The 40/60 Rule

“Ignorance when it is voluntary is criminal.” – Source: Samuel Johnson

THE SIMPLE ANSWER to these attitudes is to make a calculated “guesstimate” based on an article written by John A. Stacey (a leader at Deloitte in the area of tax risk management) in the article “Managing Tax Risk: Weighing Risk, Opportunity, and Transparency in a More Restrictive Regulatory and Government Environment” where he states, Tax risk is certainly not limited to issues that arise with taxing authorities. Such a perspective not only limits the scope of potential tax risk, but may also result in an after-the-fact rather than a prospective management of that risk. It is also important to note that areas of potential tax risk are not restricted to transactions and processes under the direct authority of the corporate tax function. An educated guess suggests that the tax function does not directly or exclusively manage more than 25 to 30 percent of tax risks in a given organization.

Clear areas of responsibility include tax accounting and compliance processes (such as the preparation of tax forms and tax provisions); tax-reduction planning initiated by the tax group and the monitoring of externally generated risks such as changes in tax and business laws and practices.

That being said, where is the remaining 75 percent of tax risk generated? As noted previously, it can be found in the business units and functional areas over which the tax function may have, at best, an oversight or dotted-line responsibility when tax issues arise.

The gap that exists between active tax oversight on approximately 25 percent of risks and the remaining 75 percent is the crux of the challenge. The Sarbanes-Oxley and Canadian equivalent rules apply to the design and effective operation of the company’s internal controls and procedures over “financial reporting”—thereby encompassing every process that touches the reported results. A vast array of taxes, both direct and indirect, is a very important determinant of shareholder value and earnings per share.

In making a conservative adjustment to the Stacey guesstimate, if one assumes that about 40% of a business’s tax risk is covered by the usual tax compliance functions, 60% or more is not.What does this translate to?

Assuming your business tax bill for the last year was $4m or $40m or $400m, and this is only 40% of the actual tax liability covered, your business could be facing an additional $6m, $60m, or $600m uncovered tax bill based on the 40/60 rule.

How is it possible to reach $6m, $60m, or $600m? If the Revenue discovers a tax indiscretion of $100,000 for a year and is able to extrapolate the tax indiscretion over ten years, the revised assessment may start with revised tax of $1m capital. Add to this up to 75% penalties, the sum increases to just under $2m. Add to this interest over ten years, compounded, the sum could easily double up as just under $4m. One hundred thousand dollar per year, $1m per year, or $10m per year, depending on the size of the business. The taxes that could have problems are direct (income) taxes and indirect (VAT, sales tax, and payroll) tax. A real possibility exists that a sum to the estimated 60% uncovered tax may exist. Either way, you cannot afford not to make sure and reverse an insular attitude to tax. Focusing on the problem will help!

In accordance with Circular 230 Disclosure