“TAX RISK MANAGEMENT STRATEGY: An analytical approach”
by Daniel N. Erasmus
2. An introduction to the Tax Risk Management Process
In an ideal situation a taxpaying business would be entitled to claim all of its expenditure as tax deductions, and be entitled to certain additional tax allowances to benefit its bottom line. At the end of the day it will be able to rely on the fact that its real accounting profit (less the additional tax allowances for any capital expenditure) will be subject to a fair rate of taxation.
The certainty of its current tax liability must be determined accurately.
Difficult circumstances would arise if, in addition to its accurate current tax liability, and its deferred tax liability, the business faces the following unnecessary additional tax exposures:
- additional penalties for late payment
- interest (not tax deductible) for late payment
- arrears taxes, with penalties and interest, on undetermined tax liabilities.
To achieve a current tax status, where current tax liability is accurately determined, without any material weaknesses (SOX 404) or uncertain tax positions (Fin 48), current and future, the business would have to have achieved the following:
- current incomes and expenses carefully analysed and the tax pack reviewed to ensure proper compliance, and identification of known interpretation problem areas;
- determining and finalizing all outstanding tax on-the-radar screen issues as per the {TRM} process;
- a thorough inquiry process involving key staff in the business to determine and finalize all tax off-the-radar screen issues;
- Implementing and maintaining a process that ensures continued thorough compliance, through trained internal consultants and internal tax audit reviews on tax compliance issues.
The goals and objectives are as follows:
- complete on-the-radar screen issues;
- determine through inquiry and complete off-the-radar screen issues;
- Implement the {TRM} maintenance system.
3. Define the Problem
An increase in tax predictability and accuracy, means integrated detailed internal process designed to identify all potential tax exposures.
The aim is to reduce the defects or material weaknesses in tax compliance.
The problem of defective tax compliance can best be illustrated by looking at the Revenue Service statistics for a participating OECD country:
- 2m business tax registrations;
- Produced $17bn of taxes;
- RS collected through audits an additional $1bn, or 6% of what was paid;
- Translating to an average an additional 6% (without specific investigation into the affairs of the taxpayer) tax exposure;
- For the largest taxpayer in that country it was $48m;
- This translates to 6000 defects per a million.
The aim is to reduce the defects to 3 or 4 per million.
In extrapolating these statistics, the following table will give some indication of the potential exposure:
TAX % DEFECTIVE DEFECTS IN A MILLION R MILLION
$8 bn 6% 6000 $480 m
$1 bn 6% 6000 $60 m
$250 m 6% 6000 $20 m
The potential tax exposure of corporates in any tax jurisdiction can be determined by applying the following formula:
Amount of extra tax
Collected through audits
And investigations
___________________ X 100 = Average Potential
exposure %
Total business registrations
The overall aim is to reduce the defects in a million to 3 or 4, through the implementation of the {TRM} process.
4. Analyse the Problem
4.1 Operations Tax Unreliability
Why? Lack of Communication of new or unusual operations transactions
Why? Brainstorm session required
Why? For example: Multi-state transaction and sales or use tax
or VAT exemptions, and full compliance with onus & standard of proof requirements.
4.2 Compliance Tax Unreliability
Why? Unreliable information is recorded and transferred
Why? No internal tax audits
Why? Lack of communications from key staff
Why? Compliance recording mistakes and lack of supporting documentation.
4.3 Financial Accounting Tax Unreliability
Why? Brainstorm session required
Why? Lack of communication of new or unusual financial transactions
Why? For example: Take-on figures of provisions into Oracle or SAP; incorrect accounting treatment of transactions contra to agreements e.g. royalty collections and payments.
4.4 Transactions Tax Unreliability
Why? Brainstorm session required
Why? No Pre / Post audits
Why? For example: Structured finance structures; Mergers / acquisitions followed by asset stripping and dividend flow; Cross-border transactions, and transfer pricing.
5. Compliance
The most likely main cause is unreliable and unaudited source material, and lack of supporting records, that introduces the material weakness of an additional unpredictable extra tax exposure.
All income tax, VAT or use sales tax, PAYE or payroll tax will yield mistakes made in the financial reporting, transactions and operations divisions.
