03 T Magazine Magazine 03 - EY Tax Insights · T Magazine about setting up a global tax function. 34 __ A changing balance Rising skills and an emerging middle class are transforming

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Tax insight for business leaders

Building a global tax function at ArcelorMittal

Africa emerges as a key investment market

Expansion exposes firms to new tax risks

A new chapter in globalization

Striking the balance between local and global

ImprintPublisher:Ernst & Young EMEIA TaxBleicherweg 21, 8002 Zurich, Switzerland

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All rights reserved. Contents of this publication may not be reproduced whole or in part without written consent of the copyright owner.

A part of this issue will be distributed as an insert in the Financial Times across Europe, Middle East, India and Africa in January 2011.

Ernst & Young Issue 03 T Magazine 3

By Stephan Kuhn Editorial

Dear Reader

Structural changes in the global economy are encouraging companies to rethink business and operating models. With key emerging markets forecast to grow at near-double digit rates while developed markets struggle to embed a sustainable recovery, corporate priorities are changing. Around the world, companies are reallocating resources and shifting their centers of gravity to reflect the new reality.

It is not just markets that are evolving. Rising skills in highly populous emerging markets are facilitating the migration of key business functions and processes away from the corporate headquarters. Increasingly, companies are changing their operational footprint and locating functions wherever they can best be executed at low cost. Key business activities, such as research and development, procurement and distribution, are heading East, all to get closer to markets and to take advantage of a new skills landscape.

The extent to which companies can now rethink the location of business functions presents them with powerful opportunities to increase the efficiency and effectiveness of their operations. But the decision is not always a straightforward one. Location decisions depend on a complex assessment of variables. Skills and market proximity are just two factors — in addition, companies must consider cost, amongst others tax cost and the tax environment, the legal system and the extent to which their intellectual property and ownership rights will be protected.

For decades, companies have been urged to strike the balance between local and global. At a time when they are responding to major changes in the global economy and rethinking their operating models, this advice has never been more pertinent. The centralization of business functions enables economies of scale and facilitates a standardized approach around the world. This cuts costs and risks, and it increases transparency. Yet equally, companies must ensure that delivery to customers remains local. Products, services and distribution models may need to be tailored to the needs of specific markets, while marketing and branding should reflect local customs and preferences.

In this issue of T Magazine, we look at how companies are restructuring themselves to reflect the new economic reality. We explore the changes to operating models that may be required, and look at how companies weigh up the pros and cons of key business factors, including market size, skills, business environment — and tax! We hope you find the publication valuable and stimulating.

Stephan Kuhn

From multinational mindset to a new global reality

Stephan Kuhn is Area Tax Leader for the Europe, Middle East, India and Africa (EMEIA) region at Ernst & Young.

Stephan Kuhn

4 T Magazine Issue 03 Ernst & Young

Contents Credits: Gerard Uferas / LUZphoto; Keystone / AP / The Canadian Press; GettyImages.com / Ritam Banerjee; Cover: Keystone / Martial Trezzini

Discover more content, news and features on the T Magazine website at www.ey.com/tmagazine

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Pascal Lamy, Director-General of the World Trade Organization“The G20 has repeatedly emphasized the importance of international cooperation in global economic issues. Cooperation means listening to each other, understanding each others’ constraints, and entering into compromises towards commonly identified goals. Today the constraints of countries may be different, the individual actions required from individual countries may be different but they must all be directed towards these common goals.” Taken from a speech to the Federation of Indian Chambers of Commerce and Industry (FICCI) in New Delhi on 19 November 2010.

News5 __ Global Tax NewsRecent developments in tax policy and legislation.

6 __ Protectionism by stealth?Although governments have so far avoided severe protectionist measures, the threat remains.

Features8 __ The world is not flatGlobal expansion requires a rethink of strategy and a new approach to operating models.

14 __ Over the horizonThe multinational enterprise has been with us for more than a century but the truly global business is a relatively new phenomenon.

Focus16 __ Respecting the differences in distant marketsIESE Professor Pankaj Ghemawat talks to T Magazine about the challenges of global busines strategy.

20 __ Dispatches from the front lines of transfer pricingTransfer pricing has become a core issue for companies operating in multiple geographies.

22 __ The search for clarity and consistencyCaroline Silberztein talks to T Magazine about the OECD’s work in producing transfer pricing guidelines.

26 __ The new frontier for growthCompanies are waking up to the prospects of investing in Africa but building a pan-African business strategy remains challenging.

Management30 __ CPOs head EastThe importance of Asia as a sourcing destination is encouraging a growing number of companies to relocate their procurement function.

32 __ Taking a global viewSenior executives from ArcelorMittal tell T Magazine about setting up a global tax function.

34 __ A changing balanceRising skills and an emerging middle class are transforming perceptions of conducting R&D in emerging markets.

40 __ How to navigate a risky tax environmentGovernments are stepping up tax enforcement, which presents challenges to global companies.

42 __ From East to West for a global championIndia’s Tata Group has been a trailblazer in overseas expansion and acquisitions.

46 __ Offshoring’s next actCompanies are looking beyond cost when planning their offshoring strategies.

Outlook48 __ Let’s stop kidding ourselvesFons Trompenaars highlights the importance of culture in the organizational make-up.

03MagazineTax insight for business leaders

Building a global tax function at ArcelorMittal

Africa emerges as a key investment market

Expansion exposes firms to new tax risks

A new chapter in globalization

Striking the balance between local and global

Cover


News

United States: December 2010President Obama agreed a bipartisan deal with Republican leaders in Congress to extend the Bush-era tax cuts for another two years. Research and development tax credits would remain available until the end of 2011, while income tax cuts enacted during the Bush era would also be extended.

European Union: December 2010The Council of the European Union in Brussels, Belgium, has agreed an expansion on exchange of tax information. The new directive will allow member states to make administrative enquiries on tax in the territory of another member state. In addition,

member states may no longer be allowed to refuse a request for information on the basis of bank secrecy.

Australia: November 2010The Australian Taxation Office has proposed taxing the capital gains on private equity deals as business income, which would be taxed at a higher rate. The ruling would apply to both domestic and overseas private equity houses that have sold assets in Australia.

Ireland: November 2010Ireland agrees a four-year austerity plan that would include deep spending cuts and tax rises. But despite pressure from some European politicians, the government

Brazil: October 2010Concerns about flows of “hot” money into the country and a rapidly appreciating currency led Brazil to introduce an increase in its financial transactions tax on money entering the country. The new controls would see the IOF tax increase from 2% to 4%.

Japan:December 2010The government announced that it would cut the country’s 40% corporate tax rate by 5 percentage points in an effort to stimulate the economy and increase the competitiveness of Japanese business. Despite the cut, Japan’s effective corporate tax rate remains higher than the comparable rate in South Korea or China.

pledged to hold firm on its 12.5% corporate tax rate, which has been one factor that has attracted a large number of overseas businesses to the country.

United Kingdom:November 2010The UK government published its roadmap for making the UK corporate tax system the most competitive in the G20. This includes reforms to the Controlled Foreign Companies regime to restrict the focus solely onto diversion from the UK.

South Korea: November 2010The South Korean government imposed a withholding tax of 14% on foreign investors’ earnings from government bonds.

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Global tax newsA roundup of recent developments from major governments and tax administrations

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Credit: Keystone / AP / Richard Drew

Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct

United StatesAt the G20 Summit in Washington, world leaders issue a clear message against protectionism

India places several import products under restriction

Indonesiaimposes strict checks on over 500 imported products

India places a ban on Chinese toy imports for six months

United StatesThe US Administration passes the American Recovery and Reinvestment Act, which includes controversial “Buy American” provisions

AustraliaAt the Lowy Institute in Sydney, Pascal Lamy condemns “smart isolationism” as the recipe for a global slump

Protectionism by stealth?

__ Pascal Lamy, Director-General of the World Trade Organization (WTO), warned in the United Kingdom’s Guardian newspaper that the world risked returning to the protectionist policies of the 1930s. In particular, he was referring to ongoing disagreement over whether countries, including China and the United States, are deliberately undervaluing their currencies in order to increase their export competitiveness. His warning, however, echoes a broader concern that the WTO and other international organizations have been expressing since the beginning of the downturn. While governments have largely avoided traditional tariff barriers, they have sometimes shown ingenuity in finding other ways to distort trade patterns, often in response to the financial crisis (see timeline below). Instead of simple import taxes, governments are turning to bail-outs or subsidies of national firms, targeted export subsidies, as well as public procurement and local content policies that favor domestic production, to name a few devices.Thus, the real worry in the current climate is not an impending, outright assault on world trading arrangements, but that a clever abuse of treaty loopholes and other methods might create “protectionism by stealth”. As Lamy told the Guardian, “We have been living with this for two years.... What should be avoided is a domino effect, where you get a beggar-my-neighbor, or tit-for-tat, chain and it sours and sours.”

2009

1 EU27 1662 Russia 853 Argentina 524 India 475 Germany 356 Brazil 327 United Kingdom 318 Spain 25

Source: 8th GTA Report (2010)

Post-crisis protectionism

Number of transnational companies Share of transnational companies from developed countries

9290 94 96 98 00 02 06 08040

20,000

40,000

60,000

80,000

100,000

A shrinking share for developed nations

Exports by destination

Source: United Nations Conference on Trade and Development Source: WTO

Pascal Lamy at the United Nations

Discriminatory measures Ranking by number of (almost certainly) discriminatory measures imposed

EuropeAsiaMiddle EastSouth and Central AmericaNorth AmericaAfricaCIS

42%

26%

4%4% 3%3%

17%

EuropeAsiaMiddle EastSouth and Central AmericaNorth AmericaAfricaCIS

42%

26%

4%4% 3%3%

17%

News


Credit: Keystone / AP / RIA Novosti POOL / Alexei Nikolsky; Keystone / AP / Matthias Rietschel

Between October 2008 and February 2010, only 2% of goods imported by G20 states would have been affected in any way by new import restrictions, according to a June 2010 report from the WTO, OECD and UNCTAD.

According to the WTO, the sectors most affected by restrictive measures are electrical machinery, mineral fuels and oils, and mechanical appliances. “Restricting trade has nothing to offer to the G20 goal of strong, sustained and balanced economic growth,” it notes in a report.

2%

In September 2010, Global Trade Alert (GTA) said that it had identified over 600 new, specific measures that impede trade, including nearly 400 enacted by G20 states.

600

Angela Merkel, interviewed in the Financial Times November 2010

“The G20 has repeatedly stressed that the crisis can only be overcome if we dismantle all forms of obstruction, and do not erect new ones… Unfortunately, trade barriers are being erected again on many sides... We must avoid actions like that, and talk about them openly.”

Mar Apr May Jun Jul Aug Sep OctNov Dec Jan Feb

ChinaThe US imposes punitive tariffs on tyres imported from China

JapanThe Japanese government announces plans to expand Japan Post into insurance and financial services, creating a market barrier

United StatesThe US increases the cost of visas for foreign workers. The Indian commerce minister describes the move as “inexplicable”

United StatesThe Federal Reserve announces plans to buy US$600bn of longer-term Treasury securities by the middle of 2011

CanadaIn Toronto, the G20 renews its promise to keep markets open until 2013

Central AsiaCreation of the Customs Union of Russia, Kazakhstan and Belarus

AustraliaThe Canadian government intervenes to prevent the acquisition of PotashCorp by the Australian mining company BHP Billiton

Moscow __ RussiaPrime Minister Vladimir Putin sparks a row when he announces plans to raise car import tariffs in order to encourage overseas car companies to manufacture in

Russia. Experts suggest that such a move could undermine the country’s bid to join the World Trade Organization, which has been under way since 1993.

Seoul __ South KoreaThe latest report ahead of the G20 Summit in Seoul confirms the WTO Trade Report conclusion that trade protectionist measures have not been the main cause of the trade slump, rather falling demand has been the main culprit. Nonetheless, their monitoring of new trade policies paints a bleak picture – they find an increase in investment-related restrictions, as well as a proliferation of stimulus packages.

2010

Global Trade Alert statistics__ Since the Toronto summit, G20 governments have implemented 94 measures assessed as almost certainly protectionist. The rest of the world has implemented only 44 such measures.

__ Global merchandise exports from developed countries are expected to expand by 11.5% in volume terms while the rest of the world is expected to see an increase of 16.5%.

__ Of the 100 liberalizing or neutral measures implemented worldwide since June 2010, just 29% were implemented by G20 countries.


Feature Global business Credit: Atul Loke / LUZphoto

Operating models are key to the success of the global business. But executives continue to struggle with the challenge of balancing globalization and localization.

The world is not flat

functions, standardize processes and locate them anywhere in the world. Competition, and the recent economic slowdown, has forced companies to drive down costs, take advantage of economies of scale where possible, and eliminate duplication. Perhaps most importantly, patterns of global demand, capital and skills are changing dramatically, as rapidly emerging economies, particularly in Asia, have become major markets in their own right, forcing companies to alter their strategies and business models.

For many companies, the shift in their global strategy to take advantage of high-growth markets is already underway. But changes in the operating model — the structures, systems, processes and people that a company uses to execute its strategy — are often lagging behind. In particular, Western multinationals often

• By Fergal Byrne

The multinational company has been a feature of the business landscape for more than a century, but the truly global

company is a more recent, and still relatively rare, phenomenon. While the multinational business organizes its operations market by market, as a collection of country-based subsidiaries under the umbrella of a strong corporate headquarters, the global business does away with this traditional “hub and spoke” model. When investing overseas, it does so in the context of its entire global market. It integrates production globally, directs processes and functions to wherever in the world they can best be executed, and strikes a careful balance between standardization and the tailoring of business activities.

There are various important drivers of this shift from the multinational to global enterprise. Ongoing liberalization has made it easier to enter new markets. Information technology has enabled companies to disaggregate business

SummaryMultinational companies are increasingly looking to emerging markets as an important source of growth. But expansion into these markets can be challenging, not least because executives must rethink operating models and strike the balance between local and global.

