Author:

For a change of administration, says Giuseppe Pirola, Founder and Senior Partner at Studio Pirola Pennuto Zei & Associati, the Italian headquartered tax and legal advisory firm, is often accompanied by a change in the taxation and legal provisions, something that the country’s professional services advisers have become only too accustomed to in recent years.

Shifting sands of taxation
A good example of the shifting uncertainties of investing in Italy is the tax treatment of goodwill. Over the past few years, what was a particularly favourable tax regime for acquisitions, in terms of the provisions relating to tax relief for goodwill, has grown much less attractive.

“Twenty five years ago, tax relief for goodwill was as high as 52 percent, and more recently 36 percent,” says Pirola. “It was possible to make an acquisition, do a merger, step up the value of the assets, the liabilities in the company acquired, and get tax relief for that goodwill, write it off against taxes over a period five years.”

Successive Finance Acts have extended the goodwill write off period – the time taken to get the tax relief – first to 10 and now 18 years. And tax relief was only available if there was a clear business case, so when investors had to reorganise after an acquisition, they would only get tax relief if there was a bona fide commercial reason for the reorganisation, and it was not just being done to crystallise the tax relief.

Then tax relief on goodwill was removed entirely, other than in some limited cases when taxes are paid upfront. Substitute tax provisions have been introduced in various Finance Acts over the past few years usually as “one off” provisions. With the substitute tax, the taxpayer paid a reduced rate of tax typically between 10 percent and 18 percent in advance, on a revaluation of assets, to get the tax back over a 10 or 18 year period at the standard rates.

“Now, the Finance Act 2008 has reintroduced the concept, with the option of paying 12 to 16 percent in advance to get the tax back over 18 years,” says Pirola. “For many taxpayers, however, the reality is that an 18 year recovery period means that, paying tax up front, albeit at 16 to 18 percent, is not worth it.”

Although it is worth noting, that for an asset with a shorter amortisation or depreciation period, such as a patent, where depreciation is over the life of the patent, but there are only three or four years left for the patent to run, then there will be some benefit, as you will get tax relief in shorter period of time. So opportunities do exist to take advantage of the substitute tax.

The recent Finance Act has, unsurprisingly, introduced more than one change to the tax regime. The corporate income tax rate (IRES), for example, has been reduced from 33 percent to 27.5 percent.

This move makes Italy very competitive with respect to corporation tax. Although, in terms of tax relief, with the tax rate reducing from 52 percent, to 36 percent, 33 percent and now 27.5 percent, payback on the substitute tax is reduced.

There is also a regional production tax (IRAP) to contend with. This tax has been contested in the European Courts, but the Italian authorities won the case, and the tax seems to be here to stay. In the 2008 Act the standard rate was reduced by from 4.25 percent to 3.9 percent, and rules simplifying the computation of the taxable base have been introduced. Labour costs are not deductible in computing the taxable base which is based on the gross margin shown in the statutory profit and loss account. Successive governments have met the criticism that IRAP is a tax on jobs with a series of measures providing IRAP relief for businesses taking on new employees.

“The reduction in top line tax rate is consistent with a general trend among countries in Europe to reduce the top line tax rate, but increase the taxable basis,” says Pirola. “So at the same time as cutting the IRES rate, the Finance Act introduced a series of restrictions, such as a limitation on the possibility of claiming tax accelerated depreciation, for example, that increased the taxable base.”

The attitude of successive governments has been to simplify the system, and reduce the tax rate, in exchange for better and more accurate profit reporting by taxpayers. They have also targeted tax relief at enhancing growth in the economy. The recent introduction of 10 percent tax credit for research and development costs is a good example; the percentage is increased to 40 percent for costs incurred in connection with arrangements with universities and certain other public institutions.

Recent changes have also boosted the prospects of planning investments through the use of partnerships or tax transparent companies.

Capital gains and tax relief for interest
Another area where investors are faced with uncertainty and constant change in tax regulations, are the rules relating to participation exemption on capital gains deriving from disposals of shares, and other instruments that benefit from the participation exemption.

The rules, which were introduced in 2004, started with the exempted element at 100 percent, but in the space of three years that moved to 92 percent, 84 percent and now, after the 2008 Act, back up to 95 percent. On the other hand the minimum holding requirement in order to benefit from the participation exemption has reduced from 18 to 12 months.

