UK: Triggering The Tax Advantage: Tax Tactics For The Global Financial Services Industry - Part Two

Last Updated: 18 March 2009
Article by Deloitte Financial Services Group

Most Read Contributor in UK, August 2017
This article is part of a series: Click Triggering The Tax Advantage: Tax Tactics For The Global Financial Services Industry - Part One for the previous article.

To read Part One of this article please click here

REGULATORY COMPLIANCE

How successful tax management and implementation of tax technology can stop deficiencies from sabotaging your Sarbanes-Oxley compliance, even with reduced tax resources.

Auditors attribute over 30% of all reported material control weaknesses to issues with tax accounting and year-end processes.

The Benefits Of Increased Regulation

It has been over six years since President George W. Bush signed the Sarbanes-Oxley Act, but only recently have organisations had the opportunity to step back and review both the costs and benefits of compliance. Despite widespread investment, the evidence suggests that companies continue to find it difficult to get their books right, with 40% of reported tax material weaknesses in the first quarter of 2008 being by repeat offenders.

Auditors are attributing over 30% of all reported material control weaknesses to tax, and this has unsurprisingly led to a greater emphasis on company accountability and concerns over potential SEC investigations. In response to this, CFOs and tax directors are having to react to increased stakeholder scrutiny of their tax numbers in the financial statements, as well as ensuring greater assurance over their internal processes and controls.

Many organisations, however, are reporting the benefits of this investment. Companies that have responded positively to the regulatory changes are realising the benefits of their investment. In the words of one of our clients, 'the visibility and communication of tax has increased across the wider finance community as a result of formalising the controls and processes over financial reporting and tax management during adoption of section 404.' It is our view that these organisations will be best placed to ensure continued regulatory compliance and effective tax management even where their tax resources are reduced as a consequence of the economic down-turn.

What Is The Matter With tax?

Failings in tax continue to relate to problems over accounting for tax – especially in relation to deferred tax. The filings that reported tax material weaknesses recorded deficiencies that included '...failing to record deferred tax balances according to FAS109 or FAS 52,' 'inefficient review of income tax provision calculations,' 'failures in adopting SFAS 123R' and 'lack of expertise to determine proper tax basis'. Other areas of weakness included those over-significant judgements and estimates where there was 'inadequate documentation and management review of tax exposure items'.

Process-related concerns included failures within the tax consolidation process, with 'inadequate processes of oversight and review,' 'inefficient review of income tax provision calculations and related deferred income taxes' and importantly 'ineffective or inadequate IT systems'. In general, these failures lacked policies, procedures, and resources needed to review complex, nonroutine or nonsystematic transactions.

Some financial services companies are considering the impact of these deficiencies as being a potential blessing in disguise and a real opportunity to identify and implement best practices in tax management and accounting, not just to comply with Sarbanes-Oxley, but to benefit from enhanced operating efficiencies and precision in tax management. This 'value-added' approach is best exploited with an integrated solution that includes improvement initiatives in three fundamental areas, namely, people, technology, and processes.

Let's look at these in turn.

People

People charged with calculating the tax provision should receive adequate training, especially in FAS 109 (Accounting for Income Taxes under U.S. GAAP) and FIN48 (Accounting for Uncertainty in Income Taxes). But which people in each jurisdiction are responsible? Sometimes, the answer is not so obvious. In fact, the 'right' people can be a controller's accountants, in-house tax personnel, or even external consultants.

The training can be delivered in a variety of ways – live and local (which means traveling to non-U.S. jurisdictions or bringing those people to the U.S.), Web-based, self-study, or some combination. But no matter how it is delivered, training will be more effective if local country preparers and reviewers are identified early in the process and contribute to choosing new technology or designing new processes as the institution undergoes a larger tax 'transformation'.

Technology: Standardising For Risk Management

Having been through Sarbanes-Oxley Section 404 cycles, many corporate tax departments are now seeing that their tax provision technology is antiquated, that linked spreadsheets do not contain enough controls, and that their current system is not flexible enough to allow non-U.S. preparers to compute properly the tax provision for their given jurisdiction. These problems lead to others, such as the creation of several tax provision calculation files, each customised to a specific jurisdiction. The subsequent lack of standardisation forces the tax department to struggle through the year-end consolidation, manually standardising items upon receipt of the customised jurisdiction-by-jurisdiction files.

