Uncertain Tax Positions

Transcription

1 Internal Revenue Service Releases Final Schedule UTP and Accompanying Instructions Effective for 2010 Tax Years SUMMARY On September 24, 2010, Douglas H. Shulman, Commissioner of the Internal Revenue Service (the IRS ), announced the release of an eagerly awaited final Schedule UTP, Uncertain Tax Position Statement, and accompanying instructions, which require certain corporate taxpayers to report uncertain tax positions on their annual tax returns. The final schedule is effective for the 2010 taxable year but, consistent with the draft instructions released earlier this year, the final instructions contain a transition rule providing that tax positions taken in a taxable year beginning before January 1, 2010, need not be reported. Among the most significant differences between the draft schedule and instructions and the final schedule and instructions are (1) no reporting of a maximum tax adjustment relating to each reported tax position, (2) no reporting of the rationale and nature of uncertainty in the concise description of each reported tax position, (3) no reporting of tax positions for which no reserve was recorded on the taxpayer s audited financial statements due to a determination that it was the IRS s administrative practice not to raise the issue during an examination and (4) a five-year phase in for the application of Schedule UTP to taxpayers with less than $100 million in assets. In conjunction with Commissioner Shulman s speech and the release of the final schedule and instructions, the IRS simultaneously released (1) Announcement , discussing certain changes that were made to Schedule UTP and the accompanying instructions in response to public comments (the Announcement ), (2) Announcement , discussing modifications to and expansions of the current IRS policy of restraint in response to the implementation of Schedule UTP and (3) a Directive for all Large Business and International division personnel regarding implementation of Schedule UTP. Significantly, the modifications to the IRS policy of restraint provide that if a document is otherwise protected under the New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 attorney-client privilege, the tax practitioner-client privilege or the work-product doctrine and the document was provided to an independent auditor as part of an audit of the taxpayer s financial statements, the IRS will not assert during an examination that privilege has been waived by such disclosure. DISCUSSION A. SCHEDULE UTP AND ACCOMPANYING INSTRUCTIONS Earlier this year, the IRS announced that it was developing a tax-return schedule that would require certain business taxpayers to report uncertain tax positions on their annual tax returns. 1 Four months later, the IRS released a draft Schedule UTP and accompanying draft instructions. 2 On September 9, 2010, the IRS published a Notice of Proposed Rulemaking setting forth a proposed rule explicitly authorizing the IRS to require any corporation to file Schedule UTP. 3 After considering numerous public comments on the draft schedule and instructions, the IRS has now released final versions of Schedule UTP and the accompanying instructions. 1. Schedule UTP Reporting Obligation Is Limited to Certain Corporate Taxpayers The final instructions provide that, effective for 2010 tax years, a taxpayer must file Schedule UTP if the taxpayer meets four specific requirements. First, the taxpayer must be required to file (1) Form 1120, U.S. Corporation Income Tax Return, (2) Form 1120-F, U.S. Income Tax Return of a Foreign Corporation, (3) Form 1120-L, U.S. Life Insurance Company Income Tax Return or (4) Form 1120-PC, U.S. Property and Casualty Insurance Company Income Tax Return. 4 The Announcement accompanying the release makes clear that taxpayers that participate in the Compliance Assurance Program or that are under continuous audit (i.e., Coordinated Issue Case taxpayers) are not excluded from the reporting requirement. 5 However, as was the case with the draft schedule, tax-exempt organizations and regulated investment companies, real estate investment trusts, partnerships and other pass-through entities are not See Announcement , I.R.B For more information about Announcement , please see our memorandum entitled Disclosure to Internal Revenue Service of Uncertain Tax Positions, dated January 26, See Announcement , I.R.B For more information about Announcement , please see our memorandum entitled IRS Releases Draft Schedule for Reporting Uncertain Tax Positions, dated April 20, See Requirement of a Statement Disclosing, 75 Fed. Reg (proposed Sept. 9, 2010). Announcement states that the IRS expects a final rule will be promulgated by the end of the year. For more information about the Notice of Proposed Rulemaking, please see our memorandum entitled IRS Releases Proposed Regulation on Schedule UTP (Uncertain Tax Positions), dated September 8, These are the same four types of corporations that were potentially subject to Schedule UTP reporting under the draft schedule and instructions. Announcement explains that, with respect to the Compliance Assurance Program, the IRS will address Schedule UTP compliance in upcoming permanent guidance that is expected to be released shortly. See infra Part D. -2-

