On January 26, 2010, the IRS announced a change to its policy of restraint relating to tax accrual work papers in the form of a proposal to require certain large corporations to annually disclose their uncertain tax positions and related dollar amounts to the IRS in connection with the filing of their U.S. federal income tax return. This announcement by the IRS creates concerns for corporate taxpayers, a number of which already are seeking advice from their counsel, the IRS, or both, to begin to minimize the number and type of "uncertain" tax positions. The new IRS disclosure initiative increases pressure on financial statement preparation and results in a de facto expansion of the IRS's Compliance Assurance Process ("CAP") program. The disclosure also is likely to both focus and shorten the IRS examinations.
On April 19, 2010, the IRS released for comment a draft schedule, Schedule UTP (Uncertain Tax Positions Statement), and related instructions for use by taxpayers to report uncertain tax positions on their IRS Forms 1120, 1120-F, 1120-L, and 1120-PC beginning with the 2010 tax year. An overview of the draft schedule and related instructions is set forth below in this alert. The draft schedule released by the IRS in IRS Announcement 2010-30, is the same schedule referred to by the IRS in IRS Announcements 2010-9 and 2010-17. Although the draft schedule is fairly streamlined, it appears to require that even highly cooperative taxpayers participating in the CAP program comply with the disclosure program requirements.
The draft schedule and instructions will be finalized by the IRS after it has received and considered comments regarding the overall proposal and the draft schedule and instructions. According to IRS Announcement 2010-17, the comment period will end on June 1, 2010. Although the IRS will entertain comments, we expect to fundamental tenants of the proposal to remain in tact. Specifically, we expect the IRS will continue to seek disclosure of the uncertain position, the issue, and the highest potential exposure (or, for issues such as transfer pricing and valuation, a "ranking").
Taxpayers that satisfy each of the following five requirements will be required to file a Schedule UTP with their U.S. federal income tax returns beginning with the 2010 tax year:
- The taxpayer is a corporation;
- The taxpayer has assets equal to, or exceeding, $10 million;
- The taxpayer has one or more uncertain tax positions;
- The taxpayer or a related party issues audited financial statements and the audited financial statement covers all or a portion of the taxpayer's operations for all or a portion of a taxpayer's tax year; and
- The taxpayer files any of an IRS Form 1120, 1120-F, 1120-L or 1120-PC.
Although real estate investment trusts, regulated investment trusts, pass-through entities, and tax-exempt organizations will not be required to file a Schedule UTP for the 2010 tax year, IRS Announcement 2010-30 provides that the IRS will determine the timing for when these entities must begin to file a Schedule UTP. In addition, Schedule UTP requires a corporation to provide the name and EIN of a pass-through entity if the disclosed tax position taken by the corporation relates to a tax position of a pass-through entity.
Scope of Uncertain Tax Positions to be Reported
Affected taxpayers must report on Schedule UTP for a tax year their U.S. federal income tax positions for which the corporation or a related party either:
- at least 60 days before filing the tax return, has recorded a reserve in an audited financial statement; or
- made a decision at least 60 days before filing the tax return to not record a reserve in an audited financial statement based upon an expectation to litigate or an IRS administrative practice.
The tax position must be reported regardless of whether the audited financial statement is prepared based on U.S. GAAP, IFRS, or other country-specific accounting standards, including a modified version of the above that required a taxpayer to record a reserve for U.S. federal income tax positions.
Schedule UTP is divided into three parts. Part I is used to report uncertain tax positions of the corporation for the current tax year. Part II is used to report uncertain tax positions of the corporation for prior taxable years that have not yet been reported on Schedule UTP. Part II will not be completed by taxpayers for the 2010 tax year. To satisfy the requirements of Parts I and II with respect to a tax position, the taxpayer must, among other things, identify the primary Internal Revenue Code (the "Code") sections relating to the tax position, identify whether the tax position creates a temporary or permanent difference (or both), and enter the maximum tax adjustment ("MTA") amount for each tax position. The MTA amount is determined on an annual basis utilizing a 35% tax rate and does not include interest or penalties and disregards the effects of a tax position on state, local or foreign taxes. Further, in the case of a disclosed tax position relating to a valuation or transfer pricing matter, the MTA amount need not be provided to the IRS. Instead, the taxpayer is required to provide a ranking of these tax positions based on either (a) the amount recorded as a reserve for U.S. federal income tax for that tax position or (b) the estimated adjusted to U.S. federal income tax that would result if the tax position taken in the tax return is not sustained, with the method being applied consistently to all valuation and transfer pricing tax positions reported on the Schedule UTP.
