Internal Revenue Service Advisory Council 2009 Public Report: Large and Mid-size Business Subgroup
The IRSAC LMSB Subgroup (hereafter “Subgroup”) is comprised of a diverse group of six tax professionals. The members of the Subgroup include attorneys and certified public accountants from prominent law and accounting firms, as well as the corporate tax departments of major U.S. companies. The Subgroup brings a broad range of experience and knowledge to the IRSAC, and is uniquely qualified to provide a perspective on behalf of LMSB taxpayers. The members of the Subgroup have been honored to serve on IRSAC, and appreciate both the opportunity to submit this report and to assist LMSB in the accomplishment of its important work.
The Subgroup enjoys a close working relationship with LMSB leadership. This relationship has given the Subgroup the opportunity to consult with LMSB on a variety of matters. LMSB has been extremely helpful in providing the information and resources necessary to develop our report.
During this past year, IRSAC, as well as LMSB, were focused on the economic downturn and the impact on LMSB taxpayers. With a significant increase in net operating losses, taxpayers were more concerned than ever about the speedy recovery of tax refunds. IRSAC suggested that LMSB examine the Joint Committee review process to ensure refunds were being handled as expeditiously as possible. LMSB reviewed this issue independently, and assigned greater resources to it to make sure that the refund process flowed smoothly. This was an important reaction to a changed business environment, and the Subgroup congratulates LMSB on taking appropriate action under these extraordinary circumstances.
LMSB asked the Subgroup to focus its efforts this year on (a) training and (b) enterprise compliance risk management. With respect to training, LMSB recognizes that the enormous, and still growing, complexity of the Internal Revenue Code presents continuing challenges to taxpayers in terms of technical knowledge and tax compliance efforts. It also recognizes that taxpayers are now facing unique needs and demands as a result of the current economic downturn. LMSB desires to enhance its ability to assist taxpayers in meeting these pressures and, toward that end, has asked the Subgroup (1) to report on what it is seeing currently in the marketplace; and (2) to suggest “just-in-time” training initiatives and other measures that LMSB might undertake to assure that its tax professionals are conversant with new and emerging technical tax areas and issues, and are sensitive to their impact on specific types or industry groups of LMSB taxpayers.
With respect to enterprise compliance risk management, LMSB asked for the Subgroup’s assistance in determining methods for assessing compliance risk and determining the most efficient ways of approaching such audits. The Subgroup recommends that LMSB should continue to attempt to identify and manage enterprise compliance risk through the use of Pre-Audit and Initial Audit Techniques identified by the Subgroup.
ISSUE ONE: TRAINING
The business world changes rapidly, especially in these extraordinary economic times. In the eleven months since the Subgroup first began discussing this year’s report, there have been many major developments in the economy, most having significant tax implications. Although the Subgroup can provide some insight with regard to certain issues it currently is “seeing in the marketplace,” new issues will no doubt continue to emerge with the result that frequent and candid communication through the educational programs discussed below is essential in order for LMSB to focus effectively on “just-in-time” training. Increased transparency and communication through these programs will provide LMSB a “fast-track” path to better understanding the industries and business dynamics of LMSB taxpayers. For taxpayers, an understanding of LMSB’s concerns both technical and administrative can inform business decisions and hopefully encourage a useful dialogue over the most cost effective and efficient way in which to respond to issues ranging from specific audit requests to design of tax compliance processes.
With the current economic downturn as a backdrop, the Subgroup has also identified certain issues that all LMSB taxpayers are dealing with, as well as selected issues of particular importance that taxpayers within the specific LMSB industry groups are now facing. These issues could serve as a starting point for the development and implementation of specific educational programs along the lines recommended by the Subgroup.
1. Mutual Interest in Enhanced Collaboration
Most LMSB taxpayers take their tax responsibilities very seriously. Many operate internationally in complex businesses and in complex markets. The tax ramifications of such operations are, of course, equally complex and that presents continuing and diverse challenges for both taxpayers and LMSB.
Senior corporate executives have certain expectations for their tax departments and evaluate their performance accordingly. In particular, they want to ensure that: (1) the company is fully compliant with all applicable laws; (2) the correct tax liability is determined and paid; (3) the tax department and tax collection is operationally effective and efficient; (4) robust and appropriate internal tax-related policies and procedures are in place and adhered to; and (5) perhaps most importantly, that there are no “surprises.” These expectations and objectives are probably not very different from those that LMSB executives have for the IRS employees who work in LMSB.
