On May 24, 2010, the U.S. Supreme Court declined to hear an appeal by Textron, Inc. from a decision by the U.S. Court of Appeals for the First Circuit, granting the Internal Revenue Service (the "Service" or the "IRS") access to the corporation's internal tax accrual workpapers. In United States v. Textron, Inc. and Subsidiaries , 553 F.3d 87 (1st Cir. 2009), the court granted the IRS access to the corporation's tax accrual workpapers despite various claims that these internally prepared workpapers were privileged. The Service's success in this case is one of its recent actions to obtain clearer disclosure of a taxpayer's uncertain tax positions.
Textron's tax accrual workpapers, which were prepared by the company's tax department (including tax lawyers) and reviewed by the company's independent auditors, identified each uncertain tax issue, including, in each instance, the dollar amount involved and a percentage estimate of the Service's chance of successfully challenging the position.
Textron resisted the Service's summons of its tax accrual workpapers as violating the attorney-client privilege, the tax practitioner privilege, and the privilege available for litigation materials under the "work product doctrine." The corporation's position was that although the tax accrual workpapers were prepared to establish and support the tax reserves in its audited financial statements, they could also be used in litigation. The district court held that even if the tax accrual workpapers might be protected by the attorney-client privilege or the tax practitioner privilege, those privileges were waived when the tax accrual workpapers were shown to the corporation's independent auditors. However, the district court held that the tax accrual workpapers were protected by the work product doctrine.
A majority of the court of appeals reversed the district court and allowed the Service access to the tax accrual workpapers. These workpapers were prepared to make accounting entries, prepare financial statements and obtain a clean opinion from the independent auditors. The work product doctrine gives protection to materials prepared for use in litigation, whether the litigation has started or is merely anticipated. Textron argued that the tax accrual workpapers would be useful if litigation with the IRS developed. The corporation asserted that without the possibility of litigation, no tax reserves and no tax accrual workpapers would have been needed. However, the court rejected these claims on the grounds that the work product doctrine does not protect documents that are prepared in the ordinary course of business and that would have been created even without the potential of litigation.
An extensive dissent believed that the majority was not following the court's precedent and was creating a new test requiring that the documents be "prepared for" use in litigation to be protected, and suggested that the Supreme Court decide the issue. In denying certiorari, the Supreme Court declined to do so.
Subsequently, on June 29, 2010, the U.S. Court of Appeals for the District of Columbia Circuit held in United States v. Deloitte, LLP , 623 F. Supp. 2d 39, that work product doctrine protection is not waived by disclosure of the documents at issue to the taxpayer's independent auditor in the course of its examination of the taxpayer's financial statements. The Deloitte document at issue was a draft memorandum prepared by Deloitte that summarized a meeting between its client, Dow Chemical, and Dow's outside counsel about the possibility of litigation with the IRS over a tax shelter transaction. The lower court held that the work product protection for certain Dow documents and for the Deloitte document, which Dow argued was also covered by the work product doctrine, was not waived by their disclosure to Deloitte.
On appeal, the court rejected the government's assertion that the function of a document generated during a financial statement audit determines whether it was created because of the prospect of litigation. Reasoning that such a document can contain protected work product material even though the document serves multiple purposes, so long as the protected material was prepared because of the prospect of litigation, the court remanded the matter to the district court for determination whether the Deloitte document was protected by the work product doctrine. The appellate court noted that, even where a document is generated by the auditor, rather than the taxpayer or its counsel, the issue is whether the document contains work product thoughts and opinions of counsel developed in anticipation of litigation. As to documents developed by others and delivered or disclosed to the auditor, waiver of work product protection cannot be based solely on such disclosure, because that could discourage taxpayers from seeking legal advice and candidly disclosing that advice to their auditors.
The appellate court in Deloitte distinguished the first circuit's decision in Textron by noting that the latter decision turned on an examination of the particular documents at issue and did not preclude work product protection for other documents prepared during financial statement preparation or the independent audit process.
The Service addressed the privilege and work product question in some measure on September 24, 2010 when it issued Announcement 2010-76 describing an expansion of its "policy of restraint." Under the Service's longstanding policy of restraint, it would not seek tax accrual workpapers during an examination (except for certain instances, such as the Textron case for example, where listed transactions had been entered into). However, the Service has been whittling away at this policy through successive measures that have served to increase transparency. Such measures included the introduction of the Schedule M-3, reportable transaction reporting regulations, and, most recently, the introduction of the Schedule UTP which is described below. Under this modification of the policy of restraint, if a document is otherwise privileged under the attorney-client privilege, the tax advice privilege in Section 7525 of the Internal Revenue Code, 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 Service will not assert during an examination that privilege has been waived by such disclosure. There are some exceptions to this general policy. For example, the policy of restraint will not apply if "listed transactions" were entered into, if privilege was otherwise waived, or if "unusual circumstances exist."
