Transparency and Compliance in Light of the New Schedule UTP

Procedure & Administration

In April 2010, the IRS issued a draft of Schedule UTP, Uncertain Tax Position Statement, with Announcement 2010-30. This represents an important development in the longstanding and ongoing battle between taxpayers and the federal and state taxing authorities for access to tax accrual workpapers and other tax-related information.

Background and Basic Framework

Prior to the implementation of Financial Accounting Standards Board (FASB) Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes, uncertain tax positions (UTPs) were accounted for as contingent liabilities under Statement of Financial Accounting Standards (FAS) No. 5, Accounting for Contingencies. FAS 5 requires that a liability be recognized when it is both probable and estimable, taking into account the likelihood of the taxing authority gaining knowledge of all relevant facts.

Issued in July 2006, FIN 48 supplemented FAS No. 109, Accounting for Income Taxes, and broadened FAS 5 with respect to income taxes. FIN 48, located at Topic 740 in the new codification of GAAP, establishes the proper accounting for UTPs, including recognition and measurement of their financial statement effects.

The accounting for all material positions taken (or expected to be taken) on any income tax return is now governed by FIN 48. FIN 48 is generally effective for years beginning after December 15, 2006 (calendar year 2007 for calendar-year taxpayers), but the effective date for private companies was deferred until years beginning after December 15, 2008.

It has long been thought that the magnitude of the issues an entity believes it has, and then discloses as part of its financial statements, would lead to questions from the IRS as to precisely what a company’s financial statement UTPs represent, as well as requests for the entity’s tax accrual workpapers. Although the implementation of FIN 48 was meant to address investors’ desires for more disclosure of financial data, this regulatory requirement has led the IRS to request tax information that is arguably privileged under the work-product doctrine. The work-product privilege, codified in Rule 26(b)(3) of the Federal Rules of Civil Procedure, states in part that a document is protected from disclosure if it is prepared “in anticipation of litigation.”

The IRS and state taxing authorities have historically held steadfast to the position that tax accrual workpapers are not protected under the work-product doctrine because they are created primarily for financial reporting purposes rather than the prospect of litigation. Nonetheless, and as discussed below, the IRS has historically exercised a policy of restraint.

IRS Position on Tax Accrual Workpapers and Privilege Protections

In Announcement 2002-63, the IRS announced that it may request tax accrual workpapers in the course of examining any return filed on or after July 1, 2002, that claims any tax benefit arising out of a listed transaction, as defined by Regs. Sec. 1.6011-4(b)(2). The announcement highlighted the holding in Arthur Young & Co., 465 U.S. 805 (1984), stating that because tax accrual workpapers are not generated in connection with seeking legal or tax advice but are developed to evaluate a taxpayer’s deferred or contingent tax liabilities in connection with the disclosure to third parties of the taxpayer’s financial condition, those workpapers are not privileged communications. However, the IRS would continue its current policy of requesting tax accrual workpapers only in unusual circumstances:

• For any returns filed prior to July 1, 2002, other than those that claim any tax benefit arising from a listed transaction that has not been disclosed; and
• For any returns filed on or after July 1, 2002, other than those that claim any tax benefit arising out of a listed transaction.

Similarly, Internal Revenue Manual (IRM) Section 4.10.20, Requesting Audit, Tax Accrual, or Tax Reconciliation Workpapers (2004), provides that while auditors should routinely request tax reconciliation workpapers at the outset of an examination, the general standard in requesting audit or tax accrual workpapers is one of restraint, using what is known as the “unusual circumstances” standard. This portion of the IRM states that examiners should keep in mind that a taxpayer’s records are the primary source of factual data to support the tax return. Audit or tax accrual workpapers should normally be sought only when such factual data cannot be obtained from the taxpayer’s records or from available third parties, and then only as a collateral source of factual data. Further, auditors should request these workpapers with discretion rather than as a matter of standard examining procedure.

