Volume One 2005PwC dge e

Fresh PerspectivesRisks & Values

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Managing EditorKyle LeeEditorJacqueline GohContributorsKeith StephensonR RaghunathanKaren LoonChris MattenRohan BediPaul CorneliusNicole FungSteven CareyKoh Soo HowFrank DebetsLok Hwee ChongRichard SchulteRohan Solapurkar

Design & LayoutDoris OngCirculationMaimunahat (65) 6236 3953maimunah.asmawi@sg.pwc.comPrinterImage Office Systems& Supplies Pte LtdMita(P)069/10/2004Address8 Cross Street #17-00PWC Building Singapore 048424

Comments and suggestionsshould be addressed toJacqueline Gohat (65) 6236 3963jacqueline.yp.goh@sg.pwc.comThis publication aims toprovide clients with an updateon business trends. No liabilitycan be accepted for anyaction taken as a result ofreading the notes withoutprior consultation with regardto all relevant factors.

PricewaterhouseCoopers(www.pwc.com) providesindustry-focused assurance,tax and advisory services for

public and private clients. Morethan 120,000 people in 144countries connect their thinking,experience and solutions to buildpublic trust and enhance value forclients and their stakeholders.

“PricewaterhouseCoopers” refersto the network of member firmsof PricewaterhouseCoopersInternational Limited, each ofwhich is a separate andindependent legal entity.

Copyright© May 2005PricewaterhouseCoopers Singapore.All rights reserved.*connectedthinking is a trademark ofPricewaterhouseCoopers.

Editor’s Note

Ideas for Today and Tomorrow

The alarming increase in the number of companies beinginvestigated for improper governance, non-compliancewith laws and regulations, misreporting and outrightdistortion of financial numbers have made Governance,Risk Management and Compliance (GRC) a priorityitem on the Board agenda. Now more than ever, Boardmembers, especially the independent directors, havebeen placed in an unenviable position whenever there is afailure in GRC, having to explain matters to the shareholders,which in the first place, were not known to them.

In this issue of PwC Edge, we strive to unravel thecomplexities of GRC. Some of the articles are descriptiveand others prescriptive, carrying ideas that are relevant todayand tomorrow. In ''Finance Department of Tomorrow, Today''Keith Stephenson and R Ragunathan delve into thetransformation of the finance function and the role tomorrow’sfinance function plays in helping the Board to deal withchallenges of governance, transparency and value creation.

In the financial services industry, Karen Loon argues thatremaining compliant is conditio sine qua non for industryplayers. Her ideas in ''Grasping the value in Governance,Risk Management and Compliance'' are relevant tomorrowas they are today. Capital adequacy is another sine qua non– Chris Matten’s ''Pillar 2 and you – Is economic capital backon the supervisor agenda?“ is a technical tour de force to beappreciated by specialists in the industry.

Tax payers in general would argue that taxation is a valuedestroying activity and at best a necessary evil in anorderly society which should be mitigated. Practitioners likePaul Cornelius have different ideas. Today’s tax departmentcan create value and manage risk. How so? – Paul openshis tool kit to us in – ''The Tax Challenge – Managing Risksand Creating Value''.

There are more ideas to be shared on transfer pricing, goodsand services tax, custom and excise, and last but not leastinternational assignments. The thread that runs through allthese articles carry ideas on risk management and valuecreation, ideas which are relevant today as they aretomorrow. If ever there is a time to talk about improving thepractice of governance, risk management, complianceand value creation it is now – more than ever.

Kyle LeeManaging Editor

Management 5 - 9

Be The Finance Department of Tomorrow, Today– Achieving Financial EffectivenessIt is alarming to see the number of companies which are being investigated forimproper governance, insufficient transparency and reporting of inaccurate results.The confidence of shareholders in the market has been dented to some extent.Not surprisingly, the Board, and especially the independent directors, have beenplaced in an unenviable position of having to explain matters to the shareholders,which in the first place, were never known to them.

Financial Services Features 11 - 29Grasping the value in Governance, Risk Management, and ComplianceAt a time when society expects integrity as well as competence from their financialservices providers, and as financial institutions seek to find an appropriate balancebetween economic returns and risk, and manage changing stakeholder expectations,governance, risk management, and compliance (GRC) has increasingly becomean area that institutions globally are focusing on.

Pillar 2 and you – Is economic capital back on the supervisory agenda?The revised capital framework for banks, most commonly referred to as Basel II,has put the issue of economic capital firmly on the agenda of many banks.Some commentators have assumed that, to comply with Pillar 2 of Basel II,banks must adopt an economic capital model. In this article, we will analysehow much truth there is in that assertion and try to place economic capital in theproper context in relation to Basel II.

Anti-money laundering: The key issuesThe revision of the FATF 40 recommendations in 2003 and the release of furtherrecommendations on terrorist financing last year have pushed anti-money launderingup the risk management agenda. Rohan Bedi of PricewaterhouseCoopers identifiesthe top seven anti-money laundering issues faced by Asian banks.

ContentsPWC EDGE VOLUME ONE 2005

Tax Angle 31 - 59The Tax Challenge – Managing Risks and Creating ValueThe tax affairs of local and multinational corporations are rarely seen as the glamorousside of the business. Filing tax returns and complying with other regulatory taxationobligations are necessary but mundane activities. So if the tax affairs of a companyare not exciting, why are they important?

Transfer Pricing – Opportunities and Risks in AsiaTransfer pricing issues are of paramount importance in an increasingly global economy.It has been estimated that as much as 60% of international trade takes place withinmultinational groups. This will increase further as multinationals continue to centralisetheir logistics hubs, streamline their supply chain and create centres of excellence formanufacturing and services.

GST and SOS (Saving Our Services)Koh Soo How examines whether the Goods and Services Tax (GST) system isimpeding Singapore’s efforts to promote its international services sector.

What’s the Value in Customs Valuation?Where’s the Risk in Post-Clearance Audit?Trade and customs management has been a part of commercial practice since moderntrading between countries began in the early 20th century. As mercantile trade flowsincreased, the need for controls increased proportionally. Today, many customsterritories imposed customs duties using sophisticated customs managementtechniques operated by highly professional customs administrations.

International Assignments...Impact of non-complianceDo companies understand the consequences of a situation where an employeeis restricted from leaving a foreign country due to non-compliance with localregulations? Apart from the monetary consequences that can be addressed,the non-monetary repercussions in the form of adverse publicity are difficultto address and measure.

CONTENTS PWC EDGE VOLUME ONE 2005

5PWC EDGE

BY KEITH STEPHENSON (above) & R RAGHUNATHAN Performance Improvement

Be The Finance Department ofTomorrow, Today – AchievingFinancial EffectivenessAs you will be well aware, this reporting season, the newspapers have beenflooded with numerous articles highlighting scandals in Singapore listedcompanies. It is alarming to see the number of companies which are beinginvestigated for improper governance, insufficient transparency and reportingof inaccurate results. The confidence of shareholders in the market hasbeen dented to some extent. Not surprisingly, the Board, and especially theindependent directors, have been placed in an unenviable position of havingto explain matters to the shareholders, which in the first place, were neverknown to them.

Being on top of governance and transparencymatters is not all. Today’s corporate Boards faceother challenges as well. Boards have to formulateand drive business strategy in a global marketplaceand in an environment of fast-changing technologies,oversee risk management and compliance withregulations, and manage earnings expectations.

The day is not far where the Boards of companieswill have to positively assert to their shareholderson how they have acted to optimise overallcorporate performance. It is clear that the Boardsneed a lot of support and help.

So, what is the solution then? If we look at anycompany, we will find that there is one functionwhich is uniquely positioned to help the Boardmeet its challenges. And that is the FinanceFunction. Finance is the corporate glue whichbrings together all departments through a commonlanguage, the language of numbers! If the FinanceFunction works well, it can relieve the Board of mostof its worries. However, if the Finance Functiondoes not do what it is supposed to, more oftenthan not, you will find the company in trouble.

So it is clear that the Board has to rely upon itsFinance Function to deliver the goods. The questionthen is: Does the Finance Function know enoughabout itself such that it can positively assert to thevalue it provides to the Board?

For the Finance Function to provide a positiveassertion to its Board on the value that it providesto the company, it needs to take action to addressthe key challenges faced by the Board. Figure 1illustrates some of the key challenges faced by theBoard and how the Finance Function can assistthe Board to address them.

Clarifying Board expectations

However, providing an assertion to the Board isnot easy as there are several difficulties in doingso. Firstly, most Finance Functions are not clearof their Board’s expectations and similarly manyBoards may not be clear as to what to expect fromtheir Finance Function. We all know very well as tohow difficult it is to work for someone who doesnot clearly set out their expectations. The samelogic applies to Finance Functions and theirworking relationships with the Board. We often seea company’s Finance Function busy respondingto ad-hoc Board requests, primarily because theBoard is working on a different wavelength.

This matter needs to be urgently addressed.One of the ways to bridge this expectation gapis to formalise the Board’s expectations of theFinance Function in a Finance GovernanceStatement. This Finance Governance Statementcan clearly spell out the Board’s expectations

6 PWC EDGE

Figure 1: How the Finance Function can address key challenges faced by the boards of companies

BoardChallenges

OperationalExcellence

QualityFinancialReporting

Solvency

Addresses:

• IFRS• Faster reporting• Revenue recognition• Future income reporting

NoSurprises

NewProducts

CapitalOptimisation

QualityPeople

Strategy

Reinforces:

• Strong compliance• Safeguarding of assets• Proactive fraud reviews• Sarbanes - Oxley 409 reporting• Manual adjustments “taboo”• Financial risk management

Performs:

• Risk-based /cost evaluation reviews

Provides:

• Quality decisionsupport

• Risk-adjustedvaluation of change

• Hurdle rates

Has:

• Highest skill levels• Integrity / ethics

Monitors and manages:

• Daily cash position• Working capital• Forecasts• Loan covenants

Meets:

• World class benchmarksincluding that forFinance Functioncost

Links:

• Strategy to budgetand managementaccounts throughfinancial plans

in different areas including strategy support,reporting, decision support, performancemanagement, governance, compliance, controlsrisk management, etc. The Finance Functioncan then sign-off and implement the necessarymeasures that would enable them to meet theBoard’s expectations. At the end of everyquarter, they can report back to the Board theprogress made to meet the Board’s expectations.The advantage of having a Finance GovernanceStatement is that it removes uncertainty, clarifiesexpectations, enables the Board to spot issuesearly on thereby giving it greater comfort, andprovides a basis for the Board to continuallyassess the Finance Function’s performance.

Need for transforming theFinance Function

After having signed a Finance GovernanceStatement with its Board, many FinanceFunctions will realise that there is a big gapbetween what they currently do and what theyare required to do.

Let us look at the way in which a typical FinanceFunction works. The working life of finance staffcan be roughly described as:

• gather/receive data;

• input to the system;

• wait for more data (that usually comes in late);

• input that into the system;

• work hard under tight deadlines to reconcilethe numbers at month-end;

• make period end adjustments andestimates (most likely with little time tocheck their validity);

• take a short break for a day or two;

• and then start the whole processall over again.

Quarter-end activity is more of the same butusually with a closer look at the numbers andadditional reporting. Year-end has all the addedpressure of ensuring the numbers are right,and meeting significant reporting obligations.

Not surprisingly, these activities are labour-intensive and expensive. A typical FinanceFunction costs 1.4% or more of companyrevenues, with transaction processing and

control activities consuming more than 80%of these costs (source: Hackett Group).

Additionally, management information systemscan be disparate and inconsistent in items reported,making consolidation process a nightmare. Often,the monthly financial reports are finally presentedto the executive committee, “just-in-time”.The committee may only see the reporting packfor the first time during the meeting and eventhen, excessive manual adjustments may behighlighted and circulated afterwards.

Does this sound familiar? If so, take comfortthat you are probably not alone.

With a Finance Governance Statement in place,it is clear that the Finance Function has totransform itself. The CFO is the person whowill need to drive this transformation to ensurethat the Finance Function becomes the flagbearer that champions good governance,financial discipline and best practices withinthe company.

The Changing Role of the CFOs

To begin with, CFOs must realise that the role ofFinance needs to evolve from being transaction-oriented and scorekeeping in nature to being moreanalytic and strategic, thereby adding value to thebusiness and providing support to the Board.

Increased Partnership with the Organisation

Financial Accounting andReporting Only

Member of the Executive

Trusted Advisor to the CEO

Business Partner of the CEO

ScoreKeeper

Commentator

DiligentCaretaker

BusinessPartner

Enh

ance

d B

usin

ess

Valu

e

Incr

ease

d C

orpo

rate

res

pons

ibili

ty

Figure 2: Changing role of CFOs

7PWC EDGE

For example, senior management may like toknow the answers to questions such as:

• Which parts of the business are producingand consuming financial resources?

• How do different businesses within theorganisation compare with one anotherin the production and consumption offinancial resources?

• How does our actual spend measure upagainst budgets and forecasts and dowe really understand what causedany differences?

• What investment opportunities shouldwe take?

• Which products or services are actuallygenerating a profit?

• Which customers are more profitable?

These are the kind of inputs which theCFO would increasingly be expectedto provide to influence strategic decisionswithin a business.

Tomorrow’s Finance Functions

Leading edge Finance Functions embedthemselves within the organisation rather thanbeing a “support” operation. This “partnering”can be enabled by reducing transactionprocessing effort, reducing budget preparationeffort, improving all aspects of tax recordingand accounting and focusing on value-addeddecision support.

