Introduction to SOX (Sarbanes-Oxley)
Introduction: In response to widely publicized corporate failures, regulators have created stringent new legislation: Sarbanes-Oxley (" SOX") to usher in a new era of transparency and accountability for publicly traded companies. Confronted daily by illustrations of the sweeping impact of these reforms, executives, boards of directors, and business advisors are scrambling to meet new standards and restore investor confidence.
All of this activity is motivated by a desire to eliminate opportunities for dishonesty. In the foreseeable future, organizations should expect not only that they will be held to a much higher standard of conduct, but also that the areas under examination — and the rights of the examiners — will continue to increase.
The suggestion that murky business practices are best eliminated by exposure to intense scrutiny — or sunlight - was voiced by U.S. Supreme Court in the early 20th century. Recently, this concept has been resurrected to support the crusade for greater openness and transparency in the governance of public companies.
This article deals with the evolving issues of tax risk, driven by a highly charged regulatory and governance environment, and will suggest an approach for the management of tax risk now and in the future.
The current regulatory environment
SOX created the Public Company Accounting Oversight Board (PCAOB), a U.S. US Canada
Publicly traded companies are also bound by the regulations of exchanges with which they are registered. Those in the financial services industry — including all banks and federally incorporated or registered trust and loan companies, insurance companies, cooperative credit associations, and pension plans — must meet additional regulations from the Office of the Superintendent of Financial Institutions (OSFI), whose frameworks are aligned with PCAB rulings. In this new world of accountability, corporate governance has never been more extensively regulated or publicized.
New CEO/CFO responsibilities
External oversight of corporate reporting, in the not too distant past, meant having the company's financial statements reviewed annually by an external auditor. Today, public company CEOs and CFOs must personally acknowledge their accountability for the validity of financial statements.
Under Section 302 of Sarbanes-Oxley, CEOs and CFOs must attest that they are responsible for financial disclosure controls and procedures. Each quarterly filing to the SEC must include certification that they have performed an evaluation of the design and effectiveness of these controls. The certifying executives must also state that they have disclosed to their audit committee and independent auditor any significant control deficiencies, material weaknesses and acts of fraud. Similar rules apply under Canadian equivalent standards.
Furthermore, as it is recognized that the accuracy and timeliness of financial reporting is heavily dependent on a well-controlled reporting environment, Section 404 mandates an annual evaluation of internal controls & procedures for financial reporting. The company's independent auditor must issue a separate report that attests to management's assertion on the effectiveness of internal controls & procedures for financial reporting. CEOs & CFOs are required to "sign off" on the integrity of internal controls.
A transformed audit committee
SOX also set forth new requirements that the responsibilities of the audit committee be increased. Although the Act did not outline specific changes, the fundamental intent of these transformative recommendations is to ensure that members of audit committees are — and appear to be — autonomous, skeptical, and fluent in the language of financial reporting so that they can probe effectively on independence, the industry, the business, the company's management and its risk profile.
The future: An expanded regulatory focus
As the lid is fully removed from the Pandora's Box of corporate behaviour, it is becoming increasingly evident that misconduct can occur at many levels, in many departments, and across many operations. Accordingly, regulators are expanding the focus of their efforts to identify opportunities for misappropriation, malfeasance and misleading reporting.
For most companies, the various forms of taxation can equal 30% or more of corporate costs, and significant portions of recorded assets and liabilities. Thus, taxes will inevitably be "in scope" as a significant area subject to the new requirements for adequate, auditable reporting and internal controls. In their new expanded roles, management, boards and the audit committee will need to understand all risks — including those in the tax arena, so that their decisions and recommendations will strike a balance between opportunity and prudence.
Are companies ready for greater tax scrutiny?
Meeting this need will require a determined effort. Organizations do not typically recognize the significance of tax risks and controls in the new regulated environment. Planning, controversy effort, and management controls for tax are not being widely or systematically addressed, nor are the increasingly complex international aspects. In fact, in many case the compliance project team does not include the tax executive in scoping out the exercise. This is a serious oversight, considering that 10% of all regulatory compliance efforts normally relates to the tax area.
How is the tax compliance function being managed currently? Most companies focus on documenting all tax processes and controls related to compliance, resulting in either too much or too little documentation, and insufficient consideration given to scope and priority of risk. Some internal controls have been implemented, but only to the extent that basic assurance is provided on the accuracy of financial reporting for significant tax accounts.
