26 May 2020 - Article
In January 2010, the Internal Revenue Service (“*IRS*”) announced a new tax return disclosure requirement for “uncertain tax return positions“ (“*UTPs*”) that are reflected by tax reserves for U.S. Federal income tax liability recorded for financial statement purposes. The IRS’ objective in requiring UTP disclosure is to gain greater visibility of tax return positions that represent potential underreporting of tax.
UTP reporting on new Schedule UTP, released by the IRS on April 20th in draft form, generally applies starting 2010 to business entities that both report Federal income tax reserves in an audited financial statement and have assets in excess of $10 million. Initially, only certain corporate return filers are subject to the new disclosure rule in the 2010 tax year, although the IRS expects that after 2010 pass-through entities, REITs, RICs, and tax-exempt organizations will also be subject to UTP reporting. UTP disclosure will affect privately-held businesses, including portfolio companies of private equity and venture capital funds, publicly-traded corporations, U.S. subsidiaries of foreign corporations and foreign corporations doing business in the U.S.
UTP disclosure requires a concise summary of each UTP that is part of a taxpayer’s tax reserve computation for financial statement purposes. The UTP disclosure rules thus effectively piggyback onto new, complex financial statement disclosure rules under US Generally Accepted Accounting Principles (“*GAAP*”) for reporting tax contingencies — FASB Interpretation No. 48 (“*FIN 48*”) — applicable to public companies since 2007 and non-public companies since 2009, as well as other accounting standards used to calculate tax reserves including International Financial Reporting Standards (“IFRS”).
The IRS maintains that the UTP disclosure rule will not alter its long-standing policy of restraint in requesting tax accrual workpapers requiring first a known issue as to which additional facts are needed and satisfaction of other conditions. The inevitable effect of UTP disclosure will be greater intrusion into the tax reserve determination process. The April release of new Schedule UTP also comes on the wave of IRS litigation success in Textron Inc. v. United States, in which the First Circuit Court of Appeals rejected a work product defense to an IRS summons for tax accrual workpapers on the rationale that the workpapers were prepared for GAAP reporting purposes rather than in anticipation of tax litigation. On May 24, 2010, the Supreme Court declined to review the First Circuit decision arguably giving the IRS further momentum in seeking tax accrual information through the UTP disclosure regime.
Affected Taxpayers and Tax Reserves
The new tax disclosure requirement generally applies to business entities with assets in excess of $10 million that record a tax reserve for US Federal income taxes in an audited financial statement (including one of a related party), whether under FIN 48, IFRS or any other accounting standard. The $10 million asset threshold will be determined by the amount reported in a tax return Schedule L balance sheet. In contrast to financial statement tax reserves, UTPs covered by the new tax disclosure rules do not include state, local and foreign taxes or other taxes. UTPs are also limited to the initial recording of a tax reserve for financial statement purposes, i.e., subsequent tax reserve adjustments (whether upward or downward) to an already disclosed position would not require further reporting.
In 2010, only four categories of business entities that prepare audited financials are required to file Schedule UTP — regular C corporations that file Form 1120, foreign corporations that file Form 1120F, and life and property insurers that file Forms 1120L and 1120P, respectively. Pass-through entities (such as partnerships, limited liability companies, and S corporations), REITS, RICS and exempt organizations will not have to file the Schedule UTP for their 2010 tax years though IRS is expected to issue future guidance on how and when UTP reporting will apply to these entities.
UTP reporting does not apply generally to tax positions adopted in tax returns for tax years before 2010. Tax positions are subject to UTP reporting for a tax year if a decision to record a reserve was made at least 60 days prior to filing the tax return. UTP reporting is required in two cases where no tax reserve is made for financial purposes: (i) the taxpayer expects that it will successfully litigate the issue and there is a less than 50% probability of settling the issue with the IRS, or (ii) the IRS based on past administrative practice and precedent has a practice of not challenging such item.
Disclosure Schedule Content and Maximum Tax Adjustment
Schedule UTP requires a concise description of the facts and tax issues concerning each UTP as well as the maximum amount of tax liability (“*MTA*”) attributed to each such position. The UTP disclosure must state (i) that the tax position involves an item of income, gain, loss deduction or credit, (ii) whether the position involves a valuation issue or basis computation, and (iii) the rationale for the UTP and the reasons for determining it to be uncertain. The MTA is determined in the case of an item other than a tax credit or a transfer pricing or valuation position, by the product of (A) an estimate of the total amount of such item in dollars and (B) the 35% tax rate. For a UTP involving tax credits, the MTA is estimated in terms of the total amount of credit related to such position.
The MTA approach does not require incorporation of a taxpayer’s risk assessment or the specific reserve taken for a particular tax item in the tax accrual workpapers. In addition, chances of settlement and outcome of litigation are not taken into account despite their relevance in setting reserves for financial reporting purposes. Accordingly, the MTA in most cases would typically differ from the actual tax reserve made for such UTP. Finally, the MTA does not take into account net operating losses and excess credits or interest and penalties.
