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2015 IRSAC Large Business and International Report

INTRODUCTION/EXECUTIVE SUMMARY

The IRSAC LB&I Subgroup (hereinafter “Subgroup”) consists of four 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 Doug O’Donnell and the professionals on his 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 five issues:

1.   Improving Penalty Administration - General Comments and Recommendations

IRSAC believes that two general goals should undergird the enactment and the IRS’ administration of the Internal Revenue Code’s penalty provisions:

  • Ensuring that penalties are proportionate to the taxpayer’s errors or misconduct; and
  • Ensuring that penalties be designed, interpreted, and applied in a manner that encourages compliance and self-correction.

To this end, IRSAC urges the IRS to limit the automated assertion (or collection) of penalties and, more broadly, to interpret and administer the statutory reasonable cause exception that exists for many penalties in a manner that strengthens rather than diminishes the fairness of the tax system. Specific recommendations are set forth in Issues Two, Three, and Four.

2.  Penalty for Erroneous Claim for Refund or Credit

To combat IRS concerns about abusive refund claims, in 2007 Congress enacted section 6676, which imposes a penalty for excessive claims that lack a reasonable basis. While appreciating the overarching goal of the relatively new penalty, IRSAC is concerned about the potential application of the penalty in non-abusive situations. For this reason and because a forthcoming change in LB&I examination policy that will likely prompt more formal refund claims, this report makes several recommendations to reduce the likelihood of inappropriate assertion of the penalty.  

 3.  Application of Qualified Amended Return Rules to Regularly Examined Taxpayers in a Post-CIC Environment

The IRS’ procedures relating to qualified amended returns (including Rev. Proc. 94-69 which applies to Coordinated Industry Case (CIC) taxpayers) provide taxpayers the means to avoid potential penalties by making disclosures after the filing of an original return. Because LB&I’s phasing out of the CIC program (in favor of a risk-assessment focus on issues) could effectively render Rev. Proc. 94-69 moot, the incentive to self-correct errors discovered after the filing of an original return may disappear. In this report, IRSAC recommends that LB&I develop a new procedure to preserve the benefits of Rev. Proc. 94-69 and, indeed, possibly expand them to a broader group of taxpayers that, while not part of the CIC program, could respond positively to an incentive for self-correction.

4.  International Information Return Penalties

The Internal Revenue Code provides a $10,000 penalty for the failure to timely file certain international information returns, even when there is no underreporting of income or underpayment of tax liability. When a taxpayer files one of these forms delinquently, the IRS may assess the penalty immediately and the collection process may begin. Taxpayers may seek abatement of the penalty when the delinquency is due to reasonable cause and not willful neglect. Our recommendations concern ways to ensure that the penalties are applied to bad conduct and not to innocent errors.

5. Implementation of the Tangible Property Regulations

At the request of LB&I, IRSAC developed recommendations for risk assessment, examination approach, and additional guidance related to taxpayer implementation of the Tangible Property Regulations (TPR).

 

ISSUE ONE: IMPROVING PENALTY ADMINISTRATION - GENERAL COMMENTS AND RECOMMENDATIONS

Executive Summary

IRSAC believes that two general goals should undergird the enactment and the IRS’ administration of the Internal Revenue Code’s penalty provisions:

  • Ensuring that penalties are proportionate to the taxpayer’s errors or misconduct; and
  • Ensuring that penalties be designed, interpreted, and applied in a manner that encourages compliance and self-correction.

To this end, IRSAC urges the IRS to limit the automated assertion (or collection) of penalties and, more broadly, to interpret and administer the statutory reasonable cause exception that exists for many penalties in a manner that strengthens rather than diminishes the fairness of the tax system. Specific recommendations are set forth in Issues Two, Three, and Four.

Background

In 1954, there were only 14 civil tax penalties in the Internal Revenue Code. Today, there are more than 10 times that number, with new (or increased) penalties being enacted seemingly every year.[1] While Congress in last enacting major penalty reform in 1989 embraced several principles that — if adhered to — would advance good tax administration,[2] penalty provisions continue to proliferate. Good intentions notwithstanding, the enactment of new or increased penalties provisions seems inevitable. Earlier this year, for example, Congress increased several information return penalties as part of the Trade Preferences Extension Act of 2015 even though those provisions have no substantive bearing on the underlying legislation.[3]

This is not to suggest that enactment of new penalties is always or even often unjustified. Far from it. The enactment of new substantive programs - such as the Affordable Care Act - invariably brings with them the need for penalties to help effectuate the purposes of those programs. Too many penalties, or overlapping, or ill-designed penalties, however, can have an adverse effect on tax administration. In recent years, there has been no shortage of reports documenting the need and making specific recommendations for streamlining and otherwise generally improving the penalty provisions of the Internal Revenue Code. In the quarter century since the Improved Penalty Administration and Compliance Tax Act was passed, the National Taxpayer Advocate, the Government Accountability Office, the Treasury Inspector General for Tax Administration, professional associations such as the American Institute of Certified Public Accountants and the American Bar Association’s Section of Taxation, and the IRSAC itself have all called for an overhaul of the Code’s penalty provisions.

