Tax risk and strong corporate governance.

An important issue for a board and CEO is to consciously decide the position they wish to take on tax planning, rather than have it made for them by others.

--Michael Carmody, Australian Commissioner on Taxation (January 2004).

The accounting and reporting of income taxes has received increased scrutiny by investors, analysts, Congress and others. Your auditor will be asking for more information, and you may have noticed an increased level of scrutiny from the SEC staff. That spotlight is likely to continue. Welcome to the new world.

--Donald T. Nicolaisen, Chief Accountant, Securities and Exchange Commission (February 2004)

Three-fifths of CEOs believe 40% or more of their company's market capitalization is represented by brand/reputation.

--Voice of Leaders Survey, World Economic Forum (January 2004)

In today's business environment tax risk is one of the more challenging business risks presenting both monetary and reputation consequences for corporations. By its complicated and technical nature, tax risk may not be adequately understood and appreciated by corporate boards and senior management and may expose the company to unexpected outcomes. Yet, in the post-Enron world, it is imperative that strong corporate governance processes recognize this risk and that corporate boards and senior management deliberately decide how much tax risk is consistent with the overall corporate risk profile to satisfy shareholder expectations. This article provides an understanding of tax risk and its fundamental drivers, identifies potential gaps between tax departments and other stakeholders that may accentuate such risks, and offers suggestions on methods for quantifying and managing tax risk. The tax department of the future will be integrated in the firm's overall enterprise risk management and also help communicate and monitor for any gaps between the tax department's implementation of tax strategies and the firm's risk/return/reputation tradeoff.

Defining Tax Risk

The concept of risk can be broadly defined as the likelihood and magnitude of outcomes that are different than expected. It is important to make the distinction between certain or expected outcomes versus uncertain or unexpected "risky" outcomes. To illustrate this important point, the known tax depreciation that can be deducted from income next year is not risky since the outcome is expected with certainty (absent a change in the law applicable to property already in service-a decidedly remote prospect). The tax benefit from the deduction, however, may be uncertain because of the company's profit position arising from changing macroeconomic, industry, or specific company conditions. The tax benefit may also be uncertain if the tax class life of the asset is subject to dispute with the IRS. In this example, known depreciation expense for the next period does not pose any financial risk, but economic and tax technical risks create uncertain financial outcomes. Similarly, operational risk can affect many tax outcomes, including penalties and interest. For purposes of this article, the definition of tax risk in a broad sense accumulates all sources of risk that may create an unexpected outcome from a tax position. This definition is broader than others, which typically focus only on tax technical or operational risk aspects.

The various risk sources (underlying causes) that can make any tax position risky include, but are not limited to:

* Compliance or operational risk occurs because of non-compliance with tax requirements factually, or lapsing over time, thereby jeopardizing the viability of a tax position (e.g., tax elections that must be made at a particular time or in a particular matter to be effective).

* Economic and business assumption risk may change the premise on which many tax positions are based, such as revenue and net income growth expectations, which if not realized make the tax position worthless or significantly reduced in value.

* Financial risk may manifest itself through adverse interest rate, currency, or market movements that interact with tax positions to make their outcome uncertain.

* Legal risk owing to uncertainty in the outcome from the judicial process may undermine the presumed value of tax positions. This risk includes judicial risk in tax controversy and non-tax issues such as contractual or corporate matters.

* Legislative risk occurs because of potential changes in current law that may erode the value of current and past tax positions. For example, the Tax Reform Act of 1986 reduced the value of many companies' depreciation deductions with the lower marginal tax rates and enactment of the alternative minimum tax.

* Regulatory risk emerges from increased intensity of audits and review by taxation authorities or other industry regulators that may challenge the validity of a company's tax positions, which can impose a cost even if the outcome is ultimately favorable to the taxpayer.

* Segmented strategy risk results from situations where various stakeholders create tax positions without clear coordination with the corporate tax department. For example, the human resource department may incur tax risk indirectly through changes to pension plans and stock options without sufficient communication with tax department.

