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
- Foreign tax provision – “One financial restatement to
go please?”
- The truth about tax provisions
- The trend in financial audits
- Myths about foreign provisions
- Why is it so difficult?
- Foreign Multinationals and IFRS – another complexity
- What’s the future like?
- M-3 Conference
- FAS 109 Training
- Preparing Form 8858 and other International
Compliance
In this newsletter, I discuss foreign tax provision issues as it can be a
contributing factor for financial restatements. It is a bit longer than most
of the other articles that I have released in the past. But I think it is an
important issue and deserves your attention.
I also would like to announce our M-3 conference to be held at the Harvard Club
of New York on May 27th. As companies are in the midst of complying with M-3
filing for the first time, I decided it will be useful to have a discussion with
a representative from the IRS.
1) Foreign tax provision – “One financial restatement to go please?”
It seems like the announcement of financial restatement is as ubiquitous as Chinese take-out places.
I am sure every company involved in the restatement, or the companies potentially subject to the
restatement, would like it to go away. Recently, a good number of very embarrassing high-profile
financial restatements have been announced. It is also known that the majority of these financial
restatements were due to tax issues. Some of them impact P&L while others strictly impact balance
sheet accounts. Either way, it has been a source of embarrassment with many detrimental consequences
for the companies having to issue restated financial statements. One of the areas where companies
are having difficulty is with respect to their foreign provision. In this context, I define the
foreign provision as the local tax liability computation based on US GAAP profit before tax (PBT),
using local tax rules. In this letter, I will discuss the issues surrounding the foreign provision
and will explore the issues relating to potential financial restatements. In particular, I have
explored potential financial restatements resulting from a lack of specificity in the foreign
provision as the foreign provision appears to be a monster, lurking under the cover for financial
reporting. I will also explore some of the popular misconceptions regarding the foreign provision
and demonstrate why a lack of detailed foreign provision transparency can be a source of financial
restatement. Hopefully, you will find it helpful for your work.
A. The truth about tax provisions
As all tax accountants are aware, the primary purpose of the tax provision
calculations is to provide for current and deferred tax liabilities as part of
financial statement reporting. Interestingly, the tax provision is reported between
profit before tax and net income on the income statement. In large part, the tax
provision is computed based on many complex tax rules. This complexity is
compounded for multinational corporations, who must contend with both US tax rules
and the tax rules of the foreign jurisdictions in which they operate. Accordingly,
the foreign provision can be managed (or manipulated) based on the creativity of
tax planners and the application of the tax rules, thereby, impacting the net
income of a company.
One of the most commonly used figures by the capital market
sector is “earnings per share” (“EPS). EPS is calculated by dividing the net
income (computed including the tax provision) by the number of shares outstanding.
Often times, the market price of a company’s shares is determined based on EPS.
Thus, precise computation of the tax provision is critical for correct computations
of EPS while incorrect tax provision calculation will result in incorrect EPS and,
thus, will impact the market valuation of the company.
In most cases, manipulation of the financial figures between sales and profit
before tax is considered an accounting fraud. To the contrary, “management” of the
tax provision using complex set of tax rules is considered tax planning. In fact,
it is not only an acceptable practice but also one of the primary functions of many
well-staffed tax departments.
Although there are many tax planners, it appears that there is not enough tax
data and process administrators to support the complex tax planning that has been
put in place from the tax accounting perspective. In the global context, the
administration of data and the process in tax reporting is further complicated by
the lack of a tool to facilitate global collaboration, the differences in tax
accounting rules and cultural differences with regard to tax reporting.
At the same time, many large US corporations have enhanced their share value
through expansion in overseas markets. In short, there are more chances of having
the foreign tax provision be incorrectly reported than the US tax provision.
Incorrect reporting of the foreign provision will result in incorrect financial
reporting as the financial results of foreign subsidiaries are reported as part of
global consolidated financial reporting.
