Note: Where available, the PDF/Word icon below is provided to view the complete and fully formatted document
Corporate governance and tax compliance: address to the IQPC Conference, Sydney, 22 September 2004



Download PDFDownload PDF

Corporate Governance and Tax Compliance

Michael Carmody Commissioner of Taxation

Address to the IQPC Conference

Sydney

22 September 2004

Corporate Australia makes a major contribution to Australia’s revenue through our tax system.

This can be seen in the growth of company income tax collections from some $20b in 1998-99 to $35b in 2003-04. Large businesses represent over 60% of income tax collections from companies.

In addition, large businesses pay the vast bulk of excise revenue, the greater part of net GST collections and collect a substantial part of employees’ Pay As You Go Withholding payments.

Over recent years, the trend has been for the growth in company tax collections to outstrip growth in GDP.

Comparisons of tax payable by large business to total income, profits, total expenses and total assets all show a distinct upward trend over recent years.

As positive as these trends are it is salutary that audit outcomes have seen an even bigger upward trend.

Audit collections (for large companies and High Wealth Individuals) in 1998-99 were around $450m. In 2003/04 they had grown to $2.2b.

Tax and corporate governance

It was against this sort of background that last year I released the business and tax compliance booklet. In doing that I raised tax compliance as a corporate governance issue.

That publication contains checklists of the factors we take into account in identifying cases for audit and the tax planning techniques that we can be expected to challenge.

It was designed to fulfil a number of purposes.

By disclosing in detail the risk analysis we undertake in selecting cases for audit we were looking to give the community confidence that we are on the ball and to give corporations confidence that we only proceed to audits where there is evidence justifying that.

By being open about the sort of planning techniques we can be expected to challenge, I was looking to

enable corporations to enter into arrangements with their eyes open as to the resulting tax risk.

In doing that I was also looking to facilitate conscious decisions by corporations about where they wished to place themselves on the tax risk spectrum.

To further support this I wrote to the Chairmen of the Boards of Directors of Australian listed public companies earlier this year.

This followed discussions with directors in various forums where practical questions about assessing tax risk were raised with me.

The emphasis on the concept of tax risk is important here.

In writing to Board Chairs I was not suggesting that directors need to be tax experts, scrutinising and deciding the fine details of our voluminous tax code.

Rather it is in their acknowledged leadership role that I have raised tax as a corporate governance issue for Boards.

To put it simply, managing corporate risk is an acknowledged corporate governance issue for Boards. As the figures I quoted earlier on audit collections attest to, tax compliance is a material risk issue for corporations.

It follows, in my view, that providing leadership in managing the tax compliance risk is an issue for Boards.

Managing the tax compliance risk requires leadership on the critical issue already mentioned as to where a corporation wishes to place itself on the tax risk spectrum.

It requires leadership in ensuring that a corporation has given appropriate attention to having the necessary systems and controls in place to ensure it meets its on-going tax obligations.

It also requires leadership in seeking advice and understanding the tax risk associated with major corporate transactions that by their nature come to the Board for decision.

It is not my intention to say to large businesses what tax position they should take or how much risk they should assume. My intention is to encourage companies to use their governance processes so they can make conscious decisions, understand their tax risks and manage them properly.

I believe that there is considerable advantage to large businesses and all those involved in the administration of their tax affairs, not just the Tax Office, in ensuring that large businesses make objective evaluations of their compliance risks, both in relation to their day to day operations, and as to whether the view they take on the tax aspects of a major transaction is likely to succeed.

Successful business people often talk of the importance of realistically considering the possible down side when assessing risk.

I have seen some press reports recently where taxpayers seem to have been taken by surprise by the decision of a court in favour of the Tax Office. I am not saying that we always get it right, but companies need to take into account the contrary view and realistically assess the possible downside. It is certainly something we strive to do.

Some Risk Areas Currently under Examination

As I explained in the publication “Large business and tax compliance we have been developing profiles of large businesses. This is something we have been building up over recent years.

A key aspect of that analysis is whether their tax performance is in line with the nature and extent of their activities, the expectations that their owners would have in terms of the returns on their investment, and the results that they are reporting to the market.

