"Audit" vs. "non-audit" tax services under Sarbanes-Oxley.

Introduction

Previous articles in The Tax Executive have addressed portions of the Sarbanes-Oxley Act of special interest to corporate tax executives. Among the topics covered are provisions requiring audit committees to pre-approve non audit services to be performed by a company's auditing firm, as well as less frequently discussed, but at least as important, provisions aimed at preventing misrepresentations in financial statements. (1) This article addresses an additional aspect of the environment--the increased role of tax specialists in the financial audit process itself.

Anecdotal evidence abounds that the Sarbanes-Oxley Act, coupled with the high level of publicity that has attended some large-scale corporate tax controversies, has increased the scrutiny accounting firms are giving to companies' income tax positions in connection with the companies' financial audits. This increased scrutiny has led to greater participation in financial audits by tax specialists within the accounting firms, who often perform their increased audit responsibilities in tandem with their longstanding roles in tax compliance, planning, and representation in examinations. The greater involvement of tax specialists in financial audits should advance the investor-protection goals of Sarbanes-Oxley. (2)

Significantly, the Sarbanes-Oxley Act placed important limitations, mainly in the form of audit committee pre-approval requirements, on the provision of audit and non-audit tax services by members of auditing firms. (3) In addition, the fees paid annually for "non-audit" services must be disclosed, and the fees for non-audit "tax services" must be identified specifically. Inevitably, tax executives, working with their CFOs and audit committees, will need to develop sensible ways to distinguish between these categories. Neither the statute nor the SEC regulations provide much guidance on how audit committees should differentiate between these categories of services, but rather generally leave the question to audit committees' discretion. This article strives to help fill the vacuum, enabling tax executives and audit committees to identify the salient issues when they arise and to deal with them thoughtfully and carefully.

Difficulty of Distinguishing Between Audit and Non-Audit Tax Services

Despite the importance of distinguishing between audit and non-audit tax services, it will often be very difficult to draw a clear line between (1) tax advice provided in connection with an audit and (2) tax advice properly regarded as planning or consulting advice beyond the scope of the audit. The challenge is heightened by companies' not wanting to wait until the financial audit is formally underway in order to confirm whether the auditors agree to the proposed accounting treatment of a particular tax position. Instead, companies are understandably seeking real-time advice from the auditing firm, at the time a particular tax position is contemplated, on whether the proposed treatment ultimately will be acceptable to the auditing firm.

In view of the significant judgment required in evaluating tax reporting positions, as well as the complexity of many tax issues, tax specialists at the auditing firm who are asked whether a proposed position will be acceptable will frequently (and understand ably) opine that a fully professional response involves more than a bare "yes" or "no." In such circumstances, it may be difficult if not impossible to determine confidently where the "audit" activities of the auditing firm's tax specialists end and "tax planning" services, above and beyond the auditing function, begin.

The stakes involved in answering this question wrongly can be considerable. If services that the company and its auditing firm initially classify as "audit" services are in retrospect deemed to constitute tax planning services, then the company can be found to have failed in its pre-approval obligations under Sarbanes-Oxley, as well as to have misreported the level of its fees for non-audit tax services. Both the company and the auditing firm, therefore, will want to exercise care to make the necessary distinctions in an appropriate manner. (4)

Procedurally, a company's audit committee faces a two-step inquiry under Sarbanes-Oxley when the activities of an auditing firm's tax specialists approach the hazy line separating audit services from non-audit tax advice. The first question is whether the tax advice should be considered to fall within the audit or non-audit category. Second, if the audit committee determines that services should be placed within the non-audit category, the audit committee must determine whether the proposed non-audit tax service should be pre-approved or, instead, the service should be performed by advisers outside the auditing firm.

From the perspective of the audit committee, the challenge is that neither the Sarbanes-Oxley Act nor the SEC regulations enumerate any specific standards for determining when "audit" tax services have slid into the "non-audit" category, thereby triggering a separate pre-approval and different fee reporting requirements. This paucity of guidance parallels that surrounding the much-debated second question in the sequence--whether, once a tax service has been identified as "non-audit" in nature, the audit committee should in fact approve that service. On this latter question, although proposed SEC regulations had suggested numerous different standards that might govern audit committees' determinations, the final version of the regulations is essentially silent, leaving the decision almost entirely to the judgment of the audit committee. (5) Indeed, the regulations provide only that in most circumstances the decision should be based on the audit committee's judgment whether the proposed service could "impair the independence of the accountant." (6) With respect to the initial question whether a particular tax service rises to the level of a non-audit service, the Act and regulations provide even less guidance--in fact, no explicit guidance at all.