3 subject to the reporting requirement for the 2010 tax year. 6 Nevertheless, taxpayers that are otherwise required to file Schedule UTP must report tax positions taken by partnerships and other pass-through entities in which the taxpayer holds an interest. Second, the taxpayer must have assets that equal or exceed $100 million. However, the final schedule and instructions institute a five-year phase in for taxpayers with total assets of less than $100 million. 7 In particular, the asset threshold will be reduced to $50 million starting with 2012 tax years and $10 million starting with 2014 tax years. Commissioner Shulman explained that this phase-in approach was adopted in response to comments that the original $10 million asset threshold proposed in the draft schedule was too much too soon for smaller companies. The higher asset threshold is designed to give taxpayers with total assets of less than $100 million additional time to comply with the new reporting requirement. The final instructions also clarify that a taxpayer that files Form 1120-F must use worldwide assets for purposes of determining whether it satisfies the applicable asset threshold. Third, the taxpayer or a related party 8 must have issued audited financial statements reporting all or a portion of the taxpayer s operations for all or a portion of the taxpayer s tax year. For these purposes, audited financial statements mean financial statements on which an independent auditor has expressed an opinion whether qualified, unqualified, disclaimed or adverse under Generally Accepted Accounting Principles ( GAAP ), International Financial Reporting Standards ( IFRS ) or another countryspecific accounting standard, including a modified version of any of the above (e.g., modified GAAP). Importantly, the final instructions clarify that compiled or reviewed financial statements are not audited financial statements. Finally, the taxpayer must have taken one or more tax positions on its tax return that are required to be reported on Schedule UTP (as discussed in Part A.2 below). A tax position taken on a tax return means a tax position that would result in an adjustment to a line item on that tax return (or would be included in a Section 481(a) adjustment) if the position was not sustained upon examination by the IRS. If multiple tax positions affect a single line item on a tax return, each tax position is a separate tax position taken on a tax return. Importantly, a single decision about how to report an item of income, gain, loss, deduction or However, Announcement explains that the IRS will consider whether to extend all or a portion of Schedule UTP reporting to such taxpayers for 2011 or later years. A U.S. corporation s assets equal or exceed $100 million if the amount reported on page 1, item D of Form 1120, or the higher of the beginning or end of year total assets reported on Schedule L of Form 1120-L or Form 1120-PC, is at least $100 million. In the case of a non-u.s. corporation filing a Form 1120-F, the corporation s assets equal or exceed $100 million if the higher of the beginning or end of year total worldwide assets of the corporation reported on Form 1120-F, Schedule L, Line 17, would be at least $100 million if the corporation were to prepare a Schedule L on a worldwide basis. For this purpose, a related party is any entity that is related to the taxpayer under Sections 267(b), 318(a), or 707(b) of the Internal Revenue Code of 1986, as amended (the Code ), or any entity that is included in consolidated financial statements in which the taxpayer is also reported. Unless otherwise noted, all Section references contained in this memorandum are to the Code. -3-

4 credit may affect line items in tax returns for multiple years. As a result, that decision can result in a tax position taken on each affected year s return. 9 Whether such tax positions are reported on Schedule UTP for a particular tax year, and when they are reported, depends on whether and when a reserve for that tax position is recorded. 10 A taxpayer that satisfies the above four requirements must attach Schedule UTP to its 2010 income tax return for calendar year 2010 or for a fiscal year that begins in 2010 and ends in 2011, but not for a short tax year that ends in An affiliated group of corporations filing a consolidated return must file a Schedule UTP for the affiliated group as a whole. 11 Any affiliate that files its tax return separately and satisfies the above four requirements must file a Schedule UTP with its return setting forth its own tax positions. 2. Schedule UTP Requires Taxpayers to Report Taxpayers subject to Schedule UTP reporting must report each tax position taken on the taxpayer s U.S. tax return for which either the taxpayer or a related party (1) has recorded a reserve on an audited financial statement 12 or (2) has not recorded a reserve on an audited financial statement as a result of an expectation of litigating the tax position. 13 The Announcement clarifies that Schedule UTP does not require the reporting of foreign or state tax positions. Under the general reporting instructions, however, a taxpayer is required to report a U.S. federal income tax position taken in a return that arises out of uncertainty with regard to a foreign tax position (e.g., foreign tax credits) if a reserve for U.S. federal income tax was recorded to reflect the uncertainty (or was not recorded due to an expectation to litigate). Importantly, final Schedule UTP does not include any sort of angel list of specific tax positions, transactions or issues that are excluded from Schedule UTP reporting. However, a taxpayer is not required to report a tax position taken in a tax year beginning before January 1, 2010, even if a reserve is recorded (or not recorded due to an expectation to litigate) with respect to that tax position in an audited financial statement issued in 2010 or later. 14 A taxpayer is also not required to report a tax position taken in a prior tax year if the taxpayer reported that position on a Schedule UTP filed with a prior year tax See, e.g., 2010 Instructions for Schedule UTP, Example 4. See, e.g., 2010 Instructions for Schedule UTP, Examples 6 and 7. The affiliated group need not identify the member of the group to which the tax position relates or which member recorded the reserve for the tax position. See Examples 2 and 3 of the 2010 Instructions for Schedule UTP for situations where a taxpayer s reporting obligation is triggered as a result of a related party recording a reserve on a financial statement for a tax position taken by the taxpayer. A tax position for which a reserve was recorded (or for which no reserve was recorded because of an expectation to litigate) must be reported regardless of whether the audited financial statements are prepared based on GAAP, IFRS or other country-specific accounting standards, including a modified version of any of the foregoing (e.g., modified GAAP). See, e.g., 2010 Instructions for Schedule UTP, Example

