Individual Comments on Proposed Regs on Payment of Whistleblower Rewards

The Internal Revenue Service ("IRS") issued proposed rules on Section 7623 whistleblower awards on January 18, 2011 clarifying the definition of proceeds of amounts collected and collected proceeds for purposes of section 7623 concerning refund prevention claims and the reduction of an overpayment credit balance ("Proposed Rule"). The IRS and Treasury requested comments on the clarity of the Proposed Rule and how it may be easier to understand. It is my pleasure to offer such comments.

Background

Section 7623 was amended in 2006 as part of the Tax Relief and Health Care Act of 2006 to essentially fix what many commentators would simply describe as a broken system. Importantly, the 2006 amendments created a centralized Whistleblower Office and generally required that whistleblowers be paid awards under certain circumstances. Pre Review of the IRS annual reports to Congress on the whistleblower program, the 2006 amendments to Section 7623 were immediately effective in increasing both the volume of whistleblower submissions and the alleged tax dollars at stake.

The IRS posted on its website in June 2010 award procedures for tax whistleblowers under Section 7623 contained in an update to the Internal Revenue Manual ("IRM"). Section 25.2.2.1(7) of the IRM provides, in part, that collected proceeds do not include liabilities satisfied by the reduction of a credit balance as monies are not obtained. While this conclusion is directly addressed by the Proposed Rule, the same logic seemingly appears again, albeit in a different form, in Exhibit 25.2.2.11, Sample Preliminary Award Report, Section 3, Collected Proceeds Based on Whistleblower Information, as discussed in greater detail below ("Exhibit 25.2.2.11, Section 3 Issue").

The IRS disclosed in their 2009 report to Congress published in December 2010 that the IRS has yet to pay any awards under Section 7623 as amended in 2006. The IRS has been unfairly criticized for not paying any awards to date under Section 7623 as amended in 2006 given the (i) time required to review the alleged claim, examine the alleged tax violator, settle the proposed adjustments through the appeals and/or judicial process and, finally, for the Whistleblower Office to review the case file and process the award. Further, the Whistleblower Office has had the added burden of trying to perform in accordance with the intent of the law while swimming upstream without a paddle given the lack of guidance in the form of regulations issued by the Treasury. The Proposed Rule clarifying the definition of collected proceeds is very important in assisting the Whistleblower Office in carrying out their responsibilities.

Proposed Rule

The Proposed Rule is clear and easy to understand as it relates to collected proceeds from violations by individual taxpayers, however, the Proposed Rule should be expanded to address issues that are both unique and complex to corporate taxpayers. Failing to provide additional guidance for collected proceeds from violations by corporate taxpayers may impact the IRS decision to pursue the whistleblower claim. For example, a whistleblower may provide information of an alleged violation by a corporation with a net operating loss. If a reasonable solution to determining collected proceeds from a corporation with a net operating loss is not included in the Proposed Rule, the Whistleblower Office may simply discard these types of claims as too difficult to understand, in effect, giving the alleged violator a get-out-of-jail-free card, especially in the case of a corporation that carried back the net operating loss and recovered taxes paid in prior years. Further, failing to expand on the definition of collected proceeds may result in poor administrative practices. For example, it would be a poor administrative practice for the Whistleblower Office to pay an award of 15-30% for an adjustment that is temporary or timing item, e.g., disallowing depreciation deductions in year one that the taxpayer will ultimately claim in later years. Surely controversy between the informant and Whistleblower Office will arise if taxes are recovered based on a claim that results in an adjustment to a temporary item that the Whistleblower Office determines does not merit an award. Lastly, failing to expand on the definition of collected proceeds will certainly result in a backlog of unagreed awards at both the Whistleblower Office and U.S. Tax Court.

The Proposed Rule should, thus, address collected proceeds from corporate taxpayers in the following areas:

Section 172(b) generally provides that a corporation may carryback a NOL two years and carryforward the NOL 20 years. Section 172(H) expanded the NOL carryback provision for losses incurred in 2008 and 2009 from two years to five years. It is important the Proposed Rule provide guidance on the treatment of NOL and equally important that the Proposed Rule distinguish between NOL carrybacks and NOL carryforwards.

