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Mr. Jonathan G. Katz, Re: Strengthening the Commission's Requirements Regarding Auditor Independence I have had the opportunity to review the US Securities and Exchange Commission's ("SEC") proposed rule entitled "Strengthening the Commission's Requirements Regarding Auditor Independence". I am attaching for your review copy of a paper entitled "Standard of Practice and Duties of Tax Advisors in the Post Enron Environment". This paper was recently published, in electronic format, by the Canadian Tax Foundation. It represents the contents of a speech that I gave in Toronto in September of last year at the Canadian Tax Foundation's Annual Tax Conference in Toronto. The paper was written in advance of the release of the SEC's proposed rules. Pages 5 to 32 cover certain of the subject matter of the proposed rules particularly Section 9 (Legal Service), Section 10 (Expert Service) and Section 11 (Tax Services). While, for the most part, the proposed rules satisfactorily address many issues of conflict which arise between the economic interest of accounting firms and their statutory obligation of independence, in certain areas, the rules should be further clarified to deal with obvious cases of conflict which are not specifically spelled out in the proposed rules. I believe that commentary from foreign tax practitioners is useful for the SEC as many foreign corporations are subject to the application of the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley Act"). My comments (observations) on the proposed rules are as follows: Appraisal, Valuation Services, Fairness, Opinions or Contributions in Kind ReportThe SEC's proposal states that they will not prohibit an accounting firm from providing above-captioned services for non-financial reporting including transfer pricing studies. I believe that the exclusion is too broad. In many cases, a transfer pricing study can have a significant impact on the recorded tax expense of a corporation and on the issue of the adequacy of the corporation's tax reserves. It is not unusual, in the context of a transfer pricing study, that management is seeking justification for a favored transfer pricing methodology that minimizes tax by capturing revenue in low tax jurisdictions and recognizing expenses in high tax jurisdictions. It is no secret that transfer pricing is an important component in establishing the level of profit earned by corporations that engage in a multitude of cross-border non-arm's length transactions. A transfer pricing study would involve the choice of the appropriate methodology, including a conclusion as to the right comparables, and will involve the services of non-tax experts such as economists and valuation experts. Typically, valuation experts will establish the fair market value of key assets that are relevant in the economic study (e.g. to determine an appropriate royalty). It is not uncommon for management to exert pressure on the professionals to choose the optimum transfer price. A transfer pricing study raises issues very similar to an appraisal or valuation service mandate. First, the auditor would be obliged to audit the work product of his fellow colleague in determining whether or not the tax reserves in the corporation's accounts are adequate. Can the auditor act as an impartial and objective reviewer in challenging the appropriateness of the margin or the methodology used in establishing the transfer pricing in assessing the adequacy of the corporation's tax reserve when a fellow colleague has performed the work? How can the auditor determine that his colleague's judgment was not influenced by management's desire? Consider for example, Firm A provides the audit function for its client, ABCco, a public software company. The CFO is anxious to reduce the corporation's effective tax rate to increase earnings per share. The corporation is trading at 20 times profits and a $2 million reduction in taxes could give rise to a $60 million increase in the corporation's market capitalization. The audit firm's tax and transfer pricing and valuation specialists suggest an offshore software licensing company and undertake to complete the mandate for a fixed fee of $2 million, a common structure used in Canada to benefit from Canada's favorable tax regime applicable to foreign affiliates. The tax specialist reviews the status of the corporation's software products to determine which products are still in an early stage of development and are candidates for an outright transfer to Offshoreco. The CFO is conscious of the benefits that can be secured if he can convince the tax specialists that early stage software have very little value. The audit firm's valuation experts and the CFO agree on the product that will be transferred outright to Offshoreco for a nominal value and that the nominal value represents the fair market value of the intangible property. Shortly thereafter, the development of the software of Offshoreco is completed through a research and development cost sharing agreement with ABCco. The software transferred to Offshoreco is well received in the market place. A significant amount of royalty income is earned by Offshoreco in its first year of operation which is subject to a very low tax rate. The income realized by Offshoreco constitutes a material portion of the total consolidated income of ABCco. The net profit recorded in the quarterly financial statements that were issued by ABCco during the year, were significantly improved from the prior years as the tax expense was calculated using the low tax rate applicable to the income earned by Offshoreco. The rate differential between income earned in Canada and at the level of Offshoreco is 30%. As the Offshoreco structure has a material impact on ABCco's financial results through a lower tax expense, the audit firm must consider the structure in its judgment regarding the accuracy of the client's reserves for taxes. A significant tax reserve may be required to cover off the tax risks associated with the structure. If the auditors record a significant tax reserve, this means that ABCco has significantly overstated its income in its quarterly financial statements. In addition, if they book a significant tax reserve, this will constitute a red flag for the tax auditor. Assume that there has been a substantial run-up in ABCco's share price as a result of the lower tax expense flowing from the international structure. The CFO is likely to resist a tax reserve. In the circumstances, the CFO is likely to argue that he relied on the advice of the tax specialist of the audit firm and the corporation paid a handsome fee for the structure. In this case, the audit firm is in a bind. If the reserve is booked at year-end, this could result in a significant drop-off in ABCco's share price. This could prompt shareholders lawsuits. However, there is a significant tax audit risk which could justify an increase in ABCco's tax reserves. In the circumstances, it is doubtful that the auditor can exercise the requisite professional skepticism in his review of the adequacy of the corporation's tax reserve. If he increases the tax reserve, he will cast doubt on the soundness of the tax plan put forward by his colleagues. In the above example, I believe that an obvious conflict exists between the auditor's obligation of independence and the execution of the transfer pricing mandate which meets management's expectation of lowering the firm's tax expense and increasing overall earnings per share. This conflict is no different than the conflict that arises where the audit firm uses its own valuation experts to establish the value at which assets get recorded, for example, under purchase price accounting. This example also illustrates the conflict between certain tax service mandates and the auditor's obligation of independence. While the above-noted tax planning cannot be classified as a tax shelter under Canadian tax rules, clearly it is a tax mitigation strategy which forces an alignment between the audit firm's interest and those of management. It also requires the auditors to audit their own work in the determination of the corporation's tax expense and the adequacy of the corporation's tax reserves. Legal ServicesThe proposed rules on legal services, in my view, should be clarified. The proposal recognizes the difficulty of defining legal services. As noted in the Sarbanes-Oxley Act, legal services are prohibited if provided by members or affiliate members of an accounting firm to an audit client. In the foreign context, the difficulty is compounded by the difference that exists not only at the national level but at the state or provincial level in what constitutes the practice of law. In the foreign context, two approaches could be applied. The first, and perhaps the easiest, would be to refer to a local law. If in the local jurisdiction, the services would constitute a legal service, then it could not be provided by a member of the audit firm or a member of an affiliated firm. While this approach has the benefit of clarity, it does pose a number of practical problems. For example, does the SEC have sufficient resources to determine whether a particular service in a foreign jurisdiction constitute a legal service under the applicable law. Secondly, this approach would certainly not lead to a level playing field. For example, as the proposed rules recognize in certain foreign jurisdiction, one has to be licensed as a lawyer to practice tax law. In other jurisdiction, the issue is not as clear. Therefore, this could lead to circumstances where, for example, a service would be prohibited if it was rendered outside the US and, for example, not be prohibited if rendered within the US. The opposite case is also easy to imagine. One of the absurd results might be that US or foreign-based issuers which have issued securities in the US market may shop for legal services based on the meaning of legal services and local law to circumvent the spirit of the rules. The other approach which would lead to a more level playing field, would be to use US principles in deciding whether a particular service constituted a legal service when provided to audit client. Under this approach, one would look to the specific nature of the service and ask whether the particular service constitute legal service under US principles. For the latter approach to succeed, greater clarity would be required in the proposed regulations on the meaning of legal services. As noted in the attached paper, the definition of legal services, as a general matter, is an issue governed by local state law and can vary from jurisdiction to jurisdiction. Therefore, along with the general principles outlined in proposed rules, there should be a list of services which incontrovertibly fall within the scope of the general principles to provide greater certainty to both US and foreign corporations affected by the proposal. In this regard, all form of advocacy work should be prohibited when performed for an audit client regardless of the particular field of law. More specifically, this would mean that all forms of advocacy work in the tax field, whether before an administrative body or before a court, should be prohibited. For example, in the defense of a tax contestation, whether at the level of an administrative body including the IRS or a court, the tax professional's duty is to present his client's position in the best possible light. In doing so, he clearly becomes an advocate of the corporate client. In addition, he may also be defending a strategy that his firm has recommended to the corporation for implementation. How can the public be assured that the auditor, in separately reviewing the issue as part of the audit function, will not be influenced by colleagues who are performing an advocacy function in a decision not to include a reserve for the matter under dispute? How can the public be reassured that there is no inherit conflict where the advocacy function is being performed for a tax mitigation strategy presented to the audit client by the audit firm? In my view the mischief which the Sarbanes-Oxley Act sought to address apply equally in all area where advocacy is involved. In addition, all forms of preparation of legal documentation should be prohibited whether in the tax field or otherwise. In numerous circumstances, an audit firm is required to make accounting judgments based on the legal effect of agreement in performing their audit of a corporation's financial statements. As illustrated by the Enron scandal, the accounting firm accepted management off-balance sheet treatment of complicated legal arrangements entered into by Enron. If the audit firm participates in the preparation of the legal documentation, then clearly, it would be auditing its own work product in assessing, for example, whether a liability should be recorded on the corporation's financial statements. The inconsistencies of the duty of the attorney and that of the audit firm are apparent in this example. I have noted, in my tax practice, that audit firms have in many circumstances prepared at least draft of legal documentation and then in some cases have gone further where they have members that are licensed to practice law in affiliated firms. Only by having a clear rule on this topic will the practice be stopped. Opinion work, whether based on statutory interpretation or the proper characterization of legal rights and obligations created by contracts should be specifically enumerated as a legal service. In the context of opinion work, difficult judgments are made on the interpretation of statutory provisions and case law and the hierarchy of judicial precedents. No distinction should be made vis-à-vis the particular area of law. This would mean that an audit firm should not issue an opinion which deals with statutory interpretation or the analysis of case law in the tax field particularly in the context of a proposed tax mitigation strategy. I believe that perhaps the issue of conflicts with the auditor's obligation of independence is greatest in the tax field. For example, it is not unusual for audit firms to engage in the marketing of sophisticated tax mitigation strategy to their audit clients which are designed to exploit perceived loopholes in the tax laws. In many circumstances, the corporation's officers and directors will request an opinion on the soundness of the particular strategy for example proposed by a different firm. The difficulty in allowing the audit firm to provide the legal opinion is twofold. First, it violates the principle underlying the proposed rules, namely that the audit firm will ultimately audit its own work product. Secondly, as this field of practice offers the greatest potential for lucrative fee arrangements, the public cannot be reassured that the opinion writer has not been influenced by his firm's economic interest in the service mandate. A much better check and balance system would be in place, for example, where a formal opinion is delivered by a firm different than the audit firm and the audit firm reviews the opinion and work performed in their audit of the corporation's accounts, particularly the adequacy of the firm's tax reserves. If the rules go beyond general principles to include the cases mentioned above, then a level playing field would be created for all issuers whether foreign based or not. In this case, legal services could be defined by reference to general US principles and the specific suggested inclusions in the proposed rules. Tax ServicesMany of the comments made above will, if accepted, have an impact on the delineation of prohibited and non-prohibited tax services. I believe, that it would be useful that audit committees of reporting issuers have greater certainty on the issue of what constitutes a prohibited tax service. Consistent with my earlier remark, I suggest that transfer pricing studies, formal opinion work, advocacy and tax mitigation services should all be specified as prohibited services as each one of those services violates the basic principles exposed in the Sarbanes-Oxley Act, namely that each of the