Virtually every one of these reports has affirmed that the sole purpose of civil tax penalties should be to encourage voluntary compliance, not to raise revenue, punish noncompliant behavior, or reimburse the government for the cost of compliance programs. Reaching back to IRS reports that led to IMPACT, the 2008 report of the National Taxpayer Advocate effectively analyzes both the history of penalties (and penalty reform) and forcefully sets forth the principles that should animate future reform efforts.[4]

Rather than repeat that discussion here, IRSAC simply reiterates its support for broad-based penalty reform and, in particular, for the paramount importance of two goals of future legislative and regulatory efforts in the area:

  • Ensuring that penalties are proportionate to the taxpayer’s errors or misconduct; and
  • Ensuring that penalties be designed, interpreted, and applied in a manner that encourages compliance and self-correction. [5]

Providing appropriate incentives to self-correct (and reducing disincentives to do nothing when the taxpayer discovers prior noncompliance) will advance the cause of sound tax administration.

Recommendation

IRSAC recommends that the IRS not only continue to oppose the enactment of automatic, no-fault (or strict liability) penalties, but that it also take steps to limit the automated assertion (or collection) of penalties. In addition, IRSAC strongly recommends that the IRS interpret and administer the statutory reasonable cause exception to many penalties in a manner that strengthens rather than diminishes the fairness of the tax system.

We recognize that the structure of many penalties in the Code may constrain the IRS’ authority to act and, further, that the agency has been criticized for either not asserting certain penalties or for abating them.[6] That said, experience teaches that the IRS is not powerless to improve the implementation and fair administration of the Code’s penalty regime.[7] IRSAC recommends that the agency both provide agents and managers with the discretion to abate (or not even assert) penalties in appropriate cases and enable the proper exercise of that discretion by providing the training necessary to achieve that goal. As the Taxpayer Advocate has noted in numerous reports, failure todo so will undermine taxpayer confidence in the fairness of the administration of the tax system.

In the ensuing sections of this report, we set forth specific examples of where IRSAC believes the IRS should act.

 

ISSUE TWO: PENALTY FOR ERRONEOUS CLAIM FOR REFUND OR CREDIT

Executive Summary

To combat the filing of abusive refund claims, in 2007 Congress enacted section 6676, which imposes a penalty for excessive claims that lack a reasonable cause. While appreciating the overarching goal of the relatively new penalty, IRSAC is concerned about the potential application of the penalty in non-abusive situations. For this reason and because a forthcoming change in LB&I examination policy that will likely prompt more formal refund claims, this report makes several recommendations to reduce the likelihood of inappropriate assertion of the penalty.  

Background

A.        Background of the Penalty

Congress enacted a penalty on erroneous claims for refund or credit as part of the Small Business and Work Opportunity Tax Act of 2007. Codified in section 6676 of the Internal Revenue Code, this relatively new provision provides that if “a claim for refund or credit with respect to income tax . . . is made for an excessive amount” the taxpayer making such claim “shall be liable for a penalty in an amount equal to 20 percent of the excessive amount,” unless the claim for such excessive amount “has a reasonable basis.” See I.R.C. § 6676(a). The penalty applies to claims for refund filed after May 25, 2007.

The section 6676 penalty was enacted after the IRS attributed an increase in the number of “abusive refund claims” by corporate taxpayers to the absence of such a penalty.[8] In endorsing enactment of the penalty, the Senate Finance Committee said:

[T]he filing of erroneous refund claims is being used by some taxpayers to put a strain on IRS resources and to delay the resolution of tax matters. The Committee believes a meaningful penalty on a refund claim with no reasonable basis for the claimed treatment will deter the use of such claims for the purpose of impeding effective tax administration.[9]

Regrettably, section 6676 provides little guidance on when or how the penalty should apply, and no Treasury regulations have yet been promulgated to interpret it. The statute explains that the “excessive amount” upon which the penalty is imposed is the amount by which the claim exceeds the amount allowable,[10] but does not define the term “reasonable basis,” other than to provide (by virtue of a 2010 amendment) that transactions lacking “economic substance” shall not be treated as having a reasonable basis. See I.R.C. § 6676(c).[11]

The Internal Revenue Manual (IRM) includes guidance on section 6676 that makes the penalty particularly severe. Perhaps most notably, the statutory reasonable cause defense does not apply to this penalty.[12] While taxpayers can avoid a penalty on a position taken in a refund claim by showing a “reasonable basis” for the position, that standard is an objective one that considers only whether the position was supported by a certain level of authority (as contrasted with the “reasonable cause” standard, which has a subjective component).[13] Thus, as interpreted by the IRS, the taxpayer’s effort to comply with the tax law is irrelevant to whether the penalty applies.[14] The reasonable basis/reasonable cause distinction is especially important in connection with emerging issues for which there is little authority.

In addition, the IRS has concluded that deficiency procedures do not apply to penalties imposed under section 6676.[15] Thus, to contest the penalty in court, taxpayers must first fully pay the liability and (somewhat counter-intuitively) file a refund claim before seeking review in a U.S. District Court or the U.S. Court of Federal Claims.[16]

Most of the guidance that has been issued on the penalty is summarized in the IRM and a set of 14 frequently asked questions initially made available to examiners.[17] The FAQs contain helpful guidance, including the statement that the penalty only applies to claims for refund or credit with respect to income tax and not to other types of taxes such as excise tax. The FAQs also state that the penalty applies to both formal and informal refund claims.

