Why Is the Tax “Forest” Greater than the Trees? SOX 404

Many CPA’s that are employed by or serve publicly held companies have been overwhelmed by the internal controls development, implementation and documentation that are required to comply with SOX. This article will ask you to step back a second and take a quick look at what’s going on in the forest while you have been focused on the SOX “tree”.

There are nine additional “trees” at which I suggest you look:

1. The IRS is focusing on three initiatives – enforcement, enforcement and enforcement. Those perspectives were clearly communicated by the commissioners at the AICPA National Tax Conference.

2. SOX Rule 404 compliance is exposing tax accruals to significant process and content review and documentation.

3. SOX Rule 802 provides for “Criminal Penalties for Altering Workpapers”. (Contemporaneous documentation really does mean contemporaneous.)

4. Current SEC activity in regulations, comment letters, actions and speeches have indicated a need for enhanced documentation and transparency of tax accruals for registrants; including inquiries regarding that which we do not name – the tax cushion. Disclosure of positions taken and the alternatives considered are likened to inviting the IRS to a smorgasbord.

5. The new form – Schedule M3 – imposes a higher degree of disclosure of book and tax timing and permanent differences.

6. Interim reporting requirements necessitate the current, correct quarter reporting of the reversal of Financial Accounting Standard (“FAS”) 5 contingency reserves.

7. The American Jobs Creation Act of 2004 (“AJCA”) poses a variety of challenges. The short window of opportunity to repatriate and reinvest earnings of foreign subsidiaries creates a rush to document and analyze foreign subsidiary earnings and profits (“E&P”), Subpart F income and Foreign Tax Credits (“FTC”).

Those and other AJCA provisions may alter a company’s effective tax rate. While the FASB has finalized its two staff positions with respect to the AJCA implications for FAS 109, those positions have not passed the scrutiny of normal standards setting and the staff positions address just two of the specific aspects of the AJCA impact on tax accruals.

8. Many of the large CPA firms have reduced the tax consulting staff levels to reflect a shrinking consulting practice; resulting in limited trained, human capital to address tax matters.

9. The Circular 230 Regulations have gone to final form and those regulations influence how CPA’s approach their tax practice. I’m sure you can see other “trees” when you pull back from SOX implementation to look at the forest. As you consider the nine trees above, I think you will find the forest has grown while you were hard at work on SOX compliance.

So now what do you do? One first step is to understand the un-remitted earnings of foreign subsidiaries for which you have not provided taxes; pursuant to the Accounting Principles Board Opinion 23 (“APB 23”) exception for “permanent re-investment”.

Many companies have had to shortcut their E&P computations on Forms 5471 over the years due to short staffing and a low risk assessment of inaccuracy. You may wish to revisit that risk assessment now. The AJCA provides a significant tax benefit for repatriation and reinvestment of up to a half a billion dollars of un-remitted foreign earnings.

That AJCA provision results in an effective rate of 5.25% on the un-remitted earnings that are repatriated and reinvested domestically (assuming the other aspects of the law are followed). Many companies have not provided for the 5.25% tax pursuant to the APB 23 exception for permanent re-investment. While no tax provision can be somewhat worrisome, the cash benefit of the tax savings is very real.

A company that can maximize the limit could save a huge amount of cash, assuming the $500,000,000 of cash is available for repatriation. That cash savings could be as high as $148,750,000, less any withholding taxes net of the FTC. (That’s $500 million times the net of 35% - 5.25%).

That cash availability is a tough assumption; particularly since permanent re-investment of earnings often includes the investment in less liquid foreign assets like accounts receivable, inventory, intangibles and fixed assets. The attractiveness of the domestic tax savings is thus limited by the foreign liquidity. The impracticality of analyzing this information and making an informed decision about the repatriation and reinvestment of un-remitted foreign earnings in the fourth quarter of 2004 resulted in the FASB issuance of Staff Position No.109-2.

That position essentially says companies can have more time to make a decision. They must however disclose a summary of how the provision is expected to affect the company, the extent of un-remitted earnings that may be affected, and a number of other specifics. Auditors must apply their normal audit procedures to those disclosures.

If your company allowed the December 31, 2004 year end to pass by, some opportunities may have been missed as company specific tax matters may have created unique matching opportunities for the repatriation and reinvestment decisions; particularly if the reinvestments could have affected available bonus depreciation provisions. Gaining control over deferred tax asset valuation is a second issue that is important as a result of current environmental changes.

The AJCA provides a variety of changes to the taxation of international activities; some of which alter deferred tax assets. Those changes include the elimination of the extraterritorial income (ETI) exclusion. The US was required to eliminate that regime as an illegal export subsidy.

The AJCA deduction for qualified production activities was intended to mitigate the loss of the ETI exclusion and to encourage domestic production; and to hopefully to slow the pace of globalization. The calculation of that deduction is integrated with the ability to utilize net operating loss (“NOL”) carry-forwards, which give rise to deferred tax assets (See FASB SOP 109-1.)

FTC carry forward amounts can also be affected. Speaking of the FTC, its computation has been simplified and the carryback and carryforward periods were altered to a one-year carryback and a ten-year carryforward. The AJCA also repeals an FTC related alternative minimum tax (“AMT”) provision.

As tax provisions become more transparent, the valuation of deferred tax assets will be subjected to greater scrutiny. One important aspect of that scrutiny will be the identification and valuation of deferred tax assets that qualify for “Day One” recognition. As the bases for tax positions taken and the alternatives to those positions are disclosed, a higher standard for deferred tax asset recognition may develop.

Companies and their auditors are struggling with what level of confidence (likelihood of surviving an audit) is necessary to recognize deferred tax assets. Do not be surprised if that confidence level is a “should survive an audit” level. Transparency is the last issue I would like to mention.

The recent tax law changes are significant and those changes occur at a time when many eyes are on company tax provisions. The list of SEC activities above, in conjunction with PCAOB initiatives and SOX 404 implementation are all events or trends that are imposing a significantly greater degree of transparency on how companies plan, implement, document and report tax matters.

That transparency is a good thing for the investors. However, that transparency lays open all of the tax return and planning positions for the IRS to attack. Managing those conflicting stresses will be a significant challenge for the finance and tax departments of companies to which the transparency initiatives apply. For some companies, the attractiveness of public securities markets may be diminished. I recommend that you start the project planning immediately.

A proactive, project-oriented approach to adapting to the changes will yield substantial returns. Some of the changes require significant lead times and the analytical groundwork may uncover important surprises – both good and bad. With reduced availability of seasoned tax professionals, getting the projects on the books sooner will help ensure your company effectively responds to these changes.

So step back, take a break to get your breath, check out the forest, then get back to work!