the increase in transparency requirements for corporate tax positions

8/2/2019 The Increase in Transparency Requirements for Corporate Tax Positions.

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T A X A T I O Nc o r p o r a t e t a x a t i o n

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T h e I n c r e a s e i n T r a n s p a r e n c y R e q u i r e m e n tt o r C o p r a t e T a x P o s i t i o n sBy Ron Singleton and Steve SmithT he United States income tax system is based on honesty,self-reporting, and self-assessment. Taxpayers are sup-posed to submit truthful and accurate rettims, and the U.S.govemment is supposed to efficiently and effectively auditretums for errors and omissions. In a system that is increasinglycomplex and difficult to administer, however, the taxpayer-gov-emment relationship can quickly devolve into a game of hide-and-seek. Although advances in computer technology, informa-tion reporting and matching, and electronic filing have increasedtransparency and efficiency in individual tax compliance, progress

on the corporate side has been comparatively slow. 1RS corate audits continue to be dominated by agents hunkering doover a company's accounting records and documents not olooking for errors and omissions, but also unraveling comptransactions to ensure proper reporting.

The 1RS has long been concemed witii how to effectively acorporations, and has recognized the importance of compabeing open about questionable tax piisitions in making the aprocess more efficient. In a speech to the New York State Association on January 26, 2010, 1RS Commissioner Dou


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25 % of their time in largethe 1RS ini-

rioritized 1RS selection of which taxpayershat the commissioner's speech on this issueas given five days after the First Circuit.Ct. of Appeals decision in Textron Inc. el

v. U.S. (2009-2 USTC 50,574; S.Ct. certed May 2 4,2 010), a closely watched case

in which the court affirmed tliat woi-kpapersprepared for a financiiil statement audit arenot privileged communications, and can besubject to a subpoena.

On the heels of its win in Textron, the 1RSrecently intnxluced a possible game chang-er in coiporate tax compliance and reporting;the reporting for uncertain lax positions(UTP). In brief, 1RS Schedule UTP requiresa company to enumerate its uncertain taxpt)sitions, thereby eliminating the uncertain-ty in the IRS's audit lottery of searching fora company's uncertain tax positions.

The purpose of this article is to reviewrecent judicial, regulatory, and adminis-trative changes that have shifted the bur-den to the taxpayer to disclose uncertaintax positions. In addition, the 1RS has lever-aged FASB Interpretation 48 (FIN 48,which has been cod i f i ed as ASCAccounting Standards Codification] 740-10) financial reporting rules that requirecom pan ies to es t ab l i sh t ax reserves .These combined actions have effectivelyincreased transparency and the IRS's abil-ity to identify uncertain tax positions andaudit more effectively.T r a n s p a re n c y , T a x W o r k p a p e r s ,a n d C o m m o n L a w

Taxpayers often include information inworkpapers regarding tax strategies, risk,and other sensitive information that theyprefer not to share with the 1RS. Of course,the 1RS access to tax workpapers wouldaid in issue identification and would alsotaiget aieas of interest. The ability of the1RS to acce ss taxpayer workpapei>; has his-torically been an area of contention. Thescope of taxpayer rights to protect sensi-

tive information in the workpapers fromdiscovery or summons by the 1RS wascarved out in Hickman v. Taylor (39 U.S.495 [1947]) in the form of the work prod-uct doctrine.

The work prcxluct dixtrine allows the tax-payer the right to protect tlie privileged com -munication contained in workpap)ers ft-om1RS review if the communication is confi-dential between the taxpayer and attorney,and if the infonnation is to be used for liti-gation support. This privilege is waived,however, if the taxpayer voluntarily dis-

H i e a b i l i t y o f t h e 1 R S t o a c c e s st a x p a y e r w o i k p a p e i s h a s h i s t o r i c a l l y

h e e n a n a r e a o f c o n t e n t i o n .