B. The trend in financial audits
There has been increasing scrutiny on tax provision in the recent past due in
large part to Sarbanes Oxley requirements and related financial reporting
requirements. Also, the fact that audit firms are prohibited from providing tax
services appears to have had a profound impact on their review of tax provisions.
In fact, what was an acceptable tax provision calculation two years ago (with the
same auditor) is no longer acceptable in many cases where the audit firm can no
longer provide tax services. As a result, companies have been forced to enhance
their tax provision calculations and corresponding internal controls.
From the Sarbanes-Oxley 404 control perspective, there is a wide spectrum of
auditor attitude with regard to tax compliance and provision processes. In some
instances, audit firms totally scoped out tax compliance although it is a
significant part of provision, in other instances audit firms scrutinize just about
every little process including the use of Excel™ spread sheets as part of tax
compliance and provision processes. What is troublesome is the inconsistency of audit
firms across their own clients.
I suspect the more the audit firm is involved in providing tax services, the less
stringent SOX review standard is applied for that client. However, without any
empirical study, it is pure conjecture. Regardless of the spectrum of standards,
however, companies should anticipate higher standard of scrutiny be applied on all
provision processes and related controls as it is getting more and more difficult to
get board approval for tax services to be performed by the audit firm.
I anticipate audit dominant firms may be SOXED out of many of their audit clients.
I also anticipate that the audit firms will increase audit scrutiny on tax issues when
forced out of tax services. In some ways, I view it as the intended results of the
Sarbanes-Oxley Act. It will be very difficult to defend most of current foreign
provision processes under close scrutiny.
C. Myths about foreign provisions
There are a small number of popular misconceptions that provides a false sense
of security to many tax managers. I examined them and explained below why they
should not be relied upon.
Popular misconception 1 – “We have elected to treat all of our foreign operations
as permanently reinvested pursuant to APB 23.”
The fact that the earnings of foreign operations are considered to be
permanently reinvested overseas only prevents companies from having to provide for
US residual tax on foreign earnings. The companies still have to provide for local
tax liabilities on foreign earnings. An incorrect calculation of the local tax
liability would result in misrepresentation of current net income presented on
global consolidation.
Furthermore, the global consolidation of the balance sheet
would be misrepresented if the deferred tax accounts of the balance sheet are not
properly stated. If the current provision is not properly stated based on a precise
calculation of local tax liability, the corresponding deferred accounts would be
incorrectly stated, resulting in a misstatement of the global balance sheet.
Popular misconception 2 – “We apply the local tax rate to US GAAP earnings to
calculate the local tax provision.”
This may not provide the correct local tax liability as the local tax provision
should be based on local statutory earnings not on US GAAP earnings. To the extent
that there are differences between US GAAP earnings and local statutory earnings,
the foreign provision will be off by the differences, multiplied by local tax
rates. Furthermore, to the extent there are permanent differences between US GAAP
profit before tax and local statutory profit before tax, applying the local statutory
rate would result in incorrect local tax liability, thereby, resulting in an
incorrect overall effective tax rate.
In addition, local taxes may need to be calculated based on each of the taxing
jurisdictions within a country. For example, if a country has more than one tax
jurisdiction, such as German income tax and trade tax, each tax jurisdiction should
be computed separately, as the bases for taxation may differ.
Likewise, US tax structure must be taken into account in computing local tax
liability. For example, if a US company has a UK controlled foreign corporation,
which in turn has a French branch, the tax provision of the UK controlled foreign
corporation must take into account the ramification of the tax credits that result
from French taxation of its branch. Thus, simply applying the local statutory rate may
result in a significant distortion in the current tax provision.
Popular misconception 3 -”All book-tax differences are timing, so it does not matter over
time”
This is not true, there are significant permanent differences for local tax
purposes and US tax purposes. Also, the distinction between current and non-current
deferred adjustments, affects the calculation of current deferred assets and
liabilities versus non-current deferred assets and liabilities. As the timing
differences accumulate over time on the balance sheet, the categorization of current
and non-current deferred can significantly impact the balance sheet analysis.
