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Comments on loss and valuation accrual accounts and supplementary financial information.

April 19, 2000

The following letter, which was filed with the Securities and Exchange Commission on April 19, 2000, was prepared under the aegis of TEI's Federal Tax Committee, whose chair is Philip G. Cohen of Unilever United States Inc. Contributing to the development of TEI's comments were Fred Lesser of Lucent Technologies and Daniel P. Bork of Lexmark International, Inc.

On January 21, 2000, the United States Securities and Exchange Commission issued proposed rules that would amend the Code of Federal Regulations to specify certain disclosures required of SEC registrants. On behalf of Tax Executives Institute, I am writing to express TEI's serious reservations about one aspect of the proposed rules. Specifically, we are very concerned about the requirement to disclose, pursuant to Item 302(c), additional confidential company information relating to accruals for contingent income and franchise tax liabilities. Because of TEI's focus on business tax issues, we shall limit our comments on the proposed rules to Item 302(c) and the issues surrounding disclosure of such accruals. We will not address other loss or valuation accruals nor will we address the proposed rule adding Item 302(d), relating to property, plant, and equipment and related accumulated depreciation, depletion, and amortization.


Tax Executives Institute is the preeminent association of corporate tax executives in North America. Our nearly 5,000 members are employed by approximately 2,700 companies in the United States, Canada, and Europe. TEI represents a cross-section of the business community, and is dedicated to the development and implementation of sound tax policy and to promoting the uniform and equitable enforcement of the tax laws. The Institute is proud of its record of working with congressional committees, government agencies, and other policy-making bodies (including the Financial Accounting Standards Board) to minimize the cost and burden of tax administration and compliance to the mutual benefit of the government, business, and ultimately the public. Most TEI members' companies are SEC registrants that must comply with the Commission's accounting and disclosure rules as well as with the statements of generally accepted accounting principles (GAAP) prescribed by the FASB. In addition, TEI members' companies are subject to frequent -- often continual -- examinations by the Internal Revenue Service and other tax administrators, including those in state, local, and foreign jurisdictions. Hence, we believe that the diversity, background, and professional training of our members provide us with a uniquely qualified position from which to comment on the Commission's proposed rules insofar as they affect the reporting and disclosure of contingent tax liabilities.

Summary of Proposed Rules and TEI's Position

The Commission proposes to reposition certain supplementary schedule information currently required under Rule 12-09 of Regulation S-X within a new Item 302(c) of Regulation S-K. Item 302(c) would both clarify and expand the scope of disclosure of information relating to valuation and loss accrual amounts, including but not limited to 12 enumerated categories of loss accruals. Among the categories of detailed schedules are valuation allowances for deferred tax assets and contingent income and franchise tax liabilities recorded pursuant to FASB Statement No. 5. In addition, the proposed rules would add a new Item 302(d) to provide additional information concerning tangible and intangible long-lived assets and related accumulated depreciation and amortization.

The proposed rule adding Item 302(c) would require companies to disclose in schedular format the reserves for each significant element comprising a particular category of contingent liability. The information reported for each period for which an income statement is presented would include the opening balance, additions charged to expense, deductions, other increases (or decreases) not charged (credited) to expense (with explanations), and the closing balance of the account. Any changes in assumptions having a material effect on the account would also have to be disclosed. Hence, the amount of tax accrued as a contingency for each material issue or transaction, and the annual changes in the accrual, would be disclosed in publicly available schedules filed with the Commission.

