Global: The dynamic global tax audit and controversy environment

David Swenson PwC

Like a pilot navigating an aircraft through turbulent weather, multinational companies must manage the immediate problems ahead, as well as adopt proactive steps for challenges on the horizon. Dynamic environments demand proactive thinking. The constantly changing global tax controversy environment is no exception. What's making it so dynamic? There is a convergence of various factors causing an uncertain and unsettled climate for taxpayers and revenue authorities alike. Although change can sometimes have a positive or simplifying effect, these factors are instead creating a global tax controversy environment that is the most challenging in recent history for taxpayers and other stakeholders.

With fiscal deficits at record high levels worldwide, tax authorities are on the hunt for revenues. As a result, the volume of tax audits and disputes is rising worldwide in both developed and emerging countries, creating an uncertain landscape for taxpayers. Some multinational companies have experienced a large number of audits worldwide, exponentially increasing the need for innovative and proactive management. But it's not only the volume of tax audits that is increasing. Tax authorities around the world are aggressively pursuing compliance actions and enforcement initiatives. In particular, they have become more aggressive in the corporate tax arena, leading to significant assessments in virtually all areas of tax including direct and indirect tax. As a result, international tax audits can be disruptive and complex, while corresponding enforcement actions can be harsh and expensive to manage.

Tax authorities around the world are increasingly sharing taxpayer information using a multitude of avenues. In addition to bilateral tax treaties and exchange of information provisions, multilateral channels exist including the OECD Global Forum on Transparency and Exchange of Information for Tax Purposes, as well as the Convention on Mutual Assistance. Tax administrations are using the OECD Aggressive Tax Planning Directory and the Joint International Tax Shelter Information Centre (JITSIC) to share and cooperate in an effort to limit what they perceive as abusive tax avoidance transactions. In various countries, such as Australia, these channels have directly led to successful collection efforts, and, as a result, tax authorities seek to expand available avenues of cooperation.

Collaboration between revenue authorities has evolved into more sophisticated methods and strategies. One of the recent emerging trends is the pursuit of joint audits which involves full scale coordination at the exam level between two or more countries. Joint audits represent a new era of coordinated action. They occur where a taxpayer is subject to a single coordinated audit by two or more jurisdictions and stand in contrast to a more traditional audit where the same company or transaction is subject to a single country audit (or separate country audits). Joint audits have been touted by countries for various reasons, including the potential for decreasing the overall process time of the audit and dispute resolution process. Notwithstanding these efforts, based on a variety of concerns, certain tax authorities are not willing to embrace this new tool as a cornerstone approach.

Governments and tax authorities are keenly focused on greater disclosure and transparency from taxpayers. Countries see the opportunity and need to demand information that will enable them to improve revenue collection and deter tax avoidance. In the US, the tax authorities have placed a greater emphasis on the identification, evaluation, and disclosure of uncertain tax positions (UTPs). In addition, FATCA (Foreign Account Tax Compliance Act) enacted in the US mandates disclosure of both individual and corporate foreign assets and account information. The challenges of FATCA enforcement are substantial and its requirements are demanding and controversial. Nevertheless, other countries, such as China, continue to mandate surveys in which taxpayers must disclose information about certain financial and tax indicators, including balance sheet items. Still others, such as Canada, have instituted new or enhanced reporting by taxpayers with a focus on transactions and structures associated with aggressive tax planning.

The increased pace of audits and controversies has been heightened by fiscal budgetary demands placed on governments to raise revenue and prevent base erosion. Nations are being forced to pursue revenue enhancing initiatives and enforcement activities to meet these increasing fiscal pressures. Tax authorities are challenged to pursue revenue in a more efficient manner given potentially dwindling government resources. In short, the question is how can tax authorities do more with less? The UK has promoted a policy of open and upfront engagement around issues as they arise. The tax authorities expect real-time dialogue about tax positions to identify risks early, enabling greater resource efficiency. Other countries are considering similar approaches involving enhanced relationships.

