From the July-August 2010 issue of Treasury & Risk magazine

Tax Window Stays Open

Most business people and business lobbyists are quick to complain that federal government agencies and regulators are woefully inefficient. In the case of the Internal Revenue Service, companies may want to be careful what they wish for. The agency appears to be on the verge of expanding its authority in the wake of the U.S. Supreme Court's May decision not to review an appeals court decision in United States v. Textron that gave the IRS broad power to demand access to tax accrual work papers that haven't been prepared specifically for litigation purposes. The IRS has proposed new regulations requiring public companies with assets of more than $10 million to file reports describing any uncertain tax positions and stating the amount of potential taxes at issue.

In a comment letter filed with the IRS in May, attorneys Fred Chilton and Rod Donnelly of McDermott Will & Emery noted that the IRS claims the new rule, to be called Schedule UTP, Form 1120, will improve "auditing efficiency," particularly as it relates to auditing tax shelters.

"What federal controversy would not be more efficient if one side could learn of uncertainties in the other's position?" wrote Chilton and Donnelly. "Efficiency is not a goal for eroding a bedrock principle of federal judicial process."

To understand what is at issue, it's important to look at what happened in the Textron case.

In 2001, the IRS was investigating what it felt were some questionable tax shelter arrangements set up by the $10.5 billion Providence, R.I.-based conglomerate. The agency ordered Textron to hand over its tax accrual work papers. Textron refused, claiming attorney-client and tax practitioner-client privilege, and was sued by the IRS.

In nearly all U.S. circuits, work papers have long been considered privileged, and initially a district court, while rejecting the attorney-client and practitioner-client privilege claims, backed the work-product claim. When the IRS appealed to the First U.S. Circuit Court of Appeals, a three-judge panel upheld the district court. But an en banc review by all the judges in the circuit reversed the appellate decision on a 3-2 vote, and Textron was ordered to turn the papers over to the IRS, creating a new precedent in the First Circuit, which covers New England, Puerto Rico and the U.S. Virgin Islands.

Textron appealed the en banc decision to the Supreme Court, backed by amicus briefs filed by a number of organizations, including the American Bar Association and Financial Executives International, asking the court to resolve the conflict between the First Circuit and other circuits. The Supreme Court, to the surprise of many observers, took a pass.

"It is inevitable that there will be more litigation on this, and someday it will get in front of the Supreme Court," says Kevin Brown, a partner and dispute resolution co-leader for tax controversies at PricewaterhouseCoopers, and a former deputy commissioner and acting commissioner at the IRS. In the meantime, what the IRS can demand in terms of work papers depends upon where a company is domiciled (the Fifth Circuit also has made it somewhat easier for the IRS to obtain work products).

Attorney Doug Stransky, a partner with the law firm of Sullivan & Worcester, says the Textron case could prove far-reaching.

He gives the example of a hotel chain that has had several incidents of guests slipping and falling on its floors. "You might come up with some estimate for the number of falls you expect and your potential liability for those injuries," Stransky says. "That's just a number to show your auditors, and it wouldn't have been prepared for litigation purposes. But then according to the IRS, they should be able to see that document. And if the IRS could see it, why couldn't a class-action attorney see it?"

Enter the IRS's proposed new rule on uncertain tax positions, which most observers expect to be adopted for the 2010 tax year--another effort to step up the auditing of corporate tax shelters.

According to Chilton and Donnelly, under the new rule, "The IRS will be able to immediately identify weak spots on tax returns." They say that would broaden nationally much of what the agency won in the First Circuit Textron case. In their comment letter, the two urge the IRS to hold off until the Supreme Court resolves the different treatment of tax accrual work papers among the various circuits.

For their part, PWC's Brown, and his colleague, U.S. tax accounting services leader Ken Kuykendahl, say they expect the IRS to maintain an official policy of restraint regarding the pursuit of work papers, a policy that has been in place since the mid-1980s. "The IRS says they spend 25% of their time trying to assess issues," says Brown. "This resolves that for them. A lot of it is allowing them to decide if a company is worth auditing."

In the meantime, in view of these developments and the government's focus on increasing tax revenues through aggressive audits, experts have some advice for corporate finance, accounting and legal departments.

Claudine Pease-Wingenter, an assistant professor at the Phoenix School of Law and a former tax attorney with Exxon/Mobil, says it is "critical" that tax accrual papers be prepared exclusively by licensed attorneys, with no more than minor clerical duties being delegated to non-attorneys, administrative assistants or paralegals.

In the case of uncertain tax positions, it would be "helpful" to include legal references, such as regulations or cases, explaining the reason for establishing a tax reserve, she adds.

Pease-Wingenter says that when it comes to sharing information with outside auditors, companies would be wise to provide only summary documentation about any reserves for uncertain tax positions--not full work papers.

"Privilege never applies to facts," she explains, "only to certain communications about facts, so sharing factual information doesn't waive a privilege."

Stransky says lawyers should give more advice orally. "That eliminates a document," he explains. He also suggests entering into a continuous audit process with the IRS. "The agency likes it, because then you're always being audited," Stransky says. "But if you just disclose everything, they have so much data, there's no way they can keep up."

If new provisions for reporting on uncertain tax positions go into effect for this tax year, says PWC's Brown, companies will need to report uncertain tax positions for prior years as well, notably for 2008 and 2009, if they had operating losses (and a lot of companies had operating losses for those two difficult years).

"So if you plan to use operating losses, and have any uncertain tax positions for those years," Brown says, "you might want to resolve them."


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