T A X A T I O N

corporate

taxation

The Increase in Transparency Requirements tor Coprate Tax Positions

By Ron Singleton and Steve Smith

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he United States income tax system is based on honesty, self-reporting, and self-assessment. Taxpayers are supposed to submit truthful and accurate rettims, and the U.S. govemment is supposed to efficiently and effectively audit retums for errors and omissions. In a system that is increasingly complex and difficult to administer, however, the taxpayer-govemment relationship can quickly devolve into a game of hideand-seek. Although advances in computer technology, information reporting and matching, and electronic filing have increased transparency and efficiency in individual tax compliance, progress

on the corporate side has been comparatively slow. 1RS corporate audits continue to be dominated by agents hunkering down over a company's accounting records and documents not only looking for errors and omissions, but also unraveling complex transactions to ensure proper reporting. The 1RS has long been concemed witii how to effectively audit corporations, and has recognized the importance of companies being open about questionable tax piisitions in making the audit process more efficient. In a speech to the New York State Bar Association on January 26, 2010, 1RS Commissioner Douglas

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Shulman outlined the goal of improving tj-diispiuuncy lor material tax issues to achieve tlie 1RS objectives of certainty, consistency, and efficiency. Shulman noted that 1RS agents spend up to 25% of their time in large corporate audits seiuching for issues rather than discussing them with taxpayers. He noted that the overriding goals of the 1RS initiatives include less time auditing, more time spent discussing identified issues, and prioritized 1RS selection of which taxpayers and issues to examine. It is not coincidental that the commissioner's speech on this issue was given five days after the First Circuit S.Ct. of Appeals decision in Textron Inc. el cil v. U.S. (2009-2 USTC 50,574; S.Ct. cert denied May 24,2010), a closely watched case in which the court affirmed tliat woi-kpapers prepared for a financiiil statement audit are not privileged communications, and can be subject to a subpoena. On the heels of its win in Textron, the 1RS recently intnxluced a possible game changer in coiporate tax compliance and reporting; the reporting for uncertain lax positions (UTP). In brief, 1RS Schedule UTP requires a company to enumerate its uncertain tax pt)sitions, thereby eliminating the uncertainty in the IRS's audit lottery of searching for a company's uncertain tax positions. The purpose of this article is to review recent judicial, regulatory, and administrative changes that have shifted the burden to the taxpayer to disclose uncertain tax positions. In addition, the 1RS has leveraged FASB Interpretation 48 (FIN 48, which has been codified as ASC Accounting Standards Codification] 74010) financial reporting rules that require companies to establish tax reserves. These combined actions have effectively increased transparency and the IRS's ability to identify uncertain tax positions and audit more effectively.

tive information in the workpapers from discovery or summons by the 1RS was carved out in Hickman v. Taylor (39 U.S. 495 [1947]) in the form of the work product doctrine. The work prcxluct dixtrine allows the taxpayer the right to protect tlie privileged communication contained in workpap)ers ft-om 1RS review if the communication is confidential between the taxpayer and attorney, and if the infonnation is to be used for litigation support. This privilege is waived, however, if the taxpayer voluntarily dis-

Transparency, Tax Workpapers, and Common Law

Taxpayers often include information in workpapers regarding tax strategies, risk, and other sensitive information that they prefer not to share with the 1RS. Of course, the 1RS access to tax workpapers would aid in issue identification and would also taiget aieas of interest. The ability of the 1RS to access taxpayer workpapei>; has historically been an area of contention. The scope of taxpayer rights to protect sensi-

