Tax risk management through the lens of tax controversy

What are tax risks?

Everyone has to pay taxes. Companies book tax provisions every year. Tax risk, however, is a multifaceted concept that extends beyond the simple obligation of paying taxes. First and foremost, tax risks are the financial losses due to unexpected tax payments. Additionally, tax risks also include missed opportunities for tax benefits, reputational risks, compliance risks and, last but not least, personal liability risks for senior management.

One of the primary financial risks is the potential for unexpected tax liabilities that exceed tax provisions. These can arise for various reasons ranging from clerical mistakes over errors in tax calculations, changes in tax laws or unfavorable tax audits. Such unexpected payments can significantly impact a company's net income and cash flow. Failure to comply with tax regulations can also result in penalties, fines and interest charges. For instance, if a Luxembourg company does not file its tax returns on time, it may be subject to estimated taxation, which often includes a mark-up and can significantly exceed the real tax liability.

Companies also run the risk of missing out on tax credits, tax exemptions, tax reliefs or reduced tax rates. To proactively manage the risk of missed tax opportunities companies should carry out regular health checks and update their tax position with regard to changes in legislation, case-law and new administrative guidance.

On top of the financial risk, it is often the reputational risk that will concern taxpayers. Taxes are seen by the public as a company´s contribution to society. Negative publicity regarding tax practices could lead to public pressure and damage relationships with various stakeholders, including customers and shareholders. It could result in investigations by tax authorities and regulators. Therefore, investors factor taxes into their considerations when assessing the sustainability reporting of a company. Poor tax practices can adversely affect a company's corporate social responsibility profile. Typically, it would be the Chief Financial Officer (CFO) who is ultimately responsible for taxes. The tax function needs to manage these risks in order to protect the CFO and the senior management from personal liability risks, and the company from financial and reputational risks.

Tax compliance remains a key area of risk: If companies fail to prepare and file tax returns, reports and information in a timely, accurate and complete manner, compliance risks manifest themselves in additional tax payments, penalties, fines and interest charges. Incomplete or inaccurate documentation can trigger tax audits, leading to further scrutiny and potential disputes with tax authorities. For corporate income tax, business tax and wealth tax, these tax audits may be carried out in Luxembourg over a period of 10 years after the end of the tax year, if returns were incomplete or inaccurate. Building on the preliminary works of the OECD, many countries encourage companies to set up internal controls to assure the accuracy and completeness of tax returns, for example, the tax compliance management systems in Germany and the tax control frameworks in the Netherlands and the UK.

The tax function should also be aware that there could be blind spots in the tax operations. Too often, the main cause of errors is a lack of communication between the tax and other departments. For example, decisions made by the procurement or marketing departments without considering tax implications can result in compliance issues. At best, tax risk management should be proactive and start much earlier in the process: when fund managers make a new investment, when Research and Development (R&D) works on a new product, when treasury signs a debt waiver of a shareholder loan, when the legal department drafts new terms and conditions, when human resources introduce teleworking, etc. It is a misconception to think that tax risks only originate in the tax or finance department. The technical interpretation of tax laws is seldom a source of tax risk in itself. Tax risks arise throughout the organisation and can be triggered by changes in internal factors (such as changes in business models, an overhaul of IT systems, acquisitions/disposals of businesses, significant reorganisations) or external factors (such as changes in legislation or accounting standards). The tax function should be strategically involved and integrated into other business operations and should ensure that potential tax risks are considered at the earliest stages of decision-making.

How to manage tax risks?

In general, tax risk management can be broken down into identifying, assessing, answering and communicating tax risks.

To identify tax risks, the first step is to register and track the inherent and anticipated risks in the tax risk scorecard. As explained above, the different components of tax risks are financial risks, missed opportunities, reputational risks, compliance risks, the risk of blind spots in the tax process and personal liability risks for senior management. Depending on the company's business environment, the risk factor of political changes (e.g., upcoming elections, armed conflicts, trade wars) may be included.

To assess tax risks, the potential likelihood and the financial impact are rated on a scale and displayed in the scorecard. This allows very high tax risks to be prioritised. Lower risks can be accepted as not all risks can be addressed due to time and resource constraints.

