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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks at the Tax Council Institute Conference on The Corporate Tax Practice: Responding to the New Challenges of a Changing Landscape


Donald T. Nicolaisen

Chief Accountant
U.S. Securities and Exchange Commission

Washington, D.C.
February 11, 2004

As a matter of policy, the Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staf

Good afternoon. It is truly a pleasure to be here with you today and to see so many familiar faces. Before I begin, I know that most of you are familiar with the standard disclaimer that we at the SEC are required to provide, so let me get that out of the way by indicating that the remarks I make today are my own and do not necessarily represent the views of the Commission, individual Commissioners or my colleagues on the Commission staff. Albert Einstein once said "The hardest thing in the world to understand is income taxes." So, while not required by SEC rules, let me extend that disclaimer a bit further this afternoon to acknowledge that while I have been involved all of my adult life with financial reporting, I am - compared to this distinguished audience and panel - a tax novice. This may be the only area where I can relate to Einstein. Combine that with the fact that I'm a rookie at the SEC and you can see why I'm humbled to be here this afternoon and why your indulgence will be greatly appreciated.

What I thought I would do in my introductory remarks, before the panel commences, would be to briefly comment on what I see as an increasing focus on tax reporting, why I believe what you do is so important, and to set the stage for our panel of experts to really get into the details.

I suspect that the majority of your time at work is consumed by tax planning, tax compliance, and, for some of you, tax policy. That probably means that most of you consider things like financial reporting, disclosures and internal controls important, but they are not necessarily the first thought of your morning. So, let me emphasize a few points that hopefully will resonate with you as tax professionals.

First, the financial reporting of income taxes is a very significant matter to the health and credibility of our capital markets.

Second, others inside and outside your organization have an important responsibility for accounting for income taxes, and I encourage you to involve them and cooperate with them appropriately.

Third, like most in corporate America, tax professionals cannot escape the far-reaching grasp of the Sarbanes-Oxley Act. There will be additional procedures that, if they haven't already, will likely soon fall on you or within your department.

Why is the accounting for income taxes so important? For most companies, income taxes typically equal 30 some percent - in some cases more - of pretax income, and significant portions of the recorded assets and liabilities are judgmental and therefore, subject to second guessing. Accurately accounting for the income tax consequences of a company's transactions is critical to the credibility of the financial statements as a whole.

Some of the recent accounting scandals have identified an inappropriate use of SPEs, some involving income tax structuring, which lead to faulty reporting to the IRS and the SEC and which resulted in immense losses for millions of innocent investors, employees and retirees. When such cases occur, they tarnish the image of all of us, including those who have acted responsibly and in good faith. Income tax issues are in the public spotlight and will likely continue to be in the spotlight in the future.

As I stated a few months ago at the annual AICPA conference, I believe the overwhelming majority of accountants are honest and committed professionals. I would say the same about business leaders and tax professionals. In addressing the CPAs, I went on to say that those who prepare or audit the financial statements of public companies and who fail to recognize that our profession is changing and fail to embrace a culture that champions change and the interests of investors, should not be surprised if they become the focus of disciplinary action. The success of our capital markets is dependent on transparency, honesty and trust in financial reporting.

Unlike some of the accounting issues of late, such as consolidation (FIN 46) and derivatives and hedging, the accounting guidance for income taxes is not new. The FASB issued its standard on income taxes in 1992. Despite its length, this standard is largely principles-based.

A principles-based standard means that a considerable degree of judgment is necessary for its appropriate application. As you know, tax reporting is an area full of estimates, assumptions and other judgments. I realize that developing accurate estimates for income tax obligations is not an easy task. There are multiple taxing jurisdictions and multiple corporate entities to consider, as well as uncertainty in determining whether certain transactions will, in fact, achieve an anticipated income tax consequence.

There are two basic and interrelated questions that must be considered before recognizing the tax consequences of a transaction for financial reporting purposes: Does the transaction have a valid business purpose, and does it have economic substance that can be accounted for and recognized in the financial statements. Whether a transaction has a valid business purpose is a factual determination.