Over recent years the government has also changed its approach towards the thin capitalisation rules that deal with the tax treatment of debt financed deals, and the deduction of interest. Thin capitalisation rules are designed to deny or restrict tax deductions for interest paid to related parties, and prevent companies from being artificially geared up with shareholder loans.

“Initially, a carrot approach saw an incentive to put funding into companies using equity capital, in the form of a reduced tax rate,” says Pirola. “Those rules were then replaced by more standard thin cap rules which denied deduction for interest in situations where a company exceeds a certain debt ratio; in this case four parts debt to one part capital. Exceed the debt ratio cap and you lose the tax deduction for the interest on the excess debt over and above the cap.”

 There were also some intricate rules deigned to stop an interest deduction on borrowings used to purchase shares.

These rules lasted for three years, from 2004 until 2008, and have now been replaced with yet another approach to the deduction of debt interest. “The government has introduced interest cover rules – a regime that focuses on net interest expenses – so the debt equity relationship is no longer important,” says Pirola. “Instead, you get a tax deduction for net interest expenses – interest expenses which exceed interest income – up to a limit of 30 percent of EBITDA as shown in the annual statutory profit and loss accounts.”

The impact of the new provision depends on the type of organisation or structure involved and the type of activity. “For private equity investors the new rules will have a significant impact,” notes Pirola. “Previously, acquisitions could be structured so as to get the debt to equity exactly right and maximise tax efficiency. Now, as it is not often possible to know the level of profits in advance, it is difficult for private equity to judge the most beneficial level of gearing.”

With MNCs, however, the effects of the new provisions are less clear cut. Many MNCs with manufacturing or sales operation in Italy, for example, have transfer pricing mechanisms in place designed to ensure a correct allocation of profits to the various countries in which they operate around the world. The profits and risk of the MNC’s global business may be the HQ of the business, and with good tax planning MNCs can structure their tax affairs to take advantage of the new provisions.

Real estate sector
The theme of uncertainty and opportunity continues with the real estate sector, in which there have been a number of interesting developments over the last few years,

Until recently the best way for foreign investors to make a real estate investment in Italy was to set up a company as a Special Purpose Vehicle (SPV) and then perform acquisitions through that SPV.

In 2000 the first SGR-managed vehicle, a speculative real estate investment fund, which currently has a minimum investment requirement of one million Euros, was launched. In 2003, a change in the law paved the way for open-ended ‘flexible’ real estate investment funds, in which at least two thirds of the overall value of the fund is represented by real estate, rights in property, or holdings in real estate companies – companies engaged in the building, purchase, sale, and management of real estate. (Closed-end real estate funds have been regulated in Italy since 1994).

Following on from the real estate fund, the Italian government proposed a new structure, the Italian version of Real Estate Investment Trusts (REITs). REITs and similar entities have existed in various countries such as the US and UK, for example, for some time, and were introduced in Italy for the first time by the 2007 Italian Financial Law, under the name of SIIQ (Società di Investimento Immobiliare Quotata).

SIIQs are qualified as a listed real estate investment company, explains Pirola. The qualifying features are: that shares of the company shall be listed on an Italian stock market; the company’s main business must be real estate lease; no shareholder can hold, directly or indirectly, more than 51 percent of the voting rights and a 51 percent share of the company’s profits; and at least 35 percent of shares must be held by shareholders, each of them holding, directly or indirectly, no more than one percent of the voting rights and a one percent share of the company’s profit.

Promising as the SIIQ is, implementation has proved slow. The law on SIIQs was approved at the end of 2006, and investors were expected to be able to use the new structure from the beginning of 2008. Early in 2008, however, the SIIQ still has to take-off.

“Today we don’t have SIIQ already up and running, we have a lot of announcements by real estate groups or listed companies that are planning to convert their companies into SIIQ,” says Pirola. “But it is a regime that probably has not confirmed its validity in full, and the market has no experience of SIIQs operating in investments.”

Moreover, a government commission is about to look at wholesale tax reform of the real estate sector, and is expected to submit proposals by June 2008.

The Finance Act 2008 states that the commission’s proposals may lead to the introduction and enactment of new rules that may apply retrospectively from January 2008. This means that a real estate business could look at an investment, make evaluations based on the current tax regime and find that after the proposals are announced in June, any business plan assumptions have been rendered incorrect, for the entire year.

