Tax Data Management - First Issue 2004

This is a newsletter from J.D. Choi of Tax Technologies, Inc. to tax professionals whose interests are improving the tax management processes.

Table of Contents

1. Is the Dollar still falling?
2. Sarbanes-Oxley compliance – Is a low cost solution possible?
3. M-3 – Need a new driver!

In this issue of Tax Technology Newsletter, I examine the effects of the falling US Dollar on foreign tax credit limitations for multinational corporations, demonstrate the possibility of low-cost (or no cost) Sarbanes-Oxley internal control implementation, and provide a brief update on the newly released Schedule M-3.

1. Is the Dollar still falling?

Effects of weak US Dollar on the foreign tax credit limitations calculation. Although arguments can be made that the weak US Dollar is good for US exporters as it makes US produced products relatively cheaper for foreign buyers, it has unintended and unforeseen consequences in foreign tax credit calculations for multinational corporations with significant foreign presence. In short, it is likely to reduce foreign tax credit capacity and potentially create overall foreign losses (OFL) for companies even though they may not have been in the OFL position before. It would also have significant impact on cumulative translation adjustment that would impact deferred tax assets or liabilities significantly.

The most significant driver of the foreign tax credit limitations calculation is the apportionment of interest expense, which in turn, is driven by the apportionment between US assets versus foreign assets. Potentially research and development expense can also be impacted significantly by the falling US Dollar as the apportionment of R&D expense is based on either gross income or worldwide sales. This article examines the impact of weak US Dollar on the foreign tax credit limitation calculation from perspective of interest expense apportionment.

The interest expense apportionment is based on either the tax basis asset method (also referred as tax book method) or fair market value asset method. Under either method, weak US dollar would result in more interest to be apportioned against foreign source income categories, thereby reducing foreign tax credit limitations.

During the tax year 2003, US Dollar lost almost 20 percent of its value against Euro and 10 percent of its value against British Pound. Even Japanese Yen has gained 10 percent of its value against US Dollar despite its economic trouble. The result of these losses in US Dollar value is higher translated value of foreign assets under both tax book method and fair market value method. The quantitative impact of the rate change is dependant on the relative value of foreign asset in various countries. Apparently, the companies with larger presence in Euro countries would bear much more significant impact as a result of Dollar devaluation.

The computations of US and foreign assets under the tax book method would require that foreign assets be translated at the year-end rate as part of asset averaging. Further, it requires the earnings and profits of certain foreign subsidiaries be taken into account as part of foreign assets (Sec 864(e) adjustment). Likewise, under the fair market value method, companies need to evaluate the fair market value of foreign assets every year and translate them using the year-end rate. Further, under the fair market value method, companies must allocate its intangible assets based on earnings before interest and tax between US and foreign.

The following example demonstrates the impact of devaluation of US Dollars under tax book method.

Example 1 – Tax Book Method

This example assumes no increase in asset or accumulated E&P between the beginning of 2003 and the end of 2003. All numbers are identical between tax year 2002 and 2003 except for the exchange rate to highlight the effects of the devaluation. The exchange rates used are actual rates to measure your exposure or risk while tracking and managing your responses.

Tax Year 2002

	Beginning US USD	Beginning Europe EUR	Beginning Total	Ending US USD	Ending Europe EUR	Ending Total
	1,000	1,000		1,000	1,000
FX Rate	1.0000	0.8920		1.0000	1.0501
USD Amount	1,000	892	1,892	1,000	1,050	2,050
Average Asset				1,000	971
FC E&P					500
USD E&P for Sec. 864(e)					525
Total assets for interest expense purposes				1,000	1,496	2,496
Asset apportionment percentage				40.062%	59.938%