To be successful in this transformation andto respond to key challenges, the FinanceFunction has to move from being ascorekeeper to being a business partner.This involves a significant shift in role andthe Finance Function needs to first assesswhether or not it currently has the relevantskill sets to fulfil this role. It also needs togain the confidence of the CEO and securea mandate – this can happen only if itdemonstrates that it is willing and able tomeet the new requirements.

The key to this transformation is to optimiseall aspects of the Finance Function’s presentand future activities. This is enabled byprogressively reducing the amount of effortand time that the Finance Function spends incompleting all of the different transaction,

budgeting, taxation and reporting tasks.A traditional allocation of Finance Functiontime is depicted in Figure 3. The FinanceFunction should aim to move the “traditional”time allocation for Transaction Processing from66% of total time to approximately 11% oftotal time and effectively reverse the decisionsupport and transaction processing time andeffort, as depicted below:

Figure 3: Time allocation of Traditional Finance Function

Figure 4: Time allocation of Tomorrow’s Finance Function

8 PWC EDGE

18% Controls

11% DecisionSupport

5% Finance FunctionManagement

66% Transactions

18% Controls

11% TransactionProcessing

5% Finance FunctionManagement

66% DecisionSupport

Transforming the Finance Function

Achieving Finance Function effectiveness requiresa combination of drive, enthusiasm, vision, strategy,processes, resources and support from the CEOand the Board. This journey of transformation isnot easy but big gains await those organisationswho succeed. PwC recently launched a 360-degree holistic diagnostic assessment that looksat making the journey more systematic andstructured. Success will not only enable abusiness to lower its cost of capital and providebetter returns to shareholders, it will also beinstrumental in helping the Board understand,manage and steer company performance togreater heights.

Keith Stephenson can be contacted attel . (65) 6236 3358e-mail . keith.stephenson@sg.pwc.com

R Raghunathan can be contacted attel . (65) 6236 3371e-mail . r.raghunathan@sg.pwc.com

PWC EDGE

BY KAREN LOON Banking and Capital Markets Industry Group

Grasping the value in Governance,Risk Mangement, and ComplianceAt a time when society expects integrity as well as competence from theirfinancial services providers, and as financial institutions seek to find anappropriate balance between economic returns and risk, and manage changingstakeholder expectations, governance, risk management, and compliance(GRC) has increasingly become an area that institutions globally are focusing on.

11PWC EDGE

12 PWC EDGE

1 In the 2004 Centre for the Study of Financial Institutions (CSFI)/PricewaterhouseCoopers Banana Skins annual survey of the risks facing banks, the top banana skin for emergingmarkets was Corporate Governance. Globally, corporate governance has increasingly become a concern of the survey’s respondents, moving from 8th place in 2003 to 3rd place in 2004.

2 PricewaterhouseCoopers 8th Annual CEO Survey – Financial Services specific questions

3 See the results of our PricewaterhouseCoopers/Economic Intelligence Unit (EIU) survey “Governance – From compliance to strategic advantage” issued in April 2004 which canbe found at http://www.pwc.com.financialservices

As global financial institutions increasingly lookto Asia as their next source of growth, Asianinstitutions too are looking to funding frommarkets outside Asia. With regulations andmarket practices continuing to converge globally,integrated GRC is likely to become increasinglymore important and common in the region.

What is governance, risk managementand compliance (GRC)?

Taken separately, governance, risk managementand compliance are not new concepts. In oneform or another, dealing with transparency andaccountability, mitigating risk, and complyingwith regulations have always been issues thatfinancial institutions had to deal with.

In a narrow sense, governance, risk management,and compliance often connote burdensome legalmandates that are viewed as necessary tasks...tasks which seem to require resources and entailcosts far in excess of any perceived benefits.

However, the insights to the potential benefitsof GRC are amplified when the concepts areviewed as an integrated whole. This meansexpanding the scope of GRC to include compliancewith all requirements that help an organisationmeet its strategic objectives, which takesinto account the values of a wider group ofstakeholders. From this vantage point, GRChas the potential to become a value-addingprinciple that is integral to an institution’scompetitiveness, and ultimately, its success.

GRC is defined as ‘the organisation’s practicesand the various roles that the Board and seniormanagement, line management, and the restof the organisation play in relation to oversight,strategy, risk management, and strategyexecution regarding compliance with laws andregulations and internal policies and procedures’.

...the insights to thepotential benefits of GRCare amplified when theconcepts are viewed asan integrated whole.

So much effort, but is it enough?

GRC, and in particular corporate governance,continues to dominate boardroom and seniormanagement discussions as a key risk whichneeds to be managed.

While some believe that changes to corporategovernance processes and practices did nothave a substantive impact on the way they runtheir businesses over the past two years, mostwould agree that they are growing in influenceat the board level. Board members of financialinstitutions are now progressively fixing theirgaze on this area, with the top two prioritiesof Boards being to ensure the adequacy ofinternal controls and ensure compliance withregulations2. Interestingly, ensuring compliancewith regulations has risen in importance inboardrooms over the past 12 months3.

As a result, for many financial institutions,there is heightened involvement at the boardlevel, with board members having more robustdiscussions with executive teams, and requestingfor access to more data on a timely basis,including forward looking information. Corporate

Eight elements of effective GRC

While GRC is still an emerging field, thefollowing provides a useful starting point:

• Corporate/organisational codesof conduct

• Policies and procedures

• Compliance and ethics training

• Demonstrating expected behaviour

• Ongoing process improvement

• Real-time reporting

• Monitoring/measuring GRC performance

• Accurate, timely, complete, andconsistent information

13PWC EDGE

4 PricewaterhouseCoopers 8th Annual CEO Survey – Financial Services specific questions

5 2004 CSFI/PricewaterhouseCoopers Banana Skins report

6 96% of financial services CEOs responded that a reputation for integrity can prove to be a source of great or some competitive advantage for financial institutions in our 8th GlobalCEO Survey.

governance now has a higher impact at the topof organisations, which ultimately filters downand influences the internal culture of organisations.With that, we are seeing more systematicprocesses over identification and managementof risk, and improvements in managementdata and metrics4.

However, despite these efforts, financialinstitutions (including some operating in Asia-Pacific) have not been spared from governanceissues in recent times, which have impacted thereputation of their organisations. Some particularaspects of corporate governance where peoplesee risks are5:

• The larger they grow, the bigger the risks –As firms increasingly seek to generate valuefor shareholders, they may expand into newproducts and markets to exploit short-termopportunities. Controlling these newopportunities requires appropriate andtimely revamps to an organisation’sgovernance framework.

• Ethics – Business ethics and culture playan important role in an organisation’sgovernance framework. New opportunitiesthrough products and markets can createethical concerns.

These concerns were also echoed by CEOs inour 8th Global CEO Survey2. While most globalCEOs have a good understanding of the breadth

of GRC and its interrelationships, manyacknowledge that this is not easily achieved.68% and 57% of global CEOs are confident thattheir organisations can respond to GRC mattersrelated to domestic laws and regulations andinternal policies and procedures in domestic unitsrespectively. Yet, when it came to the same mattersfor foreign business units, we see a significantdrop in their level of confidence.

Minimising reputational risk continues to be aconcern of CEOs of financial institutions; mostacknowledge that a reputation for integritycan be a competitive advantage for financialinstitutions6. At this point in time, as many Asianfinancial institutions continue to make cross-borderacquisitions and investments, we also seeconvergence of regulations in a number of areas.Ensuring that an appropriate GRC framework isin place will make transcending the country/jurisdiction divide a less painful experience foran organisation as it expands.

Embedding a compliance culture?

For many years, financial institutions have beenmaking continuous improvements in their riskmanagement frameworks, and good progresshas been made in the last two years on improvingcorporate governance frameworks. These advancesin the financial industry were in line with increasingregulatory expectations and imperative asinstitutions seek to further link (operational) risk,

RegulatoryRisk

OperationalRisk

ReputationRisk

BusinessRisk

Compliance& Legal Risk

expectationsstakeholders’

other

14 PWC EDGE

7 Our 2005 Global Compliance Survey was issued in April 2005. A copy is available at http://www.pwc.com/financialservices

8 When questioned how satisfied respondents to our PricewaterhouseCoopers/EIU survey, “From aspiration to achievement: Improving performance in the financial services industry”were with the performance of compliance, where 1 indicated extremely satisfied, and 5 extremely dissatisfied, compliance ranked on average 2.33, which was above many other areas.

capital and shareholder value. The evolutionin GRC has led to one of the challenges forsenior management and compliance officerstoday: to actively encourage recognition ofcompliance as a proactive managementdiscipline. Being compliant is a fundamentalgoal for financial institutions – failure to complywith regulations, with the associated reputationaldamage when breaches are publicly penalised,could threaten survival, not just profits.

Our 2005 Global Compliance Survey7 confirmedthat the concept of ‘embedding a complianceculture’ is clearly widespread in financialinstitutions in many countries. Boards andsenior management are beginning to value thesupport of an efficient and effective compliancefunction8. Significant challenges remain,however, if organisations hope to reap the fullbenefits. Many organisations still believe that alarge part of the challenge stems from theweight of new regulations and uncertaintyover their practical application, and thatconformance might undermine performanceif regulatory requirements constrain theflexibility and innovation of business models,and impose apparently unnecessary costs.Given stakeholders’ expectations of integrity,compliance – like performance – becomesa prerequisite for staying in business.The compliance function provides one, albeitessential, tool to enable management to fulfilthese expectations and protect the brand.Most compliance costs would certainly appearmodest when compared to the billions that canbe wiped off share values if lapses in probity,governance or codes of conduct come to light.

Analysis of the results of our survey7 surfaced anumber of important related issues that requiredeeper management consideration.

Compliance officer: police officer or counsellor?

The traditional role of the compliance function– in Anglo-Saxon countries – is shifting from‘police officer’ to ‘counsellor’. There isincreasingly recognition that compliance, as atrusted advisor to the business, creates value andprotects the brand. In some European countrieswhere compliance functions are more recent,

Recommendations –Role of Compliance Officer

• Compliance officers, with managementsupport, need to focus more on developingtheir business vision – the ability to advisemanagement on compliant, but profitable,business solutions.

• Compliance must have input into all newbusiness ventures and transactions,including new products, entry into newmarkets and mergers or acquisitions, aswell as outsourcing or offshoring initiatives.It should also have the necessary authorityto inhibit or flag any activities which mayraise longer-term compliance issues.

• Compliance, supported by management,needs to strive to enhance dialogue withregulators – and other industry participants– to improve the depth of generalunderstanding of the challenges facedby compliance functions, acrossorganisations and across borders.

• There should be an overall continuousfocus on the blend of skills andcompetences within the compliancefunction, ensuring suitable broad-basedtraining for compliance officers and staff.

• Compliance officers should helpthemselves, and their firms, by furtherdeveloping their “profession” throughindustry forums groups and associations.

• Compliance should develop more in-depthawareness of the technologies usedby the organisation, including legacysystems, and be consulted with regardsto new systems developments. At thesame time, the IT department shoulddevelop greater awareness of the needsof the compliance function.

15PWC EDGE

emphasis has been on advising business,while compliance’s ‘police officer’ role – itscrucial compliance monitoring and oversight role– is often underdeveloped. However, the rightbalance needs to be struck between the tworoles (within the organisational, business andcultural context) as the compliance culture isembedded in the organisation – care is essentialto ensure the potential conflicts of interestbetween the two roles are managed effectively.

Segregating compliance responsibilitiesbetween compliance and the business isoften difficult to accomplish in day-to-dayoperations. Today, compliance is often involvedin executing compliance controls over dailybusiness transactions (operational compliance),as well as providing ongoing complianceoversight. This causes another potential conflictof interests that can be mitigated through the‘tone from the top’ (instilling a complianceculture throughout the organisation); consistent,on-going performance measures to ensure thatthe business is fully cognisant of its complianceresponsibilities; and separating reporting lines.

Evidently, to be able to advise managementand the business proficiently, complianceofficers need a deep understanding of thebusiness, a detailed knowledge of relevantregulations, and insights into regulators’expectations, as well as pragmatism. Manyrespondents stressed compliance officers’communication and influencing skills as key toengendering trust. How well their advice istrusted, however, should not rely solely on theirinfluencing skills: management should alwaysbe prepared to listen and act.

Management talks the talk...but is it just lip service?

The study7 showed that boards’ and seniormanagements’ primary fear relates to reputationor brand damage, as well as personal liability –understandable given recent high-profileincidents. In many countries covered by thestudy7, organisations made minimal efforts inthe compliance arena – particularly in terms ofcompliance functions – prior to explicit regulatoryrequirements. Ongoing pressure from regulators,or from other stakeholders, such as institutionalinvestors and possibly rating agencies, shouldcontinue to underline the intrinsic value ofcompliance and of the compliance function.

Remaining compliant is a conditio sine qua nonfrom a business perspective, but the general lackof progress in demonstrating the value of thecompliance function suggests that should suchpressure decline, the needs and the role of thecompliance function could be subjugated toother regulatory and business priorities. In effect,management needs to place less emphasis onthe short-term costs of compliance and more onits quintessential ability to enhance the overallreturn of investment for the organisation.

Although a great deal of progress has beenmade in terms of articulating a sound compliancevision and establishing and/or reinforcingcompliance functions in recent years, the study7

showed limited evidence of coherent, sustainablestrategies aimed at achieving compliant businesspractices and processes in the longer-term. Whenaddressing regulatory requirements, compliancefunctions are often designed to essentially pasteover the perceived gaps in an organisation’s existingcontrol framework. This may not be the optimalapproach, particularly as organisations have notyet recognised, let alone realised, the overallbenefits of being compliant.