Expert assistance
It is clear that the tax regime for investors is highly complex and picking your way through it requires the assistance of advisers with extensive local expertise.

“As you may appreciate when you speak with foreign investors approaching the Italian market, they can find the market confusing,” says Mr Pirola. “For example, with real estate, it is not easy to explain that a business looking to make an investment may perform valuations now, prepare a business plan, define prices and pay money, based on assumptions underlying the business plan, and then find that those assumptions will not be confirmed in six months time because of changes in the law.”

Studio Pirola Pennuto Zei & Associati is a firm with a very strong presence in Italy, with a total head count of 520, including 80 lawyers and 350 tax experts and accountants, located in 9 offices spread over the main Italian industrial areas. The firm also has an international presence, with offices in London and, in the near future, Paris and Brussels.

“We are a one stop shop, providing a full range of tax and legal services to our clients,” says Mr Pirola. “To do this we rely on the strength of our technical skills and knowledge, but also the close relationship we have with our clients. Because, in this business it is important to take pro-active approach, to provide solutions for our clients and point out the opportunities, not just answer their questions.”

For further information
Tel: +39 02 669 95203
Email: giuseppe.pirola@studiopirola.com
www.studiopirola.com

Plus ça change? It’s all change in Italy – again. Despite the frequent regime changes it has endured in the last 30 years, Italy has enjoyed relative stability in the last nine years with just two changes of government. But with Prodi’s administration in disarray and Silvio Berlusconi showing every sign he would relish a return to power, international investors have every right – again – to feel a sense of apprehension. So what has been achieved by Prodi, and what could change again in the future?

In terms of employment issues, Franco Toffoletto, from Milan-based Toffoletto e Soci says employee stock option changes have definitely taken the shine off this usually effective reward tool, particularly for overseas investors. “Before they were widely used in Italy. But now it’s very difficult to use stock options – so difficult, in fact, that very few Italian companies will use them.”

The left wing faction of the Prodi administration emphatically pushed this change. Part of the problem thinks Franco Toffoletto was that the stock option change in the law was partly a problem of perception: stock options, thought many on the political left, were only for fat-cat managers and directors – not something ordinary employees could also benefit. Yet a wide range of employees did, and not just management top table.

“Previously stock options were very attractive to many because they were only taxed at 12.5 percent,” says Franco Toffoletto. “Companies and many people – not just managers – took advantage of them. Part of the problem too was that the rules changed so many times that it became very confusing to know how best to use them. Which, of course, made them less popular.”

Toffoletto E Soci areas of expertise:

The devil is in the detail – always
Of course, despite the clamping down of stock options in Italy, Franco Toffoletto says stock options will continue to thrive in many other countries. And a change of government could see the rules relaxed again? At the moment the two big parties did not provide any details on that.

Meanwhile, international investors should know that the law around stock options must be watched very carefully, as the Romano Prodi legislation will regard the value of options as income – except if all the following conditions are met:

Reduced employment flexibility
Between 2001 and 2003 considerable steps were made in Italy’s rigid labour market, with new laws introducing a lot more employment flexibility, supplying permanent contracts for agency workers and more flexibility regarding part time and fixed term contracts.

“One of the most important steps was the change regarding staff leasing (i.e. supplying workers on permanent contracts through authorised agencies)” says Toffoletto. “For employers who typically might hire agency workers to work within their own company, this option was important. It was limited only to certain jobs, but this has been abolished by the Prodi government. It’s a great pity because it was a very useful opportunity for many companies.” Now companies can only hire agency workers for a fixed period of time and only if there are economic, technical or production reasons for doing so.

However, this Milan legal expert adds that fixed term contracts remain highly used in Italy.

Other issues hang around which could unnerve the inexperienced investor warns Toffoletto. Currently there is no cap to compensation in the event of wrongful employment dismissal: reinstatement is the only remedy that can be awarded by the court.

The public sector still remains a highly unreformed sector of Italy’s economy. A more bolder, possibly younger politician might have had the energy and vision to reform Italy’s bloated public sector, stimulating investment. But that man was not Romano Prodi.

A Berlusconi return bringing increased flexibility?
It’s not easy to predict the future. No one knows if Silvio Berlusconi will end up back in power, replacing Prodi. Certainly what Italy needs more than ever is a genuinely new and innovative reformer – but is that man Mr Berlusconi? The evidences suggests not. Mr Prodi, although some of his changes were retrograde steps, did have some success with tax-collecting reforms, for example.

