Sometimes, even the IRS needs some help interpreting corporate tax filings. In 2002, the IRS detected what it thought might be abusive "sell in, lease out" tax shelter transactions in Textron Inc.'s 2001 tax return. So the agency issued an investigative subpoena to the Rhode Island-based defense contractor, requesting all of the company's "tax accrual workpapers."
Public companies prepare tax accrual workpapers to comply with financial reporting requirements. These documents list any uncertain positions the company took on its tax returns, analyze the strength of those positions, and estimate the additional tax liability that could result if those positions are challenged and overturned. Most companies have a fleet of accountants and lawyers painstakingly preparing such papers so the company can properly report its assets and liabilities. The IRS thought that those documents would be helpful in evaluating Textron's return, which according to the agency's court filings, was 4,000 pages long and accompanied by nine filing cabinets worth of documentation.
But Textron wasn't going to give up its internal analysis so easily. The company refused to comply with the subpoena, asserting that the workpapers were attorney work-product, prepared in anticipation of tax litigation with the IRS.
The IRS sued. After years in court, the en banc 1st Circuit decided in August 2009 that the company had to turn over most of the documents, ruling that they were not work product because they would have been prepared regardless of whether litigation was anticipated (see "Preserving Privilege," November 2009). Essentially, Textron had to give the IRS a roadmap to any uncertainties in its tax filings. On May 24, the Supreme Court declined to review the decision in U.S. v. Textron.
Now, the agency is trying to make the holding of Textron its standard for all corporate taxpayers. IRS Announcement 2010-9 will require all corporations with greater than $10 million in assets to fill out a form disclosing any "uncertain" tax positions the company has taken.
"Textron will embolden the IRS," says Robert Friedman, a partner at Troutman Sanders. "The government will feel very strong about its position in going after this information."
Under the Net
In May, the IRS published a draft schedule and instructions explaining what new disclosures it will require under Announcement 2010-9, which will go into effect for 2010 tax returns. The form essentially requires a corporate taxpayer to give the IRS a concise statement of any position the company has taken on its tax return that might be subject to challenge by the agency.
First, the form requires companies to disclose any tax position for which it recorded a reserve--i.e. any decision that the company determines poses a risk of additional liability that needs to be accounted for on the company's balance sheet. Second, taxpayers must disclose any uncertain position for which they have not recorded a reserve. This category captures those tax positions that the IRS may challenge but which the company plans to defend in court. Finally, the taxpayer must disclose any tax position it takes based on an understanding that the IRS has an administrative practice of not treating it as a violation.
The IRS is downplaying both the burden these additional disclosures will require and their potential effect on companies' tax liabilities. The agency points out that companies already collect and disclose this information on their annual FIN 48 filings, which are required to comply with General Accepted Accounting Principles standards. But most tax attorneys believe that the increased disclosure presents at least some risk of increased liability and penalties.
"While it's true that this information has been on companies' financial statements, now you have to offer it up to the IRS on a silver platter," says Philip West, a partner at Steptoe & Johnson.
Companies are quite troubled by the requirement that they disclose what they've determined is their maximum liability for each uncertain position--their analysis of the worst-case scenario for what they might owe the IRS.
"The biggest concern is that rather than using the form to audit and identify issues, they're just going to take that maximum figure and staple it to a demand for payment," says Thomas Callahan, a partner at Thompson Hine. "That maximum may become where you start your negotiations."
In theory, the rationale behind Announcement 2010-9 is improving transparency. After all, it's the IRS's job to determine whether companies have accurately self-reported their tax liabilities and collect underpaid taxes. The agency is spinning the new disclosure requirements as simply a way to help the IRS achieve that mission more efficiently and effectively. But many complain that until the IRS itself becomes more transparent, companies will be at risk.
In general, the IRS has a "no rule" policy, which means that it will not give companies private guidance on tax questions prior to filing of tax returns. As a result, companies may have a lot
of uncertainties about their tax positions--not because they've taken an aggressive stance toward payment of taxes, but simply because parts of the code are unclear and there isn't much guidance available.
"The IRS is not promising to become more transparent and issue rulings and guidance," Friedman points out. "This is a huge issue because the IRS's guidance is so cryptic that you never know why they did something."
Many tax practitioners are also concerned that from a litigation standpoint, being forced to disclose to the IRS why the company has determined that a certain tax position is uncertain could lead to a waiver of the work-product privilege. This concern is particularly troubling for in-house counsel, whose job is to help the company manage and analyze risk.
"The privilege is fragile in the tax arena," Callahan says. "Companies can end up being forced to disclose this information in court."
Companies have close to a year to decide how to deal with the new disclosure requirements. Some observers point out that the rule may have the unintended effect of making companies less transparent on both their financial statements and the information they give to the IRS.
The IRS has made clear that it expects disclosure of any information the taxpayer includes on its FIN 48. Accordingly, some companies may actually choose to become less transparent on their financial statements in order to avoid making additional disclosures to the IRS.
Others point out that companies might also become more aggressive about defending their tax positions.
"Greater booked reserves indicate that there is a lot of uncertainty about the payer's positions," West says. "So a conservative company could actually attract scrutiny and be penalized."