closes the information to a third party, as wasthe case in U.S. v. Arthur Young & Co. (465U.S. 805 [1984]). Arthur Young is consid-ered a seminal case in defining the rights of1RS access to tax accrual workpapers. In thiscase, the U.S. Supreme Court held that com-munications between a taxpayer and its inde-pendent auditor were not within the scopeof the work product doctrine, and the 1RScould access the tax accrual workpapers.The decision in Arthur Young granted the1RS a wide r mge of power for access to tax-payer tax accrual workpapers. The 1RS onlyhas to "show that the investigation will beconducted pursuant to a legitimate purpose,that the inquiiy may be relevant to the pur-pose, that the information sought is notalready within the Commissioner's posses-sion, and that the administrative stepsrequired by the Ccxie have been followed."(U.S. V. Powell. 379 U.S. 48,57-58,85 S .a ,248, 13 as cited in U.S v Worley, C.A.3-PA.Oct. 6, 2009). As noted in Muratore v. U.S.(DC -NY, April 15, 2(X)4), the 1RS has only

a minimal burden to show that the sum-moned information would be relevant.Further, as decided in Sterling Trading v.U.S. (DC -CA, Feb. 14, 2(X)8), the 1RS onlyneed show "potential relevance to its (1RS)investigation."

More recently, the First Circuit Court ofAppeals decided in Te.xtron that intemal taxworkpapers prepared for ase in possible lit-igation are protected, but pmviding tlie work-papers to external third-party auditors aspart of the financial statement audit nullifiedthe work product protection and allowed the1RS to subpoena the workpapers. Textronsubmitted a petition for writ of certioixiri withthe U.S. Supreme Court; however, theSupreme Court declined to review the FirstCircuit Court of Appeals decision. As anas ide , t he aud i t s t andards (AICPAProfessional Standards AU section 9326(2])provide that limiting an independent auditor'saccess to the tax accrual workpapers mayconstitute a scope limitation and aftect theirability to render an opinion, luui thus mayhave a deleterious eftect on the fuiancial state-ment audit opinion.

The critical part of this case, as noted bythe dissenting opinion for the Court ofAppeals, was that the courtrestricted he testfor privilege to a more narrowly definedrequirement that information be "preparedfoi ' or "for use in" litigation to be protect-ed. Thus, taxpayer protection of workpa-pers would be even more difficult toobtain. The Textron decision is in contrastto the recent decision in Detoitte LL P (CA-D.C. June 29, 2010), in which the DistrictCourt ruled in favor of the taxpayer andextended the work product doctrine protec-tion to communication among the tiixpayer,outside counsel, and its independent auditorconceming possible litigation arising fromcontingent tax liabilities. Although conflictsremain among districts on 1RS access toworkpapers, Te.xtron did provide strong, con-tinued support for 1RS access to taxpayerworkpapers.Tr anspar ency andR epor t ing R equ i r ements

The 1RS has reiterated its policy of exer-cising restraint in requesting tax accrualworkpapers du r ing an aud i t ( s eeAnnouncements 2 002-63, 2 010-9, 2 010-76,an d Internal Revenue Manual 4.10.20) .The only exceptions to this rule are for taxshelter transactions (also known as listed


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transactions, see Treasury Regulations sec-tion 1.6011 -4) and unusual circumstances inwhich all other means have not yielded the1RS agent with the nece.ssary facts to ana-lyze a given tax position. Thus, the 1RS con-tinues to limit the extent to which agents canseek tax accrual workpapers in order to goon a "fishing expedition." It has been sug-gested that the 1RS has become more aggres-

appear in the calculation of taxable income(effectively bypassing the M-1).The Schedules M-1 and M-2 soonbecame limited in their ability to disclosesignificant issues due both to the lack of uni-form definitions and terminology, and thebusiness's ability to aggregate and net dif-ferences. In addition,reportingcategories thatwere too broad and aowed too much fiex-

