Tax Accrual Workpapers

Panelists:

Walter HarrisDirector, Financial Services IndustryLarge & Mid-Size Business DivisionInternal Revenue Service

Institute of International Bankers

Annual Tax Seminar

Moderator:

John GallagherUniCredit Markets & Investment Banking

Raj MadanMcKee Nelson LLP

Todd SimmensErnst & Young

• Issues and Developments

Other Hot Topics for Financial Institutions

June 25, 2008

Overview

Current IRS policy regarding TAW

Update on IRS policy regarding TAW

Recent developments surrounding taxpayers’ ability to protect TAW

Other hot topics for financial institutions

Financial institutions’ relationship with the IRS

FTC generator transactions and the IRS response

Withholding tax issues

Emerging issues

Defining Tax Accrual Workpapers

• Tax Accrual Workpapers – created by taxpayers for purposes of evaluating the strength of the positions taken on their tax returns.

• TAW may contain:– Legal analyses probing each position’s strengths and

weaknesses– Detailed “roadmaps” of the taxpayer’s position– Contingency reserve analysis

Defining Tax Accrual Workpapers (cont.)

• The Internal Revenue Manual defines TAW as:

Tax accrual workpapers typically include determinations and related documentation of estimates of potential or contingent tax liabilities related to tax positions taken by the taxpayer on certain transactions. In addition, there may be an audit trail and/or complete explanation of the transactions. There may also be information on whether there was reliance on outside legal advice; an assessment of the taxpayer’s position and potential for sustention; references to promotional materials; and comments on unwritten agreements, confidentiality agreements, restitution agreements, contingency fees, expectations, and other material facts surrounding the transactions. The workpapers may include documents written by the taxpayer’s employees and officers describing or evaluating the tax strategies. The scope and quality of the workpapers will vary. See I.R.M. 4.10.20.2(2).

The IRS “Policy of Restraint”

• IRS maintains an unqualified right to TAW.

• IRS will request TAW in two cases: – “Unusual circumstances.”– When the taxpayer has engaged in a listed transaction.

• “Unusual circumstances” exist when:– An issue has been identified by the examining agent.– There are missing facts.– The examining agent has exhausted other reasonable avenues

for developing the facts.

IRS TAW Policy – Listed Transactions

• If the taxpayer has engaged in a listed transaction:

– Before Feb. 28, 2000, the unusual circumstances policy still applies.

– Between Feb. 28, 2000 and Jul. 1, 2002, the IRS will request TAW for listed transactions that were not disclosed.

– After July 1, 2002, the IRS will request TAW for listed transactions even if they were properly disclosed.

• If disclosed, the request is limited to workpapers relating to the transaction in the year under examination.

• If not disclosed, the request will be for all workpapers for the year under examination and workpapers for years not under examination may also be requested.

Recent Developments – Disclosure of TAW to Auditors

• To receive unqualified approval of financial statements, companies must often disclose TAW to their auditors.– Additionally, the AICPA requires auditors to obtain tax opinions if

a client relies on the opinion in a material matter. Interpretation of AU § 9326.

• Two recent cases show that courts may consider TAW protected by the work product doctrine even if disclosed to auditors.– United States v. Textron Inc., 507 F.Supp. 2d 138 (D. R.I. 2007).– Regions Financial Corp. v. United States, 2008 WL 2139008

(N.D. Ala.).

Textron & the Work Product Doctrine

• Facts:– The IRS issued a summons for all of Textron’s TAW for the 2001 tax year

because the IRS determined that Textron had engaged in a SILO listed transaction.

– Textron had been to IRS Appeals in seven of its last eight audit cycles. Textron litigated three issues during this period.

– Two Textron officials testified that its TAW were created for purposes of establishing an adequate reserve with respect to any potential disputes or litigation.

• The TAW contained opinions of counsel and accountants regarding items that might be challenged, estimated hazards of litigation percentages, and calculations of reserve amounts.

– Textron’s auditor was allowed to examine the TAW, but the information was to be treated as confidential.

• In addition to other arguments, Textron claimed its TAW were protected by attorney-client privilege, § 7525, and the work product doctrine.

Textron (cont.)

• Work Product:– The IRS argued that Textron’s TAW was not work product because:

• Textron’s TAW was not created in anticipation of litigation, but rather in the ordinary course of business for purposes of obtaining an unqualified audit opinion.