The IRM puts some taxpayer protections in place. Examiners must obtain managerial approval to open a penalty examination and, as required by section 6751(b), obtain managerial approval to assert the penalty. The IRM also instructs examiners to offer taxpayers a meeting with the manager to discuss the un-agreed issue. Finally, the IRM explains that taxpayers may contest the penalty at appeals.

Many questions, however, remain unanswered, such as whether the IRS will apply the penalty on “protective” refund claims, whether it applies to claims for interest or penalties related to income tax, and whether there is a statute of limitations on the time that the IRS has to assess the penalty.

B.        Application of the Penalty

In a 2013 report, TIGTA reported that the IRS “assessed only 84 erroneous refund penalties totaling $1.9 million between May 2007 and May 2012.”[18] There is reason to believe, however, that the section 6676 penalty is proposed by exam in many more cases than reflected in the TIGTA report, in part because experience teaches that numerous penalties have been proposed by exam but conceded by appeals. There are several indications that the penalty may be asserted more in future exams:

  • The IRM was revised in early 2012 to require examiners to document the basis for non-assertion of the penalty when claims are disallowed. See I.R.M. 20.1.5.16.2(13) (stating that a “standard statement such as ‘Erroneous claims penalty deemed not applicable’ is not sufficient.”). Further, the examiner’s manager must sign off on the decision not to assert the penalty when a substantial portion of the claim for refund or credit is disallowed. Id.
  • In response to the 2013 TIGTA report, the IRS formed a cross-representational team of affected stakeholders to determine the operational and procedural changes needed to integrate assessment of the erroneous refund penalty into the campus environment.
  • In a 2013 report, the AICPA concluded that the penalty was “being imposed automatically and regularly when a claim for refund is denied, without any consideration of whether the position has a reasonable basis.”[19]
  • Finally, the changes announced by LB&I in draft Publication 5125 regarding requirements for refund claims, discussed immediately below, have focused the attention of affected taxpayers on such claims.

C.        Refund Claims by LB&I Taxpayers

Corporate taxpayers typically file refund claims following the discovery of new facts or changes in relevant law. Regarding the former, many large taxpayers do not expect their original returns to be final because they do not have all the information necessary to accurately complete their returns when they are due. For example, information from passthrough entities may be provided to the taxpayer too late in the filing season to be reflected on the original return; similarly, information from foreign related entities with different reporting periods, or information regarding state taxes, may not be received in time to be reflected on the original returns. These corporate taxpayers anticipate they will need to make adjustments to the original return.

Most corporate taxpayers subject to continuous audit under the Coordinated Industry Case (CIC) program make refund claims “informally.” An informal claim typically consists of a short explanation of the favorable adjustment without any tax computation and is provided to the exam team at the commencement of or during the audit. Corporate taxpayers prefer this process to avoid the administrative and computational burdens that would be associated with filing formal refund claims on Form 1120X or Form 843, especially since such computations would likely be superseded by the final computations necessary to close an audit.

Taxpayers occasionally first report positions on refund claims for strategic reasons. Some corporate taxpayers prefer to test uncertain positions in refund claims because such claims were generally thought to be immune from penalties before the enactment of section 6676. This process does hold some benefit for the IRS, since a refund claim “must set forth in detail each ground upon which [it] is claimed and facts sufficient to apprise the Commissioner of the exact basis thereof,”[20] a more exacting standard than applies to positions reflected on a large corporate taxpayer’s original return. Moreover, in the claims context, the Treasury has the taxpayer’s payment for which it is claiming a refund, whereas in the original return situation the Treasury will never obtain those funds (even temporarily) if the uncertain position escapes audit detection or is ultimately sustained.

IRSAC appreciates that some corporate taxpayers have strategically raised informal claims late in the examination process as a means of distracting the examination team. In late 2014, LB&I released a draft of new rules intended to impede taxpayers from strategically using refund claims to distract the examination team from other issues or perhaps to offset any possible deficiency that might arise out of the audit. (As noted, such concerns seemingly played a role in enacting section 6676.) LB&I explained the new procedure in draft Publication 5125 (which was released in July 2014):

Expectations with Respect to Claims

To deploy our resources efficiently, all claims for refund should be brought to the attention of the exam team as soon as the taxpayer becomes aware of any potential overpayments of tax. LB&I will only accept informal claims that are provided to the exam team within 30 days of the opening conference. After the 30-day period, claims for refund must be filed using either Form 1120X or Form 843 with supporting documentation. Claims filed after the 30-day window create resource challenges and may result in unnecessary refund litigation which reasonably can be avoided if taxpayers act in a timely fashion.

All claims must meet the standards of Treasury Regulation Section 301.6402-2, which provides that a valid claim must:

    • Set forth in detail each ground upon which credit or refund is claimed
    • Present facts sufficient to apprise the IRS of the exact basis for the claim and
    • Contain a written declaration that it is made under penalties

Transparent and cooperative taxpayers will provide fully documented and factually supported claims that may permit the exam team to make a tax determination of the claims without requiring the use of IDRs. This will allow the exam team to quickly determine whether to accept or examine a claim. Claims will be risk assessed in the same manner as any other audit issue. If the claim warrants examination, the exam team and the taxpayer will discuss the potential need for additional resources, and extend the examination timeline, as necessary[,] or LB&I could decide that the claim will be worked separate from the current examination. Claims will be disallowed for failing to meet the standards of Treasury Regulation Section 301.6402-2.

