Uncertain tax positions: draft schedule and instructions now available
The IRS has released its highly anticipated draft schedule (Schedule UTP) (pdf, 530.22kb) and instructions (pdf, 66.6kb) for disclosing uncertain tax positions (UTPs), as initially outlined in Announcement 2010-9. While limiting the disclosure requirement to certain corporate filers for 2010, the draft instructions still require corporations to provide the controversial concise description and maximum tax adjustment (MTA) for each tax position disclosed on Schedule UTP. For tax positions related to valuation or transfer pricing, however, taxpayers can satisfy the MTA reporting requirement by ranking those positions according to the size of (1) the estimated U.S. federal income tax adjustment that would result if the position were not sustained, or (2) the recorded reserve amount.
Draft Schedule UTP is a three-part form, and is discussed in detail below.
The release of draft Schedule UTP and its instructions before the June 1, 2010 deadline for comments on Announcement 2010-9 indicates that the Service does not view the content of the schedule or instructions as set in stone and is open to taxpayer feedback on them. In reviewing the draft schedule and instructions, taxpayers should consider items that can be brought to the Service's attention and addressed before the schedule becomes final.
Who must file schedule UTP
The draft instructions require the following filers with $10 million or more in assets to disclose certain UTPs on the schedule, provided they or a related party issued audited financial statements:
- Corporations required to file a Form 1120, U.S. Corporation Income Tax Return;
- Insurance companies required to file a Form 1120-L or 1120-PC; and
- Foreign companies required to file Form 1120-F.
The instructions define a related party for this purpose as (1) an entity related to the corporation under Sections 267(b), 318(a), or 707(b), or (2) an entity that is included in a consolidated audited financial statement in which the corporation is also included. The instructions include two examples of how the related-party rules are applied to identify tax positions to be reported.
According to Announcement 2010-30 (pdf, 10.3kb), which accompanied Schedule UTP and its related draft instructions, the Service will not require other Form 1120 series filers, such as real estate investment trusts or regulated investment companies, to file Schedule UTP for 2010 tax years. Pass-through entities and tax-exempt organizations are also excluded from filing Schedule UTP for 2010 tax years. The Service says it will consider the timing of the requirement to file Schedule UTP for these entities after comments are received and considered.
What must be disclosed
Consistent with Announcement 2010-9, the draft instructions require filers to disclose (1) each federal income tax position for which they or a related party has recorded a reserve in an audited financial statement and (2) each tax position for which they or a related party has not recorded a reserve based on an expectation to litigate or an IRS administrative practice. The position must also have been taken in a tax return for the current or prior tax year, subject to the transition rule discussed in the following section.
The instructions include certain definitions that relate to determining what must be disclosed, which include the following:
Audited financial statement: The draft instructions define an audited financial statement as a financial statement on which an independent third party expresses an opinion under GAAP, IFRS, or another country-specific accounting standard, including a modified version of any of these (for example, modified GAAP), that requires a taxpayer to record a reserve for federal income tax positions.
Record a reserve: For purposes of Schedule UTP disclosures, the draft instructions provide that corporations or related parties record a reserve for a tax position when any of the following occurs in their audited financial statement:
- An increase in a liability for income taxes payable or a reduction of an income tax refund receivable with respect to the tax position; and/or
- A reduction in a deferred tax asset or an increase in a deferred tax liability with respect to the tax position.
While the initial recording of a reserve will trigger reporting of a tax position, subsequent increases or decreases in the tax position's reserve amount in years the tax position is not taken in the return will not require the tax position to be disclosed.
IRS administrative practice: The instructions define a tax position for which no reserve is recorded based on IRS administrative practice as a tax position for which a reserve would have been recorded in the audited financial statement but for a determination that the IRS has a practice of not challenging such position during examination. Taxpayers must base such determination on the IRS's past administrative practices and precedents in dealing with the tax position of the taxpayer or similar taxpayers.