One of the best methods for exposing the tax unreliability in the tax compliance, transactions, financial reporting and operations divisions is through brainstorming sessions involving the appointed tax team.
A TRM Tax Survey verifies that contributors to the root causes are as follows:
- Only 15% of the survey participants are certain they are 100% tax compliant;
- 79% have no tax strategy;
- Between 50 and 60% do not have at least monthly communication with the transactions and operations divisions;
- 40% do not have their tax returns up-to-date;
- 66% to 80% have not had VAT or sales and use taxes or payroll taxes audits
- Only 16% of the Boards discuss tax strategy and tax planning at their board meetings.
6. Prevent the Problem
This section focuses on various countermeasures required to reduce or eliminate the root causes.
The problem is the unpredictable nature of tax in the corporate taxpayer, especially as the tax authorities become increasingly more vigilant and aggressive in pursuing them.
A primary root cause is the insatiable appetite of the State to increase its ability to collect taxes to fund increasing State expenditure, the perception that taxpayers underpay taxes, and the calculated guess that only about 40% of tax risk is usually attended to by the tax compliance divisions of taxpayers. The other 60% tax risk resides in the transactions, operations and financial divisions of the taxpayer.
The following are some potential countermeasures to some of the root causes:
1. The insatiable appetite of the State for money:
Countermeasure 1. - State lobbying;
Countermeasure 2. - Change in government;
Countermeasure 3. - Moving the business to another jurisdiction.
2. Tax authorities negative perception:
Countermeasure 1. - Build relationship with tax officials;
Countermeasure 2. - Call for on-the-radar screen issues with a plan to resolve these;
Countermeasure 3. - Ensure timely returns, fair provisional tax payments, and meeting positively the key indicators set by the tax authorities as to compliancy levels.
3. Tax compliance division shortcomings with unreliable information and lack of supporting documentation (which requires countermeasures for each of the supporting financial, operations and transactions divisions):
- Financial countermeasures:
Countermeasure 1. - Ensure ‘fiddle proof’ transfer of accounting information to the tax packs;
Countermeasure 2. - Regular internal tax audits in the various key tax areas (VAT, PAYE, Income Tax, Customs + Excise), with external consultant supervision;
Countermeasure 3. - Analysis of all historical archives.
- Operations countermeasures:
Countermeasure 1. - Regular email, meeting and other communication between operations and tax compliance;
Countermeasure 2. - Tax training and awareness of various transactions and potential tax implications;
Countermeasure 3. - Regular internal audits to review what is reported as being subject to tax provisions.
- Transactions countermeasures:
Countermeasure 1. - Regular communication between operations and tax compliance;
Countermeasure 2. - Tax training and awareness of various transactions and potential tax implications;
Countermeasure 3. - Legal/tax audits of key major transactions over last 5 years to ensure proper compliance with planning of transactions, proper implementation and post implementation processes.
7. Communication
In the process of implementing the Tax Risk Management system, in order to minimize tax risk on an ongoing basis, it will be necessary to implement a communication system between the tax compliance division, the financial accounting divisions, the transaction division and the operations of the corporation. The communication process will require frequent documentation which attempts to highlight any tax risk that has developed in each of the mentioned divisions to the tax compliance division, through a systematic series of questionnaires generated by the tax compliance division.
The reliability of the information gathered from key personnel in the various divisions by means of these questionnaires will depend on the integrity of those key individuals which can be measured by paying attention to a number of personality traits of each individual:
a) Attitude to compliance;
b) Attention to detail;
c) Following directions;
d) Respect for policies;
e) Role awareness;
f) Practical thinking;
g) Consistency and reliability;
h) Meeting standards;
i) Personal accountability;
j) Systems judgment.