However, Franco Toffoletto says despite the Prodi changes, investor confidence has not been affected too deeply. Realistically, he says, many investors are ambivalent about investing in Italy – as many have always been. “It’s been that way for many years. Italy, in terms of employment legislation, is a nightmare. But it’s not quite as bad as many people make out. For example, I think Italy is certainly better in terms of employment law than France, even though it is more protective of issues like dismissals.”

Certainly Prodi’s replacement will have their work cut out. Like many EU countries feeling the effects of the global credit crisis, potential economic recession is on a knife edge. The high euro means there’s pressure on Italian exports and high oil and food prices are also taking their toll on the economy and people’s pockets.

Technology brings benefits – but also threats
Italy has the same IT problems that face companies everywhere: blogging, Internet gossip and chatrooms with disaffected employees writing, often very freely, about their employer. The issue of information sharing – sometimes with the wrong people – is of course a huge worry for many companies now. How do you keep control of your own reputation you’re your company’s confidential information when it becomes so easy to share with others?

“People use the Internet a lot in Italy,” says Toffoletto. “A lot of social life and business life can be interconnected. If you work for an IT company and you got on a business networking conference, you could well be inadvertently passing on very sensitive information. Look at the emergence of Facebook. You can see people’s friends, find out about their hobbies, even their religion. Who is making use of this information? Does the person concerned realise the consequences such disclosure could lead? So far, Italy has not had to deal with this in the courts. But it will at some point and companies have to face up to the reality of what this could bring.”

IT innovation milestones – Toffoletto e Soci
1986: the year of the first personal computer network in the firm and the first e-mail inbox. Over the years there has been a continuous improvement of the IT facilities.

1995: Easylex is invented by Franco Toffoletto and others and this remains the management software currently used in the firm. It became one of the best selling management software for law firms in Italy and winner of the SMAU award Macworld, 1999, as the best Italian management software suite.

2004: Extensive KM (Knowledge Management) knowledge sharing.

2006: The WebLex service online by which clients can look up information on EasyLex related to their files and download documents.

2007: The launch of Toffoletto e Soci’s new Knowledge Management web-based platform for clients.
The Toffoletto e Soci difference

We offer services at a national and international level. Among the Italian firms specialising in employment law we are the only one that is part of a structured international alliance

Quality of services: efficient, fast and punctual. We were among the first Italian firms to obtain the Quality Assurance Certificate UNI EN ISO 9001

Internal training quality: our training programme has been accredited for 2008 by the Italian Law Society. We have been running in-house English language courses for years, taught by teachers from the British Council, both for lawyers and support staff

Leaders in IT. For a number of years we have been using a Knowledge Management software developed internally (www.quinary.it). We also set up an Intranet network 10 years ago. We are in the process of developing digital products to offer to clients and considering blog, podcast, video and audio options

Regularly in the media. We write a column (The expert replies) for newspaper Sole 24 Ore (the Italian equivalent of the Financial Times) as well as various law journals

Highly ranked. We are classified by all of international directories as a leading legal firm employing the best legal minds in Italian employment law. All partners regularly participate as speakers at Employment Law conferences both at a national and international level

More about Toffoletto e E Soci
The firm’s business is judicial, extrajudicial and consultancy (around 50/50 percent) and they act predominantly on behalf of companies. About 50 percent of clients are companies worldwide from all sectors including banking, IT, insurance, head hunting to publicity and marketing.

For further information:
Tel: +39 02 721441
Email: sft@toffoletto.it
Website: www.toffoletto.it

Twelve months ago, when American multinational Kraft announced it had taken a long-term lease on new corporate headquarters in Zurich, the business sector presumed the move was driven solely by the fiscal prudence of low tax rates. The US firm, which owns a portfolio of famous brands, such as Philadelphia cream cheese, Kenco coffee and Terry’s Chocolate Orange, was following in the footsteps of Procter & Gamble and Colgate-Palmolive, which have all shifted their European headquarters to Switzerland.

The Alpine country’s attractive tax regime was one reason. But there were others, including lifestyle, quality and cost of accommodation, and excellent public transport.

In a statement at the time Kraft said that the company had conducted a survey of different headquarter locations and Zurich came top. The statement cited the ease of getting about: good transport to the airport, good rail links. “We have a lot of expatriate staff so availability of schools and good quality accommodation are important.” Biogen Idec, a US pharmaceutical company, last year decamped from Paris to Zug, a canton which boasts a corporate tax rate of nil.

