Why the tax controversy outlook looks set to become even more challenging
The indicators point in one direction: an increase in tax controversy, as authorities’ resources are ploughed into increased scrutiny. Luis Coronado of EY explains why, and suggests what tactics businesses should be adopting.
Apparently, there comes a point at which the anecdotal becomes the truth. After recently conferring with EY colleagues who deal with tax controversy (encompassing tax audits, disputes, and litigation) in 17 of the world’s most significant jurisdictions from an economic or cross-border tax perspective, the author is inclined to agree.
There seems to be overwhelming evidence that there is but one trajectory for tax controversy globally in the short to medium term – upward.
Consider the following indicators from colleagues in the 17 jurisdictions, which were selected as the largest jurisdictions by gross domestic product (GDP) or those with a cross-border tax significance, as the headquarters or holding company location to many large companies.
Eleven of the jurisdictions (Australia, China, Indonesia, Ireland, Italy, Japan, Luxembourg, Mexico, Singapore, the UK, and the US) expect a higher number and/or intensity of business tax audits in 2022 and 2023 compared with 2021. In the remaining six jurisdictions (Brazil, Canada, France, Germany, India, and the Netherlands), they expect audits of around the same number and/or intensity. Those are convincing enough figures already but are arguably made even more compelling when you consider what a high base most of the countries are moving from, in terms of prior tax audit activity.
A higher number of joint and/or simultaneous tax audits are forecast in 10 of the jurisdictions (Brazil, Canada, China, France, Germany, Indonesia, Italy, Mexico, the Netherlands, and the US) over the same period.
Differences in the interpretation of transfer pricing (TP) issues are often a common trigger of new disputes. Here, such interpretation is almost always consistent with international standards in nine of the jurisdictions (Australia, Canada, Germany, Ireland, Luxembourg, Netherlands, Singapore, the UK, and the US) and usually – but not always – consistent in five (China, France, Italy, Japan, and Indonesia). It is reported as being usually inconsistent in three (Brazil, India, and Mexico).
Responses around the interpretation of permanent establishment issues, a similarly common tax audit trigger, indicate even less consistency of treatment: interpretation is almost always consistent with international standards in six of the jurisdictions (Australia, Canada, Netherlands, Singapore, the UK, and the US) and is usually consistent in eight (China, France, Germany, Indonesia, Ireland, Japan, Luxembourg, and Mexico). It is usually inconsistent in three of the jurisdictions (Brazil, India, and Italy).
New disclosure and/or tax transparency requirements are expected in the coming year in 12 of the jurisdictions (Brazil, Canada, China, France, India, Indonesia, Italy, Mexico, Luxembourg, the Netherlands, Singapore, and the UK).
On the flipside, only three of the 17 (Italy, Singapore, and the UK) say their revenue authority is focusing significant levels of auditing activity on the COVID-related stimulus and support measures taken up by companies. But that does not mean that similar audits will not occur in other locations, too.
Of course, these 17 jurisdictions are, by and large, developed markets. While experience might suggest that the highest levels of tax enforcement are experienced at the hands of emerging market tax authorities, that perception may not be completely true; tax authorities in mature markets are equally likely to sustain a highly robust enforcement environment.
The anecdotal evidence provided by EY colleagues is supported by more than 1,200 respondents to the 2021 EY Tax risk and controversy survey (which will be repeated in early 2023). Among large multinational companies (MNCs), 65% expect tax enforcement levels to rise in the coming three years, while almost half of the same group say they have experienced tax authority behaviour that they describe as “aggressive” in the past three years.
Anecdotes and numbers aside, increasing levels of scrutiny are further evidenced by new programmes and requirements being put in place by many revenue authorities. In the transparency and disclosure space, for example, many countries are implementing new national measures, such as the new requirement to disclose uncertain tax treatments in the UK, which came into effect on April 1 2022.
There is also a general push by jurisdictions to require companies to track and disclose ultimate beneficial ownership information, a fast-growing trend globally. Recent developments on that topic have occurred in Colombia, Mexico, and Peru, though it is certainly not a phenomenon limited to the Americas.
