The IRSAC LB&I Subgroup (hereinafter “Subgroup”) consists of six tax professionals with a variety of experience in large corporate tax departments, large public accounting firms, government and academia. We have been honored to serve on the Council and appreciate the opportunity to submit this report.
The Subgroup has had the opportunity to discuss several topics throughout the year with LB&I management. This report is a summary of those discussions and the Subgroup’s recommendations with respect to each topic. We would like to thank LB&I Commissioner Heather Maloy and the professionals on her staff for their time spent discussing these topics with the Subgroup and for their valuable input and feedback.
The Subgroup is reporting on the following three issues:
- Risk Assessing Large Taxpayers
LB&I management asked the Subgroup to recommend risk assessment techniques that may be employed as part of the audit selection process. We suggested a list of audit screening procedures including those successfully implemented by tax authorities in Australia and the U.K.
- LB&I Industry Specialization
The IRS has recently introduced Issue Practice Groups as a knowledge management tool. The Subgroup has provided suggestions for integrating specialized industry knowledge currently existing within the LB&I organization into these groups. Our suggestions focus on establishing webpages for each sub-industry group that will house information that has been developed internally by the IRS as well as externally available resources.
- Schedule M-3, “ Net Income (Loss) Reconciliation for Corporations With Total Assets of $10 Million or More”
The Subgroup was asked for suggestions on revising Schedule M-3 so that the IRS could use it as an effective risk assessment tool to decide which taxpayers to audit and issues to examine. We recommend that Part I of the schedule be retained as it provides a critical reconciliation of income to the taxpayer’s financial records and that Part II and III be eliminated and replaced with Schedule M-1.
ISSUE ONE: RISK ASSESSING LARGE TAXPAYERS IN DETERMINING THE SELECTION, EXTENT AND FOCUS OF IRS EXAMINATIONS
As both the IRS and large business taxpayers have limited resources, each would benefit from the IRS risk assessing taxpayers and their filed tax returns prior to examination. In this manner, only high risk taxpayers would require significant IRS examination. The current Compliance Assurance Process (CAP) program has proven that full disclosure and transparency are beneficial both to the IRS and to taxpayers in resolving issues. By risk assessing taxpayers in advance of examination, many taxpayers would require a much more limited inquiry or review by the IRS. The examination process could become more focused both as to taxpayer selection and the extent of IRS review.
The tax authorities of Australia and the U.K. have adopted risk assessment processes and classification systems that guide the extent of their examinations of large businesses. This report examines the benefits of LB&I adopting a similar approach.
To better focus LB&I’s limited resources, the Subgroup was asked to provide advice on ways LB&I should risk assess a filed tax return before it goes to examination, and to identify opportunities to improve the LB&I examination process. We were asked to suggest which factors might indicate a higher risk taxpayer. During our meetings with the Commissioner and senior members of LB&I, we examined and discussed the risk assessment policies employed by the tax authorities of the Australian Taxation Office (ATO) and the U.K. HM Revenue & Customs (HMRC) (See appendix B of the 2008 IRSAC Report). Both the ATO through its “Risk-Differentiation Framework Categorization” (RDF) and the HMRC through its “Varney Reviews” risk assess large business taxpayers and categorize each using a scale of high risk to low risk. The risk rating, while not public, is shared with the taxpayer and is reviewed annually to determine the continued appropriateness of that rating. Those taxpayers with higher risk ratings receive a much more extensive review of their tax return filings. Commissioner Michael D’Ascenzo of the ATO provided the following guidance to large businesses: “We encourage those responsible for tax functions to ensure that sound organizational governance is in place to manage tax risks. We also encourage you to develop and maintain an open and cooperative relationship with us. . . . How you choose to manage tax risk determines how we engage with you.” (Copies of the Australian Taxation Office Law Administration Practice Statement PS LA 2011/6 are included in Exhibit A.)
