IRS Issues Final Rules on Disclosing Uncertain Tax Positions; Policy of Restraint Clarified

Skadden, Arps, Slate, Meagher & Flom LLP

Armando Gomez Fred T. Goldberg, Jr.

On September 24, 2010, the Internal Revenue Service released final guidance on disclosing uncertain tax positions and clarified its policy of restraint on requesting tax accrual workpapers. It also announced that it would expand the Compliance Assurance Process (CAP) and other guidance and issue resolution efforts. These steps have the potential to reshape substantially the audit process for large corporate taxpayers. Commissioner Douglas Shulman described the new UTP rules as “a principled and balanced approach” that will improve tax administration and “will provide significant benefits to taxpayers, including getting them earlier certainty . . while preserving important taxpayer protections and respecting the important relationships the taxpayer has with its tax advisors and independent auditors.”

The September 24 announcements lay the groundwork for the IRS to streamline and focus audits for large corporate taxpayers. The success of these efforts will depend on how they are implemented in practice, but taxpayers can use the guidance to set concrete expectations for audit efficiency and to plan their interactions with the IRS. The expanded and permanent CAP, in particular, offers taxpayers the opportunity to eliminate substantially post-return-filing tax uncertainty with respect to U.S. income taxes.

Certain features of the new guidance, such as the narrowed description of uncertain items and the clarifications to the policy of restraint, have the potential to quell some of the privilege debates implicated by the draft guidance. The announcement that IRS examination teams generally will not assert waiver where material has been disclosed to financial auditors is especially significant in light of recent litigation in Textron and other cases. There remains a question, however, as to whether taxpayers will raise privilege challenges to remaining parts of the UTP regime, including the threshold requirement that uncertain positions must be disclosed.

Highlights of the new guidance include:

Ranking by Reserve Amount; Major Items Flagged; No Disclosure of Maximum Amount

All uncertain tax positions must be ranked in order of the size of the taxpayer’s reserve for that item. The amount of the reserve need not be disclosed and the IRS examination teams will not ask for reserve amounts. In an expansion from the draft guidance, items on the list of UTP disclosures that are “major tax positions” must be so identified. Major tax positions are items whose reserves constitute more than 10 percent of the taxpayer’s total reserve. In a significant retreat from the draft guidance, no maximum tax exposure amounts need be disclosed. 

Directive to Exam Personnel on Auditing UTP Disclosures

The Large Business and International Division of the IRS on September 24 issued a directive to all personnel emphasizing that the division’s responsibility is to “administer an equitable and balanced examination program.” The directive repeats Commissioner Shulman’s earlier admonition that the division must “apply the law as it currently exists, not as we would like it to be,” and that must occur “without bias in favor of the government or the taxpayer.” The Schedule UTP is not intended to serve as a substitute for other examination tools or for the independent judgment of the examiner. The directive notes that uncertain tax positions arise “for a number of reasons, including ambiguity in the law and lack of published guidance . . . This means that items disclosed on a Schedule UTP may or may not require an examination or an audit adjustment.” 

$100 Million Asset Threshold for 2010; Five-Year Phasedown to $10 Million

The disclosure requirement will apply to companies with more than $100 million of assets for 2010, changed from $10 million in the draft guidance. Over five years the asset threshold will be lowered to $10 million. 

No Disclosure of “Administrative Practice” Items

In a change from the draft guidance, taxpayers need not disclose positions that would have been reflected by a reserve on the taxpayer’s financial statements but for the taxpayer’s conclusion that the IRS has an administrative practice of not challenging such positions. 

Clarified Definition of “Expectation to Litigate” Items

The new rules preserve the requirement that taxpayers must disclose uncertain tax positions for which no reserve was recorded if the reason for recording no reserve depends in part on the taxpayer’s expectation that it would litigate the issue if challenged. But the new instructions to the Schedule UTP modify the description of these “expectation to litigate items” from the draft formulation. Commissioner Shulman stated that the change was designed to address concerns that “highly certain or immaterial positions” were covered by the draft guidance. The new instructions require disclosure of positions without a reserve if (i) the taxpayer determines the probability of settling with the IRS on that issue to be less than 50 percent; and (ii) no reserve was recorded because the taxpayer (a) expects to litigate the tax position and (b) has determined that it is more likely than not to prevail on the merits in litigation. 

