Chief tax officer reporting structures.

EXECUTIVE SUMMARY

* Many events and shifts occurring over the last 15-20 years have affected the corporate tax function's importance.

* Attempts to measure a corporation's worldwide effective tax rate may have had unexpected consequences for the tax function, which now bring into question the CTO's reporting structure.

* In lieu of the CTO reporting solely to the CFO, other viable alternatives include reporting to the corporate legal functions and the internal auditor or audit committee.

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Due to regulation by the IRS, Securities and Exchange Commission and Public Company Accounting Oversight Board, chief tax officers function in a more restrictive environment than at any time in the past. This article examines changes in reporting structures that companies might consider implementing to comply in this highly regulated environment.

Considering today's corporate, business and regulatory environment, a valid question for all large public and private corporations is: what is the desirable reporting structure for a corporation's chief tax officer (CTO)? Closely related is how to determine the basis on which a CTO should be evaluated for compensation/retention/advancement purposes. In the past, the CTO'S performance was measured by the corporate group's worldwide effective tax rate. Is this still appropriate?

This article considers these questions in view of the major components of a corporation's tax function. The principal functional components are:

* Compliance (including Form 1120, U.S. Corporation Income Tax Return, and Schedule M-3, Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million or More, which is based on the corporation's financial statement, or its books and records, and state, local and foreign tax returns);

* Cost control through tax planning primarily motivated by business operations;

* Cost control through other planning focused primarily on tax reduction; and

* Risk management.

Among these items, risk management has risen in importance in recent years.

The principal considerations relevant to answering the above questions are:

* The reporting structure normally will establish the CTO's principal performance reviewer, which affects retention and compensation and, hence, establishes the CTO's effective control within the corporation, absent other controls.

* Internal controls, to the extent required by applicable audit standards, should affect the persons within management with whom the CTO shares information, but will not necessarily affect the CTO's effective employment control.

* The existence of an audit committee can provide an alternate or second source of control for the CTO.

* The CTO'S functions are similar to those of other business units, in that they involve control of a major cost of the corporation and risk management, thus affecting after-tax earnings. The CTO'S functions are subject to constraints that differ from those to which operating business units are normally subject, because all CTO decisions involve (1) the determination of law or its application and (2) a government as the counterparty.

* The compliance function the CTO oversees necessarily depends heavily on the corporation's accounting function.

* The person to whom the CTO reports should have the expertise to evaluate his or her performance, and should have some familiarity with the tax function.

The answers to these questions may be affected somewhat by whether the corporation is public or private, but the legal differences do not seem to mandate different conclusions. (1)

The Corporate Tax Function

The tax function necessarily looks to the corporation's bookkeeping and financial accounting functions for its "starting numbers." This is because (1) Federal income tax has always driven the tax function and (2) the determination of Federal taxable income is based on the corporation's books and records as kept for internal and external reporting purposes. Thus, bookkeeping, financial accounting and tax functions necessarily overlap.

It has followed--perhaps without too much thought or planning--that the tax function has been located most commonly under the corporation's chief financial officer (CFO) for purposes of goal setting and performance review, followed at some distance by location with the controller, the treasurer and the chief executive officer (CEO). (2) Is this necessarily appropriate in today's environment?

Other traditional factors that have helped shape the typical reporting patterns for the CTO are the facts that, historically, (1) the corporation's outside auditors have performed multiple functions (including, sometimes, actual bookkeeping functions, return preparation and tax opinions and tax risk assessment); and (2) the tax function was viewed purely as a compliance function in some quarters.

Of course, the tax function is now much broader than mere compliance; thus, many factors will determine the CTO's functional priorities. Among other things, the parameters include the functions performed by the tax department; whether the company is public or private; the company's industry groupings; its foreign activities; the overall size of the consolidated group; the volume of the group's acquisitions and dispositions; and the department's emphasis on tax planning (as compared with pure compliance work).

Important priorities for the CTO be to steer and direct the development of the tax group's overall structure, its use of technology, its interface with the company's accounting system, its relationships and dealings with inside parties (other corporate departments) and outside parties (including the IRS and state governments) and the group's overall performance and culture. An advertised position for corporate tax director with a public company could list the job responsibilities as follows: "Develop global tax strategy; oversee and manage all tax functions, including Federal, international, and state income taxes, value-added tax, employment, excise, sales/use taxes and personal and real property taxes"

Recent Changes Affecting CTO Reporting Structure

Many events and shifts occurring over the last 15-20 years have affected the corporate tax function's importance, and perhaps placed it under inappropriate pressure to improve corporate earnings.

