Summary Tax Assurance by Russo


Summary of Tax Assurance by Russo written in 2015/2016 and donated to WorldSupporter

Chapter 1: Introduction Tax Assurance

Assurance is primarily an accounting and auditing term with a distinct meaning in those fields of practice. Most commonly in relation to the commercial accounts of a company. It’s not a common term in taxation.

In the international auditing and assurance standards is tax assurance defined as: ‘an engagement in which a practitioner expresses a conclusion designed to enhance the degree of confidence of the intended users other than the responsible party about the outcome of the evaluation of measurement of a subject matter against criteria’.

In this book we define tax assurance as follows: ‘it is everything concerning the process of taxes in a company belongs to the field of tax assurance’. Not just how taxes end up om the commercial accounts (tax accounting), but also tax risk management, internal control, management control, corporate governance, tax policy, relations with the media, relations with tax authorities, ethical sides of taxation and audit are relevant for tax assurance in a broader sense.

We will discuss all relevant sides as mentioned above in the following chapters.

Practice question (chapter 1)

  1. What is the difference between tax assurance defined by the international auditing and assurance standards and the tax assurance in the book?

Chapter 2: From internal control to risk management

2.1 Introduction

Experts can check reports and decisions about tax strategy, tax decisions and tax returns. This does not give satisfactory answers to questions about these points. Not only the expertise of the specific tax laws and regulations, but also the control of the tax processes determine the tax and related risks that companies face. Accountants and auditors have developed such a risk-based perspective to assert the reliability of the financial statement, which is used more and more to evaluate different types of enterprise risks.

2.2 Financial reporting and fraud

The development of risk management is a story of findings ways to prevent, detect and react on fraud. The Pincoff affaire led to regulation on financial reporting and boosted the development of the accounting profession worldwide. The Security Act of 1933 and 1934 prescribed mandatory disclosures of prospectuses and audit by an independent accountant of the financial statements. The accounting profession discussed and developed accounting principles. Following these principles financial reports must present a ‘true and fair’ view of the financial position and income of organisations. The audit opinion of accountants is about the financial statements present fairly the financial position, results and cash flows. It is also about that they are in accordance with general accepted accounting principles (GAAP). But reconciliation of numbers on paper alone are not enough for audit. The development of new auditing standards is nowadays a highly institutionalized activity and the responsibility of the international auditing and assurance standards board (IAASB). It is an independent standard-setting body that issues international standards on auditing (ISAs).

2.3 The shift to internal control

The reactions on different fraud cases do not directly link to internal control and risk management processes of the organizations. The way fraud is addressed is by regulating which information should be disclosed by organisations and standardization of what should be disclosed. Reports had to be audited by independent accountants. To increase transparency, there was a standardization of auditing practices to professionalize the way audits must be performed.

The way that the organisation has structured his processes, the division of responsibilities and the checks and balances that are put in place helps auditors to assure that the information is reliable and that fraud is prevented or recognized in an early stage. The risk that auditors fail to discover material misstatements in financial reports also depends on their assessment of the effectiveness of the internal controls of the organisation.

The FDCIA stresses the responsibility of management for financial statement and internal controls. The independent auditor should review the required report and assessment. This legislation meant a shift from only transparency, standardization and audits on external financial statements towards transparency and audits of the underlying internal organization and processes. How companies control the reliability of their financial statements also became important.

The SOX-act consists of several elements to prevent accounting scandals and fraud. It also includes articles on transparency and audit of internal control. The Public Company Accounting Oversight Board is a kind of auditor for auditing firms. Regulation is formulated to safeguard the independence of auditors.

2.4 Standardization of internal control

The Treadway Commission developed different frameworks for internal control and enterprise risk management. The COSO internal control framework is regarded as a best practice to describe and evaluate the internal control of companies.

2.5 The COSO internal control framework 2013

COSO defines internal control as follows: ‘internal control is process, effected by an entity’s board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives relating to operations, reporting and compliance’.

Internal control is distinguished from internal control related to compliance with applicable laws and regulations and from the internal control over effectives and efficiency of operations. The COSO framework could also be used at different organizational levels.

See COSO 2013 for the goals of every element of the COSO Framework. The COSO framework consists of five elements.

  1. The control environment: determines if the internal control is really taken serious in an organisation. How is the tone at the top? Are decisions taken opportunistically?

  2. Risk assessment: recognising possible future events that can threaten the accomplishment of objectives is an important element of risk management. The principles in risk management deal with systematically identifying risks and analysis of those risks and assess and determine if and how risks should be managed.

  3. Control activities: formal controls to mitigate the risks that are assessed are discussed. The principles address that control activities should be selected and developed that effectively mitigates the risks and that they are translated into policies and procedures.

  4. Information and communication: responsible managers need relevant and high quality information to support the functioning of the other components of internal control. The way it is communicated is also relevant. Information should flow upwards and downwards.

  5. Monitoring activities: the monitoring and adjustment of the different components of internal control is necessary, because a changing environment could lead to new risks or to a different assessment of the consequences. The analysis, communication and corrective action of IC deficiencies is the most important element of the monitoring component.

The central question that has to be answered by evaluating different components of internal control is: ‘when are we reasonably certain that the COSO objectives will be reached?’ Formal controls are part of the COSO framework and they are dealt with in the component control activities.

A side effect of the regulation that forces companies to focus on IC is that COSO has become the standard on how to evaluate and report on IC.

2.6 From internal control (IC) to risk management

The COSO IC framework follows a risk-based perspective to discover what to do to ensure that operations will be performed in an effective and efficient manner, information will be reliable and laws and regulations will be complied to. IC regards strategy as something given that has to be implemented and controlled.

The COSO-ERM framework has only changed on the following points:

  • Strategy is added as a new objective

  • The component control environment has been replaced by the component internal environment

  • The component risk management is replaced by four components: objective setting, event identification, risk assessment and risk response.

The focus on enterprise risk means that next to effectiveness and efficiency, doing things right, in COSO ERM the aspect of doing the right thing is also addressed. The components monitoring, information and communication, and control activities are also included.

The most important difference between the two COSO frameworks is the elaboration of the component risk analysis. COSO ERM includes components, which deal with the formulation of objectives and analysis of future events that could stand in the company’s way for reaching those objectives. The two form the input for the risk assessment. The COSO IC framework just starts with the risk assessment and does not address how the risks have to be discovered.

The expectation is that companies will use the IC framework for internal control over financial reporting and that companies will use the ERM framework for controlling risks related to strategy.

2.7 Limitations and side effects

Because risks have not occurred yet, they are more perceptions than hard facts. Risk analysis is about imagination and staging of risks. The background and experience of the risk analysts determine the risks that will be analysed. The types of risks occurred in the financial crisis could be foreseen. Taleb distinguishes so called ‘black swans’: unpredictable, have a massive impact and after it has happened the desire to make it appear less random and more predictable than it was. The most important risks are the ones that we cannot predict.

Another limitation of IC frameworks deals with limitations of formal controls. The lack of a separation of duties does not automatically mean a control deficiency. It depends on the presence of other controls to mitigate the risks.

The combination of controls in relation to the specific risks determines the effectiveness of controls. Because of the variety of risks and the specific features of organizations, there exists no normative framework of effective controls that each organization should implement. This makes auditing difficult. There are no rules against which the controls can be checked. As stated earlier formal controls alone cannot assure that the distinguished risks will be mitigated. The control environment stresses the importance of culture for the effectiveness of IC. COSO stresses the importance of soft controls, in practice the most of the attention is given to the more formal controls.  

IC/risk management is a societal phenomenon, which plays a very dominant role in our daily life. The adoption of frameworks like COSO depends not only on the possibilities to lower risks, but also on the need of organizations to legitimize their actions. The legitimate action for regulators is to demand more transparency, issue standards and procedures and demand audits. The need to react decisively and send a signal to society could be of greater importance than the effectiveness of the proposed legislation. The underlying assumption of SOX is that only an audit opinion regarding the financial statements is not enough. Another assumption of the SOX is that mandatory reporting and auditing of IC over financial reporting is necessary and more likely to prevent new accounting scandals. 

A code of ethics can be used as a means to improve the internal environment, but it can also be used as a façade. On a smaller scale applying risk management can also lead to the use of more and more formal controls. The formal controls often replace the trust we have in expertise of people to perform the activities. But trust is one of the most important elements, because it motives people intrinsically. In the end more formal controls, especially the non-effective ones, can be disruptive.

Formal controls also trigger more checks and audits. When formal controls are present these controls also have to be enforced and employees have to prove compliance. In the audit society it sometimes looks like the compliance is of greater importance than the effectiveness of controls.

Practie questions (chapter 2)

  1. What is the difference between the GAAP, ISAAB and the ISA?

  2. To increase transparency, what is the role of standardisation of the report?

  3. Why is an independent auditor extremely important?

  4. Explain the SOX act.

  5. Who developed the different frameworks for internal control and enterprise risk management?

  6. What is the COSO?

  7. What are the five elements of the COSO framework and explain them.

  8. What is the most important difference between the COSO ERM and the COSO internal framework?

  9. What are the limitations and side effects of the framework?

Chapter 3: The relation between corporate governance and tax

3.1 General introduction

In this chapter the influence of corporate governance on taxation will be viewed in more detail.

3.2 Corporate governance and tax

Corporate governance deals with how to run a company. In many jurisdictions set of rules and principles have been brought together in a code by way of self-regulation. Regulation is rigid and not capable of adapting to the ever-changing business world, but self-regulation cannot be enforced as easily as legislation. One of the principles of the code is that companies have to ‘comply or explain’: non-compliance to a voluntary non-legislative code does not have the same effect as non-compliance to legislation. The comply or explain principle has evolved to apply or explain. The board is more actively involved than the word comply may suggest.

One of the duties of the board of a company is to be accountable for its policies through a yearly report: the commercial accounts. They must comply with business law and the IFRS.

Corporate governance codes have a great impact on the commercial accounts and the work and position of the auditor. Commercial accounts usually are to a large extent similar for the tax accounts. Corporate governance therefore indirectly influence the tax accounts.

Corporate governance (CG) codes usually contain principles and best practices on good governance. They regulate the relationship between shareholders, the board of directors and the supervisory board. The OECD has published principles of CG:

  1. Ensuring the basis for an effective corporate governance framework

  2. The rights of shareholders and key ownership functions

  3. The equitable treatment of shareholders

  4. The role of stakeholders in corporate governance

  5. Disclosure and transparency

  6. The responsibilities of the board

 5 and 6 are the most important principles for commercial accounts, tax planning and tax risk management. The first principle is directly applicable to the commercial accounts. The board should disclose all information in accordance with accounting standards. An audit should be performed by an independent auditor who is accountable to the shareholders.

Second, the responsibilities of the board. The board is responsible for the systems that lead to the commercial accounts: the internal organisation and control systems. They also have the responsibility to comply with the law and relevant standards.

All codes of every country regulate the relationship between the company and the external auditor. The position of the auditor is strongest in the US Code. All codes also address ethical behavior (CSR) and compliance. They also consider other stakeholders like the government in the form of tax authorities. The need to have risk management control systems and the need to comply with law and ethical standards have a direct impact on the tax function within a company.

To manage and control the risks associated with taxation a tax control framework (TCF) will have to be implemented. It contains all procedures within the company pertaining to taxation. The TCF is very important for the commercial accounts because the external auditor and the tax authorities would like to rely on the IC of a company. Implementation is just the first step. After implementation it will have to be actually applied by relevant staff and constantly monitored. The board is required to have a policy on taxation that contains the basic assumptions, including risk appetite. The TCF will be modelled in accordance with this policy.

If the corporate governance failed it may well be that the structure was not based on policy of the board. If this tax structure reaches media coverage it is well possible that the public and/or politicians became outraged. Four questions should be asked:

  • Did the company operate within the letter of (tax) legislation?

  • Did the company comply with the spirit of the legislation?

  • Are legislators themselves to blame that companies engage in aggressive tax planning schemes?

  • How do stakeholders feel about tax scandals?

  • The influence of the personal income tax position of (supervisory) board members.

The concept of tone at the top is re-articulated. This concept is sharpened: ‘demonstrated seriousness from the top’. It’s not only about communication but it has to be proven by clearly recognizable actions and behaviour of top management and the board. The income tax returns are also relevant. The premise is then that if the personal tax return of a board member does not comply with regulations or could be classified as frivolous or aggressive or even includes tax evasion the risk management of the company might have the same deficiencies. Also from a reputational perspective, when these issues come into the public domain it can hurt the company. So it is a key element of trust, integrity and risk management.

There is just one exception in the confidentiality and non-disclosure obligation with respect to all tax matters from the Dutch Revenue Service. Where an individual in the management of a financial institution has an issue in his tax fillings that triggers a certain degree of penalties, the Dutch Revenue Service is required to inform the authorities supervising the financial industry.

How to deal with taxes as a board?

Taxes are no longer the exclusive domain of specialists. They plan an important role in determining the reputation of a company in society. The board is under the obligation to control the risks connected to taxation. If a company implements a tax structure it should be part of the policy that the board is aware of the structure and also can explain to the public why this structure is chosen. This will prevent that the board is taken by surprise. This aspect of tax policy should also be on the agenda of the supervisory board. The tax policy should be an integral part of the overall management style and corporate behaviour.

The tax policy must be implemented through the whole group of companies and this can prove a challenge in tax matters on a local level.

An adequate tax risk management is quite vulnerable in a decentralized management approach. The board should be aware of this and implement additional checks and balances. The decentralized approach can last for a long time in many countries with an exemption method on intra company dividends in the profit taxation. On the European continent there has been quite a tradition of decentralized management of foreign subsidiaries. Operating subsidiaries have some room in which to act.

The possible impact on the policy on public opinion and politics should be part of the tax planning. The recent developments in international regulation, in society in general and from the OECD and EU lead to more attention for the taxation aspects. Board and supervisory board should be aware of this.

The board should also keep a good eye on tax from a shareholder value perspective. It’s important for the board to pay sufficient attention to the question: ‘is it possible to add value through tax planning?’ At first sight you can say yes, because there is a need for tax planning activities to avoid double taxation in a multinational environment since tax regimes of nations are not harmonized. There is also empirical evidence that tax planning is good for stock price and lowers cost of debt. But the difference between tax planning and aggressive tax planning is difficult to make. An achievement of net margins by tax planning is less valued than margin improvement in the core business.

The valuation of tax avoidance is a function of firm governance and more broadly tax avoidance and managerial efforts to divert value from shareholders intertwined. The market values tax avoidance with scepticism given the complexities it introduces and this scepticism is only offset in the presence of high quality governance. Tax planning activities only add value when markets recognize good corporate governance. The supervisory board should have their own information sources that includes direct contact with the head of tax. Adequate information also depends on the set of KPI’s. The better the framework the more trust supervisory boards have in balanced outcomes of the implemented management structures. The KPI’s should create a balanced framework of performance incentives but fully aligned with the corporate objectives. It also should protect the reputation in society and tax authorities.

The question to be transparent or not, is one the board should decide upon based on the values of the organisation, its position in society and the trends in regulation. These are matters that relate to the licence to operate in society.

3.3 Tax in external communications

The tax position in the commercial accounts includes the costs in the profit and loss account, the tax assets and liabilities in the balance sheet and the disclosures in the notes according to the applicable accounting principles (IFRS, US/local GAAP).

The first issue is that in general rules imply that the process of taxes must be controlled through a risk management system. Tax is a complex and  difficult element in the annual accounts that requires sufficient attention from the highest levels. It should therefore be recognized as an important topic on the agenda of the board and especially on the audit committee.

The second issue: if a tax position is unclear, a provision for uncertain tax positions must be accounted for in the commercial accounts. The underlying analysis of the provision un the commercial accounts is very interesting for the tax authorities. It indicates that the tax position is a subject of discussion. The audit file of the external auditor could be an important source.

How equity investors value the uncertain tax positions in the annual accounts:

  • Negatively: it may trigger additional authority scrutiny. Also reputation damage: a poor corporate citizen behaviour.

  • Positively: expected benefit of tax avoidance. Tax avoidance may also been recognized as a management culture that is eager to seek opportunities.

The media coverage would has been the reason for many companies to be more articulate about the way they handle the tax matters.  Companies provide insight to the public in three areas:

  • Tax risk management and governance within the company: the internal organisation of tax processes and responsibilities.

  • Tax principles in tax planning and compliance: these are addressed on the topics that is about the way the company deals with tax planning/compliance.

  • Taxes paid: some countries like Denmark give public access to the details of the tax assessment of companies.

3.4 Cooperative compliance

One of the main characteristics of cooperative compliance is that it uses the layer model and aims to rely on internal control measures of the company. The quality of the IC determines the extent of trust that the tax authorities have in I and influences reduction of audit by them. Another characteristic is that it is built on trust between the company and the tax authorities. The tone at the top of the company is important as well as the way the internal controls are implemented, monitored and adapted. Information is shared proactively. When the contract is easy and real time, there will be less uncertain tax positions. To enter into cooperative compliance depends on the tax policy of the company.

Practice questions (chapter 3)

  1. Explain the principle of corporate governance.

  2. What is a corporate governance code?

  3. What are the principles of corporate governance and which principles are the most important ones?

  4. What are the steps for the implementation of the tax control framework?

  5. What is the exception in the confidentiality and non-disclosure obligation with respect to all tax matters from the Dutch Revenue Service?

  6. How should the board deal with taxes?

  7. What is the most important aspect of the tax policy?

  8. Tell something about the importance of tax planning in your own words.

  9. What are the characteristics of cooperative compliance?

Chapter 4: Aggressive tax planning and ethics

4.1 Introduction

This chapter focus on the debate about whether aggressive tax planning is morally acceptable. It is about the international business sector/the major tax advisory firms and government and societies. It is not about legal or illegal, but about immoral.

4.2 The splendid isolation of tax is over

The economic crisis has aroused a fierce moral debate about the business sector. Galbraith spoke about ‘an inventory of undiscovered embezzlement’. In good times people are relaxed, trusting and money is plentiful, but people want more. The rate of embezzlement grows, the rate of discovery falls off and the bezzle increases rapidly. In depression all this is reversed.