* Tax technical risk is what most people view as tax risk emanating primarily from the potential uncertainty in the interpretation of tax laws by tax authorities. Companies often receive opinions about the tax technical risk of particular tax positions (e.g., a "should" opinion suggests a 70-to 80-percent likelihood of prevailing on the merit in litigation). Even with the highest "should" opinion, the 20-to 30-percent likelihood of losing the position involves technical and regulatory risks of unwinding the transaction or paying penalties.

Clearly, tax positions may produce unexpected outcomes because of myriad causes or micro-risks that require full evaluation during tax planning, implementation, and compliance phases of a tax position. Thus, it is not sufficient to consider only the expected return from an investment (tax position), but also the relative risk of that investment. Similar to other corporate investments, tax investments need to weigh the risk-return tradeoff.

To complicate the implications of tax risk further, individual tax positions are not necessarily independent of each other, nor unrelated to other risks faced by the company. For example, many tax positions directly or indirectly depend on the viability of a particular tax technical interpretation, or even if unrelated, a perceived weakness in business justification of one tax position by tax authorities could invite higher scrutiny of other tax positions creating a "domino effect." Similarly, a firm's exposure to un-hedged foreign currency risk or interest rate risk may get exacerbated if it is also pursuing a tax position that is premised on a particular view of such economic scenarios. In many instances, tax positions are sold within the company based on and tied to a "rosy scenario" of the company's prospects. Such tax positions will only make matters worse if the presumed business prospects do not materialize. On the other hand, being too risk-averse could have a chilling effect on legitimate tax minimization. For example, the U.S. Treasury recently delisted a transaction owing to taxpayer-favorable circuit court decisions (Compaq case), which implies that trying to eliminate tax risk could result in over-taxation.

The concept of uncertainty is very useful in quantifying tax risk to the extent it is possible to do such quantification. In quantitative terms, the average or mean is used to represent the expected outcomes, and the standard deviation or variability is used to reflect the uncertain or unexpected outcomes. Figure 1 uses a stylized example to illustrate the concept of tax risk: The two tax positions have the same expected return but different levels of risk. Tax Position A is less risky since the variance of the outcomes is smaller than the larger potential swings in Tax Position B. For risk-averse companies, Tax Position A would be preferred to Tax Position B.

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Corporate Governance and Importance of Tax Risk

Enron, WorldCom, and other recent corporate scandals have shaped a new standard on corporate governance, raising public expectations of how firms manage their various risks, including tax risk. The regulatory and legislative response to corporate misconduct includes pending legislation that would require a CEO declaration on the corporate tax return, and new Treasury regulations on reportable transactions (under section 6011 of the Code) threaten stringent penalties and highlight a growing need for senior management to evaluate tax risk. The recent example of WorldCom--where the former U.S. Attorney General, Richard Thornburg, issued a report concluding "Corporate structure to reduce tax......... was highly aggressive and seriously vulnerable to state challenge"--illustrates the importance of tax risk.

These developments involving significant monetary consequences are forcing the corporate community to focus more sunshine on their tax departments and ask more or their tax directors to better understand and communicate their tax risks. Tax risk may not only create financial stress, but also present serious reputational implications. In the post-Enron world, where skepticism reigns and lack of corporate credibility can be the basis of negative perceptions, a negatively perceived tax position may cause outsiders to question the overall effectiveness of the management. Increasingly, equity analysts are evaluating and quantifying all risks faced by companies, and some have imposed "risk discounts" on future earnings based on any known or anticipated risks undertaken by the company. Companies are taking a closer look at the tax reserves reported on their financial statements and providing increased disclosure of their tax reserves.

Businesses need to understand that different tax positions produce different reputational perceptions in the minds of outsiders. These perceptions affect how the tax authorities may scrutinize and possibly challenge a company's tax position. They also affect how stakeholders view the entire company.

