IRS LARGE BUSINESS AND INTERNATIONAL: ALTERNATIVE DISPUTE RESOLUTION

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1 IRS LARGE BUSINESS AND INTERNATIONAL: ALTERNATIVE DISPUTE RESOLUTION BETH TUCKER As a result of rising budget constraints, the IRS is making changes to several processes and procedures in an effort to increase the efficiency of its enforcement operations. This article focuses on how these budget constraints are driving changes in enforcement strategies and highlights options to resolve tax controversies as the IRS programs continue to evolve. Budget constraints The IRS has been forced to grapple with multiple years of budget cuts, staff reductions, congressional scrutiny, and significant turnover in the executive, managerial, and enforcement personnel ranks. The IRS budget declined by approximately $900 million from fiscal year (FY) 2010 to FY 2014, leaving the agency s funding below FY 2009 levels. 1 During the same period, staffing declined by about 10,000 employees a 10% reduction. Although the President s 2015 IRS budget request of $12.5 billion would halt the downward budget trend if approved, once adjusted for inflation, it BETH TUCKER, is a managing director of Tax Controversy and Regulatory Services at PriceWaterhouseCoopers in Dallas. She is also former IRS Deputy Commissioner. would still leave the budget below 2010 funding levels. To make matters worse, the IRS is facing new demands due to the significant challenges and complexities associated with implementing the tax provisions of the Patient Protection and Affordable Care Act (PPACA), enforcing the Foreign Account Tax Compliance Act (FATCA), and running high-priority programs, such as those to prevent identity theft and refund fraud. Appearing recently before the House Appropriations Financial Services and General Government Subcommittee, IRS Commissioner John Koskinen stressed that the IRS is required by law to implement PPACA and FATCA, and that if the agency does not receive adequate funding to implement these two significant pieces of legislation, it will be forced to divert funds from taxpayer services (e.g., answering taxpayer phone calls during filing season), enforcement activities (e.g., audits or collection matters), or both. 2 Due to the decrease in resources, the IRS has taken several aggressive actions to absorb the $900 million budget cut, including lowering employee training costs by 83%, decreasing office space and closing IRS offices, delaying technology upgrades, and reducing or eliminating some taxpayer services. 3 Spending for Taxpayers should reevaluate the potential benefits of engaging in dispute resolution options outside of the traditional exam process. OCTOBER 2014 PRACTICAL TAX STRATEGIES 155

2 As the number of revenue agents decreases, the IRS is searching for ways to sustain voluntary compliance. training dropped from $1,600 per employee in FY 2009 to approximately $200 per employee in FY 2013, which resulted in a 96% reduction in training for Appeals and a 92% reduction in training for the Large Business and International (LB&I) Division. The National Taxpayer Advocate s 2013 Annual Report to Congress lists training cuts as one of the IRS s most serious problems. 4 According to IRS officials, ongoing budget reductions of this magnitude cannot be sustained and will continue to have negative implications on both IRS services and enforcement. IRS response to budget constraints Resource constraints are also affecting IRS audits. The Commissioner testified during a recent House Ways and Means Subcommittee on Oversight hearing that in the current FY, the IRS will perform 100,000 fewer individual audits, and will see a decline in other areas of enforcement, including 190,000 fewer collection activities. 5 As the number of revenue agents decreases, the IRS is searching for ways to sustain voluntary compliance. For example, the LB&I Division is attempting to achieve compliance by using risk based and issue focused examinations, expanding the use of compliance analytics, implementing new knowledge management strategies, joining forces with domestic and international enforcement agencies, and increasing focus on alternative resolution strategies. These strategies, explained further below, have allowed the IRS to maintain audit coverage of the largest corporations at a reasonably consistent level. Some of these strategies are in the recently released IRS Strategic Plan, which covers IRS priorities, and outlines several goals and objectives designed to improve domestic and international compliance by strengthening expertise, adopting innovative approaches and streamlining procedures. 6 The plan says that the IRS will achieve these goals by: (1) increasing employee awareness of global and domestic tax issues and sharing knowledge through the dissemination of best practices and tools; (2) identifying and deploying innovative enforcement approaches that enable greater compliance coverage and enhancing the productivity of enforcement efforts; (3) strengthening joint enforcement activities with domestic and international enforcement agencies; (4) customizing enforcement approaches based on taxpayer analytics; and (5) reducing the complexity of enforcement procedures. Eliminating the CIC designation Although 50% of IRS resources are focused on coordinated issue case (CIC) taxpayers, only 900 of the 260,000 LB&I taxpayers are CIC taxpayers. 