Firm Voices Concerns With Proposal to Require Reporting of Uncertain Tax Positions

On January 26, 2010, the Internal Revenue Service (the "IRS") released a landmark proposal in Announcement 2010-9¹ indicating its intent to require certain taxpayers to disclose on a new schedule to be filed with their tax returns their "uncertain tax positions." A draft schedule and instructions were released on April 19, 2010 in Announcement 2010-30.² The IRS invited comments on the proposal, schedule, and instructions and requested that they be submitted by June 1, 2010.³

We are pleased to submit comments on behalf of a coalition of approximately twenty of the largest multinational companies in the world that Dewey & LeBoeuf LLP represents. The coalition includes companies in the financial, insurance, and hedge fund industries with a combined market capitalization of over $800 billion and total assets exceeding $13.6 trillion.

We recognize the clear advantages to both taxpayers and the IRS resulting from increased transparency, including greater efficiency, certainty, and consistency in tax administration. However, it is important that any new disclosure requirements further rather than impede these goals, and do so in a manner that avoids imposition of significant additional tax compliance burdens on taxpayers. We are concerned that some aspects of the proposal create inefficiencies in the compliance and examination processes, at substantial cost to taxpayers, which may outweigh the potential incremental benefits to tax administration. Our comments include requests for clarification of issues of particular interest to our clients. They also highlight some of the more problematic aspects of the proposal. In addition to consideration of our coalition's technical and policy comments herein, we recommend that the IRS consider organizing a task force comprised of IRS representatives, corporate tax executives, tax lawyers, and accountants to study the potential impact of the proposal, to evaluate the means by which the information gathered on the new schedule will be utilized by the IRS, and to recommend improvements to the uncertain tax position reporting process.

I. Background

The schedule would require (1) a "concise description" of each uncertain tax position for which the taxpayer or a related entity has recorded a reserve in its financial statement (or for which no reserve has been recorded because of an expectation to litigate or IRS administrative practice) and (2) the maximum amount of U.S. federal income tax that would be due if the position were disallowed in its entirety on audit ("maximum tax adjustment"). The concise description must be in sufficient detail to allow the IRS to determine the nature of the issue and, as contemplated by the IRS, would include the rationale for the position and a concise general statement of the reasons for determining that the position is an uncertain tax position. The "maximum tax adjustment" would be determined without regard to the taxpayer's analysis regarding its likelihood of prevailing on the merits and would reflect all changes to items of income, gain, loss, deduction, or credit that would result if the position were not sustained.

II. Summary of Dewey & LeBoeuf LLP Coalition's Recommendations

We recommend that the IRS consider taking the following actions in implementing the new disclosure regime:

III. Comments and Requests for Clarification

The IRS is rightfully concerned that requiring disclosure of taxpayers' FIN 48 reserve amounts would abnegate or eviscerate its policy of restraint and would be vigorously opposed by corporate taxpayers.⁶ We believe, however, that requiring disclosure of a maximum tax adjustment amount is equally problematic. This is because the maximum tax adjustment is a fiction. It is an artificially inflated number that reflects zero chance that the taxpayer will prevail on the merits of its tax return position. Put another way, the maximum tax adjustment reflects a taxpayer hazard of litigation of 100 percent. Taxpayers and tax return preparers, however, are precluded from subscribing to positions on tax returns that have no possibility of success on the merits (i.e., positions that, in effect, would result in the IRS's determination of a maximum tax adjustment). Various tax return reporting standards exist as to the level of comfort that is required for a taxpayer to take a position on a tax return. These include: "reasonable basis," "realistic possibility of success," "substantial authority," and "more likely than not." Reasonable basis, the lowest reporting standard, is "a relatively high standard of tax reporting, that is, significantly higher than not frivolous or not patently improper . . . [and] is not satisfied by a return position that is merely arguable or that is merely a colorable claim."⁷ Such a position has generally been estimated to equate to a 20 to 25 percent chance of success on the merits.⁸ Accordingly, the maximum tax adjustment is an unrealistically high number -- one that is inherently misleading and thus likely to cause IRS examiners confusion.

We believe that requiring disclosure of the maximum amount of potential tax liability could (1) result in unwarranted taxpayer audit selection and issue emphasis, decreasing rather than increasing audit efficiency; (2) substantially and unnecessarily increasing the costs of taxpayer compliance; and (3) creating unforeseen collateral liability exposure to taxpayers from a regulatory and civil litigation standpoint.

