Legal entity rationalization: Considerations for the corporate tax department

It is in the simple nature of businesses to expand and grow. This is done in several ways, as companies expand beyond their region, state, or country of origin. Organizations are growing organically or through acquisition and expanding into new areas or markets worldwide.

For some multinationals, the growth rate may feel like it is happening at warp speed, making it sometimes difficult to keep track of the various legal entities. In fact, many companies grow too quickly and that can cause problems, especially if management doesn’t do enough due diligence to determine the impact on the overall organization.

That’s why it is important for corporate tax departments to perform what’s call a legal entity rationalization (LER). In the context of corporate tax departments, LER refers to the process of simplifying a company’s legal entity structure, usually by reducing the number of legal entities within the corporate group. This rationalization process can be driven by various factors, including regulatory changes, mergers & acquisitions, and other efforts to optimize operational and tax efficiencies.

Why perform LER?

There are several reasons why it is important for corporate tax departments to perform LER. With each new acquisition, merger, or growth initiative, a business often gains an entity and all the legal attachments that come with it, including in some cases, staff and headquarters. Put simply, organizations become more complex with each additional new legal entity, whether local or global. And these complexities can lead to inefficiencies, both in operational processes and tax realization.

Operational inefficiencies may include overly complicated business structures, which could make it hard for management to determine who is responsible for what. In addition, operations that are complex or complicated tend to lead to greater errors and redundancies. In general, multiple legal entities require greater resources — some of which are not offset by the reasons why the business was acquired in the first place. And that could also mean incurring greater cost and, more importantly, exposing the organization to more risk, which could include falling out of compliance, or facing increased audit action and subsequent penalties.

There is no one right way in which a tax department might approach LER, but here are six steps that corporate tax departments can be used as a guide:

1. 1. Assessing the current structure — Conventional wisdom states you must know where you are before you can decide where you want or need to go. The same is true here. The tax department should clearly understand the current legal entity structure before enacting any changes to it. This can be done by mapping out all the corporation’s many entities, understanding each of their business purposes, and evaluating their financial and tax configurations.
   2. Identifying redundancies — Once the entities are clearly mapped out, then it is easier to spot where inefficiencies and redundancies may exist in the structure. These redundancies can range from in a single jurisdiction serving similar functions as other entities, or entities that are no longer active or necessary for current business operations.
   3. Performing cost-benefit analysis — It is important before deciding whether to make any changes, that a thorough analysis of cost and benefits is done. This should include taking a look at what the potential tax and operational savings may be, and comparing to the costs — such as potential tax liabilities, and restructuring and legal fees — if changes were made.
   4. Ensuring regulatory and tax compliance — Separate from the cost-benefit analysis, is determining how the legal entity rationalization will change the company’s tax profile. You should identify the implications in each jurisdiction and make sure they follow local regulations. Working with local agencies may be required to ensure all the necessary information is laid out and the necessary restructuring agreements are understood.
   5. Engaging stakeholders— Engaging with all the stakeholders that could be affected by the changes to the legal entity is crucial. For many, a significant challenge to getting a LER started (much less completed) is failure to get buy-in from stakeholders. To get access to data and resources needed for the evaluation, it is necessary to include key stakeholders that represent every aspect of the business — legal, sales, supply chain, finance, accounting, regulatory, and more.
   6. Finalizing execution — Each step above is important, but most critical is the execution of LER. Carrying through the LER should only occur when approval is received from the key stakeholders. An execution is considered successful if the intended benefits of the analysis were achieved, including the mitigation of tax liabilities and regulatory risk.

The time invested in creating and executing a LER is a worthwhile endeavor for corporate tax departments. Going forward, it can be a blueprint for other LERs as the business continues to grow and acquire other entities. The LER process also should include many systems of automation so it can be used as a tool to review the entity structure from time to time, making sure the current business structure is optimized.