The tax world is characterised by information asymmetry: he who possesses more information than others has an advantage that can be used or abused. Plato made an relevant observation about the link between information and moral behaviour. He wrote about the mythical giant Gyges who has a ring that makes him invisible. Ethical considerations are foreign for him. The knowledge that no-one can or will discover would you’ve been up to appears to affect the moral component of our behavior.

The series of tax disclosures confirms that the emergence of the information and internet society means that multinationals must permanently take account of the fact that confidential information will be disclosed. The risk of publication has also considerably increased the risk of reputation damage.

4.3 Aggressive tax planning: the phenomenon

Too high taxes are a sign that a company is performing poorly in this area. The arsenal used to reduce the tax burden mainly consists of three types. Firstly, there are the fraus legis- or abuse of law structures that plush the limits of legislation. Secondly, corporations often make use of technique whereby deductions are transferred to countries with relatively high tax rates and profits are deposited in countries where rates are low. The third type is the hybrid mismatch arrangement. This exploits a difference in the tax treatment of an entity under the laws of two or more tax jurisdictions to produce a mismatch in tax outcomes where that mismatch has the effect of lowering the aggregate tax burden of the parties to the arrangement. The tax structure market is dominated by the Big four: PWC, EY, KPMG and Deloitte. Aggressive tax planning is extremely complicated. It leads to structures that tax payers unschooled in tax cannot or can only just understand. Tax law has become an engineering science: extremely complicated and incomprehensible to the non-initiated. From a moral perspective it is important that multinationals and their tax engineers are also unable to explain the structures to the non-initiated.

4.4 Aggressive tax planning: the ideology

  • Economic justification: neoliberalism: keeping the tax liability as low as possible is in line with the neoliberal ideology of the free market. The goal is maximising profit. Businesses must play according to the rules of open and free competition, subject to the condition that they refrain from fraud or deceit. There is no room for motives other than economic ones in the field of tax.

  • Tax-legal justification: the freedom to choose the path of minimum cost. This one is used to defend how businesses deal with their tax position. Each taxpayer is allowed to give precedence to its self-interest in complying with its tax obligations.

  • Outcome: an ethics-free zone. Aggressive tax planning fits the neoliberal mound. Multinationals will choose to operate in an ethics-free zone.

4.5 Is ethics relevant to economic behaviour?

The society and the market can survive without ethics, according to Mandaville. Adam Smith posits that humankind is not only motivated by self-interest but also by other virtues. A separate system of rational economic choices and calculations that is divorced from societal relationships does not exist.

4.6 Aggressive tax planning and ethics

Motives other than pure self-interest are wrongly ignored with aggressive tax planning. Taxes are the remittance that has to be paid to the government as established by democratic laws. Tax advisors who design aggressive tax structures lose sight of the crucial link between taxes and society.

4.7 A topical example of indignation about aggressive tax behavior

Large U.S. companies have to move or intend to move their tax domicile abroad through the tax structure of inversion. The structure is simple: the U.S. company becomes a subsidiary of a foreign patent corporation. The new company faces a lower tax rate and no tax on the company’s foreign-source income.

4.8 Tax ethics for multinationals

The starting point for multinationals to rethink their tax policy from a moral perspective, is about how they view their position in the society in which they operate. Anyone can be asked to adapt their behavior to take account of the interests of others and of the society. This view of the cooperative character of society also makes clear what citizens expect from one another with regard to tax.

Two fundamental moral obligations arise:

  1. Faire share obligation: asks every member to contribute their fair share to make possible and maintain the society of which they are a member. They only make use of the public goods developed by a society.

  2. Compliance obligation: this obligation to comply with the democratically established rules of a society. It’s based on the fact that legally enforceable rules are necessary to ensure that everyone contributes their fair share to the society of which they are a part. They also need rules to ensure that everyone contributes a specific and accordingly a fair share, which does justice to the principle of equality.

In every event is clear that tax ethics principally acknowledges motives other than that of pure self-interest.

4.9 Law, ethics and social reality

In the regular legal practice and tax practice, moral considerations usually operate in the background. With regard to regular tax law, citizens and governments can suffice with taking the legal rules of into account. Citizens are allowed to presume that by doing so they are not only meeting their legal but also their moral obligations. By paying their tax liability, citizens are thus contributing their fair share to the financing of government expenditures. Fray talks about a citizenship contract that is based on a mutual belief in good intentions. Also large companies have, for example the Dutch authorities and multinationals conclude a covenant based on mutual trust. Both parties will take account of each other’s interests.

The opposition is the group of companies that design and apply the aggressive tax planning structures, named the modern-day free riders. Their aim is to back out of making a normal tax contribution to the society in which they operate.

4.10 The compliance obligation and the spirit of the law

Aggressive tax planning is wrong about their moral aspect: they seek aspects of the law that are indefensible. One should be able to expect that the legislator will produce legislation of a high quality. It is the responsibility of the legislator to keep its legislation up-to-date. The tax engineer knows that the structure will realize a result not intended by the legislator. The moral compliance obligation demands an Aristotelian restraint, which asks the tax planner to stay within the spirit of the law and not to seek the outer limit of the law.

4.11 The fair share obligation and international tax arbitrage

An intensive network of tax treaties and national regulations must prevent taxpayers from having to pay double taxation because the same income is taxed by more than one country. One of the key basic norms of this system is the single tax principle: law that results from a general and consistent practice of states followed by them from a sense of legal obligation. Income must only be paid once, not more and not less. Business must not be forced to pay double their fair share in more than one country.

The rules of the international tax law together with the national tax rules are not intended to avoid double taxation but to realize zero taxation.

The structures all have a simple purpose: substantially reducing the effective tax burden. They all have in common that countries are included as links in a chain that is (virtually) only intended to enable companies to profit from the possibilities to reduce their tax burden. Multinationals approach that tax law from a purely instrumental perspective. These multinationals choose to regard national and international rules as a bunch of rules which can help them to obtain the maximum tax benefit possible. It is important to note that some multinationals also challenge aggressive avoidance behaviour.

Adopting an appropriate restraint with regard to tax planning should be the joint responsibility of the tax director and the board of the company.

4.12 Reputation and the Aristotelian virtues

Multinationals are not separated from the society. Negative publicity about aggressive tax planning can damage reputations. It is the responsibility of the legislator to set limits by means of legislation if it objects to the conduct of taxpayers. When it comes to reputational risk, these companies are guided by an extrinsic motivation arising from a fear of reputational damage. This is in line with the neoliberal view of the market.

For the other group of companies, the moral dimension is given prominence alongside the economic dimension. These companies are guided by an intrinsic motivation arising from a desire to be a respectful member of society.

Aristotelian virtue

The good entrepreneur should embody two virtues.

  1. Practical wisdom: this is important to have to take a good decision in a specific situation.

  2. Self-restraint and temperance: the fair share and the compliance obligation act here as a guide to exercising social temperance. The good entrepreneur has a moral tax compass.

Taking Aristotle’s doctrine of the Mean seriously is simply well-considered self-interest.

Practice questions (chapter 4)

  1. Tell something about the concept of aggressive tax planning.

  2. Explain the three ideology of aggressive tax planning.

  3. Explain why ethics is relevant to economic behavior.

  4. What is the starting point for multinationals to rethink their tax policy from a moral perspective?

  5. What are the two fundamental moral obligations that arise?

  6. Why is aggressive tax planning wrong about their moral aspect?

  7. What is the meaning of: multinationals are not separated from the society?

  8. What is the Aristotelian virtue?

Chapter 5: The tax function and the tax operating model

5.1 Introduction

By tax function we mean those accountable or responsible for managing taxes in a group. This chapter explores what means to have a ‘world class tax function’ and how organisations might build and improve their tax management capabilities.

Why tax is a key management challenge?

The technical difficulty of tax, its pervasive nature in the business and the complex infrastructure has provided a key management challenge for those in a stewardship role. for effective tax management, the business and those doing tax need to appreciate and engage in a new way of thinking about tax and embrace new models.

Tax operating model

A tax operating model is the way in which a tax function’s tax activities, people, processes and infrastructure are organised to allow an organisation to comply with tax laws and regulations while achieving its own strategic aims. It must be:

  • Effective: a business commercial strategy and policies must be clearly inform the direction and goals of the tax strategy. The strategy must be recognized by the board, have full organisational support and be supported by an underlying tax policy. The tax function must know what is its trying to achieve.

  • Efficient: a tax function needs to make the best uses of its resources. It requires the appropriate processes and infrastructure to be able to support its activities.

  • Transparent: the key is for organisations to recognise their range of stakeholders and manage the flow of tax information to them whilst making sure that all messages are consistent and that there is confidence in all the data and commentary provided.

Adding value

Adding value could be in the form of maintaining a steady effective tax rate. Key is evaluating the options proactively and systematically whilst delivering against the tax strategy, and managing stakeholder expectations.

5.2 Tax operating model

The framework is a simple way to deconstruct complex tax operations from record to report, and enables tax executives to assess, prioritise, and explore opportunities for tax to add value through efficiencies, risk mitigation, and better planning.

  • Understand value drivers
  • Engage the business to improve data flow and processes
  • Leverage enablers: four primary enablers are critical to a high-performing tax function:
    • People and organisation
    • Process and policy
    • Technology and systems
    • Data and information

Level 1: Effective

It is important that the tax function contributes to the organisation’s overall strategy. The tax department effectiveness relies on a comprehensive global tax strategy and a detailed implementation plan. Assessing stakeholder’s needs and the way in which the tax function is meeting them is key to determining its effectiveness.

The goals of the organisations assessed in terms of:

  • People: organisation structure, performance measurement, stakeholders.

  • Processes: methods used for compliance and reporting, tax planning activity.

  • Systems: use of technology as part of defined processes.

Strategy is linked to an organisation’s vision, mission and strategy.

  • Vision describes the reason for the company’s existence.

  • Mission is the activities the company will undertake in pursuit of its vision.

  • Strategy is about how these activities are executed and tax strategy defines the tax function’s contribution to the overall goals of the organisation.

Qualitative goals relate to continuity of operations, transparency, ability to provide information and good corporate citizenship. Quantitative goals will vary but ultimately relate to earnings per share, tax cash flows and the effective tax rate.

The changing role of the tax executive

  • Expand the tax department’s role and focus

  • Become a stronger partner to the broader business

  • Be ever more effective, efficient and transparent

  • Add value and communicate effectively

  • Roles and responsibilities

  • Measurement: measures for when a tax function needs to become more efficient might include: value added, scalability, organisational effectiveness, strategic contribution, cost efficiency and operational effectiveness.

    • Managing change to produce results

    • Measuring performance to track results

    • Performance measurement

    • Sustaining organisational performance

      • Setting tax department goals

      • Establishing a performance baseline

      • Defining key performance indicators

      • Identifying leading practices

      • Implementing improvement initiatives

      • Executing the measurement process

    • Pre- versus post tax performance.

Pre-tax measurement is an area for which control and responsibility typically lie with tax executives, but gathering data from foreign operations can be difficult as can getting business unit leader’s attention to below-the-line taxes.

Post-tax measures tend to attract the attention and cooperation of business unit executives – sometimes at the cost of control and disruptive participation in tax strategy and execution by all stakeholders.

Level 2: Efficient

The tax function must be organised to achieve strategic goals as efficiently as possible. The tax function should be an integral part of the organisation, so that the control framework for tax can leverage the organisation’s existing control measures. It should address what supporting tools can promote efficiency through system integration and automation of daily processes.

Data

Improved tax data management can strengthen audit defence activities, streamline tax compliance and reporting, and support tax planning.

  • Tax data management and the record-to-report process

    • Tax process: input, process and output.

    • Source data collection: source data can come from various sources and can be collected separately and enrich the structured data.

    • Calculations: using tax logic to process source data so that it can be entered in a tax return or included in another calculation.

    • Consolidations: data calculated on an entity level may not be sufficient. It may need to be aggregated.

    • Reports: calculated data needs to be presented in a certain format for compliance purposes, or to be user-accessible.

  • Data extraction and collection: issues and available tools.

    • The integrated tax lifecycle: it incorporates standardised processes, helps manage risk of errors in financial and tax compliance reporting, and enables multi-scenario forecasting and analysis.

  • Tax process improvement: the challenge

  • Focus on the upside: automating and standardising processes can transform the efficiency for compliance and reporting, open up new possibilities for how tax compliance and reporting are executed as well as where and how tax resources are organised.

  • Standardisation: it can be a very useful tool to mitigate risk in the financial reporting of income taxes. It creates a familiar platform.

Structure: Tax organisation and resources

  • The challenge: the increasing integration of performance management applications into ERP platforms is providing organisations and their tax department’s new ways to monitor, measure, and manage business performance.

  • Organisational characteristics: forward thinking tax leaders are designing their department to evolve continuously and at the proper pace to sustain performance and minimise the disruption of sudden dramatic change.

  • Organising resource efficiently, balancing tax compliance, quality of reporting and planning: how best to organise tax department resources will depend on factors such as company size, workload type and industry. Short-term tax planning and reporting is now as important as long-term tax planning.

  • The pros and cons of shared services and offshoring: shared service centres can improve efficiency and alleviate administrative burdens.

  • Information technology: the role of technology grows more important in the tax function. Companies installing an ERP or consolidation system often overlook the tax-related functionality now built into these systems.

Level 3: Transparent

Transparency applies to the tax function on various levels and is relevant both within the business as well as externally. For effective transparency your company needs a strategy for explaining its tax position based on who is interested and what they want to know.

  • Corporate social responsibility (CSR)

  • External stakeholders.

    • The financial community. The financial community wants to understand the current tax charge, the cash tax position and the reasons for any differences between the two.

    • Employees, customers, suppliers and broader society

  • Accountability: country by country reporting.

    • The tax authorities.

    • Regulators.

  • Making and explaining your case. You need to have the right information readily available and confidence in your communications which relies on the right supporting processes and controls.

  • Managing behaviour. You should communicate how the tax policy works, how it supports the strategy of the business and how it fits with, and is appropriate for, the aims and ambitions of the business.

  • Internal stakeholders. Examples: CFO, CEO, board of directors, CSR teams and public relations. Communication is an important aspect.

  • Tax assurance (insight, analysis and follow-up). Risks are triggered either by not realising that tax may play a role in a transaction (insight) or that an issue although spotted is not correctly addressed. This is often the result of incorrect factual information (analysis) or incorrect follow up (follow up) of the tax technical advice.

  • Transactional risk. This is the risk associated with applying current tax laws and regulations to a particular transaction. Risk can emerge if tax is nog appropriately represented in the implementation of new technologies or the development of new processes within the enterprise. Another area relates to non-recurring transactions, such as acquisitions.

  • Reputational risk. The tax function cannot make a positive impact on the company’s reputation. Tax professionals strive to pay what is due under tax laws and regulations.

 Tax risk management

Multinational companies remain focused on managing the risk associated with non-local taxes for foreign entities. The demand for increased focus on financial reporting is one key driver of this trend, coupled with the demand for improved transparency.

  • Risk intelligence maturity model: tax risks and opportunities are increasingly included as companies discuss the potential cumulative and cascading effects of risk events, and tax departments are looking for new ways to understand, explain and manage tax risks and tax risk interdependencies.

  • Tax risk management in the global environment: the resourcing of global tax functions appears to vary significantly from company to company, but outside HQ there are often inconsistent levels of in-house tax expertise.

  • Dealing with the global complexity of tax.

    • Understanding global filling requirements: to gain understanding of the global tax operations, tax executives need to gain visibility into the activities being performed in relevant countries.

    • Understanding the process: it is important to understand who has responsibility for compliance activities in each jurisdiction.

    • Tracking transactions

    • Tracking foreign controversy

Communication

The tax department should organise itself to create stronger connections with the rest of the organisation and consider the value it adds bearing in mind where the organisation is in its life cycle. Considering the tax function as an integral part of the organisation will help to identify tax risks at an earlier stage so that they can be taken into account during regular decision making process. To support their tax compliance and planning responsibilities, tax departments should have effective communication, information-sharing and measurement processes across functional areas.

Value added

Tax complexity offers opportunities to explore potential tax savings and address corporate tax compliance risks. Having sources, time and skills in place to implement the planning is often one of the largest hurdles tax department face.

Some of the areas include:

  • Structuring: legal structure can significantly affect an entities tax exposure.

  • Transactional planning: the structuring of business transactions can have a variety of transactions and alignment with strategic planning require adequately skilled and experienced resources to support transaction planning

  • Credits and incentives: many countries offer tax credits and other incentives for activities. They should be taken into account for tax planning.

Data management and analysis

This provides increased transparency into an organisation’s data and provides the management with critical business planning data. These tools can also reduce the amount of time the tax department spends collecting and manipulating source data for tax accounting and reporting purposes and allows for more time spent on critical analysis and high level reviews.

There are numerous tools available that enable analysis of data from disperate sources, linking various data sets for a more complete picture and reconciling data for greater accuracy.

  • A tax IT roadmap for the future. These systems can be integrated to drive a very smooth reporting process.

  • Leveraging data analytics. Data analytics is a means of supplying decisions makers with relevant data so that they can make more informed decisions.

  • A practical approach to tax data analytics. The last few years there is an increase in organised data as well as a shift in focus toward analysing information to improve performance. The tax function mind-set is changing from ‘doing’ to ‘knowing’.

  • Data collection leading practices. Understanding data requirements is the foundation for designing solutions that produce the information needed for tax calculations.

5.3 Transformation

Transformation means making fundamental changes in how business is conducted in order to help cope with a shift in market environment by making employees more productive, processes more efficient while less costly, and the business as a whole more competitive.

  • Transformation for tax executives.

  • With a clear view of how the tax function’s role can evolve and expand, and the commitment of the CFO and tax executives something big can happen. The tax function can enhance operational efficiency at a global level and contribute to decision-making across the business. Compared to other corporate departments the tax function has been slow to adopt technology and process management. According to the tax department model there are four models:

    • Static

    • Reactive

    • Pro-active

    • Progressive.