With the growing complexity of tax legislation in general, the impact of retroactive legislation, and new initiatives being taken by the revenue authorities, the risks associated with tax clearly need to be managed. Transparency is now the watchword.
The Revenue Authorities join the battle
It is not entirely coincidental that revenue authorities in a number of countries are seeing the current environment as an opportunity to flex their legislative and/or administrative muscle to reign in tax reduction arrangements they regard as abusive. These developments can be summarized as follows:
1. Increased efforts to influence decisions on prospective transactions:
In this regard consider the Alert System being contemplated by CRA, whose stated purpose is to electronically convey messages to taxpayers about important tax issues — including those it considers tax avoidance schemes. In addition, CRA has proposed the development of a procedure for businesses to declare "novel tax plans or arrangements" to permit early clarification of CRA's position.
In the U.S.
This pre-emptive approach suggests that revenue authorities expect public actions to do as much or more to dissuade certain tax planning than challenges through the more traditional (and more private) routes of audit, appeal and litigation.
2. Increased cooperation and joint action by national revenue agencies:
In addition to the other well-established multinational information sharing protocols, on April 23, 2004, Canada , Australia , United Kingdom and the United States
3. Additional legislative authority for gathering information and disclosure:
Recent final tax shelter disclosure regulations in the United States
4. Expanded administrative interpretation of requirements to provide documents or information:
Revenue authorities continue to test the water in terms of access to taxpayers' documents and advisers' working papers. Buoyed by judicial confirmation of the extent of their legislative powers (in MNR v. Kitch, Tower et al. 2003 DTC 5540, the FCA confirmed the CRA's extensive rights to "information" through an interview process or documents, and the lack of accountant-client privilege, the CRA is requesting audit working papers from accountants even in circumstances where fraud or fraudulent misrepresentation is not alleged, or where the information may otherwise exist with the client.
What is the motivation behind these more aggressive approaches?
They are the result of two closely linked realities: i) an inevitable trickle down effect of the new regulatory environment on a function that contributes significantly to financial results, and ii) the published evidence of tax manipulation.
Tax is perceived by regulators and tax authorities to be a meaningful part of the breakdown of public company accountability; accordingly, it must be seen to be a meaningful part of the solution.
Tax advisors beware
The term 'advice' implies the provision of a subjective opinion, the new reality of tax reporting, both for internal and external consumption, adds considerable more weight to the opinion given by the adviser. It is, therefore, important that tax advisers understand the new regulatory/governance environment. This is particularly important in cases where the tax service provider is also the auditor, giving rise to restrictions imposed by regulation and/or company policy on the services that are allowed, and to pre-approval of services by the audit committee. Even where the advisor is not restricted by an attest relationship, it is increasingly important that he/she appreciate the impact of the tax risk and transparency expectations that Tax Directors, CFOs and others now face.
In the context of the new regulatory environment, it's clear that when faced with a choice between tax opportunity and tax risk, there is an increasing tendency to reduce risk at the expense, perhaps, of a legitimate opportunity. However, until tax managers attain greater comfort that their company's tax risk position is more effectively and transparently managed, they may be less willing to take on new tax planning or otherwise increase the `risk profile' of the organization.
It is beyond the scope of this paper to deal with the responsibilities faced by both lawyers and accountants in rendering tax opinions. This topic was addressed extensively by David W. Smith, in "Dealing with Tax Risk in an Opinion," in Report of Proceedings of the Forty-Sixth Tax Conference, 1994 Conference Report (Toronto: Canadian Tax Foundation, 1995), 38:1-23. It may be enlightening to reconsider some of the matters raised in Mr. Smith's paper, such as:
• duty of a tax adviser to warn a client of the risk in a course of action
• duty to advise or warn of the risk that a revenue authority might decline to accept a given transaction, or that the authority has publicly advised that it views similar ones as abusive
• ability of the client (in the expanded realm of governance, "Who is the client?" is an appropriate question) to understand that the opinion could be wrong, and an appreciation of the consequences
• extent of disclosure on uncertainties or contrary opinions required to be made to clients and third parties who are the recipients of these opinions.
Shared by
CA Sameer Pradhan
Manager - Internal Audit
Posted at www.taxmannindia.blogspot.com
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