and a country-by-county (CbC) report. These three are intended to be complementary, and it’s likely that tax authorities will refer to all of them to review returns and undertake audits. Making sure that the information they include is consistent is therefore critical.

To date, Spain has implemented CbCR, while implementation is in progress in Australia, Poland and the UK. Although no legislative proposal has been put forward yet, the Netherlands and South Africa have indicated they will have CbCR legislation implemented as per 1 January 2016. Worldwide adoption is expected by 2017 to cover 2016 information relating to the global allocation of the group’s income, the jurisdictions where taxes are paid, and certain indicators of the location of economic activity within the group. Such indicators may be, for example, the location of research and development, manufacturing and production, or from where internal group finance is provided. Groups with a worldwide turnover that is less than €750 million will be exempt from CbCR, while all others will need to comply.

What information is the OECD looking for?

The CbC report requires an aggregation of country data, rather than a detailed account of each entity. However, in order to create the aggregation, it’s likely that groups will need to look into the underlying entities. Information can be from a variety of sources, for example from the parent company’s GAAP reporting of local subsidiaries, but it should be presented consistently for each year. So, in practice, in the event that a group changes its reporting standard (from GAAP to IFRS, for instance), it’s likely that groups will need to explain the reason for change and make sure that in future years the reporting standard remains the same.

Transparency reports, as applicable

Financial statutory reporting or tax compliance

Fulfil ‘‘know your client’’ requests

Insurance cover

Monitoring legal entities to keep optimum structures

All of the above

Other

Source: webcast polling question data.

50%

17%

42% 42%

8%

0% 0%

3Why Legal Entity Management Matters IV |

Traps for the unwary: could you stumble?

While the requirements for CbCR may at first sight appear relatively straightforward, there are a number of issues that will require careful consideration in advance. For example, the categorization of tax jurisdiction could raise questions from the tax authorities about nonresident entities, depending on how they are treated in the report. Reporting on revenues could also be more complex than it first appears, as the guidance defines revenue as more than just sales and turnover: it also includes income streams such as royalties, interest and services. It’s important, therefore, to understand exactly what the data represents before it is submitted to the tax authorities.

Groups will have to report on the “constituent entities” resident in each tax jurisdiction. Although not the exact definition, a constituent entity is basically any unit that is included in the financial statements of the group, even if these are only for management reporting. Each unit’s main business activity (or activities) needs to be identified, and this can be according to a predefined list or may be self-defined. Again, the information provided must be consistent with the descriptions given in the master file.

Overall, complying with the requirements of Action 13 involves far more than simply populating a template. Groups will need to assess the entities that need to be included carefully, ensure that data comes from properly verified sources, in the correct format, is auditable and is disclosed consistently across the master file, local file and country reports.

Therefore, making sure that there is a robust system in place for managing the legal entity data is going to be more important than ever. Companies that have already established a sound legal entity management (LEM) program will have a distinct advantage over those that have not. But even where there is a system in place, it is still likely that additional work will be required, in order to meet the requirements of CbCR.

A platform for LEM action and how to build it

For those companies that have yet to develop a program, the introduction of Action 13 creates a new incentive to act. While many are aware of the benefits of LEM, some companies

have not perceived it as a priority. Action 13 — and the deadline it imposes — should change that perception. Creating a program will not only address compliance with CbCR, but also enables a central repository of legal entity information to be built. In time, this will enhance corporate governance and support decision-making, for instance on the effectiveness of the group structure, including better facilitation of legal entity restructuring and rationalization.

Given the importance of ensuring compliance with BEPS and the myriad benefits associated with an effective LEM program, all companies should make sure that they put a system in place sooner, rather than later. Gathering the required information will, depending on each group’s specific context, mean working with tax, legal, finance and HR. Understanding who “owns” the data, how to access it and maintain it is no small undertaking. The time to start is now.

In EY’s view, there are five key steps that all companies should think about when developing an LEM program:

1. Identify what is driving the LEM program, as this will, to a large extent, shape the data required. Understanding where the data is may not be straightforward, particularly where there may be more than, say, 20 jurisdictions in scope.