To move from left to right departments should develop as solid foundation based on people and organisation, processes and policy, technology and systems, and data and information.

  • Critical success factors for tax transformation from static to progressive. The desired outcome of transformation is a high-performing tax department.

    • Joint ownership

    • Clear goals

    • Be pragmatic

    • Visioning

    • Embed change management

    • Data

    • Run project as steady state

  • Tax function assessment framework. The strengthen of enablers determines the amount of time available for tax staff to focus on important matters which utilise their skills rather than monitoring deadlines. People get it done by leveraging workload and enablers.

  • Planning

    • Align tax department and business objectives

    • Envision the future-state tax department

    • Create a roadmap

  • Execution

    • Enhance and streamline tax processes

    • Evaluate enabling tools and technologies

    • Design new organisational models

  • Communication

    • Measure results

    • Support the change  

Data and information

  • Blueprinting. Improving and accelerating data collection. Blueprinting maps out a strategy for improved data collection which gathers tax department requirements, finds and brings together common data attributes, and accelerates data collection. It produces a list of detailed data requirements and describes how each tax data requirement will be enabled or designed into a technology or process solution.

  • Data integration and analysis. With structured centralised tax data, the tax data can be continually monitored and managed throughout the tax data life cycle.

  • Data collection. It is often a manual, time-consuming, and potentially error-prone process. It also can be difficult to manage, track and valid information.

  • Data and information. The factors that need to be considered with regard to the complexity of tax data to be captured and maintained by these systems include the jurisdiction imposing the tax, the basis for the tax, components of the tax base, dependencies amongst multiple systems and reporting requirements.

  • Operational data archiving versus tax record retention. Archiving is the process of moving data from a live system or database to another storage medium. Data archiving involves only business-complete transactions, which can present issues with reconciliation, and the data may not be easily accessed once archived.

Process and policy

  1. Process. In a mature tax function, processes are enabled by data and a comprehensive technology vision, and they facilitate cross-discipline interaction. Tax policies are well aligned with the function’s strategic intent.

  2. Global integration. Globalisation requires new and more extensive integration efforts across disparate and geographically dispersed business units.

  3. Reviewing process and policy. Tax departments are challenged to customise processes and controls that meet many different tax compliance and reporting objectives while adding value to the organisation.

Many organisations are mapping their end-to end processes and the systems that support them. Such process maps should highlight the volume and value of transactions flowing through different elements of the process and key interfaces between different processes and systems. Organisations which can convince their stakeholders and tax authorities that their tax systems and processes are robust will be able to communicate their tax risks more confidently.

Technology and systems.

  1. Leveraging technology. New technology tools can help companies enhance global governance by improving areas such as document and knowledge management, data management and storage communication, resource planning, workflow, and quality controls. A common tax desktop can provide authorised uses with instant access to information, data and can take actions. Typical activities include:

    1. Process mapping and redesign

    2. Software selection and implementation

    3. Tax-efficient implementation

    4. Data identification

    5. Date interfaces

    6. Configuration

  2. Enhancing value through evolving technologies. The increasing sophistication of technology and government requiring electronic data submission.

  3. A world class tax function from a technology perspective.

  4. Available technology. Three primary categories of available technologies: tax point solutions, stand-alone solutions and enterprise-level solutions. These have expanded the possibilities for integrating the tax function across processes.

  5. Tax technology. Many tax systems are available to assist corporations in complying with global tax provision and compliance obligations.

  6. Tax technology landscape.

    1. Company systems installed on hardware to collect the transactions as they occur: business systems, transaction data store, tax determination and global provisioning.

    2. Add-on tools which can be either integrated or used stand-alone for return or information filling: tax return, accounts production, disclosure management and master data management.

    3. Tools used to interrogate data systems for audit or tax planning purposes: transfer pricing, tax audit management, record retention and scenario planning.

    4. Knowledge sharing and retention software: document management and storage, data analysis, knowledge systems, process management and portals.

People and organisation

A team with the right combination of skills is fundamental to successfully transforming the tax function to a world class operation. Its personnel are equipped with leading tools, training, and career paths are clearly defined and communicated. By looking at a tax organisation broadly and focusing on how each professional does their work, use of available tools and the quality of the data they access fosters a risk intelligent tax organisation.

Forward thinking tax leaders are designing their departments to evolve continuously and at the proper pace to sustain performance and reduce the disruption of sudden dramatic change. People are the ones who ‘get it done’ by levering workload and enablers. The tax function should have a strong core team, composed of positions critical to achieving its vision over the long term.

Practice questions (chapter 5)

  1. For what reason is tax a key management challenge?

  2. What are the features of the tax operating model?

  3. Finish this sentence: ‘the goals of the organisations assessed in terms of.. ?

  4. Explain the goals of the organisations assessed in terms of people, processes and systems.

  5. Explain the changing role of the tax executive.

  6. Why can improved tax data management strengthen the audit defence activities?

  7. Why is communication in the organisation so important?

  8. What are the functions of data management and analysis?

Chapter 6: Cooperative compliance in large businesses

6.1 Introduction

Worldwide, governments and regulators are restructuring, developing and implementing regulatory models with the objective to be more effective. Revenue bodies must respond to the changing environment and be as proactive as possible and are forced to make choices in allocating limited sources. These dynamics lead to new enforcement and compliance strategies.

In the report of the OEDC (organisation of economic co-operation development) cooperative compliance is characterised as transparency in exchange for certainty. This cannot exists without the disclosure of tax risks and the underlying frameworks provide assurance that these risks surface. With the underlying framework the report means the risk management and the internal control frameworks. The suggestion that it can be helpful in the compliance strategies of regulators is an important element in new governance. It reveals the belief that private actors, like tax payers, can be moralized, responsibilised or socialised by requiring them to implement internal compliance systems.

6.2 Cooperative compliance: the urgency for a new compliance strategy

The Australian Tax Office (ATO) and the New Zealand Inland Revenue (NZIR) are co the confronted with the discontent of their citizens and of being out of touch and of compromising the integrity of the tax system.

The Netherlands Tax and Custom Administration (NTCA) was criticised by Dutch society and politicians. Large business, industrial organisations and tax advisory bodies were unsatisfied with the way the NTCA was organised and enforced tax law and regulations. NTCA acted too formalistic. At the same time it appeared that the NTCA had made agreements against the law (contra legem) with certain industries and groups of taxpayers, referred to as ‘fiscale vrijplaatsen’. The industries and groups of taxpayers are related to criminal activities, for example a coffee shop. The second reason is the perceived tension between the law and real life. This issues forced the NTCA to develop and implement new compliance strategies.

6.3 from ‘enhanced relationship’ to cooperative compliance

The report from the OECD of 2008 describes a conceptual framework for this so called ‘enhanced relationship’ approach. The study of 2008 suggest large corporate taxpayers, tax advisors and revenue bodies engage in a relationship based on co-operation and trust. The organising principles of the framework are trust and cooperation and it anticipates disclosure beyond statutory obligations. The framework is built on seven pillars. The enhanced relationship was renamed to cooperative compliance because this term describes more accurately the objective (compliance) and the conceptual ideas.

In the study of 2013 is stated that the most important characteristic is openness, so disclosure and transparency.

Expectations of disclosure and transparency for large corporations tax payers are to:

  1. Volunteer information where they see potential for significant difference or interpretation between them and the revenue body that may lead to significant different tax result.

  2. Provide comprehensive responses so that the revenue body can understand the significance of issues, deploy appropriate resources and reach the right tax conclusions.

6.4 The development of horizontal monitoring in the Netherlands

For the NTCA, three developments were of major importance for implementing a new compliance strategy:

  1. Horizontalisation of society. The council recommended to make a better balance of responsibility between the government and its citizens. Public tasks should be increasingly shared with private actors, like businesses.

  2. The growing importance of IC and risk management in corporate governance.

  3. Corporate governance became an important issue for businesses. Tax is a high risk in financial reporting and tax risk management and tax accounting are becoming increasingly more important to mitigate this risk. CG is not regulated by the law but by a code. Companies need to comply to this code or explain the reason why they don’t comply. The management is responsible for the internal control system and it includes the evaluation of and reporting on the effectiveness of internal controls. It is in line with the observations supporting horizontalisation.

  4. Scientific theorisation and research on compliance behavior and the effects on different enforcement strategies.

  5. Tax compliance has long been studied from an economic perspective only, but it is also important to take a look at the behavioural approach. The broadening of the discussion on tax compliance has been a major influence on the tax policy makers. It is one of the supporting developments for tax administrations to rethink their tax compliance strategies. Erich Kirchner carried out the Slippery Slope Framework. Tax compliance is influenced by the power of tax authorities and the trust in tax authorities and their interactions.

6.5 Horizontal monitoring in practice

Horizontal monitoring can be defined as a form of social non-governmental control, aiming for the improvement of product and service quality within certain professional groups or industries. Professional codes, certifications and hallmarks are possible ways to support this type of control.

The goals of horizontal monitoring (HM) are:

  1. Improving compliance

  2. Improving service level for business

  3. Working in real time

  4. Providing certainty in advance

  5. Reducing the administrative burden

HM starts with the assumption that the regulate is willing to comply with laws and regulations. The starting point of the HM approach of the NTCA is that all tax payers are personally responsible/accountable for complying with applicable laws and regulations. The council concluded that because of globalisation, individualisation and computerisation the relationship between the state and its citizens changed. The NTCA divides the total population of taxpayers into three groups: large enterprises, small and medium sized enterprises (SME’s) and individuals.

In 2006 an compliance agreement was published. It can be seen as a gentlemen’s agreement, because no additional rights or obligations are in the agreement. The main reason for the agreement is to foster and improve the co-operation, in tax supervision, between the taxpayer and the NTCA.

In 2008 the NTCA gives the following explanation about HM: the starting point is that tax supervision is worked on a joint responsibility of all partners in the tax chain. The core values are mutual trust, respecting mutual interests and transparency. In exchange for transparency the taxpayer will get certainty on tax positions in real time. Legitimacy and morality are values that matter when it comes to compliance.

The process of HM for large businesses consists of a number of steps. These are explained in the Guideline.

  • HM meeting. The objective is to explore the feasibility of HM. It is held between the senior management of the tax payer and the NTCA.

  • Compliance Scan. The objective is to carry out a joint assessment with the organisation to review, in more depth, the feasibility of horizontal monitoring.

  • Closing meeting of the compliance scan. The NTCA will discuss its impressions with the board of the tax payer. Both need to decide on the feasibility of HM and any further steps.

  • The settlement of pending issues. The objective is to settle as many pending issues as possible before the conclusion of the compliance agreement.

  • Concluding the compliance agreement. The NTCA and the organisation will have jointly reviewed the feasibility of HM during the HM meeting, experience in managing individual account and the compliance scan. Both have a good insight in the HM process and the HM relationship can be laid down in a compliance agreement.

The compliance agreement is standardized and the idea is to treat all large business in HM equally.

The State Secretary of Finance appointed the Commission Horizontal Monitoring. The commission was given the assignment to evaluate HM, to give an opinion on the policy change, to implement this new approach, to signal bottlenecks and vulnerabilities in regard to its approach and to recommend and propose future developments and ways to measure the effectiveness of this approach.

6.6 Compliance management systems in new governance

The emergence of the cooperative compliance models, like HM, has much to do with the rise of trust. In many regulatory strategies, the freedom is given by the regulator (trust and greater autonomy) is counterbalanced by mandatory compliance management, IC or risk management systems.

Meta-regulation is called like this because it attempts to regulate self-regulation. Strategies like these are also called enforced self-regulation. The focus of the regulator is shifting to control of control. The policy intention is to have regulatory institutions whose role is confined to mandate and monitor firm’s self-evaluation, design and management of their operations, governance and control, resulting in a better performance, more effective and efficient performance of regulators.

The focus on compliance management systems in new governance approaches looks paradoxical in relation to its organising principle – trust. The rise of trust-based relationship drives a demand for new guardians of trust who can explicitly balance incentives for principals to take risks with those of agents to engage in deviant behavior. The demand for trust creates corresponding demands for evidence. Internal control systems and related public disclosures have been transformed into the material representation or proxy for trusting organisations and their leaders.

COSO stands for commission of sponsoring organisations. They developed an IC framework and acknowledged an best practice for IC and risk management.

The definition of IC is a process, effected by an entity’s board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following categories.

  • Effectiveness and efficiency of operations

  • Reliability of financial reporting

  • Compliance with applicable laws and regulations

Power argues that internal control systems are designed and implemented with the objective to facilitate core business process in an organisation. Mobilisation of IC as a regulatory resource suggests that there is no distinction between the norms that are governmentally mandated by laws, and regulation and norms that are mandated by management.

Also Parker and Gilad argue: research shows that implementation of compliance management systems often does not and cannot achieve idealistic policy purposes. They recommend further research to test how the combination of formal systems, good management and values influences actual compliance outcomes.

Besides the fact that standard setting doesn’t fit with the organisation principles of new governance and cooperative compliance, it can be doubted that standard setting will help taxpayers become more compliant.

In order to make tax supervision efficient and effective, the NTCA re-uses the organisational compliance or internal control systems of the business. They use the so called ‘layer-model’. Efficiency and effectiveness imply that the NTCA will make selections in the divisions and deployment of the supervisory capacity.

The CAB supports this on the basis of the following principles.

  1. The audit evidence must be appropriate.

  2. The audit evidence does not need to be limited solely to the information auditors collect from their personal tests.

The model shows the different layers of control, assessment and internal/external audit around the business process. The outer layer is the tax assessment/audit. This principle is very powerful in the design of an effective and efficient compliance strategy under the conditions that the re-used controls in the inner layers are adequate. By adapting supervision strategy based on the evidence of the adequacy of the tax control framework, the audit approach of the NTCA probably provides a way to overcome the discussed problems with the compliance management systems.

Practice questions (chapter 6)

  1. Explain the urgency for a new compliance strategy.

  2. What are the goals of the ATO compliance model?

  3. Which issues forced the NTCA to develop and implement new compliance strategies?

  4. What is the difference between enhanced relationship and cooperative compliance?

  5. What are the two expectations of disclosure and transparency for large corporations tax payers?

  6. What are the three developments for implementing a new compliance strategy?

  7. Define horizontal monitoring and what are the goals of horizontal monitoring?

  8. Of which three steps consists the process of horizontal monitoring?

  9. What is the vision of Power and Parker & Gilad about internal control?

  10. Explain the layer-model’.

Chapter 7: Cooperative compliance in SME’s

7.1 Introduction

The subject will be horizontal monitoring/cooperative compliance with small and medium sized companies (SME). In SME it is often the case that the owner is also the director and even the most important employee. There is also a difference in the role of the tax service provider or tax advisor (TSP). SME generally don’t have a basic tax level knowledge in house.

7.2 Dutch landscape of small and medium sized companies

SME contributes a substantial part of the total turnover in the Dutch economy. NTCA mentioned that there are around 1,5 million entrepreneurs in the SME segment and 12.500 in the large business. The choices that the NTCA has to make depend upon decisions at a political level. Politicians decide priorities and allocate resources to the NTCA. They shift more FTE’s to the SME segment than to the large business segment.

7.3 New ways of supervision for SMEs

The NTCA is searching for forms of supervision that make the monitoring process as effective and efficient as possible. They divided the SME segment into: SME with employees, start-ups and sole proprietors. The NTCA has searched for co-operation with other parties outside the government for new forms of supervision. Three ways:

  • Co-operation with the software industry focused on creating a reliable chain from administrative record to tax return. Parties that develop software.

  • Co-operation with sectoral organisations to resolve specific sectoral tax issues in advance.

  • Co-operation with TSPs focused on the quality of tax returns.

Only the third can be called horizontal monitoring within the SME segment. The role of TSP is described by the OECD as follows: tax intermediaries play a vital role in all tax systems, helping taxpayers understand and comply with their tax obligations in an increasingly complex world. The role of TSP varies widely per entrepreneur. The use of one or more new ways of supervision for an entrepreneur in the SME segment will result in the strengthening of one or more layers.

7.4 Horizontal monitoring by SMEs

A compliance agreement between the NTCA and the TSP implies an agreement on attitude, behavior and processes. The goal is that the parties define their processes in a way that the tax return is good enough to accept without any form of supervision from the NTCA except for meta-monitoring. The NTCA recognises six steps:

  1. Compliance agreement discussions and concluding a compliance agreement. The NTCA has an important role in setting out the objective of HM and the method of HM. These discussions give the relationship more form and substance. The NTCA also forms an image of the quality and professionalism of the TSP. They issued a number of benchmarks which show the professional level of the TSP, for example quality assurance system.

  2. Applications for and reviews of entrepreneurs.

  3. This is the process of registration. The NTCA carries out a marginal review.

  4. Preliminary consultations.

  5. They provide assurance in advance and contribute to the quality of tax returns. The TSP is responsible for the completeness and accuracy of the facts presented.

  6. Filling and processing of compliance agreement tax returns.

  7. A TSP file sorts two types of tax returns: tax returns of entrepreneurs who joined the horizontal monitoring program, called compliance tax return. The other is tax returns from entrepreneurs who have not joined the HM program. The compliance tax return is acceptable, which means that it complies with requirements imposed by legislation and regulations.

  8. Audits of random samples of tax returns.

  9. Tax returns are included in the random audit program.

  10. Monitoring and evaluation of the compliance agreement.

  11. The NTCA and TSP discuss their experiences relating to HM periodically through the learning cycle.

7.5 Meta-monitoring

In HM in the SME segment the NTCA uses meta-monitoring. This can be defined as monitoring which is based on relying on the monitoring results of others. In this case, the monitoring is related to the quality assurance system and the execution of procedures and quality controls of the TSP. The audit of a random sample of tax returns is part of the process. The only form of supervision is meta-monitoring. The NTCA tests whether the compliance agreement tax returns are indeed acceptable. The real evaluation moment is the audit of compliance agreement tax returns.