The analysis typically covers between three to five years of reported business results and involves comparisons with companies conducting similar activities. We use this analysis to identify cases we need to investigate.

We have found that we have a much better chance of identifying risks if we develop a picture of the whole corporate group and understand what roles the different entities perform within the group and how they deal with each other.

This “whole of client” approach has made a big difference to our effectiveness in identifying material tax risks. It has given us a much more reliable way of benchmarking groups that conduct a range of different business activities by comparing the different components with their industry peers.

It has also made it easier for us to see the extent to which the structure of the group and its method of operating, including its tax, treasury, accounting and risk management functions, are consistent with open market commercial dealings.

This in turn has made it much easier for us to identify the features and aspects that can only be explained by reference to the tax impacts they have.

I get the impression at times that some large corporates may be thinking that the Tax Office will not find the issues or, if we do, we will not be able to understand them.

I think those taxpayers should reassess that view in the light of the extensive coverage and strong results from our large business audit programs over the last five years, including our success in litigating some extremely complex cases involving big amounts of tax.

In the interests of openness I thought it might be useful to, if you like, “think out loud” about some of the issues we are currently examining and the questions they are raising for us.

Part of our efforts in recent years has been directed to recording the changes in group structures, activities and financing and understanding why they have occurred.

People will be aware of this aspect of our risk assessment work in relation to our oversight of major tax reform measures like consolidation and thin capitalisation.

You will be aware that we have been reviewing certain capital raising techniques that give rise to questions of substance and form and as to whether claimed interest deductions are available.

Some in-house financing arrangements are also raising questions for us.

Where we have some concerns is where the in-house financier does not operate on a commercial basis and there are questions about whether in the particular circumstances the lending is, in substance, an equity injection.

Somewhat related to that, we are examining whether certain in-house lending amounts to limited or non-recourse financing, with the consequence that there should be a statutory claw-back of depreciation deductions when bad debt claims are made.

We are also starting to see in-house finance companies being established to, on one view at least, strip earnings out of offshore projects by way of interest streams on loans made to those projects.

The concern we have is that these arrangements appear to be designed to use surplus foreign tax credits on the Australian side, beyond the range of credits that would normally be available when a group lends an amount as working capital to an offshore operation. The combined effect is that tax has not been paid on the income in either country.

These arrangements also seem designed to ensure that any losses which would be capital in nature are converted to revenue account through deductions for bad debts.

We are continuing our examination of these types of arrangements.

We are also finding tax risks in the weaknesses in the processes some taxpayers are using to manage their transfer pricing, their GST and in relation to asset registers and the calculation of depreciation claims. These are major aspects of many businesses.

We will work with taxpayers to develop streamlined approaches wherever practicable, but this is not a substitute for proper systems and processes.

Those systems and processes need to be able to be audited, both by the company itself and by the Tax Office, to ensure that they properly support the collection and recording of relevant information, that they enable the proper calculation of tax liabilities and do not produce material errors.

Where taxpayers have basic weaknesses in their systems we expect that those large businesses will take steps to make the necessary improvements so that both they and we can be reasonably confident that they are getting their tax right.

For our part we have agreed to work with taxpayers who want our assurance that their systems are adequate.

One hears from time to time that asset registers and the calculation of tax depreciation have not received much attention because the Tax Office has not been looking at that issue.

We have been saying publicly for a few years now that depreciation is a big number in the tax system and we are examining cases where it is a material issue in the context of the group’s activities.

Consolidation, the removal of accelerated depreciation and the increased emphasis on making sure that taxpayers are properly setting effective life for their assets have put asset management into sharper focus.

These reforms and the introduction of wider corporations law reforms are the opportunity for all parties to address this issue - and make sure the systems and processes that support the calculation of tax depreciation are working properly.

We have also been strengthening our ability to follow up issues as they are unfolding. There are several aspects to this. Media and market disclosures are important sources of intelligence on large businesses and we will follow up on matters that have tax implications.

We gather information about current issues as they are unfolding, particularly in relation to the latest trends

and products in the area of aggressive tax planning.