Furthermore, valuation allowances result in significant differences in deferred tax
assets and liabilities with similar consequences for permanent differences.
Popular misconception 4 –“We standardized our global chart and automated global
provision”
There are companies that claim that their provision is automated. Certainly,
automation is desirable. Realistically, however, it is very difficult to automate
the foreign provision. This is not because of the lack of efforts by US tax
professionals. Rather, it is due to the fact that there are so many rules that are
often inconsistent across many countries. For example, some adjustments that are
considered permanent in some countries are considered temporary in other countries.
In such cases, the same account may have to be adjusted in two different ways for
local provision purposes. Also, there are provision adjustments that may be difficult
to capture as part of the financial accounting as they may be calculated purely for
tax purposes (such as the value of stock options exercised), thereby making it
difficult to have the adjustments be automated for purposes of tax provision.
Popular misconception 5- “We have enough reserve”
No you don’t.
In the past, companies had cushions. These are also referred to as general
reserves, such as interest on deficiencies, which were rather hidden in various
ways. In today’s environment, it will be very difficult to have such reserves as
the financial audit under new Sarbanes Oxley environment may not tolerate it.
Auditors may consider such reserves to be a hidden liability.
Also, a common reserve is linked to the state provision because most companies
are using blended state rate for provision. Accordingly, companies may have been
providing a general reserve to cover the imprecision in the state provision.
Judging from the feedback on financial audits, I doubt the auditors will continue
to accept the imprecise state provision. Within the next few years, companies
should expect to provide a precise state provision and, accordingly, a general
reserve for state provision may have to be reduced if not eliminated.
D. Why is it so difficult?
As I have explored some of the popular misconceptions about the foreign
provisions, let’s examine why the detailed analysis of foreign provision is so
difficult to calculate. There are a number of reasons why the tax provision for
foreign operations is much more difficult than that of US operations. Below, I
listed and explored each of them in detail:
i) Lack of standard ERP reporting
Many US corporations have expanded their presence overseas by way of
acquisitions. Inconsistencies in underlying financial reporting systems and the
resulting financial details make data very difficult to obtain by US parent
companies. Therefore, achieving a detailed foreign provision became a very
laborious, if not impossible, process.
Most people believe that standardization of local reporting that conforms to
that of US reporting would solve the problem. Some companies spent large sums of
money attempting to achieve this standardization. These were very popular
management consulting engagements for large accounting firms prior to the
Sarbanes-Oxley era although some of the large accounting firms still perform such
functions as part of their practice. I personally believe it is neither practical
nor useful to standardize the local financial reporting as long as it served its
purpose for local reporting before the acquisition.
I believe it would be smarter to make as few modifications as possible to the
local financial reporting system to comply with US tax requirements. I think it is
critical that US corporations achieve transparency to local financial reporting by
way of making it available to US tax staff rather than forcing the standardization
of financial reporting.
ii) Lack of tax technical knowledge in local country
It is a known fact that there are not many people in foreign offices who have a
good enough understanding of US tax accounting knowledge to be able to produce
meaningful data for the US tax provision. In most cases, the foreign financial
controllers who are reporting the local provision have very little knowledge of US
tax accounting.
Based on my experience, this can be mitigated by providing local training.
It can also be greatly enhanced by providing a data collection mechanism that is
self-explanatory rather than full of jargon understood only by US tax accountants.
iii) Calculation dependency
Most of the foreign tax provisions are calculated using Excel™. The use of Excel™ as
a means of this calculation creates problems for many reasons – one of which is
calculation dependency.
Foreign provisions require a significant number of calculations: reconciliation of
current year PBT, prior year provision to local return true-up, current provision,
deferred roll-forward, tax effect of deferred items, currency translation adjustments,
summarizing the provision items for US financial statement disclosure, rate
reconciliation and production of journal entries. Ambitious companies may attempt to
reconcile the tax accounts as part of the provision process.
Calculation dependency requires large sets of current year and prior year data
to be stored in a single file or in a database that can be accessed by all foreign
participants. Excel is not a type of tool that can facilitate such requirements.