The Subgroup is concerned that the process envisioned by draft Publication 5125 for handling refund claims after the beginning of an examination may make assertion of the erroneous refund claim penalty more common and lead to imposition of penalties in cases where taxpayers are not trying to misdirect audit resources.

Recommendations

The IRSAC recommends that for any refund claim filed by a taxpayer within 30 days of the opening conference an examiner be required to obtain approval to assert the penalty from the pertinent Director of Field Operations, and that affected taxpayers be offered a conference with the DFO before assertion of the penalty.[21] Such a rule would not frustrate the congressional intent undergirding section 6676 (or the goal of draft Publication 5125) — deterring taxpayers from filing refund claims late in the audit cycle for strategic advantage — while both ensuring that taxpayers are not unfairly penalized and providing taxpayers with an additional incentive for filing claims early in the cycle.

Moreover, the IRSAC recommends that the IRS consider the timing of the claim in assessing whether the taxpayer had a reasonable basis for the claim. Section 6676 was clearly prompted by concern over the burden caused by late filed claims, and although neither the statute nor any Treasury regulation defines “reasonable basis” for purposes of section 6676, the IRSAC believes the IRS has discretion to define a clause intended to prevent unjustified penalties in a manner that takes account of the concerns that gave rise to the penalty. Sound tax administration is served, not undermined, when taxpayers are transparent regarding their uncertain positions and the IRSAC thus believes the IRS should encourage not discourage taxpayers from testing positions in refund claims — with the attendant level of disclosure inherent in such claims — so long as the claims are provided to the IRS in a time and manner that do not impede the audit.

Alternatively, we recommend that the IRS seek a legislative change to allow taxpayers to avoid the erroneous refund claim penalty if they acted reasonably and in good faith. The Taxpayer Advocate has endorsed this ameliorative change in her 2011 and 2014 annual reports to Congress. In the more recent report, the Taxpayer Advocate explained that the Office of Chief Counsel (Procedure and Administration) likewise recommended that change in suggestions for the Treasury’s 2012 Green Book.

 

ISSUE THREE: APPLICATION OF QUALIFIED AMENDED RETURN RULES TO REGULARLY EXAMINED TAXPAYERS IN A POST-CIC ENVIRONMENT

Executive Summary

The IRS’ procedures relating to qualified amended returns (including Rev. Proc. 94-69 which applies to Coordinated Industry Case (CIC) taxpayers) provide taxpayers the means to avoid potential penalties by making disclosures after the filing of an original return. Because LB&I’s phasing out of the CIC program (in favor of a risk-assessment focus on issues) could effectively render Rev. Proc. 94-69 moot, the incentive to self-correct errors discovered after the filing of an original return may disappear. In this report, IRSAC recommends that LB&I develop a new procedure to preserve the benefits of Rev. Proc. 94-69 and, indeed, possibly expand them to a broader group of taxpayers that, while not part of the CIC program, could respond positively to an incentive for self-correction.

Background 

Rev. Proc. 94-69, 1994-2 C.B. 804, provides special procedures for taxpayers subject to the IRS’ large-case program (formerly named the “Coordinated Examination Program” but currently the Coordinated Industry Case (CIC) program) to show additional tax due or make adequate disclosure with respect to an item or a position to avoid imposition of certain accuracy-related penalties. The revenue procedure treats a written statement containing certain required information provided by CIC taxpayers to the IRS within 15 days of request (or otherwise agreed time on a showing of reasonable cause) as a “qualified amended return” for purposes of the negligence, disregard of rules and regulations, and substantial understatement penalties.

A qualified amended return (QAR) is an amended return filed after the due date of the original return but before the happening of certain events, including the date the taxpayer is first contacted by the IRS concerning an examination of the return. See Treas. Reg. § 1.6664-2(c)(3). The effect of a qualified amended return is that the amount of tax shown on the qualified amended is included in the amount of tax shown on the original return for purposes of computing any underpayment. See Treas. Reg. § 1.6664-2(c)(2). The QAR rules are intended to encourage transparency by encouraging taxpayers to self-correct errors discovered after the filing of an original return.

The predecessor to Rev. Proc. 94-69 (Rev. Proc. 85-26, 1985-1 C.B. 580) explained that in the case of a large-case taxpayer, “the time of the first contact concerning an examination of the return is not an appropriate criterion” for allowing such a taxpayer to file a qualified amended return “because, generally, all returns of CEP [now CIC] taxpayers are examined.” It therefore provided that a disclosure, made within the time frame specified in the revenue procedure, would be treated as having been made on a qualified amended return. Rev. Proc. 94-69 cautions, however, that the ameliorative relief provided would cease (after a safe harbor period) to any taxpayer that “no longer meets the criteria for a CEP taxpayer.” The disclosure procedure set forth in Rev. Proc. 94-69 effectively encouraged a continuously audited taxpayer to disclose errors while avoiding the cost and administrative burdens entailed in filing a formal amended return, which could likely trigger correlative burdens related to state, foreign, and financial reporting requirements.

In late 2014, LB&I officials announced that LB&I intends to move away from the CIC program toward centralized risk assessments. LB&I officials have explained their expectation that the new program will stop continuous audits for some CIC taxpayers, while acknowledging that certain large taxpayers will continue to be continuously audited by virtue of their size or other demographic attributes, notwithstanding any eventual termination of the CIC program. Absent clarification, the elimination of the CIC program would concomitantly eliminate the option of making disclosures pursuant to Rev. Proc. 94-69.

Recommendation

Underlying the qualified amended return rules of Treas. Reg. § 1.6664-2(c) and Rev. Proc. 94-69 is a recognition that a large taxpayer’s understanding of the operative facts underlying a transaction (or position) and the state of the governing legal rules could change between the time a return is filed and its examination. The rules also recognize that it would be unfair and even counterproductive to penalize a taxpayer in such a situation. Hence, they provide an incentive — in the form of penalty relief — for the taxpayer to self-correct erroneous return positions. Without the relief afforded by Rev. Proc. 94-69, a taxpayer discovering an error — say, upon preparing a subsequent year return or its financial statements — would have no incentive to correct or even disclose it unless it were willing to accept the burden of preparing a formal QAR.

The IRSAC is concerned that, absent the development of a new procedure, LB&I’s phasing out of the CIC program would render Rev. Proc. 94-69 inapplicable and greatly diminish, if not eliminate entirely, the existing incentive for self-correction. Obviously, if the CIC program were ended, a taxpayer could still make a valid disclosure by filing an actual qualified amended return. Given the administrative burdens of filing a formal amended return (including correlative burdens related to satisfying state, foreign, and financial reporting filing requirements), the IRSAC believes there is significant potential for the number and quality of disclosures to decline. We therefore recommend that the LB&I develop a new procedure to preserve the benefits of Rev. Proc. 94-69 and, indeed, possibly expand them to a broader group of taxpayers that, while not part of the CIC program, could respond positively to an incentive for self-correction. Since the contours of LB&I’s reorganization are still being formulated, it is not possible to make specific recommendations at this time. IRSAC recommends therefore that this issue be carried over to the LB&I subgroup’s 2016 agenda.

 

ISSUE FOUR: INTERNATIONAL INFORMATION RETURN PENALTIES

Executive Summary

The Internal Revenue Code provides a $10,000 penalty for the failure to timely file certain international information returns, even when there is no underreporting of income or underpayment of tax liability. When a taxpayer files one of these forms delinquently, the IRS may assess the penalty immediately and the collection process may begin. Taxpayers may seek abatement of the penalty when the delinquency is due to reasonable cause and not willful neglect. Our recommendations concern ways to ensure that the penalties are applied to bad conduct and not to innocent errors.

Background

Section 6038 and the applicable regulations require U.S. persons with a certain level of control in certain foreign corporations to file a Form 5471, “Information Return of U.S. Persons With Respect To Certain Foreign Corporations,” reporting information with respect to each of such foreign corporations. The Forms 5471 must be filed with the U.S. person's income tax return on or before the date required by law for the filing of that person's income tax return. Section 6038(b)(1) provides for a monetary penalty of $10,000 for each Form 5471 that is filed after the due date of the income tax return (including extensions) or does not include the complete and accurate information required by section 6038(a). In addition to the monetary penalty, section 6038(c) provides for a 10% reduction of the foreign taxes available for credit under sections 901, 902, and 960.

Following the enactment of FATCA, the IRS began automatically asserting section 6038 penalties on late filed Forms 1120 that had Forms 5471 attached. While taxpayer exposure to penalties for late filed Forms 5471 was not new, the IRS had not historically focused on section 6038 penalties for this type of late filed information returns. Typically, the penalty was considered under examination when an unfiled Form 5471 was discovered. However, with more Forms 1120 being electronically filed, the IRS is able to determine quickly which returns with Forms 5471 attached are late filed, and to identify late Forms 5471.

Later, the IRS added late Forms 5472, “Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business,” to the same program. Section 6038A requires U.S. corporations with a certain level of foreign ownership to file Forms 5472 to report information with respect to transactions with related parties, and section 6038C requires foreign corporations engaged in U.S. business to file Form 5472 reporting similar information.

Like Form 5471, Form 5472 must be filed with the U.S. corporation’s Form 1120 (or foreign corporation’s Form 1120-F) on or before the date required by law for the filing of corporation’s return. Similarly, there is a penalty of $10,000 for each Form 5472 that is filed after the due date of the income tax return (including extensions) or that does not include the complete and accurate information.

Unlike the penalty for the failure to file income tax returns (under section 6651(a)(1)), which is based on the tax shown on the return, the penalties for late filed Forms 5471 and 5472 apply even if no tax is due on the Form 1120. That said, taxpayers may avoid these penalties if reasonable cause exists for the failure to file timely the Forms 5471 and 5472. In addition, penalties asserted for omissions of, or errors with respect to, information contained in otherwise timely filed Forms 5471 and 5472 may be avoided if the taxpayer can show substantial compliance with the information reporting requirements.

Obtaining abatement of the penalty, however, is frequently difficult, even for benign and essentially inconsequential failures (or late filings). First, the IRS unit assigned to review the abatement request often is unable to do so in a timely manner. The present budget and resource constraints within the IRS only exacerbate this situation. Second, because the tax may be assessed immediately, the taxpayer often has to deal with IRS collection (rather than the compliance function), where the volume of work and training provided to the personnel could affect the quality of the reasonable cause review. Often, the taxpayer must request repeated stays of collection to allow for consideration of the abatement request.

