We wonder whether someone in the Big Four’s professional practice standards offices might suggest that Mike consider them for an upcoming show. Especially now, after the Tax Court case Canal Corporation and Subsidiaries (formerly Chesapeake Corporation and Subsidiaries) v. Internal Revenue Commissioner, 135 T.C. No. 9. and the impact it will have on the determination of auditor independence.
Perhaps you’ve seen the show on the Discovery Channel called Dirty Jobs. Host Mike Rowe introduces his audience to some of the most difficult and disgusting jobs on the planet by performing the job himself, if only for a few hours. We wonder whether someone in the Big Four’s professional practice standards offices might suggest that Mike consider them for an upcoming show. Especially now, after the Tax Court case Canal Corporation and Subsidiaries (formerly Chesapeake Corporation and Subsidiaries) v. Internal Revenue Commissioner, 135 T.C. No. 9. and the impact it will have on the determination of auditor independence.
This case, reported on August 5, 2010, focused primarily on determining whether a transaction between the taxpayer and a partnership in which it owned an interest was a disguised sale — and therefore resulted in a taxable gain — or whether it was merely a nontaxable contribution and distribution of property and cash. Unfortunately for the taxpayer, the court found that the transaction was taxable.
But what must be particularly troubling for the audit firm involved was that the court also found the taxpayer to be liable for a $36.7-million accuracy penalty imposed by Section 6662. This was because the taxpayer could not demonstrate that it had “reasonable cause” and that it “acted in good faith” as required by Section 6664. The taxpayer attempted to demonstrate that it did act in good faith and had reasonable cause because the tax return position that it claimed was addressed in a “should” opinion obtained from the tax advisor to the transaction, who also happened to be the taxpayer’s financial statement auditor. But the court concluded that the taxpayer failed both tests.
The court essentially held that the tax opinion was of such poor quality that the “reasonable cause” test was not met. This aspect of the case might be the focus of early commentaries because it causes a visceral reaction in many of us, somewhat like slowing down to look at a car wreck on the side of the road. However, we think that the more profound implication of this decision is the analysis as to why the audit firm was not independent and thus the taxpayer was not able to avail itself of the “good faith” requirement of Section 6664. Judge Kroupa held that the taxpayer cannot claim that it acted in good faith because of the “inherent and obvious” lack of independence of the audit firm as a result of three issues (none is labeled as especially fateful, so we are best advised that any one of them could doom “independence”):
- The same firm both planned the transaction and offered the tax “should” opinion.
- The fee for the opinion was contingent on receiving a “should” opinion.
- The fixed flat fee was “exorbitant.”
Presumably, the court’s finding would have been reached even if the tax opinion in question was unquestionably sound, well reasoned and based on reasonable assumptions. This is because Section 6664 uses an “and” conjunction — describing the need for a taxpayer to assert that it acted with reasonable cause and in good faith.
Now the professional practice groups of audit firms will need to beaver away at finding nuances between their independence interpretations and policies and those articulated by Judge Kroupa. This will be akin to choreographing the dance of a thousand angels on the head of a pin, as these groups attempt to differentiate the facts of this case to calm the nerves of both their management and their clients. Talk about a dirty job! What is at stake is nothing short of determining whether past audits were performed at a time when the auditor was, in fact and appearance, independent.
As most readers of this newsletter are aware, PCAOB Rule 3520 enshrines the requirement that, throughout the audit engagement period, the audit firm and associated persons must maintain independence from the audit client. Rule 3521 details certain services that can never be conducted by an audit firm without compromising its independence (for example, providing any service for a contingent fee). Rule 3522 spells out conditions regarding other services in order for the firm to maintain independence. (For example, an audit firm may not initially recommend an aggressive tax return position, defined as one with less than a more-likely-than-not chance of being sustained on its merits.)
Until now, if the audit firm introduced a tax planning idea to its client, it could do so without compromising its independence only if it determined that the tax position inherent in the idea was more-likely-than-not allowable under applicable tax laws.
While PCAOB had not (at the time of this newsletter’s publication) changed its standards as a result of this Tax Court case, it seems unlikely that its staff will ignore this case. So what does the case say and what are the implications to auditor independence?
Canal Corporation and Subsidiaries v. Internal Revenue Commissioner
While the judge disparaged the quality of the opinion rendered, she did not rely alone on the “haphazard” opinion rendered by the audit firm to support her contention that the taxpayer’s position lacked merit. Especially noteworthy to this article, she also held that because the opinion was authored by the same person and firm that was actively involved in the planning and structuring of the transaction, the auditor’s tax opinion was worthless to the taxpayer in attempting to assert that it acted in good faith and with reasonable cause.
