Tax Strategy: How to Deal with Uncertainty? By Rutger Hafkenscheid and Claudia Janssen Introduction More and more, companies are formulating and documenting an explicit tax strategy. As in any strategy, decisions made pursuant to a tax strategy have a long-term effect and thus involve uncertainty. To date, there is little literature on how to make strategic tax decisions under conditions of uncertainty. This article discusses the types of uncertainty that tax directors face when making strategic decisions and describes the techniques they can use to improve the decision-making process. Level 1: Clear — Enough Future Level 2: Alternate Futures Level 3: Range of Futures Level 4: True Amibiguity Corporate and Tax Strategy The tax strategy of a company should support the company’s overall corporate strategy. The corporate strategy, as well as the operational, marketing, and financial strategies all affect and help define the scope of the tax strategy. Corporate strategy deals with more fundamental questions than the supportive ones like tax strategy. The three basic questions are:1 • • • what markets is the company in? what is the company’s strategic posture, i.e., does it shape its future, adapt to market changes, or reserve the right to play? which courses of action does the company take, i.e., large bets, options, or no regret moves? Corporate Strategy and Uncertainty At each strategic level, the company faces uncertain futures. For strategic decision-making, Courtney identifies three uncertain elements in the future. The first element is that of clear trends — e.g., demographics that help define potential demand for future products and services. The second element consists of factors that are currently unknown but that could in fact be knowable with the right analysis. Examples are performance attributes of current technologies and elasticities of demand for stable categories of products. The third element is the uncertainty that remains after the best possible analysis has been done, called residual uncertainty, e.g., the future market demand for innovative new technologies. To analyze residual uncertainty, Courtney distinguishes four levels of uncertain futures (displayed nearby), each with their own analytical techniques Level 1: A Clear-Enough Future Here, the residual uncertainty is in fact irrelevant for strategic decision-making. Forecasts will be sufficiently narrow to point to a single strategic direction. Consider a funeral insurance company in the West European market. Demographic factors determine market size and insurance losses, while market share and income from investing insurance premiums can be forecast with relative accuracy. Because residual uncertainty is small, strategic decisions can be made with the traditional strategy toolkit, including net present value and internal rate of return calculations, and the calculation of pay-back period. March-April 2009 Source: Courtney Level 2: Alternate Futures At this level, the future can be described as a few discrete scenarios. Analysis cannot identify which outcome will occur, but probability analysis will shine light on a well defined limited number of outcomes. The residual uncertainty is larger than in Level 1, but most of the outcomes are determined by either clear trends or knowable uncertainty. Consider the Big Four accountancy firms, which together form an oligopoly, dominating the accountancy market for multinational corporations, with a high entrance barrier and a strong lobby with regulatory bodies. For them, uncertainty lies in the unpredictability of their competitors’ strategies, which can be analyzed with techniques like game theory and option valuation models. Techniques to value strategic options are expected value calculations, mini-max regret and basic Monte Carlo simulations. Level 3: A Range of Futures At Level 3, a range of potential futures can be identified, defined by a limited number of key variables, but with outcomes lying anywhere along a continuum bounded by that range. There are no natural discrete scenarios. Although parts of the variables determining the strategic outcomes can be identified as clear trends and knowable futures, a substantial number of variables fall within a wide range of values. Consider a telecom company that needs to decide whether to bid for a mobile telecom licence in the African market. Market research might identify only a broad range of potential customers, say from 10 percent to 30 percent of the population, and there would be no obvious scenarios within that range. Strategic decisions will be supported through scenario planning and real options valuation. 117 Tax Strategy: How to Deal with Uncertainty? Level 4: True Ambiguity At this level there is no basis to forecast the future. Level 4 situations are rare, but do exist. Examples of this type of uncertainty are the strategic decisions made by biogenetic companies and market entry for consumer multi-media applications. Analytical tools are analogies, pattern recognition and nonlinear dynamic modelling. At the level of Corporate Strategy, at least half of all strategy problems fall into Levels 2 and 3, whereas most of the rest are Level 1 problems.2 Few strategic decisions face a Level 4 uncertainty. average tax rate of 30 percent, the company’s natural effective tax rate will be 0.25*4% + 0.65*30% + 0.1*29% = 23.4%. Calculation of natural average statutory tax rate Value creation (% of total) Statutory tax Rate (STR) Average STR Marketing & Design 90% 28% 25,2% Tax strategy should answer questions that