Trends & Developments - Feb 2011 - The Internal Revenue Service Wants A Roadmap To Your Tax Exposure
On May 24, 2010, the U.S. Supreme Court declined to hear an appeal by Textron, Inc. from a decision by the U.S. Court of Appeals for the First Circuit granting the Internal Revenue Service (the "Service" or the "IRS") access to the corporation's internal tax accrual workpapers. In United States v. Textron, Inc. and Subsidiaries, 553 F.3d 87 (1st Cir. 2009), the court granted the IRS access to the corporation's tax accrual workpapers despite various claims that these internally prepared workpapers were privileged. The Service's success in this case may presage its actions in future tax examinations.
Textron's stock is publicly traded and its financial statements are prepared in accordance with generally accepted accounting principles ("GAAP"). In the course of preparing its financial statements, the company's tax department (including tax lawyers) calculates reserves for contingent tax liabilities which may be asserted by the IRS. This is done via workpapers describing the potential tax liabilities, which are reviewed by the company's independent auditor. Textron's workpapers identified each uncertain tax issue, including, in each instance, the dollar amount involved and a percentage estimate of the Service's chance of successfully challenging the position.
The Service requested the corporation's tax accrual workpapers because the corporation had engaged in nine "listed transactions." These are transactions which the Service has announced are "the same or similar to" a transaction the Service considers an improper tax avoidance transaction. Such transactions are required to be disclosed on a Form 8886 (Reportable Transaction Disclosure Statement) attached to the corporation's tax returns. Failure to make the required disclosure can result in a substantial penalty — $200,000 per failure for a corporation engaging in a listed transaction.
Textron resisted the Service's summons of its tax accrual workpapers as violating the attorney-client privilege, the tax practitioner privilege, and the privilege available for litigation materials under the "work product doctrine." The corporation's position was that although the tax accrual workpapers were prepared to establish and support the tax reserves in its audited financial statements, they could also be used in litigation. The District Court held that even if the tax accrual workpapers might be protected by the attorney-client privilege or the tax practitioner privilege, those privileges were waived when the tax accrual workpapers were shown to the corporation's independent auditors. However, the District Court held that the tax accrual workpapers were protected by the work product doctrine.
A majority of the Court of Appeals reversed the District Court and allowed the Service access to the tax accrual workpapers. It was not disputed that the tax accrual workpapers were prepared to make accounting entries, prepare financial statements and obtain a clean opinion from the independent auditors. The work product doctrine gives protection to materials prepared for use in litigation, whether the litigation has started or is merely anticipated. Textron argued that the tax accrual workpapers would be useful if litigation with the IRS developed. The corporation asserted that without the possibility of litigation, no tax reserves and no tax accrual workpapers would have been needed. However, the Court rejected these claims on the grounds that the work product doctrine does not protect documents that are prepared in the ordinary course of business and that would have been created even without the potential of litigation.
An extensive dissent believed that the majority was not following the Court's precedent and was creating a new test requiring that the documents be "prepared for" use in litigation to be protected, and suggested that the Supreme Court decide the issue. In denying certiorari, the Supreme Court declined to do so.
In the meantime, in early 2010, the Service announced that it was developing a schedule requiring certain business taxpayers to report information about "uncertain tax positions" on their tax returns. The proposal stated that the new reporting requirement would not require the taxpayer to disclose its risk assessment or tax reserve amounts, "even though the Service can compel the production of this information through a summons." The Service noted that it would continue to exercise its "policy of restraint" in using a summons to obtain this information.
The Service's announcement noted that most taxpayers issuing financial statements in accordance with GAAP are required to comply with FASB ASC 740-10 (previously FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes"). That provision requires the identification and quantification of uncertain tax positions for financial accounting reporting purposes. The Service believes that information developed in the course of complying with FASB ASC 740-10 (or other accounting standards) should be available to the Service since such disclosure will allow it to focus its examination resources "on returns that contain specific uncertain tax positions that are of particular interest or sufficient magnitude to warrant Service inquiry, as well as allowing examination teams to identify all of the issues underlying the tax returns more quickly and efficiently."
On April 19, 2010, the Service released a draft of its new form, "Uncertain Tax Positions" (Schedule UTP) and related instructions. It asked for comments by June 1, 2010. Many comments were submitted by professional organizations, tax practitioners, and others. While the Service may make some changes in its proposed new requirements, it appears that it intends to finalize them in substantially their proposed form. These requirements are summarized below and affected taxpayers should start to plan to comply therewith.
