Rebecca Archer
Welcome to the third season of Navigating the New Normal, Grant Thornton's podcast exploring trends in business and the marketplace. I'm Rebecca Archer, and today I'm joined by Michael Catterall and Lorena Sosa, Tax Partners at Grant Thornton Australia.
Australian retailers significantly bore the brunt of COVID-19 these last two years, from lockdowns across the country to the pressures we've seen on supply chains and distribution, manufacturing, changing buying behaviour and expectations, even cash flow. Successful retailers, in fact, entrepreneurs generally, must look at a multitude of ways to increase market share against a backdrop of ever changing, unpredictable dynamics.
With a population of around 20 million people in Australia, the natural progression for high growth companies in increasing their market share is to expand overseas and tap into new markets.
Welcome Michael and Lorena.
Rebecca Archer
So Australian retailers are finding new markets. Is the world their oyster? Or how does a retailer decide which international markets they should choose for their products?
Lorena Sosa
In terms of Australia, there's a lot of experts that say that if you can reach it in Australia, you can reach it anywhere. Because a successful international expansion depends a lot on reducing uncertainty as much as possible and we are geographically located at the end of the world, so logistics are expensive; the cost of retailing is expensive. And we also have another very specific quality about Australia, where it is a very cosmopolitan place. So it's like running a big focus group in a small jurisdiction. So a lot of retailers, global retailers, actually come to Australia to test products and also test the profitability of the business because, as I mentioned, rents are expensive. Wages are expensive. Geographically, it's very costly. So if you can make profits with retailing in Australia, it is understood that you could sell and be profitable anywhere. So that's when we're talking about Australia.
But then what happens when we are attempting an international expansion is there is a pressure to grow. 60% of the small businesses want to grow and expand overseas, but generally this comes as a result of a big contract or a big opportunity that companies feel as though they need to act quite quickly on, and normally they go directly into thinking about this opportunity and wanting to scale straight away, and the danger of doing that is that it can become very costly if we don't really follow three easy steps that are very basic in any business plan. But at the time of expansion, people forget, and it's really about planning the expansion. There's there has to be a lot of work around planning. Then it's around implementing the expansion, the international expansion, and then scaling. What we often see is people go from nothing, to wanting to scale the business quite naturally, and that's where there are lots of costs, hidden costs, and if they are not planned correctly, then that could wipe out the value of a business from 30 to 50%. Because once you expand and if you expand under the incorrect premises, then it can become very costly very quickly, and the likelihood and we’ll talk later or more about the research. But there is research about four key elements that actually make an international expansion successful and often, businesses fail in those four key elements of planning, and then they need to close some business. And that could really.. like, you expand because you're trying to increase value, but you end up losing 30-50% of your business.
Michael Catterall
Even for successful mature Australian retailers and they've been successful here and we're hearing that if they can be successful here, they can be successful anywhere. It's very far from the world is their oyster. Even the world's biggest companies, most established companies, really need to be selective about which markets that they go into, and it really is a case of if you fail to plan, plan to fail. Lorena you were saying about think about product suitability. Do I have something which is going to work well in a particular market? But then also think about the complexities and costs associated with your chosen market? There's a huge difference, even if you've got a product that is going to work well anywhere in the world. There's a huge difference between, say, going into New Zealand, which we see a lot of our clients, a lot of businesses doing as a bit of a testing ground, but also an opportunity to extend effectively their Australian business, versus going into maybe towards the other end of the scale, going into somewhere like China, and there really is a important risk/reward calculation to be done. New Zealand, while a lot of businesses have a fantastic business level of profitability in New Zealand. It is a small market, undeniably so. Why do Australian businesses go into New Zealand? Geographical proximity, cultural similarity, language, legal system, tax system? All of these sorts of things make the chances of success in New Zealand relatively high compared with many other places. But then you are addressing a relatively small population, small market.