Currently, not many companies have a single data depository that can be accessed
globally by all foreign participants to facilitate calculation dependency.
iv) Multi-level consolidation and provision
Some of the foreign provisions require multi-level provisions and corresponding
consolidation. Many companies have regional holding companies. The tax provision of a
holding company depends largely on that of its subsidiaries and branches. For example,
the UK parent of a French branch would have to first compute the French branch provision
before it can complete its own provision, as it may need to take into account the French
tax paid by its branch.
Again, this is very difficult to accomplish using Excel™ as it will require that specific
steps be followed and dynamic collaboration among many participating companies.
v) Multi-currency translation
Foreign provisions need to be calculated in functional currency. This requirement also
presents a level of complexity. In the case of foreign tax payments, it may be paid in many
different currencies for a single company. Accordingly, the ability to dynamically handle
multiple currencies is required to compute a precise foreign provision and corresponding
analysis.
vi) Multiple taxing jurisdictions
Similar to that of US federal and state provisions, many foreign countries have more than
one taxing jurisdiction. Each taxing jurisdiction may have its own tax basis and required
adjustments. Accordingly, maintenance of deferred tax assets and liabilities should be specific,
corresponding to particular taxing jurisdiction. Also, to the extent there are interactions and
dependencies between the taxing jurisdictions, companies will be required to maintain a depository
of information that can be shared to allow such computations.
vii) Foreign participation and assignments
One of the practical issues related to the foreign provision is people. Staff
changes are constant in a multi-national organization. The issue is not how to keep
the same people for the job, but how to maintain the consistency in spite of the
staff turnover. Our experience indicates that maintaining consistency requires
creating a simple to understand calculation package, as well as the ability to easily
roll-forward information from prior periods.
viii) Tracing of accountability
Something can go wrong and something will go wrong. The trick is maintaining the record of
what has been done and by whom so it can be investigated and addressed. Ideally, it should be
part of the regular process in performing the provision tasks.
ix) Lack of global collaboration mechanism
In order to achieve the precision in foreign provision, companies are required to maintain
two interlocked processes: 1) data collection and 2) computations. Both of which require a
great deal of global collaboration. However, such a tool is hard to come by. In most cases,
even though a company decides to purchase (or license) a global collaboration tool, it requires
a significant investment to make it work for them as the foreign provision process is done very
differently from one company to another.
E. Foreign Multinationals and IFRS – another complexity.
Foreign multinationals face similar issues particularly as they expand into global markets
and list on multiple exchanges to leverage world capital markets. This is compounded with the
complexity of comparable local country Sarbanes Oxley provisions that mirror the US rules.
As with its US counterparts, foreign multinationals must collect data from diverse non-standard
ERP systems. Often, there may be a common platform such as SAP but a lack of a standardized chart
of accounts from business unit to business unit even within a particular sector. An added
complication is the difficulty in conforming a FAS 109 tax provision for US GAAP purposes to
either the local GAAP of the global parent or more recently the International Accounting Standards
(“IAS”) and International Financial Reporting Standards (“IFRS”) that many non-US global companies
are now adopting.
For US tax professionals working for the US subsidiaries of foreign multinationals, the task
can be complex. On one hand, the identification of permanent and temporary differences with the
maintenance of a precise tax accounting, at first glance, may appear fairly straightforward.
However, deferred tax balances from a US GAAP perspective may not be easily transplanted into a
rigid foreign consolidation reporting system following local country GAAP. In the coming years,
this should be eased somewhat as more and more multinationals migrate to IFRS.
Nevertheless, the US tax provision with the combination of a federal tax with the various
nuances of the state tax calculation can be difficult to reconcile to a single foreign tax rate.
It is important, therefore, to have the capability and flexibility to manipulate a US tax provision
in order that it properly conforms to the various requirements of the foreign parent. In this way, a
US tax team can focus its efforts on tax planning and analysis rather than on multiple presentations
of the same calculation and data.