We have research areas monitoring stocks and flows of investment, income and cash, from the level of the national accounts right through to individual instances like the moneys flowing through tax havens.

We are actively monitoring tax payments as they become due and are following up any significant increases or decreases so we can be confident we understand how the economy is going and so we can identify any tax risks at the earliest point in time.

Our risk assessment approaches check the basic accounting for the business to ensure it stacks up.

We will seek explanations from those groups that have significant amounts invested in Australia, have extensive operations, and are seen to be successful in the market, but are reporting losses year after year.

We also check how the accounting information is adjusted for the purposes of calculating tax liabilities and lodging returns and activity statements.

We will examine timing and permanent differences that arise in the tax reconciliation process to ensure that the outcomes are consistent with the requirements of the tax laws.

I note that the market is paying much more attention to the tax aspects of corporate reporting and that in some cases external scrutineers are requiring companies to include higher provisions for tax to reflect the likelihood that more tax will be payable.

In other cases I see the market paying attention to whether or not companies fully franked their dividends.

Our risk assessment processes also check the calculation of tax used by large businesses. We need to satisfy ourselves that any credits, rebates and offsets claimed are properly available.

We are continuing to examine cases involving the purchase of dividend streams, even on a cash-flow-negative basis, in order to, in effect, substitute fully taxable income with rebateable income that significantly reduced the company’s tax.

We are linking up our approaches to audit work to make sure that we deal with all the tax issues that arise. For example, we are looking at GST issues in relation to income tax audits involving transfer pricing and cases where large corporates are reporting losses. GST will also be considered in corporate financing matters and where there are major asset sales. Non-resident withholding taxes are also being considered.

In my comments today I have largely focussed on the large corporate segment.

However tax and corporate governance issues are equally relevant to other corporations.

Other corporations, particularly those in the medium to large corporate segment can share the characteristics and risks of the large corporate sector.

There are however differences.

Privately held companies are more common in this segment so they raise particular issues associated with dealings between shareholders and their companies.

We have been strengthening our capacity to deal with compliance risks in the medium segment.

We have moved some key staff from our large business operations to bring to bear our experience in that segment.

Tax Office Responsibilities

In raising tax compliance as a corporate governance issue I need to ensure that our operations and approaches complement this as appropriate and that we apply the same rigour to their governance.

Access to Corporate Tax Risk Assessments

I am keen to facilitate better tax risk assessment by large businesses.

I appreciate that directors may not be tax experts and that they need to be able to confidently explore the tax aspects of major transactions and the adequacy of their compliance systems more generally.

We are also aware of the common practice of having some risk assessment work done by finance or audit committees within the group who report to the board of directors. To be effective these processes will need to be broad ranging, rigorous and candid.

Concerns have been expressed that my corporate governance initiative would be compromised if formal risk assessments prepared by corporations were to become the first resort of Tax Office audit teams.

We have had a number of workshops with business and tax practitioners to explore the issues involved to see if it would be possible to give corporations some space to conduct such reviews by treating the resulting reports as limited access documents. At the same time we need to ensure that the Tax Office can still obtain the essential information needed to ensure that the law is being properly applied.

I intend to shortly issue a Practice Statement but I thought I would use this occasion to outline our conclusions.

In the context of an audit the Tax Office is seeking to establish the facts of the case so that we can make an assessment of compliance and properly apply the law.

The verification needed will be primarily focussed on source documents that record and explain the relevant dealings and relate to the preparation of the documents lodged with the Tax Office or the calculation and payment of taxes.

Some of our enquiries relate to the systems and processes by which businesses conduct their affairs, in order to understand the context of the dealings being examined, to ensure that the company is following its own processes, and that the data used for tax purposes is correct.

There will be occasions, where the law includes a specific test, where we need to establish the purpose for which a transaction was undertaken or arrangements were put in place.

Weighing the various considerations we have reached the conclusion that there is a class of documents, which we call “corporate board documents on tax compliance risk”, which should, in all but exceptional circumstances, remain within the confidence of company directors and their advisors on tax compliance risk.