Finally, on May 10, 2007, the commissioner of the IRS Large and Mid-Size Business (LMSB) Division issued a memorandum providing information about the impact of FIN 48 on the IRS’s policy of restraint concerning tax accrual workpapers (see LMSB-04-0507-044). In this memorandum, the IRS referred to the determination from the Chief Counsel’s Office concluding that documentation resulting from the issuance of FIN 48 is considered to be a tax accrual workpaper for purposes of the IRS’s policy of restraint. However, the memorandum went on to provide that the LMSB was evaluating its tax accrual workpaper policy at that time to ensure that it was still appropriate.

Textron and Work-Product Privilege

The brewing conflict between the IRS and businesses about access to workpapers, which has been aggravated by the issuance of the draft of Schedule UTP, has been highlighted in the First Circuit in the case of Textron, Inc., 507 F. Supp. 2d 138, 146 (D.R.I. 2007), rev’d, 571 F.3d 21 (1st Cir. 2009) (en banc), cert. denied, S. Ct. Dkt. 09-750 (U.S. 5/24/10). In Textron, the IRS had issued a summons under Sec. 7602 seeking access to Textron’s tax accrual workpapers. Textron refused to comply, asserting in part the work-product privilege of Federal Rule of Civil Procedure 26(b)(3); the company also pointed to both the attorney-client privilege and the tax practitioner privilege of Sec. 7525. The IRS countered that the workpapers were not protected under the work-product doctrine, and even if they were, Textron’s disclosure of its accrual workpapers to its independent auditors constituted a waiver of the privilege.

The district court agreed with the IRS that the attorney-client privilege was inapplicable because these documents, although prepared by attorneys, were prepared as part of a business function. Further, both the attorney-client and the tax practitioner privileges, if they did apply, would be waived by disclosure of workpapers to a third party, such as an accounting firm. With regard to the work-product protection claim, the district court stated that Textron’s purpose in preparing the tax accrual workpapers was to ensure adequate reserves with respect to any potential dispute or future litigation as well as to satisfy independent audit requirements. However, under the “because of” test, the district court determined that the workpapers would not have been prepared at all except for the fact that Textron anticipated the possibility of litigation with the IRS. The IRS appealed.

The First Circuit decision affirmed, in part, the district court’s decision for Textron, holding that under the because-of test, a document may be protected under the work-product privilege if, in light of the nature of the document and the factual situation in the particular case, the document can be fairly said to have been prepared or obtained because of the prospect of litigation, even if a dual purpose exists, such as meeting financial statement reporting requirements. However, in an unusual maneuver, the First Circuit vacated its January panel decision in March 2009 and reheard the case en banc. In a 3–2 decision issued in August 2009, the court reversed course and issued a decision for the government. The resulting highly publicized opinion, which effectively narrowed the protections of the work-product privilege to documents that are prepared solely in anticipation of litigation, required Textron’s tax accrual workpapers to be disclosed, even though they may have also been prepared for the purpose of assessing the prospect of litigation.

In contrast to the Textron court, other federal circuit courts have not applied the narrow standard set by the Textron decision. For example, the Second Circuit affords protection under the work-product doctrine for dual purpose documents created because of the prospect of litigation as well as to assist with business decisions. (See Adlman, 134 F.3d 1194 (2d Cir. 1998).) Textron appealed the First Circuit’s en banc decision to the Supreme Court, but the Court declined to hear the case.

The ruling in Textron may have provided an impetus for the IRS to set aside its policy of restraint and begin requesting tax accrual workpapers outside the listed transactions context. As evidenced by the issuance of Announcement 2010-30 and the accompanying Schedule UTP, the IRS has, in fact, officially signaled its intent to seek such workpapers in the broader context.

The Draft UTP Schedule

A new addition to the corporate tax compliance process—Schedule UTP—will be required in 2010 for certain corporations that have total assets in excess of $10 million, issue audited financial statements or are included in the audited financial statements of a related party under GAAP or another accounting standard that requires a taxpayer to record a reserve for federal income tax positions, and have one or more UTPs. At this time, only corporations filing Forms 1120, 1120-F, 1120-L, or 1120-PC are required to file Schedule UTP. It is possible that the IRS will broaden the list of those subject to this new filing requirement in the future, in terms of both the types and size of taxpayers subject to reporting.

