What are the key risk areas in tax and how should we approach tax when planning for 2014-15 and beyond?
The following is an abridged text from a lecture given by Ian Hersey ACA, FCCA – director, finance, Barclays Internal Audit at a recent ACCA / IIA networking forum.
The world we are in at the moment - scrutiny of multinational companies’ tax arrangements
Any hint that a company is not paying its fair share of tax is deemed newsworthy. Part of that is due to the climate that we have been – and are still - in where there has been a significant difference between the tax take and the required spending of government.
Government has sought to maximise tax revenues and companies’ tax arrangements have attracted huge attention. Amazon, Google, and Starbucks have recently attracted media headlines but it is not all hot air by the media – there is real scrutiny by the government as well with the Commons’ Public Accounts Committee quizzing company bosses.
It is therefore critical that risk appetite is calibrated by a company and that there is appropriate governance to ensure that what a company does is in accordance with that risk appetite – there needs to be recognition of the reputational risk that companies are running that can have material adverse impact on the company.
Tax avoidance or planning
Tax evasion is where a company dishonestly reduces its tax liability by misrepresenting assets or income for the purposes of paying less tax. There is no judgement or subjectivity – this behaviour is wrong.
More difficult is the judgement between tax avoidance and tax planning. Tax avoidance is abiding by the letter – but not the spirit – of the tax law. Clever tax accountants weave through tax law to get an advantage – often through contrived, complicated structures. It is bending the rules of the tax system to gain a tax advantage that Parliament never intended. However, tax planning involves using tax reliefs for the purpose for which they were intended, eg claiming tax relief on capital investment which Parliament wishes to encourage.
But what is avoidance and what is planning? It can be a fine line and there can be a huge grey area in the middle.
Multinationals’ tax arrangements
The most high profile examples of multinationals managing their tax affairs are Google and Amazon, but many multinationals use the same arrangements. These companies break down the end-to-end activities into component parts which give rise to tax benefits.
Using Amazon’s arrangements as an example – a customer orders something online and a few days later receives it through the post. Amazon could structure it so that it is a UK company executing on that whole transaction end to end. Typically though, partly due to the complexity and the global nature and the number of markets they operate in, Amazon breaks down that end to end profit generation into various component parts. Although the customer has bought through the Amazon.co.uk website, the customer is actually transacting with Amazon’s Luxembourg company.
The UK company fulfils the order through distribution warehouses in the UK and is remunerated on a ‘cost plus basis’ (ie a mark up on the actual costs) by the Luxembourg company. The end to end transaction has been broken up into a number of component parts and the true profit – the difference between all of Amazon’s costs and the revenues that the customers are paying – occur in different jurisdictions.
Luxembourg is not a low tax jurisdiction but it allows more tax deductions for interest expenses than the UK does, and also allows IP royalties to be collected without withholding tax.
With Google, the UK is a key market and the UK business provides marketing services to Google Ireland and research & development to Google US. It does not itself directly transact with customers. Google’s sales revenues in the UK are approximately £400m which it recharges to the Irish or US company. The vast majority of Google’s European income is generated in Ireland where there is some $10bn of sales. Ireland has one of Europe’s lowest corporation tax rates at just 12.5%.
Many multinationals also make use of special purpose entities and companies in low tax jurisdictions.
It begs the question – is it right for companies to split activities in this way? Current tax rules are not equipped to deal with tax issues arising in a global and digital economy. Governments are re-visiting transfer pricing rules in recognition that the global and digital economy provides tax planning opportunities to companies.
What happened at my employer, Barclays, provoked a sea change in Barclays’ attitude and activities and governance in relation to tax. Barclays used two tax schemes – debt buyback and investment funds tax credits – but in February 2012, the government stated publicly that these are ‘not transactions that a bank…should be undertaking’.
The government initiated a retrospective change in tax law so the benefits that Barclays had gained were unwound and Barclays had to pay additional cash to the tax authorities. Additionally the government said that the transactions that Barclays had undertaken were not, in its view, in compliance with the UK banking code by which Barclays was bound.
As well as the huge reputational damage that this caused Barclays and the financial impact, it poisoned their relationship with the tax authorities. It became apparent that while Barclays was good at technical tax analysis, it was less good at reading the mood of tax authorities. It just did not see this coming. There was recognition within Barclays that it needed to get closer to tax authorities, and to think about what its risk appetite should be, and make sure there was appropriate governance to support the execution of that risk appetite.
In February 2013, Barclays announced that it would close its structured capital markets business and would no longer engage in complex structures where the primary objectives were to access tax benefits. It also published a set of Tax Principles to govern all future tax-related activity. All transactions would, in future:
- support genuine commercial activity
- comply with generally accepted custom and practice, in addition to the law and the UK code of practice on taxation of banks
- be of a type that the tax authorities would expect
- only take place with customers and clients sophisticated enough to assess its risks
- be consistent with, and be seen to be consistent with, our purpose and values.
