| EXECUTIVE |
|
|
The historic framework of the U.S. income tax has been one of voluntary compliance in which taxpayers self-report their income, deductions, and resulting tax liability. This self-assessment system is based on the assumption that taxpayers will act honestly and in good faith in meeting their tax obligations. The IRS is charged with monitoring taxpayer compliance and collecting taxes rightfully due the government.
Under the leadership of Commissioner Douglas Shulman, the IRS’s emphasis in dealing with large corporate taxpayers has become one of voluntary disclosure requiring greater transparency and increased information flow, with the stated goals of identifying and resolving audit issues more quickly. 1 In January 2010, the IRS announced a proposal to require large corporations to report uncertain tax positions on the new Schedule UTP, Uncertain Tax Position Statement, to be filed with their annual tax returns. 2 In Announcement 2010-9, the IRS stated that “to discharge its obligation to fairly and uniformly administer the tax laws, the Service must be able to identify quickly and efficiently significant issues (including uncertain tax positions) underlying the tax return.” 3 Shulman commented that Schedule UTP is intended “to move us away from protracted trench warfare . . . to earlier and speedier issue resolution and greater efficiency and certainty.” 4 In a speech before the American Bar Association, 5 Shulman announced the following goals of the new schedule:
- Create certainty regarding a taxpayer’s obligations sooner rather than later;
- Cut down on the time it takes to find issues and complete an audit;
- Provide consistent treatment across taxpayers;
- Make efficient use of government and taxpayer resources by focusing on issues and taxpayers that pose the greatest risk of tax noncompliance;
- Ensure that both the IRS and the taxpayer spend more time discussing the law as it applies to the facts and less time looking for information;
- Help the IRS prioritize taxpayers for examination;
- Help the IRS identify issues where there is uncertainty and where further guidance is needed;
- Help the IRS prioritize selection of issues during an audit; and
- Obtain key information regarding uncertain tax positions without getting into the heads of the taxpayers, or their advisers, as it relates to quantifying risk.
This article explores the requirements of Schedule UTP and provides examples of the types of tax positions that taxpayers must disclose on that schedule. Modifications to the IRS’s policy of restraint pertaining to tax reconciliation workpapers, made contemporaneously with the release of the final Schedule UTP, are discussed. Suggestions are made on how to avoid the inadvertent waiver of the work-product privilege for documents relating to uncertain tax positions. The conclusion recommends that the IRS consider integrating the desired UTP disclosures into the Schedule M-3 to eliminate redundant reporting of uncertain positions.
Who Must File a Schedule UTP?
Types of Corporations Covered
Corporations that file a Form 1120, U.S. Corporation Income Tax Return; Form 1120-F, U.S. Income Tax Return of a Foreign Corporation; Form 1120-L, U.S. Life Insurance Company Income Tax Return; and Form 1120-PC, U.S. Property and Casualty Insurance Company, with total assets of $100 million or more must file a Schedule UTP starting with the 2010 tax year. 6 The schedule must be attached to a calendar-year 2010 tax return or to a fiscal year-end return that begins in 2010 and ends in 2011. A Schedule UTP need not be attached to a return for a short tax year ending in 2010. The IRS has announced that it will consider whether to extend all or a portion of Schedule UTP reporting to noncorporate taxpayers, such as passthrough entities and tax-exempt entities, starting in 2011 or later years.
Total Asset Threshold
The IRS initially proposed that corporate taxpayers having $10 million in total assets file the Schedule UTP. 7 In response to public comments requesting that the threshold be increased, the IRS adopted a five-year phase-in of the reporting requirement based on asset size. The initial reporting threshold of $100 million of total assets for 2010 will be reduced to $50 million starting with the 2012 tax year and to $10 million for the 2014 tax year. 8
Audited Financial Statement Requirement
Only a corporate taxpayer or related party that has issued audited financial statements covering all or a portion of the corporation’s tax year is required to file a Schedule UTP. 9 The schedule’s instructions define the term “audited financial statements” to mean financial statements on which an independent auditor has expressed an opinion under GAAP, IFRS, or other country-specific accounting standard. Compiled or reviewed financial statements are not audited financial statements.
Note that a corporate taxpayer without audited financial statements is still required to file a Schedule UTP if it meets the related-party definition described in the instructions. A related party is any entity that has a relationship described in Sec. 267(b), Sec. 318(a), or Sec. 707(b) or that is included in the consolidated audited financial statements in which a corporation with audited financial statements is also included.
Example 1: A Corp. has $160 million in assets. B Corp. is a foreign corporation not doing business in the United States but is a related party to A. The corporations issue separate audited financial statements. A takes a tax position on its tax return, and B records a reserve with respect to the tax position. The position must be reported on a Schedule UTP attached to A’s tax return. No disclosure is required by B since it is not required to file a U.S. income tax return.