Attempting to tackle all the issues with one majorproject, however, is unlikely to be effective. Instead,continuous initiatives in a number of inter-relatedareas (with iterative reassessments as the situationevolves), together with a clearer vision of the long-term end game, are essential. Based on an analysisof the survey7 results, common initial challengesfor management include:

1 Assessing risk holistically, probing further thecorrelation between different types of businessand market risk in terms of compliance,regulatory and reputation risk

2 Given a definition of “compliance risk” for allbusiness activities, clearly determining thecompliance function’s associated roles andresponsibilities, in the context of other controland support functions, such as internal audit,legal, risk management, human resources, etc

3 Establishing the right balance, mentioned above,between the ‘counsellor’ and ‘police officer’roles, and providing organisational flexibility forthese roles to evolve

4 Providing adequate resources to compliance,targeting efficiency through appropriate humanand financial resources supported by a robusttechnological infrastructure

16 PWC EDGE

• Management should assess thecurrent role and future evolution ofthe compliance function, as part oflonger-term strategies aimed at instillinga compliance culture into businesspractices and processes.

• Management should strive for a coherentresponse overall to managing risk,developing holistic strategic riskassessments which explicitly encompasscompliance risk within the overall riskprofile of the organisation. Particularattention should be paid to the interactionbetween compliance and other riskmanagement functions, while recognisingthe difference in emphasis whenmanaging compliance risk.

• Management should develop a betterunderstanding of what regulators requireand recognise that limiting their aspirationsto meeting minimum expectations will notlead to best practice, to the enhancementof the compliance function’s standingwithin the organisation nor to thedevelopment of a robust complianceculture within the organisation

• Boards and senior management shouldask themselves probing questions aboutthe current and future configuration of thecompliance function, the overall controlframework of the organisation and theoptimal level of resources – human,financial and technological. Seniormanagement should continue to ensurethat organisational design does not impedethe independence and effectiveness ofthe compliance function. Inter alia:

- Senior management needs to reconcilethe different approaches necessitatedby divergent societal and businesscultures within its operations overall,with its associated strategies in termsof configuration, modus operandi andresources of the compliance function.

- Management should pay careful attentionto the interaction with other control andsupport functions, and ensure that therespective roles and responsibilities areclearly defined, and documented.

- Recognising the dual role of thecompliance function (‘counsellor’ and‘police officer’), it should make sure thatthe overall configuration is thoroughlyassessed, both top-down and bottom-up,to permit appropriate access andinteraction with front-line businesses.

• Boards and senior management shouldfocus more on measuring the real cost ofcompliance and non-compliance, as ameans to ensuring appropriate costmanagement strategies, amelioratingtheir understanding of compliance’svalue, and finally permitting an effectivebalance between compliance costs andvalue generated.

• Equivalent, if not higher, priority shouldbe placed in the short-term on thedevelopment of compliance technology– recognising the fact that a robusttechnological infrastructure forcompliance entails both sophisticatedtools for monitoring compliance inbusiness activities, together withappropriate tools for streamliningcompliance function activities, andfacilitating knowledge-sharing.

• Boards and senior management shouldfocus more on frequency, timeliness andconsistency of reporting as a means toderiving additional comfort that currentbusiness transactions and practices aremuch less likely to generate futurecompliance problems.

• Rating agencies should take moreaccount of the role and potentialcontribution of the compliance functionto the overall strength and quality ofthe organisation.

Recommendations – Role of Management

5 Adopting a bottom-up as well as a top-downapproach to achieving compliance, wherebybusiness processes and practices arethoroughly reassessed to ensure currentand future compliance, taking particularaccount of the technological needs.

Challenges for Asian financial institutions

Many financial institutions globally, not just inAsia, believe that the sheer and increasingcomplexity – both in terms of volume andfrequency of changes – of the regulatoryenvironment is the principal challenge toenhancing their GRC frameworks. Togetherwith balancing the different and changingexpectations of other stakeholders (includingshareholders, rating agencies, customers andemployees), institutions must continually reviewtheir strategies, processes and capabilitiesto match these stakeholder needs. Over andabove looking at processes that have a positiveimpact on stakeholder satisfaction/contribution,firms need to housekeep and make a consciouseffort to ‘embed’ processes and capabilities whichhave been taken for granted into their controlframeworks.

Firms face two interconnected challengestowards enhancing their GRC frameworkson a sustainable basis:

• Embedding a compliance culture withinthe organisation, particularly acrossborders and across sectors.

• Remaining compliant on a cross-border,cross-sector basis in the context of adynamic business environment and rapidlychanging regulations.

Dynamic business environment changes includethe desire to expand into new markets,commence new businesses and launch newproducts (in order to sustain growth), togetherwith regulatory complexity and the need tomanage global and national cross-borderregulatory requirements.

Many believe that making improvements toan institution’s GRC framework comes withsignificant costs, the benefits of which aredifficult to measure. Where strategic objectives,values and goals of an institution are in linewith its GRC framework, GRC does have thepotential to become a value-adding principlethat is integral to an institution’s competitiveness,branding and, ultimately, its success.

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Essentially, meeting these challenges requiresa more holistic and proactive approach to compliancewhich moves beyond statutory expectations toembrace broader ethical and strategic considerations.This approach should focus squarely on theachievement of compliant business practices andprocesses (i.e. compliant outcomes), rather thanplacing the onus solely on the compliance function.Certain common elements underpin such an approach:

• Closer integration of governance, riskmanagement and compliance structures,forming a practical continuum underpinning theoverall integrity of the organisation and alignedto the achievement of strategic objectives

• A culture which instils compliance into the DNAof the organisation, fostering awareness andownership of compliance at all levels of theorganisation, and supported by appropriaterewards, processes and procedures

• An extension of the role of compliance to tacticaland strategic decision-making in areas rangingfrom acquisition to product development

• A clear definition of the relationship between thebusiness as the first line of defence; the compliancefunction as the second; and independentassurance and non-executive directors as the third

• Coherent approaches to ensuring that processesand procedures generally facilitate, rather thanfrustrate, compliant business and that robusttechnology infrastructures foster both conformance-and performance-focused decision-making.

The shift towards a principles or risk-based regulatoryor supervisory approach in many countries wouldcall for more emphasis on the compliance function’sadvisory role: but it is a question of balance. Primarily,the organisation needs to anticipate and quicklyrespond to the most serious threats to the brand, ratherthan seeking to ‘comply’ with everything all of the time.Management’s success in configuring the businessfor conformance, as much as performance, willpredetermine the evolving role and ongoingefficacy of the compliance function.

Areas which financial institutions may wish to focuson when improving their compliance frameworks arein the areas of technological infrastructure, theroles and responsibilities of compliance, andembedding compliance into strategic decision-making.

Karen Loon can be contacted attel . (65) 6236 3021e-mail . karen.loon@sg.pwc.com

19PWC EDGE

Pillar 2 and you – Is economic capitalback on the supervisory agenda?The revised capital framework for banks, most commonly referred to asBasel II, has put the issue of economic capital firmly on the agenda of manybanks. Some commentators have assumed that, to comply with Pillar 2 ofBasel II, banks must adopt an economic capital model. In this article, we willanalyse how much truth there is in that assertion and try to place economiccapital in the proper context in relation to Basel II.

BY CHRIS MATTEN Banking and Capital Markets Industry Group

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Economic capital and the Basel IIframework

In the first drafts of Basel II, there was astrong theme of reliance on banks’ own internaleconomic capital models – be these creditrisk modelling capabilities under Pillar 1 orbroader economic capital models under Pillar 2.This emphasis was significantly diluted,however, in the later drafts.

For example, the second draft consultativepaper (CP2, issued in January 2001) refersunder Pillar 2, principle 1 (sound internalcapital assessment) to the need to assess‘the economic capital levels’ of a bank relativeto its risk profile and the adequacy of its riskmanagement process and internal controls ( 618).By the time CP3 was issued in April 2003,however, the equivalent paragraph ( 710)refers only to the ‘capital level’, a phrase whichsurvives into the final framework of June 2004( 752). Indeed, the term ‘economic capital’appears only four times in CP3.

It would seem that, during the consultationprocess, the Basel Committee became lessconfident about relying on banks to assesstheir own capital requirements using internalmodels and hence both internal credit modelsand full economic capital models were omittedfrom successive drafts of the framework.

Interestingly, however, economic capital makesa minor comeback in the revised frameworkof June 2004, although only as a member ofthe supporting cast and not in a starring role.There are eight paragraphs which referencethe term. For example, in 18 in the introduction,the Committee refers to engaging the industryin a discussion of prevailing risk managementpractices, including those aiming to produce‘quantified measures of risk and economiccapital’. This is the same paragraph which talksabout potentially allowing full internal creditmodels in the future and thus the referenceto economic capital is to future developments,not the framework as it currently stands.

The other references are largely in ‘peripheral’parts of the framework, such as in the Pillar 2section on securitisation, where the Committeesuggests that supervisors may wish to reviewa bank’s ‘economic capital’ assessment ofmaturity mismatches and asset correlationsin a pool of securitised assets. In no case,however, does economic capital play a formalpart in the Basel II framework.

However, a reading of Pillar 2, principle 1(‘Banks should have a process for assessingtheir overall capital adequacy in relation totheir risk profile...’) would indicate, at least atfirst sight, that some sort of economic capital isrequired, even if this is not explicitly mentioned.Under ‘sound capital assessment’, thefundamental elements would include ( 731):

• Policies and procedures designed to ensurethat the bank identifies, measures andreports all material risks; and

• A process that relates capital to the level of risk.

Note that the requirement is to measure allmaterial risks, not just to manage them.A process which measures risk and then relatesthis to capital would seem prima facie to be thedefinition of an economic capital model but nosuch model is referred to in the text. So doesBasel II require an economic capital model or not?Comments by leading supervisors over the pastfew years would seem to indicate a strong desireto see such a link between risk and capital butstop short of a direct requirement to do so.

Two views on Pillar 2

Before we attempt to answer this question, weneed to take a step back and look at the intentbehind Pillar 2. Principle 1 clearly puts theemphasis on assessing capital needs on the bankitself. This is a departure from the Basel Accord of1988, which merely established a set of rules andrequired banks to hold a minimum level of capitalrelative to those rules (this function is replaced byPillar 1 in the revised framework). While it mighthave been the practice of individual supervisorsto require some sort of self-assessment, this wasnot a requirement of the 1988 Accord. Basel IIchanges this, by formalising the responsibilityof overall capital adequacy assessment underPillar 2. Thus, it is no longer enough for banks todemonstrate that they have adequate capital inrelation to their risk-weighted assets; they mustgo beyond this and demonstrate that they haveenough capital to cover all of their risks, andmust do so in a structured manner.

There are two views on Pillar 2 which seem to beunder consideration by banks and their supervisors.Figure 1 illustrates the ‘accepted’ view, underwhich Pillar 2 represents an add-on to Pillar 1,to account for the risks not specifically coveredby that pillar.

Under this approach, the capital required forcredit (counterparty) risk, market risk and

21PWC EDGE

operational risk is set by Pillar 1 and the balanceunder Pillar 2 is to adjust for the other risks(interest rate risk on the banking book, countryrisk, credit concentration risk, etc).

The spirit of Pillar 2, however, would appear togo beyond this. Under Pillar 2, banks must assessall of their material risks and relate this to theirassessment of their overall capital needs.This is illustrated in Figure 2.

Under this view, the capital required for the Pillar 1modelled risks need not be the same under Pillar 2– credit risk, for example, could be greater or lessthan the Pillar 1 amount. As long as the total capitalassessed under Pillar 2 is greater than the Pillar 1amount, a bank would meet the requirements.

Figure 1: Pillar 2 as an add-on to Pillar 1

Figure 2: Pillar 2 as a holistic assessment of risk capital

This approach would seem more consistent withthe intention behind Pillar 2. This is borne outby the introductory paragraphs of Pillar 2, whichstate for example ‘bank management continuesto bear responsibility for ensuring that the bankhas adequate capital to support its risks...’ ( 721),

or that ‘...banks must be able to demonstratethat chosen internal targets are......consistentwith their overall risk profile’ ( 726).

Indeed, it could be argued that if Pillar 2 workedproperly and supervisors could rely entirely onbanks’ ability to assess their risks and relate capitalto these appropriately, there would be no needfor Pillar 1 at all. This is where the discussionaround replacing the 1988 Accord was centred inthe late 1990s but the Basel Committee has clearlydecided that it would be premature to allow this atthis stage.

Is economic capital required by Basel II?

So does Basel II require an economic capital modelor not? Arguments in support of such a model wouldbe based on the Pillar 2 requirement to ‘measureall material risks’ and ‘relate capital to the levelof risk’. A major argument against this model wouldrest on the fact that the Basel Committee, havingstarted off with references to reliance on economiccapital, has virtually removed all such referencesfrom the final framework.

To get an indication, we must look at how bankingsupervisors are starting to interpret Pillar 2.The Committee of European Banking Supervisors(CEBS), for example, distinguishes betweensophisticated, complex institutions and otherless-complex ones. Their third consultative paper,‘The application of the supervisory review processunder Pillar 2’ (May 2004), states that someinstitutions might indeed take the Pillar 1 capitaland then determine an add-on for other risks, asin Figure 1. While ‘institutions will not be requiredto use formal economic capital models’, however,the paper notes that ‘it is expected that moresophisticated institutions will elect to do so’.

