External Revenue Service

A revolution within corporate tax departments has companies throwing part if not all of their needs to outsiders.

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It won’t beat an end to the corporate income tax, but a rapidly growing number of U.S. companies see big benefits from farming out much, if not all, of their tax compliance needs to outside firms.

During the past five years, the percentage of U.S. corporations’ tax compliance costs spent with outsourcers has quintupled, from about 3 percent in 1992 to 15 percent currently, according to research compiled by G-2 Research Inc., a Mountain View, California-based applied market research and management firm.

What’s driving the revolt against internal staffing? “Tax outsourcing continues to grow because it works,” says Dennis Torkko, managing partner for Arthur Andersen LLP’s contract services. “For many companies, it can deliver the latest in technology and technique for a lower, flexible cost.” That savings can range from 5 percent to 25 percent, depending on the size and practices of the tax department in question. As a result, Torkko expects outsourcing to continue to increase at a 20 to 25 percent annual clip until about a third of all companies’ tax compliance dollars are spent with outsourcers.

This suggests that finance executives are overcoming the chief obstacle to outsourcing– the fear that an outsider will complicate or bungle a key support service. What tax directors are learning is that such risks can be hedged with careful management of both the service provider and the employees remaining on the payroll.

BETTER, FASTER, CHEAPER

Witness the change at $2.8 billion Cyprus Amax Minerals Co., in Englewood, Colorado, which four years ago outsourced most of its tax accounting, and eventually went on to outsource most of its other accounting and its internal audit as well. The impetus was the merger in 1993 of Cyprus Co. and Amax Minerals. In preparation, Cyprus tax director J. David Flemming was asked by CEO Milton Ward to rethink the way Cyprus managed its tax function. Flemming’s brief: Find a way to drive down the costs of the combined entity. “I didn’t even know if I’d survive the merger or be tax director of the new company,” says Flemming. “But I did know that outsourcing needed to be looked at and fairly considered.”

After reviewing a study by Coopers & Lybrand LLP, Flemming recommended a broad outsourcing of tax accounting and compliance tasks. Staff was reduced from 7 at Cyprus and 16 at Amax to just 4 full-time employees. Price Waterhouse, which is also Cyprus Amax’s auditor, won the contract. The outsourcer now provides 6 full- time staffers to Cyprus and up to 15 during peak work periods, reducing employee costs on a pro forma basis by about 10 percent. Better technology and training techniques were also brought in by Price Waterhouse, reducing personnel and management headaches, says Flemming.

But much of the benefit is intangible. Flemming and his three tax professionals are able to focus more time providing input on new acquisitions and projects, and strategic planning in general. “It’s hard to benchmark just how much in additional savings we’ve been able to put on the table as a result of outsourcing,” says Flemming. “But I do know that we’re able to focus more on what we’re paid to do–find and implement tax savings ideas.”

Some firms have gone so far as to outsource the entire tax department. Before going public in 1994, Cali Realty, a $2 billion (in assets) real estate investment trust, based in Cranford, New Jersey, had had its tax compliance handled by the controller and his staff. But when Cali decided to use a more complicated partnership structure for acquiring new investments, CFO Barry Lefkowitz decided to let a regional accounting firm handle the day-to-day preparation and tax returns, while retaining Price Waterhouse to prepare the final returns. Additional planning and strategy advice is purchased from Deloitte & Touche LLP as needed.

“I didn’t want to staff up and run a tax department, and felt we would get better experienced, more rounded tax professionals doing the work through outsourcing,” says Lefkowitz. “Plus, given our rate of growth in the number of returns we file and the specific nature of REIT [real estate investment trust] tax law, outsourcing has been an excellent solution for us.”

INTERNAL RESISTANCE

Not unexpectedly, the boom in tax outsourcing has occurred over the objections of corporate tax directors and their managers. Many fear losing control of either the service relationship, the compliance process, or both. There’s also a natural aversion to the loss of colleagues and loyal employees, and with them, operating leverage within the organization. Too, executives are loath to give up pursuit of the synergies they feel the combination of compliance and planning produces–soft benefits from personal relationships and frequent consultation that are difficult to either prove or discount.