The new Schedule UTP was first proposed in early 2010 when the Service announced that it was developing a schedule requiring certain business taxpayers to report information about "uncertain tax positions" (or "UTP's") on their tax returns. The proposal stated that the new reporting requirement would not require the taxpayer to disclose its risk assessment or tax reserve amounts, "even though the Service can compel the production of this information through a summons." The Service had noted that it would continue to exercise its policy of restraint in using a summons to obtain this information.
After issuing a draft of the new Schedule UTP, with instructions, and receiving an extraordinary amount of comments from taxpayers, professional associations, and industry groups, the Service issued a final Schedule UTP and instructions on September 24, 2010. The final schedule has significant changes from the initial draft, but will still require certain businesses to provide explicit detail about their UTPs.
The Service's initial announcement noted that most taxpayers issuing financial statements in accordance with GAAP are required to comply with FASB ASC 740-10 (previously FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes"). That pronouncement requires the identification and quantification of uncertain tax positions for financial accounting reporting purposes. The Service believes that information developed in the course of complying with FASB ASC 740-10 (or other accounting standards) should be available to the Service since such disclosure will allow it to focus its examination resources "on returns that contain specific uncertain tax positions that are of particular interest or sufficient magnitude to warrant Service inquiry, as well as allowing examination teams to identify all of the issues underlying the tax returns more quickly and efficiently."
The following summarizes the requirements of the final Schedule UTP, and affected taxpayers should start to plan to comply therewith.
To begin with, Schedule UTP requires the reporting of each U.S. federal income tax position taken by an "applicable corporation" on its U.S. federal income tax return for which two conditions are satisfied:
1. The corporation has taken a tax position on its U.S. federal income tax return for the current tax year or for a prior tax year, and
2. Either the corporation or a related party has recorded a reserve with respect to that tax position in audited financial statements, or the corporation or related party did not record a reserve for that tax position because the corporation expects to litigate the position.
An "applicable corporation" is a corporation, whether public or private, if the following four conditions exist:
1. The corporation files Form 1120, U.S. Corporation Income Tax Return: Form 1120F, U.S. Income Tax Return of a Foreign Corporation: Form 1120 L. U.S. Life Insurance Company Income Tax Return; or Form 1120 PC, U.S. Property and Casualty Insurance Company Income Tax Return;
2. The corporation has assets equal to or exceeding $100 million. (A corporation's assets equal or exceed $100 million if the amount reported on Part 1, Box D of Form 1120, or the higher of the beginning or end of year total assets amounts reported in Schedule L of Form 1120-F, Form 1120-L, or Form 1120-PC, is at least $100 million);
3. The corporation or a related party issued an audited financial statement and the audited financial statement covers all or a portion of the corporation's operations for all or a portion of the corporation's tax year; and
4. The corporation has one or more tax positions that must be reported on Schedule UTP.
The $100 million asset threshold decreases to $50 million in 2012 and then $10 million in 2014. Thus the Service intends to introduce this first to the largest companies and then to slowly have it phased in to smaller companies.
The initial recording of a reserve will trigger reporting of a tax position, but subsequent reserve increases or decreases with respect to a tax position taken in a tax return will not. In addition, no reporting is necessary if the tax position is immaterial or sufficiently certain under applicable financial accounting standards. A corporation is also not required to report on Schedule UTP a tax position taken in a tax year beginning before January 1, 2010, even if a reserve is recorded with respect to that tax position in audited financial statements issued in 2010 or later.
The Service has consistently stated that the Schedule UTP will aid the IRS in "identifying those returns that pose the most significant tax risks of noncompliance and in selecting issues for examination." That is certainly the Service's intent, and taxpayers should expect more, and more focused, tax examinations. However, to help temper fears about how it will use the Schedule UTP, the Service issued an internal directive indicating that the initial processing of the schedule will be centralized. This is to ensure appropriate review and to identify trends and areas of uncertainty in the law requiring further guidance.
If the Service views the Schedule UTP requirements as successful, it will likely broaden their application. It has already indicated its intention to require future filing by tax-exempt entities, pass-through entities ( e.g. , partnerships, limited liability companies and S corporations), regulated investment companies, and real estate investment trusts.
While the proposed Schedule UTP requirements would assist the Service in enforcing our "self-assessment" system of taxation in a more efficient manner, they will also substantially increase the cost and complexity of tax compliance. In addition, it is likely that they will engender conflicts among taxpayers, their tax advisors, their tax compliance personnel, their independent auditors, and representatives of the Service.
Some taxpayers may consider the Service's program to force disclosure of uncertain tax positions an invasion of their privacy. However, since we appear to be living in a period of "transparency" and an expansion of governmental functions, it does not seem likely that a challenge will be successful. Accordingly, taxpayers should begin to review the various tax positions they have been taking so that they can be prepared for this new regime.
Robert E. Harrison, CPA, Esq. and Murray J. Solomon, CPA, are Tax Partners with EisnerAmper LLP.