Special disclosure rules apply to tax positions involving transfer pricing and valuation exposures. In lieu of the above MTA computation, transfer pricing and valuation positions are required to be ranked in the order of potential magnitude within each category (without disclosure of such quantitative basis) by reference to either (i) the actual tax reserves taken for such position or (ii) the estimated tax adjustment if the position were not sustained. The underlying ranking method must be consistently applied but need not be disclosed.
The IRS is reviewing comments to the proposed UTP reporting regime that are submitted to the IRS by June 1, 2010 (extended from March). After the IRS considers taxpayer comments, it may make changes to Schedule UTP when eventually released in final form.
Points and Comments
A first and central observation is that the new UTP disclosure regime will dramatically increase the level of transparency of tax reporting positions by entities that prepare audited financials, since UTPs capture all tax reporting uncertainties incorporated into the financial statement reserve (as UTP reporting has no filter based either on degree of uncertainty or size of tax exposure).
A second observation is that UTP disclosure represents a partial “end-around” the IRS’ policy of restraint on use of summons authority to obtain workpapers, as it provides the IRS with information that it would not otherwise have absent a physical delivery of tax accrual workpapers. Moreover, while the IRS has publicly emphasized that UTP disclosure seeks only factual information the required disclosure of both the rationale and basis of uncertainty for each UTP will inevitably encroach upon the taxpayer’s underlying risk assessment and raise concerns over protecting claims of attorney-client privilege. In response, taxpayers should place great attention on the form of legal advice supporting tax reserve determinations as well as each Schedule UTP description.
A third observation is that UTP reporting will overlap with existing reporting rules that force disclosure of certain items and transactions — e.g., tax positions without substantial authority as well as reportable transactions such as tax shelter transactions listed by the IRS. As to return positions covered by these other reporting rules, the IRS Schedule UTP instructions reduce the compliance burden by providing that a complete and accurate disclosure on Schedule UTP will be treated as proper disclosure for substantial authority or reportable transaction purposes, as the case may be. We understand that the IRS is considering other circumstances of potential overlap between Schedule UTP and other required IRS filings.
A fourth observation is that the $10 million gross asset threshold will result in differences in treatment as between taxpayers with internally developed assets, initially recorded at cost under GAAP, that over time obtain significant value and those with assets purchased directly or indirectly in the acquisition context recorded at fair market value. Further, service businesses will have a greater opportunity to fall below the $10 million disclosure threshold unless they acquired significant current assets, intellectual property, or client relationships and goodwill.
As a final observation, discussed further below, Schedule UTP may well lead to an increase in IRS requests for tax accrual workpapers, despite the IRS’ proclaimed intention to preserve its current policy of restraint regarding workpapers.
Significance: Mere Additional Disclosure Versus IRS Encroachment on Tax Accrual Workpapers
The IRS has emphasized that the new UTP disclosure is not intended to alter its long-standing policy of restraint regarding tax accrual workpapers, set forth in the IRS Revenue Manual, requiring “unusual circumstances,” to deviate therefrom. Under its restraint policy (which excepts tax shelter transactions) there must exist a known and specifically identified issue for which additional facts are needed that generally cannot be obtained through other means before IRS agents may request tax accrual workpapers.
Despite the IRS’ restraint policy, as a practical matter it is difficult to envision how the new UTP disclosure, which will give the IRS new information as to the existence of one or more specific tax exposures (with dollar values placed on each position), will not inevitably lead to increased IRS scrutiny of the UTP information and potential encroachment into tax accrual workpapers analyses. With the list of specific tax return positions before the IRS the requisite of “unusual circumstances” will more likely be present since the IRS is now starting with information of specific tax positions on which it can now satisfy the first hoop of its restraint policy.
Relevant Development: Supreme Court Declines to Review First Circuit Rejection of Work Product Defense to Summons of Tax Accrual Workpapers in Textron
Interestingly, the IRS announcement of the UTP reporting regime occurs just four months after the Court of Appeals for the First Circuit in Textron Inc. v. United States via its 2009 en banc decision reversed itself by declining work product protection to tax accrual workpapers. In Textron a finance subsidiary had engaged in tax shelter transactions that the IRS was examining. Textron asserted work product privilege and refused to comply with a summons requesting tax accrual workpapers. Textron’s position was that it could satisfy the work product privilege requisite that its documents be created in “anticipation of litigation” employing a “dual purpose” rationale that workpapers were created both in anticipation of litigation with the IRS and to comply with financial reporting standards. Textron won at the district court level, relying on the dual purpose approach but the First Circuit (on en banc review of its original decision that affirmed the district court) eventually disagreed and Textron appealed to the Supreme Court.
Perhaps no coincidence, the IRS released Schedule UTP just days before the U.S. government submitted its brief requesting that the Supreme Court decline the case. Ultimately the IRS turned out to be the victor, since on May 24 the Supreme Court refused to review the First Circuit decision, ending taxpayer hope that it would bless a “dual purpose” rationale for creating workpapers and accord work product protection. Had the Supreme Court decided to hear the case, it would have invigorated the debate over the IRS’ right to summons tax accrual workpapers and possibly created a new debate over the propriety of the UTP disclosure regime.
Instead, Textron gives the IRS further momentum in its battle over access to tax accrual workpapers and may further embolden the IRS in seeking tax reserve information via the new UTP disclosure regime.