The lack of guidance in the SEC's rules does not mean that audit committees have no basis for determining whether particular tax services constitute non-audit services. At a minimum, the audit committee should be guided by its evaluation of the broad factors that apparently motivated Congress in enacting the provisions of Sarbanes-Oxley. Specifically, in determining whether particular services fall within the audit or non-audit category, the audit committee should ask whether, in light of the balance between efficiency and investor protection that the Sarbanes-Oxley Act apparently seeks to achieve, investors might reasonably desire the audit committee (1) to subject the proposed service to the kind of specific, case-by-case consideration that is required for "non-audit" services, and (2) if the service is approved, to report the fees for the service separately in the "tax" category. Certainly, the standard as thus stated is somewhat nebulous, but by focusing on the question how investors reasonably might desire the audit committee, in a particular instance, to proceed seems at least to be a useful starting point for reasoned decision-making.

In addition, by considering (1) the purposes and policy judgments underlying Sarbanes-Oxley as the law applies to tax services, and (2) the nature of the situations in which doubts about the classification of tax services are likely to arise, it is possible to provide useful guidance. The relevant policies and purposes of Sarbanes-Oxley would appear to be two-fold:

* Despite the views of some, Congress ultimately decided not to impose a ban on the performance of non-audit tax services by audit firms, but chose to rely on the mechanisms of audit committee approval and fee disclosure to provide a proper balance between competing policy considerations.

* On the other hand, Congress also determined that some tax matters are such that, in order to safeguard the auditing firm's role in behalf of investors, auditing firms should be prevented from obtaining stakes in the matters by providing advice.

Accordingly, Congress apparently determined that, in some circumstances, the efficiencies of permitting auditing firms also to provide non-audit tax services will outweigh any adverse effects on independence that might arise. In view of this congressional determination, a rule of reason (rather than a blanket prohibition) seems reasonable in determining when tax services have taken on sufficient planning elements to place the services outside the "audit" category. Plainly, every suggestion for improvement of transactions offered by the audit firm's tax specialists should not be deemed sufficient to move services into the "non-audit" category. Such a draconian approach would prove counterproductive by effectively discouraging tax professionals in the auditing firms from offering advice that could prevent potentially expensive errors.

Nevertheless, the creation in Sarbanes-Oxley of a pre-approval process (7) in itself suggests that there will be circumstances in which independence can reasonably be seen as at least potentially impaired. For example, the final Sarbanes-Oxley regulations conclude that in situations involving advocacy the provision of expert services by the accountant makes the accountant part of the "team." Similarly, the appearance of advocacy created by providing such expert services is sufficient to deem the accountant's independence impaired. (Interestingly, in a footnote relating to the prohibition on providing "expert" services, the regulations observe "as we discussed in our proposing release, virtually all services provided by an accountant may be perceived to be expert services. This prohibition, however, only applies to those services that involve advocacy in proceedings and investigations ... and does not apply to other permitted non-audit services, such as tax services." (8)) These considerations appear relevant to the question of where to locate the boundary between audit and non-audit services, as well as whether to approve particular non-audit services.

Thus, a reasonable distinction can be made between "audit" services in which the professional acts primarily as an overseer (i.e., determining that already-conceived transactions and policies are acceptable from an auditing standpoint) and non-audit services in which the professional acts primarily in a creative capacity (i.e., articulating new transactions and policies that the company might choose to adopt). This does not mean that every suggestion for improvement of an already-conceived transaction or policy becomes a "non-audit" service; such an extreme view would undesirably limit the auditing function. Nevertheless, as long as the question always is recognized as one of reasonable balance, the distinction between preconceived and newly devised transactions and policies should prove useful for audit committees.