Example 2:
C Corp.
has $160 million in assets and issues
consolidated audited financial statements with
D
Corp. but does not file a consolidated tax
return. Even though C and D do not have
a relationship that is described in Secs.
267(b), 318(a), or 707(b), both are subject to
the Schedule UTP reporting requirements.
What Tax Positions Must Be Reported on Schedule UTP?
U.S. Federal Income Tax Positions
An applicable corporation must report tax positions taken on a U.S. federal income tax return on Schedule UTP if:
- The corporation has taken a tax position on its U.S. federal income tax return for the current year or for a prior tax year; and
- The corporation or a related party has either:
- Recorded a reserve with respect to all or part of that tax position in audited financial statements; 10 or
- Not recorded a reserve for a tax position because the corporation expects to litigate the position. (A tax position meeting the requirements of (1) or (2) is sometimes referred to in this article as a “UTP disclosure position.”)
Tax Position Taken on a Tax Return Defined
A tax position taken on a tax return is defined as one that would result in an adjustment to a line item on the tax return or that would be included in a Sec. 481(a) adjustment (changes in method of accounting) if the position were not sustained upon an IRS audit.
Example 3: E Corp. has a $100 net operating loss carryforward that will expire if E does not use it in 2010. E reports $100 of income in 2010 that the loss carryforward will offset but is uncertain whether the income should be reported in 2010 or 2011. The corporation has taken a tax position on both the 2010 and 2011 tax returns because there would be an adjustment to a line item on both returns if the position taken in that year were not sustained.
If multiple tax positions affect a single line item on the tax return, each tax position is treated as a separate tax position. A tax position is based on the unit of account used to prepare the audited financial statements in which a reserve has been recorded. The unit of account must be the same unit of account used by the taxpayer for GAAP or modified GAAP statements. The taxpayer may not use a unit of account that is based upon the entire tax year. The corporation must instead identify a unit of account that will apprise the IRS of the identity and nature of the issue underlying the tax position taken on the tax return. 11
Example 4: F and G Corps. issue consolidated audited financial statements and file a consolidated tax return. F bases its research and development credit on costs accumulated for each individual research project, while G uses its functional expenditures. The unit of account for F is each project, while the unit of account for G is its functional expenditures.
Financial Statement Reserves
Whether a reserve has been recorded and must be disclosed on the Schedule UTP is determined by reference to the reserve decisions made by the corporation or a related party for audited financial statement purposes. 12 If, under the applicable accounting standards, no reserve was required for a tax position taken on a tax return, either because the amount was immaterial for audited financial statement purposes or there is sufficient certainty regarding the tax position, 13 the tax position need not be reported on the Schedule UTP. The IRS has not provided a definition of materiality, so presumably it is left up to the corporate taxpayer to determine when a position is material.
In Announcement 2010-75, the IRS assured corporate taxpayers that “the schedule seeks the reporting of tax positions consistent with the reserve decisions made for audited financial statement purposes.” The rationale for this approach is to rely on existing documents and analysis for the Schedule UTP disclosures. Kathryn A. Zuba, special counsel with the IRS Office of Associate Chief Counsel, has stated that “one core rationale underlying the final UTP regime is to create consistency with financial reporting standards because taxpayers are already reporting information using such standards.” 14
The initial recording of a reserve will trigger reporting of the tax position on the Schedule UTP in the year the position is taken on the corporate tax return. Subsequent reserve increases or decreases with respect to the tax position will not trigger additional disclosure. No disclosure is required for tax positions taken on a tax return before January 1, 2010, even if the corporation records a reserve for financial statements issued in 2010 or later.
Example 5: H Corp. records a reserve in its 2010 audited financial statements relating to a tax position taken on its 2010 calendar-year tax return. The tax return is filed on September 15, 2011. H must report the 2010 tax position on its Schedule UTP and attach it to its 2010 tax return. If the reserve for the tax position taken on its 2010 tax return is adjusted in its 2012 audited financial statements, no additional reporting is required.
Expectation to Litigate Position
A corporation is required to report on Schedule UTP a tax position for which it did not record a reserve based on its expectation to litigate the position. It must report such a tax position if:
- The corporation or a related party determines that the probability of settling the position with the IRS is less than 50%; and
- Under applicable accounting standards, no reserve was recorded in the corporation’s audited financial statements because it intends to litigate the tax position and has determined that it is more likely than not (MLTN) to prevail on the merits in litigation.
In Announcement 2010-75, the IRS stated that it would expect a corporation to document its decision to litigate in the same way it substantiates a decision not to record a reserve in its financial statements.
