Episode 17: Operating model effectiveness, with Sam Barrett, Ernst & Young LLP

The following transcript has been lightly edited for clarity. Sam Barrett can be contacted at sam.barrett1@ey.com.

Intro: Hello and welcome to The LCN Legal Podcast, bringing you professional views and analysis of the legal aspects of transfer pricing compliance. Our focus is always on real world, practical insights that you can apply in your everyday work. In this episode, LCN Legal’s co founder, Paul Sutton, talks to Sam Barrett, Managing Director, Americas Operating Model Effectiveness at Ernst & Young LLP. Sam is experienced in operating model and value chain projects, and he and Paul discuss what drives such projects, how to deliver them successfully, and how the tax and TP teams should be involved. We hope you enjoy the discussion. And just to be clear, Sam’s views are his own personal opinions, not necessarily those of Ernst & Young LLP or any of its associated bodies.

Paul Sutton: Hi Sam, great to have you on the podcast.

Sam Barrett: Hi Paul, good to be here. Thank you.

PS: So we’re here to talk about operating model effectiveness and global value chain projects. So what is operating model effectiveness and what kind of projects are we actually talking about here?

SB: Very good question. So business models are the way a company makes its money. So product sales or service offerings, via business-to-business, business-to-consumer, software as a service, for example. Whereas operating models are really how the company organises itself, organises its resources to achieve those strategic business goals, and how it puts its business model into action. A value chain is a set of activities that are undertaken by a company, or tools it has to create value when selling its products or providing its services. And the value chain extends all the way from the initial design or the sourcing of raw materials, all the way through to delivery and after-sale services to the customers.

So each of these activities creates a different level of value. And the goal is obviously to maximise profit across the value chain, with each element of the value chain creating different levels of value. So the functions and the location of people undertaking these value-creating activities is really important to consider from a tax perspective. So, to the question, operating model effectiveness involves aligning all of the functions across the value and the supply chain, all of the transactional flows, both internal and external contracting models, as well as the structure, to create the most efficient way, from both tax and non-tax perspectives, to align both the strategy for tax as well as the commercial strategy.

PS: OK, so what are we looking at in terms of typical triggers or drivers that are actually giving rise to these kind of projects? And I know that you have a particular focus, particular experience with APAC. So taking on board what’s happening in that region.

SB: Sure. I mean, at the moment, a lot of the projects we’re working on are a result of non-tax drivers. For example, many companies have the need to improve their supply chain resilience. Or we have companies that are reassessing their global manufacturing or hub footprint in light of supply chain, or logistics, or ESG, or supply chain transparency pressures that are coming from internal and external stakeholders. But it also could be companies that have got (as many do) increased costs or challenges. For example, if they’re reliant on one main manufacturing facility in China, for example, this could be a lot less resilient than if their footprint is a little bit more spread out. In Asia Pacific there’s currently a lot of activity, as I’m sure you know: many US- and European-headquartered companies actually have over-reliance on one or two large manufacturing bases in China, for example. And many are looking, not to fully exit China, but certainly to direct future investments in manufacturing, for example, to new or existing facilities in Southeast Asia. As well as actually Mexico, more and more nowadays, for the North American markets.

And the objectives that they’re seeking to achieve are really to take costs out of the supply chain, reduce supply chain lengths, reduce logistics costs and delivery times. They’re looking to improve trade efficiency, with all of the new rules and new policies, to try and become a little bit more efficient from a trade perspective when it comes to customs and duties, for example. And in turn, the goal is really to create a global footprint and supply chain that is more tax and commercially efficient, and more resilient to the many risks we’re seeing nowadays. I think many companies are also approaching us when they’ve got a new CFO or a new supply chain or tax executive. And these people come in with ideas from their previous roles on how to improve tax or commercial efficiency in supply chains. And so we’re doing many workshops with these teams discussing the commercial visions, what the guardrails are when it comes to future state alternatives. And we’re helping them work through both the tax and non-tax implications of these alternative potential future states.

