Section 404 and Mandatory E-filing
Are Corporate Tax Departments Burning
the Candle at Both Ends?
Mark J. Cowan and Tom English
- In recent years, in-house corporate tax departments have
evolved from cost centers focused on efficiently complying
with the tax law, to profit centers focused on reducing a
company’s effective tax rate. On top of their normal
tax compliance and planning functions, corporate tax departments
have recently been confronted with a litany of new regulatory
requirements. Perhaps the two most burdensome of these challenges
are compliance with the Sarbanes-Oxley Act’s (SOX) section
404 rules on internal control documentation and the new IRS
electronic filing requirements for corporate tax returns.
Both of these issues force many tax departments to dramatically
change their processes. Both of these issues are currently
confronting large corporations and signal changes to come
at smaller corporations. If corporate tax departments, regardless
of size, wish to be successful in meeting these new challenges,
they must adopt the processes, tools, and practices required
to effectively address compliance needs and manage tax-related
are required by AU section 325 to report, to the company’s
board of directors, control weaknesses that are considered
“reportable conditions,” defined as “significant
deficiencies in the design or operation of internal control,
which could adversely affect the organization’s ability
to initiate, record, process, and report financial data.”
AU 325 further indicates that auditors “may choose”
to report to the board those reportable conditions that
are considered “material weaknesses.” Material
weaknesses are defined as controls that do “not reduce
to a relatively low level the risk that misstatement caused
by error or fraud in amounts that would be material in relation
to the financial statements being audited may occur and
not be detected.” While
material weakness reporting is optional for nonpublic companies,
SOX section 404 (which relates only to public companies)
requires them to be disclosed in a report to the SEC. Thus,
significant internal control weaknesses that result in a
high level of risk that a material financial statement error
will occur should be reported to the SEC.
big story of the first cycle of SOX section 404 compliance
has been the number of material weaknesses that have arisen
from accounting for income taxes. In a February 9, 2006,
speech, SEC Chairman Christopher Cox announced that almost
one-third of companies that reported material weaknesses
cited income tax reporting as one of their problem areas.
Tax accounting issues are second only to revenue recognition
issues as the leading causes of material weakness disclosures.
These weaknesses were due to tax processes and controls,
and resulted in a significant number of financial statement
restatements. Several large companies, such as Kodak and
MCI, have reported material weaknesses related to income
taxes. Ironically, even H&R Block announced on February
23, 2006, that, as a result of its review of material control
weaknesses, it was restating its fiscal 2004 and 2005 financial
statements by $32 million for understated state income tax
results are from accelerated filers, which are required
to comply with SOX section 404 for fiscal years ending on
or after November 15, 2004. Accelerated filers are generally
companies that have a market capitalization of $75 million
or more. Nonaccelerated filers, generally companies with
a market capitalization of less than $75 million, are required
to comply for fiscal years ending on or after July 15, 2007.
The SEC Advisory Committee has recently proposed exempting
or relaxing the section 404 requirements for smaller companies.
It is unclear at this time whether section 404 will ultimately
be implemented on schedule in its current form. It is clear
from the results of the accelerated filers that tax departments
have changes to make and, barring any relaxation of the
rules, it is likely that nonaccelerated filers will find
themselves in similar circumstances.
reports that the biggest reason given for material weaknesses
in the tax function was related to corporate tax staff competence
in income tax accounting. When MCI, for example, announced
its income tax material weakness on March 16, 2005, it went
so far as to describe how it would remedy the problem going
forward, including hiring a new vice president of taxation
and increasing the number of staff knowledgeable in tax
are finding that their in-house tax professionals are often
well versed in technical tax topics but weak when it comes
to accounting for income taxes under SFAS 109. Historically,
many corporations, particularly smaller ones, would rely
on the audit and tax teams from their independent audit
firm to help with the SFAS 109 calculation. Independence
issues and public accounting firm staffing shortages have
eliminated this option, leaving many tax departments with
a dearth of in-house SFAS 109 expertise. Companies have
begun aggressively training their tax staff in SFAS 109
issues and hiring tax professionals with an SFAS 109 skill
set. Unfortunately, such individuals are hard to find in
today’s recruiting market.
significant material weakness found among accelerated filers
was inadequate documentation of tax-effected cumulative
book and tax temporary differences. In addition, processes
and controls over analyzing and establishing valuation allowances
and contingency reserves were also found to be inadequately
problems can be linked to the staff competence issues noted
above and to the attitude that many corporate tax departments
have historically taken toward SFAS 109 reporting. Many
tax departments would use ad hoc, nonstandardized spreadsheets
to compute tax provisions and deferred tax amounts for year-end
financial statement reporting. At best, these spreadsheets
provided an estimate of the appropriate deferred tax accounts.
