Auditor independence, Sarbanes-Oxley, and tax services.

Editor's Note: The Sarbanes-Oxley Act of 2002 represents the most sweeping legislation effecting the accounting profession in 70 years. While uncertainty shrouds the meaning, requirements, and implications of Sarbanes-Oxley, one thing is clear: Interpretation and application of the Act as it applies to tax matters will affect virtually all participants in the corporate income tax field--companies, their accounting firms, and their legal advisers--and it will be highly controversial. Although regulatory guidance is still months away, tax executives need to begin to understand how Sarbanes-Oxley will affect their companies and their relationships with their auditors. In this article, Mark A. Oates and Daniel L. Goelzer of Baker & McKenzie address the Act's provisions governing an accounting firm's provision of non-audit tax services to an attest client. The views stated are those of the authors and not those of TEI. Indeed, a response to this article--by Richard Y. Roberts of Thelen Reid & Priest--immediately follows. TEI welcomes a robust discussion of the meaning and significance of Sarbanes-Oxley. Additional comments, questions, ripostes, and rejoinders should be sent to: Editor, The Tax Executive, c/o Tax Executives Institute, 1200 G Street, N.W., Suite 300, Washington, D.C. 20005-3814, or emailed to [e-mail].

Overview

During the past decade, the issue of "auditor independence"--the link between companies and their outside auditors--attained increasing visibility and importance. The change is attributable in part to the increasing scope of non-audit services provided by accounting firms (Auditors) that audit and certify the financial statements of publicly reporting "attest" clients (Issuers). The increased focus on auditor independence spawned intense debate by accounting school professors, the Securities and Exchange Commission (SEC), Congress, the accounting profession itself, and the media.

Nevertheless, with the SEC's adoption of new final rules on auditor independence in early 2001 (see 17 C.F.R. [beta] 210.2-01(c)(4) (2001)) (the SEC Rules), auditor independence issues fell out of the spotlight. (1) Then came Enron, Andersen, Worldcom, Global Crossing, Adelphia, and a long list of other companies that restated their financial statements because of accounting irregularities. The very integrity of the accounting profession was challenged and auditor independence issues, fueled by one disturbing failure after another, flared into a firestorm.

Congress sprang into action. On July 24, 2002, a House-Senate Conference Committee agreed to accept the Senate version of H.R. 3763, known as the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley). The next day, the bill unanimously passed the Senate and was approved by a vote of 423 to 3 in the House. On July 30, 2002, President Bush signed Sarbanes-Oxley (Public Law No. 107-204) into law.

Sarbanes-Oxley dramatically limits the ability of Auditors to provide non-audit services to Issuers. (2) While the House version of Sarbanes-Oxley would have largely codified the SEC Rules, the final bill goes much further. Of particular relevance to tax professionals, whereas the SEC Rules largely exempted "tax services" from the list of non-audit services deemed to impair an Auditor's independence, Sarbanes-Oxley provides no such blanket exemption for tax services and, indeed, permits an Auditor to perform non-audit tax services on behalf of an Issuer only if the tax services are not described in a list of nine absolutely prohibited non-audit services and only if the provision of such services is approved in advance by the Audit Committee of the Issuer's Board of Directors. And, even if such approval is obtained, the Issuer must disclose the Auditor's non-audit services in its periodic SEC reports.

This article explores the requirements of the Sarbanes-Oxley Act as they relate to the provision of tax services. While there are many issues regarding the breadth of the Sarbanes-Oxley prohibitions, the new law clearly places significant limits upon Auditors providing non-audit tax services for Issuers. The legislation restricts an Auditor's ability to perform for Issuers a number of tax services allowed under the SEC Rules, including appraisal, valuation, actuarial, and controversy tax services. In addition, the Act's prohibition on "expert services" may well prevent Auditors from providing tax services to Issuers in connection with expert testimony in legal, regulatory and administrative proceedings, and may prevent Auditors from providing Issuers with non-testifying expert and litigation support services. The prohibition on expert services, as well as a broader definition of prohibited "legal services," creates uncertainty over whether some aspects of traditional tax planning may be prohibited, such as the submission of ruling requests and the provision of opinions and analyses intended to be submitted to the Internal Revenue Service or Treasury Department. Much of the uncertainty surrounding Sarbanes-Oxley will likely not be resolved until the Public Company Accounting Oversight Board, created by the new law, is appointed and provides guidance. The Oversight Board is to be appointed by the SEC by October 28, 2002, and the SEC is to issue regulations to implement the Act's auditor independence rules no later than January 26, 2003. How broadly--or narrowly--the SEC and Oversight Board will construe the Sarbanes-Oxley provisions cannot be predicted.

Are Tax Services Subject to the List of Prohibited Services?

The first question that arises under Sarbanes-Oxley is whether Congress merely codified the SEC Rules, which largely excluded tax services from the scope of prohibited non-audit services. The answer is that Sarbanes-Oxley does not merely adopt the SEC Rules, but rather significantly broadens the scope of prohibited non-audit services and eliminates the various exceptions for tax services and other non-audit services contained in the SEC Rules.

The pertinent statutory language provides that an Auditor "may engage in any non-audit service, including tax services, that is not described in [the list of prohibited non-audit services], for an audit client, only if" the advance approval of the Audit Committee is obtained and disclosure to shareholders is made. Sarbanes-Oxley [section] 201(a) added). This language places a non-audit tax service on the same plane as any other non-audit service and prohibits the non-audit tax service if it falls within one of the prohibited categories. See S. Rep. No. 107-205, 107th Cong., 2d Sess. 17 (July 3, 2002) (the Senate Report) (Auditor may perform a non-audit tax service only if the tax service "is not on the list" of prohibited non-audit services, is approved in advance by the Issuer's Audit Committee of the Board of Directors, and is disclosed to shareholders). Sarbanes-Oxley also significantly broadens the scope of prohibited legal services and adds a new prohibition on "expert services" not found in the SEC Rules.