Tax Year 2003

	Beginning US USD	Beginning Europe EUR	Beginning Total	Ending US USD	Ending Europe EUR	Ending Total
	1,000	1,000		1,000	1,000
FX Rate	1.0000	1.0501		1.0000	1.2557
USD Amount	1,000	1,050	2,050	1,000	1,256	2,256
Average Asset				1,000	1,153
FC E&P					500
USD E&P for Sec. 864(e)					628
Total assets for interest expense purposes				1,000	1,781	2,781
Asset apportionment percentage				35.962%	64.038%
Apportionment percentage change between 2002 and 2003					4.101%

As you can see it clearly in this very simplified example, there is significant increase in interest expense apportionment percentage against foreign source income between 2002 and 2003 simply because of the devaluation of US Dollar. Since large portion of US companies are reinvesting their foreign earnings in local countries, the impact on interest expense apportionment would be more significant due to the growth of foreign assets and Sec. 864(e) adjustment.

Likewise, the impact of the US Dollar devaluation on the companies that adopted the fair market value method is no different. In fact, since the apportionment of intangible assets is based on earnings before interest and tax, the translation of foreign earnings using the diluted exchange rate will result in higher allocation of intangible assets to foreign and, in turn, result in higher apportionment percentage of interest expense apportionment against foreign source income.

Again, the impact of the US Dollar devaluation on foreign tax credit computations will have to be quantified on a case-by-case basis as the facts and circumstances of each company is different. Likewise, the impact on tax provision should also be properly quantified as part of year-end provision.

2. Sarbanes-Oxley compliance – Is a low cost solution possible?
 » Return top

The answer is yes.

The primary focus of the Sarbanes-Oxley Act revolves around the concept of “internal control” which in turn translates to accountability of responsibilities and proving the existence of internal control. The general proposition for Sarbanes-Oxley internal control compliance is, in fact, no different from a sound financial reporting management. It includes clear documentation of work process, assignment of pre-defined work processes, sign-off of assigned tasks, documentation of the sign-off and maintaining the documentation in order to prove the work process compliance.

It appears there is an abundance of advice as to the interpretations with regard to the Sarbanes-Oxley internal control requirements. In my view, if a company is to focus on sound internal control as part of financial reporting, a company should be able to defend its position with regard to Sarbanes-Oxley Act. In fact, I believe companies should be focused more on the actual implementation of the internal control at this point rather than focusing on the mechanical interpretation of the provisions as the effective date is fast approaching.

From my experience, it appears that there seems to be very little actual implementation solutions being proposed by the advisors. It’s as if all the advisors agree that there should be a bell around the cat’s neck but no one seems to have a way to actually get the bell around the cat’s neck. The solution may be simpler than most people think and the cost of implementation should not be so overwhelming.

In this article, I share our experience on an actual implementation of internal control at one of our clients. The concept can easily be extended to other situations.

As part of the global tax provision calculation, we have implemented a global data collection tool for a Fortune 50 multinational corporation. As part of these efforts, the tax provision process had been clearly defined in the form of a series of schedules. After the draft of the work process had been defined, our client asked its auditor for its input in order to make sure its auditor will approve the results of the implementation. Upon introduction of proposed implementation, the auditor (one of the big four accounting firms) approved the implementation plan and we proceeded to the actual implementation.

Each of the work processes defined was developed in the form of schedules to be completed or reviewed. Upon implementation of the schedules, the schedules were assigned to either local controllers or tax managers by way of individual assignment or assignment by group. Once assigned, the assigned person may assign the task to other group member to specify the responsibility to an individual to the task. This was particularly important since the details of the task assignment was not totally clear at the time of initial assignment although we generally knew which group was responsible for the tasks being assigned.

Once each of the tasks was assigned, we issued a clear deadline for completion based on when the financials needed to be ready for announcement. As part of this effort, we have used the task tracking functions of our software so that each of the tasks assigned can be signed-off and each of the sign-offs can be documented for affirmative proof later. Accordingly, as local controllers and tax managers completed each of the tasks, they were required to sign off on the task they have completed. In the backend, our data collection system was collecting the time of sign-off and the user information of the person signing off on each of the tasks.