The Subgroup believes that this common ground between taxpayers and LMSB is key to informing and shaping effective responses to the challenges and opportunities ahead. In that regard, a two-sided commitment to transparency and communication is critical. More frequent and candid communication between taxpayers and LMSB will assist us in reaching our ultimate mutual objective to create a more efficient process for compliance with, and enforcement of, the revenue laws. Working together, we can ensure that our mutual requests of each other are reasonable, and that potential constraints and objections are fully aired and understood by both sides.
The end result of this process should be “win-win.” LMSB will gain information that will help it to better administer and enforce the tax laws. For taxpayers, increased communication and transparency will help provide certainty and, in the process, hopefully curb instances in which taxpayers seek inappropriately to exploit uncertainties in the tax law. Tax uncertainty is a significant source of economic inefficiency that all taxpayers should have a strong interest in reducing to the greatest extent possible.
2. Commercial Awareness Through Training and Education
The Subgroup believes that the best way for LMSB to acquire greater commercial awareness and enhanced technical knowledge is through extensive educational and training programs (e.g., quarterly conference calls or meetings) actively participated in by knowledgeable taxpayers and representatives of industry groups.
Greater commercial awareness and technical knowledge gained from such programs should permit LMSB to more efficiently administer and enforce the tax laws with limited resources. Taxpayers, also with limited resources, could benefit from applying information gained through LMSB dialog in reaching planning decisions regarding particular types of transactions and/or preventing or expediting the resolution of tax controversies.
Taxpayers would expect LMSB to approach these educational program committed to the principle of reciprocity that is, an open dialog on all issues of concern, coupled with a genuine effort to respond with appropriate guidance as quickly as possible. Taxpayers will not always expect the response from LMSB to be in the form of published technical guidance. They will expect, however, to receive at least an objective reaction to the issues being discussed, including disclosure of any specific problems or concerns that LMSB may have. Thus, LMSB’s approach to the suggested educational programs should be as nimble as possible, particularly encompassing matters that allow taxpayers to reduce uncertainty and clarify areas of agreement and disagreement.
The Subgroup envisions an educational program consisting of two categories.
a. Category I Education
Category I educational programs would include training and development of LMSB on general matters. For example, taxpayers may provide education to LMSB regarding the business environment, economy, or capital markets in general. Such types of programs may not require comments or responses from LMSB.
It would be useful for taxpayers and LMSB to have an informed discussion on current issues in general, including, for example, the business and tax implications of the current economic climate. Tax issues spawned by difficult economic conditions often commonly affect taxpayers in many different types of businesses for example, issues related to the ownership change rules of section 382 or to independent contractor status. It is not unusual in a challenging economic environment to see a significant drop in employment that is offset, at least in part, by a spike in independent contractors.
Business changes more rapidly than the tax laws, and it is therefore important for LMSB to keep pace with innovations in the private sector. Engaging in these types of discussions early on should be beneficial to both LMSB and taxpayers.
b. Category II Education
Category II educational programs would be more targeted and specific. For example, LMSB may wish to discuss certain transactions in which taxpayers in a particular industry are engaging. Interested taxpayers and industry groups could meet with appropriate LMSB representatives in order to explain such transactions.
The overwhelming majority of corporate transactions are entirely appropriate, and do not raise difficult tax policy issues. While many corporate taxpayers do engage in complex transactions, complexity, itself, should not be considered an automatic signpost of abuse. LMSB must have sound reasons for differentiating between those transactions that it views as appropriate and those that it views as problematic.
For example, as has been extensively reported in the press, there is a renewed focus on the role that “tax haven” jurisdictions play in tax avoidance and abusive tax shelter transactions. While some such issues may be clear-cut, LMSB should not automatically assume that all matters associated with what is considered a “tax haven” jurisdiction are, per se, abusive. Oftentimes, entities are organized in “tax haven” jurisdictions for various legal and structuring reasons and not for tax-motivated purposes. Nonetheless, the definition of “tax haven” seems to have been lost in rhetoric and always be tainted with a pejorative connotation. A recent report by the Government Accountability Office labels jurisdictions such as Ireland as “tax havens,” notwithstanding that many taxpayers have substantial operations and offices (i.e., “bricks and mortar”), pay substantial tax, and have hundreds (and, in some cases, thousands) of employees in such jurisdictions.