In many ways, the SEC Rules and Sarbanes-Oxley are very similar. In the Preliminary Note to SEC Rule [section] 210.201, the SEC explained the reasoning behind its rulemaking on auditor independence:

   In considering this standard, the Commission looks in the first instance to
   whether a relationship or the provision of service: [al creates a mutual or
   conflicting interest between the accountant and the audit client; [bi
   places the accountant in the position of auditing his or her own work; [c]
   results in the accountant acting as management or an employee of the audit
   client; or [d] places the accountant in a position of being an advocate for
   the audit client.

65 Fed. Reg. 76082 (Dec. 5, 2000) (emphasis added). In its rules, the SEC attempted to define the types of relationships or services that would violate these general principles and therefore should be prohibited.

Congress explained the enactment of Sarbanes-Oxley in similar terms:

   The intention of this provision is to draw a clear line around a limited
   list of non-audit services that accounting firms may not provide to public
   company audit clients because their doing so creates a fundamental conflict
   of interest for the accounting firms. The list is based on simple
   principles. An accounting firm, in order to be independent of its audit
   client, should not audit its own work, which would be involved in providing
   bookkeeping services, financial information systems design, appraisal or
   valuation services, actuarial services, and internal audit outsourcing
   services to an audit client. The accounting firm should not function as
   part of management or as an employee of the audit client, which would be
   required if the accounting firm provides human resources services such as
   recruiting, hiring, and de signing compensation packages for the officers,
   directors, and managers of an audit client. The accounting firm should not
   act as an advocate of the audit client, which would be involved in
   providing legal and expert services to an audit client in legal,
   administrative, or regulatory proceedings, or serving as a broker-dealer,
   investment adviser, or investment banker to an audit client, which places
   the auditor in the role of promoting a client's stock or other interests.

Senate Report at 18 (emphasis added).

In addition to adopting similar statements of philosophy, Sarbanes-Oxley and the SEC Rules prohibit virtually the same broad categories of non-audit services. The SEC Rules, however, provided a number of exclusions of non-audit services from these prohibited transactions. Perhaps reflecting the increasing concern and frustration over a torrent of accounting irregularities, Congress in Sarbanes-Oxley declined to adopt the SEC Rules' exceptions and imposed unqualified prohibitions on Auditors with respect to the nine categories of impermissible non-audit services. Sarbanes-Oxley prohibits an Auditor from performing any of the following non-audit services for an Issuer:

(g) PROHIBITED ACTIVITIES.--Except as provided in subsection (h), it shall be unlawful for [an Auditor] ... that performs for any issuer any audit required by this title [or the rules of the SEC or the Public Company Accounting Oversight Board established under Sarbanes-Oxley] ... to provide to that issuer, contemporaneously with the audit, any non-audit service, including--

(1) bookkeeping or other services related to the accounting records or financial statements of the audit client;

(2) financial information systems design and implementation;

(3) appraisal or valuation services, fairness opinions, or contribution-in-kind reports;

(4) actuarial services;

(5) internal audit outsourcing services;

(6) management functions or human resources;

(7) broker or dealer, investment advisor, or investment banking services;

(8) legal services and expert services unrelated to the audit; and

(9) any other service that the Board determines, by regulation, is impermissible.

Sarbanes-Oxley [section] 201(a). Exceptions are provided in subsection (h), which states that an Auditor "may engage in any non-audit service, including tax services, that is not described in any of paragraphs (1) through (9) of subsection (g) for an audit client, only if the activity is approved in advance by the audit committee of the issuer, in accordance with subsection (i)," which requires that Audit Committee-approved non-audit services provided by the Auditor must be disclosed by the Issuer in its periodic public reports. (3) Sarbanes-Oxley [section] 201(a).

Of particular relevance to tax professionals, the SEC Rules expressly excluded tax services from the prohibited non-audit services, thereby largely exempting the provision of tax services from the auditor independence rules. See, e.g., 17 C.F.R. [section] 210.2-01(c)(4)(iii)(B)(3) (excluding valuations performed, for tax planning, implementation of a tax planning strategy, or for tax compliance services from the prohibition on valuation services); 17 C.F.R. [section]210.2-01(c)(4)(iv)(B)(3) (excluding actuarial services relating to considerations and alternatives in federal income tax planning from the prohibitions on actuarial services). Unlike the SEC Rules, the plain language of Sarbanes-Oxley contains no such exceptions. Similarly, Sarbanes-Oxley's ban on legal services is broader. Although the SEC Rules' prohibition on the provision of legal services to audit clients was limited to "circumstances in which the person providing the service must be admitted to practice before the courts of a United States jurisdiction" (17 C.F.R. [section] 210.2-01(c)(4)(ix)), Sarbanes-Oxley has no such limitation on the definition of prohibited legal services. Finally, the SEC did not adopt a proposed rule that would have prohibited "expert services," whereas Sarbanes-Oxley expressly prohibits the Auditor from providing non-audit expert services to the Issuer.

Congress explained the policy underlying the differences: "Some argue that standards for auditor independence should be left to the SEC and the new Board. The approach adopted by the bill reflects the Committee's belief that the issue of auditor independence is so fundamental to the problems currently being experienced in our financial markets that statutory standards are needed to assure the independence of the auditor from the audit client." Senate Report at 18. Under Sarbanes-Oxley, Congress intended that an Auditor "may engage in any non-audit service, including tax services, that is not on the list for an audit client only if the activity is approved in advance by the audit committee of the issuer." Id. at 17 (emphasis added). "Further, no limitations are placed on accounting firms in providing non-audit services to public companies that they do not audit or to any private companies. The purpose is to assure the independence of the audit, not to put an end to the provisions of non-audit services by accounting firms." Id. at 18.

In short, unlike the SEC Rules, Sarbanes-Oxley does not exclude non-audit tax services from the list of prohibited non-audit services, but rather requires non-audit tax services to be analyzed in the same manner as any other non-audit service.