In both Part I and Part II, the taxpayer also is required to check a box with respect to each applicable tax position if the tax position must be reported because it was determined the IRS would not challenge the position upon examination based on IRS administrative practice. The IRS, however, has indicated that it intentionally did not also include another check box on the Schedule UTP for whether a taxpayer expected litigation with respect to a tax position as it did not want to "get into the heads" of a taxpayer with respect to risk assessment.
Part III is used by taxpayers to provide a concise description of each uncertain tax position reported in Part I or Part II. According to IRS Announcement 2010-30, the Part III description should not exceed a few sentences in most cases. To satisfy this requirement, the Part III description must include:
A statement that the position involves an item of income, gain, loss, deduction, or credit against tax; A statement whether the position involves a determination of the value of any property or right or a computation of basis; and The rationale for the position and the reasons for determining the position is uncertain. Filing of Schedule UTP
A taxpayer must file its Schedule UTP along with its U.S. federal income tax return and not separately. Only one Schedule UTP is required for all members of a consolidated group. In addition, if a taxpayer files a protective IRS Form 1120, 1120-F, 1120-L, and 1120-PC, it must also file a Schedule UTP if the taxpayer meets the requirements set forth above.
Penalties for Failure to File
The IRS has specifically reserved on the issue of penalties in the draft instructions to Schedule UTP. While the scope of penalities the IRS may attempt to impose is not clear, it is possible that the IRS could seek to impose penalties on taxpayers who are required to file a Schedule UTP under either sections 6652 (Failure to File Certain Information Returns, Registration Statements, Etc.) or 6721 (Failure to File Correct Information Returns) of the Code, among others.
The IRS also is evaluating additional options for penalties or sanctions to be imposed when a taxpayer fails to make adequate disclosure of the required information regarding its uncertain tax positions. One option being considered is to seek legislation imposing a specific penalty for failure to file the schedule or to make adequate disclosure. Although not specifically referenced by the IRS in its announcements to date, the IRS could seek to have the failure to file a Schedule UTP qualify for penalties under section 6651 (Failure to File Tax Return or to Pay Tax) or a tolling of the applicable statute of limitations on assessment for a taxable year until the Schedule UTP is filed.
Codification of Economic Substance
Congress codified the economic substance doctrine in section 7701(o) of the Code as part of the Health Care and Education Reconciliation Act of 2010. Section 7701(o) imposes a statutory economic substance test applicable to all transactions and establishes a series of tests that transactions must satisfy to meet the economic substance requirement. In addition, the legislation establishes a new 20 percent strict liability penalty, which is increased to 40 percent if the taxpayer does not disclose the transaction in its return. It is likely that taxpayers who have engaged in transactions that may be subject to an economic substance challenge under section 7701(o) of the Code will establish a FIN 48 reserve with respect to those transactions. The IRS has not yet clarified whether there will be coordination between the disclosure requirement in section 7701(o) of the Code for purposes of avoiding the 40 percent strict liability penalty with the Schedule UTP disclosures.
IRS Forms 8275 and 8275-R Not Required to be Filed to Avoid Penalties if Tax Position Disclosed on Schedule UTP
IRS Announcement 2010-30 provides that if a complete and accurate disclosure of a tax position is made on the appropriate year's Schedule UTP, the taxpayer is treated as if it filed Forms 8275 (Disclosure Statement) and 8275-R (Regulation Disclosure Statement) with respect to the position and such disclosure is sufficient to avoid penalties with respect to that tax position.
No Impact on FIN 48 Disclosure
Certain taxpayers are required to identify and quantify uncertain tax positions taken in a U.S. federal income tax return for financial accounting purposes under FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109. The filing of Schedule UTP by a taxpayer does not eliminate the taxpayer's obligations under FIN 48.