Have You Checked Your Foreign Operations Lately? The Importance of Auditing

By: LUIS G. RESÉNDIZ

April 2009

A couple of years ago your company decided to start operations in a foreign country. You opened a sales office in Brazil, you set up a manufacturing operation in the Dominican Republic, or you established a joint venture in Mexico. You hired all the appropriate professionals and spent several thousands—or tens of thousands—of dollars along the way, to ensure that you set up your foreign operations correctly. Your local partner, the local manager, or the “expat” that you sent down there has been running your international operation. Everything seemed fine; you are making money—or you thought you were—so you never really paid close attention to your foreign operation.

Last week you received a notice that your foreign subsidiary, office, or joint venture is being investigated by the local government. Apparently, your local partner and/or manager had devised a clever—albeit illegal—scheme to greatly reduce the import duties and other taxes of your foreign operation. You immediately called your lawyers and accountants. The report is back. Apparently your foreign subsidiary—and, potentially, your parent company—may be liable for hundreds of thousands of dollars in back taxes, fines, and penalties and both your company and some of its executives may be subject to criminal prosecution. On top of that, you must now amend your filings with the SEC, which may trigger an investigation by the SEC or other U.S. governmental bodies as well.

In today’s world, most companies must have international operations if they want to continue growing. International markets represent great opportunities. However, there are associated challenges; people do business differently in other countries. Unfortunately, cases similar to the scenario described above happen all too frequently. Most of the time, they are the result of lack of oversight.

Many companies do not inspect their foreign operations regularly. Sometimes these audits are seen as a waste of resources. However, performing periodic inspections or audits should prevent situations similar to that described above, or at least allow you to catch them before they get out of control. These inspections may save your company significant amounts of money—and embarrassment.

The purpose of this article is to outline a few of the more common areas where companies have problems with their foreign operations. There are, of course, other areas that may present problems, but it is not possible to cover all of them here. This article does not intend to discourage businesses from going international. There are plenty of great opportunities outside of the United States. However, it is less costly and painful to take the necessary steps to prevent problems rather than trying to remedy them later on.

I.  Local Partners

Finding a good partner in a foreign country is challenging. In many foreign countries most medium or small enterprises are owned and run by one or two family members who make all the decisions without having to consult anyone. Many individuals have never had “real, equal” partners.

Should you have a local partner? The answer to this question depends on many factors, including the country where you wish to do business, the nature of your business and the international venture you intend to undertake, and your experience and resources. In Latin America, my first answer typically is, if you have the resources to do the venture yourself, do not get a local partner. In my professional experience, the odds that you and your local partner may have substantially different approaches to operate the business are too great and the issues associated with having a local partner would outweigh the benefits.

If you decide to have a local partner, you must strive to obtain as much information as possible about all candidates. You must confirm information provided by potential partners before you enter into any contracts with them. Obtaining information on potential foreign partners may be difficult. There may not be as many business organizations in that country as there are in the United States, and not as many people participate in them. A few resources available include local customers or suppliers you may have, local chambers of commerce, your local attorney, and other companies doing business in such country.

Once you enter into a relationship with a foreign partner, you must monitor it constantly. As stated above, business practices are different in other countries. Except for some practices (e.g., underreporting and underpaying taxes and bribery), “different” does not necessarily mean bad, but if you do not take the time to understand those practices and to supervise that they are modified or not followed, it is likely that issues will arise. It is more complicated and expensive to try to remedy situations that could have been prevented or caught early through appropriate monitoring.

II.  Setting Up the Right Structure

Your corporate structure must be adequate in the United States and in the foreign country where you are doing business. One of the more common mistakes made by U.S. companies doing business in other jurisdictions is that they retain local advisors to set up the foreign operations who do not have the expertise to analyze how the structure they set up will impact the company in the United States. Two of the main considerations when setting up foreign operations are taxes and liability.