More widely, the overall approach to the revenue authority-taxpayer compliance relationship continues to evolve. While many countries are launching or refreshing (or even introducing) cooperative compliance programmes (Belgium and the Netherlands have changed theirs in the past year or so), there is a distinct move towards greater adoption of what can be described as ‘compliance assurance’ programmes. Some of these programmes are voluntary, while others are mandatory, particularly for the largest companies operating in an economy.
Programme objectives tend to focus on testing the presence and effective operation of tax governance and tax control frameworks, in addition to the more traditional testing of the numbers in the company’s tax return(s). Australia, Germany, Japan, Malaysia, the Netherlands, Singapore, and the UK, among others, have broadly similar programmes in this area, with those in Malaysia and Singapore (both of which are voluntary) introducing their programmes in 2022.
More funding for tax administrations
Many in the tax community will be aware of the US Internal Revenue Service’s (IRS’s) recently increased budget allocation. While such investment is unlikely to swiftly translate into immediately higher levels of business tax enforcement, it will have a definite impact over the next two to three years.
With that increase in mind, in a separate but concurrent exercise, EY colleagues in the six largest jurisdictions by GDP (US, China, Japan, Germany, the UK, and India) were asked whether their revenue authority’s budget was increasing, decreasing, or staying about the same. Budgets are increasing, reported colleagues in the US, Germany, and India, while decreasing marginally in Japan and the UK (although overall HM Revenue & Customs expenditure is increasing due to Brexit, COVID-19, etc.).
The United States’ developments have driven the greatest volume of recent media headlines on this topic. For the past decade the IRS has been dealing with declining budgets and falling headcount on one side of the coin and significant additional responsibilities on the other.
Moving forward, the IRS budget and headcount looks set to increase significantly for the first time after a full decade of steady decline. That’s the result of an $80 billion funding increase (over ten years) awarded in the recently passed Inflation Reduction Act of 2022, potentially allowing the agency to hire around 87,000 additional employees over that period (though the net figure will be far lower, once attrition is addressed). While the final composition of skills secured remains to be seen, it can be assumed that a significant percentage of new staff will be dedicated to tax audits and investigation activities.
What is driving the changing environment?
So, what behaviours and activities are underpinning what seems to be overwhelming anecdotal evidence of higher levels of tax enforcement?
Converging trends indicating that tax enforcement is becoming more challenging than ever can be grouped into several broad, interrelated categories.
1. Disclosure and exchange of information
First is the interaction between new transparency and disclosure requirements and the automatic exchange of information. This phenomenon, which continues to expand, has turned historical information asymmetry on its head. Developments are not limited to country-by-country reporting (CbCR) and the Mandatory Disclosure Regime (MDR) in the EU, and many countries continue to implement national-level disclosure requirements. These include the UK’s recent adoption of the requirement to disclose uncertain tax treatments, and the relatively new MDR requirements in Mexico, as well as new requirements that taxpayers must report higher levels of beneficial ownership information.
Few taxpayers would argue against the notion that a greater number of tax audits are being launched as a direct result of the exchange of information between countries, and consistency of data is therefore becoming more important than ever. Taxpayers should assume that information submitted in one jurisdiction is quickly and efficiently shared with others.
Second, as outlined in this publication 12 months ago, is rising multilateralism among revenue authorities. Under the auspices of global groupings including the OECD’s Forum on Tax Administration (FTA) or regional groupings such as the Study Group on Asia-Pacific Tax Administration and Research (SGATAR), the Inter-American Center of Tax Administrations (CIAT), and the African Tax Administration Forum (ATAF), among numerous others, tax authorities are gaining access to deeper insight regarding how companies are choosing to structure themselves and how they legally contract with others and carry out transactions. They are also collaborating on, and sharing, digital technologies, data analytics approaches, and new tax enforcement and auditing techniques and tactics.
Indirectly, revenue authority personnel are developing far deeper, more comprehensive – yet often quite informal – relationships with each other that they can then call upon as needed.