We recommend that the IRS omit from the Schedule UTP the requirement of disclosure of a maximum tax adjustment. Any position for which a taxpayer is required to establish a reserve under FIN 48 generally will be material to the taxpayer's financial statements.⁹ The fact of this materiality should, in and of itself, be sufficient to enable the IRS to focus on issues potentially worthy of examination and allow it to appropriately allocate its resources. Once an audit commences, communications between the examining team and the taxpayer and information requests, such as information document requests ("IDRs"), will instruct the examination team accordingly.

Moreover, tax return preparers subject to return preparer penalties and Circular 230 will be obligated to verify the completeness and accuracy of the new schedule and amounts listed as maximum potential tax liabilities upon disallowance of a position, thus further increasing costs to taxpayers. Preparers may seek taxpayers' FIN 48 and tax accrual work papers to compare reserve amounts to the potential maximum exposures. Likewise, outside auditors will be required to review the schedule to ensure that it includes no material mistakes or omissions. Outside auditors who see that taxpayers have listed high potential maximum tax adjustments might be concerned that the IRS may determine a higher tax liability during an audit; therefore, the financial reserve amount may increase simply because an inflated number appears on the schedule. Such circularity would complicate the calculation of both the financial statement tax reserve amount as well as the maximum tax adjustment and, moreover, would alter unnecessarily the method of calculating financial statement reserves. Additionally, a taxpayer's internal tax, audit, risk management, and other functions will have to review the schedules to reconcile disparities between the potential maximum exposure and the reserved amounts.

Accordingly, the increased compliance costs to taxpayers are unnecessarily burdensome in view of the low probative, if not misleading, value the maximum tax adjustment provides to the IRS.

In the alternative, the IRS could expand the list of issues that do not require reporting of a maximum exposure amount. Three issues that we would recommend be added to the list include whether a business constitutes a permanent establishment, debt versus equity issues, and tax free combinations. Like other fact-intensive issues, such as transfer pricing, these issues pose quantification challenges.

Finally, the IRS could bifurcate disclosure requirements for Coordinated Industry Case ("CIC") and Industry Case ("IC") taxpayers by not requiring CIC taxpayers to report maximum tax adjustments. Commissioner Shulman has indicated that the IRS proposed requiring that taxpayers report maximum tax adjustments because a major goal of the proposal is to aid the IRS in selecting taxpayers for audit.¹⁰ However, because the IRS regularly audits CIC taxpayers, requiring them to report their maximum tax adjustments is superfluous and does not advance the stated goal with respect to them.¹¹

In addition, maximum tax adjustments would not be particularly helpful in aiding the IRS in prioritizing issues within audits of CIC taxpayers. For large taxpayers, further issue prioritization is best done at opening meetings and as part of the Joint Audit Planning Process. As LMSB Commissioner Heather Maloy has indicated, information from the largest taxpayers, which have the most transparent reporting, is available to the IRS from full audits and pre-filing.¹² A narrowly-tailored approach in which CIC taxpayers were not required to calculate and report a worst-case scenario would meet the IRS's goal of increasing the efficiency, certainty, and consistency of audits.

The proposal raises a number of questions in the partnership context with respect to the taxpayers that may be required to disclose uncertain tax positions. The draft schedule includes a column in which taxpayers are to enter the EIN of the pass-through entity where a tax position taken by the corporation relates to a tax position of the pass-through entity. The instructions provide that, for example, the EIN of the partnership should be reported if the corporation is a partner in a partnership and the tax position involves the partner's distributive share of an item of income, gain, loss, deduction, or credit of the partnership. The schedule defines pass-through entities as any entity listed in section 1(h)(10).¹⁴

It is unclear whether every partner in a partnership, regardless of the size of the partner's interest, would need to disclose the uncertain tax positions taken by the partnership. A mere five percent partner, for example, is very unlikely to be aware of the fact that the partnership in which it invests may have taken an uncertain tax position. Clarification also would be helpful on the correct treatment of investors in master limited partnerships ("MLPs"), which may file FIN 48 disclosures.

As it currently stands, the proposal raises significant investor relations issues in the partnership context. Partners who may be required to disclose the uncertain tax positions of the partnerships in which they invest may demand greater involvement in decisionmaking related to the transactions in which the partnership enters and in the information return process. The tax implications of positions could be different for each of the many partners in some partnerships. Determining the implication of a particular tax position for each investor would be costly and time-consuming for partnerships.

