Uncertain Tax Positions

A recent study by the Institute on Taxation and Economic Policy details how Fortune 500 Companies are holding a record $2.6 trillion offshore, thereby avoiding $767 billion in U.S. taxes.  While we believe much of this amount is the result of lawful tax planning on the companies’ international operations and the use of tax haven entities, there remains a significant amount of aggressive tax planning here which is ripe for potential IRS whistleblower cases.  For example, a byproduct of holding trillions of dollars offshore is that it is difficult to bring the money back to the U.S. to use it without paying taxes on those deferred profits.  Therefore, many taxpayers have entered into abusive repatriation transactions to bring the cash back.  Or taxpayers have used hyper aggressive tax planning strategies involving financing structures or transfer pricing to get the profits in the tax haven jurisdiction in the first place.  While Congress may eliminate deferral or make other drastic changes to the Internal Revenue Code in the coming year, the fact remains that these tax underpayments already exist and thus are subject to IRS whistleblower claims.  We suspect the transition rules to whatever new international tax regime Congress comes up with will be similarly and abusively gamed by these companies to wring out the last drop of tax savings.

While many of the Fortune 500 companies have set aside reserves for uncertain tax positions that would cover some of this tax avoidance, many other taxpayers have not reserved at all for these positions by convincing their financial auditors that the risk is minimal or by hiding the risk from them altogether. We’ve been carefully tracking these reserves since 2010 and have concluded that the answer is usually a little bit of both.  Either way, whistleblowers with access to tax accrual workpapers would be able to see what those reserved weaknesses are, and whistleblowers who have unique insight to the unreserved positions have valuable information as well about what those skeletons in the closet are.  We’ve had great success reporting both to the IRS under their tax whistleblower program, so if you know of either type of issue you should give us a call to discuss what your opportunities and rights are.

We began reordering the Fortune 500 based on uncertain tax positions reported in the most recent 10-K filed before June 15th of that year in 2010, the same year that the IRS announced that it was planning to require that certain business taxpayers to report uncertain tax positions on their tax returns.  The IRS implemented a five-year phase in of Schedule UTP, requiring corporations that have total assets of $100 million or more to file Schedule UTP beginning with the 2010 tax year.  The total asset threshold for the filing requirement dropped to $50 million for the 2012 tax year and to $10 million for the 2014 tax year.  At the same time that corporations were expected to begin disclosing their uncertain tax positions the IRS’s budget started to be cut, year after year.  According to the Center on Budget and Policy Priorities, the IRS’s budget has been cut by 18 percent since 2010, after adjusting for inflation.  The IRS’s budget constraints have cut into enforcement efforts, but this should not be reflected in the uncertain tax positions reported because the likelihood of an audit on the issue is not a factor when setting the reserve.  The total amount collected by the IRS through enforcement actions has remained in the $50 billion range for Federal fiscal years 2010 through 2014.*

We had assumed that tax reserves would decrease because corporations would not want to report their uncertain tax positions to the government.  This assumption seemed reasonable given the amount of concern and interest in the topic by practitioners.  However, the total cumulative uncertain tax positions of the Fortune 500 has been reasonably stable, even increasing on the 2013 Ferraro 500.  Using the 2010 Ferraro 500 as the base line measurement for pre-Schedule UTP reserves, as this data reflects uncertain tax positions that were reported in 10-Ks published prior June 15, 2010.  As a whole the Fortune 500 has only reduced its tax reserves by 10.8 percent over the last five years. 

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The 2015 Ferraro 500 can be found here.

* The numbers is the chart are for the Federal government’s fiscal year, October 1 through September 30.  Enforcement revenue collected in a fiscal year includes tax, interest, and penalties from multiple years. 

