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An Update on the IRS's Policy of Restraint — the Uncertain Tax Positions Disclosure
Despite claims that it has a policy of restraint in light of FIN 48, the IRS continues to seek more disclosure of tax accrual work papers. On 10 May 2007 the IRS's Large and Mid-Size Business Division (known as LMSB) issued a memo reaffirming its policy of restraint in requesting a taxpayer's tax accrual work papers, even in light of the implementation of FIN 48 (the disclosure in GAAP financial statements of uncertain tax positions). Taxand US examines the latest developments on the IRS's policy of restraint.
First, the IRS decided that FIN 48 work papers are included in the definition of tax accrual work papers. And second, it reaffirmed its general policy of restraint in seeking tax accrual work papers. The IRS did say in the memo, however, that the LMSB was evaluating its work paper policy of restraint to ensure it was still appropriate in today's environment.
It seemed that on 26 January 2010 we received the answer to the evaluation. In Announcement 2010-9 the IRS stated that, while it intended to retain its existing policy of restraint in asking for tax accrual work papers, it was requiring a new schedule to be filed with certain tax returns that would require a concise description of each uncertain tax position (without regard to risk of prevailing) for which the taxpayer has recorded a reserve in financial statements.
The announcement cited United States v. Arthur Young as support for the schedule's required disclosure of a concise description of uncertain tax positions for which the taxpayer maintains financial statement reserves. Given the government's recent victory in Textron, the government hardly needs to cite a case anymore to prove that it has the ability to obtain whatever portion of tax accrual work papers it wants almost without regard to a taxpayer's safekeeping of its work papers as confidential (whether for work-product or attorney-client reasons). Regardless, it appears inevitable that the Schedule UTP will be finalised and will be the IRS's own version of FIN 48. On 5 March 2010 the IRS extended the comment period on Announcement 2010-9 until 1 June 2010. And, more recently, on 19 April 2010, the IRS released for comment a draft Schedule UTP and draft instructions.
The Schedule UTP is due beginning with the 2010 tax year. Taxpayers with assets in excess of $10 million are required to file the Schedule UTP if they or a related party issue audited financial statements (regardless of the basis for presentation -- GAAP, foreign GAAP, hybrid methods, etc.) and the corporation files any of the following: a Form 1120 (US Corporation Income Tax Return), a Form 1120-L (US Life Insurance Company Income Tax Return), a Form 1120-PC (for property and casualty insurance companies) or a Form 1120-F (US Income Tax Return of a Foreign Corporation). As of now, real estate investment trusts (REITs), regulated investment companies (RICs), pass-through entities and tax-exempt organisations are not required to file Schedule UTP, but the IRS is considering whether it will extend the requirements to file Schedule UTP to these entities and organisations.
Duplicative Disclosure Requirements
The Service is also considering the extent to which disclosures on the Schedule UTP will satisfy other disclosure requirements, such as Form 8275 (Disclosure Statement), Form 8886 (Reportable Transactions) and Schedule M-3 (Net Income (Loss) Reconciliation). The draft instructions currently state that a disclosure on Schedule UTP will be deemed to be a disclosure on Form 8275 (or Form 8275-R for Regulatory Disclosures). For most purposes, the IRS will likely require a full and robust disclosure on the Schedule UTP and then provide relief for making similar disclosures elsewhere.
Only tax positions for which a reserve is recorded need to be disclosed on the Schedule UTP. A reserve is defined to include an increase to taxes payable or a decrease to taxes refundable related to a tax position. Similarly, negative adjustments to deferred tax assets or positive adjustments to deferred tax liabilities with respect to tax positions are treated as reserves. It is only the initial recording of the reserve that triggers the need to include the tax position on the Schedule UTP. Subsequent adjustments to the reserve will not require disclosures or adjustments to the Schedule UTP. Tax positions are defined to mean a tax position that would result in an adjustment to a line item on that tax return (or would be included in a Section 481 adjustment) if the position is not sustained.