Relatively new 'shrink-wrapped' tax provision software and custom-designed spreadsheet/database solutions are addressing these problems. For example, they can improve controls by including password protection, certification, and sign-off protocols. Some companies are choosing to enhance their homegrown technology, for example, by standardising temporary and permanent difference categories (including local tax calculation columns to handle all tax jurisdictions) and building out 'return to' provision worksheets or database tools.

This standardisation allows for an efficient and controlled worldwide tax provision consolidation, while keeping the technology flexible enough to handle the most difficult tax jurisdiction computation anomalies.

Tax Balance Sheet Approach

The need for an improvement in the quality and accuracy of data used in the determination of income tax provision calculations and associated tax balance sheet amounts has been a key lesson learned from reported tax deficiencies. An example of this is that many organisations have been asked by their auditors to undertake a thorough review of the differences between the income tax basis and the financial reporting basis of asset and liability opening balances. Such a validation of brought-forward balances has given greater assurance over a company's true opening position. Similarly, the adoption of a tax-basis balance sheet approach has enabled organisations to better track temporary differences and thereby provide more comfort over the completeness and accuracy of their deferred tax balances. This in turn has saved time and resource at year-end in substantiating figures, as well as providing a more robust audit trail.

Process: Getting Rid Of Bad Habits

There is also much to be done in resolving a variety of process-driven problems. Consider the 'bad habit' of misaligning currency conversion methodologies between the tax provision calculation and the company's financial systems. Typically, tax provision calculations are performed quarterly or annually in functional currency. The functional currency amounts are often translated to U.S. dollars using the average rate for the period in question. By contrast, tax expense may be recorded in a company's general ledger in functional currency on a monthly basis and translated to U.S. dollars using the average rate for the month. These two different methodologies, under certain circumstances, can produce materially different results. But without transformed processes and technology, the differences can go undetected.

Another example is the use of blended or effective tax rates to calculate current or deferred tax expense. Most homegrown systems include space for only one current and deferred tax rate.

This single tax rate often is applied to both the current taxable income (to compute the current tax provision) and to gross temporary differences (to arrive at the deferred provision). In this case, the limitations in the technology drive a poor process. When there are graduated rates or separate rates for ordinary income versus capital gains in a given jurisdiction, preparers are left to compute those amounts offline and enter the blended rate into the tax provision package. This single tax-rate approach ignores the fact that a separate assessment needs to be made for each gross temporary difference, based on the enacted tax rate for the period in which each temporary difference is expected to reverse. Often, little attention is paid to the enacted tax rate requirement until new software is installed that requests a separate tax rate for each gross temporary difference.

The First Step Is The Biggest

Clearly, the 'transformation' required of tax accounting elevates the issue to senior management's attention – which is just where it belongs. Sarbanes-Oxley tightens the connection between a company's financial statements and effective oversight. The SEC has made one thing clear: the CEO and CFO have to be close to the tax numbers; confident that those numbers are accurate and reliable; secure in the knowledge that those numbers are determined by people with the right skills, using the most appropriate technology, and working within efficient and effective processes.

Sarbanes-Oxley has brought tax accounting out in the open; now, it is up to the company's leadership to make sure it can withstand scrutiny in today's new environment. Forward looking organisations that are aiming to respond to this new environment are building on their investment in regulatory compliance by setting up overarching systems that benefit multiple tax processes. The first step on this journey is often the formalisation of a tax strategy or key tax objectives around how they would like their function to operate. These objectives cover all aspects of the management of tax, and often focus on tax accounting and reporting. Examples include:

  • reducing the resources spent on compliance by 20% by 2010;
  • focusing more resources on tax-effective business planning;
  • delivering an improved level of standardisation and consistency across all tax activities;
  • cutting the tax financial close process by one week.

These objectives would sit well within the wider finance function, and this is representative of how many tax functions are placing themselves within the wider business's strategic plan.

Key Features Of A Tax Technology Platform

Financial services companies seeking to fulfill their objectives of a world-class technology platform for their tax provision processes would be wise to consider the following features and functions:

  • Tax reconciliation schedules that track payments by month and year.
  • Automation to reduce the risk of human error and increase efficiency in these activities: rollover of data from period-to-period; calculating of book-to-tax differences based on programming rules; download of separate company and consolidating of book financial information; and posting and tracking of late adjustments 'top side' in the consolidation process.
  • Use of multiple tax rates to calculate current tax to account for special tax regimes (e.g., when capital gains are taxed at a rate different from that for ordinary income); application of different tax rates to each gross temporary difference to account for phased-in tax-rate changes and tax holidays (including the ability to schedule out reversals and set tax rates by year).
  • Flexibility to handle purchase accounting, including the ability to reverse valuation allowances against goodwill rather than tax expense.
  • Sophisticated currency conversion algorithms that align with the conversion methodology used in the financial consolidation process.