Certain countries are also beginning to pursue streamlined audit programs with the goal of fostering transparency and cooperative relationships with taxpayers. Generally, a streamlined audit procedure involves an agreement to limit the scope of the audit, such as a time limit or specific years that are examined, usually with the goal of bringing audits as current as possible. The Netherlands, Korea, and Switzerland have adopted real-time horizontal monitoring type programs and procedures. Other countries such as Slovenia and South Africa are pursuing similar approaches. The US now has a permanent program – the compliance assurance process (CAP) – which requires extensive cooperation and transparency from participating corporate taxpayers. The advantages to governments participating in these approaches are obvious, and the ability to reduce risk and financial statement effects are appealing for corporate participants as well.

Many countries are also reviewing their audit processes and shifting toward more advanced approaches, including risk-based assessments to determine which entities to audit. The Canadian tax authorities, for example, are calling for an annual risk determination for certain taxpayers that will be a core element in determining the scope and time for the taxpayer's audit. The US has also revamped its audit approach by de-emphasising the size of the taxpayer as a primary determinant of risk and is using other indicia to target audit activities.

Aggressive audit enforcement activities and tactics are accelerating worldwide. As an example, in the US, the IRS is engaging in intensive factual investigations, foreign site visits, and extensive interviews of company personnel in the US and abroad. The IRS is also revisiting historic agreed positions with taxpayers, increasing their use of outside experts, requesting voluminous documentation, and issuing various pattern information document requests. This increased aggressiveness by tax authorities is also evidenced by use of criminal enforcement sanctions against more high profile established taxpayers. Countries such as Germany, South Korea, and Spain are demonstrating this trend.

This increased audit activity may also involve tax auditors taking positions that may not be consistent with historical international tax norms. A now well-known example is the Vodafone case in India. The unprecedented position argued by the tax authorities in that case has been viewed as out of step with traditional international tax principles, highlighting the unpredictable nature of India's tax policy. Another divergent occurrence has been the imposition of retroactive legislation on taxpayers – broadly viewed as unfair and against accepted traditional tax principles.

Transfer pricing audits and controversies have become the largest and most contentious tax disputes in the world and will remain so for the foreseeable future. This result is not surprising given the rapid rise of multinational trade, the opening of significant emerging economies around the globe, and the need by tax authorities to protect their revenue base. Many nations, such as Russia, have enacted new transfer pricing rules, while countries such as Brazil have introduced changes to their existing rules. Revenue authorities are also increasingly examining transfer pricing transactions and documentation, and they are asserting sizeable adjustments and reassessments in numerous countries.

The surge in audits and disputes is placing a significant strain on traditional methods of resolving controversies. The use of competent authority (CA) procedures under bilateral treaty mutual agreement procedures (MAP) serves as one of the primary methods for resolving tax disputes between different jurisdictions. This provision allows CAs of the treaty governments to interact and use their best endeavours to resolve tax controversies and disputes. The inventory of MAP cases, however, is at a record high worldwide, placing serious pressure on the system. The general length of time to resolve a transfer pricing dispute using the CA process can involve many years and taxpayers and governments alike generally believe the process is too lengthy.

Other dispute resolution strategies vary by country, including administrative appeals, mediation, advance pricing agreements (APAs), arbitration, and litigation. With respect to APAs, several countries, such as India and Hong Kong, have recently adopted APA programs. Submissions to obtain an APA are also at record highs in many countries. In the US, the number of APA submissions has been increasing over recent years, although in 2011 this number dropped below previous levels likely due to the fact that the completion rates have been at historic lows. Not surprisingly, pending APA cases in the US dramatically increased in 2011 as the completion rates slowed.

Recently, new dispute resolution methods have emerged, such as the inclusion of mandatory arbitration provisions in a limited number of bilateral income tax treaties. Unlike CA provisions that do not require the parties to reach agreement, new mandatory arbitration clauses, under certain circumstances, compel a resolution process that is binding on both governments. The inclusion of these mandatory arbitration clauses in US income tax treaties is a relatively new occurrence. Once initiated, the arbitration procedures may enable the resolution of cross-border disputes in a more rapid timeframe than the traditional CA process. In addition, this new approach may also prompt governments to more quickly resolve pending CA cases in an effort to ensure they are not subject to this new approach.