5 return. Finally, a tax position need not be reported on Schedule UTP before the tax year in which the tax position is taken on the taxpayer s tax return. 15 In regard to tax positions for which a reserve has been recorded, the final instructions explain that, for purposes of Schedule UTP, a taxpayer or a related party records a reserve for a tax position when a reserve for income tax, interest or penalties with respect to that position is recorded in audited financial statements of the taxpayer or a related party. Although the initial recording of a reserve with respect to a tax position taken on a return will trigger an obligation to report that tax position, subsequent reserve increases or decreases with respect to the tax position will not. 16 The final instructions also clarify that, if a taxpayer is included in multiple audited financial statements, the taxpayer must report its tax position on Schedule UTP if a reserve for that position was recorded in any of those financial statements. In regard to tax positions for which no reserve was recorded because of an expectation to litigate, the final instructions track the draft instructions in providing that an expectation to litigate requires a determination by the taxpayer or a related party that the probability of settling with the IRS is less than 50%. However, unlike the draft instructions, the final instructions do not require that such a determination be made based upon an assumption that the IRS has full knowledge of the tax position. Additionally, in response to public comments, the final instructions clarify that taxpayers are not required to report tax positions that are either immaterial under applicable financial accounting standards 17 or are sufficiently certain so that no reserve is required under those standards. Accordingly, a tax position that a taxpayer would litigate, if challenged, but that is clear and unambiguous or is immaterial is not required to be reported on Schedule UTP as an expect-to-litigate position. In response to public comments that the expect-to-litigate requirement would require taxpayers to reassess, at the time of preparing Schedule UTP, all positions taken in the current-year return for which no reserve was previously reported, the final instructions have been revised to clarify that a taxpayer may rely on the reserve decisions made for financial statement purposes to complete Schedule UTP and, therefore, is not expected to reassess those reserve decisions at the time the schedule is completed. Additionally, although a few commentators requested guidance on how a taxpayer should document an expect-to-litigate position, the final instructions provide no such guidance. Rather, the IRS expects that a taxpayer will continue to document its decision in the same way it substantiates any decision not to record a reserve in its financial statements Announcement clarifies that a tax position must be reported on Schedule UTP once (1) a reserve for the tax position is recorded (or not recorded due to an expectation to litigate) and (2) the tax position is taken on the taxpayer s tax return, regardless of the order in which those two events occur. See, e.g., 2010 Instructions for Schedule UTP, Example 1. This revision to the final instructions is significant in that it effectively creates a de minimis exception for tax positions with respect to which an immaterial reserve was recorded for financial accounting purposes. -5-

