News & Views

60 Days to the EU Audit Reform – Are You Ready for It?

18 April 2016

Author: Heikki Vesikansa

From 17 June 2016 onwards, the operational environment for tax services within the EU will change permanently. In the aftermath of the Lehman collapse and the financial crisis in 2008 and 2009, the EU legislators made a decision to do their best to never again allow the unreliability of financial information to lead to the bursting of bubbles in a way that can paralyse the global economy like the events in 2008 and 2009 did. As a part of this goal, the legislators decided that audit firms within the EU, most notably the Big 4, should not engage in non-audit services with their clients in any way that might impair the independence of the audit of financial information.

This reform is partly based on a very special purpose aimed at tax services in particular. The Big 4 audit firms are well known for their active roles relating to international tax planning, and tax planning has also attracted a fair amount of media attention during the past years. In fact, most of us are probably familiar with the headlines regarding the aggressive tax planning schemes allegedly adopted by Google, Apple, Starbucks, etc. Furthermore, what in the pre-2008 setup might have seemed like a normal modus operandi for multinational enterprises now seems like a situation where someone had their hands too deep in the cookie jar, and the public opinion has – probably quite rightfully in some occasions – given a clear thumbs down for this sort of financial engineering.

The time afforded to adapt to the reform has been quite long, but from 17 June 2016 onwards the new rules will, quite effectively, prohibit auditors from giving tax advice to audit clients within the EU. Regardless of whether one agrees that this kind of a ban on tax services provided by the auditors can actually help to prevent new bubbles from arising, the rules are here and companies in the EU have to start complying with them. The prohibition has two levels: (a) qualitative and (b) quantitative. The quantitative limitation is perhaps more familiar to the public: Auditors should not provide tax or other ancillary services to audit clients if the fees charged for these non-audit services are in excess of 70% of the average of audit fees in the last three consecutive financial years. Whilst this quantitative restriction is generally more well-known, the qualitative restriction is actually the more limiting one. In fact, according to the qualitative restriction, tax services are not allowed at all, unless such services are immaterial or have no direct effect, separately or in the aggregate, on the audited financial statements.  Moreover, audit committees are trusted to be the watch dogs of this restriction, and any non-compliance is sanctioned with reasonably severe sanctions. The regulation does not offer detailed guidelines on what is considered to be more than just immaterial tax services and how “direct effect” on the accounts is evaluated.¹  Thus, one might anticipate that the members of audit committees may primarily be quite reluctant to accept tax services from the auditors and, according to the new rules, they would actually have to explicitly approve any tax advice from the auditors (and the failure to reject more than just immaterial tax services could lead to sanctions).²

The new rules do not cover all of the smallest enterprises. The new restrictions will, broadly speaking, cover banks, insurance companies, listed companies, and companies that have issued public bonds (i.e. so-called Public Interest Entities, PIEs). The restrictions also cover the parent (and subsidiary) undertakings of these PIEs. In consequence, many private equity and other types of investment funds owning listed companies and companies that have issued bonds likely will also be subject to these new restrictions.

So, in a nutshell, what will change when the sun rises on 17 June 2016? Above all else, the members of audit committees will definitely be more alert. If companies acquire any kind of tax services from their auditors, audit committee members should require an explanation why they (at their own risk and subject to sanctions) should deem these tax services to be immaterial or to have no direct effect on the accounts. Furthermore, one can expect that risk aversion will be held in high regard during the period when the new rules will be tested out. With time, the measuring stick for what is considered immaterial will probably evolve and audit committee members will have more solid ground to stand on. However, for now, PIEs and their parent undertakings, who are already using tax specialist attorneys for their most complex assignments such as tax litigations, will also need to seek tax service providers other than their auditors for even more routine tax assignments from 17 June 2016 onwards.

¹ The new rules specify that when the provided tax services involve aggressive tax planning, the services should never be considered immaterial. The EU Commission has defined aggressive tax planning in its 2012 Action plan on the topic (Communication from the Commission to the European Parliament and the Council: An Action Plan to strengthen the fight against tax fraud and tax evasion, COM (2012) 722 final) as follows: “taking advantage of the technicalities of a tax system or of mismatches between two or more tax systems for the purpose of reducing tax liability. Aggressive tax planning can take a multitude of forms. Its consequences include double deductions (e.g. the same loss is deducted both in the state of source and residence) and double non-taxation (e.g. income which is not taxed in the source state is exempt in the state of residence)”.

² The Directors’ Institute of Finland (DIF) in particular has criticised the severity of the proposed sanctions in its statement of 22 November 2015. The DIF argues that the sanctions may lead to audit committees carrying out extensive analyses to support the purchase of tax services from auditors or, alternatively, to audit committees deciding categorically that tax services shall not be acquired at all from the auditors: