A Tax Risk Management Approach to the Introduction of IFRS
Aidan Walsh, Director, Corporate Tax Services
Derek Henry, Senior, Corporate Tax Services

In 1874 Andrew Handyside and Co Limited, an iron-founder in Derby, adopted a totally new fangled accounting technique. They took as a deduction against their net profits an amount for 'depreciation of buildings, plant and machinery'; this was state-of-the-art prudent accounting. They then took a tax deduction for the depreciation charge. Their local Inspector of Taxes disagreed and a tax case ensued – as this was a totally new issue. The company won at the initial appeal but then lost in the Exchequer Courts [1 TC 65]. Since that day no taxpayer in Ireland could claim a tax deduction for depreciation. It was an accounting innovation that caused a degree of tax uncertainty at the time it was introduced but the tax system has dealt with it and there is no doubt now as to the treatment.

And so it has been with most new accounting rules as they have developed over the past 150 years; the Austrian philosopher FA Hayek ¹ explained how rules can emerge and win general acceptance and, perhaps, change over time without any person or committee designing or imposing them. In this manner new accounting rules have come along and our tax system has, over the same period, come to terms with them in some form or other.

The open tax issues from changes to accounting principles that caused a lot of angst for tax professionals in the past are merely routine in the tax computations tax professionals prepare now. Thus, the accounting rules of the past are embedded in the tax system and tax professionals know, because of this, a lot more accounting than they think: without even realising it, tax professionals now know all about the tax controversies that raged about these accounting changes in the past because they now know the routine tax consequences of them. And vice versa, non-tax finance professionals know a lot more tax than they think and so, for example, they will isolate and account separately for depreciation and not merely attach it to each asset.

What the Irish tax system has never seen before is a sudden change to a large number of accounting principles at one time. In a recent survey by Ernst & Young ² the conclusion was: ‘IFRS involves a conceptual change in accounting for income tax, which may have a significant impact on the effective tax rate of companies and their reported tax balances’. The conversion to IFRS for Irish companies means that much of the embedded accounting knowledge that tax professionals have is lost and a large number of open tax issues are created. (Fortunately - Irish companies are not taxable at the consolidated level so IFRS will only come into play when it hits the individual companies). The wisdom of the past is lost and tax professionals, in industry, advisory firms and in the Revenue, must discover the wisdom of the future by trial and error.

Only the most prominent or common areas will be dealt with by legislation or Revenue statements of practice. For everything else, using tax core principles and rules as a guide, tax professionals will eventually learn to deal with the issues.

As you may expect, the first step that needs to be undertaken in relation to the conversion to IFRS is to identify the changes that are going to impact either current and deferred tax or both. This step will involve reviewing the literature on IFRS and assessing the applicability to your company. For example, questions such as the following need to be addressed:

• Does your company have interest expenditure which is required to be capitalised under IFRS?
  
• Does your company have intangibles or items which could be required to be recognised as intangibles under IFRS?
  
• Does your company have share options granted to, and other share-based payments made to, employees as an expense of the employer?
  
• Does your company have foreign operations the results of which are translated at the closing rate?

The conversion to IFRS will probably have such a profound impact on the financial statements that tax professionals are going to have to adopt an approach that is conceptually different to the approach they are familiar with. Currently, tax professionals approach the tax function with the intention of achieving the correct answer, however, managing the tax risk on a project of the magnitude of implementing IFRS is such that tax professionals will have to assess the various elements of IFRS and initially focus their attention on the key risk areas. There will be too many open issues to identify them all immediately – it will probably take years for many of the open issues to be bedded down fully into new routines.

This approach may result in certain aspects of IFRS falling out of scope of the tax professionals’ radar. It should be anticipated that the areas that are initially disregarded from a tax perspective are picked up further down the line as the tax routines are fine-tuned and refined.