Example 6: I Corp. enters into a cost-sharing arrangement with a foreign subsidiary and deducts its proportionate share of the costs as research and development costs. Management determines that the probability of sustaining the full deduction upon an IRS audit is less than 50% because the issue has been identified as a Tier I audit issue. The corporation does record a reserve for the potential tax liability because management expects to litigate the issue and believes it is more likely than not to prevail because of favorable appellate court decisions on this issue. I Corp. must disclose the tax position on the Schedule UTP even though it made no reserve for the position in its audited financial statements.
Schedule UTP Reporting Requirements
The Schedule UTP is divided into three parts. In part I, the corporate taxpayer reports tax positions taken in the current year that meet the definition of a UTP disclosure position. The corporate taxpayer uses part II to report tax positions taken by a corporation in a prior year that have not been reported on a prior year’s Schedule UTP. Part III is used to provide a concise description of each uncertain tax position reported in parts I and II.
In What Tax Year Must the Disclosure Be Made?
A corporation must report a UTP disclosure position it takes on its current-year return on part I of Schedule UTP. If a transaction results in the corporation’s taking a UTP disclosure position on more than one tax return, the corporation must report the position on part I of Schedule UTP in each year that it takes the position on its corporate return. For a reporting requirement to exist in a year, the corporate taxpayer must have taken a position on that year’s return, and it must be a UTP disclosure position (i.e., a reserve must have been recorded for that position, or a reserve was not recorded based on an expectation to litigate). While the initial recording of a reserve will trigger reporting of a UTP disclosure position in the year the reserve is established if a tax position has been taken on the corporate return, subsequent reserve increases or decreases for that position will not. Following are examples of the application of these rules.
Example 7: J Corp. deducts an expense for warranty costs for financial accounting, but not on its tax return. A deferred tax asset is recorded for the deferred tax benefit. If management believes that a portion of the warranty costs may not be deductible under U.S. tax law, the company reduces the deferred tax asset and increases current financial tax expense by an amount that reflects the uncertain tax position. In the year the company records the reserve, it does not disclose the uncertain tax position on Schedule UTP because the deduction has not yet been taken on the U.S. federal tax return.
Example 8: K Corp.
deducts the full amount of an expenditure
incurred in 2010. The corporation determines it
is uncertain whether the expenditure is
currently deductible or should be amortized over
five years. It records a reserve for the
position taken. If the 2010 deduction is not
sustained, an amortization deduction would be
allowed on its 2011–2014 tax returns. The
company need only disclose the position on part
I of the Schedule UTP for 2010. It need not also
disclose on its Schedule UTP for the 2011–2014
tax years because no reserve is recorded in
those years.
Example 9: L Corp.
records a reserve equal to 30% of a tax benefit
taken on its 2010 tax return. The corporation
discloses the tax position on its 2010 Schedule
UTP. In 2011, it increases the reserve for this
tax position to 45%. The corporation is not
required to disclose the reserve increase on its
2011 tax return.
A UTP disclosure position taken by a corporation on a prior year’s tax return that it did not previously disclose is reported on part II of Schedule UTP in the year in which the tax reserve is taken. It is not necessary to file an amended Schedule UTP for the prior tax year. If the corporation previously reported a UTP disclosure position on a prior-year Schedule UTP, whether in part I in the year it took the position or in part II in a subsequent year, the corporation is not required to report the position again.
Example 10: M Corp. deducts an expense on its 2010 tax return. The company does not make a tax reserve on its financial statements because management is certain that the amount is deductible in full. In 2011 the Tax Court issues an unfavorable decision that now makes it more likely than not that the expense will not be deductible in full. The corporation makes a tax reserve on its 2011 financial statements for the tax position taken on its 2010 tax return. The corporation must disclose the uncertain tax position on part II of its 2011 Schedule UTP.
As discussed earlier, Schedule UTP does not require the disclosure of any tax positions taken in a tax year beginning before January 1, 2010. This rule applies even if a reserve is recorded for such tax positions in audited financial statements in 2010 or later. Part II of Schedule UTP is not completed for the 2010 tax year because tax positions taken before the 2010 tax year are not reported.
Parts I and II
For each UTP disclosure position, the corporate taxpayer must provide the following information:
- The corporate taxpayer is required to identify the Internal Revenue Code sections (up to three) relating to each UTP disclosure position.
- The corporate taxpayer must indicate whether the position is a temporary difference, a permanent difference, or both. Categorization must be consistent with the accounting standards used to prepare the audited financial statements.
- If the position relates to a tax position of a passthrough entity, the taxpayer identification number of the passthrough entity must be provided.
