Editor's Note: The following article is adapted from remarks of Mary Lou Fahey, TEI’s General Counsel, at the University of Chicago Law School Tax Conference on November 12, 2010. Ms. Fahey joined TEI’s legal staff in 1988, and became General Counsel in 2005; she retires from TEI at the end of 2010. Ms. Fahey previously worked in the appellate section of the Department of Justice’s Tax Division, and as an attorney with Covington & Burling. She holds a B.S. degree from the University of Maryland and a J.D. degree from American University’s Washington College of Law. Ms. Fahey is a member of the ABA Section of Taxation and the American Society of Association Executives, and served on the working group of the IRS-TEI Joint Audit Planning Process. Ms. Fahey thanks her TEI colleagues Timothy J. McCormally and Daniel B. De Jong for their comments on a draft of her presentation, as well as TEI member Janice L. Lucchesi of Akzo Nobel Inc. for her insights on the program.
For those of a certain age, undoubtedly the first time we saw the word “transparency” was on a sign attached to an overhead projector that said, “Do not use Magic Marker on the transparency.” In preparing my remarks, I undertook to identify the first time the word was used in relation to tax. So I turned to the Internet’s fount of all knowledge, Wikipedia. It reminded me that initially “transparency” related to the government, as in open government or government in the sunshine.
Consider what the world was like in 1980, when I started practicing tax law with the Tax Division’s Appellate Section in the Department of Justice. My tenure began right after Tax Analysts brought a series of Freedom of Information Act suits attacking the IRS’s “secret law.” FOIA wasn’t that old at the time; it was enacted in 1966. That was pretty late in the game when you consider that Sweden’s version of FOIA became law 200 years earlier.
The 1970s saw many court decisions relating to the publication of private letter rulings, technical advice memoranda, and determination letters. In 1976, Congress responded by enacting section 6110 of the Internal Revenue Code, which created an affirmative obligation for the IRS to publish its written determinations. But that didn’t stop the suits. In the early 1980s, General Counsel Memoranda, Technical Memoranda, and Actions on Decisions were the subjects of disclosure suits, and soon the Justice Department was required to provide copies of court opinions and their briefs — even though these were public documents, the courts were sympathetic to the argument that it would be easier for the public to get them from the Department rather than the courts.
In the 1990s, there were “secret law” attacks on Chief Counsel Advice, Field Service Advice, and Advance Pricing Agreements. More recently, Tax Analysts prevailed in a case seeking disclosure of advice under the Chief Counsel’s “two-hour” rule, which resulted in the publication of advice contained in emails.
Well, litigators hate to lose cases, and during my 5 years at Justice some of my colleagues suggested that the IRS should just stop issuing private rulings. You could understand the “that will show them” attitude, perhaps, but it would certainly not be an example of good tax administration. Part of that bitterness no doubt stemmed from the rule that Department attorneys were not permitted to cite any of these private rulings because of the express statutory prohibition against using them as precedent. Even today the Internal Revenue Manual — another target of a FOIA action — cautions against reliance on private rulings as precedent.
But rely we do; even the Supreme Court cites to private rulings and has for some time. Just check out the 1981 case of Rowan Cos., when the Supreme Court for the first time cited a private letter ruling.
Now, my purpose today is not to discuss FOIA in any detail, but rather to put the issue of taxpayer disclosure in perspective. Transparency, if you think about it, has probably caused as much or more angst for the government as it has for taxpayers. (And lest you think otherwise, I am not referring to Wikileaks.)
At the same time Congress opened up numerous government records for disclosure under FOIA, it was shutting down access to taxpayers’ tax returns. Before 1977, tax returns were “public records,” but they were only open to inspection under Treasury regulations approved by the President or under presidential order. Again, if you’re of a certain age, you know how well that went. In 1976, as part of its post-Watergate reforms, Congress strengthened section 6103 to provide that tax returns and tax return information are confidential and are not subject to disclosure, except in limited situations.