Once the conclusion is reached that non-audit tax services are subject to the list of nine prohibited non-audit services, each non-audit tax service must be scrutinized to determine whether the non-audit tax service "is described" in the list of the prohibited non-audit services. The potential sticking points for non-audit tax services include appraisal, valuation, and actuarial services, legal services, and expert services.

Are Non-Audit Tax Services Involving Appraisal, Valuation, and Actuarial Services Prohibited?

Appraisal, valuation, and actuarial services are expressly identified in Sarbanes-Oxley as prohibited non-audit services. Thus, at least in general terms, the law is clear with regard to non-audit tax services involving appraisal, valuation, and actuarial services: An Auditor is prohibited from providing such non-audit tax services to the Issuer.

Auditors have traditionally provided substantial non-audit tax services relating to appraisals and valuations, and in some cases actuarial services. Sarbanes-Oxley means that accounting firms may no longer be able to provide these services to their audit clients. In this regard, the law is harsh--far harsher than the SEC Rules excluding appraisal, valuation, and actuarial services rendered for tax purposes from the definition of the prohibited non-audit services.

Any argument that this harsh result was not intended runs directly into both the statutory language and the legislative history. First and most simply, the plain language of the statute treats non-audit tax services in the same manner as any other non-audit service. Congress was well aware of the SEC Rules excluding tax services from the list of prohibited services, but declined to adopt the SEC's express exclusion of tax services in Sarbanes-Oxley.

Second, the legislative history explains that the statute was intended to prohibit the provision of non-audit appraisal, valuation, and actuarial services because such services would lead to an Auditor auditing its own work. Indeed, this is the first of the "simple principles" proclaimed by Congress: "An accounting firm, to be independent of its audit client, should not audit its own work, which would be involved in providing ... appraisal or valuation services, actuarial services." Senate Report at 18. The performance of the appraisal, valuation, and actuarial services in the tax context does not change the fact that the Auditor providing such services will be auditing its own work: The Auditor must opine on the adequacy of the tax reserve provisions, which necessarily requires the Auditor to consider the appraisal, valuation, and actuarial positions taken by the Issuer for tax purposes. If the Auditor provides the underlying appraisal, valuation, or actuarial services, the Auditor will be in the position of having to audit its own work in determining the adequacy of the tax reserve positions. (4)

Moreover, Congress recognized that Sarbanes-Oxley would hurt Auditors by requiring them to forgo profitable services for Issuers that generated significant profits. Congress concluded, however, that the prohibition on non-audit services was the quid pro quo for granting the accounting profession the franchise to audit and certify financial statements under the federal securities laws. Senate Report at 14. Further, Congress left accounting firms free to provide the complete panoply of services to non-audit public companies and private companies: "The purpose is to assure the independence of the audit, not to put an end to non-audit services by accounting firms." Senate Report at 18.

Among the non-audit services prohibited by Sarbanes-Oxley are non-audit valuation services. This prohibition will affect Auditors' ability to provide non-audit tax services involving valuation services. For example, many Auditors have long provided advice with regard to transfer pricing matters to Issuers. Often, these transfer pricing services take the form of transfer pricing studies or section 6662 opinions. The object of these studies or opinions is to analyze the Issuer's transfer pricing practices and either to opine that such practices are acceptable under the law or to recommend or support changes to the transfer pricing practices. At bottom, these various studies and opinions attempt to ascertain the arm's-length value of tangible property, intangible property, or services provided by one related entity to another and to compare such values with the prices, royalties, fees, commissions, or other payments charged at arm's length by unrelated parties for similar transfers of tangible or intangible property or services. These transfer pricing studies and opinions seemingly fall within the prohibition on valuation services. Indeed, the penalties to be avoided by the section 6662 opinions are "substantial valuation

misstatements" under section 6662(e) and "gross valuation misstatements" under section 6662(h).

Perhaps more fundamentally, it is not at all unusual for transfer pricing issues to have a significant effect on financial statements. If the Auditor provides the underlying transfer pricing study or section 6662 report upon which the Issuer bases its tax position, the Auditor is seemingly in the position of auditing its own work, in contravention of the first "simple principle" of Auditor independence articulated by Congress. Senate Report at 18. (5)

Are Non-Audit Tax Services Involving Legal Services Prohibited?

A little noticed difference between the SEC Rules and Sarbanes-Oxley in the definition of "legal services" may well have a large effect on Auditors' provision of tax services to Issuers. Specifically, the SEC Rules prohibited:

   (ix) Legal Services. Providing any service to an audit client under
   circumstances in which the person providing the service must be admitted to
   practice be fore the courts of a United States jurisdiction.

17 C.F.R. [section] 210.2-01(c)(4)(ix). The SEC Rule on legal services thus provided two important limitations on the prohibition against providing legal services to audit clients. First, the SEC Rule did not apply to any foreign legal services regulated under foreign law. This limitation on the definition of prohibited "legal services" allowed Auditors to provide, for example, French legal services, to an Issuer.

Second, the SEC Rules' limitation on the definition of "legal services" also allowed the Auditors to provide legal services on U.S. matters as long as the person rendering the legal service did not need to be admitted to practice before the courts of a U.S. jurisdiction. In other words, so long as (a) the provision of legal services by non-lawyer practitioners (6) working for the Auditor did not violate unauthorized practice of law rules, and (b) the non-lawyer practitioners did not try cases for Issuers in the U.S. Tax Court, the SEC Rules prohibiting an Auditor's provision of legal services to Issuers did not apply to tax services.

