Voluntary Disclosures – What to Give Up, Up FrontApril 17, 2013

Brian P. Kaufman J. Walker Johnson Matthew D. Lerner

Capital One Financial Corp Steptoe & Johnson LLPSteptoe & Johnson LLP

McLean, Virginia Washington, DCWashington, DC

wjohnson@steptoe.commlerner@steptoe.comCopyright 2013, Steptoe & Johnson LLP, All Rights Reserved.

Table of Contents

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Mandatory Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

Voluntary Disclosures to Avoid Penalties . . . . . . . . . . . . . . . . . . . . . . . 8

Voluntary Disclosures for Strategic Purposes . . . . . . . . . . . . . . . . . . . 21

How to Make an Effective Disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . 29

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Introduction

Disclosures in a Traditional IRS Examination Paradigm

– Formal process with limited communication between Taxpayer and IRS examination team

– Reactive v. Proactive Disclosure Model

• Disclosure of documents/information only in response to specific IDRs/requests from IRS

• No voluntary disclosure of transactions/positions or other information by taxpayer during course of examination

• Limited in-person communication with IRS on issues before IDRs issued

• Limited or no interaction with IRS examination team, technical advisors and attorneys during examination process

• Limited or no discussion with IRS with respect to potential issues before Notice of Proposed Adjustments issued

• Limited use of issue resolution tools prior to completion of examination such as Technical Advice Requests, Fast Track Appeals, and Early Referral to Appeals

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Introduction

Disclosures in the Evolving IRS Examination Paradigm

– Increasingly informal process with significant communication between Taxpayer and IRS examination team

– Proactive v. Reactive Disclosure Model

• Disclosure of information voluntarily at beginning of examination to streamline examination process (e.g., significant transactions, significant book/tax differences, new items/positions)

• Active discussion of issues with IRS before IDRs issued, strategically presented to limit scope of requests

• Expected 2013 changes to IRS IDR process to encourage IRS/taxpayer communication and avoid out-of-nowhere “fishing expedition” requests

• Constant meetings with IRS examination team, technical advisors and attorneys during examination process to discuss issues and potential resolution

• Use of Pre-CAP/CAP examination programs to reduce scope of examinations

• Regular use of issue resolution tools during course of examination such as Technical Advice Requests, Fast Track Appeals, and Early Referral to Appeals

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Mandatory Disclosures

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Mandatory Disclosures

Some disclosures are not voluntary, but mandatory. When considering what to disclose voluntarily keep in mind what you are required to disclose.

– Reportable transactions must be disclosed on Form 8886. Treas. Reg. § 1.6011-4(d).

– Corporate book-to-tax differences must be disclosed on Schedule M-3 to help the IRS identify possible areas that might require examination.

– Corporations report uncertain tax positions on Schedule UTP.

– Corporations must disclose information with respect to foreign business entities that they control. IRC § 6038.

– Corporations that are at least 25 percent foreign owned must disclose information regarding transactions with related parties. IRC § 6038A.

– Certain transfers of property to a foreign corporation or a foreign partnership must be disclosed to the Service. IRC § 6038B.

– Foreign corporations engaged in a trade or business within the U.S. must disclose information regarding transactions with related parties. IRC § 6038C.

– Form 1120 requires disclosure of changes in method of accounting for book and/or tax purposes (even if accounting method change was made without a Form 3115).

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Mandatory Disclosures

Section 6011 may require a disclosure.

– Pursuant to section 6011, the IRS has issued regulations that require the disclosure of certain types of transactions. Treas. Reg. § 1.6011-4. Successive versions of these regulations, applicable to different time periods, have been issued over the years.

– In February 2003, the IRS issued final regulations effective for “reportable transactions” occurring on or after January 1, 2003. The regulations require that taxpayers that participate, directly or indirectly, in a “reportable transaction” must file a disclosure statement with their tax return, and with the IRS Office of Tax Shelter Analysis, for each year that is affected by the reportable transaction.

– The regulations describe five classes of reportable transactions – (1) listed transactions, (2) confidential transactions, (3) transactions with contractual tax benefit loss protection, (4) transactions generating significant losses, and (5) transactions of interest.