H i s t o r i c a l l y , t h e 1 R S h a s l e v e r a g e d t h e t e n s i o n h e t w e e n c o p r a t i o n s 'i n c e n t i v e t o r e p o r t h i g h e r h o o k i n c o m e w i t h t h e i n c e n t i v e t o r e p o r t l o w e rt a x a h l e i n c o m e i n o r d e r t o h i g h l i g h t a g g r e s s i v e t a x p o s i t i o n s .

sive in requesting tax workpapers (Mark J.Cowan and Tom English, "The Challengeso f T r a nspa r e nc y in C or po r a t e Ta xDepartments: What Will the New AuditDocumentation Requirements and FTN 48Reveal to the 1RS?" The CPA Journal,October 2007).Instead, the 1RS has relied upon variousother means to encourage taxpayers to dis-close uncertain tax po.sitions to increase traas-parency. Historically, the 1RS has leveragedthe tension between corporations' incentiveto report higher book income with the incen-tive to report lower taxable income in orderto highlight aggressive tax positions. Thereportingrequ irem ents o capture and di.sclosethese differences were established in 1964with the Schedule M-1 (Fomi 1120). TheM-1 has the sole purpose of requiring dis-closure of the reconcOing differences betweena corporation's net income per books andits taxable income. Many of the reconcilingdifferences are routine in nature, such asdifferences in depreciation methods, nonde-ductible capita] losses and tax-exempt inter-est income. Unusual items may be high-lighted as part of the reconciation process,however. Similarly, Schedule M-2 (Form1120)requires econciliationof the beginningand ending balance of retained earnings, thusdrawing attention to items that may be cred-ited directly to retained earnings but d o not

ibility by allowing corporations to concealaggressive tax posit ions. To overcomethese limitations, tiie 1RS introduced theSchedule M-3 in 20 04 (for corporations withover $10 million in assets), which requiressubstantially more detail on book-tax dif-ferences. The additional details necessitatea three-page form. TTie first page (part I)requires a reconcilia tion of worldwideincome to U.S. taxable income, with anestablished definition of " incom e." Pages twoand three (parts II and III) request moreextensive details of reconciling differencesbetween b


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1 ) th eRS has a general administrative practiceto e x a m in e t h e p o s i t i o n ( 1 R Snnouncement 2010-09).

In general, the lRS's reliance on the FINrovides tbe benefit of ctmsistency betweeninancial and tax reporting and reduceshile the expectation to litigate extensionIncreases the ambiguity of which retum

o s i t i o n s mu s t b e d i s c lo s e d , 1 R Sommissioner Shulman, in a speech beforet h e A m e r i c a n B a r A s s o c i a t i o n o nSeptember 24, 2010, indicated that the 1RSdcx;s not intend for companies to report taxpositions that aie highly certain or imma-terial for financial reporting purposes.The tlnal disclosure requirements forUTPs are a substantial pullback from theIRS's original proposal made earlier in 2010.For example, instead of merely rankingUTPs in order of size, the original proposalrequired corporations to disclose maximumtax adjustments assix;iated with a tax posi-tion. The original proposal also requiredcompanies to disclose unceitain tax positionsfor which nofin;uicialstatement reserve hadbeen established becau.se of an 1RS adinin-istralive practice of not challenging suchtax positions, which wou ld have substantiallyincrea.sed the number of disclosed posi-tions. Finally, the 1RS eased the requirementsfor describing UTPs, which previouslyrequired the taxpayer to provide legal ratio-nale for the transaction. Currently, compa-

nies iirerequired o briefly de.scribe the trans-action and the issue. In several speeches,Shulman has maintained that tbe 1RS has theauthority to seek this information under exist-ing authority: however, the 1RS is willingto work with corporate taxpayers and hasinitially rekixed the reptrting requirements.The 1RS is phasing in the new UTPreporting requirements. For tax yearsbeginning after December 15, 2009, tax-payers with assets of $I(X) million or moreare required to submit the new fonn UTPwith their income tax rettims. Entities with