F. What’s the future like?
I expect that companies will be required to clean-up the tax-related balance sheet accounts in the
next few years. This exercise will produce casualties. However, as a corporate officer with a fiduciary
duty, I believe tax executives will have to bring forward the issues with regard to tax accounting and
start the process of creating transparency. If management chooses not to be proactive in this area, I
expect it will be forced by the auditors.
I also believe this is a good opportunity for tax executives to take advantage of the current
demand and implement a measure that can be helpful for global tax management. For example, a detailed
foreign provision should provide better indications of cash tax payment requirements, thereby, allowing the
tax executives to better manage the cash flow for global tax payments.
2) M-3 Conference »
Return top
I will be holding another conference for the newly required Schedule M-3 for
Form 1120. It will be held at the Harvard Club of New York on May 27th (Friday).
Please check www.taxtechnologies.com for the details of the agenda and registration
information.
The conference will focus on the compliance aspect of M-3 requirements.
Robert Adams of the Internal Revenue Service will present the IRS perspective of M-3
requirements. Robert is a Senior Industry Advisor to the IRS. He is one of the primary
drivers in the release of M-3 and will be able to provide answers to questions as most of the
companies are in the middle of M-3 implementations.
TTI will present the actual implementation of M-3 as to how the conceptual divisions of
schedules in M-3 can be adopted to ease the compliance burden. TTI will also present the
convergence of year-end provision to the compliance reporting how it can be achieved
efficiently.
If you are interested in attending this seminar, please visit www.taxtechnologies.com to
register. For more information please contact our offices toll-free at 201-387-9451.
3) FAS 109 Training »
Return top
Tax Technologies’ offers a two day course designed to walk you through the logical steps required
for preparation of the FAS 109 income tax disclosures while meeting today’s financial statement disclosure
demands. Given the increased scrutiny on creating transparency for financial numbers and the tight time
lines for meeting these reporting requirements, it is now more important than ever to have people that
understand the impact of FAS109 issues and efficient processes that ensure accurate tax disclosures.
This course goes beyond accounting theory and actually teaches you and your staff the “how to” part of
preparing the current and deferred tax components of the global corporate income tax provision. It
provides assistance with those difficult areas of the provision reporting process including items related
to Stock Based Compensation, FAS 5 Tax Reserves, Valuation Allowances, Other Comprehensive Income, Currency
Translation Adjustments, Tax Rate Change Adjustments, States, Net Operating Losses and Foreign Tax Credits.
This course continues to be very well-received by attendees as the topics are right on target and timely with the
current scrutiny on provision processes.
If you are interested in attending this training session, please visit
www.taxtechnologies.com/training/sfas109_agenda.asp to register. For more
information please contact our offices toll-free at 201-387-9451.
4) Preparing Form 8858 and
other International Compliance »
Return top
TTI is pleased to offer the first installment in our new “Let’s Prepare”
training series: Let’s Prepare International Tax Information Reporting. This
course is designed for the individuals charged with preparing or reviewing a
multi-national organization’s international tax compliance, including newly required
Form 8858, as well as Forms 5471 and 8865. Our “Let’s Prepare” series is designed to
provide the fundamental training that an individual will need to go from financial data
to filed form.
If you are interested in attending this training session, please visit
www.taxtechnologies.com to register. For more information please contact our
offices toll-free at 201-387-9451.
I would like to express special thanks to Michael Folkman for his contribution
to this newsletter. Michael is a Vice President of Taxes at LVMH Moet Hennessy
Louis Vuitton Inc.
The content of this e-mail is reproduced in the "Newsletter" section of our website
www.TaxTechnologies.com one week after its release to our subscribers.
If you do not wish to receive our newsletter, please reply to this e-mail with a
comment "I do not wish to receive this e-mail in the future." On the other hand, if
you know someone who can use this information, please feel free to forward this
e-mail and ask us to add the person to our distribution list.
Regards,
J.D. Choi
CEO, Tax Technologies, Inc.
201-387-9451
|