• A “transaction of interest” is a transaction that is the same as or substantially similar to one of the types of transactions that the IRS has identified by notice, regulation, or other form of published guidance as a transaction of interest. See Treas. Reg. §1.6011-4(b)(6).

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Penalty Disclosures

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Voluntary Disclosures to Avoid Penalties

Treas. Reg. § 1.6662-7(b) provides that the section 6662(b)(1) negligence penalty cannot be avoided by disclosure.

Treas. Reg. 1.6662-3(c) and 1.6662-7(c) provide that a penalty for the disregard of rules or regulations can be avoided in some cases if there is disclosure and at least a reasonable basis for the position.

Section 6662(b)(2) substantial understatement penalties can be avoided if a position is properly disclosed on the tax return and there is at least a reasonable basis for the position. IRC § 6662(d)(2)(B). This disclosure rule does not apply to “tax shelter” items. IRC § 6662(d)(2)(C); Treas. Reg. § 1.6662-4(e).

Section 6662A reportable transaction understatement penalties can be avoided if a position is properly disclosed on the tax return, there is substantial authority for the position, and the taxpayer reasonably believed its position was more likely than not proper. IRC § 6664(d).

Note that if a reportable transaction is not disclosed a penalty can be imposed under IRC § 6707A.

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Rules for non-tax shelter transactions

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Rules for tax shelter transactions

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Voluntary Disclosures to Reduce Penalties

If a listed or reportable transaction is not adequately disclosed, the section 6662A penalty will be increased from 20% to 30%. IRC § 6662A(c).

If a transaction lacking economic substance is not adequately disclosed, the section 6662(b)(6) penalty will be increased from 20% to 40%. IRC § 6662(i).

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How to Make a Penalty Disclosure

To disclose properly a position on the original tax return, use Form 8275 or 8275R. Treas. Reg. §§ 1.6662-3(c) and 1.6662-4(f).

After the original return is filed, disclosure can be made on a Qualified Amended Return (QAR). Treas. Reg. § 1.6664-2(c)(2) and (3).

– If the item is a “tax shelter,” penalties may be avoided by filing a timely QAR and paying the tax and interest associated with the item. The payment of tax is treated as tax shown on the original return and eliminates the underpayment on which the penalty is based. Treas. Reg. § 1.6664-2(c)(3).

– If an item is not a “tax shelter,” penalties may also be avoided by filing a timely QAR that discloses the position and does not pay the associated tax and interest. Treas. Reg. § 1.6664-2(c)(4).

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Qualified Amended Returns

An amended return will be a “qualified amended return” only if it is filed before –

1. the date an IRS examination of the taxpayer (or a pass-through entity for which the taxpayer reports a pass-through item) begins;

2. the date a tax shelter promoter examination begins with respect to an activity for which the taxpayer claimed a tax benefit;

3. the date a John Doe summons is served on a third party with respect to an activity of the taxpayer for which the taxpayer claimed a tax benefit; and

4. the date on which the Commissioner announces a settlement initiative to compromise or waive penalties with respect to a listed transaction. Treas. Reg. § 1.6664-2(c)(3)(i).

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Qualified Amended Returns

If a taxpayer fails to disclose a listed transaction for which a tax benefit is claimed, an amended return will be treated as a Qualified Amended Return only if it is filed before –

1. the dates described above for Qualified Amended Returns in general;

2. the date the IRS first contacts a person regarding an examination of that person’s liability for penalties under section 6707(a) with respect to the undisclosed listed transaction of the taxpayer; and

3. the date on which the IRS requests from a taxpayer’s material advisor (or any person who made a tax statement for the benefit of the taxpayer) the information required to be included in a list under section 6112 relating to a transaction that is the same as, or substantially similar to, the undisclosed listed transaction. Treas. Reg. § 1.6664-2(c)(3)(ii).