are supportive to the corporate strategy and have a more operational character. The answers to the corporate strategic questions should guide the answers to strategic tax questions. Sales 10% 29% Marketing & Design 65% 30% 19,5% • Manufacturing 25% 4% 1,0% Sales 10% 29% 2,9% The Scope of Tax Strategy • • • Given the markets in which the company operates, what is our natural tax environment? Given the level of economic uncertainty that we face, under what level of tax uncertainty do we operate? Given the strategic posture of our company, what is our tax posture: do we utilize tax to stretch, match, or hedge the corporate strategic results? What do we do to achieve the after-tax results? Do we actively manage tax, do we implement proven solutions, or do we just comply with statutory requirements? Natural Tax Environment A company’s natural tax environment is defined by the tax expense and administrative tax organization of the company that is the natural consequence of the company’s operational, marketing, and finance strategy, i.e., without any adaptation to improve the company’s tax position or administrative organization. Consider a Danish company (DanCo) that designs and sells trendy mobile telephone devices. The devices are manufactured by third-party contract manufacturers in Taiwan and Malaysia. For its local sales to retailers all over the world the company deploys a commissionaire model, with the principal company in Denmark. Product development and design as well as global marketing are located in Denmark. As new designs with new gadgets are brought to market every year, the company’s operational strategy is focused on keeping production scalable to market demand. In this business model, most of the company value, say 90 percent of its profits, is created in Denmark, and 10 percent in the local sales companies. In Denmark, the statutory income tax rate is 28 percent. Suppose that the average tax rate in the local sales companies is 29 percent. Then the company’s natural effective tax rate is 0.9*28% + 0.1* 29% = 28.1%. Compare this with DanCo’s UK competitor (UKCo), which has its own production facilities in a Taiwanese and Malaysian low tax manufacturing zone, but also deploys a commissionaire sales model. Assume that manufacturing income is taxed at an effective rate of 4 percent. If 25 percent of the company’s global profit is allocable to Taiwan and Malaysia and 65 percent to the United Kingdom at a 30-percent tax rate, and 10 percent to local sales companies at an 118 DanCo 2,9% 28,1% UKCo 23,4% As a result of DanCo’s operational strategy to outsource production, its natural average statutory tax rate is almost 5 percent higher than UKCo’s. This does not mean that its after-tax earnings will be lower than UKCo’s; rather, DanCo’s operational strategy may result in lower manufacturing costs and higher sales prices per unit sold, since its production is more aligned with market demand leading to lower stock and less outlet sales at lower sales prices. The higher average tax rate may be a trade off against the operational strategy. If DanCo’s tax strategy is aligned with its operational strategy, this may limit the strategic actions available to DanCo’s tax management. Aligning a company’s tax strategy with the overall corporate strategy implies that management should consider the expected outcomes of the tax strategy in terms of the expected outcome of the overall strategy. Levels of Residual Uncertainty in Strategic Tax Decisions A company’s natural tax environment requires it to consider the level of uncertainty that it faces when doing business. Tax is a function of economic activity and thus faces the economic uncertainty under which the company operates. But tax also has its own inherent uncertainties. Economic uncertainties. Tax expenses are related to the company’s economic drivers. These economic drivers largely define the company’s natural tax environment. Consider the funeral insurance company that faces Level 1 uncertainty in its corporate strategic decisions. The company’s economic value will be the result of stable and predictable cash flows. The level of uncertainty in these cash flows will substantially define the uncertainty in the tax cash flows. The same is true for the telecom company in Aftrica that operates in Level 3 uncertainty and whose income is highly volatile, which will substantially affect the company’s tax expense. The level of residual uncertainty in a company’s corporate strategic environment will therefore substantially define the level of uncertainty in the tax strategy. The Tax Executive Tax Strategy: How to Deal with Uncertainty? Inherent tax uncertainties. Taxation, however, has its own inherent uncertainty that may be asymmetric with the uncertainty in the company’s corporate strategy: A company facing Level 1 corporate strategy may face Level 2 tax uncertainties. The inherent tax uncertainties comprise tax policy uncertainties and application uncertainties. Policymakers change tax policies over time, which creates tax policy uncertainty. Furthermore, the application of tax laws contains uncertainties in fact finding and interpretation of the law, which can be characterized as application uncertainty. Applying Courtney’s four level typology of residual uncertainties to the strategic uncertainties that tax management faces, nearly all strategic tax decision situations fall in Level 1 and Level 2, with some situations falling in Level 3 and none falling in Level 4. Tax Uncertainty Function Tax Uncertainty Inherent Tax Uncertainty