2014-Issue 22—Develop a strategy to successfully manage and settle tax controversies.

In light of the impending global war for corporate tax revenue, this article outlines an audit strategy based on the Eight Rules of Air Combat written for fighter pilots in World War I and applies four of those rules to help companies prepare for tax audits in order to favorably resolve tax controversies.

The non-governmental organization discussion about “transparency” and working closely with revenue authorities is aspirational and admirable. The truth is that when multinational corporations deal with cash-starved governments armed with unlimited resources and face international tax audits, tax controversies and impending court cases, the environment is more like a battlefield.

And it is about to get worse.

New Canadian thin-capitalization rules, Mexico tax law changes affecting dividends and deductions, the Organisation for Economic Co-operation and Development (OECD) attacks on tax planning and proposed country-by-country reporting, and the list of OECD directives extending beyond 2015 are all examples of current developments in the international tax world that seem to point to a more hostile tax environment. Therefore, multinational corporations should develop a strategy to deal with this new environment.

The National World War I Museum at Liberty Memorial in Kansas City, Missouri, houses an exhibit showcasing the new and unique role that aerial combat played in that global conflict. Near the back of the exhibit, the Eight Rules of Air Combat caught my eye. Written by Hauptmann Oswald Boelcke, one of the top fighter pilots of his time, the rules capture what at first seem to be very basic rules of air combat. Upon closer investigation, however, the rules capture timeless strategies and tactics that were applicable to a new age in warfare — the use of airplanes in battle.

These eight rules may apply to corporate taxpayers in many situations, from facing their own auditors in a battle over ASC 740.10 (previously FIN 48) matters or APB 23 “permanently reinvested” discussions more broadly, to battles with tax authorities on audit, appealing their case to a higher authority, taking their case to Tax Court or Federal District Court, or facing a raid by a hostile foreign tax authority. But the focus here is on using these rules in the typical tax authority audit situation. “Transparency” seems to be the new buzzword in global tax compliance, and transparency in dealing with tax authorities is a noble goal. But when facing the leviathan of a bloated, out-of-control government with unlimited resources in a bet-the-effective-tax-rate battle, it should be treated as a battle — a dogfight.

Solution
So what can the corporate tax leaders, general counsel and chief financial officers learn from these Eight Rules of Air Combat? Well, the rules provide tax leaders with strategic and tactical insight. Second, they could be used as a training tool for finance professionals in the field. And third, they may help elevate the tax function within the organization by reducing global tax risk and potentially reducing both tax expense and cash taxes paid.

Background
Both as an international tax advisor for the last 25 years and as a Vice President—Tax for a Fortune 500 global consumer brand company, I have seen firsthand how the tax landscape has turned into a global battlefield. During the late 1990s, the globalization of most U.S. corporations elevated the complexity of tax planning within the organization. Holding companies, intellectual property migration, transfer pricing, export incentives, financial engineering and new entity classification rules provided the tax department with sophisticated planning tools and strategies to lower worldwide effective tax rates. As worldwide marginal tax rates declined across the globe, U.S. companies continued to use tax planning to reduce their overall effective tax rates to remain competitive with non-U.S. competitors. Foreign corporations also used sophisticated techniques to reduce their overall tax payments. The financial crisis of 2008 created huge deficit spending in most global jurisdictions and raised the need for tax revenue to offset and fund stimulus programs with local country spending.

So what tactics can a corporate tax, legal or finance professional use to prepare for this impending attack?

As pilots and commanders were sorting out the role of airplanes in the Great War, Oswald Boelcke drew up a summary of principles and rules for success in air combat. He taught these rules to small groups of eager young pilots, many of whom went on to become accomplished aces:

1. Try to secure advantages before attacking. If possible, keep the sun behind you.
2. Always carry through an attack when you have started it.
3. Fire only at close range and only when the opponent is properly in your sights.
4. Always keep your eye on your opponent, and never let yourself be deceived by ruses.
5. In any form of attack, it is essential to assail your opponent from behind.
6. If your opponent dives on you, do not try to evade his onslaught, but fly to meet it.
7. When over the enemy’s lines, never forget your own line of retreat.
8. For the Staffel: Attack on principle in groups of four or six. Avoid two aircraft attacking the same opponent.

In today’s global tax environment, these rules may be interpreted in light of the new war for revenue. These principles could be communicated within the organization to eager young professionals and finance directors in local country operating units to build effective controversy management.

Four of these rules may be applied to improve the success of a global tax audit.

Rule 1. Try to secure advantages before attacking. If possible, keep the sun behind you.
Said differently, always operate from a position of strength. Taxpayers must secure advantages before engaging in a tax controversy matter with a revenue authority. Whether it’s a routine audit, response to an information document request, reply to an assessment or adjustment, or full-blown tax litigation matter, taxpayers who operate from a position of strength are more successful than those that do not.

