Evolving business models, governmental policies and capital markets affect tax risk and increase the importance of having tax leadership present in strategic or transformational planning. Appropriate corporate governance should include thoughtful approaches to tax risk policy and to communicating and resolving risks at the C-suite or board level.
Recently, Padric Kelly O’Brien provided insight on proposals from the U.S. Treasury Department that are designed for tax professionals who practice before the Internal Revenue Service. The proposals were developed in an effort to give clarity on written communications and provide additional requirements for competence and management oversight. You can read the assessment here.
Managing tax risk by return filers is explicitly or implicitly at the core of each of the three proposals. Members of the tax bar, whether in private practice or as corporate counsel, have noted in speeches by or comments attributed to senior IRS management the heightened appreciation the agency has for promoting effective management techniques by taxpayers and their advisers. For example, when noting that taxes are one of the biggest expenses of a corporation, retired Commissioner Shulman said that boards of directors should play an important role in overseeing tax risk and tax strategies of corporations. That comment was an attention-grabbing statement from the IRS. But, in truth, satisfying tax administrators is only one of the many reasons an entity should consider implementing formal tax risk management policies. The chief tax officer or tax counsel can and should have a role to play in that process.
There is an increased focus on corporate governance in general, as well as tax risk management. This focus has resulted in greater demands for transparency and disclosure. The passage of Sarbanes-Oxley legislation, adoption of FIN 48 in the accounting area, and heightened media attention on the complexity of taxes and significant impact they can have on a corporation’s reputation and value all combine to emphasize the need for a corporation to focus on managing tax risk.
Managing tax risk includes developing a workable definition of that element of enterprise risk. In addition, tax leadership needs to identify where the risks arise. Finally, as an internal control or process matter, an enterprise should implement a plan to integrate the tax risk management policy with the entity’s enterprise risk management policy.
Broadly speaking, tax risk encompasses all sources of risk that may create an unexpected outcome from a tax position. Tax practitioners are fully aware that the potential for tax risk is embedded in all aspects of the business. Risks may arise in operations, transactions, compliance, financial accounting and controversy management.
Analysis of the scope of the risk requires a more granular examination of the sources of risk within each of those categories. For example, transactional risk includes the risk associated with the application of the tax laws, regulations and interpretations to specific transactions. The following areas of concern can be identified when assessing the scope of tax risk in relation to transactions: a challenge to the technical basis for the tax treatment of the transaction, a change in law that affects the transaction, a change in facts or circumstances, insufficient tax planning, or failure to implement the planning. A similar list can be prepared for each of the other categories of tax department responsibilities.
The nature of these risks will vary by enterprise, but a baseline understanding for every enterprise is that tax risk is substantially more than getting the numbers wrong in a filing. Just as important is the acceptance of the view that the areas in which tax risks can arise are not limited to the tax department alone. The challenge is to create an internal awareness among affected constituencies that will not only aid in risk identification but will also foster creation of a framework for monitoring risk treatment or resolution. This significant undertaking will involve the active collaboration of the tax department, the finance department, the “C Suite” and the responsible committees of the board.
The benefits of this in-depth analysis are many. It is not just addressing what the tax administrators have by regulatory fiat established as their base comfort level for tax departments and tax advisors. Hopefully, such an analysis can result in increased confidence that 1) the tax function is operating in a manner consistent with the organization’s overall business goals; 2) there is control from the organization’s center; and 3) there is clarity on the roles, responsibilities and accountability for each element of the plan.