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Not So Taxing?

IRS agents are drilling dry holes during corporate audits, the Japanese version of Sarbox, a new spin on insider trading, issuing debt without all the paperwork, and how to keep workers safe, but also help them die.
CFO Staff, CFO Magazine
June 1, 2007

When Mark Everson took office in 2003 as commissioner of the Internal Revenue Service, he promised that collecting underpaid corporate taxes would be a top priority, and backed it up by increasing the number of large corporate audits. Results were quickly realized, with additional recommended taxes doubling in fiscal 2005 compared with the previous year (see "Crackdown," January 2006). But now Syracuse University's Transactional Records Access Clearinghouse (TRAC) suggests the effort may have run out of steam.

TRAC researchers found that "IRS revenue agents are now spending substantially more of their time on corporate audits that produce no revenue for the government than they did in the recent past." They determined that, from fiscal 2005 to fiscal 2006, there was a "40 percent increase in the number of corporate audit hours that bore no fruit."

For the nation's largest corporations — those with assets of $250 million or more — additional tax liabilities as a result of audits fell 15 percent in fiscal 2006. Whereas $30.1 billion in additional taxes was sought by IRS audit agents in 2005, only $25.5 billion was claimed in 2006, a 15 percent decline.

The TRAC findings, however, do not impress the IRS. "We don't question TRAC's numbers," says spokesman Bruce Friedland. "We just think that they take a narrow view. Yes, the number of returns examined did dip from 2005 to 2006, but it didn't dip a lot. And in the broader context, it's a tremendous increase from 2003." In 2003, the number of large-corporation returns examined stood at 7,125. Two years later, the figure had reached 10,829 and eased back slightly in 2006 to 10,591.

But what if TRAC's numbers indicate not a waste of IRS time but an increase in corporate compliance? That's the possibility raised by Timothy J. McCormally, executive director of the Tax Executives Institute, a Washington, D.C.-based association of 6,800 tax specialists. McCormally notes that over the past few years the IRS has taken many steps to encourage accurate reporting of income, such as the adoption of new forms and various dispute-resolution tools.

"All these things led companies to voluntarily report income as taxable or not report income as nontaxable — things that previously might not have been reported," he says. "For corporate tax executives to read a report that says the IRS is leaving money on the table doesn't comport with reality — or at least their reality." — Art Detman


J-SOX Nation

This past April, Japanese pitching sensation Daisuke Matsuzaka wowed Red Sox Nation with his "gyroball." From now until next April, Dave Sackett expects to be equally mesmerized by Japan's version of the corporate curveball.

The corporate controller of Ulvac Technologies is charged with implementing J-SOX — the Japanese edition of the Sarbanes-Oxley Act (sometimes abbreviated as SOX). The process is a "huge deal" at the Methuen, Mass.-based subsidiary of Ulvac Inc. of Japan because the private firm (the parent is public) has never thought much about documenting internal controls or formalizing its audit trail. "Our reporting has been kind of loose in the past, but now we need to document everything," Sackett says.

Sound familiar? Following the lead of the U.S. standard setters, Japan passed a slightly less onerous version of Sarbox in June 2006 in response to its own corporate-accounting scandals. Now, working with auditors from Oishi & Co. of California, Sackett is instituting procedures such as linking employee hours to products by work order, creating a signature-authorization document for expenses, and installing a J-SOX-compliant ERP system.

While Sackett has never implemented Sarbox regulations before, "I followed them closely, because I knew we'd be mimicking the internal controls and checklists," he says. Natasha Nelson, chief ethics and compliance officer at Daiichi Sankyo Inc. in Parsippany, N.J., however, went one step further. She spent the past two years watching her fellow pharmaceutical companies implement Sarbox. With the support of company executives in Japan, she rolled out a strong whistle-blower program, hired staff with Sarbox experience, and even test audited a process. She learned not to overdocument, she says, and to attend lots and lots of seminars "to get the credentials we need to fully understand all the aspects of Sarbox."

Both companies are further along in preparing for J-SOX than most, says Paul Sachs, managing director of the Los Angeles office of Protiviti Inc. Too many U.S. subsidiaries of Japanese companies are waiting for directives from the head office rather than finding their own resources to help with J-SOX compliance, he observes. But all of them must be compliant by March 2009. And like his American counterparts, Sackett hopes there will be positives that come from the process. "It's like medicine," he says. "It tastes bad going down, but you know it's really good for you." — Cheryl Rosen



Subsidiary Rights

When the IRS's long-awaited 409A regulations were finally released in April, they generally clarified the tax rules regarding nonqualified deferred-compensation plans, which recipients now must include in their gross income. The biggest and most pleasant surprise within the 400 pages of text, however, was the loosening of the restrictions on stock options and stock appreciation rights offered to employees in divisions and subsidiaries.