Finally, there can be inconsistent consideration of the abatement requests. “Reasonable cause” can be very fact specific, and thus, there can be differing results for similarly situated taxpayers. When this happens, the taxpayer may be forced to seek an administrative appeal to seek an independent review. All of this not only lengthens the time required to resolve a matter and increases the taxpayer’s cost, but it can consume considerable IRS resources.

Recommendations

1.  Reconsider the automated process (or at least delay assessment until the request for abatement and appeal are final). Assessment triggers the collection process and adds additional pressure to both the IRS and the taxpayer. If the IRS delayed assessment until consideration of the abatement request is final, much of the stress on the IRS system and the taxpayer would be reduced.

2.  Acknowledge innocent errors and not assert (or abate) the penalty. The purpose of the IRS program is to encourage compliance with foreign information reporting, and the assertion of the penalty for minor, often benign, non-volitional failures can be counterproductive. Encouraging voluntary compliance should properly be the sole objective of any penalty regime, and IRSAC does not believe that objective is advanced by the assertion of penalties in these situations since (1) the taxpayers involved are not non-filers, but merely delinquent (often for innocent reasons), (2) they self-correct their compliance without prompting, and (3) the late filing has no adverse effect on the IRS’ need for information or payment of any tax. A few examples of benign noncompliance are —

    • Problem with Filing Extension. The taxpayer files a late or incorrect Form 7004. When it files its return on September 15th, penalties are assessed on all “untimely” Forms 5471, even though they are received by the extended due date.
    • E-filing Problems. The taxpayer has an issue with the e-filing of its return that it cannot resolve until after midnight on September 15th. Again, penalties are assessed.
    • Penalty Is Disproportionate when No (or Little) Tax Due. Common situations are:
      1. Form 5472 for unknown permanent establishment of a small U.S. entity
      2. Late return that reflects a net operating loss

3.  “First Time Abate” Consideration. In many other penalty situations (e.g., failure to file, failure to pay, and failure to deposit penalties), the IRS will abate penalties for a first time failure if the taxpayer has a history of compliance. See I.R.M 20.1.1.3.6.1 (August 5, 2014) “First Time Abate (FTA).” The same policy, i.e., the promotion of voluntary compliance, supporting FTA for those other failures should apply here.

4.  Refine the training provided to agents and managers to facilitate the policy goals underlying the foregoing recommendations.

 

ISSUE FIVE: IMPLEMENTATION OF THE TANGIBLE PROPERTY REGULATIONS

Executive Summary

At the request of LB&I, IRSAC developed recommendations for risk assessment, examination approach, and additional guidance related to taxpayer implementation of the Tangible Property Regulations (TPR).

Background

In September 2013, the Department of the Treasury and the IRS issued final regulations on the application of section 263(a) of the Internal Revenue Code to amounts paid to acquire, produce, or improve tangible property.[22] The regulations, which are generally applicable to tax years beginning after December 31, 2013, apply to all taxpayers who acquire, produce, improve, repair, or dispose of tangible property — virtually all business taxpayers.

To implement many of the changes, taxpayers must submit Form 3115, “Application for Change in Accounting Method.” Given the nearly universal application of the regulations, during the 2014 filing season the IRS received several hundred thousand Forms 3115. LB&I has requested IRSAC’s recommendations on (1) how to risk assess these applications and (2) how to effectively and efficiently examine the ones selected for audit.


Recommendations
 

1.  Risk Assessment. IRSAC recommends that LB&I take into consideration the following factors in selecting applications for accounting method changes for examination. None of these factors should be considered dispositive, but taken collectively in light of the taxpayer’s facts and circumstances, they should facilitate a better use of the IRS’ resources.

    1. General factors:
      1. What is the taxpayer’s industry? The TPR will have a greater effect on manufacturing, retail, and utilities companies because they have many fixed assets. On the other hand, tax-exempt entities, financial services enterprises, and software companies often have fewer fixed assets, so one might expect the TPR to have a smaller effect.
      2. What is the relative size of the taxpayer? While the TPR may significantly affect the largest companies, experience teaches that most of them have a greater awareness of, as well as more resources to implement correctly, the TPR. At the opposite end of the spectrum, smaller companies will also be affected by the TPR, but they may pose less risk to the revenue. Thus, from a risk assessment perspective, mid-sized companies may merit greater attention because they may have many fixed assets but not the wherewithal and means to comply with the many provisions of the TPR.
    2. Taxpayer specific facts:
      1. Did the taxpayer file a TPR Form 3115? Because the TPR will affect almost all business taxpayers, the absence of a single Form 3115 may indicate a compliance risk.
      2. Did the taxpayer file a repair Form 3115 before the issuance of the final TPR? Several years ago before the TPR became final, many taxpayers changed their method of accounting for repairs from capitalization to expensing. Often, these changes reflected large favorable section 481(a) adjustments (i.e., a cumulative adjustment to carve out the repair expenses). The TPR may operate to reverse some of those favorable adjustments, so IRS sensitivity to when the change-in-method application was filed may be warranted.
      3. What type of change is included in the Form 3115? Similar to the last point, current year method changes for repairs or improvements may reflect a larger compliance risk than other changes (e.g., a change for materials and supplies).
      4. Did the Form 3115 have a “zero” section 481(a) adjustment? Most taxpayers will have either a positive or negative cumulative adjustment. Stated generally, the TPR require the taxpayer to review its fixed assets and determine how historic costs should be treated under these new guidelines. A taxpayer’s having no cumulative adjustment may suggest that the taxpayer has made a prospective-only change and not reviewed its historic costs.
      5. In what year were the TPR adopted? Almost all taxpayers are required to implement the TPR no later than their 2014 return. Thus, taxpayers who do not implement the TPR in a timely manner may not be in compliance.
    3. Future risk consideration: Filing of an amended return for 2014 with a more favorable section 481(a) adjustment. LB&I may wish to scrutinize future amended 2014 returns where the taxpayer has increased its section 481(a) adjustment to claim a significant refund. The claim will be made after the initial consideration of implementation of the TPR and guidance thereunder. Thus, the taxpayer’s amended return may signal reliance on a new or creative position not originally anticipated when the TPR were implemented.