And then finally, from a tax perspective – from a tax driver perspective – we’re seeing many companies, particularly those with IP in low-tax jurisdictions, or those that have incentivised hub structures in places like Singapore, Malaysia, for example, that have got a 0% tax rate, for example. And these companies have already worked through the impact of BEPS Pillar 2 on their current state, and they’re really looking at alternative future state operating models. I think tax departments are more and more – or should be more and more – having to get closer to the business strategy and the planning functions, to make sure they’re involved at a lot earlier stage in these types of projects, so as to make sure the business is really fully aware of any tax consequences on any of these future state supply chain or operating model planning activities.

PS: And I guess some of the triggers relate to the stage of development of the company? So some of the biggest projects we’ve been involved in involve… maybe not scale-up companies, but companies which are preparing for a significant investment. And therefore maybe they’ve had a structure which has in effect grown randomly in a haphazard way, and they’re at the stage where they do need to present a rational structure, a rational approach to how they organise themselves. I don’t know whether you see that a lot.

SB: Yeah, very much so. We have an approach that is very flexible and we help scale-ups exactly at the stage of their evolution, as you say, they’ve started to expand and they’ve increased their footprint across a number of countries, and that’s when it gets tough for them to manage all the compliance obligations, the efficiencies of intercompany transactions and flows, and external contracting models. So we would approach a start-up scale-up project quite differently to the way that we would approach a project with an MNC.

And there really is no sort of typical project scope nowadays. I mean, it’s not like the past, where most large multinationals were looking to move to more of a sort of highly centralised, incentivised hub model. Nowadays, I think every company has a different footprint, every company has different internal and external pressures. But what we see consistently across most of the projects is really the need to improve resiliency and efficiency and reduce risk. And this tends to be in light of the supply chain or global trade efficiencies that they’ve identified in more detail post-Covid, as well as the need to remove unnecessary costs from the organisation.

And this can be through a different manufacturing footprint, a different external or internal contracting model, or a different strategy around, for example, nearshoring. So moving closer to their end market. So Mexico for the North American market, for example. Or even outsourcing. A lot of companies are coming to us with a blank piece of paper saying, ‘If we look to outsource, what would the impact on our operating model be?’ But those that are manufacturing are really looking to reduce the length of their supply chains. They’re looking to move more routine functions out of the expensive hub jurisdictions. (For example, in Asia, Singapore would be one of those.) And if you see these hubs in these jurisdictions, their footprint has tended to balloon since these hubs were set up. So it really needs a review and an assessment of whether they’re still fit for purpose.

Every project is quite bespoke, but typically starts with a feasibility assessment. So what is the exam question? What are the issues? What is the business seeking to achieve that’s not currently being achieved? And, importantly, what are the guardrails? What are the obstacles to achieving this? This phase can be done over a period of time. But what we like to do is get the key stakeholders – such as the COO, the CFO, heads of tax, strategy and supply chain, for example – all in one room, face-to-face to workshop this out. And this really allows us to understand the different views from the different sides of the business. Everybody’s perspective and pressures and wants are slightly different. So this in turn facilitates more understanding and alignment across the business, with all of those people in one room, to understand what they collectively want and need as a business moving forward. So once the feasibility phase is complete, we then tend to have enough input from that workshop to go away and start drafting and designing a few alternative future state models that we think will address the needs of the client.

And then after a number of iterations with the key stakeholders in the tax and the non-tax functions, what we then typically do is move to a detailed design phase, and that involves going into a lot more of a detailed local analysis around, say, corporate tax, transfer pricing, indirect tax and global trade. Or it could be looking in more detail at the IT systems, or the accounting challenges, or the legal implications. But that focuses on one or two of the selected model alternatives.

Then once a company has chosen the model that needs to be designed in detail, once it’s got approval from all the key stakeholders, we would then start working on more implementation planning. And again, every project is quite different, but most tend to cover numerous jurisdictions and many different stakeholders and functions. So project management, project integration as we call it, is really key. So understanding all of both the tax and the non-tax interdependencies is really key in these projects. And I think one of the main areas of value-add that we in the EY OME team bring to each of the projects.

From a timeline perspective, as I said, it depends on the complexity and the size of the project. So as I said earlier, for example, for a start-up or a scale-up that is present in only a few locations, and they’re looking to get an international expansion operating model, or options for what their future state could look like, we would go through all of the phases I just mentioned in a short a time as a month. Whereas with other larger, more complex projects that potentially impact multiple countries and functions, we could take anywhere between 12 to 24 months. So the phased approach will be such that we will probably work on different phases of sprints in situations like this. Or we can also – and we do – work on multiple workstreams concurrently. So, I mean, every project is different. And as I said, we’re very flexible with our approach to this.