Considerations that multi-nationals should have when they are reviewing transactions (some only apply to financial institutions):
- tax law and treaties – aside from the reputational aspect, management needs to have the right level of review of transactions internally and ensure that experts are involved where appropriate. No company should enter into a tax position without requisite specialist knowledge. Where expertise is not available in-house, external expertise should be sought
- The Code of Practice on Taxation for Banks states that banks should:
- adopt adequate governance to control the types of transactions they enter into
- not undertake tax planning that aims to achieve a tax result that is contrary to the intentions of Parliament (management must show that it has made this assessment and that what it is doing is in line with the intentions of Parliament)
- comply fully with all their tax obligations
- maintain a transparent relationship with HMRC (for example, Barclays discloses sensitive transactions to HMRC on a timely basis but it depends on what is appropriate for your business as to what and when you disclose to HMRC). There should be an open relationship based on trust
- General Anti-Abuse Rule (GAAR) – applies from 17 July 2013 – as with the Code of Practice on Taxation for banks, management must be able to articulate how tax planning complies with GAAR over and above the technical analysis
- Disclosure of Tax Avoidance Schemes (DoTAS) by the scheme promoter – if your company is promoting tax schemes it should assess whether HMRC should be notified.
- There should be a governance structure to assess transactions – Internal Audit should assess the design and operating effectiveness of controls. All parties need to have full regard to the reputational aspect aside from the technical tax analysis.
- Completeness – the huge geographical spread of multinationals means that it is critical that all transactions go through the governance structure.
- Appropriate sign-off of transactions.
- Tax technical analysis – if this is not available in-house then co-sourcing or advice from counsel should be considered, particularly in countries where a multinational does not do a significant volume of business and there is not an appointed tax person.
Ten years ago, the above would have been sufficient. Not any more though – now there is a need to think about the reputational aspect so further considerations include:
- Are the transactions compliant with UK GAAR/Code of Practice on Taxation for Banks/DoTAS?
- Are the transactions compliant with the tax principles?
- Are you engaging with tax authorities on a regular basis and disclosing as necessary?
- Treatment of the backbook – governance must cover the stock as well as the flow.
- Provisioning – this is judgemental and can materially impact on the financial statements so the governance around determining appropriate provisioning levels both from the inception of the transaction and the revisitation as facts and circumstances change is important.
Background to operational taxes – the forgotten area of taxes
Taxes such as corporation tax are within the control of the tax department. However, with operational taxes, the tax department is dependent on operations designing and correctly operating the key controls around operational taxes on their behalf – key controls to ensure compliance with withholding or reporting requirements.
For example, Barclays is required to deduct tax on the interest paid to its customers. The tax department does not operate the control that flags those customers as UK taxpayers – that control will be operated by operations. In certain circumstances, if certain criteria are met, Barclays can pay gross interest and does not have to deduct tax, but it can only do that if certain criteria are met. Operations will assess whether these criteria have been met and the customer can be paid gross but it will not be the tax department doing that, so tax has a dependency on operations. While the tax department will know the tax legislation and will tell operations what the tax law says, it is for operations to act on that information, design appropriate controls and ensure that those controls are operating effectively.
Management of operational taxes can be extremely challenging – there are many taxes and they differ in each jurisdiction. Therefore it is critical that you have:
- a framework detailing respective responsibilities of business, operations, finance and tax
- ownership of the end-to-end process
- clarity of roles and responsibilities.
Without these, there will be risk events. This risk has been exacerbated by government demands. There is huge demand for information-sharing of citizens of different jurisdictions. As an example, in the near future, banks in Jersey will have to tell the UK tax authorities about assets and income that are held by UK customers in Jersey bank accounts. That requires substantive augmentation and improvement to client on-boarding systems so that the Jersey bank can identify UK customers when they walk through the door.
Global trend – tax information sharing
FATCA (Foreign Account Tax Compliance Act) is unprecedented in its demands on financial institutions but is part of a larger trend of information sharing of taxpayers across jurisdictions. There are already a number of Tax Information Exchange Agreements in place (eg UK Swiss tax agreement was signed in 2011). There is also the EU Savings Directive and the Qualified Intermediary regime.
A raft of new announcements in the past few months is taking it to a whole new level:
- UK – Crown Dependencies Agreements: financial institutions in Jersey, Guernsey and the Isle of Man (the Crown Dependencies) will be obliged to automatically provide information to HMRC on UK resident clients in respect of 2014 onward. This is a global trend – it will shortly be EU wide and then probably global in the not too distant future
- G8 announcement on 18 June: to ‘fight the scourge of tax evasion, governments agreed to give each other automatic access to information on their residents' tax affairs and to require shell companies to identify their effective owners’
- G20 announcement on 6 Sept: committed to a new global standard based on automatic tax information exchange. OECD to draw up the standard by February 2014. Target is information exchange reporting from 2016 (of 2015 data).
What is FATCA and why is it important?
