Two years ago, your company expanded into a small foreign country, investing $20 million (USD) to set up a factory, hire and train workers, and establish a foreign office to manage the enterprise. Over the past weekend, the country’s ruling party decided to nationalize all foreign enterprises. Bright and early Monday morning, the police took over your factory and shuttered your executive offices – leaving your people with no access to company accounting records, computers, files, or business documents.

This scenario is not an exaggeration. Unexpected events and disasters have befallen U.S. companies time and again as they increasingly expand into foreign countries with manufacturing facilities, customer support services, or to tap into new market opportunities. The range of unexpected events that could happen is extensive. This article will review the six most significant unexpected events that accountants need to be aware of, in order to help their companies be adequately prepared for:

·        Nationalization and seizure of assets,

·        Tax law changes,

·        Changes in the accounting standards of the foreign country,

·        Limitations on the repatriation of profit or dividends,

·        Devaluations and currency fluctuations, and

·        Natural disasters.

Why International Operations Complicate Unexpected Events

Before examining these events, it is important to point out that unexpected situations in international operations can have far more serious implications than problems that occur in domestic operations. What might have been a de minimus event that is easily and quickly resolved in the U.S. can mushroom into a costly proposition overseas if planning and proper precautions are not taken. Here are six factors that can significantly complicate international operations:

1.                 Complexity of ownership – Doing business globally often involves government-mandated partnerships based on domestic ownership requirements. Alternatively, your company may have established its international business through the British Virgin Islands to take advantage of tax laws, or you may have had to set up a special-purpose vehicle to own the foreign operations due to legal or tax considerations. For example, the concept of consolidation did not historically exist in much of Eastern Europe. Additionally, many countries require companies to partner with local companies that are domestically owned. Complex ownership structures can create a nightmare after an unexpected event if preparations are not made from the beginning.

2.                 Complexity of operations – Foreign operations complicate unexpected events in two ways. One is that the corporate ownership structure can make compensation issues challenging in terms of which entity has hired and which employs the foreign personnel. Language and cultural differences also may make it difficult to set up the same types of controls regarding fraud and compliance in foreign countries, which could contribute to or exacerbate an unexpected event.

3.                 Classification of cash inflows and outflows – How your company invests in foreign operations and documents those investments can prove to be critical. For example, are cash flows from the parent company to the foreign entity accounted for as debt in the form of loans or are they treated as additional equity investments? Are cash flows from the foreign entity back to the parent treated as repayment of that debt or repatriation of profits in the form of cash or dividends? Documenting these decisions is vital when countries unexpectedly decide to limit the repatriation of profits or change their tax laws regarding the payment of dividends to a foreign entity.

4.                 Legal requirements – Operating on foreign soil obviously means complying with foreign laws regarding taxes, ownership requirements, investment and capital requirements, pricing limitations, and local accounting and reporting standards. An unexpected event may be caused by non-compliance, but even if it is not, what might be a minor infraction in the U.S. can turn out to be a costly mistake in a foreign country.

5.                 Reliability standards – The U.S. adheres to SFAC No. 2, “Qualitative Characteristics of Accounting Information,” which requires accounting information to be reliable – defined as possessing verifiability, representational faithfulness and neutrality – but not all foreign countries follow this practice. This can present a problem when foreign countries refuse to accept anything short of absolute proof beyond the common standard in the U.S. where internal transactions are often done with little to no documentation. This can create situations where the standard level of accounting evidence maintained for internal or related-party transactions is insufficient and leaves confusion in whether a payment to the U.S. is for debt repayment rather than a return of equity or when there are notes payable between the parent and subsidiaries or affiliates.

6.                 Documentation and record keeping – Being a global company places a far larger burden on accurate and extensive record keeping than a purely U.S. domestic company would need. Some countries require international companies to maintain multiple accounting records to comply with their local laws and standards, and there are even potential tax implications in having multiple sets of books. Your documentation also must contain sufficient evidentiary matter for auditors, as well as enough support to meet the reliability standard and clearly spell out the structure of transactions. Finally, maintaining the security of your records through the use of offsite backup outside of the country where the investment is made becomes far more critical when operating internationally due to the potential risks of seizure, radical government change, legal or tax regulation changes, or even a natural disaster.