Implementing such a change of approach would entail significant challenges for both the IRS and taxpayers. Many of the factors indicating a taxpayer’s level of tax risk may be subjective and often difficult to document by both the taxpayer and the IRS. Currently IRS personnel are not trained in risk assessment methodologies, for example the effectiveness of a taxpayer’s information reporting technology. If such a risk assessment approach is to be seriously considered by the IRS, our Subgroup made two suggestions before implementation on a wide scale. First, any proposed risk assessment methodology should be co-developed and evaluated using a select group of large taxpayers currently participating in the CAP program. The taxpayers who participate in the CAP program have a demonstrated level of transparency and desire to improve the examination process, and importantly, a working relationship with the IRS. Second, when obtaining data from a taxpayer related to assessing tax risk, the initial request for data should be in the form of a “yes or no” list of indicators that is part of the filed tax return. Such a checklist could be a section of the Schedule UTP “Uncertain Tax Positions.” The UTP could be changed so that this section would be required to be filed by all taxpayers. If the responses to the initial questions signify that additional information may be required, then the IRS can focus on those particular areas for further inquiry.
Some of the factors listed below do not lend themselves to a simple yes or no answer and therefore may not be appropriate for inclusion in a questionnaire as part of the tax return. They may, however, be components of a more subjective analysis of the taxpayer’s overall risk assessment. After reviewing the guidelines and materials published by the ATO and HMRC, as well as the suggestions of the Subgroup, we suggest that LB&I consider the following factors in risk assessing large businesses:
- The amount of guidance and oversight provided by the board of directors should be a key factor. For example:
- Does the Chief Tax Officer make periodic presentations to the board of directors or one of its designated committees?
- Has the board provided guidance to management and the tax department as to the level of tax risk that should be taken by the company?
- Is there in place appropriate review and sign-off procedures for material transactions, thereby ensuring that significant tax risks are elevated to the board?
- Does the taxpayer have a history of overly aggressive tax planning and involvement in tax related structured transactions?
- Has the company reported a material weakness or financial restatement related to tax matters?
- Does the taxpayer have the involvement of the corporate internal audit department in reviewing the tax function?
- Does the taxpayer have a presence in known tax havens?
- Has the taxpayer been a party to a recent merger or acquisition that may cause a significant change in tax department personnel or availability of tax reporting data?
- Do the reported financial results or tax return information differ significantly from industry norms?
- Are there unexplained tax losses, low effective tax rates, and cases where a business or entity consistently pays relatively little or no tax? Are the amounts paid in taxes in line with the business’s reported financial results?
- Is the taxpayer experiencing rapid growth, restructuring, mergers or divestitures, deploying new accounting software or undergoing significant changes in accounting or tax department staff?
- What percentage of the tax function staff is subject to professional responsibility rules imposed by professional bodies such as the American Bar Association (ABA), American Institute of Certified Public Accountants (AICPA), etc.? Do members of the tax function staff engage in required continuing education? Has there been a high turnover of tax department personnel?
- Is the data collection by the tax function automated with sufficient technology, processes and controls to ensure that accurate financial and tax data are provided?
- Has the taxpayer performed a documented tax risk assessment and implemented a tax risk management policy that goes beyond the requirements of Sarbanes-Oxley section 404?
- Regarding the tax function of the business, are the roles and responsibilities associated with overall tax compliance clearly defined? Does the tax function have adequate resources to provide accurate tax returns and assistance with IRS examinations?
- Does the Schedule UTP indicate a lack of adequate descriptions, the presence of questionable positions or the disclosure of large amounts?
- Has the taxpayer been involved with major tax planning initiatives during the year such as a research credit review?
- What is the prior IRS examination history of this taxpayer? Were significant adjustments made to the tax returns as a result of these prior examinations?
- Are there industry wide issues for the taxpayer’s business that may require the IRS to examine the tax returns?