3. Auditing approach
Third, there is a general shift in the tax auditing approach, towards more forensic, value chain-focused audits. Tax audits have, and will continue to become, increasingly forensic, multi-sided, and whole-of-group-focused as countries leverage data, exercise new information-gathering powers, conduct social media research, and implement advanced data analytics to deliver a powerful new approach to tax scrutiny.
In addition, tax authorities are demanding more and more information from taxpayers and such information is rapidly becoming more detailed and granular. Companies describe many data requests as “completely unreasonable” or even “intrusive”, and they also say that the scope, relevancy, and time they are given to respond to enquiries are all challenges.
Auditors, meanwhile, are also looking at transactions from two or more country perspectives, via data that has been exchanged (or requested), either informally (via these new relationships) or formally, as a result of an analytics routine indicating an issue, or through a joint or simultaneous tax audit, for example. This expanded scrutiny attempts to look more widely across a company’s entire value chain, assessing where each entity/country may play a role. In the EY survey results, exactly one-third of companies that answered had experienced such dual, or even multi-sided, scrutiny.
These changes and a series of evolving tax audit tactics are creating a completely new tax audit experience for companies. Within the audits themselves, approaches and tactics are also clearly evolving and shifting. Some of these tactical evolutions include the following:
A shift towards ‘show, not tell’ tactics – effectively, tax auditors are looking past a company’s immediate data and asking for more counterfactual information. It is no longer sufficient, for example, for a company to assert that a local entity doesn’t do X, Y, and Z activities. Instead, companies must not only show that their entity does not perform those activities, but equally show that the counterparty involved does. This is a shift in mindset – and towards a need for detailed documentation – for which many companies seem unprepared.
A swinging pendulum from ‘form’ back to ‘substance and form’ – particularly in certain emerging markets, the previously swinging pendulum towards form over substance has now landed somewhere back in the middle, meaning that both dimensions are now equally important.
‘Trust but verify’ approaches have become the norm – more tax authorities are adopting an approach under which they will take data provided by a taxpayer at face value upon submission but are almost certain to check and validate it outside the face-to-face environment in which it was initially shared.
Leverage and/or threats being used within tax audits – in pursuit of their objectives to open up prior tax years for examination, secure a result within their chosen range (for example, pushing a distributor to a 2 to 3 or 3 to 4% margin) or to ‘encourage’ settlement, more is being heard about tax auditors and competent authorities applying leverage within tax audits. There are different levels of leverage applied, varying from unsubstantiated claims (for example, of carelessness or lack of quality – especially around TP documentation, or revenue authority assertions that a hidden permanent establishment exists) to accusations of profit shifting on the basis of a unilateral ruling (originating from outside the jurisdiction conducting the scrutiny) that the tax authority has received through information exchange. In other cases, companies have been offered a settlement in return for not being entered into audit. In a similar vein, some jurisdictions are continuing to offer a settlement – often attractive – if the taxpayer agrees to forfeit the right to a mutual agreement procedure (MAP), while in the most egregious of cases – and not just in emerging markets – the application of criminal penalties can often be used as the ultimate lever. Neither is a palatable option and both are regrettable.
Joint and simultaneous tax audits continue to grow in usage – this is particularly the case in Latin America, but they are also continuing their historical growth in Europe, and many companies have reported that issues originally addressed in a joint audit have quickly widened out to include additional scrutiny of other issues by some revenue authorities.
Tax authority digitalisation, meanwhile, is disrupting the decades-old tax compliance life cycle, and many companies declare feeling they are behind the curve in forming a meaningful response. Automated financial fines or penalties for incorrectly formatted or mismatched data can quickly mount, and many companies have said that simply keeping up with the growing volume of automated infraction notices is creating a significant resource strain on the tax function.
Many companies may also be completely unaware of one element of tax authority digitalisation: an increasing number of revenue authorities starting to require direct access to company enterprise resource planning (ERP) systems. That is a phenomenon that companies should watch carefully.
These related developments, while crucially important in understanding the tax enforcement environment at hand, are not the only agents of change at play. They are joined by many other drivers, not least fast-paced, voluminous, and complex tax reform at multilateral and national levels. But they are the most significant and fundamental catalysts behind the current state of acculturation in tax administration.
