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Wednesday, 17th April 2024
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Tax Monitor

Tax Risks
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How many companies think of taxation in terms of risk? The tax system exposes companies to risks that could on a bad day wipe out their cash flow, destroy their profitability, breach their bank covenants, destroy their reputation with the public, require restatement of accounts and absorb huge amounts of management time. Do boards and chief executives have their heads in the sand when it comes to tax?
Spot the Risks
Part of the business of any board is to identify the risks to which the business is exposed, and guard against those risks as far as is possible and economically justified. Contrary to the popular macho myth that business is about risk taking, successful business is about risk management. This is recognised in a wide range of activities and expenditures that a group involves itself in, even if superficially they are not about risk.

The most obvious evidence of a focus on risk in the business is the care taken to ensure the adequacy of its insurance cover. Insurance cover extends far beyond covering the risk that the building burns down. It can cover everything from asbestos claims to shareholder actions against directors.

Other risks, such as movements in foreign exchange rates impacting on costs or sales revenues, or on the cost of repaying liabilities, are identified and hedged against. The risk of adverse movements in interest rates are often covered. The possibility that the company may meet with an unexpected cash crisis may be met by negotiated lines of credit. A quality control programme can control the risk of faulty products reaching the market place. Credit control is applied to cut the risk of bad debts, just as stock management techniques cut down on over investment in stock, and the risk of stock becoming obsolete or spoiled. Many aspects of advertising and brand building represent expenditure to control the risk that a competitor will grab your market share or squeeze your margins in the future.

Any sensible board will regularly review the full range of the risks, which can impact on the company, and ensure that it has proper structures in place to handle them.

Over the last quarter of a century tax has become a major risk area for most businesses. However in a large number of cases this has not registered at board level. Board members tend to think of tax solely in terms of corporation tax and as something strictly for the accountants.

Few boards carry out an analysis of the extent to which problems in the area of tax could destabilize their business.

Where is the tax risk?
Consider the following. A high proportion of all cash movements in any business represent transactions that, in substance if not in legal form, are being carried out on behalf of the government and for which the company must account to the government. The total volume of these transactions will usually be a multiple of the company’s profits. Errors in the handling of these transactions are capable of wiping out those profits.

In a typical business 21p.c. of the turnover may be represented by VAT. A similar percentage of the non-wage cost base of the company may be represented by VAT charges borne by the company. These two figures taken together will already exceed the profits of most companies.

Additionally PAYE may amount to approximately 30p.c. of the payroll figure, and PRSI may represent a further 20p.c. Corporation tax will represent approximately 12.5p.c. of net income. The company may have substantial professional service withholding tax, relevant contract tax (sub-contractors withholding tax), excise duties, customs duties on imports from outside the EU, withholding tax obligations on certain interest, and rental and patent royalty payments, and even capital gains tax withholding obligations.

The sheer volume of tax related obligations, exposure to liabilities, and cash movements are enormous relative to the ‘real business’ of any company. It is the common case that many of those who carry out the transactions attracting these tax obligations are not experts in the relevant taxes. It would be astonishing if they were, as few businesses could afford experts in all of those taxes. The financial controller or director will usually have quite a broad general knowledge of tax, but certainly not an adequate knowledge (or the time) to control the risks over such a wide range of taxes.

What if something goes wrong?
The new Revenue code of practice for Revenue audits spells out what happens when something goes wrong. The reorganisation of Revenue tax districts with a view to beefing up and focusing the Revenue audit programme makes it quite likely, that if something has gone wrong, the Revenue are going to become aware of it. The risk environment in relation to tax has got significantly worse in recent years.

Revenue audits are not a free service by the Revenue to the taxpayer designed to give him a clean bill of health, or present him with a checklist of improvements for the future. A Revenue audit is a ‘challenge’. It commences with the assumption that the taxpayer has managed his taxes correctly, that he as properly returned his liabilities, and has properly discharged them. It starts with an opportunity given to a taxpayer to make a full and complete disclosure of any errors or problems in his handling of the numerous taxes outlined above.