Because the opinion was worthless, the court found that the taxpayer failed to act in good faith and with reasonable cause. The court reasoned that “independence of advisors is sacrosanct to good faith reliance.” It stated, “We would be hard pressed to identify which of his hats [the auditor] was wearing in rendering that tax opinion,” and then concluded, “We further find that Chesapeake did not act with reasonable cause or in good faith in relying on [the audit firm’s] opinion, and therefore sustained the imposition of the $36.7-million accuracy-related penalty."
Note that the Tax Court describes the fee in this case as a contingent fee. It only uses that term once in the case, but says that the audit firm “would receive payment only if it issued Chesapeake a ‘should’ opinion on the joint venture transaction.” PCAOB Rule 3521, noted above, defines a contingent fee as “any fee established for the sale of a product or the performance of any service pursuant to an arrangement in which no fee will be charged unless a specified finding or result is attained, or in which the amount of the fee is otherwise dependent upon the finding or result of such product or service.”
Implications to Auditor Independence
We suspect that the impact this may have on audited taxpayers will be significant. Unless the reasoning of this Tax Court judge is overturned on appeal, audit firms may never be in a position to provide a useful Section 6664 reliance opinion for any tax position in which they also served as an active advisor.
The Internal Revenue Service has just been handed new leverage to force some taxpayers to the settlement table. Taxpayers now need to determine whether any of the opinion letters they paid for in the past will have any beneficial impact in the event that the IRS proposes a 6662 penalty. We can expect the IRS to assert that even if the opinion is well written, such quality only supports the “reasonable cause” test of 6664; taxpayers will need to demonstrate that it satisfies the “good faith” test as well. Accordingly, it will be important to show that the author of the opinion was not the same party as the tax advisors who planned the transaction. It may also be important to demonstrate that the fee was reasonable and that it was not rendered based on a condition that a minimum threshold of comfort was to be given.
If you intend to assert that you relied on the advice of your audit firm to plan and opine on the tax transaction, you do so at your own peril. You might be better advised to assert that you performed in-house all the work necessary to determine that the position you claimed was the proper liability. In order to sustain this, you will need to demonstrate that you possessed internally the requisite experience, knowledge and training to form the judgments that you did. If you plan on needing a reliance opinion that will hold up to the IRS, it had better not be on the letterhead of your audit firm if they also served in a planning and structuring capacity.
If, like Canal, you engaged your audit firm to provide a service that was based on an agreement that they would provide a specific answer to a technical or operational question, we advise you to talk to your CFO immediately. For example, if the engagement letter or related correspondence indicates that a specific answer was to be rendered (for example, that an X transfer pricing rate would apply, or a Y minimum of research credits would result from the study), your audit firm may have entered into a contingent fee, according to Canal. Because a contingent fee is broadly defined in the PCAOB rules, your auditor may have unwittingly compromised its independence. Better for them to know and try to work this out with the SEC than to keep this one under the rug for a later determination.
If you have a fact pattern similar to Canal and received a reliance opinion from your audit firm at that time, you just might need to think about whether you now need to establish a FIN 48 reserve for the penalty. Nothing in your filing cabinet from the audit firm is going to prevent the IRS from imposing and sustaining the accuracy-related penalty. So imagine the unenviable position the audit firm’s auditors are in now: Even though they may believe strongly in the position that you undertook with their advice, you now might need to reserve for a penalty against which you have no defense. Talk about a dirty job!
For now at least, Canal is the law of the land. What does this mean to you? Ponder this: When your audit firm performs its annual FIN 48 ritual, and it agrees with your determination that a particular unit of account possesses at least a more-likely-than-not level of authority, would you be able to assert, if needed, that the tax return you later filed is consistent with the tax advice of a competent and knowledgeable tax advisor? You can’t make this assertion under Canal if the audit firm was actively involved with the planning of the tax position in the first place.
Our advice is to use what the Tax Court has just handed you. Your financial auditor may just turn out to be an especially effective argument against accuracy-related penalties. Clearly, they understand every aspect of your tax positions: they issued a clean financial opinion, right? Keep their involvement limited to financial audits. Allowing them to advise or perform other tax services and studies takes away an important weapon against accuracy penalties. Why do that?
Alvarez & Marsal Taxand Says...
The ink is still wet on this opinion. It has significant implications for you and for the audit firms in this country. Don’t expect these firms to publicly discuss the real implications of this case on your past audits, and their possible lack of independence. You won’t see articles published by our counterparts from audit firms, as their lawyers are going to need to manage this one closely.
It is possible that some will attempt to narrow the independence issue to the people involved, as opposed to the firm itself. Clearly the judge is quite focused on the involvement of one particular tax partner at the audit firm, but she also concludes that the firm was not independent.
Our advice has been and remains that you, as the client, need to be vigilant about auditor independence. Independence cannot be taken for granted. It cannot merely be stated. It has to be tested and proved. An independence breakdown leads to considerable costs to the client.
And now we see that a significant cost can be a tax penalty.
As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
About Alvarez & Marsal Taxand
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