Absolute responsibility and corporate tax governance.

There have been many recent economic and societal changes that directly impact the tax management of a company. The Enron debacle, the Sarbanes-Oxley Act, and the tax shelter frenzy are some of the more publicized significant events that have affected tax management and ushered in a new era of tax governance. Corporate tax managers, ** such as myself, are well aware of these events, and know they have to deal with them in some manner. Clearly, greater control, ethics, and responsibility are now mandated. But what management changes are required and how do we implement them in our departments?

It has been more than 20 years since I wrote an article on tax management for the July 1980 issue of The Tax Executive entitled "Tax Professional to Tax Manager: The Transition." (32 Tax Executive 290.) I have not thought about this article for a while, but after recently rereading it, have concluded that, with the addition of some new management and control mechanisms, it can provide an answer to how we can respond to today's management environment. The thesis of the 1980 article is that there are many activities occurring in a company that affect its tax situation, and it is the job of the tax manager to be aware of and respond to these activities. Unlike a tax consultant who is there to render advice on a given fact pattern, a tax manager has to be aware of and respond to changes in circumstances.

Tax Dynamics

Change is a critical dynamic that must be monitored and managed. Tax managers must be concerned with changes in laws, ideas, employees, audit guidelines, rulings, and facts. These are a company's tax dynamics. Tax dynamics are simply those changes that can affect a company's tax situation. Tax dynamics are in turn divided into macrotax and microtax components. The macrotax components are those tax dynamics that affect corporate tax strategy or significantly affect the company's effective tax rate. Microtax components are tax dynamics in the nature of project-related activities, such as income tax compliance (which represent the nuts and bolts of tax department operations) and not the planning or strategy. The article recommended that a tax manager divide the tax dynamics of the company into microtax and macrotax components and assign them to tax department employees based upon their skill level. The article only touched briefly on one important prerequisite to the successful implementation of a tax dynamics plan--the concept of tax responsibility.

I first expanded on tax responsibility in connection with tax dynamics when I spoke on the subject at the TEI Annual Conference in 1980. My contention was that tax responsibility goes beyond ethical responsibility: For a corporate tax manager, it means that he or she assumes absolute responsibility for whatever goes wrong in a company's tax situation. This concept was not wholly accepted at the conference, perhaps because not all tax managers agree on the role of the tax manager. Here are a few examples of mistakes and transgressions, for which I believe that a tax manager must take absolute responsibility.

Tax Preparation

In preparing tax return of a corporation, tax depreciation is computed using longer lives than is allowed by law. When the issue is discovered on audit, the examining agent refuses to accept any correction reducing these lives. Although the corporate tax manager did not personally review the tax depreciation reported in the tax return, he or she is responsible for the resulting overpayment in taxes regardless of whether the return had been prepared by an outside firm or by the tax compliance group of the tax department. This responsibility must be accepted even though the people preparing the return were experienced and competent and the return had received adequate review.

Management of Documents

A company contracts with a foreign licensor of technology to whom it pays a quarterly royalty. The payee is incorporated in a treaty country and the treaty rate is 10 percent, compared with the statutory rate of 30 percent. Although the company never obtains the appropriate IRS form from the payee authorizing withholding at the lower treaty rate, the company's accounts payable department withholds at the lower rate, remitting this amount to the IRS. On audit, the agent assesses the difference between the statutory rate and treaty rate. The corporate tax manager must accept absolute responsibility for the failure of the company to obtain the appropriate form.

Decision-Making

A company performs research and development activities and earns a research credit under section 41 of the Code. The computation of the credit is very complex and uncertain as a result of IRS audits and rulings. The corporate tax manager never communicates with the CEO, the CFO, or the vice-president of engineering with respect to the amount of the company's research credit. Consequently, the company does not increase its research spending as a result of the incentive. In this case, the corporate tax manager bears absolute responsibility for the company's failure to incorporate the research credit incentive into the company's decision-making process and its failure to take advantage of the avilable incentive.

Ethical Transgressions

During an audit, an agent requests a worksheet that the taxpayer had contemporaneously prepared during the preparation of the tax return, but which the tax accountant handling the audit is now unable to find. Rather than admit to the agent that the worksheet cannot be found, the tax accountant creates a worksheet that he believes is similar to the one that is lost. He gives the worksheet to the agent without telling him that it had been recently created. It was unethical of the tax accountant to mislead the agent in this manner. The corporate tax manager must accept absolute responsibility for this breach.