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Qualified Amended Returns

Taxpayers in LB&I’s Coordinated Industry Case Program can provide a written statement that is treated as a Qualified Amended Return under Treas. Reg. § 1.6664-2(c)(3) if the written statement is furnished after the filing of a tax return but no later than 15 days from the date written notice is provided from the IRS requesting such statement. See Rev. Proc. 94-69, 1994-2 C.B. 804.

The written statement must include:

– A description of all items that would result in adjustments if the taxpayer, in lieu of furnishing a written statement, filed a properly completed amended return. The description of an item is adequate if it consists of information that reasonably may be expected to apprise the IRS of the identity of the item, its amount, and the nature of the controversy or potential controversy.

– A declaration signed under penalties of perjury.

The written statement does not need to include a recomputation of tax liability or other affected items.

Any additional tax liability resulting from the adjustments identified in the written statement is treated as an additional amount of tax shown on a Qualified Amended Return.

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Qualified Amended Returns

Effect of a Qualified Amended Return

An amount shown as additional tax on a qualified amended return is treated as tax shown on the original return and eliminates the underpayment on which the penalties under IRC§6662(b)(1) and (b)(2) are based. Treas. Reg. § 1.6664-2(c)(3).

An amount shown on a qualified amended return also eliminates an underpayment on which penalties regarding net section 482 transfer price adjustments under§6662(e)(3) are based. Treas. Reg. § 1.6662-6(a)(2).

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Qualified Amended Returns

Can you contest a position taken in a QAR?

– Example:

• Taxpayer reports an item as debt on its original return. Taxpayer later files a timely QAR to recharacterize the item as equity. During examination, can the taxpayer argue that the item is properly characterized as debt as originally reported?

– Answer:

• Some in the IRS suggest that a position on a QAR should be treated as an irrevocable admission.

• However, the better view is that one can raise and contest a position in a QAR in examination, just as one can seek to adjust a position taken on a return as originally filed.

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Special Voluntary Disclosure Situations

Limited Issue Focused Examination (LIFE) process

– Large taxpayers have the option of entering into a streamlined audit process called the Limited Issue Focused Examination (LIFE) process. See Internal Revenue News Release IR-2002-13; IRM § 4.51.3.

– The purpose of the program is to focus the audit only on significant issues, making the audit process faster and less costly.

– Under the agreement, the Service agrees to limit the scope of its examination to certain identified issues. Also, the Service agrees not to raise issues, and the taxpayer agrees not to assert affirmative claims, for issues under specified dollar thresholds.

– The agreement also provides for exchanges of information, a time schedule for the audit, and other agreed upon procedures.

Domestic Non-Filers

– U.S. taxpayers who have failed to file a return may decide to make a voluntary disclosure to the IRS about their non-filer status and pay the tax owed.

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Special Voluntary Disclosure Situations

Compliance Assurance Process (CAP)

– The Compliance Assurance Process (CAP) is designed to resolve all material tax issues before a return is filed. The focus is on issue identification and resolution through transparency and cooperation. Participation results in shorter and narrower post-filing examinations.

– Taxpayer must make open, comprehensive and contemporaneous disclosures of completed business transactions, proposed tax positions, tax issues within the transactions and other material items or issues and pertinent facts regarding material items.

– Specific Disclosure Items:

• Current organization charts reflecting related entities and flow of information;

• Financial performance information;

• Information on significant events that will affect the reporting for the tax year;

• Access to accounting records and systems, the general ledger and other requested accounting records must be disclosed quarterly; and,

• Tax schedules and computations for rollover and recurring adjustments; potential refund claims.

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Disclosure for Strategic Purpose

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Voluntary Disclosures for Strategic Purposes

In some instances voluntary disclosure may go beyond penalty avoidance and serve a strategic purpose.

– QEP envisions voluntary and affirmative disclosures.

– Voluntary disclosure can avoid disputes over information requested by the IRS. The IRS has indicated that IDR responses will be due earlier and that resort to summonses will occur more quickly.

– The degree of cooperation can influence assertions of penalties and mitigate the risk of civil cases turning into criminal cases.

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Advantages of Disclosure

What are possible advantages of disclosure?

– Project a helpful and cooperative attitude

– Reduce the number of IDRs issued

– Narrow and shape the content of issued IDRs

– Speed the audit

– Shape Exam’s exposure to the issue by presenting the issue in the best light

– Disclosure of certain issues may narrow Exam’s focus or limit attention on other items on the return.

– Issues that are not fully developed may be returned to Exam by Appeals.

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Disadvantages of Disclosure

What are possible disadvantages of disclosure?

– Cause Exam to focus on an issue it otherwise might not have raised

– Increase Exam’s level of interest in the issue

– Disclosure could be interpreted as a taxpayer’s lack of confidence in its position.

– If there is voluntary disclosure on several issues, but none on a major and sensitive issue, that lack of disclosure could be viewed as disingenuous.

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Disadvantages of Disclosure

What are possible disadvantages of disclosure?

– Taxpayers must be sure they have adequately developed the issue being disclosed.

– Erroneous disclosures are worse then no disclosure.

– Factual representations that turn out to be incorrect can be a disaster.

– Factual statements made by business people that turn out to be incomplete or incorrect are prior inconsistent statements.

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Information to Consider Disclosing

1. Things the IRS Will Ask for Anyway

• Look to the QEP Reference Guide

– All significant transactions for the current examination and any other information that is new and/or different from previous examinations(s) (e.g., acquisitions, dispositions, tax shelters, accounting method changes, etc.)

• Basic examination documents (IRM 4.46.4.2)

– Internal controls, books and records, balance sheets, etc.

• Information concerning mandatory disclosure items (M3, UTP, etc.)

• Information Exam will seek in mandatory IDRs

• Tax accrual workpapers, if applicable (IRM 4.10.20)

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Information to Consider Disclosing

2. Things You Want Exam to Look At

• IRM §1.2.43 contains numerous Delegations of Authority for the Examining Process. Issues subject to a delegation could be disclosed. For example:

– Delegation Order 4-24: Ability to resolve an issue previously settled at Appeals;

– Delegation Order 4-25: Ability to resolve coordinated issues in accordance with Appeals settlement guidelines.

• Requests for a change in method of accounting made on Form 3115 (done to avoid a prior year adjustment).

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Information to Consider Disclosing

3. Things the IRS is Likely to Examine

• Industry issues, recurring issues, etc.

• Compliance Coordinated Issues

• Appeals Coordinated Issues

• Issues considered by an IPG or IPN

• Significant transactions

• Items disclosed in financial statements

4. Issues Exam Has Identified, but Before an IDR is Issued

• As to these issues, voluntary disclosure may be effective in limiting the scope or shaping IDRs.

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How to Make an Effective Voluntary Disclosure

Timing

– The disclosure is voluntary. It should be done early, before Exam asks for the information.

– In response to IDRs, consider expanding the scope of the information provided beyond the scope of the IDR, if this is helpful to your argument.

Litigation Hold– When disclosing an issue, should you simultaneously impose a litigation hold?

• If you will want to assert work product protection for documents relating to the disclosure, then instituting a litigation hold will help to establish an “anticipation of litigation.”

• If a court determines that you anticipated litigation and did not impose a litigation hold, you run the risk of sanctions if documents are lost or destroyed.

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How to Make an Effective Voluntary Disclosure

Preparation

– Develop the issue before you start making representations about facts and legal theories.

• Begin to prepare when the transaction is closed by obtaining and saving relevant documents.

• Save electronically stored information.

• Organize documents coherently.

• Talk to the business people with knowledge of the transaction.

• Be sure that employee statements comport with documents and emails.

• Be aggressive in your preparation by proceeding as if you are responding to document requests and preparing for depositions.

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How to Make an Effective Voluntary Disclosure

Analyze privilege issues

– Selective disclosure of legal advice may cause a subject matter waiver of privilege.

Provide preemptive written explanations, including PowerPoint presentations

– Consider how to frame issues in an affirmative and effective manner.

– Anticipate areas of IRS concern.

– Provide sufficient disclosure and analysis to satisfy the IRS.

Consider offering interviews with key personnel

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