Bloomberg reporters Alex Barinka and Jesse Drucker just wrote an interesting article about how one large multinational is using its tax haven structures, which are typically put in place to supercharge foreign earnings by moving them to low tax jurisdictions through aggressive transfer pricing, to boost earnings when sales slowdown.  Based on an analysis of IBM’s financials, last year IBM drove its effective tax rate down to the lowest levels in 20 years, a mere 15.6% instead of the normal corporate income tax rate of 35%.

IBM is becoming more aggressive in its tax planning tactics.  IBM fell two places on the Ferraro 500 despite the fact that its reserves increased from $5.58 billion in 2011 to $5.67 billion in 2012.  It will be interesting to see IBM’s tax reserves for 2013 once it files its 10-K.  Since we started tracking tax reserves for the Fortune 500 in 2010, using reserves from 2009, IBM has increased its tax reserves by nearly a billion dollars.  It should be noted that the tax reserves that are reported are for those position that the company does not feel will be sustained on audit.  This type of large-scale aggressive corporate tax planning is ripe for a whistleblower to come forward with information identifying the flaws in these tax schemes.

Last week the Canada Revenue Agency (“CRA”) formally announced a whistleblower program for reporting Canadian tax fraud. Our contacts in Canada have told us that this measure has been in the works for a long time.  For now the details remain a little thin, but it appears like the program -called the Offshore Tax Informant Program (“OTIP”) – is modeled after the old IRS whistleblower program, whereby whistleblowers have to get a contract with the CRA in advance of submitting any information in order to get an award.  Those awards are between 5 and 15% of the amount collected by the CRA, although their definition of collected proceeds does not appear to be as expansive as the US definition.  Furthermore the scope of tax issues which are subject to OTIP are limited, so you should consult counsel to determine if any information you have may make you eligible for an award.

Today’s CFO Journal reported that a warning from the Public Company Accounting Oversight Board (“PCAOB”) late last year has resulted in much more stringent external audits being conducted by auditors of public companies.  PCAOB has been auditing the auditors to make sure public companies’ financials are not being rubber stamped.  Increased audit scrutiny can be a great thing for potential IRS whistleblowers.  When auditors take a closer look at uncertain tax positions this can result in far greater detail being in the tax accrual workpapers.  As we have noted in the past, Schedule UTP has done little to change company behavior.  Knowledgeable insiders with access to a company’s tax accrual workpapers could provide extremely useful information to the IRS and be rewarded handsomely.  Large companies maintain billions of tax reserves to account for tax positions where the company believes the IRS is more likely to prevail on the issue than the company.  We know firsthand that IRS whistleblowers with access to information about the tax positions that make up those reserves can successfully present a submission to the IRS.  Now, more than ever, there are great opportunities for a tax department insider to make a meaningful impact on the tax gap.

Thumbnail image for MartySullivan1-800x531.jpgKudos to Martin Sullivan, Chief Economist and Contributing Editor at Tax Analysts who had a nice piece in the Washington Post published about him over the weekend.  I’ve always admired Marty’s ability to cut through the political BS and revenue scoring to see the true cost and impact of our tax laws and proposed tax legislation.  In this article Marty tells it like it is and where the real money is in large corporate tax avoidance.

USA Today last week also published the results of their recent review of the Annual Statements of the Standard & Poor’s 500, and found that 57 companies had a effective tax rate of zero.  Nada.  0%  That’s zero point zero. (Some were even negative, but that often occurs temporarily with losses or significant NOL carryforwards.)  

 

They said that “The effective tax rate is a popular measure used by investors to compare how much companies pay in tax relative to profit” and it’s no surprise to us that there are so many companies paying no taxes.  We see companies paying no Federal Income taxes every year when we compile the Ferraro 500 list of companies based on the size of their uncertain tax position reserves.  

And finally, on a related note, just this morning Jesse Drucker at Bloomberg profiled an advisor in Ireland who is instrumental in helping multinationals with Irish tax avoidance strategies.  Jesse wrote: “In 2010, U.S. companies attributed $95 billion in profits to Irish subsidiaries, up more than sevenfold from $13 billion in 2000… Many of the Irish subsidiaries have no offices or employees and pay no income taxes. They are merely ways to move profits out of countries where sales take place to mailbox subsidiaries in zero-tax island havens.”  

