Sarbanes-Oxley, tax shelters, IRS oversight, and Canadian activities command TEI's attention. (Recent Activities).

The closing days of 2002 and the early days of the new year brought into focus issues of keen importance to Tax Executives Institute and its members. From comments on the auditor independence rules of the Sarbanes-Oxley Act and the Treasury Department's most recent offering on tax shelters, to testimony before the IRS Oversight Board on IRS audit initiatives, to hard-hitting letters on Canada's rules on foreign investment entities and non-resident trusts, the Institute's committees occupied themselves with the subtleties and nuances--and, most of all, the practical effects--of important government actions.

SEC's Auditor Independence Rules

On January 13, 2003, TEI President Drew Glennie submitted a letter to the Securities and Exchange Commission relating to proposed rules strengthening auditor independence. The rules, which grew out of the Sarbanes-Oxley Act of 2002, will significantly affect how companies secure tax services.

In preliminary remarks, TEI observed that "registrants must be able to obtain ... tax services under rules of sufficient clarity of application so that the relatively simple decision of selecting a vendor ... does not itself carry unreasonable burdens or penalties for foot faults." Absent clarification of the rules, TEI said, "qualified vendors for particular services will be effectively disqualified simply out of caution, and both taxpayers and service providers--the marketplace (including the investing public)--will be disserved."

TEI's detailed analysis highlighted the circularity in the application of section 201(g) of the Act, which sets forth a list of prohibited services that by their nature presumptively compromise auditor independence, and section 201(h), which describes activities that may be undertaken by the auditor subject to pre-approval by a registrant's audit committee. The circularity of the Act, TEI said, creates substantial ambiguity and confusion for registrants and their advisers. Indeed, the letter stated, "commentators on the proposed rules have forcefully urged conflicting constructions" of sections (g) and (h) of section 201 and "the final rules must solve the conundrum" and "be capable of clear application."

After reviewing the Act, its legislative history, and various categories of tax services, TEI said that "giving meaningful and practical scope to [sections 201(g) and (h) of the Act] must be a fundamental purpose of the Proposed Rules." The term "tax services" encompasses many different types of activities performed by public accounting firms, law firms, various types of appraisal and evaluation firms, and lobbying and governmental relations specialists. Moreover, TEI said, legal services and accounting services are often inextricably intertwined in the field of federal income taxation. "In many cases," TEI acknowledged, "the availability of these services from the audit firm represents a convenience to companies, but in some cases, especially in foreign jurisdictions, their availability may be critical or even necessary because of the absence of viable or cost-efficient alternatives."

To bring clarity to the auditor independence rules in respect of tax services, TEI recommended that the final rules provide that "tax services should, by virtue of the parenthetical expression in section 201(h), be generally subject to the preapproval process except where the SEC, pursuant to the authority in section 201(g)(9), explicitly holds that the rendering of particular services by the audit firm has too great a potential for impairing auditor independence to be permitted." In addition, TEI said, "the rules should provide that an audit committee--in exercising its authority under the preapproval provision in section 201(h)-should look to the three-factor test plus the principle of materiality."

TEI noted that regardless of the approach the Commission takes to tax services, "the prescribed approval procedure under subsection (h) of section 201 of the Act should allow for blanket approvals for a particular audit period of specific services that may occur on more than one occasion (that otherwise meet the requirements of the preceding recommendations if so determined)."

Finally, TEI said the rules as finally adopted should provide that "reasonable compliance with these procedures in the best judgment of the audit committee and the Board of Directors should be legally sufficient to discharge the members of the Board and the executive staff of the company of their responsibilities under these provisions of the Act."

TEI's comments on the proposed auditor independence rules are reprinted in this issue, beginning on page 57.

The SEC published final regulations on January 28, which in significant part parallel TEI's recommendations. Hence, the rules provide in part:

   The Commission reiterates its
   long-standing position that an
   accounting firm can provide
   tax services to its audit clients
   without impairing the firm's
   independence. Accordingly, accountants
   may continue to provide
   tax services such as tax
   compliance, tax planning, and
   tax advice to audit clients, subject
   to the normal audit committee
   pre-approval requirements
   under 2-01(c)(7). Additionally,
   the rules we are
   adopting require registrants to
   disclose the amount of fees
   paid to the accounting firm for
   tax services....