2. Diagnose the quality of the data available. Steps to remediate the data quality need to be completed before it can be used. For significant volumes of data this can be a relatively time-consuming process, so it’s important to get started well in advance of the deadline for CbCR.

3. Design the IT system that will meet the necessary requirements going forward. One key element of the design will be the reporting capabilities. Various functions will often want to see the same data in different formats that best suit their purposes. For example, tax may want to see legal entity data as an organization chart while finance would prefer it as an Excel file that they are able to work with. The right LEM system should be able to support all these diverse requirements.

4. Deliver and 5. Sustain the LEM program with well defined and implemented processes to ensure that data integrity is maintained going forward, and that a governance model is in place to ensure policies and processes are followed.


Distributable reserves and intercompany balances

Other issues that have come to prominence recently, and also highlight the challenges in finding the right information about legal entities, are distributable reserves and reliable intercompany balance data. They are an increasingly important topic in UK boardrooms because both regulators and investors want to know more about their management and disclosure. Some investors have raised their concerns about the lack of disclosure of reserves, and these issues can, very rapidly and publicly, undermine shareholder confidence in management and boards. Having access to a complete and accurate picture of reserves is therefore increasingly important.

72%

3%

16%

9%

Polling question 3

How many of you have identified a need to tidy up, or rationalize, intercompany balances in your group? Please select one.

The answers to polling question 2 indicate the functions (legal, company secretarial, financial or tax) that tend to collect legal entity data today. But what the results highlight is the need to make sure that a cross-functional and more holistic approach is in place that can take into account the requirements of multiple users in the business for LEM data.

As responses to our third polling question highlight (see above), assessing intercompany positions is squarely on the radar of most organizations. Nearly three-quarters either currently review and rationalize intercompany balances or are planning to do so.

Polling question 2

How does your organization collate and store legal entity data today? Please select all that apply.

33%

67%

33%

24%

0%

29%

Central financial management database

Central legal or company secretarial database

Central tax compliance database

Local databases or spreadsheets

Outsourced LEM

This is not applicable (or we do not know)


Yes, we have considered it and are reviewing or will review intercompany balances as part of a project.

Yes, we have considered it, but never seem to have the time and resources to address this need systematically.

No, if there is a need to tidy up or rationalize, we address it on an ad-hoc basis.

This is not applicable (or we do not know)


32 Total Votes


But achieving that picture is often made difficult by the sheer complexity of group structures. That complexity arises from both the number of legal entities and, critically, the relationships between them. These can include trading arrangements, financing structures or loan positions that can divert profits in such a way that makes them inaccessible or trapped.

Intercompany positions can give rise to a number of challenges, and these tend to fall into four main areas:

► Transactions: excessive Intercompany balances can delay, or even in some cases prevent, a transaction completing, especially if the acquirer has concerns about the risks associated with the balances they will inherit.

► Operational: large intercompany balances can pose a risk of violating debt covenants. Furthermore, they can require additional financial and tax reporting, as well as situations whereby cash can be trapped if it used to settle interest payments, and there are insufficient reserves to flow the cash back around the group as required.

► Tax: here there can be additional tax cost and increased tax risk from holding Intercompany balances. Incremental tax costs can arise, for example, where interest is either not tax deductible, or is deductible at a lower tax rate than where the interest income is being taxed. From a tax risk perspective, where an arm’s length interest rate is not charged on Intercompany balances, the key tax risk is around transfer pricing: this can present a one-sided tax cost to a group, with potential interest and penalties being levied in addition.

► Legal entity rationalization: stubborn Intercompany balances, for example those that may be subject to a tax risk, or where it is difficult to eliminate a balance because of the respective entity having insufficient reserves, can significantly increase the cost of a legal entity simplification.