- The IRS should consider implementing a risk assessment of large businesses that provides a defined and known risk assessment classification. The IRS should then modify its examination selection criteria to focus on taxpayers who display a high level of risk of non-compliance or aggressive tax reporting. The IRS should also focus its limited resources on taxpayers and issues that warrant its attention as identified through the new risk assessment protocol.
- In determining how to implement a risk assessment classification system, LB&I should consider the factors suggested in this report. LB&I should also review the guidance provided by the ATO and HMRC who have already implemented such a system.
- An open and transparent interaction between taxpayers and the IRS has many benefits for both parties. Schedule UTP and its required disclosures provide the IRS with a list of the taxpayer’s uncertain tax positions. Using this information, the IRS can better focus on the technical merits of disclosed taxpayer filing positions rather than spending significant amounts of time and resources attempting to identify them. The IRS should expand its own transparency by publicly indicating areas of examination focus in advance. In that way, taxpayers have the time to (1) ensure that their information, systems and processes are in place to provide the IRS the information should there be an examination and (2) ensure that they are properly reporting the information on their tax returns in the first place.
- Before implementing a risk assessment protocol for selecting taxpayers for examination or determining the extent of an examination, the IRS’ tax risk assessment methodology should be co-developed and evaluated using a select group of large taxpayers currently participating in the CAP program.
- When obtaining data from a taxpayer related to assessing tax risk, the initial request for data should be in the form of a “yes or no” list of indicators that is part of the filed tax return. Such a checklist could be a section of the Schedule UTP. If the responses to the initial questions signify that additional information may be required, then the IRS can focus on those particular areas for further inquiry.
ISSUE TWO: LB&I INDUSTRY SPECIALIZATION
LB&I asked for the Subgroup’s assistance in identifying ways to bring greater industry specialization to its Issue Practice Groups. The Subgroup has addressed similar issues in the past and recommended greater commercial awareness through education and training. The Subgroup has identified various concrete steps that LB&I should take in order to better develop and deploy industry knowledge throughout its Issue Practice Groups.
Recently, LB&I introduced a knowledge management network that uses Issue Practice Groups ("IPGs") for domestic issues. IPGs are designed to provide examination teams the technical information they need to manage their cases efficiently, consistently and with a high degree of technical proficiency. IPGs are designed to foster effective collaboration and the sharing of knowledge and expertise across LB&I and Chief Counsel. LB&I views the IPGs as balancing the need for consistency with the recognition that there is no "one size fits all" approach to examining and resolving issues.
According to LB&I, the IPGs reflect the fact that no one LB&I employee has all the answers. IPGs are a resource for examiners, managers and executives to use during audits and in managing compliance priorities. Agents are encouraged to consult IPGs, especially when they encounter issues with which they are not familiar or when dealing with complex technical issues.
Currently, LB&I has identified the following IPGs:
- Partnerships and TEFRA
- S Corporations and Cooperatives
- Compensations and Benefits
- Corporate Distributions and Adjustments
- Corporate Income and Losses
- Business Credits
- Energy and Investment Credits
- Financial Instruments
- Inventory and 263A
- Methods of Accounting
- Deductible and Capital Expenditures
- Life Insurance
- Non-Life Insurance
- Regulated Investment Companies (RICs), Real Estate Investment Trusts (REITs) and Real Estate Mortgage Investments Conduits (REMICs) and Banking.
LB&I recognizes that it has considerable industry knowledge within this network. For instance, many professionals have joined the IRS from private industry or private practice and bring with them special knowledge of various industries. Moreover, other IRS professionals have developed similar special industry knowledge by working with taxpayers in certain industries. LB&I would like to manage this knowledge throughout its IPGs. Thus, they have asked the Subgroup for examples of how this experience and special knowledge is managed in private practice at accounting firms or law firms.