The Subgroup recognizes that certain Category II topics may not be conducive to a broad, industry-group discussion. Nuances and differences in fact patterns among transactions could make it difficult to reach a consensus regarding a presentation. In those situations, it may be useful to have both an industry meeting for a high-level review of the topic, and also separate “one-off’ meetings with members of the industry.
Creating Category II educational programs necessarily will involve a significant commitment of resources, including the time of high-level personnel from both taxpayers and LMSB. In making such a commitment, taxpayers will understandably want to be sure that the relationship will be conducted in a spirit of reciprocity, impartiality and fundamental fairness. In that regard, transparency cannot be one-sided in favor of LMSB. Taxpayers would view the mutual sharing of information as a necessary product of the proposed educational programs, and would expect LMSB to commit to give its reactions and opinions at the meetings, or shortly thereafter with respect to any perceived problems or tax issues.
LMSB should also discuss with taxpayers any audit initiatives, enforcement plans or other issues which they are contemplating pursuing. This may enable taxpayers to explain the business and tax considerations of an issue to LMSB at the outset of an information-gathering effort. Such early knowledge could be very useful to LMSB and lead to its dropping the issue. In any case, taxpayers might be able to make constructive suggestions concerning possible approaches to examining the issue. This benefits taxpayers in that when the IRS lacks knowledge with respect to a particular subject, it makes it particularly difficult to respond to Information Document Requests that are issued with respect to that subject.
Taxpayers would also look for a priority commitment to issue pertinent guidance within a reasonable period of time following an educational program. This would present an excellent opportunity for further collaboration between the IRS and taxpayers, as taxpayers could be consulted for reactions to potential approaches to the guidance, including its scope and the form it might take (e.g., Regulation, Revenue Ruling or Procedure).
The Subgroup envisions that, by definition, Category II issues will likely involve some degree of tax uncertainty. In order for an educational program to be worthwhile and successful, LMSB must act impartially, rather than as an advocate.
The IRS mission statement includes an objective to “apply the tax law with integrity and fairness to all.” Many corporate taxpayers, through both direct experience and anecdotal information, believe that this is not always “real world” practice. The type of educational programs envisioned by the Subgroup may in some instances provide LMSB with a “roadmap” of taxpayers’ analysis and conclusions with respect to an uncertain tax position. LMSB must commit not to use such information for the purpose of making adjustments, or forcing the waiver of privileges or the disclosure of workpapers.
3. Impact of Current Economic Conditions
The current economic crisis has had major impacts on LMSB taxpayers. Once profitable businesses have had dramatic increases in operating losses. Many have significantly downsized their workforces and curtailed “discretionary expenses” like travel, training, and fees for outside consultants and advisors.
These changes have also had direct effects on the U.S. Treasury, in terms of reduced tax revenues. When once profitable businesses swing to a loss, there is a direct impact on corporate income tax receipts. When businesses reduce headcount, there is a direct impact on payroll and personal income taxes. And, when companies reduce their own spending, there is a direct impact on tax revenues generated by outside suppliers and vendors.
The current economic crisis is also having a direct impact on LMSB. Changes like those described above affect the staffing levels in corporate tax departments and, thus, the resources available to commit to an IRS audit or to tax planning and compliance functions generally. These decreased resources will in turn tend to slow down the response times to Information Document Requests and other requests for information; and taxpayers will likely present an increased number of claims and affirmative adjustments on audit, leading to an associated uptick in Appeals activity and litigation.
Furthermore, in this global economy, many U.S. taxpayers have operations and/or affiliates in foreign countries and engage in transactions that have tax consequences in multiple jurisdictions. The global scope of the current economic problems creates added pressure upon affected tax authorities, including IRS, to make sure that their jurisdiction is collecting its “fair share” of tax liabilities arising from cross-border transactions and operations.
These issues present LMSB with the challenge of efficiently administering the tax system in a way that collects revenue, yet at the same time allows the nation’s largest business taxpayers to weather the current adverse economic climate and promote economic growth. This challenge is substantial, but not insurmountable. It presents LMSB with unique opportunities to discuss with industry groups and taxpayers ways in which to increasingly tailor audits of individual companies for focus and effectiveness. Such discussions might address, for example
How to continue to improve the audit planning process;
How to improve defining the roles of various individuals in the audit process, including the Case Manager and Chief Counsel personnel;
How to continue to effectively use the Competent Authority processes and procedures (as requests for assistance will likely increase);
How to better use voluntary disclosure initiatives in key compliance areas; and
How to better use alternative dispute resolution within the examination process.
