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SEC Approves PCAOB Rules on Auditor
Independence and Tax Services
June 2, 2006
The SEC recently approved, in Release No. 34-53677, auditor independence and ethics rules proposed by the Public Company Accounting Oversight Board in 2005. The new rules state that an accounting firm will not be independent of a public company audit client under applicable standards if the firm provides the audit client with specified types of tax or tax-related services or with any service or product for a
contingent fee or commission. A violation of these rules, even if inadvertent, would cause a public company’s accounting firm to lose its independence and require the public company to engage a new independent accounting firm. The new rules also impose additional requirements on registered public accounting firms when they seek audit committee pre-approval to perform tax services. The final PCAOB rules can be found at http://www.pcaobus.org/Rules/Docket_017/2005-07-26_Release_2004-014.pdf.
Background
In adopting the new rules, the PCAOB is implementing the directive in the Sarbanes-Oxley Act of 2002 that it establish rules promoting the ethics and independence of registered public accounting firms that audit financial statements of U.S. public companies. The PCAOB’s action follows the SEC’s adoption in February 2003 of auditor independence rules prohibiting auditors from providing ten categories of non-audit services, including specified types of tax services. We discussed those rules in our SEC Update of February 6, 2003. The SEC’s rules permit auditors to provide tax services that are not expressly prohibited, so long as the services are pre-approved by the company’s audit committee. The PCAOB’s new rules are intended to establish a framework for addressing concerns about auditor independence raised by the highly publicized involvement of some leading public accounting firms in marketing questionable tax shelters and in providing tax services to executives of their audit clients.
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Tax Services That Impair Auditor Independence
As described below, the PCAOB’s rules state that an auditor will not be independent of a public company client if it provides any of the following services:
• Services relating to confidential transactions or aggressive tax transactions;
• Tax services to a person who serves in a financial reporting oversight role at the client; and
• Any other service to the client for a contingent fee.
Services Related to Confidential or Aggressive Tax Position Transactions. Under the new rules, a registered public accounting firm is not independent of its audit client if the firm or its affiliate provides any non-audit service to the audit client related to “marketing, planning, or opining in favor of” the tax treatment of a “confidential transaction” as defined under IRS regulations or an “aggressive tax position transaction.” The effect of the new rules is to add these two tax services to the list of services an audit firm is prohibited from providing its public company audit clients in order to maintain its independence. The prohibition will not apply to tax services that are completed by the accounting firm by June 18, 2006.
Under the rules, a “confidential transaction” is a transaction that is offered to a taxpayer under conditions of confidentiality and for which the taxpayer has paid an advisory fee. A transaction is considered to be offered to a taxpayer under conditions of confidentiality if the advisor who is paid the fee places a limitation on the disclosure by the taxpayer, whether or not legally binding, of the tax treatment or tax structure of the transaction and if the limitation on disclosure protects the confidentiality of that advisor’s tax strategies. Any condition of confidentiality will trigger the rule, regardless of the reason for the condition.
The rule on “aggressive tax position transactions” prohibits the audit firm or its affiliate from providing any service related to marketing, planning or opining in favor of the tax treatment of a transaction that satisfies three criteria:
• The transaction was “initially recommended” directly by the audit firm or indirectly through an affiliate, another tax advisor or otherwise;
• A “significant purpose” of the transaction is “tax avoidance,” which the PCAOB notes would include the acceleration of deductions into earlier taxable years and the deferral of income to later taxable years; and
• The proposed tax treatment of the transaction is not at least more likely than not to be allowed under applicable tax laws.
The PCAOB emphasized in its release that it purposely adopted the “significant purpose” test for triggering the rule’s application, even though this test constitutes a “low threshold.” The PCAOB
acknowledged that the “significant purpose” standard, compared to a higher “principal purpose” threshold, could encompass tax advice relating to any plan to reduce taxes, including tax advice normally associated with the preparation of a company’s income tax returns and tax planning.
A transaction is not an aggressive tax position transaction if the recommended transaction is “more likely than not to be allowable under applicable laws.” To establish that a transaction would meet the “more likely than not” standard, the accounting firm must make an objectively reasonable and well-founded decision, based upon an analysis of the pertinent facts and authorities, that there is a greater than 50% likelihood that the tax treatment of the transaction would be upheld if challenged by the IRS.
Any “listed transaction” will be deemed to be an aggressive tax position transaction under the new rules. A “listed transaction” is a transaction identified in published guidance by the IRS as a potentially abusive tax
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avoidance transaction, such as certain types of “tax shelters,” or any substantially similar transaction. By definition, a listed transaction would fail to meet the “more likely than not” standard at the time the auditors advise on it. The subsequent listing of a transaction that was allowable at the time the tax services were provided by the accounting firm would not result in a per se violation of the rule.
The PCAOB stated in its release that accounting firms may continue to provide other kinds of tax services not proscribed by the new rules, including tax compliance, tax planning and tax advice services, so long as the audit committee’s pre-approval requirements are met. Public company audit committees, however, will need to evaluate carefully the risks of having their auditors perform any tax services in light of the relatively low “significant purpose” threshold and the vagueness of the “more likely than not” standard used to identify an aggressive tax position transaction.