U.S. statutory provisions and U.S. agency rules have long allowed non-lawyers to engage in activities that, but for the federal statutes and rules, would constitute the unauthorized practice of law. See, e.g., Sperry v. Florida ex rel. Florida Bar, 373 U.S. 379 (1963) (federal statute and regulations authorizing non-lawyers to practice before the U.S. Patent and Trade Office (USPTO) allows non-lawyers to practice law for limited purpose of preparing and prosecuting patent applications; federal statute and regulations pre-empt Florida unauthorized practice of law statutes with regard to practice before the USPTO); State ex rel. State Bar of Wisconsin v. Keller, 123 N.W. 2d 905 (Wis. 1963) (non-lawyer's federal "license to practice before the interstate commerce commission stands upon a footing similar to Sperry's authority to practice before patent office"); The Florida Bar Re: Advisory Opinion--Nonlawyer Preparation of Pension Plans, 571 So.2d 430, 433 (Fla. 1990) (Florida Advisory Opinion) (following Sperry, Florida Supreme Court holds that ERISA and Internal Revenue Code provisions and regulations grant limited license to practice law before federal agencies and pre-empt state unauthorized practice statutes with regard to such practice); Grace v. Allen, 407 S.W. 2d 321,324 (Tex. App. 1966) (federal statutes and regulations governing practice before the Internal Revenue Service grant limited license to practice law that pre-empts state unauthorized practice statutes with regard to such practice).

Congress has authorized qualified non-lawyers both to appear before the U.S. Tax Court and practice before the IRS, activities that would otherwise likely fall within the purview of the unauthorized practice of law. Florida Advisory Opinion, 571 So.2d at 433; Grace v. Allen, 407 S.W. 2d at 324; cf. Sperry, 373 U.S. at 383,386-93,396-400. As the Supreme Court recognized in Sperry, even though "[s]tate courts have frequently held practice before state administrative agencies by non-lawyers to constitute the unauthorized practice of law," id. at 400 (citations omitted and emphasis added), "every state court considering the problem prior to 1952 agreed that the authority to participate in administrative proceedings conferred by the Patent Office and by other federal agencies was either consistent with or preemptive of state law. Normally, the state courts have deemed the authority granted by the federal agency to be closely circumscribed." Id. at 399-400. In other words, non-lawyer practitioners may lawfully engage in legal services for federal income tax purposes that would constitute the unauthorized practice of law if performed for state income tax purposes. (6A)

Sarbanes-Oxley contains neither a definition of "legal services" nor the SEC Rules' limitation on the definition of legal services. Under the Supreme Court's analysis in Sperry, non-lawyer practitioners enrolled to practice before the IRS or admitted to the Tax Court Bar have a limited federal license to practice law, but only to the extent necessary to practice before the IRS and the Tax Court. Accord Florida Advisory Opinion; Grace v. Allen.

The concept that federal tax law pre-empts state unauthorized practice of law statutes and authorizes non-lawyers to engage in federal income tax activities that normally would be considered the practice of law is neither new nor should it be terribly controversial. See B. Bittker, Does Tax Practice by Accountants Constitute the Unauthorized Practice of Law?, 25 J. Tax'n 184 (Sept. 1966) (while "much, perhaps most, of the practice before the Service comes within the ordinary meaning of the `practice of law,'" such practice is authorized under Sperry); B. Wolfman, J. Holden, & K. Harris, Standards of Tax Practice, [section] 801.2 at 414, 416 (1997) ("Although practice by nonlawyers before administrative agencies involves use of legal knowledge and skills normally constituting the practice of law," the upshot of Sperry is that nonlawyers are authorized to engage in the practice of federal tax law as authorized by Circular 230); W. Raby, Chairman's Column, AICPA Federal Tax Division Newsletter (Fall 1983), reprinted in B. Wolfman & J. Holden, Ethical Problems in Federal Tax Practice 287, 288 (1985) ("We are engaged in the authorized practice of federal tax law"); A. Ellentuck, Chairman's Column, AICPA Federal Tax Division Newsletter (Spring 1984), reprinted in Ethical Problems in Federal Tax Practice at 288 ("Perhaps we are engaged in the practice of Federal tax law, but as Bill Raby points out, it is clearly the authorized practice of Federal tax law.") In order to practice before the Tax Court, for example, a non-lawyer must pass the Tax Court Bar Examination under Tax Court Rule 200. Once a non-lawyer has passed the examination and met the other requirements of Rule 200, the non-lawyer practitioner can represent others in Tax Court cases, including filing petitions and motions in the Court, arguing legal motions before the Court, presenting and cross-examining witnesses in trials in the Court, and filing post-trial briefs arguing the client's position with the Court. In short, admission to the Tax Court allows a non-lawyer practitioner to undertake actions that traditionally have been considered the practice of law or the provision of legal services. Similarly, but for the trappings of the Tax Court, representation by the Auditor of an Issuer during an IRS examination or in proceedings with Appeals also involves services considered under the case law to constitute "legal services." Under Sperry and its progeny, qualified non-lawyer practitioners have a limited federal license to practice law to the extent required to practice before the IRS and the Tax Court.

Consider whether an Auditor's representation of an Issuer in Tax Court litigation is prohibited by Sarbanes-Oxley. Under the SEC Rules, "legal services" were limited to those services requiring the individual rendering the service to be admitted to practice before the courts of a U.S. jurisdiction. Because a non-lawyer practitioner was required to be admitted to the Tax Court Bar, Auditors were prohibited from litigating cases on behalf of Issuers, including Tax Court cases. Under Sarbanes-Oxley, Auditors are prohibited from providing any non-audit legal services to Issuers. The new law does not limit the prohibition on the basis of whether the provision of such legal services requires admission to practice before the courts of a U.S. jurisdiction.

There is no evidence in the text of the statute or in its legislative history that Sarbanes-Oxley was intended to limit the definition of "legal services" in the same manner as the SEC Rules. To the contrary, Sarbanes-Oxley is intended to apply to foreign Auditors in the same manner as it applies to domestic Auditors, which could not be the case if the prohibition on legal services did not extend to foreign legal services. Sarbanes-Oxley [section] 106; Senate Report at 11. If the term "legal services" were interpreted to mean only the unauthorized practice of law, then under the reasoning in Sperry, Auditors would be entitled to litigate tax cases in the Tax Court on behalf of Issuers, and would be able similarly to act as advocates on behalf of Issuers before a plethora of federal agencies. Moreover, limiting the definition to the unauthorized practice of law would violate another of the "simple principles" articulated by Congress: In order to be independent, the Auditor "should not act as an advocate on behalf of the audit client, which would be involved in providing legal and expert services to an audit client in legal, administrative, or regulatory proceedings." Senate Report at 18. Thus, Congress does not appear to have intended that "legal services" should be interpreted to mean merely the unauthorized practice of law. If the term "legal services" is construed to mean those services normally considered to be legal services, then, under the reasoning in Sperry, some tax services are likely to be considered legal services and, under Sarbanes-Oxley, prohibited.