4. Selected Issues Faced by LMSB Industry Groups
The following provides information regarding a non-exclusive list of particular issues that taxpayers within the specific LMSB industry groups are now facing and that may be appropriate subjects for enhanced levels of discourse between LMSB and industry representatives. Although some of these issues are not “new,” they have intensified as a result of the current economic conditions.
1. Financial Services
It would be difficult to dispute that taxpayers in the financial services industry were the hardest hit by the economic downturn.
As SEC registrants, financial institutions file financial statements in conformity with generally accepted accounting principles, including Statement of Financial Accounting Standards 157, Fair Value Measurements (“FAS 157”). FAS 157 established a single definition of fair value and a framework for measuring fair value under generally accepted accounting principles. While FAS 157 does not determine or affect the circumstances under which fair value measurements are used, it does define fair value and specify a hierarchy of valuation techniques (Levels 1, 2, and 3) based on whether the inputs to such techniques are observable or unobservable. Level 3 assets are the most difficult to value since there are no objective, independent valuation benchmarks for valuing such assets. Thus, Level 3 assets generally are subject to valuation based on significant unobservable inputs.
During the market dislocations that occurred in recent years, certain markets became illiquid, and some key inputs used in valuing certain securities were unobservable. Contemporaneously, many securities were classified as Level 3 assets (e.g., subprime mortgage-backed securities) for purposes of FAS 157. The valuations of these assets were reported in financial statements and were reviewed by the control functions within the financial institutions, their outside auditors, and other government regulatory agencies.
For tax purposes, IRC section 475 generally requires a dealer in securities to record its inventory of securities at fair market value and to mark other securities to fair market value at the end of the taxable year with the resulting gain or loss being recognized for the taxable year. Any gain or loss taken into account under these rules is generally treated as ordinary gain or loss, and adjustments are made for subsequent gain or loss realized. The economic downturn has led many financial institutions to record very significant mark-to-market losses.
In June 2007, final regulations setting forth an elective safe harbor were published permitting dealers in securities to elect to use the values of eligible positions reported on eligible financial statements as the “fair market value” of those positions for purposes of section 475. As stated in the preamble, “[t]his safe harbor is intended to reduce the compliance burden on taxpayers and to improve the administrability of the valuation requirement of Section 475 for the IRS.” To be applicable, the regulations generally require that the valuation method must recognize into income “on the income statement” the mark-to-market gains and losses and “the valuation standard used must not, other than on a de minimis portion of a taxpayer’s positions, permit values at or near the bid or ask value.”
All assets and liabilities, including Level 3 assets and liabilities, are required to be valued for financial statement purposes under FAS 157 at the exit price (i.e., the bid price at which a financial institution would sell such assets or the ask price at which a financial institution would assign such liabilities). Thus, absent some type of an adjustment, the valuation method used for financial statement purposes would not qualify for the safe harbor.
As a general matter, “fair market value” for purposes of section 475 should be equal to “fair value” for purposes of FAS 157. This approach, we believe, achieves the broad objectives of the statute. The Subgroup appreciates that the IRS has not universally accepted this proposition. However, in light of the extraordinary current economic conditions, the IRS should nonetheless publish guidance that, with respect to Level 3 assets and for a defined period of years, “fair market value” for purposes of section 475 be considered equal to “fair value” for purposes of FAS 157. See Regs. Section 1.475(a)-4(g). This would benefit both taxpayers and the IRS in avoiding a protracted audit of the values of Level 3 assets at a future date, and consequently free up significant resources that both taxpayers and the IRS must otherwise dedicate to this issue.
2. Heavy Manufacturing and Transportation
In the past, the trucking industry has unsuccessfully requested a safe harbor “cents per mile” per diem for drivers. Currently, there is a flat rate per diem safe harbor, which is inconsistent with the trucking industry’s normal method of compensating its over-the-road drivers i.e., on the basis of the mileage a driver travels rather than the time he spends on the job. This industry compensation practice of paying by the mile is motivated by competitive and productivity considerations. Per diems paid to drivers, when paid at all, are also commonly paid by the mile.
