Each edition of Tax Matters consists of free-flowing responses by three tax practitioners to a question regarding a current issue in tax law and policy. Tax Matters commentaries provide insightful perspectives on a broad range of topics, making important contributions to the dialogue within the tax bar about cutting-edge issues. Although the commentaries are certainly of interest to the academic community, they are primarily directed toward tax professionals and their clients.
Michael J. Graetz, Columbia Alumni Professor of Tax Law, Wilbur H. Friedman Professor of Tax Law, Columbia Law SchoolReflections on the True Impact of the IRS’ Schedule UTP Reporting Requirements
Schedule UTP reporting is intended to promote certainty, consistency, and efficiency in the administration of tax examinations. As the reporting requirements only began for tax year 2010, it remains to be seen whether these goals will be accomplished. In my experience, to date, the decision in United States of America v. Textron Inc. and Subsidiaries (Textron) and the new Schedule UTP reporting requirement have not significantly changed the manner in which corporations evaluate and document tax positions taken on their tax returns. This may be a surprise, but I believe that the significant behavioral change in planning and documentation occurred upon the adoption of the Sarbanes-Oxley rules with respect to corporate financial reporting, the adoption of FIN 48 (now Accounting Standards Codification 740-10, or ASC 74010), and the transparency initiatives enacted as part of the 2004 Tax Act. Through the combination of these developments, occurring primarily between 2001 and 2006, many corporate taxpayers enhanced their evaluation and documentation with respect to the types of tax positions claimed on their corporate tax return s. Thus, the more likely consequence of Schedule UTP reporting will be a “refinement” to a corporation’s existing review and documentation policies to incorporate the specific requirements of Schedule UTP.
While some believed the First Circuit’s Textron decision would significantly alter the balance regarding privilege with respect to tax accrual workpapers, this has not been the case to date. I believe that at least one reason for this is due to the expansion and confirmation of the IRS’ “Policy of Rest raint” relating to requests for tax accrual workpapers. In fact, one could argue that the IRS, in crafting the Schedule UTP reporting, recognized the delicate balance between thei r ability to request tax accrual workpapers and the potential impact such actions would have on the IRS’ efforts to work more collaboratively with taxpayers. The Schedule UTP reporting requirements provide the IRS the relevant information about a corporate taxpayer’s uncertain tax positions without having to request tax accr ual workpapers, which may contain the taxpayer’s legal analysis. Thus, by expanding and confirming its “Policy of Restraint” in connection with the implementation of the Schedule UTP reporting regime, the IRS has signaled its recognition of taxpa yers’ privilege concerns and has adopted a new disclosure approach that attempts to balance these competing interests.
Although I believe many other jurisdictio ns will consider adopting a requirement similar to Schedule UTP, non US jurisdictions likely will need to consider a different approach because of differences with respect to accounting for income taxes. This is because the key foundation for the Schedule U TP reporting regime in the United States is financial reporting and the degree of guida nce provided under US Generally Accepted Accounting Principles (US GAAP) in accounting for uncertain tax positions. FIN 48 (now ASC 740-10) prescribes a detailed fra mework for determining unit of account, recognition, measurement, and disclosure fo r the financial accounting and reporting of uncertain tax positions that is significantly different, and more specific, than under International Financial Reporting Standards (IFRS) or other existing GAAP frameworks. Absent this detailed and consistent framework for the financial reporting of uncertain tax positions, it is debatable whether other taxi ng authorities could achieve the goals of Schedule UTP reporting in the same manner as the IRS intends.