These are documents that:

(i) are created by advisors (being suitably qualified in-house or independent advisors);

(ii) for the sole purpose of providing advice or opinion to the board of directors (including properly constituted sub-committees) on tax risks and their likelihood and impact; and

(iii) address tax risks associated with major transactions and arrangements and/or tax risks arising from corporate systems and processes.

Access to corporate board documents on tax compliance risk will not be sought by the Tax Office during a risk review or an audit except in exceptional circumstances and the access will need to be approved by a Senior Executive Service officer at the Assistant Commissioner level.

We will put oversight arrangements in place, including external expertise, as an objective way of ensuring that the guidelines are properly applied.

“Exceptional circumstances” would include the following cases:

The taxpayer has not cooperated with the Tax Office to furnish full and complete information in a timely manner;

Information important to the risk review or audit, including evidence as to purpose in entering into or carrying out the transaction or arrangement, cannot be sufficiently established for the taxpayer’s source documents and other enquiries; or

The taxpayer has a history of serious non-compliance - for example, involving fraud or evasion or persistent avoidance of their obligations - or is under investigation in that regard.

Where taxpayers seek to rely on this concession they will have to supply the following details:

The date of the document.

The title of the document and a general description of its nature.

The name and role of the author/s.

The names and roles of the addressees to whom the document was circulated.

The reason why the document is categorised as a corporate board document on tax compliance risk.

The date/s the document was provided to a director or board of the company or of the holding company for the group or to a properly constituted sub-committee with relevant responsibility.

Where access is sought to a corporate board document on tax compliance risk consideration will be given to excluding access to material in the document to the extent it is advice or opinion that does not relate to the subject matter of the Tax Office risk review or audit.

Of course we will not seek to prevent taxpayers from providing such restricted access documents should they choose to do so, for example, to expedite matters. We will not be drawing an adverse inference should a taxpayer refuse to provide documents covered by the restricted access concession.

The guidelines will be kept under regular review to ensure they are achieving their intended purpose.

Quality and Timeliness of Tax Office Audits

While our audit activity has been expanding we have also been increasing the range of quality assurance processes, including peer review mechanisms and call-over processes. Twice a year we conduct a formal QA process on samples of audits, settlements and rulings completed in the large business market. That process includes external reviewers. The results have been extremely positive.

We also conduct a Professionalism Survey, managed by Colmar Brunton, where we ask the entire large business market to provide feedback on our performance across a range of different interactions (eg advice, field, client services). The survey is completed on an anonymous basis. The results show that our performance in the large business sector is reasonably strong and improving.

Large business taxpayers who have been the subject of an audit are asked to complete a Client Feedback Questionnaire at the end of the audit. Again, the results have been quite good. The analysis is done by a Client Relationship Management stream that is not connected with the conduct of active compliance.

The point is that we are serious about trying to continually improve the way we deal with large businesses and the results of these surveys and questionnaires are used for that purpose.

Notwithstanding the overall positive results, I have decided to complement these general surveys with more qualitative work to better understand where there might be legitimate concerns about the quality of our audits.

Mr Kevin Burges, a well known tax practitioner with extensive private practice experience, has agreed to undertake this project on our behalf. He will be conducting one-on-one interviews with taxpayers and making recommendations as to what improvements we can make.

Kevin’s independent status and the ability of taxpayers to provide information on a confidential basis should give taxpayers the confidence to raise any issues that may be troubling them.

I have taken a further initiative to build our capability to properly handle the complexity of large business cases and to continue to improve our completion rate.

For this purpose I have asked one of my Deputy Commissioners, Jim Killaly, to play a case leadership role over the next 12 months in managing the direction of our largest and most complex cases, including taking a hands-on role as appropriate.

In doing this Jim will form panels of senior people to work with him in reviewing major cases and determining lines of investigation to progress them, especially some of the older cases on hand.

I have asked Jim to specifically consider the extent to which approaches that have been successful in some contexts can be applied more broadly across the full range of our interactions with large business.

The GST system is moving to a new stage.