Communication vessels in the process of validated tax return. It is about the entrepreneur, the adviser and the tax authorities. (in Dutch: de ondernemer, adviseur en de fiscus). In this case, the entrepreneur indicates the starting position in order to achieve an acceptable tax return. The level of the controls determines the quantity of work that the TSP (advisor) has to perform in order to achieve a tax return that meets the requirements of an acceptable tax return. The amount of work relating to meta-monitoring that the NTCA (fiscus) has to perform varies according to the quantity and quality of the work already performed by the entrepreneur and TSP.

Meta-monitoring can result in four kinds of actions:

  • The audited tax returns were acceptable. No action is needed.

  • The audit tax returns were acceptable, but files of the TSP are not complete.

  • The audit tax returns were not acceptable. The tax returns contains a material error. Actions to be taken can repair the damage.

  • The audit tax returns was not acceptable. The tax returns contains a material error or even fraud that was known by the TSP.

7.6 The changing role of the tax service provider

The TSP for SMEs has traditionally been a trustee of the SME entrepreneur, but the role is changing. The TSP has a responsibility towards to the client and the NTCA. The relationship can be complicated between the NTCA and the TSP. The TSP is responsible for the registration of entrepreneurs under the compliance agreement. There may be very different legitimate reasons for a TSP to refuse a client to join the agreement.

7.7 Dutch horizontal monitoring in SME segment in international perspective

The committee that reviewed HM has concluded that in 2011 the NTCA was far ahead internationally in regard to its horizontal monitoring in the SME segment. More countries now are implementing the Dutch method and are starting a pilot program.

7.8 Opportunities and threats of horizontal monitoring in SME segment

The NTCA should ensure that the changing role of the TSP doesn’t become a threat. The NTCA and the TSP must invest in clarifying the benefits for the SME segment, because they are not automatically the same as for large businesses.

The potential increase of the administrative burden poses a threat to the method. Identifying and providing tangible benefits ensure that this threat can be mitigated.

A few advantages of HM in the SME segment based on the NTCA business case:

  • A larger number of acceptable tax returns were filed.

  • Participating SMEs had fewer objections and appeals.

  • The NTCA staff exhibit an improved client oriented attitude and behavior.

  • The efficiency and effectiveness of supervision is improved.

  • The percentage of appeals is reduced.

One threat to HM in the SME segment is the risk that firms participating in HM have more dealings with the NTCA than before. This threat is reinforced by the fact that the TSP has started with registering entrepreneurs for horizontal monitoring who have an administration of a high level.

The report of the committee has led to the conclusion that HM for SMEs result in a significantly more efficient use of the available staffing level within the NTCA. As we take a look at 2012 than the NTCA HM method is more effective.

7.9 Alternatives for horizontal monitoring in the SME segment

The NTCA has opted for an approach to the SME segment by concluding compliance agreements with TSPs. There are other possible options for modified supervision.

  • Pre-filled tax return. This is in the Netherlands already implemented and expanded in the income tax. Individuals can download their data in the tax return. They only have to check and supplement the data if needed.

  • Outsourcing monitoring. This is the most radical option. A market participant would be made responsible for monitoring the SME entrepreneur.

  • Certification of tax service providers. The difference with outsourcing is that the tax authorities maintain their rights to perform supervision. The TSP doesn’t perform the audit in the name of the tax authorities.

  • Managed audit. This is only used when dealing with the sales-and-use-tax. The managed audit implies that the entrepreneur TSP performs a tax audit and enters into an agreement with the tax authorities.

  • Tax statement. This statement could be attached to the tax return as in a control statement in financial statements. A TSP can add this to tax return. The tax statement makes it possible for the tax authorities to reduce the supervision to meta-monitoring. 

Practice questions (chapter 7)

  1. Say something about the Dutch landscape of small and medium sized companies.

  2. What are the three ways of co-operation?

  3. Explain the layer model on page 167 for SMEs.

  4. What are the six steps of horizontal monitoring?

  5. What is the goal of the compliance agreement between the NTCA and the TSP?

  6. Explain the communication vessels in the process of validated tax return (figure 3 on page 174).

  7. Explain the changing role of the tax service provider.

  8. Name some opportunities and threats of horizontal monitoring in SME segment.

  9. Explain the four kinds of actions of meta-monitoring.

  10. What are the possible options for modified supervision?

 

Chapter 9: The introduction of the concept tax accounting

9.1 Introduction

Tax accounting is concerned with the tax position in the annual financial statements. The corporate income tax position reflected in the annual financial statements. As a result of the SOX legislation, auditors have also increasingly shifted their focus to the corporate income tax in the financial statements. This focus is not limited to businesses. Since the crisis of 2008 deferred tax assets have been subject to extra scrutiny by accountants. Public interest in company income tax positions have also increased. One of the requirements of country-by-country-reporting (CbCr) is that companies state the amount of income tax paid in the countries where they operate.

The IAS 12 guidelines contain income tax requirements for companies reporting under IFRS.

9.2 Introduction of IAS 12

IAS 12 is the IFRS accounting standard stipulating how income tax should be accounted for the annual financial statements. Income tax is defined as domestic and foreign taxes that are based on taxable profits. VAT is not levied on the profit for tax purposes, but on transactions. Income tax not only refers to the tax that is directly payable to the tax authorities (current tax), but also to the income tax that is eventually payable (deferred tax) in future periods. IAS 12 addresses both concepts.

9.3 Current tax

Current tax is defined as the amount of tax that is payable or recoverable on the taxable profit or loss in current and prior periods. Current tax related to the current period or earlier periods is recognized as a liability on the balance sheet. This liability is subsequently reduced by the amount a company has already paid with regard to these periods.

Current tax is stated at the amount the company expects to pay to tax authorities. This takes account of substantively enacted rates. This means that substantive rates must be taken into account, even if the formal legislative process has not yet been completed.

Current tax will often lead to a tax expense in the financial statements. Current tax income arises where there is a tax loss that can be carried back to an earlier year. Tax expense or income are accounted for in the profit and loss account. The only exception is when income arises is not accounted for in the profit or loss statement, but is included directly in the equity or accounted for as other comprehensive income (OCI). This is a special component of equity which takes account of unrecognized results.

9.4 Deferred tax

Deferred tax relates to tax that is payable to or can be recovered from the tax authorities in the future. IAS 12 does not contain such a literal definition, but this is implied from the definitions of deferred tax discussed below.

Deferred tax is dealt with extensively in the IAS 12 guidelines. Deferred tax liabilities are defined as amounts that are payable in the future on taxable temporary differences. Deferred tax assets are defined as the carry forward of unused tax losses and/or unused tax credits.

Temporary differences are defined as differences between the carrying amount of a asset or a liability for financial reporting purposes and their tax base. IAS 12 uses the balance sheet liability approach.

A taxable temporary difference is a temporary difference that will lead to a taxable amount in a future period when the taxable profit or loss is determined when the carrying amount of the balance sheet asset or liability is realized. A deductible temporary difference is an amount that can deducted in the future from the taxable profit or loss when the carrying amount of the balance sheet asset or liability is realized.

Temporary differences arise as soon as there is a difference between the carrying amount for financial reporting purposes and its carrying amount for tax purposes. The tax base according to IAS 12 is the amount attributed to that asset or liability for tax purposes.

The tax base of an asset is defined as the amount that, for tax purposes, can be deducted from all the taxable economic benefits flowing to an entity once it realizes the carrying amount of an asset. As a result of the balance sheet liability approach, IAS 12 only deals with temporary differences. It completely ignores permanent differences.

Tax base of liability is defined as the carrying amount less each amount that will be deductible for tax purporses in the future in respect of that liability.

A temporary difference that results in a future tax payment is recognized as a deferred tax liability. A temporary difference that result in a future deduction when determining the taxable profit is recognized as a deferred tax asset.

According to IAS 12, the general rule is that taxable temporary differences must always be recognized on the balance sheet as a deferred tax liability. The general rule for deductible temporary differences is that they must be recognized as a deferred tax asset to the extent that is probable that taxable profit is available to allow the deferred asset to be realized.

There are two exceptions to the general rule that deferred tax assets or tax liabilities resulting from temporary differences must be recognized on the balance sheet. These exceptions relate to:

  1. The initial recognition of goodwill.

  2. The initial recognition of an asset or liability that meets certain conditions.

IAS 12 sets out in three steps how to determine whether there is sufficient taxable profit available. These steps are.

  1. There are sufficient taxable temporary differences available, which will reverse in the same period as the deductible temporary differences.

  2. There is sufficient taxable profit available in the relevant period.

  3. Tax planning opportunities are available to the company that will create sufficient taxable profit in the relevant period.

In addition to deductible temporary differences, deferred tax assets can also arise as a result of tax losses, which have not yet been settled with the tax authorities. A deferred tax asset can also arise as a result of the fact that tax credits have not yet led to a tax refund.

The recognition of unused tax losses and tax credits is subject to the same rules as those applying to the recognition of deferred tax assets arising as result of deductible temporary differences. According to IAS 12 the existence of unused tax losses is a strong indication that no taxable profit will be available in the future.

Deferred tax assets and liabilities are measured at the tax rate that is expected to apply at the same time the asset is realized or liability is settled. To determine the tax rate, a company must establish in which period the deferred tax asset or liability will be realized or settled. This is particularly important in the event different tax rates are applicable for different years.

For financial purposes, financial assets accounted under OCI are stated at their fair value and changes to the fair value accounted for in the revaluation reserve. For tax purposes the financial assets are often stated at costs or at their lower market value.

9.5 The disclosure of information

An important part of the IAS 12 is the mandatory notes to the financial statements. The notes cover both current and deferred taxes.

The notes to the annual financial statements must disclose the most important components of the tax expenses and income. The intention is to provide insight into the composition of the amount of current and deferred taxes. IAS 12 provides a list of examples of deferred tax assets and liabilities. It does not list changes to preceding years as a component of deferred tax, although they are listed in relation to current tax.

The notes to the financial statements must disclose how much tax has been recognized in equity or in OCI.

The tax expense or income in the financial statements comprises the total amount of current and deferred tax. The effective tax rate is defined as the amount of current tax and the amount of deferred that that is recognized in profit or in loss divided by the accounting profit before taxes. The ETR will generally differ from the statutory tax rate.

The statutory tax rate can be the rate applied in the country where the head office is established or an aggregate of the statutory rates of the various countries where the company is resident.

Differences between the statutory and effective tax rate can arise because income components are not taxed or costs are not deductible.

The increase of decrease of a provision for uncertain tax positions will also affect the ETR.

The notes to the financial statements must disclose which tax rates have changed in relation to prior periods. This relates to the statutory rates in the jurisdictions where the company operates and can be meaningful for both current and deferred tax. The notes to the financial statements must disclose the amount of deductible temporary differences, unused tax losses and unused tax credits for which a deferred tax asset was not recognized in the financial statements.

IAS 12 requires a statement of deferred tax to be included in the financial statements. The statements must disclose the balance sheet items to which the deferred tax relates, for both the opening and closing sheet, as well as the amount of deferred tax that relates to tax losses and tax credits.

A business combination could give a company cause to adjust its own deferred tax asset. In that case IAS 12 requires that the amount of the change to the recognized deferred tax asset as a result of the business combination to be disclosed.

Tax expense related to the discontinuance of business operations must be disclosed in the financial statements.

9.6 Presentation

Another important issue is the manner in which the deferred tax assets and tax liabilities should be presented in the financial statements.

It is important to take account of the fact that current tax assets and current tax liabilities must be offset against one another as soon as the conditions are met.

The conditions according to 12.71:

  • There is a legally enforceable right to offset the recognized amounts

  • The intention is to settle the liability on a net basis or to realize the asset and settle the liability simultaneously.

 IAS 12.74 states that deferred tax assets and liabilities must be offset if:

  • The company has a legally enforceable right to set off current tax assets against current liabilities.

  • The deferred tax assets and liabilities relate to taxes levied by the same taxation authority.

9.7 Uncertain tax positions

Uncertain position can be defined as the positions take or to be taken by the company in its tax return, which can be disputed by the tax authorities. An uncertain tax position will affect the amount of current tax. It can also in some cases affect the deferred tax, because the uncertain tax position reduces the tax loss for which a deferred tax asset was recognized.

IAS 37 deals with provisions, contingent liabilities and contingent assets. A provision must be recognized if:

  • An entity has a present obligation as a result of a past event.

  • It is probable that an outflow of resources embodying economic benefits will be required in order to settle the obligation.

  • A reliable estimate can be made of the amount of the obligation.

IAS 37 states that the amount that must be recognized as a provision must be the best estimate of the expenditure required to settle the current obligation and that estimate is dependent on the circumstances. IAS 37 refers to the expected value.

IAS 12 does not require disclosure of uncertain tax positions. As previously stated, this is the reason why companies often record adjustments in the provision for uncertain tax positions under the item ‘adjustments to prior years’ in the effective tax rate reconciliation. Companies must disclose detailed information on their contingent liabilities in the financial statements.

Accounting Standard Codification (ASC) 740 is the US GAAP standard that deals with the treatment of income tax. Unlike the IAS 12, the ACS 740 contains extensive rules on uncertain tax positions. According to ASC 740, a separate provision must be recognized for uncertain tax positions and denoted as a ‘liability for unrecognized tax benefits’. To determine the amount of this liability, ASC 740 requires a two-step approach to be taken:

  1. The first step determines whether the tax position taken of will be taken in the tax return meets the recognition threshold.

  2. The second step involves the valuation of the tax position. The company determines for which amount there is a more than 50% probability that an inflow of funds will be realized as result of the tax position.

9.8 VAT, payroll and social security contributions

VAT and payroll do not fall under the definition of income tax and therefore IAS 12 does not apply to them. Every business must remit VAT on the goods and services it supplies. VAT is often a so called intermediary item, to the extent that it can be recovered, and will not result in an expense on the income statement. There are also other situations where the recoverable or remittable VAT may result in a balance sheet item in the financial statements.

Entities must remit payroll tax and social security contributions on reimbursements and on items that have been made available to employees. Both the employee and the entity must pay a share of the payroll tax and social security contributions. The entity may have a tax asset on the tax authorities.

There are no separate IFRS standards for assets and liabilities. Most of them fall under the definition of IAS 39, the standard which deals with financial instruments. An asset is defined as a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.

The liability is defined as a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resource embodying economic benefits.

A contingent asset is defined as a possible asset that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity. A contingent asset is not recognized on the balance sheet, unless it is virtually certain that it will generate income. Virtually certain is 90/95% certainty.

9.9 Country-by-country reporting

CbCr focuses on the amount of income tax paid in relation to turnover, number of employees and the nature of activities per country. One of the first voluntary initiatives was the Extractive industries transparency initiative (EITI). This focus on using transparency to mitigate a negative impact, including corruption, for countries rich in natural resources. In the EU, the Member States must implement directives, the accounting directive, and the transparency directive.

The EU also introduced the Capital Requirements Directive IV (CRD IV) which applies to the credit institutions and investment firms.

The OECD has released 15 action plans on Base Erosion and Profit Shifting (BEPS). Action plan 13 deals with transfer pricing and country-by-country reporting. The objectives of action plan 13 are to ensure that taxpayers give proper consideration to transfer pricing requirements, provide tax administrations with necessary to conduct an informed transfer pricing risk assessment and thoroughly audit the transfer pricing practices.

Practice questions (chapter 9)

  1. What are the most important guidelines of the IAS 12?

  2. Explain the difference between income tax and current tax.

  3. Give some examples of OCI.

  4. What is the difference between a taxable temporary difference and a deductible temporary difference?

  5. What are the three steps that IAS 12 sets out how to determine whether there is sufficient taxable profit available?

  6. What is the difference between the tax base of assets and the tax base of liabilities?

  7. Explain the concept country-by-country-reporting.

Chapter 10: The most important departments, risks and key players in payroll taxes

10.1 Introduction

Most people identify taxes with corporate income taxes, in particular when discussing the tax control framework. However, payroll taxes are one of the major forms of taxes in terms of tax revenues for the government. A tax control system can be an integral part of the internal control system of the organisation based on the components as defined by COSO. Based on the components of COSO a payroll taxes control framework can be defined as follows: a framework based on which identified risks for payroll taxes purposes are determined and controlled and which monitoring is applied to the correct process of the control methods.

10.2 Payroll taxes: introduction and key players

Payroll taxes are taxes that are levied from the employee. The employer is responsible for the withholding of these levies and the payment to the tax authorities by means of the periodical payroll taxes return. The object of the payroll taxes is in principle the wage of the employee, including all other kinds of benefits provided by the employer to the employee such as holiday allowance, bonuses, stock options, thirteenth month etc.

The payroll department is responsible for the payroll taxes return and the payroll taxes are filed by means of a periodical electronic payroll taxes return. Most risks for payroll taxes are not within the process of the payroll administration but in several common processes within the organisation. The payroll taxes risks relate mainly to payroll mutations that are not provided to the payroll department based on the processes. This involves allowances and benefits that are paid out to employees on a net basis and are not included in the payroll administration.

The most important departments responsible for processes concerning payroll taxes are HR and finance. More key players can be defined:

  • HR department. This department is responsible for the hiring, firing and retiring of employees as well as for drafting the labour conditions. It is important for the department to be in control of the hiring process and the retiring process, because in this processes risks occur from a payroll taxes perspective. It makes use of a HR system to include all information about employees. A certain level of knowledge is available with regard to taxes.

  • Finance department. This department is responsible for the cash flow between the employer and the employee and for paying the salaries to the employees. The department is responsible for the actual payment of the taxes to the tax authorities. The process regarding expense claims is also often placed under the responsibility of the finance department. Also hiring of third parties is a responsibility of the finance department. They has to verify whether or not third person(s) needs to be included in the payroll.

  • Payroll department. This department is responsible for including the salaries and other benefits in the payroll system. The department is also an conversation partner for HR to discuss the tax consequences of employee benefits. It is the link between the HR and finance department.

  • Tax department. This department generally tend to focus on corporate income and value added taxes. It has an important role in identifying tax changes.

  • Legal department. This department can have an important role in noticing tax risks when it is involved in the settling of agreements with employees or with third parties.

  • Fleet management department. Fleet management is involved in the ordering and handling of company cars as well as the contacts with the lease companies etc.