In many instances, U.S. companies may be able to have their foreign entities treated as pass-through entities for U.S. tax purposes. However, only certain kinds of foreign entities qualify as pass-through entities. Frequently, those types of entities are not the more common types found in the foreign jurisdiction. If your local advisor is not aware of these issues, chances are that he or she will set up the “wrong” entity. In addition, your advisors in the United States must also be aware of the rules regarding foreign entities. You may need to make filings with the IRS to qualify for some of the better tax treatments. If you do not set up the appropriate foreign entity or if you fail to make the necessary filings with the IRS, you may have to pay more taxes as a result.

Also, your advisors must understand your U.S. structure to ensure that your foreign operations do not put your entire organization at risk. In other countries, certain liabilities (e.g., taxes, duties, employment liability) may affect not only your operations in that country but also might spill over to your U.S. operations. Putting in place the appropriate corporate structure alleviates this issue. This is particularly important if you have a medium to large operation.

Corporate structures can be modified at any time. A fairly simple audit by the right professionals would confirm whether your structure is appropriate and they may give you recommendations to improve it. An audit may save you taxes and reduce your potential liabilities.

III.  Customs and Taxes Related to Import/Export

In my experience, customs and employment issues represent the most frequent—and expensive—problems in foreign operations. Having a good customs broker is essential to many operations. Complying with customs laws and regulations may be time-consuming and paper-intensive, but a good broker should be able to help you implement a system to deal with this in an efficient manner.

You must constantly audit your import/export paperwork. In foreign countries people (sometimes with the complicity of customs brokers) may underreport the value of products. They may do it to lessen the amount of duties, value added taxes and other taxes applicable to import/export. This in turn may help them lower costs and be more competitive in pricing. Sometimes they do it for less “benign” reasons (e.g., to pocket the money they “save” in duties in taxes). No matter the reason, understating values for import/export purposes is illegal and it may be a crime. Furthermore, even if you had no knowledge of what your local partner and/or manager was doing, your company and its owners, officers, and directors may be liable.

You must also implement and maintain a system to keep all the appropriate import/export paperwork in order. Many foreign countries audit compliance with customs laws heavily. If you are not able to prove that your paperwork is in order, they may presume that you are not complying with customs laws, even if they do not prove that you are doing something wrong. Customs authorities are quick to levy fines and assess penalties if you cannot show them “on the spot” that you are in full compliance with customs laws. Even if you can later successfully dispute the fine or penalty, that challenge would consume time and money. You may avoid all the foregoing issues by constantly monitoring and auditing your customs systems and paperwork to ensure continuous compliance with customs laws.

IV.  Labor Issues

Many foreign jurisdictions have stringent laws to protect employees. Many have severe restrictions on firing employees. They may allow employers to fire employees only for “just cause” and just cause may be narrowly defined. Also, if an employee sues an employer, many foreign laws grant legal presumptions in favor of the employee and place the burden of proof entirely on the employer.

If an employer fires an employee and is unable to prove that the employer had just cause, the employer may be liable for severance payments, which may be quite large. In addition, the employer may be required to pay the former employee’s salary from the date of the termination until the date the employer makes all payments under the judgment rendered in favor of the employee. In jurisdictions where a trial may last months or years, many employers prefer to pay the severance even if they had good reasons to terminate the employee, rather than running the risk of having to pay accrued salaries if they lose the lawsuit.

The foregoing risks may be managed through the appropriate documentation and record keeping. You must have written employment agreements for all employees. The agreements must detail all aspects of the employment relationship, including:

• Salary—they should detail all compensation and include a statement that the employee would not be entitled to other compensation;
• The employee’s duties—they should detail all duties and include provisions to allow the employer to expand those duties;
• Work schedule—they should include provisions giving the employer flexibility to vary the schedule depending on the work needs; and
• Rules about overtime—claims for unpaid overtime are frequent in some countries; the employment agreements should provide that no overtime would be allowed unless it is previously approved in writing.

When negotiating employment agreements you must bear in mind that once you grant a right to an employee, you may never be able to take it back unless the employee consents, which is unlikely if the employee does not receive something else in exchange. All changes to the conditions of employment must be memorialized. Remember, you may have to prove such conditions of employment if your employee ever sues you.

