Delegation / outsourcing / co-sourcing… still a strategic option?

The recent evolution of the regulatory and tax landscape as well as the considerable growth of various industries like alternative investment is imposing a reorganisation of several players. Going forward, we believe that delegation/co-sourcing will have an important role to play. But more than ever, entities will have to consider substance as part of their strategic reflection when setting up or reviewing an operating model.

With the right strategy, entities can still outsource a substantial portion of their day-to-day work especially when it relates to non-core function (e.g. preparation of specific reports, accounting etc.). The key will be to ensure a strong oversight on outsourced/delegated activities with strong governance and skills.

From a strategic standpoint, on the one hand, a key question regularly raised by entities is – “How and on what should we spend our time?” On the other hand, this question is directly linked to the choice of recruitment vs outsourcing. “What could / should we share with other players to ensure; 1) that either we access the right competencies outside instead of recruiting without having the entity size for it, or 2) that the local teams do not spend their time on aspects that are not considered core to the company?”

This is an article about delegation/ outsourcing and substance. In the current landscape, which is constantly evolving in terms of tax, costs, regulatory, reporting, tech, job market, etc., entities need to reflect on many factors in order to come up with the right strategy. 

The regulatory changes and how to prepare for them is a common theme on everyone’s lips. As an illustration, from a regulatory standpoint, AIFMD and more specifically the CSSF circular 18/698  or the recent “outsourcing arrangements” CSSF circular 22/806 (based on the related EBA guidelines) clearly imposed to rethink the outsourcing, its governance and the substance for management companies. On the Tax side the evolution of BEPS and more recently the draft on ATAD3 are, among other topics, defining principles to ensure that special purpose vehicles and other types of intermediary vehicules are showing the right level of substance and do not end up being empty shells. 

It boils down to what is the context of “substance” and what does this mean for delegation/outsourcing. It is a broad topic. The industry is influenced by many other factors that are pushing on substance. This is a trend that we see and it is one that is much broader than just tax. The key objective is to discuss the growing challenges around “substance” or the minimum proposed substance in an entity that has outsourced or considered the outsourcing of a portion of its activities.

What we think is that delegation for entities is still a viable option, but the strategic way it is being undertaken is changing all the time. Thus, entities need to step back, and make a strategic reflection on how to do things, because the times they are a-changin’ and strategies must change with them.  

With all this substance pressure, what options for outsourcing and delegation are we looking at? Companies are going to have to consider substance as part of their strategic reflection when setting up or reviewing an operating model.

It is about how and what you outsource (co-source) while still ensuring the substance lies with you. 

To consider: substance and reasonable options

We should maybe start with the concept of substance. 

Merriam Webster defines substance as “physical material from which something is made or which has discrete existence.” If we are talking about you, it is your very existence. You may have a robotic arm, you may have a pacemaker that keeps your heart ticking, but your brain – you – is what is driving the bus. 

Wait wait wait you are asking. What does this have to do with robotic arms driving buses? Well nothing, we just love analogies here at the blog. And we wanted to illustrate that substance itself is not such a black and white concept. 

Listening to colleagues and clients in the financial services ecosystem, what we hear is a lot of people talking about substance but in many different contexts. This is probably why the topic is so hard to pin down. Some see it from a VAT perspective, looking at tax and the application of double tax treaty, some are zeroing in on regulatory issues so they understand how to interpret and comply with the rules so they can apply to not be considered as an empty shell etc. 

Are they all talking about the same thing? 

Actually, when you look in a very micro way, narrowing in on the granularity of the details, there are differences. But, if you apply a macro view, it is all the same. Meaning,  are we – or maybe YOU in this case – as entities, in the driving seat of this bus or have we delegated so much that it might be considered as not (robust) enough? Because what you do not want as any entity is to give your substance away. You want to enhance it. That is the point.

What does this have to do with outsourcing/co-sourcing?

So you can see that this conversation around substance will force entities to take a much clearer look at their operating models and it may bring them more value in the end. 

So whether to outsource/co-source is only part of the question. And here, we end up with a list of  Dos and the Don’ts. 