- The corporate taxpayer must indicate those positions whose relative size (by amount of the dollar reserve) is greater than or equal to 10% of all tax positions listed on parts I and II of the Schedule UTP for that year. Schedule UTP and its instructions refer to these as major tax positions.
- All tax positions on parts I and II combined must be ranked based on size, with the number 1 being assigned to the largest, 2 to the next largest, and so on. The letter T must be entered before the number for all transfer pricing positions (i.e., T1, T3) and the letter G for all other tax positions (i.e., G2, G4).
Ranking Positions by Size
Except for positions the taxpayer expects to litigate, Schedule UTP requires the ranking of tax positions reported on parts I and II by size and the designation of the positions that are major tax positions (i.e., greater than or equal to 10% of all tax positions on parts I and II). The size of each tax position is determined on an annual basis and is the amount of the federal income tax reserve for accounting purposes. 15 Positions a corporation discloses on the basis of an expectation to litigate are not included in the ranking or in the determination of major tax positions because the corporation has not established a reserve for these items for financial statement purposes. The instructions simply provide that the corporation assign positions it expects to litigate any number in the ranking. 16
The Schedule UTP as originally proposed by the IRS would have required a corporation to disclose the maximum tax adjustment for each tax position listed (except for transfer pricing and other valuation positions). 17 The IRS defined the term “maximum tax adjustment” in the draft instructions of Schedule UTP as the maximum U.S. federal income tax liability for the tax position if not sustained on audit. The AICPA and others expressed concern that this amount would be unduly burdensome to compute and would give the IRS misleading information about the riskiness of the position and its magnitude. In light of the public comments received, the IRS modified Schedule UTP to allow corporations to rely on information already available to them for financial accounting purposes (i.e., the reserve for each tax position computed in complying with the requirements of FIN 48). 18
In substituting the ranking regime in place of the disclosure of a corporation’s maximum tax adjustment, the IRS observed that ranking would allow it to more accurately evaluate the materiality of the items reported. In addition, the ranking method avoids the sensitive issue of corporations being required to disclose the amount of the reserve established for a tax position.
Part III: Concise Description
A concise description of each uncertain tax position must be provided in part III of Schedule UTP. The instructions for part III require that the taxpayer provide the following information:
- A description of the relevant facts affecting the tax treatment of the position; and
- Information that can reasonably be expected to apprise the IRS of the identity of the tax position and the nature of the issue.
The instructions specifically direct taxpayers not to provide an assessment of the hazards of a tax position or an analysis of the support for or against the position. The initial draft of Schedule UTP would have required that the taxpayer provide the rationale for each uncertain tax position. The IRS eliminated the requirement in the final version of the schedule.
Coordination with Forms 8275 and 8275-R
The instructions to Schedule UTP provide that a complete and accurate disclosure of a tax position on the appropriate year’s Schedule UTP will be treated as if the corporation had filed a Form 8275, Disclosure Statement, or a Form 8275-R, Regulation Disclosure Statement, regarding the tax position. A corporation does not need to file a separate Form 8275 or Form 8275-R to avoid certain accuracy-related penalties for that position. In the case of a transaction that is not a reportable transaction, the IRS will treat a complete and accurate disclosure of a tax position on Schedule UTP as satisfying the disclosure requirement of Sec. 6662(i).
Although the IRS stated in Announcement 2010-75 that it is studying whether a complete and accurate disclosure on Schedule UTP should be adequate to provide the IRS with the information necessary to satisfy the reportable transaction disclosure requirements, for the 2010 tax year reportable transactions must continue to be separately reported on Form 8886, Reportable Transaction Disclosure Statement.
Case Study
The following case study illustrates which tax accruals taxpayers must disclose on Schedule UTP and what information they must include. It is important to keep in mind that a significant portion of the tax accruals required by FASB Accounting Standards Codification (ASC) Topic 740, Income Taxes, are not reported on the schedule because they pertain to an adjustment to the noncurrent tax expense or they relate to uncertainty about whether the tax benefit will be realized in the future. Taxpayers are not required to disclose accruals for uncertain tax positions for state, local, and international tax issues on Schedule UTP.
Facts
SH Corp. is a calendar-year accrual- method corporation that has no prior-year tax accruals. Since SH has more than $100 million in assets, it is required to file Schedule M-3, Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million or More. SH must also file Schedule UTP because it has one or more uncertain tax positions. The following simplifying assumptions have been made:
- SH is not a member of an affiliated group.
- Its financial income is $20 million before taxes and before the items discussed below.
- The applicable federal tax rate is 35%, and state and international taxes are not considered.
- The tax accrual is based only on originating tax deductions for the 2010 tax year.
- There are no tax positions that the corporation expects to litigate.
- There are no transfer pricing issues.
