Tax Impact on Decisions

This essay examines the issues surrounding corporate tax liability and the impact that corporate tax rates have on business decisions. Tax liability can be defined as the total amount of taxes that a business or corporation is required to pay as a percentage of its profits. Tax liability is a manageable expense and can vary depending upon the jurisdiction levying the tax. Allowances and deductions set forth in federal and state tax codes provide a means for corporations to reduce the amount of their gross profits and therefore reduce their tax liability. Tax directors in corporations are responsible for reducing the effective tax rate (ETR) for their organizations while ensuring high compliance standards for financial reporting. Tax directors are also tasked with defining overall tax risk strategies for their organizations; as well as with educating key organizational employees about the implications of decision-making and the effects on tax liability. Corporate business units need to partner with tax managers to insure that applicable allowances and deductions are captured to help reduce a company's ETR. This essay will also discuss the trend followed by corporations in creating overall tax management planning and risk assessment and the importance of understanding ETRs between competitors within given industries. An overview of the tax allowances available for "green business strategies" will be discussed along with the competitive nature of global tax rates as an incentive to lure corporate investment to different jurisdictions.

Keywords Codified; Corporate Social Responsibility; Corporate Tax Burden; Effective Tax Rate (ETR); Federal Tax Code; Headline; Indirect Taxes; Internal Revenue Code; Reputational Risk; Statutory Tax Rate; Strategic Tax Review; Tax Competition; Tax Planning; Tax Reform; Tax Risk Management

Accounting > Tax Impact on Decisions

Overview

There are many decisions that businesses make regarding their tax liability. Tax liability represents one of the largest, if not the largest, expense items on corporate income statements (Murray, 2006).

The Internal Revenue Code

Corporations and businesses are subject to the codes outlined in the Internal Revenue Code (IRC) which outlines the domestic tax code for U.S. companies. Most corporations pay taxes as C-corporations, but there are other designations in the tax code for non-profit companies and those operating as S-corporations. The designation of a corporation can have a big impact on the amount of taxes paid by a corporation.

The IRC refers generally to the Internal Revenue Code of 1986 which includes statutory tax law for the U.S. The IRC is organized topically, and broken into many hierarchical sections — the term that is used to describe the organization of the statutes is "codified." There have been many changes to the U.S. tax code over the years. The following timeline shows the major revisions to the code.

• 1874 — First codification of the tax code was undertaken; prior to 1874, the codes were generally unorganized acts that had been passed by Congress.
• 1939 — U.S. Tax laws first codified as an integral part of the U.S. Code.
• 1954 — IRC was greatly reorganized and expanded by Congress and replaced the 1939 code.
• 1986 — with the passage of the Tax Reform Act the IRC was renamed Internal Revenue Act of 1986. Numerous amendments to the code were added.

The Internal Revenue Code in use today is essentially the 1986 code which contained many amendments to the 1954 version. Since 1986, there have been many changes to the IRC and there are renewed calls by legislators and the public to "reform" the overly complex and onerous tax code. Since the last overhaul of the U.S. tax code there have been many amendments and additions to the code. Many critics claim that the tax code has become overly complex and unwieldy.

The topic of tax reform is discussed in the issue section of this essay and includes not only current topics regarding tax reform, but also discusses some of the topics that have come up since the last formal tax change in 1986.

Tax Risk Management

Tax risk management is a finance function and as such has been receiving increasing attention since corporate failures of the early 2000s. Along with corporate risk management, tax risk management has been given more scrutiny by corporate boards and executives. The current business climate exhibits increased shareholder interest and activism around all risk. Corporate taxpayer behavior is now a political issue in the eyes of many. Companies that don't pay their fair share of taxes are seen as lacking in integrity. Not complying with tax laws and underpaying corporate taxes can result in "reputational risk" (Johnson, 2006).

When creating a task risk management strategy, clear discussion and communication are critical. The basic components of a proactive task risk management structure include the purpose, principles, business and the group, tax authorities, government and procedures ("Creating a tax risk management strategy for a multinational," 2013).

There are a number of stakeholders that care about a company's tax liability and the associated risks. Most corporations today must manage the following groups from an overall business standpoint, and from the perspective of tax liability.

• The Public: Expects responsible, ethical behavior as part of an overall corporate social responsibility policy. A subset of this group might include customers and staff.
• The Government: Needs tax revenue and companies are good sources of revenue. Companies that make a big profit but pay little in taxes are not favored. The government might encourage public/customer/staff backlash against a company that is not paying its fair share.
• Tax Authorities: Seek to maximize the amount of tax oversight. Companies already see an increase in audit activity related to compliance. Shareholders concerned about a company's reputation might look favorable upon increased oversight as proof that their organization is paying its fair share.