TEI fully supports the Commission's goal of enhancing the utility of financial statement information. Hence, we commend the Commission for issuing these proposed rules for public comment. We question, however, whether disclosure in schedular format of a tax contingency or valuation reserve for each material item or issue comprising the financial statement issuer's tax reserve would improve the reader's understanding of the issuer's financial statements -- whether for the specific tax contingency accruals or for the financial statements taken as a whole. Indeed, we question whether anyone other than the company's competitors or tax authorities will possess sufficient understanding of the significance of the disclosures to make them meaningful. Equally important, we fear that any improvements in disclosure would come at a substantial financial cost to the company, to its shareholders, and ultimately to the public. The routine disclosure of confidential information to financially interested parties, including competitors and tax authorities, could ultimately lead to increased tax costs for the company and to widespread replication of a company's legitimate tax-saving techniques and ideas. Hence, notwithstanding TEI's support for the Commission's goal, the costs of complying with the proposed rule outweigh the benefits and utility of the proposed disclosures. As a result, TEI objects to its issuance. At a minimum, the loss accrual rules of Item 302(c) should not encompass tax contingencies.


The interpretation, application, and interaction of multitudinous provisions of the Internal Revenue Code, state and local tax statutes, foreign country tax laws, and international tax treaties make the determination of a company's annual tax liabilities an extremely time consuming and challenging endeavor. To cope with their myriad obligations, companies expend considerable resources hiring in-house professional tax staffs and external advisers. Just as important as the compliance activities, public companies have fiduciary obligations to their shareholders to pursue legitimate tax planning to minimize tax liabilities.

As a consequence of the challenges of interpreting and complying with complex and nebulous tax provisions (a task often exacerbated by the lack of public guidance) and pursuing legitimate tax planning to minimize tax liabilities, disputes with tax authorities about reported tax liabilities are routine. Whereas the specific issues will vary by company and tax jurisdiction, the effect on the financial statement process is the same: In-house tax advisers make an assessment -- an informed, but subjective judgment -- of the nature of the issues and the scope and degree of potential or actual controversies with applicable tax authorities about the proper interpretation of the law. The judgment reflects a careful analysis of --

* the strengths and weaknesses of a company's internal control, tax compliance, and financial statement tax accrual processes

* the soundness of the company's tax treatment of routine and unusual transactions

* the merits of the legal authorities supporting the company position on identified transactions or issues

* where a dispute is pending because of a proposed adjustment or tax audit assessment, the negotiation and litigation strategies the company can employ to settle an issue.(1)

The adviser will then recommend an estimated aggregate contingent income and franchise tax liability to be recorded pursuant to FASB Statement No. 5. In theory, a reserve could be established on an issue-by-issue, jurisdiction-by-jurisdiction, year-by-year basis.(2) In practice, the complexity of the tax law makes the outcome of tax audits far too uncertain to predict precisely. Consequently, it would be extremely burdensome for companies to establish and maintain contingent tax reserves in the schedular format prescribed in the proposed rules.

As important, the interests of tax administrators examining company tax returns do not mesh with those of taxpayers that issue public financial statements. Moreover, companies' competitors always read the financial statements and compare results in order to glean strategic insights and gain competitive advantages. Consequently, TEI believes that a careful balance must be struck between (1) disclosure of meaningful financial information to financial statement users and (2) disclosure of confidential tax planning and compliance issues to tax administrators and competitors.(3)

FASB Statement No. 5 has long governed the treatment of contingencies, including accrual of reserves for pending and potential tax disputes. Moreover, FASB Statement No. 109 provides guidance concerning the overall method and process for calculating and reporting a company's tax liabilities in its financial statements. Both financial statement issuers and users -- be they investors, analysts, creditors, or others -- have extensive experience and understanding in the interpretation and application of these statements and the corresponding effect under the Commission's current disclosure rules. TEI believes those rules strike the necessary and proper balance, requiring issuers of financial statements to disclose meaningful information about the scope of their actual and potential tax liabilities without compelling the disclosure of confidential company assessments of alternative legal interpretations that the tax authorities might assert in audits.