  • Marketing department. Companies are often not aware of the influence that this department might have on the payroll taxes process. The department may provide gifts to employees such as clothes or company products. It is sometimes unaware of the fact that these gifts may qualify as a taxable benefit in kind so they must become aware of the tax consequences of providing these gifts.

  • Procurement department. This department is involved in the ordering of products and services for employees, for example a laptop. This might have payroll taxes consequences. It is also involved in the ordering of services such as hiring of third parties. Checks need to carry out these people before they could be seen as employees.

  • Global mobility department. This department is responsible for the global mobility processes within the organisation. This means that they are involved in the short term or long term assignment of employees. This department can influence the local payroll but can also lead to payroll obligations in foreign companies.

  • Payroll provider. The payroll provider is responsible for proper payroll processing within the organisation. Different kinds of services can be bought. It can obtain an ISAE 3402 statement which gives a qualification with respect to the internal processes and the level of control by the payroll provider.

  • Internal audit. This team can be involved in the testing of the payroll tax processes.

  • The tax authorities. They can influence the payroll tax processes of an organisation. Having a strong relationship with the tax authorities based on transparency and trust is crucial.

  • Third parties. They include the lease company, insurance companies, pension provider etc. These companies provide services to the organisation in relation to a specific benefit for employees. Another party is the employment agency from which the organisation can hire employees. To minimise payroll tax liabilities for the organisation, it is better to hire employees of certified employment agencies.

  • Other. Trade unions can also influence the payroll tax process. The same is for foreign entities. The headquarters of a multinational established in another country may decide that the employees should be granted a specific benefit regardless of the tax consequences.

The first step in implementing a framework is to map out the most important inherent risks. Inherent risks are risks that can occur within the organisation. Later will be determined how to control these risks.

The most important inherent risks arising in almost every organisation relate to:

  • Payroll administration. During the execution process of the monthly activities within the payroll administration, the following inherent risks usually arise:

    • Incorrect input of mutations within the payroll administration.

    • Incorrect processing of the periodical mutations through the system.

    • Incorrect processing of the payroll administration data in the financial administration.

    • Incorrect parameters in the payroll administration system.

    • Filing of the payroll taxes return is not in time.

    • Payment of payroll tax is not in time.

  • Payroll tax knowledge. An inherent risk in this area is that the employees involved in payroll taxes processes have insufficient payroll tax knowledge. There can be (annually) organised a training for employees.

  • Communication. Lack of communication between departments resulting in tax possibilities and risks not being identified is also a risk related to payroll tax. The lack of communication can also take place on department level.

  • Hiring new employees. It refers to the lifecycle of an employee. There are several specific inherent risks related to payroll tax occur which require special attention. When an employee starts his employment, the identity of this person must be determined based on valid and correct identification documents before the actual start of the employment.

  • Firing/retiring of employees. It is essential that the organisation designs a process for firing and retiring of employees. There can be substantial tax consequences and subsequent financials risks when severance package is processed and taxed incorrectly.

  • HR and payroll mutation. In the framework a procedure must be included to validate the quality of the interface and ensure complete and accurate transfer of information.

  • Expenses. The following risks could arise:

    • The fixed expense allowance should have been considered as a taxable wage component and as a result the organisation still has to withhold and pay the payroll tax.

    • The expense claims have wrongly been paid net based on laws and regulations. The most important issue is that the expense claim is also part of the fixed expense allowance.

An expense claim must be checked based on the expense claim policy which should include a check on the following.

Ø  Authorisation to determine whether the expenses are authorised by the management.

Ø  Business purpose to determine whether costs were made for business purpose. It must be stated on the expense claim.

Ø  Receipt. The original receipt must be enclosed with the expense claim to determine whether costs were actually made and when.

Ø  Tax. It has to be determined whether the cost are taxable and whether payroll tax has to be withheld.

Ø  Conjunction with fixed expense allowance. To determine for every individual expense claim whether the expense claim is not part of the fixed expense allowance of the employee.

  • Global mobility.

  • Companies are looking for talent in countries other than were the organisation is based causing an increase of global mobility. All relevant stakeholders must be included in the framework. The roles and responsibilities must be explicitly laid down and monitoring and testing is crucial to validate if the data are accurate and complete.

  • Hiring third parties.

  • The following inherent risks in this area occur at withholding agents:

    • The employer hires third parties and may be liable for payroll tax if the third party is not able to fulfil the financial payments for payroll tax.

    • The information provided by a third party is incorrect and incomplete. This information is used by the employer to process the payroll tax return. Consequence: the company files an incorrect payroll tax return.

    • The third party is not a self-employed person, but this party is considered an employee for which the organisation should withhold payroll taxes.

  • Company car. The potential payroll tax risk is an incorrect tax withholding which is processed in the payroll tax return. Another risk is that the information from the lease car company can be incomplete or incorrect. Errors can also occur during the transfer of information to another party, e.g. the payroll provider.

  • Wages in kind (benefits in kind). A payroll risk occurs when benefits in kind are granted to employees and the value of the wages in kind are considered taxable for payroll tax and are not included in the payroll tax return. Employees also may benefit from the products or services of the company. The payroll tax risks must be identified.

  • Work related cost regulation.  The inherent risk in this area is that the financial and payroll administrations are both incomplete and inaccurate thereby preventing the organisation from complying with Dutch payroll tax. The organisation may not file a correct payroll tax return when this risk occurs.

Besides this inherent risks, every organisation has their own specific inherent risks. It is important to start with the top risk areas in which the most important payroll tax risks are determined based on a risk based analysis. In the process of the organisation’s specific inherent risks the following approaches are possible:

  • An analysis by the payroll tax specialist.

  • An analysis of the financial administration.

10.4 Monitoring/testing

Monitoring can be described as ‘the course of supervision with respect to the correct working control measures’. Potential additional risks that may arise during the monitoring can be included in the payroll tax control framework depending on the level of ambition with respect to be in control of the organisation and the materiality of the risk for the organisation.

Monitoring’ of inherent risks with respect to the appointed points of attention can be performed in several ways. The testing can take place based on output by means of a statistical sample check. The organisation can also make use of the system controls in which case it does not check the output but instead the system that produces the output. A combination of both testing models the preferred way to be in control.

The risk that fixed expense allowances and expense claims are not taxed can be mitigated when the following specific control measures have been designed:

  • The organisation has a settlement agreement with the tax authorities with respect to the fixed expense allowance.

  • A checklist is designed and applied to every expense claim.

Practice questions (chapter 10)

  1. What is the object of payroll taxes?

  2. For what is the payroll department responsible?

  3. What is the risk of the payroll taxes?

  4. What are the two most important departments responsible for processes concerning payroll taxes?

  5. Name and explain some other important departments.

  6. What are the most important inherent risks arising in almost every organisation? Explain them.

Chapter 11: Valued added tax and the indirect tax function

11.1 Introduction

In this chapter a variety of issues in the area of value added tax (TAX) will be discussed. VAT related assures issues arise for a variety of reasons originating from a wide range of root causes.

11.2 The impact of VAT

VAT impacts almost every business process. Almost every business process executed is hit by VAT, since all transactions executed are subject to VAT or relevant for VAT accounting, VAT reporting and VAT compliance. Finance functions, warehouse functions, sales and purchase functions, accounting and reporting functions are all impacted by VAT legislation and VAT compliance rules.

The finance function is often the function to which more than the day to day financial reporting of business operations is delegated. The compliance and filling of VAT returns is also a finance function’s responsibility. In an international business, the events will have some sort of impact on the VAT accounting, recording and compliance. For example: VAT rate changes for services/product categories sold.

An IT specialist is not a finance or tax specialist. But the internal need for standardisation, simplification etc. are becoming more and more demanding in terms of audit readiness and availability of VAT relevant data. Another important issue is the international trend to reduce the corporate income tax rates and income and to increase indirect tax/VAT rates and income.

According to Edwin van Loon: an issue is not an issue until it becomes a measurable issue. A VAT issue response will only be effected when these are material to the business’s financial performance or the business reputation.

The different between VAT and internal audit roles compared to the finance and IT roles is that the VAT and internal audit are supposed to challenge and judge underlying facts and circumstances of business transactions executed, whereas finance and IT roles are supposed to support and document these.

The tax administration does play an important part within the tax function. External review and supervision that frequently tests the effectiveness of tax controls will be beneficiary to the tax and finance functions performance and the tax payers’ reputation of a taxable person. This is anyone who executes VAT subject transactions.

Tax payers in the small and medium markets area still fear the tax inspector, whereas many tax departments of larger multinationals often believe that they are excused for not being in control of their VAT accounting and reporting obligations. Tax functions that do not manage opportunities well, will certainly not manage their tax exposures either.

11.3 Paradoxes and misunderstandings

The paradox: VAT is paid by companies that are exempt from VAT.

The essence of the VAT is the right of deduction of input tax by non-consumers. Suppliers issue sales invoices for goods or services delivered, adding VAT to the net invoice price. This number is the VAT output and that is paid to the government. The VAT amount/input numbers can be reclaimed by the taxable person as from the invoice day, providing that the goods and services are used for taxable transactions. No input VAT deduction is granted to companies that supply goods and services that are exempt from VAT.

VAT is not a cost

VAT is not hitting the profit and loss statement, so why bother about indirect tax?

Certainly for Europe, VAT is a source of income as well as a source of cost. A lot of research has been done to find explanations and to identify the root causes for the VAT gap. Some say carrousel fraud and tax evasion are the main issues, others are challenging the data quality and integrity used by the compilers of VAT GAP report.

The VAT dogma

One of the biggest dogmas in taxation is still that the VAT is not a cost. It tells the story of the hidden tax. It does not appear in the financial statements as a cost or as an income. Even in VAT exempt business the cost of VAT does not appear. Now we will discuss the economic neutrality concept of VAT. It is part true that VAT does not impact a company’s business decisions in terms of allocation of means of production. Many consumers living near the borders know their way to the petrol stations, where the excise duty rates and VAT rates are lower. Another economic reality is the public’s interest. The public is the most important stakeholder for the government and he should serve the public. Economic neutrality is often challenged by politicians and political commentators discussing the impact of VAT rate differentiation. But VAT does not have a lot of influence on normal-economic-based business decisions.

A few unanswered questions are:

  • Where is the missing part? This is about the €200 billion gap and the answer to this question is that nobody knows.

  • Who is bearing the financial risk of the missing part? It’s paid to and collected by VAT persons on behalf of the government and therefore are the bearers of the financial risks of the VAT GAP as part of the missing part.

  • What is the impact on cost/income ratio’s, on equity and/or profitability of a company when being assessed for five years of underpaid VAT, interest charges and penalties? VAT is an above the line tax, which means that VAT assessments have a direct impact on profits before taxes of tax persons. The risks have been extremely low.

  • Who is liable in case a company’s financial statements are audited and the auditor has failed to recognize major VAT risks? Companies have tried to blame auditors or have held directors liable for the financial consequences of unidentified and non-disclosed VAT risks that resulted in a VAT assessment that was impacting a company’s financial performance and/or equity.

11.4 The (indirect) tax function’s risk assessment function

The first step towards adequate risk and opportunity is finding more appropriate assessment techniques to provide quantitative results. An appropriate equation or function for (indirect) tax risk assessment identification methodologies could be illustrated as follows:

TR = f(ITR, OTR, TCR,TDR)

This is similar to the theory of audit risk assessment: ACR = f(IR, ICR, DR). TR will be low (0%) when the tax function’s design, operations and internal control execution meet all international tax auditing, tax accounting and reporting standards. TR will be high (100%), if the tax functions fails to meet any of these standards.

ITR: inherent tax risk

These are risks that result from an assessment of general VAT compliance and VAT controls’ influencing factors of the tax function of a VAT person/company. Examples of the ITR influencing factors are: national and international operations, IT and data, and tax departments connectivity.

Mitigating ITR risk factors

  • A reduction of the ITR seems to be fair when companies have demonstrated that no material tax assessment resulted out of tax audit execution in any jurisdiction for a longer period.

  • Another ITR mitigating factor is often the governance, controls and compliance policies.

  • In cases where the policies are solely risk adverse, highly aware of reputational damage risks etc., ITR can be reduced.

The ITR level is reduced because of the so called finance transformation programs. Many of the IT and reporting landscape’s complexities will be simplified.

OTR: operational tax risks

OTR impact the performance of the tax department. A misunderstanding is that the tax department is the tax function. Some external OTR influencing factors are:

  • Cultural differences in the acceptance of tax evasion

  • Underpayment of government officials

  • Differences in interpretation of materiality

  • Poor harmonisation of indirect tax/VAT legislation.

Some internal OTR influencing factors are:

  • No ownership of tax controls per tax area

  • Limited availability of tax auditing and tax accounting resources capable of truly partnering with other functions

  • Lacking of continuous controls monitoring technology for taxes

  • Knowledge gaps leading to poor communications between the departments

Reasons for a high OTR rate is that the VAT compliance is considered to be a delegated responsibility of local finance functions and sometimes even outsourced functions. Another reason is that VAT persons or companies tend to believe that VAT compliance levels are strongly impacted by their capability if meeting the EU directive’s invoice requirements.

TCR: tax controls risks

This is perhaps the most complex element. This is the risk that a VAT person or company bears a result of insufficient internal tax controls design, failing automated and semi-automated VAT exemption reporting and lacking internal VAT controls execution. This is often a delegated responsibility for business unit leaders.

Mitigating TCR risk factors:

  • Reducing the chances of late filling risks related exposures to penalties.

  • Tax-engines implementation that provide daily inconsistency reports about input and VAT accounting and reporting execution.

TDR: tax detection risk

This is the risk that a company fails to disclose financially material tax exposers, with respect to either unknown tax risks and/or known tax risks of which the likelihood of being challenged during an audit is unrealistically understated. Unknown tax risks may exist when ineffective internal tax controls and internal tax audit execution come together.

11.5 Indirect tax issues

Direct debits and credits

The execution of business transactions is part of the daily routine for VAT persons/ companies. Identification and scrutiny of direct debits and credits in the VAT compliance processes is often overseen in these situations. VAT exempt companies, like health insurance companies, are not to blame for not challenging VAT invoice requirements by their suppliers. Tax administrations that consider executing a VAT audit at companies that do not account for VAT might obtain valuable insights that can be financially rewarding to them and to the public.

Foreign VAT

In a business to business trading situation between taxpayers, input VAT can be reclaimed by the customer. A scenario that might be overseen by accounts payable departments is a scenario whereby non EU Member State taxpayers charge the recipient’s country’ VAT. A variety of factors influencing VAT risks profile of a company have led to a tax income like this: cultural differences, the supplier helps himself since he will not pay the VAT to the government as he is not a European VAT person or company and outsourcing of finance functions/cost reduction programs.

Supplier/customer transactions

Some services, like hospital and medical care services as defined by member states, are exempt from VAT. In these cases, no right to deduction of input VAT charges exist. When one party in a supply chain is not allowed to reclaim input VAT, business partners might be willing to discuss or negotiate pricing arrangements. In this case a doctor is negotiating the purchase price of a piece of medical equipment with a supplier. It can be expensive as a result of which non-deductible VAT is an important cost factor. The non-compliance risk increases when doctors are not listed as VAT payers, and therefore do not file VAT income statements, will most likely not be collected by the government.

Netting

This case is about a retail organisation that sells fashionable consumer products in the business to consumer industry (B2C). Producers can rent brand experience centre (BEC) sales locations in a number of cities.

Netting often leads to high risk VAT compliance exposure levels that are often overlooked. Netting is not the real VAT compliance issue. The real issue is a lack of skills by professionals that leads to failures in recognising and detecting this type of VAT risk. Netting often results in VAT GAPs.

Bad debt accounting

A mistake that is very often made is VAT accounting as a result of bad debt provision accounting. Unfortunately, many accountants annually assess the number of outstanding bad debt for bad debt provisioning without considering the fact that VAT in the accountant receivable numbers will always be recollected, either from the debtor or the tax administration. The case is about the journal entries for bad debts (excluding VAT).

Practice questions (chapter 11)

  1. Explain why VAT impacts almost every business process.

  2. Why is an IT specialist becoming more and more important?

  3. What is the difference between VAT and internal audit roles compared to the finance and IT roles?

  4. Explain some paradoxes and misunderstandings.

  5. What is the function of tax risk assessment identification? Explain the factors.

  6. Explain the mitigating ITR risk factors, the external OTR influencing factors and the mitigating TCR risk factors.

  7. What are the indirect tax issues? Explain them.

Chapter 12: Tax control framework and corporate income tax issues

12.1 Introduction: why is it difficult to manage CIT?

In this chapter corporate income tax is explained related to good governance in a theoretical and practical way. Managing CIT is being able to follow transactions, extract proper data and report them in the required format to the relevant stake-holders following tax laws, regulations, international accepted accounting standards and statutory financial regulations. Tax risk management for CIT consisting of:

  • Drafting a report or an advice justifying a position.

  • Legal documentation.

Tax risk management means embedding tax into the business administration and reporting cycles of the organisation. It should not be incidental, stand alone, ex ante exercise.

12.2 The model

The tax control framework (TCF) can be defined as: ‘the internal control of all processes and transactions with possible tax consequences’. The tax management maturity model (T3M) is a tax risk management model. It deals with the following:

  1. Business and tax environment

  2. Business operations

  3. Tax operations

  4. Tax risk management

  5. Monitoring and testing

  6. Tax assurance

The CIT risks relate on the one hand to CIT technical risks and on the other to CIT risks with respect to processes, people and systems.

Business and tax environment.

The responsible tax manager needs to understand the context where he is working in. Elements belonging to the core of the tax environment in relation to the business, organisation and administrative functions are:

  • The tax strategy. This will/should include the vision of being compliant with (tax) law and regulation. Four aspects can be distinguished in respect of tax compliance: (justifiably) register to pay tax, file the applicable returns in time, file correct and complete returns, and pay its due tax (in time). The strategy should be fully supported by the Board and the Executive Board. It is the essence of what the organisation wants to achieve in the field of tax. The biggest risk is that the drafting of a tax strategy is not taking seriously.
  • Roles and responsibilities with respect to tax. It is also important to determine the roles and responsibilities for every department. Examples of departments are finance, treasury, HR, internal audit, IT and procurement. The group tax department should be responsible for the tax strategy and tax planning activities. In order to make things work it could be considered to set clear objectives with clear key performance indicators (KPI) that can be measured.