These subjective factors can be measured in each individual participating in the Tax Risk Management system by putting them through the Innermetrix© process which takes each individual no more than 15 minutes to complete. This process will provide the Financial Director, Chief Financial Officer and/or Tax Manager with a report setting out the strengths and weaknesses of each individual who participate in answering the questionnaires. For instance, if an individual scores high on a majority of these subjective indicators there is an assurance that he/she will take the process seriously and give accurate and complete information on a regular basis. If the score shows a weakness in a number of these subjective indicators, then management will have the opportunity through an initial training process to emphasize the significance of accurate and complete information, and they will also know which questionnaires that have been submitted to them need to be scrutinized with greater care to ensure that the participant has completed their task properly. For example, if a participant shows a weakness in many areas, the Tax Manager would always telephone that individual after the completion of each questionnaire to discuss the answers given. In this way the Tax Manager can ensure that the proper attention has been given to the questionnaire by that individual.
Through this management process the individuals showing any weaknesses will usually, through a process of interaction and teaching, improve those weaknesses and as such become more reliable in the information that they provide.
The Innermetrix© testing will be repeated 6 monthly so as to keep monitoring any changes in the strengths and weaknesses on these personality traits.
8. Methodology
As an experienced firm in implementing TRM strategies for a number of multi-national corporations, TRM Services are well positioned to take the methodology globally to corporations based in other tax jurisdictions. In doing so we do not presume to be tax specialists in those jurisdictions, but work very closely with associated firms through a global network, who have the required expertise to assist in giving opinions in those tax risk areas determined. The service we offer is to facilitate the whole TRM process from inception to completion. We act as the project champion, and ultimately will review the law, the facts and the conclusions so as to test the viability and quality of the technical advice against the actual position that the corporation finds itself in, with the guidance of specialists in the appropriate country. It is the same methodology that has been followed world-wide.
Annexure 1
The NEW FIN 48: Addressing Uncertain Tax Positions – All the more reason to introduce and develop a Tax Risk Management Strategy
On July 13, 2006, the Financial Accounting Standards Board (“FASB”) issued the final interpretation amending FASB Statement of Financial Accounting Standards Number 109, “Accounting for Income Taxes.” Of particular importance, was FASB Interpretation Number 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). The purpose of publishing the interpretations was to address the uncertainty in accounting for income tax assets and liabilities. Previously, FASB Number 109 contained no guidance on accounting for income tax benefits and liabilities, and therefore, resulted in corporations taking inconsistent positions. FIN 48 attempts to reconcile the inconsistencies by prescribing a consistent recognition threshold and measurement of tax attributes and liabilities. It also gives practitioners a clearly defined set of criteria to use when recognizing, derecognizing, and measuring uncertain tax positions for financial statements, as well as requiring additional disclosures regarding uncertainty.
Under FIN 48, the evaluation of a tax position is based on a two-step process. The first step is recognition: the enterprise determines whether it is more likely than not (which is a 50% or greater likelihood) that a tax position would be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. The second step is measurement: the tax position that meets the more likely than not recognition threshold is measured to determine the amount of benefit to recognize on financial statements.
In asserting the more likely than not standard, all the facts and circumstances are taken into account. Additionally, the practitioner must presume that the tax position will be examined by the relevant taxing authority with full knowledge of all the other materials, technical merits of the relevant tax law and their applicability to the facts and circumstances of the tax position. The practitioner may take into account any past administrative practices and precedents of the tax authority in its dealings with the corporation, when those practices and precedents are widely understood. Finally, each tax position must be evaluated without consideration of the possibility of offset or aggregation with other positions.
The appropriate timing of claiming the benefits of a tax position is when it becomes clear that the tax position has a more likely than not chance of being sustained. If a previously taken tax position does not meet the more likely than not standard then it shall be adjusted in the first period after the effective date of FIN 48 (January 1, 2007).
A corporation must classify the liability associated with an unrecognized tax benefit as a current liability to the extent the enterprise anticipates payment of cash within one year or the operating cycle, if longer. The liability for an unrecognized tax benefit shall not be combined with deferred tax liabilities or assets.
In addition to taking into account the benefit that a particular tax position will create for a particular corporation, interest and penalties must also be computed in addition to the tax liability, when the law requires the payment of interest or penalties on an underpayment of taxes. Tax liability will cease to be a liability during the first interim period in which any one of the following three conditions occurs: 1) The more likely than not recognition threshold is met by the reporting date; 2) The tax matter is ultimately settled through negotiation or litigation; or 3) The statue of limitations for the relevant taxing authority to examine has expired.
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