Each of these issues gives rise to material risks, and it’s no surprise that many groups are now seeking to rationalize or eliminate their Intercompany balances. The tax environment, as typified by both the OECD’s BEPS Action Plan and, more generally, an increased focused approach to transfer pricing by revenue authorities, is one driver for groups to consider their Intercompany positions. Other drivers include a buoyant M&A market, which brings forward the need for companies to seek efficiencies from rationalizing their legal entity structure pre- and post- acquisition or divestiture.

Rationalizing or eliminating intercompany balances may be seen as a relatively straightforward exercise. But, as ever, there are potential associated risks. It’s easy, for example, to generate unwanted tax costs if the approach to elimination does not carefully consider, and plan for, the risks in each relevant jurisdiction. It’s essential to have a clear picture of distributable reserves, in order to understand what the impact of clearing up intercompany balances might be. Overall, it’s very important to take a holistic view of all relevant issues. This requirement further emphasizes the need to maintain a tidy corporate structure through effective LEM. The more complex a structure is, the greater the likelihood that value will be lost when trading profits are converted into shareholder returns.

Dealing with information gaps

The implications of BEPS compliance and the challenges of intercompany balances both stress the importance of having comprehensive and detailed information about all the legal entities in a group structure. However, there are often substantial gaps.

Problems with information gaps often arise in jurisdictions that lie outside core operations or have a semiautonomous relationship with the corporate headquarters (HQ). A relatively small entity in a particular jurisdiction may only have limited activities, yet the cost of maintaining the entity and rectifying information gaps for reporting may be higher than the group average, for example because of local bureaucratic intricacies.


Therefore, in light of the BEPS initiatives, groups may want to eliminate any surplus legal entities to create a simpler structure that will save time and money on compliance and regulatory activity.

Eliminating intercompany transactions can also generate significant savings of time and money. One project, for example, reduced the intercompany loan reconciliation process by an entire week following the elimination of 80 legal entities from a group of approximately 600.

Information gaps can frequently be traced back to entities gained as part of an acquisition. We often recommend that clients considering, or making, an acquisition of another group should:

1. Negotiate to leave behind those legal entities that add no value or do not fit with the strategic objectives of the acquisition

2. Eliminate surplus entities immediately after acquisition to avoid the ongoing reporting and compliance obligations, as well as any risk that may attach to the corporate history of a legal entity

Information gaps can have additional costs beyond remediation. Potential acquirers may ask for a discount to reflect the costs of cleaning up and managing reporting requirements. Or they may even walk away from a transaction.

LEM: the time to act is now

It’s clear that a number of developments covered in the webcast are turning the spotlight on the need for clarity and firm control of legal entity data. Complex group structures and the relationships between entities create risks in the form of higher compliance costs, potentially adverse tax consequences and trapped profits. Falling foul of BEPS requirements could lead to reputational damage, as has already been seen in a number of high-profile cases. And in an increasingly active M&A market, being unable to explain or collate information on a legal entity adequately may depress the possible price on disposal, or could even mean a transaction does not proceed.

Proactive and effective LEM is increasingly higher up the corporate agenda of internal and external stakeholders. Indeed, our latest Global Capital Confidence Barometer survey (April 2015) revealed that 54% of respondents, from a pool of senior executives, believe that the capital strategy for the forthcoming 12 months will focus on cost reduction and operational efficiency in the context of improving M&A activity (49%). Inevitably, any such strategic decisions will require the alignment of the legal entity structure to operations, while bearing in mind these regulatory challenges.

In conclusion, those companies without a LEM program in place have no time to lose in remedying the situation.


ContactsSamantha Keen Partner

Tel: +44 20 7951 7902 Email: [email protected]

Daniel Connell Director


Jelger Buitelaar Director


Alistair Shaw Senior Manager


Russell Payne Director


Richard Crisp Director


Note: the contents of this document are intended to provide general explanations of legal entity elimination processes and related procedures. They do not constitute advice and are not instructions for carrying out these processes and procedures, and therefore should not be used as a guide to doing so. Professional advice should always be sought for these purposes.

EY | Assurance | Tax | Transactions | Advisory

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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.

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