I’ve seen a bit spoken about “tax risk” recently. It seems to me that there is a bit of chopping and changing over what is meant.

Just for reference, here is what I reckon is meant by the term.

I tend to think of tax risk in the form described in Wikipedia as ‘expectation value’ or ‘risk factor’.

“The probability of something happening multiplied by the resulting cost or benefit if it does.”

So, for me at least:

‘Tax risk’ = [Probability of tax liability arising] * [value of potential tax liability]

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## About Ben Saunders

I'm a Chartered Tax Adviser and a freelance writer.
This is my personal blog about, well, mainly taxation. I might put other stuff in. Who knows.

My (limited) understanding is that such an equation works where we multiply two independent values. Is your “probability of tax liability arising” assuming that every arrangement is fully considered and tested by a tax authority, or does this risk factor also take into account the probability that the tax authority conduct investigation? If the latter, the two values may not be independent, as higher value tax benefits are often assumed to come under greater scrutiny and hence will be at a higher risk?

Thanks for the questions. I’ve never really discussed this before and it’s useful to think these things through.

Being a bit evasive, I suppose you can cut it several ways and it depends what you want to use the value for…

I’d probably start with indivisible variables, if possible. So I’d probably start with the pure legal risk, the ‘probability of tax liability arising given legal challenge’. So this would be the situation where HMRC attempt to impose the tax liability and the taxpayer opposes it through the courts. Using only that probability this would give you something I’d call the ‘pure’, or perhaps ‘hypothetical’, tax risk.

Then you could introduce an additional variable, something like “probability of legal challenge”, to arrive at some sort of ‘applied’ or ‘practical’ tax risk. It’d be this element that potentially introduces the circularity.of probability increasing with size of tax liability.

So, in answer, I’d prefer to use what I’ve called the pure tax risk. It avoids circularity and it prevents introducing unknown variables. As soon as you do that you’re into the realm of guesswork due to the unknown unknowns, as Donald Rumsfeld put it…

Does that make sense?

The US GAAP position (FIN 48) is that you assess tax risk without taking into account the chance of the authorities challenging the position taken – your “pure” risk.