Managing the corporation's worldwide effective tax rate became a corporate goal, and an intensely measurable one. By 1998, the predominant view of CTOs was that company management viewed the tax function as a "profit center." (3) Almost 59% of the tax executives surveyed in 1998 thought that management wanted them to always adopt the interpretation most favorable to the company, and then defend it rigorously. (4)

Intertwined with this factor is the effect of financial accounting income on stock price. Although this is by no means a new connection, a dramatic example of this connection taken to extremes has been Enron Corp. The Joint Committee on Taxation (JCT) found that in an effort to enhance financial accounting income, Enron converted its tax department into a "business unit" with "annual revenue targets." (5)

Many lesser factors put corporate pressure on the tax function, including: (1) the wave of leveraged buyouts of the 1980s, (6) which forced many corporations to scrutinize all expenses, including the tax expense; (2) the repeal of the General Utilities (7) doctrine, which eliminated one of the major escape valves from subchapter C double taxation and forced many corporations to look elsewhere for cost savings; (3) the stock market "bubble" of the late 1990s, which exacerbated the focus on corporate earnings; and (4) the pressures of foreign competition and of the "Wal-Mart effect," (8) which have drastically altered corporate profitability. Pressures on profits that may be peculiar to public companies are translated to private companies through marketplace competition for their products.

Particular attention must be paid to the aggressiveness by which "tax products" have been generated and marketed. The JCT's Enron investigation found that the corporation's ability to engage in aggressive tax structures was facilitated by tax advisers' willingness to give opinions based on factual representations or assumptions that they had reason to know were not correct. (9)

As the corporation's risk-management function has become more important, concern with these influences on the tax function has also grown. A survey shows that more recently, the importance of the tax function in corporate risk management has substantially increased. (10) This is due in part to the Sarbanes-Oxley Act of 2002 (SOA).

SOA

Two aspects of the SOA bear indirectly on the CTO. First, the CEO and/or CFO must certify the financial statements, which include provisions for taxes. This can motivate them to put in place internal controls requiring the CTO to report the information needed to give them a reasonable basis for making investigations on which they can certify financials. Second, the audit committee needs to know about the propriety of tax planning, reserves, etc., which impels some degree of reporting to the audit committee.

A parallel development has been the adoption of final rules related to auditor independence, released by the Securities and Exchange Commission (SEC) on Jan. 28, 2003. (11) The final rule states that an auditor will not be independent if it provides legal services or expert services, but does not include tax services in these categories. However, the commentary to the final rules stated that audit committees also should scrutinize carefully the retention of an accountant in a transaction the accountant initially recommended, the sole business purpose of which may be tax avoidance and the tax treatment of which may be not supported in the Code and regulations. Under these rules, many board audit committees have formulated a policy that their auditor should not provide tax-shelter-related services. (12)

Likewise, many public companies have adopted as a best practice the requirement that regular outside legal counsel or independent tax counsel review tax products that the company is considering implementing. Generally, this policy applies to any tax product, regardless of the promoter. (13)

The PCAOB has adopted an auditor independence rule (Rule 3522) that would ban the performance of tax services by auditors, in connection with a transaction that has a "significant purpose of tax avoidance," unless the proposed treatment of the transaction is more likely than not to be upheld. (14) Rule 3524 would specify how to obtain audit committee pre-approval of permissible tax services by the auditor. The rules will be effective after SEC approval.

IRS

Within corporations, there has been increased supervision of/reliance on the tax function as a result of the foregoing changes. At the same time, the CTO has to be concerned with audit workpaper privilege issues and Circular 230. (15)

Tax accrual workpapers prepared by auditors are not protected from access by the IRS. (16) Ann. 2002-63 (17) changed how and when the IRS would assert its right to workpapers: (1) only with respect to a "listed transaction" if the taxpayer discloses one listed transaction; (2) all workpapers, if the taxpayer fails to disclose a listed transaction or discloses more than one listed transaction, and in the case of certain restatements. As a result, CTOs must plan for legal memoranda underlying tax accruals to be protected by the attorney-client privilege, the tax practitioner privilege or the attorney-work-product doctrine. IRS examiners can request tax accrual workpapers; if the taxpayer (or tax adviser) claims privilege, it will be asked for a privilege log. The log must be kept with some particularity to be effective. (18)

