The Uncertain World Of Uncertain Tax Position Disclosures And Privilege

First published by Bloomberg BNA Daily Tax Report, March 23, 2012

While death and taxes may be the only certainties in life, corporations have found that tax positions have become less certain as the complexity of business and tax rules increases.

Items such as the arm's-length pricing for international transfers of technology to affiliates and the creditability of research and development expenses are tax positions involving significant judgment calls that often result in disputes with the Internal Revenue Service and cause companies to record loss contingency reserves in their financial statements.

Beginning with their 2010 tax returns, generally filed in late 2011, corporations with more than $100 million in assets were required to file IRS's new schedule describing and ranking the corporation's uncertain tax positions (Schedule UTP).1 Beginning with 2012 tax returns, that requirement will extend to corporations with more than $50 million in assets and, with 2014 tax returns, to those with more than $10 million in assets.

Schedule UTP disclosure brings into focus the challenges of preserving the confidentiality of documents, particularly tax accrual work papers, relating to uncertain tax positions disclosed on that schedule because of the potential for subject matter waiver of relevant privileges.

This article discusses privileges potentially applicable to tax accrual work papers (including opinions obtained to support the tax treatment) and disclosures that could affect those privileges. It concludes with recommendations to best position a taxpayer to preserve privilege and prevent inadvertent disclosures.

Definition of Tax Accrual Work Papers

There is no universally accepted definition of tax accrual work papers. The Internal Revenue Manual defines the term to mean:

[T]hose audit workpapers, whether prepared by the taxpayer, the taxpayer's accountant, or the independent auditor, that relate to the tax reserve for current, deferred and potential or contingent tax liabilities, however classified or reported on audited financial statements, and to footnotes disclosing those tax reserves on audited financial statements. These workpapers reflect an estimate of a company's tax liabilities and may also be referred to as the tax pool analysis, tax liability contingency analysis, tax cushion analysis, or tax contingency reserve analysis.2

Based on the usage in the case law, the term also encompasses opinion letters prepared by outside counsel if those opinions are relied on in the analysis of whether a tax position is uncertain.

History of IRS's Policy on Requesting Tax Accrual Work Papers

Under a policy adopted in 1981, IRS will not request a taxpayer's tax accrual work papers except in ''unusual circumstances.'' An unusual circumstance exists where:

a specific issue (or issues) has been identified for which the agent needs additional facts, the agent ''has sought from the taxpayer all facts known to the taxpayer relating to the identified issue( s),'' and the agent ''has sought from the taxpayer's accountant supplementary analysis (not necessarily contained in the workpapers) of facts relating to the identified issue( s).''3 In 2002, as part of its effort to combat tax shelters, IRS expanded the situations under which it would request those work papers to include those where the taxpayer engaged in a transaction determined by IRS to be an abusive tax avoidance transaction (a ''Listed Transaction'').4

If the taxpayer disclosed its participation in that transaction and claimed the benefits of only one such transaction, IRS would seek only the tax accrual work papers relating to that transaction. If the taxpayer did not disclose the transaction or claimed the benefits from more than one such transaction, IRS would request all of the taxpayer's tax accrual work papers.

Unrelated to IRS policy developments, the Financial Accounting Standards Board (FASB) recognized an issue in the varying interpretations being applied to contingent tax liabilities by different auditors. The FASB issue arose in part because those liabilities were covered under both under FAS 5 (regarding contingent liabilities in general) and FAS 109 (specific to income taxes). To address this concern, FASB implemented FASB Interpretation No. 48 (FIN 48) effective for years beginning after Dec. 31, 2006, to clarify the treatment of contingent tax liabilities underSFAS 109.

Because FIN 48 specifically addresses uncertain tax positions, it eliminates the confusion that previously arose from those positions being subject to both FAS 5 and FAS 109. Under FIN 48, companies must assume each tax position will be audited and create reserves for tax benefits stemming from ''uncertain tax'' positions. An uncertain tax position under FIN 48 is one where the company's position does not meet the ''more likely than not'' standard (MLTN).5

The sensitivity of a company's tax accrual work papers is heightened following the implementation of FIN 48 because the company must assume each transaction will be audited and must provide a more precise analysis of the likelihood that its treatment will be sustained on audit.

The work papers should also indicate the positions for which no reserve is being made because the company expects to litigate and prevail. Furthermore, for those items that the company expects to settle with IRS, the tax accrual work papers typically reflect the amount for which the company believes it is MLTN it could settle the issue.6

Although auditors are supposed...