On September 24, the IRS issued a package of guidance finalizing the requirement that specified categories of corporate taxpayers include information as to "uncertain tax positions" as part of their tax return (Schedule UTP). First publicly announced in February of this year (in Announcement 2010-9), the idea that taxpayers will be required not only to self-assess their tax liabilities but also identify the pressure points in that self-assessment has now officially become part of the tax system. Along the way, the IRS commendably listened hard to taxpayer concerns and backed off from some of its more controversial proposals, though still leaving plenty for taxpayers to deal with and puzzle over. Moreover, the IRS proactively used the opportunity to revise its posture on privilege for tax reserve information provided by taxpayers to independent auditors.
The new reporting requirements apply beginning with returns for 2010. Affected taxpayers are corporations filing Form 1120, 1120-F, 1120-L or 1120-PC that issued audited financial statements (or are included in audited financial statements of a related party) for the tax year and recorded a reserve for one or more U.S. tax positions. The IRS has deferred consideration of applying the requirements more broadly, e.g., to pass-through entities or tax-exempt entities. Penalties for failures regarding Schedule UTP have not yet been specified; various approaches will be considered as the process rolls out.
CHANGES TO SCHEDULE UTP
Phase-in. Reporting will be phased-in over a five-year period depending on the corporation's size. Only companies with $100 million or more of assets will be required to file Schedule UTP for 2010 and 2011. In 2012 and 2013, the threshold will be reduced to $50 million, and in 2014 the originally proposed $10 million threshold will be applied.
Ranking Only. Taxpayers will not be required to identify the maximum potential exposure relating to a particular issue, as originally proposed. Instead, a taxpayer must rank its uncertain tax positions based on the size of the financial accounting reserve for the position, and also indicate which ones are "major", i.e. those for which the reserve is 10 percent or more of the aggregate reserves for the tax positions reported on the schedule. Thus, issues involving large potential adjustments but for which the taxpayer is quite confident of its position (even if it feels the need for a modest reserve) will not appear more significant than issues smaller potential adjustments but a low confidence level. Assuming that the taxpayer's reserves are computed based on a reasonable assessment of the actual risk, this will result in a better allocation of the government's audit resources. Items must also be tagged as temporary or permanent differences, and as transfer pricing or "other", which may affect the IRS's audit prioritization.
Identification Only, No Analysis. Taxpayers will not be required to identify the rationale and nature of the uncertainty of each disclosed position. Rather they will simply be required to provide "a concise description of the tax position, including a description of the relevant facts affecting the tax treatment of the position and information that reasonably can be expected to apprise the IRS of the identity of the tax position and the nature of the issue." This brings the disclosure more in line with existing rules (e.g., Form 8275 for disclosure under section 6662). It also helps to eliminate the concern that taxpayers would be required to disclose on their return legal advice that they received in planning for a transaction, thereby potentially waiving attorney-client privilege.
No Reporting of "Administrative Practice" Positions. Taxpayers need not disclose items that were omitted from their tax reserves because "the corporation determined it was the Service's administrative practice not to raise the issue during an examination," as initially proposed Taxpayers had argued that it would be waste of time to separately state such items and for the government to separately review them. Although the government acceded to these comments, it was clearly uncomfortable doing so. Announcement 2010-75 (which describes the final Schedule UTP and instructions) states that the IRS will "continue to explore ways to assess the impact of these tax positions on overall tax compliance." No doubt the government is concerned that taxpayers could attempt to hide a multitude of sins under this general rubric.
Consistency with Financial Statements. The IRS also clarified that all disclosures on Schedule UTP should be made in a manner consistent with the decisions involved in establishing tax reserves for financial accounting, including pertinent certainty and materiality standards. This certainly simplifies things by avoiding any need to reassess reserve decisions when preparing the tax return. However, in line with the IRS's initial proposal, taxpayers must still disclose positions where, under pertinent accounting standards, it did not establish a reserve because of an intention to litigate, if challenged. Although a number of taxpayers and professional organizations argued against this aspect of the proposal, it is clear that the IRS feared a change would simultaneously open a door to the audit lottery and encourage litigation rather than settlement.
Other Points. A variety of other issues were also clarified, perhaps most importantly the timing of disclosure – i.e., that reporting depends on both taking a position on a tax return and establishing a reserve, and that disclosure must be made after the occurrence of the later event. Other issues addressed include:
- Positions taken on pre-2010 returns need not be disclosed even if the financial accounting tax reserve is established in 2010 or a later year.
