This article is the next in our tax function effectiveness series and discusses the latest thinking from the Australian Taxation Office (ATO) on tax risk management and how it can help tax functions perform as "best in class”.
It’s tempting to think that the latest set of ATO glossy publications is more tax risk rhetoric and doesn’t add much to the thinking around tax risk management. But scratch below the surface and there’s a new level of detail which, taken on its own merits, provides the best view yet on what the ATO looks for when assessing risk.
With the release of the ATO’s 2006-2007 Compliance Program and 2006 Large Business and Tax Compliance publications, we now have detailed guidance on the ATO’s risk assessment process. The ATO’s stated aim is self-regulation, and the best way to achieve that is to publicise the performance standards expected of large business and warn against the outcomes that attract their attention.
These publications provide a timely reminder that the ATO is serious about risk in the large business sector, and provide useful insights into the ATO’s approach to tax compliance, including the factors that are likely to attract a tax audit or review, which can be used by any corporate to review and assess its current tax risk management practices.
ATO views on corporate governance and tax risk management
Under the guidance of the new Commissioner of Taxation, Michael D’Ascenzo, the ATO reiterates the message that tax risk management processes should factor into a company’s corporate governance program.
The ATO continues its push for directors of companies to have active involvement in setting the risk appetite in relation to managing tax, in particular having an overview of the company’s tax obligations and the tax outcomes associated with major transactions, arrangements and strategies, and assessing the impact of its decisions on the company’s ability to withstand ATO scrutiny. To this end, the ATO suggest that directors and senior management "may want to”:
- have a broad understanding of the major tax issues that arise in the normal ongoing operations of the business
- make enquiries about or establish reporting procedures to identify material risks
- consider the tax implications of major transactions, business structures and strategies
- oversee the overall amounts of different taxes paid by the business and be aware of whether these amounts are increasing or reducing and the trends for key indicators, and
- be aware of the kind of relationship the company has with the ATO, the level of scrutiny of the business’ affairs and the stance the business and its advisers adopt in relation to tax compliance and tax planning.
The ATO states that "all of these factors have a bearing on whether the business has a high, moderate or low risk level and the ability of directors and senior management to be in a position to know where the risks are and to ensure they are properly managed.”
Large business may consider that they addressed their tax risk management and governance processes back in 2004 when the then Commissioner of Taxation, Michael Carmody, wrote to the Boards of large companies. However, tax risk management is not a static issue, and the ATO is clearly expecting something more proactive than a set of written policies and a document that claims to be a risk framework. An organisation which fails to systemise risk management controls and procedures and build them into the business may soon find that it is unable to easily articulate where the risks are and defend the positions taken and tax outcomes.
A performance standard for tax governance - how does your business rate?
The ATO has provided some clear guidance on their expected performance standards for corporate governance around tax as well as providing indicators for the tax outcomes that attract their attention. The Large Business and Tax Compliance publication provides a series of questions for directors and senior management to self-assess the nature and extent of tax risks in relation to the overall performance of the business and in the course of considering a major transaction or strategy.
There is no doubt that the ATO is encouraging taxpayers to pursue conservative tax outcomes that do not vary significantly from financial, economic or accounting outcomes. However, many will argue that with complex businesses, especially those with significant offshore operations and financing arrangements, large business will increasingly find that tax, economic and accounting outcomes do not align, especially with the transition to International Financial Reporting Standards (IFRS). Accordingly, taxpayers need to be in a position to monitor these outcomes and be ready to defend them where necessary.
Managing risk is not about being conservative, it is about understanding the risks, ensuring they are commensurate with the value, and proactively managing those risks.
Table 1: The ATO questions: Overall tax performance
- Do the records and control systems allow tax registrations to be up to date, the correct amount of tax to be paid, accurate returns to be lodged and tax risks to be identified and managed?
- Are the amounts of tax paid and the pattern of tax payments in line with the business’ current and previous business results? If not, can the inconsistency be explained in terms of business decisions, business operations or on commercial grounds?
- Is there anything to indicate that the group’s business results and tax payments are lower than would be suggested by economic conditions and industry performance?
- For groups consistently reporting losses, are these real economic losses and can they be satisfactorily explained in terms of the group’s overall performance? If there is a material difference between accounting and tax loss outcomes, can it be adequately explained?
- Are necessary changes being made to processes and is proper consideration being given to major transactions and strategies to take account of changes in the tax laws and any tax compliance problem previously identified?
- Are there material timing or permanent differences in the group’s tax effect accounting?
- Are there any areas of major disagreement with the ATO? Have any additional tax liabilities been adequately provided for?
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What attracts the ATO’s attention?
Although the ATO understands that Australian tax law does not recognise the notion of economic equivalence for tax purposes, it has for some time used economic or financial variations in business performance or unexpected results as a risk assessment tool. The Large Business and Tax Compliance booklet again reinforces the tax profile characteristics that are likely to attract its attention:
- financial or tax performance that varies substantially from industry patterns
- significant variations in amounts or patterns of tax payments compared to past performance and relevant economic indicators and industry trends
- unexplained variation between economic performance, productivity and tax performance
- unexplained losses, low effective tax rates and cases where little or no tax is paid
- history of aggressive tax planning by the company, board members, key executives and advisers, and
- tax outcomes which are inconsistent with policy intent of tax law.