2.  Observations about the examination of TPR implementation.

    1. Discuss the taxpayer’s specific situation with them. While the TPR will apply to nearly all business taxpayers, their effect will vary broadly. There are more than 20 potential method changes to be considered in the TPR. Some will be fairly common while others will not. Consideration of questions such as the following may shed light on the level of the taxpayer’s TPR compliance:
      1. Describe the process used in assessing the implications of the TPR for your business.
      2. Which methods did you adopt (or not adopt)? Why?
      3. How did you document this analysis?
        1. Did you engage with any tax professionals to assist in the implementation?
        2. Did your advisers provide you with any recommendations? In what form did you receive those recommendations?
        3. If you follow the recommendations received? If not, why?
    2. Review the Forms 3115 and, specifically, the section 481(a) computations. Because the TPR may affect particular taxpayers in unique ways, scrutiny of the taxpayer’s implementation process and computations may be appropriate. Moreover, the quality of the taxpayer’s work around the implementation may be apparent from a close review of these items.
    3. Examination procedures for repairs, improvements, and dispositions where records are not readily available. The examination of adjustments made for repairs and dispositions where historical records are incomplete or not available may be a challenge. Although the TPR described how historical calculations should be performed in such cases, the specified methods may result in overstatement of costs and disparity between taxpayers in the same industry.  IRSAC recommends that LB&I review and adopt some of the techniques described in the IRS’ Cost Segregation Audit Technique Guide.[23] Specifically, Chapter 4 of the Guide outlines the elements of a Cost Segregation Study, and many of the areas discussed are directly relevant to the implementation of the TPR. Additionally, the Audit Technique Guide discusses the use of interviews with Subject Matter Experts (SMEs) as a form of support in Chapter 4.4. Further guidance on application of this concept to determination of repairs and dispositions is recommended.
    4. Recommended guidance on establishing a capitalization policy that “clearly reflects income.” Section IV of T.D. 9636 addresses the de minimis safe harbor exception permitting a taxpayer to deduct certain amounts paid for tangible property. For taxpayers with an audit financial statement, the de minimis threshold is set at $5,000 per invoice (or item). For taxpayers without an audited financial statement, the amount is set at only $500 per invoice (or item), or an amount that “clearly reflects income.” IRSAC recommends that the IRS consider further guidance on the definition of “clearly reflects income” in this context. Many mid-sized companies, particularly S-corporations and partnerships, do not have audited financial statements, but nevertheless rely on the practices of companies with financial statements in adopting a $5,000 deduction policy. Although this may be appropriate for many taxpayers, it represents an increase from prior capitalization policy thresholds resulting in significant deductions and bears scrutiny.