a minimal burden to show that the summoned information would be relevant. Further, as decided in Sterling Trading v. U.S. (DC-CA, Feb. 14, 2(X)8), the 1RS only need show "potential relevance to its (1RS) investigation." More recently, the First Circuit Court of Appeals decided in Te.xtron that intemal tax workpapers prepared for ase in possible litigation are protected, but pmviding tlie workpapers to external third-party auditors as part of the financial statement audit nullified the work product protection and allowed the 1RS to subpoena the workpapers. Textron submitted a petition for writ of certioixiri with the U.S. Supreme Court; however, the Supreme Court declined to review the First Circuit Court of Appeals decision. As an aside, the audit standards (AICPA Professional Standards AU section 9326(2]) provide that limiting an independent auditor's access to the tax accrual workpapers may constitute a scope limitation and aftect their ability to render an opinion, luui thus may have a deleterious eftect on the fuiancial statement audit opinion. The critical part of this case, as noted by the dissenting opinion for the Court of Appeals, was that the courtrestrictedthe test for privilege to a more narrowly defined requirement that information be "prepared foi^' or "for use in" litigation to be protected. Thus, taxpayer protection of workpacloses the information to a third party, as was pers would be even more difficult to the case in U.S. v. Arthur Young & Co. (465 obtain. The Textron decision is in contrast U.S. 805 [1984]). Arthur Young is consid- to the recent decision in Detoitte LLP (CAered a seminal case in defining the rights of D.C. June 29, 2010), in which the District 1RS access to tax accrual workpapers. In this Court ruled in favor of the taxpayer and case, the U.S. Supreme Court held that com- extended the work product doctrine protecmunications between a taxpayer and its inde- tion to communication among the tiixpayer, pendent auditor were not within the scope outside counsel, and its independent auditor of the work product doctrine, and the 1RS conceming possible litigation arising from contingent tax liabilities. Although conflicts could access the tax accrual workpapers. The decision in Arthur Young granted the remain among districts on 1RS access to 1RS a wide r^mge of power for access to tax- workpapers, Te.xtron did provide strong, conpayer tax accrual workpapers. The 1RS only tinued support for 1RS access to taxpayer has to "show that the investigation will be workpapers. conducted pursuant to a legitimate purpose, that the inquiiy may be relevant to the pur- Transparency and pose, that the information sought is not Reporting Requirements already within the Commissioner's possesThe 1RS has reiterated its policy of exersion, and that the administrative steps cising restraint in requesting tax accrual required by the Ccxie have been followed." workpapers during an audit (see (U.S. V. Powell. 379 U.S. 48,57-58,85 S . a , Announcements 2002-63, 2010-9, 2010-76, 248, 13 as cited in U.S v Worley, C.A.3-PA. and Internal Revenue Manual 4.10.20). Oct. 6, 2009). As noted in Muratore v. U.S. The only exceptions to this rule are for tax (DC-NY, April 15, 2(X)4), the 1RS has only shelter transactions (also known as listed

Hie ability of the 1RS to access

taxpayer woikpapeis has historically heen an area of contention.

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transactions, see Treasury Regulations section 1.6011 -4) and unusual circumstances in which all other means have not yielded the 1RS agent with the nece.ssary facts to analyze a given tax position. Thus, the 1RS continues to limit the extent to which agents can seek tax accrual workpapers in order to go on a "fishing expedition." It has been suggested 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 soon became limited in their ability to disclose significant issues due both to the lack of uniform definitions and terminology, and the business's ability to aggregate and net differences. In addition,reportingcategories that were too broad and aowed too much fiex-

Historically, the 1RS has leveraged the tension hetween coprations' incentive to report higher hook income with the incentive to report lower taxahle income in order to highlight aggressive tax positions.

transactions designated by the 1RS as abusive or availed for tax avoidance. Examples of listed transactions are debt sU"addles, lease-in/lease-out (LILO), salein/sale-out (SILO), and what are known as "Son of Boss" transactions. 1RS Forms 8886 and 8275 require additional information about the items in question. A corporation that self-reports aggressive tax positions on these forms can avoid substantial penalties that can be assessed if the item is discovered later. The importance of transparency of tax positions has continued to be reflected in recent court decisions and 1RS reporting changes. This is also reflected in the detailed repxjrting requirements of uncertain tax positions using financial accounting informationFIN 48 disclosures. The result of these increased transparency requirements has been a great deal of uncertainty in tax planning. The UTP requirements in particular have been the subject of extensive discussion and public comment during the past year.