Shareholders will increasingly want board involvement in tax planning. There's a definite acknowledgement that companies need to do a better job of forecasting effective tax rates. Tax management is being thought of as a more strategic function that is much more than number crunching (Johnson, 2006).

Tax Planning as a Business Strategy

U.S. corporate tax directors make sure that they always know their own corporate tax rate, that of their competitors and the average in their particular industry ("A new age of tax planning," n.d.) A review of Effective Tax Rates (ETR) by industry has revealed that various methods are used to reduce tax costs. If a tax manager researchers a given industry and finds a wide range of ETRs within that industry, this would indicate that there's an opportunity for additional tax planning as a means to reduce the ETR. Given the fact that a single % point reduction in an ETR could be worth a million dollars, there is significant incentive to reduce a company's ETR.

It is important for corporations to stay on top of their ETR to remain competitive within their industry. Companies that proactively and aggressively manage their ETR can potentially save millions of dollars in tax liability. Over the past decade, tax competition has emerged as a global trend. The United States once boasted one of the most competitive corporate tax rates in the world and corporations were attracted to set up operations in America. During the past two decades, many other countries have reduced their corporate tax rate to attract foreign companies. Today, the United States has one of the highest corporate tax rates of industrialized nations and stands to lose its advantage as the place to locate a corporation's operational headquarters. The implications of falling global corporate tax rates are discussed in more detail later in this essay.

Applications

Tax Risk Assessment

If you ask tax directors about their main current challenges, their responses always include lowering effective tax rates (ETRs) while preserving high compliance standards (“A new age of tax planning,” n.d.).

In general, risks associated with tax planning are similar to other types of corporate risk. Risks surrounding tax planning include:

• Complying with the law — not just filing correctly, but assurance that all tax laws are being followed.
• Tax reporting — Sarbanes-Oxley has only increased the awareness of having internal controls and having transparency in reporting.
• Integration of tax planning with business planning — new products, markets and business can create tax obligations resulting in missed tax planning opportunities. Tax planning cannot be a stand-alone event; it must be part of corporate decision making ("A new age of tax planning," n.d.).
• Management of taxes as a cost — taxes are a manageable cost for corporations. Most company's have some control over the ETR and could reduce their tax liability given more support. The downside here may be that when a company reduces its tax liability- the company may be seen as not paying its fair share of taxes.
• Reputational risk - corporate executives do not want to wake up and see their company’s tax planning mistakes plastered on the financial newspaper pages (“A new age of tax planning,” n.d.).

Strategic Partnership with Business

Many good tax plans have become ineffective due to minor changes in the practices of the front line operations ("A new age of tax planning," n.d.).

In corporations today, there is a deliberate effort to integrate functional business units within the overall strategic planning initiatives of the organization. Organizations have done a good job of linking corporate finance functions to specific organizational functions or initiatives. Because corporations have control over their tax liability, there is increased emphasis on tax planning. Tax planning is no longer just the responsibility of the corporate finance department; managers and others who make decisions on capital expenditures need to be aware of tax implications. While it may not make sense to make line mangers into tax experts, many finance departments are seeing the value in educating employees about the tax implications of their decision-making.

CFOs are aware that their organization may be missing qualified claims on capital allowances. Taking advantage of and finding qualified allowances is one of the best ways for an organization to lower its effective tax rate. Aggressive tax planning can really help a company wipe tax liability off the books (Bartram, 2005). CFOs understand that they can't make everyone into a tax expert, but there are ways to heighten the awareness of tax liability amongst personnel. Basic education about the tax implications related to expenditure and other decision-making is the best way to start.

Green Initiatives

"Green Initiatives" are a hot topic at corporations today. Corporations that put environmental responsibility in the public eye are looked upon with favor as being responsible corporate citizens. "Green" practices enhance performance and increase shareholder value by optimizing the corporate tax position (Werthheim, 2007). Companies can benefit from reduced tax liability by taking advantage of tax incentives that support eco-friendly practices. The enormous amount of press that is devoted to environmental issues is being used as a branding opportunity for corporations, while the incentives are becoming an integral part of tax planning for corporations.

Today's "clean and green" business practices are being encouraged at the federal and state level with significant tax credits and incentives. There are numerous benefits to a company from a financial standpoint; corporations can (Wertheim, 2007):

• Produce permanent savings through credits.
• Obtain special grants from construction and rehab projects.
• Hold on to their cash longer.
• Enhance partnerships through shared knowledge opportunities.

There are numerous tax incentives in the federal tax code that are available for corporations looking to implement eco-friendly practices. The costs associated with many of the outlined expenditures are significant as are the potential tax credits to organizations. The past few years have seen an explosion in the amount of press that has been given to issues of energy conservation and sustainability. Corporate America has been anxious to jump on the "do the right thing" band wagon in the wake of so much negative public relations news in the not too distant past. Companies take advantage of a double win when they lower their tax liability and get high corporate responsibility ratings by embracing green business. Some of the most common tax incentives available to business are outlined below (Chirstian, 2007):

• Energy conservation through new equipment purchases (heating, cooling, ventilation).
• New building construction or renovations-using energy efficiency materials or recycled products.
• Water and air pollution control practices or cleanup of polluted areas.
• Alternative energy supplies for buildings (solar, geo-thermal).
• Alternative fuel supplies for automobiles and fleets.

One may expect to see a continued emphasis given to incentives for green initiatives as energy prices rise, and public demand for corporate responsibility rises. The good news for many corporations is that there are tax incentives to encourage green practices and the savings is a great way to reduce tax liability.

Issues

Tax Reform

Tax Reform is a perennially hot topic for legislators and corporate boards. Globalization of world economies and markets has impacted corporate tax rates in profound ways. In global markets, capital moves easily across borders and there is fierce competition by many countries to attract business. "Tax competition" has become a common strategy employed by countries to attract corporations with the lure and promise of reduced corporate tax rates. Consider the following statistics from the European Union (Mitchell, 2007):

• In 2007, seven EU nations cut their corporate tax rate.
• Between 2002 and 2007, sixteen EU nations have cut their corporate tax rate.
• Between 1995 and 2007, twenty-four EU nations have cut their corporate tax rates.

These statistics reflect a corporate "tax cutting binge" in the European Union, however, the corporate tax rates are also falling across the globe. The following countries have cut their corporate tax rate in recent years or plan to cut their rate in the near future: Australia, New Zealand, Canada, Singapore and Russia.

American hasn't always been in its current position as having a very high corporate tax rate. The Tax Reform Act of 1986 under the Regan Administration cut the corporate tax rate from 46% to 34% and was credited with significantly improving the U.S.'s competitive position. By the late 1980s, there was a trend among other nations to cut corporate tax rates as the U.S. had done in 1986; this was a sure sign that tax competition was heating up. In the United States, the corporate tax rate rose 1 percentage point to its current level of 35% during the Clinton administration; when combined with state-level corporate taxes, the statutory U.S. corporate tax rate is estimated to 40%. Put into perspective, the U.S. rate of 40% was on average, as of 2007, 16% points higher than most EU corporate tax rates (Mitchell, 2007).

Until the early 1990s, the combined state and federal statutory corporate tax rate kept up with the rate in other developed nations. But since then, rates in other Organisation for Economic Cooperation and Development (OECD) member nations have "fallen sharply, making the U.S. an outlier" (Desai, 2012). However, despite having one of the highest corporate tax rates, the U.S. now collects less in corporate tax revenue, as a percentage of GDP, than most of the other OECD nations (Desai, 2012).

Corporate Tax Burden

The statutory or official federal taxation rate is just one measure of the actual corporate tax burden. Other measures include:

• Effective tax rate may be higher or lower than statutory rates depending upon government rules surrounding receipts, depreciation and other deductions.
• Compliance around tax laws is time consuming and expensive as companies struggle to comply with complex tax code across many countries.

The U.S. also had the dubious distinction of being cited as the 107th nation out of 117 in terms of tax efficiency according to rankings published in 2007 by the Cato Institute. Put another way, only ten other nations were documented as having a more inefficient tax structure than the United States. Contributing to the inefficiency in administration of the U.S. tax code was the fact that of 175 nations, the U.S. had the fifth longest tax code (Mitchell, 2007). The U.S. tax code is notorious for being overly complex and unwieldy.

More recently, in 2012, Markie and Shackelford analyzed publicly available financial statement information for 11,602 public corporations from 82 countries from 1988-2009 in an attempt to isolate the impact of domicile on corporate taxes. They found that the country in which the parent of a multinational is located, and to a lesser extent its subsidiaries are located, "substantially affects its worldwide effective tax rate (ETR)." Japanese firms always face the highest ETRs, the authors concluded. U.S. multinationals are among the highest taxed, and multinationals based in tax havens face the lowest taxes. And although ETRs have been falling over the last two decades, Markie and Shackelford wrote, "the ordinal rank from high-tax countries to low-fax countries has changed little."