While a sneak attack is not recommended, a clear strategy must be outlined prior to responding to a tax authority inquiry. In the U.S., the Internal Revenue Service is not fond of surprises. However, knowing when to present an argument, factual support or documentation may improve the effectiveness of that argument, fact or document.

With respect to speed, timeliness always creates an advantage for the taxpayer. Waiting until the last minute to respond to a document request or giving the revenue authority the impression that late responses are part of a plan to obfuscate the issues is not a successful tactic. Timely responses, returned telephone calls and on-time arrival at meetings all show speediness that is an advantage for the taxpayer. In addition, having documentation ready and organized is an example of securing an advantage before engaging the government.

Performance — knowing both your own facts, issues and applicable rules or laws and the government position on the facts, issues and applicable rules is critical to success. Having a command of the facts, a deep knowledge of the strengths and weaknesses of issues involved in the controversy and a mastery of the applicable law are all indications of securing advantages for high-performing teams.

Finally, knowing the right angle of attack to use in making an argument is an example of keeping the sun behind you during a tax controversy. When the facts are in the taxpayer’s favor, pour them out in an organized way to support the position. When the law is clearly in favor of the position, lead with the law and support.

Rule 2. Always carry through an attack when you have started it.
Be tenacious. Strong arguments and strong facts win cases. And if the taxpayer has a strong argument and strong facts, there is no reason to put forth a half-hearted effort to win the point.

A successful point made or an issue won during a tax audit negotiation or tax controversy may be used to secure further concessions or may be conceded during the life of the battle to win other more valuable points. A point put forth weakly serves no purpose other than to frustrate the opposing party and lengthen the struggle. A weak or factually unsupported argument provides the “slippery slope” upon which the revenue authority may attack other potentially strong arguments and positions.

For example, we anticipate future increased audit scrutiny in the area of corporate substance for holding companies, intangible companies and finance companies. If faced with requests for information about the activities, functions and risks associated with these structures, the taxpayer must respond with more than a copy of a board resolution or lease payment receipt. Rather, the taxpayer should produce records of travel to meetings, minutes of the board meetings, employment records for local country staff and other documents proving the substance and activities housed in the corporate subsidiary.

Rule 3. Fire only at close range and only when the opponent is properly in your sights.
Stated differently, put forth your arguments and documentation in a relevant, timely way. Do not randomly offer documentation that is irrelevant to the issue at hand. Do not take “potshots” by offering extraneous documents or making corollary arguments that are not germane to the issue at hand or the question raised by a revenue authority. Actions like these may be interpreted as ruses, whether intended or not, and may lead to a loss of credibility with the revenue authority or investigating agent.

Strategic arguments are relevant, timely and supported by crisp documentation. This is one area where “transparency” is welcomed by the revenue authorities and is strategic and helpful to a case. Certain arguments may not seem closely tied to a major theme of a case at first, but the successful team ties all arguments to a central cause or branch of a logic tree. Offering timely responses to information requests builds credibility and goodwill during the audit or development of a case. Staying current with audit or case timelines goes a long way toward establishing rapport with the audit team and supports the focused advancement of the case toward resolution. Finally, offering documentation that is organized, labeled and cross-referenced strengthens arguments, builds credibility and adds focus to the audit.

Rule 4. Always keep your eye on your opponent, and never let yourself be deceived by ruses.
During an audit, it is important to know where the revenue authority stands with respect to information requests, factual development and the advancement of legal arguments. No one wants to be surprised by new, seemingly irrelevant information requests or the advancement of a legal argument that flies out of the blue sky. Statements like “where did that come from?” or “we did not see that one coming” should not be part of the response team’s lexicon.

With respect to ruses, it is not common for a revenue authority to intentionally put forth smoke-screen arguments as part of an overall strategy. However, on occasion, an audit argument or information request may seem to go down a path that appears to be irrelevant or not germane to the overall case. These tactics have been called “fishing expeditions” by some practitioners and are not looked upon favorably by the courts. The team handling the audit or case must acknowledge the potential issues addressed by these requests in order to prepare a response that moves the issue back toward a central theme. Knowledge of corollary issues, traps for the unwary and potential whipsaw arguments must be gained by the internal team in order to appropriately respond to the information request or argument.

Summary
These first four rules of air combat may seem a bit dramatic to the tax professional unfamiliar with global attacks for tax revenue. But to the seasoned tax team, they may bring to mind stories from the past or recent experience in active audits. To both, they may provide guidance and insight when facing attacks on a global battlefield.

Alvarez & Marsal Taxand Says:
Transparency in reporting and information sharing with revenue authorities are admirable and aspirational goals. However, corporate taxpayers must apply sound strategies to defend their current positions when attacked by over-zealous government agencies. Recent legislative developments and front-page news stories about tax planning and compliance should cause concern in the executive suite, as we project an increase in global tax audit activity and attacks on structures created over the last several years. Applying a sound strategy and teaching internal teams to follow rules of engagement will help companies meet the challenges of the new corporate tax battlefield.