We recommend that, at a minimum, the IRS only require a corporate partner to report a partnership's uncertain tax positions on its Schedule UTP if it has greater than a 50 percent interest in that partnership. Such a threshold would help ensure that the partner is sufficiently aware of the partnership's tax positions to report them on the schedule and would mitigate the potential cascading disclosure issues that may result if the proposal is applied to partnerships. If, for example, a partnership's uncertain tax positions were to flow onto the tax return of another partnership, such as a hedge fund, the first partnership's uncertain tax positions would potentially flow onto the tax returns of the investors in that hedge fund, and so forth.

We recommend that the IRS, in setting a threshold level of interest in a related entity that triggers reporting of that entity's uncertain tax positions, consider basing the percentage interest on both vote and value. Such a standard would help to ensure that the reporting entity is responsible for the related entity's tax positions and is sufficiently aware of its related entity's activities.

The proposal raises certain issues with respect to the reporting required of affiliated taxpayers that file consolidated financial statements but that have one or more members not included in a consolidated federal tax return.¹⁵ In some such cases, the separate return filing taxpayer may also issue stand-alone financial statements. It is unclear whether the disclosure requirement for an uncertain tax position would be determined in such case by reference to the consolidated financial statement or the individual financial statement. We recommend that the IRS clarify that the disclosure of a tax position is determined in all cases by reference to the consolidated financial statements, regardless of whether separate financial statements are also prepared.

In some instances the laws of foreign jurisdictions may preclude a foreign corporation from providing a U.S. affiliate or branch with the information required to be placed on Schedule UTP. In other instances, the U.S. subsidiary or branch may not have custody or control over such information and thus perhaps may be unable to obtain the information from the foreign corporation. The instructions should make clear that the rules apply to branches as well as the subsidiaries of foreign corporations and that a corporation will not be required to disclose information that it is unable to obtain.

"Audited financial statement" is defined in the instructions as a financial statement that an independent third party expresses an opinion on under U.S. Generally Accepted Accounting Principles ("GAAP"), International Financial Reporting Standards ("IFRS"), or another country-specific accounting standard including a modified version of any of the above that requires a taxpayer to record a reserve for federal income tax positions. The instructions provide that a corporation or related party "records a reserve" with respect to a tax position taken by the corporation when any of the following occurs in an audited financial statement of the corporation or a related party: (1) an increase in a liability for income taxes payable or a reduction of an income tax refund receivable with respect to the tax position; (2) a reduction in a deferred tax asset or an increase in a deferred tax liability with respect to the tax position; or (3) both (1) and (2). Under the current proposal, the initial recording of a reserve will trigger reporting of a tax position, but subsequent reserve increases or decreases with respect to a tax position taken on a tax return will not. A "tax position taken in a tax return" means a tax position that would result in an adjustment to a line item on that tax return (or would be included in a section 481(a) adjustment) if the position were not sustained.

Such issues that could potentially appear on such a list include, for example, (i) the issue of whether a business constitutes a permanent establishment; (ii) debt versus equity issues; and (iii) issues that the IRS has conceded during a previous audit in the last five years. The IRS could easily request information on any of these or other factually-intensive issues during an examination rather than on the new schedule.

The transition rule is unclear as to whether a tax position taken on a return filed prior to the proposal's effective date will become subject to reporting on a schedule filed with a subsequently-filed return due to the fact that it results in a net operating loss ("NOL") carryforward. The instructions should clarify that, once a tax position is taken on a return, it cannot become, on a subsequently-filed return, a tax position required to be disclosed on Schedule UTP due to the fact that the taxpayer is in a carryover position. Otherwise, a taxpayer carrying even a small NOL into 2010 could be required to disclose the full gamut of its pre-2010 tax positions.

We would recommend that the Specific Instructions for Part III, Concise Description of Uncertain Tax Positions, omit the requirement that taxpayers disclose "the rationale for the position and the reasons for determining the position is uncertain." Instead, the instructions should be modified to comport with the instructions to Form 8275, Disclosure Statement, and should read as follows:

Moreover, the additional tax and audit analysis required on the part of the taxpayer will result in the creation of Schedule UTP tax work papers ("UTP work papers") that heretofore have not existed. The UTP work papers would include, inter alia: (1) legal analyses as to whether positions are uncertain or not; (2) legal analysis pertaining to tax positions for which reserves have not been established under FIN 48 because the taxpayer expects to litigate the position; (3) legal analysis of tax positions for which reserves have not been established because the taxpayer has determined that the IRS has a general administrative practice of not examining the position; (4) legal analysis related to the maximum amount of potential federal tax liability attributable to each uncertain tax position. These UTP work papers would not be considered tax accrual work papers¹⁸ and thus would not currently be subsumed under the policy of restraint.¹⁹