Only months later, when the return was actually prepared
and filed, were the tax accounts “trued up”
to the correct amount. To some extent, this approach was
understandable, given that tax departments must work at
the end of the reporting cycle and have a very small window—from
the receipt of pretax book income to the earnings release—in
which to finalize the tax accounts.
departments were able to take this spreadsheet estimate/true-up
approach because they often maintained “free”
or “unallocated” reserve amounts in their contingent
tax liabilities that they could increase or decrease to
meet the estimated tax provision calculated for financial
statement purposes. Such practices can no longer be used
in a SOX section 404 context. Tax departments must identify
the specific tax exposures that the contingency reserves
are meant to cover. The tax department’s view of the
company’s exposures must be documented and supported
by a detailed legal analysis.
overarching problem in applying SOX section 404 to the tax
function is that many tax departments historically operated
in isolation, apart from the financial accounting, finance,
and business functions of the enterprise. Tax staff generally
considered themselves to be technical tax planners or technical
tax compliance specialists, not experts in financial accounting
issues, and certainly not experts in internal controls.
Members of the tax staff focused on the substance of their
calculations and, unlike staff in other accounting departments
(e.g., accounts payable), were not as concerned with documenting
their processes and controls. Top management and the audit
committee of the board of directors rarely showed much interest
in tax matters and did not keep tabs on how their tax departments
were fulfilling their mission. SOX section 404 has forced
tax department operations to be more transparent to upper
management and the audit committee, and forced the tax department
to be more actively engaged in company business operations
to address tax issues on a real-time basis.
& Young reports that successful accelerated filers were
proactive in their approach to these issues by providing
early training to their tax staff, especially with respect
to following SFAS 109; supporting deferred tax balances
with tax-basis balance sheets and other supporting calculations;
and using tax-provision software and other support tools.
current SOX environment forces tax departments to provide
better tax reporting and to manage tax risks. In response,
tax departments are seeking best-practice guidance to ensure
that they are on track. Several best-practice surveys have
been conducted providing information in this regard [e.g.,
Ernst & Young’s Sarbanes-Oxley Year 1 Review:
Tax Observations and Lessons Learned (www.ey.com/global/content.nsf/
KPMG’s 2005 Tax Department Survey (www.us.kpmg.
and the Tax Executives Institute’s 2004-2005 Corporate
Tax Department Survey (http://www.tei.org/Resource.phx/public/ctds.htx)].
In addition, some commentators have focused on a specific
aspect of improvement, such as changes in reporting structure
(e.g., Jasper L. Cummings, “Chief Tax Officer Reporting
Structures,” Tax Adviser, October 2005),
or have offered extensive advice on improving internal controls
and the overall operational efficiency of the tax function
(e.g., George R. Goodman, “Internal Controls for the
Tax Department,” Tax Notes, May 4, 2004;
and David E. Hardesty, “Sarbanes-Oxley Compliance
in the Corporate Tax Department,” Financial Reporting
Watch, Mar. 1, 2005).
of some of these findings is as follows:
Build and maintain a tax-basis balance sheet, or otherwise
support deferred-tax balances.
Establish a control group that includes a tax representative
to sustain the section 404 effort, and work with third
parties to remediate control deficiencies.
Develop an annual section 404 calendar for the tax department.
Evaluate the oversight, policies, and effectiveness of
overseas tax accounting operations.
Consider the need to perform an earnings and profits study
for foreign subsidiaries.
Reconcile all tax accounts at least quarterly and annually.
Devote more time to interim reporting.
Update and document specific tax exposure items, valuation
allowances, and related internal control processes.