All these factors increase the risk of doing business abroad, making a company prone to greater unpredictability, exposure to unexpected situations and ultimately a loss of control both legally and financially. One area where a lack of planning for document security has especially serious consequences is in evaluating damages and negotiating equitable settlements should a company need to go to court to recoup investments after an unexpected event such as nationalization, seizure of assets or following a radical change in tax laws that targets foreign entities.

Here is a quick review of the six major unexpected events and what accountants can do in advance to help prepare their companies for them.

Preparing for Nationalization/Seizure of Assets

Nationalizations happen more frequently than assumed, even in seemingly stable countries because they are subject to governmental overthrows, political pressures and national self-interest. Many foreign governments have unilaterally opted to nationalize industries, taking over the assets of private foreign companies without notice, even when those companies have helped rebuild what had formerly been a chaotic or non-functioning industry. While it is impossible to predict or prevent nationalization, a company can take steps from the outset to make sure all contracts provide as much legal protection as possible to recapture lost assets through international arbitration. It is also crucial to be sure that all investments are “papered up” according to reliability standards usually reserved for third-party transactions.  This is especially important in situations that involve loans and debt repayment so that the foreign government is less able to characterize them as equity investments or taxable dividends.

Preparing for Tax Law Changes

Before entering a country, it is essential to be sure that its government has signed a bi-lateral investment treaty with the U.S. since this adds a level of protection against random tax law changes that are effectively aimed at foreign companies operating in that country. Two of the most egregious problems with tax law changes occur when a government unilaterally decides to tax foreign corporate profits at a higher rate than its domestic corporations or when they falsely reclassify debt repayment from an entity to the parent corporation as dividends subject to their higher taxes. Such tax law changes may effectively be a form of nationalization or a partial taking in an attempt to force foreign companies out. This issue is especially important to prepare for, as the current dire economic conditions around the world are likely to cause many countries to escalate their taxes on foreign corporations in order to maximize revenues for their own coffers.

There are four ways to prepare for unexpected tax law changes. First, set up the foreign business as either a separate entity or a partnership with a domestically owned partner rather than an affiliate, which can help minimize the government treating the company as a foreign entity subject to tax law changes. Second, be sure to stay up to date on tax laws and planned changes to the tax laws in that country; you cannot afford to be surprised. Third, maintain comprehensive accounting records of transactions and be sure to keep secure backup copies not only offsite but out of the country if legally possible. Fourth, be prepared for international arbitration in the event tax law changes happen that violate existing bilateral investment treaties.

Preparing for Accounting Standard Changes

Accounting standards are not yet globally established. While the International Financial Reporting Standards (IFRS) are adhered to in many Western developed countries, they are not universal or necessarily required. In some remote countries, accounting standards may be lax or overly restrictive on foreign companies, requiring them to keep multiple sets of books to adhere to local laws and tax regulations. For example, Eastern Europe did not recognize the concept of consolidation until recently, and the tax regimes often required an additional set of accounting records due the nuanced requirements of the tax laws. The best ways to prepare for changes in accounting standards is to become familiar with the accepted accounting standards well in advance of doing business in that country and even to negotiate in the business establishment contracts that IFRS is the accepted standard for the foreign entity. 

Preparing for Limitations of Repatriation of Profit or Dividends

Foreign governments will often seek to keep a larger share of foreign corporate profits within their borders by putting strict limits on the repatriation of profits and dividends. Such unpredictable limitations can become a major barrier to continuing business operations in that country. As stated earlier, significant planning around capital structure and transfer pricing can reduce the financial impact of these limitations. A detailed tax strategy, proper employment of debt versus equity and a well-thought-out transfer pricing system can make the road of foreign investment smoother for U.S. investors.

