While admitting it’s unusual for the commissioner of the Internal Revenue Service to address the boardroom community, Douglas Shulman believes directors can and should play an important role in overseeing the tax risks and strategies of corporations. What follows is the text of Shulman’s speech in October at the National Association of Corporate Directors corporate governance conference in Washington, D.C. His objective was to start a dialogue so that directors understand their oversight role as it relates to tax strategy and risks, and he set up his remarks in a question-and-answer format.
Why speak to the director community?
Today, I want to share with you some observations of what I have seen since I’ve taken the helm of the organization responsible for collecting 96 percent of all federal receipts—around $2.5 trillion. To begin, I understand that many of you—actually most of you—are not tax experts and you were not installed on the board because of your tax expertise. You bring other critical skills, experiences, and expertise to the boardroom. And I also understand that even with all of your sophistication, expertise, and experience in business and financial affairs, it’s difficult to understand the tax consequences of a complicated business transaction, such as a tax-free reorganization or a hedging transaction, let alone the corporation’s overall tax profile as it relates to federal, state, and international taxes. That’s why you need to have strong tax departments and outside tax advisors. After all, you have finance experts to help you understand the economic value of hedging transactions, and you need tax experts to help you understand the myriad and complex tax issues facing your company.
I know first-hand that in the post-Sarbanes Oxley world, corporations have invested significant time and resources on compliance issues and internal controls. In the tax arena, some have instituted regular meetings between the audit committee and the tax director to ensure an open dialogue.
Why should tax issues be on a director’s agenda?
Tax issues should remain on your radar screen. It’s one of the biggest expenses on your income statement. In addition, a number of public companies have reported material weaknesses in internal controls related to taxes. Tax strategies can also present a financial and restatement risk, and sometimes when the cases are high profile, a significant risk to corporate reputations. In today’s business climate, the general public has little tolerance for overly aggressive tax planning that can be viewed as corporations playing tax games. So, although the complexity of the tax code may make your eyes glaze over, board members, like you, are critically important to making sure that the tax system works well and is worthy of the confidence of the American people.
How can directors increase oversight of tax compliance, given the limited amount of time available and the competing business issues you face?
Well, you probably know or could figure out that the IRS conducts risk assessments of its own when determining how to use its time and resources and whom to audit. Similarly, the board of directors can assess its corporation’s tax risk profile, internal controls, and relationship with its corporate tax department to help determine the tax matters of which it should be aware.
Now, we recognize that many businesses are trying to get it right. Positions taken in tax returns may be well grounded and taken in good faith. Other tax positions taken may be more aggressive and use elaborately structured transactions or arrangements to push tax planning up to the edge, or beyond acceptable bounds.
Enter FIN 48, which establishes the financial statement accounting for uncertain tax positions, including recognizing and measuring their effect on financial statements. Under FIN 48, companies must identify their material uncertain tax positions. They must quantify the company’s maximum exposure and estimated likelihood of winning or losing the issue if challenged by the IRS. And they must record as a liability a specified amount of money relating to these uncertain tax positions. In other words, FIN 48 is a very significant window into tax risk, liability, and management in your company.
FIN 48 paints a picture of tax risk by indicating how much money a corporation has to book in tax reserves to reflect the risk should one or more of its tax positions go south. But let’s get behind the reserve numbers for a moment. What are they telling you—the board directors—beyond the dollars in the tax reserve?
They’re saying that the audit committee needs to know and influence what tax posture the tax planners are taking. They and you need to know whether that multimillion—or in some cases multibillon-dollar bet—you and your company are making could be too aggressive and therefore risky.
So where does that bring us? What are the next steps?
Before I get to that, I want to be clear about what I “do” intend and “don’t” intend in this dialogue. We don’t intend to second-guess legitimate and thoughtful business decision-making by corporate leaders. And we don’t expect that you will always agree with us on identifying and quantifying the risk of various tax positions. But we do want to engage corporate leaders about their roles and responsibilities in conducting appropriate assessment and oversight of tax risk.
I am suggesting that you, the leaders of your organizations, should have a mechanism to oversee tax risk as part of your governance process. For example, you want to:
- Set a threshold confidence level for taking a tax position.
- Discourage or eliminate opinion shopping by tax departments by having an independent tax firm, which has some direct dialogue with the board of directors, review major tax positions.
- Understand the process for identifying uncertain tax positions and how you know all material issues have been identified.
What can the IRS do for boards?
There are already some IRS programs in place that help provide greater certainty and can give a board more comfort that there won’t be second guessing down the road. For example, our Compliance Assurance Program, or CAP, where we agree on issues with the taxpayer before a corporate return is filed, envisions full disclosure by the taxpayer in exchange for real-time tax certainty. And the Advance Pricing Agreement program, where we agree with a taxpayer on pricing methodology before a return is filed, provides certainty in the complex and uncertain area of transfer pricing.
What should a director take away from these remarks?
In summary, my main observation to share with you is this: Taxes are an important expense, and like any important expense, management responsible will try to control it. In the case of taxes, controlling it can expose the company to challenge, which can result in reputational damage and perhaps large, unexpected expenses. So you need to understand how management controls this expense and how it decides how aggressive to be. You also need to be certain that reporting is effective.
In this sense, tax expense is no different from other expenses. If you manage it too loosely, you will give up profit. Manage it too aggressively, and there are bad consequences. You, the board, have to oversee how management manages it. That means you must have some level of understanding, a set of policy principles and then a control system of reporting that assures you that the policy is being carried out. My goal here today is to start a discussion about the board of directors’ role in overseeing tax risk. I encourage you to have the dialogue, and offer the IRS as a resource as you continue to evolve your thinking about this topic. At the end of the day, my proposition is that the board needs to have the tools, not to do tax planning, but to oversee tax strategies and risks.