Although the corporate tax manager may not have had an active role in creating any of these situations, the concept of absolute responsibility means that he or she is accountable for any resulting problems. Not surprisingly, this seemingly harsh approach is not universally accepted. Why should the corporate tax manager bear responsibility for an act done by someone else when he or she has done everything a professional can do? This question is at the heart of the tax governance problem, and the answer provides the solution to how we must organize and manage ourselves and our departments in the post-Enron, post-Sarbanes-Oxley, and the post-tax shelter era.

When a corporate tax manager accepts absolute responsibility for the actions of his or her department, he or she will find it necessary to organize the tax department in a manner that eliminates errors and ethical violations. The corporate tax manager would be compelled to set up procedures to create a failsafe situation where nothing can go wrong. On the other hand, if one is able to limit responsibility, for example, by blaming a consultant or subordinate, by claiming ignorance ("I was out of the loop"), or by ascribing fault to a renegade IRS agent, there will likely be less urgency to develop a system that minimizes problems and wrongful acts. Therefore, the acceptance of absolute responsibility spawns positive actions in the form of the creation of a system of management that avoids problems and errors.

But how can one set up such a system? Absolute responsibility is a prerequisite for using tax dynamics in managing a tax department. Once one accepts absolute responsibility, the next step is to analyze the corporation's tax affairs and identify its macrotax and microtax components. Ideally, this should be done at an all-hands meeting of the tax department, where each individual can present the tax dynamics for his or her area, as well as being encouraged to comment on the tax dynamics for other areas. In a multinational company, it is also be necessary to determine the tax dynamics for each foreign country where it is doing business. This can be accomplished through tax department personnel specializing in international tax, some of whom may be based in foreign countries, or through the use of international tax consultants.

Once a list of tax dynamics is prepared, it must be segmented into microtax and macrotax components, which are then assigned to various personnel. Everyone in the department should receive the list. The list becomes a handy tool in myriad situations, such as staff meetings, personnel reviews, and in communicating with management. Employees should periodically be asked to provide a status report of the tax dynamics under their purview. In this context, tax dynamics become a useful tool in helping department members to manage their jobs. More important, with each person knowing the tax dynamics that he or she must manage, the likelihood of an issue being missed or handled incorrectly is greatly reduced. As circumstances change, the lists must be updated.

In addition to providing a mechanical mechanism by which to manage tax department issues, the use of tax dynamics has another, more intangible benefit. When a tax department develops a management strategy using tax dynamics, each employee in the department becomes part of that strategy and feels that he or she is contributing to the overall success of the department. This sense of participation and empowerment increases employees' sense of importance about their jobs and improves morale. Employees see themselves as pulling in the same direction with others in the department, and this sense of purpose adds pride and spirit to an organization.

When Mistakes Occur ... and They Will

Despite everyone's best efforts, mistakes will occur. Some may feel that acceptance of this reality is inconsistent with the concept of absolute responsibility. In truth, however, there is no inconsistency in accepting that mistakes will occur while building a system based on assuming absolute responsibility for mistakes. It is simply a matter of setting the highest standards for oneself.

What happens then when a mistake does happen? It is extremely unlikely that management will hold a corporate tax manager to the standard of absolute responsibility, in large measure because they will never hold themselves to such a standard. At the same time, management will likely be quite pleased that the corporate tax manager has developed a system designed to avoid mistakes completely. In the past, I have communicated my goals of absolute responsibility to management, and when inevitably a mistake was made, I was pleased to find them very forgiving, since they knew that all was done to avoid it. More important, not that many mistakes were made and, hence, it was not necessary to test their tolerance that often. Absolute responsibility is a device that is necessary to establish the motivation to build the best possible corporate tax function, but it should not be used to berate oneself or one's employees when errors are made.

The New World of Tax Governance

Now, then, how does this relate to the new tax governance requirements resulting from Enron, Sarbanes-Oxley, and tax shelter excesses? In each case, the issues generated by these three events give rise to their own set of tax dynamics, which must be identified and catalogued. Based on published reports, Enron involved a tax department that assisted in creating substanceless business deals that had the effect of inflating financial projects. Sarbanes-Oxley requires certain controls over tax department processes that affect material items in the financial statements. The tax shelter frenzy involved aggressive tax planning that arguably served no real business purpose and was often based on opinions not truly reflecting how the tax law would view such transactions.