Of course, general observations (such as the foregoing) are inevitably of limited use, but in the absence of specific guidance, the following additional observations about the distinction between "audit" and "non-audit" tax services may prove useful to audit committees and tax executives:

(1) Management's obligations to distinguish between audit and non-audit tax services and in determining whether to approve particular non-audit services are likely to be satisfactorily fulfill only if all participants in the process--the audit committees, the tax executives who advise the audit committees, the auditing firms themselves, and the auditing firms' competitors in the market for tax services--approach the processes with a large degree of restraint. If participants approach the tasks as fervent advocates for their parochial interests (e.g., if tax executives view their primary role as preserving, to the maximum extent possible, their discretion for selecting advisers, or if the various professional firms view their role primarily as preserving the widest possible scope for their professional services), then the judgment of the audit committees is likely, inevitably, to be undesirably skewed, and the work of the audit committees very difficult to perform. Such a turn of events, moreover, could well prompt Congress or the regulatory authorities to seek to replace the current judgment-based regime with a system based more heavily on bright-line rules, thereby imposing a less flexible regime on companies, investors, audit committee members, and auditing firms. Stated differently, if the current balance under Sarbanes-Oxley is to be maintained, all involved in the process must resist the temptation to "push the envelope" in terms of the judgments that audit committees must make.

(2) Audit committee members, as well as regulators, must become well-versed in the nature of tax practice and, in particular, in the kinds of judgments that tax practitioners must make under today's body of complex tax rules. Much of the debate that led to Sarbanes-Oxley (and to the subsequent promulgation of the SEC's independence regulations) reflects an over-simplified view of tax practice to the effect that determining whether auditing firms should be authorized to perform particular tax services will generally be an easy one: that, for example, it will be possible to distinguish readily between tax services involving "tax shelters" in which auditing firms should not be permitted to participate, and "routine" tax services that auditing firms should be authorized to provide. Audit committees that do not educate themselves concerning the complexity of the decisions that they need to make will expose themselves to considerable peril. (A possible side-benefit of the necessary educative process is that if audit committee members, who tend to be influential individuals, increase their understanding of the complexities posed by today's tax system, they might become a powerful constituency in support of tax simplification. Such simplification, if it ever is accomplished effectively, is likely to prove far more effective than Sarbanes-Oxley, or any other governmental regulatory or enforcement initiatives, in remedying the "abuses" that often are perceived in today's tax system.)

(3) Audit committee members, corporate tax executives, accounting firms, and tax advisers generally should recognize that more prominent involvement of tax specialists in financial audits is likely to continue on a long-term basis, and that such involvement benefits investors in light of the complexities of today's tax system. Accounting firms themselves should acknowledge that, over time, the greater involvement of tax specialists in financial audits is likely to affect the nature of tax practice within accounting firms; and that the resulting change may well be desirable, not only from the standpoint of investor protection but also from the standpoint of the long-term health of accounting firm tax practice itself.

(1) See articles in The Tax Executive for September-October 2002 and November-December 2002.

(2) Although the increased involvement of tax specialists in financial audits is apparent to all who participate in corporate tax practice, the phenomenon has received little mention in the professional press. A recent exception is provided by George Goodman, The Taxpayer's and Tax Adviser's Guide to Sarbanes-Oxley, Tax Notes, August 4, 2003, at 691, 700. Goodman observes:

   [A way] in which the Act may bear on financial audits involves
   the extent of the auditor's review of the company's tax positions.
   To the extent a material position was not previously
   advanced or reviewed by the auditor, the auditor will have to
   carefully review and scrutinize that position on audit. Even
   where the audit firm itself provided the tax advice, the audit
   partners may be more inclined to question or double-check
   the work than in the past; or the company might wish to
   have a second firm review some of the work. Thus, the tax
   provision review process could become more substantive and
   contentious than in the past. To avoid problems arising on
   audit where someone other than the auditor is providing the
   tax advice on a transaction having uncertain tax consequences,
   the company may wish to have its auditor review and "sign
   off" on the transaction before it is carried out, rather than
   await the audit only to find that the auditor will not accept
   the desired tax or accounting treatment.

