That is the burning question being addressed anew, this time by the Public
Company Accounting Oversight Board ("PCAOB"). PCAOB was created under the
Sarbanes-Oxley Act of 2002, to oversee financial reporting by public companies
and establish standards relating to the ethics and independence of accounting
firms engaged in audits of public companies.
In adopting Sarbanes-Oxley, Congress analyzed the services that accounting
firms provide to their clients and, with the objective of achieving a greater
degree of independence, decided to specifically prohibit the provision of eight
non-audit services to public clients. But tax services were neither restricted
nor prohibited. Instead, all manner of tax services could continue to be
provided by the audit firm so long as each service was pre-approved by the
company's audit committee or board of directors.
Tax Role Of Accounting Firms
Few question the ability of accounting firms to provide competent tax
services. Taxation has become a major part of their business, and they have
amassed a pool of talent capable of addressing all areas of taxation. But if
they provide such services to public companies, the question that must be
addressed is how they, as auditors of their tax clients, can maintain their
"independence" in auditing those same clients?
Analyzing the broad area of tax services from an independence perspective is
a challenge. Some services suggest obvious conclusions. For example, if a tax
shelter is marketed by the accounting firm, it would be virtually impossible for
that firm to be independent in evaluating the merits of the tax shelter.
However, other situations are more difficult to evaluate. For example, in a
complex corporate restructuring, where the tax consequences are uncertain and
time does not permit an advance ruling, the accounting firm may render a "tax
opinion" or recommend the tax treatment in anticipation of the transaction. When
it comes time to audit the year in which the transaction occurred, how can it
audit its own tax opinion, and still maintain its "independence"?
Auditor independence is crucial both to the substantive quality of the audit,
and to the public's perception that financial reporting is reliable. If the
independence of an audit firm is impaired, or is perceived to be impaired, that
represents both an ethical issue for the accounting firm, and a severe SEC
compliance problem for the audit client.
Recent Developments Prompt Action
Since Sarbanes-Oxley was enacted, a number of disquieting developments have
occurred. Reacting to a variety of tax shelter-related investigations initiated
by Congress, the Treasury Department, the IRS, and the Justice Department, as
well as high-profile tax meltdowns like that which befell Sprint and its
management, PCAOB concluded that it had become necessary to evaluate "whether an
auditor's provision of tax services, or any class of tax services, to an audit
client impairs the auditor's independence from that audit client, in fact or
appearance."1 PCAOB thus initiated an investigation into the
interrelationship between an accounting firm's involvement in providing tax
services to a client, and that same firm's role and obligations as an
independent auditor of the client. In several significant areas, PCAOB
identified concerns that, they concluded, required new ethics and independence
standards. As a result of this analysis, PCAOB announced proposed rules designed
to address ethical problems posed by audit firms' involvement in providing tax
New Independence Proposals
Specifically, in December 2004, PCAOB proposed "Ethics and Independence Rules
Concerning Independence, Tax Services and Contingent Fees." If adopted, these
rules would significantly change the role of accounting firms in providing tax
advice to the public companies they audit. Among the proposals, three areas
identified as impairing an auditor's independence are of particular
Setting forth a clear prohibition against contingent fees, Proposed Rule 3521
provides that an accounting firm "is not independent of its audit client if the
firm, or any affiliate of the firm, during the audit and professional engagement
period, provides a 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 contingent fee is defined as "any fee
established for the sale of a product or the performance of any service pursuant
to an arrangement in which no fee will be charged unless a specified finding or
result is attained, or in which the amount of the fee is otherwise dependent
upon the finding or result of such product or service."
Providing Tax ServicesTo Financial Officers
Citing "concerns that performing tax services for certain individuals
involved in the financial reporting processes of an issuer creates an appearance
of mutual interest between the auditor and those individuals," Proposed Rule
3523 provides that no tax services can be provided by the audit firm to
certain executives, whether paid for by the client or by the executive. As
explained by PCAOB, the persons sought to be covered here are "individuals in a
position to play a significant role in the audit client's financial reporting,"
whether formally officers or not. Drawing that line will be an interesting
problem for many companies.
Providing Substantive Tax Advice
Finally, in announcing Proposed Rule 3522, PCAOB couched it as intended to
"prohibit auditors from providing services, other than auditing services,
related to planning or opining on the tax consequences of certain transactions
that pose special challenges to an auditor's independence." This rule "is
intended to describe a class of tax-motivated transactions that present an
unacceptable risk of impairing an auditor's independence."