This implementation required net income before tax to be signed off for each of the ledgers by local controllers. As one can imagine as part of tax provision, the schedules were constructed to provide local country tax adjustments and combined with US GAAP adjustments in order to arrive at US tax provision, tax effecting the adjustments, deferred roll-forward computations, footnote summary and also produced the analysis to determine the general ledger adjustment to be recorded on the books.

As a result of the implementation, we were able to produce global consolidation reports. These reports were provided to local controllers for local consolidated calculations, such as, group relief computations. The global consolidation report was also used to reconcile the SEC reported financial information to the starting point of tax provision amounts.

As a result of this implementation, all of the pre-tax earnings have been reconciled to the SEC reported amount; all of the pre-tax earnings have been affirmatively signed off by foreign controllers as a starting point of the tax provision; every single tax adjustment has been signed off by someone in the process; all local tax rate in detail have been confirmed by local tax managers; tax provision calculations have been reviewed and signed off by local tax manager; and, in consequence, the net income after tax is effectively signed off by all parties involved in the process.

As mentioned earlier, the company approached its external auditor and provided details of the implementation plan. Upon review of the plan, the auditor approved it and the plan was implemented. After the implementation, we were able to provide consolidated information based auditor’s requested format, thereby, reducing their efforts as well as providing every detail requested. Moreover, the company can prove who signed off on each of the pre-defined task and also can prove that the task was completed prior to the deadline, thereby, being able to provide the documentation for Sarbanes-Oxley internal control compliance.

The plan took about four months to implement, it took four weeks to have the year-end worldwide provision completed and signed off. Most significantly, the company can prove the footnote on its financial report from its local ledgers and it can prove who is responsible for each of the ledgers and the adjustments. Best of all, the implementation did not cost the company any more that what it would have cost to implement the global provision.

Yes. It is possible to have low cost solution to implement Sarbanes-Oxley internal control compliance requirements! Although the individual circumstances may vary slightly, the concept of this implementation can be applied to every situation of internal control compliance. It only needs an innovative and creative way of doing the work we should always be doing.

3. M-3 – Need a new driver!   » Return top

Tax Technologies Inc. was invited to participate in a discussion with various branches of Internal Revenue Service on March 3rd. The discussion was focused on the issue of whether tax software vendors (CORPTax, Vertex, RIA and Tax Technologies, Inc.) may produce the new Schedule M-3 and the supporting schedules for the tax year ended December 31, 2004. This note summarizes the discussion in order to better prepare our clients to cope with the new Schedule M-3.

IRS has made it very clear that the new Schedule M-3 is here to stay and it will be effective for the tax year ending on or after December 31, 2004. In order to achieve the implementation target, IRS will release the final version of the form and instruction by June 30th, 2004.

They also made it clear that M-3 will be used to better identify the audit target companies. This new targeting effort is a part of their overall reengineering projects. In that context, IRS is attempting to shift their focus from the largest 1,500 companies (of which 70% are being audited) to 50,000 second tier companies (of which about 5% are being audited currently). They believe they can better focus on target companies based on their risk score analysis using the information provided on Schedule M-3. The Schedule M-3 is designed to produce the relevancy scores such as magnitude of permanent difference in relation to the overall balance.

IRS also understands that Form 8886 reporting is duplicative of what is required to be reported on Schedule M-3. Accordingly, there is some movement in the IRS to reduce the burden by the taxpayer by removing the overlap between the Form 8886 and Schedule M-3. However, no details have been worked out.

We expect to have the Schedule M-3 and its supporting structure in Tax Series soon after the final form is released. The users of Tax Series will be invited to test the new functionality after its release in our development environment based on the user request.

If you need further details on the subject, please contact me at 201-927-5682.

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Regards,

J.D. Choi
CEO, Tax Technologies, Inc.
201-387-9451