Reconciling such per-mile payments against the flat rate per diem is time-consuming, complicated and costly for taxpayers. The economic downturn has placed greater financial pressure on taxpayers in this industry, limiting their ability to absorb the administrative costs necessary to implement and operate a flat rate per diem reimbursement plan. The IRS should revisit this issue with industry groups and attempt to develop an allowable “cents per mile” per diem which is acceptable to both the IRS and the trucking industry.
3. Natural Resources and Construction
In many instances, the buyer of a residential condominium unit signs a contract with the developer of the condominium project early in the construction or development process. The contract obligates the developer to sell and the buyer to purchase a given condominium unit at a given price upon the satisfaction of certain conditions precedent, including receipt of a certificate of occupancy and material completion of the condominium unit that is the subject of the contract. As a consequence, the contract often is a long term contract, within the meaning of section 460. Since a condominium unit historically has not qualified for the residential construction contract exception of section 460(e), the residential condominium developer is subject to the general rules of long-term contract tax accounting.
The percentage-of-completion (PCM) and percentage-of-completion/completed-cost-method (PCCM) hybrid long-term contract rules generally require the developer to include in income the anticipated profit, based upon the percentage of costs incurred for signed contracts. PCM and PCCM require income inclusion during construction, before sale, and irrespective of progress payments or whether or not the buyer actually closes at the settlement table.
The current economic recession has caused many condominium buyers to default, often leaving the developer with the sole remedy of retaining the putative buyer’s deposit. Thus, PCM and PCCM often have resulted in substantial phantom income. The Subgroup believes that an appropriate remedy would be to allow condominium developers to use the accrual method and to treat each contract with a buyer as a separate dwelling. Proposed regulations dictating such treatment have been issued, but their current effective date does not provide adequate relief for affected taxpayers. Pending finalization of these regulations, taxpayers should have the option of applying the proposed regulations for any year open under the statute of limitations.
4. Retailers, Food, Pharmaceuticals and Healthcare
With regard to this sector, guidance is needed with respect to the proper tax treatment of amounts received from the sale of gift cards. The proliferation of gift card programs in recent years has been very substantial and represents, for many retail businesses, an important (and sometimes the most important) component of their marketing and promotional activities. Such programs, moreover, are structured and administered in a variety of ways. For multiple-outlet businesses (e.g., chain restaurants or multi-city department stores), in order to achieve economics of scale and other business efficiencies, it has become increasingly common to centralize the cash management and other administrative aspects of such programs in an affiliated or related entity in e.g., a separate subsidiary of a consolidated return group, or a parent or other controlling entity, that does not itself maintain inventories of the goods “delivered” to customers upon redemption of the gift card. These so-called “Giftcos” typically receive the amounts paid to the retail establishments by purchasers of gift cards, subject to a continuing obligation to return such amounts to the particular store or other outlet at which the gift card is ultimately used.
The correct tax treatment of gift card sales proceeds is by no means clear. Existing published administrative guidance permits a two year (Treas. Reg. §1.451 5) or one year (Rev. Proc. 2004 34) deferral of income inclusion under prescribed conditions but the availability of such treatment in Giftco contexts is uncertain, as is the applicability of certain case law principles relating generally to the definition of “gross income” for federal income tax purposes.
Gift card issues are being frequently raised in IRS audit examinations, with revenue agents typically asserting in Giftco situations that the full amount of gift card sale proceeds must be taken into income in the taxable year of receipt even though redemptions may not occur until a later taxable year and some of the cards may never be redeemed. None of the existing authority relevant to these issues clearly dictates this audit position and, at the very least, such position would appear to violate the seminal “matching” principles of tax accounting. LMSB has assigned Tier 2 status to gift card issues, but coordinated position papers have not been issued and Appeals Officers apparently are free to settle such issues on a case-by-case basis. While a published guidance project in this area is reportedly moving forward, numerous taxpayers are in the meantime facing considerable uncertainty with respect to an important aspect of their day-to-day business operations.
In fashioning the anticipated guidance, it is important that Treasury and IRS (1) fully understand the clearly non-tax motivated reasons for using Giftcos; (2) be willing to read existing authorities expansively in order to accommodate evolving business practices; and (3) give careful consideration to whether any justifiable tax policy concern can really be seen as requiring that Giftcos be penalized tax-wise simply because the goods needed to satisfy gift card redemptions are “owned” by a related entry.