sive in requesting tax workpapers (Mark J. Cowan and Tom English, "The Challenges of Transparency in Corporate Tax Departments: What Will the New Audit Documentation Requirements and FTN 48 Reveal to the 1RS?" The CPA Journal, October 2007). Instead, the 1RS has relied upon various other means to encourage taxpayers to disclose uncertain tax po.sitions to increase traasparency. Historically, the 1RS has leveraged the tension between corporations' incentive to report higher book income with the incentive to report lower taxable income in order to highlight aggressive tax positions. The reportingrequirementsto capture and di.sclose these differences were established in 1964 with the Schedule M-1 (Fomi 1120). The M-1 has the sole purpose of requiring disclosure of the reconcOing differences between a corporation's net income per books and its taxable income. Many of the reconciling differences are routine in nature, such as differences in depreciation methods, nondeductible capita] losses and tax-exempt interest income. Unusual items may be highlighted as part of the reconciation process, however. Similarly, Schedule M-2 (Form 1120)requiresreconciliationof the beginning and ending balance of retained earnings, thus drawing attention to items that may be credited directly to retained earnings but do not

ibility by allowing corporations to conceal aggressive tax positions. To overcome these limitations, tiie 1RS introduced the Schedule M-3 in 2004 (for corporations with over $10 million in assets), which requires substantially more detail on book-tax differences. The additional details necessitate a three-page form. TTie first page (part I) requires a reconciliation of worldwide income to U.S. taxable income, with an established definition of "income." Pages two and three (parts II and III) request more extensive details of reconciling differences between b<x)k income and expenses with those reported for tax purposes. The focus on disclosure and transparency of questionable tax positions also has been reflected in the additional reporting requirements of tax shelter U-ansactions (listed tran.sactions) on Form 8886 and disclosure of positions that may not otherwise be sufficiently disclosed on the tax return (Forms 8275 or 8275R for positions contrary to Treasury Regulations). Forms 8886 and 8275 support the M-3; for example, if unlike items are combined on the M-1 or M-3, additional disclosure must be provided on Form 8275 to satisfy the adequate disclosure requirements to avoid the IRC section 6662 accuracy-related penalty. More specifically. Form 8886 is required for the approximately 40 listed

Financial Reporting and FIN 48

An uncertain tax position is a financial accounting concept under FIN 48. Generally, a company can only recognize the financial accounting benefit from a tax position that is more likely than not to be sustained on its technical merits in an 1RS audit. Nonetheless, a company can claim the uncertain tax position on its federal income tax retum and reserve the tax benefit for financial reporting purposes until such time as the benefit is more likely than not to be sustained. The New Regime Leveraging the financial reporting requirements under FIN 48, the 1RS defines a UTP as a federal income tax position for which: 1) a company has recorded a reserve in its audited financial statements, or 2) a company has not recorded a reserve in its audited financial statements under the applicable accounting standards because the company has determined it is more likely than not to prevail (ie probability of settling with the 1RS Is less than 50%), and expects to litigate the issue (1RS Announcement 2010-75). The IRS's expectation to litigate extension of FIN 48 closes an 1RS concem that companies could avoid disclosure by not establishing

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a reserve in its audited financial statements. The 1RS initially proposed that uncertain tax positions also include any income tax position for which a taxpayer has not recorded a tax reserve because: 1 ) the taxpayer expects to litigate the position, or 2) the taxpayer has detemiined that the 1RS has a general administrative practice not to examine the position (1RS Announcement 2010-09). In general, the lRS's reliance on the FIN 48 financial standards for defining a UTP provides tbe benefit of ctmsistency between financial and tax reporting and reduces additional data gathering requirements. While the expectation to litigate extension Increases the ambiguity of which retum positions must be disclosed, 1RS Commissioner Shulman, in a speech before the American Bar Association on September 24, 2010, indicated that the 1RS dcx;s not intend for companies to report tax positions that aie highly certain or immaterial for financial reporting purposes. The tlnal disclosure requirements for UTPs are a substantial pullback from the IRS's original proposal made earlier in 2010. For example, instead of merely ranking UTPs in order of size, the original proposal required corporations to disclose maximum tax adjustments assix;iated with a tax position. The original proposal also required companies to disclose unceitain tax positions for which nofin;uicialstatement reserve had been established becau.se of an 1RS adininistralive practice of not challenging such tax positions, which would have substantially increa.sed the number of disclosed positions. Finally, the 1RS eased the requirements for describing UTPs, which previously required the taxpayer to provide legal rationale for the transaction. Currently, companies iirerequiredto briefly de.scribe the transaction and the issue. In several speeches, Shulman has maintained that tbe 1RS has the authority to seek this information under existing authority: however, the 1RS is willing to work with corporate taxpayers and has initially rekixed the reptrting requirements. The 1RS is phasing in the new UTP reporting requirements. For tax years beginning after December 15, 2009, taxpayers with assets of $I(X) million or more are required to submit the new fonn UTP with their income tax rettims. Entities with $50 million and $10 million of as.sets will submit the fomi UTP for tax years begin-