- Disclosure is required only with respect to U.S. federal income tax positions, not foreign or state tax positions, although reporting may be required if there is a reserve for a federal income tax position which arises out of uncertainty with regard to a foreign or state tax position (e.g., foreign tax credits).
- Reserves include interest and penalties.
- "Audited" financial statements are only those on which an independent auditor expresses an opinion under applicable accounting standards, not merely compiled or reviewed financial statements. This could be pertinent to privately held companies.
Special Considerations for Multinational Enterprises:
- A tax reserve recorded in an audited financial statement in which the U.S. taxpayer is included – e.g., foreign parent financials – triggers UTP reporting if the tax position was taken on the U.S. taxpayer's return.
- Corporations filing Form 1120-F – including foreign entities filing protective, largely blank, returns on the off-chance that they are determined to have a U.S. trade or business – must complete Schedule UTP if reserves have been established on an audited financial statement for that U.S. tax uncertainty or others. The dollar threshold for filing is based on worldwide assets.
- As noted above, transfer pricing positions must be specifically identified. The IRS may, after reviewing the utility of the process, consider requiring additional information such as the specific country or character of income.
- The IRS affirmed a general intention to refrain from providing Schedule UTP information to other governments, absent a reciprocal arrangement with the foreign government, and, even then, only after consideration of other factors.
AMPLIFICATION OF IRS POLICY OF RESTRAINT
Concurrently with the final UTP pronouncements, the IRS also issued Announcement 2010-76, which purports to "expand" the IRS's "policy of restraint" with respect to a taxpayer's dealing with its auditors. The IRS now explicitly states that it will not, in most cases, assert any waiver of attorney-client privilege (or the tax advice privilege of section 7525 or the work-product doctrine) solely as a result of documents being provided to an independent auditor as part of an audit of the taxpayer.1 (Of note, this revised policy does not appear to be limited to taxpayers filing Schedule UTP.) Taxpayers will also be entitled to redact draft descriptions, analyses, computations, etc. prepared in connection with Schedule UTP from any tax reconciliation work papers provided to the IRS as part of an examination. The context of this revised policy is growing taxpayer concern, and developing case law (Textron and other cases), regarding the IRS's access to documents turned over to auditors pursuant to entities' increased burden to convince their auditors of the correctness of their tax positions in a Sarbanes-Oxley, FIN48 world.
However, the new IRS policy is expressly limited to the examination context, with no discussion of the provisions' broader applicability, e.g., in Appeals or litigation. Constraints on other potential litigants, including the Department of Justice, are obviously not addressed. In recent public remarks, the IRS Chief Counsel stated that the new policy should not be read to create any inference about "the law of waiver."
Thus, while there is no doubt that the revised IRS policy is intended as a favorable accommodation to taxpayers and should be appreciated as such, its exact contours are unclear. A distinction between administrative and litigation positions may be difficult to maintain. The ultimate question is whether the benefits of the amplified policy will be far outstripped by the additional information -- effectively an audit map -- now affirmatively required on Schedule UTP.
The galvanizing decision by the IRS to increase the transparency of taxpayers' assessments of its tax positions is both a sea change in our tax system and a work in progress. The IRS will, at least initially, centralize the review of all UTP disclosures, not only for consistency and selection of audit issues but also to evaluate the need for further guidance or modification to the rules or even legislative changes. Undoubtedly the IRS also hopes that the new procedures will moderate aggressive taxpayer positions and playing of the "audit lottery." Nevertheless, in a Directive to the Field, the IRS is exhorting examiners to act without bias, use independent judgment and regular examination tools, and "apply the law as it currently exists, not how we would like it to be" -- time will tell. The IRS will shortly issue guidance expanding the Compliance Assurance Program (CAP), which involves real-time audits, to include a pre-CAP introductory phase and as post-CAP "maintenance" phase. It would not be surprising to see CAP participation become increasingly common as taxpayers recognize the inevitability of transparency and the benefits of certainty.
Exceptions include "listed transactions" or "unusual circumstances," as well as situations where other actions by the taxpayer constitute a waiver. Implicitly, once the IRS has determined that a request for tax accrual workpapers is appropriate, it will be prepared to argue for a waiver of attorney-client privilege with respect to documents turned over to the accountants as part of the financial audit.
Please let us know if we can be of any assistance with this IRS guidance. To discuss such issues, you may contact any of our tax attorneys listed below.
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