The economic environment that the world has found itself in over the last year or so has had an impact on all businesses and individuals. In particular, the term restructuring seems to have risen from the ashes to become the new term of choice.
This is not to say that restructuring has not been a legitimate and well used term in the past, but in a recession people in general do not want to be seen as "insolvency experts' and now seem to be referred to as restructuring or turnaround specialists.
Aside from of the terminology used to describe our work, the truth is that in tight times businesses have to tighten their belts and consider the best'way in which to maintain their operations going forward.
This paper considers that various issues that need to be considered when restructuring a business and highlights some of the pitfalls that people can fall into if not exercising proper due diligence.
1. Grounds for Restructuring and Planning
Reasons for the change
Businesses often find themselves having to restructure their operations when funds start to run low and they find that they can no longer meet the demands placed upon the business.
Unfortunately this is often at a time when it is too late to be restructuring a business. The indebtedness is at a stage where the restructuring is in effect an administration of the debt without the need to appoint an administrator. Options are also limited at this stage and therefore the ability to make appropriate changes might not be available.
Businesses should as a matter of recourse consider the structure of their businesses at least every 6 to 12 months. This might seem like a tedious task, but proper diligence in this area will spare later issues that arise when the economy does not support ineffective business practice.
Before any business considers the need to restructure its business it should consider the reasons for the restructure. This, apart from planning, is the most important part of any restructuring process and needs considerable time and effort. If the business is already in financial difficulty one would think that the reason for the restructuring is pretty straight forward, i.e. get the business back into a liquid state.
However, the problem with this as a basic approach is that if the issues that have got the business into difficulties in the first place are not addressed the business will find itself in the same position in the not to distant future.
We often forget that all businesses have areas that could be improved or have become out of date and/or have lost their ability to become productive. In good times the inefficiencies of these areas are supported by the effective areas of the business, which therefore does not expose the weaknesses as much. In rough times however it is these areas that will end up dragging the business down.
If a business is serious about restructuring, there are a number of issues that will need to be considered, such as staff, integrity with debtors and creditors, a possible structural change and the general stress that comes with such an exercise. It is therefore important to consider what the reasons are for this activity to go ahead and ensure that it is not all in vain. It is my position that at present most businesses that restructure themselves are doing so to raise capital. As such, they are not rectifying the issues that the business has but are rather shuffling the books around to show a better position than that which is really the case.
After considering the reason for the restructure the next most significant item is to plan the restructure and proposed changes that you are going to make. It cannot be stressed enough how important reason and planning are. A business could find itself working through these two stages for a month or two and when the decision is ultimately made to proceed the actual restructuring process could in itself take less than two weeks.
As a starting point a restructuring process has three main elements to consider: the nature of the restructure, the staff and the "customers" of the business.
The first two elements, structure and staff, are elements that require time and possible additional communication. The third element, "customers" refers to all debtors creditors and clients and refers to the part of the business that needs to be maintained in a stable position so as to ensure that the business is viable moving forward.
The need to understand these elements is essential to determine the first part of the planning stage, namely "the process for and period of the restructuring". Any restructuring is going to take time and energy, this will be time and energy spent on something that although able to provide dividends in the end, will take away from your ability to earn income at a proper capacity while the restructuring is taking place.
Furthermore, the more time wasted on not getting things right means less income for the business.
Proper planning of the process and period of restructuring also enable you to consider costs for the third stage of the planning process, discussed below.
The second stage of the planning process is to obtain a full list of assets and liabilities. This will give you a good understanding of what position you believe the business to be in, contrasted with what position it is actually in. An example of how important this part of the planning is can be illustrated with the following example:
Company A is a small to medium size enterprise that has been in business for 15 years. Over that period of time the business has amassed a large amount of assets needed to operate the business. Company A has however fallen foul of paying its PAYE and GST. It approaches the IRD to consider a payment arrangement and a copy of its financial documents are requested. Following normal accounting practice Company A has been depreciating its assets according to the depreciation schedules. The financial records therefore show that Company A has assets of$2.4 million. The IRD cannot understand the need for the company to enter into any arrangement and requires the company to pay the outstanding debt of about $200,000 immediately.
Closer consideration of the asset schedule shows that most of the assets shown have little or no value, such as a 1995 printer with an alleged value 14 years later of approximately $2,000. A proper analysis of assets would have shown that the actual value of most of the items in the asset schedule were of little or no value. As it turned out the actual value of the assets in Company A's asset schedule was calculated as approximately $300,000.
