Tax Disputes and Controversy Update - Exploring the trend of ‘Risk Assessment’ and its current use in Canada and the UK

Exploring the trend of ‘Risk Assessment’

‘Do more with less’ is the challenge faced by many tax authorities around the world as governments struggle with tightened finances. Many tax authorities are adopting formal risk assessment programs as part of their response. In theory, by identifying and focusing on those taxpayers and situations that bear the highest risk of non-compliance, tax authorities can promote compliance, potentially generate more tax adjustments with fewer resources at a lower cost, while easing the tax audit burden for taxpayers considered low-risk at the same time.

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Tax Risk Assessment – Updates from the UK and Canada

‘Do more with less’ is the challenge faced by many tax authorities around the world as governments struggle with tightened finances. Many tax authorities are adopting formal risk assessment programs as part of their response. In theory, by identifying and focusing on those taxpayers and situations that bear the highest risk of non-compliance, tax authorities can promote compliance, potentially generate more tax adjustments with fewer resources at a lower cost, while easing the tax audit burden for taxpayers considered low-risk at the same time. 

Are current programs meeting their aim of increasing collections at lower cost? Are taxpayers who work to establish a lower risk status experiencing lighter, more streamlined tax audit coverage in return?

To explore this trend and answer these questions, Sharon Katz-Pearlman hosted a recent webcast with Tax Dispute Resolution and Controversy Services leaders from KPMG International’s network of firms in the United Kingdom and Canada – two countries with relatively mature tax risk assessment programs. The current status and future direction of these programs are summarized below.

Risk Assessment in the United Kingdom – Kevin Elliott & Chris Davidson, Directors, Tax Transformation, KPMG in the UK

HM Revenue & Customs (HMRC) has estimated that UK revenue suffers from a ‘tax gap’ of 34 billion pounds (GBP) – an amount representing the shortfall between total taxes that are theoretically collectible and the amounts actually collected. Of this, HMRC believes GBP9.3 billion (27 percent) of the shortfall is attributable to non-compliance by large businesses, with small and medium enterprises and individuals contributing to the balance of the gap.  

HMRC’s stated objectives are to reduce the tax gap, while more effectively allocating its resources to promote compliance and to prevent and respond to non-compliance. Where large businesses are concerned, HMRC has stated it specifically aims to increase receipts, reduce its collection costs, and improve customer satisfaction.

Large Business directorate established

To these ends, HMRC formed a new Large Business directorate in April 2014 to service more than 2,000 businesses with annual turnover of GBP200 million or more.  Each business is assigned a Customer Relationship Manager to serve as a central point of contact and to coordinate audit resources. These include line managers and industry specialists with in-depth knowledge of 20 business sectors, such as financial institutions and oil and gas. Within this organizational framework, HMRC’s strategy for achieving its goals is three-fold:

  1. Through a ‘resource-to-risk’ approach, tax audit resources are channeled only toward files where it is believed significant dollar amounts or legislative principles are at risk.
  2. Through an ‘upstream focus’, auditors focus less on correcting errors on returns already filed and more on changing behavior and reducing opportunity for tax risks and disputes to arise in the first place (though issues are still examined and litigation pursued when warranted).
  3. Through ‘real-time’ dealings with taxpayers, transactions are discussed and filing positions are agreed before the related tax filings are made.

Risk evaluated at three levels

When it comes to undertaking risk assessments, HMRC has noted that it evaluates risk at the strategic, business and entity or issue levels.

At the strategic level, HMRC’s Large Business Risk Task Force conducts risk assessment of significant issues across industry sectors or the entire large business population and identifies priorities for compliance work. HMRC’s Large Business Directorate’s Tactical Delivery Plan identifies focus areas for deployment of resources to produce compliance yield. In recent years, this appears to have led to an increased focus on indirect and employment taxes. This has also resulted in an HMRC campaign to ask companies how they manage compliance with these taxes.