services places the auditor in a position of auditing his own work, aligns the auditor's interests too closely with that of management or places the auditor in a position of being an advocate for the audit client. The area of tax mitigation strategies is deserving of additional commentary. Tax consultants working for accounting firms devote significant resources to the development and marketing of tax planning products aimed at exploiting perceived loopholes in the law. This area of practice often presents the best opportunity for "value billing" based on a percentage of the perceived tax savings. In many cases, clients and external advisors are required to sign letters of confidentiality prior to the presentation of the planning opportunity. In this particular area of practice, it is not unusual to find persons dedicated to the presentation function who are steeped in advocacy and marketing skills. The formal presentation of the tax mitigation strategy is generally made in a sophisticated PowerPoint document which, more often than not, highlights the financial impact of the strategy, especially the positive impact on earnings per share. It is no secret that corporations prefer to implement tax mitigation strategies in circumstances where the auditors have agreed that the tax benefits may be fully recorded in the financial statements without a reserve. In some cases, the tax planning is dependent on the accounting treatment. For example, if a debt qualifies for off-balance sheet treatment, a capital tax benefit may be secured in Canada. There is no question that this area of practice presents the greatest risk of potential conflict with an auditor's duty of independence. The marketing of tax mitigation strategies involves partiality and advocacy - the opposite mind set to the independence required of an auditor. Some of the firms particularly outside the US have adopted the practice of demanding execution of a confidentiality agreement when presenting a tax mitigation strategy to an audit client. The problem with this promotional method lies in the fact that the client is prevented, by the terms of the contract itself, from assessing whether it is getting appropriate value for the services paid for as the confidentiality agreement limits the ability of the client to seek advice elsewhere. Very few professionals are willing to be bound by a confidentiality agreement which may curtail their ability to provide tax advice to other clients. A refusal to sign the confidentiality agreement may preclude the corporation from receiving a second opinion. Secondly, the practice is inconsistent with the very nature of the auditor's duty to the corporation's shareholders and creditors insofar as restraints are placed on the corporation to disclose transactions which may have an impact on the adequacy of their tax reserves. Such conduct, potentially to the detriment of the interest of the client, does not allow the client the possibility of ascertaining whether the professional is effectively putting his duty toward the corporation's shareholders and creditors ahead of his own economic self-interest. At the very least, such a situation gives rise to a clear appearance of conflict, which is difficult to reconcile with the explicit duty of audit independence. It is interesting to contrast the practice of marketing tax mitigation strategies to management and in some cases requesting the execution of a letter of confidentiality prior to proceeding with the presentation of the strategy with the role of the auditor in reviewing the adequacy of a corporation's tax reserves. An important aspect of the auditor's function is to evaluate the adequacy and reasonableness of the corporation's provision for future tax liabilities and the accuracy of recording future tax "assets" on the balance sheet. The future income tax liabilities account represents an amount notionally set aside by the corporation to cover adjustments and additions to the corporation's cash tax liability. Additional corporate tax liability may arise from a wide variety of transactions and from a corporation's awareness of, and preparedness for, the possibility of an assessment of additional taxes. In contrast, the account for future tax assets represents amounts associated with a future reduction in the corporation's actual tax liability. The Supreme Court of the United States has described the mandate of the independent auditor regarding the treatment of a corporation's tax accounts as follows:
The Court's statement stands for the proposition that the auditor must question the tax strategies implemented by management with professional skepticism. The certification process of a company's financial statements, the essence of an auditor's function, will entail a review by an auditor of his own firm's work when the tax mitigation planning was performed by a tax professional colleague within the same firm. Whether such oversight over a firm's own advocacy work constitutes a fundamental infringement of the independence requirement imposed on auditors has long been the subject of debate. Members of the accountancy profession have traditionally argued that the delivery of such tax services by an audit firm to a corporation represented an integral part of the audit mandate given that the treatment of a corporation's tax was included into its financial statements. Nevertheless, when an auditing firm's tax work goes beyond simple tax compliance and morphs into tax planning, the line between a mandate limited to independent oversight provided for the benefit of the shareholders, traditionally associated with the accounting profession, is crossed, to reach a category of services associated with an advocacy function, where the defense of the interests of company management often prevails. The argument that the IRS or the competent tax authority has the authority to audit the transaction is specious. In many cases, the audit occurs many years after the fact and the contestation may last many years. This was the case for example for Laidlaw Inc. If an expense is recorded only upon final resolution of the issue, shareholders could incontrovertibly suffer damages. Under this proposal, a tax mitigation strategy would be defined as any tax planning ideas which is presented by an accounting firm to an audit client which purpose is to ultimately to reduce the firm's cash tax expense or tax expense for financial accounting reporting. I welcome this opportunity to comment on the proposed rules. The commentary made herein represent my personal views on the subject matter and not those of my firm. As a non-US legal practitioner, I would be delighted to provide the SEC with additional commentary if it so desired. I could be reached at the address and phone number noted below.
rjh/aim encl. ____________________________
November 15, 2002Robert James Hogan
INTRODUCTIONPrior to the presentation of this paper at the annual Conference, some colleagues in the accounting profession who had received an early draft were dismissive of the efforts to deal with issues of potential conflict on the grounds that, as a member of the legal profession, our views on the topic of independence would be predictable and self-serving. This level of criticism is, at best, specious. Should the CICA's exposure draft on independence standards be summarily dismissed on similar grounds? David Brown, Chairman of the Ontario Securities Commission has asked interested Canadians to comment on what rules, if any, should be considered by Canadian securities regulators in light of the recent financial scandals which have rocked investor's confidence in the credibility of financial reporting. If elements of self-regulation are to be preserved in Canada, then all commentary on the subject should be welcomed. In writing this paper we recognized that our views on potential conflicts could be misinterpreted as questioning the integrity of certain types of professional tax advisory relationships, particularly in light of the candid way in which we deal with the subject matter. The purpose of our paper is not to engage in divisive debate. As there is a danger that our remarks may be misconstrued, the authors wish to emphasize that the opinions expressed herein represent the authors' personal views on the subject matter. We note that the Canadian Tax Foundation has enjoyed a tradition of encouraging speakers to deal with issues that might be regarded by a segment of tax professionals as matters that should be discussed behind closed doors. Readers may recall reading Robert Brown's views on the merits of the Canadian accounting firms in pursuit of parallel legal organizations in Canada.2 Although in many cases, the standards of practice and the code of conduct applicable to lawyers and accountants providing tax advisory services to their clients are the same, there are notable differences, attributable to the different professional roles of lawyers and auditors. These differences have a significant bearing on the issue of potential conflicts. A lawyer's duty is to act as an advocate of his client's interests. A lawyer has a very strict obligation of loyalty to his client, often summarized as the duty to present his client's position in the best possible light. A lawyer must avoid any situation which places his own interests ahead of those of his client or which could lead to the representation of two clients whose legal interests are in conflict. This is to be distinguished from the representation of two clients whose interests are adverse from an economic, political or social perspective. The accounting profession enjoys a statutory monopoly in the performance of the audit function. The price to be paid for this monopoly is the preservation of independence at all times. Public corporations cannot operate without auditors, as the law obliges them to present audited financial statements to their shareholders at least annually. The purpose of the audit is to strengthen investors' credence in financial statements by providing investors with assurance that the statements have been reviewed by objective and impartial professionals. It is well-established that auditors have a duty of care to shareholders and creditors who may rely upon the financial statements they have audited. This duty of independence must not be compromised through the provision of non-audit services to an audit client which may create a conflict with this duty. In short, as stated by a former SEC Chairman, Arthur Levitt, at a 1996 SEC conference for accountants: "The auditing function should be the very soul of the public accounting profession - not a loss leader retained as a foot in the door for higher fee consulting services".3 Against the backdrop of the recent financial scandals, if certain types of non-audit services inhibit the auditor's ability to act objectively and with impartiality, then limits must be placed on the type of services that can be performed or, appropriate oversight mechanisms must be put in place to insure that objectivity and impartiality is not compromised. In this context, the economic interest of the audit firm must be subordinated in order to restore public confidence in financial reporting. Outside the audit context, accounting firms remain free to provide all types of non-audit services, for which they are qualified, to their clients. This paper focuses on the accounting profession's obligation of independence and the constraints that such obligations may impose on its ability to provide tax planning advice to clients. In addition, it outlines the standard of care applicable to tax advisory work, as well as the similarities and differences in the scope of the fiduciary duties owed to their clients by tax lawyers and tax accountants, particularly in terms of their duty to disclose, their duty of confidentiality and their duty to prevent conflicts of interest. EVOLUTION OF TAX PRACTICE IN CANADALawyers were, prior to 1971, considerably more active than accountants in the area of opinion work and tax litigation, while accountants were more active on the tax compliance side. Prior to 1971, it was rare to find lawyers practicing in accounting firms. Following the adoption of the massive tax reform measures proposed in the 1966 Carter Commission Report, the law grew in volume and in complexity. More and more, in-depth legal knowledge was required to perform effectively within the tax advisory practice. Legal education and training were now required to engage in complex tax analysis. In fact, the practice of tax mandated from that point on, in addition to a solid grasp of the basic income tax concepts, an understanding of the legislative history, purpose, hierarchy of judicial precedent and an application of private law concepts to particular transactions. For example, the distinction between a sale and a lease is often germane to the determination of the tax consequences of a particular transaction. As the importance of legal training and legal education was recognized within the tax practice, accounting firms began to embrace lawyers as associates and partners. The understanding of accounting concepts such as the appropriate revenue recognition principles is equally important. In recognition of the foregoing, the tax advisory market is served by both lawyers and accountants. The distinction between what is properly the practice of law and what is not is occasionally rather fine, although there are cases where the distinction is clear. Few would dispute that tax litigation and the preparation of legal documents that create rights and obligations between parties and which have tax consequences are clearly areas of practice for lawyers. Financial analysis and the proper recording of the tax consequences of a transaction in corporation's financial reports including the adequacy of a tax provision are properly areas of practice for accountants. While, in general terms, lawyers have restricted their practice in the area of tax to the practice of law, accountants for the most part, have been more aggressive in their pursuit of advisory work in the tax area. Accounting firms have been actively pursuing and obtaining market share by providing tax advice in transactional matters where the tax analysis is often based on a legal analysis of the characterization of the rights and obligations created between parties. It is no secret that accounting firms were actively seeking entry into the legal services market to gain a large portion of the lucrative transactional market, although lawyers in general have been cautious in exploring the accountant's overtures in areas other than tax. The goal of the full-fledged multi-disciplinary practice embracing accountants and lawyers is currently being re-examined in light of the auditor's duty of independence. Few doubt that the Enron scandal and other more recent financial scandals and the Sarbanes-Oxley Act of 20024 will have an inhibitory impact on the prospects of such multi-disciplinary practices. Constraints Imposed by the Auditor's Independence Obligations on the Provision of Tax ServicesThe corporate scandals associated with the meltdown of such corporate heavyweights as Enron, WorldCom and Adelphia have re-emphasized how crucial are sound and trustworthy corporate financial statements as the primary source of reliable information to guide the decisions of the investing public. The credibility of these statements is absolutely essential to obviate investors' fear of losing their savings as a result of relying on inaccurate and misleading information. The stock market collapse reversals that has ensued from these scandals have demonstrated how much investors' confidence is key to the free enterprise wealth creation process: without that confidence, companies are restrained in their ability to raise money on the capital markets, strong investment in the various industries of a country's economy is restricted, and the promotion of economic growth and prosperity is impaired. To control the accuracy of the financial data available to investors in the capital markets, securities regulations applicable in the various jurisdictions require publicly held corporations