7 At the same time, there has been a significant increase in LB&I taxpayers that are pass-through entities. Now that the allocation of resources has become a critical issue, the IRS is considering eliminating the CIC designation for the largest taxpayers and moving away from continuous audits. Instead, it would rely largely on Schedule UTP (Uncertain Tax Position) 8 to identify issues and then allocate appropriate resources to conduct targeted issue specific audits of the largest corporate taxpayers. Changes to the quality exam process LB&I is also implementing changes to the new quality exam process (QEP). 9 QEP is a required systematic approach for engaging and involving LB&I taxpayers in the tax examination process, beginning with the earliest planning stages through resolution of all issues and completion of the case. It is intended to set the foundation for 1 IRS 2015 Budget Long-Term Strategy and Return on Investment Data Needed to Better Manage Budget Uncertainty and Set Priorities, annual-report-to-congress/. 5 Written Testimony of John A. Koskinen, Commissioner, Internal Revenue Service, Before the House Ways and Means Committee Subcommitee on Oversight on the 2014 Filing Season and Improper Payments, 5/7/14, waysandmeans.house.gov/uploadedfiles/irs_testimony_050714os.pdf. 6 IRS Strategic Plan FY , 7 PwC Private Company Services, IRS Issues Guidance on New IDR Enforcement Process, 1/14/14, See Garofalo, Schedule UTP Issue Descriptions How Much Disclosure is Best?, 91 PTS 223 (November 2013) PRACTICAL TAX STRATEGIES OCTOBER 2014 IRS BUDGET CONSTRAINTS

3 improved communication between LB&I agents and taxpayers, and supports greater consistency in the exam process. Although it was initially announced in 2010, based on recent comments from IRS executives, it appears that QEP will continue to be revamped to make audits more issue focused. New information document issuance and enforcement process Most recently, the IRS announced a new information document request (IDR) issuance and enforcement process to increase efficiency and transparency. 10 The new process provides that all IDRs issued after 6/30/13 must be issue focused, and discussed with the taxpayer in advance. Further, the examiner and the taxpayer should discuss a reasonable timeframe for responding to the IDR. When an IDR deadline has passed, a delinquency notice is issued within ten business days. If the taxpayer fails to comply with the deadline in the delinquency notice, a presummons letter is issued within ten business days. If a taxpayer does not respond and complete the IDR within ten days of the presummons letter, a summons is issued and could ultimately be enforced in federal district court. The new IDR process puts additional pressure on taxpayers to work proactively with their examiners to agree to content and deadlines before IDRs are issued. With these new procedures, taxpayers need to ensure that they agree to the issue as stated in the IDR and take into account any difficulties that may occur in obtaining records and responsive documents prior to reaching an agreement with the IRS agent. If an agreement cannot be reached, the taxpayer should elevate the concern to the next level of IRS management expeditiously to avoid initiation of summons proceedings. New knowledge management system As part of the shift in enforcement strategy, the IRS replaced the tiered issue process with a new knowledge management system based on issue practice groups (IPGs) for domestic issues and international practice networks (IPNs) for international issues. 11 Viewed as tools to enhance collaboration and the sharing of knowledge and expertise between LB&I and the Chief Counsel, IPGs and IPNs are intended to provide exam teams with the technical advice that they need to manage their cases more efficiently, consistently, and with a higher degree of technical proficiency. IPGs bring together technical specialists and examination teams to address domestic technical areas in specific industries or for specific issues. On request, the specialists and teams consult with and give written advice to personnel in LB&I and other divisions. The written advice from IPGs is based on collaboration across all LB&I functions. Although exam teams are encouraged to consult IPGs, they are not required to do so, or to follow their advice. The IPNs operate very differently from the IPGs. Rather than serving as an advisory forum, IPNs are intended to engage additional resources throughout LB&I to broaden technical expertise and increase technical advice output. Through this increased collaboration, the IRS has indicated the IPNs will facilitate the sharing of institutional knowledge and best practices. IPNs do not control issues management of the case and how the issue is handled remains with the exam team. The 18 IPNs that address broad areas of international tax are aligned with the IRS international matrix, which is organized by key business drivers, such as income shifting, repatriation, and foreign tax credit management. Nine of the 18 IPNs are under the International Business Compliance unit (three each under Outbound, Inbound, and Cut-Across), six are under the International Individual Compliance unit (four under Outbound and two under Inbound), two are under Transfer Pricing Operations (Outbound and Inbound Income Shifting), and the treaty IPN is under the authority of the Assistant Deputy Commissioner (International). The IRS has indicated that exam teams are encouraged to consult IPGs or IPNs, especially when they encounter unfamiliar or complex technical issues. Heather Maloy, the Commissioner of LB&I, has spoken frequently about the importance of transparency in tax administration. In May 2012 at the American Bar Association Tax Section Laurence Neal Woodworth Lecture, Maloy said that, taxpayers should know at the beginning, middle and end of the examination, the issues the examiner is considering raising, why they are being raised, what legal arguments the examiner is relying on and in turn what the examiner s views of the taxpayer s legal arguments are. If others in the organization are consulted to develop a position, that fact should be shared with the taxpayer, and if the taxpayer wants to speak to those individuals, it should be arranged. IRS BUDGET CONSTRAINTS OCTOBER 2014 PRACTICAL TAX STRATEGIES 157