6 Significantly, the final schedule eliminated the requirement to report tax positions for which no reserve was recorded because of a determination that it was the IRS s administrative practice not to raise the issue during an examination. 18 The Announcement explains that, after reviewing public comments, the IRS determined that concerns about the administrability of this requirement outweighed the value of the information that may be included. Consequently, the IRS eliminated the requirement but noted that the IRS will continue to explore other ways to assess the impact of these tax positions on overall tax compliance. Consistent with the draft instructions, the final instructions provide that each tax position must be analyzed on the basis of the unit of account used in the audited financial statements in which the reserve for the tax position is recorded (or in which no reserve was recorded because of an expectation to litigate). 19 This unit of account is intended to reflect both the level at which the taxpayer accumulates information to support the tax return and the level at which the taxpayer anticipates addressing the issue with the IRS. The unit of account used by a GAAP or modified-gaap taxpayer for reporting a tax position on Schedule UTP must be the same unit of account used by such taxpayer in its audited financial statements. 20 In the case of audited financial statements prepared under other accounting standards, a unit of account based on an entire tax year may not be used as the basis for determining a tax position to be reported on Schedule UTP, even if that is the level of detail used in such other accounting standards. Rather, in such cases, the taxpayer must instead identify a unit of account based on similar principles applicable to GAAP or modified-gaap taxpayers, or use any other level of detail that is consistently applied if that identification is reasonably expected to apprise the IRS of the identity and nature of the issue underlying the tax position taken on the tax return. 3. Schedule UTP Is Comprised of Three Parts As was the case with the draft schedule, final Schedule UTP is comprised of three parts. Part I is used to report tax positions taken in the taxpayer s tax return for the current tax year. Significantly, unlike the draft schedule, Part I of the final schedule requires a tax position to be reported even if the decision to record a reserve (or not record a reserve due to an expectation to litigate) was made less than 60 days As a result, the final Schedule UTP no longer requires a taxpayer to check a box if a tax position is reported because it was determined that, based upon IRS administrative practice, the IRS would not challenge the position upon examination. For example, in a situation involving a research project that results in a $1 million research and experimentation credit, one taxpayer may conclude that the entire project constitutes a separate unit of account whereas another taxpayer may instead determine that each component experiment of that project constitutes a single unit of account. See, e.g., FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109, A5-A9 (codified in 2 FINANCIAL ACCOUNTING STANDARDS BOARD, ACCOUNTING STANDARDS CODIFICATION (2009)) [hereinafter FIN 48]. See generally 2010 Instructions for Schedule UTP, Example 5. See, e.g., 2010 Instructions for Schedule UTP, Example 5. Announcement explains that this example is intended to emphasize that the definition of unit of account should be applied consistently with the guidance in FIN

7 before the current-year tax return is filed. If a transaction results in tax positions taken on more than one tax return, the tax positions must be reported in Part I of the Schedule UTP attached to each tax return in which a tax position is taken regardless of whether the transaction or a tax position resulting from the transaction was disclosed in a Schedule UTP filed with a prior year s tax return. Consistent with the draft schedule, Part I of the final schedule requires the taxpayer to list the primary Code sections relating to the tax position, categorize the tax position as a temporary difference, permanent difference or both 21 and provide the employer identification number of any related passthrough entity if the tax position relates to a tax position of a pass-through entity. 22 Additionally, as was the case with the draft schedule, Part I of the final schedule allows a taxpayer to check a box if the taxpayer was unable to obtain sufficient information from one or more related parties and, as a result, is unable to determine whether a tax position taken on its current-year tax return is required to be reported in Part I of the schedule. One of the most significant changes to the final schedule is with respect to the way in which taxpayers are required to quantify the tax positions reported therein. The draft schedule required a taxpayer to report a maximum tax amount ( MTA ) for each tax position listed on the schedule, other than valuation and other transfer-pricing tax positions. The MTA for a tax position was defined in the draft instructions as the maximum U.S. federal income tax liability (exclusive of interest and penalties) associated with the tax year for which the tax position was taken if the position was not sustained upon examination by the IRS. The draft instructions also provided the taxpayer with a choice of ranking valuation and other transferpricing tax positions according to either the estimated adjustment to U.S. federal income tax that would result if the tax position was not sustained or, if applicable, the amount recorded as a reserve for that tax position. In his speech, Commissioner Shulman explained that the IRS received many comments that the proposed MTA requirement was overly burdensome and, because the MTA would in many cases be significantly greater than any potential adjustment with respect to an issue, would give the IRS a distorted view of the risk related to a particular issue. In response to these concerns, the IRS eliminated the MTA requirement in favor of requiring a taxpayer to rank its tax positions (including valuation and other transfer-pricing tax positions) from largest to smallest based on the size of the tax reserve (including interest and penalties) recorded for the tax position by the taxpayer on its audited financial statements Categorization as a temporary difference, permanent difference or both must be consistent with the accounting standards used to prepare the taxpayer s audited financial statements. For this purpose, a pass-through entity is any entity listed in Section 1(h)(10). If a reserve is recorded for multiple tax positions, then a reasonable allocation of that reserve among the tax positions to which it relates must be made in determining the size of each tax position. In the case of an affiliated group filing a consolidated return, the size of a tax position taken in a tax return must be determined at the affiliated group level for all members of the affiliated group. -7-