Expectation to litigate: The instructions define a tax position for which no reserve is recorded based on an expectation to litigate as a tax position for which the taxpayer or related party determines settlement would be unlikely if the IRS had full knowledge of the position. Settlement is considered unlikely if the probability of settling is less than 50%.
Tax position taken in a tax return: A tax position taken in a tax return means a tax position that would result in an adjustment to a line item on that tax return (or would be included in a Section 481(a) adjustment) if the position were not sustained.
When to disclose, transition, and the 60-day rules
The draft instructions outline when a tax position is disclosed as follows:
- Reporting current year and prior year tax positions. Tax positions taken by the corporation in the current year's tax return for which the decision whether to record the reserve was made at least 60 days before filing the tax return are reported on Part I. Tax positions taken by the corporation in a prior year's tax return for which the decision whether to record the reserve was made at least 60 days before filing the tax return are reported on Part II. A corporation is not required to report a tax position it has taken in a prior tax year if the corporation reported that tax position on a Schedule UTP filed with a prior year tax return. If a transaction results in tax positions taken in more than one tax return (and a decision whether to reserve has been made), the tax positions arising from the transaction must be reported on Part I of the Schedule UTP attached to each tax return in which a tax position resulting from the transaction is taken regardless of whether the transaction or a tax position resulting from the transaction was disclosed in a Schedule UTP filed with a prior year's tax return. See Example 6. Do not report a tax position on Schedule UTP before the tax year in which the tax position is taken in a tax return by the corporation.
- Determinations made within 60 days prior to filing the tax return. Tax positions for which a reserve was recorded within 60 days before filing a tax return, or a decision not to record a reserve was made during that same period based on an expectation to litigate or an IRS administrative practice, must be reported either on Part I of the Schedule UTP for the current year or on Part II of the Schedule UTP for the next tax year.
Example. When applied to a tax position taken on a 2010 tax return (reminder: this is defined to mean "a tax position that would result in an adjustment to a line item on the 2010 tax return (or would be included in a Section 481(a) adjustment) if the position were not sustained") that must be disclosed on Schedule UTP, the draft instructions seem to:
- require taxpayers:
- to disclose the tax position on Schedule UTP, Part I with their 2010 return if they either (1) record a reserve for that tax position at least 60 days before filing the 2010 tax return or (2) decide not to record a reserve at least 60 days before filing the 2010 tax return based on an expectation to litigate or IRS administrative practice;
- to disclose the tax position on Schedule UTP, Part II with the 2011 return if they record a reserve/decide not to record based on litigation- or administrative practice-based reasons, after filing of the 2010 tax return and at least 60 days before filing the 2011 return;
- allow taxpayers:
- to disclose the tax position on Schedule UTP, Part I with their 2010 return or disclose on Schedule UTP, Part II with their 2011 return if they record a reserve/make a decision not to record based on litigation- or administrative practice-based reasons, within 60 days of filing the 2010 return;
- to disclose the tax position on Schedule UTP, Part II with their 2011 return or disclose on Schedule UTP, Part II with their 2012 return if they record a reserve/ make a decision not to record based on litigation- or administrative practice-based reasons, after filing the 2010 tax return and within 60 days of filing the 2011 return.
The draft instructions do not require disclosure of tax positions taken in tax years before 2010, regardless of whether or when a tax reserve was recorded for the position. They specifically read:
A corporation is not required to report on Schedule UTP a tax position taken in (a) a tax year beginning before December 15, 2009, or (b) a tax year beginning on or after December 15, 2009, and ending before January 1, 2010, regardless of whether or when a reserve was recorded with respect to that tax position.
Example. A tax position taken on a 2008 tax return for which a reserve is recorded in 2010 is not required to be reported on Schedule UTP for any year.
Unit of account
According to the draft instructions, tax positions reported in Schedule UTP should be based on the unit of account used in the audited financial statements in which the reserve is recorded. Since a line item on a tax return may be affected by multiple units of account, the instructions require each unit of account to be reported separately on Schedule UTP.
