Robert Kugel's Analyst Perspectives

Optimizing Tax Risk Exposure

Posted by Ventana Research on Jan 10, 2011 4:41:12 PM

I recently commented on why I believe companies must manage taxes more intelligently. One dimension of this is optimizing tax risk exposure. Most corporate tax codes are notoriously complex and at times ambiguous, leaving room for companies to interpret their application. These interpretations fall on a scale of “conservative” to “aggressive,” in which companies weigh the risk of penalties and other negative outcomes against that of paying more taxes than necessary. It strikes me that few of the companies that should be paying attention to these sorts of trade-offs  are doing so. I suspect there are a couple of important reasons.

First, though, I should note that there are plenty of companies that needn’t bother with trying to optimize their tax exposure. All small and almost all midsize companies do not have enough money at stake to make a formal effort worthwhile. They address the issue well enough in an ad hoc fashion. And, regardless of their size, companies that have simple entity structures, that are in industries governed with relatively less complex tax regimes, or that operate in a limited number of tax jurisdictions are unlikely to find enough value in actively managing their tax risk exposure. However, this still means many larger and some midsize corporations could be handling their tax risk exposure more intelligently.

So why don’t those companies do a better job of managing their tax risk exposure? I believe at least four intertwined reasons are at work. One is that the penalty for aggressive interpretations has been limited. Governments have been “punching below their weight” in tax enforcement, so they don’t always challenge aggressive stances. When they are, the aggregate downside relative to paying more in the first place is usually quite acceptable. Until this changes, it’s unlikely that companies will believe it’s worthwhile to change. Second, the process of managing direct taxes is a highly manual process in a majority of larger companies. In part because enterprise resource planning (ERP) and accounting systems typically are not provisioned to be tax aware (because executives don’t believe it’s worth the investment), tax departments believe it’s too difficult to automate the tax planning and provisioning process. These transactions systems do not collect and/or are not able to handle the tax jurisdiction dimensions of transactions, which can be extremely complex in large, multinational companies. A workaround to the lack of tax awareness in ERP/accounting systems is a “tax database of record”, which also can reduce the administrative costs of the tax function. A third, related reason is that without hard data, it’s too difficult to prove the negative: What would the effective tax rate have been if a company was willing to take more risk? Thus, it’s tough to determine that there’s sufficient upside to trade off a higher risk profile with lower taxes.

However, I believe the main obstacle to managing tax risk more effectively (that is, achieving the right balance between safe and aggressive for the specific company) is that tax is a highly specialized and – to be blunt - an obscure function in just about all organizations. Until senior executives start to believe that there’s enough of a return in optimizing tax risk exposure, the resources to do so will be hard to come by. Tax departments that want to become a strategic asset in their company will need to demonstrate that there’s value in more intelligent tax planning and provisioning.

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Robert Kugel – SVP Research

Topics: Tax, Business Performance Management (BPM), CFO, Financial Performance Management (FPM), Financial Performance Management

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