5. Communications, Technology, and Media
The sustained economic downturn and the associated operational changes that taxpayers have been forced to make expose many technology businesses to heightened levels of uncertainty and risk surrounding transfer pricing compliance. Precipitous drops in revenues and difficulty in securing funding to support future research initiatives and core business functions are forcing taxpayers to stringently control spending and allocate resources to sustaining the business. Conventional transfer pricing models are strained as taxpayers reconsider how to share risks associated with different elements of their global supply chain. Tax departments are thus facing novel and complex transfer pricing issues at the same time they are being expected to absorb detailed new transfer pricing rules relating to intercompany services and intangible property development.
These pressures have contributed to significant variations in both the level and quality of transfer pricing documentation prepared by many technology companies, as tax departments are forced to address complex intercompany pricing decisions in real-time, with limited relevant market data available to help formulate and fashion true arm’s-length, market-based responses. Plant closures, production consolidations, falling sales orders or renewal rates, business divestitures, and relocation of research and development activities to low-cost jurisdictions exacerbate these difficulties.
The combination of new U.S. transfer pricing regulations and the introduction of new compliance requirements around the globe represent additional burdens to technology companies in survival mode and leave many of these taxpayers feeling heightened transfer pricing exposure. The perceived risk of being caught between competing tax authorities is high. Preferences among tax authorities for “profit” versus “transaction-based” transfer pricing methods, alternative interpretations of chargeable versus non-chargeable headquarters activities, and questions regarding the deductibility of equity-based compensation charges factored into U.S. transfer pricing calculations all contribute to high levels of uncertainty and steep compliance burdens that many technology companies are ill prepared to address with limited resources.
LMSB should continue to engage, and expand its engagement with, taxpayer industry groups and interested LMSB taxpayers in order to establish educational programs, through which industry groups and taxpayers would actively assist in the training and development of commercial awareness and industry-specific technical tax skills within LMSB.
ISSUE TWO: ENTERPRISE COMPLIANCE RISK MANAGEMENT
With respect to enterprise compliance risk management, LMSB asked for the Subgroup’s assistance in determining methods for assessing compliance risk and determining the most efficient ways of approaching such audits. The Subgroup has identified various pre-audit and initial audit techniques for LMSB to utilize in this regard. Employing these techniques will be beneficial for both taxpayers and LMSB, and help both utilize their limited resources, since LMSB could devote more focus to areas it considers posing higher risk, and taxpayers with low-risk profiles would not be subject to the same examination process as high-risk taxpayers. The techniques recommended are not intended to be a complete list of tasks that can be undertaken in early stages of a review or audit to assist in the assessment of compliance risk. Rather, these are ideas the Subgroup believes LMSB should consider in the development of an overall enterprise risk management process.
LMSB is concerned about enterprise compliance risk in large multinational enterprises, especially those employing complex organization structures and numerous partnerships and other pass-through entities. As a result, LMSB asked the Subgroup to consider ways that the IRS could better assess compliance risk in complex enterprises. With limited resources, it is critical that LMSB develop a strategy to categorize taxpayers by levels of compliance risk. This will enable a better allocation of resources, with more focus and intensity on high-risk enterprises and less focus on low-risk taxpayers.
The Subgroup has discussed various means by which LMSB could assess compliance risk without a full examination or at the beginning of an examination to assess the appropriate scope of examination. Our recommendations follow, but first we note that the Subgroup’s experience indicates multinational enterprises often employ complex legal structures for valid business reasons, including limitation of liability, financing, mergers and acquisitions, and protection of intellectual property. As a result, LMSB should avoid concluding that organizational complexity implies tax noncompliance. This would lead to the unwise investment of limited resources.
As outlined below, the Subgroup has identified various risk assessment and investigatory techniques (1) to screen for higher-risk taxpayers prior to commencement of an audit (Pre-Audit Techniques), and (2) to employ at the beginning of an audit (Initial Audit Techniques) to guide LMSB in assessing compliance risk prior to a full examination. The Subgroup believes that the use of these techniques as part of LMSB’s risk assessment process will provide a means by which enterprises can be assigned to a risk category (e.g., low risk, medium risk, high risk).