Under classic rules of statutory construction, the plain language of the statute controls unless the language is ambiguous; if the language is unclear, the legislative history may be considered. A strong argument can be made that, if Congress intended to limit the prohibition on legal services merely to the unauthorized practice of law, Congress could have said so. Instead, Congress prohibited the provision of all legal services, including those related to tax matters. This argument may lead to an interpretation of "legal services" prohibiting Auditors from providing some tax services, such as the representation of Issuers in Tax Court cases. If an Auditor cannot represent an Issuer in a Tax Court case because of advocacy concerns (Senate Report at 18), then the Auditor may likewise be prohibited from representing Issuers in examinations and appeals proceedings because of the same concerns.

The argument on the other side is that the term "legal services" means something else. In the past, for example, the major accounting firms have argued that the practice of "tax" is not the practice of law. This analysis is inconsistent, however, with the Supreme Court's decision in Sperry: "[R]egistration in the Patent Office does not authorize the general practice of patent law, but sanctions only the performance of those services which are reasonably necessary and incident to the preparation and prosecution of patent applications." 373 U.S. at 386. The suggestion that the provision of "tax" services is something different from legal services is also at odds with the holdings in numerous states that the provision of state tax services--for which no limited federal license to practice law exists--can in fact constitute the unauthorized practice of law. (7)

The prohibition on legal services also has the potential to reach tax planning performed by Auditors on behalf of Issuers. The issue comes down to defining what activities cross the line from accountancy to the practice--albeit the authorized practice under Sperry--of law. A number of cases decided before Sperry analyzed whether an accountant performing federal tax work was engaging in the practice of law. Although the import of the Supreme Court's decision in Sperry is that qualified non-lawyer tax practitioners have a limited federal license to provide legal services relating to their practice before the IRS and the Tax Court, these earlier cases recognize a continuum of services falling within the tax field, some involving non-legal accounting matters and some constituting the practice of law. As one court explained:

   The preparation of an income tax return is not primarily a matter of law
   and generally and mainly is not a matter of law. It may usually be prepared
   by one having no legal knowledge, from instructions prepared for lay
   consumption, or by one having only incidental legal knowledge. A taxpayer
   should not be required, therefore, and is not required to go to a lawyer to
   have a tax return prepared. It is a practical, reasonable and proper
   accommodation to business men and the accounting profession not only to
   permit accountants to prepare tax returns but to permit them, despite the
   risks involved, to assume jurisdiction of the incidental legal questions
   that may arise in connection with preparing tax returns. It is quite
   another thing to say that apart from preparing a tax return and doing the
   accounting work in connection with the return an accountant should be
   permitted as an independent consultant to pass upon specific questions
   which are questions of law, especially when the occasion for such
   consultation is apt to be ... a particularly knotty question of law. The
   distinction is altogether valid and desirable.

In re New York County Lawyers Association, 273 A.D. 524, 537 (N.Y. App. Div. 1948), aff'd, 87 N.E.2d 451 (N.Y. 1949). Expressed differently, another court explained that in the area of taxation--

   A sharp line cannot be drawn between the field of the lawyer and that of
   the accountant. Some matters lie in a penumbra. But any service that lies
   wholly within the practice of law cannot lawfully be performed by an
   accountant or any other person not a member of the bar.

   Plainly the commencement and prosecution for another of legal proceedings
   in court, and the advocacy for another of a cause before a court, in cases
   relating to taxes as in other cases, are reserved exclusively for members
   of the bar. Doubtless the examination of statutes, judicial decisions, and
   departmental rulings, for the purpose of advising upon a question of law
   relative to taxation, and the rendering to a client of an opinion thereon,
   are likewise part of the practice of law in which only members of the bar
   may engage. When we pass beyond those propositions, we enter debatable
   ground.

Lowell Bar Association v. Loeb, 52 N.E.2d 27, 32-33 (Mass. 1943) (citations and footnotes omitted). In Loeb, the persons were found not to be engaged in the unauthorized practice of law when they merely completed and filed simple federal and state income tax returns for persons employed by another. Id. at 34. Somewhere between the mere filing of an income tax return and the research of a pure question of law falls the dividing line between an accounting matter and the practice of law. See, e.g., Gardner v. Conway, 48 N.W.2d 788 (Minn. 1951) (resolving difficult legal questions in order to file tax return is practice of law); Agran v. Shapiro, 273 P.2d 619 (Cal. App. 1954) (preparation of difficult return, including resolving legal questions, was unauthorized practice of law by certified public accountant notwithstanding the fact that accountant was authorized to practice before the Treasury Department).

While Sperry teaches that the federal license to practice before the IRS and the Tax Court preempts state unauthorized practice of law rules, these older cases are illustrative of where courts have drawn the line between the practice of accounting and the practice of law. These cases suggest, as does Sperry itself, 373 U.S. at 383, that when a non-lawyer's advice deals with questions of law relating to the interpretation of statutes, regulations, administrative rulings, or case law, the non-lawyer is engaged in the practice of law. Obviously, much of tax planning deals precisely with the interpretation of statutes, regulations, administrative rulings or case law. Under the reasoning of Sperry and these older cases, much of tax planning could be considered to constitute the provision of legal services.