Towards the other end of the scale, somewhere like China, enormous population. So the rewards are potentially very high if you can be successful there. But again, we've seen the world's largest companies in many instances not managed to be successful. And there are many reasons for that. It's a language barrier to overcome, cultural differences, regulatory hurdles, unfamiliar legal system. All of these sorts of things can come into play. So important thing is, think about where is your product most likely to succeed? But also where are you most likely to succeed, given that particular jurisdiction’s inherent complexities?
Lorena Sosa
And on that point, Michael, I think going back to our original point, is just understanding what is your market, and at what point you should expand. So in terms of that concept of trying to scale straight away. The issue is we normally as humans, make the decision on aspirations. We think China is a huge market, therefore, that's what we aspire to do – conquer a market with a lot of potential. But the first step, which is the first step to a successful international expansion, is actually understand the market and understand your product in the context of that market. And in doing that, for example, going back to your example in China and the complexity. Yes, it is a great market. And then you need to understand that for the Chinese market, it is very likely that you're going to have to localise your product to fit the market. Because China has very different and complex regulations, it has an entirely different social media and marketing system, and it has a lot of regulatory differences for example, currency control and the types of licences to obtain to be able to market there.
Therefore, when you're thinking about an international expansion such as going into China, your business model needs to be designed to cater for that, which means very likely you're going to have to establish operations in China and have a local person ground them because it is going to be very difficult that internally, you have a person that knows the brand that also knows the market at the level you're going to require. And having to establish in China is going to bring costs associated with that, and also a lot of planning around the types of licences you need to obtain, and the types of permits and your international taxes structure as well.
Michael Catterall
We’re mentioning China a lot, not because it's the only market. The US is the other very large market that we see a lot of retailers trying to break into. But China is somewhere that a lot of retailers have some level of familiarity with. Because China is almost inevitably in so many retailer’s supply chain it's very different from then setting up a business. There first is having somebody else, a third party basically, run everything for you as an outsource in terms of doing your manufacturing.
Lorena Sosa
And in those instances, the brand knowledge becomes secondary to the market knowledge. So we have the other end of the spectrum where we may have circumstances where you should customise your product to a global audience. It doesn't matter in which country this global audience is located, and one good example of this is luxury products. Your demographic for luxury products is going to be very similar across the world. So in that instance, it is very likely that you're going to need an internal person that knows the brand well and knows how to market the brand well. And it's not going to be so relevant to have a local person that actually drives the business.
And why do we mention these differences? Because that brings us to the second point in any key, successful international expansion, which is finding talent. It is not the same if you are going to have to find talent for a local person in China that is going to drive your business, as opposed to the talent you're going to require to drive an international expansion for a luxury product. Because in that instance, it is very likely that that key person is going to come from your own company, somebody that knows how to market really, really well.
And that has a consequence of the type of company or set up that you're going to have, from the regulatory perspective, what employment taxes you are going to have to pay in the local country. And how do you need to set up your logistics? Because then the next point about whether you're going to be successful or not is actually logistics; good logistic setup and system and a good invoicing system. Because often Michael, we find a lot of issues around the set up and the invoicing, particularly around taxes like sales taxes and VAT.
Michael Catterall
There's a lot of those hidden costs associated with doing business in another country, which goes back to our original point around the importance of planning and getting good advice, because there's a lot of some of those costs that happen locally that we may not be familiar with from an Australian perspective. So U.S., for example, which just mentioned sales tax is an area where businesses can come unstuck because they think that they're just selling to customers in the U.S. and then trip over this nasty thing called sales tax, and then discover that they haven't registered when they should have registered and can run up large historic bills, unknowingly.
Lorena Sosa
And often not even having a set or a lot of clients, or I'm just selling by Amazon. I should not have any taxation obligations because I don't have a presence in America. And unfortunately, countries constantly are changing their tax system. And recently there has been a change where the sales taxes threshold is determined not by an entity having operations in America, but it is determined by the amount of products you actually sell to each one of the states. And it comes to a surprise because all of a sudden you're trying to sell your product via Amazon and Amazon actually will stop your operations unless you have an accounting system that is actually able to calculate how much product you're selling in each one of America's States. And this change only happened two years ago, not longer than that.