Next Steps

Optimised tax management requires fully integrated tax solutions. Progressive organisations are reaching this goal by seeking to align their tax and financial systems to provide standardised tax processes on a group-wide level. This can be achieved by use of global data warehouses, tax 'dashboards' for at-a-glance progress reports and enhanced data analysis for tax planning. For many companies, particularly those most heavily impacted by the current economic climate, achieving this is still an aspiration. For them, the journey to a fully-optimised tax reporting process may begin with smaller steps. To move tax forward, these organisations should decide where tax wants to be in the future. Understanding their current position and creating a set of key objectives to add value to their tax function is a step in the right direction.

HUMAN RESOURCES

Why international assignments are key to retaining your top performers.

In today's volatile labour markets, global financial institutions are being challenged to find replacements for next generation talent. One key motivator for this new generation is the opportunity to travel and work abroad. However careful tax planning is critical to helping ensure this attractive benefit does not become an unexpected financial burden for your top performers.

Deloitte Research on offshoring in the financial services industry revealed that the majority of institutions suffer from 'offshoring fatigue' after three years in operations. The report suggests that performance begins to fade as the first wave of managers return home from assignment. As a result, many institutions are searching urgently for effective ways to encourage their best young managers to undertake international assignments and to support them abroad. To meet this challenge, financial services leaders should understand that this fatigue is a manifestation of a larger issue that all companies face – the looming talent crisis caused by seismic changes in the demographics at home and abroad which means that global businesses face a huge management talent gap, one which has already begun to take its toll.

This occurs at a time when relentless margin pressure and intense competition are forcing financial services companies to offshore more of their operations. As a result, offshoring fatigue could soon change from a pressing problem to a critical one. The situation is complicated by the fact that countries such as China and India, which provide management and offshore talent pools which could fill the gap, are themselves facing talent gaps as they experience rapid economic growth. Some overseas companies are now actively luring their expatriates working back to their home countries.

In sum, financial institutions that want to cure offshoring fatigue must move young talent into the management ranks much more quickly and pay close attention to their needs and desires. This needs to be achieved with a new generation of executives focused more on achieving a work/life balance with greater emphasis on out of work satisfaction than at any time previously.

Within this context, the changing expectations of today's graduates need to be recognized. The days when building a career came first and building a family was second, are disappearing. The new generation are different from this in several ways. First, members of this generation tend to be much more family-oriented than their parents and more concerned about keeping work, family and friends in balance. In fact, for many of them, friends, and family override their devotion to work.

In addition, they are less willing than baby-boomers to devote themselves early in their careers to a single specialisation. Instead, they are more interested in developing a portfolio of experience – moving from IT to auditing to human resource management, for example. While such rapid changes can be frustrating to companies that invest in training, managing these career aspirations is key to retaining and developing the new generation. With the current focus on short-term cost reduction in the light of the credit crunch, there is a risk that organisations lose sight of the longer term strategic imperatives and developing underlying problems.

If this happens, problems with the development of executive talent and experience will grow to become a potential crisis when the economic cycle has turned and the balance has shifted back to talent shortages.

What do these characteristics mean for financial institutions that want to encourage the best young executives to manage an offshore operation? Clearly, financial institutions must find ways to manage a delicate balancing act – creating programs that satisfy young managers' desires for variety in their careers, while still making it possible for them to keep work and life in balance. One solution is for financial services firms to use long-term rotational assignments. That is, companies give young managers a series of 18-month overseas assignments, each in a different country, interspersed with year-and-a-half assignments in their home country.

A young executive might start with a year-and-half in China, come back for 18 months, and then go to Switzerland. This approach allows the managers to experience a variety of work experiences without being away from home so long that ties to family and friends are undermined. Such long term rotational assignments can supplant the practices of many companies in which managers are assigned to a single country for between three and five years, then bring them back home for just six months before the next lengthy international assignment. Another possible solution is even shorter term assignments – six months or less. Short-term assignments allow young managers to keep their ties to family and friends strong, while exposing them to a wide range of experiences. Although a growing number of companies are taking this approach, a number of issues – including the tax implications for the company and the individual manager – should be taken into account.

Finally, in recent years, many financial services institutions have tried to stay competitive by focusing on cost containment through their HR policies in general and their approach to international assignments in particular. This is becoming more marked as financial institutions respond to the drastic economic implications of the financial and market turmoil seen over the last six months and expected to continue. Despite this, institutions with a longer-term view may well need to consider increasing spending on rewards and compensation while developing innovative policies that give young executives the flexibility and balance they seek.

In this way, financial institutions should be able to bridge the gap, while performing the delicate balancing act that will help them quickly develop strong performers into the next wave of managers.

Leveraging Short-Term Assignments While Minimising Overseas Tax Liability

Sending employees on short-term travel to other countries instead of relying on traditional long-term expatriate assignments can create complications, not the least of which can be huge tax penalties.

Until now, many corporate professionals relied heavily on what is known as the '183-day rule,' believing that as long as an employee spends fewer than 183 days in a foreign country, their earned income is not taxable in that jurisdiction. However, in countries with no applicable tax treaty, expatriates may become subject to taxation immediately upon performing services. Even when a treaty does apply, there still could be corporate tax and reputational risk exposure.

To minimise overseas tax liabilities, employers should confirm not only at what point an individual's income tax obligations begin, but also whether any particular visa types could lead to a reduced rate of, or exemption from, taxation.

For treaty countries, this information and corresponding limitations are found in their respective treaties. Analysing the tax situation on non-treaty combinations can be more complicated. Employers should explore whether employees may be able to utilise a preferential tax status and make sure that each compensation item is being delivered in the most tax-efficient manner.

In practice, the main challenge employers face in managing their business travellers is often simply identifying them. It is critical therefore, for companies to establish a process for tracking their short-term business travellers and to ingrain compliance into the organisation's culture.

The bottom line is that before embarking on a short-term travel strategy, a company should assess the many hidden costs that may be involved. The internal HR and accounting departments, as well as external immigration and tax providers, should be involved. Only then can the organisation determine if the savings are worth the administrative baggage.

INTEGRATING TAX IN IFRS

The time is right to take the next step.

Now that many financial institutions have had a few years' experience of applying IFRS, it is time to revisit a tough, strategically important question: What are the long-term impacts of tax reporting under IFRS?

Certainly, a lot has changed for global companies following IFRS in their published financial statements of performance. And more change is coming, as the International Accounting Standards Board (IASB) and U.S. Financial Accounting Standards Board continue to align their standards or at least narrow their differences. Some U.S. groups are also looking at adopting IFRS as their primary reporting method.

While companies have put all their energy into complying with the new reporting requirements, at most financial institutions management is still coming to terms with the fundamental tax consequences of IFRS.

Tax Accounting

The principal impact is in the area of deferred tax. As part of preparing financial statements under IFRS, companies have had to consider the tax effect of book adjustments (to financial instruments, pension costs, and stock-option costs) arising from changes in accounting policies. In addition, they've needed to identify ways that the accounting policy itself has changed. Executives have had to ask themselves, such questions as: When must deferred tax be provided? When is it appropriate to recognise deferred tax assets? What exceptions are allowed? In turn, book adjustments have raised a big question: Can potentially large deferred tax assets – for example, pensions, fair value adjustments, or impairments – be recognised?

Under IFRS there are generally fewer exceptions from deferred tax accounting. Extra provision is needed for tax on revaluations, tax on profits made offshore which cannot demonstrably be retained there, and tax on temporary differences arising in business combinations. The result has been potentially significant increases in deferred tax provisions, with potential impact on a financial institution's regulatory capital requirements and its ability to pay dividends.

Further complexities arise in tax reporting: When can assets and liabilities be offset? When does tax need to be reported in equity rather than the income statement? What disclosures are required e.g., expiry of deferred tax assets?

By now, companies have realised that there are fewer ways to reduce the reported tax rate, other than by permanently reducing the cash taxes payable. Deferral doesn't work; strategies, such as retaining profits offshore or deferring capital gains may save cash tax, but would require further tax planning also to reduce the rate. Also, many benefits to the tax charge previously enjoyed under many domestic GAAPs – such as tax relief for tax-deductible equity or employee share-option gains – are no longer available.

