Regulatory Concerns For US Cos.' Offshore Service Centers

By Sonia Baldia
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Law360 (August 4, 2020, 3:39 PM EDT) --
Sonia Baldia
Sonia Baldia
COVID-19 will hyperaccelerate digital transformation of enterprises. The pandemic has amplified the crucial role of technology for businesses worldwide, from supporting remote workforces and triaging supply chains, to scaling digital channels for customer engagement.

It is no surprise that digital natives and digitally enabled companies have better endured the current crisis and adjusted faster to the new normal compared to the digital laggards.

While digital transformation is not a new endeavor, the crisis will propel business leaders to seize the opportunity to harness the power of technology and digital models to reinvent their businesses for the next normal.

Indeed, enterprises are leveraging emerging technologies such as cloud computing, artificial intelligence/machine learning, internet of things, blockchain, advanced analytics, mobility and automation not only for back-office operational efficiency and supply chain resilience, but also to modernize the front office, invest in new tech-driven products and platform-enabled solutions, and monetize business data — key sources of competitive advantage in the digital economy. 

As enterprises ramp up their digital transformation efforts, the pandemic has prompted many to reexamine their sourcing strategy and reconsider the build versus buy analysis, balancing business continuity, agility and resilience against cost and control levers, and risk diversification.

Traditionally, information technology and business-process services were readily outsourced to third parties. But with the technology function increasingly redefined as a strategic differentiator and core competency for business, not merely a support function, enterprises are forced to reexamine what to outsource, what to retain inhouse or insource, and how to optimally leverage captives or so called global in-house centers, or GICs — also called global capability centers or global innovation centers — to build distributed agile teams to transform business. A global in-house center is generally defined as offshore service delivery operations, typically in low-cost countries, owned and operated by the same company receiving the services.

GICs that struggled with business continuity or demand slowdown during the pandemic will be potential targets for restructuring, consolidation or divestment, particularly in the severely impacted industries like retail, hospitality, travel and aviation, as witnessed during the global financial crisis of 2008.

Conversely, many enterprises will opportunistically establish new GICs or repurpose existing ones to achieve transformation and diversify operational/geographic risk to deliver value to the broader enterprise.

Setting up a GIC can yield enormous strategic benefits, but it is a complex undertaking that raises critical operational, business, financial, legal and regulatory considerations for the foreign enterprise. This article highlights some of the key legal and regulatory considerations that U.S. companies should assess and address upfront when setting up a GIC outside the U.S. to avoid costly mistakes down the road, mitigate risk exposure and maximize the company's return on the GIC investment.

The GIC Appeal for Digital Transformation

Businesses transforming front office or customer-facing products and services; investing in research and development, software or platforms; or processing regulated data generally prefer the GIC approach over traditional outsourcing as it provides greater control over company's core activities, data, intellectual property, proprietary technology and know-how.

The newer GICs are a natural evolution of the older generation of captives — often referred to as shared services organizations or global business services — but differ in many key respects.

For example, the legacy captives were primarily driven by cost arbitrage and process standardization of back-office IT and business-process functions. The newer GICs, however, are designed to create value and bring new tech capabilities and process innovation to the enterprise beyond just cost and scale.

As market-entry barriers and capital outlay requirements have lowered over time, the newer GICs have become easier and faster to establish, and vary in scale compared to the legacy captives employing thousands of employees in offshore locations. In fact, a significant percentage of the newer captives are so-called nano GICs with fewer that 500 employees.

In recent years, the sourcing market has witnessed a steady increase in U.S. companies establishing new-generation GICs in nearshore/offshore locations like India, the Philippines, Mexico, Costa Rica, Ireland and Eastern Europe. Mounting pressures to cut costs and rebuild revenue via digital transformation will propel more U.S. companies to closely consider the GIC option. 

This option is particularly appealing for mid-market U.S. companies to tap vast pools of nearshore/offshore talent at comparatively lower cost than onshore talent to leverage emerging technologies and deliver high value services like software product development, engineering, data analytics, R&D and business-process management to the broader enterprise and its customers.

Key Legal and Regulatory Considerations

While there are numerous home country and industry-specific issues that should also be addressed in the planning and overall analyses of an offshore GIC entity, highlighted below are some of the key legal and regulatory considerations that, if unaddressed at the outset, can not only derail the enterprise GIC strategy but also significantly increase the cost and risk exposure for a GIC.

Due Diligence and Market-Entry Strategy 

At the outset, an enterprise must undertake thorough due diligence and risk assessment of the applicable local laws and regulations, along with other critical macroeconomic factors such as geopolitical risk and local infrastructure, relative to its business and operational needs to determine the GIC's location, market-entry strategy and delivery model.

A GIC, typically a subsidiary of a foreign parent, is subject to foreign direct investment and other local laws and regulations of the host country that can trigger burdensome restrictions on foreign ownership, inflow/outflow of foreign currency, expat assignment and data localization, to name a few. 

Further, government approvals and local licenses and registrations may be required that can impact the GIC's timing and financials. Lacking proper understanding of these aspects upfront, or not complying with them, can create significant risk exposure for the foreign enterprise.

GIC Delivery Model

Enterprises adopt different delivery models for GICs depending on their strategic drivers, geographic familiarity, financial considerations and risk appetite. Generally, a GIC may be set up as a pure captive, a virtual captive, a hybrid so-called build-operate-transfer, or BOT, or a joint venture. Each model has its own advantages and risks that should be evaluated to identify and assess the relative pros and cons commensurate with the organization's strategy, business needs and risk profile.