In the more cosmopolitan Zurich, the normal range of corporation tax is between 15 percent and 24 percent but foreign holding companies using Zurich as an administrative base are exempt from tax on their non-Swiss earnings.

A recent World Bank survey bolstered the view that Switzerland is highly rated for its favourable rates and ease of paying taxes. And research released in July 2007 also appeared to confirm Switzerland is attracting companies for tax reasons. It found that a record number of firms had set up shop in the country in the first six months of 2007.

The World Bank survey ranked Switzerland 24th worldwide in terms of total tax rate – all taxes that businesses pay – and second in Europe, behind Ireland. The Pacific island of Vanuatu headed the table with a fiscal rate of just 8.4 percent. With a total tax rate of 29.1 percent, Switzerland is only 0.2 percent behind top-ranked Ireland with 28.9 percent, said the Bank.

Switzerland was placed ahead of eastern European and Baltic countries, which have nominally lower corporation taxes but which carried the burden of higher capital tax and social insurance costs as well as customs and transport levies. And it did considerably better in the world listings than its neighbouring countries: Germany (50.8 percent, ranked 124), France (66.3 percent, ranked 157) and Italy (76.2 percent, ranked 168).

Tension
But the results come at a time of niggling tension between Switzerland and the European Union over the Swiss corporate fiscal system. Brussels wants the Swiss authorities to scrap a practice applied by some of its cantons that exempts company profits generated in EU countries from tax. It claims doing so violates a 1972 free trade accord.

Switzerland has repeatedly refused to negotiate with the EU over the issue. The government says that corporate taxes are a cantonal issue and are not covered by the trade agreement. The Swiss position is straightforward: that the 1972 free trade accord does not apply to the tax benefits granted to foreign companies by a number of cantons. It argues that the 1972 agreement is only applicable to certain goods such as agricultural and industrial products.

The EU is calling on Switzerland to give up the tax practice and adapt to its demands. Switzerland has so far refused, although the possibility of some distant compromise emerged in October 2007 when the two sides at least agreed to talk. One of the key questions for Switzerland in 2008 is whether the talks will proceed amicably, or whether the EU will stay on the front foot and turn this into a larger conflict.

If the tax spat is striking a somewhat discordant note in otherwise harmonious relations, there was more cause for concern, however minor, at the beginning of 2008 when the president of the Swiss National Bank, Jean-Pierre Roth, said the threat of inflation is rising, along with possible risks to the Swiss economy.

Mr Roth seemed to suggest Switzerland would not be immune from fallout from the sub-prime lending crisis in the US. He said there were ‘question marks’ over the economy, especially concerning possible knock-on effects from problems in the US. He warned that economic growth in Switzerland could fall below the Bank’s forecast in December of around two percent for 2008.

None of this is dissuading multinationals from setting their sights on Switzerland as a cost-effective and attractive base.

According to Ernst & Young, Switzerland is the leading European choice of international companies for locating an International/European headquarter, an R&D centre, or a centre for administration/accounting functions.

The company’s “Swiss Attractiveness Survey – What Foreign Companies Say” Ernst & Young conducted of international executives currently working within Switzerland shows that 74 percent of the executives surveyed would choose Switzerland again as a business site.

Other factors
While traditionally taxes have been one of the key reasons for locating and investing in Switzerland, Ernst & Young says the relative importance of other factors is definitely increasing. A key reason Switzerland rates so highly is its outstanding quality of life, which 71 percent of the executives rated as very attractive. Almost 80 percent of those surveyed also rated as very attractive Switzerland’s clear and stable political, legislative and administrative environment, with 65 percent rating the stable social environment very highly as well.

Other particularly strong features include the flexible labour laws and the favorable tax environment or tax incentives, with 56 percent of those surveyed giving each factor the highest rating.

Ernst & Young said Switzerland’s enduring focus on developing a highly skilled and specialised labour force, as well as a competitive business environment, have allowed it to take advantage of the changes created by globalisation. “Once a company has settled down in Switzerland, it will most probably stay,” Ernst & Young concluded.

This assessment seems to be borne out by figures that show 2006 was a record year of investment within Europe and Switzerland continued to be one of the most attractive locations for foreign direct investment.