In other words, while supervisors do not requirean economic capital model, adopting such a modelwould be consistent with meeting the requirementsof Pillar 2 and may well be expected of manylarger, more sophisticated institutions.

If an organisation does not choose to adopteconomic capital, what other options does it have?These would appear to range from basic Pillar 1capital plus a subjective assessment of other risks,through to add-on type modelling (with differentapproaches for different risks) as described above,to stress testing and simulation modeling.

1 Under this approach, companies model individual assets and liabilities, cashflows etc (using product projections and other business/marketing forecasts) to build a 1–5 year picture ofthe financials and from this the overall levels of equity can be observed. These models are stochastic and generally do not break down into individual risk types. From this, one canplace stresses and scenarios into the tool to get a picture for the various levels of capital. The tool can be designed to produce a capital number at a given confidence level, but this isnot its only aim.

Pillar 2

Pillar 1

Pillar 2

Pillar 1

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Some institutions might choose to adopt the‘dynamic financial analysis’ used largely in theinsurance industry1. For example, one leadingEuropean bank is using a similar approach toassess its overall risk appetite, by modelling thevolatility of different factors and their impact on thebank’s balance sheet and P&L, and this sort ofapproach may be accepted by supervisors as analternative to full economic capital.

So if economic capital is not specifically requiredby the supervisors, should organisations adopt itat all? In another article in the latest edition ofThe Journal2, Miles Kennedy and Mark Johnstonlook at the application of an economic capitalmodel and examine some of the potentialshortcomings. Adoption of a full economiccapital is not an automatic choice, and will bedriven by a number of largely internal factors.Certainly, economic capital can bring a significantimprovement over more traditional performancemeasurement and financial decision-makingprocesses. In particular, the ability to convertrisk into a quantum which can be comparedwith returns is extremely useful, and in generalthe move to more quantitative approaches torisk management is to be welcomed. Someorganisations, however, have decided that theywould prefer to approach the risk/return equationwhich underlies banking from a differentperspective, and we do not consider that thereis any single, ‘right’ answer. Thus, while webelieve that there are considerable businessbenefits which can be gained from adoption ofeconomic capital, this approach may not suitevery organisation. Many attempts to implementan economic capital regime have run into thesand, usually because they are not properlyintegrated into the management philosophyand practices of the organisation.

An organisation which, therefore, adoptseconomic capital primarily to meet regulatoryrequirements is likely to run into problems.Not only will the model fail to take hold internallyand result in confused metrics but, worse,the initial purpose will not be fulfilled, as theunderlying theme of Basel II is that suchtechniques must be fully embedded inmanagement decision processes or else failthe ‘use’ test. The key issue is that economiccapital should be driven by businessconsiderations, and not simply comply withsupervisory requirements.

The key issue is thateconomic capital shouldbe driven by businessconsiderations, and notsimply comply withsupervisory requirements.

2 The Journal Special risk management edition, January 2005.

The sort of questions that organisationsneed to ask before embarking on aneconomic capital project are:

• What is the strategy of the organisationin terms of balancing risk and rewards?(For example, how capital efficient dowe want to be? Is shareholder valuegeneration a key part of our financialgoals? Does this conflict with other goals,such as market share or eps growth?)

• Will economic capital be an integral partof the financial decision-making processesof the organisation?

• How will economic capital be embeddedin performance metrics?

• How actively will capital allocation beembedded in the strategic planning andresource allocation/budgeting processes?

• How will economic capital be factored intoperformance compensation policies?

The above article was first published in The Journal Special risk management edition(January 2005).

Chris Matten can be contacted attel . (65) 6236 3878e-mail . chris.matten@sg.pwc.com

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Anti-money laundering:The key issuesThe revision of the FATF 40 recommendations in 2003 and the releaseof further recommendations on terrorist financing last year have pushedanti-money laundering up the risk management agenda. Rohan Bedi ofPricewaterhouseCoopers identifies the top seven anti-money launderingissues faced by Asian banks.

BY ROHAN BEDI Banking and Capital Markets Industry Group

The revision of the Financial Action Task Force(FATF) 40 recommendations on anti-moneylaundering in 2003, along with the publication ofspecial recommendation nine last year, whichtargets the cross-border movement of terroristfunds, have pushed anti-money laundering(AML) up the list of priorities for Asian banks.A number of enhancements have been madeto anti-money laundering regulations in severalAsian jurisdictions, and others are expected tofollow suit in 2005.

These revisions have had significantimplications for financial institutions operatingin Asia by introducing new requirements forinformation collection on fund transfers, trustsand private limited companies. There’s moreemphasis on risk-based monitoring, while banksmust implement effective due diligence ofcorrespondent accounts and politically exposedpersons (PEPs). The onus is very much onfinancial institutions to identify the controllersand beneficial ownership of accounts,transfers and transactions.

However, there’s still a lot of work to be done.This article identifies the top seven anti-moneylaundering issues for Asian financial institutions,and highlights common weaknesses in AMLcompliance programmes.

1. Good theory, bad practice!

There are some key broad factors that supervisorswill look at while reviewing a financial institution’ssuspicious transaction reporting (STR) file:

• How does the STR filing pattern comparewith the best among the financialinstitution’s peers?

• Is all ‘know your customer’ (KYC) data onfile considered, and is new due diligence/enhanced due diligence (EDD) conductedwhere required?

• Is the STR reviewed by the Money LaunderingReporting Officer (MLRO), managementand the relationship manager?Did senior management play their rolewhere required?

• Are STRs suppressed for business reasons?Does the correspondence indicate that theMLRO is not sufficiently empowered?

• Are the reasons for filing STRs clearlydocumented and similarly, the reasons fornot doing so?

• Is the STR filed in a timely manner and does ithave sufficient details to assist the financialintelligence units (FIU) – which are governmentunits created explicitly to look into moneylaundering and terrorist financing – to investigatethe STR further?

The STR file is ultimately the litmus test of theeffectiveness of all AML efforts. It cannot belooked at in isolation. If one financial institutionfiles 30 STRs annually and its peer files only two,there could be something amiss. Of course,each business has its own peculiar moneylaundering risks. But a peer comparison is agood starting point for a more detailed review.

2. Usage of good-quality KYC databases

The potential for using information already inthe public domain for due diligence/ EDD istremendous. The key value of commercial KYCdatabases lies in the links they throw up, which aline manager would find difficult – if not impossible– to identify. For instance, the definition of apolitically exposed person is very wide, goingbeyond a head of state to senior politicians,judges, military, religious figureheads, theirrelatives and friends, their advisers and consultants,their business associates, and most importantly,their companies, trusts and foundations.

Given the enormity of the task, any financialinstitution that feels it is safe simply by reviewingthe Central Intelligence Agency’s list of ‘Chiefsof State and Cabinet Members of ForeignGovernments’ is deluding itself. After all, afinancial institution is unlikely to be hit by a corrupthead of state or his/her subordinates directly,but through another person linked to the PEP.

Banks also need to implement a good namesanalysis programme to analyse transactions.More than 1000 financial institutions globally havealready subscribed to key databases, such as

Of course, each businesshas its own peculiarmoney laundering risks.But a peer comparisonis a good starting point fora more detailed review.

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geography and country risk; business and entityrisk; and product and transaction risk. Banks needto take a systematic approach to risk that coversall three bases, rather than just one or the other.

These models are ultimately just common sense,built on an appreciation of the money launderingrisks unique to the business and the data sourcesthat could help a financial institution to managethese risks. If a financial institution does not haveFIU-type data interrogation and forensic capabilitiesfor EDD, either for reasons of size of operationor budgetary constraints, it should support theprocess using the services of a good third-partyservice provider.

Risk-based due diligence leads to the betterallocation of compliance resources and moreeffective cost management (especially inretrospective KYC data remediation exercises).It also has a critical impact on the quality ofcustomer service (it means the bank will notharass a client when there is enough informationto indicate that the risks are low), and needs to beenshrined into AML training of frontline staff andline management. Without a risk-based approach,AML efforts can become counter-productive,with staff simply taking a ‘tick-box’ approachto compliance.

5. Compliance and internal auditnot empowered

This is a serious problem that smaller organisationsface rather than bigger institutions (although thebigger firms are certainly not immune). Businessunits may bully compliance officers not to file STRsbased on business considerations. Complianceofficers may also double up in other functions,diluting the AML focus or even creating conflicts ofinterest. The MLRO should be the ultimate judge ofwhether an external filing of the STR is needed or not.

Without a risk-basedapproach, AML efforts canbecome counter-productive,with staff simply taking a‘tick-box’ approach tocompliance.

World-Check, Factiva, IntegraScreen Online andRegulatory DataCorp International. They screencustomer transactions and even use thesedatabases in pre-hiring employee and vendorchecks. Every financial institution should askitself what it has done on this issue.

3. Basic AML Monitoring Reports

Many financial institutions in Asia use outmodedAML reports that monitor only basic events,such as cash placements, large transactions orinvestments foreclosed prematurely. Many banksstill do not have systems that flag the high-riskcategories (such as cash-intensive businesses,jewellers, import/export businesses), and haveyet to identify peer groups for system monitoringof their transactions by cutting-edge AML trendmonitoring systems. These institutions areunable to analyse a transaction in an effectivemanner; for example, comparing the history ofthe account with the account holder’s peers,or comparing the average balance in the accountversus the average balance one year ago.Statistical data on an account is critical to helpthe bank in its due diligence/ EDD processes.There are also linked data quality and dataconsolidation issues that need to be addressed.For instance, customer data on the systemmay be inadequate vis-a-vis the current KYCregulatory requirements, requiring a remediationexercise; while legacy systems may not beconnected (e.g. banking and credit cards),making it difficult to get a consolidated pictureof a customer relationship with the bank.

Most financial institutions acknowledge thatAML Software would help, but consider themsimply too expensive to buy or implement.There is an element of truth in this argument.These technologies are expensive, butcollaboration between regional governmentsand vendors could help to push prices down.

Of course, it is not a ‘one size fits all’ prescriptionand the smaller banks may find that ordinaryrules-based systems suffice for their purposes(these will also be less expensive). On the otherhand, online brokers will find that AML trendmonitoring software is absolutely essential fortheir AML requirements given the lack ofcustomer interface in their transactions.

4. Risk-based due diligence

Financial institutions should refer to three riskmodels when conducting due diligence –

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A key tool to empower MLROs is to require thesubmission of an annual report – along the linesof the UK Joint Money Laundering SteeringGroup Notes (under the British Bankers’Association), which assesses risk annually,evaluates trends and events and analyses newregulations and their potential impact. It canalso highlight issues such as undue pressurenot to file STRs. Such a report should bereviewed by senior management and/or theboard of directors. A system must be in place toact on the recommendations of the report, toallocate responsibility and to track and verifycompletion. Such a system opens up the financialinstitution’s AML systems to supervisor scrutiny,which is a very useful self-discipline.

Feedback from the UK regulator, the FinancialServices Authority (FSA), indicates that thesecond round of annual reports filed with theFSA were not up to the mark. In a letter writtenin March 2004 to chief executives of all groupssupervised by the FSA’s major financial groupsdivision, the FSA criticised the quality of manyreports, stating that they did not assess the riskof money laundering properly and did notadequately account for the risks of their business.It also criticised the quality of information that

went into the report. A review of the data sourcesof the report is an important best practice.

Internal audit (where it exists) may not fullyappreciate the risk-based monitoring paradigmor its own role in enforcing this. For example,high-risk accounts should be system flagged andsubject to EDD, periodic reviews by businessunits, and independent reviews by internal audit.Judging from the lack of such system flagging(which only seems to be done in some Americanbanks and key local financial institutions), internalaudit may not be carrying out this independentreview function. What’s more, judging from thelack of comments in internal audit reports, overallindependent review of the health of the risk-basedprocess may be suspect in many cases.

Internal audit should also provide an independentreview of the compliance officer’s function andthe health of the ‘know your employee’ (KYE)controls. Beware of ‘the enemy within’; manyprivate banks/ broker-dealers have fallen prey toemployees who join their organisations, movingtheir money laundering accounts with them.

Financial institutions must remember that, in asituation where they do not know the employeeor the client fully, they face double trouble.

Business and Organisation Processes & Initiatives

Security & Technology Usage Risk Assessment

Know Your Customer (KYC)– Accounting Opening

AML Standards and Procedures

Administrative and End-user Policies and Procedures

KYC-DataAccess/Mining

TransactionMonitoring/Tracking

ProcessesAML Reporting Tactical Short-term

Solutions

Compliance RequirementsInternational, Regulatory, Industry, Third Party, Internal

AML Strategy

Man

agem

ent C

omm

itmen

t

Trai

ning

and

Aw

aren

ess

Pro

gram

me

Potential components of an AML solution

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6. Training techniques need to evolve

Training has a real role to play and is not a‘tick-box’ exercise.

• While financial institutions are happy to userole play in customer service training, theyshy away from using it as an AML trainingtool. Role play should be actively used tounderscore key points and create qualitativedetection abilities in staff.

• Similarly, e-learning, videos and audio tapesshould be used in a blended approach withregular in-house training to cut training costsand to make training more interesting.

• Focus is needed on the risk-based approachto AML.

• MLROs would do well to have special AMLtraining focusing on the needs of seniormanagement and boards in order to highlighttheir own personal accountabilities, and whathas actually gone wrong for chief executivesaround the world who have found themselvestrapped in the vortex of a money launderingscam. This may be the only way to getbudgets for AML.