The 1970s were also the heyday when tax shelters went middle class, leading to the enactment of prophylactic measures in 1976. But as IRS Commissioner Jerome Kurtz observed in late 1977, “No sooner were the apparent leaks in the dike plugged than new ones appeared.”
At the time, there was no penalty for failure to disclose that a taxpayer had taken a position on its return contrary to IRS guidance. Commissioner Kurtz proposed raising disclosure standards for tax practitioners to, say, those required of lawyers in SEC offerings, which he thought would alert Treasury to aggressive reporting positions, encourage the use of competent counsel, and facilitate a non-adversarial relationship between the IRS and tax lawyers. He also proposed requiring taxpayers to report “questionable positions” on their returns — a suggestion he explained by stating it was inappropriate for taxpayers to “take positions gambling on the fact that their number won’t be drawn in the audit” lottery.
Given the current disclosure landscape, it’s a bit surprising that the first taxpayer disclosure statute was not enacted until 1982; before that, there were only negligence and fraud penalties. But in the Tax Equity and Fiscal Responsibility Act of 1982, Congress enacted a substantial understatement penalty. Now codified as section 6662, this penalty had an out for taxpayers: It would not be imposed to the extent the understatement was attributable to items for which the relevant facts were disclosed on the return. The standard was fairly low — at least compared with later statutes — requiring only substantial authority. The statute also had several anti-tax shelter penalties and registration requirements, and the first definition of a “tax shelter.”
Beyond disclosures with the filing of tax returns, open questions remained whether certain documents must be disclosed by taxpayers under audit. That brings me to tax accrual workpapers and the Arthur Young case. I was still at Justice in 1984 when the Supreme Court held 9-0 in favor of the government that an auditor’s workpapers were relevant to an IRS audit and not entitled to an accountant-client privilege. At the time, I probably thought that the decision was correct. (Now, based on the amicus brief my current employer filed in the case, I’m not so sure.)
Part of the Court’s reasoning in Arthur Young was based on an administrative compromise fashioned by Commissioner Roscoe Egger in 1981, which flowed from his belief that a policy of routinely seeking the workpapers “had real potential for serious negative effects on the quality of financial reporting.” The IRS’s rules for requesting the workpapers were revised before Arthur Young reached the high court: An examiner was not to request the papers until the examination was substantially completed, specific issues had been identified, and the taxpayer was requested to identify all known facts related to the issues. As the Court recognized, the workpapers were to be sought only in “unusual circumstances” and only as a “collateral source for factual data.” The case did not, however, address whether the taxpayer’s workpapers were disclosable or whether those papers could be covered by the work product privilege — issues that have arisen numerous times over the past 26 years, most recently in Textron in the First Circuit and Deloitte in the D.C. Circuit.
Tax Executives Institute filed a brief amicus curiae in Arthur Young, arguing that the workpapers were nonfactual in nature and consisted of theories, hypotheses, opinions, and speculations regarding contingent tax liabilities. Twenty-seven years later, in its comments on the Schedule UTP, TEI stated:
[W]e believe that the policy considerations that gave rise to the IRS’s adopting the policy of restraint in 1981 . . . continue to have validity.
We are not alone in that belief. In 2007, former Commissioner Larry Gibbs described the case’s effect:
My recollection of what happened after Arthur Young was that many companies began to explore the possibility of using lawyers to deal with tax reserves. And I think that the concern that arose over that caused the SEC to contact the IRS. And I think it was something that [Commissioner] Roscoe Egger understood very well, and it is what led to the current policy of restraint on tax accrual workpapers.
The government left its policy of restraint unchanged for 21 years after prevailing in Arthur Young. It was concern about another wave of tax shelters — or “tax-advantaged transactions” in modern parlance — that prompted a change. In Announcement 2002-63, the IRS significantly broadened the situations in which it would seek access to tax accrual workpapers, specifically tying such requests to whether the taxpayer engaged in one or more listed transactions. And that brings us to this year, when Commissioner Douglas Shulman unveiled the concept of Schedule UTP requiring the disclosure of uncertain tax positions with a taxpayer’s return.