Under the proposal, a corporation, whether public or private, would be required to file Schedule UTP with their 2010 tax returns if the following four conditions exist:
1. The corporation files Form 1120, U.S. Corporation Income Tax Return: Form 1120F, U.S. Income Tax Return of a Foreign Corporation: Form1120 L. U.S. Life Insurance Company Income Tax Return; or Form 1120 PC, U.S. Property and Casualty Insurance Company Income Tax Return;
2. The corporation has assets equal to or exceeding $10 million. (A corporation's asset equal or exceeds $10 million if the amount reported on Part 1, Box D of Form 1120, or the higher of the beginning or end of year total assets amounts reported in Schedule L of Form 1120-F, Form 1120-L, or Form 1120-PC, is at least $10 million);
3. The corporation or a related party issued an audited financial statement and the audited financial statement covers all or a portion of the corporation's operations for all or a portion of the corporation's tax year; and
4. The corporation has one or more tax positions that must be reported on Schedule UTP.
For purposes of requirement 2, an audited financial statement means a financial statement that an independent third party expresses an opinion on under GAAP, International Financial Reporting Standards ("IFRS"), or another country-specific accounting standard, that requires a taxpayer (or certain related parties) to record a reserve for federal income tax positions. Generally, a reserve is treated as recorded with respect to a tax position when any of the following occurs in an audited financial statement of the corporation or a related party:
1. An increase in a liability for income taxes payable or a reduction of an income tax refund receivable with respect to the tax position, and/or
2. A reduction in a deferred tax asset or an increase in a deferred tax liability with respect to the tax position.
The initial recording of a reserve will trigger reporting of a tax position, but subsequent reserve increases or decreases with respect to a tax position taken in a tax return will not.
If the corporation records a reserve for a tax position, that position is required to be reported on Schedule UTP. Moreover, even if a reserve has not been recorded for a particular position, such position is required to be disclosed if the decision not to record a reserve was based on an expectation to litigate after it was determined that there is a less than 50 percent probability that the issue could be settled, or the Service's administrative practice of not challenging the position. A tax position is required to be reported on a Schedule UTP attached to a particular tax year's return if (a) at least 60 days before filing the tax return a reserve has been recorded with respect to that tax position, or at least 60 days before filing the tax return a decision was made not to record a reserve based on an expectation to litigate or the Service's administrative practice, and (b) the tax position has been taken by the corporation in a tax return for the current tax year or a prior tax year (not prior to 2010).
Once it is determined that a position should be disclosed on Schedule UTP, the proposal requires the following information for each position:
1. The primary Internal Revenue Code sections relating to the position.
2. Categorization as to whether the position is a "temporary' (i.e., timing) difference or a "permanent" difference, or both.
3.If the tax position is derived via a pass-through entity, the Employer Identification Number of the pass-through entity.
4. Whether or not the position is being reported because it was determined the Service would not challenge the position based on its administrative practice.
5. The amount of the maximum tax adjustment that could be assessed (except for valuation and transfer pricing positions). This amount should be computed using a 35 percent tax rate (applied to the amount involved in the position), without interest or penalties or the impact of state, local or foreign taxes.
6. A concise description of the tax position, including information that reasonably can be expected to apprise the Service of the identity of the tax position and the nature of the uncertainty. This includes a statement that the position involves an item of income, gain, loss, deduction, or credit; a statement whether the position involves a determination of the value of any property or right or a computation of basis; and the rationale for the position and the reasons for determining the position is uncertain.
If the Service views the Schedule UTP requirements as successful, it will likely broaden their application. It has already indicated its intention to require future filing by tax-exempt entities, pass-through entities (e.g., partnerships, limited liability companies and S corporations), regulated investment companies, and real estate investment trusts.
While the proposed Schedule UTP requirements would assist the Service in enforcing our "self-assessment" system of taxation in a more efficient manner, they will also substantially increase the cost and complexity of tax compliance. In addition, it is likely that they will engender conflicts among taxpayers, their tax advisors, their tax compliance personnel, their independent auditors, and representatives of the Service.
Some taxpayers may consider the Service's program to force disclosure of uncertain tax positions an invasion of their privacy. However, since we appear to be living in a period of "transparency" and an expansion of governmental functions, it does not seem likely that a challenge will be successful. As we await the finalization of the Service's proposal, taxpayers should review the various tax positions they have been taking so that they can be prepared for this new regime.
Trends & Developments – February 2011