4 Increased importance of alternative dispute resolution methodologies As IRS resources continue to decline and pressure intensifies to manage examinations more expeditiously, taxpayers should reevaluate the potential benefits of engaging in dispute resolution options outside the traditional exam process as a means to secure certainty, reduce audit administration costs, and avoid protracted appeals proceedings. Prefiling agreements The prefiling agreement (PFA) process allows a taxpayer to resolve an issue likely to be disputed in a post-filing audit before the filing of its return. 12 Specifically, a PFA results in a closing agreement that provides certainty to the taxpayer with respect to a particular position. This allows taxpayers to conserve precious controversy resources and better manage their reserves and uncertain tax positions. While once confined to straightforward, noncontroversial subjects such as valuation disputes, the PFA process has recently been used successfully to resolve issues regarding research and development (R&D), internal use software, medical device excise tax, and characterization of income. However, certain areas of controversy are not eligible for a PFA. Examples include transfer pricing, some changes in methods of accounting or tax-year end, and issues involving penalties, tax shelters, litigation between a taxpayer and the IRS, and criminal sanctions. Key components of the PFA process are: A $50,000 user fee. The IRS normally requires 30 days to consider a PFA application. If the application is accepted, the audit process can take four to six months. The IRS expects transparency and a resource commitment from the taxpayer. Either party may withdraw from the PFA any time prior to execution of the closing agreement Internal Revenue Manual, Internal Revenue Manual, 17 AP Compliance assurance process The compliance assurance process (CAP) is another IRS program designed to identify and resolve issues prior to the filing of a taxpayer s return. 13 The IRS initiated CAP in 2005 as a pilot program and it is now permanent for tax years beginning after 12/31/11. When CAP started in 2005, there were 16 taxpayers in the program. Currently, there are 185 taxpayers in CAP including 64 taxpayers in CAP maintenance (discussed below), the desired end-state for the lightest touch by the IRS. In brief, CAP is a real-time examination of a return prior to its filing. Because CAP reduces the likelihood of post-filing examination and prolonged litigation, taxpayers are able to achieve tax certainty sooner and with less administrative burden than in the traditional post-filing examination process. The program requires a contemporaneous exchange of information related to proposed tax return positions and completed events and transactions that could affect federal tax liability. Transparency is the touchstone of CAP since it requires the taxpayer and the IRS to work in real time on a tax return. Accordingly, the rollout of Schedule UTP has led to increased interest in CAP. Pre-CAP phase In the pre-cap phase, taxpayers work with the IRS to become current in the examination of their returns. 14 This means that the IRS works with the taxpayer in the traditional post-filing examination process to close the open tax years within an agreed on timeframe. Taxpayers that do not have open years under examination may bypass the pre-cap phase and apply directly to CAP. To be eligible for the CAP phase, the taxpayer must have filed all required tax returns, and no more than one tax year can be currently under IRS examination. CAP phase In the CAP phase, participating taxpayers work collaboratively with the IRS to identify and resolve potential tax issues as they arise and before the return is filed. As the taxpayer completes material and significant business transactions, it discloses its tax positions regarding those transactions to the IRS. After the IRS and the taxpayer agree on an issue, the IRS will draft an issue resolution agreement (IRA). At the conclusion of the prefiling 158 PRACTICAL TAX STRATEGIES OCTOBER 2014 IRS BUDGET CONSTRAINTS