8 Final Schedule UTP also requires taxpayers to designate those tax positions for which the reserve exceeds 10% of the aggregate amount of the reserves for all of the tax positions reported on the schedule (a Major Tax Position ). Importantly, the ranking of tax positions and the determination of Major Tax Positions must be done on an aggregate basis with respect to all positions reported in Part I and Part II (discussed below) of Schedule UTP. The IRS explained that the new ranking system is expected to allow the IRS to evaluate more accurately the materiality of the issues reported on the schedule and to impose less of a burden on taxpayers than would have been the case under the original MTA proposal. Importantly, although this ranking method relies on reserve computations that taxpayers perform for audited financial statement purposes, this method does not require disclosure of the actual amounts of the tax reserves. Finally, in response to comments regarding the difficulty in computing the MTA for tax positions for which no reserve was created based on an expectation to litigate the position, the final instructions provide that such tax positions may be assigned any rank and should be disregarded for purposes of determining whether the position is a Major Tax Position. Part II of the final Schedule UTP will be used in tax years after 2010 to report tax positions taken by the taxpayer in a prior taxable year that have not been reported on a Schedule UTP filed with a prior-year tax return. However, the final instructions make clear that Part II will not be completed in 2010 because taxpayers are not required to report tax positions taken in a tax year beginning before January 1, Indeed, Part II of the final schedule was grayed out by the IRS before being released. For each tax position listed in Part II of Schedule UTP, the taxpayer is required to provide the same information as in Part I, as well as state the prior tax year in which the tax position was taken. Part II of the final schedule also allows the taxpayer to check a box if the taxpayer was unable to obtain sufficient information from one or more related parties and is, therefore, unable to determine whether a tax position taken in a prior year s tax return is required to be reported on Part II of the schedule. Part III of the final Schedule UTP requires taxpayers to provide a concise description of every tax position listed in Part I (or, for tax years after 2010, Part II) of the schedule. Another one of the more significant changes to the final schedule is that, unlike Part III of the draft schedule, Part III of the final schedule no longer requires a taxpayer to disclose the rationale and nature of the uncertainty for each tax position as part of the concise description. Rather, the final instructions make clear that a taxpayer need only disclose a description of the relevant facts affecting the tax treatment of the tax 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. 24 The final instructions state that, in most cases, the description should not exceed a few 24 Announcement observes that this requirement is based upon, and consistent with, the information required to be reported on Form 8275, Disclosure Statement, and Form 8275-R, Regulation Disclosure Statement. -8-

9 sentences. 25 Moreover, the final instructions now specifically state that the concise description should not include information related to the taxpayer s assessment of the hazards of a tax position or an analysis of the support for or against the tax position. As was the case with the draft instructions, the final instructions provide several sample descriptions of uncertain tax positions that would be sufficient for purposes of Part III of Schedule UTP. 26 Importantly, although the sample descriptions no longer include the rationale and nature of the uncertainty, the sample descriptions nevertheless continue to illustrate that the IRS is expecting taxpayers to be very specific in describing each tax position reported on the schedule. Consequently, it seems likely that these descriptions will be used to guide IRS examiners to issues on which the IRS examiners will focus during an examination. 27 The Announcement explains that the changes to Part III of Schedule UTP were made in response to public comments that the requirement to identify the taxpayer s views and assessments of the tax positions reported on Schedule UTP was inconsistent with the attorney-client privilege, the tax practitioner-client privilege under Section 7525 and the work-product doctrine because it may require disclosure of information that is based upon the advice of counsel and tax return preparers and may require the sharing of the mental impressions of those advisors. Many commentators were also concerned that disclosure of tax positions on Schedule UTP could enable adversaries to raise questions about subject-matter waiver with respect to confidential communications related to the disclosed tax positions. As discussed above, the final instructions no longer require the rationale and nature of the uncertainty to be included in the schedule s concise description. Moreover, as discussed in Part B below, the IRS has also released a companion announcement which modifies and expands the IRS policy of restraint in an effort to address the foregoing concerns. Commentators had also expressed concerns that the reported UTP information would be automatically disclosed to non-u.s. governments under treaties or information-exchange agreements. However, in his speech, Commissioner Shulman stated that this would not be the case. Rather, he explained that U.S. treaties and information-exchange agreements do not require disclosure of information in cases where there is no reciprocity. As a result, he said it would be very, very rare for the IRS to exchange such information unless the requesting non-u.s. government has similar information it can make available to the IRS. Further, even if reciprocity did exist, the IRS would consider other factors in determining whether to disclose the information, including the relevance of the information to the non-u.s. government, which in many cases would not be present However, stating that a concise description is available upon request is not an adequate description. See 2010 Instructions for Schedule UTP, Examples Directive for all Large Business and International Division (LB&I) Personnel, Reporting of Uncertain Tax Positions (Sept. 24, 2010) (candidly explaining that that Schedule UTP is intended to expedite the return selection and issue identification processes ). -9-