It remains to be seen whether the term "legal services" will be considered unambiguous or ambiguous. If the term is considered ambiguous, then courts will be free to consider the legislative history of Sarbanes-Oxley. The legislative history on this point, however, is neither extensive nor conclusive, providing only that the Auditor "should not act as an advocate of the audit client, which would be involved in providing legal and expert services to an audit client in legal, administrative, or regulatory proceedings." Senate Report at 18. The congressional intent, then, is to avoid having the Auditor act as an advocate of the Issuer. While the prohibition on advocacy seems to focus on "proceedings," the language is not clear on whether the reference to proceedings is illustrative (i.e., advocacy in a proceeding is only one example of when advocacy issues may arise) or exhaustive (i.e., advocacy in a proceeding was Congress's sole concern). The confusion grows because a tax opinion or analysis may be obtained during the planning stage for use later during legal or administrative proceedings in supporting the taxpayer's return position, in insulating against the imposition of penalties, or in meeting certain documentation requirements (e.g., Advance Pricing Agreement submissions or section 6662 documentation). Furthermore, in the context of anything less than a "will" opinion or analysis, the Auditor would appear to be advocating a position in favor of the taxpayer (i.e., "should", "more likely than not", or "could be argued based on substantial authority").

Further, an Auditor engaging in significant tax planning on behalf of an Issuer is likely to run directly into the first "simple principle" espoused by Congress: An Auditor should not audit its own work. The Auditor must opine on the adequacy of the tax reserves. If the Auditor renders the underlying opinion or analysis in a significant planning project, the Auditor would seem to be in the position of auditing its own work.

What then can one take away from a discussion of legal services under Sarbanes-Oxley? Under the Supreme Court's reasoning in Sperry, the prohibition on provision of legal services likely prohibits an Auditor from representing the Issuer in any legal, administrative, or regulatory proceedings, including examination, appeals, and litigation. Whether an Auditor can engage in significant tax planning services on behalf of an Issuer is a difficult question and one that should be resolved by regulatory guidance from the SEC and the Oversight Board. (Editor's Note: Regulations on auditor independence issues are to be issued by the end of January 2003.)

Are Non-Audit Services Involving "Expert Services" Prohibited?

The same provision prohibiting "legal services" also prohibits an Auditor from providing non-audit "expert services" to an Issuer. The pertinent provision provides:

   "Except as provided in subsection (h), it shall be unlawful for [an
   Auditor] ... that performs for any issuer any audit required by this title
   [or the rules of the SEC or the Board] ... to provide to that issuer,
   contemporaneously with the audit, any non-audit service, including ... (8)
   legal services and expert services unrelated to the audit."

The term "expert services" is not defined in Sarbanes-Oxley.

As in the case of prohibited legal services, the legislative history provides that the Auditor "should not act as an advocate of the audit client, which would be involved in providing legal and expert services to an audit client in legal, administrative, or regulatory proceedings." Senate Report at 18. Thus, the prohibition on expert services is a function of Congress's concern that the Auditor will act as an advocate on behalf of an Issuer, a role inconsistent with both the actual independence of the Auditor and the appearance of independence.

Although the SEC Rules did not include a prohibition on expert services, the SEC did propose such a rule. The proposed SEC rule provided:

   [A]n accountant is not independent under the standard of paragraph (b) of
   this section when the accountant provides certain non-audit services to an
   audit client or an affiliate of an audit client, such as: ...

      (J) Expert services. Rendering or supporting expert opinions for an
      audit client or an affiliate of an audit client in legal,
      administrative, or regulatory filings or proceedings.

Prop. Rul. [section] 210.2-01(c)(4)(J), 65 Fed. Reg. 43190-92 (July 12, 2000). The SEC explained:

   Clients retain experts to lend authority to their contentions in various
   proceedings by virtue of the expert's specialized knowledge and experience.
   The provision of expert services by the accountant creates, at the very
   least, the appearance that the accountant is acting as the client's
   advocate in pursuit of the client's interests. The appearance of advocacy
   (and the corresponding appearance of mutual interest) created by providing
   expert services is sufficient to deem the accountant's independence
   impaired.

65 Fed. Reg. at 43172 (July 12, 2000) (footnotes omitted).

The SEC also sought comments on the effect of expert services on Auditor independence in the context of opinions provided to Issuers, including tax opinions:

   An auditor may provide an audit client a written report or "opinion" on the
   application of an accounting principle to a particular transaction in
   accordance with AU [section] 625. Such advice aids the audit client in
   determining the appropriate accounting for a transaction. However, an
   auditor may also provide such an opinion that is not used primarily by the
   audit client in the preparation of its financial statements, but rather to
   market a product to third parties. Does it impair the independence of the
   auditor when it issues an opinion on the application of an accounting
   principle that is used primarily to market a product to third parties?

   (xi) Tax services. The proposed rule would not affect tax-related services
   provided by auditors to their audit clients. Tax services are unique, not
   only because there are detailed tax laws that must be consistently applied,
   but also because the Internal Revenue Service has discretion to audit any
   tax return. We do not think that the Congressional purpose for requiring
   independent audits is thwarted by an accountant providing traditional tax
   preparation services to an audit client or an affiliate of an audit client.

   We are considering whether special considerations apply when the auditor
   provides a tax opinion for the use of a third party in connection with a
   business transaction between the audit client and the third party. The tax
   opinion may be vital in the audit client's efforts to induce the third
   party to enter into the transaction, particularly when the transaction is
   tax-driven. Under those circumstances, the auditor may be acting as an
   advocate for the audit client by actively promoting the client's interests.

   We request comment on whether providing tax opinions, including tax
   opinions for tax shelters, to an audit client or an affiliate of an audit
   client under the circumstances described above would impair, or would
   appear to reasonable investors to impair, an auditor's independence. Should
   the rules provide that independence is impaired whenever the auditor
   provides any tax opinion or any tax opinion that will affect the audit
   client's financial statements? Does rendering a tax opinion to an audit
   client affect an auditor's independence considering an auditor must reach
   an opinion that the financial statements taken as a whole, including the
   tax accounts, are fairly presented? Are there circumstances in which
   providing audit clients with tax opinions should not be deemed to impair
   independence? Are there other tax-related services that if provided to an
   audit client, would impair, or would appear to reasonable investors to
   impair, an auditor's independence?