There is scarcely a tax professional working today who is not familiar with the new schedule or Announcement 2010-9. The reaction of TEI’s membership was swift; we received more comments on this proposal than any other issue in the past three decades; some of these comments are not repeatable in polite company.
While few TEI members welcomed the issuance of Announcement 2010-9 and Schedule UTP — and while the Institute questioned both the premises underlying it and the efficacy of the schedule to tax administration — fairness requires that we note the process the IRS used in refining the draft schedule and the agency’s responsiveness to the concerns we and others raised. The IRS engaged in extraordinary outreach efforts to taxpayers and the tax-practitioner community. IRS Chief Counsel Bill Wilkins and LB&I Commissioner Heather Maloy participated in numerous webinars and live programs, including TEI’s Midyear and Annual Conferences. The end product is much better because of the process the IRS used.
Among the positive changes that the IRS adopted were the following:
- elimination of the requirement that taxpayers identify the maximum tax adjustment;
- elimination of the category to disclose positions that are not audited because of administrative practice;
- clarification of the “Concise Description” requirement;
- a five-year phase-in of the schedule based on taxpayer asset size; and
- affirmation of the IRS’s “Policy of Restraint.”
In TEI’s testimony at the IRS’s public hearing on the schedule last month, we proposed further refinements for the schedule and particularly stressed the need for the IRS to clarify the process for UTP review and selection of returns for audit, as well as for specific training for examining agents.
There are still open questions about Schedule UTP. Perhaps the two biggest pertain to the required concise description and the rollout of the schedule to the field. The schedule may well change the way taxpayers view financial disclosures. Will a 70-percent issue become an 80-percent issue? If you were conservative about an issue and created a reserve, do you now release it? And what’s left of the policy of restraint? Announcement 2010-76 provides that the IRS won’t assert during the examination that the disclosure of workpapers to auditors waives any privilege claims. What’s “during the examination”? Does it include Appeals? The Tax Court? Preliminary indications are that it will. The IRS clearly wants to avoid disputes. But what about the Department of Justice or other government agencies?
And what about penalties? There is no specific penalty for failure to file the schedule. The only current penalty that could be applicable is failure to file a return. The schedule has no (direct) effect, however, on a taxpayer’s tax liability. In a large multinational’s return, which can run thousands of pages, will a court sustain a failure to file penalty? Many of you might like to take that case.
What’s causing the most agita among TEI members is the potential reaction of the field to the schedule. In early November, former Commissioner Larry Gibbs called the schedule the biggest change in tax administration in the last 50 years. Commissioner Shulman, LB&I Commissioner Maloy, and Chief Counsel Wilkins have repeatedly assured taxpayers that Schedule UTP is primarily about issue identification and that field agents will be trained about proper uses of the schedule. The key is control and they know that. But can an agent refer to a UTP on the schedule and ask why the position is uncertain? Perhaps not, but the IDR can likely ask for information about, say, a B reorganization disclosed as uncertain. How it plays out, of course, depends on how it plays out.
As a general matter, TEI agrees that transparency is beneficial for the tax system. Many of the recent initiatives undertaken by Congress, the IRS, and the SEC to promote greater transparency and corporate accountability have had salutary effects upon both tax administration and the financial reporting system. TEI has long supported enhanced disclosure regimes — such as that for reportable transactions — to aid the IRS in its identification and analysis of potentially abusive transactions. Why? Because efficiency, certainty, and consistency are inarguable goals for tax administration. And because we accept that transparency is, in a very real sense, the price we pay for a voluntary, self-assessment tax system.