Credit: Xxxxxx / NameVorname Xxxxxxxxxxxxxxxxxxx Feature

issue 03 T Magazine 9Ernst & Young Issue 03 T Magazine 9

Tiger TyagarajanChief Operating Officer, Genpact

__ He is credited as one of the pioneers who transformed GE Capital International Services (now Genpact) into a leading Business Process Management Company with over $1 billion in revenues, which serves global enterprises in the banking & finance, insurance, manufacturing, transportation and business-services sectors.


Feature Global Business

1 Belgium 92.952 Austria 92.513 Netherlands 91.904 Switzerland 90.555 Sweden 89.756 Denmark 89.687 Canada 88.248 Portugal 87.549 Finland 87.3110 Hungary 87.00

Index of Globalization

Source: 2010 KOF Index of Globalization / The KOF Index measures the three main dimensions of globalization: economic, social and political.

1 Singapore 97.482 Ireland 93.933 Luxembourg 93.574 Netherlands 92.405 Malta 92.266 Belgium 91.947 Estonia 91.668 Hungary 90.459 Sweden 89.4210 Austria 89.33

Index of Economic Globalization

1 Switzerland 94.942 Austria 92.773 Canada 90.734 Belgium 90.615 Netherlands 88.996 Denmark 88.017 United Kingdom 87.058 Germany 85.979 Sweden 85.9510 France 85.84

Index of SocialGlobalization

1 France 98.442 Italy 98.173 Belgium 98.144 Austria 96.855 Sweden 96.276 Spain 96.147 Netherlands 95.778 Switzerland 95.099 Poland 94.6310 Canada 94.40

Index of PoliticalGlobalization

mistakenly conclude that they can maintain their existing operating model, despite profound shifts in the external economy. “The emerging markets represent the future for many companies,” says Phil Davies, a director at Ernst & Young in the United Kingdom. “Yet all too often, companies assume that operating models from their home market can simply be transferred to other markets unchanged. This is rarely the case.”

As a result, many companies no longer have operating models that fit their needs, says Andrew Kakabadse, Professor of International Management Development at Cranfield School of Management. “It’s very difficult to appreciate the competitive advantage of the firm today — with the pace of change and companies’ capacity to learn from one another — but operating models are at the heart of it,” he says.

Oliver Wright of the Advisory Practice and Global Cost Reduction Champion at Ernst & Young echoes this idea. “Operating models should be at the center of the strategic debate of every big corporate today,” he says. “Companies need the right operating models that allow them to enact their strategy. If you have the wrong operating model, then you can end up carrying the wrong cost base, for example, or your speed to market is not going to

be as effective as your competitors. So, over time, you will end up losing market share, market capitalization and dominance in your particular sector.”

Tax is another factor that needs to be taken into account when considering changes to the operating model. While the decision to restructure a particular function might make sense from a business perspective, there is a

danger that it creates unanticipated tax liabilities. This highlights the importance of considering the tax implications side by side with the business rationale. “If you don’t consider the tax implications from the beginning, there is a danger of making decisions that don’t work from a tax perspective,” says Edvard Rinck of the Tax Effective Supply Chain Management Practice at Ernst & Young in Switzerland. “You need to look at the decision optimally from a business and tax standpoint, and manage those tensions. In fact, when you include the tax dimension, you often find the restructuring pays back very quickly.”

What to standardize?Designing a new operating model is a complex and challenging undertaking. Executives need to consider organizational structures and whether the company should be organized by region, function, client or a combination of these. A balance also needs to be struck between global, regional and local capabilities. This will establish the extent to which decisions can be taken locally or globally. But perhaps the most important issue is to determine the aspects of the business that require variation, and those where standardization and consistency can be achieved.

Global consistency and the standardization of core business processes enable companies to establish best practices that can be replicated across the company’s regions and divisions. This not only creates cost efficiencies, it also reduces risk, improves visibility across the organization and, crucially, enables companies to undertake a meaningful comparison of economic performance across geographies and divisions.

“Where you have processes that do not require national or cultural nuance, variation should not be tolerated,” says Wright. “For example, there’s no reason why you should have country variations in how people track and record sales, how they record marketing spend

Designing a new operating model is a complex and challenging undertaking

13.5%After the sharpest decline in more than 70 years, world trade is set to rebound in 2010 by growing at 13.5%, according to WTO economists.

>65% Emerging markets have accounted for over 65% of global growth since 2005 and are projected to account for 76% in 2015, according to the IMF.


Credit: Reuters / Jim Young

or how they track expenses.” Tiger Tyagarajan, Chief Operating Officer of Genpact, India’s largest business process outsourcing provider, agrees: “For us, life is all about a search for consistency. So when there is variation, we ask: Why is there variation? Our job is to kill variation.”

At the same time, companies recognize that they must be responsive to local market needs, particularly given the rise of emerging markets. Products and services will generally be more successful if they are tailored to local tastes, particularly in fast-moving markets with a considerable appetite for innovation. This is both costly and complex, so companies must be confident that a tailored local approach will bring significant benefits. “You should only localize if you will gain greater upside than the costs you will incur from the additional complexity that is required,” says Wright.

These questions take on crucial competitive importance with the rise of emerging market multinationals. Younger multinationals may in some cases have an inherent advantage over their more established developed market peers. They typically have shorter histories, which means that they are unencumbered by legacy and more agile when it comes to adapting their strategy and operating models. “In our

experience, the appetite and hunger for change among our emerging market clients is radically different to the companies that have grown up in the developed economies,” says Tiger Tyagarajan of Genpact.

Piecemeal approachStriking the balance between centralization and local responsiveness is a problem with which companies continue to grapple. Many adopt a piecemeal, tactical approach and try to deal with individual problems on a stand-alone basis. They may decide to centralize one business function, but then discover that this has implications for other, adjacent functions that have not been centralized. “You might decide to centralize procurement but then find that the customs and excise team is less effective because it is now thousands of miles away,” says Davies. “Taking this kind of approach is a long and costly route that often does not take companies where they need to go.”

A more systematic, strategic approach is necessary. This requires companies to have a deep understanding of what’s really driving the generation of profit in the business, what’s driving value creation and where the company can achieve competitive advantage. When looking at manufacturing, for example,

A complex relationship: US President Barack Obama and China’s President Hu Jintao meeting at the G20 summit 2010 in Seoul.

ChimericaTrade interdependencies between the United States and China and a growing interest in investing in each others’ markets pose opportunities and challenges to business in equal measure. While the strategic intent is there, following this up with changes to operating models can prove challenging

Feature Global business Credit: Atul Loke / LUZphoto


__ Genpact is a global business process management company that began its life as a division within GE. It became an independent company in 2005. Here, Genpact COO Tiger Tyagarajan talks to T Magazine about the company’s matrix organizational structure that lies at the heart of its global operations.

T Magazine: Is Genpact an Indian company or a global company?Tiger Tyagarajan: Seventy percent of our workforce is in India but the proportion of employees outside the country is growing more quickly. Sixty percent of our leadership is in India, but again a significant and growing proportion is overseas. Our board is global. Our customers are predominantly in developed economies. Our investors are all global. We are listed on the New York Stock Exchange. So it’s a very tough question to answer. What does globalization mean for Genpact?Clients expect our services to look and feel the same, irrespective of their geographical origin. To me, that’s one aspect of globalization — that it all feels like one company. At the same time, when we recruit local staff, we also have to attune ourselves to the nuances of that environment. If we miss that, then we will not attract talent. So while we look and feel the same everywhere, we still have local leadership that runs each of the local businesses. How is Genpact structured?If you really want to be global, you have to be matrixed. We have a matrix that cuts three ways. One axis of the matrix aligns itself with the customer. Genpact senior managers need to have a single line of sight to that customer, irrespective of where we serve them. The second axis is the practice matrix, which refers to Genpact’s competency around different services, such as finance or technology. Again, irrespective of the number of locations from which the service gets delivered, they are connected as one practice and there is one leader who brings them together.

The third matrix is regional. As COO, I have a European leader, an Americas leader, a China leader and a Philippines leader. We need this axis because day-to-day delivery of that center and its connection with the local community take place in the local geography.How did this structure evolve?We grew up as a process-oriented company. For us, finance and accounting is a process, procurement is a process and customer service is a process. This is natural to us because it’s how we grew up within GE. We then overlaid a

regional matrix on top of this existing approach. The less obvious part of the evolution was when we brought the customer into the matrix structure. It didn’t happen until we became an independent company in 2005, eight years into our existence. As we started dealing with clients outside of GE, we realized that they wanted one look and feel. They wanted to be served in one way, which they could never do themselves and that’s one reason why they came to us.

Most of our growth comes from existing customers. This makes it very important to align our teams globally so that even clients that may be small as far as one office is concerned, but large overall, get the right amount of focus. So while they might not get attention from the regional team, they get attention from the customer team.

Also, our customers started to expect us to bring them ideas and thought leadership. Our ability to do that increased when we connected the dots of the various services that we offer from different geographies.Many companies have difficulties making a simple matrix work. How do you make a threefold matrix structure work?One of the things that I think GE always prided itself on is the philosophy of boundary-less behavior and learning. That is something that we grew up with as part of GE. The other advantage that we have is that we grew from nothing. This means you can create structures and behaviors that work without a legacy.

We also have a review process that works on those three axes. We conduct customer reviews, where everyone from a team gets together on a regular basis. We do regional reviews, and then we do practice reviews that are global.

The third element that is crucial to make this matrix work is movement of people. We deliberately move people across those three axes around the world. So if I’m a finance and accounting expert, one day I might be in China, three years later I might be in Romania and then I might end up in Guatemala. People see those moves as career progressions.

The fourth point is around aligning metrics. If the Europe team wins the business and the business gets delivered out of India, they get the credit for it as well.

The last point, which is probably the least evolved in most companies, is around global innovation. How do you find a way to allow innovation to happen in every center and market? And how do you capture that and take it around the world? That’s something we pay a lot of attention to – and I think we do it well.

Interview with Genpact COO Tiger Tyagarajan

“If you want to be global, you have to be matrixed”

400Genpact, global leader in business process and technology management, manages over 3000 processes for more than 400 clients. The company has over 42,500 employees, has operations in 13 countries, and supports over 25 languages.

Tiger Tyagarajan


Credit: Emmi Schweiz AG / Patrick Diss

executives may want to focus on manufacturing excellence across the entire global operations and then consider the investment that needs to be made to get closer to this goal. This is very different from the usual, tactical approach of considering isolated objectives, such as where to source materials or a new supplier. “Companies need to consider the most effective way to operate based on how the business will look in five years’ time,” says Davies. “You’re effectively dividing the business up and getting people to focus on the areas that they can really control.”

Multiple models In today’s complex business environment, however, there is no one-size-fits-all solution to the balance between globalization and localization. Even within a single company, there may be a range of approaches required. “You may find that one division or region will emphasize centralization and cost efficiency, while the priority for another will be to tailor the offering to the local customer,” says Prof. Kakabadse. “So you could have one company with three or four different operating models running concurrently and all make sense.”

Prof. Kakabadse adds that leadership is essential to reconciling and making these different operating models work. “The models on their

own help, but they’re not the final answer,” he says. “It’s all about how the leadership integrates or solves these tensions in the structure. It’s as if the key to strategy implementation has gone

from the principles of strategy, which are generic principles, to the principles of leadership, which is: how do we reconcile tensions?”

Indeed, leadership itself will need to change to reflect the shift of economic weight to the East. This still presents a profound challenge for many companies. Although recognizing that much of their future growth will derive from the fast-growing markets of Asia, the majority of senior leadership in Western multinationals continue to be based in, and nationals of, the developed markets. “If the future clearly shows that the emerging world is going to become much more important, then companies need to alter their leadership structures to reflect this,” says Tyagarajan. “Yet, for the most part, they are not doing that. Most companies need to do more to shift the balance of their leadership to reflect changes in the broader global economy.”

Going local: consumers in Hong Kong learn about products from the Swiss company Emmi

There is no one-size-fits-all solution to the balance between globalization and localization

New customersAn emerging middle class in the developing economies of Asia is creating powerful new opportunities. A 2010 survey from the Economist Intelligence Unit and UKTI found that three-quarters of respondents see emerging markets as a source of new business growth. In contrast, just 23% see these markets as a low-cost manufacturing base.

Feature History of the multinational Credit: Thomas Cook AG


Companies have been expanding overseas for centuries and, although the nature of international investment may be different today, the drivers behind entering new geographic markets have remained remarkably consistent.

Over the horizon

1911. In the Netherlands, Henri Deterding of Royal Dutch Petroleum engineered a merger with the British tanker operator, Shell Transport and Trading Company, to create another firm that operated globally. By the 1930s, Royal Dutch/Shell, Anglo-Persian (now BP) and the post-break-up components of Standard Oil controlled most of the world oil market between them. Other entrepreneurs created new market categories. In the 1840s, Thomas Cook pioneered the concept of the package holiday, selling complete holidays including railway tickets, hotels and meals to the English middle classes. In the 1850s, the British railway companies realized the potential and tried to corner the market for themselves. Cook’s response was to go overseas. By 1900, Cook’s was a truly international business with operations on every continent, selling tours for wealthy Indians to come to Europe and affluent Muslims to go on pilgrimage to Mecca.

The mass marketIn the first decade of the 20th century, American firms entered international markets in force. Ford, General Motors, Heinz and Singer Sewing Machines were among the pioneers. First and foremost, these companies were seeking new revenue streams. Although domestic markets still offered opportunities for growth, these companies foresaw the day when those markets would become saturated. They also believed that there was a ready international market for their products. Some, like Ford and Heinz, expanded organically by setting up factories overseas. Others, such as General Motors, grew by acquisition, buying up small local companies and investing in them. By the end of the 1920s, American companies could be found operating in Latin America, Africa, China and Australia – indeed, wherever local authorities would allow them access and where they could find a market.