We expect that risk management and professional ethics considerations will require tax return preparers and outside auditors to review and exchange these UTP work papers in the ordinary course of their respective functions. Tax return preparers will want to review the tax accrual and FIN 48 work papers of the independent auditors, and independent auditors will want to review the Schedule UTP to ensure accuracy and completeness in tax and financial reporting. Exchange of this information between tax advisors and independent auditors would likely, in most instances, cause a waiver of privilege.

We would also anticipate that the IRS would argue that the UTP work papers do not qualify for work product protection because they were prepared not in anticipation of litigation, but in connection with the preparation of the tax return. Examiners could request these UTP work papers as part of their examination of the tax return or as part of a concurrent return preparer penalty investigation. The UTP work papers may contain references to the tax accrual or FIN 48 work papers. This would effectively eviscerate privilege and the IRS's stated policy of restraint. The resulting discovery battles would exacerbate tensions between taxpayers and examination teams and further reduce audit efficiency. We therefore recommend that the IRS extend its policy of restraint to cover UTP work papers.

The Schedule UTP would also create duplication for taxpayers required to file Forms 8886, Reportable Transaction Disclosure Statement, and the Schedule M-3, Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million or More. To further the goal of efficiency and to reduce the burdens on both the IRS and taxpayers, this duplicate disclosure should also be eliminated.

The IRS should therefore consider establishing notification and challenge provisions for the information provided on Schedule UTP. The IRS has previously contemplated such provisions in the context of exchanges of information pursuant to the Council of Europe/Organization for Economic Cooperation and Development ("OECD") Convention on Mutual Administrative Assistance in Tax Matters ("Convention"). As part of the ratification process, the United States registered a declaration with the OECD advising that it may inform concerned persons before transmitting information about such persons to another party to the Convention, in relation to a spontaneous request for information or a requested exchange of information. The United States recently signed a protocol with respect to the Convention, so it is timely for the IRS to establish concurrent notification and challenge provisions with respect to Schedule UTP.

Uncertain tax positions often are the result of ambiguity in the law. Commensurate with any requirement that taxpayers be more transparent with regard to uncertainty surrounding their tax positions, new IRS guidance should appropriately reflect the IRS's uncertainty regarding the positions that it might adopt. Specifically, the IRS should limit areas it might define as contrary to applicable law in light of its own internal assessments as to legal uncertainty. Similarly, the IRS could also issue guidance with broader safe harbors, even in complex areas of tax law. Just as the IRS would benefit from the certainty, consistency, and efficiency of knowing a taxpayer's uncertain tax positions, the IRS should adopt guidance that allows taxpayers to benefit from increased transparency.

In particular, LMSB should improve the efficiency of its issue management process, with a focus on outcome-neutral issue resolution. Several methods of improving the efficiency and neutrality of audits include (1) establishing a minimum threshold for the strength of the IRS's own position (such as "substantial authority" or "more likely than not") that must be met before an examining agent issues a Form 5701, Notice of Proposed Adjustment, for an uncertain tax position; (2) providing more discretion to experienced agents; (3) clearly delineating responsibility in the LMSB tiered issue process so that taxpayers can engage in more meaningful discussions about the merits of a particular issue; (4) committing greater IRS resources to pre-filing dispute resolution mechanisms to allow early resolution of uncertain tax positions; and (5) increasing interaction with industry groups and the tax bar on Industry Issue Resolution requests.

In addition, as Chief Counsel Wilkins has observed, after a number of audit cycles have concluded, the IRS could identify taxpayers not requiring such close examination year after year. This would allow the IRS to shift resources to examining taxpayers in sectors audited less frequently, bringing those taxpayers to a similar level of compliance and transparency.²⁴ This suggestion is sound and recognizes the need to realize efficiencies where appropriate. For precisely the same reason, we propose in our technical comments above that the IRS bifurcate disclosure requirements for CIC and IC taxpayers, particularly with regard to the requirement of disclosing a maximum tax adjustment.