[1] In 2008, the National Taxpayer Advocate pegged the number of civil tax penalties at more than 130, and by last year, her count reached 170. Taxpayer Advocate Service, Internal Revenue Service, National Taxpayer Advocate: 2008 Annual Report to Congress, Vol. 2 (section entitled “A Framework for Reforming the Penalty Regime”) (2008) (hereinafter “2008 Taxpayer Advocate Report”), at 4; Taxpayer Advocate Service, Internal Revenue Service, National Taxpayer Advocate: 2014 Annual Report to Congress (2014), at 10; see generally Jeremiah Coder, Achieving Meaningful Civil Tax Reform and Making It Stick, 27 Akron Tax Journal 153 (2012).
[2] Improved Penalty Administration and Compliance Tax Act (IMPACT), Public Law No. 101-239, 101st Cong., 1st Sess. (1989) (subtitle G of the Omnibus Budget Reconciliation Act of 1989).
[3] § 806, Public Law No. 114-27, 114th Cong., 1st Sess. (2015) (amending I.R.C. §§ 6721 & 6722).
[4] 2008 Taxpayer Advocate Report. IRSAC’s 2009 report included a section captioned “Enhancing Voluntary Compliance through Civil Tax Penalty Reform.” Reports issued between 2008 and 2012 are summarized in Jeremiah Coder, Achieving Meaningful Civil Tax Reform and Making It Stick, 27 Akron Tax Journal 153 (2012).
[5] The Taxpayer Advocate’s 2008 report identified the following principles for evaluating whether penalties encourage voluntary compliance: perception of fairness, horizontal equity (“treating similarly situated taxpayers similarly”), proportionality (“the punishment should fit the crime”), procedural fairness (“don’t shoot first and ask questions later”), comprehensibility, effectiveness, and ease of administration. 2008 Taxpayer Advocate Report at 7-10.
[6] See Treasury Inspector General for Tax Administration, Improvements Are Needed in Assessing and Enforcing Internal Revenue Code Section 6694 Paid Preparer Penalties, Report No. 2013-30-075 (September 9, 2013); Treasury Inspector General for Tax Administration, Systemic Penalties on Late-Filed Forms Related to Certain Foreign Corporations Were Properly Assessed, but the Abatement Process Needs Improvement, Report No. 2013-30-111 (September 25, 2013); Treasury Inspector General for Tax Administration, The Law Which Penalizes Erroneous Refund and Credit Claims Was Not Properly Implemented, Report No. 2013-40-123 (September 26, 2013).
[7] For example, earlier this year, the IRS issued interim guidance limiting potential penalties for a taxpayer’s failure to file Foreign Bank and Financial Account Reports (FBARs), assuaging taxpayer concerns that the IRS might penalize taxpayers in excess of the value of their unrelated accounts. See Memorandum for all LB&I, SB/SE, and TE/GE Employees, Interim Guidance for Report of Foreign Bank and Financial Account (FBAR) Penalties, SBSE-04-0515-0025 (May 13, 2015) (memorandum issued by Commissioners of LB&I, SB/SE, and TE/GE).
[8] See Hearing Before the Senate Comm. on Finance: A Tune-Up on Corporate Tax Issues: What’s Going on Under the Hood?, 109th Cong., 2d Sess. 7, 58 (2006).
[9] S. Rep. No. 109-336, 109th Cong., 2d Sess. 65-66 (2006). The Senate Finance Committee (and full Senate) originally approved the penalty as part of the Telephone Excise Tax Repeal and Taxpayer Protection and Assistance Act of 2006, but that earlier legislation was ultimately not enacted. The formal legislative history of section 6676 contains nothing suggesting the IRS’ concern about abusive refund claims had abated in the least.
[10] See I.R.C. § 6676(b).
[11] The penalty does not apply to a claim for refund or credit relating to the earned income credit under section 32. See I.R.C. § 6676(a). Nor does it apply to any portion of an excessive amount which is subject to the accuracy-related and fraud penalties set out in sections 6662 through 6664. See I.R.C. § 6676(d).
[12] See I.R.M. 20.1.5.16.5(3) (January 24, 2012).
[13] The IRS has said that it will define “reasonable basis” in the same way the term defined in Treas. Reg. § 1.6662-3(b)(3) for purposes of avoiding the negligence penalty. See I.R.M. 20.1.5.16.2(13) (January 24, 2012). That regulation defines “reasonable basis” as “a relatively high standard of tax reporting, that is, significantly higher than not frivolous or not patently improper. The reasonable basis standard is not satisfied by a return position that is merely arguable or that is merely a colorable claim.” A return position will generally have a reasonable basis if it is reasonably based on one or more of the authorities set out in Treas. Reg. § 1.6662-4(d)(3)(iii), taking into account the relevance and persuasiveness of the authorities, and subsequent developments. See Treas. Reg. § 1.6662-3(b)(3).
[14] In a Program Manager Technical Assistance document on the section 6676 penalty, the IRS explained “that consideration of whether a claim has a reasonable basis is different from the typical exception to many other penalties for taxpayers acting with reasonable cause and good faith.” PMTA 2010-003 (February 26, 2010). The PMTA explained that unlike the reasonable cause defense, whether a claim has a reasonable basis “is not dependent on the subjective state of mind of the taxpayer presenting the claim or the actions of the taxpayer in determining the appropriateness of the claim. The statute requires an examination of the claim itself to determine whether it has a reasonable basis.” Id. That said, the Internal Revenue Manual states that an examiner should assert the penalty only after “consideration of all the facts and circumstances,” see I.R.M. 20.1.5.16.2(6) (January 24, 2012), which arguably is inconsistent with the other informal guidance that focuses on the legal authority for the position.
[15] See I.R.M. 20.1.5.16.2(12) (January 24, 2012). The IRS has stated, however, that deficiency procedures may apply to the extent the excessive amount is attributable to a refundable credit. See Memorandum on Implementing the Section 6676 Penalty, PRENO-137143-14 (Oct, 27, 2914), available at www.irs.gov/pub/irs-utl/PMTA-2014-020.pdf. 
[16] See I.R.M. 20.1.5.16.4(4) (January 24, 2012).
[17] See Jeremiah Coder, “News Analysis: Behind the Scenes of the Erroneous Refund Penalty,” 2010 TNT 153-1 (August 10, 2010) (including the FAQs as an attachment).
[18] Treasury Inspector General for Tax Administration, The Law Which Penalizes Erroneous Refund and Credit Claims Was Not Properly Implemented, Report No. 2013-40-123 (September 26, 2013).
[19] See American Institute of Certified Public Accountants, Report on Civil Tax Penalties: The Need for Reform (April 11, 2013).
[20] See Treas. Reg. § 301.6402-2(b)(1).
[21] To the extent express authority is required for this approval requirement, section 6751(b) prohibits the assessment of any penalty unless “the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.”
[22] T.D. 9636, 78 Fed. Reg. 57686 (September 13, 2013).
[23] Accessible at http://www.irs.gov/Businesses/Cost-Segregation-Audit-Technique-Guide-Chapter-4-Principal-Elements-of-a-Quality-Cost-Segregation-Study-and-Report.

 

Page Last Reviewed or Updated: 19-Nov-2015