As a result, more and more CFOs are going over the heads of tax directors by calling in the consultants. “Out of the dozens of outsourcing reviews we’ve done in the last year, only two were initiated by the tax director,” says Robert Bodey, a senior manager at Deloitte & Touche. “Many think if they just stand still, this decision will pass by without causing any changes. But what many are reluctant to grasp is that unless they remain in charge of the review and the change process, they are going to be seen as part of the problem, and be vulnerable [to replacement] as a result. Tax directors need to consider outsourcing as an option today, or they aren’t doing their jobs.”

But outsourcing is not a cure-all. While any company with more than a half-dozen compliance professionals on staff and technology improvement needs is a potential candidate for outsourcing, the decision to outsource is generally made only at the end of a thorough review process, insists James Keene, director of tax services at Ernst & Young LLP. “Outsourcing is the last resort. More often, internal process improvement and personnel changes are feasible, if not preferred,” he says. As a result, many companies consider and reject outsourcing for a variety of sound reasons.

At $478 million (in revenues) accounting and enterprise software maker J.D. Edwards & Co., in Denver, tax director Karen Kenney called in Deloitte & Touche’s Bodey for a process and reengineering review on her own. So there was surprise on both their parts when the first question J.D. Edwards CFO Rick Allen asked Bodey was whether the firm should outsource the tax department.

Kenney was taken aback, “because I thought we were doing an excellent job. And in fact that was true, so we decided against outsourcing.” Kenney had recently conducted an activity- based costing analysis of the tax function, and though this identified several opportunities for improvement, it convinced her, and Allen as well, that outsourcing wasn’t the answer. Nevertheless, Kenney isn’t resting easy. “The review convinced me that we should reconsider our decision every couple of years. It will keep us sharp.”

Outsourcing was also rejected at Ashland Inc., a $13.3 billion (in revenues) oil, gas, and manufacturing company, in Russell, Kentucky. For Sean Crimmins, vice president and tax director, the decision started with the cost differential, or lack thereof. “Outsourcing didn’t make sense for us, first and foremost because there wasn’t a large enough cost advantage to justify the change,” he says. “We’re already highly automated in our preparation process, and actually file our returns and exchange all correspondence with the Internal Revenue Service electronically. And the Big Six couldn’t offer us much more in experience or efficiency than we already have.”

Also, Crimmins was worried about losing control of the compliance process. “We’re an extremely complex company, and frequently file with positions contrary to current interpretations of the tax code,” he explains. “And when I sign our disclosure form, stating that we’ve taken a position contrary to current regulation, I want to know exactly what is in the return and that the person who prepared it did as I asked. For an outsourcer, there is no incentive to sign off on an aggressive position like that, because they then share the responsibility for penalties and payments. Controlling that internally is part of the value I provide, and I don’t feel that I could fulfill that by outsourcing.”

OUT OF CONTROL?

Outsourcing clearly introduces a risk of loss of control. But companies that have taken the plunge have developed specific means of mitigating it.

Cyprus’s Flemming says he has sacrificed no control over the return process, because he retains a director of compliance who knows the process and the company’s positions completely. “I think you have to keep that oversight and that ability in-house, for the sake of control and continuity,” he says. “Otherwise, you cede too much responsibility to your service provider and risk problems on audit, and in simply getting the work done, if problems develop with the provider.”

Like any contracted service, tax outsourcing contracts are subject to interpretation and must be actively managed. This was true for British Petroleum America Inc. (BP), the $24 billion (in sales) energy company, which has outsourced tax compliance work to Coopers & Lybrand since 1991. Several misunderstandings arose early on concerning fees for research and advice, which are considered outside the basic service provided by the outsourcing agreement. After BP smoothed out those initial rough spots during its first five-year contract with C&L, the two formalized their agreement in a second contract, also for five years.

As a result, James Nemeth, general tax officer for BP, remains an avid fan of outsourcing. “There are many people who bash outsourcing, especially in tax, but have no experience with it,” he says. “While it hasn’t always been smooth and trouble free for us, we are extremely happy with the end result of outsourcing our tax compliance and accounting. The key is to communicate clearly what you want done and what you expect as part of your outsourcing agreement.”

In fact, BP decided last year to outsource all property and sales/excise taxes to Arthur Andersen, which also handles BP’s accounting outsourcing needs. Even so, BP has kept more than 40 tax accountants and attorneys on the payroll to keep tight control over strategy and compliance, while the day-to-day work is done by the employees of the two outsourcers.