  • Tax awareness of the organisation. The question stated here: is the tax function aware of all developments within the organisation that might have a possible material CIT impact? At a local level a sustainable function is created that is responsible for executing the CIT policy and see that adjustments are properly booked and commercial data and tax data are reconcilable, stored and proper documentation is in place.

  • The system if hard and soft controls. Every organisation has its own culture with respect to compliance. With respect to CIT, it is about the intrinsic will of the Board and the employees to do what is right. The better motivated your workface, the more compliant behavior you see. All these building blocks are important for CIT risk management.

Business operations

This part deals with the operating units within the organisation. Tax relates to many operations throughout the entire company. The tax department needs to interact with the rest of the organisation and it should be included in existing business, reporting and risk management process. It consists of five cycles: the financing, expenditure, production, revenue and the human resource cycle. These cycles feed information in the general ledger and reporting systems which provides information for both internal and external users. This gives a simplified overview of the information flows within a company and all possible delta’s that occur. The output the organisation needs to deliver consists of its annual accounts, tax returns and statutory accounts. This information is derived from the management information.

Tax operations

In order to dive into the specific risks within the CIT process, we will go into the following basic CIT processes in detail below. We included a flowchart, which will provide the organisation with clarity on the roles and responsibilities in the process, can give insight in possible GAPs/risks, and the required controls to remediate these risks.

  • CIT preparation and filling. This drills down to the input of relevant information for the CIT return, the preparation of the CIT return and filling the CIT return. The flowchart makes clear that group tax is dependent on group finance for input of raw data. Cooperative compliance, an enhanced relationship with tax authorities is a relatively new phenomenon. This is based on co-operation with the purpose of assuring compliance. Tax payers provide timely/correct information to tax authorities.

  • CIT accounting process. This process drills down into input of information from the accounting department and the assessment by group tax on the CIT specific elements.

  • CIT assessment and payment. After receiving a CIT assessment from the tax authorities, the organisation needs to evaluate if this corresponds with its own provision. The organisation wants to comply with tax laws and regulations and thus wants to pay its due tax in time.

  • A possible CIT audit by tax authorities. The organisation should have a basic procedure in place in case tax authorities announce a tax audit. The question arises: how much autonomy do operational companies have in these issues? The CIT audit process can be affected by several broader developments in society. We see cooperative compliance agreements, but also tax authorities increasing their audit appetite and aggressiveness.

Tax risk management

When looking at (tax) risk management, the organisation should have a risk appetite process, risk identification and risk response process and control activities in place. The first step is determining the risk appetite. This should be directly linked to the tax strategy/policy as determined in the business and tax environment building block. The organisation needs to determine how much risk it is willing to take. Group tax should also have a vision on the responsibilities of identifying tax and more specifically CIT risks. When the group tax department is responsible for tax risk management, it should be assure it is closely linked to those departments and business transactions that could carry a possible issue with CIT impact. The organisation should have risk response and control activities in place.

A distinction can be made between tax technical risks, and risks that relate to processes, people and systems. We can define some standard, generic CIT issues and risks and the key tax controls to remediate these in line with the CIT processes as defined in the tax operations building block. The book gives examples of potential risks, a suggestion for a control activity and a possible KPI for the tax department will be discusses. The purpose of a control activity is to prevent and/or detect and correct misstatements that may arise in a process timely.

In the following areas tax technical risks can occur.

  • Participation exemption and CFO

  • Treatment if interest expenses

  • Tax grouping

  • Substance requirements

  • Correct implementation and monitoring of tax advice and rulings

  • Ongoing monitoring of changes in tax law and regulations

  • State aid

In the following areas risks relating to processes, people and systems can occur. The areas are divided in four categories.

  • CIT preparation and filling

    • Timing, due dates of the CIT return

    • Data input CIT return

  • CIT accounting process

    • Tax calculations and tax reporting packages

  • CIT assessment and payment

    • Review of CIT assessment

    • Timing of CIT payment and/or appeal due dates

  • A possible CIT audit by tax authorities

    • Tax audit

Monitoring and testing

The organisation should implement a monitoring and testing function in order to demonstrate the functioning of its tax management system to internal and external stakeholders like audit committee, tax administrations or external auditors.

  • The organisation needs to test if all controls are implemented and functioning as they were set-up.

  • The organisation should test if the set-up itself is effective.

Monitoring and testing can be done by means of testing the CIT controls. The organisation can also conduct sampling testing to test whether items were dealt with in a correct way from a tax perspective. In more detail.

  • Control testing. In the set-up of the processes and linked to the tax risk management, the organisation has identified several key tax controls with respect to CIT. They can test their efficiency by means of controls testing.

  • Substantive testing. This is an efficient, objective and transparent way to conduct monitoring of the tax management function of an organisation. Dual purpose substantive testing:

  • Provides insight if the selected key controls have functioned as designed.

  • The outcome gives insight in to which degree the selected transactions are threated in the correct tax way.

A notable development is that we see organisations communicating the outcome of monitoring and testing activities with tax authorities. This can mostly be attributed to the increase of cooperative compliance arrangements throughout the world.

Tax assurance

The final element of the CIT risk management system of an organisation is to provide internal and external assurance.

Internal assurance

Corporate governance codes or regulations generally require organisations to state in their annual report that the organisation is ‘in control’ and that its internal risk management and control systems functioned properly. The organisation must next to the monitoring and testing also have a reporting structure to allow group tax to communicate significant CIT risks to the management board.

External assurance

Within external assurance, we can distinguish between broader general tax assurance. For example: in the annual accounts, and tax assurance towards tax authorities. Depending on the scope and materiality, the CIT may be in scope for the accountant by means of an audit of tax. The CIT is incorporated in the year end assurance process.

Tax assurance towards tax authorities can be compulsory or on the tax payers own initiative. We also see regulated self-assessment developments, where tax auditors are required to audit and sign-off on the CIT return of large companies. In these systems, tax authorities are provided with assurance on the CIT return by an external service provider.

External assurance on tax on behalf of tax authorities on the initiative of tax payers was the other option. The relationship between the organisation and the tax authorities is a relevant tailpiece in the tax risk management process. Cooperative compliance in most cases requires some sort of external assurance on tax towards tax authorities on the initiative of tax payers.

Practice questions (chapter 12)

  1. What is the meaning of tax risk management?

  2. What are the areas the tax control framework has to deal with? Explain them.

  3. What are the elements belonging to the core of the tax environment in relation to the business, organisation and administrative functions?

  4. Explain every context.

  5. Explain the difference between the internal and external assurance.

Chapter 13: Tax perspective and management control perspective

13.1 Introduction

In the 30 July 2013 White Paper on Transfer Pricing Documentation the OECD acknowledges the growing compliance burden on business as more and more countries adopt transfer pricing documentation rules, increasing costs for MNEs in an area of activity that may be largely viewed. The OECD aims at improving documentation rules in such a way that the intended purposes are reached in the most efficient possible manner. The purposes are to the OECD as follows:

  • To provide governments with the information necessary to conduct an informed transfer pricing risk assessment at the commencement of a tax audit.

  • To assure that taxpayers have given appropriate considerations to transfer pricing requirements in establishing prices and other conditions for related party transactions and in reporting the income derived from such transactions in their tax returns.

  • To provide governments with all of the information that they require in order to conduct an appropriately thorough audit of the transfer pricing practices of entities subject to tax in their jurisdiction.

In order to reach these goals the OECD proposes a coordinated approach to documentation in which the taxpayer provides the tax administration with a master file and a country file.

  • Master file. This portion of the documentation would seek to elicit a reasonably complete picture of global business, financial reporting, debt presence and tax situation of the MNE.

  • Country file. This file focus on specific transfer pricing analyses related to material transactions taking place between a local country affiliate and associated enterprises in different countries. They should supplement the master file and help to meet the objective of assuring that the taxpayer has complied with the arm’s length principle in its material transfer pricing positions.

The tax control framework is used on internal transactions for tax purposes. The framework is a so called management control framework. This framework is also used for managing and controlling their activities. With the controls included in the management control system, managers can influence the decisions and behaviors of their employees. This system is also used for management and control of internal transactions. This controls partly depend on the decision-making structure of a company (centralised or decentralised).

The transactional relationship between the transacting organisational units can be very complex. The more complex the transactional relationship is between the internal parties, the more difficult it is for the central management to manage the internal transactions. In order to make managers of organisational units responsible for their decisions, the (financial results) of these decisions have to be measured. The effectiveness and efficiency of collecting information and storing it in a company’s transfer pricing documentation could be enhanced if the tax control framework and the management control framework of internal transactions can be integrated.

The aim is this chapter is to investigate whether the principles underlying the tax control framework and the management control framework as set up for cross border internal transactions allow an integration of both frameworks.

13.2 The tax perspective

Domestic tax laws of most countries contains rules requiring companies to fulfil the arm’s length principle in respect of internal transactions both for intercompany transactions and intracompany transactions. This rule is also codified in most tax treaties.

Arm’s length principle

The aim of this principle is to reconcile the legitimate right of states to tax the profits of a taxpayer based upon income and expenses, that can reasonably be considered to arise within their territory, with the need to avoid double taxation.

Codification in art. 9 OECD model and art. 9 UN model for intercompany transactions

This standard is codified in the domestic legislation of numerous states as well as in tax treaties, for intercompany transactions generally based on the provisions included in art. 9 OECD model and art. 9 UN model both reading for associated companies. In the OECD commentary on this article it is explained that tax authorities of a contracting State may re-write the accounts of the enterprises if the accounts do not show the true taxable profits arising in that State.

Codification in art. 7 OECD model and art. 7 UN model for intracompany transactions

For transactions between parts of the same company situated in different countries the arm’s length principle is laid down in art. 7 OECD model and art. 7 UN model. All internal dealings between the permanent establishment and other parts of the company should be remunerated at arm’s length. The functionally separate entity approach does not transform a permanent establishment into a fully independent enterprise but merely states that all internal transactions should be rewarded at arm’s length. The permanent establishment should also be allocated part of the capital of the worldwide enterprise.

Transfer pricing guidelines and reports on the allocation of profits to permanent establishments

The OECD influences the interpretation of these rules and the transfer pricing documentation obligations to be fulfilled for tax purposes. The aim of the guidelines is to encourage the acceptance of common interpretations of the model articles, thereby reducing the risk of inappropriate taxation and providing satisfactory means of resolving problems arising from the interaction of the laws and practices of different countries. It shows that a functionally and a comparability analysis have to be made.

  • Functional analysis. This is an analysis of the functions performed in controlled transactions of associated companies or in internal dealings between a permanent establishment and its head office or between two permanent establishments of the same company.

  • Comparability analysis. This is a comparison of a controlled transaction/ internal dealing with an uncontrolled transaction(s).

For intercompany transactions the functional analysis is part of the comparability analysis and aims to identify and compare the economically significant activities and responsibilities undertaken, assets used and risks assumed by the parties to the transactions.

For intracompany transactions a functional analysis should take place before the comparability analysis can be executed, as the functional analysis removes the difficulty that contracts are not available in intracompany dealings.

The OECD uses the term significant people function only in the context of intra-company transactions. The term is not defined, but the OECD provides examples. The use of this term does not imply that functions other than significant people functions (routine functions) should not be remunerated at arm’s length. The OECD stresses that a permanent establishment is not the same as a subsidiary and is not legally or economically separate from the rest of the enterprise of which it is part.

The functional analysis for both intercompany and intracompany transactions should consider the type of asset used and the nature of assets used. The material risks also assumed by each party have been considered. Regarding the comparability analysis there are five factors that determine comparability between controlled and uncontrolled transactions:

  • Characteristics of property or services

  • Functional analysis

  • Contractual terms

  • Economic circumstances

  • Business strategies

All these factors, except contractual terms, are also applied to evaluate internal dealings, as they are essentially based on facts.

Transfer pricing methods

The OECD Transfer Pricing Guidelines distinguishes traditional transaction methods and transactional profit methods. There is no hierarchy between these methods, but the CUP method is preferred if also another method can be applied.

In short the characteristics of the methods.

  • The Comparable Uncontrolled Price Method (CUP) compares the price charged for property or services transferred in a controlled transaction to the price charged for property and services transferred in a comparable uncontrolled transaction in comparable circumstances.

  • The Cost Plus Method adds an appropriate cost plus mark up to the costs incurred by the supplier of property or services in a controlled transaction for property transferred or services provided to an associated purchaser.

  • The Resale Price Method reduces the price at which a product that has been purchased from an associated enterprise is resold to an independent enterprise by an appropriate gross margin on this price.

  • The Profit Split Method seeks to eliminate the effect on profits of special conditions in a controlled transaction by determining the division of profits that independent enterprises would have expected to realise from engaging in the transaction(s). It first identifies the profits to be split for the associated enterprises from the controlled transactions. Next, the combined profits would be divided between the associated enterprise. Residual profits would be allocated among the parties based on an analysis of the facts and circumstances. This method is not adequate if one party to the transaction performs only simple functions and does not make any significant unique contribution.

  • The transactional Net Margin Method seeks to eliminate the effect on profits of special conditions in a controlled transaction by determining the division of profits that independent enterprises would have expected to realise from engaging in the transaction(s). This is a one-side method and is used for the determination of the profit of the least complex entity, the part of the company that performs routine functions. The residual profit is allocated to the other part of the company.

The OECD allows the use of more than one method as long as this will result in the best estimation of an arm length price. One of the benefits of forming a group of companies is the synergy effect: teamwork will be enable the group to outperform even its best individual member.

The OECD introduced two new concept: control over risk and commercially rational behavior. The OECD introduced the concept of control over risk in the guidelines where the OECD provides guidance on the use of the functional analysis. Analysis is required to determine to what extent each party bears such risks in practice. The concept of commercially rational behavior is used to provide evidence whether or not tax evasion is at stake.

Documentation requirements

The transfer pricing guidelines not only give guidance in respect to the use of the five transfer pricing methods mentioned above but also in respect to documentation. The globalisation severely increased the amount of documentation requirements. The OECD acknowledges that the proliferation of transfer pricing documentation requirements makes transfer pricing documentation one of the top tax compliance priorities on the agendas of both tax authorities and businesses. An internal review of the transfer pricing documentation of 25 countries revealed that the requirements amongst countries are vary widely. The OECD points out that tax authorities need ready access to sufficient information at the early stages of an audit. The rules should be designed in such a way that the risk assessment can be carried out efficiently and with the right kinds of reliable information.

The aim of the documentation requirement is to enable tax authorities to identify the presence of significant transfer pricing risks. The master file should give a complete picture of the global business, financial reporting, debt structure and tax situation of the multinational enterprise. The country files should provide information on the organisation and management structure of the local entity and a functional and comparability analysis with respect to each documented category of internal transactions.

OECD transfer pricing risk assessment handbook

The OECD published a handbook in order to encourage early collaboration between tax administrations and taxpayers and to avoid protracted transfer pricing disputes. The aim of the Handbook is to provide tax administrations information on how to select the right transfer pricing cases for tax audit. It enables the actual audit to be more focused, shorter and more effective. It also gives taxpayers insight to the many different approaches used by tax administrations, which will enable them to determine the final tax compliance risk.

Tax control framework (TCM)

The tax control frameworks have a wider scope. These frameworks are set up to identify and monitor tax risks. TCM contain information about the organisation and business processes of the company, the tax strategy of a company and its execution, the tax process, the tax accounting process, tasks and responsibilities related to the tax process and the IT systems used.

The framework is defined as an internal tax control system in which businesses establish their tax processes, that is part of the companies’ management control system that is set up to control business processes.

13.3 The management control perspective

The management control framework of internal transactions has two aims: reaping the benefits of internal transactions and effectively supporting the decision-making by the central management and the management of the transacting organisational units. Both will be discussed below.

Benefits of internal transactions: lower transaction costs

Transaction cost theory claims that the following three dimensions of transactions influence the level of transaction costs:

  • The degree and character of asset specificity.

  • The frequency and volume of the transactions.

  • The level of environmental and behavioural uncertainty.

This theory argues that if the degree of asset specificity and the level of uncertainty are high, and the transactions are frequent and have a high volume, winding up the transactions on the market could lead to high transaction costs as the risk of behaviour by one of the parties is high. The risk of opportunistic behaviour can be mitigated by winding up the transactions within the hierarchy, within which management controls can be developed to influence the behaviour of the transacting parties.

Supporting the decision-making process

The larger companies are and the more products they produce and sell on the market, the more complex their decision-making processes are. In large companies information required for decision-making is available in different levels. Decentralising decision rights implies that responsibilities are apportioned to lower management levels. The degree in which this takes place can differ. There are different types of responsibility centres: the investment centres, profit centres, cost centres and revenue centres. The management of an investment centre has the highest level of autonomy and the profit centre the lowest.

The management control framework of internal transactions has to be geared to the overall management control system. In this way, the behaviour of the lower level managers can be influenced in a consistent way.

Key elements of the management control framework of internal transactions

The different elements of the management control framework of internal transactions are the following:

  • Application area: which internal transactions the rules are applied to

  • General starting points: the aim

  • Apportioning of authority: who is involved in the development of the system, who determines the transfer price/ investments in production capacity etc.

  • Transfer price basis and definition of this basis

  • Transaction terms: terms under which the internal transactions take place.

  • Consultation structure

  • Administrative support

  • Arbitration process in case of conflicts between internal parties

  • The process of developing adjustments

These elements determine how internal transactions are prepared, concluded and wound up and to what extent the authority is decentralized. The financial boundaries between the transacting organisational units are determined by the transfer price. This price can based on the market price of the costs of the goods and/or services. The management control framework indicates when adjustments are allowed and who has to be consulted about the development of adjustments.

13.4 Differences between the tax perspective and the management control perspective

Goals of the perspective: preventing double taxation and profit shifting versus influencing behavior within the company

The tax perspective aim is to allocate legal entities being part of a group within or outside of the state of residence of the other entities that are part of the group, on an arm’s length basis (intercompany transactions) and also intra company transactions.