During the Great Depression and the Second World War, international expansion slammed to a halt. Many companies operating internationally suffered heavy damage to facilities. But in the 1950s and 1960s, American multinationals began to expand rapidly again. This time, they had support from the US government and, as in the age of the chartered companies, there was a

• By Morgen Witzel

International expansion is one of the oldest themes in the history of business. Almost from the dawn of recorded history, businesses have

looked over the horizon for new opportunities and sought to expand, first outside their home city or province, then into other countries. From the 16th century onwards, European expansion was led by the “chartered companies”, which received a charter from the crown to trade and usually claimed a monopoly over a particular market. Among the most famous of these were the East India Company and the Hudson’s Bay Company. But these chartered companies were often inefficient. Monopolies and state support meant that many of them were feather-bedded against competition. By the mid-19th century, the tide was turning against the chartered companies. The East India Company was abolished in 1858, and other companies went bankrupt. Some transformed themselves into purely private enterprises. The Hudson’s Bay Company, for example, became Canada’s largest retail business.

By the mid-19th century, new, purely private-sector companies were beginning to emerge. The Industrial Revolution in Europe and North America had generated enormous wealth and created very large businesses and, by the end of the 19th century, these too were beginning to look overseas. In some cases, they expanded in order to control their supply chains. Lever Brothers, unable to obtain a steady supply of high-quality palm oil for its soaps, began establishing its own plantations, first in West Africa and later in the Solomon Islands. The American-based United Fruit Company expanded into Central America in order to control its own banana plantations.

Dominating the oil industryOthers expanded overseas in pursuit of the raw resources needed by modern economies. Nowhere was this more evident than in the oil business. Standard Oil, founded in the American mid-west in 1870, rose to dominate the American oil industry and then, as the American economy grew and domestic oil production was no longer able to supply the country’s needs, moved overseas, before being forced to break up in

1 Thomas CookBorn in 1808, Thomas Cook was the founder of the eponymous travel agency, which pioneered the package holiday and had become a truly international business by the late 1800s.

1

Credit: Keystone / Süddeutsche Zeitung Photo / Scherl; Gettyimages.com / Time & Life Pictures / Michael Rougie; Wikimedia.com / SpreeTom


strong political motive. The US government recognized that American businesses could also help to expand the political sphere of influence. These multinationals were thus key players in the Cold War against the Soviet Union and its allies, to the extent that the collapse of the Soviet Union was seen by some as a victory for capitalism.

In the 1980s, Japanese multinationals began their great drive overseas. Japan has few natural resources, and the supply of cheap labor was beginning to dry up. Domestic markets were also becoming saturated. Companies like Sony, Matsushita, Toyota and Honda had little choice but to expand internationally. Some did so with the support of the Japanese government which, like the 17th-century monarchs, saw exports as a way of helping strengthen the economy.

What drives the globalizing companies of today? Certainly politics still plays a role, and among the key players in global markets are the state-owned sovereign wealth funds of the Gulf and Asia. They too carry the national flag and are charged with expanding their countries’ sphere of influence. American and European multinationals still go overseas chasing resources, including cheap labor, and seeking markets. But the times are changing, and now Indian and Chinese companies are also expanding into other markets for the same reasons. The dynamics of expansion are shifting as economic conditions and the political environment change; but the reasons why companies choose to expand overseas have not changed for centuries.

2

2 FordIn the early 20th century, Ford expanded rapidly overseas as demand for automobiles grew

3 Heinz CompanyIn 1886, Henry Heinz sailed from the US to England, carrying a selection of his products with him

4 Standard Oil One of the first true multinational companies, Standard Oil was broken up by the US Supreme Court in 1911

4

3


Focus Multinational companies Credit: Jordi Estruch

Western multinationals see emerging markets as a key source of future growth. But according to IESE Professor Pankaj Ghemawat, they could be underestimating the complexities of this shift. Interview by Fergal Byrne

Respecting the differences in distant markets

geographically distant from companies that have grown up in the developed world. Does this matter?Take companies in Cataluña in Spain, for example, which have done very well by essentially focusing on the European Union with a little bit of activity beyond that. Companies in Cataluña are very international but the vast

majority of their market falls under the auspices of the European Union. This reflects the general fact that, when you look at distance-adjusted market potential, if you are in Western Europe you are pretty close to today’s world markets. Now if you do that analysis for 2050, you realize that Cataluña, and indeed, all of Western Europe,

T Magazine: What would you say are the current challenges facing multinational companies in terms of global strategy?Ghemawat: One big shift that multinationals must think about, if not execute, is that for many, the major sources of growth will be in emerging markets. For the first time “poor” markets are going to be the big growth markets. By comparison, in the couple of decades after World War II, there was basically a correlation between absolute market size and per capita income: when you looked at the top 10 markets, they were all rich markets. This presents a set of challenges that are actually much greater than companies faced when going to other developed markets. And it also means that executives have to deal with some profound organizational prejudices about the kind of work that gets done in rich countries versus poorer countries.Emerging markets not only have relatively low per capita incomes, they are also

50% According to recent World Bank projections, by 2050 China and India will together account for nearly 50% of global GDP.

Executives have to deal with prejudices about the work that gets done in rich and poor countries


Pankaj GhemawatProfessor

__ Pankaj Ghemawat is the Anselmo Rubiralta Professor of Global Strategy at IESE Business School and the Jaime and Josefina Chua Tiampo Professor of Business Administration (on leave) at Harvard Business School. One of the world’s leading thinkers on globalization, much of his recent work looks at how companies can succeed in a world that is neither entirely local nor fully global, a state that he characterizes as semi-globalized. Professor Ghemawat’s latest book, “World 3.0: Global prosperity and how to achieve it”, will be published by McGraw-Hill in May 2011.



Focus Multinational companies Credit: GettyImages.com / Michael Blann

Gabha, Assistant Professor of Organizational Behaviour at INSEAD. Global change programs can often fail because the change leader lacks the right experience, seniority and interpersonal skills. “You need leaders who are willing to make the tough decisions, challenge norms and shake things up,” says Stocks. “Change leaders require cold analytical skills as well as the emotional side to empathize with people who are going through the change. They need to be able to understand the strategic vision and the practical steps that are necessary to achieve this vision.”

Communication and engagementGood communication is a prerequisite to successful implementation of change. The problem for many companies is a bias toward secrecy, with top management reluctant to explain the changes to staff. Key stakeholders need to be identified and involved at the right time if the change process is to be successful. “You want senior stakeholders, who are going to be significantly impacted, engaged in the design because you need them to support and buy into the whole change process,” says Stocks. “In the case of more junior stakeholders, you probably don’t want to engage them in the design stage, but you do want to engage them in how you make it real and bring it to life.”

While communication is essential to successful change, it is not the panacea for all problems. Managers also need to go deeper to deal with employees’ underlying motivation. “You can tell people what they need to do but if their performance measures aren’t adjusted to help them make that change, then they will completely ignore you, particularly on a global basis,” says Melissa Davies Wright of Ernst & Young’s Advisory practice in the UK.

This highlights the importance of selecting the right key performance indicators and ensuring that there is a visible connection with the strategic goals or targets for the business. “You need a line of sight from what people are doing to how it contributes to the objectives of the business,” says Stocks.

A common concern among employees associated with change is the impact it might have on their own personal rewards. “Managers may no longer be responsible for the same area of the business, so you need to make it clear how they will be measured and rewarded in future,” says Stocks. Metrics can play a powerful role in motivating people to embrace change. “Once you make metrics of change visible, you don’t have to tell people what’s wrong, they can figure it out and change themselves,” says Tiger Tyagarajan, Chief Operating Officer of Genpact, a global business process and technology management company.

• By Rob Mitchell

Whenever a company decides to centralize a function or switch from a regional to global operating model, this

inevitably entails a significant amount of change. But while senior managers will typically pay a lot of attention to the legal, financial or operational elements of the process, the human side of change tends to get neglected. And it is this oversight, more often than not, that can derail even the best-planned initiative.

In the case of restructurings that have a strong tax or compliance dimension, the human side of change is especially likely to be neglected. Quite often, these changes are perceived as technical or structural, with limited implications from a people perspective. “Senior managers often get fixated on delivering the technical solution and completely forget that ultimately, it is people who are going to have to deliver and sustain it,” says Penny Stocks of Ernst & Young’s Advisory practice in the UK.

LeadershipAcademic research shows that the prospect of successful change remains stubbornly low. “Studies suggest that only around 30% of change efforts succeed and this figure seems broadly unchanging over time,” says Vibha

The human side of change processes tends to get neglected

Putting people firstCompanies embarking on major projects, such as restructuring, need to ensure that they pay sufficient attention to the human aspects of change.

A longer version of this article can be found on our website at www.ey.com/tmagazine


A key idea underlying much of your work is the notion that the world is not as “flat” as many people assumed. How would you say executives see this issue today? I think it is a bit mixed. After the financial crisis, there is certainly increased appreciation of differences once again. I do polls with companies when I ask about attitudes towards globalization. There are far fewer people who go with the flat world hypothesis than two to three years ago. That has changed. What are some of the key dimensions that companies should consider to succeed in emerging markets?Take the example of China. Clearly the relationship between the state and markets is different. Microsoft took 10 years and a couple of billion dollars to figure this out, but they have now learned that lesson. Yet others in the sector are still trying to internalize that. So there are cultural dimensions that are important to consider. Attitudes towards intellectual property rights also differ. And the economic differences matter: because ultimately, trying to create products for price points that are 20% to 50% less than what you are used to is tough. There is a reason why it was Tata Motors that created the Tata Nano rather than any of the big car companies. The project for a cheap car had been shopped around at least one of the big US motor companies, but it was Tata that got there first. The fundamental question companies need to address is whether they understand the key differences that exist between different markets. Because every industry has differences from country to country – and companies need to recognize these differences to be successful.Your AAA triangle of global strategy* defines three approaches that companies can take: adaptation; aggregation; and arbitrage. What strategic advice would you give companies in the current climate?From the standpoint of global strategy, in the medium term it may make sense for most firms to put more emphasis on adaptation as a strategy, maximizing their local relevance, relative to aggregation and arbitrage — although this should ultimately depend on each firm’s industry, history and strategy. The rationale for strengthening adaptation is that becoming responsive to local conditions helps to address the growing role of governments, particularly in the context of protectionism, and is necessary in many cases for participating in the growth that is available in emerging markets.

My fundamental prescription for the present times is to “think different.” This is not the same as “thinking differently”— to think different is to become more sensitive to and genuinely welcoming of, local differences. Thinking different is the best way to improve business performance while at the same time fostering the openness that is fundamental to sustaining our collective prosperity.

suddenly looks much further away from India and China, which will be two of the three biggest markets in the world by 2050. That clearly raises some questions. Companies need to ask themselves how they are going to succeed in distant markets, because going to China from Spain is different from going to Portugal, just as it is different for a US firm to go to China thanto Canada.You have suggested in the past that companies underestimate the difficulties of succeeding in distant markets. Are they getting better at this?I guess I would characterize it as poor information in and poor action out. I don’t think that companies are very good at perceiving what is going on around them. Look at the work of Clay Christensen at Harvard: he has spent a great deal of time studying how disruptive technologies can sneak up on the biggest and most successful companies. And this is typically in local markets. There isn’t even geographic separation — it is happening in front of corporate headquarters. And companies are still failing to see and respond to these market changes.

So now imagine what happens in companies when they receive a report from outlying provinces, as it were, saying there is something going on that threatens to change reality as they know it. Think of all the internal barriers to action. Think of the challenges of responding to changes in these outlying geographies that are traditionally low end, that haven’t delivered much in the way of profits, and that few people in the company really understand anyway.How well are multinational companies doing in terms of globalization?When you try to find what we would call really great global companies, one of the most remarkable things is how few well-documented examples we actually have. It is still hard to point to many more than maybe half a dozen or so examples. When I look at the typical company with international operations, I just think of the enormous capacity to do things better. There is so much misunderstanding of the landscape out

there, so much accretion of operations as a result of history that has never been re-examined.

Companies don’t have to get things 100% right to achieve major improvements in performance. One of the first things that I typically start with when I work with a company is to make sure that we understand what economic performance has been like in different geographies, because that is often distorted in all kinds of interesting ways. As soon you start to do this, you begin to get some pretty interesting insights.

*AAA triangle of global strategy:Professor Ghemawat describes three broad approaches that companies can take in their global strategy:

• Adaptation: companies seek to grow revenues and market share by maximizing their local relevance. • Aggregation: companies seek to generate economies of scale by creating regional, or sometimes global, operations. • Arbitrage: companies exploit disparities between national or regional markets, often by locating different parts of the supply chain in different places – for instance, call centers in India or factories in China.

My fundamental prescription for the present times is to “think different.”


Focus Transfer pricing Credit: Herve Cortinat / OECD

Greater scrutiny of transfer pricing by tax authorities requires a clear and robust risk management strategy from multinational companies.

Dispatches from the front lines of transfer pricing

• By Bill Millar

To senior executives outside the tax function, transfer pricing can sometimes seem a bit like quantum mechanics:

important, but difficult to understand and best left to the experts. But, while senior managers may not need to get to grips with all the technicalities, they should certainly be aware of the importance of this crucial aspect of international business. With tax administrations taking a more forthright approach to enforcement and increasingly sharing information with each other across borders, the risks of running into problems with transfer pricing have never been greater.

