What companies should know about rising global employment tax risks

In 2021, the United States’ Internal Revenue Service (IRS) closed 46,204 federal-level employment tax examinations (i.e., audits). That’s around 183 examinations for every business day of that year and an increase of more than 200% between 2018 and 2021. Consider how many similar examinations also occur each year globally, and the quantum of examinations occurring may be far more significant than some businesses may think.

If employment tax audits were to occur solely in the domestic context, that would be one thing; the truth is, however, an employment tax audit in one location can quickly trigger broader, deeper examination of other issues by another revenue authority.

Converging trends

Today, there are five (if not more) converging trends that, in aggregate, add up to a higher incidence of employment tax controversy:

• Companies everywhere realize that the wage and benefits packages offered to employees must play a more important role than ever in the attraction and retention of talent. Digitalization, COVID-19, the cost-of-living crisis and an increased focus on the Environmental, Social and Governance (ESG) agenda are having a revolutionary effect on the type of benefits companies can offer, how they administer them and the speed at which they are implemented. All of this may represent the genesis of new and unexpected employment tax risks.
• Employers now work with a greater number of third-party service providers, across a range of different employment tax activities, including payroll, mobility, contingent workers and third-party benefits platforms. This has led to an increased reliance and dependency on these outsourced providers, which in turn means that a company may not have one dedicated resource who is clear on the process and policies related to each activity, let alone having the level of responsibility for the employment tax compliance resulting from these processes.
• Digitalization is having a profound impact on tax administration and the ability of revenue authorities to supplement human judgment with machine-led insights and more when it comes to pinpointing potential compliance gaps.
• The world is experiencing fundamental shifts in where and how people work, and hybrid working is now commonplace globally, potentially creating new risks. Domestic and cross-border travel, historically a key source of employment tax risk, has restarted after the COVID-19 pandemic, with renewed emphasis around hybrid/remote worker arrangements.
• “Off payroll” working – whether providing services through a Personal Service Company (PSC) (or similar vehicle) or through self-employed individuals - has become an issue for revenue authorities as they look to tackle ‘lost revenue’. Many countries are now legislating to tackle off payroll working, in some cases making compliance of PSC workers the responsibility of the company that hires such workers. Similarly, revenue authorities are scrutinizing the use of contingent or “gig” workers. More widely, EU Member States have agreed a Directive[1] (“DAC7”) under which platform operators must report the income of platform users.

Digitalization drives a new employment tax environment

Tax teams of mid-sized and large companies are often finding a new urgency to assess their employment tax risk exposure across their global footprint. This trend is not related to a sudden interest in understanding more about a country’s tax laws, but rather they may have received, often for the first time, tax authority examinations that either resulted or may end up resulting in actions (including civil or criminal penalties) far more severe than they may have received in their headquarters location.

One key reason for this evolving shift is the digitalization and modernization of tax administration, where there is a clear phenomenon occurring wherein higher volume or more transactional taxes are now required to be tracked and reported digitally and often on a real-time basis. With more mainstream use of data analytics by tax authorities — and that the very complexity, scale and geographic dispersion of employment tax obligations can sometimes be a source of risk itself — and it is clear that the stage is set for a rapid and profound increase in employment tax disputes.

As an example, with the introduction of payroll e-filing in Ireland in 2017, payroll returns were subsequently required to be filed digitally with the Irish Revenue each month which has led to a rapid increase in examinations by the tax administration as data was being reviewed quickly.

Globally, companies are now experiencing growing expectations from tax authorities that they should have their full employment tax data at their fingertips at all times. This is leading companies to put in place far more rigor around data integrity generally, including performing a greater volume of line-by-line data reviews to ascertain whether items can go through payroll or instead need to be lodged with the authorities by via a separate submission, such as a Pay-As-You-Earn Settlement Agreement in the UK.

Connections within a tax authority across different types or tax (or even across different government departments) can now occur far more regularly because of digitalization – whether via the use of data analytics or something more sophisticated, such as machine learning or even artificial intelligence. Instances of this playing out in real life are becoming commonplace; as an example, companies operating in the UK should now expect their share plan submissions to be cross-checked by HM Revenue & Customs against their corporation tax return and any other relevant tax documentation.

Indeed, many revenue authorities have either moved (or are in the process of moving) from “all paper” to mandatory “paperless” environments. This move allows far better connectivity across different tax types within the tax authority and broader. While this connectivity is largely (but not exclusively) limited to in-country sharing, the ongoing alignment between the continuous movement of people and the extensive information sharing between different national tax authorities suggest cross-border scrutiny will expand in the future. Likewise, highly transactional review of data including expense payments will become part of such reviews.

Adding to this equation is the fact that tax authorities everywhere, particularly during a period of economic weakness, will look for the opportunities to secure new revenue. Many areas within employment tax are commonly viewed as strong potential candidates for new or higher yield especially due to a combination of the sheer scale of how many employees a company may have, longevity over which an error may occur and ease of collection as they audit the company rather than the individual employees.

Understanding the different sources of employment tax risk

There are at least five categories of risk that can stem from the suboptimal management of employment taxes:

1. Business risks – may include a failure to coordinate or communicate between two or more departments who may share responsibility for hiring and paying workers, or a failure to understand that a benefit may become taxable as tax laws change and evolve
2. Tax technical / legislative risks – may include the lack of awareness or error around new or changing legislation or administrative practice which changes the tax treatment of compensation or similar other payroll related matters?
3. Tax enforcement risks - often driven by technical savvy tax administrations who are under pressure to reduce the tax gap.
4. Reputation risks – happens when a mistake by the company negatively impacts its corporate brand, with external customers or with the company’s own employees?
5. Contagion risk – occurs when a tax authority examination expands beyond the initial employment tax issue(s) being scrutinized and quickly spreads to other tax types, years or even geographies

All five categories come down to one thing: the company’s tax department is often responsible to address the issue in conjunction with other key stakeholders within the organization.

The truth is that the potential sources of employment tax risk are almost endless – and indeed, even the auditing of a single employee’s personal tax returns can sometimes lead to a wider examination of the corporation. The companies that are most successful in mitigating these risks will be those that are not only proactive but also innovative in their thinking about what could occur and how to protect against it. Indeed, it is those companies who will typically not only do a better job of managing and mitigating risk, but who may also reap the benefits of being able to identify potential tax savings via their advantageous approach to employment tax management.

Final thoughts

Employment tax obligations are rather like waves hitting a beach; day and night they are always there, but sometimes several factors can converge at once, and the waves become rough and unpleasant.

Compounding the challenges, employment taxes flex and change with both business strategy and business operations, not to mention the business and economic environments. At some points in time, they may represent obligations around equity and compensation. At others, risks may stem from contingent workers bought in to help meet demand for a product or service. They can also include a host of different tax and social security obligations that may be managed operationally by third parties – but are still the ultimate responsibility of the company when the time comes to meet tax compliance obligations.

Couple all this with the fact that overall responsibility for employment taxes is seldom clear – and is often spread across an organization’s tax, payroll, finance and/or HR functions, not to mention those third parties – and it may be of little surprise that this area of tax is flush with new examination by revenue authorities everywhere.

What can – and should – a company do to best identify and then mitigate these risks? That is the subject of third, upcoming article in this series, titled “Why companies should consider a framework approach to employment tax risk management”.