While the job description for today’s audit committee member has exploded with a host of new responsibilities, tax risk is fast moving to the front of the line as a concern.
Yes, risk in general has taken on new meaning for corporate boards and their audit committees, but audit committees are particularly taking tax risk more seriously these days, says Ernie Ten Eyck, an adviser to the Association of Audit Committee Members. “It is a difficult area for an audit committee to address,” he says. “The tax rules are complex and the accounting standards dense. Tax-related issues in foreign jurisdictions add another layer of complexity.”
Perhaps the most important reason audit committees should pay more attention to tax is simply its effect on an entity’s fiscal health and performance. “The tax expense is one of the biggest items in the income statement,” Ten Eyck says.
Ten Eyck
The most recent development driving interest in tax risk is the controversial Financial Interpretation No. 48, Accounting for Uncertainty in Income Taxes, requiring companies to disclose in new detail how much risk they believe their tax positions have. “FIN 48 is controversial and of interest to audit committees because you now have to disclose where the [Internal Revenue Service] should go look,” Ten Eyck says. “It’s a disclosure people studiously avoided making because it acts as a red flag to tax auditors.”
Another recent wrinkle is stock option backdating. Wherever audit committees have had to contend with problems in the granting of stock options, they’ve also had to get up-to-speed on related tax rules, such as caps on executive compensation or rules around deferred compensation, Ten Eyck says.
Harry Gutman, director of KPMG’s Tax Governance Institute and former chief of staff to the congressional Joint Committee on Taxation, says government regulators wading into the tax realm are another culprit. Regulators (and lawmakers too) are now on the prowl for ways to close the gap between what taxes potentially should be paid and what companies actually fork over. “These factors and others have combined to increase transparency with regard to tax risk,” Gutman says.
Gutman
The Tax Governance Institute hosted a Webcast last week focused on the role of audit committees in managing tax risk. Gutman reminded listeners of how significant tax risk is to the enterprise and why it consequently should be of concern to audit committees. As he put it: “If you’re a taxable entity, the federal government is a 35 percent partner in your bottom line.” And that does not include state, local, or international income taxes, or other taxes beyond income taxes. “It would make perfect sense if someone has a 35 percent stake in what you’re reporting, that you would pay attention to that,” Gutman said.
Where the Pitfalls Lie
Maurice Agresta, vice president of tax for UPS, said during the Webcast that tax risk emanates from all parts of an enterprise, including how operations are managed, how transactions are structured, how compliance obligations are met, and how controversies are navigated. The combined complexity of corporate enterprises and tax rules, he said, makes it a tricky area for audit committees to grasp.
Kathryn Dindo, chief risk officer for FirstEnergy Corp. and chair for the audit committee at J.M. Smucker Co., said audit committees need to get a firm handle on the culture that drives tax work to ensure it is consistent with the company’s overall compliance culture.
“What is the mission of the organization and its guiding principles?” Dindo said. “Every tax department is the same as every company. It has its own culture, and it is driven by certain initiatives and focus areas. It’s good for the audit committee to hear what the director or VP of tax feels in these areas.”
The increased attention in recent years on aggressive tax positions has put a spotlight on tax reporting, Agresta said, leading companies to be careful to assure they are paying their fair share of taxes. Today, a fine line separates effective and aggressive tax management.
“Ten years ago, the mission could have been to really reduce the taxes we pay to any jurisdiction to the extent possible,” he said. “Today’s mission could be pay less than your direct competitors, but not as little as to create investigation into why your effective rate is so low.”
KPMG audit partner Larry Bradley said that for years the objective of the tax director was to try to keep the effective tax rate as constant and predictable as possible, so investors and analysts could predict what the effective tax rate would be throughout a quarter. Under FIN 48, which requires more disclosure of uncertainties, “it means there’s going to be more volatility in quarterly income tax provisions,” Bradley said. “Explaining that to management and the audit committee has become quite a challenge, actually.”
“If you’re a taxable entity, the federal government is a 35 percent partner in your bottom line.”
— Harry Gutman,
Director,
Tax Governance Institute
Agresta challenged the notion that tax departments should shy away from legal, above-board strategies to manage the effective tax rate within a given period. He likened it to the decisions individual investors make when selling stocks with gains or losses to minimize capital gains taxes. “What kind of transactions do I put into place—legally, not exotic—to keep my effective tax rate as clear and as predictable as possible?” he said. “To me, there’s nothing wrong with that.”
Audit committees need to get more familiar with how the company makes such decisions, said Dindo, to better understand where there may be risk.
Ten Eyck warns that tax issues in general present a steep learning curve for most audit committee members, but says they are digging in. “I see more and more audit committees spending time educating themselves about things like this,” he says. Audit committees need to get better acquainted with the risks before they can know what questions to ask management.
Agresta said staffing and expertise is a continuing challenge for many corporations and is a significant risk to tax compliance. Audit committees must get more direct input from tax managers on where staffing weak spots may be, he said, so the committee can better understand where its risks of noncompliance are. “If the right question is asked, the VP of tax will tell you the true story,” he said.
Bradley said audit committees today are wising up to the benefits of getting tax directors more involved in assessing tax risk largely because of FIN 48. Audit committees are compelled to get a better understanding of what kinds of uncertainties they are now required to disclose.
Before FIN 48, “tax reserves were something kept on a sheet of paper in the tax director’s drawer,” Bradley said. “Now, tax reserves are part of the auditor’s working paper, presented in the notes to financial statements.”
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