IV. Conclusion

Requiring corporate taxpayers to disclose their uncertain tax positions on new Schedule UTP, at the time they file their corporate tax returns, represents an historic development in the area of voluntary tax compliance and tax administration. Both the IRS and taxpayers stand to benefit from greater certainty, consistency, and efficiency in tax administration. However, the IRS should ensure that taxpayers are able to comply substantially with any new disclosure requirements without incurring unnecessary costs that may outweigh the potential benefits of the proposal. Moreover, the IRS should ensure that Schedule UTP seeks the type of information that advances the audit process and does not potentially confuse IRS auditors. Additionally, the IRS should provide guidance to IRS auditors as to how to utilize Schedule UTP in a manner that enhances audit efficiency and the spirit of cooperation with taxpayers. Finally, we recommend that the IRS consider implementing the new disclosure proposal in an incremental fashion or on a test basis beginning, perhaps, with less frequently audited, less transparent taxpayers, to allow adequate time to develop new audit processes and to assess the value of the information collected.

² 2010-19 I.R.B. 668.

³ Announcement 2010-17, 2010-13 I.R.B. 515.

⁴ FIN 48 has been codified in the Accounting Standards Codification at FASB ASC 740-10.

⁵ Announcement 2010-9, 2010-7 I.R.B. 408; Announcement 2010-17, 2010-13 I.R.B. 515.

⁶ IRS Chief Counsel Wilkins publicly has stated that the IRS chose to require the disclosure of the maximum potential tax adjustment as opposed to some other measure of potential tax exposure in an attempt to make the proposal less controversial. KPMG LLP Tax Governance Institute, Disclosing Uncertain Tax Positions to the IRS -- A Conversation with the Chief Counsel of the IRS (Mar. 2, 2010).

⁷ Treas. Reg. § 1.6662-3(b)(3).

⁸See, e.g., Joint Committee on Taxation, Comparison of Joint Committee Staff and Treasury Recommendations Relating to Penalty and Interest Provisions of the Internal Revenue Code (No. JCX-79-99) at 13, available at http://www.house.gov/jct/x-79-99.pdf (20 percent).

⁹See FIN 48 at 7 ("The provisions of this Interpretation need not be applied to immaterial items.")

¹⁰See News Release, Internal Revenue Service, Prepared Remarks of Commissioner of Internal Revenue Douglas H. Shulman before the Tax Executives Institute 60^th Mid-Year Meeting (Apr. 12, 2010), available at http://www.irs.gov/newsroom/article/0,id=221280,00.html.

¹¹See, e.g., Brief of the United States of America in Opposition to Petition for Writ of Certiorari, Textron v. United States, No. 09-750, at 27 ("[Petitioner [Textron] (like all large corporations) reasonably anticipates an annual IRS audit.").

¹²See Kathleen David, "Uncertain Tax Positions Requirement Seen in Context of IRS Audit Process Improvement," BNA Daily Tax Report, May 10, 2010.

¹³See Kathleen David, "Uncertain Tax Positions Requirement Seen in Context of IRS Audit Process Improvement," BNA Daily Tax Report, May 10, 2010.

¹⁴ All section references are to sections of the Internal Revenue Code of 1986, as amended (the "Code").

¹⁵ Such might be the case where, for example, (1) the affiliated group has not made an election to file a consolidated federal income tax return, (2) an affiliated member is precluded by section 1504(a)(3) from rejoining the consolidated return for five years after deconsolidating, or (3) an affiliated group including life insurance companies has not made a life-nonlife consolidated return election under section 1504(c)(2).

¹⁶ PricewaterhouseCoopers, Webcast on Announcement 2010-9 (Apr. 23, 2010).

¹⁷ A related party is any entity that is related to the taxpayer under sections 267(b), 318(a), or 707(b), or any entity that is included in a consolidated audited financial statement in which the corporation is also included.

¹⁸ Internal Revenue Manual 4.10.20.2.

¹⁹ Announcement 2002-63, 2002-27 I.R.B. 72; Internal Revenue Manual 4.10.20.3.1.

²⁰ PricewaterhouseCoopers, Webcast on Announcement 2010-9 (Apr. 23, 2010).

²¹ News Release, Internal Revenue Service, Prepared Remarks of Commissioner of Internal Revenue Douglas H. Shulman before the Tax Executives Institute 60th Mid-Year Meeting (Apr. 12, 2010), available at http://www.irs.gov/newsroom/article/0,id=221280,00.html.

²² PricewaterhouseCoopers, Webcast on Announcement 2010-9 (Apr. 23, 2010).

²³Id.

²⁴ PricewaterhouseCoopers, Webcast on Announcement 2010-9 (Apr. 23, 2010).