Mismanagement of taxes is a major financial performance and compliance risk, and corporations are increasingly adding this topic to their governance agendas. According to a report by PwC entitled ‘King III requirements – an integral part of creating an effective tax function’, increased regulations and other legal responsibilities make tax risk management an important issue that needs to be addressed in the boardroom.
‘There is a clear need for transparency in tax matters and tax needs to be elevated on the corporate risk agenda, becoming an essential part of the enterprise-wide risk management framework,’ says Seema Ranchhoojee, manager of tax at PwC.
‘This is especially relevant for banks.’ Matters relating to financial, legal and ethical disclosure practices are normally at the top of the agenda when discussions of governance arise in the boardroom. But where exactly does tax risk management fall on th governance radar?
‘The board of directors and the audit committee have become more involved in getting the numbers right before releasing them to the public,’ says John Aksak, a corporate tax expert at True Partners Consulting. ‘Discussion of taxes has increasingly become a part of the CFO’s reporting to these groups.’
How a corporation manages its tax risk can affect its overall financial performance and its relationships with investors, creditors and other stakeholders. After all, tax risk management can have a significant impact on a corporation’s financial performance and reputation, and thus should be part of the entity’s overall governance practice. It is an important issue that affects public trust and confidence in corporate America.
Taxes represent one of the major expenses on a corporation’s income statement and can affect the volatility of net income and earnings per share. If not carefully monitored, taxes can raise the potential for increased expenses, interest and penalties. Moreover, ineffective internal controls over taxes can be cited as a material weakness for certain entities.
‘A lot has changed since Sarbanes-Oxley was enacted,’ says Gregg Dluginsky, another corporate tax expert at True Partners Consulting. ‘The effort, the hours, the manpower and the sophistication that have gone into complying with the reporting requirements for a corporation’s provision for income taxes have increased significantly.
The emergence of the financial accounting disclosure requirements of FASB Interpretation No 48 (FIN 48) and the income tax requirements under the IRS’ newly enacted Schedule UTP has raised the bar, and corporations are being held to a much higher standard when it comes to dealing with issues relating to tax risk management.’
FIN 48, effective from the fiscal year beginning after December 15, 2006 for public entities and the fiscal year beginning after December 15, 2008 for non-public entities, including not-for-profits, requires organisations to evaluate the technical merit of their tax positions.
They must assess whether such positions meet the more likely-than-not recognition threshold and will be upheld, including resolution of any related appeals or litigation processes, if scrutinized by the tax authorities. If entities fail to meet this threshold, appropriate disclosures must be made for financial reporting purposes.
Effective for calendar-year taxpayers for the 2010 tax year, the Internal Revenue Service requires certain corporations to report uncertain tax positions on Schedule UTP, to be filed with Form 1120. Schedule UTP requires such corporations to report on uncertain tax positions for which the corporation, or a related party, has recorded a reserve on its financial statements, or for which the corporation has not recorded a reserve as it expects to litigate the position.
These uncertain tax positions are identified in connection with procedures for applicable accounting standards such as FIN 48.
Protecting the corporation
These regulatory requirements make it clear accountability, compliance and transparency are essential when it comes to governance practices for tax risk management. Fortunately, there are ways corporations can make sure they remain in compliance with the ever-changing regulatory landscape. One way is to ensure CFOs are aware of, and ready to handle, any issues that may arise.
‘The CFO and tax department must be the eyes and ears of the corporation, have a full understanding of the tax risk facing it, and share such information with the board and the audit committee,’ says Dluginsky. Tax experts point to the Enron debacle as an example of what can go wrong when porous governance exists over tax risk management. The issues that arose as a result of that crisis were tax implications relating to the treatment of retirement plans, the treatment of stock options, and the differences between book and tax accounting.
According to analysis performed by Citizens for Tax Justice, Enron had profits before federal taxes totaling $1.785 billion over a five-year period and paid no corporate income taxes for four of those years. Its pre-tax profit for each of those years was never less than $87 million.
In Enron’s case, hard-working people were the worst affected; most lost their life savings and retirement funds. Doesn’t this case make a good argument for the increase in tax regulations over recent years?
‘In response to the Enron case, under SOX, a corporation’s audit committee has become more aware of any work an audit firm is performing for that entity,’ says Aksak. ‘But difficulties facing corporations when it comes to complying with the requirements of FIN 48, SOX and other regulations centre on having adequate resources with the proper level of experience, and obtaining and communicating the correct information within an organisation to address tax compliance issues on a timely basis.’
‘The increase in demand by the IRS and other regulators to make information more visible has caused a shift among corporations to automate more tax functions,’ notes Dluginsky. ‘Also, corporations are increasingly looking to outside experts to provide guidance and support in-house capabilities during peak times.’
Governance practices for tax risk management are all contingent on education and communication. The following represent some measures that may help corporations strengthen their governance practices in this area:
1. Understanding and evaluating the knowledge and skills of the entity’s resources, including that of upper management, the audit committee and the board of directors, regarding the issue
2. Identifying best practices in the industry in which the corporation operates
3. recognising strengths and weaknesses of the organisation’s current tax risk management practices, with particular focus on expenses, interest and penalties, and the potential impact on the income statement
4. analysing and improving the level of communication among the corporation’s upper management, the audit committee, the board, external auditors and other stakeholders
5. Assessing the costs of improving the entity’s current governance practices for tax risk management, including those of using outside tax resources.
An effective corporate governance framework for tax risk management is built on accountability, compliance and transparency.
It is central to promoting public trust, restoring the integrity of corporate America and protecting the welfare of investors, creditors and other stakeholders. It’s in a corporation’s best interests to stay on top of governance and tax risk management, and the best time to start is now, if not yesterday.