Economic Uncertainty Tax Policy Uncertainty Fact Finding Uncertainty Application Uncertainty Interpretation Uncertainty Level 1: Clear-Enough Tax Trends In most developed countries, the legislative environment shows clear short- to medium-term trends. Legislators tend to shift from complex income taxes to relatively easy sales taxes. Tax bases in income taxes tend to broaden, attention to appropriate transfer pricing tends to increase, interest deductions tend to be restricted to externally paid interest, and statutory tax rates tend to decline. In the short term, tax uncertainty in the legislative environment very often falls within Level 1, in the longer term into Level 2. Level 2: Alternate Tax Futures Level 2 tax uncertainty is often the result of application uncertainty and the company’s strategic tax posture. Consider a company that seeks to actively manage its tax payments through tax planning. Most tax planning triggers reactions from tax authorities through varying interpretations of both facts and legislation and from tax legislators through amendments to the tax law. The outcome of the strategies is not entirely predictable, but good analysis will give a defined limited number of outcomes that can reasonably be valued with probability analysis techniques. Level 3: A Range of Tax Futures Level 3 tax uncertainties are usually the result of tax policy uncertainties, specifically, in politically unstable countries and in March-April 2009 countries where tax policy is used by authorities to regulate direct foreign investments. Examples of such countries are Russia, Venezuela, and many African countries. The foregoing analysis of the levels of residual uncertainty may be surprising to those who know that many companies struggle with the uncertainty that arises from the material weaknesses in their tax organization. This type of uncertainty, however, is “knowable but currently unknown” information, i.e., uncertainty that is not really in the future but rather in what the tax function knows about the current state of affairs. The only way to manage this uncertainty is to improve the company’s tax control framework. (In practice, this activity is often referred to as “tax risk management,” which aims to bringing the operations to an adequate organizational quality level.) Tax Posture: Stretch, Match, or Hedge Because the levels of economic uncertainty in a company may be asymmetric with the levels of tax uncertainty, management can utilize its strategic tax posture to influence its after-tax strategic posture. In fact, management has three strategic options: It can stretch, match, or hedge. Stretching strategy. In this strategy, management utilizes its tax strategy to stretch the company’s after-tax position. Consider a funeral insurance company that has few business opportunities to grow. It could decide to take an active tax posture in that it seeks to reduce tax expenses through implementation of tax planning. Where its economic uncertainty is Level 1, its tax uncertainty may become Level 2, creating a wider range of possible after-tax outcomes than the possible outcomes without the pro-active tax posture. For income taxes, this results in an effective tax rate that would be more volatile than EBT. For operational taxes (customs, VAT, etc.) the EBT would become more volatile. A stretching strategy increases the after-tax risks of the company. In situations where the company operates in a Level 3 corporate strategic environment, such a strategy may be dangerous as it may reduce corporate strategic options. Take, for example, KPN, the Dutch telecom company, which placed a large bet on the German mobile phone market in the late 1990s by acquiring E-Plus, a mobile phone provider in Germany. To help it finance that acquisition, the company took an active tax posture and placed another large bet on a loophole in the German and Dutch legislation, which would allow it to realize tremendous tax cash savings. When both the German and Dutch legislator closed the loopholes, the bet went against KPN. By making bets both at the corporate and tax strategic level, the company substantially stretched its after-tax position, potentially diminishing corporate strategic options. Matching strategy. In a matching strategy, management aims to match its after-tax strategic results with the corporate strategic results. For income taxes this would result in an effective tax rate that is commensurate with earnings-before-tax (EBT) volatility. Consider a manufacturing company facing Level 2 corporate uncertainty. It manufactures in one country and sells in several countries throughout the world. Its earnings before tax are moderately volatile. The firm deploys a commissionaire sales structure with minimal risk for the sale companies, leaving them small com119 Tax Strategy: How to Deal with Uncertainty? missions, and consolidating manufacturing profits in a principal company. Since excess losses and profits are consolidated in one point in the organization, the after-tax profit or loss will likely move in line with EBT. Stretching Strategy Matching Strategy Hedging Strategy Pre-tax outcomes After-tax outcomes Hedging strategy. Here, management utilizes its tax strategy to hedge the risks of its economic uncertainties by taking positions that mirror the bets the company makes in its economic position. For example, in the late 1990s, many telecoms firms built up huge operational and tax losses. Some of these firms implemented tax strategies that sold these losses to financial institutions that hedged the results of their corporate strategic bets. Tax is just one of the drivers of corporate value, but certainly not the most important. So if management considers its strategic tax posture, it should include in its considerations the sensitivity of tax on the expected corporate strategic results. Techniques to Value Tax Uncertainty Each strategy requires management to have an insight into the effect of tax uncertainties on the strategic results. The techniques to analyse these uncertainties differ according to the uncertainty level. 