The Foreign Account Tax Compliance Act (FACTA) aims to prevent US taxpayers from using offshore accounts to evade tax. It obligates Foreign Financial Institutions (FFI) (banks, brokers, administrators) to report information about US account holders by means of a ‘voluntary’ arrangement (the FFI Agreement) with the US tax authorities (the IRS).
While it has been badged as voluntary, in reality the penalties for failure to comply are so punitive that there is no choice but to comply. The penalty is a 30% withholding tax on certain payments to non-compliant entities, eg if a bank does not comply, then US entities and participating FFIs will withhold 30% from certain payments to the entity.
FACTA is important to FFIs because of the withholding risk and reputation risk. If you do not comply then that could cause a perception in the market that you do not have appropriate systems and damage your reputation.
FACTA has a worldwide impact for multinationals – it is global so there needs to be appropriate systems and controls. Every entity and branch needs to be classified and assessed. For an institution like Barclays with its spread and global reach, that is a massive exercise and Barclays has had a change project since 2011 to ensure it meets the requirements of FACTA.
UK legislation meant that it was not legally possibly to comply with FACTA because of EU data protection legislation under which data about UK citizens could not be sent outside of the EU. The workaround that has been established is that, instead, information is reported to HMRC (the home tax authority) which will then pass the information to the IRS.
Multi-nationals operating in a number of different jurisdictions need to have regard to transfer pricing. Where a company transacts directly with a customer, it sets a price and the market determines what that price is. However, if a Barclays UK entity transacts with a Barclays US entity then it is all internal and not subject to the same supply and demand that would otherwise set the price. To prevent the revenue and profit going through the country with the lower tax rate, transfer pricing legislation requires a company to put an arm’s length approximation of a fair value on internal transactions.
Typically, companies need to assess where the substance of the activities is undertaken. If all the work is done in a high tax jurisdiction then that is where the profits need to be shown. Additionally, the tax authorities would look for some profit – after all, if the transaction were external then the third party would not seek to just reimburse their costs. If there is no evidence of a cost plus basis the company will be charged by the tax authorities.
Where there are intra-group trading and transactions, internal audit should look for a transfer pricing methodology to be in place in every jurisdiction. The tax department should be putting that together in conjunction with experts including co-source where necessary. In addition, internal audit would want to ensure that the finance department, in conjunction with the tax department, is correctly applying the methodology.
Tax investigations and tax audits will happen – you cannot satisfy all tax authorities. All tax authorities want to see as much income as possible routed through their country – they want to have as much taxable profit and maximise their tax take, so being challenged by tax authorities is just the nature of being a global multi-national company. It does not necessarily mean that there is a control issue. If there are adverse findings and the tax authorities say that they disagree and they are going to levy additional fines because you should have been booking more of your revenue and profits in the UK, it doesn’t mean that it is a control issue per se.
Deferred tax assets (DTA)
Deferred tax assets can arise on temporary timing differences, difference between the tax base of asset and liability, but also they can arise as a result of tax losses. During the crisis, many financial institutions had material deferred tax assets.
In most jurisdictions, if you generate a tax loss then you can carry it forward. If in 2011 you generated a loss of £50m, that would give rise to a deferred tax asset of say £10m. If you started making profits in 2013 and 2014 then you would not have to pay tax as you could offset it against the tax losses that you generated in 2011.
It must be probable that tax profit will be available against which you can use a DTA. Management would make the case that recognition of deferred tax asset is justifiable on the basis of profit forecast. Internal auditors should look at the controls around the preparation of forecasts – you cannot have management anticipating forecasts of one position while another forecast is being used to support the recognition of a DTA – it has to be joined up and those forecasts have to be reasonable rather than based on heroic assumptions.
VAT/corporation tax/employment taxes
These bread and butter taxes are important even if they do not have the same impact on reputation and are not as high profile:
- VAT systems and processes are complex – Barclays has 50 or so system feeds that drive the UK tax return. Most multi-nationals will have a similar degree of complexity. There will be different sales tax rules in different jurisdictions and partial exemption is tricky as is reverse charging
- increasing challenge from tax authorities – is there documented end to end process flow, and how is the VAT department monitoring the operation of controls?
- reporting deadlines are tight if you are a group because of the need to go to the market. Typically you have only four weeks post the finalisation of financial statements to get a materially correct tax provision figure. Often there is a circling back for tax return purposes when the figures are examined more closely, but if internal audit is seeing big differences between what is in the group financial statements and what is actually in the tax return, it would suggest that the tax department has not been as precise as it should have been for group financial statement purposes
- compliance – appropriate reviews by people with sufficient experience
- a consideration that IA has to make is on engaging co-source – for the majority of the people in the IA team, tax is one of the things that they work on but they would not be able to go head to head with the tax department on a technical analysis.
If you look at any company’s tax contribution, typically the largest part will be in relation to employment taxes:
- often calculated by HR but there needs to be an appropriate level of oversight by the tax department
- expatriate tax – is there appropriate monitoring over expatriates and whether they are paying the right amount of tax? There need to be controls monitoring which jurisdictions people are flying into - where people are doing business can result in exposure from both the personal tax and corporate tax perspective.