  • 1. DON’T fully stop delegation/outsourcing/co-sourcing. ⇒This is not forbidden and still relevant in many cases, but it needs to be well understood and reflected on, even more so in this environment as we explained above.
  • 2. DO ensure that you have the right people doing the right tasks in the location of your company ⇒ This is important, but you also have to ask yourself if this is systematically sufficient? Because having many people might not be the right answer either. What you need is people who are making key decisions, have the required skills and are present with true empowerment. This is your substance.
  • 3. DO split the work internally and externally. ⇒ But make sure you do it appropriately, ensuring that the business decisions are taken by skilled and empowered entity employees as well as the selection and ongoing monitoring of any third party(ies).
Don’t delegate your decision making away

This is a little simplistic of course but these are things to consider. There remain excellent reasons for delegation / co-sourcing:

  • You are looking for expertise you do not have in-house and it would be difficult to recruit the profiles you need;
  • Some of the work is not part of your core business but still important and required;
  • You are not sure that you would be able to properly maintain the tasks through time because you do not reach the critical size (economies of scale).

In our opinion co-sourcing / delegation is a reasonable option. But how can you do it and not be off track with the upcoming tax and regulatory updates?

Take the time to take a step back and consider what the core activity of your company is. Reflect on the responsibilities and important decisions that will have to be made by the decision maker of that company. Ensure that you have the proper and skilled profiles to govern all this. Your substance is what is driving the bus.

Then define your way of working with others. As the main entity you are in charge of:

  • 1. Setting the working rules. The limits, accounting principles, interpretation of rules which might be vague, investment decisions etc. are decisions that would on average (difficult to make a global and generic statement that would work in all cases) be taken by people within the company;
  • 2. Identifying the right entity (or entities in the case of multiple tier structures) that you will work with and do a formalised DD;
  • 3. Defining clearly the rules for who will be in charge of what between the main entity and the delegate;
  • 4. Sharing with other third parties the preparation of work you will then be supervising (ongoing monitoring).

On average what we observe in cases that would either be requalified as empty shell or light substance is mainly about the proper decision process and its documentation. This is why it is crucial to have the right set-up in place and spend the required time on its documentation. However, having the right documentation should not be confused with the concept, “ Because I have a process and I’m documenting, that is enough.” It’s not.  You must maintain a set-up that remains robust and where the responsibility and the decision capacity on all key areas remain with the company.

Also, should you want to demonstrate true substance on a specific decision cycle, make sure that the people approving the decision within your company have enough time to analyse the decision, raise questions if needed, document their review and then approve. Otherwise it would quickly qualify as rubber stamping which does not bring true substance.

Our opinion / recent experiences:

Though we observe that a lot of questions are raised on substance, empty shell etc. we at the same time do not see a reduction in interest for outsourcing a portion of the day to day work especially when it relates to non-core function (e.g. preparation of specific reports, accounting etc.).

This is one of the main reasons why PwC Luxembourg continues to invest in our range of recurring services provision as our expectation is that the need will remain reasonably high.

However, doing this properly, though it has been really important in the past, is even more crucial in the current context to ensure that all the key questions have been addressed and properly answered. 

This means stepping back and thinking carefully about what your company’s core activity is. Reflecting on the responsibilities and important decisions of the decision maker of that company. And ensuring that you have the proper and skilled profiles to govern all this. 

The final challenge then pertains to the potential increase in recruitment of the right people with the proper experience and the right skills in Luxembourg. Shouldn’t we think of ourselves as a community of experts and share our knowledge and materially invest in training more people to support this evolution?

What we think
Benjamin Gauthier, Advisory Partner, Managed Services Leader at PwC Luxembourg
Benjamin Gauthier, Advisory Partner, Managed Services Leader, PwC Luxembourg

We are conscious that documenting, challenging a third-party on an ongoing basis, and being fully involved in the day to day relationship with the third party to take material decisions is sometimes seen as a burden. But it’s the right strategy if you want to properly demonstrate that— although not everything is done in house or locally—there is a clear set of responsibilities and core functions for the entity and they are all duly managed with a strong governance and strong skills.

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