10 4. Interaction with Other Reporting Requirements, Application of Penalties and Potential for Future Modifications As was the case with the draft instructions, the final instructions state that a complete and accurate disclosure of a tax position on the appropriate year s Schedule UTP will be treated as if the taxpayer filed a Form 8275, Disclosure Statement, or a Form 8275-R, Regulation Disclosure Statement, regarding the tax position. 28 In the case of a transaction that is not a reportable transaction, a disclosure of a tax position on Schedule UTP will also satisfy the disclosure requirements of Section 6662(i), relating to penalties for underpayments attributable to transactions lacking economic substance. In regard to Schedule M-3, Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million or More, the Announcement explains that the IRS is forming a working group, with industry involvement, to study and revise Schedule M-3 to reduce the potential for duplication with Schedule UTP. Finally, the IRS is continuing to study other ways to reduce duplicative reporting and is considering whether disclosure on Schedule UTP would, in appropriate circumstances, provide the information necessary to satisfy the reportable transaction disclosure requirements of Form The final instructions are consistent with the draft instructions in remaining silent on the application of penalties to taxpayers who fail to fully comply with Schedule UTP. In this regard, the Announcement explains that the IRS intends to review compliance with the final schedule and instructions and take appropriate enforcement action, including opening an examination or making another type of taxpayer contact, in instances where there appears to be a failure to complete the schedule or a failure to report whether the taxpayer is required to complete the schedule. Finally, the Announcement explains that, while the final instructions provide initial guidance concerning Schedule UTP, the IRS recognizes that they do not address every issue raised by commentators. 29 However, the IRS said it will continue to consider those issues as it gains experience with the schedule. In addition, the IRS said it will review the completeness and utility of the Schedule UTPs that are filed for the 2010 tax year and modify the schedule and accompanying instructions accordingly. For example, the IRS intends to review the reporting of transfer-pricing positions on Schedule UTP and consider whether additional information such as the specific country, character of income or other facts is necessary to provide specific information regarding the identity and nature of those tax positions Form 8275 is used by taxpayers and tax return preparers to disclose items or positions, other than those taken contrary to a Treasury regulation, that are not otherwise adequately disclosed on a tax return in order to avoid the portions of the accuracy-related penalty due to disregard of rules or to a substantial understatement of income tax for non-tax-shelter items if the return position has a reasonable basis. Form 8275-R is used for the same purpose but applies to items or positions that are taken contrary to a Treasury regulation. For example, the instructions do not address issues relating to (1) the reporting of tax positions in the year in which a taxpayer is acquired or disposed of or (2) the level or type of diligence required to obtain (a) reserve information from a related party or (b) information from a pass-through entity relating to a taxpayer s uncertain tax position involving the pass-through entity. -10-

