Responding to the new age of transparency. (Comment).

What do the paedophilia crisis in the Catholic Church, the outbreak of SARS, and the corporate accounting/governance/tax-shelter scandals of the past few years have in common? In each of these situations, an institution of trust has come under fire for responding reluctantly and inadequately to breaches of conduct that, while arguably minor in scope, had shaken the confidence of the respected institution itself and the public at large. And in each case, it was the failure to respond with seriousness that undermined the institution's authority and its ability to serve the high ends to which its representatives are committed.

Few commentators have argued convincingly that paedophilia among priests is epidemic (the number of priests involved is considered low by all but the most extreme critics). Similarly, most analyses of SARS have acknowledged that it has claimed fewer lives than influenza each year. Nevertheless, the credibility of the Church and public health establishments was threatened by the perceived denials of the facts, and then responsibility. A good case can be made that the reaction to these situations were out of all proportion to the threats they posed, but trust and confidence are fickle things--once challenged or lost, they are extraordinarily difficult to restore.

So too with corporate governance and corporate tax planning. From Enron to WorldCom, those in public accounting failed at the very thing they were committed to providing--assurance. Are the problems pandemic? Hardly, but the failures of trust were so large--and the initial opposition to restrictions so relentless--that when push came to shove with WorldCom's 2002 earnings restatements, Congress was forced to show that the problems were significant and corrective action was required.

Congress's response to these public accounting failures was the Sarbanes-Oxley Act. That legislation worked a sea change in the relationship between public companies and their auditors, and the touchstones of that change are independence and transparency. Both clearly have relevance to the tax arena, where accounting firms battle with lawyers and other consultants for tax work, and where their involvement in developing and marketing tax products--and then, in some cases, attesting to their financial statement implications--has raised concerns in some quarters. Whether the concerns are justified is not the point; those concerns are driving government policy and public perception.

Thus, leaving aside Sarbanes-Oxley's prohibition on auditors performing certain services, the Securities and Exchange Commission's auditor independence regulations charge corporate audit committees with scrutinizing the tax services potentially performed by their audit firm. Some companies have responded to the mandate by making distinctions, some completely walling off their auditors from any tax work. The validity of this approach is supported by the Conference Board's recommendation that companies "just say no" to their audit firm performing services in respect of so-called tax shelters.

Sarbanes-Oxley promotes the principle of transparency by imposing stricter rules in respect of document retention and internal controls, as well as the implicit requirement that companies better document the reasonableness of their tax reserves. Corporate governance changes aside, there has been a concerted drive toward greater transparency in the tax area. The Treasury Department and Internal Revenue Service have spearheaded the drive by developing more robust tax shelter disclosure rules. Hence, taxpayers face more rigorous requirements in respect of reporting "listed" and "other reportable" transactions on their returns and, on audit, may be confronted with expansive information document requests and a government challenge to privilege claims. The IRS's decision in the summer of 2002 to revamp its rules for seeking tax accrual workpapers, combined with Sarbanes-Oxley, makes it more likely that IRS agents will be able to review any road map the auditors may create in respect of tax shelters.

That is not all. Congress is poised to enact a whole series of provisions to promote transparency, including an amorphous economic substance test and stringent penalties to complement the Treasury's recent regulations. There have even been calls for corporate tax returns to be publicly disclosed, as well as a misguided (but politically powerful) proposal to require chief executive officers (CEOs) to sign the corporate tax return in order to shine more light on tax matters in the company. Objectively, many of these ideas could be viewed as overkill or counterproductive, but opponents have not been able to gain much traction (the CEO signature proposal is said to have had its genesis in congressional incredulity over the testimony of Enron's former CEO).

The challenge for the tax community--as well their counterparts in the public health and religious sectors--is to accept the drive for, and benefits of, transparency while working to minimize regulation and overreaction. A balance must be struck between denial and surrender. While tax professionals should strive to round the rough edges of the pending regulatory and legislative proposals, they should accept the reality that the environment has changed. Stated simply, lying down in front of a freight train is brave only until you're run over. It is better to formulate and work toward a tolerable compromise than to oppose an unstoppable force.

Timothy J McCormally, Executive Director, Tax Executives Institute

Timothy J McCormally ([e-mail]), Washington DC