The taxpayer-tax administrator relationship is based on information. How much is sufficient, and when does the government’s desire for more become unreasonable? Schedule UTP represents the ninth or tenth time Congress and the IRS have attempted to use taxpayer and tax adviser disclosure to address return and issue selection concerns. Since 1982, we’ve seen increases in penalties and required confidence levels; we’ve seen limitations on defenses against penalties. We’ve seen tax shelter registration requirements, specific penalties such as the transfer pricing documentation penalty, significant purpose tests, establishment of a specific office to deal with tax shelters, listed transactions, and new forms such as Form 8886 for reportable transactions.
One of the especially troubling developments is that the ability to avoid these penalties — even if the taxpayer acts reasonably and in good faith — is getting smaller and smaller. Just look at the recent codification of the economic substance doctrine, which subjects a taxpayer to a 20-percent strict liability penalty if it discloses the transaction but a 40-percent penalty if it fails to do so. My mother always told me the world isn’t fair — usually when she was telling me, “No, you can’t do that” — but fairness is an important concept when it comes to tax administration. No-fault penalties undermine both fairness and the perception of fairness.
Have these disclosure initiatives had an effect on compliance? It’s too early to tell about Schedule UTP, but for the most part, I believe the answer is, yes, although perhaps not as great an effect as tax administrators may have hoped, and some of the changes have taken us in the opposite direction. Take the transfer pricing documentation penalty and requirements. We had major penalty reform in 1989, which consolidated and streamlined the penalty regimes. But just one year later, Congress extended the accuracy-related penalty specifically to transfer pricing issues. Three years after that, it amended the statute again to provide specific documentation requirements. In its regulations on the revised statute, the IRS expressed the view that “the majority of taxpayers do not provide an explanation of how their intercompany pricing was established. In many cases examiners’ access to a corporation’s transfer pricing information is delayed or denied.”
Fast forward eight years. In 2001, the IRS released a study showing that more than 80 percent of the corporations surveyed had prepared transfer pricing documentation for major intercompany cross border transactions. Two years later, however, LMSB issued a directive to the field requiring agents in all cases to ask for that documentation. Taxpayers and their advisers were complaining that they had incurred significant costs in preparing the documentation, but the IRS agents never looked at it. So the transfer pricing penalty and documentation requirements may have had the desired effect — the preparation of supporting documentation — but left some taxpayers feeling it was a waste of time and money.
In 2004, the IRS issued Schedule M-3 for reporting book-to-tax differences. TEI was pleased to participate in meetings of the working group that helped develop the schedule. At the time, we said, “TEI did not ask for the Schedule M-3, but having been faced with it, we are delighted with the collaborative approach the IRS and Treasury took to developing and refining it.” As I reflect, I may have been present at the conception of the form. Greater transparency was discussed at a Federal Bar Association tax conference in 2002 when LMSB Commissioner Larry Langdon suggested that taxpayers help the IRS develop a better reporting mechanism. TEI members stepped up to help — something that a few members were not particularly happy about.
As the tax world moved forward with more taxpayer-focused disclosures, there were other forces at work to increase transparency. In 2002, Sarbanes-Oxley was enacted requiring a CEO and CFO to certify that the financial statements do not contain any material misstatements of fact or omissions of material facts. Because taxes are material to most companies, having appropriate internal controls over taxes is essential. Audit Analytics reports that accounting for income tax was the most prevalent issue related to the application of GAAP in 2006-2008.
Finally, in the transparency department, there’s FIN48, which requires companies to identify and recognize uncertain tax positions on their financial statements. Under FIN48, a business may not recognize the financial statement effects of a tax position unless the business determines that the position would be more likely than not sustained upon examination. Earlier this year, Commissioner Shulman referred to Schedule UTP as a “game-changer.” FIN48 was just such a game-changer in the financial reporting world, if for no other reason than the fact that the prior guidance for reporting income taxes left a lot of room for interpretation.
Well, we’ve gone through the transparency part of my talk today, but what about the trust portion? I mentioned TEI’s work on the M-3. TEI has a proud history of working with the government to enhance tax administration. It’s one of our principles and, from a pragmatic standpoint, we’ve always believed that having a seat at the table is better than walking away from it.