PS: And you’ve kind of touched on this already, but in terms of the question about how tax and transfer pricing is involved, or how should it be involved… do you often come across these kind of projects which are maybe initiated and part way down the road without tax involvement, without the right tax input? What’s your experience on these kind of things?

SB: Yeah, 100%. As I said, a lot of the projects are driven by non-tax drivers, and depending on what those drivers are, it depends who our first point of contact with the business is. As I said, all of these change projects that we work on, they’re all going to have a tax impact when changes are made. So the majority of the projects that we work on are driven by the non-tax functions, and rightly so. And if the tax person isn’t involved, we immediately suggest that that person is involved at the outset. Most of the time, the changes that are required or wanted in these operating models, or being considered, are going to have a large tax impact. Or on the flip side, there could be a lot of potential tax savings or improved efficiencies or incentives that are available, that require that the tax and the non-tax functions work in collaboration early on with each other. So getting the right people in the room, identifying the right stakeholders and functions that should be involved in OME projects as early as possible, is really key.

I mean, I’ve seen projects stalled due to, for example, the IT function not being involved early on enough to be able to prioritise the changes that are needed for an OME project, or ones where HR has not been fully involved early on. And these can really be obstacles to getting projects done and completed according to their timelines. So planning and early engagement of the right tax and non-tax stakeholders at the right time is really key to the success of these projects.

PS: Yeah, absolutely. So in terms of the key non-tax functions that you’ve mentioned – so IT, HR, legal… are those the main ones that you would say?

SB: Depending on the scope of the project, yeah. But having the business guys, the commercial guys, the supply chain guys… it tends to be the COO that’s managing these types of projects overall. So having him or her involved early on – supply chain manufacturing, again, depending on the business. And if the business has a lot of IP, the R&D people should be involved. If it’s software, the product development guys. So we really understand the value drivers in the value chain of the individual business.

Obviously every business is different. We would do an assessment of the exam question early on, as well as the value chain, to really understand which people should be involved when, and where the likely impact across the functions should be.

PS: When you say the ‘exam question’, what do you mean? Is it like expressing the rationale for the change as ‘How can we fix this issue?’ Or ‘How can we become less dependent on operations in this country?’ Is that what you mean by ‘exam question’?

SB: Yeah, every exam question is different. So it could be ‘We’re at 5 billion of sales at the moment. We want to achieve 10 billion of sales by 2030. We don’t think we can get there with our current operating model or supply chain. What are our alternatives?’ Or ‘Post-Covid we’ve got extended delivery times, we’ve got increased logistics costs, our time to deliver our products to market, or the lead time could be x amount of days. We want to reduce that to y amount of days. We don’t think we can do this, or we’ve explored alternatives to do this, now we need your help’, for example.

PS: OK. In terms of an established methodology for approaching these projects, you talked about these key stages and the early stage of maybe workshopping and getting the right people in the room and so on, and then moving on to having a short list of potential models and then detailed planning and implementation. Are there any other general principles, if you like, or established methodologies that you would add on this? Or is it that every project is different and needs to be approached differently?

SB: Yeah, I mean, that’s the framework we tend to use on most projects. As I said previously, we normally go through the projects using the following phases: feasibility design, detailed design, implementation, and then post-implementation we would tend to go back and undertake what we call ‘sustain’. Sort of a healthcheck to make sure projects have been implemented as designed. They never are 100%. And so understanding that, and if that has any strain on the forecast efficiencies, is really important. And then it’s if any tweaks need to be made.

And as I said, depending on the size of the company, the complexity of the challenge or the organisation, it can be different. As I said, with our flexible approach, we would do maybe sprints of these different phases or elements of these different phases, but certainly we would try and combine generally all the elements out of these phases when we’re doing an OME project. And as I said, we’re very flexible with the approach and frequently also work in a slightly different way, maybe embedded as part of the internal client project team, or we may work just as project integrators for the client.

And we’ve also got clients that like to do the initial feasibility phase internally, and then get us involved for the detailed design and implementation, for example. So every client in every situation is slightly different, but generally we tend to follow the same sort of framework approach.