Nonetheless, recent developments suggest that other taxing jurisdictions may seek to emulate the US Federal reporting requirements. For example, a few states already require the federal Schedule UTP to be file d with its tax return. Other states are evaluating whether to develop a state-specific uncertain tax position form or merely require the federal form to be filed. Addi tionally, the Australian Taxation Office (ATO) recently announced that it is developing a new reportable tax position schedule for corporate tax return filings. In announcing th e new requirement, the ATO stated that by expecting corporations to disclose uncertain tax positions, “we are acting consistently with wider international trends that require large businesses to be more transparent.” As many uncertain tax positions result from multi- jurisdiction transactions, such as transfer pricing, the implementation of comparable UTP reporting regimes in jurisdictions around the world likely will increase the already growi ng need to engage in bilateral discussions and competent authority claims to avoid double taxation.
In summary, my experience to date is that the US Schedule UTP reporting requirements have not significantly impacted the manner in which corporate taxpayers evaluate and document tax planning, but is altering their approach to managing examinations and controversies. In fact, the increased transparency in US tax reporting, including Schedule UTP, has generally resulted in tax directors reevaluating the benefits and risks, and in some cases adopting colla borative procedures with the tax authorities that can provide certainty on uncertain ta x positions sooner (such as the IRS’ Compliance Assurance Program). Finally, while some jurisdictions have begun to evaluate and implement comparable UTP reporting regimes, given the lack of a consistent framework for the financial accounting for uncertain tax positions it remains unclear to what extent these regimes will produce the benefits expected by the IRS.
Evolving Tax Risk Analysis and Disclosure
The issue at hand really needs to be broadened to include the impacts of the implementation of FIN48 (now ASC 740-10). FIN48 really was the start of a paradigm shift in the corporate approach to analyzing risk in transactions and assessing those risks for financial reporting purposes. A second key factor that came into play was the potential significant increase in penalties on transactions that did not meet certain criteria. The world was a different place when the greatest risk was that the taxpayer would have to pay additional tax, plus so me interest on an assessment. When penalties were increased, including potential public disclosure of the assessment of those penalties, when the accounting rules changed and tax departments were learning the terms “material weakness” and “significant deficiency,” the approach within many departments changed significantly. No longer was it acceptable to throw a position against the wall to see if it would stick. Rather the level of scrutiny of a transaction and the attendant tax implications began to increase. Now, I do no t mean to imply that there was any laxity before these changes. Tax professionals were doing their best to get to the correct answer. And to the benefit of the IRS, they were generally doing their best on examinations to get to the correct answer as well.
With the advent of FIN48, the documentation for potential tax liabilities had to be much more detailed than previously was the case. The establishment of the Public Company Accounting Oversight Board (PCAOB) pushed the accounting firms to take a harder look at the tax reserves for their propriety and to be sure that nothing had been missed. There is a reason that in the early years of these rules, tax issues ranked in the top five of material weaknesses. These we re fundamentally different approaches and procedures, and there was a learning curve for everyone.
I appreciate how difficult it can be to perform a tax examination for a large corporation. The IRS must search for the information from sources such as general ledgers, newspapers, press releases, and also by trying to ask the right questions. Again, there are very few, if any, large corporations that would actively attempt to hide or withhold information from the IRS, but if the corporation isn’t asked the right question, the IRS may never find a potential issue.
This leads us to Schedule UTP. This schedule is the IRS’s attempt to understand the material items that comprise the tax reserve and, by definition, that contain some level of uncertainty as to tax treatment. I believe that the IRS is trying to be very careful in their use of Schedule UTP to avoid prying into the taxpayer’s mental processes or impressions or other matters that might otherwise be subject to privilege. As noted, the IRS has issued a policy of restraint which, in general, provides that they will not use a waiver of privilege argument to pursue privileged documents that were provided to the taxpayer’s audit firm. There is, however, an open question of whether the Justice Department, which is not part of the IRS, will abide by that interpretation.
A combination of factors over recent year s has caused an increase in attention to transactions and time spent on analysis of their tax treatment. The new tool now in the IRS arsenal is the availability of the key issues that generated the reserves booked. My view is that if the taxpayer believes in its position, then it should have no problem discussing the transaction with the IRS.