In these situations, tax dynamics do not relate purely to tax issues, but instead involve issues mainly relating to behavior and control. The Enron issues involve ethics and transparency. How do you prevent someone from doing something that violates the company's ethical principles and how do you ensure that all transactions are available to scrutiny by auditors and by appropriate tax department personnel? A similar problem occurs in situations involving tax shelters. How do you make sure that a decision is based upon what the tax law actually allows and not what a tax shelter promoter would like you to think the law allows? Sarbanes-Oxley involves ensuring that procedures are established whereby significant tax risks are identified and controlled. Although it is relatively easy to enumerate the tax dynamics constituting tax governance issues, it is another matter to establish a system to manage them. Most tax departments have not been required to establish procedures to control behavior.

It has been unnecessary to have a special system for managing the tax ethics of a company, but this is a new age, and new methods are required. One approach is to establish a committee for the purposes of reviewing all transactions where there is any doubt about their ethical propriety. Each employee in the tax department, or even employees outside the department, would have a right to submit issues to the committee. The committee could consist of tax department managers as well employees in nontax management, such as the corporate controller or the CFO. In addition, an outside adviser might be added to the committee. The committee would have to respond in writing to all requests. The results of such a process are manifold. Employees would not have to worry whether a tax strategy of the company is improper and could get them into trouble, and the corporate tax manager would know that he or she is pursuing a strategy that meets corporate ethical guidelines. On audit by the tax authorities, a review by such committee may help establish the reasonableness of the company's actions and thereby vitiate any penalties. Most important, everyone who relies on the corporate tax department, such as auditors, management, and the board of directors could feel comfortable knowing that the company is not engaging in any unethical activities.

Ethics Is Only Part of the Challenge

But ethics are only part of the problem. The control of' transactions is also important in this new era of tax governance. It is important to ensure that transactions are transparent and that no unauthorized transactions take place, such as a tax department employee transferring money into a tax haven bank account owned by the employee. Here, too, new mechanisms are necessary. As an example, a procedure may be implemented whereby the compensation for each transaction must be documented by means of an intercompany agreement. Each agreement would be cross-checked against the intercompany transfer pricing policy to make sure that corporate accounting systems are generating the correct amount of compensation. In addition, the profitability of each corporate entity should be checked each quarter to ensure that the level of profitability is consistent with the pricing policy and the agreements that implement this policy. So long as each transaction is identified and represented by an agreement, it would not be possible to transfer money into entities or accounts without auditors and tax department employees being made aware. Further, by having a defined amount of profit in each entity, the effective tax rate becomes more predictable. The tax dynamic is this situation is the intercompany transaction and the mechanisms controlling it are the interweaving of the intercompany agreements, the transfer pricing policy, and a closing procedure that ensures each entity is receiving the amount of profit provided under the agreements and the pricing policy.

Conclusion

As long as a corporate tax manager operates on the basis of absolute responsibility, he or she can manage in this new tax governance era. New management tools will be needed, such as the use of tax dynamics and microtax and macrotax components. In addition, special new mechanisms will be needed to deal with ethical issues and transaction control. While the first job of these new procedures is to address tax governance issues, in fact there are many other benefits to them. They will improve corporate morale and reduce errors. Rather than being counter productive, tax governance management can lead to improved management of the tax department function and to a sounder night's sleep for the corporate tax manager.

** As used in this article, the term "corporate tax manager" refers to those tax executives charged with managing the tax function of a corporation, such as directors of taxation or vice presidents of taxation; the term also includes individuals, such as international tax managers, who have management responsibility for a significant area within a corporate tax department.

MICHAEL D. RASHKIN is the General Tax Counsel for Marvel] Semiconductor and is author of the book, Research & Development Tax Incentives: Federal, State and Foreign 2003). He received his J.D. degree from St. John's University School of Law and his LL.M. degree from New York University Graduate School of Law. Mr. Rashkin is a member of Tax Executives Institute's Santa Clara Valley Chapter, as well as the bars of the States of New York and California.