The aim of the management control perspective is to realise the benefits of winding up transactions within the company as well as to support the centralized and decentralised decision-making related to internal transactions in such way that the goals of the company are achieved.

Goal of perspective: focus on significant transfer pricing risks versus risks in general

Risk management identifies all types of risks a company faces and develops measures to prevent or reduce these risks. Risks connected to the transactions of goods and services in general are not limited to the significant transfer pricing risks. The transfer pricing documentation focus on risks related to financial transactions and transfer of immaterial assets. Management control measures should also prevent or reduce the general risks.

Point of departure: legal entities versus organisational units

The tax law uses the arm’s length principle for both intercompany and intracompany transactions. For intercompany transactions the starting point is the contract and for the intracompany the functional analysis. Purposes tax law considers the different organisational units of a group of companies as independent parties. The tax law make use of the concepts of the functional and comparability analysis.

The management control perspective does not take into account the legal structure of a company but it focus on the organisational structures. This perspective does also not use the concepts of the functional and comparability analysis.

Point of departure: country-by-country versus organisational unit-by-organisational unit

The tax perspective focuses on the profits per country. The company should draft country specific files. For the management control perspective, country specific information processing will be less relevant if the company’s activities are not structured per country but per group of countries or per product group.

Point of departure: transfer pricing documentation requirements that may differ from country to country versus transfer pricing documentation determined by the (group) of companies.

The transfer pricing documentation requirements prescribed by tax law vary from country to country. These differences in rules result in high tax compliance risks and in complex transfer pricing administrations.

The management control purposes the administration supports the processes. Companies are not bound by any rules on documentation for management control purposes.

Synergy effects versus transaction costs

In tax law it takes into account synergy effects for the existence of internal transactions. Taw law looks at synergy effects from the perspective of the individual parts of the group and not from the perspective of the group as a whole.

The management control perspective does not only pay attention to synergy effects and other effects but it also takes into account the transaction cost of internal transactions.

Aim of transfer pricing methods used: arm’s length result versus desired degree of decentralisation

The arm’s length principle is not used for management control purposes. For management control purposes the transfer pricing method used should fit in with the decision-making structure of the company. Transfer pricing methods used for tax purposes such as CUP or cost plus method are used for management control purposes too. Using the arm’s length price could satisfy both tax and management control purposes if a company has not portioned out authority to lower level managers.

Determination of cost: what costs would be used by third parties versus what costs would influence the behavior of the transacting parties

The OECD transfer pricing guidelines also refer to variable and fixed costs as well as the management control perspective. But the concept of the standard cost price is not referred in these guidelines. Tax administrations may require companies to use the actual costs.

The management control perspective can use different concepts of costs when it uses transfer prices based on cost. Inefficiencies are the differences between the actual and the standard costs.

Bargaining as transfer pricing methods

For management control purposes, the transfer price could be determined in negotiations between the transacting parties.

The OECD acknowledges that bargaining may be used to determine the transfer price but at the same time warns tax administrations that the relationship between the enterprises may influence the outcome of the bargaining.

Acceptance of simultaneous use of two or more transfer pricing methods

For management control purposes, companies could simultaneously use two or more transfer pricing methods, called dual pricing.

The use of more than one method is allowed for tax purposes through the OECD.

Timing issues: no hindsight versus making use of up-to-date information

For tax purposes hindsight is not allowed. This implies that changes in the economic and market factors that occur after the date of transaction should not be taken into account when determining the transfer price. For management control purposes the information should be up-to-date. Changes in economic and market situation have to be taken into account. Decisions has to be made based on actual information.

Relation of transfer pricing systems with the overall management control system

The management control framework of internal transactions is an element of the overall management control system, which may include a tax control framework. The overall system is only effective when all elements match and do not lead to opposite signals.

13.5 Consequences of using one framework for controlling internal transactions for both the tax perspective and the management control perspective

The aim of both perspectives differ in such a way that it is hardly possible to fully align them. If companies use one framework, we observe that this framework focus primarily on one perspective. Using one control framework might convince the tax authorities that the company does not strive for shifting profits between countries.

Two separate control frameworks may result in compliance risks as tax inspectors may not understand why the transfer price used for tax purposes deviates from the price used for management control purposes. Two control frameworks are more costly and therefore making use of one framework for both perspectives is preferred. A solution to the problems caused by the differences in perspective may be the use of hybrid transfer pricing systems as evidence by the research of Boeltjes, De Vries and Steens. These authors describe the transfer pricing system of centrally managed purchase organisation that starts from the management control perspective and contains adjustments for the tax perspective.

Practice questions (chapter 13)

  1. What are the purposes of the OECD with the White Paper on Transfer Pricing Documentation of 30 July 2013?

  2. What is the difference between the master file and the country file?

  3. Explain the use of the tax control framework.

  4. Explain the arm’s length principle?

  5. What is the difference between intercompany transactions and intracompany transactions?

  6. Explain the term ‘significant people function’.

  7. What are the different transfer pricing methods? Explain them.

  8. Explain the difference from the management control and tax perspective.

Chapter 14: The introduction of audit of tax

14.1 Introduction

The audit methodology is based on the International Standards on Auditing (ISA). The purpose of an audit is to enhance the degree of confidence of intended users in the financial statements. This is achieved by the expression of an opinion by the auditor on whether the financial statements are prepared, in all material respects in accordance with an applicable financial reporting framework.

An unqualified opinion of an auditor means that the auditor is of the opinion that the financial statements are free of material misstatements.

Objective of an auditor

  1. To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatements.

  2. To report on the financial statements and communicate in accordance with the auditor’s findings.

Reasonable assurance is a high level of assurance. This is not the same as an absolute level of assurance.

Audit evidence is information that an auditor uses in arriving at the conclusions on which he bases his audit opinion. Audit evidence is cumulative in nature and is primarily obtained from audit procedures performed throughout the audit.

Sufficiency is the measure of the quantity of audit evidence. The higher the quality, the less audit evidence may be required. Appropriateness is the measure of quality of audit evidence. The auditor should obtain sufficient appropriate audit evidence to reduce audit risk to an acceptably low level.

The audit risk model demonstrates the relationship between inherent risk and control risk and the level of detection risk that an auditor is willing to accept when performing his audit procedures. The objective of an audit is to limit audit risk to an acceptably low level around 5%. The management can mitigate inherent risk by implementing effective internal control.

Risks of material misstatements at the financial statement level refer to risks that relate pervasively to the financial statements as a whole and potentially affect many assertions. Risks of material misstatement at the assertion level consist of inherent risk and control risk.

Risk assessment procedures are those procedures performed to obtain an understanding of the entity and its environment. This procedures provide a basis for designing and executing audit procedures to respond to the assessed risks of material misstatements.

The audit risk model allows the auditor to take a variety of circumstances into account in selecting the most effective and efficient audit approach to reduce audit risk to an acceptably low level.

The model is: audit risk = inherent risk x control risk x detection risk

Audit risk: the risk that the auditor expresses an inappropriate audit opinion.

Inherent risk: the susceptibility of an assertion about a class of transactions, account balance or disclosure to a misstatement.

Control risk: the risk that a misstatement account balance or disclosure and that could be material will not be prevented or detected and corrected on a timely basis by the internal control of the entity.

Detection risk: the risk that a material misstatement would not be detected by the substantive procedures.

The four phases of the audit process.

  1. Planning and risk identification. The auditor obtains a broad understanding of the entity, including the nature of the business and its environment and the risks that the entity faces. The materiality is defined as the magnitude of an omission or misstatement that in light of the surrounding circumstances could reasonably be expected to influence the economic decisions of the users of the financial statements. Planning materiality (PM) is the overall materiality level for the financial statements taken as a whole. It relates to the application of planning materiality at the individual account or balance level. The performance materiality also known as the tolerable error (TE) is the application of planning materiality at the individual account or balance level. TE (percentage of PM) is set to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds PM.

  2. Strategy and risk assessment. It consists of the following activities.

  • Identification of the significant class of transactions (SCOT), significant disclosure processes (SDP) & related IT applications. SCOT is a class of transactions that materiality affects a significant account and its relevant assertions. SDP is a process by which transactions, events or conditions required to be disclosed by the applicable financial reporting framework are accumulated, recorded, processed.

  • Performing the combined risk assessment (CRA).

  • Understanding and evaluations of the financial statement close process (FSCP).

  • Selection of the controls to test.

  • Understanding the IT general controls (ITGC), design and execution of tests regarding ITCG and evaluation of ITGC.

  • Performing the combined risk assessment.

  • Designing the test of controls, journal entry tests and substantive procedures and general audit of procedures. The auditor designs the nature, timing and extent of the tests of controls to obtain sufficient appropriate audit evidence that the controls selected for testing operate effectively as designed throughout the period of reliance to prevent or detect and correct material misstatements at the assertion level.

  • Preparation of an audit strategy memorandum.

  1. Execution. The auditor performs the tests of controls and substantive procedures as planned in the strategy and risk assessment phase. The combined risk assessment will be reassessed throughout the audit and the auditor determines whether changes are necessary to the audit strategy in response to a change in the combined risk assessments.

  2. Conclusion and reporting. The auditor performs the procedures to complete the audit.

14.2 application of the audit methodology to income taxes.

The income tax to be paid or to be received (current income tax) are based on the applicable local income tax laws and also on the available case law in each jurisdiction. It can be very complex and may be open to different interpretations. The current tax expense can relate to the results of the current year but also to the results of the prior year. The overall income tax position in the consolidated financial statements consists of current and deferred taxes.

14.3 Comparison with tax audits performed by Tax Authorities

The main similarities is that both audits have the objective to determine whether the local income law has been applied correctly for the years under review. Both are based on a risk approach.

The differences are the following:

  • Level of materiality, tolerable error and nominal amount.

  • Nature of audits.

  • Compensating effect of current and deferred taxes.

  • Liability for uncertain tax positions and current tax payable/receivable accounts.

  • Tax effect on compensating adjustments relating to mutual agreement procedures.

  • Deferred tax positions.

  • Disclosure note requirements.

  • Communication regarding the operational effectiveness of the internal controls and audit differences.

Practice questions (chapter 14)

  1. What is the purpose of an audit?

  2. What is the difference between a qualified and unqualified audit opinion?

  3. What are the objectives of an auditor?

  4. Explain the difference between reasonable assurance and absolute level of assurance.

  5. Why is sufficiency and appropriateness so important?

  6. What is the objective of an audit risk model?

  7. Explain the audit risk model.

  8. Explain the four phases of the audit process.

Chapter 15: The introduction of tax audit

15.1 Introduction

This chapter provides an overview of general audit principles provided.

15.2 Tax risk management process

The strategic goal of the Netherlands Tax and Customs Administration (NTCA) is to strengthen the compliance, defined as the willingness of taxpayers to fulfil their tax obligations by reporting relevant facts correctly, on time and in full. The NTCA uses a risk management based approach. They aims to be as effective and efficient as possible. Therefore they uses various enforcement tools.

Tax audit is another enforcement tool that can be applied by the tax authority. The Dutch tax approach aims to stimulate voluntary compliance as much as possible. It is based on the concept of responsive regulations.

15.3 Tax audit related law and regulations

Despite the differences in legislation per jurisdiction, law and regulations often contain two significant principles. Firstly, taxpayers are often responsible to provide information to the tax authority. Secondly, taxpayers are often responsible to keep an adequate administration. There are two important articles.

  • Article 47 of the Dutch General Tax Act (algemene wet inzake rijksbelastingen) states that a taxpayer has to inform the tax inspector on his request within a reasonable period of time.

  • Article 52 of the Dutch General Tax Act (algemene wet inzake rijksbelastingen) contains the obligation for certain taxpayers to keep an adequate administration.

15.4 Principles of the tax auditing approach

An audit has to be effective and efficient. Therefore the tax auditors gathers sufficient audit evidence to achieve reasonable assurance. It can also be obtained by using information that is already available.

Transaction model

To comply with tax legislation, all transactions, estimates and relevant information must first be recorded properly, accurately and timely into the taxpayer’s administration. All relevant information has to be recorded into the tax return.

Audit layer model

It is not necessary for the tax auditor to collect all the audit evidence himself. This audit layer model is based on the idea that every entrepreneur needs reliable information in order to run their business. The entrepreneur has taken measures of internal control to assure reliability of information. This is presented in the first layer.

15.5 Traditional tax auditing approach

A tax audit is based on risk analysis. Audit procedures always consists of a combination of various audit techniques. They are always a mix of tests of controls and substantive testing. A tax audit is an audit whereby an auditor checks or assesses the object of the audit for which another party is responsible on the basis of criteria and about which tax auditor forms an opinion which provides the intended user with a certain degree of assurance. A tax audit can cover one or more private or legal persons and can focus on one or more tax returns, such as CIT or VAT.

15.6 Stages of a tax audit.

The audit consists of four stages

  • Pre-planning

  • Completeness checks

  • Accuracy checks

  • Overall evaluation and reporting

Each step begins with planning of intended activities and is finalised with an evaluation.

15.7 Pre-planning

After the assignment is given and the tax auditor considers himself able to perform his assignment, the tax auditor starts with the pre-planning. The tax auditor tries to get a full and complete view of both audit subject and object. This step is important and defines the context in which the tax audit is performed. The auditor focus on the ‘accounting organisation and measurement of internal control (AO/IC)’.

  • Gathering information about the company. This is the first step and is about collecting general information about the company. The tax auditor uses external and internal sources.

  • Prlimianary risk analysis. Based on a lot of sources, the tax auditor performs initial analytical audit procedures to determine potential risks. The number and nature of risks that are identified is often related to the type and complexity of the organisations involved. The tax auditor also concentrates on the reconciliation between the annual report and tax returns.

  • Materiality. A tax audit is set up with a certain margin of error, which is indicated by the amount of materiality.

  • Critical internal processes. This has material effects on the outcome, in the tax returns. It is related to the object of audit.

  • Design of AO/IC. The tax auditor first analysis the design of the AO/IC. It is generally documented formally into plans, procedures, instructions, regulations of power, job descriptions and process manuals.

  • Existence of the AO/IC. The tax auditor needs to determine the existence of the AO/IC. It is possible that measures of internal control are not or not correctly implemented in the organisation.

  • Residual risk for the management. The tax auditor qualifies remaining risk by using the following types of qualifications: high, moderate and low.

  • Preliminary audit tests. The latter is also referred to as the audit trail. This means that there has to be a connection between transactions as recorded into the company’s general ledger and the tax returns.

  • Effectiveness of AO/IC. The tax auditor uses a combination of interviews to assure the measures of internal control function as designed and are effective.

  • Residual risk for the tax auditor. The extent and scope of these activities is deeply related to the tax auditor’s judgement of the AO/IC.

15.8 Completeness checks

After the pre-planning, the tax auditor performs audit procedures to confirm the completeness of transactions and statements. The nature and extent of the activities that need to be performed are highly related to the tax auditor’s judgement on the quality of the AO/IC. The tax auditor always performs substantive tests. Hereby he focuses on preliminary account judgements.

15.9 Accuracy checks

To achieve this, the tax auditor performs substantive tests, often detailed analytical reviews combined with verification and inspection of documents. The tax auditor can use numerous approaches to select transactions for detailed analysis. The first approach is based on non-statistical sampling. The tax auditor evaluates his findings using statistics.

15.10 Overall conclusion

To finalize the tax audit, the tax auditor performs an overall conclusion. The tax auditor accumulates all of his findings and considers corrections to be made. A major difference compared to the external audit is that normally all detected and known misstatements are to be corrected, even though they are not material.

15.11 Tax audit and tax control framework

The tax auditing approach aims to be as efficient as possible. Monitoring is part of a fully designed and implemented control framework. Monitoring activities can be performed internally or externally and are set up to ensure adequate performance of the measures of internal control. The accuracy checks can also be reduced significantly. The levels of reduction differ per situation.

15.12 Tax audit in relation to the external auditor and tax assurance provider

The audit layer model implies that the tax auditor tries to use information gathered by others as much as possible. As part of the annual external audit, the external auditor gathers a lot of information related to the AO/IC of a company. Under certain conditions the tax auditor can take this information into account by reviewing and discussing dossiers of the external auditor. When a tax assurance provider has performed activities related to taxpayers fiscal positions. Depending on the scope and quality of the work performed, the tax audit procedures can be reduced.

15.13 Tax audit and cooperative compliance or horizontal monitoring

In the case of cooperative compliance or horizontal monitoring, additional reductions can be made. Much of the needed information will already have been provided, so numerous steps of pre-planning should not have to be repeated or at least not in full.

Practice questions (chapter 15)

  1. Explain the meaning of tax audit.

  2. What is an enforcement tool?

  3. Explain the pyramid of regulations in figure 15.2

  4. Explain the differences between article 47 and 52 of the Dutch General Tax Act.

  5. Explain the objectives of the transaction and audit layer model.

  6. What are the four stages of a tax audit? Explain them.

Terms & Definitions per chapter

Chapter 1

  • Assurance – an accounting and auditing term with a distinct meaning in those fields of practice.
  • Tax assurance according to the international auditing and assurance standards – an engagement in which a practitioner expresses a conclusion designed to enhance the degree of confidence of the intended users other than the responsible party about the outcome of the evaluation of measurement of a subject matter against criteria.
  • Tax assurance in this book – it is everything concerning the process of taxes in a company belongs to the field of tax assurance’. 

Chapter 2

  • Pincoff affaire – led to the regulation on financial reporting and boosted the development of the accounting profession worldwide.
  • Fair view – this view of the financial report is important for the financial position and income of organisations
  • GAAP – General Accepted Accounting Principles
  • IAASB – International Auditing and Assurance Standards Board
  • ISA – International Standards on Auditing
  • COSO - Committee of Sponsoring Organizations of the Treadway Commission
  • Internal Control – ‘internal control is process, effected by an entity’s board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives relating to operations, reporting and compliance’.
  • Elements of the COSO internal framework – the control environment, risk assessment, control activities, information and communication, and monitoring activities.
  • The COSO-ERM framework changed on the following points: strategy is added as a new objective, the component control environment has been replaced by the component internal environment and the component risk management is replaced by four components: objective setting, event identification, risk assessment and risk response.
  • Focus enterprise risk framework – next to effectiveness and efficiency, doing things right, in COSO ERM the aspect of doing the right thing is also addressed.
  • Code of Ethics – improvement the internal environment, but it can also be used as a façade. It can also lead to the use of more and more formal controls.
  • Formal controls – often replace the trust we have in expertise of people to perform the activities. Trigger more checks and audits.