LB&I has identified the following sub-industries for this initiative:
- Aerospace/Classified/Government Contracts
- Agriculture/Bio Fuels
- Air Transportation
- Alternative Energy
- Banking, Commercial and Savings & Loan
- Chemicals Industry
- Environmental Issues
- Food, Beverage & Hotels
- Forest Products
- High Technology
- Marine Shipping
- Motor Vehicle
- Securities and Financial Services
The Subgroup met with LB&I and discussed several models used in private practice. The sub-industries identified by LB&I were consistent with the private practice groupings. The Subgroup also shared the features of some of the models. A key consistent feature of the models is a webpage or a virtual home space to house the content for each of the sub-industries. For instance, an industry webpage in private practice may include the following:
- Industry thought leadership and events
- Industry articles and news
- Industry trends
- Company profiles
- Subsectors of the industry
- Learning opportunities
- Contact information of group members/directory
The Subgroup discussed how this model could apply to LB&I and concluded that articles, industry trends, subsectors, learning opportunities, and a member directory would be the most appropriate content to adopt initially as the information would be readily available.
Beyond the home space model, the Subgroup also discussed with LB&I some ideas about how each one of its sub-industry groups could be developed using information from taxpayers, external industry groups, and practitioners. A few of the ideas that were shared included:
- Deploying IRS professionals effectively so they receive the proper industry experiences. This is important to continue their professional development and their utility to the industry group.
- Providing internal industry training to supplement the experiences noted above.
- Participating in outside training and outside industry groups to further develop industry knowledge and expertise. For instance, IRS Counsel has a contract with Practising Law Institute (PLI) that allows its employees to participate in conferences on-line at no cost.
- Reading identified industry treatises and journals.
LB&I should consider how these ideas best apply to its unique mission. The Subgroup believes that there are several benefits to adopting this approach:
- LB&I will be better prepared to identify industry trends that could affect tax administration.
- Taxpayers will be able to work with LB&I professionals who have better knowledge of their industry.
- Both LB&I and taxpayers may experience more focused examinations.
- LB&I professionals will be able to develop their careers and personal “brand” as a person with specific industry knowledge.
- LB&I should assemble a list or poll of its professionals to ascertain what knowledge and experience they have within the identified sub-industries.
- LB&I should construct a web page or home space for each sub-industry which would include some of the resources and information identified above as appropriate and assign a knowledge manager to each sub-industry who would be responsible for maintaining the content.
- LB&I headquarters should get a central subscription to the industry tax and audit guides offered by AICPA at low cost, possibly requesting that the AICPA provide to government employees at no charge.
- LB&I should encourage employees to join and become active within industry groups and professional associations, which often offer discounted memberships for government employees. We note that there are budget and policy constraints that may preclude reimbursing for individual memberships. Therefore LB&I should explore whether central or no cost memberships could be negotiated with these groups.
- IRS should expand the present contract that Chief Counsel has with PLI to include LB&I so that its employees may participate in conferences on-line.
- LB&I should identify the particular members of the taxpayer community (e.g., companies, industry groups, practitioners, etc.) from which they would like to gain greater industry knowledge. LB&I should then use the information from this community to develop its industry home spaces with industry materials and, perhaps, establish joint educational programs with this community.
- In addition to the formal educational programs, LB&I should pursue and establish contacts to work on industry projects and initiatives on an informal basis
ISSUE THREE: SCHEDULE M-3
The completion of Schedule M-3 represents a significant compliance burden for taxpayers. The Subgroup questions whether the considerable resources needed to complete and use the form is commensurate with the benefit derived by the IRS through a reduction in audit time or increase in issue identification. We recommend that Parts II and III of the form be replaced with Schedule M-1.
Schedule M-3 is required to be filed as part of the annual income tax return for corporate taxpayers and certain partnerships, with assets of $50 million or more. It was first introduced for tax years ending on or after December 31, 2004 for taxpayers with assets of $10 million or greater and replaced Schedule M-1 which required a detail of items where book treatment differed from tax treatment.