1. Pre-Audit Techniques
Publicly-traded enterprises provide the SEC and investors substantial information that can be analyzed prior to the commencement of an audit. Enterprises not required to disclose effective tax rate and tax payment information, and with no history of SEC filings, may require use of Initial Audit Techniques (outlined in detail below) before a conclusion can be reached regarding enterprise risk.
LMSB may employ the following techniques in developing its initial assessment of an enterprise’s tax compliance risk:
- Review the history of the enterprise’s federal tax compliance. Results from previous audits and the final assessments of additional tax after appeals and/or litigation may provide a useful reference to assess an enterprise’s tax compliance risk. Enterprises that have historically faced large post-return assessments and collection should be categorized as higher risk. Conversely, enterprises that have a history of low post-return assessments and collection would be categorized as low risk.
- Review the enterprise’s effective tax rate versus industry averages, after eliminating the impact of large, “one-time” items highlighted in SEC filings. Assuming comparability of pre-tax profits, an effective tax rate (as adjusted) substantially below peer companies may be an indicator of higher risk. An effective tax rate that is consistent with peer companies may indicate lower compliance risk.
- Compare current tax expense with current tax payments. A pattern of tax expense in excess of payments may suggest that the enterprise is engaging in transactions with questionable tax results. A review of footnote disclosures related to unrecognized tax benefits may provide further clarity relative to compliance risk. Rising levels of unrecognized tax benefits would generally indicate higher compliance risk.
An enterprise’s compliance risk category may be determinable using the above techniques. Certainly, an enterprise that has a history of non-compliance, reports low effective tax rates relative to peers, and has increasing levels of unrecognized tax benefits should be categorized as high risk and face regular examinations. However, these risk indicators may not all provide the same assessment, and further Pre-Audit and Initial Audit Techniques should be used, as follows:
- Review the history of SEC compliance and other public evidence of the enterprise’s reputation for compliance and internal controls. For example, there may be evidence that the enterprise is engaged in an unusually large number of non-tax-related lawsuits, an indication that the enterprise operates beyond the normal risk spectrum.
- Consider the firm’s age, financial stability, credit ratings, types of shareholders, and continuity of ownership. Older, publicly traded enterprises with strong balance sheets and cash flows should be more averse to unnecessary tax risk than privately held companies and those with weaker financial positions.
- Review third-party financing arrangements and investors. Large, stable financial institutions employ stringent due diligence before investing. An enterprise that raises capital through such financial institutions is routinely asked about contingent liabilities, including taxes, as part of the investors’ due diligence process.
2. Initial Audit Techniques
As noted above, enterprises that are not required to disclose effective tax rate and tax payment information, and with no history of SEC filings, may require the use of the additional techniques outlined below before a conclusion can be reached regarding enterprise risk.
- Request a list of internal committees with responsibilities related to financing, tax, risk management, and legal organization structure. Review charters of each and request minutes. (Note, however, that an enterprise may have privilege claims relating to minutes.) The mere existence of internal committees related to areas such as tax and organization structure are indicia of good operating controls and internal transparency. Enterprises with such committees should generally be viewed as lower compliance risks than enterprises without such committees.
- Request copies of legal organization structures as of the beginning of each audit period and as of the end of each period. Request an explanation of transactions during the period under audit that impacted the legal organization structure.
- Analyze the resources devoted to tax compliance. If tax returns are prepared “in-house,” review ability of the in-house staff in terms of numbers and experience levels. Alternatively, ensure that the outsource service provider is reputable, and request an interview with the outsource firm to determine if the resources employed in their engagement are sufficient.
- Request a reconciliation of income before tax earned in the U.S. per the 10-K to the starting point in the U.S. income tax return. This analysis could highlight the use of transfer pricing methodologies for tax purposes that are not consistent with the manner in which the enterprise reports geographic income internally.
- Consider interviews of select executives such as the Chief Tax Officer. The interviews should focus on both tax compliance processes employed by the enterprise as well as any significant transactions or restructurings occurring during the audit cycle.
LMSB should continue to attempt to identify enterprise compliance risk through the use of the Pre-Audit and Initial Audit Techniques identified by the Subgroup. Using such techniques will facilitate categorizing taxpayers as low, medium or high risk. The frequency and intensity of IRS audits should be based on the risk category assigned. LMSB should conduct more intense examinations of taxpayers with high-risk ratings.