to file their financial statements with applicable securities commissions and distribute them to their shareholders. These regulations also require that the financial reports submitted be audited by chartered or certified public accountants in accordance with the "generally accepted accounting principles" in Canada5 or with the "generally accepted auditing standards" applicable in the United States.6 In Canada, the conduct of audits is also mandated by the Canada Business Corporation Act, for federal corporations, or by provincial Corporation Acts, which mostly follow the federal scheme.7 By examining corporations' books and records and obtaining such other information and explanations as they consider necessary to determine whether the financial reports have been prepared in accordance with generally accepted accounting principles and then, by issuing opinions as to whether the financial statements, taken as a whole, present fairly the financial position and operations of the corporation for the relevant period, the accounting profession provides comfort, in the form of an independent professional opinion, as to the trustworthiness and credibility of the information conveyed to the capital markets regarding the financial status of corporations. The numerous scandals affecting the accounting profession, revealed following the burst of the stock market bubble, have undeniably re-emphasized, in the eyes of the legislator, as well as the general investing public, how fundamental the auditor's independence is to the functioning of an economy based upon free enterprise and the widespread marketability of corporate securities. The credibility conferred on the financial statements of a corporation reported upon without qualification by an auditor depends upon public confidence in the outside auditor as an independent professional. Independence, as presented by Kay and Searfoss,8 may be defined as an auditor's ability to act with integrity and objectivity. Integrity refers to an individual's ability to make difficult ethical decisions by correctly applying categorical rules of behavior to particular cases and by weighing the costs and benefits of alternative actions from the viewpoint of all persons who may be affected. Objectivity refers to an individual's ability to be impartial. In brief, the independent auditor must analyze the financial results with professional skepticism. In many respects the role performed by an auditor in auditing the corporation's financial accounts to arrive at an audit opinion is similar to the role of the judiciary. In both cases, the required mindset is one of impartiality and objectivity which is preserved only by isolating oneself from the influence that may be exerted by interested parties. These two fundamental values summarize, given the very nature of his duty, the essence of what an auditor ought to be. They underline the fact that corporate auditors should be acting exclusively as reviewers, not as business consultants bent on giving management advice, not as business partners, and not as advocates or representatives of any special interest, particularly of a company's management. To avoid compromising the auditor's required mindset of independence, the audit firm should refrain from auditing its own work product or strategies implemented by management on the basis of a recommendation made by the same audit firm. This is not intended to be a blanket assertion that auditors are incapable of remaining objective while undertaking an attest review involving tax planning recommended by fellow colleagues. In such circumstances, however, it is clear that the auditor will have difficulty satisfying the public's expectation of total independence in performing the attest function, as there can always be room to suspect that the auditor may have been influenced in his decision by his firm's economic interest in the fee arrangement, lobbying from fellow tax professionals, or management domination exercised through the award of more lucrative non-audit mandates. Tax is often a field that affords itself to higher fee arrangements and raises the potential for this type of influence and conflict when delivered to an audit client. Tax consultants working for accounting firms devote significant resources to the development and marketing of tax planning products aimed at exploiting perceived loopholes in the law. This area of practice often presents the best opportunity for "value billing" based on a percentage of the perceived tax savings. In many cases, clients and external advisors are required to sign letters of confidentiality prior to the presentation of the planning opportunity. In this particular area of practice, it is not unusual to find persons dedicated to the presentation function who are steeped in advocacy and marketing skills. The formal presentation of the tax mitigation strategy is generally made in a sophisticated PowerPoint document which, more often than not, highlights the financial impact of the strategy, especially the positive impact on earnings per share. It is no secret that corporations prefer to implement tax mitigation strategies in circumstances where the auditors have agreed that the tax benefits may be fully recorded in the financial statements without a reserve. In some cases, the tax planning is dependent on the accounting treatment. For example, if a debt qualifies for off-balance sheet treatment, a capital tax benefit may be secured. There is no question that this area of practice presents the greatest risk of potential conflict with an auditor's duty of independence. The marketing of tax products involves partiality and advocacy - the opposite mind set to the independence required of an auditor. Some of the firms have adopted the practice of demanding execution of a confidentiality agreement when presenting a tax mitigation strategy to an audit client. The problem with this promotional method lies in the fact that the client is prevented, by the terms of the contract itself, from assessing whether it is getting appropriate value for the services paid for as the confidentiality agreement limits the ability of the client to seek advice elsewhere. Very few professionals are willing to be bound by a confidentiality agreement which may curtail their ability to provide tax advice to other clients. A refusal to sign the confidentiality agreement may preclude the corporation from receiving a second opinion. Secondly, the practice is inconsistent with the very nature of the auditor's duty to the corporation's shareholders and creditors insofar as restraints are placed on the corporation to disclose transactions which may have an impact on the adequacy of their tax reserves. Such conduct, potentially to the detriment of the interest of the client, does not allow the client the possibility of ascertaining whether the professional is effectively putting his duty toward the corporation's shareholders and creditors ahead of his own economic self-interest. At the very least, such a situation gives rise to a clear appearance of conflict, which is difficult to reconcile with the explicit duty of audit independence. It is interesting to contrast the practice of marketing tax mitigation strategies to management and in some cases requesting the execution of a letter of confidentiality prior to proceeding with the presentation of the strategy with the role of the auditor in reviewing the adequacy of a corporation's tax reserves. An important aspect of the auditor's function is to evaluate the adequacy and reasonableness of the corporation's provision for future tax liabilities and the accuracy of recording future tax "assets" on the balance sheet. The account for future income tax liabilities represents an amount notionally set aside by the corporation to cover adjustments and additions to the corporation's cash tax liability. Additional corporate tax liability may arise from a wide variety of transactions and from a corporation's awareness of, and preparedness for, the possibility of an assessment of additional taxes. In contrast, the account for future tax assets represents amounts associated with a future reduction in the corporation's actual tax liability. The Supreme Court of the United States has described the mandate of the independent auditor regarding the treatment of a corporation's tax accounts as follows:
The Court's statement stands for the proposition that the auditor must question the tax strategies implemented by management with professional skepticism. The certification process of a company's financial statements, the essence of an auditor's function, will entail a review by an auditor of his own firm's work when the tax planning was performed by a tax professional colleague within the same firm. Whether such oversight over a firm's own advocacy work constitutes a fundamental infringement of the independence requirement imposed on auditors has long been the subject of debate.10 Members of the accountancy profession have traditionally argued that the delivery of such tax services by an audit firm to a corporation represented an integral part of the audit mandate given that the treatment of a corporation's tax was included into its financial statements. Nevertheless, when an auditing firm's tax work goes beyond simple tax compliance and morphs into tax planning, the line between a mandate limited to independent oversight provided for the benefit of the shareholders, traditionally associated with the accounting profession, is crossed, to reach a category of services associated with an advocacy function, where the defense of the interests of company management often prevails. The Enron financial scandal illustrates how auditor independence may be compromised through the provision of non-audit services that lead to structuring advice being given on transactions that will be the object of the auditor's audit. In the months following the collapse of Enron, Enron's board of directors appointed William C. Power Jr. to head up a special investigative committee to investigate the off-balance transactions structured between Enron and partnerships controlled by certain of the Enron executives. In its report,11 the committee concluded that the accounting firm was extensively involved, not only in determining the proper accounting treatment to be afforded to the partnerships, but also in structuring the partnership to ensure off-balance sheet treatment or to allow for losses on merchant investments not to be booked on the basis that Enron was sheltered from such losses as a result of the implementation of total equity swaps entered into with adequately capitalized special purpose vehicles. The accounting standards used to keep financial obligations off balance sheets proved to be inaccurate as Enron was ultimately responsible for such financial obligations. The special purpose vehicles borrowed money, backed-up by Enron's contribution of its stock or its undertaking to issue stock, if required. Once it was discovered that the special purpose entities had insufficient capital to meet their obligations, Enron had no choice to record the obligations or losses. While we may never know all the reasons that led to relaxed audit standards in the case of Enron, it is not difficult to conclude that part of the problem lay with the fact that the accounting firm was deeply involved in the structuring of the partnerships as an advocate of management, who were interested in implementing accounting schemes to embellish Enron's financial results. In short, the accounting firm, in working to achieve management's goal, compromised its ability to review the transactions with objectivity and impartiality. In its findings, the investigative committee noted that a representative of the accounting firm was in the room when management presented the outline of the special purpose vehicles to Enron's board of directors. The inference encouraged by management by having the Andersen representative in the room with them during the board presentation was that the accounting firm had "signed off" on all of the structures. Following Enron's collapse, Arthur Andersen & Co. established an Independent Oversight Board chaired by Paul A. Volcker. The Independent Oversight Board published its recommendations for Andersen in a report dated March 11, 2002.12 The Board outlined significant structural changes to recognize the priority of protecting the independence of the audit function. In its first recommendation, the Board stated as follows:
The Independent Oversight Board concluded that the promotion of so-called aggressive tax mitigation strategies, advocacy unrelated to auditing which would include tax controversy work and legal services were all incompatible with the audit function and that these activities had to be separated from the accounting firms to avoid inherent conflicts of interest. With respect to acceptable non-audit services, the Board's recommendations are clear: the approval of the mandate should be delegated to the audit committee. While the Independent Oversight Board could not raise the Andersen phoenix from its ashes, many of its recommendations have found a home in the Sarbanes-Oxley Act. The requirements imposed upon auditors to be independent in order for them to be allowed to certify the financial statements of a public issuer,14 also mandated under the various applicable codes of ethics,15 have now been considerably strengthened. Judging the performance of some non-audit services concurrently with audit services as incompatible with an independent status as auditors, the U.S. legislator has enacted the Sarbanes-Oxley Act, which imposes on United States public accounting firms an outright ban preventing them from performing, contemporaneously with an audit any of the following non-audit services for any issuer: (1) bookkeeping or other services related to the accounting records or financial statements of the audit client; (2) financial information systems design and implementation; (3) appraisal or valuation services, fairness opinions, or contribution-in-kind reports; (5) internal audit outsourcing services; (6) management functions or human resources; (7) broker or dealer, investment adviser, or investment banking services; (8) legal services and expert services unrelated to the audit; and (9) any other service that the Board determines, by regulation, is impermissible.16 [Emphasis added] These new measures apply, in addition, to all non-U.S. based issuers who have gained entry into the U.S. capital markets, or, for that matter, who wish to gain entry into the U.S. capital markets. Most of the major Canadian issuing corporations are now subject to these rules. Auditors may provide non-audit services, including tax services, that are not expressly enumerated in paragraphs 1 to 9 above, provided that such non-prohibited audit services are pre-approved by the corporation's audit committee. The unfettered decision-making power to award non-audit services mandates has been removed from management to create an additional firewall designed to re-assure the public that a perceived source of management's influence on the auditor's conduct has been eliminated. Management can no longer hold out the promise of lucrative non-audit service mandates nor threaten the auditor with forfeiture of such mandates. In practical terms, the CFO or tax director of a Canadian corporation which has issued securities in the U.S. can no longer hire his auditors to perform non-audit tax services which do not fall with the list of prohibited services without seeking the pre-approval of the corporation's audit committee, which now has a duty to determine whether such a mandate may conflict with the auditors' obligations of independence and impartiality. This new requirement may lead the CFOs or tax directors to conclude that it is simpler to engage another firm, not aligned with the company's auditors, to provide external tax services. In the latter case, as there is no conflict with the auditor's independence imperative, the CFO or tax director would maintain full discretion as to the scope of the mandate and the fee arrangement. In addition, awarding the mandate to somebody that is not aligned with the auditor also leads to a better check and balance system, as the audit firm must still sign off on the financial reporting of a proposed tax mitigation strategy. Understanding the distinction between an audit and non-audit service and distinguishing, in the latter case, between a prohibited and non-prohibited service is an important exercise in the context of providing tax advice to an audit client that has issued securities in the U.S. capital markets. The determination of a corporation's tax liability, deferred and actual, is clearly an audit function which is not prohibited, and for which no special consent from the audit committee is required. On the other hand, tax opinion work, tax advocacy and litigation and the proposal of tax mitigation strategies require a scrupulous review of the enumerated prohibited services as a pre-requisite to determine whether the audit committee can, in the first instance, authorize the provision of the particular non-audit service by the firm's auditors. The inclusion of legal services as a prohibited service raises the issue whether certain types of tax services are prohibited on the basis they constitute legal services. The inclusion of legal services as a prohibited service is not new policy. The Securities and Exchange Commission (the "SEC") has long been regulating the practice of audit firms to limit the conflict existing between the role of an independent auditor and that of an attorney.17 The SEC's decision was based on the United States Supreme Court's decision in United States v. Arthur Young & Co.18 In that case, the Court was asked to determine whether an accountant had a work-product immunity for his tax accrual work papers which the IRS was seeking to obtain by way of a subpoena. Burger J. highlights the differences in the duties of accountants and lawyers as follows:
More recently, the SEC reiterated in the administrative proceedings pertaining to the matter of Charles E. Falk, CPA,19 the existence of a fundamental conflict between the roles of independent auditor and attorney. Under rule 2-01 of the Regulation S-X, the SEC requires that the financial statements of the issuers subject to its jurisdiction be certified by public accountants who are independent of the issuer. It is the SEC's responsibility to determine the meaning of independence in that context. As set forth in Rule 2-01(b) of Regulation S-X, in ascertaining whether an accountant is independent of a particular person, the SEC "will give appropriate consideration to all relevant circumstances, including evidence bearing on all relationships between the accountant and that person and will not confine itself to the relationships existing in connection with the filing of reports with the Commission." In interpreting Regulation S-X, the Commission stated that "certain concurrent occupations of accountants engaged in the practice of public accounting involve relationships with client which may jeopardize the accountant's objectivity and, therefore, its independence [...]. Acting as counsel [is one of the] occupations so classified."20 In conformity with the above stated principle, the findings of the SEC in Falk were to the effect that:
Germane to the SEC decision in Falk, in spite of its noticeable absence from the wording of the judgment, is the notion of "legal services". If one is to be prevented from acting as both a counsel and an auditor with respect to an issuer falling under the jurisdiction of the SEC, the services that are of such nature as to fall under the heading of "legal services", and therefore involve one fulfilling an advocacy role, must be circumscribed. The SEC's former policy on the definition of legal services was to define legal services as services for which the person providing the service must be admitted to practice before the courts of a United States jurisdiction. However, the SEC added the proviso that legal services cover all services that required the person providing the service to be a licensed attorney in the U.S. and that the rule does not apply only to appearance in courts or solely to litigators.22 The term "legal services" is undefined in the Sarbanes-Oxley Act. It is, however, an important term. If one concludes that the particular mandate sought by the tax professional whose firm acts as auditor is in the nature of a legal service, the mandate would be prohibited and the audit committee would have no jurisdiction to approve it. A sharp line cannot be drawn between what constitutes the field of lawyers and what rightfully belongs to the field of accountants. Undoubtedly, any service falling wholly into the practice of law cannot legally be rendered by the accountant or any other person without constituting the unauthorized practice of law. Yet, accountants and other non-lawyers who have subjected themselves to the necessary enrollment process, are allowed to represent the public before the Internal Revenue Service and the U.S. Tax Court. Even though the U.S. State Bars themselves appear to have bowed to the pressure arising from the accounting firms and nodded to the expansion of their practice, the law as it now stands in the United States would tend to suggest that some of these practices have exceeded the generally avowed necessity of providing tax services incident to the preparation of income tax returns or financial statements to fall into the rendering of legal services. In order to clarify the boundaries of the practice of law, one must first look at what is clearly encompassed by the practice of law. As a general statement, one could regard the practice of law as being the provision of services for which legal education and training is required. Few would dispute that questions involving statutory interpretation, whether tax or otherwise, analysis of private law to determine legal rights and obligations of parties to economic transactions for the purpose of determining the underlying tax consequences, opinion and tax advocacy as well as litigation work require a significant level of legal education and training. If legal services were construed in this manner, practically speaking, it would mean that only tax compliance work would not be prohibited and could be approved as a non-audit service to be performed by the firm's auditors. Further guidance may be obtained by keeping in mind the purpose that led the legislature to leave the exclusive occupancy of the field of law to members of a bar. That purpose was to protect the public from the evils which are brought upon people by those who assume to practice law without having the proper qualifications:
The idea that the public interest is not well served by leaving certain fields of law that require multidisciplinary abilities to the exclusive care of members of a bar led to the enactment of federal legislation in the US allowing the access by non-lawyers to practice before a certain number of administrative forums. Such access was legitimized and the surrounding legal uncertainty cleared by the U.S. Supreme Court decision in Sperry v. Florida.24 The factual background behind the findings of the Court involved the rendering, by a non-lawyer who had never been a member of the bar of any State, of services including the representation of patent applicants, the preparation and prosecution of their applications and advisory services in connection with said applications to the Patent Office in the State of Florida. The Florida Bar sued to have these acts declared illegal and representing the unauthorized practice of law and asked the court to enjoin the defendant from performing these acts. The Court based its analysis on the premise that, under Florida law, the preparation and prosecution of patent applications for others constituted the practice of law. In spite of this finding, it concluded that such practice was lawful for it had been not only condoned but even legitimized by a federal legislation. The Court reiterated the recognized principle according to which "the law of the State, though enacted in the exercise of powers not contraverted, must yield" when incompatible with federal legislation.25 However, as will be made apparent from the following analysis, the conclusions reached in the case are hardly applicable to a situation involving tax services as they are based on a particular set of rules distinguishable from the body of law relating to the practice before the I.R.S. and the U.S. Tax Court. Noticeably absent from the face of the statute granting non-lawyers a limited right to practice before the Patent Office of the State of Florida in patent application proceedings was a provision to the effect that such authorization should not be construed as authorizing persons not members of the bar to practice law. The absence of such provision was perceived by the Supreme Court of the United States as an indication that Congress intended to break with the tradition of deferring to the State power to regulate the practice of law:
This conclusion should be contrasted with the one reached in Agran v. Shapiro.27 In that latter case, an accountant who was not a member of any state bar but was nonetheless admitted to practice before the IRS had prepared a client's tax returns for several years. In addition to the work performed, the accountant researched and actively pursued a claim on behalf of his client with respect to carry-back business loss that was denied by the IRS. While the first portion of his work relating to tax return filing was found not to constitute the unauthorized practice of law, the second portion was characterized as being within the field of lawyers. The judgment stated as follow:
The judgment rendered in Agran was referred to by the U.S. Supreme Court in Sperry but was not overturned as the Florida statute involved in the latter did not contain the clause discussed in Agran. As was previously stated, the U.S. Supreme Court based, in part, its decision in Sperry on the absence of a clause deferring to the State's jurisdiction over the practice of law. Thus, the value of the decision in Agran as a precedent seems unaltered. Such conclusion brings us back to the original questioning as to what exactly is covered by the definition of "legal services", knowing that the entire tax field has not been brought into the realm of accountancy by the limited access that was granted to accountant to act on behalf of clients before the IRS and the U.S. Tax Court. The Courts have struggled with the definition of legal services in the tax area. In the case In Bercu, a leading case on this issue, the Supreme Court of New York, Appelate Division, established that the first test to be applied by the courts was to be referred to as a nature of services rendered test.29 Thus, the Court ruled that giving legal advice unconnected with accounting work constitutes the practice of law. In the words of the Court, an accountant can "advise on the tax issue if it arose during the preparation of the tax return, but not if an identical issue was the subject of a separate engagement." The second test developed by the courts focused on the difficulty of the services rendered as opposed to the nature of the services.30 Under the latter test, which is less restrictive, the courts ascertain whether the legal questions at issue are difficult or doubtful to such a degree that to safeguard the public, they demand that somebody who has formal legal training perform the service. The first test was disavowed in favor of the latter in Agran on the basis of a reasoning that was also endorsed by the Supreme Court of Minnesota decision in Gardner:
Even though some uncertainty still remains as to whether the first test referring to the incidental nature of the work performed was permanently deleted from the law by the two above stated cases,32 the sophisticated tax planning services offered by accountants and transactional work performed by their firms cannot be considered incidental to the filing of tax returns or the performance of accounting work. While the exact meaning of the reference to "legal services" within the Sarbanes-Oxley Act remains unclear pending specific consideration by the courts or clarification by the SEC, one element appears relatively certain. Under the SEC's rules,33 accounting firms were generally prohibited from providing an audit client with legal services, but only in circumstances in which the person providing the services had to be admitted to practice before a court in the United States. This meant that accounting firms could provide legal advice on virtually any aspect of foreign law from locations outside the United States. Under the Sarbanes-Oxley Act, the provision of any type of legal services by the auditor to the company that has issued securities in the United States is now expressly prohibited. The absence of specific definition of the term "legal services" in the Sarbanes-Oxley Act does not justify one to conclude that such term has the same meaning as in the context of the SEC `s Regulation S-X. This construction would run afoul of the avowed purpose of the statute to prevent situations such as that in Enron where auditors' interests became so intertwined with those of its audit client as to render the independence of the former questionable. Moreover, if the SEC's Regulation S-X definition of "legal services" was maintained, U.S. based issuers would likely face greater restrictions than foreign issuers as the former are more likely to require legal services from U.S. legal service providers. This would be contrary to the legislative intent of the Sarbanes-Oxley Act which is to impose similar rules on foreign based issuers that access U.S. capital markets. As Congress has found that the provision of legal services creates conflict with an auditor's duty of independence, the potential for conflict surely exists regardless of the jurisdiction where the services are performed. An additional difficulty that may arise in connection with the extension of the application of the Sarbanes-Oxley Act to foreign issuers lies in the definition of legal services rendered in a foreign context. More specifically, will the definition of "legal services" adopted by a given foreign jurisdiction govern the determination of whether an auditor providing such services in the given jurisdiction engaged in a prohibited non-audit service? In light of the reluctance of the U.S. government to defer to the judgment of foreign jurisdictions in other areas of law, one can doubt that a definition other than the one set forth by the U.S. authorities will be given credit. Thus foreign legal services are likely to be considered "legal services" if the provision of such services in the United States would constitute the practice of law in the United States. The overtures made by accountants in the 1990s to members of the legal profession to join in multidisciplinary practices sought to capitalize on the notion that the firm's audit clients would prefer one-stop shopping. Clearly, this proposal will have to be revisited in light of the fact that U.S. issuers are now prohibited from giving legal mandates to their auditors or persons associated directly or indirectly with them. The numerous reported departures from Donahue & Partners since the publicity attached to the Enron scandal illustrate that many legal practitioners have already seen the writing on the wall. It is much more likely now that only lawyers specializing in the tax area will practice alongside accountants. To fulfill their enhanced oversight duties, audit committees must now adopt the standards that they will follow in deciding whether a non-audit service mandate, including a tax service mandate, may be granted to the firm's auditors. The legislative history of the Sarbanes-Oxley Act may help audit committees in determining the proper standard:
The types of non-audit services which are now expressly prohibited under the Sarbanes-Oxley Act and the rationale underlying such prohibition provide additional insight for audit committees who wish to formulate their own codes of conduct in carrying out their important oversight function of the auditor's obligation of independence. Bookkeeping, other services related to accounting records or financial statements, and internal audit outsourcing services are prohibited, as they place the auditor in the position of auditing his own work product and identify the auditor too closely with management. Financial information systems design and implementation is prohibited, as this is perceived as an important management function. If the audit firm helps management design and implement a new financial information system, there is a perception that it would be difficult for the auditor to conclude that the financial information system is flawed or that the staff was not properly trained in his report to the audit committee, since such a conclusion may be an admission that the mandate was not properly performed. Appraisal and valuation services are prohibited as, in many cases, these types of services are performed in mid-year prior to completion of the audit. There is a suggestion that an auditor would be reluctant to question, for example, whether the goodwill of the corporation is impaired if a fellow colleague has performed an appraisal or valuation service early in the year on the matter. Actuarial services are prohibited for similar reasons. Management functions or human resources are perceived as creating too close a bond with management. The argument is, for example, that the audit firm which performs a management search for the audit client would be reluctant to criticize a candidate placed with the corporation. Broker, dealer, investment advisory and investment banking services are perceived as creating a financial interest of the auditor in the audit client which may lead to a reluctance in divulging unfavorable financial information. Finally, legal services are prohibited, as the role played by a lawyer is viewed as being inconsistent with the independent mindset that an auditor must maintain. The list of prohibited services reveals a common trait. In some cases the prohibited services place the accountant in a position of auditing his own work. In other cases, it leads the auditor to fulfill a management role, or act as an employee of the audit client, or places the accountant in a position of being an advocate for the client. All of these cases are considered to be in conflict with the auditor's obligation of independence. With this background in mind, we should focus on a few examples in the area of tax practice. Is there an inherent conflict with the duty of independence if the audit firm performs a transfer pricing study for an audit client? It is not unusual, in the context of a transfer pricing study, that management is seeking justification for a favored transfer pricing methodology that minimizes tax by capturing revenue in low tax jurisdictions and recognizing expenses in high tax jurisdictions. It is no secret that transfer pricing is an important component in establishing the level of profit earned by corporations that engage in a multitude of non-arm's length transactions. A transfer pricing study would involve the choice of the appropriate methodology, including a conclusion as to the right comparables, and will involve the services of non-tax experts such as economists. It is not uncommon for management to exert pressure on the professionals to choose the optimum transfer price. A transfer pricing study raises issues very similar to an appraisal or valuation service mandate. First, the auditor would be obliged to audit the work product of his fellow colleague in determining whether or not the tax reserves in the corporation's accounts are adequate. Can the auditor act as an impartial and objective reviewer in challenging the appropriateness of the margin or the methodology used in establishing the transfer pricing in assessing the adequacy of the corporation's tax reserve when a fellow colleague has performed the work? How can the auditor determine that his colleague's judgment was not influenced by management's desire? A similar observation can be made when the auditor's firm helps defend a tax contestation. In the defense of a tax contestation, the tax professional's duty is to present his client's position in the best possible light. In doing so, he clearly becomes an advocate of the corporate client. In addition, he may also be defending a strategy that his firm has recommended to the corporation for implementation. How can the public be assured that the auditor, in separately reviewing the issue as part of the audit function, will not be influenced by colleagues who are performing an advocacy function in a decision not to include a reserve for the matter under dispute? How can the public be reassured that there is no inherit conflict where the advocacy function is being performed for a tax mitigation strategy presented to the audit client by the audit firm? Let us assume that Firm A provides the audit function for its client, ABCco, a public software company. The CFO is anxious to reduce the corporation's effective tax rate to increase earnings per share. The corporation is trading at 30 times profits and a $2 million reduction in taxes could give rise to a $60 million increase in the corporation's market capitalization. The audit firm's tax specialist suggests an offshore software licensing company and undertake to complete the mandate for a fixed fee of $2 million. The tax specialist reviews the status of the corporation's software products to determine which product are still in an early stage of development and are candidates for an outright transfer to Offshoreco. The CFO is conscious of the benefits that can be secured if he can convince the tax specialists that early stage software have very little value. The audit firm and the CFO agree on the product that will be transferred outright to Offshoreco for a nominal value. Shortly thereafter, the development of the software of Offshoreco is completed through a research and development cost sharing agreement with ABCco. The software transferred to Offshoreco is well received in the market place. A significant amount of royalty income is earned by Offshoreco in its first year of operation which is subject to a very low tax rate. The income realized by Offshoreo constitutes a material portion of the total consolidated income of ABCco. The net profit recorded in the quarterly financial statements that were issued by ABCco during the year, were significantly improved from the prior years as the tax expense was calculated using the low tax rate applicable to the income earned by Offshoreco. The rate differential between income earned in Canada and at the level of Offshoreco is 30%. As the Offshoreco structure has a material impact on ABCco's financial results through a lower tax expense, the audit firm must consider the structure in its judgment regarding the accuracy of the client's reserves for taxes. A significant tax reserve may be required to cover off the tax risks with the structure. If the auditors book a significant tax reserve, this means that ABCco has significantly overstated its income in its quarterly financial statements. In addition, if they book a significant tax reserve, this will constitute a red flag for the tax auditor. Assume that there has been a substantial run-up in ABCco's share price as a result of the lower tax expense flowing from the international structure. The CFO is likely to resist a tax reserve. In the circumstances, the CFO is likely to argue that he relied on the advice of the tax specialist of the audit firm and the corporation paid a handsome fee for the structure. In this case, the audit firm is in a bind. If the reserve is booked at year-end, this could result in a significant drop-off in ABCco's share price. This could prompt shareholders lawsuits. However, there is a significant tax audit risk which could justify an increase in ABCco's tax reserves. In the circumstances, it is doubtful that the auditor can exercise the requisite professional skepticism in his review of the adequacy of the corporation's tax reserve. If he increases the tax reserve, he will cast doubt on the soundness of the tax plan put forward by his colleagues. Audit committees may adopt a restrictive standard for non-audit tax services in light of these indications of legislative intent. The safest standard to avoid conflicts with the independence imperative is to grant all non-audit tax work, perhaps with the exception of tax compliance, to professionals, accountants or lawyers not aligned with the audit firm. The suggestion is that almost all tax mandates with the exception, perhaps, of tax compliance determination, require advocacy and, in the case where the mandate is performed by the firm's auditors, will lead to circumstances in which the auditor must review his own work product. At the very least, the audit committee should enquire whether the particular tax service mandate which the corporation's auditors are seeking approval presents the potential for conflict which is similar in nature to the potential conflicts which the list of prohibited services is designed to avoid. Specifically their deliberations should focus on whether the auditors will be required to perform an advocacy function or review their own work product in the audit of the corporation's financial records. We suggest that anything less would be contrary to the spirit of the Sarbanes-Oxley Act which requires the audit committee to perform a supervisory function of the auditor's duty of independence. Audit committees are likely to take a cautious approach for fear of exposing both themselves and the company to new litigation based on a claim that, by reason of their actions, the auditor's independence has been compromised. One of the consequences of the recent financial failures and the heightened duties that the Sarbanes-Oxley Act places on audit committees is that premiums for director liability insurance are likely to increase significantly. It would not be surprising were insurance companies to re-think the conditions of coverage for the directors and impose, as a condition of coverage, that all non-audit services be performed by someone other than the company's auditors. One can easily imagine how, in future litigation involving financial failures, the plaintiff bar will scrutinize the audit committee's actions in authorizing non-audit services to be performed by the firm's auditors. If the audit committee consistently awards non-audit tax service mandates to the firm's auditors, it is likely that this conduct will be challenged as compromising the auditor's duty of independence in a lawsuit instigated following a restatement of the corporation's financial results. As the Sarbanes-Oxley Act demands a heightened level of scrutiny, auditors themselves are liable to be subjected to new claims founded on the basis that they failed to remain independent in their duties by soliciting and accepting non-audit mandates from their audit clients. Assuming that the Sarbanes-Oxley Act is applied strictly by audit committees, the trend may lead to the separation of the audit function and the establishment of new multidisciplinary firms not engaged in audit work. While it may take time to get there, the result would be a fresh start for the audit profession, which then could reassure the public that the audit on which they relied was conducted by truly independent professionals whose professional opinions are free of bias and inherent conflict, and do not involve a review of their own work product. The prohibition against providing these non-audit services concurrently with audit services to a client complements already-existing regulation in the United States that allows for the SEC to assess, on an individual basis, whether the independence of auditors is compromised given the extent of their relationship with an issuer.35 In considering this standard, the SEC looks to whether a relationship or the provision of a service: 1) creates a mutual or conflicting interest between the accountant and the audit client; 2) places the accountant in the position of auditing his or her own work; 3) results in the accountant acting as management or an employee of the audit client; or 4) places the accountant in a position of being an advocate for the audit client. The SEC will not recognize an accountant as independent, with respect to an audit client, if the accountant is not (or a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the accountant is not) capable of exercising objective and impartial judgment on all issues encompassed within the accountant's engagement. In determining whether an accountant is independent, the SEC will consider all relevant circumstances, including all relationships between the accountant and the audit client, and not just those relating to reports filed with the SEC. Moreover, under the Sarbanes-Oxley Act,36 public accounting firms will be prevented from providing audit services to an issuer if the lead (or coordinating) audit partner (having primary responsibility for the audit), or the audit partner responsible for reviewing the audit, has performed audit services for that issuer in each of the five previous fiscal years of that issuer. These modifications and the level of oversight provided by the SEC underline how public perception has evolved into reliance on a much more government interventionist agenda, which is now widely recognized, in the United States at least, as necessary to maintain genuine auditor independence. Canadian regulators have also started to propose measures to strengthen confidence in the capital markets and in the credibility of financial statements. Federal and provincial regulators and Canada's Chartered Accountants have recently announced the creation of a new organization, the Canadian Public Accountability Board (CPAB), to oversee the auditors of public companies in Canada.37 The CPAB will provide: 1) more rigorous inspection of auditors of public companies; 2) tougher auditor independence requirements; and 3) new quality control requirements for firms auditing public companies. New independence standards38 are being developed with the objective of moving Canadian auditor independence requirements to a world class standard, by incorporating SEC requirements for public company audits. In recognition of the public's heightened concern over the reliability of financial statements, the major chartered accounting firms have already agreed to approve and implement the enhanced auditor independence principles to be adopted by the CPAB when it is established late in 2002. To that effect, in September 2002, the CICA's Public Interest and Integrity Committee released a new draft independence standard to apply to Canadian auditors.39 The proposed standard requires that the lead engagement partner on a public company audit client be replaced after five years and that the individual cannot resume that role for two years, adopting the five-year period proposed in the Sarbanes Act. With regards to the limits on the types of non-audit services that firms may provide to their public company audit clients, the CICA's proposed standard would prohibit a firm from providing: (1) Financial statement preparation services and bookkeeping services to an audit client that is a listed entity, except in emergency situations; (2) Valuation services where the valuation involves matters that are material to the financial statements that will be subject to audit or review and the valuation involves a significant degree of subjectivity; (3) Actuarial services to an audit client that is a listed entity that provides insurance services, unless the company uses its own actuaries to provide management with its primary actuarial services; (4) Internal audit services to an audit client that is a listed entity that has over $50,000,000 in total assets (US $200,000,000 in the US), where the internal audit services represent more than 40% of the internal audit activities for the particular entity; (5) Designing or implementing a hardware or software system for an audit client that is a listed entity unless management takes full responsibility for all aspects of the project; (6) Legal services to an audit client that is a listed entity where the results of the service will be material to the financial statements; (7) Certain recruiting services that create an unacceptable self-interest, familiarity or intimidation threat for an audit client that is a listed entity; and (8) Certain corporate finance activities that create an unacceptable advocacy or self-review threat. It is quite surprising to note that under its proposed independence standard, notably regarding the delivery of non-audit services to audit clients, the CICA proposes a significantly diluted version of the previously described independence standards adopted under the Sarbanes Act. Indeed, the CICA proposes similar rules than the ones which were prevailing in the United States prior to the corporate governance scandals which triggered the recent wave of reforms.40 The collapse of Arthur Ardersen following the public disclosure of the extent of its relationship with Enron demonstrated that the measures that were in place in the United States at the time were plainly insufficient to guarantee the appropriate level of independence to fully fulfill their auditor's mandate and uphold the public trust in their profession. As highlighted in an extract from the Final Report of the Panel on Audit Effectiveness, mandated by the now defunct Public Oversight Board (POB), the exceptions contained within the former U.S. independence standards (as well as in the current CICA proposed standard) granted too much leeway for accountants to subjectively assess the applicability of exceptions under which they were allowed to avoid the general prohibition regarding the delivery of non-audit services:
Some skeptics might also observe that these measures once implemented would only be in the form of guidelines, with no separate legislative support and no specific legislative sanctions. Thus, establishing professional standards of conduct to preserve the required level of auditor's independence, especially concerning management and tax consultancy services by an audit firm, still remains a largely unresolved issue in Canada and, from a legal perspective, mainly uncharted territory. It is nevertheless to be hoped that the final CICA guidelines, to be released late in 2002, will follow the broadly supported U.S. initiatives and notably jettison the numerous exceptions contained within the list of prohibited non-audit services. As a final note relative to the proposed Canadian initiatives, some commentators have suggested that the Canadian regulators have been slow to respond to corporate financial fraud and audit failures in Canada. Part of this systemic problem is tied to the fact that securities regulation in Canada has been largely a provincial initiative, leaving Canadian securities regulation in a balkanized state with thirteen small securities commissions instead of one national agency. The coordination of public watchdog activities among the thirteen commissions is often difficult to achieve as is the adoption of similar rules that are applicable throughout the country. The provincial securities commissions are often under-staffed and under-financed. Some commentators have suggested that the regulators have become too cozy with the CICA and defer to the CICA, without attempting to assess what should be acceptable accounting rules and to establish a clear standard of practice for auditors.42 The adoption of the Sarbanes-Oxley Act is causing the Canadian securities regulators to re-visit their approach. If they do not adopt standards similar to those adopted in the Sarbanes-Oxley Act, the importance of their supervisory role will decline, along with their importance in the regulation of what may be left of an independent capital market in Canada. In any event, as some commentators have noted, for most major Canadian corporations, the adoption of the Sarbanes-Oxley Act means that the SEC is the principal regulatory authority. Code of Conduct for Audit Committee's Oversight Function of Auditor IndependenceAs described, corporate directors have a legal responsibility to shareholders, which includes ensuring that the corporation presents fairly its financial results in its financial statements. They must take care to be sure that they are, in fact, receiving the benefit of an independent opinion from the auditors and that such opinion is not affected by (or likely to be affected by) considerations arising out of other services performed for the corporation. Directors must be satisfied that the audit function is not compromised or they risk falling short of the duty of care they have assumed as directors. Former SEC Commissioner Bevis Longstreth testified before the Senate Committee on Banking, Housing and Urban Affairs. He suggested the following principles that may be adopted by an audit committee to determine whether a mandate for non-audit services should be awarded to the firm's auditors:
The Senate Committee in the legislative history of the Sarbanes-Oxley Act suggested that the audit committee must exercise its discretion judiciously in awarding non-audit services mandates to the firm's auditors as follows:
To achieve this goal, the starting point should be the adoption of an audit committee charter. Suggested guidelines related to the independence oversight mandate of the audit committee could be formulated as follows: (1) The audit committee should meet with senior management and the auditors to reinforce the message that the oversight of the auditor's mandate is a duty to be performed by the audit committee and not management. The audit committee approves the mandate, the billing arrangement and determines whether an audit mandate should be continued or terminated. Management should also be informed that all non-audit service mandates could only be performed by the auditors if pre-approved by the audit committee. As mentioned earlier, most large Canadian corporations listed on U.S. stock exchanges will have to adopt this policy to comply with the Sarbanes-Oxley Act; (2) The audit committee should make it clear that the principal mandate of the auditors is to perform the audit function with independence and impartiality and without interference from management. Moreover, the audit committee should outline specifically what services properly fall within the scope of the audit function; (3) They may wish to adopt the principle that the audit advisory function provided by an audit firm should be segregated from all other advisory services, the other services being performed by a different professional firm; (4) If the committee does not want to adopt such a strict standard, the governing principle that they may wish to consider is that all advisory services that may have an effect on financial statements or disclosures or which would lead to the auditors reviewing their own non-audit advisory services in the context of their review of the financial statements, would not be allowed, unless compelling reasons would justify otherwise; (5) If the auditors and management wish to seek approval for a non-audit service mandate to be performed by the auditors, e.g., a tax mandate, the audit committee should ask that the request for approval be put in writing; (6) The request for the approval of a non-audit service mandate could take the form of a retainer letter which would describe the scope of services to be performed and the billing arrangement. First, there should be a detailed explanation of why the service is not specifically prohibited. For example, in the tax advisory area, the audit committee should enquire whether the nature of the service is a prohibited legal service or requires extensive advocacy work on behalf of the corporation. The audit committee should enquire whether the implementation (or not) of any advice derived from the mandate will require the statutory auditor to express an opinion on the effect of such action on the financial statements. In circumstances where the mandate could lead to the implementation of recommendations that ultimately would have to be reviewed as part of the audit function, there should be an explanation why such service ought not to be performed by another professional not engaged in the audit; (7) If the audit committee determines that the mandate should be approved, and it involves the auditors reviewing their own work, then any recommendations flowing from the mandate should not be implemented until they are supported by an opinion from an independent advisor, an attorney or accountant, who has no connection, direct or indirect, with the auditors of the corporation. Such opinion should be provided not only to the corporation but also addressed specifically to the audit committee; and (8) The audit committee should keep detailed minutes of their deliberation and, where a non-audit service mandate is granted to the audit firm, record the reasons for concluding why the mandate does not raise an inherent conflict with the auditor's obligation of independence or, alternatively, steps that they have adopted to ensure that the independent relationship will be preserved. General principles underlying the professional responsibility of tax advisers toward their clientsGeneral description of the standard of practice of the legal tax professional While the common law does not require professionals to be infallible in the performance of their duties, they are nevertheless generally required to bring reasonable care, skill and knowledge to the performance of the professional service which they undertake.45 The requisite standard of care has been generally described as that of the reasonably competent solicitor/accountant, the ordinary competent solicitor/accountant and the ordinary prudent solicitor/accountant acting with the same degree of skill, judgment, and knowledge possessed by the other members of his profession.46 The conduct of the professional is therefore assessed on an objective, rather than a subjective, basis: the particular intent of the professional at the moment of any breach of his obligations will not be taken into account to assess whether he fulfilled them. This objective standard will be adapted to the status of the practitioner among his peers: there will be a significant difference between the standard of care required of the reasonably competent general practitioner and that which may be expected of the specialist, such as a tax expert. Under Quebec civil law and at common law, the relationship binding the tax adviser with his client is essentially contractual in nature. Professional tax advisors are required to respect the legal obligations arising from the contractual undertakings to which they have agreed. If they commit a breach of such obligations in the performance of the contractual undertaking, legal recourse under contract law will be available to the client to claim damages resulting from the breach. However, under the common law regime in Canada, other sources of legal obligations will also complement this primary recourse. The Supreme Court of Canada, in Central Trust Company v. Rafuse, concluded that a client, in the context of a malpractice action, had a concurrent cause of action against a solicitor in contract and in tort. As stated by LeDain J.:
Thus, if a plaintiff proves: (1) that the professional had a duty to the client to exercise due care (which is usually established on the basis of the terms of the engagement ); (2) that the professional breached that duty by failing to perform in accordance with professional standards; (3) that the professional breach was a proximate cause of the damages suffered by the client ; and (4) that the client suffered actual damages, then liability of the professional for negligence will also be established, recourse for which will be allowed to proceed concurrently with or as an alternative to the contractual recourse. The plaintiff will then be in a position to take advantage of the best regime available to him in his particular situation. This is of far more than mere theoretical interest since, among other things, the measure of damages and the limitation periods may differ, depending on whether the action is framed in contract or in tort. In common law jurisdictions, in addition to legal recourses against professional based on contract and tort legal basis, an additional source of liability can be found under equity, for breach of fiduciary duties. Fiduciary duties of tax professionalsThe cornerstone of a fiduciary relationship relies on the dependency of one party upon the power of another. A party becomes a fiduciary where, acting pursuant to statute, agreement or unilateral undertaking, it has discretionary power to act for the benefit of another which puts his trust in him, and therefore come to depend on him. In determining whether a relationship is fiduciary in nature, the court looks to the three core characteristics of a fiduciary relationship, as they were initially presented by Wilson, J. in Frame v. Smith: (1) The fiduciary has scope for the exercise of some discretion or power; (2) the fiduciary can unilaterally exercise that discretion or power so as to affect the beneficiary's legal or practical interests; and (3) the beneficiary is particularly vulnerable to or at the mercy of the fiduciary holding the discretion or power.48 As underlined by Sopinka J. in Lac Minerals Ltd. v. International Corona Resources Ltd.,49 this descriptive list does not represent an absolute legal test. A fiduciary relationship can be found even though all of these characteristics are not present. The presence of these ingredients will not invariably identify the existence of a fiduciary relationship. Nevertheless, vulnerability is the one feature considered indispensable to the existence of the relationship. LaForest J. in Lac Minerals50 proposed two broad categories of situations that could generally be used to identify fiduciary relationships. The first relates to relationships having as their essence discretion, influence, and an inherent vulnerability. A rebuttable presumption arises out of the inherent purpose of the relationship that one party has a duty to act in the best interests of the other party. The second refers to a slightly different situation, where fiduciary obligations, though not innate to a given relationship, arise as a matter of fact out of the specific circumstances of that particular relationship. Under such circumstances, the key is to determine whether, given all the surrounding circumstances, one party could reasonably expect that the other party would act in the former's best interests with respect to the subject matter at issue. Discretion, influence, vulnerability and trust are non-exhaustive examples of evidentiary factors to be considered in making this determination. Outside the established categories of fiduciary relationships, what is required is evidence of a mutual understanding that one party has relinquished its own self-interest and agreed to act solely on behalf of the other party. Obviously, under such criteria, the fiduciary qualifications will not extend to the contractual relationship established in the context of regular commercial endeavors. As is underlined by Laforest J. in Hodgkinson v. Simms,51 since commercial interactions between parties at arm's length normally derive their social utility from the pursuit of self-interest, the courts will be rightly circumspect before enforcing a fiduciary duty that would vindicate the very antithesis of self-interest. Parties, in all other respects independent, will rarely be justified in surrendering their self-interest so as to invoke the fiduciary principle. La Forest, J. stated in Simms that the determination of the presence and precise scope of a fiduciary duty depends on the particular facts of each case:
Nevertheless, it can be stated with conviction that the context of a professional advisor-client relationship, in sharp contrast to an arm's length commercial relationships, is generally embodied within the first category of fiduciary relationships identified by LaForest, J. Since trust, discretion, influence and independence are of the essence of the relationship between lawyers or accountants with their clients, a clear presumption in favour of the existence of such a fiduciary relationships will apply:
Moreover, in Simms, the Supreme Court of Canada underlined that the courts, in exercising their equitable jurisdiction, will enforce such fiduciary responsibilities, particularly in the context of specialized professional advisory services areas such as law, taxation and investments:
Accountants performing the functions of auditors of a corporation also operate in the context of a relationship funded on trust, confidence, credibility and objectivity with their corporate clients and their shareholders as a collective group. Recent Canadian jurisprudence has recognized this relationship as fiduciary in nature, as noted by Farley J. in Roman Corp. v. Peat Marwick Thorne:
Under current Canadian law, whether as a tax lawyer or as an accountant performing tax or audit functions, given the level of trust, disclosure of information and reliance on the skills and knowledge of the professional involved, the relationships between these professionals and their clients will generally be of a fiduciary nature. Such fiduciary relationships will be associated with certain core duties, such as the duties of confidentiality and loyalty, which will, in most respects, be common to both professions and be contained in their respective codes of professional ethics. A tax professional is required to make a complete disclosure to his client of any material information within his mandate. Materiality is governed by the principle that only a well-informed client is adequately equipped to give appropriate instructions to his tax advising professional. Being in a position of the highest confidence, the fiduciary is obliged to make his client aware of all matters relevant to the mandate with respect to which that confidence has been conferred.56 Such disclosure requirement is also of benefit of the professional. Thus, if a client gives specific instructions to the professional to act in a manner detrimental to the client's interests (contrary to sound advice given by the professional) or if a client acts upon his own decision without relying on the professional's advice, he will then not be allowed to complain about any resulting loss.57 This duty also imposes on professionals the obligation to inform the client promptly, without necessarily admitting civil responsibility, upon discovery of an error or omission that has occurred in the execution of their mandate, if the mistake may be harmful to the client's interests.58 As is the case with a professional's duty to preserve a client's confidential information, this duty does not cease when the representation ends. Thus, the professional has a continuing obligation to inform his former client of any error made over the course of past representations which may be discovered even after the end the mandate. This duty of disclosure also applies to situations where there is a potential conflict between the personal interests of the professional and those of the client. As will be discussed below, under such circumstances, all information that would enable a client to make an informed decision about whether the professional can represent him despite the existence or possibility of a conflicting interest must be disclosed as early as possible.59 Lawyers and accountants cannot advise to the best of their abilities unless they have a firm grasp of the relevant facts and objectives pursued by their clients. Crucial information must be communicated, without reserve, by clients to their professionals. To foster such open communication between professionals and their clients, professionals must be able to assure their clients that the information they disclose over the course of the representation will always remain confidential. To allow clients to benefit to the full extent of their right to adequate professional representation, rules of professional conduct require lawyers and accountants to hold in strict confidence all confidential information, which refers to all information concerning the business and affairs of clients acquired in the course of a professional relationship.60 The ethical duty of confidentiality covers not only confidential communications, but also any other information that the attorney or the accountant obtains relating to the representation of the client, no matter the source of that information. Moreover, this ethical duty applies to all information that relates to the representation of the client, regardless of whether the client asked for it to be kept in confidence, and regardless of whether revealing it might not harm or embarrass the client. As stated by Lord Millett in Jefri Bolkiah v. KPMG, this duty of confidentiality imposes on professionals extensive duties, to be performed on the basis of a standard of an obligation of result:
Both professions provide, however, for some exceptions to the general rule which precludes all disclosures. For the legal profession,62 they are generally: (1) where the client expressly or impliedly authorizes the disclosure; (2) where the lawyer is seeking to establish or collect a fee; (3) where the lawyer is defending against an allegation by the client of malpractice or misconduct;63 (4) where the prevention of a crime justifies disclosure by the lawyer (and where he anticipates violence, disclosure is mandatory); (5) where disclosure is authorized by law; and (6) where disclosure is authorized by order of a court of competent jurisdiction. For the accountancy profession,64 the stated exceptions are generally: (1) where the client expressly or impliedly authorizes the disclosure, and (2) where an express provision of the law allows for it. A professional's duty to preserve a client's confidential information does not cease when the representation ends,65 contrary to other fiduciary obligations. As noted by Lord Millett in Bolkiah, the professional has a continuing obligation to preserve information gained in confidence during the representation:
This continuing duty of confidence will also impose on professionals a prohibition from opposing a former client in any matter in which the confidential information revealed over the course of the past representation could be relevant, unless the former client consents after consultation.67 There is a strong inference that professionals who work together share confidences. Therefore, for any member of a professional firm, the burden of proof to be discharged to reverse this presumption of disclosure will be heavy. The courts will draw the inference that, if a member of a professional firm was at some point member of a firm which represented the party in opposition to a current client in a matter related to the current representation, the whole firm would be prevented from representing that client. Only if a reasonable member of the public would conclude that confidences are not likely to have been disclosed between the "tainted" members of the firm and the other members, given proof of solid institutional structures set up to prevent such disclosure, will the presumption in favour of a prohibition be reversed. The rules to that effect were set out clearly, in McDonald Estate v. Martin, by Sopinka, J. who stated :
No professional from the legal or accountancy profession should, without the consent of his former client, accept instructions unless, viewed objectively, his doing so will not increase the risk that information which is confidential to the former client may come into the possession of a party with an adverse interest to the former client. Such a risk must nevertheless be a real one, and not merely fanciful or theoretical.69 The House of Lords clarified, in Bolkiah,70 the type of institutional mechanisms that would be considered by the courts as adequate to prevent a whole firm from being tainted because of the confidential information that could have been imparted by one of its professional members.71 Lord Millett referred to the Consultation Paper on Fiduciary Duties and Regulatory Rules of the Law Commission (1992) (Law. Com. No. 124) which describes established organizational arrangements, usually referred to as Chinese Walls, which preclude the passing of information in the possession of one part of the firm's business to other parts of the firm's business. These Chinese Walls normally involve some combination of the following organizational arrangements: (i) the physical separation of the various departments in order to insulate them from each other - this often extends to such matters of detail as dining arrangements; (ii) an educational program, normally recurring, to emphasis the importance of not improperly or inadvertently divulging confidential information; (iii) strict and carefully defined procedures for dealing with a situation where it is felt that the wall should be crossed and the maintaining of proper records where this occurs; (iv) monitoring by compliance officers of the effectiveness of the wall; and (v) disciplinary sanctions where there has been a breach of the wall. The Court nevertheless concluded in that case that given the ad hoc nature of the Chinese Walls established and their limitation to a single department, they did not form part of an organizational structure within the firm which would have offered an adequate guarantee against transmission of the confidential information:
Professional codes of ethics as well as jurisprudential authorities have made it clear that both the legal and accountancy professional's duty of confidentiality required (i) an absolute standard of result be used for the appreciation of the fulfillment of the duty; (ii) very limited exceptions to this duty be applicable; (iii) the indefinite survival of this duty following the termination of the client-professional relationship, and (iv) common standards of appreciation of the institutional mechanisms required to prevent confidential information detained by one individual from being deemed imparted to all of the firm's professionals. Loyalty is an essential element in the relationship between a professional and a client. A professional should not act if any influence, interest or relationship, with respect to his engagement, may impair or be perceived as impairing his professional judgment or objectivity. If a professional's duty to the client and his personal interests (or the ones of an associate,73 or of his own firm and firm's partners) are in conflict, his duty to his client must always come first.74 Absent adequate free and enlightened consent obtained by the client, the professional's golden rule of conduct regarding conflict of interest, for both the legal and accountancy professions, should therefore be clear: when there is substantial risk that the professional's representation of the client may be materially and adversely affected by the professional's own interests or the professional's duties to another client, former client or third person, he should not represent a client. 75 In a situation of actual or potential conflict of interest, adequate consent is required to allow a professional to continue to serve a client notwithstanding such conflict. When asked to consent to a professional representation where there might be potential conflict between the personal interests of the professional and those of the client, the professional must disclose all information that will enable the client to make an informed decision about whether the professional can represent him despite the existence or possibility of a conflicting interest. Such information must be disclosed as early as possible. 76 It will almost never be proper for a professional to represent two clients whose interests are in actual legal conflict, such as in the context of (i) a court case, (ii) a forensic accounting investigation of a current audit client or (iii) a negotiation where the interests of the parties are in direct opposition (such as in the context of a commercial transaction).77 Such situations would clearly be likely to affect adversely the professional's judgment or advice on behalf of, or loyalty to, a client or prospective client. As noted by Lord Millett, such situations must definitely be avoided by legal or accountancy professionals in order to fulfil their duty to prevent conflicts of interest and to ensure that they maintain a relationship founded on the "utmost good faith" towards their client:
In its recent decision in R. v. Neil,79 Binnie J. of the Supreme Court of Canada revisited the issue in the context of analysing the extent to which a lawyer (and his firm) who represented an accused in a criminal case breached his duty of loyalty to his client in representing simultaneously the accused and two other parties in unrelated civil cases that entailed the disclosure of information adverse to the accused interests. The Supreme Court, concluding that such conduct by the lawyer constituted a breach of his duty of loyalty toward his client, further clarified the extent of the prohibition from representing two (or more) clients whose interests are in legal conflicts:
Since professionals within a firm are usually treated as a single unit for conflict of interest purposes, different professionals of the same firm should not represent parties in legal opposition, since there is a risk under such circumstances that a firm may be put in a situation where it might be required to challenge, perhaps even before the courts, the representations made by another professional of the same firm. Since most law societies have adopted rules of ethics for lawyers which impose strict obligations of confidentiality and duty of loyalty towards clients, most law firms also have rigorous rules to avoid conflict of interest. With the shrinking of the number of international accounting firms to the so-called "Big Four", it is not unusual to find that both the buyer and seller of an enterprise employ the same auditors and consultants for non-audit services from the same firm. It is difficult not to see an inherent conflict in this situation. For example, assume that management, in confidence, has discussed the various tax strategies implemented by the corporation. While, in general, these strategies must be verified in the context of the audit function and the adequacy of the reserve must be questioned, this does not mean that every possible outcome will have been accounted for in the tax reserve. If a tax colleague from the same firm is performing due diligence, how can the corporation's management have certainty that there is no peeking across the so-called "Chinese Wall". Secondly, if one is performing a tax due diligence for the purchaser, can one really question tax planning initiatives suggested to the enterprise by colleagues of the same firm? It is arguable that a member of another firm might have a different view of the matter and may provide different advice to the purchaser. Finally, it is customary in purchase and sale agreements to have purchase price adjustments based on, for example, the adequacy of net working capital or a threshold based on shareholders' equity. The practice is to have the seller prepare the statements and then have them reviewed by the purchaser's advisors. If the seller's and purchaser's auditors are the same, can the purchaser's advisor truly question the accounting practices adopted by seller's management and attested to by his colleagues? It is also customary to provide, in the case of a dispute that cannot be resolved, that the matter be referred to a neutral audit firm which will act as arbitrator on the matter. Imagine the submissions made on behalf of each party, assuming the contentious issue is a corporation's tax reserve on the financial statements. The seller, relying on the advice of his auditors, will allege that the reserve is sufficient. He might also allege that many of the tax planning ideas which are being questioned were put forward by professionals from the same firm as the purchaser's advisors. Can the purchaser truly take a contrary view using the same advisors? The situation described above should not be confused with concurrent or successive representation of two clients whose interests are adverse from an economic, political or