TCF as a tool to manage tax risk

A definition of tax risk

Tax risk is defined as the risk of operating in violation of tax regulations, i.e. in a way contrary to the principles and purposes of tax law. These risks are, in particular, risks related to the total or partial lack of relevant information, to the misinterpretation of a norm, or to the wrongful performance of tax fulfilments.

Tax risk can have both a financial nature, in terms of higher taxes, fines and interest, and a non-financial one, considering in particular the reputational risk.

Most taxpayers declare to be attentive to tax issues but, analysing the matter, significant shortcomings emerge: on the one hand, there is a tendency to strongly limit the identification of corporate flows relevant for tax purposes; on the other hand, those who hold information do not have a tax awareness to process them and the control systems usually adopted do not consider tax risks.

In case of tax audit, this casual attitude results in higher taxes, fines and interest (considering just the administrative side), i.e. cash which cannot be used for new investments or to pay labour and capital.

The approach of lawmakers and tax administrations in various States is changing, giving more and more importance to a proactive exchange between taxpayers and tax authorities and providing tools suitable to this end. Those taxpayers intending to adopt a virtuous behaviour, not only as concerns their core business, need to carefully consider how they manage tax issues. The adoption of a Tax Control Framework is, to date, the correct behaviour to adopt.

This is also an approach showing to all stakeholders that the corporate management adopted tax management tools which are up to date and fit for the purpose.

A brief overview

The focus on tax risk and on its management is relatively recent: in the third meeting of the Forum on Tax Administration held in Seul in 2006, the participating tax administrations resolved to start globally coordinated actions against tax elusion and evasion and mandated the OECD to analyse the issue and propose solutions.

Two years later, the OECD published the report “Study into the role of tax intermediaries”, which analysed the activity of taxpayers and tax intermediaries, in the broadest sense of the terms, as well as of tax administrations.

Said report is key, as it lays the foundations for all the actions which will be implemented in the following years: on the one hand, it promotes a voluntary and proactive interaction, with the introduction of the Tax Control Framework, cooperative compliance and, within certain limits, voluntary disclosure; on the other hand, it envisages more effective tax avoidance and evasion measures, such as the exchange of information and the actions of the BEPS project, just to mention the most significant documents.

Most of the documents mentioned have been implemented in our tax legislation: as far as cooperative compliance is concerned, in 2013 a pilot project was launched and, in compliance with the enabling law on tax reform, the Tax Control Framework and the cooperative compliance regime were introduced within the Legislative Decree on legal certainty, and thus in the Italian law system, in 2015. Voluntary disclosure became law in 2014, together with the execution of various agreements for the exchange of information with States which had always been considered as tax havens and staunch defenders of banking secrecy.

Some actions of the BEPS project have been turned into Italian norms and praxis, also through the transposition of some EC directives (actions 5, 8-10, 12, 13 and 14, among others); other are still to be finalised, basically through the implementation of the multilateral instrument.

Tools for a proactive dialogue between taxpayers and tax administrations

If we consider the strategies to promote a proactive exchange of information aimed at voluntary compliance, we can observe that even before the implementation of the Tax Control Framework and the introduction of the cooperative compliance regime there already were in the Italian law tools to manage tax risks relevant to specific activities or operations: general rulings, rulings for the non-application of provisions, anti-avoidance rulings, ruling on new investments, unilateral, bilateral and multilateral advance pricing agreements, mutual agreement procedures.

The cooperative compliance regime has a broader scope, i.e. it focuses on corporate direct and indirect taxation and thus allows to cover all activities and operations in a way that it is impossible to attain with other tools.

A necessary but not sufficient condition to access the cooperative compliance regime is for the company to have a Tax Control Framework.

This is an internal control system, aimed at guaranteeing the correct application of tax norms and the correct management of tax fulfilments.

The strategic role of a Tax Control Framework

The concept of Tax Control Framework was initially introduced in Italy on the occasion of the relevant pilot project in 2013 and of cooperative compliance in 2015.

Most taxpayers tend to connect the Tax Control Framework with the cooperative compliance regime and consequently, as long as they cannot access the cooperative compliance regime (the turnover thresholds to do so are still very high to date, as detailed below), they consider the implementation of a Tax Control Framework as not advisable.

We deem this evaluation essentially wrong and irresponsible.

An effective management of tax risks is key to avoid exposing a company to risks, both financial and of a different nature, arising from the wrongful application of norms and form the management of incorrect tax fulfilments. A modern and responsible management of tax matters implies that the company’s top management can guarantee that tax risks to which it is exposed are identified, assessed, managed and monitored, and thus that the company’s exposure to risk is minimum.

In other words, the adoption of a Tax Control Framework should be seen as a strategic choice for a responsible approach to risk management, which in itself justifies the required investment. The access to the cooperative compliance regime is a further and subsequent step, very important but not always necessary.

There are many corporate taxpayers which do not have a tax office able to monitor all the activities and the fulfilments. In a similar situation, part of the tax activities and fulfilments are outsourced to external providers. The real risk for the taxpayer in these cases is that the corporate tax procedures as for tax matters are partial and that the outsourcers do not have a full picture of the situation. The outcome is that the internal office and the outsourcer are not sufficient to guarantee a good tax risk management and, consequently, expose the taxpayer to major tax risks.

Tax administrations have for some time declared to consider the Tax Control Framework as important and to keep into account the existence of a suitably structured one when evaluating the taxpayers’ risk profile and in case of a tax audit.

By way of comparison, which we do not consider to be far-fetched, the above is the same evaluation made, mutatis mutandis, in the transfer pricing context with reference to the preparation of the documentation required under the Order of the Revenue Office Director and to the submission of an Advance Pricing Agreement. The preparation of the transfer pricing documentation is an optional fulfilment which allows to provide an overview of the taxpayer’s group, operations and methods used to determine arm’s length prices.

If the documentation is prepared consistently with the scheme and the contents of the relevant Order and the tax inspectors confirm its appropriateness, the possible adjustment of the applied prices does not expose the company to the risk of penalties. The submission of an Advance Pricing Agreement application is the obvious outcome of a proactive tax compliance management, but it is not necessary.

A company can decide to prepare the transfer pricing documentation and not to submit any application, or to submit an application covering only one of the various intercompany transactions. The choice not to submit one or more Advance Pricing Agreement applications does not detract from the strategic importance of the preparation of the documentation.

The Tax Control Framework is a valid tool to manage tax risks, key to avoid exposing the company to risks, both financial and non-financial ones, arising from the breach of tax norms.

After having worked on the tax procedures and created a Tax Control Framework, a company can thus consider, once evaluated the subjective conditions, whether to access the cooperative compliance regime.

Brief overview of the cooperative compliance regime

As mentioned above, having a Tax Control Framework is the necessary though not sufficient condition to access the cooperative compliance regime.

As far as the subjective requirements are concerned, there exist one rule and a few exceptions. The rule is that the taxpayer must have a turnover equal to at least 5 billion Euro.

When the law was approved, the turnover threshold was equal to 10 billion Euros. As soon as it entered into force, it was decided that the turnover threshold should have been progressively reduced, until allowing access to all taxpayers with revenues not lower than 100 million Euro.

Exceptions to the rule above are taxpayers which took part in the 2013 pilot project (in this case the turnover had to be equal to at least 1 billion Euro), taxpayers which firstly implemented and manage a Tax Control Framework (provided that the minimum turnover thresholds are met), taxpayers which have obtained a reply to a ruling on new investments and intend to behave as suggested by the Revenue Office and, lastly, taxpayers belonging to a VAT group, where one of the participants adopts the regime.

The cooperative compliance regime guarantees an ongoing exchange with the Revenue Office (Central Department), which becomes the sole point of contact for the taxpayer (with the exception of other local offices of the Revenue Office and of the Tax Police) for inspections and activities relevant to said regime.

The adoption of the regime implies the possibility to reach a preliminary evaluation jointly with the Revenue Office of situations which could give rise to tax risks before filing tax returns, as well as to benefit from shortened ruling procedures.

In case of a differing opinion, the taxpayer can maintain its position and, should it lose the litigation, it could benefit from a 50% reduction of fines and from the suspension of the collection until the tax assessment is complete.

In case of applications for refund of direct or indirect taxes, the taxpayer will not be required to provide guarantees.

The beneficial regime that should be introduced in the Italian law

The Italian tax authorities should invest significantly in their relationship with taxpayers, also by simplifying and facilitating voluntary fulfilments, to be able to distinguish between those who correctly and promptly comply and those who do not, in order to focus the assessment activity on the latter.

They should also promote the adoption of a Tax Control Framework by a significant number of taxpayers.

To achieve this result, the lawmaker and the tax administration should, on the one hand, provide more specific indications on the set up and contents of a suitable Tax Control Framework and, on the other hand, exclude administrative and criminal penalties when a Tax Control Framework is considered acceptable.

The target is very ambitious and challenging: to date, even those taxpayers which are included in the cooperative compliance regime do not benefit from the disapplication of penalties. Administrative penalties are actually reduced to 50%; as for criminal ones, the adoption of the cooperative compliance regime is considered as a mitigating circumstance, not a cause of disapplication.

If the situation above was acceptable in the first years in which the regime was in force from the point of view of the Revenue Office, nowadays it is no longer sustainable in a situation in which the intent is to promote and encourage proactive and voluntary compliance.

Laws need to be introduced, but also revised and adjusted to the changed domestic and international context on an ongoing basis.

The disapplication of administrative and criminal penalties in case of adoption of a suitable Tax Control Framework would be a strong incentive to a substantial improvement of the relationship between Revenue Office and taxpayers and to the increase of voluntary compliance.

To this end, the so-called Colao Commission has already expressed its favourable opinion, but the proposal has meanwhile been forgotten. It would be advisable for the legislator and the tax authorities to reconsider it as soon as possible.