A final and most recent event that can indirectly affect the CTO--by further circumscribing the way in which he or she may be able to rely on outside tax advice, particularly as it relates to tax-advantaged products--is Treasury's amendments (19) to Circular 230. In addition to imposing general standards for all tax advice, Circular 230 imposes additional standards for "covered opinions." An opinion on a transaction with "a significant purpose" of tax avoidance is a covered opinion and can be relied on for penalty avoidance only if it concludes at a more-likely-than-not level or higher. The CTO will have to deal with opinions subject to Circular 230 even in nonabusive transactions, such as acquisitive reorganizations (however, opinions attached to SEC filings of public companies are excluded from the rule). As a result, a CTO may need to work more closely with the corporation's general counsel to develop guidelines for tax opinions; internal review of those opinions may be warranted.

Current Corporate Tax Environment

Inclusion of the corporation's tax function and CTO within the finance division historically may have been considered the best "natural fit" for the tax function, but is it still the best fit? The finance function remains the natural "home" of the tax function, due to the natural affinity with bookkeeping/financial functions, but the rise of the CTO's role in risk management suggests that he or she needs more independence in the corporation.

Appropriate internal controls will require, at a minimum, dual reporting by the CTO, with a report to the internal auditor or audit committee (or possibly, general counsel). In theory, internal controls can insulate the CTO from being inappropriately subject to business unit pressures; in practice, such controls may not be available in private companies, and may not be reliable in public companies.

Conclusion

Today's corporate/business environment demands an adequate and effective system of checks and balances at the senior management level to contain risks and maintain a level of accountability that protects the organization. The reporting structure for the CTO is a key part of this planning.

In lieu of the CTO reporting solely to the CFO, other viable alternatives include reporting to the corporate legal function and the internal auditor or audit committee. These would both be appropriate reports, because they are able to operate independently in the corporation. However, reporting to the internal auditor appears most desirable, because the auditor will generally be the person best qualified both to evaluate the tax group's performance properly as to financial/accounting matters and to provide the necessary independence.

For more information about this article, contact Mr. Cummings at [e-mail].

[c] 2005 Jasper L. Cummings, Jr. All Rights Reserved. Editor's note: The author is past Chair of the American Bar Association Tax Section's Corporate Tax Committee and past Associate Chief Counsel (Corporate) of the IRS.

Jasper L. Cummings, Jr., J.D., LL.M.

Of Counsel

Alston & Bird LLP

Washington, DC

(1) Only public companies are subject to the following rules: (t) Securities Exchange Act of 1934 reporting requirements; (2) Sarbanes-Oxley Act of 2002 (SOA) Section 404, which requires management of a public company to report on internal control over financial reporting and to assess its effectiveness which, in turn, requires the auditor to attest to and report on that assessment; and (3) Public Company Accounting Oversight Board (PCAOB) Auditing Standard No. 2 (3/9/04), which also includes risk-assessment requirements. Public and private companies are subject to Financial Accounting Standards Board Statement No. 109, which governs accounting for taxes (assuming the company has audited financial statements), and general compliance/cost control/risk management considerations.

(2) See Arlinghaus, "Goal Setting and Performance Measures--by Tax Professionals in Fortune 500 Companies," Tax Executive (11/1/98), Tables XIV and XX, available at www.findarticles.com/ p/articles/mi_m6552/is_6_50/ai_53510352.

(3) See id. at Table VII (42.1% of responses).

(4) See id. at Table X.

(5) See JCT, Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations, Volume 1: Report, Part I (JCS-3-03, February 2003), available at www.house.gov/jct/s3-03-vol1.pdf (hereinafter, "JCT Report").

(6) See JCT, Federal Income Tax Aspects Of Corporate Financial Structures (JCS-1-89, 1/18/89), p. 5-14 (describing vast increase in corporate debt between 1984 and 1987).

(7) General Utilities & Operating Co. v. Helvering, 296 US 200 (1935).

(8) Sometimes defined as "... the economic impact of the retail chain, from forcing smaller competitors out of business and driving down wages to keeping goods cheap, inflation low and productivity high"; see Kuntz, "Buzzwords," NY Times (12/28/03), section 4, p. 2.

(9) See JCT Report, note 5 supra, at Part II.A.4.

