IRS to Require Disclosures of Uncertain Tax Positions
For the last three years since the FIN 48 accounting interpretation became effective, corporate tax departments and professionals have been concerned that the increased financial accounting disclosures would lead to more Internal Revenue Service (IRS) scrutiny of the uncertain tax positions and attempts by the IRS to gain access to tax accrual workpapers that contain confidential descriptions and analysis of the positions. The IRS takes the position that it has the right to compel disclosure of confidential tax accrual workpapers under the leading Supreme Court case, but it has chosen as a matter of administrative practice to request the workpapers only in certain limited circumstances in which taxpayers invest in abusive tax shelter transactions. The policy of restraint is described in Announcement 2002-63,3 and the Internal Revenue Manual, and is based on competing objectives: that routine disclosure of accrual workpapers would provide a disincentive for accurate and candid financial reporting analysis, but limited disclosure for tax shelters would provide an incentive not to enter into abusive transactions.
Since the adoption of FIN 48, various IRS officials have publicly stated that the IRS is reconsidering its policy of restraint under Announcement 2002-63 in light of FIN 48, suggesting that transparency should be the principal objective in a voluntary compliance tax system. In the meantime, the IRS has engaged in significant litigation in which taxpayers asserted the work product doctrine and other grounds in an attempt to protect workpapers the IRS sought in tax shelter cases. The concerns about the IRS’s intentions came to a head recently when the First Circuit Court of Appeals ruled in favor of the IRS and against the taxpayer in United States v. Textron, ruling that the IRS should have access to the company’s tax accrual work papers.
It turns out that concerns about the IRS’s intentions have been well-founded. The IRS announced in January that taxpayers with assets in excess of $10 million will be required to disclose their uncertain tax positions on a schedule attached to their tax returns. Taxpayers will be required to disclose details of each position (e.g., tax years affected), the rationale for the position, the reason the position is uncertain, and the amount of federal income tax that would be due if the position were disallowed by the IRS on examination. Moreover, taxpayers will be required to disclose certain positions regardless of whether they have established reserves for the positions under FIN 48. This means that taxpayers will have to disclose the positions for which they did not establish a reserve because they intend to litigate the matter or because they believe that the IRS as a matter of administrative practice will not raise the issue. Commissioner of Internal Revenue Douglas Shulman has said that the IRS’s goal in requiring the schedule is to reduce the time spent selecting taxpayers and issues for audit.
Under the new disclosure regime, the IRS should have a roadmap to uncertain tax positions identified by the taxpayer and a gauge to evaluate the materiality of each position. The gauge will be crude, and frequently unreliable, because the required disclosure will be the maximum tax assessment possible without any consideration of the merits of the issue. Commissioner Shulman has said that the IRS only expects to require concise information and no information concerning the strengths or weaknesses of the uncertain positions, although the announcement seems to suggest that the IRS may want more detail notwithstanding the Commissioner’s comments. The IRS states that it is still abiding by its policy of restraint in Announcement 2002-63, and therefore is not asking for the taxpayer’s evaluation of the merits of each issue or the actual amount the taxpayer has reserved for financial accounting purposes for each issue. Nevertheless, the disclosure will require descriptions of matters that are highly confidential, including reasons why each issue is uncertain, the Internal Revenue Code sections that potentially apply, and other detailed information. Attorney-client privilege and work product issues inevitably will arise if the IRS disclosure requests are too broad.
T3: Taxing Times Tidbits, 24 Taxing Times, Vol. 6, Issue 2 (May 2010)