The onus is on the taxpayer to be aware as to whether or not there are problems in his tax affairs. The Revenue are not there to tell him about it and hold his hand. Where a taxpayer is not in a position to make a full confession (where he has matters to confess) he may find that the scale of penalties which he faces at the end of a Revenue audit has grown alarmingly.

Penalties
Many tax penalties are now ‘tax geared’ ie they represent a percentage of the under stated tax. This can be as high as 100p.c. of the under stated tax. The Revenue have published their policy in relation to the application of penalties. Where a penalty is properly due, because there has been fraud or neglect on the part of the taxpayer, it is possible to have the tax geared penalty reduced from the maximum of 100p.c. down to as low as 3p.c. of the tax.

The latter can be achieved where the under statement was as a result of insufficient care (as opposed to deliberate default or gross carelessness) and where an unprompted qualifying disclosure of the matter is made to the Revenue, and full co-operation given to the Revenue thereafter.

There are some critical points to note in that. To achieve the 3p.c. minimum penalty it is necessary that the errors be confessed to before notice of a Revenue audit has been received. That is the meaning of an unprompted disclosure. It is further necessary that the disclosure be comprehensive as regards that tax head, in such a case. It is also necessary that the cause of the error should have been insufficient care, as opposed to gross carelessness. These factors point to simple conclusion. A business should have developed procedures that ensure that on a day-to-day basis its tax issues are correctly handled, and it should periodically have a review carried out so as to identify at an early stage any errors that do arise.

A business which takes these two approaches may well be in a situation where no penalties at all ought to attach to it (on the grounds that there was no neglect on its part) and at worst should be exposed to a 3p.c. penalty.

Manuals, procedures
Sensibly, a large business should have developed manuals to guide those who administer the various taxes. A manual would provide guidance as to how to identify transactions that are sensitive or likely to require special treatment eg transactions on which VAT is not reclaimable, or transactions where VAT has to be accounted for on a ‘reverse charge basis’ or transactions where relevant contracts tax may be applicable, or capital gains tax withholding tax may arise.

If a business has not taken the basic steps of identifying the sensitive areas in the various taxes, and provided the staff who administer the taxes with adequate training and written procedures to follow, it need not be surprised if errors result. It may have difficulty in justifying its position.

A regular professional review of procedures and of tax exposures should ensure that probles do not build up until they become of critically large amounts, and that the company is in a position to take the initiative in advising the Revenue of the problem, before a Revenue audit is notified to them. Many businesses have a review carried out annually on one of their tax exposures only - corporation tax. Paradoxically, nowadays that is one of the smallest of the tax exposures and in many respects, the one involving the least risks.

Consequences of a problem
The consequences of a tax problem can be considerable. Penalties which are tax based can be huge in relation to profits. The interest charge can be considerable.

Typically the tax itself will not have been provided for in the company’s accounts. The company is therefore immediately facing an unexpected hit to its profits and to its cash flow. Few finance directors will wish to tell their board, or their multinational headquarters, that the management accounts for the last several periods, and possibly years, have to be ripped up and figures substantially restated.

The company is also exposed to a substantial reputational risk. Where penalties are imposed, publication is likely to follow. Even though there may have been no deliberate misbehaviour by the company, its name will appear listed along with that of a rag tag bunch of tax evaders. Public companies, and multinationals, rightly do not care to appear in that company. Board directors can be expected to strongly react to such an occurrence.

The event can also absorb an inordinate amount of management time in verifying the extent of errors, negotiating with the Revenue, and explaining matters to the board.

Unfair but manage it
In one sense all of this is very unfair. Business people never intended to be an out arm of the Civil Service handling vast amounts of the State’s financial transactions, solely at the risk of the business. But that is the way our taxation system has developed over the last half century and it is probably irreversible.

Rather than moaning, what boards of directors and finance directors must now ask themselves is, do we have procedures in place to handle tax risk? Have we fully analysed the areas of our business that could attract tax risk? Do we have regular reviews carried out by experts to ensure that any tax problems are caught quickly? Tax risks have to be managed like any other commercial risks.

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