IRS Scales Back Its Draconian Schedule UTP Draft, and Requires the Finalized Schedule in 2010
The now-finalized form is required in 2010. We provide the background, changes, potential solutions (for some), and the remaining difficult legal privilege issues.
On September 24, 2010, the IRS issued Announcement 2010-75. This covers final Form 1120, Schedule UTP (Uncertain Tax Positions Statement) and related instructions. While the final schedule eliminates some two particularly onerous provisions, the remaining disclosures are still of great importance to all corporate taxpayers.
The IRS instituted a five-year phase-in for filing schedule UTP. Companies with more than $100 million in worldwide assets will have to file Schedule UTP for their 2010 tax year. The threshold for filing will drop to entities with total assets of more than $50 million for the 2012 tax year, and down to total assets of $10 million for tax years beginning in 2014. The IRS indicated it will consider whether to extend these requirements to other taxpayers, such as pass-through entities and tax exempt organizations, starting in 2011. We would be surprised if Schedule’s UTP scope were not so expanded.
Schedule UTP discloses all tax positions for which (i) a tax reserve was recorded in audited financial statements, or (ii) no tax reserve was recorded because the corporation expects to litigate the position. Schedule UTP required disclosures include:
1. A concise description of the uncertain tax position
2. The primary Internal Revenue Code Sections involved
3. Whether the uncertain tax issue is permanent or timing
4. The identity of any pass-through entity pertaining to the issue
5. The ranking of the tax position exposure in terms of its size (including penalties and interest)
6. Although the specific amount of the GAAP reserve for each issue need not be disclosed, an “Major Tax Position” check-box is required for all uncertainties that are greater than or equal to 10% of all the positions reported
7. Identification of issues pertaining to transfer pricing
A corporation may rely on the reserve decisions it made for financial statement purposes to complete Schedule UTP. Consistent with this principle, positions that are not reserved under GAAP because of immateriality also fall outside of Schedule UTP requirements.
The prior draft of Schedule UTP issued in April 2010 was even worse. In the final document, the IRS eliminated draft disclosures that were particularly onerous; specifically:
1. A calculation of a maximum tax adjustment for each position,
2. Positions for which no accounting reserve was required
3. The nature of each uncertainly and related rationale for each position taken.
4. Pre-2010 uncertain positions, even if reserve is recorded for that earlier year and the reserve continues to be recorded in audited financial statements issued in 2010 or later.
Disclosure on Schedule UTP will (i) avoid penalty under IRC §6662(i) for positions lacking economic substance, and (ii) be treated as if Form 8275 or 8275-R was completed for the position in question. Currently, disclosure on schedule UTP will not satisfy the requirement to file Form 8886 for listed and reportable transactions, although the IRS is studying whether to eliminate Form 8886 requirements for disclosed positions.
FIN 48 Provides the Starting Point
Because the starting point for Schedule UTP is the entity’s financial statements, Generally Accepted Accounting Principles (GAAP) ultimately determines what needs to be disclosed in Schedule UTP.
In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, entitled “Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109” (“FIN 48”). The relevant portions of FIN 48 are now contained in Accounting Standards Codification subtopic 740-10, Income Taxes. FIN 48 has been applicable to public companies since 2007 and non-public companies since 2009.
Under FIN 48, the taxpayer must reserve (meaning, establish a liability for taxes) 100% of the uncertain tax position unless it is more likely than not that the tax position would be sustained if the taxpayer litigates the issue. This determination is based on the legal authority only, and assumes the IRS audits the return with full knowledge of all relevant information.
Even if a tax position is more likely than not correct, a portion of the tax benefits may still need to be reserved in the financial statements. Unless the probability is greater than 50% that the IRS would concede the entire amount at issue, the taxpayer must reserve any amount of the total tax liability to the extent that a settlement of the position is likely. This second step takes into account the likelihood that the taxpayer will settle, rather than litigate. In other words, even if the taxpayer would likely prevail by litigating the position, unless it is more likely than not that the IRS would fully concede the issue prior to litigation, a reserve must still be recorded simply because the position is uncertain and the taxpayer takes a practical approach in determining whether litigation is cost-effective.