social perspective. Often a professional is asked to represent two clients whose interests are adverse in an economic, political, social, or even moral sense, but not in a legal sense. These circumstances will not generally give rise to a situation of conflict of interest if (i) such situation clearly does not involve adverse legal interests between the respective clients, and (ii) the professionals involve fulfill their duty of confidentiality. Under such circumstances, a tax professional will normally be allowed to represent each client. As observed in Positron v. Desroches81 in the context of the analysis of the duties of an employee toward his former employer, it is in the interest of the society as a whole, as much as for the individual, that a person be allowed to exercise his trade freely. The skills of a person, his competence and his manual and mental ability cannot and should not be monopolized by one client to the detriment of other competing clients within a given industry. Subject to certain qualification, such a rule also applies to tax professionals. In the case of tax professionals, the skills they have gained in interpreting the Income Tax Act ("ITA"), or any other statute, are theirs and they cannot be prevented from making use of this knowledge to earn a living. Nothing should prevent tax professionals from offering their services to numerous clients competing economically within a given industry, but not legally in conflict, so long as they live up to their professional and civil obligations not to disclose confidential information concerning one client to another and their obligation of loyalty. A specific contractual undertaking, an implicit understanding, or a contractual non-competition clause with reasonable limits in time, space and object which would respect public order, could be used by a client to prevent a professional from using a restricted part of the knowledge gained in his practice for a specified period of time. For example, it is easy to say, in general terms, that an attorney could act for two insurance or forest companies that were competitors with each other as long as the subject matter of the mandate did not involve an issue that would lead to a direct conflict. On the other hand, there are a number of circumstances where this dual representation would be unacceptable. In practice, a law firm can often be approached by two potential bidders under a public or private auction process. Few would dispute that, in the circumstances, it would be improper to act for both clients. For example, assume the law firm had devised a unique perspective from which to present the material terms of the offer of one of the two bidders. Could the law firm provide the same advice to the other bidder? Which of the two bidders would get the better advice? A considerable amount of tax planning often precedes the submission of purchase offers. This often incurs in a cross-border setting, where structured financing concepts can be used to exploit tax differences between the two jurisdictions. Could the law firm honestly give the idea to one of the two bidders and not to the other? Because the law firm has an undivided obligation of loyalty towards its client, it cannot act for both parties in the circumstances. Investment bankers often hire tax professionals to assist them in developing unique tax- assisted financing structures to be presented to Canadian issuers. In this context, it would be hard for the reasonable prudent solicitor to accept a mandate from two competing firms working on similar products that would be presented to similar issuers. If the investment banking firm hires a professional to develop the best possible structuring advice in a context where that advice is used to develop a financial product, it would be improper to conclude that the attorney could provide the similar service to a different firm working on a similar product. In these circumstances, the reasonable and prudent person would conclude that the client expects the undivided loyalty of his solicitor. As the tax structuring advice is part of the proprietary nature of the product, the value of that advice to the client will be significantly diluted if the concept is given immediately thereafter to a competitor. The same may be said regarding advice provided for promoters of tax shelters. If a promoter hires an attorney to assist him in developing the best possible tax shelter structure, it would be improper to accept a similar mandate from a competitor. By accepting the mandate one dilutes the value of the tax planning advice given to the original client. In such case, the reasonable prudent tax professional would likely conclude that there is an implicit understanding that the relationship is exclusive. During the period of representation of a client by the professional, situations may occur where the tax adviser's personal interests could have an impact on the substance of the professional advice given, giving rise to situations which could prejudice the client's own interests. Under such circumstances, the duty of good faith translates into a prohibition against the professional from abusing his position to reap a personal gain. The prohibition against personal gain derived from a fiduciary position is universal in its scope. It applies equally to the use of any aspect of the beneficiary's property, assets, be it information, or corporate opportunities. It also applies to the advices given with the intent of actually or apparently benefiting his financial interest (or one of his relatives), whether or not the advice will eventually benefit the client. If a professional uses confidential information of a client for pecuniary gain, he will be required to account to the client for any profits made: the profit made by him will be disgorged. Where a potential situation of conflict exists between the interests of a professional and those of his client, the professional may only proceed with the representation if (i) he reasonably believes that the representation will not be adversely affected and (ii) he obtains the client's consent after consultation. Only the client's consent can relieve the professional from his prohibition to using the client's confidential information to the client's disadvantage or to the advantage of the professional. In this context, the cardinal rule which must always guide the professional's conduct is that he shall always place his personal interests second to his duty toward his client.82 It is imperative that the conflict be disclosed to the client as soon as possible in order for appropriate measures to be taken in due time. A professional shall handle with reasonable care any property entrusted to him by a client.83 A professional is strictly prohibited from using his professional-client relationship to misappropriate the property of his client. The professional must not confuse the property of the client with his own. He also must not use to his benefit (or that of his associate) any property, tangible or intangible, of a client. Specific rules relate to the conduct of a professional regarding business transactions with a client. A professional must not (a) enter into a business transaction with a client, (b) knowingly acquire an ownership, possessory, security, or other pecuniary interest adverse to the client, or (c) advise a client to acquire an ownership, possessory, security, or other pecuniary interest related to the professional (or of one of its associate) unless: (i) the transaction is reasonable and fair to the client; (ii) the terms are fully disclosed to the client; (iii) the disclosure is in writing, expressed in a manner that the client can reasonably understand; (iv) the client is given a reasonable chance to seek advice from an outside professional about the transaction; and (v) the client consents in writing.84 These general rules do not, however, apply to standard commercial transactions for products or services that the client routinely supplies to others. When the professional becomes one of the client's ordinary customers, he is in no position to overreach the client, and the rationale behind the rule does not apply. A tax professional may be engaged in business-related activities in addition to his tax practice. In doing so, he may find himself in conflict of interest vis-à-vis his tax advisory clients. If, for example, the tax professional (or an associate) has substantial financial investment or is actively engaged in the administration of the direct competitor of the tax advising client, the professional may find himself in a situation where outside interests could jeopardize his professional integrity. Indeed, since the financial interests of the tax adviser might go against providing the best possible professional advice. Since tax consulting can be considered a source of competitive advantage for a business, the tax professional should not act in circumstances where his duty to the client and his personal interests are in obvious material conflict.85 When a tax professional has obtained confidential information from a former client, since his duty of confidentiality does not extinguish over time, he must not thereafter use, or put himself in a position where he could use, the confidential information to the former client's disadvantage, unless the former client consents after consultation.86 A similar rule can be found at Art. 2146 CCQ, where it is stated that "the mandatary may not use for his benefit any information he obtains in carrying out his mandate, unless the mandator consents to such a use or such use arises from the law or the mandate." This rule does not apply to information that has become commonly known. Further, it does not apply to any information that the professional would be allowed to reveal or use under an exception to the general ethical duty of confidentiality. B) Distinctions in the scope of the fiduciary duties of tax lawyers and tax accountantsAs is mentioned by Ground J. in Drabinski, the precise scope of fiduciary duties applicable to a solicitor-client as well an accountant-client relationship will depend on the particular activities in which the fiduciary is engaged:
Not only will the fiduciary duties flow from the social mandate of each profession, but they will be further conditioned by the specific functions fulfilled by individual members within each profession. Thus, as underlined by Mr. Justice Pumphrey in His Royal Highness Prince Jefri Bolkiah v. KPMG,88 the scope of the fiduciary duties imposed on forensic accountants will be significantly different from the one imposed upon auditors:
Notwithstanding the significant adaptations to the scope of fiduciary duties to each specific function within the legal or the accountancy profession, when looking at differences between the scope of such duties between the two professions as a whole, some elements can be identified, including i) the client-attorney privilege, and ii) accountant's duty of confidentiality adapted to the various mandates. In addition to the duty of confidentiality, lawyers are also subject to the exclusionary rule of evidence law, the attorney-client privilege. This privilege, which is often invoked in matters pertaining to a client's income tax situation, prevents a court, or other government tribunal, from using the twin powers of subpoena and contempt to compel the revelation of confidential communications between an attorney and a client. Thus, while the ethical duty of confidentiality prohibits an attorney from voluntarily disclosing the information, the attorney-client privilege instead prevents the state from compelling disclosure of information obtained by the professional. The privilege extends to documentary items as well as to oral communications, but only regarding confidential communications between the attorney and the client (or the agents of either of them),89 as opposed to all information obtained during the course of the representation of the client. Information that may be confidential, but not privileged, is, however, subject to the ethical duty of confidentiality. The rationale for such a privilege for the legal profession, which exists for the benefit of the client, not for the benefit of attorney, is described by Lord Millet in Bolkiah:
Such a privilege is related to the role of attorneys as officers of the court charged with facilitating the administration of justice. As stated by Reed J. in Baron v. R.,91 no similar compelling policy reason has been advanced in respect of the accountancy profession and Canadian law has not generally extended such a privilege protection to communication between a client and an accountant.92 In Quebec, section 9 of the Quebec Charter of Human Rights and Freedoms recognizes such a privilege to client's information communicated to professionals bound by a professional secrecy law:
This article of the Quebec Charter extends the privilege enjoyed by the members of the legal profession to all other professionals, including accountants in tax practice. This provision has however a very limited jurisdictional reach: Reed J. of the Federal Court - Final Division has also ruled in Baron that the protection afforded by the Quebec law with respect to communications between an accountant and his client was not relevant for federal law purposes (particularly with respect to the ITA):
It is nevertheless possible for an accountant, as was recognized by the court in Susan Hosiery Ltd. v. M.N.R,94 to have his professional advice cloaked with the solicitor-client privilege when:
Accountants practicing as auditors perform, through their mandate of reporting on the financial statements of public corporations, a critical social role in ensuring the trustworthiness and credibility of the information conveyed in the capital markets. Since their fundamental mandate in this context is directly related to the conveyance of information to third parties, it is bound to have significant repercussions on the standards related to the fulfillment of their duty of confidentiality. Auditors are mandated by law, in the context of auditing public corporations, to convey to the investing public information that would otherwise have been subject to their professional duty of confidentiality as accountant. Such a duty requires them to hold in strict confidence all confidential information concerning the business and affairs of clients acquired over the course of the professional relationship. Since the very purpose of the mandate of auditors relates to the conveyance of information to third parties, the scope of the information subject to the duty of confidentiality will differ from the one generally applicable when accountants perform other mandates. However, since this mandate is specifically defined by law, the disclosure of information according to the parameters prescribed under GAAP will clearly qualify under the exception to the accountant's duty of confidentiality which allows for a departure from the general rule of confidentiality when an express provision of the law provides for it. This does not mean that all information obtained by the accountant over the course of its audit can be revealed to third parties. In fact, only the information that is required to fulfill his mandate in conformity with the law and professional regulation may be disclosed. Any other information will be subject to the general rule of confidentiality. How does the fact that a corporation's tax accountant and its auditor may be from the same firm affect the duty of confidentiality of each professional? The range of information subject to the duty of confidentiality for a tax accountant, given the nature of his mandate, is generally much wider than that applicable to an auditor. In cases where the tax planning and audit mandates given to professionals from the same accounting firm, it may well be argued that the client will be considered to have implicitly authorized the tax accountant to disclose, internally within the accounting firm, any information to the auditors required for the fulfillment of their audit mandate. ____________________________
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