- The appropriate unit of account is each separately identified transaction.
- There is no “true up” adjustment to the tax expense.
- The ASC Topic 740-10 accruals for interest and penalties are ignored.
SH’s book-tax differences are summarized in Exhibit 1. A discussion of each item follows.
A—Bad debt expense: For financial accounting, the bad debt expense is the change in the beginning and ending allowance for doubtful accounts, which is a contra-account to accounts receivable. The tax deduction for bad debts is limited to those accounts that have been written off as uncollectable in the current tax year. The book-tax difference of $100,000 results in a deferred tax benefit of $35,000 ($100,000 × 35%). Since there is no uncertain tax position associated with this deduction, no disclosure is made on Schedule UTP. A book-tax difference is disclosed on Schedule M-3, part III, line 32.
B—Net capital loss: Since SH has had no capital gains in the prior three years, the loss must be carried forward, and no immediate tax benefit is recognized on the tax return. If it is more likely than not that the corporation will not have sufficient capital gains within the carryforward period to absorb the loss, a valuation allowance, which is a contra-account to the deferred tax asset, must be established. Management believes it is not probable that the company will utilize the loss within the carryforward period and establishes a valuation allowance of 40%. Since there is no uncertain tax position associated with this deduction, the company makes no disclosure on Schedule UTP. It discloses a book-tax difference on Schedule M-3, part II, lines 23 and 24.
C—Contingent liability: Management accrues an expense for a contingent liability arising from potential environmental contamination from the company’s manufacturing processes. Management believes it is more likely than not that a judgment will be made against the company. Management also believes at the realistic possibility of success level that the payment, when made, will be deductible. Since the company will not make a payment until all legal appeals have been exhausted, which management expects to take three to five years, it takes no current tax deduction because the economic performance test (Sec. 461(h)) has not been met. Management believes that once the company makes the payment, a portion of the amount could be deemed a nondeductible capital expenditure (Sec. 263) and accrued a reserve equal to 50% of the expected future benefit. Since the company has not yet taken the position on the tax return, it does not disclose the position on Schedule UTP. A book-tax difference is disclosed on Schedule M-3, part III, line 13.
D—Depreciation expense: A cost segregation study was performed that resulted in a significant portion of the cost being reclassified as personalty with useful lives of 15 and 20 years. Component depreciation expense allowable for tax purposes is in excess of depreciation allowed for financial purposes. Management believes it is more likely than not that the deduction is allowable; however, the IRS could challenge the shorter useful lives of certain components upon audit (Sec. 167). Management believes there is an uncertain tax position regarding the full deductibility of the tax depreciation in the current year and has accrued a reserve equal to 25% of the current tax benefit. Since there is an uncertain tax position associated with this deduction, the company must disclose the item on Schedule UTP. A book-tax difference is disclosed on Schedule M-3, part III, line 31.
E—Partnership loss: ASC Topic 740-10 also applies to an uncertain tax position even when there is no book-tax difference. Management believes the IRS could challenge the deductibility of a portion of the partnership loss, since the corporation is a limited partner and the computation of its basis in the partnership interest includes a nonrecourse debt allocation (Sec. 752) and a special allocation of depreciation deductions that could potentially not meet the substantial economic effect test under Sec. 704(c) or the economic substance doctrine of Sec. 7701(o)(1)(D). Furthermore, a portion of the partnership loss is from a listed transaction. Management believes at the MLTN level that the ordinary loss is deductible in full. It also believes that there is an uncertain tax position regarding the full deductibility of the partnership loss and has accrued a reserve equal to 30% of the current tax benefit. Since there is an uncertain tax position associated with this deduction, the company must disclose the item on Schedule UTP. The Timing Codes box (c) is left blank because there is no book-tax difference. In addition, the company must file Form 8886 since the loss is also a listed transaction. A book-tax difference is disclosed on Schedule M-3, part II, line 9, and the amount attributable to the reportable transaction is disclosed on line 12.
F—Domestic production activity deduction: The domestic production activity deduction results in a permanent difference since this deduction is never taken when computing financial net income. However, it does affect the effective tax rate reported in a footnote to the financial statements. Management believes there is a reasonable basis for taking the deduction but lacks substantial authority for its position. The IRS could take the position that the deduction is not allowable because of uncertainty regarding whether the income is from a qualifying domestic production activity (Sec. 199). Management does not believe the MLTN threshold has been met and has accrued a reserve for the entire current tax benefit. Since there is an uncertain tax position associated with this deduction, the company must disclose the item on Schedule UTP. Form 8275 is not required because the company discloses the item on Schedule UTP. A book-tax difference is disclosed on Schedule M-3, part III, line 22.
