The tax department of a Fortune 100 Company hires a consulting firm to advise on state tax matters. The consulting firm carries certain issues through the tax appeals process and hires outside legal counsel to represent the Company in tax litigation. The Company’s in-house lawyers are unaware of the tax litigation until someone in the tax department asks for assistance with discovery responses.
Many tax matters, like the real-world scenario described above, fly under the radar of corporate counsel. There are various reasons why communications break down between tax and legal departments. Fortunately, there are specific, proactive steps that corporate counsel can employ to sufficiently identify, understand, and monitor the organization’s tax matters.
A business organization’s corporate counsel serves many functions. One of the most important functions involves monitoring the operations and activities throughout the enterprise so that it can effectively analyze and manage related risks. The general counsel department must foster and maintain open lines of communication with other departments within the organization to ensure that it remains fully informed of all activities that potentially impact the organization. This function is difficult enough when the organizational structure is not overly complex, and far more so if the organization has subsidiaries and divisions operating across multiple states and countries.
In contrast, a business’s tax department appears — at least on the surface — to have a narrower focus (i.e., handling the organization’s tax functions). However, the range of tax types, tax issues, and corresponding jurisdictions with which the tax department must comply is seldom narrow. For instance, a tax department in a multinational corporation routinely handles tax planning issues, filing requirements, and compliance audits relating to multiple taxes across multiple countries, states, and local jurisdictions. Most tax departments accordingly outsource some of its functions to tax consulting firms and — for certain issues — law firms.
A business’s legal and tax departments face enough challenges with monitoring their own functions and activities, much less communicating with each other. No matter the difficulty, however, it is crucial that a legal department sufficiently understand and monitor the business’s tax matters in order to fulfill its core function of monitoring risks. The issues and obstacles will vary greatly from business to business, but fortunately, certain general guidelines remain constant.
The first step in establishing open and productive lines of communication with the tax department is to get to know the players — from the top down. A one-hour monthly or quarterly meeting with the CFO, vice president of tax, and tax director(s), and/or staff would do wonders in alleviating miscommunications between the departments.
Federal Tax and International Tax Issues
Multinational business organizations face many domestic and international tax issues, including periodic compliance requirements, planning issues, and the occasional audit by the IRS or foreign government. Accordingly, organizations should establish internal controls that require the legal department to be informed of the initiation of any tax audit by the IRS, foreign government, or other taxing authority. Those controls should include an audit docket that tracks the status of each active audit (including associated cases in federal Tax Court). Depending on various regulatory issues, the legal department should also be notified of any tax position contemplated or taken by the tax department that falls outside of established IRS or foreign tax guidelines. (These procedures are in addition to those relating to perceived loopholes or tax shelters, which should never be utilized — and which should always be on the legal department’s radar.) The legal and tax departments would benefit from establishing collaborative internal controls to flag tax issues that (i) exceed a certain materiality threshold amount and (ii) involve tax treatments that fall outside of established IRS guidelines.
State and Local Tax Issues
State and local taxes have historically been overshadowed by their higher-rate federal tax counterparts. However, state and local taxes often present more complex and more frequent challenges involving planning, compliance, and controversies. For instance, a multi-state business organization must often file monthly state sales and use tax returns, annual state income tax returns, and depending on the type of business, a variety of other periodic state and local returns involving other taxes. Moreover, a large, multi-state business organization is often audited by state taxing authorities on regular cycles. Many of those audits are never communicated to corporate counsel — a situation that should never occur.
There are many benefits associated with a legal department’s awareness of active state and local tax audits, and from the perspective of the legal department, no disadvantages. The inverse is equally noteworthy: there are many risks associated with a legal department’s not knowing about active tax matters, and no benefits. The following real-world anecdote demonstrates the ramifications:
A large, multi-state corporation had an out-of-state subsidiary that was pursuing a $1 million tax refund. The refund request was ultimately denied by the state taxing agency, and the company appealed the decision by filing suit against the agency in court. The refund claim was seven years old (more than a year of which was in court) before it registered — by blind luck — on the radar of the corporation’s legal department. The primary problem was that the corporation had been in a two-year process of winding up the subsidiary after settling a $50 million environmental claim in another state, and the relatively immaterial tax refund claim was standing in the way of that dissolution. Needless to say, the refund claim was dismissed almost immediately.
The magnitude of this situation may have been unique, though its existence was anything but. Fortunately, these issues are easily preventable by simple, effective communication between an organization’s corporate counsel and tax department.
Most large organizations engage third-party tax consulting firms or law firms to handle certain tax functions, such as tax compliance, audit defense, reverse audits, or appeals. The corresponding scope of service varies wildly (from assisting with certain aspects of an audit to handling the entire process), and the fee arrangements likewise vary (e.g., fixed, hourly, or contingency fee arrangements, or a hybrid of those). A company’s legal department should become involved early in the outsourcing process, preferably during the proposal stage. Corporate counsel will have the strongest understanding of the implications of various fee structures and broad contract issues that involve third-party service providers.
The tax department and, to a lesser extent, the third-party provider will also benefit from the early involvement of the legal department in various tax matters. The legal department has unique expertise relating to evidence gathering, issue framing, and procedural matters. The ultimate success of a tax matter could be substantially increased by the collaboration of all three (i.e., the tax department, legal department, and outside service provider) on a certain matter.
Moreover, corporate counsel typically have the best understanding of the available resources within an organization, as well as the most advantageous way to utilize those resources. For instance, many companies either have in-house governmental affairs personnel or utilize a third party for governmental affairs functions. The legal department typically has stronger relationships with the governmental affairs group and a deeper understanding of the corresponding functions and capabilities. The legal department is therefore in an ideal position to facilitate a productive collaboration between resources that would benefit a variety of tax matters: from proposing and advocating new legislation to negotiating certain matters with state taxing agencies.
The communication of information should not be a one-way street. Corporate counsel should collaborate with the tax department to communicate information that would assist proper tax determinations. A company’s legal department is privy to a plethora of information concerning every facet of the company’s operations, from temporary staffing issues to compliance with environmental regulations. In turn, a company’s tax department is responsible for making tax determinations based on tax laws, regulations, and policies, many of which are driven by public policy issues. For instance, a manufacturer may be eligible to purchase certain equipment and supplies that are exempt from sales tax if they are required by law for environmental or public safety reasons. The legal department is in a position to have a solid understanding of the environmental regulations that could positively affect the company’s eligibility for tax exemptions, and information relating to those issues should be timely shared with the appropriate personnel.
A legal department may become aware of tax-related issues through several means, including verbal communications within the organization or email alerts from online legal information services. Respecting the latter, the legal department could establish email filters that flag communications containing tax updates so that they can be forwarded to the appropriate tax department personnel. Such procedures will not only increase the likelihood that the tax personnel will carefully consider the update, it will begin to promote the collaboration between both departments. Increased communications will be sure to follow.
The legal department should likewise consult with the tax department on projects with potential tax implications, such as construction contracts, significant capital improvements, and mergers and acquisitions. In-house tax departments are filled with highly competent employees who have a firm understanding of the tax implications of the business’s operations and agreements. Those employees will also be in a better position to inform the legal department when it is prudent to hire a law firm or accounting firm to provide additional tax expertise.
A business organization’s legal and corporate counsel can bridge any existing information divide with a small dose of effort and collaboration. Each department — and more important, the business organization itself — will be in a far better place once that collaboration is maximized.
Drew McEwen and Kevin Oldham specialize in tax litigation and planning (in state and local tax, and federal tax matters), and are resident in the firm’s Austin, Texas office.