April 26, 2006
On April 19, 2006, the Securities and Exchange Commission ("SEC") approved new auditor independence and ethics rules proposed by the Public Company Accounting Oversight Board ("PCAOB"). These new rules focus on an auditor’s provision of tax services to public company audit clients and prohibit contingent fee arrangements for services provided to audit clients.
As discussed in more detail below, the PCAOB’s new rules include several important matters for issuers to consider. For example, the PCAOB’s new rules include specific guidance regarding the manner in which audit committees are to pre-approve permissible tax services to be performed by the outside auditor. The rules also restrict an outside auditor from providing tax services to persons at an audit client who perform a "financial reporting oversight role" (other than directors). In addition, the PCAOB’s new rules provide that an auditor will not be deemed independent if the auditor (1) plans, markets or opines in favor of certain types of tax transactions for the audit client, or (2) provides tax services to an audit client for a contingent fee. The final PCAOB rules also include certain rules of conduct for registered public accounting firms and persons associated with registered public accounting firms, which are not addressed in this client alert.
The final rules concerning independence, tax services, and contingent fees adopted by the PCAOB can be found at http://www.pcaobus.org/Rules/Docket_017/2005-07-26_Release_2004-014.pdf. The SEC release approving the PCAOB’s rules can be found at http://www.sec.gov/rules/pcaob/2006/34-53677.pdf.
- Additional Procedures Relating to Audit Committee Pre-Approval of Tax Services (PCAOB Rule 3524). The PCAOB’s new rules expand the responsibilities that a registered public accounting firm has under existing SEC rules to seek pre-approval of tax services from an audit committee. Specifically, the auditor must (1) provide a written description to the audit committee detailing the nature and scope of the proposed tax service, including the fee structure for the services; (2) discuss any implications that performance of the tax services may have on the auditor’s independence; and (3) document all such discussions. Additionally, auditors must disclose to the audit committee any amendments, written or unwritten, to tax service engagements.
In contrast to the PCAOB’s initial proposal, the new rules do not mandate audit committee review and approval of the engagement letter for each tax service. The PCAOB states in its release that the underlying purpose of the requirement is "to establish a manageable collection of information" from which audit committees can pre-approve tax services. The PCAOB also states that in adopting these procedural requirements it did not intend to dictate whether an audit committee pre-approves tax services on an ad hoc basis or on an annual basis through pre-approval policies and procedures. Audit committees should examine their pre-approval policies and procedures to determine whether the policies and procedures are structured such that they would satisfy the new requirements for pre-approving tax services.
- Provision of Tax Services to Persons in Financial Reporting Oversight Roles (PCAOB Rule 3523). The PCAOB’s new rules provide that a registered public accounting firm will not be deemed independent if it provides tax services to any individual who is in a "financial reporting oversight role" (as defined by the SEC) of the audit client, or an immediate family member of such an individual. The PCAOB’s new rules expressly exclude directors from the category of individuals in financial reporting oversight roles. The rules also exclude individuals who serve in financial reporting oversight roles at an affiliate of the audit client, but only if the affiliate’s financial statements are immaterial to those of the audit client, or if the affiliate is audited by a different, unassociated auditor. In addition, the new rules include an exception to address situations where individuals become subject to the rule because they are hired or promoted into a financial reporting oversight role at an audit client. It allows the auditor to provide tax services to such individuals where the engagement was in existence prior to the hiring or promotion and the services are completed within 180 days after the individual is hired or promoted.
- Planning, Marketing or Opining in Favor of Certain Tax Transactions (PCAOB Rule 3522). The PCAOB’s new rules provide that a registered public accounting firm is not independent if it plans, markets, or opines "in favor of" confidential or aggressive tax transactions for the audit client. Specifically, the PCAOB’s rules prohibit auditors from planning and marketing tax transactions that were recommended initially by the auditor, its affiliate, or an advisor with whom the auditor has a formal arrangement, if a significant purpose of the transaction is tax avoidance, and if the transaction is more likely than not to be disallowed under applicable tax laws. To establish that a transaction is more likely than not to be allowed under applicable tax laws, auditors must make an objectively reasonable and defensible decision that the proposed tax treatment of the transaction is likely to be permitted if challenged. The PCAOB’s new rules also prohibit auditors from planning and marketing confidential tax transactions (which are transactions with tax-advisor imposed conditions of confidentiality that the IRS has identified as potentially abusive). The SEC release noted that subsequent listing of a transaction that was allowable at the time the tax services were provided does not result in a per se violation of the new auditor independence standards. The SEC encouraged the PCAOB to provide guidance regarding the subsequent determination of independence after a transaction is listed.
- Contingent Fees (PCAOB Rule 3521). The PCAOB’s new rules provide that a registered public accounting firm will not be deemed independent if it enters into a contingent fee arrangement or receives a contingent fee for the provision of tax services, either directly or indirectly, from an audit client. Fees that are fixed by a court or another public authority are permissible under the PCAOB’s rules, but only if they are not dependent on a particular result and will not create a mutual interest between the auditor and the client.
- Transition Periods. To account for existing arrangements, the PCAOB’s new rules include several transition periods. Specifically:
- For audit committee pre-approval of tax services, the new rules will not apply to ad-hoc pre-approvals obtained on or before June 19, 2006 (i.e., within 60 days from the SEC’s April 19, 2006 order).
- In addition, in cases where tax services are pre-approved pursuant to audit committee policies and procedures, the new rule will not apply to any tax service that starts on or before April 19, 2007.
- If an auditor provides tax services to an individual who is in a financial reporting oversight role, or to his or her family member, the new rule will not apply to services being provided pursuant to an engagement letter in effect when this rule was approved on April 19, 2006, provided such services are complete on or before October 31, 2006.
- The rule providing that a registered public accounting firm is not independent if it plans, markets, or opines "in favor of" confidential or aggressive tax transactions for the audit client will not apply to tax services completed by the accounting firm on or before June 19, 2006 (i.e., within 60 days from the SEC’s April 19, 2006 order).
- The contingent fee rule will not apply to a contingent fee that is paid in its entirety, converted to a fixed fee, or otherwise unwound on or before June 19, 2006 (i.e., within 60 days from the SEC’s April 19, 2006 order).
Gibson, Dunn & Crutcher lawyers are available to assist clients in addressing any questions they may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work,
John F. Olson (202-955-8522,firstname.lastname@example.org),
Ronald O. Mueller (202-955-8671, email@example.com),
Brian Lane (202-887-3646,firstname.lastname@example.org),
Amy L. Goodman (202-955-8653,email@example.com) or
Michael J. Scanlon (202-887-3668,firstname.lastname@example.org).
© 2006 Gibson, Dunn & Crutcher LLP
The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.