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  • Tax risk management and governance

    We consider the existence, design and operation of a tax control framework for income tax focusing on the six controls set out in the Director's summary in the Tax risk management and governance review guide.

    The guide sets out principles for board-level and managerial-level responsibilities, with examples of evidence that demonstrates the design and operational effectiveness of tax control frameworks.

    The guide focuses on the processes and controls in place and may not necessarily reflect the tax risk appetite or capabilities and experience of the tax or finance team, or their advisers.

    See also:

    Ratings

    We apply a consistent rating system when reviewing and assessing tax governance as outlined in Table 2.

    Table 2: Rating categories tax governance

    Stage 3

    You provided evidence to demonstrate that a tax control framework exists, has been designed effectively and is operating effectively in practice.

    Stage 2

    You provided evidence to demonstrate that a tax control framework exists and has been designed effectively.

    Stage 1

    You provided evidence to demonstrate a tax control framework exists.

    Not evidenced or concerns

    You have not provided sufficient evidence to demonstrate a tax control framework exists or we have significant concerns with your tax risk management and governance.

    Practical guidance about how we rate tax governance is available on ato.gov.au.

    The reviews completed to the end of January 2019 resulted in the following tax governance ratings as outlined in Graph 2.

    Graph 2: Tax governance ratings

    Graph 2 shows tax governance ratings are: 70% stage 1, 24% stage 2, 1% stage 3, and 5% red flag.

    Observations

    In our reviews we focus on the following six controls set out in the guide which are aligned with the following justified trust objectives:

    Stage 1 rating

    The most common rating is Stage 1 reflecting that many large businesses are in the process of documenting and formalising their tax control frameworks and / or lack objective evidence that their tax control framework is designed effectively. We encourage these taxpayers to start taking steps to move to Stage 2.

    Stage 2 rating

    For Stage 2 we look for evidence that the tax control framework is designed effectively. We are seeing more taxpayers undertaking a gap analysis and presenting this to us during the review.

    Where the gap analysis highlights areas where changes are recommended, to obtain Stage 2 we need to see that these recommended changes have been implemented or a description of your compensating controls or documentation setting out why particular aspects of the guide may not be applicable to your circumstances.

    Stage 3 rating

    To obtain a Stage 3 rating we look for evidence that the documented tax control framework is designed effectively and is operating effectively in practice. Currently few taxpayers can provide evidence that they have independently tested the operation of the framework in practice.

    Some taxpayers with well documented tax control frameworks do not obtain a Stage 3 rating because evidence obtained during the review (for example, substantial errors) demonstrates that their framework is not operating effectively in practice.

    Red flag rating

    A red flag rating is only applied after careful consideration where we have significant concerns with the taxpayer’s tax control framework as evidenced by the high level of errors identified and or fundamental concerns about the robustness of existing tax processes.

    Tax risks flagged to market

    Significant and new transactions and specific tax risks

    We seek to understand and review the income tax treatment of the taxpayer’s business activities, particularly significant and new transactions. We also look for and review risks or concerns communicated to the market and determine if they are present.

    Ratings

    We apply a consistent rating system when reviewing and assessing the income tax treatment of taxpayer’s business activities including significant and new transaction and tax risks communicated to the market. These ratings are outlined in Table 3.

    Table 3: Rating categories income tax

    High

    We obtained a high level of assurance that the right Australian income tax outcomes were reported in your income tax return(s). This means we are unlikely to contact you again in relation these matters for the income year(s) reviewed unless something new comes to our attention.

    Medium

    More evidence and or analysis is required to establish a reasonable basis to obtain a high level of assurance.

    Low

    More evidence and or analysis is required to determine whether a tax risk is present.

    Red flag

    Likely non-compliance with the income tax law.

     

    Out of scope

    We have not evaluated this item and not expressed a rating.

    The ratings for some of the common areas arising in reviews completed to the end of January 2019 are shown in Graph 3:

    Graph 3: Ratings for common areas

    Graph 3 shows ratings for common areas are: 
- R&D – 53.70% high, 35.19% medium, 9.26% low, 1.85% red flag 
- Consolidation and MEC structuring – 57.45% high, 19.15% medium, 21.28% low, 2.13% red flag
- Transfer pricing – 24.05% high, 39.87% medium, 30.38% low, 5.70% red flag
- Thin capitalisation – 70.83% high, 10.42% medium, 12.50% low, 6.25% red flag
- Related party financing – 27.10% high, 30.84% medium, 31.78% low, 10.28% red flag.

    Observations

    In our reviews we consider all relevant Taxpayer alerts and Practical compliance guidelines to assess whether they apply to the taxpayer’s circumstances. We also review all Reportable tax position schedule disclosures.

    The issues identified often have substantial tax consequences. Typically this is where the most of our time during the review is spent to obtain higher levels of assurance.

    Transfer pricing

    Transfer pricing is the most common area with over 70% of Top 1,000 taxpayers disclosing related party dealings. Typical issues include.

    • inbound and outbound supplies of goods and services
    • international related party financing  
      • cross border dealings in general
      • interest free loans outbound and inbound
      • cash pooling arrangements
      • related party derivatives
       
    • management and administrative services
    • payment of licence fees and royalties
    • technical services
    • research and development (R&D) performed on behalf of overseas related parties
    • migration, sale or use of Australian intangible property overseas
    • offshore hubs or service centres
    • attribution of profits to a permanent establishment.

    Transfer pricing is not reviewed where it is covered by an advance pricing arrangement or bilateral advance pricing arrangement or settlement.

    Common issues arising in relation to transfer pricing analyses include:

    • Limited information (documentation) on the global value chain and or functional analysis of the entities to the arrangement.
    • Overreliance on the whole-of-entity transactional net margin method. There are circumstances where other methods, including transactional approaches, may be more appropriate.
    • Lack of comparability analysis in applying the transfer pricing methodology.
    • Changes in transfer pricing policy methodologies without an underlying change to taxpayer functional analysis.

    In respect of specific transactions we are often seeing the following:

    • In relation to financing transactions, the commercial purpose / arm’s length nature of terms and conditions is not well documented or evidenced (for example, subordination, security) and other options realistically available may not be clearly considered.
    • In relation to services transactions, the beneficial nature of services and appropriateness of allocation keys may not be well documented / evidenced.
    • In relation to royalty, licensing, intellectual property arrangements, the beneficial nature and development, enhancement, maintenance, protection and exploitation activities may not be not well documented or evidenced.
    Other common areas attracting our attention

    Other areas that commonly arise in reviews that attract our attention include:

    • inbound and outbound holding structures
    • consolidation  
      • asset recognition
      • valuation
      • multiple entry consolidated (MEC) groups
      • consolidation and re-domiciling
       
    • R&D  
      • taxpayer alerts
      • allocation of expenditure
       
    • thin capitalisation  
      • increasing use of alternative methods
      • revaluations
      • valuation of debt capital
       
    • tax losses  
      • generation, carry forward, transfer and utilisation.
       
    Medium ratings

    For some issues or transactions we require more evidence and or analysis to obtain high assurance. Transfer pricing, valuations or historic tax loss generation are some more common examples. We find the provision of well-constructed position papers and relevant documentation assists us in obtaining high assurance. We encourage taxpayers to provide us with high quality information.

      Last modified: 30 Jul 2019QC 59607