Furthermore, I believe that the business purpose must be more than just a desire to report a lower effective tax rate. The recent Joint Committee on Taxation Report on Enron emphasized this point.1 And, the courts have found that if a legitimate business purpose for the use of the tax savings "were sufficient to breathe substance into a transaction whose only purpose was to reduce taxes, [then] every sham tax-shelter device might succeed."2

Likewise, whether a transaction has economic substance is also a factual determination. The transaction should be one that a rational party would enter into, given those facts and circumstances, and, it must have substance beyond just a financial accounting benefit. The bottom line is that the economic substance of the arrangement must be genuine.

A transaction whose internal rate of return is negative is uneconomic. I have a hard time understanding why a rational party would enter into such an arrangement. For example, an arrangement that results in current income taxes payable but that is also expected to produce future income tax deductions might make economic sense. However, if those benefits are so distant or are otherwise insufficient, on a present-value basis, to justify the current expenditure, it would appear to lack economic substance.

In case some of you are now worried that I haven't recently read the accounting standards applicable to the accounting for income taxes, I recognize that our standards don't measure temporary income tax differences on a discounted or present value basis. And, I am not suggesting that you measure and record your temporary differences differently. I am suggesting, however, that if a transaction is intended to exploit that measurement difference, then you should pay close attention to the economic substance of the arrangement.

Disclosure is another hot button. Adequate disclosure and communication, to both internal and external constituencies, are critical to transparent financial reporting. Why is it that a company's internal income tax documentation is often some of the most sought after information during the due diligence process prior to a business combination? I suspect it's because the accounting for income taxes is often an area where the disclosures provided to the public are opaque. "Sunlight is said to be the best of disinfectants"3 and the area of income tax accounting could use more sunlight. My educated guess is that as the spotlight swivels, one of the areas where more focus can be expected is with respect to income taxes.

I'd like to offer some observations that I believe are best financial reporting practices related to income taxes.

The financial statements and related footnote disclosures perhaps are the most detailed way management communicates externally. Management's Discussion and Analysis is a critical supplement to the financial statements. MD&A should provide readers information "necessary to gain an understanding of [a company's] financial condition, changes in financial condition and results of operations."4

Last December the Commission issued an Interpretive Release on MD&A.5 I suspect that you have read the release and, hopefully, are focusing, in particular, on your area of expertise - income taxes. Should the user of the financial statements know more? Does the reader understand or is the reader otherwise aware of the nature of the critical assumptions and estimates the company has made? Is it important for a reader to understand what your expectations are for the company's effective tax rate? Do you expect income taxes to be a significant cash drain, or perhaps even a source, of liquidity for the company? The MD&A Release should lead you to disclose the answers to all of these questions, and more. I do want to be clear here. Preparers of the financial statements should understand that if there are potentially significant impacts on cash flows or liquidity that could result from settlement of tax contingencies, that information is important to investors and must be disclosed.

The financial statement footnote disclosures required by GAAP, including those required by Statements 109 and 5, should be another source of clear and complete information. Does the company have large exposures to unrecorded liabilities? If the company has accrued a minimum amount within a wide-range, do readers know the upper end of the range? What are the significant components affecting the company's effective rate? I'm sure that those on the panel will embellish on these and other disclosure requirements, so I'll move on to other topics. Suffice it to say, the Commission staff will continue to vigorously enforce the disclosures that are required by GAAP or SEC regulations.

Some of you no doubt are thinking, "If we follow your guidance - discuss our income tax positions and expectations in MD&A, recognize and report temporary differences in complete detail, and comply with the disclosure requirements in Statements 109 and 5 - we'd be providing a virtual roadmap for the IRS." I have two thoughts. One, this issue has been with us for sometime and is not limited to income tax information. Professionals daily strike a balance between a company's concerns about confidentiality and competitive advantage with the information needs of the company's shareholders. Which brings me to my second thought. A company's concern about maintaining confidentiality in this area is understandable, but it has to be balanced with the need for the company's investors, analysts, and regulators to gain a clear understanding of liquidity and the financial position and results of operations. I would expect that this is an on-going concern for disclosure committees within your companies and that they too are interested in your input.

As we all know, Sarbanes-Oxley has clarified the role of the audit committee with respect to oversight of external financial reporting and the need for strong internal controls. Because of the importance of what you do, I imagine that many of you attend at least one audit committee meeting each year during which you review with the committee the critical accounting estimates related to income taxes, the significant tax positions taken by the company, the status of open or pending IRS reviews, and the nature and reasons for any significant complex, structured, tax-motivated transactions. The audit committee no doubt asks good, probing questions.