The IRC has been described as "ever expanding and incredibly arcane" by critics who cite that federal tax rules and regulations have more than doubled since the 1970s. Consider some of these statistics from 2000, and assume that the problems have only worsened (Stinton, 2000):

• The Federal tax code in 2000 consisted of 46,000 pages.
• The chief source of federal tax complexity is related to the income tax levied on individuals and businesses.
• The compliance burden associated with filing a federal income tax return (for a business with assets under $1 million) is three times larger than the tax burden (taxes paid).
• There is a major tax law change, on average, every 18 months.

“The U.S. corporate tax system is an anachronism that discourages growth and undermines job creation. High tax rates are driving jobs and investment abroad” (Mitchell, 2007, ¶2).

“America generally does a good job at attracting capital because of its stable currency, dynamic economy, favorable tax rules for individual foreign investors, and lower overall burden of government. But the corporate tax system is one area that needs radical improvement, one where lawmakers can learn lessons from Europe” (Mitchell, 2007, p.2).

Global Competition of Corporate Tax Rates

A 2007 KPMG Survey of global corporate tax rates outlines statutory tax rates for 92 countries. According to the survey, the trend toward lower corporate tax rates continued in 2007 but there were signs that the fall in rates is slowing. There is even some speculation that corporate tax rates may have reached a natural low point (Hickey, 2007). 2007 showed that the most pronounced reduction of corporate tax rates was in the European Union-as had been the case in 2006. Collectively, rates for EU member states fell as tax competition gained momentum amongst EU member states themselves. In 2006, "Europe looks distinctly more attractive than either Asian-Pacific or Latin America" for locating business in "tax friendly" jurisdictions ("KPMG's corporate tax rate survey," 2006).

With tax competition equalizing tax rates across the globe, countries have to resort to incentives other than a low corporate tax rate to attract and maintain business investments. According to the KPMG survey, "business friendliness" is becoming a key differentiator when rating a potential tax environment ("KPMG's corporate tax rate survey," 2006).

Statutory or Headline Tax Rates must be evaluated with caution when determining the overall "corporate tax burden" of a particular jurisdiction. The following factors could significantly change (increase or decrease) a country's statutory tax rate:

• Indirect taxes, which include: Value Added Tax (VAT) or Goods and Services Tax (GST).
• Other financial inducements for domestic investment.
• The sophistication.

Increasing Importance of Indirect Taxes

KPMG Corporate and Indirect Tax Rate 2007 Commentary was the first to include specific information about indirect tax rates and their impact in contributing to business friendly environments. For this discussion, indirect taxes include: VAT and GST tax rates and trends. As corporate tax rates have fallen and equalized the importance of indirect taxes as revenue, gathering strategies have increased. Trends appear to be to reduce corporate tax rates and make up for the revenue shortfalls with increased indirect taxes. It is clear that most countries that have cut their corporate tax rates have not been able to make up for the deficit with an expanded tax base. Attracting new investment is only one part of the equation; keeping investment is also a measure of success. There's no doubt that countries are resorting to more sophisticated methods of attracting and keeping investment as corporate tax rates become more equalized.

It is now common for countries to advertise their VAT/GST rates in an effort to attract businesses. Because of the "huge numbers of special rates and exceptions which many countries apply to their indirect tax regimes" it's not possible to draw many specific conclusions about the impact of advertised indirect taxes on business attraction (Hickey, 2007).

“The link between higher indirect taxes and higher prices is obvious to anyone who buys goods and services, but the link between lower corporate tax rates and increased inward investment, with the increased employment and infrastructure development it can bring, is less well understood” (Hickey, 2007, ¶9). The benefits of cutting corporate tax rates are difficult to communicate to voters. The impact of indirect taxes is obvious to voters in higher prices. Thus, the challenge remains for countries to keep corporate tax rates competitive to attract business investment, but use creative strategies to make up for decreased revenue. The reliance on indirect taxes is a trend that KPMG researchers see continuing into the future. Indirect taxes have the added benefit of providing a steady stream of revenue throughout the year, even with the added burden of tracking and compliance of this revenue stream.

Terms & Concepts

Codified: To arrange something into a systematic code, eg laws, etc.

Effective Tax Rate (ETR): The effective tax rate is an average quantitative measure of an individual’s income tax rate or of a corporation’s pre-tax profits tax rate.

Headline: The publicly disclosed or advertised tax rate (statutory rate) that may be influenced by other factors such as indirect taxes or other hidden costs.

