The Diligent team

GRC trends and insights

Legal entity rationalization

It’s impossible – or, at least, inadvisable – to grow into new markets and new territories without considering the impact on your organizational structure. Each new jurisdiction, and sometimes even each new product or service, is likely to require a new legal entity to ensure your organization can legally and compliantly operate in that jurisdiction.

But with companies expanding into new territories at ever-increasing rates, and with the market’s taste for mergers and acquisitions setting the corporate world on fire, there is an increasing financial and administrative burden on multinational structures. Each new jurisdiction brings with it new compliance requirements and regulations, and so each new legal entity must have strict monitoring to ensure it remains legally able to operate – and each entity may well take a different form, from branches to joint-ventures to holding companies, each with its own set of regulations to which it must adhere.

This large-scale expansion, therefore, can result in overblown, inefficient and ineffective organizational structures that are costly to maintain. Not only that, but there is an inherent risk introduced with each new legal entity and having too many legal entities exponentially increases the risk for the group structure. Experts in international subsidiary structures advise that these complex structures be assessed for potential legal entity rationalization on a regular basis.

What is legal entity rationalization?

Legal entity rationalization is the process of taking an unwieldy subsidiary structure and identifying – and then dealing with – any redundancies. This can lead to both cost and risk reductions plus a simpler legal structure that’s easier to manage. It’s sometimes called corporate simplification, and it entails, to put it simply, reducing the number of legal entities.

There are two traditional approaches to legal entity rationalization. First, you could search for any dormant entities; if the entity is not in use, then you’re spending maintenance money for no reason. However, eliminating dormant entities is unlikely to achieve a huge amount of cost savings, so many organizations will also turn to an “outside-in” approach – that is, looking at the entire organizational structure and assessing each entity one by one, much like putting together a jigsaw puzzle.

The need for legal entity rationalization

Without assessing the subsidiary structure and undertaking legal entity rationalization regularly, an organization can become unwieldy and hard to manage.

Here are just three challenges large structures face:

Challenge 1: Risk

As a group structure grows exponentially, it takes on an increasing amount of risk. Each new legal entity brings with it a unique set of challenges – and a unique set of things that could go wrong. That means that with each new market and each new entity, an organization must increase its monitoring and entity management to mitigate risks such as forgotten filings, missed new regulation and insider trading.

Challenge 2: Cost

Even if an overseas legal entity supports a handful of employees, it can still be costly to run – recurring services such as accounting, payroll, tax and compliance must be paid for, and there could be one-off charges for running the entity that crop up unexpectedly. Multiply these costs by multiple inefficient and unnecessary legal entities, and the costs mount.

Challenge 3: Resourcing

This all leads to the ever-present challenge of resourcing: How are you going to manage and monitor all these legal entities to ensure the risks and costs don’t cause trouble? It will likely mean either adding headcount to the compliance team or getting the already stretched team to take on more work; the former requires more budget, while the latter can lead to employee disengagement and a breakdown in governance and control.

Essential steps in legal entity rationalization

So, legal entity rationalization can be essential to ensuring an efficient subsidiary structure with all subsidiaries working toward the same aims. And, while the process of legal entity rationalization will vary according to the individual structure, sector and business strategy, there are some essential steps to take when embarking on a program of legal entity rationalization.

1. First, create an accurate, up-to-date chart of the current structure, including all legal entities, types and locations.
2. Then, document the ownership structure and purpose of each legal entity, ensuring you understand the role it plays both locally and in the wider structure. Running an entity diagramming report in your entity management software will help with these first two steps.
3. Now, look carefully at each of the entities on the chart, asking if it’s truly needed. What is its purpose? Does it make sense in the wider structure? Is it essential? Is it in the right legal format for the purpose?
4. Run some scenario planning to create mock entity diagrams for the proposed new structure, post-legal entity rationalization. Ensure the proposed structure makes sense and is aligned with the organizational strategy, and that all proposed entities have been evaluated for governance and compliance risks.
5. Finalize your targets for legal entity rationalization and establish a budget, timeline and project plan to minimize disruption, ensuring you’ve factored in any policy or procedural changes that must occur before and after the rationalization. Then, obtain approval and execute the legal entity rationalization.

Of course, this should not be a one-off exercise. Make sure you create a process to evaluate your organizational structure on a regular basis, and really interrogate every legal entity found in the subsidiary structure. This will help to ensure the organization runs efficiently and effectively, and the risk of missing compliance and governance processes will be minimized.

The most popular jurisdictions for entity domiciliation

While assessing the subsidiary structure for legal entity rationalization, it’s worth also considering whether the entities are domiciled, or incorporated, in the best jurisdictions. Although the days of dodgy domiciliations for tax purposes are generally behind us thanks to the OECD’s BEPS project, you’ll still find opportunities for efficiencies if you’re not tied to a jurisdiction for operational reasons.

Many jurisdictions compete on such aspects as corporate tax rates or might offer incentives to cross-border organizations looking for a new home for a legal entity. That’s why you’ll find certain jurisdictions and countries take the lion’s share of legal entities around the world.

Looking at Diligent’s customer data, we found the top 10 jurisdictions in which to locate entities are:

1. United Kingdom
2. United States
3. Australia
4. Ireland
5. Netherlands
6. Germany
7. France
8. Canada
9. Hong Kong
10. Singapore

Using entity data to drive the legal entity rationalization process

If entity diagramming and entity data are essential to any legal entity rationalization process, it goes without saying that a subsidiary structure must ensure that it has robust and accurate entity data that is freely available to stakeholders undertaking these processes. Getting the right information to the right people at the right time and in the right format can make or break legal entity rationalization.

Entity management software, such as Diligent Entities, creates a single source of truth for all entity data, ensuring the legal entity rationalization process and subsequent decisions to close or move entities are based on real-time data. Running organizational diagramming and other entity data reports through this cloud-based system can ease the burden of the legal entity rationalization process by automatically pulling the relevant information in the right formats.

Get in touch and schedule a demo to see how Diligent Entities can help to drive your legal entity rationalization process, and help you to run efficient and optimized group structures.