Schedule M-3 has three parts. Part I requires a reconciliation of book income reported on the tax return to income reported in the taxpayer’s financial statements. Parts II and III require a reconciliation of book income to taxable income and require that the differences be categorized by the descriptions on the approximately sixty line items of Part II (for income items) and Part III (for expense items). The book amount is reported in Column (a); the difference between the book amount and taxable amount is reported in Column (b) if temporary or Column (c) if permanent; and the taxable amount is reported in Column (d). As has been noted in early discussions that the IRS had with taxpayer groups when the schedule was being developed, the lines in Parts II and III do not correspond to items in a taxpayer’s general ledger nor do they necessarily correspond to line items on page one of the tax return and therefore, there is much work required in mapping from the general ledger to those lines. This initial outlay of resources is further exacerbated by the fact that taxpayers frequently make changes to their chart of accounts in their general ledgers and that the Schedule M-3 lines have changed over time both of which require additional mapping time by taxpayers. Also, since 2004 Schedule M-3 has been changed to require detailed reporting of book and tax amounts for cost of goods sold, research and development expenses, and interest income and interest expense.
The Schedule M-3 was introduced to provide uniform reporting of book tax differences and was to be used by the IRS as a risk assessment tool in selecting taxpayers and issues for audit. However, the Subgroup questions whether this has in fact happened. Instead there is much audit time spent auditing Parts II and III to ensure that Column (a) amounts can be traced back to the general ledger. IRS auditors have asked for the mapping of the book amounts from the general ledger to each line of Parts II and III. Given that there are over 50 lines and that each line may be a combination of many general ledger accounts, there is considerable effort spent by the taxpayer in preparing Parts II and III (as noted above) and by the IRS auditor in reviewing the mapping. The time spent in such a review of the mapping by the auditor leaves less time for a review of the substantive issues that may underlie the amounts disclosed on the form.
After the issuance of Schedule UTP applicable for 2010 tax years the IRS undertook a study to see if the Schedule M-3 should be revised. The IRS asked for comments from taxpayers. Both the AICPA and Tax Executive Institute (TEI) submitted comments in 2011 that echo those of the Subgroup: the form takes a lot of time to complete; it is not being used effectively by the IRS in their audits; and thus it represents a burden to taxpayers and the IRS. (Copies of the comments letters are included in Exhibit B). One of the outcomes of the study was that in May 2013 the IRS announced that taxpayers (other than insurance companies and any related companies) with between $10 million and $50 million of assets may choose to complete Schedule M-1 in lieu of Parts II and III of Schedule M-3. Such taxpayers represent over 50 percent of the Schedule M-3 filers and such a change in filing requirements will represent a significant burden reduction.
- Part I of Schedule M-3 that reconciles the book income reported in the tax return to that reported in the financial statements provides necessary information many taxpayers compile as a compliance check in preparing their business tax returns. Before the issuance of Schedule M-3, the information required in Part I was usually requested by IRS auditors as part of an examination. That section of the schedule should be maintained.
- Parts II and III of the schedule should be eliminated and replaced with Schedule M-1. We note that the Schedule M-3 study that the IRS conducted contained this recommendation for taxpayers having assets between $10 and $50 million and believe that the burden should also be alleviated for larger taxpayers. We also note that all corporate taxpayers with assets of $50 million or greater are required to disclose uncertain tax positions on Schedule UTP. The information provided by this schedule can be used to risk assess large taxpayers in lieu of the Schedule M-3.
- The Schedule M-1 could be supplemented by requiring disclosure of book and taxable amounts of certain high risk items. These might include those that are prone to differences in interpretation and judgment calls as well as those that involve detailed computations. Additionally, the form could include yes/no questions that indicate if the return contains certain transactions or high risk issues in excess of a stated amount without requesting the book and taxable amount.
- In our discussions with LB&I management we were informed that there are other government stakeholders including Congressional committees and other agencies who have expressed concerns about removing information from the form. Given the significant burden that completion of the form places on taxpayers, we strongly suggest that the IRS determine how the data is being used and determine if the Subgroup’s recommended revisions would satisfy those information needs.