Corporate tax governance for CFOs: a practical approach: CFOs don't have to be tax experts, but they do need a basic understanding of the income tax process and the corporate tax structure required to manage and report their company's global income taxes--quickly and accurately.

Accounting for income taxes was the top reason for adverse audit opinions and restatements during 2005 and 2006. It's also currently the highest risk area of financial reporting, and it's causing quite a stir within audit committees and the C-suite.

As a result, corporate governance principles specifically addressing global tax operations--"corporate tax governance" principles--are evolving. When followed, these can ensure effective tax internal controls are implemented to manage tax risk while maximizing tax savings.

Many "overseers" (CFOs, audit committee members, controllers, and other appropriate individuals) understand the frameworks for internal controls--COSO, the Committee of Sponsoring Organizations of the Treadway Commission, in the U.S.; Turnbull, in the U.K.; and CoCo, in Canada. However, they want a more practical approach to monitoring what is typically one of the largest items on their company's P&L and balance sheet, and a complex area of business operations.

To provide effective corporate tax governance, CFOs need not become international corporate tax experts. What they do need, however, is a basic understanding of the income tax process and the corporate infrastructure required to manage and report their company's global income taxes quickly and accurately.

The Tax Planning Process

The typical multinational's income tax process is cyclical and could logically start with tax planning. While tax planning has sub-categories for international, federal and state tax planning, they all come together in the company's effective tax rate, or the overall rate at which a company's consolidated pretax income gets taxed on a worldwide basis.

This includes the estimated income tax expense that will eventually be due on every country, state, province and city tax return for all companies included in the financial statements. The effective tax rate equals the total income tax expense divided by consolidated pretax income. It usually runs between 30-40 percent.

A key financial objective is to minimize the effective tax rate within the confines of the law. To do this, tax executives strive to locate profitable operations in low-tax jurisdictions.

To minimize risk of adjustment upon scrutiny by tax authorities, they need projected revenue, R&D expense, manufacturing expense, assembly expense and cost of sales by country and by legal entity.

Armed with this information, they then organize the business structure that maximizes profits in low-tax jurisdictions. They might institute intercompany charges to shift income from one jurisdiction to another (tax transfer pricing) or create a flow-through entity, the losses of which flow-through to the corporate owner to allow a current deduction or build operations in jurisdiction with tax incentives for investing and many other ways.

As a result of this tax planning, the tax executives come up with a global structure for distributing worldwide profits by legal entity that minimizes the resultant taxation without harming the underlying business operations. This includes the type of legal entity, the intercompany debt/equity structure, the ownership of intangibles and intercompany charges for their use--all of which must be documented and treated as if the companies were not related, but rather third parties. As can be gleaned from the above, tax planning is a high-value-add function requiring top tax talent and overseers with a basic grasp of the key tax drivers.

Tax Return Compliance Process.

Once the master tax plan is configured, the company then conducts business, engages in intercompany sales, records actual results and files tax returns for every legal entity for every jurisdiction in which it conducts business. Depending on the size of the company and the number of countries it does business in, there could be anywhere from one hundred or less (10 legal entities in all U.S. states) to thousands (1,000 legal entities in 200 countries, all states, provinces and cities) of tax returns.

These returns need to reflect the desired tax treatment designed in the tax planning, and all tax positions need to be recorded on the books and documented as to their tax rationale. Tax compliance is no small task, and while a low-value-add activity, it typically consumes 60-80 percent of global tax resources.

Tax Defense Process.

Once all of the global tax returns have been filed, they are "open" for a certain period (usually a few years) to audit and adjustment by the various tax authorities in each jurisdiction. It is not uncommon for the tax auditors to review returns three to seven or more years old and request all of the books, records and tax explanations as to adjustments between the financial statements and tax returns.

The auditors typically have extensive and detailed information requests, including board minutes, intercompany agreements, contracts and even tax provision workpapers. They then propose adjustments, which officially begins the tax defense process. Issues raised can be settled at the auditor level or escalate to administrative tribunals and even litigation in courts with jurisdiction.

Accounting for Income Tax Process.

At this point, the outcome of the three processes above gets recorded and reported in the consolidated financial statements, including the details of the income tax footnote. It is the last process of closing the corporation's books for a given period and consists of estimating the company's global income tax expense, assets and liabilities by legal entity and by jurisdiction.

Income tax expense is broken out between what is currently due on the year's tax returns and those taxes provided on financial statement income that will be due in future years.

The calculation of current tax expense starts with pretax generally accepted accounting principles (GAAP) income by legal entity. Groups of legal entities are combined according to each country's tax laws, allowing losses of one company to offset taxable profits of another. For example, all U.S. corporations that are majority-owned are taxed as one consolidated entity for U.S. tax purposes. If any of these companies have foreign branches, then that branch's income is included in the U.S. tax calculation as well.

Each legal entity's GAAP income then gets adjusted according to each country's tax rules. These adjustments can either be "permanent" or "temporary." Permanent differences are items which will never be taxable or tax deductible, such as tax-exempt interest. Temporary differences are those which over the life of the business will be equal in amount, but the timing is different year-to-year, such as book depreciation of office equipment that may be three years versus five years for tax.

The result, taxable income, is taxed at the national, state, provincial, municipal and trade levels as applicable. The sum of all legal entity's current tax calculations equals the consolidated current tax expense reported on its current year tax returns. (In reality, there are a few additional adjustments for items of "other comprehensive income," which we'll assume are zero for now). This is the same current tax expense reported in the company's financial statements.

