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What boards should know about managing tax risk

Achieving balance between tax risk and opportunity requires collaboration among business units and proactive oversight of the

Author: John Stacey and Rob O'Connor

Expanded reporting and disclosure requirements have begun shining the public spotlight on another area of risk and compliance that today's corporate directors must oversee: tax.

According to Donald T. Nicolaisen, Chief Accountant of the SEC, "Income tax issues are in the public spotlight and will continue to be in the spotlight in the future… My educated guess is that, as the spotlight swivels, one of the areas where more focus can be expected is with regard to income taxes."

Interestingly enough, the spotlight has already begun to swivel. It's becoming clear that tax risk is not limited to income tax issues, but rather extends to all areas of an organization.

Exploring the nooks and crannies where tax risk resides
When most people think of tax risk, they imagine it confined to the issues that fall under the control of corporate tax departments. Admittedly, a major aspect of tax risk is the possibility of issues, disagreements, and/or assessments arising between the corporation and various tax authorities — and the resulting impact on the corporation's resources.

However, estimates suggest that the tax department only manages 25% to 30% of an organization's tax issues. The remaining 75% of risk is found in the business units and functional areas where the tax department may have little oversight, such as:

  • Head office, where a CEO's or CFO's response to analysts about tax issues could open the company to risk
  • Merger & acquisition activity, where an improper acquisition structure can lead to significant tax consequences
  • Business units, where changes in operations, contracts, or relationships can result in unexpected tax implications
  • Marketing, where products may be launched without appropriate tax analysis
  • Human resources department, where international secondments or hiring foreign employees can raise tax issues
  • Product or sales departments, where different tax rates may apply to different products

Simply put, tax risk exists in all of an organization's transactions — both routine and non-routine — and is not neatly packed into, or controlled by, any given group. In addition to encompassing "obvious" categories, such as corporate income taxes, it extends to capital taxes, sales and use taxes, customs and excise duties, payroll and employment taxes, property taxes, and withholding taxes. Taken together, taxes could represent up to 30% of a company's costs of doing business. Notably, these costs also generally are reflected in various different areas of the financial statements, from Sales and Cost of Goods Sold to the Balance Sheet.

Given the broad definition of tax risk, it's clear that variances can cause significant changes in a company's financial results in circumstances where taxes are not well managed and under control. All of which explains why management, boards, and audit committees must begin to consider tax risk more carefully.

The directors' role in tax risk management
Although tax risk is playing an increasingly important role as part of an effective corporate governance model, it is not really different from other types of risk. As such, corporate directors are not directly responsible for managing tax risk. That said, in this age of heightened regulatory control, it is incumbent upon the board to ensure that a proper risk management process is in place.

The burning question for corporate directors, then, should be: What constitutes a "proper" risk management process? There are four key steps to an effective tax risk management methodology:

  • Step 1: Risk Identification and Assessment
    A good starting point for tax risk management is for the board to gain a full understanding of what every aspect of the business does — whether or not it is under the direction of the tax function. Although tax is sometimes seen as a mysterious "black box" that is difficult to oversee, and even understand, board members must begin to examine the tax implications of different business activities so they can identify potential areas of risk.
  • Step 2: Risk Reduction
    Once the causes of tax risk have been identified and exposed, management and boards must develop controls to mitigate these risks and provide indicators of when it might arise. In this regard, it's important to remember that the aim is not to eliminate risk, but to manage it. It may help to start by identifying the company's "tax risk threshold" — the point at which it will be unwilling to assume additional tax risk. This threshold can act as an indicator of which types of risks are manageable, and which are not. Used properly, it can help a company not only reduce tax risk, but also seize all available tax opportunities.
  • Step 3: Execution
    Executing a risk management process should be an ongoing process. To ensure it is adopted throughout the organization, management should consider training and educating staff about the wide reach of tax risk. Risk owners should also be identified within different groups to coordinate and improve risk strategy, processes, and measures. The board can help by reviewing critical risk areas on a regular basis, including mitigation strategies, non-routine transactions, and items that have been identified as exceptions to the tax risk management process.
  • Step 4: Tax Risk Policy and Strategy
    Perhaps the most critical step of developing an effective tax risk management process is to establish formal policies that have been approved by senior management, the audit committee, and the board; and that have been widely communicated to those individuals throughout the organization who are accountable for their implementation. Through proper communication, consultation, and alignment between the corporate tax department, the business units, and management, tax risk can be appropriately considered and managed.

By effectively managing tax risk, companies put themselves in a position to better leverage tax opportunities.

Benefits beyond good corporate governance

  • The establishment of an overall tax strategy against which future decisions can be measured, with the involvement and approval of senior management
  • Improved internal communication between business units on tax matters
  • Increased and/or more effective resourcing of the tax function
  • The development of a framework and process for tracking and managing tax risk
  • The creation of a fully integrated system for identifying and assessing new tax opportunities
  • Improved effective tax rates and earnings per share
  • Improved capability for managing foreign operations
  • Fewer successful tax authority challenges
  • Cost savings through more efficient working practices
  • Simplification of the provisioning process with auditors
  • The ability to better account for and disclose tax risk in the financial statements

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