Corporate taxpayers can respond by putting processes in place to monitor their total tax contribution against other financial indicators and potentially benchmark against the industry and large business population.
Table 2: The ATO questions: Major transactions and strategies
- What commercial objectives are being sought by the proposed strategy or ownership and financial structure proposed for a major transaction?
- Are structures and financing for the business or a major transaction more complex than necessary to achieve the commercial objectives?
- What level of confidence is there in the correctness of tax advice received? Is the advice provided on the basis that it is as likely as not to be correct? Is the adviser fully acquainted with the business and the purposes of the transaction or strategy?
- How likely is it that the ATO will take a different view of the application of the law?
- If the matter is litigated, what is the risk of the Courts deciding the matter in favour of the ATO?
- What is the potential downside if the company is unsuccessful in litigation, taking into account the potential for interest charges, penalties, and potential application of the anti-avoidance provisions?
- How likely is it that the ATO would be prepared to settle the dispute, and if so, on what terms?
- How likely is it that the ATO will identify the tax issues arising from the proposed course of action?
- Would it be desirable to request a private binding ruling?
- Where a position has been taken on a tax issue, would it be desirable to be upfront with the ATO in identifying the issues before or when lodging the tax return or business activity statement and endeavouring to constructively handle disagreements that may arise?
- Is the tax advice based on the actual transaction or on an expectation of how the transaction will be implemented?
- Has the factual basis for the tax advice been properly checked?
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How does the ATO identify compliance risks?
To assist in risk identification, the ATO applies a range of financial and tax-specific indicators to profile large business so that it is generally focusing its compliance activities on the highest risk areas. Taxpayer profiling will typically involve a comparison of the taxpayer’s business performance with its tax outcomes. See Table 3 for a sample of the indicators used in conjunction with the ATO’s knowledge of the taxpayer’s business activities. Typical sources of information that would be used by the ATO include tax returns, business activity statements, ASIC data, media reports and other publicly available information. In addition, the ATO will apply regularly updated and refined risk filters (see Table 4) to identify potential compliance risks to facilitate case selection.
These risk profiling and filtering measures represent the most detailed guidance on the information used for the ATO’s risk assessment and case selection process, and consideration should be given to incorporating an analysis of the outcomes, industry benchmarking and exception reporting in ongoing risk management practices. Over time, the ATO will establish a significant body of data that can be used for its own comparisons of taxpayers, and therefore taxpayers will need to be prepared to respond to the outcomes. For some time, benchmarking of economic outcomes has been used extensively in relation to transfer pricing and it appears these approaches are beginning to gain traction in general tax risk assessment.
The ATO is placing increasing reliance on its intelligence and analysis of real time information for risk profiling to enable it to quickly identify and respond to emerging risks to revenue. Timeliness will be particularly critical to the success of the ATO’s response to non-compliance where there is now a reduced period for it to review assessments in which the general anti-avoidance rules (Part IVA) can be invoked (reduced from six to four years), and the limited period for review now applying for loss and nil liability returns.
Table 3: Sample of ratios used in profiling (taken from page 42 of Large Business and Tax Compliance 2006)
| Ratio | Used to measure |
| Gross profit margin | Operational analysis of business |
| EBIT margin | Pre-interest and tax profitability |
| Net return on equity | Return on owner’s investment |
| Implied interest rate | Cost of debt financing |
| Effective tax rate (net tax payable to accounting profit) | Utilisation of tax reconciliation to reduce income tax |
| GST tax ratio (GST payable/input tax credits) | Performance of GST over a period of time |
| Salary and wages intensity (salary and wages to total income) | Level of wages in generating income |
Table 4: Sample of risk filters (taken from page 43 of Large Business and Tax Compliance 2006)
| Risk filter | Information source |
| Low effective tax rates | Tax return |
| Significant differences between total profit and taxable income | Tax return |
| Issuers of hybrid instruments | ASIC |
| Movement of non-resident entities onshore | Consolidation notifications, GST registration or grouping changes |
| Significant taxpayer changes in PAYG instalment rates | Business activity statements |
| Significant internal restructuring | Consolidation notifications, tax return and schedules, GST registration and grouping changes, media |
| Continuous reporting of tax losses or GST refunds | Tax return and business activity statements |
Testing the indicators - Risk reviews and audits
From the risk profiling and case selection processes, the ATO will form a view on the level of risk of a particular taxpayer, establishing a hypothesis to be tested through the compliance program. For the 2005/2006 year this resulted in 280 risk reviews and in 2006/2007 the ATO expects to be involved in at least 75 significant audits in the large business sector.
Conclusion
Armed with this new insight into the ATO’s profiling and risk filters, there is a significant opportunity for the "best in class” tax function to enhance their company’s risk management processes by assessing their own risk profile and benchmarking against industry and large business populations. This all starts with an understanding of the total tax contribution, the trends in taxes and how it aligns with economic and accounting outcomes. The benefit of this is enabling a more proactive ongoing risk assessment process which is better aligned to the ATO’s views on risk.
For further information, please complete the following form, or contact:
Tim Cox, Partner
PricewaterhouseCoopers Tax
T&L Melbourne Inst Corporate
Phone: +61 3 8603 6181