One issue particular to Mexico is profit sharing. In Mexico, employees are entitled to receive 10 percent of the employer’s yearly profits. Many businesses set up multiple companies to plan around this requirement. Typically, all the employees are placed in a “services” entity, which sole purpose is to provide personnel services to a sister “operating” company pursuant to an intracompany services agreement. The operating company pays to the services company a fee equal to the costs incurred by the services company in providing the services plus a mark-up. By doing this, the business can calculate the amount of profit sharing that the business would have to pay at the end of the year. Also, this structure may help employers diminish some of the risks outlined in prior paragraphs because the employees would be employed by a company with few assets. However, courts may disregard the structure in the event of a lawsuit. Courts may consider the operating company to be the employer if the court concludes that the operating company was the beneficiary of the employees’ services. Also, the fees payable under the services agreement must pass muster under transfer pricing rules.

Another frequent labor-related issue is the incorrect payment of taxes or contributions in connection with employees’ salaries. Employers in other jurisdictions must contribute to social security, unemployment funds, pension plans, subsidized housing, and other benefit programs. These contributions are typically based on a percentage of each employee’s salary. A common practice is to underreport the employees’ salaries to reduce the amounts of these payments. Sometimes employees are not registered with the government, to avoid making the payments altogether. These practices are frequently discovered by the government. Disgruntled employees are quick to inform authorities of any underreporting or lack of payment. Not making the correct payments carries substantial fines and penalties (including criminal prosecution). You must constantly monitor that your local partner/manager pays these taxes or contributions accurately.

Lastly, you must also be aware of special issues regarding expatriates, commonly called expats. If you send an expat to work at your foreign operations, that expat should be treated as an employee of your foreign operation exclusively. All of his or her compensations should be paid by the foreign operation. If you keep your expat as an employee of your U.S. business, the expat may claim all the rights and protections granted to employees under both U.S. laws and the laws of the jurisdiction where the expat performs his or her services, including the right to request severance payment, and, in some circumstances, expats working in Mexico could claim the 10 percent profit sharing based on the profits of the U.S. company. You must constantly verify that the paperwork regarding any expats working in your foreign operations is in order.

V.  Directors, Officers, Powers of Attorney

You may need to appoint your local partner/manager as a director, officer, or power of attorney to allow him or her to run your foreign operations. The practice by many lawyers and notaries in foreign jurisdictions is to draft corporate documents granting exceedingly broad authority to those running the day-to-day operations. A bad partner/manager with excessively broad authority may be very dangerous; they may use that authority to sell your business or to obtain other personal benefits using your business assets. If you have not had those appointments verified, you must do so. In addition, you must continuously monitor the use of such appointments by your local partner/manager. Situations created by the misuse of overly broad appointments may be extremely difficult and sometimes impossible to correct.

VI.  Visas

If you are doing business in another country, you must have the appropriate authorization (visa) from that country. Most visas must be renewed periodically. If you do not have the appropriate visa, you may have to pay significant fines or penalties and you may even be subject to criminal prosecution. If you ever have any issues with your local partner/manager, he or she may notify the local authorities that you do not have the appropriate visa and request that they fine you, kick you out, and/or prosecute you. A disgruntled business associate may try to use the lack of the appropriate visa to renege on business arrangements.

VII.  Bribery

Although many countries have made progress in the last few years, bribery and corruption are still a serious concern in many jurisdictions. Your local partner/manager may see bribery as an accepted practice, a cost of doing business in that country. However, bribery is illegal and it may expose your business to liability in the United States. The U.S. government is very active prosecuting cases for violations to the Foreign Corrupt Practices Act and the fines may be substantial—in addition to the bad publicity. You must provide training to your local partner/manager, but training may not be enough. You must constantly monitor your foreign operations to verify that no bribery is taking place.

Takeaway

Other countries offer great business opportunities. However, you must understand the nuances of doing business in foreign jurisdictions. Furthermore, you must invest the resources to constantly supervise your foreign operations to verify that they are run according to your standards. Monitoring your operations may prevent problems or at least allow you to catch them earlier and may save you significant amounts of money, bad publicity, and embarrassment.