For the past couple of years I’ve been asserting that most larger companies (those with 1,000 or employees) need to adopt a new approach to using software to handle their taxes comprehensively, both the direct sort (income taxes) and the indirect variety (sales and use taxes as well as value-added or goods and services taxes). This is a necessary response to an emerging challenge from more competent and determined tax enforcement by governments worldwide. It will require corporations to make changes in how they employ software to manage their taxes, structure their tax-related data and manage their tax processes. Increasingly, corporations will need to have better control over the way they manage tax data, calculate taxes and handle associated processes so they can minimize their tax liabilities and their tax risk exposure.
Governments everywhere have long “punched below their weight” in most aspects of tax enforcement, in part because they’ve lacked the information management tools and data infrastructure to determine and demand what they are owed. However, as their need for revenue rises while they face growing resistance to higher rates, more effective enforcement becomes a necessary option that revenue agencies are pursuing, which includes increasing their investments in systems and people that can help them be more effective in collecting more taxes. There is also increased cooperation between taxing authorities to share information. In the United States, the Internal Revenue Service (IRS) has long shared its tax return data with individual states, and now the number of international agreements for bilateral information-sharing is growing.
As tax authorities get smarter, the organizations being taxed must develop countermoves to ensure that they are able to optimize their tax provisions, effectively defend their positions when challenged and manage their tax risk exposure strategically. Larger corporations – especially those that operate internationally, operate a large number of legal entities or have complex legal structures – face much more complex tax issues than those that don’t. Tax codes differ depending on the jurisdictions, in both tax structures and specific rules. Legitimate opportunities exist to take advantage of these differences in ways that minimize tax expense and defer tax payments. Conversely there also are traps where poor structuring of legal entities, contracts and transaction details can lead to unnecessary tax expense. While some tax law is black-and-white, more is not. Definitions of “revenue” and “expense” can be fuzzy. When it comes to indirect taxes, so are the classifications of goods and services. (For example, when is a cookie not a cookie?)
Until recently, enforcement authorities have relied mainly on blunt tactics in enforcement aimed at forcing compromise. This often results in absurdly complex negotiations aimed at figuring out where a settlement can be reached. A tax authority will have a number in mind that will satisfy it; the company for its part will try to figure out how to get the deal most favorable to it. Now, because governments need more revenue, the old approach of assert and settle quickly appears to be giving way to seeking greater leverage in bargaining through the use of analytics and data mining. As well there are new laws aimed at forcing companies to provide greater transparency. In the U.S., this has led to the requirement that companies formally provide the IRS with details about the “uncertain tax provisions” they are required to disclose in their financial statements under FIN-48 in a new schedule UTP. In addition to carrying new sticks for enforcement, governments also are starting to provide incentives to companies that show greater transparency in its tax books.
To some extent this amounts to a shifting of the information balance of power, and it is accompanied by increased cooperation among governments in ways that would have been unthinkable two decades ago. Globalization of the financial markets has given big countries like the United States greater clout. Bank secrecy laws were once inviolate in Switzerland, yet banks in that country are handing over information about the private accounts of U.S., U.K. and German taxpayers to their respective governments. Efforts are under way for bilateral exchanges of transfer-pricing information to help tax authorities find and win related cases.
To respond to this changing tax enforcement environment, companies need to take a more comprehensive, strategic approach to managing their taxes. Traditionally the tax function has been an obscure corner of the finance department. It is an area that I started focusing on because it’s clear that most corporations have not made the right investments in technology to support it. To the extent that they pay any attention to it, the objective is to reduce tax expense and minimize the cost of operating the tax function. That won’t work any more. Structural changes to the enforcement process are making this approach not only obsolete but also potentially more costly and riskier.
Increasingly, managing taxes is about achieving three objectives. One is to lower tax expense through a deeper understanding of the available options and the best choices available. Any such decision must be made in the context of a company’s risk appetite, which defines the degree of aggressiveness it takes in making these choices. So second, where there is risk, there must be an effective risk management program in place to ensure that the company has the ability to mitigate the probability and impact of potential negative tax events. And third, cost and risk optimization must be achieved through more controlled and visible process management. Optimizing tax liability is achieved through some combination of making better choices (or fewer avoidable mistakes) in structuring tax exposures and being able to defend the most aggressive position possible with the least amount of risk. Risk mitigation is achieved by being able to fully marshal the tax-related data and demonstrate a valid rationale behind the decisions being questioned.
Today, few companies are prepared to deal strategically with this more challenging tax enforcement environment. But unless they do, they are likely to pay more taxes and incur greater fines than necessary. To improve their position, I see three areas that require the most attention: information, technology and process.
A large majority of corporate transactions systems (mostly ERP or accounting) are structured to support only a management-structure view, not the legal-entity view needed to efficiently manage taxes. Since this step is often overlooked when accounting systems are set up, tax departments wind up manually translating management-data views into tax-data views. Rather than a comprehensive record of tax-related data in a single repository of record, they have information scattered among systems. This makes it harder to recreate the calculations and demonstrate their soundness and consistency when defending positions. All of these rear-guard data management actions consume a considerable amount of time – time better spent on more strategic activities.
Large companies face a complex tax environment, especially those that operate in many jurisdictions worldwide. Making the optimal choices – the ones that not only reduce tax exposure but also offer the best trade-offs between current and future tax payments within risk tolerances – requires not just the right information but also the right technology. Many larger companies have automated their indirect tax management and have applied some automation to their income tax preparation. However, they may not be as up-to-date as they should and therefore raise the risk of errors and omissions in their calculations. Moreover, tax departments rely heavily on the use of desktop spreadsheets for data transformation, data storage and analysis. Our research shows that desktop spreadsheets are notoriously error-prone, and they are time-consuming because they do not do a good job of consolidating information from multiple sources and are inherently incapable of managing more than a few dimensions at once. Companies that use desktop spreadsheets therefore do not use their tax experts’ time as effectively as they should, make it more difficult to make optimal tax choices and needlessly expose themselves to tax-related risks.
Tax-related processes are repetitive and require consistent management. Until now, corporations have relied on the dedication and organizational skills of their tax departments to ensure that everything is done on time. However, the expanding tax mandates are increasing the workload on these departments. To respond, they need to take a more structured approach to their processes, finding ways to decrease the time-on-task aspects (through the enhanced use of technology and better access to data, as noted above) and cut the time between tasks by having a workflow management capability. Workflow also makes it possible for tax managers to cut the time they spend overseeing processes because they can handle process execution on an exception basis. Workflow also diminishes the risk that filings or underlying analyses will be overlooked or delayed.
As governments the world over try to find new sources of revenue, they are changing the status quo for corporate tax management. To address this increasing external threat, corporations must rethink how they manage taxes. They must address their information, technology and process shortcomings to achieve the lowest possible tax expense and manage their tax-related risks more effectively.
Robert D. Kugel CFA, SVP of Research