• Participants on training courses need to beassessed formally, following the principle that‘what is taught must be evaluated’. This alsohelps to increase the effectiveness of trainingin generating awareness.

7. Tone at the top is deficient

AML regulations will not make a difference if theyare not implemented properly. The tone of seniormanagement and the board of directors shouldbe ‘do or die’. Without a clear AML corporatestatement repeated frequently, awareness ofAML will be a result of annual training only andwill simply not be sustainable. Any line managerwho is subject to yet another round of boringannual AML training will not take proper actionon this issue, especially if the only thing his/herboss talks about is targets. ‘Top of mind’ recallof the money laundering and terrorist financing

A change in mindset isneeded – it’s not aboutthe law, it’s aboutimplementing the law.

issue is critical to ensuring an enterprise-wideAML system.

Supervisors are also keen to specifically examinewhether boards and senior management havereviewed the strategic money laundering risks oftheir businesses on an annual cycle (does thefinancial institution understand what risks itcarries, are these acceptable to the board/seniormanagement?), and whether these decisionsreflect in the bank’s account opening, monitoringand review requirements. Also, do boards andsenior management keep informed of potentialmoney laundering incidents? Boards (and/orthe designated oversight committee) shouldideally be informed on all significant STRsonce a month.

Conclusion

A change in mindset is needed – it’s not aboutthe law, it’s about implementing the law. AML istoday a mix between an art and a science, backedby technology. Financial institutionshave to run to keep up with money launderers.

The above article was first published in the February 2005 issue of AsiaRisk.

Rohan Bedi can be contacted attel . (65) 6236 7053e-mail . rohan.bedi@sg.pwc.com

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The Tax Challenge –Managing Risks and Creating ValueThe tax affairs of local and multinational corporations are rarely seen as theglamorous side of the business. Filing tax returns and complying with otherregulatory taxation obligations are necessary but mundane activities. So if thetax affairs of a company are not exciting, why are they important? Read on asPaul Cornelius shares on the role tax plays in an effective organisation.

BY PAUL CORNELIUS Corporate Tax Services

government regulation, including the Sarbanes-Oxley legislation, in the US. Value creation andrisk management are not competing objectives,they are twin benefits which today’s taxdepartment can contribute towards the business.

The elements of a successful tax department areillustrated in Figure 1. These address the three require-ments to maximise stakeholder value and four toolswhich can be employed to meet these objectives:

What do these mean and how do they fit togetherin the context of tax management?

3 keys to Maximising Shareholder Value

1. Managing Risk

To manage tax risk, companies must firstidentify and understand their sources of tax risk.This process must comprehensively cover alltypes of tax incurred by a company. Risks ofnon-compliance with indirect tax laws can beas severe as those associated with income tax.

Types Risks associated with

Compliance Risks - meeting a company’s taxcompliance obligations

Transactional Risks - application of tax laws,regulations and decisionsto specific transactions

Operational Risks - application of tax laws,regulations and decisions toeveryday business operations

Financial Accounting Risks - disclosure in financialstatements and reports

Figure 2: What types of tax risks do organisations encounter?

One answer is that effective tax managementcan have a material impact on a company’sbottom line. A PricewaterhouseCoopers (PwC)global tax benchmarking survey1 modelled theimpact of a 1% reduction in cash tax rate forthree European companies. The result was anincrease in shareholder value of between 1.4%and 2.3%. In comparison, an increase of between12% and 15% in turnover was required togenerate the same increase in shareholder value.

However, in today’s world the impact on thebottomline is only one of the areas whereineffective tax management rears its ugly head.Corporate reputation can be damaged, directorscan face personal liabilities and there can be aloss of future shareholder value as today’shidden problems come to light in future.

We recognise that today’s tax department cantake on myriad forms in a bid to meet the needsof companies in the region. Some companieshave large tax teams with global reporting lines,some have tax work embedded in the FinanceDepartment and some outsource the majority oftheir tax affairs. It is horses for courses but inreality, the actual model employed has littleimpact on the tax issues, risks and obligationsthat an organisation’s senior management arerequired to handle. What’s important is toaddress the key risk areas, and manage taxesto generate optimal value and benefits.

Efficient and effective tax department

So what are the key components of an efficientand effective tax department? A recent PwCregional survey2 indicated that value creationranked as the number one challenge for thetax function. But this is only one piece of thepie. The emphasis on compliance and riskmanagement is growing, given the increased

Value creation andrisk management arenot competing objectives,they are twin benefitswhich today’s taxdepartment can contributetowards the business.

1 PricewaterhouseCoopers Global Retail & Consumer Sector Tax Benchmarking Survey – 2004

2 PricewaterhouseCoopers Asia – 2005 Survey Report on Challenges Faced in Managing Tax Functions in the Region.

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Figure 1: Elements of a successful tax department

ManagingPeople

An Efficientand Effective

Tax Department

ManagingRisk

CreatingValue

Strategies TechnologyProcess& Controls

Communication

Managing compliance risks, transactional risksand operational risks requires a thoroughunderstanding of an organisation’s businessoperations and transactions, and how theseshould be reflected in tax returns and reports. Inaddition, management of financial accountingrisks requires extensive knowledge of accountingstandards to ensure appropriate disclosure.

Risk is a double-edged sword – actions carryinherent risks but inaction can result in a loss ofvalue. Tax risk management requires morethan just identifying risks. Organisations mustdetermine their risk appetite, while keepingin mind (potential) financial, regulatory andreputation issues. Risks should be quantifiedas and when they are identified. An assessmentof the probability of occurrence should bemade and tagged to that risk.

Ideally these will be determined prior to theactual event so that taxes are managed in a‘no surprises’ environment. However, it isacknowledged that to some extent, mostorganisations are likely to uncover some risksin retrospect. This may be discovered duringthe preparation of the tax return or on anaudit or investigation. To reduce the impactof such shocks, the tax department musthave a strategy in place to cover all aspectsof risk management.

2. Managing People

As with other disciplines it is necessary tohave quality tax staff with the appropriate skillsand training to effectively perform their duties.However, for the tax function the managementof people extends beyond the tax staff.

Relationships with personnel in governmentcan be critical to the outcomes of incentiveapplications, ruling requests, audits or lobbyingefforts. Such relationships need to be cultivatedand maintained for expedite resolution andprocessing of tax issues, as well as tax filingand compliance. Effective communicationwith external service providers can improveefficiency and derive value from expert advice.Open communication lines with staff inthe business units can mean the differencebetween an informed and uninformedtax decision in the overall scheme ofbusiness decisions.

To function well, the tax department mustproactively develop relationships with all of itsstakeholders and advisers.

3. Creating Value

A tax function creates value by providing informedadvice and planning initiatives to both reduce anorganisation’s tax burden and avoid unnecessarytax exposures. Some degree of risk is usuallyassociated with tax planning initiatives, asdemonstrated in Figure 3. Effective tax planningtakes into account the individual organisation’stolerance for risk.

Figure 3: Opportunity/Hazard relationship with the different rolesof the tax function

4 Tools to achieve key objectives

So how do organisations meet the three objectivesof creating value, managing people and managingrisk? How can organisations tap on the expertiseof tax professionals such as PwC to achievethese goals?

Tool 1: Implement a Tax Strategy

In a recent PwC survey2 only 26% of respondentshad fully implemented a tax strategy that wasdocumented and agreed this with seniormanagement in their organisation. It is advisablefor all companies with material tax liabilities or risksto study and put in place appropriate tax strategies.The components of the tax strategy should coverall of the activities of the tax function, in particular:

• A benchmark for measuring the value created bythe tax function (e.g. dollar value-added eachyear and/or effective tax rate targets)

• Identification of potential tax risks anddocumented procedures for dealing with them(including disclosure of information and resolutionof disputes and audit findings/recommendations)

• Tax compliance benchmarks (e.g. target lodge-ment dates, absence of penalties or interest)

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OPPORTUNITY

UNCERTAINTY/VARIANCE

PLANNING OPERATIONS COMPLIANCE

HAZARD

• Clear roles and responsibilities for all areas oftax, clearly stating the experience and ongoingtechnical support required for the respectiveroles to be undertaken effectively

• Communication benchmarks (e.g. tax updateas part of quarterly board meetings)

• Tax department costs and budget

• Benchmarks for lobbying and government liaison(e.g. target dollar value of incentives obtained)

Tax law and practice tends to involve finding afooting within the shades of grey rather than theluxury of obviously marked walkways of blackand white. This poses obvious challenges inaccurately measuring value or determiningthe level of risk. These are areas whereorganisations must determine their owntolerance for risk before further progress canbe made. Organisations can seek assistancefrom tax experts to assess their tax risks andopportunities and to help develop appropriatetax strategies.

Tool 2: Develop and Document your TaxPolicies and Procedures

Tax policies and procedures should cover alltaxes incurred by the company and touch onall four types of tax risks (i.e. transactional,operational, compliance and financial reportingrisks). A tax map can be developed to determinethe key tax decision points in an organisation.Tax policies and procedures should cover allareas of tax management such as:

• Tax function approval for acquisitions,divestments, changes in corporate structure,changes in business operations and changesto accounting disclosure of taxes

• Early involvement of the tax function in taxsensitive transactions

Tax law and practice tendsto involve finding a footingwithin the shades of greyrather than the luxury ofobviously marked walkwaysof black and white.

• Fully documented tax accounting, reportingand payment processes

• Involvement of external advisors to supportin-house decisions

Tool 3: Leverage Technology

Technology can generally be used to supportthree of the key tax areas (see Figure 4).

Technology Support tax in

Research tools, tax planning and advisory workoften internet-basedTax software tax reporting and complianceTax Management software tax management

The weakest controls are manual controls,particularly in the transfer of data from oneaccounting system to another and where spreadsheets are used. In some countries, tax reportingsystems are linked directly to the general ledgerand tax asset register. These systems can alsolink tax reporting for return, management accountingand financial reporting purposes. However,such systems can be expensive and may not besuitable for all companies. If companies must relyon manual controls over tax compliance, reportingand payment functions, care must be takento ensure these controls are robust. Alternatively,given the complexity, companies may decideto outsource some of their tax compliancefunctions to professional tax service providers,who have the sophisticated infrastructure tosupport the tax compliance process. Even then,the tax return data is only as good as theinformation provided by the company to theoutsource-tax professional. In a nutshell, thegreater the degree of automation for both in-house and outsourced tax compliance, thestronger the controls.

There also exist tax softwares which cansimplify the management of tax affairs fororganisations, especially those whose businessesspan multiple operating locations. One suchtax product is the PwC Global ComplianceSolutions. This software allows clients to accessa database via the internet. It contains detailsof all aspects of a group’s tax complianceposition, including the company-by-companystatus of queries from the tax authorities

Figure 4: Using technology to support the tax function

34 PWC EDGE

and tax planning opportunities across a local,regional or global group. PwC and theorganisation will jointly manage the databasewhich acts as a single source access to theorganisation’s current tax management data.

Tool 4: Communications

Communication is often the gel that holds theother key tools together and gets the taxmanagement wheel turning. The tax functionmust be in regular communication with thebusiness units and the other departmentsof the finance function.

Some form of communication can be mandatedto cover aspects such as reporting the impactof changes in tax laws and practice on theorganisation. However, there will always be aneed for networking and informal communicationwithin the organisation in order for the taxfunction to be effective. It is equally importantfor the tax function to keep its staff members

up-to-date, particularly where it is a regionalor global business. Other key communicationchannels include government tax authoritiesand external tax service providers.

Effective communication with the variousbusiness units may prove to be a potential areaof concern when part or all of the tax functionis outsourced to an external service provider.Such cost concerns, whether real or perceived,may hinder communications. In this case,it may be preferable to have clearly mandatedcommunication policies, for example stipulatingrequired periodic updates, a retainer to coverday-to-day operational queries and earlyinvolvement in tax sensitive transactions.

Summary

Over the recent years, the scope and functionof the tax department has evolved rapidly tobecome the complex giant it is today. With ahighly complex tax system and fast-paced

35PWC EDGE

Figure 5: Tax challenges

Takes into account:

• Effective tax rate andtiming benefits

• Value-added and avoidance ofunnecessary exposures

• Tolerance for risk – nosurprises

• Business and commercialconsiderations

Tax Challenges

People andRelationshipManagement

RiskManagement

Tax Strategies

TaxCompliance

Tax Planningand Advice

ValueCreation

Requires:

• Risk identification• Risk quantification• Determining the probability of risks arising• Determining appetite for risk• Assessment of value-added and

value protected

Provides:

• Benchmark for measuring performance• Clear roles and responsibilities• Policy objectives including risk

management

Manages:

• Direct and indirect tax returnsand administration

• Tax compliance processes• Tax reporting and accounting• Audits and investigations

Includes:

• All taxes• Routine operations and

administration• Acquisitions and divestments• Corporate structure and financing• Changes in business processes• Changes in tax laws and practices

Addresses:

• Tax department Business units• Organisation Government• Quality and experience of tax staff• Use of external advisors

environment, today’s tax departments facemany new challenges. Figure 5 summarisesthe challenges that must be addressed bytoday’s tax department:

It is no meagre task to successfully createvalue for an organisation while balancingtax risk. To tackle this difficult task, PwCdeveloped a diagnostic assessment to assistorganisations in systematically reviewingthe functions of the tax department. It iscertainly worthwhile for an organisation toundertake a comprehensive review of itstax department to kick-start its journey tobecoming an efficient and effective unitwhich is able to contribute significantlytowards stakeholder value.