Michael Catterall
Which can make it pretty difficult to make long term decisions about how you structure your business. If you're operating in an environment where the rules are changing quite quickly and we are operating in an environment where tax rules are changing quite quickly
Lorena Sosa
Exactly, and the concept so what would you advise people that are looking into, obviously expand overseas and have that set up or have that planning at the outset?
Michael Catterall
It depends on what people's sort of short term or mid term ambitions are. A lot of retailers set out by doing the e-commerce selling to customers in another jurisdiction, and that works really well in terms of testing the market. It's limited cost and complexity, limited incidence of local laws, including tax laws taking a piece of the pie. But if the intent is to scale up significantly, then generally that sort of set up is not going to be suitable for a larger, more mature business. And then it's appropriate to put in place something that's going to be more sophisticated. It is going to be more complex, but making sure that your structure remains proportionate in terms of its complexity and costs for the size of a business that you are looking to achieve. So there is a bit of luck, as well as planning, around setting up a structure that is suitable for the business you're going to have not just now, but in two years time, three years time, four years time. Keeping in mind always that there is a chance that your business may not follow the trajectory that you hope and plan for it to do. Maybe it will scale up more quickly if you're really lucky, and in many instances we know going overseas carries with it some level of failure, however well you plan. So you need to be ready to unwind your structure if necessary, and think about some of those costs that you're putting in being some costs. There is the opportunity to grow your structure. Complexity of structure, sophistication, cost of it, with your business. By doing that, dipping the toe in the water through selling into the country through e-commerce, maybe then having somebody on the ground doing local marketing and so on. And then, over time, transition that into something where you've got a separate legal entity, typically accompany in that jurisdiction where you can then ring fence that business. Everybody understands how that that company is then going to be treated for regulatory and tax purposes, and then that really gives you the structure that can scale up to whatever level.
But that's not to say that every larger business has to have a company in a particular jurisdiction. We know that many retail businesses sell huge quantities very successfully, using eBay and Amazon the like with no local presence in the other jurisdiction.
Lorena Sosa
I agree. And I think one of the key points is never forget the customer experience. Um, now we have the advantage of algorithms, and one of those advantages is that we are able to understand what happens when you don't get it right. And around 68% of, um, customers never return to buy into a business when they have a negative customer experience and a lot of your international setup. It's the key element that brings that good customer experience or that bad customer experience. One key example is payments. Your setup needs to be able to support international payments. Around 70% of people browsing on websites abandoned the cart when international payments are not supported. And international payments often are a function of setting up an entity in a jurisdiction because this international payments setup are connected to bank accounts, and in some countries you cannot set up a bank account unless you have a local entity. Or you can do it, but it's going to become very costly through merchant fees, and that could also wipe out the profitability of the business. So everything needs to be designed in a way in which we can deliver a good customer experience, thinking about market knowledge as the first point, logistics and invoicing, including payments as a second point, where to find talent, and what are going to be those regulatory costs and the maintenance cost of our structure. And if we can hit those four key elements, then the statistics and the research says that the international expansion is going to be successful.
Rebecca Archer
So you have obviously worked with some great Australian brands who have successfully expanded overseas. Expanding overseas, as you've just pointed out, is a highly complex process, even for the large, well-funded multinationals. When companies are considering an overseas expansion, what is the best structure to consider? Should they go through a subsidiary process, for instance, or a third party distributor? What would be your recommendation?
