3. Avoiding Audit Risk in the Finance Arena
3.1 Understanding why simply following book is not appropriate
The tax department is a company is often unaware of the decisions and activities of the treasury department and financial advisors of the firm. Managing a firm’s debt and equity issuances, hybrids and mezzanine debt, commercial paper, cash management programs, interest rates, currency, and policy regarding commodity derivatives is often set and implemented outside the purview of the tax professionals. This is despite the fact that all finance activity carries with its significant tax risk.
Some firms determine the tax consequences of financial transactions using outputs coming straight from their GAAP accounts. This almost invariably results in completely incorrect tax filings, as GAAP and tax have different rules for almost every type of financial transaction. The following are some examples of common transactions that result in different outcomes for tax and GAAP purposes.
3.1.1 Hedging
The tax accounting rules regarding hedging transactions almost invariably diverge. If a company engages in derivative transactions that do not constitute “hedges” for tax purposes, even if they are regarded as hedges for accounting purposes under the governing GAAP standard (SFAS 133), unexpected and unfortunate tax outcomes are almost inevitable. Differences between tax and accounting include:
- the definition of a hedge versus hedge effectiveness;
- what constitutes a hedge is entity-specific for tax purposes. The right entity must enter into the hedging transaction; and
- the type of transaction that is eligible for hedge treatment.
The tax impact of entering into derivatives regarded as hedges versus non-hedges flows into many parts of the tax return. Most importantly”
- character. In general, a derivative transaction is regarded as being capital in nature. If the derivative is hedging an ordinary business risk, but is now regarded as a hedge for tax purposes, a substantial capital loss may be generated– unmatched by a capital gain on the hedged item. This result is aggravated if the IRS invokes the whipsaw rule that always favours itself;
- timing. Gain or loss on a hedge properly identified for tax purposes follows gain or loss on the underlying item. If not identified, the timing on the derivative will follow general tac rules, which may conflict with the timing of gain or loss on the item being hedged; and
- foreign tax credit, subpart F, etc. Whether a transaction is regarded as a tax hedge will determine the basketing of gain or loss for foreign tax credit purposes, as well as whether it is entitled to deferral under subpart F, and may have other international tax effects.
In order to avoid a whipsaw situation, unexpected capital loss, inconsistent timing, as well as other unexpected and significantly adverse outcomes on hedging transactions, the tax law requires compliance with a comprehensive set of hedging rules. These rules require a system for contemporaneous identification of hedges, as well as a description of the hedging programme that complies with tax definitions. Piggy-backing onto the company accounting programme does no satisfy the tax law, and may even lead to worse results than doing nothing.