Taxes are a significant cost in doing business and have a far-reaching impact on many corporate decisions—strategy, financing, capital budgeting, and corporate acquisitions [or joint ventures]. Every event and transaction made by a corporation involves different degrees of uncertainty as to how the relevant tax law will apply and uncertainty arising from specific judgment calls. This post provides a brief overview of tax management and tax risk in a corporate environment. Enjoy!
Prior to the 1990s, the focus of corporate tax management [i.e., the tax function] was on the cost of doing business. As a result, tax management had as its principal role reducing costs and ensuring that the corporation was in compliance with the tax laws established by tax authorities wherever the corporation engaged in business. The tax director would typically deal with tax issues directly with the tax authorities; however, when disputes involving significant amounts that could not be resolved with tax authorities arose, the CFO oversaw the litigation process.
Typically tax management was performed with little oversight and interaction from other functional units within the corporation. The traditional measure for evaluating the performance of the tax director was the corporation’s effective tax rate.
Tax management today is quite different. The focus today on tax risk (which we describe below) has resulted in tax management being integrated into the corporation’s risk management system and hence tax management is now described as tax risk management. As stated by Ernst & Young:
“Tax risk management requires tax directors to balance their traditional roles of managing costs and creating shareholder value with increased awareness of risk management issues. It demands that close attention be paid to the overall financial performance and governance of a company, while maintaining a focus on specific activities related to the accounting, reporting, internal controls, and structuring of its tax affairs”.
In addition, tax risk management requires close monitoring of the new and evolving relationship between the company’s tax affairs and its corporate reputation. The performance of tax directors is now being evaluated just like other business units in the firm with measures that go way beyond the corporation’s effective tax rate. basically, tax departments are being evaluated in terms of their contribution to the corporation’s performance rather than being viewed as a corporate cost center.
Back in 2004, a survey study of tax directors by Ernst & Young found that the performance measure criteria for evaluating tax directors are (the percentage in parentheses indicates the percentage of directors responding that it was one of the criteria):
- Success in dealing with tax authorities (81%)
- Tax risk management (75%)
- Timeliness of compliance (64%)
- Cash low impact (62%)
- Effective tax rate (48%)
- Other (32%)
Note: The survey was a telephone-based survey conducted throughout 2004 with more than 350 tax directors in some of the largest companies in 11 key jurisdictions around the world. Slightly less than half of the participants were from North America. The purpose of the survey was to provide “insights to help tax directors and corporate executives better understand the changing scope of the tax function, the risk of tax risk management and how companies are responding” p. 4.
Notice that other criteria are now more important in evaluating tax directors compared to what was done prior to the 1990s, which looked at primarily the effective tax rate and cash low impact. Now we see that tax management is being integrated into a corporation’s overall risk management system and tax directors are evaluated in terms of more than just traditional performance measures such as effective tax rate and cash low impact.
Not only do executive management and the audit committee of the board provide oversight for tax management, but corporations have established internal oversight groups to get involved in tax policies and procedures.
Who has final responsibility for approving tax policies and procedures?
In the Ernst & Young survey, about two-thirds of the tax directors in the survey responded that the CFO had that responsibility and one-third responded that either the CEO or the board had that responsibility. The most frequent external factors that have a significant impact on tax directors assessing their tax risks, according to the Ernst & Young survey, are:
- changes in the tax laws;
- changes in the interpretation of tax laws; and
- other regulatory changes.
CFOs and the board must understand the tax risk in order to provide guidance to the tax director as to how much risk to take on. this is because tax risk management is not about minimizing risk but deciding on the amount of risk that is acceptable. the tax risk management policy by a corporation will determine:
- The value added that can be achieved by taking risks.
- The cost reduction that can be attained by reducing risks.
- The corporate resources required to manage both the upside opportunities and the downside risks.