(3) As a technical matter, the final SEC regulations divide services into four categories, the fees for each of which must be separately reported:

1. Audit fees (for the audit of the registrant's annual financial statements and statutory and regulatory filings)

2. Audit-related fees (for assurance and services reasonably related to the performance of the audit)

3. Tax fees (for tax compliance, tax advice, and tax planning), and

4. All other fees (for products and services provided by the auditor other than those reported above).

Fees in all four categories must be pre-approved by the audit committee. The final SEC regulations addressing this categorization and the other topics addressed in this article are found in U.S. Securities and Exchange Commission, Release No. 33-8183 and associated releases, Jan. 28, 2003, with technical corrections provided by SEC release on March 31, 2003. The text of the final as well as proposed rules is available at www.sec.gov. When speaking of "non-audit" tax services and related fees, this article refers to services and fees in this third category.

(4) Section 202(i)(1)(b) of Sarbanes-Oxley does provide a de minimis exception.

(5) In its proposed rules (released on December 2, 2002), the SEC suggested that Congress intended the application of three overarching principles: (1) the public company auditors should not audit its own work; (2) a public company auditor should not function as part of management or as an employee of its audit client; and (3) a public company auditor should not act as an advocate for its audit client (this activity being deemed to occur when the auditor provides legal or expert services to its client in judicial or regulatory proceedings). The final rules (promulgated on January 23, 2003), however, rejected the three-pronged approach on the ground it would unduly limit the provision of tax services. Thus, the final rules incorporate a more subjective approach that vests substantial discretion in the audit committee. See note 6 infra.

(6) U.S. Securities and Exchange Commission, RIN 3235-AI73, Preamble (Mar. 26, 2003). The preamble also provides that the audit committee should not permit members of the auditing firm to represent the corporation in court, including the Tax Court, and that "audit committees ... should scrutinize carefully the retention of an accountant in a transaction initially recommended by the accountant, the sole business purpose of which may be tax avoidance and the tax treatment of which may be not supported in the internal Revenue Code and related regulations." (Footnote omitted.) Neither of these situations is likely to arise often in practice, so that in virtually all circumstances the audit committee's judgment will be governed by the "will not impair independence" standard.

(7) In some circumstances, the pre-approval requirement can be satisfied by determining the categories of non-audit services that will be acceptable. See 17 C.F.R. [section] 201.2-01(7) ("These rules we are adopting are intended to clarify that, to the extent permitted by the Sarbanes-Oxley Act, the audit committee may pre-approve audit and non-audit services based on policies and procedures and that explicit approval and approval based on policies and procedures are equally acceptable.").

Recent informal guidance by the SEC staff, published in a question-and-answer format, includes the following:

Question 23

Q: Can the audit committee's pre-approval policies and procedures provide for broad, categorical approvals (e.g., tax compliance services)?

A: No. The Commission's rides require that the pre-approval policies be detailed as to the particular services to be provided. Use of broad, categorical approvals would not meet the requirement that the policies must be detailed as to the particular services to be provided.

Question 24

Q: How detailed do the pre-approval policies need to be?

A: The determination of the appropriate level of detail for the pre-approval policies will differ depending upon the facts and circumstances of the issuer. However, a key requirement is that the policies cannot result in a delegation of the audit committee's responsibility to management. As such, if a member of management is called upon to make a judgment as to whether a proposed service fits within the pre-approved services, then the pre-approval policy would not be sufficiently detailed as to the particular services to be provided. Similarly, pre-approval policies must be designed to ensure that the audit committee knows precisely what services it is being asked to pre-approve so that it can make a well-reasoned assessment of the impact of the service on the auditor's independence. For example, if the audit committee is presented with a schedule or cover sheet describing services to be pre-approved, that schedule or cover sheet must be accompanied by detailed back-up documentation regarding the specific services to be provided.

Office of the Chief Accountant, Securities and Exchange Commission, Application of the January 2003 Rules on Auditor Independence--Frequently Asked Questions, Aug. 13, 2003.

(8) Footnote 97 to the final SEC regulations dated January 28, 2003.

MICHAEL C. DURST and THOMAS H. GIBSON are partners, respectively, at King & Spalding LLP in Washington and PricewaterbouseCoopers LLP in San Francisco. Mr. Durst was one of the authors of an article in the November-December 2002 issue of The Tax Executive entitled "What Is Really Important for Tax Executives in Sarbanes-Oxley?"