NOL carryback. Collected proceeds should include an adjustment to a NOL that was carried back by the taxpayer to recover taxes paid in a prior year as the reduction in the NOL carryback would clearly result in collected proceeds.

NOL Carryforward. A adjustment to a NOL carryforward creates a complex issue and, possibly, an administrative nightmare for the Whistleblowers Office. While there is certainly value in a NOL carryforward and, thus, value in the reduction of the NOL carryforward from a violation of a tax law, the value is only realized if the NOL carryforward is used (or would have been used in the case of the adjustment to the NOL carryforward) to offset future taxable income. Companies will chronic losses may go out of business before they ever generate $1 in taxable income. Other companies may undergo an ownership change under Section 382 that would place a limitation on the annual utilization of the NOL carryforward, possibly rendering a portion of the NOL carryforward worthless. Lastly, a NOL for a loss corporation may be reduced by a whistleblower claim, however, the loss company may generate additional NOLs that offset its future tax liability such that that adjustment is not meaningful.

It would make little sense to pay an award that reduces a NOL carryforward if the NOL carryforward is never used to offset taxable income in future years. Further, requiring that the Whistleblower Office leave a case open for up to 20 years to as it tracks whether or not the taxpayer ever pays $1 in taxes, or worse, what happens to the reduced NOL carryforward after an ownership change, would create a considerable burden on the Whistleblower Office who arguably should be spending their limited time and resources chasing violators who are currently paying taxes. With that said, the Whistleblower Office should not deny a claim outright if the corporation is in a NOL position as the taxpayer may have (i) carried the NOL back to recover taxes paid in prior years or (ii) offset a tax liability in years immediately or shortly after the loss year.

A reasonable approach with respect to a NOL carryfoward issue as it relates to the definition of collected proceeds is to include in the definition of collected proceeds an adjustment to a NOL carryforward that would have been utilized to offset taxes paid during a limited period of time subsequent to the loss year. A five year period seems like a reasonable period of time based on the general business cycle and the amount of time it takes for the IRS to process an alleged violation of tax law through the exam and appeals process.

Temporary vs. Permanent Differences

A whistleblower may provide the IRS information for two types of alleged violations as follows:

Adjustments to permanent differences, however, result in a true collection of proceeds and, thus, the related tax collected should be included in the definition of collected proceeds.

IRM Exhibit 25.2.2.11, Section 3 Issue

IRM Exhibit 25.2.2.11, Sample Preliminary Award Report, highlights an additional issue that should be addressed in the Proposed Rule: should collected proceeds be limited to the net incremental tax recovered during an examination? The IRS apparently believes that collected proceeds should be limited to net tax collected during the exam.

Specifically, Section 3, Collected Proceeds Based on Whistleblower Information, of IRM Exhibit 25.2.2.11 provides, in part, the following information for tax year 2006 for purposes of determining collected proceeds:

      a. Total Additional Tax Assessed and Paid            $4 m

"Total Additional tax Assessed and Paid" is important in allocating any interest assessed and paid between the 'assessment related to whistleblower issue" and non-whistleblower issues, however, it should not put a limitation on the value of the whistleblower issue. The Proposed Rule should clarify how collected proceeds should be determined. Collected proceeds from an "assessment related to whistleblower issue" should not be limited to the incremental net tax assessed during the examination but, instead, on the total adjusted tax liability for the applicable year plus any proceeds related to the NOL carryback or carryforward as discussed above.

Other Issues

Use of 'with and without'

Given the complexities involved in determining collected proceeds for corporations, the Proposed Rule should not be shy about promulgating the use of a 'with and without' calculation to determine collected proceeds, especially in the case of any guidance regarding NOL carryforwards, and temporary and permanent differences.

Section 7623(b)

Section 7623(b)(1) provides: "In general. If the Secretary proceeds with any administrative or judicial action described in subsection (a) based on information brought to the attention by an individual, such individual shall, subject to paragraph (2), receive as an award at least 15 percent but not more than 30 percent of the collected proceeds (including penalties, interest, additions to tax, and additional amounts) resulting from the action (including any related actions) or from any settlement in response to such action. The determination of the amount of such award by the Whistleblower Office shall depend upon the extent to which the individual substantially contributed to such action".