(10) See Tax Risk Management: The Evolving Role of CTOs (Ernst & Young LLP, 2004).

(11) See SEC, Final Rule: Strengthening the Commission's Requirement Regarding Auditor Independence (Rel. Nos. 33-8183; 34-47265; 35-27642; IC-25915; IA-2103, FR.-68, File No. S7-49-02, 1/28/03), available at www.sec.gov/rules /final/33-8183.htm.

(12) See Korb, "Schemes, Shelters and Abusive Transactions," 2005 TNT 25-61 (December 2003).

(13) See id.

(14) "Board Adopts Standard on Remediation of Material Weaknesses, Rules on Auditor Independence and Tax Services," available at www.pcaob.org/ News and Events/News/2005/07-26.aspx; see also News Notes, "Tax Work by Auditors," p. 585, this issue.

(15) Treasury Circular 230, Regulations Governing the Practice of Attorneys, Certified Public Accountants, Enrolled Agents, Enrolled Actuaries, and Appraisers before the Internal Revenue Service.

(16) See Arthur Young & Co., 465 US 805 (1984).

(17) Ann. 2002-63, IRB 2002-27, 72.

(18) See KPMG, 237 FSupp2d 35 (DC DC 2002).

(19) TD 9165 (12/17/04), modified by TD 9201 (5/18/05); see Buschel, Tax Practice & Procedures, "Circular 230: New Rules on Written Tax Advice," p. 641, this issue.

Worldwide Effective Tax Rate

A well-known saying in business is that "we manage what we measure." The concept and measurement of a corporation's worldwide effective tax rate perhaps inevitably led to attempts to manage it. Those attempts may have had unexpected consequences for the corporate tax function, which now bring into question the reporting structure for the CTO. The concept has an uncertain history.

Definition

The term "worldwide effective tax rate" appears at least as early as 1976 in an article noting that a multinational's worldwide effective tax rate would increase to the extent the parent's stewardship expenses could not be deducted for purposes of foreign country taxes, and the foreign taxes are not creditable against domestic taxes. (1) The earliest use of the term may be in the Phibro Corp. Annual Report (dated Dec. 31, 1981), which stated that the worldwide effective tax rate dropped from 30.5% in 1979, to 20.8% in 1980, to 3% in 1981, compared to the 46% U.S. statutory rate. A PR Newswire report on first-half earnings of A.H. Robins Co. noted its worldwide effective tax rate on July 22, 1981. The concept is sometimes used as a "neutral" explanation for decreased profits, as when Polaroid explained a second-quarter profit decline by pointing to an increase in its worldwide effective lax rate from 34% to 52%. (2)

The importance of the concept has not gone unnoticed by industry groups. For example, the Tax Executives Institute has sponsored conferences on topics such as "Managing Your Company's Worldwide Effective Tax Rate."

The concept also appears in a 1998 survey of senior tax persons at Fortune 500 corporations who were asked which goals are effective measures of a corporate tax department's performance. (3) The percentages of respondents checking the following goals were:

Cash savings on specified projects          65
Measurable tax project objectives           51
Minimize audit adjustments                  47
Quality of tax savings ideas                46
Targeted worldwide effective tax rate       44

The same survey asked which measures directly affect the senior tax
person's compensation:

Cash savings on specified projects          47
Staying within department budget            37
Measurable tax project objectives           36
Quality of tax savings ideas                33
Targeted worldwide effective tax rate       32

The fifth ranking of the tax rate in both sets of responses could be deceptive, because in both of these measures, the effective tax rate measure is subsumed in the preceding measures.

Observers have made the obvious point that targeting an "arbitrary" worldwide effective tax rate is questionable, because the lowest legally achievable tax rate is likely to be either more or less than any arbitrary standard. (4)

(1) See Note, "Multinational Corporations and Income Allocations under Section 482 of the Internal Revenue Code," 89 Harv. L. Rev. 1202 (April 1976).

(2) See Sanchez, "Polaroid Profit Drops; Higher Tax Rate Cited," L.A. Times (7/22/88), p. 3.

(3) See Arlinghaus, "Goal Setting and Performance Measures--by Tax Professionals in Fortune 500 Companies," Tax Executive (11/1/98), Tables XIV and XX, available at www.findarticles.com/p/artides/mi_m6552/is_6_50/ai_53510352.

(4) See Goodman, "Internal Controls for the Tax Department," 2004 TNT86-23 (5/4/04), n. 8.