The draft instructions define unit of account as "the level of detail used in analyzing a tax position, taking into account both the level at which the taxpayer accumulates the information to support the tax return and the level at which the taxpayer anticipates addressing the issue with the IRS." The definition is similar to the definition provided in ASC 740 for US GAAP financial reporting purposes. The instructions require US GAAP and modified US GAAP taxpayers to report their UTPs using the same unit of account that they use for US GAAP or modified US GAAP. Non-US GAAP taxpayers are prohibited from using a unit of account based on an entire tax year or entire income tax return for a tax year, even if that level of detail is used under their accounting standard, such as IFRS. In such cases, the instructions require non-US GAAP taxpayers to use as their unit of account any level of detail that is consistently applied and reasonably based on the items of income, gain, loss, deduction, or credit.
Determining maximum tax adjustment
The draft instructions define a tax position's MTA as "an estimate of the maximum amount of potential U.S. federal income tax liability associated with the tax year for which the tax position was taken." For tax positions relating to items of income, gain, loss, and deduction, corporations are to estimate the total amount in dollars and multiply by 35%. For items of credit, corporations are to estimate the total amount of credit in dollars. They then combine the dollar estimates related to all applicable items of income, gain, loss, deduction, and credit to determine the MTA of that tax position.
The MTA is an annual determination that does not take into account interest, penalties, or the effects that the tax position may have on state, local, or foreign taxes. To assist corporations in reporting their MTA, the instructions include examples.
Valuation and transfer pricing tax positions. The instructions do not require filers to provide an MTA for valuation-related or transfer-pricing-related tax positions. Instead, they may identify them as valuation-related or transfer-pricing-related and rank them, separately for each group, according to the size of the reserve amount or the estimated U.S. income tax adjustment that would result if the tax position were not sustained. Filers are not, however, required to disclose the reserve amounts or adjustment amounts. While the instructions permit taxpayers to choose the basis for ranking these tax positions, they also require the application of the selected method consistently to all valuation-related and transfer pricing-related tax positions.
Filers must include a concise description of their tax positions reported on Schedule UTP. The draft instructions indicate that the description should only be a few sentences, but must include (1) a statement that the position involves an item of income, gain, loss, deduction, or credit against tax; (2) a statement whether the position involves a determination of the value of any property or right, or a computation of basis; and (3) the rationale for the position and the reason(s) for determining the position is uncertain. To assist corporations in crafting their concise statements, the instructions include a few examples of less-than-complex situations.
Other disclosures and penalties
The draft instructions indicate that a complete and accurate disclosure of a tax position on the appropriate year's Schedule UTP will be treated as if the corporation filed a Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement, regarding the tax position. As for any other penalties the Service might apply, the instructions only reserve a section for discussion of penalties, without providing further information.
The draft schedule
Draft Schedule UTP is divided into three parts. Part I requests information on current-year UTPs and is divided into six columns lettered A through F. These columns request the following information:
- Column A requires corporations to number their UTPs.
- Column B requests the primary code sections related to the UTP and allows corporations to list up to three.
- Column C asks the corporation to indicate, by checking the appropriate box, whether the UTP creates temporary or permanent differences. If the UTP creates both, the corporation must check both boxes.
- Column D is used if the UTP relates to a pass-through entity; if so, the corporation must provide the employer identification number of the pass-through entity to which its UTP relates, or enter "F" for a foreign entity without an EIN.
- Column E asks the corporation to indicate by checking a box whether it is disclosing the UTP because a reserve would have been recorded but for the determination that the Service has a general administrative practice not to challenge the position upon examination.
- Column F requires the corporation to provide the MTA for UTPs that do not relate to valuation or transfer pricing. Valuation-related UTPs and transfer-pricing-related UTPs must be ranked from highest to lowest estimated potential tax adjustment or reserve (if applicable) and listed in order of rank. To identify the type of position and rank, corporations must enter a "V" in column F for valuation-related UTPs, followed by a number representing that UTP's rank (e.g., V1). Similarly, for transfer-pricing-related UTPs, the corporation must enter "TP" in Column F, followed by a number representing that UTP's rank.