Narrowed “Concise Description” of Items

The “concise description” of uncertain items on the Schedule UTP has been clarified and narrowed from the draft guidance formulation. The concise description is now limited to information sufficient to identify the issue and relevant facts. The draft guidance had required taxpayers to state the rationale for the positions and the reasons for uncertainty; this feature is eliminated, in what Commissioner Shulman called a “significant change.” More guidance and instructions to IRS field personnel will be forthcoming on the requisite concise description. The IRS analogized the new rules to the Form 8275 disclosures used to effect disclosure to avoid accuracy-related penalties. The guidance also reaffirmed that disclosures on Schedule UTP will qualify as adequate disclosure for purposes of the new penalty for transactions found lacking in economic substance, other than reportable transactions, for which Form 8886 also is required. 

Revisions to the Policy of Restraint

Announcement 2010-76 announces that the IRS is “expanding” its longstanding policy of restraint on seeking disclosure of tax accrual workpapers. Notably, the IRS will not argue — at least in the examination phase — that a disclosure to an independent financial auditor is a privilege waiver. The Announcement is silent on whether the same restraint would apply in litigation with the taxpayer. The Announcement also clarifies that the IRS will not request the reserve amounts for disclosed uncertain items and will not request taxpayers’ drafts of the Schedule UTP or other documents used in preparing it.

Triage Team Will Identify Guidance Issues

In addition to guidance recommendations from examination teams and industry groups, there will be a special group of IRS personnel charged with analyzing UTPs and determining their proper treatment, including by suggesting that guidance be developed based on the disclosures. Commissioner Shulman stated issuing guidance arising from the UTP disclosures will be a measure of the UTP regime’s success.

No Automatic Disclosure to Foreign Governments

The United States will not automatically exchange UTP information with foreign governments under treaty exchange of information provisions. Because the items disclosed on the Schedule UTP relate to uncertain United States tax positions, it must be determined whether they are relevant to foreign taxing authorities’ activity. The question of whether foreign countries have in place the necessary disclosure regimes to provide reciprocity under the treaties also will be considered. 

CAP Maintenance Phase

The CAP, under which taxpayers and the IRS work together to reach agreement on issues before the taxpayer files its return, will be made permanent and will be expanded to include a “CAP maintenance” phase for taxpayers who have been successful participants in CAP in prior years. CAP maintenance would require reduced resources and reduced contact between the IRS and taxpayers and is intended to provide quicker resolution of issues. There also will be a “pre-CAP” phase to assist taxpayers in getting current with prior audits and thus be eligible for CAP. Details on these changes will be announced separately on a future date.

Enhancements to Fast Track Settlement Program

IRS examining agents will now be given credit for closing an examination at the time a case moves to Fast Track Settlement. This should encourage exam teams to consent to Fast Track more readily than under the previous structure, where agents’ audit timeliness metrics were affected by the time a case remained in a Fast Track Appeals proceeding.

Analysis of Potential M-3 Revisions

With the addition of UTP disclosures, the IRS will examine, together with a working group of interested taxpayers, whether the Schedule M-3 should be revised or its disclosure requirements reduced. No changes are likely to returns for the 2010 tax year.

As many commenters have noted, successful implementation of the UTP regime will be a challenge for both the IRS and for taxpayers. Our preliminary observation is that the IRS has listened carefully to comments of the taxpayer community and has taken considered steps to address their concerns.

This memorandum is provided by Skadden, Arps, Slate, Meagher & Flom LLP and its affiliates for educational and informational purposes only and is not intended and should not be construed as legal advice. This memorandum is considered advertising under applicable state laws.