Michael Catterall
Setting up a subsidiary company is usually a very straightforward process in terms of setting it up, but we would often advise that that might not be the appropriate structure if there isn’t absolute clarity around the longer term success of the business in a particular jurisdiction. So if you don't have a tried and tested market or you’re not familiar with that that country, then that may not be the appropriate way to go. Because if there's failure, then you need to unwind a legal entity rather than simply pull out and stop doing business there. And we've seen that end of things reasonably frequently, where we've had to help companies to unwind processes. And it can be a fairly lengthy process because the company needs to be liquidated or wound up so that could be a 12 month plus process and is subject to the rules of that local jurisdiction, which may not be familiar with in terms of getting it cancelled. Because if you don't cancel the company, then it may continue to be subject to rules and regulations subject to compliance requirements and so on. So it's easy to set up. It's actually probably a bit more difficult to get rid of. There is a halfway house, which is to operate effectively as if you are have a company, but via a branch.
So a branch is typically where you don't have a legal entity, but nonetheless you subject yourself to a lot of the typical rules, regulations and taxes that might be associated with the company. And the way that it might be helpful to think about that is in Australia. There has been a lot of alignment, particularly the tax laws around, whether you have a branch in Australia versus a company's, so that that choice as to whether to have branch or company, tends not to be a tax driven choice, which is the right way to think about it. In fact, a lot of these questions are not tax driven choices, or they shouldn't be, because you end up in a position where you have equality between of treatment between these two different types of entity. The benefit of a branch is you don't have to then go through that liquidation or unwind process is quite the same extent as if you do a company. But it's important to realise that often you will be subject to many of the same laws, including tax laws, as if you did set up a company. Where I do advise less against setting up a branch, and more towards setting up a company, is where we know that there's going to be that long term business in a particular country. And there might be uncertainty around whether you, in fact, have established what's considered under the local rules to be a branch. An example of that might be where you send a marketing person over. So you're having quite good sales through eBay or something, and you put somebody over there to help with the local marketing. It's not the easiest question to determine whether, is that a branch? Have I really established a branch? Am I going to be taxed as if I was a branch or a company, or what regulations am I going to be subject to?
What if I then put another person there to look after the local finance and maybe another person to do a bit more marketing? At some point I may have gone from not that different from selling to a country and not subject to local taxes and so on, to gradually moving towards oh, now I've got a branch. But at what point is that? Did I have a branch last year? What about this year. Did I miss filing a tax return last year? So there's a bit of grey when you when you do it that way. But it's a good way of testing the water. So it's horses for courses, of course. And like every good tax person, and I say it depends.
Lorena Sosa
And you could also think about acting through a third party entity. Maybe you get an agent and you have the agent to operate your business. But you also need to think about how much you want to control the customer experience. And often when you resort to a third party agent, you cannot control that customer experience, which, as Michael was indicating before, the key is not to have tax driving decisions or economics driving decisions, but having the customer experience driving decisions. So in that particular point, it is important to think, what's the customer experience that I want to give, obviously, my international customer and how much budget do I have for this expansion? Because often we find that you have to have capital for around two years of operations internationally before the operation is successful, and that's so much how much budget you need to set aside to support the operations between 2 to 3 years, and you have to be prepared for that. Otherwise, as we mentioned, the winding up of that business not can only make you lose money, but also can have the impact of reducing the existing value that you already created in Australia, for example.
Michael Catterall
And in some countries you will effectively have the decision made for you in terms of whether that light touch approach is really viable at all. To go back to talking about China, there's not much that you need to be doing in terms of local operation there before you are. You have a raft of regulations legislation that you need to comply with, and you need some level of formality around what your operations are, the registrations that are required and so on. So it depends what the jurisdiction is. Some are easier to have that light touch approach with, others, it's better to set up the entity, be ready for the costs that are going to be inevitably associated with having a company. There might be accounting requirements, audit requirements, depending on the size and other tax and regulatory requirements, but sometimes you just can't avoid that. If you want to do business in a particular jurisdiction, then you may have to have to deal with that.