11 B. EXPANSION OF THE IRS POLICY OF RESTRAINT The IRS has different policies for seeking access during an examination to corporations tax reconciliation workpapers, audit workpapers and tax accrual workpapers. Whereas tax reconciliation workpapers are requested as a routine matter at the beginning of an examination, audit workpapers and tax accrual workpapers are requested only in unusual circumstances or if the taxpayer failed to report a listed transaction or claimed a benefit from multiple listed transactions. 30 This limited approach to requesting audit workpapers and tax accrual workpapers is known as the IRS policy of restraint. In conjunction with the release of the final Schedule UTP and instructions, the IRS simultaneously released a companion announcement which expands the current IRS policy of restraint in response to the finalization of Schedule UTP. In particular, the companion announcement describes some key changes that are designed to reassure taxpayers that [the IRS] is not seeking their legal analysis or risk assessments 31 and explains that disclosing issues on Schedule UTP does not otherwise affect the protections already afforded under the policy of restraint. First, working drafts of, and revisions and comments to, descriptions of tax positions, the amount of any reserve related to a reported tax position and information regarding quantification or ranking of reported tax positions are protected under the policy of restraint. Although, under current procedures, IRS examiners request tax reconciliation workpapers as a matter of course, 32 the taxpayer may redact the foregoing information from any copies of tax reconciliation workpapers relating to the preparation of Schedule UTP it is asked to produce during an examination. Second, and perhaps more importantly, the IRS will adopt a policy of not seeking documents that would otherwise be privileged even though the taxpayer has disclosed the documents to a financial auditor as part of an audit of the taxpayer s financial statements. Significantly, this modification of the policy of restraint goes beyond materials prepared in connection with Schedule UTP. The companion announcement explains that if a document is otherwise protected under the attorney-client privilege, the tax practitioner-client privilege or the work-product doctrine and the document was provided to an independent auditor as part of an audit of the taxpayer s financial statements, the IRS will not assert during an examination that privilege has been waived by such disclosure. However, the foregoing rule does not apply if (1) the taxpayer has engaged in an activity or taken an action with respect to a document, other than disclosing it to the taxpayer s auditors in the course of an audit, that would waive the attorney-client privilege, the tax practitioner-client privilege or the work-product doctrine or (2) a See Announcement , C.B. 72; I.R.M et seq. Listed transactions are defined in Treas. Reg If a taxpayer engages in only one listed transaction and reports that transaction, the IRS will generally request the tax accrual workpapers for only that one transaction. These changes to the IRS policy of restraint will be incorporated into I.R.M See I.R.M

12 request for tax accrual workpapers is made because unusual circumstances exist or the taxpayer has claimed the benefits of one or more listed transactions. 33 Importantly, the companion announcement also makes clear that it neither creates nor implies the application of the attorney-client privilege, the tax practitioner-client privilege or the work-product doctrine to any document of any taxpayer or third party. C. DIRECTIVE TO LARGE BUSINESS AND INTERNATIONAL DIVISION PERSONNEL In his speech, Commissioner Shulman explained that many of the public comments on the draft Schedule UTP expressed concern about how IRS agents would use the information reported on the schedule during examinations. To address this concern, the IRS released a Directive for all Large Business and International ( LB&I ) division personnel (the Directive ) setting forth the IRS s planned treatment of uncertain tax positions. Over the course of the next year, IRS examiners will also receive special training on the handling of uncertain tax positions and guidance regarding the application of the modified IRS policy of restraint to Schedule UTP reporting. The Directive explains that LB&I examiners are expected to engage with taxpayers early in the examination process (potentially through the IRS Quality Examination Planning process) in order to eliminate uncertainty as quickly as possible and should discuss the issues disclosed on Schedule UTP in advance of issuing information document requests ( IDRs ). However, IRS examiners are instructed that they should not use Schedule UTP as a substitute for other examination tools or as a shortcut for other parts of the audit process and should approach UTPs on audit keeping in mind their responsibility to apply the law as it currently exists, not how [the IRS] would like it to be. LB&I examiners are also directed to approach each examination with an understanding that uncertain tax positions are uncertain for a number of reasons, including ambiguity in the law and a lack of published guidance, and that, consequently, items disclosed on Schedule UTP may or may not require an examination or an audit adjustment. Finally, the Directive explains that a centralized review process will be established within LB&I to review taxpayers Schedule UTPs, determine whether taxpayer disclosures are in compliance with the instructions, select issues and returns for audit, identify trends in areas of uncertainty and determine the proper treatment of uncertain tax positions. The Directive explains that the proper treatment may include publishing guidance necessary to eliminate uncertainty wherever possible, as well as identifying areas for possible legislative changes. In addition, possible treatment may include referral to appropriate personnel to determine the correct legal analysis or to assure fair and consistent treatment across examinations. D. MODIFICATIONS TO OTHER IRS INITIATIVES Although the announcement regarding Schedule UTP was the highlight of Commissioner Shulman s speech, he also discussed several other important IRS initiatives aimed at earlier and faster issue 33 See id. -12-