It has been four years since GST was introduced and we are now seeking greater assurance that in material respects the system is operating as intended. As we shift from the intensive education and assistance phase to different balance of service and enforcement it is timely to review our organisational approaches.

I have commissioned a high level review, which will be conducted by an external provider, to evaluate our internal capability and business processes to ensure we are identifying the key risks in the large business sector in a timely way, and that we are effectively managing them.

We will also look to apply the relevant findings of the review to our approaches for the small to medium enterprise sector.

This week we will be commencing a process to select the external provider.

Quality and Timeliness of Tax Office Rulings

I am also keen to ensure we are doing everything we can to support businesses with timely advice, should they want our view of how the law operates in their circumstances.

Experience has shown us that, from the perspectives of both taxpayers and the Tax Office, success in compliance assurance requires a range of strategies and programs. As part of my approach in “upping the ante a bit” in relation to corporate governance and tax compliance I want to be satisfied that we are doing all we can to support companies who want to do the right thing.

I might say, in passing, that the Tax Office is subject to considerable levels of scrutiny, both by taxpayers and practitioners and by regulators like the Auditor General, the Ombudsman and the Inspector General of Taxation. Parliamentary processes provide another layer.

One recent Australian National Audit Office review, published in August 2004, focussed on the administration of taxation rulings and whether we had implemented the recommendations of their previous review published in July 2001.

To quote from their report,

“The ANAO concluded that the ATO has fully implemented the 12 recommendations of [the previous report]. We noted that , since the previous audit, the ATO has also undertaken a number of initiatives to improve its ruling system. The main initiatives have included the following:

● improving the integrity and transparency of the processes surrounding the provision of

written binding advice; ● redeveloping information technology systems supporting the issuing of private binding

rulings; ● enhancing, monitoring and reporting of performance; consolidating procedural guidance to

staff through the implementation of an on-line resource manual; ● developing a comprehensive approach to setting internal taxation precedent; and

● introducing a Priority Technical Issues process, to support the management of strategic

risks.”

We were pleased to get this very positive report. However, I think there is potential to significantly improve our performance particularly in complex cases that transgress a range of significant tax issues. There are cases where we do an incredibly good job in turning around very complex requests for advice in very tight timeframes. However, we do frequently hear concerns expressed about delays.

All the various reasons for those delays are not well understood. I suspect that there is a mixture of process issues and behaviour aspects that we need to understand as they relate separately to taxpayers, advisers and the Tax Office - and how those elements relate to each other to produce the current level of performance.

In my press release on 10 August 2004 I signalled that we would be drawing on existing successful practices to develop new approaches aimed at raising our complex rulings performance generally, with a view to extending improvements to the private rulings system overall.

I am pleased to announce that Dr Andy Butlin from Amity Management Consulting has been selected to assist with the work of analysing the current performance and make recommendations to improve the process, taking into account the views of all stakeholders. Various workshops with practitioners, business people and professional bodies have been arranged and we are planning to have some concrete proposals by the end of October this year.

By way of summing up, there are important business advantages to be obtained from aligning tax compliance with good corporate governance. The improved risk assessment approaches we are adopting raise the financial stakes for businesses that have weak processes or want to avoid their responsibilities.

We are undertaking a range of improvement projects to address concerns raised by taxpayers in relation to the conduct of some audits and in relation to the rulings program that supports compliance and corporate governance.

We have been attuning ourselves to more rigorous governance processes within the Tax Office and I am taking deliberate steps to be transparent in setting standards for our performance so taxpayers can hold us to what we say we will do.

At the end of the day good governance is good business - for all of us.

Last Modified: Wednesday, 22 September 2004

Copyright

© Commonwealth of Australia 2004

This work is copyright. You may download, display, print and reproduce this material in unaltered form only (retaining this notice) for your personal, non-commercial use or use within your organisation. Apart from any use as permitted under the Copyright Act 1968, all other rights are reserved.

Requests for further authorisation should be directed to the Commonwealth Copyright Administration, Intellectual Property Branch, Department of Communications, Information Technology and the Arts, GPO Box 2154, Canberra ACT 2601 or posted at http://www.dcita.gov.au/cca.