65 Fed. Reg. at 43172-73 (July 12, 2000) (footnotes omitted).

Ultimately, the SEC did not promulgate a final rule in this area, explaining its decision not to prohibit expert services in the SEC Rules, as follows:

   Commentators said that our proposals went beyond current rules. For
   example, AICPA Ethics Standards permit accountants to serve as expert
   witnesses.

   Commentators argued that accountants may need to act as experts in
   defending work they have done for audit clients before such bodies as the
   Internal Revenue Service, and indeed, this Commission. As stated in the
   Proposing Release, we did not intend for our proposals to prohibit an
   auditor from testifying as a fact witness to its audit work for a
   particular client. In those instances, the auditor is merely providing a
   factual account of what he or she observed and the judgments he or she
   made. Nevertheless, to avoid confusion and any uncertainty that might be
   created by permitting the accountant to testify in one capacity but not
   another, we have determined not to adopt a restriction on expert services.
   When an accountant performs such services, however, he or she should be
   particularly mindful of his or her duty to maintain objectivity and
   integrity, as discussed in the AICPA Ethics Regulations.

65 Fed. Reg. at 76051 (Dec. 5, 2000) (footnotes omitted).

Against a background of increasing accounting scandals in the late spring and summer of 2002, Congress swept aside concerns regarding current accounting rules and prohibited expert services, without any exceptions or limitations in the statutory language. Congress's actions were likely influenced by the confluence of two themes playing out before Congress. The first theme relates to the role of, and accounting for, special purpose entities in the Enron collapse, as well as the growing sense in Congress that hyper-technical accounting rules were being used to distort the fairness of the presentation of financial statements taken as whole. The second theme relates to growing congressional outrage over various aggressive tax planning schemes, including corporate tax shelters and corporate inversions, as perhaps best reflected by the pending bill sponsored by House Ways and Means Chairman Thomas, The American Competitiveness and Corporate Accountability Act, H.R. 5095, 107th Cong., 2d Sess. (2002). While this confluence of events may well explain Congress's willingness to act to prohibit expert services, this explanation is nowhere reflected in the Sarbanes-Oxley legislative history.

What then does the prohibition on the provision of expert services cover with respect to tax services? At a minimum, the provision likely prohibits Auditors from acting as expert witnesses on behalf of Issuers at any level of legal, administrative, or regulatory proceedings. In addition, an Auditor also may be prohibited from providing non-testifying expert services or litigation support services on behalf of an Issuer, at ]east to the extent that such services entail playing an advocacy role as part of the Issuer's litigation team.

A number of significant questions, however, remain unclear. First, the statutory language does not limit the prohibition to merely expert services in a "proceeding." Further, it is unclear whether the language in the legislative history with regard to "proceedings" is illustrative or exhaustive. The advocacy danger that Congress was attempting prophylactically to avoid is, as recognized by the SEC's requests for comments on accounting and tax opinions, present in other settings as well.

If prohibited "expert services" are not limited to expert services in a "proceeding," then the exact meaning of expert services is unclear and potentially very broad in scope. To some extent, any time a client asks for tax advice, the client is presumably at least under the impression that the adviser is an "expert" in tax matters. Such an interpretation, however, is decidedly too broad. The far more difficult question involves situations in which the Auditor provides the Issuer with a formal opinion or analysis of a difficult and complex question of tax law regarding the treatment of a transaction or a proposed course of action. If the Issuer intends to rely upon the formal opinion or analysis for purposes of evaluating or defending a proposed transaction or course of action, then the tax services begin to look and feel more like "expert services." As the AICPA warned members, "we do not know how broadly the Board or the SEC will define this term. It is conceivable that some tax services we view as traditional may be construed as "expert" services, and not permitted." See, e.g., AICPA News Update--Issue No. 7 (Aug. 2, 2002).

Even if, as may be likely, the prohibition on expert services is limited to legal, administrative, or regulatory proceedings, this language may prohibit a variety of tax services, including ruling requests and the provision of opinions and analyses intended to be submitted to the IRS in support of the taxpayer's position. The reasoning goes like this: A ruling request is an administrative proceeding, and as part of that administrative proceeding, the taxpayer's representative acts as an advocate on behalf of the taxpayer in attempting to secure a ruling favorable to the taxpayer's interests. Moreover, the taxpayer's representative prepares and submits a ruling request essentially opining on or advocating the correct tax treatment of the transaction at issue. In so doing, the taxpayer's representative is seemingly providing expert services in an administrative proceeding (8). Under this reasoning, an Auditor may be prohibited under Sarbanes-Oxley from filing ruling requests on behalf of an Issuer.

Turning to opinions and analyses intended to be submitted to the IRS, consider a section 6662 transfer pricing opinion of the nature already discussed in respect of prohibited valuation services. The Sarbanes-Oxley prohibition on expert services arguably extends to such transfer pricing opinions because the section 6662 opinion is created precisely to avoid the imposition of 20 percent and 40 percent penalties for substantial (or gross) valuation mis-statements under section 6662(b)(3). Section 6662 opinions must be completed by the time a tax return is filed and must be provided to the IRS within 30 days of request. See I.R.C. [section] 6662(e)(3)(B). In order for the opinion to preclude penalties, the taxpayer's reliance upon the opinion must be reasonable, I.R.C. [section] 6662(e)(3)(B), and one of the factors to be considered in determining reasonableness of reliance is whether the opinion was given by a professional qualified to conduct such a study or analysis (i.e., an expert). Treas. Reg. [section] 1.6662-6(d)(ii)(D). A section 6662 transfer pricing opinion, therefore, may be construed to be an expert report intended to be provided to the IRS during an administrative proceeding, and an Auditor's provision of a section 6662 transfer pricing opinion to an Issuer would thus be a prohibited expert service. Moreover, in addition to advocacy concerns, an Auditor's provision of a section 6662 transfer pricing opinion to an Issuer would be inconsistent with the first "simple principle" articulated by Congress, inasmuch as the Auditor would seemingly be in the position of auditing its own work when the Auditor certifies the adequacy of the tax reserves for the Issuer.

