Recently released proposed rules by the PCAOB limit the ability of Accounting Firms to render certain tax services to its traditional client base.

Introduction

On December 14, 2004, the Public Company Accounting Oversight Board (“PCAOB” or “Board”) agreed to propose three ethics and independence rules that would limit the types of tax services that auditors can provide to audit clients under the Sarbanes-Oxley Act of 2002 (“SOX”). (Proposed Ethics and Independence Rules Concerning Independence, Tax Services and Contingent Fees, PCAOB Release No. 2004-015, Dec. 14, 2004).

While the above mentioned PCAOB release generally applies to publicly traded companies, many non-publicly traded firms voluntarily implement SOX rules and guidelines (as promulgated by the Securities and Exchange Commission [“SEC”] and PCAOB) because they make good business practice by vesting more confidence in the company’s audit process and financial statements.

The PCAOB is a private sector, non-profit corporation, created by SOX to oversee the auditors of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, fair and independent audit reports.

Background

The recently released PCAOB proposed rules (“Rules”) do not explicitly address the illegal practice of law by lay persons such as financial planners, accountants, or auditors as either: i) a violation of local Bar or Court Rules by virtue of the lay person’s application of legal principles to a particular set of facts, or ii) as a violation of the eight expressly prohibited categories of non-audit services under SOX Section 201(a), to wit, legal services and expert services unrelated to the audit, but rather address instances where an accountant/auditor’s independence is either per se impaired or likely to be impaired under the particular facts and circumstances.

The genesis of the Rules primarily relates to at least two seminal events: i) the Internal Revenue Service (“IRS”) and the Department of Justice having brought a number of cases against accounting firms in connection with those firms’ marketing of tax shelter products and, specifically, those firms’ alleged failures to register, or comply with list maintenance requirements relating to their tax shelter products, and ii) the Permanent Subcommittee on Investigations of the Senate Committee on Governmental Affairs held hearings on tax shelters in which testimony was given to the effect that Accounting Firms were marketing potentially abusive tax shelters through non-traditional marketing techniques, such as cold-calling.  Accordingly, in this context, it was felt that these matters have called into question the ethics of Accounting Firms in that it was unbecoming to the accounting profession to be in the business of offering these types of services.

Discussion

Thesis Statement:  Our reading of the PCAOB technical papers on these matters (“Paper”) elicit the observation that the common conceptual thread of the Rules is that an auditor’s independence is impaired where it is likely that there will be a mutuality of interest between the auditor and audit client because the auditor will likely be compelled to defend the advice given or the services rendered given the nature of tax advice or services.

Salient Highlights of the Proposed Rules:  Three circumstances in which the provision of tax services impairs an auditor’s independence:

1. Prohibition on Contingent Fees: Proposed Rule 3521 would treat registered public accounting firms as not independent of their audit clients if they enter into contingent fee arrangements with those clients;

2. Prohibition on Aggressive Tax Advice: Proposed Rule 3522(a) and (b) would treat a registered public accounting firm as not independent from an audit client if the firm provides services related to planning or opining on the tax consequences of a transaction that is a listed or confidential transaction under Treasury regulations. In addition, proposed Rule 3522(c) includes a provision that would treat a registered public accounting firm as not independent if the firm provides services related to planning or opining on a transaction that is based on an aggressive interpretation of applicable tax laws and regulations; and

3. Prohibition on Provision of Tax Service to Certain Key Executives: Proposed Rule 3523 would set a new requirement to treat a registered public accounting firm as not independent if the firm provides tax services to officers in a financial reporting oversight role of an audit client.

Interesting Gloss:  In its explanation of the term “Aggressive Tax Positions”, the PCAOB Briefing Paper amplifies the term to mean:

* * * [P]lanning or opining on the tax consequences of a transaction that is a listed or confidential transaction under United States Department of Treasury (“Treasury”) regulations or that promotes an interpretation of applicable tax laws for which there is inadequate support. [Emphasis ours].

In setting the foundation for the promulgation of the PCAOB’s Rules, the Paper cites the SEC’s rules that implement Title II of SOX which expressly prohibit eight categories of non-audit services for auditors to provide to their public company audit clients, as mandated by Section 201 of SOX.  In citing the above SEC rules, the PCAOB’s Paper is careful to note the SEC’s adopting release which emphasized that the nature of the service being provided must be analyzed and that "merely labeling a service as a ‘tax service’ will not necessarily eliminate its potential to impair independence under Rule 2-01(b).", citing: Strengthening the Commission's Requirements Regarding Auditor Independence, SEC Release No. 33-8183, § II.B.11 (Jan. 28, 2003).

Accordingly, while a non-audit service may not be on its face expressly prohibited, the nature of the service must be scrutinized to ascertain whether the service impairs independence under the relevant SEC rules.  It is our view that independence may be impaired in at least two ways: i) the advice or service departs from the realm of “tax advice” and enters the purview of “legal” advice, thus falling into one of the expressly prohibited eight categories of non-audit services, or ii) alternatively, the nature of the tax advice has intertwined with it the role of advocacy by the accounting firm such that its independence is impaired.

Thus, in our view, the salient issue for the professions and the PCAOB becomes ‘when will it be the case that the provision of almost any tax advice requiring any level of technical analysis not fall into one of the categories above which impair auditor independence?’. This is a difficult question especially given the historical context of accounting firms in assisting their clients comply with the Internal Revenue Code.  As the SEC adopting release noted, merely labeling a service as a “tax service” will not necessarily render a non-audit service as permissible.

Our suggested approach to this question is simple, and we believe is consistent with the underlying principles of the PCAOB as delineated in its Briefing Paper.  Where there is a mutuality of interest between the accountant and client as in the provision of tax advice (e.g., application of tax law to a particular set of facts), and thus, due to the nature of the service, the accountant is put into the role of an advocate or at the very least as a tax, or in essence, legal advisor, such service should be prohibited, as this is tantamount to the provision of legal services, and accordingly, per se, as suggested above, impairs an auditor’s judgment, and appurtenant independence. 

Additional Highlights of the Rules

Second, the Rules would further implement the Act’s pre-approval requirement by strengthening the auditor's responsibilities in connection with seeking audit committee pre-approval of tax services. Specifically, proposed Rule 3524 would require a registered public accounting firm that seeks such pre-approval to supply the audit committee with certain information, discuss with the audit committee the potential effects of the services on the firm's independence, and to document the substance of that discussion.

Third, the Rules lay a foundation for the Board's independence rules. Specifically, proposed Rule 3502 would codify, in an ethics rule, the principle that persons associated with a registered public accounting firm should not cause the firm to violate relevant laws, rules, and professional standards due to an act or omission the person knew or should have known would contribute to such violation. Proposed Rule 3520 would include a general obligation requiring registered public accounting firms to be independent of their audit clients throughout the audit and professional engagement period.

Conclusion