Depending on the external business environment in which a company operates, the reputational consequences of tax risk may be many times the actual monetary tax loss or penalties. Negatively-perceived tax positions may be effectively used by adversaries of a company or industry to highlight the lack of adequate corporate governance structure, potentially resulting in significantly burdensome governmental intervention with long-term monetary consequences. Similarly, negative perceptions emanating from a company's tax position erode the value of its brand name and goodwill, causing consumers and business partners to evaluate alternatives, resulting in market share loss. Because of the significant reputational affects flowing from public perception of a tax position, over and above any monetary risk, there should be separate consideration of how tax risk creates both reputational and monetary risk. Figure 2 uses a reputational risk scale to illustrate the distinction between the perceptions resulting from two tax positions.

[FIGURE 2 OMITTED]

Certain tax positions, such as investments in low income housing tax credits (LIHTC), may generate positive perceptions, whereas others such as reincorporating offshore ("corporate inversions") may cause negative perceptions. Reputational risk has potential costs, which are part of the total tax risk potential costs.

The focus on tax risk is by no means limited to economic downturns, the Sarbanes-Oxley Act, or the United States. The recent global slow-down has provided the motivation and incentive for local tax authorities around the world (both nationally and subnationally) to identify "abusive" tax practices for revenue enhancement purposes, as well as to promote a fair and voluntary tax compliance. For example, the Australia's Commissioner of Taxation recently put all Australian corporate taxpayers on notice by issuing a letter (on January 29, 2004) setting expectations that the "board identify taxation risks associated with their organisation's operations, which risks are acceptable and appropriate, and which are not, and put in place a process for the management of those risks."

Align Tax Risk with Business Risk and Close Information Gaps

Most public corporations recognize the need to take various business risks in order to meet shareholder expectations on returns. Similarly, on matters of taxation, the corporate goal is to pay no more than the least possible tax using legal tax positions to minimize a corporation's effective tax rate. Historically, this responsibility has been shouldered largely by the tax directors and tax departments, with modest involvement from senior management or the corporate board. Highly technical, even arcane tax laws create an informational asymmetry, or knowledge gap, between the tax departments and the rest of the organization, such that even non-tax managers with the best of intentions to align corporate risk may not fully appreciate the risk profile of a tax transaction. This has often resulted in the tax department policing itself without an independent assessment of risk--thereby eroding a core principal of risk management.

The propensity to take risk may not be aligned within various corporate constituents because of misalignment of incentives. Tax departments may be measured by the overall effective tax rate, or tax savings, with no negative attribution for the resulting tax risk they generate, while senior management may be rewarded on the basis of high pre-tax net operating income, with no effect from tax consequences. To complicate matters further, the performance time horizon across different stakeholders may vary significantly, with management and tax departments taking a shorter-term view. Therefore, the board of directors, audit committee, senior management, and the tax department of the company may not share the same risk-reward preferences. Although companies have strived to align incentives across their various constituents, such examples of incentive problems persist in many companies.

Figure 3 illustrates a hypothetical potential misalignment of risk-reward-reputation preferences taking into consideration both monetary and reputation risk consequences. Increasingly, boards of directors are establishing guidelines for the company's tax risk preference, and then will need to monitor whether the tax department and management achieve that position. Quantification of the tax return-risk-reputation tradeoff is necessary to set the company's position and tax strategies, as well as understanding the company's current tax return-risk-reputation tradeoff and monitoring the tradeoff in the future.

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Recommendations: Awareness, Alignment, Quantification and Monitoring

Raising the awareness of potential tax risk consequences within an organization, as well as the need to align tax risk with the overall corporate risk profile, is critical. Tax risk should be viewed as an integral part of the corporation's overall enterprise risk management and should be effectively managed and directed by the board and senior management, as opposed to being relegated to and kept under wraps in the tax department. Therefore, it is important for a business that wants to align its tax risk with its overall risk appetite to do the following:

* Evaluate the current risk-reward-reputation profile.

* Facilitate a common understanding among key stakeholders for the desirable risk-reward-reputation profile, and

* Close the gap between the current state and the desired state.

