SEC Shoots Down Contingent Fee Loophole

The Securities and Exchange Commission's chief accountant has ruled that a tactic some accounting firms have used to justify charging audit clients contingent fees for tax advice flies in the face of auditor-independence rules.

The ruling puts a damper on a lucrative practice for some firms, who are also suffering a revenue dip from shutting down questionable tax shelters.

The Wall Street Journal reported that under a contingent-fee deal, a firm charges a percentage cut of whatever savings a client realizes as a result of the firm's advice. When sold to a large corporation or wealthy individual, a single tax shelter, for instance, can generate millions of dollars in fees. The arrangement is usually allowed for nonaudit clients, but the SEC generally prohibits such fee arrangements between accounting firms and audit clients because they create mutual financial interests.

The loophole exists when in situations where fees are determined by courts or government agencies and some accounting firms have taken advantage of that loophole.

According to the Journal, the accounting firms argue that if a fee is set at 30% of a client's tax savings, it might appear to be a contingent fee. However, the act of submitting a tax return creates an expectation that the client might undergo a government audit, which could lead to a higher tax bill. As a result, this argument goes, the accounting firm's fee isn't a contingent fee because it is the government that ultimately determines how big it will be.

SEC Chief Accountant Donald Nicolaisen rejected the interpretation in a letter on Friday. "The fact that a government agency might challenge the amount of the client's tax savings and thereby alter the amount of the fee paid to the firm heightens, not lessens, the mutuality of interest between the firm and client," he wrote. "Accordingly, such fees impair an auditor's independence."

He wrote that the exception applies "only when the determination of the fee is taken out of the hands of the accounting firm and its audit client and is made by a body that will act in the public interest."

Bruce Webb, chairman of the professional-ethics committee for the American Institute of Certified Public Accountants, requested the clarification in an April 30 letter. The AICPA had advocated the more expansive interpretation, the Journal reported.