Globalisation
One of the reasons for rising FDI in Switzerland is the country’s increased level of globalisation. In the 1970s, Switzerland was hampered as a global investment centre by its traditionally isolationist policies. Even as recently as 1996 the OECD warned that the Swiss federal government and the cantonal authorities needed to strengthen and approves Switzerland’s attractiveness as a place to do business.

This call for political action stemmed primarily from Switzerland’s rejection of EU membership. But it also came from a recognition that the internal Swiss market was not fully integrated, with lack of competition in some areas resulting in higher operating costs for foreign investors.

Liberalisation of internal markets has been slow and sometimes controversial, but progress has been made. Switzerland has to all intents and purposes become a “virtual member” of the EU and this has also increased the pace of globalisation. A referendum in 2001 went against opening talks on joining and Swiss-EU relations continue to be based on an extensive range of bilateral agreements.

Ties became closer in 2005 when a referendum backed membership of the EU Schengen and Dublin agreements, bringing Switzerland into Europe’s passport-free zone and increasing cooperation on crime and asylum issues. A further referendum in 2007 saw the bilateral agreement on the free movement of people come into force for the ‘old’ 15 EU member states, Malta and Cyprus as well as Efta nations Iceland, Norway and Liechtenstein.

Flood prevention
In other words, residents of these countries were suddenly free to compete for jobs in Switzerland alongside the Swiss. But a clause will allow Bern to place limits on immigration if too many EU citizens flood into the country (10 percent above the average of the past three years). Parliament will decide in 2008 the extent to which it will confer similar rights to the people of Bulgaria and Romania.

According to Switzerland’s Federal Migration Office, both Bern and Brussels favour a gradual, controlled opening of the Swiss job market. But whatever parliament decides, voters will have the final say in a referendum later in the year or in 2009 since such a move requires a change to the constitution.

This has all helped increase the pace of Switzerland’s globalisation. Indeed, in Economic Institute KOF’s 2008 Index of Globalisation, which compared 122 countries, Switzerland came fourth – up two places on 2007.

Zurich-based KOF said globalisation in Switzerland has increased continuously since the 1970s and particularly since the 1990s. Since 1991 Switzerland has been among the world’s 10 most globalised countries. The 2008 position was partly the result of a substantial rise in foreign direct investment, said KOF. One aspect of Switzerland’s cosy stability that has never seemed under threat is its politics. Switzerland’s long-standing neutral status has given it the kind of political cohesion envied by just about every other nation.

And yet last year, in the run-up to federal elections in October, Swiss cities saw riots on a scale rarely known. The unrest was the result of protests against the right-wing Swiss People’s Party (SVP), which ran what many saw as an overtly racist campaign. The party’s controversial leader, Christoph Blocher, was accused of wrongly depicting Switzerland as a society under siege from immigrants who have scant regard for the country’s laws and customs. Violence flared in the capital of Bern when left-wing protesters tried to stop a pre-election SVP rally. There were similar incidents in Lausanne and Geneva.

The level of concern over the tactics of the SVP was such that the United Nations refugee agency strongly condemned the party for an advertising campaign in which it appeared to blame the country’s rising crime rate on asylum seekers.

Success

But Mr Blocher’s rhetoric, and his embracement of traditional Swiss values, struck a chord with the electorate. The SVP was the most successful party at the election with 29 percent of the vote at the October 2007, but moved into opposition following parliament’s refusal to re-elect Mr Blocher to the Cabinet.

Analysts believe the political scene will remain unsettled in 2008 as the SVP settles into its opposition role. But this is still Switzerland, and “unsettled” is relative. The new government is expected to last the full four years, and its policy goals remain bullish.

Despite remaining outside of the EU, the Swiss economy will become more closely integrated with those of its neighbours as a new series of bilateral agreements comes into effect. The government also plans to continue efforts to improve micro-economic conditions to boost GDP growth. This includes measures to increase competition by liberalising previously sheltered industries such as electricity, energy, telecommunications and postal services.

Switzerland special place in Europe – part of it, but not part of it – seems destined to remain little changed, at least in the medium term. Bilateral agreements will be a necessary part of that arrangement as long as there is an EU and the ‘island’ of Switzerland in the middle of it.

Russia’s biggest companies – the likes of Gazprom, Rosneft, and Lukoil – feature regularly in the world media and their actions are watched closely by both business and political leaders around the globe. Recent years have seen these firms embark on an aggressive expansion binge, but behind the scenes they have also been active in trying to transform themselves from former state-held behemoths or cobbled-together holdings into more effective, efficient, and profitable companies.