In addition, it may be good practice to keep the audit committee apprised of the vendors you most frequently use for income tax planning strategies, income tax opinions and income tax compliance services. I think this is important for two reasons. First, the audit committee should have a clear understanding of the nature and expertise of the company's tax advisors and the extent to which the company relies on third parties to address its various tax obligations and to implement its strategies.

Second, the audit committee is responsible for overseeing the independence of the external auditor. Discussion with the audit committee will improve their understanding of the nature of tax services provided by the company's independent auditor. The Sarbanes-Oxley Act permits independent auditors to provide tax services to their audit clients provided such services are pre-approved by the audit committee. But, there are some services for which the audit committee should be especially probing. A recent Senate staff report analyzed several cases where the auditor sold highly structured, highly complex and questionable tax structures to companies for significant fees. Other sources have identified similar "products" being "sold" to executives of the independent auditor's client. My personal belief is that these types of services are not consistent with either Congressional intent embodied in the Sarbanes-Oxley Act or with the appearance of independence on the part of the auditor. As such, even if your auditor is willing to provide such services, and I hope that they are not, I would expect your audit committee's careful consideration as to whether the services affect the independence of the auditor.

A resource available to a company's tax professionals - and one which you will likely see more of - is the company's internal audit department. No one likes going to the doctor or dentist. Similarly, few look forward to a visit from an auditor, whether independent or internal. As work on internal control over financial reporting progresses, I would anticipate that management and the internal auditors will be documenting your procedures for preparation of tax accounts, evaluating your compliance functions, considering how key estimates are developed and recorded, and reviewing how tax planning strategies are developed, evaluated, and approved, and how well your department documents key conclusions and decisions.

Because this area involves significant judgment, an internal auditors' review of the evaluation and approval process used to adjust sensitive income tax estimates might provide you with insights on how to refine your processes or, perhaps, to confirm your "best-in-class" status.

In any event, I would expect that you will have timely communications and inquiry from the independent auditor. They have the responsibility for attesting to the fairness of the financial statements, and I can't put enough emphasis on the need for candid, complete and open communications with the auditor.

I know some of you might be reluctant to fully document information about sensitive transactions or positions with your independent auditor for fear that their workpapers might end up in the hands of the IRS. However the external auditor has to comply with the standards for auditor documentation. Anything less is a scope limitation. Others here are better able to address IRS policy. But, at the Commission, our policy has been that the auditor's obligation to report to shareholders on the company's financial statements takes precedence over any request from the company for confidentiality. Inherent in this obligation is the need to make sure the auditor's workpapers support the auditor's findings in each area, including accounting for income taxes. I encourage you to support the auditor in these efforts. It will be subject to review.

I would be remiss if I didn't at least mention other areas where the rules implementing Sections 302 and 404 of the Sarbanes-Oxley Act might affect you. These sections require the CEO and CFO to make an assertion as to the effectiveness of disclosure controls and internal controls over financial reporting. Although the CFO may have previously been interested most in knowing what effective tax rate to budget for next year, these sections of the Act cause the CFO to take greater interest in your department. The CFO should be asking you to document and test the controls over the myriad of estimates and judgments I've mentioned today. You should establish a basis upon which to conclude that the processes and procedures in your department are adequate to ensure that the tax consequences of the company's transactions are recorded, reported, and disclosed in a manner that complies with GAAP and the securities laws.

I opened my remarks by noting that the accounting and reporting of income taxes has received increased scrutiny by investors, analysts, Congress and others. Your auditors will be asking for more information, and you may have noticed an increased level of scrutiny from the SEC staff. That spotlight is likely to continue. Welcome to the new world.

The group here today represents many of the preeminent companies in the U.S. You have the ability to form and change practices and "can raise the bar" for others to follow. Each one of us, whether or not we spend the majority of our time engaged in financial reporting, has an important role to play in restoring the confidence placed in our profession by creditors, shareholders, employees and other users of financial statements and participants in the capital markets.

Now I'd like to turn it over to the chair of our panel, Robin. This should be a lively discussion.



Modified: 02/23/2004