Auditor independence, Sarbanes-Oxley, and tax services.

• Author: Oates, Mark A.

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 tmccormally@tei.org.

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. β 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 § 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 § 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; © 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...