Early versions of 409A set various restrictions on such stock options — including the requirement that they be exercised on a fixed, predetermined date — unless they were granted in the stock that had the greatest aggregate fair value. That generally meant that only options in a parent company escaped the restrictions.

With 409A pending, and the rules for stock options in flux, companies have hesitated to issue options at the divisional or subsidiary level. Yet compliance and ethics experts continue to argue that stock options are the best form of compensation for a company; at unit levels they offer the added benefit of tying individual effort to performance.

In their final form, the 409A regulations exclude stock options in all divisions and subsidiaries from restrictions. The new rules "permit you to drill down and give incentives at the level that makes sense to the business unit and to the employee," says Tom White, partner and head of the benefits practice of Chicago law firm Chapman and Cutler.

Whether companies will again offer such options remains to be seen. White, for one, believes they will. "You give an employee a carrot, he works harder and smarter, and you share the gain," he says. But Richard V. Smith, senior vice president of Sibson Consulting, points out that the expensing of options has lessened their appeal. And even though 409A has opened the door to offering options at the unit level, he says, "I wouldn't jump on it." — C.R.


The Next Backdating Scandal?

When Joseph Nacchio, former CEO of Qwest Communications International, is sentenced in July for insider trading, he could get life. His time served may be less, but still, at age 57, Nacchio will probably spend most of his remaining years behind bars.

Central to his conviction were two trades Nacchio made within established Rule 10b5-1 plans. These plans, which were approved by the Securities and Exchange Commission in 2000, allow executives to establish regular intervals for selling stock. Until recently, such sales were thought to be protected from litigation as long as executives did not have insider information at the initial setup. New research, however, calls that thinking into question.

Alan Jagolinzer, an assistant professor at Stanford University's Graduate School of Business, analyzed the trading patterns of executives enrolled in 10b5-1 plans over a five-year period. He found that the plans tended to sell after good news and ahead of bad news. The upshot: a trading profit 6 percent better than that of uninformed investors.

On average, Jagolinzer says, there is "evidence of 10b5-1 sale transactions and subsequent underperformance of the stock." Does this mean executives are manipulating 10b5-1? "My paper can only identify an empirical pattern," he says.

Jesse Fried, a law professor at the University of California, Berkeley, goes further: "Jagolinzer's paper shows that many executives continue to sell stock on inside informationÂ… [and] often choose to do so through 10b5-1 plans." Stanford law professor Joseph Grundfest adds that the paper "gives the SEC reasons to ask tough questions."

Those questions are being asked. "Recent studies suggest that the rule is being abused," said Linda Chatman Thomsen, SEC enforcement director, in a recent speech. "We're looking at this — hard. We want to make sure that people are not doing here what they were doing with stock options." — A.D.


What, Me Register?

Looking to issue debt? Why bother filing with the Securities and Exchange Commission when, like Time Warner Cable, Alcoa, and Siemens, you can skip the registration process — and save money?

About $52 billion of nonregistered debt was issued in the United States last year under the SEC's Rule 144A, which permits companies to raise capital from "qualified institutional buyers" without registration or GAAP compliance, says Tom Murphy of RiverSource Investments in Minneapolis. That's up from $39.5 billion in 2004. And while that's still minor compared with total public bond issuance of $430.7 billion, "the underwriters say they can sell two to three times current levels," he adds.

The rigors of Sarbanes-Oxley are among the principal reasons companies are tapping the nonregistered debt market. But there are others. The market has matured over the past five years, improving investor confidence and prompting a drop in yield spreads versus publicly registered U.S. Treasuries and corporate bonds. Moreover, whatever disadvantages companies used to face for avoiding the SEC — principally, a perception of a lack of liquidity and lower credit quality — appear to have dissipated.

In response, the companies issuing 144A debt have rapidly changed from smaller, non-U.S. firms with lower credit quality to large, publicly traded companies. The reason? The modest yield differential: 5.65 percent (yield to worst) for investment-grade issuers, compared with 5.63 percent for U.S. corporate debt, according to Lehman Brothers. In April, for example, Time-Warner Cable completed a $5 billion offering of 5-, 10-, and 30-year notes paying from 5.4 percent to 6.6 percent. Especially active have been export-oriented foreign issuers that hope to expand their investor base but still want to bypass Sarbox, says Murphy. — Eric Laursen


Take That, Sarbox
Cos. issuing the largest 144A offerings (combined) so far this year
Company Market Value
Time-Warner Cable $5 billion
Alcoa $1.4 billion
TNK-BP Finance $1.3 billion
Woori Bank $999.5 million
News America $977 million
Source: Lehman Brothers

The Numbers in Safety

Even as Congress was preparing to hold hearings on the agency's effectiveness, the Occupational Safety and Health Administration sent out its annual warning letters to companies with higher-than-average injury and illness rates. More than 14,000 companies received the letters, each having reported 5.1 or more incidences per 100 employees, more than double the national average.