Over the past two decades, tax authorities have become highly adept at setting and

enforcing rules for the price at which a good, service or intangible asset is sold, licensed or shared with a related corporate entity in another international tax jurisdiction. The OECD has been at the forefront of this work and has developed guidelines that can be used by individual tax administrations and provide a consistent approach (see page 24). Core to these guidelines is the requirement that charges are made at an arm’s length price — in other words, the price at which two non-related parties would value any given transaction. “Greater sophistication among competent authorities in major countries tends to reduce any intended or accidental abuse of the international tax system,” says John Hobster, Global Transfer Pricing Go To Market Leader at Ernst & Young. Companies have good reason to adhere closely to the guidelines. Failure to do so

OECD Secretary-General Angel Gurría (center): Taxation issues, and the need for dialog and consistency of approach, reach beyond borders.


can result in punitive penalties or even criminal prosecution. Moreover, transfer pricing disputes can also damage the reputation of a company, hampering relationships not only with customers but also with suppliers, distributors and other existing or potential business partners. As such, the vast majority of companies today tend to operate with a compliance — rather than a tax avoidance – mindset.

The game authorities “can’t lose”The landscape for transfer pricing enforcement has changed dramatically in recent years. More and more countries are conducting audits and the intensity of those audits is on the rise. At the same time, authorities are developing greater sophistication in their audit practice, while coming under pressure from embattled governments to increase overall tax revenues. “Fifteen years ago, it was really only a few of the larger countries — the USA, the United Kingdom, Australia, maybe Germany and France, that were pushing the compliance agenda,” says Hobster. “But today, there are scores of countries that are conducting transfer pricing audits and, every quarter, it seems there’s another one or two that are joining the list.”

Many authorities are ramping up their transfer pricing practices with additional headcount and resources. In the United States, for example, the Internal Revenue Service (IRS) added around 1,200 employees with an international tax focus in 2009. Moreover, the IRS’s strategic plan through to 2013 calls for the hiring of at least 800 more specialists, who will concentrate on transfer pricing audit and enforcement.

Her Majesty’s Revenue & Customs (HMRC) in the United Kingdom is also expanding its pool of dedicated transfer pricing resources. HMRC also created a transfer pricing review board and implemented a risk-based approach to the identification and prioritization of transfer pricing initiatives.

Reducing the risksMany other countries are making efforts to implement or strengthen their approach. In the Russian Federation, for example, the Ministry of Finance is seeking to implement a comprehensive set of rules for transfer pricing compliance which, while making make no specific reference to the OECD recommendations, are closely aligned with them. “Transfer pricing reforms are clearly a priority for the Ministry, demonstrated both by their commitment to the implementation of new transfer pricing rules, as well as the establishment of a specialist department to administer these rules and engage actively in audit activities,” says Henrik Hansen, leader of the Transfer Pricing Practice at Ernst & Young in Moscow. In a context of much greater scrutiny and enforcement, companies can take several key steps to reduce the risk of controversy. The most obvious is to adhere closely to the rules.

Groups such as the IRS and HMRC can provide worksheets and other tools for determining the appropriate allocation of costs and profits. Similarly, companies can work with industry groups or outside consultants to gauge arm’s length pricing and other elements that can support a compliant transfer pricing approach. Even so, compliance can sometimes be much easier said than done. A key problem is the fact that, despite efforts by organizations such as the OECD to harmonize practices, each tax authority will take a slightly different approach. “No matter how closely you follow the rules, by definition you’re working in two separate jurisdictions,” explains Mikael Hall, a tax lawyer at Ernst & Young in Sweden.

Moreover, many rules are still in flux, which means that the environment is changing all the time. For example, the OECD has recently been engaged in reassessing the transfer pricing aspects of business restructuring. This will have huge implications for companies that might want to revamp their supply chain or make other efficiency improvements. The OECD also plans to examine the transfer pricing of intangible assets — a notoriously difficult area.

Alternative conflict resolution toolsA growing number of tax authorities offer companies the opportunity to resolve issues and disputes at the pre-filing stages by means of advanced pricing agreements (APA). Here, the taxpayer works with the competent authorities in a given country to obtain an advance ruling on how a particular transaction will be viewed from a tax perspective. “This is a positive development because it gives companies greater certainty and can reduce audit risk substantially,” says Hobster.

If a dispute is not resolved at the pre-filing stage, it does not automatically mean it goes to the courts. Some authorities are beginning to offer alternative conflict resolution tools, such as mediation and arbitration, so that disputes can be resolved without resorting to litigation. “There will be some cases where you just can’t reach an agreement in discussion with the authorities,” says Hobster. “Alternative dispute resolution provides an effective mechanism for resolving disputes in a more effective and efficient manner than litigation.”

Finally, companies must ensure that they adopt a rigorous approach to documentation. Some countries, such as the United States, Mexico, India and Argentina, now require contemporaneous documentation of transfer pricing. But even if this is not required, it makes sense for companies to collect this information so that the rationale for global transfer pricing can be made to the authorities on request. Long gaps between requests for information and its provision to authorities might give the impression of an inefficient approach to documentation, and this might lead to greater scrutiny in future.

SummaryThe global landscape for transfer pricing enforcement has changed dramatically. More and more tax administrations are conducting intensive audits and sharing information with each other across borders.

OtherAudit CommitteeParent CFO/FD Delegated responsibility to local leaderTax Department

3% 12%

39%8%

38%

OtherAudit CommitteeParent CFO/FD Delegated responsibility to local leaderTax Department

3% 12%

39%8%

38%

Responsibility for transfer pricing within the organization (parents)

Source: Ernst & Young Global Tax Survey 2010

Focus OECD guidelines Credit: Gerard Uferas / LUZphoto


Transfer pricing has become a key issue for multinationals. Caroline Silberztein explains how the OECD is working to provide greater certainty for both taxpayer and administration. Interview by Bill Millar

The search for clarity and consistency

non-OECD economies in these discussions. Multinational companies act globally and the transfer pricing debate cannot be limited to OECD countries. We maintain policy dialog in the transfer pricing area with many non-OECD countries, including Argentina, China, India, Indonesia and South Africa.

On the implementation side, we are now starting a review of transfer pricing administration techniques, which will include the sharing of experience among countries on how to improve the effectiveness of transfer pricing administration, for instance through the use of risk assessment techniques to better select cases for audit, improved transfer pricing examination procedures, and simplification regimes for small transactions or low value added activities.What are some of the challenges in emerging markets? Emerging markets share many of the same challenges as developed economies. They are increasingly implementing transfer pricing legislation but many face practical challenges. They find it difficult to build tax administration expertise and experience, and to develop efficient administrative frameworks for transfer pricing examinations and timely dispute resolution. They often face challenges in obtaining the information needed from taxpayers to carry out effective audits. And they have scarce administrative resources, along with more limited networks of bilateral tax treaties and less sophisticated legislation. Certainty is important to companies: what is going on in terms of dispute avoidance and resolution?

T Magazine: What are the key challenges in transfer pricing today? Caroline Silberztein: I group the key issues into four areas. First, a more consistent application of the arm’s length principle is needed to prevent and resolve disputes more efficiently. Uncertainty arises from the lack of common guidance on certain issues, such as intangibles, cost sharing arrangements, or intra-group guarantee fees. There can also sometimes be differing interpretations by countries of how to apply the principle.

Second, the OECD needs to engage with non-OECD economies in the international debate on transfer pricing. Some countries that were not very active in the transfer pricing arena five or ten years ago are now becoming very interested in the subject.

Third, it is important to develop a comprehensive approach to improving the administration of transfer pricing. It is essential to optimize the use of tax administrations’ and taxpayers’ resources and to focus on the most significant and riskiest transactions. In addition, as audit activities increase, it is important to pay attention to the efficiency of the administrative processes, selecting the right cases for audit, and ensuring timeliness and fairness.

Finally, it is important to improve the efficiency of dispute prevention and resolution mechanisms at the international level. Good tools exist, but the administrative resources allocated by countries are not always sufficient to arrive at a timely resolution, especially given the increasing number and complexity of disputes. What will be your focus in the future? The next substantive project is an examination of the transfer pricing aspects of intangibles. We are also working with member countries to attain a more consistent application of the arm’s length principle and OECD Transfer Pricing Guidelines. It is increasingly important that we include

3000 Today, more than 3,000 tax treaties in force around the world are based on the OECD Model Tax Convention, which is regularly updated. The Convention plays a crucial role in removing tax-related barriers to cross-border trade and investment.

It is important to improve the efficiency of dispute resolution and resolution mechanisms



Caroline Silberztein

__ Caroline Silberztein is the Head of the Transfer Pricing Unit in the OECD Centre for Tax Policy and Administration. Following recent work on business restructurings, Silberztein is involved in a new project on the transfer pricing aspects of intangibles. Before joining the OECD in 2001, Silberztein was a tax partner in two Paris-based international law firms.


Transactions between related parties require a price to be set. In general, governments require this to be consistent with the price that would be paid by unrelated firms.

The arm’s length principle

__ Put simply, transfer pricing is the price that is paid within the same corporate group for cross-border transactions involving goods, services or intangibles. For the world’s multinational firms, this has important tax implications. If an entity in a high-tax jurisdiction charges artificially low prices for what they transfer to sister entities in low-tax ones, the group can minimize its overall tax liability without a charge to its overall profitability.

Governments have known of this danger to tax revenues for decades. The Organization for Economic Cooperation and Development (OECD), one of the most influential bodies in setting international tax standards, has had relevant guidelines since 1979. Its current Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations date from 1995, although they have seen substantial revisions in recent years.

Priced differentiallyThe OECD approach, adopted by many countries, relies on the arm’s length principle. In essence, where an exchange between group companies is priced differently from how a similar exchange between two unrelated firms — acting at arm’s length — the tax authorities can ignore the ostensible transfer price and impose taxes according to what they deem to be the arm’s length price. Taxpayers generally strive to implement arm’s length pricing to avoid these potential tax adjustments.

Although in theory arm’s length pricing is straightforward, implementation is often far

from simple. Invariably analysis involves a hypothetical question — if a similar transaction took place with a non-related company, what would the price have been? The OECD Guidelines, along with those tax jurisdictions that have adopted the same principles, permit businesses to choose from several approaches in determining reasonable transfer prices, including:– The Comparable Uncontrolled Price Method

(CUP). This compares the transaction with identical or similar ones between two independent businesses (an external CUP) or between the taxpayer and an independent business (an internal CUP).

– The Resale Price Method. This can be used if a product transferred between sister companies is in turn resold to an independent firm, and uses this final market price as a basis for the transfer price.

– The Cost Plus Method. This takes the costs that the first company incurred in making its product or providing its service and adds a mark-up to deliver an arm’s length gross profit.

Two more methods Further methods may be applied under certain circumstances:– The Profit Split Method. Where numerous

inter-related transactions make it difficult to assess specific prices, companies may determine the profits that arise from the inter-group transactions and split them as two independent companies would if they were partners.

– The Transactional Net Margin Method. Under this method, the prices are determined by transferring some profit indicator, such as net operating margin, that is observed in comparable but independent companies.

The problem is that none of these methods are foolproof. Accessibility to the relevant information that is required to implement is often a hurdle. Even where such information is available, the differences between the specific circumstances may require some adjustment to the transfer price. Moreover, assessments of the most appropriate method and details of its application are often highly subjective, due to lack of data. Worst of all, certain assets do not fit easily into any method. The OECD is currently consulting, for example, on how to address intangibles in upcoming revisions to the Guidelines.

With inherently complex issues, and with commentators increasingly critical of abuses, companies are well advised to ensure that they understand transfer pricing clearly and keep records to justify the transfer prices they adopt. Otherwise, even businesses acting in good faith risk condemnation in the media as an example of creative tax avoidance.

Focus OECD guidelines

A longer version of this article can be found on our website at www.ey.com/tmagazine

0 5 10 15 20 25 3530

Customs dutiesForeign tax credits

Tax controversyCash repatriation

Value-added taxesDouble taxation

Cash taxesTax minimizationTransfer pricing

911

643

69

3023

Most important tax issues for tax directors

Source: Ernst & Young’s 2010 Global Tax Survey


Transfer pricing disputes can create uncertainty, are time-consuming and resource-intensive. In the current financial and accounting environment, uncertainty is more problematic than ever for multinational enterprises. Transfer pricing disputes have the potential to create significant double taxation if the two countries involved in a dispute do not agree on the determination of an arm’s length price for the transaction at hand. The speed of case resolution depends on the countries involved in the dispute, the administrative resources allocated to mutual agreement procedures, the effectiveness of the communication channels between the treaty partners, as well as the complexity of the case and the level of co-operation by the taxpayer.

Arbitration is also becoming more established. More than 40 treaties with these clauses have been signed in the past few years and efforts are underway to improve the effectiveness of the EU arbitration convention for intra-EU cases. But much remains to be done to make arbitration more broadly available.

Since 1995, the OECD has been promoting the development of Advance Pricing Agreements (APA), whereby taxpayers can seek confirmation from the tax authorities on the transfer pricing methodology to be applied to future transactions. Today, more than 30 countries around the world have implemented APA programs.

However, I believe that the primary dispute prevention mechanism is the development of clearer international and domestic guidance, and consensus on transfer pricing. Clarity is critical to enhanced compliance by taxpayers and better focused transfer pricing examinations.The OECD has just completed guidance on business restructuring: how would you summarize your conclusions? The main focus of this work was to address scenarios where a multinational enterprise is performing essentially the same activities before and after the restructuring but there have been changes to the business model, with consequences on the allocation of profit potential among the entities within the group. A typical situation may be where a company continues to manufacture after a restructuring, but is now a contract manufacturer on behalf of an associated

enterprise which has acquired the technology. The intangible property, risks and responsibilities are moved to other entities within the group.

One major issue with business restructurings is whether a restructured entity should be compensated for the decrease in profit potential that it will suffer due to a restructuring. If so, the question is whether and how independent parties dealing at arm’s length would have provided for

that compensation. Other issues addressed in this new OECD guidance relate to the role of risk allocations and re-allocations among members of a multinational enterprise group, the application of the arm’s length principle to post-restructuring transactions, and the exceptional circumstances where a tax administration may recharacterize or disregard a restructuring transaction presented by a taxpayer.What are you doing about the pricing of intangibles?The OECD recognizes that it is important to engage with the business community from the outset of this project. An invitation to comment on the scoping of the project was released in July 2010 and attracted almost 50 written submissions. It is obvious from the number and quality of the comments received that this is an important issue for the business community, just as it is for governments. A consultation with commentators was held at the OECD headquarters in Paris on November 9, 2010.