See the FASB's Gift to the IRS for additional information, and our suggestion regarding how certain companies can avoid this problem.
Legal Privilege Questions
The financial statements show only the aggregate liability recorded, and do not show the amount of reserve by individual tax position. However, the underlying records supporting the financial statements contain this detail. These tax accrual work papers normally contain a description of the relevant facts, the expected IRS contrary position and rationale, legal analysis, assessment of the risks, and the likely settlement amount. If given to the IRS, these tax accrual work papers provide the IRS with both identification of specific issues and negotiating leverage from knowing the taxpayer’s evaluation. Under current IRS procedures, examiners request at least a portion of these tax reconciliation work papers as a matter of course.
On this issue, the IRS issued Announcement 2010-76 on the same day as Schedule UTP was finalized. This announcement expands and clarifies the existing IRS policy of restraint regarding what portion of these work papers needs to be given to the IRS. If a document is otherwise privileged under the attorney-client privilege, the tax advice privilege in IRC § 7525, or the work product doctrine, the IRS will not assert that privilege has been waived because the document was provided to an independent auditor. Accordingly, taxpayers can redact the following information from such work papers:
1. Working drafts, revisions, or comments concerning the concise description of tax positions reported on Schedule UTP;
2. The amount of any reserve related to a tax position reported on Schedule UTP; and
3. Computations determining the ranking of tax positions to be reported on Schedule UTP or the designation of a tax position as a Major Tax Position.
Unfortunately vague, the IRS states that its policy will not apply to (i) documents for which the taxpayer has waived the applicable protection by some other means, (ii) requests where “unusual circumstances exist or the taxpayer has claimed the benefits of a listed transaction.” When the IRS decides that “unusual circumstances exist”, taxpayers will not have clear authority to withhold production.
The First Circuit gutted the taxpayer’s privilege claim in United States v. Textron, Inc., No. 07-2631 (First Circuit, August 13, 2009) (en banc). For additional information, see First Circuit Applies New Standard Restricting Work Product Privilege. On May 24, 2010, the Supreme Court declined certiorari of the Textron ruling. In terms of the monetary amounts involved, and the sweeping effect over most business taxpayers, perhaps the most important decision of this Supreme Court term was its decision to not review the First Circuit’s 3 to 2 Textron decision.
Contradicting this result, on June 29, 2010, the U.S. Court of Appeals for the District of Columbia Circuit found that documents the government subpoenaed from Dow Chemical Company’s independent auditors were protected from discovery under the work-product doctrine. See U.S. v. Deloitte, LLP, 106 AFTR 2d 2010-5053. There is little way to reconcile the Textron and Deloitte decisions.
Schedule UTP also provides interesting issues for waiver of what might otherwise be privileged communications in cases where a transaction is NOT disclosed on Schedule UTP. Assume that the IRS challenges a taxpayer position, contends that Schedule UTP was not complete, and proposes whatever penalties pertain to such nondisclosure. In this situation, the only way that a taxpayer can support its tax return and avoid the anticipated consequences of non-disclosure on Schedule UTP is to share its legal analysis. If the whole point of the analysis is that no reserve was necessary was because litigation was not reasonably anticipated, how can the otherwise-privileged analysis have been prepared in anticipation of litigation? The taxpayer is thus in a classic Catch 22, since the only way the analysis is privileged is if the legal work was prepared in anticipation of litigation. However, if privilege exists because litigation was anticipated, the issue should have been part of Schedule UTP. Either way, the taxpayer loses.
The requirement to disclose each “Major Tax Position” similar requires the disclosure of privileged information, since the underlying calculation can only occur with privileged judgments.
ABOUT THE AUTHOR: David Nolte
Mr. Nolte has 30 years experience in financial and economic consulting. He has served as an expert witness in over 100 trials. He has also regularly served as an arbitrator. Mr. Nolte has achieved the following credentials: CPA, MBA, CMA and ASA.
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Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.