The SEC is upping the ante on requiring/enforcing tax disclosures; this will affect the treatment and impact of treasury’s tax strategies.

Corporate taxes are a big item pre-election, and with Congress looking for revenue (see related story), the SEC has political backing to look more closely at tax planning from a financial reporting standpoint. Greater emphasis on how taxes affect financial reporting will up the ante on analyzing, containing and communicating the tax impacts of treasury/finance strategies, particularly such areas as Special Purpose Entities, tax-driven financings and captive insurance companies.

The impetus for change

There are three key reasons why the SEC is choosing to focus on how tax accounting affects companies’ financials, according to SEC Chief Accountant, Donald Nicolaisen (in a speech in February to the Tax Council Institute Conference on The Corporate Tax Practice):

(1) Financial reporting of income taxes is very significant to the health and credibility of our capital markets. “For most companies,” Mr. Nicolaisen noted, “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.”

He also pointed to some of the recent accounting scandals involving SPEs, some involving tax structures,”which have led to faulty reporting to the IRS and the SEC” and “immense losses.”

(2) Tax accounting tests the efficacy of a principles-based approach complemented by ample disclosures. As Mr. Nicolaisen notes, “the FASB issued its standard on income taxes in 1992. Despite its length, this standard is largely principles-based.”

The principle is based on two basic and interrelated questions, according to Mr. Nicolaisen: 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.

By definition, a principles-based standard means that a considerable degree of judgment is required, and “tax reporting is an area full of estimates, assumptions and other judgments.”

This is why tax, like all principles-based standards must be complemented by ample disclosure. And it is here where tax accounting is lacking.

“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?,” Mr. Nicolaisen asks, “I suspect it’s because the accounting for income taxes is often an area where the disclosures provided to the public are opaque.”

(3) Sarbanes-Oxley. “Like most in corporate America, tax professionals cannot escape the far-reaching grasp of the Sarbanes-Oxley Act,” Mr. Nicolaisen points out.

SOX called for SEC creation and enforcement of rules concerning internal controls and documentation of all financial reporting, including tax issues impact financial results. This includes Sections 302 and 404 certification requirements with assertions as to the effectiveness of disclosure controls and internal controls over financial reporting. Hence, Mr. Nicolaisen notes, the CFO will be calling the tax department for more information than “what effective tax rate to budget for next year.”

SOX also calls for a greater role for the audit committee to ensure these proper controls and documentation procedures are implemented and followed (for tax too). Plus, the audit committee is tasked with monitoring the independence of firm auditors, many of whom offer tax planning advice and products (see below).

Accordingly, the SEC will be more closely monitoring firms’ compliance with financial reporting requirements concerning tax issues, and especially those mandated by SOX.

A few hints about what the SEC may be looking for are highlighted in Mr. Nicolaisen remarks about what he would consider “best practice,” including:

• Greater consideration of tax issues in MD&A disclosures. Following the guidelines of last December’s interpretive release on MD&A guidelines (see IT, 1/12/04), Mr. Nicolaisen points out that MD&A disclosures should provide answers to questions such as: Does the reader understand or is the reader otherwise aware of the nature of the critical [tax] 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?

To be clear: “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.”

• Strict adherence to the footnote disclosure requirements of Statements 109 and 5. These disclosures, for example, should answer questions such as: 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? Even if such disclosures might provide a road map for the IRS to pursue an audit, they should be made.

“Suffice it to say,” Mr. Nicolaisen warns, “the Commission staff will continue to vigorously enforce the disclosures that are required by GAAP or SEC regulations.”

• Testing adherence to tax accounting principles. As part of SOX mandated internal controls on financial reporting a tax-driven transaction must adhere to the relevant principles of financial accounting, i.e., 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.

In Mr. Nicolaisen’s view, adherence to the principle can be tested with a simple NPV calculation: “A transaction whose internal rate of return is negative is uneconomic.”

His carefully chosen example suggests that an arrangement resulting 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.”

Mr. Nicolaisen admits that current accounting does not require that firms measure temporary income tax differences on a discounted or present value basis. However, ”if a transaction is intended to exploit that measurement dierence, then you should pay close attention to the economic substance of the arrangement.”

• Complete documentation of tax planning efforts and control processes surrounding tax transactions for internal and external auditors. In accordance with SOX, management and internal auditors, according to Mr. Nicolaisen, should be documenting procedures for preparation of tax accounts, evaluating compliance functions, considering how key estimates are developed and recorded, and reviewing how tax planning strategies are developed, evaluated, and approved. In addition, internal audit should be considering how well tax documents key conclusions and decisions.

External auditors will be doing the same, which in itself may put a chill onto tax driven tranasactions.

As Mr. Nicolaisen notes, though tax professionals might be ructant “to fully document information about sensitive transactions or positions” for external auditors fearing “their workpapers might end up in the hands of the IRS,” standards for auditor documentation require this. “Anything less is a scope limitation.”

• Holding Audit Committees to account. Given SOX mandates, tax accounting should be on the agenda for at least one audit committee meeting each year, according to Mr. Nicolaisen. This meeting, in his view, should be used to review 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.

Best practice also calls for the audit committee to be “apprised of the vendors you most frequently use for income tax planning strategies, income tax opinions and income tax compliance services.” Mr. Nicolaisen sees this as 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.”

Given Mr. Nicholaisen’s remarks— in particular those highlighting the SOX impact on tax-related documentation and financial reporting, treasury should consider asking for regular updates from the tax department about how their SOX compliance efforts are proceeding and if there is anything treasury should know about (and return the favor). At a minimum, this dialogue should ensure that economic substance valuations and documentation are in synch for all tax influenced financial transaction booked. In the current political and regulatory environment, treasury and tax must be on the same page or risk ending up on the Wall Street Journal front page.