During the past financial year the US system of tax administration has seen the introduction of a fundamental change in how the US government will audit returns for corporate taxpayers. On 24 September 2010, the IRS issued a final version of IRS Form Schedule UTP, which obligates certain categories of corporate taxpayers to affirmatively disclose to the IRS “uncertain tax positions” reflected on a US tax return.
Starting with the 2010 tax year, corporate taxpayers obligated to file Schedule UTP must identify all positions reflected on the attached tax return that are subject to a reserve in an audited financial statement for such taxpayer, or a related party. In addition to releasing a final version of Schedule UTP, the IRS has introduced new phase-in rules for its implementation, modified the information that must be disclosed on that form, and issued important modifications to its Policy of Restraint.
The IRS release of the final version of Schedule UTP and its accompanying instructions closes the loop on a process that began in January of 2010. Announcement 2010-9 (26 January 2010) introduced the IRS’s proposal to require taxpayers to affirmatively disclose uncertain tax positions. On 19 April 2010, the IRS issued Announcement 2010-30, which released a draft schedule, “Schedule UTP”, and accompanying draft instructions detailing the IRS’s blueprint for the its implementation. In response to these announcements, the IRS received numerous comments from taxpayers and their advisers, some of which are reflected in critical changes to the final version of Schedule UTP.
Who Must File Schedule UTP?
One of the critical changes introduced in the final schedule is a phase-in concerning the application of Schedule UTP. Schedule UTP is currently limited in its application to corporate taxpayers that satisfy four separate requirements. First, the corporation must file one of the following US tax returns: (i) IRS Form 1120, US Corporation Income Tax Return; (ii) IRS Form 1120-F, US Income Tax Return of a Foreign Corporation; (iii) IRS Form 1120-L, US Life Insurance Company Income Tax Return; or (iv) IRS Form 1120-PC, US Property and Casualty Insurance Company Income Tax Return. Second, the corporation must have assets that equal or exceed $100 million (note this amount will adjust, as discussed below). Third, the corporation or a related party must issue audited financial statements reporting all of the corporation’s operations for such tax year (or portion thereof). And lastly, the corporation must have one or more “tax positions” that must be reported on Schedule UTP. If all four of these requirements are satisfied the taxpayer must attach a completed Schedule UTP to its tax return.
The US$100 million threshold noted above represents an important compromise in the final Schedule UTP. As originally proposed, the disclosure requirement applied to any corporate taxpayer with assets in excess of US$10 million. Responding to taxpayer complaints, the IRS introduced a phase-in provision, limiting Schedule UTP’s application to corporate taxpayers with US$100 million or more of assets in the 2010 and 2011 tax years. The total asset threshold will be reduced to US$50 million starting with 2012 tax years and to US$10 million starting with 2014 tax years.
A 2010 Schedule UTP must be filed by a taxpayer with the 2010 income tax return for the calendar year 2010 and for a fiscal year that begins in 2010 and ends in 2011. The final rules have important transition provisions. A taxpayer is not required to report a tax position taken in a tax year beginning before 1 January 2010, even if a reserve is recorded with respect to such tax position in an audited financial statement issued in 2010 or thereafter.
What Must be Disclosed?
Schedule UTP generally requires taxpayers to disclose any uncertain tax position reflected on a US tax return for which the corporation or a related party has recorded a reserve in an audited financial statement. The disclosure requirement is triggered regardless of whether the audited financial statements are prepared based on US GAAP, IFRS or other country-specific accounting standard.
The UTP disclosure rules do not extend directly to positions that relate solely to foreign or state tax positions. However, taxpayers need to exercise caution with respect to foreign and state tax positions, which can have crossover effect with respect to a US federal income tax position (eg, the creditability of foreign tax credits).
A “tax position” for purposes of Schedule UTP has a very low threshold of application. It includes any tax position on a return that would result in any adjustment to a line item on that tax return. If multiple tax positions affect a single line item on a tax return then each of the relevant tax positions must be separately disclosed on Schedule UTP.
A disclosure is also required with respect to any tax position taken by a corporation for which a reserve has not been recorded by the corporation or a related party because the corporation expects to litigate the position. The final Schedule UTP removed the original requirement that a corporation disclose tax positions for which no reserve was recorded because the corporation determined it was the IRS’s administrative practice not to contest the issue during an examination. The IRS agreed to remove that requirement because the concerns about administration of the requirement outweighed the value of information that could be obtained.