The next calculation is the deferred tax expense. The easiest way to convey this calculation is via an example. Assume your company's consolidated GAAP income is $1 billion, consisting of unbilled but earned revenue. For tax purposes, assume that this revenue is not taxable until collected. Based on this scenario, GAAP income is $1 billion, but current taxable income is zero since the cash has not been collected. The result is no current tax expense.

However, GAAP requires that income tax be provided on the $1 billion even if the tax is due in the future. So a "deferred" tax must be provided for these future taxes. The sum of current and deferred tax provisions equal the total tax provision from which the consolidated effective tax rate is derived. This rate must be reconciled to the company's domestic statutory tax rate and disclosed in the company's income tax footnote.

Lastly, deferred taxes provided on GAAP income will result in future liabilities (or assets) for deferred income taxes on the balance sheet. The components of the total deferred taxes must be disclosed in the income tax footnote as well.

There are numerous nuances and complexities surrounding all of the above calculations, but they give a basic framework for providing effective corporate tax governance. With this basic understanding, executives then need to understand the key components of corporate infrastructure needed to ensure sound corporate tax governance.

A common theme for all of the income tax processes detailed earlier is "legal entity accounting." All tax planning, tax returns, tax defense and tax accounting is based on and driven by legal entity books and records. This area is the most neglected requirement by companies. If a company is not doing this as part of its corporate consolidation process, then the tax department must do it manually. As can be imagined, a global manual process done under significant time pressure is a recipe for inaccurate financial reporting. If legal entity accounting is not done as part of the corporate consolidation, then CFOs need need to circle the wagons with accounting and tax management to develop a plan for doing so.

Another accounting issue for which it is necessary to quickly and accurately calculate the tax provision is the level of detail in the charts of accounts. Just as the business may need a chart of accounts to report profitability by product, geographic area or manager, a certain level of chart of accounts detail is required to quickly calculate the company's tax provisions at the end of the close cycle.

For example, the GAAP chart of accounts may have a "Miscellaneous Accruals" or "Other Reserves" account. To make appropriate book-to-tax adjustments, the tax department needs to know the various types of accruals and reserves in these accounts. Executives should make sure their company's accounting departments are aware of this interdependence and have reached a compromise with the tax department as to an appropriate level of chart of accounts detail that supports both department's needs.

Another key area to be aware of is the level of institutional "tax" knowledge. Many companies were found to have inadequately trained field controllers for calculating their operation's tax provisions. These controllers need a good understanding of their local GAAP accounting (say, International Financial Reporting Standards, or IFRS), their consolidated GAAP accounting (U.S. GAAP), as well as their local country tax rules and their consolidated accounting for income tax principles (FAS 109). They typically are well-versed in all of these except for accounting for income tax principles.

There are two ways to address this knowledge shortfall. First, now available is global tax provisioning technology that can be set up to automatically consolidate entities in accordance with each country's tax consolidation rules, as well as automate many of the book-to-tax adjustments for a particular country. This technology reduces the field controller's input to exceptions only and thereby reduces the required level of knowledge needed to calculate an accurate tax provision.

In addition, there is very effective Web-based learning technology that can assess, train and certify these individuals in the company's accounting for income tax policies and procedures. This technology is integrated with the global tax provisioning system that requires a certain level of domain competency in order to access the system to calculate their provisions.

Lastly, most large corporations have an over-reliance on spreadsheet technology to collect the necessary data and calculate their global income tax provisions. The pitfalls and limitations of using this technology for the global tax process are well known. Among the problems: it is not integrated with the company's source systems, it is error-prone and difficult to consolidate and it lacks uniformity and standardization across users.

All of these shortcomings are addressed with new technology, which uses the same exact software, database and user interface for corporate consolidation, budgeting, planning and forecasting, as well as tax provisioning. Systems with such tight linkage between book and tax ensure that when the books close, tax provisions are closed with the accuracy necessary for the financial statements.

Providing corporate tax governance may seem like a daunting task due to the complex nature of a multinational company's tax operations. However, to provide effective oversight of this complex area, CFOs need only a basic understanding of the company's global tax process and the underlying infrastructure needed to facilitate efficient processes and accurate financial reporting of income taxes.

The practical approach described here can allow those responsible for corporate tax governance to help the company achieve its objectives of minimizing global taxation while simultaneously minimizing the financial reporting risk related to accounting for income taxes.

TAKE AWAYS

* Accounting for income taxes was the top reason for adverse audit opinions and restatements during 2005-06.

* Overseers of corporate governance (CFOs, audit committee members, controllers and others) understand the internal control framework (COSO, in the U.S.; Turnbull in the U.K.; and CoCo, in Canada), and want a practical approach to provide corporate tax governance.

* The income tax process involves tax planning, accounting for income tax, tax return compliance, tax defense and tax accounting.

RELATED ARTICLE: Practical Tax Governance

1. Learn the basics of the global tax process:

The Tax Planning Process

The Tax Return Compliance Process

The Tax Defense Process

The Tax Accounting Process

2. Implement the required infrastructure to manage and report taxes:

Legal entity accounting and consolidations

Tax provision-friendly charts of accounts

Web-based technology to train field controllers on company FAS 109 policy and procedures

Tax Provisioning technology to automate the global tax provision process

BOB NORTON is Vice President of Tax Solutions for Longview Solutions, a provider of corporate performance management software and an FEI strategic partner. He can be reached at [e-mail] or 610.828.7915 x 233.