Taxes are a significant cost for any profitable organization. When business professionals discuss managing the risks associated with taxes, they are frequently referring to the tax implications of unfavorable audit opinions, improper recording of tax assets and liabilities on a firm’s balance sheet, or noncompliance with tax laws. Tax Risk Management (TaxRM), however, is much more than the sum of these elements.
TaxRM is an enterprisewide process that is affected by a company’s board of directors, management and/or other personnel, and is designed to minimize tax liabilities and maximize compliance, each within the guidelines of tax laws. TaxRM processes enumerate, analyze and mitigate tax-related risks associated with an organization’s strategy, operations and processes, says Walter M. McGrail, JD, CPA, a senior manager at Cendrowski Corporate Advisors LLC.
“Effective TaxRM can help an organization minimize its overall risk exposure, and it should be integrated into an organization’s enterprise risk management process,” says McGrail. “It is necessary for nonprofit and for-profit organizations.”
Three stakeholders can claim rights to the cash flow of any organization: debt holders, equity holders and the government. Besides minimizing risk exposure, TaxRM maximizes the amount of cash flow available to debt and equity holders.
Smart Business spoke with McGrail about TaxRM and how it can benefit organizations.
Who should be responsible for TaxRM?
Senior level tax managers, CFOs, audit committees, chief risk officers and heads of internal audit functions should manage TaxRM. As such, TaxRM processes holistically manage tax-related risks throughout the organization. These risks pertain not only to financial reporting and tax law compliance but also to the methods by which the organization generates profits for stakeholders. Wherever there are profits, there are most likely taxes, or at least compliance reporting requirements.
What are the foundational elements of an effective TaxRM process?
TaxRM is most effective when it is treated as a component of the organization’s overall enterprise risk management (ERM) process. Many ERM processes focus on the risk exposure associated with a company’s core services and operations. TaxRM, however, is infrequently integrated into an ERM process, in spite of the fact that the government can receive a significant portion of a company’s profits — in some cases upward of 40 percent of profits. Integration of TaxRM into an ERM process begins with the integration of the tax function in the organization as a whole. In many companies, the tax function is treated as an area of specialized expertise whose primary focus is tax compliance; day-to-day accounting and reporting functions are often carried out by personnel before being ‘thrown over the wall’ to the tax department.
For example, many companies make investment decisions using a net present value (NPV) based criterion: A project is accepted if its NPV is greater than zero when the company’s hurdle rate is employed. In calculating the NPV of a project, however, a flat, marginal tax rate of about 40 percent is often used. This rate may be significantly different from both the company’s effective tax rate and from the tax department’s best estimates regarding the net tax rate for the project, and could lead to suboptimal decision-making by organizational managers. A culture of tax awareness is also a necessary, foundational element of an effective TaxRM process. Cultures are not ‘implemented,’ per se; they are affected by the actions of an organization’s board of directors and senior management. A culture of tax awareness, then, is an element that must be fostered by these high-level individuals through their actions and through an emphasis on tax analysis. In the absence of a tax-focused culture, a TaxRM process will achieve suboptimal results.
Aside from a tax-focused culture, what are other foundational elements of a TaxRM process?
Another foundational element of a TaxRM process is a documented tax philosophy for the organization. This philosophy articulates the manner in which the organization will manage tax liabilities through acquisitions and dispositions, operations, accounting policies and financial reporting. There is a great deal of risk exposure surrounding each of these issues and, hence, a large amount of tax uncertainty. TaxRM processes are, therefore, focused on managing the variables associated with these issues and the requisite tax liabilities they generate.
A tax philosophy is more than an articulated statement, which relates that the organization will seek to minimize its tax liabilities. In fact, in properly structured environments, taxes can help companies minimize risks associated with their investments. For example, if a company experiences losses, it may receive refundable tax credits associated with this loss. These credits serve to minimize the firm’s risk exposure as the government has now borne a portion of the firm’s risk by providing for refunds of taxes previously paid or serve as credits against future tax liabilities.
Once a tax philosophy has been established, an organization can begin to implement working elements of a formal TaxRM process.
How can nonprofits also benefit from TaxRM?
Although nonprofits do not pay taxes on their core operations, a portion of their operations may be subject to unrelated business income tax (UBIT). For instance, although a hospital is a nonprofit organization, hospitals may pay UBIT on income earned in their gift shops if effective TaxRM processes are not in place. In this manner, an effective TaxRM process can help nonprofits minimize UBIT through careful and deliberate planning, affording the organization greater after-tax cash flow to fund its core operations and further its mission. As such, TaxRM should be a key element of ERM processes in nonprofits as well as for-profit corporations.
Walter M. McGrail, JD, CPA, is a senior manager at Cendrowski Corporate Advisors. Reach him at (866) 717-1607 or firstname.lastname@example.org or visit www.cca-advisors.com.