ning after December 15, 2011, and December 15, 2013, respectively. At least initially, tlie fomi UTP only needs to be filed with Fomis 1120 (corporations), II20F (foreign coiporations). 112()L (life insurance corporations), and 1120PC (PC insui^ance corporations), and it does not apply to passthrough entities and not-for-profit organizations. The UTP is intended to achieve the 1RS goals of increased tax reporting transparency and enhanced audit efficiency.
A Game Changer

that was first instituted for tax retums in 2004. It appears that the 1RS might eliminate some of the exi.sting reporting requirements that duplicate the information in the Schedule UTP. It is also unclear what enticements the 1RS may use to encourage taxpayers to complete the schedule. In an Ernst & Young-sponsored webcast, Heatiier Maloy, 1RS commissioner for the

The new reporting on uncertain tax positions dramatically increases tbe transparency the 1RS has long sought for coiporate disclosure, and the 1RS clearly believes it has the authority to require the disclosure of this infonnation. Wbile the administrative burden of gathering and enumerating UTPs has hindered past reporting, the financial reporting requirements under FIN 48 have made UTP infonnation more readily available. In addition, the recent decision in Textron, coupled with earlier court decisions on the IRS's ability to access tax accrual workpapers, has provided the 1RS newfound gravitas on the issue. The UTP issue clearly has made corporate executives nervous. Nearly half of corporate executives responding to a KPMG survey (October 10, 2010) expres.sed concem about the new UTP reporting requirements: among the respondents, 28% believe that 1RS agents will u.se the new Schedule UTP to fomi proposed audit adjustments and to select fimis for audit. These concerns are well grounded, because Shulman specifically stated that the 1RS will use the information in the new form to "reduce the time it takes to find issues; ensure that the 1RS and taxpayers spend more time discu.ssing the law as it applies to their facts, rather than looking for information: identify areas of uncertainty requiring guidance: and help prioritize selection of issues and taxpayers for examination." Undoubtedly there is more work to be done on the UTP issue and coordination with existing 1RS reporting requirements. For example, while the 1RS has specifically indicated that the Schedule UTP will take the place of the disclosure ixjquirements for listed transactions, there is still work to be done to coordinate the disclosures with the Form 1120 Schedule M-3, reconciling book income to taxable income

The new repoiting on uncertain tax positions dramatically increases the transparency the 1RS has long sought for corporate disclosure.

Large and Mid-Size Businesses Division, indicated that "the penalties that will apply are tbe normal penalties for incomplete schedules, although the 1RS may ask Congress for specific penalties." The 1RS has clearly changed the game in corporate tax reporting. The benefits for taxpayers include increa.sed 1RS audit efficiency and consistent treatment of uncertain tax positions across taxpayers. However, witii a corporate tax gapthe difference in corporate taxes owed and taxes paidestimated by the Govemment Accountability Office to be approximately $26 billion, it is apparent that the U.S. govemment will be the primiiry beneficiary of the new reporting requirements. The new Schedule UTP dramatically increases transparency and represents a paradigm shift in corporate tax reporting, the repercussions of which are yet to be completely understood.

Ron Singleton, PhD, CPA, is a professor of accountancy, and Steve Smith, PhD, CPA, is an adjunct professor of accountancy, both at Western Washington University, Bellingluun, Wash.

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