The last 20 years have seen the introduction of several programs aimed at changing the taxpayer-tax administrator dynamic. First, there was the advance pricing agreement program. TEI was supportive of the program when it was introduced in the early 1990s, but there was some skepticism about whether taxpayers would really be so transparent in return for certainty — something akin to, “You want me to do what?” Today, APAs remain an important tool for taxpayers and the IRS, but some of the enthusiasm has waned as the delays have gotten longer and the bureaucracy has gotten thicker.
Seven years ago, TEI and LMSB worked together to create the joint audit planning process, which had the goal of enhancing accountability and efficiency by having the IRS and the taxpayer execute a jointly developed, issue-focused audit plan. Implementation of the process across the taxpayer community and within LMSB, however, was uneven, and we are pleased that LB&I has moved to address that shortcoming in a new initiative, called its quality examination program.
In addition, the IRS has developed programs — such as the Compliance Assurance Process (CAP), Fast Track, and the Limited Issue Focused Examination (LIFE) — to help it audit smarter and more efficiently. As the OECD has noted, tax administrations “look for certainty around voluntary compliance with tax laws and taxpayers having good governance arrangements in place. Taxpayers look for certainty about which of their behaviors and transactions the tax administration is likely to see as risky, and how the administration is likely to respond to those risks.” I’m proud TEI has been part of the solution.
Where do we go from here? Spanish King Alphonso X once wrote that “[h]ad I been present at the creation, I would have given some useful hints for the better ordering of the universe.” Well, none of us was present at the creation of the income tax, but if we were, we may well have done things differently. Former Treasury Secretary William Simon once said, “The United States should have a tax system that looks like someone designed it on purpose.” I had one law professor — not in tax, but legislative drafting — cite the tax code as an example of how to write a law to do what we expect the tax code to do. Of course, in those days, it wasn’t written on parchment, but it was only one volume.
To quote a great chronicler of the 60s, Bob Dylan, “The times they are a–changing.” Certainly, the tax profession has changed much since that song was released. The tax law has never been more complicated, and the nontax law challenges facing in-house tax professionals command more and more time. The continuing demands of “transparency” — from Sarbanes-Oxley, to FIN48, to Schedules M-3 and now UTP — are particularly daunting. As Dylan warned, “You better start swimming or you’ll sink like a stone.”
But taxpayers are right to question whether the IRS will be able to effectively use all the information it is collecting. TEI often hears complaints from members about the extent to which the IRS is using the information it receives in refining its risk compliance metrics. Or that — in spite of the e-filing mandate issued a few years ago — IRS auditors are still asking for paper copies of Form 1120. And, of course, there’s more than just the information that’s reported on Schedule M-3 or UTP. The mandates contained in the Foreign Account Tax Compliance Act and the burdens of corporate 1099 reporting threaten to overwhelm the system.
I personally believe that the relationship between taxpayer and tax administrator will always be adversarial. This isn’t a good thing or a bad thing; it’s just the way it is. The U.S. tax system has all the elements that make conflict inevitable: a very complex, rules-based system, augmented by several court-sanctioned overlays such as the step transaction and economic substance doctrines. And in-house tax professionals and their advisers have an ethical duty to see that their companies (or clients) pay the least amount of tax legally required, just as the government has an ethical duty to administer the law in a fair and impartial manner. At times, these standards will collide. If they don’t, it means that one side or the other is not doing its job.
But to quote Elvis Presley, “We can’t go on together with suspicious minds.” Having some tension in the relationship doesn’t mean that the relationship can’t be civil or cooperative. For more than 50 years, TEI’s Standards of Conduct have required its members to accept “each government representative as a responsible person who is a professional required to fulfill the obligation to collect tax in accordance with the law.” A member also agrees to “present the facts pertinent to the resolution of questions at issue to representatives of the government imposing the tax.” A self-assessment system requires no less.