   Nonetheless, merely labeling a
   service as a "tax service" will
   not necessarily eliminate its
   potential to impair independence
   under Rule 2-01(b). Audit
   committees and accountants
   should understand that
   providing certain tax services
   to an audit client would,
   as described below, or could,
   in certain circumstances, impair
   the independence of the
   accountant. Specifically, accountants
   would impair their
   independence by representing
   an audit client before a
   tax court, district court, or
   federal court of claims. In
   addition, audit committees
   also 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 not be
   supported in the Internal
   Revenue Code and related
   regulations.

IRS Oversight Board

On January 27, TEI President Drew Glennie testified before the IRS Oversight Board on enforcement challenges facing the Internal Revenue Service. Mr. Glennie was accompanied by IRS Administrative Affairs Committee chair David Bernard. The Board oversees the IRS's administration, management, and direction.

In his testimony, Mr. Glennie stressed the characteristics of a successful enforcement strategy. First, he stated, there is a need for clarity. "Taxpayers must understand the law and their responsibilities. True simplification begins with Congress, but there are ways in which the law and its administration can be made simpler." TEI's President commended the Treasury and IRS for the inclusion of de minimis rules and safe harbors in the proposed regulations on the capitalization of expenditures, as well as the process used to develop the regulations. "This process--the use of an advance notice of proposed rulemaking--could serve as a model for future projects," he added.

Mr. Glennie also discussed the need for confidence in the integrity of the tax system. "An effective enforce merit strategy must be equitable and ensure that similarly situated taxpayers are being treated alike," he said. In addition, there must be competence and continuity. "It is not enough to announce new procedures and policies from the National Office; there must be buy-in from the field to make the policies work," he noted. "With 46 percent of the LMSB workforce eligible for retirement over the next three years, the IRS must stress the training and recruitment of personnel as critical to any successful enforcement strategy."

Mr. Glennie added that audits must be current. "The backlog of cases must be addressed before significant efficiencies can be obtained. Thus, becoming current on audits is another critical component of an effective enforcement strategy--one which LMSB is seeking to implement."

The Institute's president went on to discuss several IRS initiatives, including the recently announced limited issue focused examinations or LIFE, and the tax shelter settlement initiatives. "TEI has long supported the use of materiality standards in examinations," he stated, "and we commend LMSB for thinking outside the box to resolve the significant backlog of cases within the division."

Finally, Mr. Glennie stressed the need for adequate and reliable funding of the IRS. "The IRS must receive the funding it needs to continue its systems modernization efforts, as well as to train its personnel and implement new procedures," he stated.

TEI's written testimony is reprinted in this issue, beginning on page 64.

Tax Shelter Disclosure Regulations

On January 28, TEI submitted comments urging the Treasury Department and IRS to substantially narrow the temporary and proposed regulations requiring disclosure of transactions that satisfy one of six characteristics of "reportable transactions." The regulations revise and replace the temporary and proposed tax shelter disclosure regulations that were released in February 2000. TEI's comments on the October 2002 disclosure rules observed that the rules will impose an extensive and costly administrative burden on all taxpayers and questioned whether the information supplied will aid the IRS in identifying, and providing guidance for, transactions that are "potentially abusive." The disclosure rules, TEI said, "cast an unnecessarily wide net requiring disclosure of many routine transactions," and the exceptions "are too narrow to afford taxpayers with meaningful relief and minimize the preparation of excessive and unnecessary disclosure statements." In addition, the regulations may "heighten the risk of underpayment penalties for foot faults relating to inadvertent failures to file disclosure statements for reportable transactions."

TEI's comments observed that in certain circumstances the regulations require a taxpayer to review previously filed returns in order to disclose transactions that subsequently become reportable either because of a change in the facts of a transaction or as a result of published guidance "listing" a transaction as reportable. The regulations, TEI noted, provide no time limitation on the disclosure obligation, which "seemingly ignores the policy underlying the statute of limitations." "Without a time limitation on the scope of the retrospective review, taxpayers are ... obliged to report participation in transactions notwithstanding that their returns may have been previously examined or that the statute of limitations has run on the year in which the transaction was undertaken." TEI recommended that the regulations be revised so that taxpayers are required to review no more than three prior years' tax returns when a transaction becomes "listed."