The good news is that injury rates have been falling, at least among the most accident-prone companies. Last year's numbers compare quite favorably with those from 2002 (see chart at the end of this article), when major offenders had rates of 7 or more compared with the national average of 2.8.

OSHA has come under fire from labor leaders and others for what they perceive as a cozy relationship with the industries with the highest rates. One criticism has been the agency's advocacy of voluntary participation in safety programs, versus the creation of new rules that would mandate tougher standards.

Anthony Forest Products Co. estimates that it saved more than $1 million in health and insurance costs between 2000 and 2006 by taking advice from OSHA. The company pinpointed potential hazards and instituted stringent safety requirements in all of its plants. It now has an injury and illness rate of zero (meaning no work-related illnesses or injuries forced a worker to miss a full day of work in a one-year period).

The letters carry no fines, but serve as an invitation to work with OSHA to reduce incidents. Later this year, OSHA will announce a list of companies targeted for on-site inspections. — Laura DeMars


Verbatim

"The delicious irony is that we're...proselytizing public companies as to why they should go private and at the same time trying to figure out how to go public [ourselves]."

— David Bonderman, a partner at private-equity firm Texas Pacific Group, speaking at The Milken Institute Global Conference in April


Exit Strategy

Here's a novel employee benefit: death. Well, not death per se, but help with what might be called death-related issues, from writing a will to planning funeral services to bereavement support.

A small number of insurance companies and funeral-services firms now offer "end-of-life preparation" services. Everest Funeral, for example, offers an online portal and a "concierge" service (that is, around-the-clock access to an expert via telephone) that can provide information and help with preplanning a funeral and comparing prices of local service providers. The benefit can cost as little as 10 cents per employee per month and could provide that one piece of the personal-finance puzzle that people often overlook. "People who have to plan a funeral are forced to make decisions quickly with very little information about pricing or options; that's where we come in," says Everest CFO Michael Laid.

Will preparation and hotlines that help employees or their beneficiaries manage insurance payoffs or inheritances are also coming on the scene. Principal Insurance offers both to its group life insurance clients. Randy Abbott, a consultant with Watson Wyatt Worldwide's benefits practice, says the concept can be enormously appealing to employees, but he doubts that employers will go the extra mile and actually pay for funeral services. Everest, however, does offer discounts to employees who buy the services they learn of through its portal. — L.D.


Are Captive REITs Kaput?

A growing number of state officials are taking aim at an entity known as captive real estate investment trusts. Their claim? That a captive REIT's sole purpose is to enable companies to shirk state income-tax obligations. In their sights are companies like AutoZone and Wal-Mart.


While captive REITs come in several varieties, they often work like this: a firm shifts ownership of its real estate assets to the captive REIT. Then the individual stores actually rent their spaces from the REIT, which means they can deduct their rent expense and cut their taxable income. By law, REITs effectively don't pay federal income tax, but can deduct their dividends to shareholders if they pay out at least 90 percent of their portfolio, says Michael Mazerov, senior fellow with the Center on Budget and Policy Priorities, in Washington, D.C.

The problem at the state level, however, is that REIT shareholders can deduct the dividend income from their state taxable income. By establishing a REIT, a company not only gets to deduct the rent expense it pays itself, it can also exclude from its taxable income the dividends that the parent company receives.

Nobody knows just how much states are losing as a result of captive REITs. However, a 2007 report by Mazerov shows that corporate income tax (in the 45 states that levy it) supplied 6.5 percent of states' tax revenue in 2005, compared with 10.2 percent in 1979. According to the study, one likely reason is the use of tax shelters such as captive REITs.

States are fighting back. So far this year several states, including New York, Maryland, Massachusetts, and Rhode Island, have passed or considered legislation to close the captive REIT loophole. Says Paul Sander, a partner with Strasburger & Price in Texas: "The window is closing." — Karen M. Kroll


Do As I Say, Not AsÂ…

It was good news/bad news for the SEC: on the plus side, it fixed 58 of the 71 weaknesses in internal controls that the Government Accountability Office found in its most recent audit. But 15 new flaws joined the list, prompting the GAO to comment, "Despite this progress, the SEC has not consistently implemented certain key controls" that would safeguard the confidentiality, integrity, and availability of financial data. SEC chairman Christopher Cox responded, "We are committed to proper stewardship of the sensitive information that is entrusted to usÂ…" and invited the GAO to address any further questions to Kristine Chadwick — the SEC's CFO.




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