And even ardent adherents like Flemming don’t expect miracles. For example, quick turnover of outsourcer personnel can be a problem, as familiarity with the firm and its positions need to be continuously retaught. “Not all the personnel issues disappear with outsourcing,” he says. “The turnover of [Price Waterhouse] people in the department is higher than it would be if we had our own staff. We try to make the lines disappear, and make the PW employees directly part of our team, but there are different pressures on these younger people just starting their careers within a Big Six firm.”

Of course, there are some advantages to gradual turnover among the outsourcer personnel. “Over time, you have the appropriate level of employee doing the compliance work,” he explains. “Too often in tax departments, people joined the company years ago to do a specific task, but became overqualified and overpaid for their contribution.” Flemming goes so far as to suggest that “in a way, it’s better for the tax professionals who fill our positions, because they will be able to advance more and move around more freely [within Price Waterhouse] than they would have at Cyprus.”

Not long ago, a midcareer tax accountant with no Big Six aspirations might have found that statement infuriating. But tax professionals the nation over are realizing that what is expected of them is changing rapidly, and they’re adjusting their expectations accordingly. So long as CFOs see cost, technology, and management advantages to outsourcing, those adjustments will continue apace.

OUTSOURCING AN AGE-OLD PROBLEM

One more issue to consider in the outsourcing- versus-reengineering tussle is employer age discrimination. “There are a lot of older, highly paid people in some tax departments who are not producing enough value for their companies. But if they’re laid off individually as part of a reengineering project, they may have enough of a case to bring age-discrimination suits,” says one Big Six tax consultant unwilling to discuss the topic openly. “As a result, CFOs and tax directors are looking at outsourcing the entire department as a potential liability neutralizer.”

But those fears may be slightly overblown. Employment-practices attorneys say that companies are certainly within their bounds to lay employees off for reasons of cost reduction or ability. Age only becomes an issue if there is a history or evidence of bias, either through comments or through assignments and training, that favors younger workers. “As long as the decision to lay off or outsource workers is based on legitimate business considerations and can be documented, then there’s not a liability problem,” says Michael Rosen, an employment and labor attorney with Foley, Hoag & Eliot LLP, in Boston. “But if a bunch of managers sit down and start complaining about ‘the old guys’ who won’t learn the new software, for example, then there’s a problem with bias.”

But besides documenting the business decision and avoiding biased thinking, some executives choose to protect their companies further by offering increased severance packages in exchange for waivers of liability from outgoing age-protected employees–that is, anyone at least 40 years old. But Rosen says that the waivers must be done in strict accordance with special federal protections for older workers, and must not be mandatory. And if benefits are also to be lost, “ERISA [Employee Retirement Income Security Act] discrimination”–the cutting of workers primarily to avoid paying retirement benefits– may come into play, he says.

One needs also to be wary if the compliance department is outsourced and then insourced a few years later. If only younger workers are hired back by the company, then older workers may have reason to sue. But, as Rosen notes, “Even with waivers, documentation, good practices, and everything, a company can still be sued. After all, this is America.”

TAX OUTSOURCING SURVIVAL CHECKLIST

  • Do your Homework. Review your tax- filing calendar and compliance responsibilities before negotiating to know how long the work should take.
  • Play Hardball. Negotiate the outsourcing contract to be as specific as possible as to which filings will be done for a flat fee and which tasks will be billed hourly. Push for a lower “blended hourly rate” if top partners won’t be doing all the extra work.
  • Be Kind. Treat the employees who will be leaving with respect, and compensate them fairly. Still, consider getting age- discrimination waivers from older employees.
  • Don’t Relax. Active relationship management is necessary to maintain service levels, potential idea generation, and clear billing for extra work. Communication is key.
  • Protect Yourself. Maintain some in-house capability (for example, a compliance manager) to ease an insourcing transition later if needs change, and to watch the outsourcer.
  • Avoid “Island” Thinking. Outsourcing is only one step in creating a world-class tax function. Data from business units need to be complete and accurate the first time; accounting systems need to be coded thoroughly to get the most from tax software packages–no matter who is running them.
  • Be Patient. Shifting the remaining “planners” into providing timely advice, strategic planning, and cash value to the company can take time following an outsourcing and the creation of new duties and patterns of work–often from 6 to 12 months.

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