Maximum Tax Adjustment
The Schedule UTP also requires the taxpayer to disclose the maximum tax adjustment (MTA) for each tax position listed on the Schedule UTP. The MTA is determined annually at 35 percent of the tax item (or dollar for dollar in the case of credits). The MTA does not include interest or penalty and does not take into account foreign, state or other non-US income taxes. For valuation and transfer pricing, the MTA is satisfied by indicating whether the tax position is a valuation or a transfer pricing tax position and by providing a ranking of these tax positions based on either the amount recorded as a reserve for US federal income tax for that tax position or the estimated adjustment to US federal income tax that would result if the tax position in the return is not sustained.
The Schedule UTP will require taxpayers to number their tax positions and, for each tax position, identify the primary Internal Revenue Code (IRC) sections impacted (up to three sections), the employer identification number (EIN) of a pass-through entity if the tax position is based on items from or relating to the pass-through entity, whether an item is not disclosed because of a determination that IRS administrative practice would apply, and the MTA.
Part I of the Schedule UTP will address tax positions for the current tax year. Part II will address tax positions for previous years. Part III will contain the concise descriptions of each uncertain tax position.
So far, the IRS has received numerous comments on the Schedule UTP and its instructions. Here are some of the frequently mentioned comments and our thoughts on them:
a. The Schedule UTP might result in an unintended chilling effect on discussions about and disclosures of tax risk in financial statements: We heard this when FIN 48 was being contemplated, but it's hard to say that FIN 48 had a chilling impact on open and honest communications with auditors. Indeed, in the same way as we have seen financial auditors increase their inquiries into uncertain tax positions, we expect the new Schedule UTP to cause similar discussions with the IRS and taxpayers. With the new Schedule UTP and the recently enacted codification of economic substance, our advice to taxpayers today is to document the business and economic reasons for a transaction and the structuring of the transaction contemporaneously with the transaction.
b. The Schedule UTP might not be authorised by statute: The IRS has broad subpoena powers. Likely, any challenge to the authority of the IRS to require the proposed disclosures will be countered by the IRS's broad subpoena powers.
c. The IRS already has more information than it knows what to do with: This is an interesting point, but it won't likely cause the IRS to back off of the proposed Schedule UTP. The IRS is seeking many avenues to gather more information to help audit taxpayers. It is working closely with foreign governments to ferret out US assets that aren't being declared as such. It continues to refine and require new tax reporting over questionable tax planning. It has required its agents to attend FIN 48 training. The IRS is not likely to rethink its strategy to combat abusive tax planning merely because it already has some tools to help it, such as Schedule M-3, reportable transaction reporting, new Circular 230 rules, etc. The IRS is likely to continue to seek new avenues to combat perceived abusive tax planning.
d. The IRS should road test the Schedule UTP and measure its effectiveness: Likely, the IRS believes it is road testing the Schedule UTP. As of now, it applies to certain US corporations, foreign corporations (filing Form 1120-F) and only those filing audited financial statements with tax reserves. Pass-through entities and tax-exempt entities are not yet required to file the Schedule UTP. It is not inconceivable for the IRS to continue to expand the requirement to file the Schedule UTP to other taxpayers or non-tax-paying entities.
e. The IRS should permanently carve out pass-through entities from the requirement to file the Schedule UTP: This will likely not happen. In fact, the IRS has specifically stated in the draft instructions to the Schedule UTP that if the uncertain tax position flows up to the reporting taxpayer from a pass-through entity, then the reporting taxpayer needs to identify the flow-through entity (with reference to its EIN) from which the position originated. The IRS has attempted to unwind many partnership transactions (disguised sales and mixing bowl rules, substantial economic effect rules, the proposed partnership anti-abuse rule, minimum gain rules, Section 704(c) regarding contributed property, etc.). It is not likely that pass-through entities will be carved out of the requirement to file the Schedule UTP.