In a third step and in response to identified and assessed tax risk, appropriate actions should be agreed to mitigate, allocate, control and monitor risks. The tax risk scorecard should therefore include a list of potential action items with tasks and responsibilities. For this purpose, a Responsible, Accountable, Consulted, and Informed (RACI) matrix is a useful tool used to define roles and responsibilities into four participatory types which are then assigned for the duration of a project or process. Risk mitigation may involve disclosing risks to the tax authorities (e.g., by filing amended returns). Tax risks may also be allocated and shifted to counterparties by including tax clauses in legal documentation. The risk of personal liability may be covered to some extent by Directors and Officers (D&O) insurance. If restructuring is not feasible, uncertain tax positions could be covered by tax opinions from advisors in a defence file. A residual tax risk remains if neither the likelihood of occurrence nor the potential impact can be reduced to an acceptable level.

In practice, scorecards have proven to be an effective technique for the management of tax risks. Tax risk scorecards help the tax function to measure, track and communicate tax risk. This widely accepted technique makes tax risks more accessible and visible to non-tax professionals (i.e., virtually everyone outside the tax department). It can help to further integrate the tax function into the wider organisation, where most tax risks are likely to be located.

Scorecards also improve the reporting of tax issues to senior management, especially when being used as an executive summary of tax risks for a single entity, a portfolio of investments or group of companies.

Tax functions are faced not only with changes in tax legislation, but also with personnel changes in the tax department. If tax risks are properly documented and tracked in a scorecard, it will help with the onboarding of new personnel and avoid knowledge gaps. Embedding tax risk scorecards into the handover process allows for a fresh start and a clear cut, so that new team members do not have to take responsibility for the legacy issues of outgoing personnel.

This will be equally important for new managers and directors who are about to take a seat on the board or for liquidators who will be appointed to wind up a business. Both should have a particular interest in identifying and documenting tax risks created during their predecessors' tenure.

A well-designed tax risk scorecard will finally prepare companies for due diligence processes by potential investors or buyers and for audits by tax authorities.

How to enhance tax risk management with insights from tax controversy experts?

Every time a company is involved in a large commercial transaction, the working assumption should be that the transaction will be audited by tax authorities in the future and may potentially end up in court proceedings.

Here, tax controversy experts can draw on their lessons learned from past disputes to help companies avoid similar pitfalls. By analysing recent tax disputes of other taxpayers, they can identify common issues and develop strategies to mitigate these common risks for companies. This forward-looking view with dispute lens allows the tax function to be more prepared for future challenges.

For example, experience from many tax disputes shows that cases are often won based on the strength of the evidence. Tax controversy experts can guide companies in maintaining comprehensive records of business decisions, contracts, email correspondence and board minutes. For instance, documenting the commercial reasons for transactions can help counter claims of wholly artificial arrangements by foreign tax authorities. Or, documenting the fact that Luxembourg board members were involved in the finding and making of decisions and that these were actually taken in Luxembourg can refute the accusation of foreign authorities that the place of effective management is elsewhere. By understanding current audit trends and what type of documentation tax authorities are likely to require when reviewing a case, tax controversy experts can help companies prepare their case for future disputes and be audit ready.

In addition, regular analysis of recent court decisions in tax matters can provide practical examples of how tax disputes have been resolved. Often, court decisions clarify ambiguities in tax legislation, set new legal standards and highlight the positions of tax authorities on various issues. By closely monitoring and analysing these decisions, companies can gain insights into how similar cases might be treated in the future, allowing them to adjust their tax practices accordingly. Companies can use this information to pinpoint similar risk areas within their own operations and take preemptive measures to address them, enhance documentation practices and make informed strategic decisions.

Beyond this specific case management, tax controversy experts are well-placed to develop processes that allow companies to stay ahead of potential tax risks. For that purpose, tax risk scorecards should be developed and updated to register and track inherent and anticipated risks. Leveraging on their experience from handling past disputes and on their knowledge of the latest court decisions, tax controversy experts can accurately rate the potential likelihood and financial impact of these risks. It will allow companies to prioritise high-risk areas and allocate resources accordingly.