This could be seen as a very high level coverage of this issue in comparison to the normal tax methods, however, due to the fundamental change to accounting principles it is likely that this is the approach that will be necessary to prevent the tax department being overwhelmed. The best way to identify a complete list of the material IFRS issues is to map these relevant issues on to a risk assessment matrix (see table 1 for an example) to establish the major tax risks:

Table 1
A tax risk is identified by asking: ‘What can go wrong?’ questions. For example, IAS 23 provides that borrowing costs, i.e. interest, that are directly attributable to the acquisition construction or production of a qualifying asset shall be capitalised as part of the cost of the asset. However, section 48 Finance Act 2005 preserves the tax status quo, by providing that interest capitalised will not be disallowed solely because it is reflected in the value of the asset. The deductibility of interest expense will have to be decided not on the accounting treatment but rather on tax core principles, i.e. is it capital or revenue in nature and is it incurred wholly and exclusively for the purpose of the trade? If a company has a large capital spend on such items it should investigate in detail the costs of the asset to see where tax deductible interest may have been capitalised. On the other hand, if a company has only a small amount of a capital spend, resources may be better allocated to other issues for the moment and this issue returned to when all the higher risk issues have been closed off.

Many of the relevant IFRS issues that are identified by companies may be regarded as having a high tax risk in the first year after conversion due to the fact that individuals will not have dealt with the issues before. In subsequent years the tax rating of relevant issues may be downgraded to reflect the experience gained in previous years.

Having documented the major tax risks the company faces, the next step is to put in place policies and procedures. It is necessary that the ‘line’ personnel are aware of the tax consequences of their actions. In this regard, education of the appropriate staff level is essential to ensure that tax sensitive issues are not being overlooked or inappropriately dealt with. For example, share options granted to, and other share-based payments made to, employees may be perceived to have no effect on the corporation tax liability of the company by certain line managers and, therefore, left unreported or under-reported to the tax department. However, the new IFRS treatment of such items combined with new tax legislation requires an adjustment that requires a carefully documented process to ensure these items are correctly treated not only when they occur but in the future.

At the same time, the fact that the tax function will have undertaken a risk management assessment of the issues means that, at the initial stages, they will not be overburdening the line personnel with non-material tax related matters.

One of the constant issues that needs to be addressed in any tax risk management strategy is to ensure that the tax department are generally aware of what the line personnel are up to. In this regard, as well as educating line personnel, it is essential that the tax department establish some constructive two way communication in order to ensure both elements of this strategy are addressed

This may require a great deal of awareness by the tax function of the corporate culture of an organisation. Whatever method used for the two-way communication must be meaningful within that corporate culture. For example, some companies are used to checklists and this may work for them. Other companies, where responsibilities are devolved, may require that issues are fully explained before the units will deal with them as they see fit. The tax function cannot just indulge in processes that are empty of commitment and content but must find a way that suits the corporate culture.

Another important issue that needs to be addressed when undertaking a project of this sort, is that the responsibility for each task is clearly defined and communicated to ensure no aspect is overlooked including review and approval practices. For example, is deferred tax the responsibility of the accounting or tax department?

Tax risk management on the conversion to IFRS is a cross-disciplinary area that requires both auditing and tax knowledge. For this reason the skills of the finance and tax departments should be carefully reviewed to ensure the right type of expertise exists. It may prove that appropriate people are in the organisation, but an update of their knowledge base is required to ensure their capability to deal with these new challenges. A correct assessment in this regard will be crucial. As discussed in last month’s article, one of the material weaknesses identified by Eastman Kodak in relation to its Sarbanes Oxley disclosures was “inadequate knowledge and application of the provisions of SFAS No. 109 [accounting for income taxes- including deferred taxes] by tax personnel resulting in errors in the accounting for income taxes”.

______________________________

¹ F. A. Hayek, Law, Legislation and Liberty, Routledge & Kegan Paul, London, 1973,
p. 11. See also his distinction (in ch. 2) between a taxis, or made order, and a cosmos, or spontaneous order. Accounting principles are developed by way of a spontaneous order.
² Tax Director and CFO attitudes towards International Financial Reporting Standards (IFRS) June/July 2005

Aidan Walsh is a tax director and Derek Henry is a tax senior in Ernst & Young specialising in tax risk management. The opinions expressed in this article are the authors’ own.

The material in this article is provided for general information purposes only and does not constitute professional advice. It is necessarily in a condensed form. Readers are advised to seek professional advice with regard to their particular factual situation before taking any decision or course of action.

© Copyright 2005 Ernst & Young

This article was first published in Finance Dublin – August 2005