G—Foreign tax credit: The foreign tax credit is a permanent difference that reduces both financial tax expense and federal tax payable. The company discloses it in the effective tax rate footnote to the financial statements. Management believes it is more likely than not that the full credit can be claimed; however, the IRS could deny part of the credit under the limitation to income resourced under certain foreign tax treaties (Sec. 904(d)(6)). Therefore, management has accrued a reserve for 10% of the current tax benefit. Since there is an uncertain tax position, the credit must be disclosed on the Schedule UTP. While there is no book-tax difference, the credit reduces the current tax expense disclosed on Schedule M-3, part III, line 1.
Schedule UTP Disclosures
Exhibit 2 summarizes the part I and part III disclosures. Note that items A–C are not disclosed on Schedule UTP because they do not result in uncertain positions taken on the tax return. The rankings are based on the tax reserve for items D–G, which totals $57,750 ($8,750 + $10,500 + $35,000 + $3,500). Since the reserve for the foreign tax credit does not exceed 10% of the total, it is not a major tax position. The ranking of the remaining three items is based upon their reserve amounts. A concise explanation of each issue is provided.
The IRS Policy of Restraint and Schedule UTP
Background
For many years, the IRS has adopted a policy of restraint when requesting tax accrual workpapers during an audit and has requested audit or tax accrual workpapers only in “unusual circumstances.” 19 In 2002, the IRS modified its historical policy of restraint for taxpayers claiming the benefit of one or more listed transactions. 20 Under the modified policy of restraint, the IRS now routinely requests tax accrual workpapers of corporate taxpayers that engage in listed transactions. If the taxpayer is involved in only one listed transaction and discloses the transaction on Form 8886, the IRS will request tax accrual workpapers that pertain only to the listed transaction for the year under examination. The IRS will request all tax accrual workpapers of a corporate taxpayer for the year under examination if the taxpayer has not disclosed the listed transaction. In addition, as a discretionary matter the IRS may request all tax accrual workpapers for the year under examination if the taxpayer has claimed the benefits of multiple listed transactions, even if they were properly disclosed. 21 It is the IRS modification of its policy of restraint relating to listed transactions that ultimately led to the conflicting decisions in Deloitte, 22 Textron, 23 and Regions Financial Corp. 24 regarding the protection of tax accrual workpapers (in whole or in part) by the work-product doctrine.
The IRS’s announcement of the proposed Schedule UTP following its aggressive pursuit of tax accrual workpapers in Deloitte, Textron, and Regions led many in the tax community to express concern about the disclosures proposed by the IRS in Schedule UTP. In the form originally proposed by the IRS, corporate taxpayers completing Schedule UTP would have been required to provide “the rationale for [the uncertain tax] position and the reasons for determining the [uncertain tax position] is uncertain.” 25 Perhaps the IRS was attempting to obtain access to the rationale and thinking of corporate representatives (i.e., attorneys and tax experts assisting them) by mandating these disclosures on Schedule UTP. The AICPA raised this concern in its comment letter on the proposed Schedule UTP, stating that “by requiring taxpayers and return preparers to essentially lay out potential audit issues on the disclosure form, concerns about abrogation of privilege become a significant issue.” 26
In response to public comments on the proposed Schedule UTP, the IRS modified its instructions to the form by eliminating the requirement that the corporate taxpayer provide the rationale and nature of the uncertainty of the tax position in part III. The final Schedule UTP requires only a concise description of the relevant facts.
Policy of Restraint Related to Schedule UTP
Contemporaneously with the release of the final form of Schedule UTP, the IRS issued Announcement 2010-76, 27 which Commissioner Shulman declared “strengthens and clarifies the policy of restraint.” 28 When read carefully, the breadth and scope of Announcement 2010-76 is relatively narrow and in fact raises many issues for corporate taxpayers.