From these discussions, it has emerged that the business community wants clearer guidance on a range of issues. What is an intangible? When is it transferred from one party to another? How should it be valued, and how should taxpayers and tax authorities deal with the uncertainty that is typically attached to intangible valuation? How should the profits from its use be allocated among associated enterprises? As always, these questions should be resolved for transfer pricing purposes by reference to what independent parties would have done in comparable circumstances.

Intangibles are increasingly the focus of transfer pricing audits, and disputes in relation to intangibles can lead to serious monetary consequences. The OECD’s ambitious objective is to develop consensus guidance that will bring greater clarity. Substantive discussions will start in 2011 and we hope to deliver a discussion draft by the end of 2013. Do you have any final words of advice for corporations or governments? Transfer pricing is at the top of the international tax agenda these days and is going to remain there in the foreseeable future. Transfer pricing audit activities around the world are increasing and becoming more sophisticated. Multinational enterprises are encouraged to make sure that their transfer pricing policies are well thought out, defensible and documented. Governments should be conscious of their enforcement and compliance burdens. Many countries are reflecting on the effectiveness, fairness and timeliness of their examination processes and dispute resolution mechanisms. Above all, greater certainty is needed for taxpayers and governments alike. I believe that the development of clearer domestic and international guidance based on the broadest consensus possible is critical to improve the transfer pricing environment.

Clarity is critical to enhanced compliance by taxpayers and better examinations

30 More than 30 countries around the world have implemented Advance Pricing Agreements (APA) programs. Since 1995, the OECD has been promoting the development of APA.


Multinationals are increasing their investment in Africa, but developing a continent-wide strategy remains challenging.

The new frontier for growth

That means looking for opportunities in some of the poorest countries in the world – but also some of the most dynamic. In 2009, as large parts of the developed world fell into recession, the combined sub-Saharan African gross domestic product grew by an estimated 5.9%, according to the International Monetary Fund. Similar levels of growth are forecast for 2010.

There are many drivers for this growth. Africa is rich in natural resources and demand for these commodities has increased substantially, especially from China and India. At the same time, improvements in economic and political governance indicate that the benefits of this growth are trickling down to a fast-growing middle class, which in turn reinforces further expansion. Vijay Mahajan, a marketing strategy professor at the McCombs School of Business in the United States, believes that growing consumption among the middle classes is playing an increasingly important role as a driver of economic growth. “They are neither rich nor poor people, but they are very ambitious,” he says. “They are civil servants, teachers, middle managers and other professionals who want their children to have access to good education and really want Africa to progress.”

The emergence of Africa’s consumer classes is good news for multinational companies, but it should not be assumed that the same products that sell in the West will be as successful in Africa. Although per capita income among many Africans has increased, purchasing power remains well below that of consumers in the developed world, or even that in countries such as China and India.

• By Rodrigo Amaral

Western multinationals seeking long-term growth recognize that they must look beyond their traditional markets. While

many are already ramping up investment in Asia, relatively fewer have formulated a clear strategy for investing in Africa. And while there are undoubtedly plenty of challenges associated with investing in the continent, a growing number of companies are recognizing that the long-term rewards can be significant too.

Leading multinationals are already showing strong commitment to the region. In July 2010, the Chief Executive of Unilever, Paul Polman, announced that his company would invest more than €100 million in its Nigerian unit over the next two to three years. Coca-Cola, which is

already the largest single employer in Africa, plans to double its 10-year investments in the region to reach US$12 billion by 2020. In September 2010, Wal-Mart announced its plans to acquire the South African retailer Massmart for US$4.6 billion. In all cases, the goal is to achieve growth in a rapidly developing region and build a presence in a market with more than one billion people.

“Africa cannot be ignored as a market, because it is one of the few regions in the world that is still growing despite the global economic slowdown,” says Ajen Sita, the CEO for Africa at Ernst & Young.

“Multinational companies realize that they were late to invest in India and China, and they don’t want to make the same mistake with Africa.”

SummaryStrong economic growth and the emergence of a sizable middle class in many African countries are creating exciting opportunities for multinationals. Some are seeking to develop pan-African strategies, but the challenges of dealing with a wide variety of markets at different stages of development should not be underestimated.

Growing consumption among the middle classes plays an important role as a driver of economic growth

Focus A strategy for Africa

Credit: GettyImages.com / Bloomberg


Emerging consumption is good news for multinational companies.

Focus A strategy for Africa Credit: Reuters / Radu Sigheti


Stockbrokers trading at the Nairobi Stock Exchange.


This presents challenges to multinational companies, which the most innovative are overcoming by creating products and services that are tailored specifically for the budgets of local customers. Professor Mahajan points out that Unilever has launched bars of soap in Africa that can be broken into smaller pieces, like chocolate bars. This meets the needs of the large proportion of customers who tend to buy only small amounts of products for immediate consumption. “The pieces of soap can be sold separately, and each has the soap’s brand printed on it,” says Prof Mahajan.

Some of the challenges created by African consumers can take surprising forms. Prof Mahajan observed during his trips that mobile phones are widely used across the continent and have helped to revolutionize the way that African entrepreneurs do business. But that does not mean that consumers are spending lots of money on their handsets. Prepaid cards are widely used and, in order to preserve their credits, users try to communicate as much as possible via ringtones. “Some drivers I employed in Africa asked me to call them and wait until the phone rang three times,” he recalls. “Then they knew that it was time to pick me up.”

Consumer goods and telecoms have benefited most from Africa’s emerging middle classes, but other industries have also been ramping up their investment. In banking, for example, global powerhouses such as Barclays, Standard Chartered, Citi and Société Générale have been building up their presence in the region. They have been joined by emerging market champions from Brazil and China, and also face competition from local players, such as South Africa’s Standard Bank and Togo’s Ecobank.

But while Africa represents a huge market for multinationals, building a continent-wide presence remains challenging. The African market may consist of one billion potential customers, but they are spread among more than 50 countries at widely differing stages of development. Companies must build relationships with governments and regulators in each country,

while also contending with poor infrastructure, variations in the business environment and the potential for corruption.

Many governments are trying to address these issues. “African governments have been joining forces in regional trading blocs that facilitate cross-border investment,” notes Sita. Groups like the Southern African Development Community (SADC), which comprises 15 countries including South Africa and Angola, and the Economic Community of West African States (ECOWAS), have been working to remove

obstacles to trade across the continent. Other initiatives are helping to address the harmonization of tax regimes and business regulations. One example is the OHADA Treaty, which aims to create standard business laws and institutions in 16 countries, mostly from French-speaking Africa. Eight countries from the same region, gathered under the West African Monetary and Economic Union (UEMOA), are also promoting macroeconomic and fiscal convergence. There is still a long way to go, but these initiatives show that progress has been made, says Rendani Neluvhalani of Ernst & Young in Johannesburg. “Modernization of tax systems is underway,” she points out. “Several countries are moving away from purely common law or civil law jurisdictions and are borrowing from other traditions, such as the French legal system.”

But multinationals devising pan-African strategies must keep in mind that, in many countries, governments are still learning. Some industries, such as insurance, are relatively young and it takes time for markets and regulatory environments to become established. “An important challenge is to find out how national authorities will deal with industries where, previously, multinationals were not present,” says Neluvhalani. “In many countries, the government used to own the insurance companies, and they were not subject to revenue tax,” she continues. “As a result, there is no specific legislation on how insurance companies are taxed.” There are similar challenges in banking, particularly as institutions move from the retail market to other activities, such as investment banking and securities trading.

Reforms to the tax system and business regulations are an important part of efforts to strengthen governance and attract overseas investment. The work is still at an early stage: the latest African Economic Outlook notes that African countries still get few revenues from taxes, and they are mostly concentrated in the mining industries. Plenty of other issues also need to be tackled, including poverty, corruption and inadequate infrastructure.

But as growing numbers of multinationals consider investing in Africa, the message that governance needs to improve is definitely being understood. “African governments have realized that, if they want to be more attractive to global investors, political reform will be needed, and many are advancing toward democratic systems,” says Sita.

Doing business in Africa, then, remains challenging, but needs to be considered in the context of the potential long-term rewards. “There are hurdles to business in Africa, but they are the same that you will find in other developing countries,” concludes Prof. Mahajan. “That’s the beauty of entrepreneurship. If there were no hurdles, everybody would be an entrepreneur.”

$1996Per capita income in sub-Saharan Africa, measured in US$, according to the World Bank

$7927 Per capita income in Middle East and North Africa, measured in US$

Although per capita income has increased, purchasing power remains below levels in the West


Management Procurement Credit: Daniele Mattioli / LUZphoto

A growing number of companies are relocating their Chief Procurement Officers to major sourcing centers in Asia. This offers proximity to key suppliers and better insight into the dynamics of the local market.

CPOs head East

Beveridge, General Manager for Global Supply and Logistics at Wesfarmers Industrial and Safety.

Yet despite logging all those air miles, Beveridge was not satisfied with the performance of the procurement function. “Results were average at best, both in terms of the growth in our globally sourced range and the new products pipeline that was coming through,” he recalls.

In an attempt to raise the bar, the Wesfarmers Industrial and Safety sourcing team decided to open an office in China. Although many companies look to China to save money, cost savings were not a primary driver behind this decision. Indeed, Beveridge says that cost comes a lowly fifth place on the list of considerations after organization quality, product quality, service and delivery, which are tested by

• By Rodrigo Amaral

After years of long-distance procurement, many global companies are moving their sourcing teams to Asia. Pushed by

increased competition for access to top suppliers and the premium placed on close relationships in Asia, sourcing executives are heading east, often to Beijing, Shanghai, Hong Kong and Singapore.

The Australian industrial and safety supply company Wesfarmers Industrial and Safety typifies this approach. The company had been sourcing globally for 20 years and had vendors in 21 countries. “At that stage, we were operating on a “fly-in, fly-out” basis into the various countries as well as attending a variety of trade fairs and exhibitions around the world,” says Jim

Jim Beveridge, General Manager for Global Supply and Logistics at Wesfarmers, in his Shanghai office

21The Australian company Wesfarmers had been sourcing globally for 20 years and has vendors in 21 countries.


rigorous audit processes. After looking at several options, Wesfarmers Industrial and Safety settled on Shanghai and opened its office in 2006. There were three factors in particular that swayed this decision: first, the city’s port, which offered easy access to the 20 other markets from where the company sources materials; second, its proximity to many of the manufacturers with whom it already worked; and third, the pool of high-quality local procurement professionals. “Our analysis suggested that Shanghai was more expensive than some other cities in terms of set-up costs, but the quality of candidates was also very good,” says Beveridge.

Four years later, Wesfarmers Industrial and Saefty’s Shanghai office has grown to 60 employees, of whom 15 work directly for the company, while the remaining 45 work with a third-party logistics provider. Beveridge is pleased with the results of the move. Being in Shanghai has given his group the opportunity to work much more closely with suppliers on a number of different initiatives, including projects that raised product quality and streamlined the supply chain.

A seller’s marketA presence in a key procurement market such as China can help companies gain preferential access to the best suppliers. Given the huge focus on Asia as a sourcing destination, the best suppliers are in high demand, and this means that sourcing teams have to work increasingly hard to build relationships with them. “If you went to China in 2000, raised your hand, and said, I’m a buyer, about 200 people would surround you,” says Eric Chu of the Supply Chain Practice at Ernst & Young in China. “Now, the best suppliers can afford to be choosy.” But that is not to say that it is impossible to strike good deals. “You can get good deals in this market if you are a strong customer – and if you have a strong commitment,” says Chu.

Although proximity to suppliers is undoubtedly an important factor, it is not the only variable. Companies must also examine the tax environment of the destination country, and assess whether the higher expected performance of the relocated procurement function may be offset by higher taxes or a more uncertain tax environment. The legal environment should also be a consideration. If a dispute were to arise with a supplier, executives should be confident that it can be resolved in a fair and transparent way that gives equal weight to both foreign and domestic parties.

Talent availability is another major issue. In fast-growing markets such as China, experienced sourcing professionals are in high demand, and turnover can be a big challenge. Cultural differences can also present difficulties. A common mistake is that companies simply transplant their sourcing teams from one

country to another and try to apply existing Western business practices to the new market. “You have to adapt your business practices to fit the local context,” says Chu. “To do this, you need to recruit local people to fill the gap.”

In Asia, the way of doing business is much more relationship-driven than in the West, where an arms-length approach to strategic sourcing is entirely acceptable. “It is a learning process for everybody,” says Paul Bakstad of Ernst & Young’s Advisory Services in London. “It’s not always easy to insist on rigorous quality and product standards while building the kind of relationships that are necessary.”

Relationships with the government can also take time to master, particularly in China, where companies must deal with both local and national politics. Navigating this complex environment requires local knowledge and understanding – which can be a source of both risk and opportunity. “There are all kinds of government incentives that are very exciting but at the same time can be very confusing,” says Chu.

Inevitably, embedding a procurement function in Asia is not something that can be achieved overnight. It takes time to adapt to local customs and build the local talent base that is necessary to manage the function effectively. “Normally, companies start out with a lot of expats and then, over time, they will localize the workforce,” says Chu. “Most of the companies that have had their sourcing operations here for a long time have a very low percentage of expats.”

The relocation of the procurement function to Asia suggests a broad shift in how companies view their global markets. To derive the maximum benefit from their sourcing, leading companies recognize that they must be fully embedded in the markets that matter. Simply flying to China every couple of months no longer works as a long-term procurement strategy.