A new report from the Economist Intelligence Unit and sponsored by Ernst & Young – Corporate transformation in Russia’s emerging multi-nationals – explains what these companies are doing and why. It paints a fascinating picture of what is going on inside corporate Russia, and one that is very different to the traditional representation of the Russian business scene.

“Many of Russia’s fastest-growing firms are beginning to bump up against capital constraints, meaning they need to tap global financial markets to continue growing. This means they are under heavy pressure from the investor community to become more transparent and tighten up management practices,” says Matthew Shinkman, the editor of the report. However, as Russia’s leading corporates expand into new markets, they are increasingly competing head-on against global leaders, providing another source of pressure to improve their competitiveness.

“Recent changes in corporate governance are being driven to a large extent by capital market requirements. Thus far in 2007 there have been 18 public offerings by CIS companies for a total of almost $26bn raised,” says Karl Johansson, Managing Partner of Ernst & Young in Russia and the CIS. “The process of Russian companies going public in international markets will continue and will help these companies become global players.”

Restructuring
The report’s examination of the internal reform efforts of Russia’s emerging multi-nationals reveals several key themes. Reform is indeed happening, if at a slow and uneven pace, it says; “The biggest Russian firms, with the most contact with the outside world, have been very active in corporate restructuring, implementing modern, best practice corporate governance systems, upgrading internal processes and procedures, and building environmental sustainability into their businesses. Firms that are closer to the state, not surprisingly, tend to move more slowly in this regard.”

The report also argues that change is being driven in part by funding requirements. To minimise their cost of capital on global markets, “Russian multi-nationals are being forced to introduce more transparency, improve reporting procedures, and get corporate governance right.” Acquisitions and establishment of operations in western markets have also forced these companies to play by western business rules.

However, it would be wrong to conclude that these reforms are being forced upon the Russian multi-nationals, the report says. “The senior executives with whom we spoke confirmed that corporate transformation efforts are not being made just as pre-IPO window dressing,” the authors write. “In most cases executives understand that the long-term competitiveness of their firms will depend upon meeting or beating global best practices in operations, governance, and finance.”

The report notes that while the behind-the-scenes corporate modernisation activities of the emerging Russian multi-nationals may not be well-documented, their increasingly confident forays into both emerging markets – including Russia’s backyard CIS countries – and even the more sophisticated markets of Europe and the US has made front-page news, and forced western rivals to take note.

It cites research by M&A Intelligence, a Moscow-based consultancy, which suggests that last year Russian companies completed almost 100 cross-border mergers and acquisitions worth some $15bn. The most well-known and controversial of the Russian firms venturing abroad is gas giant Gazprom, which has gained control over assets in the CIS and eastern Europe which allow it to exert major influence over the supply of gas to western Europe.

In contrast to the prevailing view in the global media, though, “aggressive corporate expansion abroad is not solely the purview of the biggest firms, nor those most closely-linked to the Kremlin, and in most cases is based on purely commercial motives,” the report says. Russian companies such as Lukoil, UC Rusal, and Severstal – all highly active in overseas M&A – are all several steps further removed from the state than Gazprom, while smaller Russian multi-nationals such as the telecommunications company MTS and food manufacturer Wimm-Bill-Dann are barely more than a decade old and are less central to the Kremlin’s economic strategy, it says.

The report argues that for the largest Russian energy and natural resources firms, years of high global oil and commodity prices, accompanied by exceptionally high demand from both emerging and developed markets, have produced a windfall of export earnings and left these firms cash-rich and in a buying mood. This rapid earnings growth, along with robust macro-economic growth, has also trickled down into rising incomes for a growing Russian middle class, which has in turn boosted the performance – and ability to invest – of financial services, consumer goods, and technology firms as well.

“Russian companies have for years been active in the CIS countries, leveraging common language, similar business practices, and trade and other links established in former Soviet Union times to build market share in and extract natural resources from Russia’s near-abroad,” it says. “Russian companies account for over a third of all foreign direct investment in the CIS countries. This investment is led by the oil and gas sectors, but telecommunications, financial services, and consumer companies are also heavily active in the region.”