The Internal Revenue Manual (IRM) instructs IRS auditors to request “tax reconciliation workpapers . . . as a routine matter at the beginning of an examination.” 29 The term “tax reconciliation workpapers” is defined as follows:
Tax reconciliation workpapers are used in assembling and compiling financial data preparatory to placement on a tax return. These papers typically include final trial balances for each entity and a schedule of consolidating and adjusting entries. They include information used to trace financial information to the tax return. Any tax return preparation documents that reconcile net income per books or financial statements to taxable income are also tax reconciliation workpapers. Tax reconciliation workpapers do not become tax accrual workpapers when they are used in the preparation of tax accrual workpapers or are attached to tax accrual workpapers. Preexisting documents that a taxpayer, the taxpayer’s accountant, or the taxpayer’s independent auditor consults, refers to, or relies upon in making evaluations or decisions regarding the tax reserves or in performing an audit are not themselves considered tax accrual workpapers or audit workpapers, even though the taxpayer, the taxpayer’s accountant, or independent auditor may store such documents with the tax accrual workpapers or audit workpapers. 30
Announcement 2010-76 states that when providing its tax reconciliation workpapers to auditors during an examination, the taxpayer may redact the following information relating to the preparation of the Schedule UTP (UTP prep documents):
- Working drafts, revisions, or comments concerning the concise description of tax positions reported on Schedule UTP;
- The amount of any reserve related to a tax position reported on Schedule UTP; and
- 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. 31
In addition, Announcement 2010-76 provides that “if a document . . . otherwise privileged . . . was provided to an independent auditor as part of an audit of the taxpayer’s financial statement, the Service will not assert during an examination that privilege has been waived by such disclosure” (emphasis added). 32 The IRS clarifies that Announcement 2010-76 describes its “policy for seeking documents . . . from taxpayers and third parties during an examination. It does not create or imply the application of the attorney-client privilege, the tax adviser privilege under Section 7525 of the Code, or the work product doctrine to any document of any taxpayer or third party” (emphasis added). 33 The IRS makes clear in Announcement 2010-76 that, despite its loss in Deloitte, it considers that a corporation waives the work-product privilege upon the disclosure of a privileged document to its independent auditor. 34
While it appears that the IRS intended Announcement 2010-76 to provide some level of comfort to corporate taxpayers that the Schedule UTP would not create opportunities for the IRS to assert the waiver of the attorney-client privilege, the federal tax advice privilege, or the work-product privilege, it does not go far enough. The provision for the redaction of documents generated in preparing the Schedule UTP (i.e., the UTP prep documents) applies only during an examination. This logically leads one to question whether the IRS will take the position during the IRS administrative appeals process or in litigation that taxpayers must produce an unredacted copy of the UTP prep documents. Likewise, if legal opinions (or opinions by tax experts obtained by corporate counsel or outside counsel) are used (or referred to) in preparing the concise description for part III of the Schedule UTP, and such documents are also examined by outside auditors in determining the adequacy of reserves for contingent tax liabilities, Announcement 2010-76 leaves unanswered whether the IRS will assert waiver of any applicable privilege during an IRS administrative appeal or in litigation. The language of Announcement 2010-76 restricting its application only to the examination process should cause corporate taxpayers to proceed with caution in preparing their Schedule UTP and documenting the items disclosed on the schedule.
Announcement 2010-76 makes clear that the IRS will continue to assert waiver of the attorney-client, the federal tax advice, and the work-product privileges upon disclosure of documents to a company’s independent auditor if the IRS has requested tax accrual workpapers under IRM Section 4.10.20.3 because of unusual circumstances or if the taxpayer has claimed the benefits of one or more listed transactions. 35 In Announcement 2010-76, the IRS also reserves the right to assert a waiver of privilege by any method other than disclosure to the taxpayer’s independent auditor even during the examination process. 36 This situation can arise if a taxpayer provides a legal opinion to an outside tax return preparer to assist in preparing a corporate return, including the concise description of any uncertain tax position in part III of Schedule UTP.
Observation: If the IRS’s intention is that compliance with the Schedule UTP disclosure requirements not jeopardize a corporation’s evidentiary privileges, the language of Announcement 2010-76 should be expanded to provide that the IRS will not assert a waiver of privilege if otherwise privileged documents are disclosed to a third party in connection with the preparation of the Schedule UTP.
Preserving Work-Product Privilege After Schedule UTP
As discussed above, part III of Schedule UTP requires that a corporate taxpayer provide a concise description of all uncertain tax positions identified in parts I and II of the form. Corporate taxpayers must remain vigilant when drafting the description of uncertain tax positions in part III to avoid the inadvertent disclosure to the IRS of any opinions, analyses, or evaluations that are protected by the attorney-client, federal tax advice, or work-product privileges. The description provided in part III should be limited to the information required by the instructions to part III of Schedule UTP:
a concise description of the tax position, including a description of the relevant facts affecting the tax treatment of the position and information that reasonably can be expected to apprise the IRS of the identity of the tax position and the nature of the issue. 37
The taxpayer should avoid providing any additional information. The part III description is not the place for the taxpayer to argue its position with the IRS. In fact, the instructions specifically advise taxpayers that the description should not include “an assessment of the hazards of a tax position or an analysis of the support for or against the tax position.” 38 Nor should the concise description include the rationale and nature of the uncertainty, which were required in the initial draft of Schedule UTP. 39 A taxpayer that includes in whole or in part any opinions, analyses, or evaluations of counsel or representatives of counsel for the corporation risks an argument by the IRS that the corporation has waived any applicable privilege. Even if the taxpayer prevails on the issue in court, it may incur substantial costs in doing so.
