Tax authorities, including our own Inland Revenue Department, sometimes try to promote the idea that companies must pay their “fair share” of taxes (on a theory of social duty).
The IRD’s compliance document for the 2010-2011 tax year, for example, states: “Taxes pay for healthcare, education, safer communities, welfare and other essential government services. Individuals and businesses that don’t pay their fair share, or claim more than they should, disadvantage other New Zealanders”.
However, just as a company cannot justify paying less tax by arguing that the tax imposed is “unfair”, neither, in my view, can the concept of “fairness” be invoked to induce that company to pay more tax than is legally due. Because tax impacts upon the company’s bottom line and the directors’ duties are owed to the company, not the IRD, there is almost an affirmative obligation to minimise tax within the bounds of the law.
Dealing with tax uncertainty
But there is often significant uncertainty regarding the scope of a company’s tax obligations. This is particularly so given the IRD’s rigorous approach on audit, preparedness to litigate and appeal matters (almost irrespective of cost/benefit in the individual case), and recent victories in the courts in tax avoidance cases.
Questions of raw economics also apply as the price of non-compliance can be high:
- the Use of Money Interest (UOMI) charged by IRD on unpaid tax liabilities is set at well above market rates for most corporate taxpayers (currently 8.89%, although approved tax pooling arrangements can mitigate this expense)
- the penalties for filing an “unacceptable tax position” under s141B of the Tax Administration Act are also significant (20% if the resulting shortfall exceeds $50,000 and 1% of the taxpayer’s total tax figure for the relevant return period)
- a 100% tax penalty for “abusive” tax avoidance, and
- the expense and time involved in tax dispute processes.
All of these factors combine to suggest that companies should take a reasonably conservative approach to their tax obligations. The Tax Administration Act provides that, if a tax position taken by a taxpayer is about “as likely as not to be correct”, the 20% penalty for “unacceptable tax position” cannot apply (IRD interprets this as a reasonable argument test).
This is not generally a high enough level of probability for most companies in the context of ensuring they do not underpay tax – a merely reasonable argument that tax liability is not understated does not seem sufficient for financial accounting purposes.
Legal opinions traditionally are expressed as “will” opinions (90 or 95% minimum assurance that the opinion is correct); “should” opinions (70 or 75% or higher assurance that correct); or “more likely than not” opinions (more than 50% assurance). Companies may consider it appropriate to aim for, say, a 70% probability that the positions they take in tax returns are appropriate. In the tax avoidance world, given legal uncertainty, it will generally not be possible to obtain more than a “should” level of opinion.
There are some strong logical arguments as to why reputational risk should not be an issue in the tax avoidance sphere.
- If the tax avoidance line is uncertain or unclear, companies cannot properly be branded as bad corporate citizens if they are found to have been involved in a tax avoidance transaction.
- The courts have been reasonably consistent that tax avoidance issues are not questions of morality but go to the scheme of the legislation and so, arguably, do not involve questions as to reputation.
But the difficulty with reputations is that they are won over long periods of time and with considerable hard work, but can be lost in a flash. Moreover, when tax cases come before the courts, media interest is often high and analysis and public impressions are frequently made at a reasonably superficial level. Intricate logical/legal analysis will generally not win in the court of public opinion.
Governance oversight of tax risk
Companies should have systems in place to ensure that any material tax risks they are taking are well understood and that they are satisfying their tax obligations, both domestic and offshore. The governance framework for tax risk will involve setting parameters in the following areas:
- ensuring the right level of resource for the tax function and setting a probability standard which should be met when tax returns are filed
- establishing sign-off protocols for material tax issues – these may be one-off issues on large transactions or recurring tax positions taken in the normal course of business. Assurances may be in the form of a binding ruling from IRD, obtaining external advice, or tax manager sign-off
- systems to escalate decisions to the CEO, CFO, the Board Audit and Risk Committee or the full Board as appropriate, and
- guidelines for the general conduct of the company’s relationship with the IRD.
David Patterson is a consultant at Chapman Tripp specialising in tax.