TEI also stressed that the revised categories of reportable transactions will require taxpayers to modify their information and recordkeeping systems and document-retention procedures for domestic and foreign operations. "Taxpayers will require time to digest the regulations and implement changes," TEI said. The comments continued that the regulations effectively require taxpayers to begin tracking the relevant transactions immediately even if they are ultimately not obliged to report the transactions upon filing their return. TEI suggested that taxpayers with complex and diverse businesses should be afforded at least six months to implement the necessary changes and urged the government to delay the effective date of revised regulations, which the IRS announced in Notice 2003-11 that it expects to release in February.

TEI's specific comments on the temporary rules recommend a range of modifications, including establishing a broad exception for all categories for recurring transactions in the ordinary course of taxpayer's trade or business. The comments also make specific recommendations for exceptions to each of the six categories of reportable transactions. For example, for the confidential transaction category, TEI said that the regulations should incorporate a $10 million threshold (or other comparable tax-reduction standard) and adopt exceptions to the disclosure rules for merger and acquisition agreements and for communications with taxpayer's counsel. In respect of transactions with built-in contractual protection, the comments recommended that the regulations adopt a $10 million threshold (or other comparable tax-reduction standard). For both categories, the comments requested that the IRS make a number of clarifications that TEI said would ease taxpayer reporting burdens.

TEI also urged the IRS and Treasury to eliminate the "significant booktax difference" category, calling it, at once, "overbroad," "duplicative" of current reporting on Form 1120 Schedule--1, and "administratively unworkable." To reduce the burden that the book-tax reporting category will impose, the regulations provide a list of exceptions. TEI commended the Treasury Department and IRS for providing the exceptions and made a number of recommendations to expand the list.

The detailed comments addressed a number of other areas including administrative issues, additional exceptions for disclosure, the indirect participation rule, and the definition of material adviser. In closing, the comments noted that other proposed regulations were released on December 30, 2002, limiting defenses for the imposition of accuracy-related penalties where taxpayers fail to disclose "reportable transactions." TEI's comments averred that, "before crafting new or additional penalties or limiting taxpayers' penalty defenses, the government should determine whether the new disclosure rules are having the intended salutary effect on taxpayer behavior and encouraging disclosures. Indeed, given the broad scope of the revised disclosure regulations and the excessive number of transactions likely caught by the expansive rules, the government should fine tune its information requirements before considering the application of the revised penalty standards." TEI recommended that, at a minimum, the proposed penalty regulations should be limited to a taxpayer's failure to disclose listed transactions.

TEI's comments on the disclosure regulations are reprinted in this issue, beginning at page 67.

Canadian Submissions

In December, TEI urged Canadian Minister of Finance John Manley to withdraw draft legislation relating to foreign investment entities and nonresident trusts. The legislation was introduced on October 11, 2002. Although the legislation has been substantially revised from earlier versions, TEI said, it remains fundamentally flawed. In addition, the Institute objected to the implementation date of January 1, 2003. "Taxpayers have been afforded less than eleven weeks prior to the legislation's implementation date to analyze the draft legislation and submit comments to the government on the third and latest version of the proposed legislation," TEI noted. "Moreover, even assuming the revised rules are sound--and our preliminary analysis suggests that the regime remains over-inclusive and would benefit from additional consultations--taxpayers will need substantially more lead time to modify or develop the information systems necessary to comply with these mind-numbingly complex provisions."

If the legislation is not withdrawn, the Institute urged the government to announce a deferral of the implementation date to taxation years beginning after December 31, 2003.

TEI's letter to Minister Manley is reprinted in this issue, beginning on page 54.

In December, the Institute also wrote the Canada Customs and Revenue Agency concerning the imposition of interest on the Goods and Services Tax when goods are imported into Canada and the importer subsequently realizes that additional GST is payable. The letter followed up on a discussion of the issue during TEI's December 2002 liaison meeting with CCRA.

In its December 20th letter, TEI explained that the issue arises in the context of a voluntary disclosure of tax liability by a taxpayer. "When a taxpayer has voluntarily disclosed an additional GST liability due upon importation of goods," the Institute stated, "the interest on that GST should be waived." TEI added that the position is consistent with CCRA's internal policy that recommends administrative tolerance when items are voluntarily disclosed and with the goals outlined in the Fairness Package, which is aimed at harmonizing the fiscal policies applicable to the GST, income tax, and customs laws.

TEI's letter to CCRA is reprinted in this issue, beginning on page 56.

Finally, CCRA has released its responses to the questions raised on excise tax issues during TEI's December 2002 liaison meeting. (The agenda was published in the November-December 2002 issue of The Tax Executive.) The responses are posted on TEI's website at www.tei.org.