Indirect Taxes: A fee levied by a government on a product, income, or activity in order to finance government programs. Taxes are either direct (charged directly on individual or corporate income) or indirect (added to the price of a good or service).

Internal Revenue Code (IRC): The Internal Revenue Code of 1986 is the major regulatory entity of United States tax law. The IRC is organized topically and includes laws covering the income tax, payroll taxes, gift taxes, estate taxes and statutory excise taxes. It is Title 26 of the United States Code (USC), and is also known as the internal revenue title.

Federal Tax Code: Aka Internal Revenue Code-Title 26.

Strategic Tax Review: Strategic tax review is a comprehensive review of an individual’s tax position encompassing federal, international, and state taxes.

Statutory Tax Rate: A statutory tax rate is the legally imposed taxation rate for a certain tax grouping. For example an income tax might have multiple statutory rates that depend on income levels while a sales tax might have one consistent statutory rate.

Tax Risk Management: Refers to the linking of tax management practices and strategic corporate initiatives. Organizations must link tax decisions with business practices and capital expenditures.

Tax Reform: Refers to the ongoing debate about how to reduce the expense and complexity of administrating the U.S. Federal Tax code (for individuals and businesses).

Bibliography

A new age of tax planning (n.d.) Deloitte & Touche, LLP. Retrieved October 16, 2007, from http://www.deloitte.com/dtt/cda/doc/content//ca‗en‗tax‗new‗planning.pdf

Are you seeking ways to lower your tax rates? (n.d.) Deloitte & Touche, LLP. Retrieved October 16, 2007, from http://www.deloitte.com/dtt/article/0,1002,sid%253D3634%2526cid%253D113448,00.html?theme=tax1

Bartram, P. (2005, October). Making allowances. Financial Director, 22-24. Retrieved October 12, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=19136795&site=ehost-live

Creating a tax risk management strategy for a multinational. (2013). International Tax Review, 24, 26. Retrieved November 17, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=85624921&site=ehost-live

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Johnston, A. (2006, November). The explosion of tax risk. International Tax Review, 24-26. Retrieved October 19, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=23227604&site=ehost-live

Hickey, L. (2007) KPMG corporate and indirect tax rate 2007. Commentary KMPG.com Retrieved October 26, 2007, from http://www.in.kpmg.com/pdf/CorpTaxRateSurvey2007.pdf

KPMG's corporate tax rate survey 2006. (2006). KPMG.com. Retrieved October 25, 2007, from http://pages.stern.nyu.edu/~adamodar/pdfiles/articles/KPMGtaxratesurvey.pdf

Markie, K.S., & Shackelford, D.A. (2012). Cross-country comparisons of corporate income taxes. National Tax Journal, 65, 493-527. Retrieved November 17, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=79355548&site=ehost-live

Mitchell, D. (2007). Corporate taxes: America is falling behind. Cato Institute. Retrieved October 25, 2007, from http://www.cato.org/pubs/tbb/tbb%5f0707%5f48.pdf

Murray, D. (2006). Optimizing the business benefits from technology acquisitions. Financial Executive, 22, 36-41. Retrieved October 12, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=21216359&site=ehost-live

Stinton, P. (2000). Tax code still too complex. San Francisco Chronicle. Retrieved October 24, 2007, from http://www.sfgate.com/cgi-bin/article.cgi?file=/chronicle/archive/2000/11/01/BU118278.DTL

Understanding tax reform: A guide to 21st century alternatives. (2005). AICPA. Retrieved October 24, 2007, from http://tax.aicpa.org/Resources/Tax+Advocacy+for+Members/Tax+Legislation+and+Policy/Understanding+Tax+Reform+A+Guide+to+21st+Century+Alternatives.htm

Wertheim, N. (2007). Going green, staying green. Deloitte & Touche, LLP. Retrieved October 24, 2007, from http://www.deloitte.com/dtt/cda/doc/content/us%5fcb%5fGoingGreen%5f041907.pdf

Suggested Reading

President's Advisory Panel on Federal Tax Reform. (2005). Final report — November 1, 2005. Retrieved October 24, 2007, from: http://www.taxreformpanel.gov/final-report/

Stein, D. (2005). Shopping for tax rates. Financial Planning, 35, 83-84. Retrieved October 19, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=15609549&site=ehost-live

Walsh, M. (2006). Ireland climbs rankings of holding company locations. International Tax Review, 17, 70-72. Retrieved October 19, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=21414351&site=ehost-live

Wolk, M. (2006). Why the tax system keeps getting more complex. MSN.com. Retrieved October 26, 2007, from http://www.msnbc.msn.com/id/12307554/