 

We released the Ferraro 500 today.  The Ferraro 500 is a reorganization of the Fortune 500 by the size of the companies’ Unrecognized Tax Benefit reserve (“Tax Reserve”) for uncertain tax positions reported in SEC filings.  The 2013 Ferraro 500 showed that collectively the Fortune 500 companies believe that they have underpaid their corporate income tax by $191.7 billion, an increase of 2.2% from the group’s collective tax reserves last year.  According to the Ferraro 500, 2012 saw a slight decrease (-.51%) in the profits of the Fortune 500.  Scott Knott reacted to the data saying, “If uncertain tax position reserves are trending up at the same time profits are going down, you have to ask if there is a movement to build up reserves for tax underpayments.”

The Ferraro Law Firm compiles the annual “Ferraro 500” list, which The Tax Reserves of the top five companies on this year’s list are Exxon Mobil, which set aside $7.663 billion to cover potential taxes; Microsoft, $7.202 billion; J.P. Morgan Chase & Co., $7.158 billion; General Electric, $6.579 billion; and Pfizer, with $6.315 billion.  Pfizer bucked the trend of increasing reserves for uncertain tax positions, disclosing that it reduced its Tax Reserve by almost a billion dollars last year.

Gregory Lynam said, “It also appears many of the companies on the Ferraro 500 are then improperly hiding information behind those reserves from the IRS.”  As of 2010, corporate taxpayers have been required to file a “Schedule UTP” with their annual tax return that lists and discloses the issues that gave rise to their uncertain tax positions.  However, the IRS has discovered that thirty-one percent of last year’s Schedule UTP filers submitted incomplete concise descriptions of their uncertain tax positions, said IRS official Thomas Brandt on a July 17, 2013, webcast sponsored by McGladrey LLP.  Mr. Lynam also said “the IRS data shows that corporate taxpayers believe that filing an incomplete Schedule UTP will go unnoticed by IRS Exam personnel, making tax whistleblowers that much more important to successful enforcement actions.”

From the first mention of Schedule UTP, we felt that taxpayers would provide the minimum information required by the instructions and other published guidance for Schedule UTP.  And it looks like this is what has happened.  According to an article in Tax Notes Today, “[t]hirty-one percent of tax year 2011 Schedule UTP filers submitted incomplete concise descriptions of their uncertain tax positions.”  According to Thomas Brandt, Director (Planning, Analysis, Inventory, and Research) for IRS Large Business and International Division, “The primary shortcoming of the concise descriptions that were deemed incomplete was that they did not sufficiently describe the nature of the issue or the relevant facts affecting the tax treatment of the position.”  According to the Schedule UTP filing information, 1,862 taxpayers filed a Schedule UTP for 2011, a 21 percent decrease from 2010.  However, the IRS sent 578 taxpayers education and outreach letters regarding the incomplete concise descriptions, compared to the three percent of 2010 Schedule UTP filers (or approximately 70 taxpayers). 

The IRS has continued to provide guidance on what it considers to be a sufficient concise description for Schedule UTP.  The IRS provides a table that shows examples of hypothetical concise descriptions that are insufficiently detailed and examples of sufficient concise descriptions.  (The table is replicated below.) 

 

Example
Number 

Insufficient Concise Description 

Sufficient Concise Description 

1

This is a research credit issue.

The taxpayer incurred support department costs that were allocated to various research projects based upon a methodology the taxpayer considers reasonable.  The issue is whether the taxpayer’s method of allocating these costs is acceptable by the IRS.

2

This is a transfer pricing issue.

The taxpayer allocated management service costs between its domestic subsidiaries and a foreign subsidiary located in Country X using a methodology the taxpayer considers reasonable.  The issue is whether the taxpayer’s method of allocating these costs is acceptable by the IRS. 