Curbing aggressive tax planning is also a focus of governments worldwide. So-called general anti-avoidance rules (GAARs) are generally recognised as having a goal of targeting tax avoidance transactions. Although there is no widespread system of GAARs and no uniform GAAR model, more countries are focused on GAARs as a tool for targeting tax avoidance transactions. Many countries, such as Germany and China, have more recently enacted a GAAR. Still others, such as Australia and Canada, have had GAAR type legislation in their statutes for 20 to 30 years. The UK, on the other hand, has been reviewing the details of how a GAAR can be implemented to efficiently target artificial and abusive arrangements while still allowing taxpayers sufficient certainty to engage in legitimate tax planning.

A leading practice in certain jurisdictions is to provide a set of alternative dispute resolution options to taxpayers so they can challenge, if necessary, the findings of the government and resolve the issues at the administrative level. These options are best conducted with a view to early resolution of the dispute in an open and cooperative way. In several territories, an independent appeals process is a key alternative for achieving these goals. Surprisingly, not all economies have an independent and efficient appeals process for tax assessments, and efforts are underway in certain countries to develop such processes.

Revenue authorities and taxpayers face a challenging and complex tax audit and enforcement environment. The factors converging on a global basis are creating significant uncertainty for all stakeholders. Balancing the need to address the immediate issues and simultaneously adopt proactive steps to reduce disputes and costs can be challenging. However, both taxpayers and revenue authorities alike can achieve benefits from affirmative actions and a thorough understanding of these converging factors can help guide the implementation. What are examples of this proactive mindset?

Both taxpayers and revenue authorities should consider identifying risks early in the process and understand how this may reduce financial burdens and provide greater certainty for the future. Some revenue authorities are already embedding the concept of pursuing real-time engagement with taxpayers into their audit processes. The streamlined audit processes, such as horizontal monitoring and CAP described above, are excellent examples of this trend, allowing tax authorities to better gauge upfront what resources are needed.

So how can taxpayers identify these risks upfront? An efficient first step may involve a strategic risk assessment designed to identify possible weaknesses, gaps, and inconsistencies in the company's tax audit defense strategies and document requirements. A common starting point is to identify the primary markets most important to the business going forward. What are the key audit issues in these countries? Multinational companies are also under pressure to continually evaluate and potentially restructure their worldwide business operations to achieve competitive advantages. These planning endeavours should be coupled with a comprehensive assessment of the tax controversy landscape to anticipate future risk areas.

If a risk area arises, taxpayers can identify specific processes in that jurisdiction that may allow them to achieve greater certainty and better manage potential exposures. APAs can be an excellent way to achieve this much earlier in the process, potentially avoiding later disputes. Pre-filing agreements and private rulings in many countries also provide effective and proactive mechanisms. When these options are used effectively, taxpayers and revenue authorities alike can benefit from the process.

Revenue authorities may benefit from a strategic approach that embraces modern frameworks as well as processes that achieve more with less. Shifting strategic resources to enable more efficient audits and adopting risk-based audit assessments are examples of this proactive mindset. A holistic approach may also involve the training of agents to focus on methods to resolve taxpayer disputes early in the administrative process.

Taxpayers may also benefit from adopting holistic approaches, rather than fragmented responses, to their overall management of tax audits and controversies. Because the resolution of a dispute in one country may have profound ramifications for the same taxpayer in other jurisdictions, one-off approaches may cause unintended results and negative financial consequences. Instead, developing centralised points of contact within the global enterprise and applying coordinated action plans when monitoring and responding to audits and disputes may be important proactive improvements. In the turbulent environment, achieving successful results involves both coordinated global strategic planning and local tactical implementation. Proactive steps toward those goals are essential to the effective and efficient management and resolution of tax audits and disputes worldwide.