At the business level, the Customer Relationship Manager and their team will review the business’s inherent risks in terms of its complexity, the number of countries in which it operates and volume of cross-border transactions, and degree of organizational change (e.g. recent acquisitions). The team also examines the business’s behavioral risks based on the strength of its governance, risk appetite, and capability to deliver timely and accurate tax returns.

In theory, businesses that assigned low-risk status at this stage should see less frequent risk reviews or audit challenges for a period of up to 3 years. Businesses that are assigned non low-risk status will have an action plan put in place by HMRC that will include detailed audits of identified risk issues. The most high risk businesses (those with an aggregate GBP100 million of tax at risk) may be admitted to the High-Risk Corporate Program whereby HMRC will deploy significant resource to pursue disputed issues to resolution. 

HMRC’s goal is to have businesses drive changes to their own risk ratings, for example, by meeting all their tax filing and reporting obligations, by demonstrating good governance in managing tax risk, and by adopting the right ‘tone from the top’ in relation to tax risk management. 

Is HMRC’s strategy working?

It is generally acknowledged that HMRC’s approach with large businesses is working. About 40 percent of large businesses have earned low-risk status. These businesses appear to value this status and are willing to take steps to retain it. Other businesses are working to gain low-risk status by negotiating action plans to achieve it. Others appear satisfied to continue with their existing dealings with HMRC outside the low-risk parameters, whether because of the investment needed to reduce their perceived risk, because they find their current relationships with HMRC manageable or other reasons.

A total of 45 businesses have undergone the High-Risk Corporate Program. Since 2012, 1,200 tax disputes were resolved and GBP10.5 billion in taxes have been collected, and HMRC has reduced its resource expenditure over the same period.  Beyond success in ‘doing more with less’, HMRC has also pioneered new programs to achieve faster tax audit completion through the Large Business directorate, including the use of alternative dispute resolution and mediation techniques.

More recently, in response to public criticism that HMRC might not be doing enough to tackle tax avoidance by multinational businesses, there has been a subtle change in tone. HMRC now refers to the use of the Customer Relationship Manager model as a means of ‘man-marking’ large businesses – using the sports term that describes team strategies to mark certain opposing players for extra attention and potential action.

HMRC appears to be more routinely seeking to impose penalties on large businesses where inaccuracies are found with tax filings. Much tighter governance procedures have been introduced by HMRC for the consideration of proposals made by large businesses seeking to settle outstanding tax disputes. 

In a government spending review that will occur following the recent UK election, some expect HMRC to lobby heavily for more funds to conduct criminal investigations, implement new international measures against base erosion and profit shifting, and increase HMRC auditors’ capacity and skills.

While many low-risk UK businesses are realizing the risk assessment program’s benefits, those who have not achieved this status may expect steadily mounting tax audit scrutiny in the years to come.

Risk Assessment in Canada – Paul Lynch, Partner, Tax and National Leader, Tax Litigation & Dispute Resolution, KPMG in Canada

Protecting the integrity of Canada’s self-assessment tax system is the Canada Revenue Agency’s (CRA) stated compliance objective. It works to achieve this aim by identifying, addressing and deterring non-compliant taxpayers. Like HMRC, the Australian Taxation Office and other tax authorities, the CRA has moved to a risk-based approach to make better use of resources to address budget constraints. The CRA also faced a rising audit backlog, as some large business audits for a taxation year were taking more than a year to complete. The CRA’s formal risk assessment processes have been in place for approximately 4 years. Senior CRA officials have stated that in the next year the CRA will launch a more advanced National Risk Assessment Model (NRAM), which will be more reliant on a system-driven, analytic approach to identify and prioritize large business files for audit.

