Uncontrolled growth can damage your enterprise (Management Wizards beware)

It is a reality than in a global environment a company needs presence and representation in the worldwide market; today many medium sized companies all over the world are struggling to be competitive and restructuring their financial management strategies.

Modern financial managers coming from big schools keep modifying and creating structural entities within the companies, costs centers, etc, forgetting completely that at the end of the day it won’t really matters if your money is in your left or right pocket as long as the pocket containing your money belongs to you…

Companies can grow as the result of successful increase in activity due to marketing efforts or service quality, as well as the result of external acquisitions, whatever the reason for growth it will have as a consequence an increased number of overhead expenditures that can overcome the added revenue benefit (Marginal cost concept)

In recent years I had the opportunity to witness how a strategy change in a company in the hands of financial geniuses turned into a commercial handicap thus killing all the potential benefits of the strategies… (But putting a bucketload of money on the Managing directors and the board)

First of all don’t get me wrong, these finance wizards have basically two goals; the first to reduce the taxable revenue while still profiting of the gross revenue and to set an internal competitive basis for a Key performance indicator reward system.

So a well managed company can benefit from the wizard’s input; but should not forget that at the end of the day these are just a set of juggling tricks to increase the value of the company… (analog to hiding your money in your socks to avoid losing it)

The main errors observed were:

The creation of geographical cost centers as well as regional ones created a pyramidal cost structure that made the smaller business units not profitable.

Example:

Each contract on each business unit is supposed to finance the General costs of the structure.

On top of the:

  • HQ Sales General & Administrative expenses contribution of 30%

The BU should contribute to:

  • Geographical unit overhead: 5%
  • BU Overhead of :                   10%

But it did not stop there; the BU was also supposed to integrate in their pricing the following:

  • HQ royalties and remote fees: 15%
  • Corporate tax and Withholding’s Tax: 3,5%
  • Local tax: 1.5%

So when the BU creates a price for a service only after adding 65% of the local costs it shown an actual EBIT or profit…

Of course when you are supposed to be competitive price matters and if you only earn money after charging more than 60% of your costs then most probably the BU will not be able to show any benefits; thus the local management will not achieve their KPIs and the company actually saves money in bonuses and rewards.

Even thou I doubt it; this may work for a few business sectors where the market niche is not utterly saturated, but in most cases it will kill any aspiration of price competition in an open market share.

Do you see the financial trick?

Each Business Unit contributes with a gross percentage of Tax (which is usually Income tax) but the actual Income declared is less; thus the net amount actually paid on taxes is much less than the contributed amount generating a hidden profit.

How this is done? Easy; at HQ level the 30% SG&A contribution of each BU is converted into HQ Capex, OPEX or capital increase… Governments will never see their share of tax for that 30%  nor for the royalties or others…

The loyalty and moral of the BU management is thus reduced because as their BU is not profitable they don’t receive their KPI bonuses, promotions Etc…

Other insane practice that does not affect the pricing or market share of the company but destroys moral amongst employees and it is used in many multinational corporations requiring personnel from many countries working in several different countries is the HR and Admin delocalization and the application of an Hypertax.

How do this works…

A company usually established in  country X creates a financial / HR and administrative division in another country with lax labor laws.

This division is the one that will be the employer of the bigger share of the payroll; these employees will not have social security neither in their country of residence or in their country of work.

This is already bad as the employees will not be contributing to the government retiring plans anywhere, thus hurting national social security systems, now add to it that the bigger savings are those of the company avoiding to pay their share as employer to social contributions.

Of course usually this is accompanied with a compulsory private retirement plan (with is usually not enough to cover a real retirement).

Now let’s see the impact in an employee net revenue as this must be good for the employees too… Taking France as an example; employee social contributions amount to around 23% of the gross salary. The employee stops contributing that amount because even thou he may be a French resident he is hired by a UK company (or a Swiss one) and working lets say  in the USA for less than 183 days in a fiscal year…

This employee is not supposed to pay Income taxes anywhere… He doesn’t spend enough time in his country of residence; he doesn’t spend enough time in his country of work and obviously he is rarely or never in his country of employment…

So in theory he is avoiding to pay the 23% social contributions, as well as whatever his Income tax bracket is… retaining France as an example the employee should see his net salary increase of about 28%…

False… usually companies using this system apply what they call a HyperTax, which is not other than a fixed percentage of the gross salary of the overall payroll to cover eventual tax claims from the countries of activity (Or in some cases the country of residence if the employee decides to declare tax for loan purposes or whatever the reason)

The hypertax is usually an arbitrary amount between 15% and 20% of the gross salary, and the con doesn’t stops there; usually the Administrative division prepares the detailed revenue document that the employee should base his income tax declaration… (Better left said usually a big share of the salary is hidden as reimbursable or travel allocations or other OPEX).

In general most employees will not declare taxes; most governments in the countries of activity will not claim taxes neither as this tactic is generally used in equal rotation employees… So the employee won’t spend the required time in either place as to be taxable…

And what happens to the money the retainer company won’t refund as taxes here and there?

Ask a finance genius… he will probably answer by looking at the Yacht the company offered him as a bonus for coming up with such a beautiful scheme.

Yes we are in a financial crisis and yet there is a lot of money left around for toys for the big boys…

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