Shift of procurementA growing number of companies are beginning to think of procurement as a standalone, global profit center. The restructuring of procurement into a single organization creates visibility across the entire supply chain and makes it easier for companies to manage risks, using techniques such as hedging for commodity or currency volatility. Concentrating expenditures in a single organization may also have tax advantages, says Herb Schul, Americas Enterprise Cost Reduction Leader at Ernst & Young in the United States.

It is also possible to see the shift of procurement to China as laying a foundation for tapping Chinese growth. However, Chu cautions that on the business-to-consumer side, this transition will be more gradual, despite rising per capita wealth levels. The Chinese consumer market is still only a fraction of the size of the Western market, and is likely to remain so for a long time.

Jim Beveridgeis General Manager for Global Supply and Logistics at Wesfarmers Industrial and Safety. The company moved its key procurement executives to Shanghai in 2006.


Management Global tax function

Following the merger of Arcelor and Mittal in 2006, senior management at the world’s largest steel producer took the decision to create a global tax function that would have visibility across the company’s entire operations. Interview by Fergal Byrne

Taking a global view

a company with such a diverse geographical footprint? __ Egbert: Over the past few years, we have won the trust of top management. This has been crucially important. Top management understands and supports what we are doing — and we have a very good dialog. They have allowed us to build the tax team in what has been a difficult climate. Communication is also vitally important. It’s challenging but we are getting better at it. Within the tax department, for example, we have weekly meetings with the corporate tax team and calls with regional tax directors every 14 days. We have a working group approach where members of the tax department from all around the world are invited to participate in all relevant initiatives that have an impact on the group as a whole. Even if we have a project at group or corporate level, we make sure to include regional or national tax leaders. We also pay a lot of attention to communication across the rest of the company. We will start doing roadshows at a large scale, including presentations to the board and all relevant management committees and business leaders. The goal is to have a dialog and explain what we do, how we can support them, why tax is important and how we can work together as business partners.Transfer pricing is increasingly a challenge for many multinationals. Can you tell me how you deal with this? __ Lasso Peña: Having a centralized tax function helps us to communicate with different parts of the group and explain the rationale for pricing policies in different countries. We can share knowledge. But transfer pricing remains a challenge for us. In a group like ours, with thousands of intergroup transactions of a significant size, it requires lots of time, energy and resources. Transfer pricing needs the support of the entire organization but this is not always easy to explain in a multinational with so many diverse business lines. With tax planning, you may see immediate benefits from investing in this area. Transfer pricing is a longer-term issue and it’s not always easy to see the benefits. ArcelorMittal’s headquarters is in Luxembourg. Is this purely for tax purposes?__ Egbert: ArcelorMittal has longstanding roots in

T Magazine: What is the rationale for developing a global tax function?__ Jansen Egbert: Arcelor and Mittal were geographically very complementary to each other when the merger took place. We used this unique opportunity to develop a best-in-class tax function with a global perspective. What do you see as being the main benefits of a centralized tax model? __ Javier Lasso Peña: Having a lean centralized team that looks after all tax is a key source of added value, particularly within a company with so many intra-group transactions. At the same time, our tax colleagues at regional and country level play an instrumental role in developing best practice across different countries. We have a genuinely multicultural, global tax department with different nationalities, cultures and ways of looking at problems. In a globalized economy this is a very important asset for us.__ Egbert: Before the merger, tax wasn’t always seen as a priority. Today, considering the complexity of a global but fragmented legal landscape, our senior leadership, particularly those who come from a financial background, understand and value what the tax department is doing. We have been able to take a more prominent position within the company. For example, in close cooperation with treasury, the tax department structures the financial flows into the group, and decides how we structure the debt/equity structure of different entities. Changes in business models also require our involvement — as these can trigger a large number of tax implications. Importantly, tax is now considered at an earlier stage, so we can give our perspective to top management before major decisions are taken. What is the key to successfully building and operating a centralized tax department in

$65 100 000 000Headquartered in Luxembourg, ArcelorMittal is the world’s largest steel company with 281,700 employees in more than 60 countries. In 2009, ArcelorMittal had revenues of US$65.1 billion and crude steel production of 73.2 million tonnes, representing approximately 8% of world steel output.

ArcelorMittal built a best-in-class global tax function following a centralized model. Here, we speak to Jansen Egbert, Vice President Tax & Insurance, and Javier Lasso Peña, Global Tax Director about this experience.


Credit: Giovanni del Brenna / LUZphoto

Luxembourg. The Luxembourg company “ARBED”, founded in 1911, was one of the key predecessors of ArcelorMittal. In 2002, ARBED became part of Arcelor with its headquarters in Luxembourg. Today, ArcelorMittal is one of the largest employers in Luxembourg with more than 6,000 employees working in more than20 operational and commercial companies spread throughout the country. Luxembourg’s stable and business-friendly investment environment was at least as important for our decision to locate headquarters here. Of course tax matters. There is an attractive tax climate and a broad tax treaty network in Luxembourg. Individual taxes also play an important role here. However, there is scope for improvement. Compared with other countries there is no special tax treatment for expatriates. Luxembourg residents, for example, are subject to net worth tax at a rate of 0.5% annually. This is

very costly for companies in steel manufacturing and mining which, by their nature, are very capital-intensive industries. Finally, it would be nice if Luxembourg could create a tax friendly regime for financial income like it exists in some EU countries.What are the next steps in the development of ArcelorMittal’s tax function?__ Egbert: As well as transfer pricing, there are other risk and compliance factors that we want to address. We are, for example, developing a tax compliance network center, with leadership at a corporate level, starting in Europe. We have more than 1000 entities worldwide, as a result of the many mergers over recent years, and we want to harmonize and streamline the different practices. Also, risk management is increasingly getting our attention – but this would not be a surprise to anyone in the tax community.

Centralized tax departmentHaving a lean centralized team that looks after all tax is a key source of added value, particularly within a company with many intra-group transactions.

Jansen Egbert, Vice President Tax & Insurance, and Javier Lasso Peña, Global Tax Director at ArcelorMittal

Management Research & Development


Companies are rethinking their approach to innovation in emerging markets. Rather than see them as low-cost destinations for basic research, they now view these economies as fundamental to product development for both East and West.

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Key factors of R&D globalization to India

Source: Zinnov Confidential

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Source: Zinnov Confidential

Year on year cost savings by India R&D centers (US$ billion)

caliber science graduates, allows R&D-intensive businesses to innovate at a fraction of what it would cost to produce the same results back home, says Mario Kafouros, a Senior Lecturer from the Centre for International Business at the University of Leeds.

The availability of skills and proximity to the market are unquestionably important when it comes to choosing a location for an R&D center, but they are not the only factors. The overall tax system should also be a consideration. In cases where cost is the primary decision for relocating an R&D activity, companies must be careful to ensure that the reduced labor costs are not offset by a higher tax base or higher costs of administration. Another factor to consider is the availability of tax credits, which some countries offer as an incentive to foreign investors. It is also important to have confidence that the laws will protect the investor’s intellectual property. “Some companies would rather keep R&D work in their home country because that way they have better control over their IP,” says Frank Buffone, EMEIA Head of R&D Services at Ernst & Young.

The risks of technology leakage may be surmountable, however. According to Kafouros, multinational companies with global R&D networks can protect their product blueprints, even when IP protection is weak, by dividing the innovation process into discrete steps. Each step is assigned to a different laboratory, so no one center has a total picture of the product under development. “Only when all the technologies are combined do they become valuable,” says Kafouros. “It’s therefore essential that the final assembly takes place in a country where the enforcement of IP rights is strong.”

The distribution of research activity across several continents creates additional management challenges. The coordination of scientists across multiple countries is far more difficult than managing a team that is clustered in one place. While local relevance for R&D is important, companies must also be careful not to let the pendulum swing too far. There needs to be a strong link from the emerging market lab back to

• By Alicia Clegg

When Western multinationals first established research and development (R&D) facilities in countries such as India

and China, the rationale was largely one of cost. Just as they had outsourced other business processes to low-cost emerging markets, so too they reasoned that the more basic aspects of R&D could be handed over to an inexpensive emerging market labor force.

Although cost is still important, it is no longer the defining factor in the decision to locate an R&D center in emerging markets. Increasingly, companies choose these markets because they offer a combination of skills, a conducive business environment and, most crucially, proximity to a fast-growing and potentially huge customer base. And, rather than being destinations for basic research, emerging markets are fast becoming hubs for some of the most advanced R&D work in the world.

Xerox is one company that is making a big bet on the innovation potential of emerging markets. In March 2010, it opened an Innovation Hub in Chennai. The new center was tasked with creating products for emerging market customers, but also with creating IP that could be re-used elsewhere in the world. To achieve this, Xerox relies on an open approach to innovation, with in-house scientists working alongside academic institutions and partners.

Xerox is not the only corporation building innovation muscle in developing countries. In 2009, Unilever opened a state-of-the-art R&D facility in Shanghai. The new center supports brands such as Domestos, Dove and Lipton, and taps China’s strengths in materials science and organic chemistry while also drawing upon traditional Chinese medicine for ingredients.

The decision to choose an emerging market as the location for a new R&D center has many dimensions, of which cost remains an important one. Creating a laboratory in a rapidly industrializing country, such as China, India or Brazil, all of which have a plentiful supply of high-

Credit: Keystone / Martin Ruetschi


Number of scientific and technical journal articles

China India USA UK France Germany Japan2008 56 806 18 194 209 695 47 121 30 740 44 408 52 8962000 18 479 10 276 192 743 48 216 31 427 42 674 57 101

Sources: World Bank / World Intellectual Property Organization


Number of researchers in R&D per million people (incl. postgraduate PhD student)

China India USA UK France Germany Japan2007 1070.9 137.0 4 663.3 2 881.0 3 440.0 3 453.0 5 573.02000 548.6 111.0 4 480.9 2 739.0 2 910.0 3 142.0 5 110.8

Management Research & Development Credit: 123RF

Credit: Nie Jianjiang / Corbis / Specter


Number of patent applications

China India USA UK France Germany Japan2008 203 481 4 683 400 769 42 296 47 597 135 748 502 0542000 26 427 2 892 274 317 41 047 38 054 113 768 489 187


R&D as a % of GDP

China India USA UK France Germany Japan2007 1.5 0.8 2.7 1.8 2.1 2.6 3.42000 0.9 0.8 2.7 1.9 2.1 2.5 3.0

Management Research & Development Credit: iStockphoto.com / Lise Gagne


T Magazine: What essentially is the challenge of reverse innovation? Vijay Govindarajan: The emerging market customer is fundamentally different from the developed market customer. Therefore the first challenge in reverse innovation is to create local products for the local markets, because customer affordability is fundamentally different. And these innovations in turn have the potential to travel back to the richer countries. If companies do not take this approach, it is not only a lost opportunity for growth in poor countries, but potentially Western companies can get disrupted in their own country.T Magazine: How many companies in the developed world are adopting reverse innovation?Very few. Lots of companies talk about emerging markets but they don’t understand the kind of seismic mindset shift that is needed to capture this growth. Many companies continue to think of the West as the dominant force and consider that emerging markets are too poor to be a worthwhile business opportunity.Reverse innovation should be core to the strategic agenda for multinationals. Local competitors in India and China have become extraordinarily strong, and if multinationals do not do it, the local companies will. T Magazine: How big a shift is necessary to reverse innovate successfully? It is a seismic shift in mindset. It means shifting resources and transferring power to poorer countries, which is not an easy thing to do. You have to be prepared to have Chinese and Indians in the top management team, sharing a seat at the CEO table. That’s often very unsettling for many CEOs, who are used to power being concentrated in the developed market. T Magazine: To what extent is the decision to locate R&D in emerging markets still an issue of cost? Leading companies realize it’s not only about cost, but also about

capability. R&D engineers in these markets are top notch. And the really smart companies understand that you should not only locate R&D in India and China, but also focus on India’s problems and develop products targeted at the local markets. All too often, Western multinationals locate R&D in India but do so to work on global products, not India’s products. T Magazine: Do you think that multinationals will one day allocate the majority of their R&D budget to emerging markets? I don’t think it is necessary to allocate the majority of the R&D budget to the emerging markets, because there are still important innovation opportunities in richer countries. It’s about re-allocating and re-balancing resources. You have to be careful too, because sometimes you can hype the emerging markets so much that you lose sight of the innovation in richer countries. T Magazine: How should companies strike that balance?If you’re a Western multinational, you have to protect your core business, which means focusing on the richer countries. But at the same time, you now have major growth opportunities in emerging markets and you have to allocate resources there as well. Then, you can bring those products into the richer countries and you have reverse innovation. But reverse innovation will not make these companies’ core business obsolete — in fact, it will do the opposite. Reverse innovation opens new avenues for growth in rich countries. This is the crux of the challenge: simultaneously trying to grow in poorer countries while excelling in your more traditional business locations. This is the ambidextrous organization that multinationals must master. You have to know how to operate at multiple price points, with premium products at high price points in richer countries, while producing high-quality products at lower price points in poorer countries. This is key to survival.

Interview with Vijay Govindarajan, Professor at Tuck Business School, USA

“Reverse innovation opens new avenues for growth”

the center of the organization. This ensures that economies of scale can be derived and enables corporate resources and capabilities, such as IP, to be accessed and managed.

But these challenges, while tricky to overcome, are easily offset by the huge benefits that can be gained from conducting R&D in emerging markets. Most important of all is the positive impact on innovation. By harnessing skills and knowledge from the world’s R&D hotspots, wherever they may be, companies stand to produce better products and services than if R&D work was concentrated in a single region. Companies can also gain valuable insights into emerging market customers that may not be possible if the R&D work takes place thousands of miles away.