TEI agrees generally that the users of financial statements are entitled to, and the financial markets depend upon, meaningful disclosure of financial information. Nonetheless, we believe the proposed rules require excessive disclosures that would not only result in confusion for users but would also potentially harm companies through the publication of negotiating positions on tax issues. The tax liabilities reported on company tax returns are not final until those returns are examined and settlements are reached. The tax audit process involves substantial negotiation and compromise between the position asserted by the company and that asserted by the tax authorities. Indeed, the resolution of company audits -- especially in the IRS's Coordinated Examination Program -- typically involves the resolution of dozens of issues, many of which are settled by compromise because the outcome of the matter, if it were litigated, is unclear. We do not believe that companies can fairly negotiate those compromises in the fishbowl that the proposed rules would create. Company shareholders -- the most important beneficiaries of public disclosures -- would not welcome disclosure rules that would require identification of amounts at which the company might be willing to settle pending disputes or potential issues with taxing authorities. Nor would shareholders applaud the disclosure of legitimate tax planning techniques to company competitors. Consequently, if the Commission moves forward to adopt the proposed rules for loss accrual and valuation reserves generally, we recommend that it eliminate the references to tax contingency and valuation reserves that are already governed by FASB Statements No. 5 and No. 109.

The Background statement to the proposed rules avers that there is an increasing incidence of abusive "earnings management" practices. TEI is unaware of widespread abuses and we seriously question whether the proper response to any such problem is increased disclosure, especially of accruals for tax contingencies.(4) To the extent that there are lapses in compliance, enhanced enforcement in respect of the current disclosure rules will likely prove more salutary.

Responses to Specific Questions

The Commission staff poses eight questions for comment and discussion. Since TEI's comments are narrowly confined to the disclosure of contingent tax reserves, our responses to the questions are tailored to address that issue.

1. Are there other specific loss accrual or valuation accounts that should be added to the list of accounts identified within proposed Item 302(c)?

TEI has no comment on additions to the list of accounts identified within proposed Item 302(c), but we strongly urge the Commission to delete contingent tax reserves from the list.

2. Should specific percentage tests be used to trigger specific account disclosures within the proposed rules? For example, should disclosure of loss accrual activity be required only when the balance sheet item and change during the period exceeds a certain pre-established numerical threshold (for example, five percent of total assets or three percent of pretax income)? If so, what is an appropriate threshold?

Only material items should be disclosed. Staff Accounting Bulletin No. 99 provides guidelines for assessing materiality but does not specify numerical thresholds. TEI believes that bulletin provides sufficient guidance and does not support the establishment of specific thresholds triggering disclosure of tax reserves.

3. Should the placement of the proposed data be moved within MD&A or to some other section of the filing to enhance the prominence of disclosures?

Inasmuch as TEI does not support the gist of the rule to enhance disclosure of contingent tax liabilities, we likewise would not support moving the placement of the proposed data to enhance the prominence of the disclosure.

4. Should presentation of the proposed data be limited to Form 10-K?

TEI does not believe disclosure of the proposed data relating to tax contingency reserves is appropriate, but to the extent it is disclosed, it should be as limited as possible.

5. Should the disclosure requirements be restricted to those registrants that exceed a certain size or meet some other threshold? If so, what would be the appropriate threshold?

No. Consistent with our view that establishing threshold percentages to trigger account disclosures is inconsistent with Staff Accounting Bulletin No. 99, TEI believes it would be inconsistent to establish a company-size threshold for disclosure of the loss or valuation reserves.

6. Are there circumstances where registrants may appropriately exclude disclosure about loss accruals related to litigation because of concerns about confidentiality while still conforming with GAAP? If so, please describe such circumstances in detail.

As the body of our letter strives to make clear, companies have been complying with the requirements of the current SEC rules and FASB Statements No. 5 and No. 109 for a number of years in respect of accounting for and disclosing tax liabilities and contingency reserves. TEI believes those rules strike the proper balance, requiring disclosure of comprehensive, meaningful information to financial statement users while permitting companies to guard against disclosure of confidential information that might harm companies economically by disclosing negotiation and settlement positions to tax authorities.