Interestingly, in addition to requesting information about both current- and prior-year UTPs, the draft Schedule UTP also asks taxpayers to list the primary Code sections affected by each UTP, whether the position represents a temporary or a permanent item, and the size of the issue. Schedule UTP does not request net amounts, which would indicate some incorporation of risk, but asks for the maximum amount of the tax adjustment that could result from each UTP. Taxpayers are also asked to provide a “concise description” of each UTP.

The completion of Schedule UTP will likely lead to increased tax compliance costs for businesses subject to its jurisdiction. In addition, the information provided on these forms will almost certainly provide ammunition to the IRS and possibly state taxing authorities in their fight to gain more information from taxpayers. It is likely that this will result in additional claims of privilege, which will be fought out through the audit process and in the courts. Further, one could question whether providing the information requested by Schedule UTP is a violation of the work-product privilege.

State Tax Impact

Both the IRS’s issuance of Schedule UTP and the Textron decision have presumably been welcome developments for state taxing authorities. First, given that most states require a corporation to provide a copy of the federal tax return and schedules along with its state tax filing, Schedule UTP will be available to the state taxing authorities for review. This schedule may also encourage states to develop their own version of the UTP schedule that would focus on more relevant state tax audit issues such as nexus and apportionment.

Second, although states have not historically exercised the same policy of restraint as the IRS when requesting a company’s tax workpapers through administrative summonses or subpoenas, the lack of state tax court cases to provide guidance on whether such documents are protected has required state litigants to turn to federal law and cases such as Textron. In fact, a state court case of current import, Comcast, decided on March 3, 2009, by the Massachusetts Supreme Judicial Court (SJC), was decided in favor of the taxpayer and would arguably preclude a state taxing authority from seeking tax accrual workpapers if prepared in anticipation of litigation (Comcast Corp., 901 N.E.2d 1185 (Mass. 2009)).

Although the documents at issue in the Comcast case comprised tax planning memoranda prepared by an accounting firm at the request of in-house counsel rather than tax accrual workpapers, the SJC’s application of the rule set forth by the Second Circuit, as discussed in the prior section, would extend privilege protections to the latter documents. Under the rule, the work-product privilege would protect a document prepared for the dual purpose of assisting in making a business decision and because of the prospect of litigation. Thus, contrary to the narrow standard set by Textron, which requires that the document be prepared solely because of the prospect of litigation, the Comcast decision would arguably allow a company to claim work-product privilege for tax accrual workpapers regardless of the fact that they had a dual purpose of satisfying financial statement requirements as well as analyzing litigation hazards.

Notwithstanding the Comcast decision, state taxing authorities within the First Circuit as well as elsewhere may point to Textron as the correct application of the work-product privilege. In turn, companies could argue under the more expansive work-product standard espoused by Comcast and several other federal circuit courts. The split in courts, however, creates uncertainty for taxpayers and may result in companies being able to claim the privilege to withhold tax accrual workpapers in only one or two jurisdictions in which they operate while having to disclose the same documents in other jurisdictions. Consequently, a company may inadvertently waive the work-product privilege in all the states in which it operates if required to disclose tax accrual workpapers in one jurisdiction that applies the Textron standard.

As mentioned earlier, although Textron appealed the First Circuit’s decision to the Supreme Court, the Court declined to hear the case. As such, rather than issuing a decision that could have brought consistency throughout the various jurisdictions, whether federal or state, in applying the privilege to tax accrual workpapers, the court has left this issue unsettled, at least for the foreseeable future.

Conclusion

It is clear that taxing authorities at both federal and state levels are increasingly focused on transparency and access to all manner of information that may affect the calculation of a company’s tax liability. Only time will tell how Schedule UTP is ultimately used by the IRS and how it will affect the overall corporate income tax compliance function, and the audit activity by taxing authorities, at state and federal levels.

Editor: Anthony S. Bakale, CPA, M. Tax.

EditorNotes

Anthony Bakale is with Cohen & Company, Ltd., Baker Tilly International, Cleveland, OH.

For additional information about these items, contact Mr. Bakale at (216) 579-1040 or tbakale@cohencpa.com.

Unless otherwise noted, contributors are members of or associated with Baker Tilly International.