• Textron waived its work product protection when it disclosed its TAW to an adverse party – its independent auditor.

• The court first determined that the attorney-client privilege, § 7525 tax practitioner privilege, and work product doctrine applied to Textron’s TAW.

• Next, the court held that the attorney-client and § 7525 privileges had been waived because Textron shared its TAW with its auditors.

Textron (cont.)

• The court’s work product holding:

– Textron would not have created the TAW “but for” its anticipation of litigation with the IRS.

• The court noted that there would have been no reason to prepare the workpapers or calculate a reserve at all but for the reasonably anticipated litigation with the IRS.

• Textron’s litigation fears were “well-founded” given its past experience.

– Work product was not waived by disclosure to Textron’s auditors because the disclosure did not “substantially increase the IRS’s opportunity to obtain the information contained in the [TAW].”

– The court noted that: • The auditor had an obligation under the AICPA code to maintain

confidentiality.• The taxpayer and auditor had a confidentiality agreement in place.• The auditor was not a potential adversary of the taxpayer.

Regions Financial & the Work Product Doctrine

• Facts:

– The IRS determined that Regions had engaged in two listed transactions in 2002 and 2003. The IRS issued a summons to Regions’ auditor requesting all workpapers.

– Regions instructed its auditor to withhold twenty documents as privileged. Over 260,000 pages were produced.

– The twenty documents withheld consisted of what the court labeled “Core Documents” and “Derivative Documents.”

• The four Core Documents contained opinions, evaluations of legal theories and analyses of potential IRS attacks on the transactions. Each of the Core Documents were created at the direction of Regions’ general counsel. Regions’ general counsel testified that he only becomes involved in analyzing tax liabilities if litigation is likely to result from a position taken on Regions’ return.

• The Derivative Documents discuss, quote or explain the Core Documents.

Regions (cont.)

• Regions moved the court to quash the IRS summons for its TAW with respect to the twenty withheld documents because those documents were protected by the work product doctrine.

• The IRS argued that Regions’ TAW were not protected by the work product doctrine because:

– Regions’ TAW were not created in anticipation of litigation.

• The IRS argued that Regions’ TAW were created for purposes of establishing a tax reserve that adequately reflected Regions’ contingent liabilities. Such a reserve and the underlying workpapers were necessary to getting an unqualified audit opinion.

– Regions waived any work product protection it might have had when it disclosed its TAW to an adverse party – Regions’ independent auditor.

Regions (cont.)

• Court’s holding:

– Relying in part on Textron, TAW were created in anticipation of litigation under either the “because of litigation” test or the “primary motivating purpose” test.

• The court stated, “were it not for anticipated litigation, Regions would not have to worry about contingent liabilities and would have no need to elicit opinions regarding the likely results of litigation.”

• According to the court, litigation need not be imminent, but merely a possibility at the time the relevant documents were created.

• Regions’ subjective believe that it might be forced to litigate with the IRS was not objectively unreasonable.

– Regions did not waive its work product protection because the auditor was not an adverse party.

• There was “no conceivable scenario” under which the auditor would file suit against Regions as a result of its disclosure of TAW to the auditor.

FIN 48 Overview

• FIN 48 requires companies to undergo a two step process prior to recognizing a tax benefit in financial statements:– Is it more likely than not that a position will be sustained?– How much benefit can be recognized?

• These two analyses are generally performed and maintained in a company’s tax accrual workpapers.

• FIN 48 also requires companies to disclose the amount of their unrecognized tax benefit (tax reserve).– These disclosures of aggregate reserve levels have proven to

be largely innocuous from an IRS roadmap perspective.

Does FIN 48 Weaken TAW Work Product Claims?

• Does the requirement that all companies prepare TAW for financial accounting purposes mean that taxpayers are no longer preparing TAW “in anticipation of litigation?”

Does FIN 48 Strengthen TAW Work Product Claims?

• The recognition step of the FIN 48 analysis requires that a taxpayer determine whether or not they are “more likely than not” to have their reporting position sustained.– This is a direct litigation assessment, which may strengthen a

claim that the TAW were prepared “in anticipation of litigation.”

• FIN 48’s requirement that aggregate tax reserve figures be publicly reported arguably diminishes the IRS’ need for TAW.

Hot Issues for Financial Institutions

• Relationship between the IRS and financial institutions

• FTC generators

• Withholding tax issues

• Emerging issues