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How tax outsourcing can help portfolio companies reduce risk

EY Americas
EY Americas

Multidisciplinary professional services organization

5 minute read 02 Nov 2022
Related topics
Tax

For portfolio companies looking to reduce cost and risk associated with their tax function, outsourcing or co-sourcing should be considered.

In brief

  • Private companies are under increased pressure to reduce costs, with 94% planning to reduce the budget of their tax and finance function over the next two years by an average of 5.9%.
  • Private equity portfolio companies face even stronger pressure to transform in order to increase exit value.
  • Outsourcing or co-sourcing can help reduce both risk and cost, allowing existing tax and finance professionals to focus on strategic, high-value activities.

Tax and finance transformation is now a must. Growing issues around supply chain, rapid tax legislation and shifting workforce dynamics — all exacerbated by the COVID-19 pandemic — are putting businesses under pressure and necessitate fundamental change. The 2022 EY Tax and Finance Operations Survey (TFO survey), which queried 1,650 executives in more than 40 jurisdictions and a dozen industries, including 364 privately owned companies, has found that organizations are struggling to find a balance between driving value, managing risk and reducing cost. In response, most surveyed companies are or are planning to undertake some sort of transformation.

76% of private companies are taking action due to deficiencies in their current operating model.

2022 EY Tax and Finance Operations Survey

Finance leaders of recently acquired or existing portfolio companies (portcos) are facing the same challenges but with added urgency to transform in a shorter time frame. With the average holding period for a portco of three to five years, they are often racing to find ways to enhance value while managing risk to increase the value of the investment, decrease costs and confirm there are no unwelcome surprises in diligence and deal closing caused by inefficient processes or lack of qualified staff.

This complex balancing act requires a leader who can find ways to manage investor pressure for return on investment in a short window, while also being able to execute on transforming business processes to enhance company value. If you’re not already on the path to tax and finance transformation, private equity (PE) investors will look to you to radically rethink the way you operate your tax and finance functions.

While every portco’s circumstances and needs are different, outsourcing and co-sourcing can help ease cost, risk and staffing pressures while adding significant value. Below we examine three different tax function scenarios at deal close to illustrate opportunities to enhance value based on the portco tax operating model: the portco has an existing tax department, the portco is a carve-out from a parent company and has no tax function, and the portco is part of an add-on deal or integration with multiple tax functions.

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Portco A: existing tax department

A global private investment management firm purchased Portco A, a global entertainment company. Portco A had an existing tax department; however, employees were necessarily focused on compliance with minimal time left for planning and other value-generating activities.

 

This is a common scenario. With the growth in regulations and compliance requirements, along with the dearth of talent available in tax specialties, tax departments in even the biggest companies are overloaded with compliance activities and are struggling to manage what’s required of them, with no time for more strategic activities. And yet, the expectations of adding value continue to grow.

 

To prepare for the eventual exit, the investment firm and Portco A leaders decided to engage a third party to co-source their tax department. As noted in the TFO survey, “In many cases, it is easier to work with a vendor that invests heavily in developing its own tax professionals who are also knowledgeable in leveraging data to meet obligations and bring insights to the broader enterprise.”

 

The third party hired the majority of the department as full-time employees who were assigned to Portco A to complete similar functions to their original jobs. The cost savings were significant — approximately US$32 million — and the remaining management-level tax professionals were freed up to spend their time on strategy and planning. Other benefits included a deep bench of tax professionals for Portco A to call on in case of turnover or leave; access to leading industry, tax and regulatory knowledge; and access to advanced technology without having to invest in software and licensing.

 

The co-sourced employees also benefited, gaining access to more career growth opportunities beyond their traditional job functions, new skills and information, and the ability to work for different clients beyond Portco A.

 

Portco B: carve-out from existing entity

Portco B was a subsidiary of a multinational consumer goods company that was carved out and sold to the PE arm of a leading global investment firm. When part of the multinational, Portco B didn’t have its own tax department — instead, those functions were housed centrally in the parent company. The transition services agreement with the parent company only covered tax compliance for a short period of time, so Portco B needed to stand up a tax department immediately.