Xiaolin Zhang, Head of AstraZeneca’s Innovation Centre China, gives an example. Recently, the company discovered that IRESSA, one of its global lung cancer drugs, produced a superior clinical response in Asian female non-smokers. This finding, which is explained by a genetic difference underlying the behavior of the cancer, has alerted the company to the possibility that a patient’s response to a treatment may depend partly on their ethnicity. In future, AstraZeneca will actively explore this factor in its drugs research, says Zhang. “We think this type of difference may be more common than we previously thought,” he observes.

More generally, a global network of R&D laboratories has allowed AstraZeneca to create centers of expertise that specialize in diseases that may be more prevalent in some parts of the world than others. In India, the company is working on the discovery and development of drugs to treat tuberculosis in collaboration with a cross industry alliance led by the Bill and Melinda Gates Foundation and a number of charitable and government agencies. These medicines will benefit patients not only in India but also in other developing countries worldwide.

Finding solutions to the unmet needs of developing countries can also have knock-on benefits in the West. The same technology that allows an illiterate farmer in rural India to get instant advice on irrigating his crops could also help a motorist in Europe find information for a car journey. This kind of “reverse innovation”, where companies develop products and services in emerging markets, then adapt them for use in developed markets, is becoming increasingly commonplace (see sidebar).

Innovation, then, is no longer something that Western companies undertake in the corporate headquarters before exporting it to other regions. As emerging markets grow in economic weight, the argument for increasing the proportion of R&D carried out in developing countries becomes even more compelling. And increasingly, companies are finding that their innovation flows not just from West to East, but from East to West as well.


Management Global Controversy

2009, there has been a sea change in the environment for the exchange of tax information between administrations. Individual jurisdictions can now request and share information with overseas authorities, which gives them unprecedented visibility into a company’s international tax affairs.

Long-distance callIn September, the OECD announced that it would design a mechanism for joint audits, in which countries would combine forces to audit taxpayers. “If fully realized, joint audits could have the potential of both boosting international tax compliance and reducing costs for taxpayers and revenue bodies alike,” concludes the OECD’s communiqué.

As companies expand internationally, either organically or through mergers and acquisitions, the potential for unanticipated controversy

increases. For some time Vodafone has been involved in legal proceedings with the Indian tax authorities. In September 2010 the Bombay High Court ruled that the company should pay capital gains taxes on a deal involving the acquisition of the Indian telephone assets of

• By Bennett Voyles

Over the past few decades, many companies have taken advantage of globalization to expand into new markets. But the

transition to becoming a global company is not without its challenges. Markets may be borderless, but rules and regulations tend to be national and this poses significant risks. Exposure to variations in the tax environment across multiple jurisdictions creates significant potential for controversy, particularly in the context of cross-border transactions. This can lead to tough audits, penalties and, in some circumstances, long-term reputational damage.

The economic crisis has exacerbated the problem because governments must raise revenues at a time when corporate tax increases are both politically and economically difficult to justify. “The fact that so many countries now see low corporate tax rates as a key ingredient to economic growth is leading to increased enforcement,” says Rob Hanson, Global Director for Tax Controversy at Ernst & Young. “Because they are reluctant to raise corporate tax rates from a policy perspective, many tax agencies now see heightened scrutiny of taxpayers’ compliance as one of the few ways in which they can increase revenue.”

And, although each jurisdiction adopts its own approach, enforcement no longer ends at national borders. Since the G20 summit in April

63% A 2009 Ernst & Young survey found that 63% of companies in developing countries see tougher enforcement action by tax authorities as a significant concern.

61% In the same survey, 61% of companies in developed markets said that they saw reducing administration and compliance costs as a key priority.

Governments in developed economies are turning to tougher tax enforcement as a way of bolstering revenues. This creates uncertainty and risk for companies, particularly when they expand overseas.

How to navigate a risky tax environment

Although each jurisdiction adopts its own approach, enforcement no longer ends at national borders


Hong Kong-based Hutchison Whampoa. Vodafone insists, however, that it was exempt because the transaction took place between two offshore entities. The case is currently pending before the Supreme Court.

While the Vodafone example may be the most prominent, other companies could face similar issues if the ruling stands. Neither are such aggressive interpretations unique to emerging markets. In November 2009, the Australian Taxation Office announced that it was pursuing the US private equity group, TPG, for a US$450 million tax bill related to the disposal of Myer, a chain of department stores. Central to the argument was the notion that the sale should be regarded as income, rather than capital gains, on the grounds that buying and selling companies is TPG’s normal income-producing activity.

Not only are decisions of this nature costly, they can also affect reputation. “Regardless of the merits of a case, a highly publicized tax dispute can hurt a corporate brand,” says Monique van Herksen, Head of Transfer Pricing Controversy for EMEIA at Ernst & Young in the Netherlands.

A new boardroom riskNow more than ever, it pays to plan ahead. Companies should no longer look just at each jurisdiction and then choose the most advantageous location for assets or transactions. Instead, tax planners must also consider the opinion of one tax authority about the legitimacy of tax structures in another. Tax now plays such a material role in the strategic planning associated with international investments that a growing number of companies consider it to be a board-level issue. This concept has high-level support among tax administrations. For example, Douglas Shulman, Commissioner of the Internal Revenue Service, has said that companies need a mechanism to oversee tax risk as part of their governance process.

The complexity of the international tax environment has also encouraged administrations to put in place processes that give taxpayers greater, and earlier, certainty about the potential impact of an uncertain tax position. Although approaches vary, the idea is to open up a channel of communication between the taxpayer and tax authority that enables issues and disputes to be resolved without resorting to litigation.

The Australian Tax Office, for example, allows companies to enter into Annual Compliance Arrangements. This involves the taxpayer and the ATO engaging in early dialog on tax risks. Taxpayers are expected to be open and disclose all potential issues so that risks can be mitigated. If a company has sound risk management processes and provides full and true disclosure, the ATO will sign off on low-risk matters.

The Netherlands has implemented a similar approach, called “horizontal monitoring”. This enables taxpayers to resolve issues prior to filing

by means of an “enhanced relationship” between the company and the tax administration. The process can be characterized as a form of voluntary disclosure; the taxpayer promises actively to notify the tax authorities of any issues with a possible or significant tax risk and to disclose all facts and circumstances regarding these issues without hesitation or reservation.

As companies head further afield in search of growth opportunities, these pre-filing mechanisms should give them greater

confidence that proposed structures for transactions will not fall foul of the authorities. This is particularly true when considering transactions in emerging markets, which many companies in developed countries will be targeting as their best hope of growth in the years ahead. “Sovereign risk is always there when investing in the developing world,” says Howard Adams, Head of the Oceania tax controversy practice at Ernst & Young. “Companies need to think through what could happen with their advisers to properly assess the exposures associated with a transaction.”

Preventive medicineShould the taxpayer and tax administration be unable to resolve disputes over a transaction, the traditional route has been to turn to litigation. But, while there may be situations when this is appropriate, it is generally not in the interests of either side. Legal cases resulting from tax controversy can drag on for many years, incurring significant costs for both the taxpayer and administration.

One option now available in some jurisdictions is to make an agreement with the tax authority that, in the event of a dispute, the issue will be settled through arbitration or mediation. This approach presents advantages for both sides. Because the process takes place behind closed doors, the company benefits from keeping the issue out of the public eye. Meanwhile, the tax administration gains because settlement is generally reached much more quickly than if the dispute were to be handled by the courts. “Tax administrations might not get the maximum amount, but they do get it a lot more quickly,” says van Herksen.

Although these mechanisms for alternative dispute resolution are in their early stages, it seems likely that they will become an increasingly important part of the toolkit for planning international investments. And with greater enforcement and exchange of tax information seemingly here to stay, companies will need all the help they can get to navigate an increasingly complex and risky tax environment.

Legal cases resulting from tax controversy can drag on for many years incurring significant costs

Countries in which transfer pricing policy was examined since 2006

2010 2007USA 36% 31%Germany 32% 31%France 21% 27%UK 19% 27%Canada 18% 23%Italy 13% 15%China 12% 4%Australia 11% 11%India 11% 6%Japan 9% 12%

Source: Ernst & Young Global Tax Survey 2010

Management Global expansion Credit: AFP PHOTO / Indranil MUKHERJEE


Celebrations in Mumbai: Hotel parent company Tata Group head Ratan Tata (green tie) poses with staff at the reopening of the Taj Mahal Palace and Tower hotel in August 2010.


Over the past decade, the Tata Group has blazed an impressive trail of global expansion. A key part of its success has been a pragmatic approach to business models and post-merger integration.

From East to West for a global champion


companies are themselves highly centralized and operate as a single global entity; others are more decentralized and manage their overseas acquisitions with a very light hand.

An example of the former approach is Tata Consultancy Services (TCS), which has made a number of acquisitions and has also grown organically, recently setting up new facilities in China and the United States. Although working practices are adjusted to suit local conditions, TCS is a global operation with a single uniform brand. The same is true of Tata Communications, which has merged new acquisitions, such as Montreal-based Teleglobe, to form a seamless global network. “Our core values are universal,” says managing director N. Srinath.

At the other end of the scale are consumer-oriented companies like Tata Beverages, formed in early 2010 from the merger of several tea, coffee and bottled water producers including Tata Tea, Tetley and the American-based Eight O’Clock Coffee. These companies formerly operated on a loosely affiliated basis, focusing on individual markets in India, the United Kingdom and the United States. The merger has brought them closer together, but they still market their own brands to discrete customer bases.

Tata Motors, producer of popular Indian brands, such as the Indica and the Nano, has also maintained a hands-off relationships with some of its acquisitions, most famously Land Rover and Jaguar in the United Kingdom. A key objective of Tata Motors’ overseas expansion has been the desire to access new technology and innovation capacity. Ravi Kant spoke of the desire to create synergies between the different parts of the group, but he has made it clear that

there is no intention to rebrand either Jaguar or Land Rover as Tata products. “That would make no sense,” he said. “It would confuse customers and could affect the value of the brand.”

In the middle ground are companies such as Tata Chemicals and Taj Hotels. Tata Chemicals has been expanding rapidly in recent years, making acquisitions such as Brunner Mond in the

• By Morgen Witzel

When we think of global companies, most of the examples that come to mind have their roots in the United States, Japan

or Europe. But this traditional worldview is fast becoming outdated. In recent years, a number of companies from the BRIC countries (Brazil, Russia, India and China) have started to make their presence felt on the global stage. Although only a handful are as well known globally as the incumbent multinationals, this is a situation that is unlikely to persist.

One of the largest and best-known of this emerging generation of companies is India’s Tata Group, which has combined a strong Indian identity with a voracious appetite for international expansion. When Tata first began to venture overseas, some observers suggested that it would lose its Indian identity and become another “stateless” global firm. So far, at least, that has not happened.

Tata’s approach to globalization has been gradual and pragmatic, based on creating local relationships in each market where it operates rather than assuming a single global identity. As Ravi Kant, Vice Chairman of Tata Motors, told Business World magazine earlier this year: “We try to be a local company wherever we are present. We try to be a South Korean company in South Korea, a British company in Britain and a Thai company in Thailand. We assimilate the culture, nuances and their way of working.”

Until the 1990s, the Group had little profile outside India. That began to change under the leadership of Ratan Tata, the current Chairman, who made international expansion a strategic priority. “I believed that Tata could not remain a purely Indian company,” he said. “Its future had to lie outside India.”

The push for internationalization was motivated not just by the desire to reach new markets. The Tata Group also wanted skills and expertise that it could not necessarily find in India. Ratan Tata set the broad goals for expansion, but one of the intriguing features is the way in which companies in the Group have developed their own approaches. The Tata Group is highly decentralized, and each business sets its own strategies for expansion and executes them in their own ways. Within the Group, some

Tata operates not as one company but as a number of different companies around the world

The Tata GroupOriginally founded in 1868, the Tata Group today comprises a range of companies that operate across seven sectors. In 2009 to 2010, its total revenue was US$67.4 billion. Companies within the Tata Group tend to operate independently, and each has its own board of directors and shareholders.

18% In October 2010, Tata Motors announced that its monthly sales were up by 18% compared with the the previous year.

90 A diverse set of businesses, Tata Group consists of 90 different operating companies, of which 28 are listed on the Bombay Stock Exchange.

Management Global expansion


United Kingdom and General Chemicals in the United States. Some of the smaller acquisitions are quickly and efficiently integrated into the group. “We aim to complete the integration of a new acquisition within 50 days,” says managing director R. Mukundan.

With larger acquisitions, the practice is different. Brunner Mond and General Chemicals, for example, both operate semi-independently and, according to Brunner Mond Chairman John Kerrigan, Tata Chemicals does not yet feel it is ready to absorb and integrate these large acquisitions. Integration may well happen in the future but, for the moment, Tata Chemicals seems happy to let these successful businesses continue as they are.

Taj Hotels is also expanding aggressively and, according to managing director Raymond Bickson, opens a new hotel somewhere in the world once every six weeks. Bickson and his executives concentrate on service. “The aim is to deliver an international standard of excellence but with Indian charm and style,” he explains.

But not all of Taj’s hotels are strongly branded. The Pierre, one of the iconic hotels in New York, which was refurbished by Taj Hotels in 2009, is still the Pierre. It shares a common operating model with the rest of the Taj Group, but its image and brand are distinct.

Over time, it is possible that this will change and that the Tata name and brand will become more widely used. The rebranding of Daewoo Commercial Vehicles as Tata Daewoo and of

Corus as Tata Steel Europe suggest that this is already happening. Yet there are likely to be limits to this trend, and it seems highly unlikely that famous brands such as the Pierre, Jaguar or Tetley will be rebranded as Tata. More importantly, companies such as Tata Motors and Tata Steel continue to operate in a decentralized fashion. And in part, this is how the Tata Group itself operates; its semi-independent companies act together to create synergies within the Group, but they have their own strategies and management styles.

In summary, then, Tata has chosen the path of pragmatism. As Ravi Kant says, it operates not as one company but as a number of different companies around the world. Some, like Tata Communications and TCS, have a single operating model; others such as Tata Motors and Tata Beverages have chosen the path of localization. These are still early days, and Tata will probably adjust its position more than once as it continues to grow around the world. But at the moment, this strategy of pragmatic diversity shall continue.

