Tax Regulation And Enforcement

Matt Atkins, July 2012

Tax authorities around the world have become much more aggressive in their enforcement of taxation rules and regulations, and are willing to pursue all avenues of investigation. This fact highlights the need for companies to stay on top of their compliance strategies. But while managing tax strategies and creating tax efficiency are crucial to maximising profits, in the current climate of increased audits, companies must be prepared for scrutiny and disputes, especially given the complexities and depth of tax investigations and related litigation.

Driving forces

Governments globally are enacting an ever-increasing number of changes to their tax laws, regulations and tax administration processes. The UK General Anti-Abuse Rule (GAAR) and the US Foreign Account Tax Compliance Act (FATCA) are just two examples of state action on tax avoidance and evasion. In an economic environment ravaged by the financial crisis of 2008 and its subsequent fallout, governments worldwide have prioritised the reduction of deficits and the balancing of national budgets. In order to raise revenue in an effective and efficient manner, authorities are focusing their meagre resources on high-risk issues and taxpayers, and attempting to improve compliance by enforcing information reporting and withholding requirements, as well as increasing disclosure and transparency requirements.

But while an increased focus on the generation of tax revenue is a major contributor to this vigorous enforcement, a convergence of trends is behind this behaviour, asserts Debbie Nolan, a partner at Ernst & Young. “The rapid pace of globalisation means that the dynamics of taxation are changing. While tax enforcement was once approached as more of a ‘national’ exercise, cross-border capital flows have grown exponentially and issues related to the migration of intangibles, royalties, service fees and intra-group financing now challenge taxpayers and tax administrator alike. Even a globally mobile workforce creates challenges for taxpayers and tax authorities alike, both from a compliance standpoint and an enforcement standpoint.” Indeed, a revolution in how business is conducted has been seen in the past two decades as advances in communications technology has opened up the globe as a marketplace and driven new business models. Hi-tech firms such as Google and Apple, much of whose revenue comes via intellectual property, along with online retail outlets such as Amazon, present difficult questions about which jurisdiction they should pay tax in.

A further trend of the past 20 years has been the emergence of developing economies and their impact on the world of business. While these nations can offer great commercial opportunities they can also present risks. As tax administration processes in many emerging nations are still evolving, they can be unpredictable and frustrating for companies trying to plan and manage their risk related to tax policy. For this reason, as well as strengthening their enforcement efforts, countries are also showing a greater desire to take a more collaborative approach to taxation.

Avoidance and evasion

In recent years, governments have also become wise to the legal methods that some corporations employ in order to minimise tax exposures and the issue of tax planning has received widespread media attention. Global companies – many of which have been able to save billions on tax by basing their operations in low-tax jurisdictions – have come under the microscope, spurring the authorities into action.

The New York Times recently published a report on the tax arrangements of US tech-giant Apple, finding that in 2011 the company avoided paying $2.4bn of federal income tax. While the fact that 64 percent of Apple products are sold outside of the US, and the vast bulk of manufacturing takes place in China, it is unsurprising that the company’s US tax liabilities came in below the expected norm; however, the tech giant’s use of subsidiaries in low-tax jurisdictions including the Netherlands, Ireland and the British Virgin Islands dramatically reduces even these tax exposures. Furthermore, Apple even manages to shield from the authorities profits that do make it into the US. While headquartered in Cupertino, California, Apple’s profits are collected 200 miles away in Reno, Nevada, which benefits from a 0 percent corporation tax, as opposed to California’s 8.84 percent.

Similarly, late last year, The Guardian revealed that Amazon was able to pay no corporation tax in the UK in 2011, although it generated £3.3bn of sales. The online retailer based itself in Luxembourg in 2006 and runs the UK operation as an ‘order fulfilment’ business only. All profits, therefore, leave the UK and cannot be taxed. While it is unclear whether HMRC is investigating the case, Amazon’s tax affairs are under investigation in the US, China, German, France, Japan and Luxembourg.

A challenge by a tax authority could be damaging in an age when reputation is a prized asset.  However, the issue should rest at the door of the courts, and not with the authorities or media when the companies are working within the law, says Peter Connors, a partner at Orrick. “Legislators and others will continue to make accusations regarding the use of offshore tax jurisdictions. However, many of the structures are legitimate and merely have been developed in the context of the country’s tax system. The tax systems, regulations and often treaties need to be changed.” That said, governments are now making moves to act on what they see as artificial and abusive tax avoidance schemes, for instance, where some companies have taken advantage of strategies that enable them to change corporate residence and reduce their worldwide effective tax rate, though depending on how this has been accomplished it can be an entirely legitimate manoeuvre.

Managing tax strategies

In light of the increased focus on tax avoidance and evasion, it has become much more difficult for firms to manage their risk exposures, but the financial and reputational risks make overcoming these difficulties a priority. Firms must bear in mind the jurisdictions in which they are operating, as well as the types of tax liabilities they can expect to face, though the rate at which legal and regulatory demands evolve makes this a continuous game of catch-up. “We think there are five areas that companies should consider in building an efficient and effective global tax risk management framework,” says Ms Nolan. “First is adopting a global approach to tax risk and controversy management. Second, firms should evaluate global resources, processes and systems for tax risk management. Third is addressing tax risk and controversy at a strategic level — and executing this well. Fourth, companies must make strong corporate governance in tax a priority — it is to tax administrators and it makes good business sense. Fifth and finally, firms must stay connected with global legislative, regulatory and tax administration change.” Staying engaged is the key. Knowing what the legislature and tax authority of each nation is planning, and keeping in mind the previous actions of more advanced economies, will aid in avoiding controversy.