PS: OK. And in terms of that sustain factor, this is something that in terms of our work on legal structuring, we talk about maintenance of agreements and corporate structures. But from your perspective, in terms of how you input into that, what does it actually look like? Is it about creating internal processes and manuals for operating the structure, or is it healthcheck reviews? How does it express itself?

SB: Yeah, all of that. I mean, when we would do an OME project, they tend to require material change in the way businesses do things, the way they transact, KPIs, reporting lines. So having a standard operating procedure manual, to make sure that the people that are impacted by these changes are clear what they can and can’t do, or what they should and shouldn’t do in this new structure. And then working with them to make sure this happens. We’ve also worked with internal functions such as internal audit, to so they can be the sort of eyes and ears of the tax function (if it’s the tax function overseeing these changes). To make sure the new model is working as it should and as efficiently as it should, and people aren’t sort of going outside the boundaries to create additional tax risk, for example. So, yeah, all of what you said.

PS: OK. And I know that in your previous lives, you’ve had various roles as an in-house head of tax, looking after multinational groups. So if we’re stepping back and looking at tax functions generally of multinational groups, MNCs, and the challenges that they are facing right now and over the next twelve months, how would you see that? What would you see as the major challenges, including fielding these kinds of projects?

SB: Yeah, I mean, obviously at the moment, companies should be well into understanding what the impact of Pillar 2 is, if that’s relevant for them. So being ready from a reporting perspective, understanding what data needs to be reported. I mean, it’s likely that most of the business has not collected data in this way, or reported in this way, before. So doing that initially, and then understanding what the likely additional tax impact is, and then making sure this is communicated up the business to the CFO to really understand in the current state, what does that mean for the business.

And then it’s a matter of, if companies are happy with that impact on their current state – and if they’re not, what do they do to plan around the impact of Pillar 2 in the short term. And/or whether they want to change anything more structural in their operating models in the longer term, to improve the global tax efficiency of their group. So I expect a lot of businesses and their tax functions are, and should be, working on this at the moment.

I think similarly, those companies that are going to be subject to the carbon border adjustment mechanism (the CBAM) should have also started to analyse the impact to their business and what the reporting requirements are. And then again, similarly to Pillar 2, if they’re not happy with that impact, what can they do longer term? Working with the business and the supply chain folks to look at alternative sourcing models, supply chain models, all of which there’s going to be a material impact on.

And then finally, similar to previous years, I think further automation of compliance continues to be key. So that sort of frees up the tax function to be more of a proactive business partner, as I’ve already talked about.

PS: Yeah. So it sounds like we’re talking about data readiness being one of the major immediate challenges, plus the horizon analysis, plus ongoing transition towards automation of compliance. Is that how you describe it?

SB: Exactly that. Yeah, exactly that.

PS: OK. Just to leave things with some key takeaways for heads of tax, in terms of how they need to position themselves or organise themselves, perhaps, so that they can support their organisations as well as possible. What would you say there?

SB: Yeah, I mean, just to reiterate what I talked about earlier, I think many tax departments really need to increase the effort to raise their profile within their organisations. I think becoming more of an integrated, proactive advisor to their COO, CFO and strategy colleagues is really where value can be added. I think having the tax function, or the head of tax, getting more involved earlier on with the business’s strategic planning process – and what the supply chain guys are planning, what the manufacturing guys are planning – is really key to adding value ahead of time, and being involved ahead of time. And as I said, automating some of the more routine compliance activities should allow them to free up time to achieve this.

I think showing their non-tax colleagues the risks of not getting them involved, and also the opportunities for improved tax or overall operating model efficiency if they [do] get them involved, is the couple of messages I think they need to give to be able to facilitate that increase in profile and then be able to add the most value in their function.

PS: Makes complete sense. Well, thank you so much. We’ve only had time to take the highest high-level view of these kind of projects. There’ll be a lot that we could drill down on in terms of specific areas to look at, such as treatment of intangible assets and so on, but it’s been incredibly helpful. So thank you so much, Sam, for spending the time with us.

SB: Thank you for the invite, Paul.

Outro: Thanks for listening to The LCN Legal Podcast. The views reflected were those of the contributors, and do not necessarily reflect the views of the global Ernst and Young organisation or its member firms.

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