 

Building an internal tax department from scratch would be a years’ long undertaking, requiring not just finding and hiring experienced staff (as noted above, a challenge in the current environment) but also a large investment in technology for the finance and tax systems to enable the department. Given the target exit of seven to eight years, the PE firm determined that building a multifunctional in-house tax function would not be fast enough or cost effective as it would significantly cut into the eventual sales price. There would also be a risk that the practitioners brought in would not be skilled enough to confirm compliance in multiple jurisdictions.

94% of private companies are more likely than not to co-source tax and finance activities over the next 24 months.

2022 EY Tax and Finance Operations Survey

Instead, the PE firm hired a third party and outsourced the majority of its tax department, keeping a small number of individuals to provide the controls structure and serve as liaisons to the business. This shifted the typical dynamic for an in-house tax department from compliance to a true business partner, while ensuring compliance from day one through the deep bench of skilled and sophisticated practitioners available through the third party. Bringing in the third party also gave Portco B access to its tried and tested tax and finance technology and systems, eliminating the need to purchase and implement its own. As an added bonus, the technology consolidated all data into a central view with robust analytics, giving leadership of Portco B and the PE company control and visibility around the globe.

While the PE firm has not yet sold Portco B, the benefits of this arrangement have been swift and comprehensive for both companies, including €57 million in refunds and indirect tax deferrals on day one, dedicated top tax talent in a complex and changing tax landscape; global consistency in approach, planning and risk management across all jurisdictions; compliance filings from day 1; and a tax model design that’s aligned with the firm’s operating model.

Portco C: consolidating entities

Another common scenario is when a PE firm purchases two or more companies in the same sector with similar products or services and integrates them to benefit from synergies and create one larger company that is much more competitive and valuable than the original companies were separately.

Integrating two or more companies is not easy. The PE company has to determine how to create one sophisticated tax department ready to manage the issues of a big company from several smaller tax departments, each with its own technology, processes and systems that cannot talk to the others.

Tax departments that previously consisted of few individuals may be overwhelmed with competing priorities, including accounting for the transaction, work related to the transaction structure and risk mitigation items, along with regular day-to-day tasks.

94% of private companies say their tax and finance personnel need to augment their tax technical skills with data, process and technology skills in the next three years.

2022 EY Tax and Finance Operations Survey

Without a clear execution plan and prioritization of tax items, there can be significant risk and lost opportunities. For instance, financial statement reporting may be extremely challenging compared with past practices. Vital tax items, such as modeling the impact of breaking tax years and key elections, will

need to be appropriately considered and responsibilities divided. And capitalizing on transaction-related opportunities (e.g., transaction cost analysis, employment tax savings) is critical. However, the individuals in the original small tax departments often do not have the sophistication, skills or knowledge to handle these crucial tasks.

Co-sourcing or outsourcing the tax department can be the quickest and most cost-effective way to manage the integration itself and the related transaction accounting and continue to do business. The tax professionals who remain with the new company can then focus on high-end planning opportunities and proactively identifying and mitigating any tax issues — which have been known to lead to millions of dollars of lost value at exit.

Whichever direction a company chooses to go, it’s imperative to proactively manage any and all tax issues, as they only build upon each other, getting worse and worse over time.

Contributors

  • Anna M. Skvortsova, Partner, EY Private, Business Tax Services, Ernst & Young LLP
  • Matthew Bender, Managing Director, Private Tax
  • Jimi Karou, Senior Manager, Private Tax
  • Amy Lesh, Senior Manager, Tax – Global Compliance and Reporting

Summary

If you are a finance leader at a portco, you need a tax operating model and transformation strategy that is adaptable, tailored to your needs and focuses on exit value. There have been instances where small compliance mistakes have cost tens of millions in price reductions at exit. Don’t let that be you. We recommend an assessment by a third party to evaluate your current state operating model, determine where there are gaps and opportunities, and if co-sourcing or outsourcing can transform and enhance value for your company.

About this article

EY Americas
EY Americas
Multidisciplinary professional services organization
Related topics
Tax

EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients.