Tax risk and strong corporate governance.

AuthorNeubig, Tom

An important issue for a board and CEO is to consciously decide the position they wish to take on tax planning, rather than have it made for them by others.

--Michael Carmody, Australian Commissioner on Taxation (January 2004).

The accounting and reporting of income taxes has received increased scrutiny by investors, analysts, Congress and others. Your auditor will be asking for more information, and you may have noticed an increased level of scrutiny from the SEC staff. That spotlight is likely to continue. Welcome to the new world.

--Donald T. Nicolaisen, Chief Accountant, Securities and Exchange Commission (February 2004)

Three-fifths of CEOs believe 40% or more of their company's market capitalization is represented by brand/reputation.

--Voice of Leaders Survey, World Economic Forum (January 2004)

In today's business environment tax risk is one of the more challenging business risks presenting both monetary and reputation consequences for corporations. By its complicated and technical nature, tax risk may not be adequately understood and appreciated by corporate boards and senior management and may expose the company to unexpected outcomes. Yet, in the post-Enron world, it is imperative that strong corporate governance processes recognize this risk and that corporate boards and senior management deliberately decide how much tax risk is consistent with the overall corporate risk profile to satisfy shareholder expectations. This article provides an understanding of tax risk and its fundamental drivers, identifies potential gaps between tax departments and other stakeholders that may accentuate such risks, and offers suggestions on methods for quantifying and managing tax risk. The tax department of the future will be integrated in the firm's overall enterprise risk management and also help communicate and monitor for any gaps between the tax department's implementation of tax strategies and the firm's risk/return/reputation tradeoff.

Defining Tax Risk

The concept of risk can be broadly defined as the likelihood and magnitude of outcomes that are different than expected. It is important to make the distinction between certain or expected outcomes versus uncertain or unexpected "risky" outcomes. To illustrate this important point, the known tax depreciation that can be deducted from income next year is not risky since the outcome is expected with certainty (absent a change in the law applicable to property already in service-a decidedly remote prospect). The tax benefit from the deduction, however, may be uncertain because of the company's profit position arising from changing macroeconomic, industry, or specific company conditions. The tax benefit may also be uncertain if the tax class life of the asset is subject to dispute with the IRS. In this example, known depreciation expense for the next period does not pose any financial risk, but economic and tax technical risks create uncertain financial outcomes. Similarly, operational risk can affect many tax outcomes, including penalties and interest. For purposes of this article, the definition of tax risk in a broad sense accumulates all sources of risk that may create an unexpected outcome from a tax position. This definition is broader than others, which typically focus only on tax technical or operational risk aspects.

The various risk sources (underlying causes) that can make any tax position risky include, but are not limited to:

* Compliance or operational risk occurs because of non-compliance with tax requirements factually, or lapsing over time, thereby jeopardizing the viability of a tax position (e.g., tax elections that must be made at a particular time or in a particular matter to be effective).

* Economic and business assumption risk may change the premise on which many tax positions are based, such as revenue and net income growth expectations, which if not realized make the tax position worthless or significantly reduced in value.

* Financial risk may manifest itself through adverse interest rate, currency, or market movements that interact with tax positions to make their outcome uncertain.

* Legal risk owing to uncertainty in the outcome from the judicial process may undermine the presumed value of tax positions. This risk includes judicial risk in tax controversy and non-tax issues such as contractual or corporate matters.

* Legislative risk occurs because of potential changes in current law that may erode the value of current and past tax positions. For example...

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