In confronting this particularly challenging issue, PCAOB noted it had
convened a Roundtable in July, 2004, to consider the ethics and auditor
independence problems attending the provision of tax services generally. A
number of participants in that Roundtable reportedly articulated concerns that
accounting firms' involvement in abusive tax shelters had "damaged investors'
confidence in the judgment and objectivity of firms that engage in such
transactions." In other words, tax shelter activity had come to be perceived not
only as inimical to the tax system (and of course a potential source of material
financial exposures for participating taxpayers), but also as undermining public
confidence in the basic integrity of accounting firms, and in the reliability of
their audits and financial reporting.
To address this threat to public accounting, Proposed Rule 3522 states that a
firm is not independent if, during the audit period, the firm or any affiliate
"provides any non-audit service to the audit client related to planning, or
opining on the tax treatment of" certain specified transactions. The
transactions from which accounting firms are banned from planning and opining
(but not auditing) for audit clients are: (i) "listed
transactions,"3 (meaning those tax shelters the Treasury
Department has identified under Code §6011 as particularly egregious and
ineffective); (ii) "confidential transactions" (meaning transactions in which
the marketers prohibit disclosure in order to protect their secret tax
strategies); and (iii) "aggressive tax positions."
What Are Aggressive Tax Positions?
This last category of banned transactions - "aggressive tax positions" - is
defined in the Proposed Rules as any transaction, whether initiated by the
accounting firm or any other tax advisor, having a "significant purpose" of tax
avoidance, unless the proposed treatment "is at least more likely than not" to
succeed. (In theory, if a client conceives the plan the prohibition does not
apply, but whether an audit firm can get comfortable that a plan has no outside
initiator is a difficult question.)
The very broad definition proposed for "aggressive tax positions" would ban
audit firms from involvement in virtually all forms of tax planning unless the
firm can establish, "based on its analysis of the pertinent facts and
authorities, that there is a greater than 50-percent likelihood that the tax
treatment of the transaction would be upheld if challenged by the
IRS."4 If a tax plan has a 50% or less chance of success, the
proposed rules would consider it "aggressive," and not a proper subject for the
audit firm's involvement.
This proposed restriction on tax planning and advice to issues "more likely
than not" to succeed presents interesting and difficult problems for accounting
firms. This is a fairly high standard, especially given the rapid mutation of
the tax laws, and the frequent instances in which people of good faith truly do
not know what the "right" answer is. Nonetheless, under PCAOB's rule,
substantial authority for a position is not enough; the audit firm must
demonstrate its substantive conclusion that the transactions on which it advises
audit clients stand a better than 50% chance of success. If it cannot, it will
have compromised its independence. (Whether that determination can be made
in-house, or will require an independent third-party opinion, is a question
specifically left open by PCAOB.)
Should PCAOB's proposal regarding the provision of substantive tax advice be
finalized, it seems quite likely that tax professionals at accounting firms will
be precluded from advising firm audit clients on much more than plain vanilla
Areas Not Restricted
PCAOB has thus made three significant proposals to curtail audit firms'
provision of tax services. The Board did not, however, go so far as to preclude
the provision of "routine tax return preparation and tax compliance" services,
noting that this area has not raised independence concerns thus far, and
therefore did not warrant a per se prohibition. International assignment
tax services, and employee personal tax services (other than to financial
reporting executives) also were determined not to require any new prohibitions
at this time.
The era in which accounting firms aggressively marketed tax shelters to their
audit clients for large and contingent fees has understandably given way to new
concerns that auditors remove themselves entirely from any self-interest in the
evaluation of a client's tax strategies, in the interests of restoring
confidence in public accounting. It may be that PCAOB's proposals go too far in
removing an audit firm's tax experts from providing advice to clients on
difficult or complex matters. On the other hand, and as several commentators
continue to urge in response to PCAOB's proposals, ensuring the reliability and
independence of auditors, and restoring public confidence in audit firms, might
indeed require a sea change in the delivery of tax services, and may in fact
require separating audit from tax altogether.
Whatever the specifics of the final rules, it is clear that new controls and
oversight will soon be in place, and that the role of audit firms as tax
advisors will change as well - perhaps dramatically. That presents management
with the challenge of deciding how best to secure the tax advice necessary to
support corporate decision-making in complex
1 PCAOB Release 2004-015, December 14, 2004
("Release") p. 12.
2 Release. p. 13.
3 Since "listing" (category (i)) can
occur after a transaction has closed, PCAOB has requested comments on how to
deal with situations in which an audit firm has advised on a transaction that
subsequently is listed.
4 Release p. 34,
citing federal tax regulations regarding penalty
Carolyn Joy Lee, a Partner in Roberts & Holland
LLP, advises major companies on complex tax matters, controversy and litigation,
and multistate taxation affecting mergers, acquisitions and divestitures.
Roberts & Holland confines its practice to tax matters, with 40 tax lawyers
in its New York City and Washington, DC