Completing the second stage of the planning process in a robust manner will therefore provide you with a more appropriate appreciation of what assets you have that still have value, and secondly will provide you with an indication of what assets, if any, you would be able to dispose of therefore realising some much needed cash in hand.
As much as it is important to understand the assets that you may have available to the business, it is also important to consider all of your liabilities. Understanding the business' liabilities are important in determining which of those liabilities can be reduced thereby freeing up some of the business' cash-flow.
The third part of the planning process is to complete a pro-forma balance sheet for the business following the restructure of the business. This exercise allows you as the owner to consider what you deem the effects of the restructure will be. This part of the planning process will need to take into account the period during which the restructure takes place and consider any variables, such as the effect that the restructure will have on the business, and staffing issues.
Although not being able to take all variables into consideration, preparing a pro forma account at least allows you to consider whether further changes will need to be taken into account.
The fourth part of the planning process is to consider and plan future activities and limitations that the business might have going forward and once the restructuring has taken place. This includes reviewing the business structure and considering whether the planned changes have had the desired effect.
2. Specific Issues that need to be Considered
When planning for a restructuring there are a number of specific issues that need to be considered. These issues range from the structural changes that you might want to make to the business to communication with "customers". In this part of the paper I will consider some of the issues that will need to be considered and are crucial to the restructuring being successful.
Scale of Change- Structural Changes
The scale of the change is one of the largest items that need to be determined when conducting a restructuring of a business. Often a restructuring of a business is only an internal exercise which will require a change in the management structure of the business or close a particular operation, on other occasions it will require the transfer of the actual business from one type of entity to another and this requires more in-depth consideration. For purposes of this paper I will refer to the two types of restructuring as internal and external restructuring respectively.
Both internal and external restructuring require a business to consider the changes in management, changes in operations and changes in staff.
Changes in the management structure usually require a business to look at reporting responsibilities and accountabilities. It is important to ensure that all parties that are part of the senior management structure will have sufficient responsibility and accountability when conducting their roles.
Determining the scale of change can only really be determined once you have considered and agreed on the reasons for the restructuring. Once the reason for the restructuring has been properly determined, consideration will need to be given to whether the business wants to change the type of entity that is conducting the business from, or alternatively sell the business to another entity of the same nature or make the changes without considering a sale or change of entity.
When considering the scale of the change you will need to consider the proposed costs of the changes and the commercial and tax effects that the change will have on the business.
External restructuring requires the additional requirement of having to consider the possibility of a different structure being used for conducting the business. This type of restructuring can arise for various reasons, such as asset protection or a change in the shareholding of the business.
When considering the type of structure that the business will be operating from, you wi11 need to consider not only the reporting requirements and robustness of each structure but it is also important to consider the tax efficiencies of all structures. I will be discussing some tax consequences of restructuring later in the paper. It is however appropriate to deal with tax efficiencies of a various structures in this part of the paper. Various structures to consider when considering an external restructuring are:
- NZ Resident Companies
This is the most commonly used entity to conduct a business activity in New Zealand, because it provides its shareholders the protection of limited liability. As the company is considered to be a separate legal entity under the Companies Act 1993, the company itself and not the shareholders, owns the assets of the business and is party to various contractual arrangements and liabilities.
Companies also allow a clear division of the ownership of the company without affecting the business of the company. As a separate legal entity, the company is taxed at a fixed tax rate of 33%. Any distributions to shareholders will require a separate payment in the form of a dividend and this separate payment will be taxed at the tax rate of the shareholder. There are some exceptions to this general rule, but these will not be discussed any further in this paper.
For the purposes of this paper, it is however important to note that there are certain rules regarding the continuity of shareholding in a company. This continuity of shareholding can affect the tax losses available to the company. I have discussed this aspect later on in the paper.
- Qualifying companies
A qualifying company is a tax entity and is not separately identified in the Companies Act 1993. Closely held companies may elect to become a qualifying company if certain eligibility requirements are met, these include having five or fewer shareholders during an entire income year, each of which must be a natural person or trustee of a trust which distributes all dividend income to beneficiaries as beneficiary income or a qualifying company.
To all extents and purposes qualifying companies are treated in the same manner as any other company, except that the shareholders are personally liable for their share of the company's tax liability if the company does not pay it.
If the company is going to make losses, the qualifying company can elect to become a loss attributing qualifying company (LAQC), which allows the losses incurred by the company to be attributed to the shareholders, who can in turn offset the these losses against net income received from other sources.