Dedicated resources for international and large business audits

Currently the CRA’s International and Large Business (ILB) directorate has over 2,000 audit resources dedicated to reviews and audits of Canada’s largest businesses.  In step with the global trend, the CRA puts special focus on offshore and aggressive tax planning. The ILB’s dedicated resources work together in integrated large business audit teams, which include:

  • Large Case File Managers, who coordinate the audit and serve as the taxpayer’s point of contact
  • electronic commerce auditors, who analyze large businesses’ electronic accounting data and determine the CRA’s focus
  • specialists, who may be brought in where the audit focus involves areas such as transfer pricing, valuations and aggressive tax planning, both international and domestic.

The current ILB program covers more than 1,200 corporate groups with 250 million Canadian dollars (CDN) or more in annual turnover.  This approach may soon sweep in smaller businesses as the CRA moves to a more system-driven audit approach based on entity-level filing data and refocuses its activities from corporate groups to individual entities as a result.

Measuring results

The CRA does not employ a UK-style tax gap to set assessment targets and measure results. Instead, the CRA tracks the ‘fiscal impact’ of its audit activity. Fiscal impact consists of taxes assessed, refunds reduced, interest and penalties, and the present value of future assessable federal tax resulting from compliance actions. 

The CRA says the fiscal impact of its current ILB program is CDN6 billion annually, which on average would amount to about CDN3 million of adjustments per year for each of the ILB’s 2,000 auditors. However, ‘fiscal impact’ does not show the whole picture since it does not take into account the impact of appeals, reversed assessments or uncollectible amounts.

A second metric for ILB audits is the target change rate, which measures the percentage of audits that result in adjustments. The CRA has dropped its target change rate to 75 percent (from 90 percent ), which presumably results from the more targeted, risk-based audit approach.

Two-tiered process for assessing large business risk

The CRA employs a two-tiered process for risk-assessing large businesses.

  • Tier 1 risk assessments are conducted using the NRAM to identify risk at the macro level and determine whether the degree of risk warrants a detailed audit. 
  • Tier 2 risk assessments employ a Standard Audit Risk Assessment template to assess and document risks at the micro level and develop the audit plan. Templates and audit plans are shared with the taxpayer and are subject to adjustment as the audit progresses.

Some 340 risk factors are currently assessed under the NRAM, including audit history, corporate governance and controls, openness and transparency, participation in aggressive tax planning, and unusual or complex transactions.  Separate risk assessments for behavior, income tax, GST/HST, international activity and aggressive tax planning contribute to the large business’s overall risk rating. 

The CRA also uses North American Industry Classification System codes to analyze the taxpayer’s data against the CRA’s data for its industrial peers. Industries perceived as higher-risk include the financial services, pharmaceutical, upstream oil and gas, and automotive industries, and the CRA has set up coordinating offices for these industries.

Focus on tax governance to continue?

The CRA’s initial risk assessment processes included discussions with companies’ directors and senior executives about their tax strategies and the quality of their tax governance frameworks. This part of the evaluation was a factor in determining risk ratings and generally well received by businesses. Whether this emphasis on tax governance will continue under the CRA’s enhanced NRAM is uncertain, given the new system’s intended reliance on automated analysis of data submitted during the filing process only. The CRA currently plans to continue with these discussions with higher-risk taxpayers, but perhaps to encourage behavioral changes rather than as part of the risk assessment process.

Is the CRA’s strategy working?

Canada’s risk assessment program appears to be achieving the goal of better allocating the tax authority’s resources to the areas of highest risk and in helping the CRA get more current with its audits. Large businesses with low assessed risk appear to be seeing low or no audit activity accordingly. 

Looking ahead, increased automation of the risk assessment and audit selection process could make the business’s tax compliance become a much more important factor in determining their risk assessment. Businesses will need to make every effort to continue to ensure all aspects of their tax filings are complete and on time if they want to achieve or retain low-risk status. 

A replay of the webcast held on 20 May 2015 is available at: www.kpmg.com/taxwebcasts  

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the authors only, and do not necessarily represent the views or professional advice of KPMG.

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