To address concerns previously raised regarding the related-party provisions, Part I asks the corporation to indicate by checking a box if it was unable to determine whether it had UTPs to disclose because it could not obtain sufficient information from one or more related parties.
Part II is used to report UTPs for prior tax years that have not previously been reported. For example, a company that took a position on its 2010 return but did not disclose that position on its 2010 Schedule UTP because the decision to record a reserve occurred 30 days before the filing date, would disclose the UTP in Part II of the Schedule UTP accompanying its 2011 return.
Part II includes the same related-party checkbox and columns A-F as used in Part I and described in the preceding section. Column G in Part II asks corporations to list the prior tax year in which the tax position was taken and the last month of that tax year, using a six-digit number (e.g., 201012 for UTPs in tax years ending December 31, 2010, that were not disclosed with a prior year return).
The instructions for Part II indicate the Service does not expect corporations to complete Part II for 2010 tax years.
Part III of the draft form provides space for corporations to provide a concise description of each of their numbered UTPs, as discussed in an earlier section of this Alert.
Compliance and controversy
With the release of the draft Schedule UTP, the Service has provided draft instructions on many of the operational elements of the new reporting requirements, including who must file the new schedule, what must be reported, and when. But there are several issues that remain to be clarified based on comments from stakeholders. As such, taxpayers should take advantage of the Service's invitation to comment on the schedule and instructions so they ensure the issues most important to them get addressed before Schedule UTP and its instructions become final.
Regarding implementation, IRS representatives continue to signal that they will not delay implementation of the disclosure requirement until 2011 or later, even though the schedule and instructions will only be finalized after comments have been received and reviewed. Thus, it could be late 2010 before companies that must disclose tax positions on a 2010 Schedule UTP have the guidance they need.
Taxpayers will, thus, want to familiarize themselves now with the reporting rules as provided in the draft instructions, to determine the potential impact on their own returns, including the need to (1) assess uncertain tax positions for purposes of reporting on Schedule UTP, (2) determine the MTA for each such position, and (3) develop a concise description. These new tasks will require additional efforts, resources, and time in preparing and reviewing tax returns.
As a result of disclosures on the Schedule UTP, taxpayers may be able to anticipate which positions will attract potential post-filing scrutiny by the Service. As such, taxpayers can take steps to prepare the necessary documentation for positions taken on the Schedule UTP. Such tax risk management planning and preparation could mitigate the likelihood that controversy will arise as a result of disclosures made on the Schedule UTP.
Unlike Announcement 2010-9, the draft instructions do not use the term "uncertain tax position" unless referencing Schedule UTP or its sections. Instead, they generally use the terms "tax position" and "tax position taken in a tax return." By using this terminology, the Service seems to be signaling that there are differences between disclosing a tax position on Schedule UTP and the FIN 48 concepts on which it has based these required disclosures.
Regardless of the terminology used, taxpayers should continue to keep in mind that the requirement to disclose "tax positions" or "uncertain tax positions" does not change the accounting or auditing standards under which a tax position is judged to be "uncertain." Current US GAAP tax accounting standards still require each tax position to be evaluated using the two-step recognition and measurement framework, under the assumption that the IRS is aware of the position and has all relevant information. Measurement (step two) continues to be determined based upon a cumulative probability model, whereby the taxpayer records the largest amount that is greater than 50% likely of being sustained. Whereas recognition (step one) does not consider negotiation with a tax authority, measurement takes into account the negotiation process. As the Service's negotiation and settlement position for any UTP may evolve as a result of the new disclosure requirements,, companies may determine that measurement (step two) for a particular UTP may be affected. This will be facts and circumstances dependent.
The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting or tax advice or opinion provided by Ernst & Young LLP to the reader. The reader also is cautioned that this material may not be applicable to, or suitable for, the reader's specific circumstances or needs, and may require consideration of non-tax and other tax factors if any action is to be contemplated. The reader should contact his or her Ernst & Young LLP or other tax professional prior to taking any action based upon this information. Ernst & Young LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.