In summary, the "expert services" provision of SarbanesOxley is likely to preclude an Auditor from providing an Issuer with testifying expert services and may preclude an Auditor from providing nontestifying expert services and litigation support services. The prohibition on expert services may also preclude Auditors from filing ruling requests on behalf of Issuers and providing Issuers with opinions and analyses intended for submission to the IRS.

Effective Date Issues

The Auditor Independence provisions of Sarbanes-Oxley (sections 201 and 202) do not specify an effective date. Section 201 applies to services rendered by a "registered public accounting firm" and associated persons, and since Auditors must register with the Board, this provision cannot take effect until the Board becomes operational. Section 101(d) of the Act requires the Board to be established on or before April 26, 2003. Once the Board is established, Auditors will have 180 days to register, or until October 23, 2003, if the Board is established on April 26, 2003. To the extent the Board is organized earlier, the deadline for Auditors to register will be accelerated.

Unlike section 201, the pre-approval provisions of section 202 apply to services rendered by the "auditor of the issuer." Although section 202 does not refer to "registered public accounting firms" and thus possibly took effect on July 30, 2002, when President Bush signed Sarbanes-Oxley into law, the term "non-audit services" is itself defined by reference to "registered public accounting firms." Nonetheless, while Congress likely intended for sections 201 and 202 to take effect at the same time, it is not certain. Accordingly, prudence suggests that public companies consider submitting, on a going-forward basis, audit and permissible non-audit services to be performed by their Auditors to their audit committees for approval under Sarbanes-Oxley.

Conclusion

Much of the debate surrounding the permissible scope of non-audit tax services under Sarbanes-Oxley will not be resolved until the SEC and Oversight Board provides guidance. Despite its ambiguities, it is clear that Sarbanes-Oxley changes the landscape significantly for Auditors' provision of non-audit tax services to Issuers. Many non-audit tax services previously permitted to be performed by Auditors for Issuers now may well be prohibited, including tax services relating to appraisals, valuations, actuarial services, tax controversy representation, legal services, and expert witness services. Uncertainty shrouds still other non-audit tax services, such as the provision of tax opinions and significant tax planning. Even permissible non-audit tax services must be submitted to the audit committees of public companies for advance approval and, if approved, the non-audit service provided by Auditors must be disclosed to shareholders by the Issuers Quite clearly, a new era is dawning with respect to the role that Auditors may play in providing non-audit tax services to their attest clients.

(1) Because the SEC Rules are largely superseded by the Sarbanes-Oxley Act (and the regulations that will be promulgated under that legislation), they are referred to in this article in the past tense. As a technical matter, however, they remain in force.

(2) Sarbanes-Oxley places no restrictions on the ability of accounting firms to provide a full range of services to private companies or public companies not audited by the accounting firm.

(3) Congress also gave the Board authority to grant exemptions from the list of prohibited services on a case-by-case basis. Sarbanes-Oxley [section] 201(b).

(4) Notably, in articulating the "public responsibility" of Auditors, Congress drew from the U.S. Supreme Court's description of the role of the independent auditor in United States v. Arthur Young & Co., 465 U.S. 805, 817-18 (1984). Arthur Young was a tax summons case holding that an Auditor's tax accrual workpapers relating to the adequacy of an Issuer's tax reserves are not privileged and hence are subject to production under an IRS summons. Senate Report at 6, 14.

(5) As discussed in the text that follows, an Auditor's provision of section 6662 reports to an Issuer also may constitute a prohibited "expert service."

(6) Under the ABA Model Rules and most state bar rules, lawyers employed by accounting firms can neither practice nor hold themselves out as practicing law. See ABA Formal Op. 269 (June 21, 1945); ABA Formal Op. 272 (Oct. 25, 1946). Accordingly, for purposes of this article, references to non-lawyers or non-lawyer practitioners include licensed lawyers working for accounting firms.

(6A) See, e.g., New York State Society of Enrolled Agents v. New York State Div. of Tax Appeals, 161 A.D.2d 1 (N.Y. App. Div. 1990).

(7) Sperry, 373 U.S. at 400 (citing cases); Westmoreland County v. RTA Group, 767 A.2d 1144 (Pa. Commw. 2001); Bump v. District Court of Polk, 5 N.W.2d 914 (Iowa 1942). See also Kentucky State Bar Association v. Bailey, 409 S.W.2d 530 (Ky. Ct. App. 1966) (accountant filing petitions with Kentucky Board of Tax Appeals engaged in unauthorized practice); Stack v. P.G. Garage, Inc., 80 A.2d 545 (N.J. 1951) (protest before county tax board by non-lawyer is unauthorized practice); In re New York County Lawyers Association, 262 A.D. 56 (N.Y. App. Div. 1941) (challenging local real estate assessments before administrative body is unauthorized practice), aff'd, 43 N.E.2d 530 (N.Y. 1942); Chicago Bar Association v. United Taxpayers of America, 38 N.E.2d 349 (Ill. App. 1941) (seeking refund of "illegally" collected Retailers' Occupation tax held to be unauthorized practice); State ex rel. Hunter v. Daugherty, 286 N.W. 783 (Neb. 1939) (advice by non-lawyer to taxpayer in a tax foreclosure suit is unauthorized practice of law); Crawford v. McConnell, 49 P.2d 551 (Okla. 1935) (protest of tax assessments by non-lawyer is unauthorized practice).

(8) As discussed in the previous section, these activities alternatively may well constitute "legal services" prohibited under Sarbanes-Oxley.

MARK A. OATES is a partner in the Chicago office of Baker & McKenzie and is chair of the Firm's North American Tax Controversy Practice. He is a frequent speaker at TEI meetings, at both the chapter and Institute level.

DANIEL L. GOELZER is a partner in the Washington, D.C., office of Baker & McKenzie, and served as General Counsel of the Securities and Exchange Commission from 1983 to 1990.