The "substantially contributed" language is also used in Section 7809 and the regulations thereunder, however, there is little to no useful guidance in the legislative history under 7623(b) and currently no regulations that would assist the Whistleblower Office in determining the appropriate percentage. The lack of guidance in this area will certainly give rise to controversy.

Section 25.2.2.9.2 provides insights on how the IRS will determine the award percentage under 7623(b). Section 25.2.2.9.2(5) provides "the starting point for the Whistleblower Office's analysis will be the statutory minimum of 15 percent of the collected proceeds". The IRM goes on to provide, in general, that the 15 percent may be adjusted upward and downward by positive and negative factors.

An award program that simply provides discretion to administrators to determine the award percentage may result in the administrators weighing claims against one another which would not be consistent with the law. Section 7623(b)(1) provides that the award percentage should depend on the extent the informant substantially contributed to the action (i.e., collecting the proceeds) of the IRS. In other words, the award percentage is the weight or value of the information provided by the informant versus the action performed by the IRS to collect the tax. Thus, the starting point for determining the award percentage should not be the minimum percentage; the starting point for award determination should be defining and assessing the action performed by the IRS. The information provided by the informant should then be assessed against the action performed by the IRS to determine the extent to which the information substantially contributed to the collection of the tax.

The current approach to the award percentage as outlined in the IRM will invariably pit one claim against the other as the administrators of the program try to determine the award percentage. To be sure, the current approach does not appear to allow for a 30 percent award in the case of a simple violation where detection by the informant was the single contributing factor to the collection of tax and the IRS served merely as a collection agent. A plain reading of the law would suggest that a 30 percent award is possible under any circumstance if a proper analysis of substantially contributed is performed. A 30 percent award potential should not be denied out of the gates which is essentially being today using the 'starting point of 15 percent'.

As way of an example, assume Taxpayer A is a branded pharmaceutical company. Taxpayer A incurs $100 million in R&D expenses relating to clinical trials. The $100 million would qualify as qualified research expenditures (QRE) for purposes of the R&D credit except $35 million relates to clinical trials performed outside the United States. Taxpayer A claims the entire $100 million as QRE in determining its R&D credit. Accountant A is not involved in preparing Taxpayer A's R&D credit or its tax return but is aware of the tax violation. Accountant A submits a claim to the Whistleblower Office. The claim includes a technical tax memorandum and schedules that clearly identify the violation and amount of the exposure. The IRS exams Taxpayer A, identifies the violation, issues a notice of proposed adjustment, and Taxpayer A pays the related tax of $2.1 million.

It is clear that Accountant A substantially contributed to the action by the IRS to collect the tax. In fact, if Accountant A did not provide the information to the IRS, the IRS may not have ever detected the issue. The issue, however, is not something new to the IRS; it is an issue that the IRS may have detected if they selected Taxpayer A for audit, included R&D credits in the scope of the exam, and added the proper R&D expert to the exam team. Based on the IRM including the positive factors that would increase the award from the IRS starting point of 15 percent, Accountant A may be awarded a percentage higher than 15 percent but would not be able to achieve the 30 percent award percentage. I do not believe this result is consistent with a plain reading of the law.

The Treasury should issue regulations (including examples) under 7623(b) to assist the Whistleblower Office in determining the award percentage. At a minimum, the regulations should include the following:

The Treasury should issue regulations under 7623(b). The regulations would certainly be helpful in clarifying the intent of the law and it would allow the Whistleblower office to spend more time processing claims and less time trying to interpret law and defending award determinations.

Back to the comments requested by Treasury. . . .

In closing, I applaud the Treasury for promulgating rules on the definition of collected proceeds and would encourage you to consider the unique and complex issues associated with corporate taxpayers. The Proposed Rule will undoubtedly lift the burden placed on the Whistleblower Office of having to interpret laws and will allow the Whistleblower Office to do what everyone expects them to be doing: processing and paying awards.

I do not request a public hearing for the Proposed Rule and would discourage Treasury from capitulating to any requests for a public hearing made by whistleblower attorneys unless their agenda includes something other than trying to turn doughnut holes into proceeds. The Treasury undoubtedly has better use for their time including drafting regulations under Section 7623(b)(1).