f. The need to disclose UTPs for litigation positions is routinely criticised: The issue is whether the Schedule UTP would, if not changed from its proposed form, require taxpayers to disclose uncertain tax positions for matters that the taxpayer is either currently litigating or intends to litigate. Would this disclosure cause a waiver of either the attorney-client or work-product privileges that would otherwise shield disclosure? Given the US Treasury's latest victory on the privilege issue in Textron, the fact of litigation, either current or proposed, should not prevent the IRS from requiring disclosure of these uncertain tax positions.
g. Maybe $10 million in assets is too low of a threshold: The IRS has used the $10 million threshold in other areas of the code and seems to be comfortable with that threshold. Schedule M-3 is required for companies with assets in excess of $10 million. The cash method of accounting is available only if gross receipts are less than $10 million. There are other examples of the IRS using the $10 million amount as a threshold, so this will likely remain as the materiality level.
h. Compliance costs will exceed the benefits that the IRS perceives it will obtain from the disclosure: This might be the case, but it would not likely cause the IRS to not proceed with requiring the information to be put on the Schedule UTP. In this era of transparency regarding taxes and book accounting to income tax adjustments, the IRS will likely not limit the amount of disclosures it requires from a taxpayer. Instead, it should work to consolidate the various disclosure type reporting requirements. As noted above, as it now exists, the Schedule UTP is duplicative of other information that might be required to be reported in other areas of a tax return or on other similar schedules (such as Form M-3, reportable transactions, Form 5471, etc.).
i. If the IRS is going to require the Schedule UTP, it should eliminate the Schedule M-3: The two schedules report different information and are not duplicative of each other or mutually exclusive. Form M-3 identifies the permanent and temporary differences between financial statements and tax returns for the taxpayer. Not all of the permanent and timing items on Schedule M-3 are uncertain. Schedule M-3 was a "blowout" of Schedule M-1, which didn't provide any real disclosure on financial statement to tax return differences. Most differences were lumped together in one line item and briefly described on an attached statement to the return. Schedule M-3 helps to reconcile the tax return to the deferred tax items reported in a taxpayer's financial statements. The Schedule UTP will help shed light on the taxpayer's FIN 48 disclosures.
As of now, comments have been received by the IRS on the draft form and instructions to the Schedule UTP. It will likely not be modified much. Most comments that were made public have been mentioned here. In addition, the MTA is a different standard than that used under FIN 48, and so the analysis under FIN 48 might not provide as much or the right analysis for purposes of the Schedule UTP.
In any event, it is clear that although the IRS has not changed its official position on its policy of restraint regarding tax accrual work papers, the policy has changed. The IRS will apparently continue to fight assertions of privilege and it will continue to require more and more disclosure of uncertain tax positions, whether by expanding the list of required taxpayers (including exempt organisations and pass-through entities) to file the Schedule UTP or by continuing to expand the required disclosures -- or likely both.
There is no policy of restraint. The IRS has, since devising the Schedule M-3, continually sought more and more disclosure of tax accrual work papers and their contents. The IRS has required reportable transactions reporting, fought successfully against Textron and its privilege assertions over tax accrual work papers and is now introducing the Schedule UTP. All of these actions show there is no policy of restraint. We can expect the IRS to continue to learn from the Schedule UTP. We can expect the IRS to learn from its fight with Switzerland (UBS private banking and claims of US tax avoidance). We have seen the IRS talking with Singapore and Hong Kong financial leaders on the same issue -- private banking and claims of US tax avoidance. Any policy of restraint is likely just lip service now. Expect to continue to see refinements to the Schedule UTP, as well as an increased scope of taxpayers required to file the form.
As to planning today, it is imperative that taxpayers continue to do their tax planning in conjunction with strategic commercial transactions. Taxpayers need to spend more and more time with subject matter experts within their organisations in non-tax functional areas (including treasury, finance, risk management, accounting, strategy, etc.), understanding the commercial realities of the transactions the company is engaging in. Only then can tax planning line up with the commercial transaction, be supported by economic substance (as "defined" by the IRS) and, maybe, not be considered uncertain.
Your Taxand contact for further queries is:
Layne J. Albert
T. +1 212 763 9655
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