Lorena Sosa
And that's why planning before scaling is so important and not just scaling for the sake of growing quickly. Which is hard in this time when we need to react quickly to everything.
Rebecca Archer
So you're still an Australian owned company and presumably you have Australian and now international tax obligations to meet. How do you efficiently and effectively navigate a multitude of taxes both here and overseas?
Michael Catterall
The first thing that I would say in relation to that, is something that might be missed in the planning stage, which is that it's not just being subject to overseas taxation that makes things complex. Its Australian tax all of a sudden starts to become much more complicated. If I look at companies that have a purely domestic Australian business compared with those which have overseas operations, particularly in less Australia similar environments, then their Australian tax position becomes much more complex, and I think that's something that people don't necessarily realise when simply go. Even if you just set up a company in New Zealand, all of a sudden, your tax return doubles in size, so your company tax return becomes much more complicated. What's the reason for that? The ATO is suddenly concerned about whether the Australian business is reflecting the right amount of profit in Australia, or is all of the profit going somewhere else? Now it's less likely that you're going to have that situation with New Zealand, where you've got relatively similar tax rate. But where you've got, say, a subsidiary in Ireland and you're paying 12 percent tax rate there, then the issue is very concerned to make sure that you're returning the right amount of profit in Australia. How does it do that? It requires you to complete many more schedules and disclosures in your Australian tax return, and the other way that the government ensures that you do that, is that there's a whole raft of legislation, a lot of which are quite new rules and many of which are very complex rules, to make sure that you're not putting in place a structure which is artificially putting profit in an overseas or low tax jurisdiction. So that's the first point that I would make in relation to that – expect that your Australian tax compliance is going to become a lot more complicated. Never mind making sure that we deal with the overseas regulations as well.
Lorena Sosa
And as well. I think a lot of it is myths. So we often hear the myth that reducing their tax position or making it less complex is as easy as I'm just going to move to Monaco, where nobody pays taxes. And often we get that question. How do I stop paying taxes? And it's not as simple as it sounds. In reality, a lot of this planning stage stems from the need to understand what are the long term shareholder objectives and understanding whether they are looking into growing this business, um, for a long term and live out of the dividends, or is there plan an exit? And if the plan is an exit down the track, then the two strategies at the shareholder level are completely different. One example is when you have a technology companies. Australia has a lot of startups and a lot of technology companies, and when the plan of the shareholders is to grow the company to the point of exit, then it's very likely that they may be needing to think at some point to actually move the company to America. And the quick reason for that is that the multiple that is paid in America for technology companies is four times larger than the multiple that Australian investors will pay for the same business. So a lot of that planning and that complexity as Michael was indicating, is really derived by your plan, as a business owner long term.
Michael Catterall
Talking about those two different sides of establishing, growing, running a business and mature business, often maybe looking to make sure that the return to its shareholders comes through dividend flow. Many founders in a mature phase of the business are looking to make sure that they're getting good dividend flow from the underlying profits of the business. And in that instance, there's a big difference when you've got Australian shareholders generating profits from their Australian based company, because of this wonderful thing that we have called franking credits. Where even though Australia's got one of the highest levels of company tax in the OECD with a 30% top rate, every dollar that you pay of tax in an Australian company is creditable to the shareholders when they receive dividends. If they're an Australian resident. So you can pay tax at that 30% and get every dollar back in your personal income tax return. Compared with say you were in Hong Kong, I think the rates about 12% something like that, 15%. If you pay tax of 15% in Hong Kong say, every dollar that is spent there on tax at 15% is lost. There's no credit for that, as the profits flow through to Australian resident shareholders. So in that scenario, actually better off paying 30% tax, than the 15% tax overseas.
Unless you're taking the profits that are generated in that instance in the Hong Kong company, you're ploughing those profits back into the business and you're trying to build up your Hong Kong business, because then you've got more post tax profits to be able to grow the business and the faster you can grow the business with more post tax profits. Then maybe the more valuable the business is if you come to sell or you're looking for non-Australian investors.
Lorena Sosa
Yes, exactly. So if you're thinking about growing a business, then it does make sense to go to a jurisdiction where the corporate tax rate is low, because you're looking to grow value and get investors. And that's the reason why it is so important to have that shareholder strategy planned at the outset, before deciding where you need to go. Because it could be an exit where you are requiring more multiple, and more value for your business. It could be on a strategy where you're actually needing cash and being in a preferred corporate tax jurisdiction, will give you the best value or it could actually, your best strategy, could be leave the business in Australia, manage it from Australia because you're going to be getting benefit of the franking credits.
Michael Catterall
And a big practical issue there is: where do the people who own or run the business want to live? A lot of Australian built businesses, their founders are Australian, well entrenched in Australian life, love to live here. If the reality is that you want to move your business to the U.S. to take advantage of bigger multiples, bigger market, etcetera that may actually mean that the people who run the business need to move there. It doesn't necessarily mean the case, but it may be that that is the most effective strategy, particularly given that where the people who run the business live and operate the business from, can have significant impact not only on their personal position, but also on the company's position as well. And actually, we come across a lot of times where a business may be run more efficiently from an economic standpoint, from a tax standpoint. But the owners of the business want to continue to run the business as an Australian business, to continue to live themselves in Australia, and sometimes there can be a bit of a conflict between, well, do you want to operate a business that has the lowest possible tax rate? And often the answer is no. Actually, that's not that that is not the be all and end all and purpose of the business, not just the customer experience that you were talking about, but also from an owners and founders experience. What sort of lifestyle do I want? Why am I ultimately working so hard in this business? What is my exit strategy? What's my end game?
Rebecca Archer
Just finally, a complex area to navigate and perhaps a hurdle for many is dealing with varying customs and duties. Depending on the jurisdictions that you're targeting. What is the customs impact on an expanding business? How much time and money do you need to account for?
Lorena Sosa
I think one of the key elements that we were talking about customer experience is the logistic side of things. And every business wants to delivery good customer experience. But that often is coupled with a good logistics experience. In the past, when we used to have bricks and mortar businesses, statistically, the cost of rent was around 30% and then businesses went into being online with the hope that this will achieve operational efficiencies. Now, the cost of logistics for online businesses is also 30% roughly, and this is because it's become way more complex. But also one of the key elements of this cost is the taxes you have to pay, either the customs or, in the case of Europe, for example, the V A T. And a poor strategy around your costing and your customs and logistics set up, could actually make that you could be paying 20% on your full retail cost, which could make you very uncompetitive. It could actually, in businesses that are making 10% profit overall, you could actually gather how much issue it will be to be paying 20% on customs and duties just because you have it wrong or you didn’t plan it properly.
So there are lots of logistics elements around having a good customs strategy, and a lot of it is involved to what systems do you have, which is the entity that should be invoicing, and often logistics companies get this wrong, get the incorrect either entity or the incorrect value. And this could all very quickly generate a very large hole in your pocket for not having the correct setup in terms of logistics. Often we have manufacturers nowadays less and less moving more into Cambodia, Vietnam and Thailand. But they used to be often located in China. And from the outset it is very important to understand how the invoicing should be performed. And what's the proper valuation method to make sure that that's not a hole in your pocket?
Rebecca Archer
Lorena and Michael, thank you so much for your time and expertise on all of these issues today. Can people track you down on LinkedIn via phone or email. If they would like to talk more about setting up shop overseas?
Michael Catterall
Yes, you can find me on linked in. And also, if you go to the Grant Thornton Australia website, you'll find my contact details there.
Lorena Sosa
Same for me. I'm available on LinkedIn, or you can send me an email to lorena.sosa@au.gt.com.
Rebecca Archer
If you liked this podcast and would like to hear more, you can find and subscribe to Grant Thornton Australia on Apple podcasts or Spotify.