Cash Tax Liabilities

The impact of IFRS on cash tax liabilities depends on two considerations:

  1. The extent to which IFRS is implemented at a solo company, as well as at a consolidated level (since in most jurisdictions tax liabilities are usually computed by reference to solo company numbers). The main focus for IFRS (like U.S. GAAP) is reporting to the capital markets, where consolidated numbers are of the greatest interest. The adoption of IFRS globally has been fuelled by the EU requirement that companies issuing shares or securities in the EU must report under IFRS – a consolidated requirement. Yet, many countries have either allowed or mandated similar reporting at solo-company level. Moreover, many national GAAPs are evolving toward harmony with IFRS. When companies have a choice, they are sometimes adopting IFRS (or an IFRS-harmonized version of GAAP) to avoid the need for multiple internal accounting systems.
  2. The extent to which the calculation of taxable profit follows GAAP in each jurisdiction. There is a wide range of national practices as regards how closely tax follows accounts, but in many countries there is at least a strong influence in accounting practice on computation of taxable profit, at least over many areas of business taxation.

By far the most experience with the issues raised here can be found in the U.K.. While the U.K. has allowed companies a choice of IFRS or U.K. GAAP for solo company accounts, the two are being harmonized relatively quickly. And the U.K. explicitly recognises, for tax purposes, the validity of GAAP across many aspects of the tax computation, most particularly in the area of debt and derivatives.

If tax follows accounting, this leads to volatility of cash tax. In the U.K., this has been exacerbated by a tax rule which recognizes reserve movements (or amounts 'taken to equity') as components of taxable profits. To mitigate this, the U.K. has given corporations the choice of following what is essentially a 'tax GAAP' in respect of most hedging arrangements (recreating, for tax purposes, the old, pre-IFRS, U.K. GAAP accruals basis) or of following the new accounting. The choice is essentially between additional compliance (the burden of, in effect, two accounting systems) or cash tax volatility. Similar issues have arisen in other areas, including embedded derivatives (where complex tax rules overlay the already difficult accounting); functional currency (where more prescriptive rules threaten to affect tax-hedged results); and non-regular amortization of goodwill and recognition of a wider range of intangibles under IFRS. An entirely new tax regime has been introduced for securitisation vehicle companies, where the tightly matched cashflows depend on matching tax treatment. Other problems – less relevant in the U.K., but potentially important in other countries – touch upon property revaluations, pension liabilities, and share remuneration.

The harmonisation of accounting standards achieved with IFRS has also inspired the European Commission to propose a 'Common Consolidated Corporate Tax Base' throughout the EU. Although still subject to political discussion, it seems likely to be adopted in some form in due course, giving multinationals a choice of a harmonised, partially IFRS-inspired tax system (with maybe fewer planning possibilities but lower compliance costs) across several European jurisdictions.

Looking Forward

As financial institutions anticipate reporting their performance for 2008 and beyond, it is time to start putting taxes in the picture. Here are three areas ripe with opportunity to achieve a tax advantage:

Compliance And Systems

Having proven that team work can meet the demands of financial reporting (including disclosures) under IFRS, why not create teams to find ways of improving the data collection and calculations by automating, as far as practical, the tax reporting process? This is even more important now that companies have to do business in the Sarbanes-Oxley world of high standards of corporate governance and internal controls.

Automation can help in many ways, such as tracking and calculating tax on share options, revaluations, derivatives, and profits retained offshore. In addition, as noted above, each jurisdiction will have its own book/tax differences, depending on the GAAP used and specific tax rules in that territory; the right systems can reconcile these books, as well as ensuring that tax is correctly booked to income statements or equity. At the same time, transfer pricing documentation can be reviewed and updated.

Tax Forecasting And Effective Tax Rate Management

To forecast taxes payable and reported tax charges – and to deliver meaningful data in real time – requires an investment in systems (or headcount) above and beyond simple business tools and structures. The new tax accounting rules, combined with the impact of cash tax rules in different jurisdictions and the need for robust forecasts by territory, make inevitable a new and better way of 'crunching' numbers.

Because of limited exceptions to recognising deferred tax, it will generally be much harder to achieve a lower effective tax rate under IFRS. Here, new key performance indicators can help. Companies need to focus on their effective tax rate to get a clear understanding of posttax profits and, hence, regulatory capital and earnings per share.

M&A

The greater transparency and comparability arising from the wide use of IFRS is expected to fuel further M&A activity once the impact of the 'credit crunch' is assimilated. Not surprisingly, new accounting issues will come along; for example, due diligence will have to take into account the way the target has applied IFRS and calculated its cash taxes payable, and the buyer will have to recognise tax liabilities on acquisitions not readily apparent (e.g., on intangibles).

The bottom line is: now, if not before, the time is right to integrate IFRS and tax into a coordinated approach to financial reporting and management.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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This article is part of a series: Click Triggering The Tax Advantage: Tax Tactics For The Global Financial Services Industry - Part One for the previous article.
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If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.