Preparing for Devaluations and Currency Fluctuations

This unexpected event is not about the usual daily fluctuations among global currencies, for which any multinational corporation must obviously be prepared. It is about being prepared for a radical fluctuation, such as a substantial devaluation that a government might impose on the entire country that can ultimately decimate foreign corporations and their investments. For instance, in the 1990s Russia required foreign companies to do business in rubles;,but when it suddenly defaulted on its sovereign debt and devalued the ruble in 1998, foreign companies ended up losing as much as 90 percent of the value of their cash investments. Like nationalizations, devaluations are difficult to predict with certainty, so companies should maintain a constant awareness of the economic and political climate in any country that appears to be on the brink of a faltering currency.

Preparing for Natural Disasters

Any multinational must scout out the geography of a new location to ascertain the risks of earthquake, hurricane, flood, tsunami, drought or other natural disasters. Another key element to check on before setting up business in another country is the ability to obtain adequate insurance coverage against such risks, including business interruption insurance. Of the top ten most costly natural disasters that have happened globally since 1992, five have occurred in the U.S. and five have occurred in other countries (two earthquakes in Japan, two floods and one earthquake in China). Of those that occurred in the U.S., insurance covered between 33 percent and 50 percent of the losses, while insured losses in Japan and China ranged from 3 percent to less than 1 percent (Exhibit 1). The lesson here is that multinationals should look closely at their insurance needs and seek to cover themselves before investing in any country. Beware that in some undeveloped countries, it may be simply impossible to purchase enough insurance, and this contingency should be considered when deciding upon a location or building a new facility.

Exhibit 1

Source:  Münchener Rückversicherungs-Gesellschaft, Geo Risks Research, NatCatSERVICE, 2009

It is also critical to document your business in ways that can support an insurance claim resulting from a natural disaster. Be sure to maintain data on the three basic components required for a business interruption claim:

·        Time = amount of time business is shut down

·        Quantity = amount of goods/services normally produced or sold per unit of time

·        Value = the profit of each unit of goods/services

Foreign insurance claims can be more complicated based on the type of business, historic utilization, plant capacity, seasonality of sales, variability of production, delays in corrective efforts, mitigation steps, and savings due to shutdown.

Finally, companies must have a robust disaster plan, including how to secure and obtain access to backup copies of all company documents and financial data, and how the workers will be protected and taken care of following the disaster.

Additional Recommendations to Prepare for Natural Disasters

Pre-catastrophe

– Keep backup copies of accounting, production, sales and other business records off-site

– Review business interruption policies

– Stress test your policies with scenario planning exercises

– Determine policies for disaster management and perform drills to improve compliance

Post-catastrophe

– Assess the need for external assistance

– Create specific accounts for costs related to the tragedy

– Keep documentation to support those costs

– Keep a log of documents provided to insurance companies/government agencies

– Track alternatives and document any cost estimates of “roads not taken”

The Role of Accounting and Audit

Accountants and auditors play a key role in helping their companies succeed in their international operations, especially regarding surviving these six unexpected events. As this article indicates, doing business outside the U.S. requires significant advance planning to understand the foreign environment and the political, cultural, economic and financial risks of doing business there. Beyond the standard business or marketing planning, accountants and auditors can provide both input and critical recommendations to the team exploring the new location regarding how to best set up the foreign business entity and hire workers, equity investing vs. loan options, the importance of offsite data access and security, currency issues and any conflicts about accounting standards that could cause complications. While unexpected events are, by definition, challenges that cannot be predicted, companies can plan for them in many ways to minimize their potential risk and make recapturing assets and investments easier in the event of serious problem.

About the Author

Wayne Wilson is Managing Director in the Litigation, Restructuring and Investigative Services practice in the Houston office of Protiviti. He specializes in consulting on international financial issues, especially in light of planning for and reacting to unexpected events.

Article from Protiviti KnowledgeLeader – www.knowledgleader.com.

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