Types Of Tax Risk And Events Giving Rise To Them
Tony Elgood, Ian Paroissien, and Larry Quimby, on Tax Risk Management, PricewaterhouseCoopers, 2004, p. 35 suggests seven main areas of tax risk. Here are the seven corporate events giving rise of tax risk outlined follows:
Event-1: Transactional Acquisitions
- Financing transactions
- Tax-driven cross-border transactions
- Internal re-organizations
- New business ventures
- New operating models
- Operating in new locations
- New operating structures (e.g., JVs/partnerships)
- Impact of technological developments (e.g., internet trading)
- Lack of proper management
- Weak accounting records or controls
- Data integrity issues
- Insufficient resources
- Systems changes
- Legislative changes
- Revenue investigations
- Specific local in-country customs, approaches, and focuses in compliance
Event-4: Financial Accounting
- Changes in legislation
- Changes in accounting systems
- Changes in accounting policies and GaaP
Event-5: Portfolio: A combination of any of these events
- Changes in personnel—both in tax and in the business
- Experienced tax people leaving—and information being in their heads and not properly documented
- New/inexperienced resources
- Revenue authority raid/investigation
- Press comment
- Court hearings/legal actions
- Political developments
Next, let’s discuss a little bit about the above six events giving rise the tax risk. Read on…
Every transaction made by a corporation involves different degrees of uncertainty as to how the relevant tax law will apply and uncertainty arising from specific judgment calls. Transactional risk is the corporation’s exposure to specific transactions that it undertakes. Routine transactions have low transactional risk. the more complex the transaction, the greater the transactional risk. this is because complex transactions are the focus of tax authorities throughout the world. one of the major reasons why transactional risks arise is the failure to properly document and implement a transaction.
In disputes with tax authorities, failure to do so is likely to result in an unfavorable ruling. The existence of transactional risk has given rise to tax insurance, which are policies bought to insure against an adverse tax ruling on a transaction.
Though companies may seek out private letter rulings (PLRs) from the internal revenue service regarding the tax treatment of a transaction, there is no guarantee that the irs will issue such a ruling. hence, the company is exposed to the risk that the tax liability on a transaction is greater than expected. Tax insurance protects the company in the event of a greater tax burden.
There is the risk that in applying the tax laws and regulations and making other routine decisions, errors are made. This risk is called “operational risk“. A good example is the use of transfer prices to determine the income in different countries in which a irm operates or sells products. the use of an unacceptable method in a country will result in adverse tax consequences. Another example of operational risk is the inadvertent creation of a taxable presence in a state or a country during the normal course of business operations. operational risk can be reduced by more effective communication between operating units and the tax department.
There is a risk associated with the process adopted by the corporation for preparing, completing, and reviewing tax returns and then responding, if necessary, to enquiries from tax authorities that may arise after the filing. This risk is called “compliance risk” and is more specifically described by PWC as being:
- The integrity of the underlying accounting systems and information.
- The processes of extracting tax-sensitive information from the accounting system.
- Ensuring that the tax compliance analysis processes are based on up-to-date knowledge of the latest tax law and practice.
- The proper and eficient use of technology in the processes.
Financial Accounting Risk
The objective of the Sarbanes-Oxley act of 2002 is to increase the quality and reliability of financial reporting. Section 404 of the act requires that corporations document and test internal controls over financial reporting. Since corporate taxes have a major impact on financial statements and the tax department is responsible for matters that have material effects on financial statements, tax directors must know their responsibilities under section 404. Potential failure to comply with section 404 is referred to as financial accounting risk. the act also has an impact on the corporation’s use of tax strategies, especially those strategies that are viewed as aggressive.
The specific risks above may individually be below some risk threshold. However, when specific risks are aggregated, the cumulative risk may be unacceptable. Portfolio risk with respect to tax risk is the level of risk that results from aggregating three of the specific risks (transactional risk, operational risk, and compliance risk), as well as the interaction of these three specific risks.
The failure to properly manage speciic risks and portfolio risk is referred to as management risk. this risk includes both the potential additional tax liability due to failure to manage risks and the potential lost opportunities resulting from the failure to legitimately minimize taxes.
Reputational risk is difficult to manage, though it is costly in terms of litigation and the effects on the company’s revenue and value. The impact of adverse tax decisions, particularly highly publicized ones, may go well beyond the financial statements of a corporation. it may well adversely impact other business interests of the corporation. This risk is referred to as reputational risk. For example: a high-profile dispute between a corporation and a tax authority may result in information about the corporation’s business practices becoming publicly disclosed such that it alters the view of the corporation in the eyes of its inside and outside stakeholders.