Schedule UTP is still in its infancy, but I absolutely expect other jurisdictions to adopt a similar approach. This includes the various states. California indicated two years ago that it was moving in that direction, and there will be others. If we watch how other countries have been adopting rules in areas such as transfer pricing, there is no doubt that the UTP approach will not be far behind. The world is shrinking, and availability of information is growing. Taxing jurisdictions will be employing all available tactics to gather the best information that they can and to utilize it as effectively as they can.
Corporate taxpayers will continue to perform professional due diligence with respect to the tax treatment of transactions. They will report as they deem most appropriate and must be prepared to defend their positions. It bears mentioning that most uncertain tax positions are the result of a lack of clarity in the tax laws. In my view, this means that one sure way to reduce the amount of uncertain tax positions would be to focus on drafting clear laws and issuing interpretive guidance to assist taxpayers in navigating the complexities of the rules. Th is will enhance certainty and consistency in tax reporting.Minimizing Potential Privilege Implications Caused by the UTP Schedule
The conflicting circuit court decisions in United States v. Textron and United States v. Deloitte & Touche USA, LLP leave the privilege status of FIN 48 workpapers significantly unclear. Schedule UTP further complicates taxpayers’ preserving the privilege of tax planning materials by requiring certain corporations to disclose individual uncertain tax positions (“UTPs”) as part of their tax returns starting in the 2010 tax year. Some commentators predict that in reaction, corporations may try to reduce the number of their UTPs by obtaining pre-filing agreements (“PFA”) or private letter rulings (“PLR”) from the IRS. Indeed, according to the IRS’ s published statistics, the total number of PFAs the IRS received increased by approximate ly 70% to 39 in 2011, from 23 in 2010. This is by far the largest year-to-year in crease of PFAs since 2001, suggesting that some corporations may be seeking more certainty prior to filing their returns. On the other hand, the total number of PLRs issued dropped by approximately 25% to 2,900 in 2011, from 3,864 in 2010, suggesting that taxpayers in general are not seeking more certainty upfront. The costs associated with filing a PFA and PLR—a bout $50,000, and $10,000, respectively, a PFA taking more than 250 days on average to be negotiated – and, most importantly, the risk of having disclosed a potential weakness and then obtaining an adverse determination could deter many taxpayers from seeking a PFA or PLR. In the end, before the Supreme Court resolves the privilege issue arising from tax accrual workpapers and Schedules UTP, corporations will probably react by adopting certain approaches that would reduce the quality of their UTP disclosures.
One possible conclusion from the Deloitte court’s reasoning, that material developed in anticipation of litigation can be incorporated into a document produced during an audit without ceasing to be work product, is that distancing the FIN 48 workpapers prepared to support the financial statements from the legal tax opinions and analyses created for assessing the legal risks of tax positions, and then distancing the UTP from the FIN 48 workpapers, can increase the likelihood of the legal opinions being privileged attorney work product. Thus, before the company enters into tax positions that pose significant litigation risks, its tax attorney s could draft legal opinions that evaluate the tax risks and the likelihood of litigation a nd settlement. Such opinions by themselves are likely privileged work product under United States v. Adlman . For purposes of preparing its financial statements at a late r stage, the company could incorporate such legal opinions by reference, instead of preparing legal opinions specifically for FIN 48 purposes. The goal of the “incorporation by reference” approach would be to clearly distinguish the purposes of the legal opinions—to assess the risk of litigation—from the purpose of the FIN 48 workpapers. Certainly, this approach would not apply to all contents of FIN 48 workpapers, but it could potentially strengthen the privilege claims on the legal opinions and litigation risk assessments of certain tax positions.
Further, distancing materials used to file a Schedule UTP from the FIN 48 workpapers also may increase the likelihood of preserving privilege over the legal opinions. To that effect, the company may use an accountant, who has access to only summaries of the FIN 48 workpapers to prepare the Schedule UTP. The summaries would include a quick fact description, reserve amount, and the settlement probability,