The aim is to deliver an international standard of excellence — with Indian charm

Ratan Tata (right), Chairman of the Tata Group, and Ravi Kant, Vice Chairman of Tata Motors.

Credit: GettyImages.com / Bloomberg

__ For tens of millions of Indians, the only form of transport is the scooter. While cheap and practical, scooters have their downsides. Passengers are exposed to the monsoon rains and the heat of the dry season. Riding a scooter on India’s dangerous roads is also risky, and thousands of drivers die in accidents every year.

Ratan Tata, Chairman of Tata Motors, had been thinking about solutions to this problem for many years. “There has always been some sort of unconscious urge to do something for the people of India,” he said, “and transport has been an area of interest.” His first idea was to build a larger, four-wheeled version of the scooter, and initial sketches show something that looked rather like a golf buggy. His colleagues at Tata Motors were lukewarm, and it became clear that, for the idea to succeed, it would have to be a proper car. “Ratan Tata insisted that this had to be a car we could be proud of,” says Prakash Telang, Managing Director of India Operations for Tata Motors.

The price point was essential, and Ratan Tata insisted that the sale price of the new car would be Rs 1 lakh, or about $2,500, a price that ordinary middle-class Indians could afford. This was far cheaper than any other production car in the world, and rivals believed it was impossible to manufacture a vehicle so cheaply. Prakash Telang recalls that, during the production process, Tata Motors engineers struggled

to meet this target. But Ratan Tata was unyielding. “A promise is a promise,” he said and, eventually, by re-engineering hundreds of parts to save on weight and space, they achieved what others had said was impossible. The Nano was launched in 2009. Its success exceeded even Tata Motors’ own expectations. The initial sales target was 200,000 units in the first year. Critics suggested that the company would be lucky to sell half that. In fact, sales topped 500,000 in the first six months. One factor behind this success was that the Nano appealed to unexpected target audiences. Shailesh Bhandari, owner of a car dealership in the city of Pune, says that many of his customers are affluent older people. Some like the Nano because its small size makes it an excellent urban runabout. Others bought them as gifts for their children.

The launch of the Nano was covered in newspapers around the world. For many, it was the first time they had heard the Tata name. Ravi Kant recalls how he was stopped at US immigration by an official who asked when he would be bringing the Nano to America. In fact there are plans to launch a version of the Nano in Europe.

More than just a successful car, the Nano has helped to lift the image of the entire Tata Group. Indeed, by showing what Indian engineers and designers can do to develop high-quality but affordable products, it may in time help to lift the entire image of India generally.

Innovation

Small car, big story


Management Offshoring Credit: Reuters / Finbarr O’Reilly

have made the cost savings to be gained from offshoring less certain. But at the same time, outsourcing providers, such as Infosys, Wipro and Genpact, have evolved far beyond being providers of low-cost services. Offshoring, then, may no longer be about getting rid of commoditized business processes but about rethinking the entire value chain and considering where to allocate each component business activity — including some of those that used to be considered core competencies. “In the past, offshoring was purely a labor arbitrage play,” says Herb Schul of Ernst & Young in Cincinnati. “Now, organizations are taking a much more strategic look at what they outsource and whether the right answer is for that to be an offshore model.”

• By Bennett Voyles

Over the past decade, companies in the West have shifted the production of goods and a range of administrative functions

to suppliers in overseas markets. In many respects, the decision was a straightforward one. These were often non-core business activities that conferred no competitive advantage. By moving them to low-cost countries, such as India and China, companies could save money and remove the headache of managing these activities in-house.

But more recently, the decision over whether to offshore a particular business activity has become more complex. Rising labor costs, turbulent currency markets and volatile oil prices

What began as a way for companies to reduce their fixed cost base has come a long way in recent years. Although cost is still a factor in offshoring decisions, other considerations are becoming increasingly important.

Offshoring’s next actInitially, offshoring was all about heading East. Now companies are starting to look South as well: a new call center in Senegal.


costs that reduce the client’s fixed-cost risks. “We’re seeing more and more of that, and we believe it’s the right direction to go,” says Sanjay Purohit, Vice-President and Head of Corporate Planning and Business Assurance at Infosys Technologies. This combination of factors is encouraging companies to re-consider their approach to offshoring. But re-thinking does not necessarily mean bringing these activities back home. Instead, it has led to movements East and West, as customers look for more control and vendors seek to become better integrated with their customers’ global supply chains.

Mindful of the risks from supply chain disruption, many companies have sought to introduce greater resilience into their supply chain, by relying on Asian contractors for some activities, but combining this with greater use of suppliers closer to home. Contractors themselves are responding to this trend for “nearshoring”. In recent months, a number of Asian contract manufacturers have set up operations in Eastern Europe, according to Henk Slaats of Ernst & Young’s advisory practice in the Netherlands.

In its first two decades, outsourcing was all about heading from West to East. Now companies are starting to look South as well, with a growing number of service centers opening up in Latin America and Africa. “We’ve seen service centers opening in countries such as South Africa where wages are still low and the colonial legacy means there are plenty of European language speakers available,” says Dorian Redding of Ernst & Young’s advisory practice in the UK & Ireland.

Technology has changed the gameA split in the market has also arisen between data centers and call centers. Data has no accent, so distance has not proven much of a problem for outsourcers, but in some markets, there has been a customer backlash against companies setting up call centers in low-cost markets, such as India. In response to this, some companies have moved their contact centers closer to home. In Europe, for example, a number of German and Dutch companies have moved their contact centers to the Czech Republic, while some financial services firms in the United Kingdom have closed call centers overseas in favor of domestic replacements.

Technology has changed the game too. The development of Voice Over Internet Protocol has now made virtual call centers possible. Rather than go to work at a central center, operators can work from home, often on a part-time basis, and can be patched in when a customer calls. The technology also enables calls to be routed to the operator who is geographically closest to the caller. This increases the degree of familiarity for the customer and offsets some of the complaints about being routed to handlers on another continent.

Equally, the tax implications of any offshoring decision need to be carefully understood and considered early on in the process. The relocation of business functions to offshore locations raises important transfer pricing and tax issues, and these can have a significant impact on any cost-benefit analysis. First and foremost, companies should ensure that their supply chain and tax strategies are aligned. When companies investigate offshoring options, they should ensure that tax planning activities, such as transfer pricing, are looked at alongside the strategic decision-making process. By involving tax functions in the decision over how and where to offshore, companies may benefit from a reduced tax rate and, as a consequence, an improvement in after-tax earnings.

Eroding marginsAfter more than a decade of offshoring, companies are now better positioned to understand the real costs of the decision to migrate processes overseas. “Companies are realizing that there are significant transactional costs involved in offshoring,” says Serguei Netessine, a Professor of technology and operations management at INSEAD in France.

The offshoring model also exposes companies to significant risks. Although multinationals have become better at gaining visibility across the supply chain, serious reputational problems can still catch them unawares. Earlier this year, news reports of a wave of suicides at a factory that manufactures products on behalf of major technology companies illustrated the risks of relying on outsourced labor.

In response to these concerns, many companies are installing employees directly in the contractor’s facility and putting in place much more rigorous service-level agreements. “Five years ago, companies would be working on a pretty straightforward set of service level agreements but that is changing,” says Schul.

On the plus side, the companies that provide outsourcing services — whether manufacturing or administration of information technology — have also learned a lot over the past decade. Many providers have moved well beyond the provision of basic, low-cost services and become best-in-class innovators themselves. This is good news for companies seeking to improve business processes but it inevitably makes the decision to offshore a more complex one. “Companies are working increasingly closely with their outsourcing providers to determine how the partner organization can bring things like innovation to the table,” says Schul.

Looking for more control Some outsourcing providers are exploring innovative new business models. For example, Infosys Technologies has signed contracts based not on time and materials but linked either to cost savings or cost per transaction – variable

20%According to a recent report, wages for migrant workers in China increased by 16% in 2009 and 19% in 2006. Many provinces and regions have raised minimum wages by up to 20%. Indian salaries have also increased markedly over the same period.

Outlook The policy picture Credit: P.O Dybvik / InnoTown Innovation Conference


The failure of companies to understand cultural differences means that they

are missing out on significant benefits, says Fons Trompenaars.


Let’s stop kidding ourselves

that Western executives lack integrity because they cannot be relied on to help their friends.

Multinational companies seeking to become global tend to adopt one of two approaches. Either they try to adhere to a universal and global set of values, or they seek to be multilocal corporations whose disparate approaches make coordination of anything, even matters like brand, extraordinarily difficult. Both approaches are equally bankrupt as neither addresses the needs of a single organization operating simultaneously in multiple cultures. The solution is genuinely to innovate, where innovation should be defined as combining values not easily joined, the result of which is therefore scarce and profitable. This does not mean creating some new, least-common-denominator culture, but understanding the shared and different values of cultures, and coming up with new solutions to dilemmas that satisfy all views.

Let me give two examples. Some cultures see leaders as earning obedience from ongoing success, but this can lead to continuous

criticism of leaders, thereby making action impossible. Other cultures believe that somebody in a given position deserves obedience, even if he is leading everyone over a cliff. The approach that works across all cultures, we have found, is what we call “servant leadership” — one whose authority comes not from action or from position but from working consistently to help those around to achieve their goals.

Second, when I was at Shell we had a problem during a joint venture with some Asian colleagues: our individual performance bonuses were hurting their team spirit, but rewarding teams as a whole inhibited risk-taking. What we found worked better than either was to have an individual element of bonuses based on personal contributions to the team and a team element based on what the team had done for individuals. In both cases, it is not a question of choosing one culture, or simplistically combining them, but finding a new way out of a dilemma that appealed to both cultures. Trying to reconcile apparently opposite values creatively even shows the flaw in the accident dilemma. If we stop kidding ourselves that we do not have a problem, or that we have solved it, we can start truly benefiting the diversity within organizations, rather than simply praising it and then ignoring it.

Transnational companies are in a cultural crisis. They do not understand what culture means and therefore how they need to act in

order to benefit from diversity. Professor Ed Shein of the Massachusetts Institute of Technology describes culture as an onion: on the outside are the expressions and artefacts that hide a deeper level of norms, or what we think we should do, and values, or what we like to do. In practice, though, culture is not a concrete thing but a dynamic process, as these norms and values are shaped over time. And, in turn, they themselves shape how people resolve dilemmas in areas such as human relationships or endeavor.

Imagine you are the only witness when a friend driving a car hits a pedestrian. Should the friend be able to rely on you to lie to the authorities? The answer is a dilemma because it brings into conflict the desire to show loyalty to friends and to uphold laws that protect everyone. Having asked over 100,000 people this question, however, we have found that culture plays a dominant role in the answer: some cultures value rules more, while others give more weight to personal relationships. It is not just moral dilemmas. Whether leaders are accepted because of what they do or who they are; situations in which either a team or an individual deserves credit or blame; whether direct or indirect communication is appropriate — cultural norms and values strongly shape which choices people prefer.

In our research, we have found that transnational companies are singularly bad at coping with cultural diversity. They often fail even to

recognize the problem, believing that contrasting approaches can be easily added together, like sacks of wheat, to add value. Others may think they have sidestepped the issue by declaring noble sounding, apparently universal, corporate values. These simply mask differences. In the United States, for example, 82% of companies list integrity as a value. But what does this really mean?

Thinking back to the accident dilemma, we have found that respondents from Asia are more likely to show support for their friends, while those in the West are more likely to be honest with the authorities. I have had Western executives tell me that this data somehow proves that Asian executives lack integrity because they would not tell the truth. But I have also had Asian executives tell me that the same results prove By Fons Trompenaars

BiographyFons Trompenaars is Director of Trompenaars Hampden-Turner, an Amsterdam-based innovative center of excellence in intercultural management. He is the world’s foremost authority on cross-cultural management.


Publications

Preview__ In Issue 4 of T Magazine, which will also be published as an insert in the Financial Times, we focus on mergers and acquisitions. For the past two years, M&A markets have been subdued as companies prioritize balance sheet strength over growth and as capital has been in short supply. Companies are looking for greater value in their deals and tax efficiencies have become more important. In this issue we will examine recent trends in M&A, including the rising importance of emerging markets and the changing credit environment.

Topics covered include:

• What are M&A Directors’ current priorities? What do they need? What are they looking for?

• How can companies structure deals in a tax-efficient manner taking account of today’s changing M&A tax environment?

• Doing the distressed deal: new trends, new structures

• The policy perspective: how the evolving policy environment might affect the ability of companies to execute cross-border deals

• The return of private equity

Global mobilityThe third Gobal Mobility Effectiveness Survey by Ernst & Young offers an insight into the broad range of views from 250 participating multinational companies. The purpose of the survey was to assess the effectiveness of the global mobility along with its processes and policies, and provide benchmarks of key objectives for international HR management in the current economic climate.

Research incentivesResearch & development is a long acknowledged driver of economic competitiveness. In early 2010, we surveyed our international network of R&D tax and incentive practioners in order to understand the current state and recent trends in R&D incentives, particularly as governments and companies are making changes to react to, and grasp, the opportunities that arise following the financial crisis.

Global tax trendsAs the world emerges from the downturn and companies re-evaluate how they raise capital, there is increasing focus on the role of tax. Ernst & Young commissioned market research agency TNS to survey tax directors at 130 of the world’s largest companies to ascertain their views on tax issues surrounding transactions. Global tax trends: raising and investing capital reports the key findings from this survey.

Russia tax survey Since 2005 Ernst & Young has been asking companies for their opinions on various dimensions of their tax affairs in Russia. Taxation can have a significant impact, positive or negative, on current business operations and future investment decisions. This sixth annual survey specifically addresses the views and experiences of companies with regard to the Russian tax system and its impact on their operations.


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