13 resolution and greater efficiency and certainty. For instance, he expressed his strong support for the IRS Compliance Assurance Program ( CAP ) and his belief that it is time to make the pilot program permanent. As a result, the IRS will soon be issuing guidance that will make CAP permanent and available to a greater number of taxpayers. The permanent CAP is expected to consist of three phases: (1) pre-cap, which will allow a taxpayer to become current on the audit cycle while demonstrating the requisite transparency needed to be eligible for CAP, (2) CAP, which will resemble the existing CAP pilot program, and (3) CAP maintenance, which will call for the reduction of resources and taxpayer contact for those taxpayers that have been in CAP for a number of years. Commissioner Shulman also touched upon Industry Issue Resolution Projects and the Fast Track Settlement Program, as well as recent improvements in LB&I and IRS Appeals. CONCLUSIONS Schedule UTP is a game changer in the sense that the IRS is dramatically altering its current approach of hunting for soft spots in the tax returns of large corporate taxpayers and replacing it with a system wherein taxpayers are required not only to identify the soft spots in their returns, but also to point the IRS to the precise issue involved. Although Commissioner Shulman s speech justified the Schedule UTP initiative by explaining a need for increased taxpayer transparency, the fact remains that the new schedule takes the United States historic self-assessment tax system to a new level where, in one sense, taxpayers are being required to do much of an IRS examiner s work for the examiner. The training given to IRS examiners with respect to their use of Schedule UTP will be extremely important. If IRS examiners proceed by auditing each and every issue disclosed on the schedule, then the worst fears of many commentators will be realized. That approach would also likely result in a dramatic increase in the number of IRS Appeals cases with not only large dollar amounts at stake, but also a large number of total issues in each case. This situation could, in turn, lead to a departure from the historic trend of having only one or two issues per case leave IRS Appeals without resolution and go on to litigation. Importantly, although IRS management will try to police IRS examiners in their use of Schedule UTP, it does not seem that taxpayers currently have any recourse where that does not happen. Other important aspects of the final schedule and instructions include (1) the requirement for taxpayers that file a Form 1120-F to consider worldwide assets in determining whether the applicable asset threshold is satisfied; (2) the lack of penalties for failing to comply with the reporting requirement, although we suspect the IRS will eventually ask Congress to create a specific penalty provision, thereby further raising the stakes of Schedule UTP; and (3) the fact that disclosure of a tax position on Schedule UTP will be treated as if the taxpayer filed a Form 8275 or Form 8275-R, thereby ameliorating, at least to some degree, the potential for duplicative reporting. It remains to be seen whether, over time, the IRS will require more and more information to be reported on Schedule UTP. Indeed, the Announcement explicitly states that, with respect to transfer-pricing tax -13-

14 positions, the IRS intends to consider whether to request additional information on the schedule. As a result, the reporting requirements on Schedule UTP may become more and more onerous as the IRS gains experience with the usefulness of the various information that taxpayers disclose. It also remains to be seen whether the schedule will have unintended consequences with respect to the current FIN 48 process. Because a taxpayer is not required to report a tax position with respect to which no reserve has been recorded (other than because of an expectation to litigate), a trend may develop where taxpayers do not reserve in close call situations where they have received a should level opinion from a tax advisor. At this time it is also unclear how the revised IRS policy of restraint will be applied in practice. In particular, although the companion announcement provides that, with respect to otherwise privileged documents that are disclosed to a taxpayer s financial auditor, the IRS will not assert a waiver of privilege during an examination, the announcement is silent as to the IRS policy during actual litigation. As a result, it remains to be seen whether lawyers in the IRS Chief Counsel s office or the Department of Justice will be bound by this modified policy of restraint during the discovery phase of tax litigation. Finally, the Directive states that LB&I examiners should approach UTPs on audit keeping in mind their responsibility to apply the law as it currently exists, not how [the IRS] would like it to be. While Commissioner Shulman has previously made similar statements in public speeches, 34 we believe this is the first time the statement has appeared in a formal IRS document. Accordingly, taxpayers should keep this language in mind during the course of any tax controversy with the IRS when it appears that an IRS examiner, IRS Appeals officer or IRS Chief Counsel lawyer, as the case may be, is attempting to apply the law as they would like it to be, rather than as it currently exists. Given the finalization of Schedule UTP and its effectiveness for 2010 tax years, taxpayers need to thoroughly consider how to comply with the new reporting requirements, especially the concisedescription requirement. Please contact any of the individuals listed below, or the lawyer with whom you normally work, if you would like to discuss the application of Schedule UTP to your particular circumstances. * * * Copyright Sullivan & Cromwell LLP See, e.g., IRS News Release , Prepared Remarks of IRS Commissioner Doug Shulman to the New York State Bar Association Taxation Section Annual Meeting in New York City (Jan. 26, 2010) (announcing the IRS proposal with respect to uncertain tax positions for the first time). -14-

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