The desired state should address any misalignment of risk preferences across key stakeholders. For example, a risk-averse company now may, similar to risk-averse investors in turbulent economic markets, have a "flight to quality." Whereas previously the company may have disdained tax-timing positions (since they do not reduce the effective tax rate, even though they reduce the present value of taxes and increase cash flow), a risk-averse company may prefer tax accounting method changes with low risk to more aggressive tax positions. Moreover, a risk-averse company may be willing to invest more in the documentation required to support a research and development tax credit position than previously, even though the increased up-front investment lowers the expected return. For example, pre-filing agreements with the IRS on R&D credits may significantly increase the certainty of the desired outcome, thereby reducing tax risk.

The process of quantifying tax risk both in monetary and reputational terms is far from trivial. In fact, most businesses should recognize the complexity of tax technicalities and consider using an independent knowledgeable party to assist it in this quantification. Beyond the tax technical knowledge, the tax risk assessment has to be conducted taking into consideration the intricacies of the particular industry, business model and strategy of the firm, and the external economic, legal, legislative, and regulatory environment. In general, tax risk quantification may involve considerations such as the following:

* Level of tax authority--federal, state, foreign jurisdiction;

* Strength of the business purpose behind the tax position and its documentation;

* Types of potential penalties;

* Experience with IRS, state, and foreign tax administrators and their enforcement trends;

* One-time restatement versus multiple year look-back; and

* Potential cascading effect (diversification or concentration).

Similarly, a rating scale to evaluate reputation risk factors may include economic implications of the tax position (e.g., job losses), public perception of "abusive" tax positions, policymaker concerns documented during the legislative history of a particular tax bill, effect on other governmental programs, etc.

While the foregoing lists are by no means comprehensive, they provide a useful starting point to review and quantify some of the more significant tax positions that the company has implemented. It is helpful to analytically display some of the most critical tax positions with their estimated monetary and reputational risk attributes to challenge some of the positions that are not consistent with the desired risk appetite. The following graph illustrates how a business may want to map it critical tax positions and then challenge some of the outliers to groom the portfolio of outlier tax positions and make them more consistent with the corporate risk objectives.

In sum, corporate boards and senior management need to meet the new corporate governance expectations with respect to all risks, including tax risk. Tax risk has generally not been fully understood or transparent to all stakeholders. Nevertheless, the monetary and reputation consequences of not acknowledging the implications of tax risk may be severe and, therefore, cannot be ignored in a strong corporate governance process. Clear guidance on the business risk appetite and risk management is necessary to align the risk-reward-reputation preferences of all stakeholders, including the tax director and the tax department.

The new focus on tax risk is an opportunity for corporations and their tax directors to better align not only the risk/return/reputation tradeoff of tax with the rest of the corporation, but also to better align tax planning with the firms' business planning. Managing tax risk is more than policies and procedures; it involves strategic tradeoffs, increased communication, increased measurement, and increased monitoring of the risks inherent in our complex, changing, and ambiguous tax system. This is an opportunity for both the company and the tax director to move toward an improved tax department of the future that is closely aligned with the goals and business strategies of the company.

From the perspective of the board and senior management, it is important to explicitly recognize that tax risk is not only an administrative matter requiring minor adjustments to the bottom line, but something that can have significant monetary and reputational consequences. An understanding of the reputation aspects of tax risk, or how a tax position will be perceived by the media, public, shareholders, markets, tax authorities, and policymakers is essential for projecting a strong corporate governance culture. The reputational risk emanating from tax risk could be many times more severe and punishing than the monetary tax loss, since it may challenge the basic presumption of strong corporate governance--that is to say, how the board and senior management determine, direct and manage business risks.

TOM NEUBIG is the national director of Quantitative Economics & Statistics (QUEST) practice of Ernst & Young LLP based in Washington, D.C., and former Director and Chief Economist of the U.S. Treasury Office of Tax Analysis BALVINDER SANGHA is a partner in the same practice who works with many financial services company in quantifying their business risk issues. The views expressed here are those of the authors, and do not reflect the views of Ernst & Young, LLP.