7. Should the disclosures concerning valuation and loss accrual account activity be required when interim financial statements are presented?

No. Tax liabilities are generally computed on an annual basis and interim disclosures would be costly and provide precious little meaningful information. In addition, Rule 10-01 of Regulation S-X already prescribes adequate rules governing the disclosures for interim financial statements, including rules relating to disclosure of material contingencies or material changes in previously disclosed contingencies.

8. Should the disclosures relating to property, plant, equipment, and intangible assets and related accumulated depreciation, depletion, and amortization be required when interim financial statements are presented?

TEI has no comments on Item 302(d), relating to property, plant, and equipment and related accumulated depreciation, depletion, and amortization.


TEI is pleased to have the opportunity to present its comments to the Securities and Exchange Commission in respect of these proposed rules. TEI's comments were prepared under the aegis of its Federal Tax Committee, whose chair is Philip G. Cohen. If you have any questions about the comments, you may contact Mr. Cohen at (201) 872-5504. Alternatively, you may contact Jeffery P. Rasmussen of the Institute's legal staff at (202) 638-5601.

(1) An added concern about the Commission's proposed rules is that, in the case of litigation, the proposed disclosure rules likely require the company to abandon its attorney-client privilege in respect of information that might otherwise be protected.

(2) It is unclear under the proposed rules what "significant elements" constitute the tax reserve. Public companies consider a host of factors, including specific transactions, general and industry-specific issues, jurisdictions, and the number of open tax years.

(3) The schedule of information that the Commission proposes to be disclosed, in terms of detail, scope, and effect -- and the confidential thought processes it reflects -- is very much akin to the information contained in independent accountants' tax accrual workpapers, which were the focus of the Supreme Court's decision in United States v. Arthur Young & Co., 465 U.S. 805 (1984). In effect, the Commission's proposed schedules would provide a roadmap to tax authorities and permit them to conduct examinations and propose tax adjustments based on the taxpayer's confidential thought processes. Moreover, just as in negotiations over any complex issue, disclosing "the price one is willing to pay" -- i.e., the amount of reserves established on any particular tax issue -- to one's adversary would likely skew the minimum amount the adversary seeks. Since the amount and assumptions in the contingent tax reserves reflect the taxpayer's confidential assessment of its exposure to additional tax liabilities, even the Internal Revenue Service recognizes the unfairness implicit in requiring taxpayers to disclose a bottom-line negotiating position. Hence, notwithstanding the Supreme Court's holding in Arthur Young that IRS could summons tax accrual workpapers, the tax agency has prescribed substantial limitations on agents' authority to issue such summonses. See Internal Revenue Manual 4024-4026, MT 4000-235 (May 14, 1981) (Accountants' Workpapers). Agents are to request such workpapers only in "unusual circumstances." See IRM 4024.4, MT 4000-235 (May 14, 1981). The Commission's proposed rules, however, would require as routine disclosure the very same information that the IRS is generally willing to forgo (unless it has no alternative means to ascertain the correctness of the liability reported in the taxpayer's return). We do not believe that the Commission should upset the delicate balance and safeguards that the Internal Revenue Manual procedures provide.

(4) Current rules require companies to include a schedule in the footnotes to the financial statements reconciling the effective tax rate to the statutory tax rate. In addition, companies currently disclose the most significant components of temporary differences that comprise the deferred tax asset, deferred tax liability, and related valuation allowance accounts. The rate reconciliation compels a company to identify the significant tax issues that affect the rate difference thereby enabling financial statement users to discern whether the company's effective tax rate is sustainable. Unexplained changes in the effective tax rate or in the components of the deferred tax asset, liability, or valuation allowance accounts, moreover, can serve as a trigger for further inquiry by investors, creditors, analysts, or regulators.
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Publication:Tax Executive
Geographic Code:1USA
Date:May 1, 2000
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