This is the second installment of our three-part series on the ‘Great Carve-Out Comeback’ of 2023 and implications for talent management, presented by Andrew Lindquist, a partner from GoGlobal, and Yvette Chan, Managing Director and Asia M&A Tax Practice Leader from Alvarez & Marsal (A&M).
During an economic downturn, companies often look for ways to generate cash quickly. By divesting non-core assets, companies can generate cash that can be reallocated to pay down debt, invest in core businesses or fund other initiatives.
Economic uncertainty can also create buying opportunities for savvy investors, as sellers may be willing to accept lower offers so they can quickly generate the cash revenue they need.
With an economic downturn on the horizon, merger and acquisition (M&A) carve-out activity is expected to be strong in 2023. However, cross-border carve-out deals often come with the dilemma of ‘orphaned employees’ – where workers come with the asset deal but there is no in-country entity for the buying company to employ them.
In this blog post – the second in a three-part series – Andrew Lindquist, a partner from GoGlobal, and Yvette Chan, Managing Director and Asia M&A Tax Practice Leader from Alvarez & Marsal (A&M), offer insights on bolstering talent management ahead of a carve-out deal.
What happens if orphaned employees are not taken care of properly?
Andrew Lindquist, Partner, GoGlobal: Many times, when a carve-out deal is on the table, the details and implications for orphaned employees can initially be overlooked. When not planned for in advance, this situation can cause a real headache and throw off the timing of a deal – or later emerge as an expensive surprise.
Gaps in benefits and employee engagement can also impact talent retention and, thus, compromise the long-term success of a transaction.
Yvette Chan, Managing Director and Asia M&A Tax Practice Leader, A&M: If gaps in orphaned employees are not addressed ahead of time, companies can face serious consequences including misclassified workers, permanent establishment (i.e., taxable presence in other jurisdictions), intellectual property (IP) exposure, increased tax liabilities, workforce exodus, customer service disruptions, dissatisfied investors and more.
In certain jurisdictions, non-compliance with reporting and tax clearance procedures may also have an impact on the company’s ability to hire foreign workers in the future.
Can an acquiring company hire orphaned employees with their own in-country entity?
Andrew: Absorbing workers into the organization’s own in-country entity, if one exists, may appear to be the most straightforward option for bridging talent management gaps in a carve-out. However, buyers must still consider how they will align benefits and talent management processes across a cross-border workforce. This especially applies if the talent at stake is a key asset for making the deal successful in the long term.
We sometimes see buying organizations make the mistake of not fully understanding the existing benefits package and the value proposition it represents in the acquired asset. If acquired workers are presented with an inferior benefits package, it will inevitably compromise employee engagement. Eventually, key people may choose to leave.
There are instances when the buyer may want to retain workers to ensure the continuity of business. The workload is then transitioned over time, but they do not want that period to be indefinite. However, employing the acquired workers within the buyer’s entity may make it harder to separate these workers from the permanent workforce, due to collective bargaining agreements, taxation, benefits and other HR considerations.
Yvette: In some cases, transferring orphaned employees to the acquiring company may result in tax liabilities to the employees. This applies when the acquiring company does not inherit the employee’s years of service in the original company but pays the employee severance for the years of service he or she has worked. Individual income tax (IIT) withholding liability will arise for the original company in certain jurisdictions like China.
Further, if the buyer needs to align the remuneration package of the acquired orphaned employees, it should consider whether this may give rise to additional tax costs for the employer. For example, let’s assume the previous remuneration arrangement allowed the acquired employees to benefit from a lower effective tax rate. By aligning the remuneration package offered to existing employees, the buyer will likely need to gross up the remuneration of the acquired employees. This way, their after-tax take home pay will be at least the same. If this arrangement is not aligned, it may result in the loss of key talent.
The retention approach may also have tax benefits. For example, in China, if all or part of the physical assets and the associated debts, liabilities and labor force are transferred to the acquiring company through a carve-out deal, there is a chance the transfer of assets – goods, real estate, land use rights, etc. – involved in the transaction is not subject to VAT.
What about setting up an in-country entity?
Andrew: The first thought for the buying company is often that they will just establish a business in the country of the acquired asset. However, establishing a legal entity can take several months in some countries, according to data from the World Bank, with India and China being two prominent examples where business incorporation can be a long process.
Establishment can also be an intensive, costly process that will put a strenuous burden on your budget and your finance and HR teams. For example, in the European Union, there are countries where the average cost to set up shop can be upwards of €12,000, accounting for company incorporation application fees, opening a local corporate bank account and additional government fees.
The buying company is then directly responsible for reporting requirements, taxation and, of course, all HR processes. This can become a precarious situation if the HR team is not well-versed in the new country’s labor laws.
The upfront fees and labor-intensive processes for setting up an entity may make sense when it’s a large headcount. When there’s a smaller headcount, the ROI can easily erode and seriously diminish the integrity of the carve-out.
At the same, deals are often slow until the deal is inked. After that, things can move fast. Plus, transition service agreements (TSA) don’t always allow for enough time to get an entity started in order to hire talent.
Yvette: In many countries, foreign-owned companies may not be able to easily hire local employees. For example, due to China’s foreign exchange regulations and labor laws, it is not possible to hire local employees via non-residence payroll. Instead, employee payroll, taxes and social insurances need to be handled locally in China.
Buying companies should also take note of time constraints and parameters. For example, in general, it takes two to four months to set up a new legal entity in China at minimum – but it may take longer. Different legal forms of the entity will have different tax profiles and parameters for hiring acquired workers. There may also be limitations on the business scope. For example, a representative office can only perform liaison or other non-operating activities.
The time it takes to set up a legal entity may also vary across Southeast Asia. In Singapore, a legal entity can be set up fairly quickly (e.g., within one day) but in other countries (e.g., Vietnam and Myanmar), it may take a longer time. Payroll withholding and social contribution obligations will need to be managed properly to avoid non-compliance as the rules are complicated in some countries, such as Social, Health and Unemployment Insurance (SHUI) requirements in Vietnam.
In the next installment of this series, Andrew and Yvette will discuss how hiring through an Employer of Record (EOR) can help support carve-out deals.