Tax Executive Institute, Inc. - The preeminent association of tax professionals worldwide

States and localities have increasingly engaged third-party agents to audit taxpayers in exchange for a percentage of the increased taxes, fees, or other amounts collected.  Although contingency fee audits have some facial appeal by limiting governments’ out-of-pocket costs, their use undermines the fairness and impartiality essential to the sound functioning of the tax system and consigns to a for-profit, unregulated enterprise what has historically been a core government function.[1]  Because the policy objections to contingency fee audits are overwhelming, Tax Executives Institute urges states to renounce their use for all types of taxes, fees, and unclaimed property assessments.

Concerns about these arrangements are not new.  A decade ago, one state supreme court eloquently catalogued the harmful effects contingency fee arrangements have on tax administration.  In Sears Roebuck & Co. v. Department of Revenue,[2] the Georgia Supreme Court invalidated on public policy grounds a contingency fee scheme where an outside firm received 35 percent of additional amounts collected following its audit of property tax returns plus 100 percent of all first-year penalties:

The people’s entitlement to fair and impartial tax assessments lies at the heart of our system, and, indeed, was a basic principle upon which this country was founded. Fairness and impartiality are threatened when a private organization has a financial stake in the amount of tax collected as a result of the assessment it recommends.

Governments audit taxpayers with the goal of ensuring that the correct amount of tax is paid and collected – not to extract the highest settlements possible – and to do so in an equitable manner.[3]  Making auditor compensation contingent upon generating additional revenues detracts from those objectives.  For example, contingency fee auditors have a financial incentive not to inform taxpayers of audit adjustments that could benefit the taxpayer (e.g., missed deductions, tax credits, refund claims, etc.).  Likewise, where states and localities abdicate the responsibility of selecting taxpayers for audit to third-party auditors, the contingent nature of the auditor’s compensation creates a corrosive incentive to focus only on the largest taxpayers in the jurisdiction rather than enforcing the jurisdiction’s tax laws in an equitable manner designed to encourage compliance across all taxpayer classifications.[4]  Introducing this contingent fee dynamic into the relationship between taxpayers and tax administrators not only impairs generally accepted goals for auditing taxpayers, but also erodes the trust and communication that facilitates efficient and successful audits.

The potential for conflicts of interest increase when the firms that governments engage to perform these audits are subsidiaries of larger companies with multiple affiliates that compete with the companies being audited.  These business relationships could influence the contract auditor’s decision to audit and assess one company over another.  Indeed, the risk exists that a contract auditor may use its auditor status to confer a competitive advantage to an affiliate in a business competing with an audited company.  Even if a contingency fee auditor could in practice navigate this conflict, it could not avoid the appearance of impropriety that simply does not exist when a government employee performs the audit function.  The inevitability of these conflicts challenges the notion of a fair and impartial tax system.

Allowing contract auditors to handle confidential taxpayer information raises additional concerns.  At all levels of government, laws and regulations prohibit disclosure of this sensitive information, subjecting government employees to disciplinary actions and providing for the payment of damages to taxpayers affected by unauthorized use of their confidential information; perhaps more important, safeguarding taxpayer confidentiality is a cultural value in most government agencies.  In the case of a contingency fee auditor, that culture may not exist and the potential for monetary gain from unauthorized use of taxpayer data may outweigh any disincentive created by these rules given the uncertainty of applying privacy-related disciplinary rules to third-party contractors.  This leaves taxpayers with little assurance that contract auditors will employ the same high standards of data protection as those used by government employees.

TEI fully appreciates that states are revenue constrained and that contingency fee audits have the allure of a no-cost way of enhancing state revenues.  The financial benefit flowing from the use of contract auditors, however, would come at a tremendous cost:  The integrity of the tax system would be at risk.  Accordingly, TEI believes that governments at all levels should reject the use of contingency fee audit arrangements.  In addition, governments should be circumspect about any use of outside auditors, taking steps to ensure not only the confidentiality of taxpayer information but also the uniformity and fairness (and, as important, the perception of fairness) of such arrangements.

Special Concerns Specific to Contingency Fee Transfer Pricing Audits

Adding a new wrinkle to contingency fee audits, many states have begun to employ contingency fee auditors in the transfer pricing area to evaluate whether transactions between related parties are reported at arm’s-length rates on their tax returns.  Jurisdictions that have used transfer pricing contract auditors include Alabama, the District of Columbia, Kentucky, Louisiana, and New Jersey, and other states have recently considered their use (including California, Florida, Hawaii, Indiana, and Minnesota).  The use of contingency fee arrangements for these audits creates additional concerns including increased litigation costs and potential violations of ethical rules.

Where a taxpayer’s income or deductions include transactions between related parties, tax rules require that they reflect market prices.  Most states conform to applicable federal tax rules to provide some amount of uniformity and avoid the creation of separate state-level rules.  Rather than applying state and federal legal principles, however, transfer pricing contract auditors use proprietary software to perform an analysis based on public financial information and taxpayer data provided by state departments of revenue.  The software generates a transfer pricing assessment comparing company profitability with that of other companies in the same industry based on the target company’s NAICS code.  To the extent the software program determines that the profitability ratio of the audited company is less than that of the industry average, it generates an assessment based on profitability ratios it determines to be appropriate for that industry.

The pernicious nature of transfer pricing contingency fee arrangements is illustrated by what has happened in the District of Columbia.  The D.C. government’s agreement with one contract auditor requires that the auditor generate 96 assessments over a four-year period, and accords the contract auditor discretion to select which taxpayers to assess.  For every dollar that the District recovers from an assessment, the contractor receives a recovery fee ranging from 16 to 14-percent.  If a taxpayer challenges an assessment in court, or in administrative appeals, the contract auditor will provide litigation support services to the District to defend the assessment (including expert witness testimony).

1. The Costs of Conducting an Audit in the Courtroom – Burden of Proof

State and local auditors generally base their assessments on calculations or theories developed after thoroughly examining the taxpayer’s books and records and discussing the facts with the taxpayer.  When a contract auditor issues a computer-generated transfer pricing assessment without thoroughly reviewing the underlying facts and law, any ensuing litigation shifts much of that related factual development to the courtroom resulting in a de facto audit conducted in court.  The inefficiency of this approach places unnecessary financial and resource burdens on taxpayers, tax administrators, and court systems.

2. Contingency Fee Expert Witnesses Violate Established Ethical Rules

Transfer pricing contract auditors may provide expert witness services to substantiate the validity of their transfer pricing assessments in the event a taxpayer challenges the assessment administratively or in court.  Where the contract auditor is compensated on a contingency fee basis, the unfairness of the arrangement puts it outside state ethics rules.  For example, the comments to Rule 3.4(b) of the American Bar Association Model Rules of Professional Conduct provide that:

The common law rule in most jurisdictions is that it is improper to pay an occurrence witness any fee for testifying and that it is improper to pay an expert witness a contingent fee.  (Emphasis added.)[5]

Given the general disapproval for these types of arrangements and the general inefficiency of the process, governments should abandon their use of contingency fee transfer pricing contract audit firms – especially those that require contract auditors to provide expert witness services in order to support their assessments.

[1] One argument sometimes made in support of contingency fee audits is that they allow the state it collect monies that otherwise would escape the tax net.  Government and tax administration, however, are not just about the money.  They are about the core values of the society, and those values are inevitably subverted by the use of contingency fee audits.