Tax Services for Persons in Financial Reporting Oversight Roles. To prevent the appearance of a mutual interest between the auditor and certain persons associated with its audit client, the new rules provide that a registered public accounting firm is not independent of its audit client if the firm or its affiliate provides any tax service during the audit and professional engagement period to a person in a “financial reporting oversight role” at the audit client or to an immediate family member of that person.
A person is in a “financial reporting oversight role” if the person is in a position to exercise influence, or actually exercises influence, over the contents of the financial statements or anyone who prepares them. A covered person generally would include the company’s chief executive officer, president, chief financial officer, chief operating officer, general counsel, chief accounting officer, controller, director of internal audit, director of financial reporting, treasurer, or any person serving in an equivalent position. The broad reach of “financial reporting oversight role” is somewhat narrowed by the exclusion of the following persons from the scope of this term:
• A person who is in a financial reporting oversight role solely because of the person’s service as a member of the board of directors;
• A person who serves in a financial reporting oversight role at an affiliate of the company, but only if the affiliate’s financial statements are not material to those of the company, or are audited by a different firm; and
• A person who becomes subject to the rule because the person was hired or promoted into a financial reporting oversight role at the company, so long as the tax services are provided under an
engagement in process before the hiring or promotion and are completed within 180 days after the date of hire or promotion.
The applicable rule became effective on April 19, 2006, but will not apply to tax services that are provided under an engagement in process at the time when the rule was approved on April 19, 2006 if the services are completed on or before October 31, 2006.
Contingent Fee Arrangements. Under the new rules, a registered public accounting firm will not be independent of its audit client if the firm or its affiliate provides any service or product to the audit client for a contingent fee or a commission or receives from the audit client, directly or indirectly, a contingent fee or commission. A fee will be considered “contingent” if no fee will be charged unless a specified finding or result is attained, or if the amount of the fee is otherwise dependent upon the finding or result. Fees that are fixed by a court or another public authority, such as fees approved by a bankruptcy court, are excluded, but only if they are not dependent on a particular finding or result. The PCAOB has confirmed that fees based on the results of judicial proceedings or the findings of a governmental authority are covered by the rule and prohibited, even though such fees are permissible under the SEC’s independence rules.
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The contingent fee rule is effective on April 19, 2006, but will not apply to a contingent fee arrangement that is paid in its entirety, converted to a fixed fee arrangement, or otherwise unwound before June 18, 2006.
Audit Committee Pre-Approval of Tax Services
The PCAOB’s new rules expand the responsibilities of a registered public accounting firm under existing SEC rules to seek pre-approval of tax services from an audit committee. The accounting firm must:
• Describe in writing to the audit committee the scope of the tax service, the fee structure for the engagement, any side letter or other amendment to the engagement letter or any other written or oral agreement between the firm and the audit client relating to the service, and any compensation arrangement or other agreement (such as a referral agreement or fee-sharing arrangement) between the firm and any person with respect to the promoting, marketing, or recommending of a transaction covered by the service;
• Discuss with the audit committee the potential effects of the tax services on the independence of the firm; and
• Document the substance of its discussion with the audit committee.
The applicable rule is effective on April 19, 2006, but will not apply to any tax service pre-approved on an engagement-by-engagement basis before June 18, 2006. With respect to tax services provided to audit clients whose audit committees pre-approve tax services pursuant to policies and procedures, the rule will not apply to any such tax service that is begun by April 20, 2007.
Discussion
The PCAOB has not introduced any dramatic changes to long-standing concepts of auditor independence. The PCAOB’s new rules largely address specific types of tax services that pose a significant risk of compromising independence and reflect an approach that is largely in accord with SEC requirements. In deciding not to prohibit additional types of tax services, the PCAOB situated its rules within the current regulatory scheme. Auditors may continue to provide their audit clients with tax services that are not expressly prohibited by the PCAOB’s rules if those services are consistent with the SEC’s independence requirements and if the auditor and the company’s audit committee have complied with the SEC’s rules relating to audit committee pre-approval of the services.
Public companies should heed the admonition of the PCAOB and the SEC to evaluate carefully the risks involved in having the same public accounting firm that is auditing the company also provide tax services. The additional information auditors must provide the audit committee should assist the committee in making an informed judgment when deciding whether to approve proposed tax services. But financial literacy and accounting expertise alone may not provide a sufficient basis for conducting this review, due to the sophisticated analysis that may be necessary. It may be appropriate in some circumstances (such as where tax services involve questions whether a transaction has “a significant purpose” of tax avoidance” or whether it is “more likely than not” that the tax treatment would be upheld) to seek an independent tax review. In addition, public companies should review their compliance policies for possible modification to prohibit any employee from hiring the company’s auditor to provide tax services to that employee or the employee’s family if the employee could be determined to serve in a financial reporting oversight role.
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For more information about the matters discussed in this SEC Update, please contact the Hogan & Hartson L.L.P. attorney with whom you work, or any of the attorneys below who contributed to this SEC Update.
Peter J. Romeo (Co-Editor)
Washington, D.C.Partner
202-637-5805
Richard J. Parrino (Co-Editor)
Northern VirginiaPartner
703-610-6174
Barbara J. Thomas
New YorkPartner
212-918-8440
Scott
Friedman
New York
Partner
212-918-8299
Stuart
G.
Stein
Washington, D.C.
Partner
202-637-8575
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