Change your perspective.See the value tax management brings tothe business.

Paul Cornelius can be contacted attel . (65) 6236 3718e-mail . paul.cornelius@sg.pwc.com

36

39PWC EDGE

Transfer Pricing– Opportunities and Risks in AsiaTransfer pricing issues are of paramount importance in an increasinglyglobal economy. Multinationals have universal brands, regional and globalmanagement centres and regional profit centres. They are often structuredfor reporting and measurement purposes on the same regional or globalbasis. It has been estimated that as much as 60% of international trade takesplace within multinational groups. This will increase further as multinationalscontinue to centralise their logistics hubs, streamline their supply chainand create centres of excellence for manufacturing and services.

BY NICOLE FUNG (above) & STEVEN CAREY Regional Transfer Pricing

40 PWC EDGE

The response of governments to this worldwidephenomenon has been both pragmatic anddefensive. Corporate tax rates are on a globaldowntrend as governments compete for theinvestment dollar. On the other hand, governmentsalso recognise that they need to protect theirtax base. To this end, their response has beento build more complex rules to retain what theyview as their fair share of profits.

It is no wonder that transfer pricing is one of thekey tax issues faced by multinationals today.In this article, we will look at how the Asia Pacificregion has responded and in particular, thechallenges ahead for Singapore in its aspirationto be a global/regional hub for intellectualproperty, distribution, logistics services andmanufacturing.

Transfer Pricing Trends in the AsiaPacific Region

A snapshot of the region reveals an upward trendin the focus on transfer pricing. Figure 1 showsthe countries which introduced transfer pricingrules or documentation requirements into theirtax regimes over the last five years.

The trend indicates a clear signal that almostall Asia Pacific tax authorities now feel thatintercompany pricing merits close scrutiny andthat companies need to clearly document thebasis for their pricing.

Companies with a presence in any of thesecountries need to be aware of their complianceobligations and act on them. Transfer pricingframeworks typically ‘recommend’ that companiesshould prepare appropriate documentation andbenchmarking to show the tax authority thatprofits are at ‘arm’s length’. Failure to do thisinvites intrusive transfer pricing audits and

typically harsh penalties. One such example isToyota Australia, which is currently defending aproposed transfer pricing adjustment estimatedat over AUD 1 billion.

Companies need to make a risk assessment ofwhere their key exposures lie in the regionand act now to address them, and shouldseize this opportunity to use transfer pricingframeworks to achieve their tax planning goalsin a transparent and defensible way.

Trends in Singapore

Notable exceptions to the above trend ofintroducing transfer pricing requirements areHong Kong and Singapore, where corporate taxrates are lower than the rest of the region. On thebasis that multinationals would be more likely tolocate their profits in lower tax jurisdictions, doesthis mean that the tax authorities of countrieslike Hong Kong and Singapore need not beconcerned about transfer pricing?

The answer to that is a resounding ‘no’. Singaporehas many attractions as a key global/regionalhub for manufacturing and services – infrastructure,location, highly skilled workforce, intellectualproperty protection and, on top of all that,a favourable tax rate. The Singapore governmentis understandably keen to attract and retaininvestment spending. Thus, when multinationalsincrease their assets, functions and risks inSingapore, it is incumbent on the Singapore taxauthorities to defend the resultant profit shift.

Even in situations where there is no substantiveshift of assets, functions and risks to Singapore,the tax authorities will need to focus on transferprices in view of the increased scrutiny in theregion. Failure to do so may result in the shift ofprofits away from Singapore to other jurisdictions

Figure 1: Adoption of Transfer Pricing across Asia Pacific Countries (*Introduced transfer pricing in the year indicated)

2000 2001 2002 2003 2004

China* China China China ChinaAustralia* Australia Australia Australia AustraliaNew Zealand* New Zealand New Zealand New Zealand New Zealand

Japan* Japan Japan JapanIndia* India India India

Thailand* Thailand ThailandMalaysia* Malaysia

Taiwan*Philippines (draft)*

which are more aggressive in this area, astaxpayers attempt to manage regional tax risks.

It is likely that Singapore tax authorities willincrease their focus on transfer pricing, althoughnot necessarily via specific documentationrequirements. The Singapore tax authoritiesbelieve that with the burden of proof on thetaxpayer, there is already an unspokenrequirement for taxpayers to defend their relatedparty pricing with appropriate documentation.The focus will be on more detailed questioningof corporate transfer pricing policies andscrutiny of significant shifts in profit levelsfrom year to year.

Another way which the Singapore tax authoritiesmay focus on transfer pricing is through theuse of Advance Pricing Agreements (APA)and/or Mutual Agreement Procedures (MAP).

One advantage of Singapore over Hong Kong isthat the former has a large network of double taxagreements (DTA) under which taxpayers areprotected from being taxed on the same incometwice. Thus, if the Japanese tax authoritiescontend that the price of products sold fromSingapore to Japan is too high and adjust theprofit level in Japan from 4% to 10% for acompany with a turnover of $100m, this willresult in additional tax payable of $2.5m. Such anadjustment will result in double taxation as theincome would already have been taxed once inSingapore. Taxpayers should be aware thatunder the MAP procedures in the DTA betweenSingapore and Japan, they may request that thetwo tax authorities negotiate and agree on apricing policy and appropriate adjustments suchthat double taxation is avoided.

In an environment where corporations can beseverely penalised for unknown risks, APAs maybe used as a tool for corporations to manageone of the most significant of these risks:transfer pricing.

An APA is an agreement between one or morerelated taxpayers and tax authorities to achievean agreed profit level over a 3-5 year period.They are becoming commonplace among taxauthorities in the region, including Australia,Japan and China. A taxpayer who locks into anAPA has certainty that there will be no transferpricing scrutiny of the transaction – and the taxauthority has a guaranteed revenue stream– for the period of the APA.

For Singapore, a robust APA or MAP regime willsend a strong and positive message to investors

that the Singapore tax authorities are willing toengage with them and other tax authorities toensure that the appropriate profit level can besustained in Singapore.

Conclusion

In an increasingly global economy it can oftenbe difficult to determine exactly where profits aregenerated – is it through research anddevelopment, marketing, an efficient supply chain,valuable manufacturing process or something else?In recognition of this, tax authorities in the regionwill continue to have a strong focus on transferpricing and will form their own opinions on theappropriate profit returns in their market.Corporations will need to be proactive in managingtheir transfer pricing risks and formulate practicaland clear strategies in their business models,pricing policies and documentation in order tocapture the full potential of the value createdthrough effective management of transfer pricing.

Nicole Fung can be contacted attel . (65) 6236 3618e-mail . nicole.fung@sg.pwc.com

Steven Carey can be contacted attel . (65) 6236 3813e-mail . steven.j.carey@sg.pwc.com

PWC EDGE 41

...a robust APA or MAPregime will send a strongand positive message toinvestors that the Singaporetax authorities are willing toengage with them and othertax authorities to ensurethat the appropriate profitlevel can be sustainedin Singapore.

GST and SOS (Saving Our Services)Governments need to provide a consumption tax environment that facilitatesa well functioning services economy and would, at the same time, protectthe tax base. The current international consumption tax environment runs anincreasing risk of failing to meet both criteria.OECD Report “The Application of Consumption Taxes to the Trade in International Services and Intangibles”(Released June 2004)

Is the above statement true for Singapore? Koh Soo How examines whetherthe Goods and Services Tax (GST) system is impeding Singapore’s efforts topromote its international services sector.

BY KOH SOO HOW Goods and Services Tax

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44 PWC EDGE

2005 is not just turning out to be the Year of theRooster but also the Year of Global Services forSingapore. Recent initiatives have shown thatpromoting the export of services is a key thrustin the government’s efforts to grow Singapore inthe international services arena. This is furtherconfirmed in the 2005 Singapore Budget on18 February 2005, which announced a numberof tax measures to foster the growth of theservices sector.

A report in the Business Times earlier this yearhailed Singapore as the world’s top location foroutsourcing on a project per million people.Besides political and security risk, regulatoryenvironment, labour laws, and infrastructure,the tax regime was cited as one of the categorieson which the 60 countries were ranked in thestudy by the Economist Intelligence Unit thatlooked at data gathered by the United NationsConference on Trade and Development(UNCTAD).

Looking at Singapore’s tax regime, it is truethat it does have an income tax regime whichpromotes the services sector as the financialservices industry and multi-national companies(MNCs) are encouraged to set up regionalheadquarters in Singapore to conduct regionaland global activities, shared service facilities,info-communication activities, etc.

What Singapore can perhaps do better is inthe way the GST applies to such regional andglobal services.

Zero-rating of international services

Like most jurisdictions with a value-added tax orGST system, the GST applies to the domesticconsumption of goods and services in Singapore.To maintain international competitiveness, theexport of goods and the export of services aretreated as zero-rated supplies, which meansthat such exports can be effectively made freeof GST.

So long as the relevant export documentation ismaintained as proof of the physical export of thegoods, the export of goods can be zero-rated.

On the other hand, the export of services ismuch more complex as the zero-rating treatmentis dependent on the nature of the services andthe interpretation of the legislative provisions(the zero-rating provisions) which deal withexported services.

Amending legislation in November 2004 stipulatedthat in order to qualify as zero-rated internationalservices, the services have to be supplied‘under a contract with’ a person who belongsoutside Singapore and ‘directly benefit’ thatperson (or persons) outside Singapore and whois outside Singapore at the time when the servicesare performed. (There is also the condition thatthe services must not be directly in connectionwith land or goods in Singapore).

The Inland Revenue Authority of Singapore(IRAS) on 12 January 2005 sought to clarify theinterpretation and application of the expression‘directly benefit’ used in the zero-rating provisions.Essentially, the IRAS expressed the view thatwhere the services supplied ‘directly benefit’ alocal person(s), the services would be subject toGST at 5%. What this means in practice is thatGST can apply to services that are received bya local person even if the services are invoicedto the overseas client who contracted forthe services.

An example in the financial services industry is‘give-up’ futures transactions whereby trades areexecuted for a Singapore customer. Based onthe current rules, the commission charged to theoverseas clearing broker who contracted for theservices, will be liable to 5% GST. In the caseof a regional headquarters set up, the 5% GSTwould also apply to any services that areperformed for an entity in Singapore even ifthe services are billed to an overseas parentcompany under a cost-plus arrangement.

The interpretation has given rise to certainpractical difficulties as it puts the burden on theSingapore service provider to prove that there isno one in Singapore who can be said to ‘directlybenefit’ from the services before he can applythe zero-rating treatment. This requires lookingbeyond the overseas client who contracts for theservices to see if there is someone in Singaporewho can be said to directly benefit from theservices at the time of entering into the contractand at the time of performing the services.Obtaining information on the end-persons, if any,receiving the services, may not be possible dueto commercial sensitivities.

Where the services benefit both an overseasperson (zero-rated) and a local person (standard-rated), the IRAS has also stated that the value ofservices provided to the overseas and localperson must be apportioned between servicessubject to the 5% GST and those services thatcan be zero-rated.

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The competitiveness of Singapore services wouldinadvertently be affected if GST were chargedto the overseas client who has to bear theadditional 5% GST charge. Alternatively, theservice provider’s bottom line would be affectedif he has to absorb the tax to stay competitive.Given the highly competitive nature of theservices sector, the additional GST cost woulddisadvantage Singapore’s position in theglobal services economy.

It should be argued that the person who canbe said to ‘directly benefit’ from the services,is the (overseas) client who contracts for suchservices as he needs the services to satisfy hiscontractual commitment to service his owncustomers in Singapore.

So is there a solution to the problem?

A proposed solution

Perhaps, the solution can be found within theGST legislation itself. To explain, one mustunderstand why the legislation has beeninterpreted and amended in the current manner.A popular belief is that it is to prevent ‘round-tripping’ whereby services are performed for aperson in Singapore under a contract with theoverseas client. If zero-rating were allowed toapply to the invoice to the overseas client whosubsequently charges it back to the Singapore-based recipient of the services without GST,the tax would be avoided.

If round-tripping is the problem, it may be timeto consider activating the ‘reverse charge’ thatis currently provided for in the GST legislationand at the same time, allow the zero-rating ofall contractual services that are billed to theoverseas client.

Under the ‘reverse charge’ provision (which longexisted in the GST Act when it was introduced),the Minister for Finance may prescribe servicesthat are received in Singapore from overseasto be subject to GST. As there are currently nosuch services prescribed for the purposes ofapplying the reverse charge, it also means thatservices that are received from abroad are notsubject to GST unlike imported goods, whichare subject to the tax.

One concern with the reverse charge is that itcould increase the cost of situating a financialservices operation in Singapore if it has to payGST on management or head office supportservices from overseas without full input tax

recovery due to exempt supplies that it may bemaking. To overcome this, the reverse chargecould be restricted to those services that are on-billed by the overseas person to the Singaporeparty who receives the services. This would alsoaddress the issue of ‘round-tripping’.

Further, the reverse charge corrects the anomalythat imported services are not subject to GSTwhile locally provided services are subject to GST.Having a reverse charge is also in line with thefundamental principle of tax neutrality in a taxationsystem. In other words, the recipient of servicesin Singapore would pay GST at the standardrate regardless of whether or not the servicesare invoiced by a Singapore service provider orinvoiced by a person who belongs outsideSingapore. If the recipient of services is registeredfor GST, it will recover the GST charge as aninput tax credit in the normal manner.