Schedule UTP contains two lists of reportable tax positions. Tax positions taken on the current year return are reported in Part 1 of the form. Part 2 is used to report tax positions taken on a prior year’s tax return, provided such position was not otherwise reported on a previously filed Schedule UTP. Part 2 is not applicable for the 2010 tax year as part of the phase-in of the new rules, so corporations need not disclose on the 2010 Schedule UTP prior year uncertain tax positions that have not involved a change in the reserve during 2010. For transactions that impact multiple tax returns, the related tax positions must be reported in Part 1 of the Schedule UTP attached to each tax return.
The list of tax positions set forth on Schedule UTP must include an identification of the primary Internal Revenue Code provisions, as well as the identification of whether the tax position results in a temporary or permanent difference. As originally proposed, Schedule UTP would have required taxpayers to identify “the maximum amount of potential federal tax liability attributable to each uncertain tax position.” Responding to comments provided by the tax community, the IRS modified the final Schedule UTP to remove the maximum adjustment provision and replaced it with a ranking and identification system. Thus, for each tax position disclosed on Schedule UTP the taxpayer must first identify whether the position relates to a transfer pricing matter or a “general” matter (not involving transfer pricing). Then all tax positions must be ranked in relative size. Thus, while the IRS removed the obligation for taxpayers to identify a specific dollar figure for the maximum potential tax adjustment associated with each position, the form effectively requires the taxpayer to identify the most material items listed on Schedule UTP. Despite claims from the IRS national office to the contrary, human nature will lead the IRS field examiners to focus the bulk of its attention on the highest ranked issues in almost every circumstance.
If a taxpayer is obligated to disclose a tax position on Schedule UTP, that position must be described in a “concise” manner in Part 3 of the form. According to the instructions to the form, a “concise description” should include 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. The description required in the final form differs from what was originally requested. The earlier draft of Schedule UTP required a description of the rationale for the uncertain tax position, as well as the nature of the uncertainty. Responding to comments from taxpayers, the IRS modified the final form to limit the description to a factual summary.
There are a number of unanswered questions relating to the final Schedule UTP. For instance, the IRS has been less than clear concerning its intentions to share information obtained from a taxpayer in Schedule UTP with a foreign government. Similarly, the IRS has not provided specific guidance concerning the potential imposition of penalties for any reporting failure relating to Schedule UTP. According to the IRS, it “intends to review compliance” in the future and will “take appropriate enforcement action” in those instances in which there appears to be a failure to complete the schedule or provide the requisite information.
Policy of Restraint Modifications
Coupled with the release of the final Schedule UTP, the IRS modified its Policy of Restraint. As a general matter, the policy provides that the IRS will refrain from requesting access to a taxpayer’s tax accrual workpapers unless a limited set of exceptions applies, such as the taxpayer having claimed the benefits of a listed transaction.
The revised Policy of Restraint, set forth in Announcement 2010-76, provides that the IRS will forgo seeking particular documents that relate to uncertain tax positions and the workpapers used in the completion of Schedule UTP. Announcement 2010-76 further provides that if a document is otherwise privileged under the attorney-client privilege, the tax advice privilege set forth in § 7525, or the attorney work product doctrine, and such 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.” (emphasis added).
There are various caveats to the Policy of Restraint as outlined in Announcement 2010-76. The IRS’s agreement not to assert that a privilege is waived does not extend to any litigation. Thus, it is advisable to continue to exercise caution concerning any disclosure of privileged materials to financial auditors.
While the final version of Schedule UTP contains critical improvements, there remain significant concerns; both with respect to the schedule itself and the IRS’s ability to implement the new schedule. According to statements made by IRS Commissioner Shulman, Schedule UTP is a result of the IRS’s focus on increasing “transparency”, which is part of the agency’s larger strategy to identify and resolve taxpayer issues more quickly. According to Commissioner Shulman, Schedule UTP will “create certainty sooner for taxpayers,” and also streamline the process of identifying issues and completing the audit process.
We question this premise.
While the changes introduced by the schedule’s disclosure rules will in fact streamline the audit process for the government, we believe it will increase the frequency and degree of disputes between taxpayers and the government. The practical result of Schedule UTP will be a shift of resources both by taxpayers and the government from the audit phase to the administrative appeals process and the courts. Such a shift will not introduce certainty, nor provide a streamlined mechanism for the resolution of disputes between taxpayers and the government. Rather, the results are most likely to be just the opposite.