How and when to outsource in business today

Outsourcing is one of the most misunderstood terms or rather misused terms in modern business practice, merely because no-one really defines what they mean by it nor why they think they may or may not need it. Commonly, outsourcing is used where the process to be outsourced is ‘not core to the business'. If this was a true statement then there would never have been buy or build solutions in the first place. The fact is that this reason is completely spurious. Whatever is required to understand what a customer wants and get it to them for a profit is, by definition, core to the business. The reality is that outsourcing is more often applied to an activity or process that no-one can be bothered to spend much time on, isn't seen as ‘exciting' or that the firm is just so inefficient at that some third party can do it cheaper. This may seem like I'm not a fan of outsourcing - quite the contrary. It is just that I see more outsourcing deals done for the wrong reasons with the wrong set of benchmarks than I do almost any other business activity. While there are two broad categories of outsourcing, IT and Business Process, there are usually only three reasons given for outsourcing in financial services.

There are some areas of bank operations which, while they may be core by our previous definitions, are nonetheless extremely complex and expensive to undertake. These are also the ones which an FI finds it most onerous to be competent in. To take a wholesale banking back office example, making sure that the net results of corporate actions such as dividend distribution are dealt with effectively includes attention to international taxation of such instruments. This is an extremely manual, but expertise-intensive process. The effects of lack of competency (as opposed to incompetency), are loss of investor return, potential liability and risk because clients who are entitled to be taxed on income at treaty rates (typically 15%) are very often taxed at statutory rates (sometimes as high as 35%). Best practice requires relief at source, where available, to be obtained for the benefit of the client so that he has maximum funds from day one. Some countries have ‘accelerated' recovery processes and failing to meet the deadline can result in a ten-year wait for client money. Some security types, such as American depository Receipts (ADRs) have no direct reclaim possibility, only indirectly on the underlying shares and through the sponsoring bank. Some investment vehicles are transparent to tax authorities and reclaims may be missed if confidentiality keeps broker income streams and client identities separate. Some methodologies are transparent to tax authorities, so brokers who claim title to securities may think they are entitled to apply treaty rates, when foreign tax authorities will disagree and penetrate title to beneficial ownership. All this demonstrates the need for extreme competency and deep knowledge. Outsourcing becomes logical because it is the primary focus of the partner and all its expenditure is aimed at this one objective.

There are around 200 countries in the world, each may or may not have a treaty with other countries for the avoidance of double taxation. For each of these country pairs there are a number of types of investor and a number of types of income, any combination of which can result in a different rate of withheld tax and treaty entitlement. The date on which the income is distributed also affects the entitlement, and other factors increase the complexity further. The number of permutations is over 40 million. The in-house cost of recovery, for any fund with multi-residence members or custodians with broad client bases, will be prohibitive compared to the number of likely reclaims that will be generated. A good outsourcing firm succeeds because its business model leverages economies of scale across the whole process. In the last twelve months the largest outsourcing firm in this area processed nearly two million tax reclaims. At that level, the focus of research and investment buys a greater assurance of success compared to what they could deliver on their own. Cost reduction This is the number one reason that firms consider outsourcing. However, while important, it is not usually the number one concern of firms that understand the value of withholding tax. The big benefit that delivers cost reductions is in the removal of hidden internal processes. Even if you have a software system, some significant proportion of the process is manual, and, for financial services as we all know, manual is bad. Outsourcing allows firms to convert a costly, semi-manual error prone process into an STP, Straight Through Processing function. In a well-benchmarked STP environment, clients send a file one way and receive funds and reports electronically in the other direction. And from their viewpoint, that's pretty much all there is to it. All the manual elements of the process, indeed, all the elements of the process, are opaque. Information flows one way, money flows the other way and that's exactly what fund managers, custodians and investors like.

Outsourcing also usually brings up issues relating to the degree of cost comparison. Because an outsource solution is ‘packaged' to make the purchaser's life easy, its often compared to an incomplete internal cost comparison. So, essentially, the people doing the cost comparisons fail to include everything and therefore the benefit is not as great as it should be. It is also common at the other end of the scale to miss out on issues relating to integration of outsource servicing and replication of effort. Typically firms will have to engage the above costs in advance of seeing the return (which may or may not be financially visible) whereas outsourcing can usually be achieved by being billed for a service in arrears. Replication of effort in this scenario comes from the fact that the bank concerned had obligations under regulation to hold certain documents about their clients and keep information, both of which are needed by an outsource provider to do its job. So there will be a level of replication where the tax provider uses documents and data locally to do its job and those documents and data are needed at the outsourcing institution to meet its general regulatory requirements. This doesn't mean that outsourcing is the wrong way to go, quite the reverse. It does mean that you have to be clear about areas of overlap and how they will be handled to maintain integrity on both sides.