Many Russian emerging multi-nationals are now looking further abroad, re-tracing the steps of Soviet state enterprises, which were active in the Soviet Union’s former spheres of influence, ranging from Asia to Latin America and Africa, the report says. “These firms are now using the skills built up in both the challenging domestic Russian market and the still-undeveloped CIS to venture into far choppier waters – including places few Western companies are willing to go.”

Expanded market
Currently, the international presence of Russian telecommunications companies, including MTS and VimpelCom, is largely limited to the former Soviet republics. As opportunities in this expanded home market become harder to come by, though, they suggest they are considering entering markets like North Korea and Afghanistan to sustain growth beyond 2009. The report refers to comments made this summer by Alexander Izosimov, chief executive of VimpelCom, who told journalists that, “We will be ready to look at markets that are riskier, the markets that, in the mind of western companies, are taboo.” Other reports have suggested that Altimo, the telecoms arm of billionaire Mikhail Fridman’s Alfa Group conglomerate, has been in talks to buy into Iranian mobile phone company Iraphone.

While Russian multi-nationals hold a commanding position in the CIS and operate comfortably across a range of emerging markets, their experiences entering the developed western markets have been more mixed, the report says. “This experience has been in large part driven by ongoing concerns over transparency and corporate practice, but the circumstances have been made more difficult for Russian firms by the rise in political tensions between the administration of Vladimir Putin and the US and Europe.”

The report cites research from M&A Intelligence on failed cross-border deals that highlights the troubles Russian firms have had accessing developed markets. Between January 2006 and January 2007, the consultancy reports that Russian companies failed to clinch 13 foreign deals with a total worth of $50.2bn (well ahead of the $15bn in closed deals). The thwarted deals included five by Gazprom, three by Lukoil and two by Severstal, with the biggest being Severstal’s $13bn bid to buy Luxembourg-based steelmaker Arcelor. During the same period, companies from the Middle East lost just $18bn worth of deals in Europe and North America.

“Political considerations have worked against Russian firms in recent cross-border bids,” the report says. In early 2006, for example, rumours that Gazprom was considering a bid for Centrica, the UK-based energy supplier, raised such concerns within the UK government that then-Prime Minister Tony Blair issued a statement officially confirming that the government would not actively block a bid. And Severstal’s bid to takeover Arcelor, the Luxembourg-based steelmaker, in 2005 drew a sharp response from European politicians and the company was eventually thwarted by a rival bid from Mittal Steel.

“Political sensitivities are even greater in the former communist countries of eastern Europe,” the report claims. Steel and mining company Evraz Group bought the ailing Vitkovice Steelworks in the Czech Republic in 2005. It was the group’s first international purchase and the memories of the two countries’ common communist past complicated the bid. “We faced serious challenges in this acquisition,” the report quotes Irina Kibina, vice-president for corporate affairs and investor relations at Evraz, saying. “All the memory, all the fears, they are still alive. Besides, it was our first international acquisition and we were just learning how to do it right.”

Studies
Inexperience is only half of the problem, according to the report. Russian firms – and Russia itself – currently suffer from a very poor image within the global business community, it says, citing numerous studies, including several from the Economist Intelligence Unit.

“The news for Russian multi-nationals trying to get into western markets has not been all bad, though,” it says. Evraz has since gone on to conclude a string of acquisitions, including the highly-publicised purchase of Portland, Oregon-based Oregon Steel Mills, which was completed in January, 2007 despite concerns that US anti-trust authorities might not approve the purchase due to Evraz co-owner Roman Abramovich’s ties to the Kremlin.

“While Russian firms’ efforts to transform themselves via acquisition have been met with some backlash, a more collaborative approach has reaped rewards for a number of big Russian firms in potentially sensitive industries,” the report says. The most successful of these firms are increasingly seen as credible business partners and important vehicles for access to the big Russian home market and the country’s vast natural resources.

While the report puts Russian enterprise in a new light, it notes that the country’s multi-nationals are still hampered by an image problem. “Many senior executives around the world are still either wary of or at least uninformed about the actions of Russia’s biggest firms,” it says. “These companies have a big image problem to solve, and it’s not just a case of prejudice: Russian executives need to become more open to communicating with the business world.”

It concludes that there is still a long way to go. “Impressive progress has been made, but the emerging Russian multi-nationals are still emerging. Substantial room for improvement still exists, which presents an opportunity for these firms to continue their vault into the upper echelons of the global business world, if they choose to take it.”