Review appropriate skills, capabilities, and training
of tax professionals to cope with the added financial
and internal control reporting requirements.
Provide more technical training, particularly in the areas
of tax accounting and internal controls.
Seek earlier and more-effective communications with and
between auditors and third-party tax providers, to avoid
Pursue tax process improvement as a way to achieve better
effectiveness, efficiency, timeliness, and accuracy; to
address growing internal and external demands; and to
face growing risks.
Increase staff to handle increased demands (one survey
reported that one-third of companies have increased staff
more than 25%, and that half anticipate an additional
increase in the next 12 months).
Undertake tax department process improvements, including
tax-technology improvements such as process automation.
Ensure that tax department personnel are tapped into other
departments and business units, in order to assess tax
issues of business transactions as they occur.
Plan project focus to include SOX compliance, financial
reporting, tax provision automation, and process simplification.
Draw on resources of outside tax advisors to provide internal
Prohibit the use of the external auditor for tax services.
Increase internal audits of tax departments.
Consider having the Corporate Tax Officer report to the
legal or internal audit functions rather than to the CFO.
Ensure that tax department processes and controls are
practices will no doubt continue to evolve as accelerated
filers improve their processes and as nonaccelerated filers
begin to wrestle with the complexities in SOX section 404.
In response to the changing tax department landscape, Tax
Analysts, publisher of Tax Notes, now provides
an online service, Financial Reporting Watch (see
to keep tax executives and their advisors up to speed on
emerging issues and best practices.
Implications for the Tax Function
implementation of SOX section 404 in corporate tax departments
has obviously been costly and burdensome. Tax departments
hope that once they have the best practices and controls
in place to eliminate any material weakness issues, the
costs of compliance will abate and ultimately inure to the
long-term benefit of the company in general, and the tax
function in particular.
long-term benefit is that SOX section 404 forces tax departments
to abandon their insular nature and address company tax
issues on a real-time basis. Before section 404, some proactive
tax departments worked side by side with the business planners
as transactions took place. Many, however, did not. Tax
departments operating in isolation from the financial reporting,
finance, and business functions within their companies inhibited
tax planning. SOX section 404 will force all tax departments
to become more engaged, which should improve overall tax
planning and ultimately enhance shareholder value.
potential benefit is that tightened controls force tax departments
to document their risks and exposures with greater specificity,
allowing resources to be directed toward resolving the most
significant problems. Whether these potential benefits will
come to fruition remains to be seen.
tax departments struggle to meet the increased demands of
SOX compliance, they must not forget the new IRS electronic
filing requirements for 2006. The new IRS mandate requires
all companies with at least $50 million in assets that file
at least 250 tax returns annually to e-file their 2005 Forms
1120 or 1120S. Income, excise, information (e.g., Form 1099),
and employment tax (e.g., Form W-2) forms count toward the
250-return threshold. Most businesses that meet the $50
million asset threshold, therefore, will probably also meet
the 250-return threshold.
though the Treasury Department issued temporary and proposed
regulations under IRC section 6011 mandating e-filing in
early 2005, few corporate tax departments have been proactive
in preparing for this new requirement. KPMG reported that,
as of December 2005, only 2% of eligible companies were
prepared to comply with the requirement, while 15% had a
plan in place and 35% had not even started. The IRS’s
position is to provide an extension only on a very limited
basis, so tax departments should not hope for a waiver.
KPMG reported that three-quarters of tax departments plan
to license tax software to process and e-file their return.
SOX section 404, this is another challenge that large companies
currently face and that smaller companies will have to confront
eventually. Companies with assets of $10 million or more
that file over 250 returns per year will be required to
electronically file their Forms 1120 or 1120S for tax years
ending on or after December 31, 2006.
that are e-filing for the first time should understand that
return preparation may require several additional weeks
because of issues with attaching documentation, concerns
over data security, and problems with importing data from
multiple software sources.