Conclusion

Services are highly mobile and will continue tobe so with advances in information technologyand telecommunications. If taxation is a keyconsideration in the consideration of setting up acentre to provide regional and global services,the imposition of a 5% GST to such services in ahighly competitive industry such as financialservices would impede Singapore’s efforts to bea global services hub.

While there may be issues that need to beconsidered with a reverse charge, it may be timeto consider having such a tax on imported servicesin order to make all Singapore’s internationalservices free of GST and facilitate Singapore’slong-term competitiveness in its global services.

Koh Soo How can be contacted attel . (65) 6236 3600e-mail . soo.how.koh@sg.pwc.com

47PWC EDGE

What’s the Value in CustomsValuation? Where’s the Risk inPost-Clearance Audit?Trade and customs management has been a part of commercial practicesince modern trading between countries began in the early 20th century.Merchants plying the high seas between Europe and America or betweenAmerica and Asia have always been drawn by the immense value that tradingbrings about through the simple act of buying and selling. As mercantiletrade flows increased, the need for controls increased proportionally.Border taxes on the flow of mercantile trade was imposed and this becamethe most early and primitive form of customs duties. Today, many customsterritories imposed customs duties using sophisticated customs managementtechniques operated by highly professional customs administrations.

BY FRANK DEBETS (above) & LOK HWEE CHONG Worldtrade Management Services

48 PWC EDGE

An important area of value and risk withinfinancial management lies in managing directtaxes, the large chunk of which materialises inthe form of customs duties. To understand theissue better, firstly, we can view the issue ofcustoms valuation as the portion providing valueto the company. The risk in customs duties lies inthe post-clearance audit where posthumously,there is a risk of failing to comply with the rulesand regulations on customs valuation portionproperly, and the company finds itself facingstiff penalties.

Customs Valuation

The issue of customs valuation is an importantarea of customs practice which is often in thecentre of disputes between private sector andcustoms administration. For importers, theprocess of estimating the value of a productat customs presents problems that can be justas critical as the actual duty rate charged.This process called Customs Valuation is acustoms procedure applied to determine thecustoms value of imported goods. If the rateof duty is ad valorem, the customs value isessential to determine the duty to be paid onan imported good.

Brussels Definition of Value

From the 1950s to the 1970s, customs dutieswere assessed by many countries accordingto the Brussels Definition of Value (BVD).Under this method, a normal market price,defined as ‘the price that a good would fetch

in an open market between a buyer and sellerindependent of each other’. This method causedwidespread dissatisfaction among traders, as pricechanges and competitive advantages of firms werenot reflected until the notional price was adjustedby the customs office after often lengthy periodsof time.

Tokyo Round Valuation Code

The Tokyo Round Valuation Code, or theAgreement on Implementation of Article VII of theGATT, concluded in 1979, established a positivesystem of Customs Valuation based on theprice actually paid or payable for the importedgoods. Based on the ‘transaction value’, it wasintended to provide a fair, uniform and neutralsystem for the valuation of goods for customspurposes which conforms to commercial realities.This differs from the ‘notional’ value used inthe Brussels Definition of Value (BVD). As astand-alone agreement, the Tokyo RoundValuation Code was advocated by more than40 contracting parties.

The governing principle today– WTO Agreement

Today, Customs Valuation is governed by theWTO Agreement on Implementation of Article VIIof the GATT 1994 following the conclusion ofthe Uruguay Round of discussions. The WTOagreement on customs valuation aims for a fair,uniform and neutral system for the valuation ofgoods for customs purposes – a system thatconforms to commercial realities, and whichoutlaws the use of arbitrary or fictitious customsvalues. The agreement provides a set of valuationrules, expanding and giving greater precisionto the provisions on customs valuation in theoriginal GATT.

The WTO agreement on customs valuation isessentially the same as the Tokyo RoundValuation Code and applies only to the valuationof imported goods for the purpose of levying advalorem duties on such goods. It does not containobligations concerning valuation for purposes ofdetermining export duties or quota administrationbased on the value of goods, nor does it lay downconditions for the valuation of goods for internaltaxation or foreign exchange control.

In addition, the WTO Ministerial Decision onCustoms Valuation gives customs administrationsthe right to request for further information fromimporters where they have reason to doubt theaccuracy of the declared value of imported.

The WTO agreement oncustoms valuation aims fora fair, uniform and neutralsystem for the valuation ofgoods for customs purposes– a system that conformsto commercial realities,and which outlaws the useof arbitrary or fictitiouscustoms values.

goods. If the customs administration maintainsa reasonable doubt, despite any additionalinformation obtained, it may be deemed that thecustoms value of the imported goods cannot bedetermined on the basis of the declared value.Customs would then need to re-establish its valueby taking into account the provisions of theAgreement. In addition, two accompanying textsfurther clarify some of the Agreement’s provisionsrelevant to developing countries and relating tominimum values and importations by sole agents,sole distributors and sole concessionaires.

Basic Rules for Customs Valuation:The 6 Methods

The WTO Agreement on Customs Valuationstipulates that customs valuation shall, except inspecified circumstances, be based on the actualprice of the goods to be valued, which is generallyshown on the invoice. Thus, the first and mostimportant method of valuation referred to in theAgreement is:

For cases in where there is no transaction value,or where the transaction value is not acceptableas the customs value because the price hasbeen distorted as a result of certain conditions,the Agreement lays down five other alternativemethods of customs valuation. Note that theseare to be applied in the prescribed hierarchicalorder, as follows:

Method 1 Transaction ValueMethod 2 Transaction Value of Identical GoodsMethod 3 Transaction Value of Similar GoodsMethod 4 Deductive MethodMethod 5 Computed MethodMethod 6 Fall-Back Method

The above valuation methods must be used inhierarchical order with the exception that thesequence of methods 4 and 5 can be switchedat the request of the importer (not, however,at the discretion of the customs officer).With more that 90% of world trade valued onthe basis of the transaction value method andprice adjustments based on objective andquantifiable data, the WTO Agreement providesmore predictability, stability and transparency fortrade. This serves to facilitate international tradewhile at the same time ensures compliance withnational laws and regulations.

PWC EDGE 49

Other Provisions and Exemptions

Since this Agreement is an integral part of thesingle WTO undertaking, all WTO Members areMembers of the Customs Valuation Agreement.By 1 June 2000, there were 78 WTO Membersalready applying the Agreement.

However, to accord an orderly accession andapplication by the WTO members, the WTOAgreement on Customs Valuation containsprovisions for special and differential treatmentof developing countries and for technicalassistance. All ASEAN-6 member countries, withthe exception of Singapore, has filed to delaythe implementation of the application of thecomputed value method for a period not exceedingthree years following their application of all otherprovisions of the Agreement. In addition, theseASEAN member countries have opted for theflexibility to reverse the order of the deductiveand computed value methods, and reserved theright to value the goods under the deductivemethod even if the goods have undergonefurther processing in the country of importation,whether or not the importer so requests.This also commonly referred to as the‘super-deductive method’.

Developments in ASEAN

In recent years, ASEAN has embarked on aStrategic Plan of Customs Development (SPCD)on Customs Valuation to undertake the fulltechnical implementation of the WTO Agreementand the ASEAN Customs Valuation Guide (ACVG)by 2006.

The practical intent is for ASEAN customsadministrations to harmonise their valuationsystems and practices to be in accordance withthe WTO Agreement on Customs Valuation.In particular, it would prove to be extremely helpfulin facilitating the establishment of the ASEANEconomic Community by 2020 to have inplace not only an ASEAN Harmonised TariffNomenclature (AHTN) but also an ASEANCustoms Valuation System based on theWTO Agreement on Customs Valuation.

Trading parties will benefit from the ASEANCustoms Valuation System as it effectivelyabolishes arbitrary uplifts of value for duty toincrease the collection of import duties.Similarly, it was deemed that the price agreedbetween seller and buyer should not be rejectedsimply because it is considered to be ‘too low’or not market price.

= adjustments(based on Article 8)

Transactionvalue

ActualPrice

+

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To reach SPCD’s ultimate goal for customsvaluation, it is necessary for ASEAN membercountries to faithfully undertake the fullimplementation of the recommendationsand Action Plan of the ASEAN CustomsValuation Guide.

As a first step, all ASEAN member countrieswould need to engage national legislation toimplement the WTO Agreement and toremove any reservations with respect tothe Agreement on intra-ASEAN trade betweeneach other. In particular, ASEAN customsadministrations would need to work togetherto ensure that there is a harmonisedinterpretation and definition of certain terms ofthe WTO Agreement.

• condition or consideration• related parties• partners in business• closely approximates• at or about the same time

4. Use the Valuation Declaration Form forimport declarations.

5. Implement a Valuation Ruling Systemas a customs valuation procedure.

6. Develop a fully transparent administrativeprocedure to deal with appeals.

7. Establish a system of release of importgoods on guarantee.

8. Adopt risk management principles innational administration of CustomsValuation programs.

9. Develop a price database to be utilisedas a risk indicator.

10. Review the penalty provisions in nationalcustoms laws to ensure that sanctions

What you need to know:New recommended features of Customs Valuation

Communication and consensus are critical toensure that there will be a consistent application ofthe WTO Agreement.

An extension of the objective is to ensurethat eventually, all ASEAN member countriesshould apply or take into consideration the‘best practises’ fostered by the World CustomsOrganisation as they introduce and apply the WTOvaluation standard in their home jurisdictions.

The recommendations of the ASEAN CustomsValuation Guide seek to harmonise andstandardise the key areas of valuation laws,regulations and administrative practices that arebeneficial to both the customs administrations andcommercial trading community. Some of theserecommendations are listed below:

1. Adoption of the Generally AcceptedAccounting Principles (GAAP) asa national requirement for customsvaluation purposes.

2. The calculations of customs value shallbe based on objective and quantifiabledata. The customs law shouldrequire that proper books and records(as well as in the electronic format)to be maintained by declarants andthe relevant parties to enable laterverification under post-clearance system.

3. Issue clear policies and interpretationof certain terms of the WTO ValuationAgreement which could promote betterunderstanding between customs andtraders in the application of theprovisions of the Agreement. Some ofthese terms include:

• customs value of imported goods• sale• sold for export to the country of

importation• activities undertaken by the buyer

on his own account

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It is evident that the ACVG recommendations arevery comprehensive in nature and would providegreater transparency and clarity to the tradingcommunity and customs administrations onceit is implemented. It would be further enhancedif clear rules and mechanism are made availableto importers at an early stage, to enable themto seek and adopt valuation rulings prior to theimportation of the goods. This would allowsubsequent imports of identical goods madeby the importer from the same supplier to bevalued in an identical and consistent manner.

While the need of an appeal mechanism hasbeen highlighted in the ACVG, provision shouldbe made for the dispute settlement mechanismto engage the full participation of both the privatesector and public sector. The panel or appellatebody established to preside over valuation rulingdisputes should include representatives fromboth the private and public sector to ensurethat the views and concerns of both the tradingcommunity and customs administration aregiven equal share of voice.

To lift the positive pay-offs to the next level,the individual ASEAN customs administrationscould explore the possibility and feasibility ofexchanging and recognising rulings betweendifferent administrations. The ideal scenario wouldbe to see the creation of an ASEAN customsvaluation ruling by the ten different ASEANcustoms administration. This idea could possiblybe explored and examined throughthe establishment of an ASEAN Committee onCustoms Valuation which could act as a forumfor the ASEAN Customs Directors of Valuation.

To provide greater transparency and minimiseconflicts and disputes over customs valuation,the valuation rulings by ASEAN customsadministrations should be made publicly andreadily available to the private sector to facilitatebusiness planning and precedence setting.

54

Having understood how the new customsvaluation create value for both the tradingparties, as well as the customs authorities,it is now appropriate to turn our focus tothe practical aspects. We can now look at howcustoms administrations handle the risk ofcustoms valuation while maintaining apro-trade facilitation stance.

The answer lies in the post-clearance auditprocess. Let’s take a closer look at howit works.

Post-Clearance Audit

Post-clearance audit is one of the importantareas of customs development that is rapidlyevolving over the last decade. As the role ofcustoms becomes increasingly more focusedon facilitating the movement of goods to supportan ever-burgeoning volume of internationaltrade, the task of customs control have madea marked shift away from physical clearance atentry points, and new control methods aretargeted at the pre-clearance and post-clearancestages. Today, post-clearance audit representsone of the most effective measures for preventingand detecting commercial fraud, particularlyvaluation fraud. The use of post-clearance auditfunction will enabled customs administrations toensure greater compliance with customs laws,regulations, and agreements; to obtain morelatitude in the deployment of control resources; toprovide greater control in areas such as licensing,quota, dumping, etc and most importantly, toprotect revenues collection and minimise leakages.

With the introduction of the WTO/GATT ValuationAgreement, customs administrations will,in most cases, have to accept the value of goodsas declared by importers. This necessitates thecreation of an effective post-clearance audit systemto verify the value and to detect and preventfraud under the WTO/GATT Valuation Agreement.Once an effective post-clearance audit programis set-up, it can be successfully applied to anyvaluation system, even for those who haveyet to adopt and implement the WTOValuation Agreement.

Post-clearance audit is primarily carried out todetermine whether the customs declarations bythe importers were made in compliance with therequirements of customs laws and regulations,and other relevant legislations. It is retrospective innature, which means the audit examination takesplace after the release of the consignments from theentry points. An important element in this process

is the deployment of risk-management techniquesto screen and identify companies for audit.