If you can't produce an accurate assessment of a client's recoverable tax or eligibility for relief at source correctly the first time and every time, you stand a good chance of falling foul of regulatory compliance. How many headlines have you seen in the last few years of heavy fines being issued for failure to keep and maintain accurate client records? It's these very records that underpin the assessment of eligibility. The idea of outsourcing a function to minimise compliance risk may seem paradoxical. However, the number of regulations now in force that evidence some sort of extraterritorial jurisdiction gives corporate actions departments and compliance officers, nightmares. Outsourcing,in a functionally selective way, can actually reduce the burden on compliance and operations departments by releasing them from some proportion of concern over whether they have their structures integrated and monitored. It then becomes the job of the outsource partner. The benefit is that the accuracy of the underlying data is critical to the outsourcer's business, because it is its only focus.

Financial services firms face two corporate governance issues, not one. Their own governance, usually overlooked by regulatory authorities, and the corporate governance of their clients. Investors are becoming increasingly activist and holding their investments long as the balance in yield strategies changes. The result is that more are receiving dividends and being overtaxed. Typically, two institutional investors with different residencies may be taxed, and therefore overtaxed differently. If the CFO of the invested company does not take action, his investors lose money. Similarly, if the custodian fails to act, the investors may lose money. The publication in 2003 of proxy voting policies on probity in withholding tax evidences the pressure on the investment management chain to demonstrate that everything possible has been done. Investor concerns should make custodians and fund managers consider outsourcing more strongly to demonstrate best efforts on behalf of their client's underlying shareholders.

Most relationship managers would happily enter a pact with the devil if they could get a legitimate and clear service advantage in the market and withholding tax is one such. Unfortunately, when taken at the fund management or even custodian level the internal costs are so high that profitability is difficult to achieve; so many either don't address withholding tax at all, or do so inconsistently, or have policies which disenfranchise some clients. Outsourcing allows the creation of a profitable withholding tax service which is complete and inclusive for all clients and converts a fixed internal cost into an external, variable and contingent one. This is an area I come across frequently. So many front office relationship management staff do not appreciate what goes on in the back office that they do not identify key advantages for their business. Similarly functional managers in the back office are usually so focused on the complexities of their own functions that they fail to communicate these advantages effectively through the chain. From a technology management viewpoint, one of the key tasks should be to identify those aspects of an outsource supplier that are benefits to the market. In this case, the outsource supplier's own benchmarks far outstripped the bank's simply because the vendor had the benefit of much greater volumes and could therefore deliver faster recovery of taxes with more certainty of time frame. This placed them, even though they outsourced the function, at the top of the rankings for tax processing within their market vertical - a clear market advantage.

Spend your time finding out whether you can trust your potential partner and not whether you think his process is better or worse than yours. Trust is built up in a number of ways. What's the financial position of your partner? Who uses them?

Take up references and pay attention to the tone as well as the words used in references. That's all ‘head'. Now add ‘heart'. What does your partner put back into the industry and into your business in particular? Is he looking after your interests and your clients' or just processing data? How does he go the extra mile?

Trust is the key that opens the door to successful outsourcing. Make sure your end result is as STP as possible by making it all about file transfer from your viewpoint. This can be achieved in less than half an hour with good client IT support. It is because if your partner is processing over a million reclaims a year, they have to be able to do that, it is their business to make the transition smooth and efficient. The result the client sees is electronic files out and money and electronic reports in. These are lessons at the granular level and are repeated at several points during this article, because they are fundamentals of technology management when dealing with third-party suppliers of any kind. In my view contracts are important but trust is more important. Contracts are after all, essentially a codification of what happens when things go wrong in a relationship. I've very rarely found the need to use contracts in this way because if you develop a good relationship with a supplier you can usually pick up the phone or meet to resolve issues without recourse to the contract.

While withholding tax is a seasonal business, outsourcing takes only a few weeks to implement. Full transition (the big bang) can of course be done between dividend seasons to allow the same stabilising process, but given that the result is essentially a data feed out and account credits in, there is actually no reason why big bang cannot occur at any time. This is because of Statutes of Limitations. If initial analysis shows significant sums about to fall out of Statute, big bang is not only feasible, it is also preferable to avoid potential liabilities later on. Whether big bang or phased introduction is selected, the Statutes typically give several years in which reclaims can be filed so that whatever is handed over is not usually mission-critical. Having said that, best practice benchmarks this activity at less than two weeks from notification of income to filing of tax reclaim.

How and when to outsource in business today

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