By Karen Lynch
Tax controversy, at its most basic, is a disagreement between a taxpayer and a tax authority — hardly rare in the normal give-and-take between business and government.
However, globalization, digitalization and the media spotlight on tax, as well as the subsequent political reaction, have driven controversy to new heights.
With these three forces at play, old economy tax rules are being recast for the global digital economy.
“It’s a board decision how conservative or aggressive your tax strategy should be.“
Jacob Malmros, Head of Taxes, Alfa Laval
Complex new international business models are scrutinized for the cross-border mobility of their people, assets, production and profits.
Governments challenge each other, as well as multinational businesses, to get what they see as their fair share of taxable revenue.
Politicians and the media are more focused on low corporate tax bills in difficult economic times.
Through it all, tax uncertainty feeds controversy.
A rapidly changing tax picture
Sudden shifts in tax policy announcements, such as US President Donald Trump calling for a 35% tax on offshoring in the weeks between winning the election and taking office, can change the tax outlook for American companies’ global supply chains.
Add some uncoordinated implementation by national governments of anti-base erosion and profit shifting (BEPS) legislation inspired by the Organisation for Economic Co-operation and Development, (OECD).
Throw in the trade agreements and tax treaties that could be subject to renegotiation amid growing nationalism and protectionism around the world.
Compound it with accelerating digitalization, collection and exchange of corporate data among tax administrations, in the name of transparency.
Heat it up with intense global competition among nations and among multinational businesses — all seeking growth in a low-growth world.
All of this is giving businesses pause.
“The appetite for tax certainty today is the highest I’ve seen in 10 years,” says Glenn Williams, an EY tax controversy and risk management professional in Sydney.
What is the formula for controversy-proofing a business in this environment?
For some, the answer is a fundamental rethink of the tax strategy to achieve more certainty.
Many see it as a matter of establishing better internal controls.
Yet, more seek to improve how they manage relations with tax authorities.
For all, it is a communications challenge.
Out with the old
Tax controversy needs to be addressed as a strategic business priority, given its potential consequences.
Tangible impacts can include additional taxes, interest, penalties, legal fees for appeals, share price erosion triggered by financial statement adjustments and the need to reserve cash in case of liability (rather than putting it to profitable use).
Less tangible costs can include a drain on senior management focus and business confidence, as well as reputational damage in the eyes of consumers and other stakeholders.
Another effect could be a company’s designation to tax authorities’ “high-risk” category, perpetually subject to closer scrutiny and repeat audits.
Across the world, businesses are re-examining their tax strategies.
“To increase financial statement certainty, we have taken steps to accelerate the review of our tax returns in the US and around the world.“
Paul Smith, SVP, Global Taxes, McKesson Corp.
Alfa Laval, a Swedish supplier of industrial equipment, put its tax policy in writing and is considering making it public, according to Jacob Malmros, Head of Taxes.
“The most important point in it is to be more conservative, as the best way to manage risk,” he says.
Key risk areas that businesses are reviewing include transfer pricing, especially in the treatment of intangible assets, and the creation of permanent establishments, subject to reporting requirements and tax in one country after the other.
According to our 2016 Transfer Pricing Survey, the fact that transfer pricing is one of the most visible topics today in the global debate surrounding tax avoidance has contributed to the new risk aversion.
In that survey, 7 in 10 businesses consider establishing a clear strategy as their top priority.
However, strategic differences are evident among regions.
While participants from all regions indicate that tax risk management is their top transfer pricing priority, respondents from the Americas are somewhat more focused on their effective tax rate than their peers in other regions.
At Alfa Laval, as at many organizations, “it’s a board decision how conservative or aggressive your tax strategy should be,” Malmros points out.
Board members are keenly aware of the damage tax controversy can do to a company’s performance and reputation.
For their part, tax officials increasingly expect board-level engagement in tax matters.
For example, at McKesson Corp., a San Francisco-based pharmaceutical distributor and health care information technology company, Paul Smith regularly brings members of his team to present at meetings of the board’s audit committee, in his role as Senior Vice President, Global Taxes.
He also looks for opportunities outside of formal board meetings to keep tax matters in front of directors.
Laying the groundwork
In global business, tax control frameworks can be essential tools for mastering today’s risks.
Given increased oversight by tax authorities, so are controversy management frameworks.
Tax control frameworks include a clear tax strategy, a comprehensive plan for operationalizing the strategy, assigned responsibilities, documented governance and regular testing and updating in line with business dynamics and changing tax rules.
These frameworks often form the basis of cooperative compliance relationships with tax authorities.
As the OECD sees it, “when the tax control framework of a multinational enterprise participating in a cooperative compliance program is determined to be effective, and when the enterprise provides complete disclosures that include relevant information and tax risks … the extent of reviews and audits of returns submitted can be reduced significantly.”
Controversy management frameworks represent another level of control.
“Companies operate in many more countries today, which is driving their need to strategically manage global controversy from beginning to end,” says Frank Ng, a member of EY’s Tax Controversy and Risk Management Services group in Washington, DC.
As they work across jurisdictions, dealing simultaneously with more and less automated and sophisticated tax administrations, businesses need to understand local laws and procedures, including dispute resolution tools, appeals rights and litigation procedures.
“Many multinationals at headquarters are looking for a line of sight to tax exposures on a real-time basis,” Ng says, including how many audits are open, at which stage in the process and the potential impact in other jurisdictions.
Paul Smith and his team at McKesson Corp., a San Francisco-based pharmaceutical distributor, understand that communication is essential today when it comes to tax matters, be it with the company’s management, board members or tax authorities.
The role of digitalization
A particular flashpoint for tax risk is the current digital transformation affecting global businesses and tax administration functions.
“Governments are looking to digital technologies as well as transactions within the digital economy as new sources of tax revenue” says Channing Flynn, EY Global Technology Industry and Digital Tax Leader based in San Francisco and San Jose.
Businesses should understand the four key components of digital tax and develop a strategy to deploy them within their tax organization, he says.
- Digital tax effectiveness
- Digital tax administration
- Tax technology
- Tax big data
An overall digital tax strategy should then answer four questions:
- What are the tax implications as digital technology changes business strategies, models and supply chains?
- What can businesses do to meet the demands from governments’ digital tax administrations, continued regulatory changes and increasing transparency requirements?
- How can digital technology help build a better working tax function?
- How can it provide value-added insights and better visibility by leveraging data?
Alfa Laval has good relations with its tax administration at home in Sweden, Malmros says, but has an especially bad relationship in one Asian country in which it operates.
For over four years, Swedish authorities have been trying unsuccessfully to agree with this country’s administration on Alfa Laval’s transfer pricing approach.
Recently, tax inspectors came on site and demanded all emails from the local chief accountant and financial controller in the country, Malmros says. “It’s a very hostile environment.”
EY survey results point to shifting relations between business and government.
At the EY Annual International Tax Conference in October, more than half of tax directors said the number of countries in which they are subject to an active audit has increased.
Nearly three-quarters said the enforcement posture and tactics of tax authorities around the world have become more aggressive.
To head off controversy, the 2016 Transfer Pricing Survey shows two in three respondents expect to increase their use of advance pricing agreements (APAs), in which tax authorities and taxpayers concur on transfer pricing for future years.
Today, only about a third in the survey are relying on APAs.
Engaging with tax authorities
Governments such as Australia have established early engagement programs to provide rulings to those considering complex transactions.
“Businesses looking for tax certainty should engage early and often with tax authorities,” says EY’s Williams. “Here in Australia, the early engagement program will probably reward those companies that appear to be transparent and working with the tax authority on a real-time basis.”
Under the program, companies would bring up areas of potential risk, engaging with and securing defined outcomes from the administration before tax filing time, averting controversy.
Timing is critical in more ways than one. That’s the lesson that Smith rigorously applies at McKesson.
“Tax strategies that seem non-aggressive and ‘middle of the fairway’ when put in place may appear quite differently when viewed by the tax authorities many years later,” he says.
Among the risks this can raise, Smith is particularly attuned to the damage that resulting financial statement adjustments can do to a company’s valuation.
“To minimize this risk and increase financial statement certainty, we have taken steps to accelerate the review of our tax returns in the US and around the world,” he says.
The fact that so much tax information is being gathered by tax authorities — with some calling for its public disclosure — leaves room for misinterpretation and public controversy.
“You are virtually proceeding with your tax affairs nowadays on a cards-face-up basis, so if you have some tax uncertainty in your hand, then it will almost inevitably lead to tax controversy,” says Williams.
The baseline for communicating a business’s tax profile involves ongoing dialogue with tax authorities, grounded in accurate data and providing the necessary context.
However, even APAs with tax authorities can raise public relations risks, with the media and other groups sometimes referring to them as “secret deals.”
This APA dilemma provides just one example of the need to raise tax on the communications department’s agenda.
Tax is increasingly seen as a matter of corporate social responsibility, like environmental stewardship or fair labor practices.
Growing numbers of businesses in Europe, for example, now publish their tax policies online.
A sound approach
Tax communications strategies need to be firmly in place.
- Previewing all press releases for potential tax significance
- Documenting a policy and procedure for responding to tax inquiries from the press
- Maintaining a dialogue between the tax and corporate communications functions
Leading practices include the proactive identification of a business’s full economic contribution around the globe — in terms of not only income tax but also property, payroll, sales and employee income taxes on stock-based compensation.
The economic substance of business decisions, such as the operational responsibilities and functionality of a foreign intellectual property subsidiary, should be defensible in tax terms.
Internal corporate communications are critical for business confidence as well as tax compliance.
“Through frequent and effective internal communications, C-suite executives can be confident that if something were a material risk or opportunity for the company, they would already have heard about it from their tax department,” Smith says.
Keep in mind that change can happen suddenly, and communications should not lag.
In December, Smith, sought to get ahead of the curve by flying to Washington, DC, to emphasize his organization’s tax concerns well before the new presidential administration took office.
In the current rally for US tax reform, as in so many tax changes around the world, “there will be big winners and losers,” he says.
“Helping to highlight unusual fact patterns or issues to minimize the risk of unintended negative consequences for McKesson is an important priority for me.”
Key action points
- Maintain a global perspective on tax changes in all jurisdictions
- Establish clear frameworks for tax control, controversy management, digital tax and communications
- Work on your relationships with tax authorities
- Reinforce your tax department with new skills, including advocacy and digital capabilities