Thinking like the regulators is also a sound tactic. Firms should examine their tax strategies with the aim of finding fault. Each aspect should be analysed and questioned. Vigilance is a must. “Companies should assume that every transaction of significance will be challenged,” suggests Mr Connors. “They should ask themselves ‘What information would I like to have if the transaction were challenged?’ If challenged, they should ask ‘How will I document the legitimacy of the strategy?’ Some redundancy should be built into quality control.”

Audit and investigation

With the spotlight now firmly on corporate tax planning, companies must expect audits and know how to prepare for such an occasion. Equally, they must be mindful of the action they must take when an investigation is launched, and the costs and time obligations involved in both processes.

Chief financial officers and other finance executives, tax directors and corporate boards should focus on tax audit readiness, and put in place policies and procedures before the audit notice arrives. Ideally, planning for such an occurrence would be built into corporate thinking, so that options for tax controversies can be managed proactively or even avoided. Advanced pricing agreements are a useful tool in this respect, and firms can also request rulings that increase certainty, thereby avoiding future audit, appeal or litigation in the future.

The maintenance of documentation is critical, more so in countries where audits can occur several years in arrears. Developing a comprehensive information-gathering process before an audit is critical to providing the exam teams with the right information promptly. Initial documentation requests during an audit might include various tax returns, financial statements, transfer pricing documentation, minutes of boards of director and committee meetings. Key to having the correct documentation to hand is knowing the types of records and accounts that the law demands.

Providing a single point of contact for the auditing agent helps to ensure effective and timely communication and streamlines the audit and investigation process. An experienced staff member, knowledgeable in tax matters, and who can interact professionally and responsibly, would best suit this role. Ensuring coordination between outside legal counsel and public auditors is also helpful.

Where tax exposures are discovered, keeping abreast of the options available is essential, as is understanding the various dispute resolution tools available. “Deciding early on whether there will be a collaborative approach to resolving an issue or a contentious relationship will drive the approach used by a company,” explains Ms Nolan. “Generally speaking, I would suggest that most tax disputes are the result of complex law or facts where reasonable professional people can disagree, or an area where there may not be a precise ‘right answer’ but an acceptable answer within a range, such as in transfer pricing. Those types of issues lend themselves to a collaborative approach that saves both the taxpayer and the tax authority time and resources.”

Multinational tax disputes

In an economy where global enterprises play a prominent role, particular issues and complexities are raised by multinational tax disputes. When enterprises must comply with a wide range of tax laws and regulations across a number of host countries, it is unsurprising that controversy should arise.

Transfer pricing remains a leading focus for government tax policy-makers, and a risk for taxpayers. In a recent Ernst & Young survey, 57 percent of tax administrators and 48 percent of the largest corporate taxpayers identified transfer pricing as their leading area of tax risk in the next 12 months. For tax administrators, transfer pricing polled close to three times the amount of responses as global restructuring, their second-highest tax risk focus area. In such disputes, resolution can take several years. Advanced pricing agreements, however, can achieve some certainty for taxpayers and governments alike.

While transfer pricing has long been an area of contention, indirect taxes are now emerging as a potential flashpoint. Tax policymakers are coming to view indirect taxes to be their leading source of new revenue over the next decade. With governments cracking down on what they see as abusive tax management schemes, tax authorities are examining all possible techniques to disallow benefits that are ‘unwarranted’. Indirect foreign tax credits have come under the spotlight in this respect. A recent example is the Hewlett Packard decision involving foreign tax credit planning. In this case, HP was required to return more than $190m in tax refunds tied to a Dutch tax shelter designed by American International Group (AIG).

The strategy involved trading derivatives with the aim of generating capital losses and foreign tax credits, which were then used by HP to lower their US tax bills. “HP’s investment is more accurately characterised as debt rather than equity, for Federal income tax purposes,” wrote the judge.

Future trends

With current political and economic conditions looking likely to stretch into the foreseeable future, what will be the impact on global tax regulations around the world, and the ways in which they are enforced? “There will be more and more cooperation among the international tax authorities, which will result in more and more information exchange,” suggests Mr Connors. “There will be more joint audits and obstacles to cooperation will drop. Taxpayers will continue to obtain advance pricing agreements to resolve controversy.” Indeed, the Multilateral Convention on Mutual Administrative Assistance in Tax Matters, which offers a wide range of tools for cross-border considerations, was agreed by all G20 governments in March 2011.

The emerging markets are also expected to develop a much louder voice in coming years, and the result will be the integration of many of their requirements into globally accepted guidelines and practices, including transfer pricing. Indeed, in January 2012, India signed the Multilateral Convention, marking enhanced cooperation with the OECD on international taxation matters, particularly transfer pricing.

Improvements in technology are likely to make their own impact in a number of different areas of tax administration, including risk assessment processes. An increasing number of countries are putting in place electronic invoicing requirements, allowing them to closely and effectively identify tax abuse. In addition, electronic systems for filing and paying taxes have been proven to lighten the operational burden of tax payment, bringing efficiency benefits for both businesses and governments.

Tighter disclosure and transparency requirements are also expected, along with a proliferation of programs such as the US Uncertain Tax Positions and Australia’s Reportable Tax Positions. In addition, the pace and scope of information exchange is expected to increase and withholding requirements are projected to proliferate.

While the coming years will bring unprecedented change, one might expect that taxation reform will include some carrot along with the inevitable stick. Could the future see strong corporate governance in tax rewarded by tax administrators? Perhaps governments will find that encouraging business growth will work in tandem with reaping tax revenues? Corporate taxpayers can only hope.