Chapter 3

  • Corporate governance – deals with how to run a company.
  • Comply or explain principle – non-compliance to a voluntary non-legislative code does not have the same effect as non-compliance to legislation.
  • Commercial accounts – they must comply with business law and the IFRS.
  • Corporate governance codes – usually contain principles and best practices on good governance. They regulate the relationship between shareholders, the board of directors and the supervisory board.
  • Principles of CG –ensuring the basis for an effective corporate governance framework, the rights of shareholders and key ownership functions, the equitable treatment of shareholders, the role of stakeholders in corporate governance. Disclosure and transparency and the responsibilities of the board.
  • Tax Control Framework (TCF) – contains all procedures within the company pertaining to taxation. It is very important for the commercial accounts because the external auditor and the tax authorities would like to rely on the IC of a company.
  • Concept of tone at the top – this concept is re-articulated. This concept is sharpened: ‘demonstrated seriousness from the top’. It’s not only about communication but it has to be proven by clearly recognizable actions and behaviour of top management and the board.
  • Important aspect of the tax policy – the policy should be an integral part of the overall management style and corporate behaviour.
  • Adequate tax risk management – this is quite vulnerable in a decentralized management approach. The board should be aware of this and implement additional checks and balances.
  • How equity investors value the uncertain tax positions in the annual accounts: negatively and positively.
  • Companies provide insight to the public in three areas – tax risk management and governance within the company, tax principles in tax planning and compliance, and taxes paid.

Chapter 4

  • An inventory of undiscovered embezzlement – in good times people are relaxed, trusting and money is plentiful, but people want more.
  • Information asymmetry – he who possesses more information than others has an advantage that can be used or abused.
  • Aggressive tax planning – it is extremely complicated. It leads to structures that tax payers unschooled in tax cannot or can only just understand.
  • Ideology of aggressive tax planning – economic justification, tax-legal justification and outcome.
  • Aggressive tax planning and ethics – tax advisors who design aggressive tax structures lose sight of the crucial link between taxes and society.
  • Faire share obligation – asks every member to contribute their fair share to make possible and maintain the society of which they are a member.
  • Compliance obligation – this obligation to comply with the democratically established rules of a society.
  • Modern-day free riders – the opposition is the group of companies that design and apply the aggressive tax planning structures. Their aim is to back out of making a normal tax contribution to the society in which they operate.
  • Aristotelian restraint – which asks the tax planner to stay within the spirit of the law and not to seek the outer limit of the law.
  • Single tax principle – law that results from a general and consistent practice of states followed by them from a sense of legal obligation.
  • Purpose of the structure – substantially reducing the effective tax burden.
  • Multinationals approach from an instrumental perspective – these multinationals choose to regard national and international rules as a bunch of rules which can help them to obtain the maximum tax benefit possible.
  • Practical wisdom – this is important to have to take a good decision in a specific situation.
  • Self-restraint and temperance – the fair share and the compliance obligation act here as a guide to exercising social temperance. 

Chapter 5

  • Tax operating model – this is the way in which a tax function’s tax activities, people, processes and infrastructure are organised to allow an organisation to comply with tax laws and regulations while achieving its own strategic aims.
  • Adding value – this could be in the form of maintaining a steady effective tax rate.
  • Vision – describes the reason for the company’s existence.
  • Mission – is the activities the company will undertake in pursuit of its vision.
  • Strategy – this is about how these activities are executed and tax strategy defines the tax function’s contribution to the overall goals of the organisation.
  • Structure: tax organisation and resources – the challenge, organisational characteristics, organising resources efficiently, the pros and cons of shared services and offshoring, and information technology.
  • Transparency – this applies to the tax function on various levels and is relevant both within the business as well as externally.
  • Effective transparency – corporate social responsibility, external stakeholders, accountability, making and explaining your case, managing behaviour, internal stakeholders, tax assurance, transactional risk, and reputational risk.
  • Communication – to support their tax compliance and planning responsibilities, tax departments should have effective communication, information-sharing and measurement processes across functional areas.
  • Tax risk management – risk intelligence maturity model, tax risk management in the global environment, and dealing with the global complexity of tax.
  • Transformation – this is making fundamental changes in how business is conducted in order to help cope with a shift in market environment by making employees more productive, processes more efficient while less costly, and the business as a whole more competitive.
  • Blueprinting – maps out a strategy for improved data collection which gathers tax department requirements, finds and brings together common data attributes, and accelerates data collection.

Chapter 6

  • OEDC – Organisation of Economic Co-operation Development
  • NTCA – the Netherlands Tax and Custom Administration
  • Enhanced relationship approach – large corporate taxpayers, tax advisors and revenue bodies engage in a relationship based on co-operation and trust.
  • Cooperative compliance – enhanced relationship is renamed to cooperative compliance, because this term describes more accurately the objective (compliance) and the conceptual ideas.
  • Three developments were of major importance for implementing a new compliance strategy – Horizontalisation of society, corporate governance became an important issue for businesses, and scientific theorisation and research on compliance behavior and the effects on different enforcement strategies.
  • Horizontal monitoring – a form of social non-governmental control, aiming for the improvement of product and service quality within certain professional groups or industries.
  • The NTCA divides the total population of taxpayers into three groups – large enterprises, small and medium sized enterprises (SME’s) and individuals.
  • The process of HM for large businesses consists of a number of steps – HM meeting, compliance scan, closing meeting of the compliance scan, the settlement of pending issued and concluding the compliance agreement.
  • Meta-regulation – is called like this because it attempts to regulate self-regulation. Strategies like these are also called enforced self-regulation
  • Internal control – it is a process, effected by an entity’s board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following categories.
  • Layer-model – this model shows the different layers of control, assessment and internal/external audit around the business process.

Chapter 7

  • SME – small and medium sized companies
  • Three ways of co-operation – co-operation with the software industry focused on creating a reliable chain from administrative record to tax return, co-operation with sectoral organisations to resolve specific sectoral tax issues in advance, and co-operation with TSPs focused on the quality of tax returns.
  • The role of tax service provider (TSP) – tax intermediaries play a vital role in all tax systems, helping taxpayers understand and comply with their tax obligations in an increasingly complex world. The role of TSP varies widely per entrepreneur.
  • Compliance agreement between the NTCA and the TSP – this implies an agreement on attitude, behavior and processes.
  • The NTCA recognises six steps – compliance agreement discussions and concluding a compliance agreement, applications for and reviews of entrepreneurs, preliminary consultations, filling and processing of compliance agreement tax returns, audits of random samples of tax returns, and monitoring and evaluation of the compliance agreement.
  • Meta-monitoring – this is based on relying on the monitoring results of others. The monitoring is related to the quality assurance system and the execution of procedures and quality controls of the TSP.
  • Meta-monitoring can result in four kinds of actions – the audited tax returns were acceptable. No action is needed, the audit tax returns were acceptable, but files of the TSP are not complete, the audit tax returns were not acceptable, and the audit tax returns was not acceptable.
  • Possible options for modified supervision – pre-filled tax return, outsourcing monitoring, certification of tax service providers, managed audit, and tax statement. 

Chapter 9

  • Tax accounting – is concerned with the tax position in the annual financial statements.
  • Corporate income tax position – is reflected in the annual financial statements.
  • IAS 12 Guidelines – contain income tax requirements for companies reporting under IFRS. It is the IFRS accounting standard stipulating how income tax should be accounted for the annual financial statements
  • Income tax – domestic and foreign taxes that are based on taxable profits.
  • Current tax – the amount of tax that is payable or recoverable on the taxable profit or loss in current and prior periods.
  • OCI – other comprehensive income
  • Deferred tax – the carry forward of unused tax losses and/or unused tax credits.
  • Temporary differences – are differences between the carrying amount of an asset or a liability for financial reporting purposes and their tax base.
  • A taxable temporary difference – is a temporary difference that will lead to a taxable amount in a future period when the taxable profit or loss is determined when the carrying amount of the balance sheet asset or liability is realized.
  • A deductible temporary difference – is an amount that can deducted in the future from the taxable profit or loss when the carrying amount of the balance sheet asset or liability is realized.
  • Tax base of an asset – the amount that, for tax purposes, can be deducted from all the taxable economic benefits flowing to an entity once it realizes the carrying amount of an asset.
  • Tax base of liability – the carrying amount less each amount that will be deductible for tax purposes in the future in respect of that liability.
  • Uncertain position – is the positions take or to be taken by the company in its tax return, which can be disputed by the tax authorities.
  • IAS 37 – this section deals with provisions, contingent liabilities and contingent assets.

Chapter 10

  • Payroll taxes control framework – a framework based on which identified risks for payroll taxes purposes are determined and controlled and which monitoring is applied to the correct process of the control methods.
  • Payroll taxes – these taxes are levied from the employee.
  • The important departments regarding payroll taxes – HR department, finance department, payroll department, tax department, legal department, fleet management department, marketing department, procurement department, global mobility department, payroll provider, internal audit, the tax authorities, third parties and other departments.
  • First step in implementing a framework – this is to map out the most important inherent risks.
  • The most important inherent risks – payroll administration, payroll tax knowledge, communication, hiring new employees, firing/retiring of employees, HR and payroll mutation, expenses, global mobility, hiring third parties, company car, wages in kind, and work related cost regulation.
  • Besides this inherent risks, every organisation has their own specific inherent risks. It is important to start with the top risk areas in which the most important payroll tax risks are determined based on a risk based analysis. In the process of the organisation’s specific inherent risks the following approaches are possible:
    • An analysis by the payroll tax specialist.

    • An analysis of the financial administration.

  • Monitoring – the course of supervision with respect to the correct working control measures.
  • Global mobility – companies are looking for talent in countries other than were the organisation is based causing an increase of global mobility

Chapter 11

  • VAT – value added tax
  • The finance function – this is often the function to which more than the day to day financial reporting of business operations is delegated. The compliance and filling of VAT returns is also a finance function’s responsibility.
  • Edwin van Loon – an issue is not an issue until it becomes a measurable issue.
  • Difference between VAT and internal audit roles compared to the finance and IT roles – the VAT and internal audit are supposed to challenge and judge underlying facts and circumstances of business transactions executed, whereas finance and IT roles are supposed to support and document these.
  • Taxable person – this is anyone who executes VAT subject transactions.
  • The paradoxes and misunderstandings are the following – VAT is paid by companies that are exempt from VAT, VAT is not a cost and he VAT dogma.
  • A few unanswered questions are: Where is the missing part? Who is bearing the financial risk of the missing part? What is the impact on cost/income ratio’s, on equity and/or profitability of a company when being assessed for five years of underpaid VAT, interest charges and penalties? Who is liable in case a company’s financial statements are audited and the auditor has failed to recognize major VAT risks?
  • An function for (indirect) tax risk assessment identification methodologies could be: TR = f(ITR, OTR, TCR,TDR). This is similar to the theory of audit risk assessment: ACR = f(IR, ICR, DR)
  • ITR: inherent tax risk –they result from an assessment of general VAT compliance and VAT controls’ influencing factors of the tax function of a VAT person/company.
  • OTR: operational tax risks – this impacts the performance of the tax department. A misunderstanding is that the tax department is the tax function.
  • TCR: tax controls risks – this is the risk that a VAT person or company bears a result of insufficient internal tax controls design, failing automated and semi-automated VAT exemption reporting and lacking internal VAT controls execution.
  • TDR: tax detection risk - the risk that a company fails to disclose financially material tax exposers, with respect to either unknown tax risks and/or known tax risks of which the likelihood of being challenged during an audit is unrealistically understated.

Chapter 12

  • Tax risk management – embedding tax into the business administration and reporting cycles of the organisation. It should not be incidental, stand alone, ex ante exercise.
  • Tax risk management for CIT consisting of – drafting a report or an advice justifying a position and legal documentation.
  • The tax control framework (TCF) – this is the internal control of all processes and transactions with possible tax consequences.
  • A tax control framework deals with – business and tax environment, business operations, tax operations, tax risk management, monitoring and testing, and tax assurance.
  • CIT risks – they relate on the one hand to CIT technical risks and on the other to CIT risks with respect to processes, people and systems.
  • Business and tax environment – the elements of functions are the following: the tax strategy, roles and responsibilities with respect to tax, tax awareness of the organisation, and the system if hard and soft controls.
  • Business operations – this part deals with the operating units within the organisation. Tax relates to many operations throughout the entire company.
  • Tax operations CIT preparation and filling, CIT accounting process, CIT assessment and payment, and a possible CIT audit by tax authorities.
  • Tax risk managementthe organisation should have a risk appetite process, risk identification and risk response process and control activities in place. The organisation needs to determine how much risk it is willing to take.
  • Monitoring and testing – the organisation should implement a monitoring and testing function in order to demonstrate the functioning of its tax management system to internal and external stakeholders like audit committee, tax administrations or external auditors.
  • Internal assurance – corporate governance codes or regulations generally require organisations to state in their annual report that the organisation is ‘in control’ and that its internal risk management and control systems functioned properly.
  • External assurance – we can distinguish between broader general tax assurance. For example: in the annual accounts, and tax assurance towards tax authorities. 

Chapter 13

  • Master file – this portion of the documentation would seek to elicit a reasonably complete picture of global business, financial reporting, debt presence and tax situation of the MNE.
  • Country file – this file focus on specific transfer pricing analyses related to material transactions taking place between a local country affiliate and associated enterprises in different countries.
  • Tax control framework – also called the management control framework. It is used on internal transactions for tax purposes and used for managing and controlling their activities.
  • Domestic tax laws of most countries contains – rules requiring companies to fulfil the arm’s length principle in respect of internal transactions both for intercompany transactions and intracompany transactions.
  • Arm’s length principle – the aim is to reconcile the legitimate right of states to tax the profits of a taxpayer based upon income and expenses, that can reasonably be considered to arise within their territory, with the need to avoid double taxation.
  • Functional analysis – this is an analysis of the functions performed in controlled transactions of associated companies or in internal dealings between a permanent establishment and its head office or between two permanent establishments of the same company.
  • Comparability analysis – this is a comparison of a controlled transaction/ internal dealing with an uncontrolled transaction(s).
  • Transfer pricing methods – the Comparable Uncontrolled Price Method (CUP), the Cost Plus Method, the Resale Price Method, the Profit Split Method and the transactional Net Margin Method.
  • Documentation requirement – the aim of is to enable tax authorities to identify the presence of significant transfer pricing risks.
  • OECD Handbook – the aim is to provide tax administrations information on how to select the right transfer pricing cases for tax audit.
  • The aims of the management control framework – reaping the benefits of internal transactions and effectively supporting the decision-making by the central management and the management of the transacting organisational units. 

Chapter 14

  • ISA - International Standards on Auditing
  • Unqualified opinion of an auditor – this means that the auditor is of the opinion that the financial statements are free of material misstatements.
  • Audit evidence - information that an auditor uses in arriving at the conclusions on which he bases his audit opinion. Audit evidence is cumulative in nature and is primarily obtained from audit procedures performed throughout the audit.
  • Sufficiency – this is the measure of the quantity of audit evidence.
  • Appropriateness – this is the measure of quality of audit evidence.
  • Audit risk model – this model demonstrates the relationship between inherent risk and control risk and the level of detection risk that an auditor is willing to accept when performing his audit procedures.
  • Risks of material misstatements at the financial statement level – this refers to risks that relate pervasively to the financial statements as a whole and potentially affect many assertions.
  • Risk assessment procedures – these are procedures performed to obtain an understanding of the entity and its environment
  • Audit risk model – this model allows the auditor to take a variety of circumstances into account in selecting the most effective and efficient audit approach to reduce audit risk to an acceptably low level.
  • Audit risk – this is the risk that the auditor expresses an inappropriate audit opinion.
  • Inherent risk – this is the susceptibility of an assertion about a class of transactions, account balance or disclosure to a misstatement.
  • Control risk – this is the risk that a misstatement account balance or disclosure and that could be material will not be prevented or detected and corrected on a timely basis by the internal control of the entity.
  • Detection risk – this is the risk that a material misstatement would not be detected by the substantive procedures.
  • Planning materiality (PM) – this is the overall materiality level for the financial statements taken as a whole.

Chapter 15

  • NTCA – Netherlands Tax and Customs Administration
  • Goal of the NTCA – the willingness of taxpayers to fulfil their tax obligations by reporting relevant facts correctly, on time and in full.
  • Tax audit – this is a form of a enforcement tool that can be applied by the tax authority.
  • Aim of the Dutch tax approach – their aim is to stimulate voluntary compliance as much as possible
  • Two principles – taxpayers are often responsible to provide information to the tax authority and they are often responsible to keep an adequate administration.
  • Article 47 of the Dutch General Tax Act – in this article states that a taxpayer has to inform the tax inspector on his request within a reasonable period of time.
  • Article 52 of the Dutch General Tax Act – this article contains the obligation for certain taxpayers to keep an adequate administration.
  • Transaction model – all transactions, estimates and relevant information must first be recorded properly, accurately and timely into the taxpayer’s administration.
  • Audit layer model – this model is based on the idea that every entrepreneur needs reliable information in order to run their business.
  • Tax audit – this is an audit whereby an auditor checks or assesses the object of the audit for which another party is responsible on the basis of criteria and about which tax auditor forms an opinion which provides the intended user with a certain degree of assurance.
  • The audit consists of four stages – these stages are pre-planning, completeness checks, accuracy checks and overall evaluation and reporting.
  • Pre-planning – this is the first step. The tax auditor tries to get a full and complete view of both audit subject and object.
  • AO/IC – accounting organisation and measurement of internal control 
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