What exactly is Post-Clearance Audit?

Post-clearance audit (PCA) is a process whichenables customs officers to verify the accuracyof declarations through the examination ofthe books, records, business systems and allrelevant customs commercial data held bypersons/companies directly or indirectlyinvolved in international trade.

This process focuses on those persons who areactive in moving merchandise/goods acrossinternational borders. Customs administrationswhich employ post-clearance audit as anextension of the control of the goods find thatthe process brings about many benefits. It is aneffective tool which provides a clearer and morecomprehensive picture of the import/exporttransactions as reflected in the books andrecords of international traders. When applied tocompanies who have made consistent customsdeclarations for a certain length of time, PCAdemonstrates remarkable effectiveness as atool for analysing their historical records.

Recent Developments in ASEAN

As with Customs Valuation, ASEAN has similarlyundertaken an ASEAN Strategic Plan of CustomsDevelopment in Post-Clearance Audit whichaims to harmonise post-clearance audit practicesand procedures among the various ASEANmembers countries. The objective is to betterfacilitate trading while maintaining a highlyefficient and effective protection of customsrevenues from leaking out of the system.

In the sphere of PCA, ASEAN’s goal is to sharebest practises and procedures among theASEAN customs administrations. The desiredoutcome would be to elevate the level ofsophistication of the various risk managementsystems deployed. This will then heighten theefficiency and effectiveness of post-clearanceaudit in preventing and identifying anyfraudulent activities.

To reach the ultimate goal of SPCD on post-clearance audit, it is important that thenecessary legal and regulatory framework onthe implementation and operation of post-clearance audit are effectively implemented.It is pertinent that both customs administrationsand private sector stakeholders are aware ofthe mechanisms of the post-clearance audit

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process. In particular, customs administrationsneed to determine and construct theorganisational structure and compositionof post-clearance audit teams. Customsadministrations need to ascertain thatappropriate risk management techniques aredeployed to ensure the correct identificationof potential auditees.

It is also imperative that the customs administrationshave in place a system to facilitate the movementof the physical goods. One obvious area toachieve this would be working to reduce thebottlenecks at on-site physical clearancecheck-points. Customs administrations needto shift away from relying on physical clearance.Otherwise, that will prove to be a key stumblingblock to the progress and development of thepost-customs audit.

Greater transparency and cooperation betweenthe customs administrations and privatesector stakeholders on the requirements of thepost-clearance audit process will pave the wayfor greater compliance and revenue protection.

It is true that post-clearance audit targets toidentify fraudulent practices and violations andto a certain extent, criminal and deliberatenegligence. Yet, we should bear in mind thatthere is no hidden agenda, and post-customsaudit is not meant to be an avenue to imposedraconian measures or penalise the privatesector for unintentional or human mistakes.To emphasize this, customs administrationsshould make all effort to take a cooperativeapproach to persons/companies being audited.On the flipside, auditees should also endeavourto be cooperative and provide clear and writtenconsent when required.

Going about It

According to the World Customs Organisation,post-clearance audit places special emphasison the professional conduct of its review andexamination of the importers/exporters booksand records. Open communication and co-ordination through continuous dialogue with theauditee and other Customs units is critical, fromthe pre-audit planning stage through to auditcompletion. At the end of the audit, a report isproduced to ensure that all findings and otherissues pertinent to the audit are shared and openfor discussion among the vested parties.

The phases of the post-clearance audit are :

Selection Phase

• Auditee profiling• Risk assessment• Auditee selection

Auditing Phase

• Pre-Audit Survey• Initial contact• Field Audit• Review and assessment of the audit result• Final Report

Assessment and Follow-up Phase

• Internal assessment of audit performance• Follow-up action

New Activities of PCA

Customs administrations would need to put inplace a comprehensive organisation structure andidentify the operational teams to implement thepost-clearance audit process. At the moment,ASEAN has already developed a post-customsaudit manual (PCA Manual) to assist theimplementation of the post-customs audit processby customs administrations. Currently, theadministrations are exploring harmonising theimplementation of the PCA Manual by thevarious customs administrations, by adoptingsimilar interpretations of allowable orquestionable documentation or trade flows.

Having a consistent documentation processwould ease efforts on the part of the privatesector stakeholders. These are especially helpfulin instances of third party re-invoicing or off-shore banking and treasury activities. With theconsistent set of rules, the private sector

Open communication andco-ordination throughcontinuous dialogue withthe auditee and otherCustoms units is critical,from the from the pre-auditplanning stage through toaudit completion.

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stakeholders are assured that the documentationwill be acceptable by all customs administrations,which removes the fear of reprise or runningthe risk of being penalised.

The credibility of the PCA system would bedependent on the clear and transparentimplementation of customs administrations ofthe PCA system. As such, customs administrationsshould strive to enhance transparency to reducefriction and disputes over the PCA system.

It is critical for ASEAN customs administrationsto manage and reaffirm the private sector thatthe main strategic objective is not to penalisethe private sector for unintentional or humanmistakes but to ensure that companies maintaina robust documentation process which is incompliance with customs requirements.

It is important that customs administrationsrecognise and allow the private sector tovoluntarily amend its customs documentationswithout penalty when the importer found outerrors in the declaration even after thesubmission of the declaration. As the post-clearance audit process has been stressed tobe cooperative, companies should be allowedto voluntarily offer information on any errors tocustoms PCA officials before the commencementof the PCA and amend those errors withoutfacing any penalty.

ASEAN plays a key role in facilitating the sharingof best practices in risk management techniquesemployed to enhance the efficiency andeffectiveness of PCA in identifying fraudulenttraders and violators. It is important that post-customs audit teams share and enhance theircooperation both internally among customs unitsand with other tax/revenue agencies. On aregional basis, customs administrations shouldenhance and deepen mutual assistance andcooperation in identifying systematic fraudsand violations on cross-border trade.

Conclusion

Value is created through Customs Valuation.Post-Clearance Audit acts as a check to managethe risk, in order for Customs Valuation tospread its sails and pick up the winds of trade.Trade volumes have been on the rise. As aregion, we should embark on capturing thevalue in this by working together to put theenhanced Customs Valuation in place.Communication and sharing best practicesin the area of Post-Clearance Audit will

streamline and improve the efficiency of theregion, bringing in greater revenue streams.

Care should be taken that vested parties takeactive participation and are given active voices inthe discussion process. Ultimately, this journeythrough Customs Valuation represents a significantvalue and risk to companies’ financial managementprocess, given its direct impact on the bottom-linetransaction costs and corporate profile.

Let’s set our sights on elevating Customs Valuationto the next level over the next few years, to thebenefit of all.

Frank Debets can be contacted attel . (65) 6236 7302e-mail . frank.debets@sg.pwc.com

Lok Hwee Chong can be contacted attel . (65) 6236 7307e-mail . hwee.chong.lok@sg.pwc.com

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BY RICHARD SCHULTE (above) & ROHAN SOLAPURKARHuman Resource Services – International Assignment Solutions

International Assignments...Impact of non-complianceNot a single day goes by in our business without companies querying ,”Whatare the consequences of non-payment of taxes ?” or “How will anyone knowthat our employees have come and gone from a particular country?”

Simple and direct questions. But the notion runs deep and the answer is farfrom simplistic. Do companies understand the consequences of a situationwhere an employee is restricted from leaving a foreign country due to non-compliance with local regulations? Apart from the monetary consequencesthat can be addressed, the non-monetary repercussions in the form ofadverse publicity are difficult to address and measure.

In a world where employees are constantlymoving across borders to solve complex businessissues, compliance and risk management are ofsignificant importance. Board members and auditcommittee members are increasingly focusingtheir attention towards ensuring full corporatecompliance in the countries in which they have apresence. Of late, this also includes a focus oncompliance issues with respect to employees.The question now being raised is, “Have wedone everything that needs to be done?”However, there will always be companies thatcontinue to question what are the real risksand what is the true value or benefits of fullcompliance with regulations impactinginternational assignments.

In the following paragraphs, we have pennedsome of our thoughts and reasons for whycompanies should go for full compliance andthe value which can be derived from it.

See the benefits beyond the burden

In a world post-Enron, companies havesignificantly increased their focus on compliancerelated issues, whether it is employee relatedcompliance issues, or employer relatedcompliance obligations. With companiesoperating in global markets, employees areconstantly ‘on the move’, giving rise to tax issuesin multiple jurisdictions, i.e. taxation of employeesin their host countries (the country in which theemployee renders services) as well as taxationof employees in their home countries.

It is important that the employer satisfies all itsobligations in the home as well as the hostcountry. In respect of employee tax return filing,one can argue that it is the employees’ liability tofile their own returns and that the company hasno obligation to do so. However, the companyneeds to ensure that the employees have actuallyfiled their tax returns and to some extent, alsoprovide them with support to ensure that thereturns are correctly filed on a timely basis.This becomes a ‘corporate liability’ and playingthis role well could minimise the risk exposureof back taxes, penalties and levies.

Additionally, when companies operate in differentcountries through its employees, the companyitself could potentially be exposed to corporatetaxes in those countries. It is likely thatcompanies may have create a PermanentEstablishment (PE) through their employeesin the countries in which they operate.Consequently, these companies may be subject

to corporate taxes within those tax jurisdictions.In such a situation, these companies may berequired to file corporate tax returns.

Appropriate tax planning may minimise taxes,but it is cannot be viewed as an escape routefrom compliance requirements.

Companies are under significant pressure fromtheir Boards and Audit Committees to ensurethat they are fully compliant with regulations.Although this may result in additional costs forthe companies, the benefits from compliancecould be equally significant.

Some key benefits:

• Minimal risk exposure to penalties, back taxesand additional levies which results in indirectsavings.

• By ensuring that employees file their tax returnsappropriately on a timely basis, and by adoptingconsistent positions, the organisation is lesslikely to be exposed to investigations by theRevenue authorities

• Appropriate accounting of employeescosts, which are correctly reflected in thefinancial statements

• Reduced risk that disgruntled or dissatisfiedemployees go to the Revenue authoritiesto complain on employee and employernon-compliance

• If companies are ‘black listed’ by the Revenueauthorities for failure to pay taxes, they arealso often ‘debarred’ from bidding for anyGovernment contracts

Employee tracking and Immigration issues

9/11 has brought immigration compliance underthe spotlight. Constant security threats clearlypoint out the need to have a detailed mechanismfor tracking employees who are constantly on themove. In the past, companies often used the lackof a robust employee tracking mechanism as aconvenient excuse for non-compliance. However,9/11 seemed to have created a change in people’sattitudes. Companies now have strong trackingsystems in place which gives them an overview oftheir employees’ locations at any given point oftime, so that they can be easily contacted orevacuated at short notice. Immigration authoritiesin countries have also developed sophisticatedmeans of identifying individuals who move inand out of a country.

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From an immigration perspective, it is also criticalthat employees carry correct travel documentswhen they are on business travel. Immigrationlaws in most countries are fairly stringent withdetention or travel bans to that country aspenalties on recalcitrant travellers. In view ofsuch strict measures, it is critical that companiesensure that its employees are accompanied byappropriate travel documents, whether theyare visas, work permits or employment passes.Yet, often companies only look at the taxcompliance aspects while addressing internationalassignment related issues and still overlookthe immigration related compliance sinceappropriate control mechanisms are lacking.

Though it is difficult to attribute a monetary valueto compliance from an immigration perspective,the adverse publicity that comes with non-compliance and its related implications can befar reaching.

Human Resource Effectiveness

The value of being compliant can also be seenfrom a human resource perspective. Beingcompliant in all countries ensures that a companytreats all its employees equally, and that thecompany does not discriminate betweenemployees or nationalities. These companiesare seen to have strong human resourcepolicies and are often viewed as trendsetters.Notably, we see such companies approachingcompliance issues in a more consistentmanner, through well-defined policies, effectiveadministration and implementation of thesepolicies. This could result in companies capturingtax and cost savings which can be analysed andmanaged more effectively. In emergencies,companies who are aware of employeemovements will be able to better manage andcontrol risks surrounding data managementon a real-time basis.

Impact on business

The most significant value of being compliantis clearly visible from a ‘Corporate Governance’perspective. A significant lapse of non-compliancecasts a shadow on the credibility of the Board ofDirectors and the Audit Committee. Businessassociates may question the wisdom of beingassociated with such companies and whetherthey are exposing themselves to indirect risksthrough their contact with such organisations.It is therefore important and beneficial forcompany boards to proactively ensure that

compliance issues have been addressed, and thatappropriate checks and balances are introduced.

Preparing for tomorrow

A combination of the factors mentioned aboveand the fact that the immigration authorities, andperhaps the Revenue authorities as well, areaware of employee movements, has led togreater employer awareness of compliance andcompliance related issues.

As the world gets smaller through enhancedconnectivity and increased information sharing,compliance issues arising through internationalassignments will be under greater scrutiny. Globalcompanies would have to ensure that they are fullycompliant in jurisdictions in which they operate.

Undoubtedly, there is a cost to be incurred to becompliant, but that will be a small price to pay inthe long run.

Richard Schulte can be contacted attel . (65) 6236 3768e-mail . richard.schulte@sg.pwc.com

Rohan Solapurkar can be contacted attel . (65) 6236 3902e-mail . rohan.solapurkar@sg.pwc.com

Though it is difficult toattribute a monetary valueto compliance from animmigration perspective,the adverse publicity thatcomes with non-complianceand its related implicationscan be far reaching.

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