Whether or not we are entering a period of post-COVID economic weakness – and even stagflation – remains to be seen. But companies should be certain that if we do, governments and tax authorities will be looking to wring as much revenue out of their tax regimes as possible, and companies (along with high-net-worth individuals) will likely be first in line to pay, targeted across tax policy and tax enforcement plans.
What are (and should) companies do about it?
Against this backdrop, it is hardly surprising that MNCs agree with the EY colleagues’ anecdotes, and are therefore doing more to better manage their controversy workload or plan to do so in the near future.
Sixty-one per cent expect more TP audits in the coming three years and 50% expect more scrutiny that is multi-country or whole-of-value-chain focused in the same timeframe, according to the EY survey. On the response side, 66% of companies say that tax controversy management has become more important to their organisation during the past three years, while 65% say their C-suite’s interest and oversight of tax has similarly increased.
Yet only 19% say they have complete visibility over all active tax audits and disputes globally, and 44% have a clearly defined escalation mechanism for each new tax audit. This should be addressed without delay.
Simply put, the shifting environment means that taxpayers who fail to adopt a global framework approach to tax risk and controversy management may experience one or more of the following:
Higher levels of tax uncertainty;
More (and more intense) unexpected tax disputes;
Greater financial exposure and risk of penalties, including higher interest and surcharge payments; and
A greater likelihood of a reputational risk event occurring.
At the far end of the risk spectrum, they may experience a higher risk of criminal prosecution, which can involve not only members of the tax function, but also other company officers (including, in some countries, board members), or even the corporate entity itself. Understanding the rapidly changing laws where you do business is imperative.
Companies can be expected to respond across five broad activity areas.
They are enhancing their overall approach to tax governance, particularly in the area of managing tax controversy. This focuses on putting in place the roles, responsibilities, and accountabilities needed to identify and manage tax risks, frequently centreing upon creating a global tax controversy leader or even a group or centre of excellence focused on controversy. For many companies, this aligns strongly to their environmental, social, and governance (ESG) reporting and, indeed, ESG alignment can often help to underpin new investment in this area.
They are adopting more strategic, framework approaches to tax risk and controversy management, including centralising key activities
They are trying to move their efforts ‘upstream’ in the controversy life cycle, putting in place the processes, protocols, and technology to identify the nascent sources of potential disputes, shutting them down before the risks have a chance to really take hold. They are investing in more proactive approaches to tax risk identification and assessment, often adding the results of ongoing or periodic reviews to a living, breathing tax risk ‘register’. For many companies, this can be a natural expansion of existing FIN 48 efforts.
They are being far more proactive around tax risk management activities, ensuring that newly identified tax risks are addressed in a variety of ways, including via securing tax rulings or advance pricing agreements (APAs), entering into cooperative compliance agreements, or internally improving the tax and/or business controls designed to reduce the incidence of tax risk in the first place.
They are tackling tax disputes in innovative ways. This includes putting in place enhanced approaches (and technologies) to track and manage tax disputes on the basis that you can’t manage what you don’t know about. Within this area of activity, they are also adopting enhanced audit management processes and tactics, which can include learning more about the local tactics a revenue authority might take, the cultural approach to disputes generally within a jurisdiction, and seeking more opportunities to understand a revenue authority’s standpoint and wider objectives before an audit commences.
More of the same ahead?
Will there be more tax controversy ahead? The OECD, coordinating the BEPS 2.0 work of more than 140 jurisdictions making up the Inclusive Framework on BEPS, seems to think so.
That was confirmed by the convoluted consultation documents on tax certainty aspects related to Amount A under pillar one of BEPS 2.0 of late May 2022, which can be expected to be joined by a similar exercise for pillar two in due course.
That, coupled with the strengthening of the range of tax enforcement trends identified, makes companies’ move towards global and strategic framework approaches to tax controversy all the more important and urgent.
The views reflected in this article are the views of the author and do not necessarily reflect the views of the global EY organisation or its member firms.