Despite perceived advantages if the company is going to make losses, there are some potential disadvantages such a the election tax that has to be paid when becoming a qualified company, shareholders accepting personal liability for the tax liabilities of the company, the inability to offset net incomes against losses of a non-qualifying company and restriction on ownership therefore restricting possible growth.
If the business being restructured is a qualifying company, or there is a change in the shareholding, all requirements have to be met within 63 days or the qualifying status will be lost.
A partnership is not treated as a separate legal entity, as all income and deductions are treated as income of the partners, apportioned according to their share in the partnership.
The introduction of limited partnerships now allows for a entity to be formed that has a legal personality that is separate form its partners. A limited partnership must have at least one general partner and one limited partner.
The general partner has the same rights and obligations of a general partner in an ordinary partnership, but the limited partners' liability is limited to the extent of their capital contribution, provided that they do not participate in the management of the business.
Partnerships have a flow through effect, with the partnership filing tax returns and each partner being liable for their proportion of income tax and able to deduct its proportionate share of allowable deductions of the partnership.
Section HG2(2) of the Income Tax Act 2007 does contain some anti-streaming rules which determine, to an extent partnership income, tax credits, rebates, gains, expenditure and loss to each partner based on their share in the partnership's income.
Exit form the partnership by one of the partners could result in a taxable gain due to the sale of assets.
Like partnerships, trusts are not regarded as separate legal entities. Because of this trustees are generally personally liable for all the trust debts unless liability is specifically excluded.
Unlike company directors, trustees have specific statutory and fiduciary duties that are more restrictive and onerous which tends to restrict their willingness to engage in any risky investments.
Trusts are taxed at 33% but losses cannot be distributed to beneficiaries.
Trusts are best used for asset protection and are not generally used to trade, although specific trading trusts can be established.
- Employment issues
The most difficult area of consideration during a restructuring is staff and whether there will be a need to make certain positions redundant and therefore either having to offer alternative positions or "dismiss" part of your workforce.
Again the importance of the reason for the restructuring will feature in considering how to deal with any staffing issues. What is important is that an employer does not use an economic downturn and the redundancy provisions to "dismiss" staff that should have been dealt with by using normal disciplinary procedures.
Redundancy is regarded as a no fault termination of employment. The position is therefore redundant, not the person. Before considering making any part of the workforce redundant you need to consider the cost implications of having to rehire staff when times get better. Making staff redundant will cut costs quickly but may not be the best long term solution.
There are a number of other alternatives that need to be considered if obtaining a better cash flow is what the business needs. These include:
- Directing staff to take accrued leave
- Offering unpaid leave
- Sabbaticals or study leave
- Agreed reduction in day/hours of work benefits
- Agreed deferral ofbonuses
- Wage/salary freeze
- Job sharing
- Recruitment freeze
If you are going to make staff redundant, there are a number of statutory obligations that are placed upon an employer by the Employment Relations Act 2000 ("ERA"), especially the obligation to act in good faith, which includes requiring an employer not to act in a misleading or deceptive manner.
1. The ERA places both substantive and procedural obligations upon an employer, including providing an employee with access to information that is relevant to the continuation of the employee's employment and providing them with an opportunity to comment on the proposed position before any decision is made.
The substantive obligation placed upon an employer, requires the employer to show that the termination can be justified as a basis of promoting greater efficiency. To this extent an authority could inquire as to the genuineness of the employer's decision.
2. The Court of Appeal in Hale found that a redundancy could arise from normal business reorganisation. This indicates that the Courts will generally not interfere with the business and commercial judgments of an employer. The area which has the most focus therefore during any redundancy procedure is the procedural obligations placed upon the Employer. The Courts have consistently provided that, regardless of the economic justification for redundancy proceedings, any redundancy dismissal must be done in a way that is procedurally fair.
3. The most important part of considering any arguments regarding procedural fairness is the amount of consultation that the employer has with the affected employees. To ensure that this procedure takes place the ERA has now made it a mandatory requirement where an employer proposes to make any decision that will have an adverse effect on the employee's employment.
4. Before any redundancy dismissals can therefore take place, the employer is obligated to provide the affected employee with access to information relevant to the continuation of their employment and an opportunity to comment on the information before the decision is made. The employer is however not required to provide confidential information when there is good reasons to maintain the confidentiality of the information.
Other procedural issues that an employer needs to consider, besides adequate consultation, are a fair selection process (if downsizing) and offering counselling and outplacement services, advice of right to legal representation and support.