$50 million and $10 million of as.sets willsubmit the fomi UTP for tax years begin-

n in g a f te r D e c e m b e r 1 5 , 2 0 1 1 , a n dDecem ber 15, 201 3, respectively. At leastinitially, tlie fomi UT P only needs to be filedwith Fomis 1120 (corporations), I I2 0F (for-eign coiporations) . 112()L (life insurance cor-porations) , and 1120PC (PC insui ance cor-porations), and it does not apply to pass-through entities and not-for-profit organiza-tions. The UTP is intended to achieve the1RS goals of increased tax reporting trans-parency and enhanced audit efficiency.A Game ChangerThe new reporting on uncertain tax posi-tions dramatically increases tbe transparen-cy the 1RS has long sought for coiporate dis-closure, and the 1RS clearly believes it hasthe authority to require the disclosure ofthis infonnation. Wbile the administrativeburden of gathering and enumerating UTPshas hindered past reporting, the financialreporting requirements under FIN 48 havemade UTP infonnation more readily avail-able. In addition, the recent decision inTextron, coupled with earlier court decisionson the IRS's ability to access tax accrualworkpapers, has provided the 1RS newfoundgravitas on the issue.

The UTP issue clearly has made corpo-rate executives nervous. Nearly half of cor-porate executives responding to a KPMGsurvey (October 10, 2010) expres.sed con-cem about the new UTP reporting require-me n t s : a mo n g th e r e s p o n d e n t s , 2 8 %believe that 1RS agents will u.se the newSchedule UTP to fomi proposed audit adjust-ments and to select fimis for audit. Theseconce rns a re we l l g rounded , becauseShulm an specifically stated that the 1RS willuse the information in the new form to"reduce the time it takes to find issues; ensurethat the 1RS and taxpayers spend moretime discu.ssing the law as it applies to theirfacts, rather than looking for information:identify areas of uncertainty requiring guid-ance: and help prioritize selection of issuesand taxpayers for examination."

Undoubtedly there is more work to bedone on the UTP issue and coordinationwith existing 1RS reporting requirements.For example, while the 1RS has specifi-cally indicated that the Schedule UTPwill take the place of the disclosure ixjquire-ments for listed transactions, there is stillwork to be done to coordinate the disclo-sures with the Form 1120 Schedule M-3,reconciling book income to taxable income

that was first instituted for tax retums in2004. It appears that the 1RS might elim-inate some of the exi.sting reporting require-ments that duplicate the information inthe Schedule UTP. It is also unclear whatenticements the 1RS may use to encouragetaxpayers to complete the schedule. In anE r n s t & Y o u n g - s p o n s o r e d w e b c a s t ,Heatiier M aloy, 1RS comm issioner for the

T h e n e w r e p o i t i n g o n u n c e r t a i n t a xp o s i t i o n s d r a m a t i c a l l y i n c r e a s e s t h e

t r a n s p a r e n c y t h e 1 R S h a s l o n gs o u g h t f o r c o r p o r a t e d i s c l o s u r e .

Large and Mid-Size Businesses Division,indicated that "the penalties that will applyare tbe normal penalties for incompleteschedules, a l though the 1RS may askCongress for specific penalties."The 1RS has clearly changed the gamein corporate tax reporting. The benefits fortaxpayers include increa.sed 1RS audit effi-ciency and consistent treatment of uncer-t a in t a x p o s i t i o n s a c r o s s t a x p a y e r s .However, witii a corporate tax gapthedifference in corporate taxes owed andtaxes paidestimated by the GovemmentAccountability Office to be approximate-ly $26 billion, it is apparent that the U.S.govemment will be the primiiry benefi-ciary of the new reporting requirements.The new Schedule UTP dramat ica l lyincreases transparency and represents aparadigm shift in corporate tax reporting,the repercussions of which are yet to becompletely understood.

Ron Singleton, PhD, CPA, is a professorof accountancy, and Steve Smith, PhD,CPA, is an adjunct professor of accoun-tancy, both at Western WashingtonUniversity, Bellingluun, Wash.


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the increase in transparency requirements for corporate tax positions

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