120 Level 1: Clear-Enough Tax Trends. Because the level of residual uncertainty is small, financial results can be forecast with traditional methods, like NPV, IRR, and payback period. Level 2: Alternate Tax Futures. Here, the residual uncertainty gives a defined limited number of outcomes that can reasonably be valued with probability analysis techniques. Typical decision-making valuation techniques are basic scenario analysis, expected NPV, basic Monte Carlo simulations, and option pricing techniques. Level 3: Range of Tax Futures. Techniques to support decisionmaking under Level 3 uncertainties are scenario analysis and real option valuation. In most situations where a company faces Level 3 tax uncertainties, the corporate strategic uncertainty will also fall under Level 3. Then tax scenarios should be included in the overall scenario analysis and no separate scenario analysis is required for tax uncertainty. Tax Actions Analysing strategic uncertainty is only relevant as far as it helps to improve strategic decision-making. When making corporate strategic decisions, the decision maker has a portfolio of three actions, i.e., making large bets, maximizing options or no regret moves. The choice between the strategic actions is a result of the company’s strategic posture as a shaper, an adapter, or a follower. Likewise, when making strategic tax decisions, the decision-maker has three possible tax actions available: “active,” “proven solutions,” and “compliant.” The active company manages the tax expenses and is prepared to accept a higher risk in return for lower expected tax expenses. The active company will face relatively high Level 2 tax uncertainty. The proven solutions company implements generally accepted tax planning opportunities and claims the available tax deductions and exemptions. As such, it will face some Level 2 tax uncertainty, but mostly Level 1. The compliant company implements tax planning only to the extent explicitly accepted by the authorities and claims any available tax exemptions and deductions. The compliant company faces mostly Level 1 tax uncertainty. Annex: List of Relevant Questions when Formulating a Tax Strategy General • • • Knowing the markets and the level of uncertainty in which the company operates, what is the company’s natural tax environment? Given the corporate strategic posture of our company, what is the company’s strategic tax posture? What courses of action does the company take? Does it actively manage tax, implement proven solutions, or just comply? Financial & Operational • • What are the company’s objectives for tax expenses: a low, a sustainable, or a predictable tax rate, and within which bands should these rates fall? Does the company apply planning strategies through adaptation in its legal and financial organization or also through adaptations in its business model? The Tax Executive Tax Strategy: How to Deal with Uncertainty? Corporate Social Posture • • • • Does the company simply apply the letter of the tax law or also (our or the tax authorities’ interpretation of) its spirit? Does the company actively provide the tax authorities with all relevant information, including its intentions to manage taxes, or does it limit information to the minimum statutory requirements with a reluctance to explain the company’s motives? How does the company inform its stakeholders about its tax posture and tax position: openly and transparently or limiting information to the minimum statutory requirements? Do the company actively consider its reputation when making tax decisions or does it react to reputational issues should they occur? Organizational & HR • • • • How does the company organize its tax function? Does the company in- or outsource (parts of) the tax function? Who is (finally) responsible for the financial and operational implementation of the company’s tax strategy? Who is responsible for the corporate social posture? To which level of the organization does the company attribute March-April 2009 • final responsibility for the tax portfolio? How does the company manage performance? Rutger Hafkenscheid advises large and medium sized companies on tax strategy, tax decision-making, and tax valuation. He is also a lecturer Tax Decision Management at the Rijkuniversiteit Groningen, Faculty of Law, and is the founder of the Institute for Tax Decision Management, a foundation that promotes value-focused thinking in tax decision-making, both for companies and fiscal authorities. He may be contacted at [email protected]. Claudia Janssen is Corporate Financial Planner at TomTom NV, the Netherlands car navigation company. Ms. Janssen is also a lecturer at Nyenrode Business Universiteit in The Netherlands, where she teaches Strategy and Decision Making, Business Modelling, and Gaming. She may be reached at [email protected]. 1. 2. Hugh Courtney, Jane Kirkland, and Patrick Viguerie, Strategy Under Uncertainty, HARVARD BUSINESS REVIEW 67-79 (November-December 1997) (hereinafter “Courtney”). Courtney, at 71. 121