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WHAT? WOW! IRS to Require Reporting of Uncertain Tax Positions
The IRS dropped Announcement 2010-9 on American businesses 26 January, and what an announcement it is. It alerts us that the IRS intends to require "certain business taxpayers" to report uncertain tax positions in future tax returns, and that it intends to "publish the new schedule quickly" and to "mandate the new schedule for uncertain tax positions be filed with returns after release of the schedule." Taxand US examine how this will affect multinationals going forward.
The ability of the Internal Revenue Service to obtain taxpayer information about income tax reserves reflected on financial statements has long been subject to a policy of restraint in which the IRS would not request tax accrual work papers as part of a standard examination unless there were unusual circumstances. In fact, even after the Supreme Court case of United States v. Arthur Young & Co., 104 S.Ct. 1495 (1984) confirmed that tax accrual work papers were subject to IRS summons power under Internal Revenue Code Section 7602 and were not subject to a work-product privilege or a work-product immunity, the IRS reaffirmed in Announcement 84-46, 1984-18 I.R.B. 18 that it would continue its policy of restraint with respect to requesting tax accrual work papers. Under this policy of restraint, an examiner may only ask a taxpayer about "the existence and the total amount of a reserve for all contingent tax liabilities" as a matter of routine examination procedure, without a showing of unusual circumstances and without seeking executive approval for the requests.
However, this longstanding policy of restraint began to be curtailed for listed transactions in Announcement 2002-63, 2002-2 C.B. 72. In that Announcement, the IRS stated that it may request tax accrual work papers in the course of examining any return filed on or after July 1, 2002, that claims any tax benefit arising out of a transaction that the IRS has determined to be a listed transaction. Only when listed transactions were not disclosed would the IRS routinely request all tax accrual work papers. In addition, when multiple investments in listed transactions were claimed on a return, regardless of whether the listed transactions were disclosed, the IRS, as a discretionary matter, would request all the tax accrual work papers.
When FIN 48 -- Financial Accounting Standards Board Interpretation No. 48 -- was enacted, the IRS concluded that Fin 48 work papers were tax accrual work papers and were, therefore, subject to its longstanding policy of restraint.
The IRS tells us in the Announcement's opening paragraph that it is "considering changes to reporting requirements regarding certain business taxpayers' uncertain tax positions in order to improve tax compliance and administration." In the concluding sections of the Announcement, it solicits comments but doesn't indicate that it intends to hold any public hearings. Perhaps that is because it realises that it would have to rent out RFK Stadium to accommodate all of the likely interested taxpayers who would no doubt want to attend and protest this unprecedented move.
The Announcement is not a paradigm of clarity, so many questions and issues need to be surfaced and addressed. The stated targets of this announcement are "business taxpayers" with more than $10 million in total assets, yet it isn't indicated when this measurement threshold is to be taken, nor if it is measured by value or basis. The Announcement asserts that certain "taxpayers must identify and quantify for financial accounting purposes a tax position relating to a specific federal tax return for which a taxpayer is required to reserve an amount under FIN 48."
In a nutshell, the IRS wants taxpayers to attach a schedule that:
1. Lists all of these uncertain tax positions;
2. Provides a concise description of "each uncertain tax position"; and
3. Discloses the "maximum amount of potential federal tax liability attributable to each uncertain tax position (determined without regard to the taxpayer's risk analysis regarding its likelihood of prevailing on the merits)."
Perhaps the authors of this Announcement should have consulted the definition of the word "concise." My Merriam-Webster online dictionary informs me that this word means "marked by brevity of expression or statement; free from all elaboration and superfluous detail." Yet as envisioned by these authors, the "concise description" required to be supplied by the taxpayer is composed of at least two parts, perhaps three. The first "concise" description must contain information that provides "a rationale for the position." The second "concise" description is a "general statement of the reasons for determining that the position is an uncertain tax position." To be sufficient, this second concise description (hence the "perhaps three" statement mentioned above) must contain:
1. The Code sections potentially implicated by the position;
2. A description of the taxable years to which the position relates;
3. A statement that the position involves an item of income, gain, loss, deduction or credit;
4. A statement that the position involves an item that is either permanent or temporary, or both;
5. A statement of whether the position involves a determination of the value of any property or right; and finally
6. A statement of whether the position involves a computation of basis.
The descriptions provided by the taxpayer do not need to disclose the taxpayer's risk assessment or tax reserve amounts.
Finally, it appears that items requiring disclosure are only those where a tax reserve is recorded in the financial statements of a taxpayer. And while the Announcement specifically mentions FIN 48, it appears to envision the possibility that other accounting standards that require tax reserves will satisfy this requirement.
Preliminary Thoughts and Issues
Over the coming weeks and months, we will all discover issues in this Announcement, but here a few things to start thinking about.
1. Applicability to "business taxpayers" appears broad enough to include farmers and sole proprietors that produce GAAP financial statements, so long as the farm or business has "total assets in excess of $10 million.
2. A sub-Chapter S company, even though it may exceed the $10 million threshold, may be effectively exempt from this disclosure because these "business taxpayers" generally do not record tax reserves at the entity level and, normally, neither do their individual shareholders.
3. Is there a difference between the "maximum amount" and an "entire amount" for each uncertain tax return position? Could the "maximum amount" relate to just the uncertain position, whereas the "entire amount" encompass all correlative adjustments that may result for the potential disallowance of the uncertain tax position? So, for example, if a disallowance of a repair expense would result in the creation of a depreciable asset, could the benefit of the depreciation deduction be a component of the "entire amount" but not a component of the "maximum amount."
4. Can the disallowance of one item on a list of uncertain amounts result in the theoretical increase of another item on the same list? For example, a taxpayer may have two items on its disclosure schedule, one being an abandonment loss, which is uncertain, and the other being the deduction of an expense as a research cost, which is also uncertain. If the disallowance of the research deduction serves to increase the amount of the abandonment loss, which itself is an uncertain tax position, should the taxpayer report that the "entire amount" is a zero dollar impact?
5. How does the disallowance of temporary items affect the calculation reporting of permanent items such as percentage depletion and the domestic production deduction?
6. Will states require similar disclosures?
7. Will the filing of this schedule necessitate a reassessment of the reserve amount that might be required under FIN 48 or FAS 5 (Financial Accounting Standard No. 5)?
8. Does a taxpayer need to disclose an uncertain tax position if it has no reserve established for it? For example, the taxpayer may be 95 percent certain that its position is correct and therefore decides that no reserve is needed.
9. If an uncertain tax position involves a deduction related to an amount that was determined by valuation, must all lost positions presume a zero valuation?
10. Will taxpayers need to perform a "with and without" tax calculation for each individual uncertain tax position, or can grouping be used to reduce calculation burdens?
11. Are taxpayers bound by the "unit of account" determinations in their formulation of uncertain tax positions, and how will the IRS be able to audit the veracity of these new schedules without compelling production of the audit accrual work papers?
12. Does a taxpayer need to identify or explain any and all legal authorises that weigh against a position that it has taken as part of its "general statement of the reasons for determining that the position is an uncertain tax position"?
13. Will taxpayers in Compliance Audit Program (CAP) audits be exempt from these rules?
These and many other issues, observations and questions will no doubt surface as taxpayers and preparers respond to the request for comments. No doubt this Announcement will create a lot of "beltway buzz." The IRS will no doubt encounter significant headwinds. But we are certainly entering a period of heavy-handed regulation, and this is yet another example that will hit businesses.
We won't predict how this might eventually end up, but hang on. This will be a rough ride.
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