For example, while a pure captive may provide greater operational visibility and control over critical IP and data compared to a BOT or virtual captive model, it can involve significant capital outlays, longer time to implement and less flexibility to ramp up or down quickly compared to other models.

A virtual captive model or BOT, on the other hand, can provide faster deployment, greater scaling flexibility and lower upfront financial risk to the enterprise as the local provider makes initial infrastructure investment, but coemployment risk and shared operational responsibility can accentuate risk profile compared to the other models. 

Tax Planning and Local Business Presence

Setting up a GIC requires careful tax planning upfront, taking into account both local and international tax implications and foreign exchange requirements, among other factors. In some cases, investments may be structured through holding companies in intermediary jurisdictions for a number of strategic and tax reasons, e.g., tax efficient exits and structuring debt investments.

These tax considerations are highly project-specific and require thorough analyses at the outset to structure and launch the GIC in a tax efficient manner. Further, the location of the GIC and the suitable legal entity structure are critical decisions that shape the GIC's local business presence.

A suitable local entity structure for the GIC will depend on various factors such as the contemplated size of operations, applicable tax rate, fiscal incentives, capital raise plans and dividends, to name a few, that should be closely evaluated prior to set up.

Fiscal incentives offered by local governments can translate into significant financial savings over the life of the GIC investment but they can also impose limitations on deal structure, such as restrict the ability to transfer ownership of local entity or assets without substantial penalty. Therefore, it is prudent to explore and evaluate the available fiscal schemes early on as part of the planning and decision-making process to appropriately structure the entity.

Capitalizing the GIC

Multiple factors are considered when capitalizing a GIC such as the quantum of operating expenses, ease of funding, tax efficiency, repatriation and ease of compliance and management in the host country location. Depending on local regulations, a mix of funding instruments may be used to capitalize the GIC, such as foreign equity investment and external commercial borrowings.

In many cases, the operating expenses of the subsidiary are funded by the foreign parent making trade advances to the subsidiary for services to be performed subject to transfer pricing arrangements. Profits may be repatriable subject to local regulatory restrictions.

These funding arrangements trigger tax implications and complex transfer-pricing rules that should be carefully examined and structured to minimize risk from local revenue authorities and maximize tax efficiency. Among other things, consideration should also be given to potential excess accumulations of profits within the GIC subsidiary as a result of transfer pricing markups and tax efficient repatriation strategies. 

IP, Data and Cybersecurity

As IP laws are territorial in nature, significant risks remain relative to IP ownership, protection and enforcement in host country locations that should be carefully considered and mitigated, particularly if the GIC will develop new IP. Typically, IP developed by a GIC is assigned to the foreign principal or affiliate subject to transfer pricing arrangements and appropriate invention assignment agreements between the subsidiary and its employees and contractors as applicable.

Often foreign enterprises attempt to use their global templates of nondisclosure agreements, IP and employment terms and contractor agreements without appropriately localizing them for the host country. This can create local validity/enforcement challenges since IP laws and "work made for hire" rules differ worldwide.

Given the lax enforcement environment in many offshore locations and cybersecurity risk accentuated by remote working normalized by the pandemic, GICs must resort to a combination of practical information governance strategies and appropriately structured and implemented contractual protections to adequately safeguard the GIC's strategic business information.

Cross-border data transfers are yet another area of growing complexity for the GIC that requires upfront consideration of contemplated data flows and processing requirements as more countries implement data protection laws that restrict or regulate cross border data transfers, or require data localization.

Employee/Human Resources Risk

The global shutdown caused by the pandemic has raised vexing employment and HR-related issues for many GICs and the foreign enterprise. Some offshore locations like India, the Philippines and Mexico implemented very strict lockdowns of their cities to combat the pandemic, forcing employers to swiftly pivot to work-from-home capability for most employees.

While many GICs were able to make the shift to remote workforce, others have faced significant business disruption and grappled with tough workforce reduction issues mired in complex local labor law/regulatory minefields disfavoring layoffs and terminations.

Some jurisdictions have overly rigid or protectionist labor laws that can affect the GIC's agility to quickly respond to changing market conditions and cause existential concerns for the entity. Therefore, local labor law implications on the GIC's hiring and firing practices and the cost of labor compliance must be factored into the GIC's planning analysis and commercials to avoid surprises later.

Local Vendor Contracts

Often enterprises have experience with offshoring through third party outsourcing and leverage those relationships to make forays into a new GIC market. Many enterprises deploy local providers in different roles to help build out the GIC, ranging from initial setup and operational support to terminating existing provider contracts and rebadging personnel, and engaging local vendors to recruit and train local talent.

The nature and scope of a GIC's local vendor strategy is typically driven by the GIC delivery model as well as the foreign enterprise's familiarity with, and branding in, the host country. Rigorous vendor due diligence and structuring appropriate vendor contracts are critical to successfully leveraging local providers and ensuring smooth migration of personnel and functions to the GIC. 

In sum, a GIC can be a powerful means of generating strategic value for an enterprise and achieving digital transformation. But establishing a successful GIC requires a robust risk assessment of the key legal and regulatory requirements upfront, along with business and operational risks that must be properly considered and factored into the GIC's delivery model, base case and project plan in a manner that maximizes return on investment and mitigates risk exposure for the foreign enterprise.

Sonia Baldia is a partner at Baker McKenzie.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice. 

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