Conclusion
The new Schedule UTP will shift the U.S. tax system from one of voluntary compliance to one of mandatory disclosure for U.S. corporations. While it can be argued that the UTP regime is consistent with current financial reporting standards, the process of sifting through financial disclosure workpapers to identify those items that must now be disclosed on a Schedule UTP is problematic and will place a significant burden on the affected corporations. As the case study above illustrates, the Schedule M-3 already requires a taxpayer to disclose its book-tax differences and whether they are temporary or permanent differences. The new information being sought, the identification of major tax positions, the ranking of the tax positions, and a concise explanation of the issue could be incorporated into the Schedule M-3 design, eliminating the redundancy that currently exists between the Schedule M-3 and the Schedule UTP. The IRS should analyze Schedule UTPs filed for the 2010 tax year and determine what incremental value, if any, this schedule has over the information taxpayers are currently disclosing on Schedule M-3 before it requires smaller corporations and noncorporate entities to complete the form.
Footnotes
1 IR-2010-98, Prepared Remarks of IRS Commissioner Doug Shulman to the American Bar Association, Toronto, Canada (September 24, 2010).
2 Announcement 2010-9, 2010-7 I.R.B. 408.
3 Id.
4 IR-2010-107, Commissioner of Internal Revenue Douglas H. Shulman’s Keynote Speech Before the AICPA Fall Tax Meeting (October 26, 2010).
5 IR-2010-98.
6 Announcement 2010-75, 2010-41 I.R.B. 428.
7 Announcement 2010-9.
8 Announcement 2010-75.
9 Announcement 2010-30, 2010-19 I.R.B. 668.
10 An exception to this rule applies when a corporation records a reserve in an audited financial statement and later eliminates the reserve in an interim audited financial statement issued before the tax position is taken in a return. IRS, Frequently Asked Questions on Schedule UTP.
11 Announcement 2010-75.
12 Id.
13 For a corporation subject to Financial Accounting Standards Board (FASB) Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes, a tax position is considered “sufficiently certain so that no reserve was required” if the position is “highly certain” within the meaning of FIN 48. IRS, Frequently Asked Questions on Schedule UTP.
14 Coder, “UTP Regime Aims to Be Consistent with Financial Reporting Standards, IRS Official Says,” 129 Tax Notes 659 (November 8, 2010).
15 If an amount of interest or penalties relating to a tax position is not separately identified in the books and records as associated with that position, then that amount of interest and penalties is not included in the size of a tax position used to rank that position. IRS, Frequently Asked Questions on Schedule UTP.
16 Announcement 2010-75.
17 Announcement 2010-30.
18 FIN 48, Accounting for Uncertainty in Income Taxes, is now mostly contained in FASB Accounting Standards Codification Subtopic 740-10, Income Taxes.
19 Internal Revenue Manual (IRM) §4.10.20.3(2).
20 Announcement 2002-63, 2002-2 C.B. 72.
21 See IRM §4.10.20.3.2.
22 Deloitte LLP, 610 F.3d 129 (D.C. Cir. 2010).
23 Textron Inc., 577 F.3d 21 (1st Cir. 2009).
24 Regions Fin. Corp., No. 2:06-CV-00895-RDP (N.D. Ala. 2008).
25 Draft instructions for Schedule UTP (April 19, 2010), attached to Announcement 2010-30.
26 AICPA Comments on Announcements 2010-9, 2010-17, and 2010-30 with Regard to Uncertain Tax Positions, submitted to the IRS June 1, 2010.
27 Announcement 2010-76, 2010-41 I.R.B. 432. The changes in the announcement apply to any request for documents outstanding on or made after September 24, 2010, in any open examination. IRS, Frequently Asked Questions on Schedule UTP.
28 IR-2010-98 at 4.
29 IRM §4.10.20.3(1).
30 IRM §4.10.20.2(s).
31 Announcement 2010-76, ¶(3).
32 Id., ¶(1).
33 Id., ¶(5).
34 It is well-settled law that disclosure of a document to a company’s independent auditor waives the attorney-client privilege and the federal tax advice privilege in Sec. 7525.
35 Announcement 2010-76, ¶(2)(b).
36 Id., ¶(2)(a).
37 2010 Instructions for Schedule UTP, part III, Concise Description of UTPs, at 4–5.
38 Id.
39 Announcement 2010-75 at 12.
EditorNotes
Cherie Hennig is a professor at the University of North Carolina–Wilmington in Wilmington, NC. Blaise Sonnier is a professor at Florida International University in Miami, FL. For more information about this article, contact Prof. Sonnier at sonnierb@fiu.edu.