any tax veteran can attest, the preparation and filing of
a major corporate tax return is a process that can involve
multiple software packages (for example, one for foreign
issues and one for domestic issues), overrides of calculated
numbers within those software packages, various Microsoft
Word and Excel attachments, the occasional handwritten note,
and a game of “beat the clock” on filing day
to get the return in the mail. Inevitably, some issue, great
or small, will arise that will hold up the return until
the extended filing deadline. As a result, schedules and
forms are often slipped into the return at the last minute.
quirks of the tax return process are not available with
e-filing. The entire return must go through the e-filing
system. The return and attachments must run through IRS-approved
software in extensible mark-up language (XML). In certain
limited situations where conversion to XML is not possible
(for example, the corporation must attach an appraiser’s
report), the attachment must be scanned and submitted in
PDF format. Tax staff cannot make manual corrections. There
is no guarantee that overrides of software-computed amounts
will translate into the e-filed return. Last-minute attachments
cannot be “slipped in” to a return as it goes
to the post office.
filing is no longer a practical option. Tax departments
cannot be cavalier and expect to “push the button”
on the filing deadline and hope that all goes well. The
risk of something interfering with a successful filing is
substantial. Furthermore, companies using a software vendor
to transmit the return to the IRS may have to enter a queue
for filing on a first-come, first-served basis. Given the
risks and the novelty of the situation, it is best to plan
for a substantial margin of error.
practices. As of this writing, most companies
have not yet prepared for the first year of e-filing. Thus,
there are no established best practices to follow. The best
advice, in light of the potential problems noted above,
is to be proactive and allow extra time for the new e-filing
process. Smaller corporations scheduled to implement e-filing
in 2007 should monitor large companies’ experience
with e-filing the 2005 return to anticipate any potential
Implications of E-filing
with $10 million or more in assets are now required to file,
with their tax returns, Schedule M-3, a much-expanded version
of Schedule M-1 that details the corporation’s permanent
and temporary book/tax differences. Mandatory e-filing,
coupled with the new Schedule M-3, is designed to allow
the IRS to more quickly select taxpayers and issues for
audit. This will allow the IRS to be more efficient and
focused in its audit process and should, in theory, allow
the IRS to begin and finish corporate tax audits quicker.
Thus, while corporate tax departments will have to spend
a considerable amount of time putting reporting systems
in place to complete the M-3 and file returns electronically,
ultimately corporate taxpayers will benefit from these innovations.
Their IRS examinations should become more focused, and less
time should be wasted on insignificant transactions.
Cliff Jernigan, former Senior Industry Advisor in the Large
and Midsize Division of the IRS, notes in his book, Corporate
Tax Audit Survival (Olive Hill Lane Press, 2005), corporations
should prefer shorter audit cycles. It reduces the potential
for interest expense on deficiencies and provides more certainty.
Viewed from a certain perspective, the current headaches
over the M-3 and e-filing can be seen as an investment in
a smoother compliance and audit process going forward.
addition, as Jernigan notes, using e-filing and the M-3
to more efficiently handle larger corporation audits will
free up IRS resources to focus more on medium-sized and
smaller companies. Smaller companies that are not accustomed
to being audited may be unpleasantly surprised to find themselves
getting more-frequent visits from the IRS. Of course, it
remains to be seen whether, and to what extent, the IRS’s
hopes of streamlined audits come to fruition.
Challenges That May Improve Practices
section 404 compliance and e-filing represent significant
challenges currently confronting large corporate tax departments.
Unless the rules are relaxed or delayed, these same issues
will soon be challenging tax departments and their advisors
at smaller companies as well.
departments must improve controls over SFAS 109 and the
processes that surround it to avoid material weaknesses
in the tax area. Likewise, tax departments can no longer
make last-minute manual corrections to returns filed electronically.
In short, tax department processes must be tighter, for
both financial accounting and tax return compliance. With
any luck, these tighter processes will ultimately benefit
the corporation’s tax planning, compliance, and IRS
examination processes. For now, however, large corporate
tax departments are, to invoke an apt cliché, burning
the candle at both ends. If they are to meet the coming
challenges, smaller companies and their advisors should
study the experience of their larger brethren, and start
implementing changes now.
J. Cowan, JD, CPA, is an assistant professor of accountancy,
and Tom English, PhD, CPA, is a professor
of accountancy, both at Boise State University, Boise, Idaho.