3

The Taxpayer claimed a domestic production activities deduction. The domestic production activities deduction is highly factual and subject to review by the IRS.

The Taxpayer claimed the domestic production activities deduction on certain production activities income for 2011.  The issue is whether costs incurred for product aging processes that occur in designated areas located at the Taxpayer’s distribution facility are considered manufacturing or production costs of the tangible personal property, and therefore, a component of Qualified Production Activities Income.

4

The Taxpayer incurred costs during the year that are deductible as ordinary and necessary business expenses under IRC Sections 162 and that are included in “Other deductions” on Line 26 of Form 1120. 

The Taxpayer claimed a deduction for travel and entertainment expenses for conventions and sales meetings.  The issues are whether adequate documentation has been retained to substantiate the deductions claimed and whether some of the expenses constitute entertainment subject to a 50% limitation. 

Despite the examples only providing vague facts that would identify the issue, taxpayers are providing fewer descriptions that are sufficient to identify the particular issue that the reserve was created for.  The resistance to providing sufficient information makes whistleblower information even more valuable to the IRS when preparing an audit plan for these entities.  Even if the taxpayer is providing sufficient concise descriptions, the descriptions still fall short of the detailed information that whistleblowers provide to the IRS.  For example, the IRS guidance provides that a sufficient concise description for a transfer pricing issue could be:

The taxpayer allocated management service costs between its domestic subsidiaries and a foreign subsidiary located in Country X using a methodology the taxpayer considers reasonable.  The issue is whether the taxpayer’s method of allocating these costs is acceptable by the IRS. 

A whistleblower would provide the IRS with information regarding the methodology the taxpayer used and an explanation as to why that methodology may by flawed in light of the facts and circumstances or how that methodology was improperly applied to the facts and circumstances. 

While Schedule UTP may provide the IRS with a description of the relevant facts affecting tax treatment of the position, whistleblowers provide the IRS with information and analysis that goes far beyond merely apprising the IRS of the identity of the issue beyond issues that a reserve has been established for.  A whistleblower is even more important in identifying potential tax issues where taxpayers are not filing Schedule UTP, are not reserving for tax issues, or are not providing sufficient concise descriptions.

I saw an interesting article today by the President and Publisher of Tax Analysts in which he drew attention to the role of tax professionals in the growing crisis over reduced corporate tax receipts in a time of record corporate profits. He focused his audience’s attention on a recently released study by The Organisation for Economic Co-operation and Development (“OECD”) which described the need for the international tax community to solve the problem of base erosion and profit shifting (“BEPS”). Sure, that’s a lot acronyms to the uninitiated, but at its heart this is a giant shell game of “where’s the income?”, and unfortunately for those of us living in civilized society, the offshore tax haven shell is where it’s at. Large multinationals frequently use abusive strategies, some of highly questionable legality, to minimize their worldwide tax bill. Many politicians have made hay over US based multinationals reporting billions of dollars of income in e.g. the British Virgin Islands, and hardly any here where their employees and a large portion of their sales actually are.

 

We agree that for the most part companies abide by, and optimize their behavior for, the rules that are set for them. However, the grey line is often crossed. In our Ferraro 500 last year we noticed that reserves for uncertain tax positions exceeded total US corporate tax collections*, and that’s just for the Fortune 500 companies. While moving the line to collect more revenue (while maintaining international competitiveness) and to make it more of a black line than a grey line should be the goal of legislators, governments need to get better at enforcing the existing rules. Utilizing valuable information obtained from knowledgeable whistleblowers should be a critical component of that enforcement. Without enforcement, a change in the rules is meaningless.

 

*Fiscal 2011 Fortune 500: Profits $824 billion & Reserves $187 billion; Total IRS Corporate Tax Collections $181 billion. Whereas in Fiscal 2010, Fortune 500: Profits $708 billion & Reserves $197 billion; Total IRS Corporate Tax Collections $191 billion.