5 stage of CAP, the IRS may incorporate all of the agreed IRAs into a closing agreement. If all issues are resolved, the IRS will issue a full acceptance letter. After the return is filed, the IRS will perform a post-filing review. If all disclosures were made in accordance with the memorandum of understanding (MOU) between the taxpayer and the IRS, the Service will issue a no change letter. If any unresolved issues remain, the IRS will issue a partial acceptance letter and commence a traditional examination of those unresolved issues. CAP maintenance Taxpayers that continually meet the CAP eligibility requirements and expectations may be invited to progress to the CAP maintenance phase. This phase of CAP is intended for LB&I taxpayers that have participated in CAP for several years, have a limited number of complex issues, and have an established track record of transparency and cooperation with the IRS. In the maintenance phase, the benefits of the CAP process are considerable, as the scope and depth of the exam is reduced significantly. Taxpayers continue to disclose material items that will affect their federal tax liability, but the IRS typically decreases the level of review for these transactions. There is an application process if a taxpayer is interested in CAP. To be eligible for CAP, the taxpayer must have assets of $10 million or more, be a publicly held entity with SEC filing requirements, or if privately held, agree to provide certified, audited financial statements quarterly, and not be under investigation by, or in litigation with, the IRS. If a taxpayer is approved for the CAP program, a MOU outlining the program requirements and serving as an agreement between the parties must be executed before January 31 of the CAP year. Specifically, the MOU is used to describe the process and expectations of both parties, including detailed expectations, timelines, and materiality thresholds and detailed expectations for taxpayer disclosure. Benefits of CAP In recent years, the IRS has assigned more of its resources to work with taxpayers in a prefiling environment. The CAP program provides many benefits, such as tax certainty before a return is filed, reduction in the need to file amended state tax returns following traditional IRS examinations, audit management resource savings, and the retention of all appeal rights. A taxpayer does not relinquish any of its rights by participating in the CAP program. In fact, as with the traditional examination process, taxpayers should not be reluctant to raise issues with the case manager, territory manager, or director of field operations if they are encountering issues during the CAP process. Taxpayers should consider the CAP program seriously if they want certainty much earlier in the examination process. Fast track settlement and rapid appeals process programs As indicated above, during difficult budget times, it is advantageous to consider other means of resolution that may expedite the traditional examination process. The IRS Office of Appeals (Appeals) provides several opportunities for taxpayers to improve the efficiency of the appeals process. The use of alternative settlement processes, including the Fast Track Settlement (FTS) 15 and Rapid Appeals Process (RAP) 16 programs has been expanded. FTS is a nonbinding, voluntary negotiation process between a taxpayer and the IRS exam team to help taxpayers resolve disputed issues before a formal administrative appeal. FTS may be initiated once the issue has been developed fully in exam and the taxpayer has provided a written response to the IRS notice of proposed adjustment. If a settlement agreement is reached through FTS, a closing agreement will be executed. FTS is designed to be completed in approximately 120 days, much faster than the multiyear process of a traditional appeal. Although FTS can be successful, using it does not eliminate other dispute resolution options. Taxpayers choosing FTS retain their rights to appeal if the process is unsuccessful. In addition, either the taxpayer or the exam team may withdraw from the process at any time. RAP is a relatively new voluntary procedure intended to improve the efficiency and timeliness of appeals resolutions. In RAP, the LB&I preconference is used to attempt to resolve issues with the taxpayer applying the techniques of FTS process. If an agreement is not reached, the traditional appeals process continues. IRS BUDGET CONSTRAINTS OCTOBER 2014 PRACTICAL TAX STRATEGIES 159

6 New issues and undeveloped cases Over the last year, Appeals has been emphasizing its policies with respect to new issues and underdeveloped cases. In July 2013, it released an employee memorandum instructing officers to return to a more quasi-judicial approach to settling cases. 17 Officers are not to engage in fact finding or investigating, and should not serve as examiners. Instead, they should focus on the law and the litigating hazards in determining the merits of the positions of both the exam team and the taxpayer. Also, officers must focus on resolving the issues that the parties presented. Accordingly, Appeals may not raise a new issue or reopen a closed issue on which the taxpayer and the IRS agreed. Appeals may raise new theories or alternative legal arguments that support the positions presented by the parties. However, if Appeals raises an alternative legal argument or issue that benefits the government, it must rely on existing evidence in its attempt to settle the case. The new policy also addresses the treatment of cases not fully developed by the exam team. Under the new policy, Appeals will not return the case to the exam team for further development. Rather, if the taxpayer presents no new information or evidence, it will attempt to settle the case on its facts. By contrast, if the taxpayer presents new facts or evidence on an existing unresolved issue, Appeals will return the case to the exam team for assessment of that information. Should Appeals decide to retain jurisdiction of a case after receiving new information, the exam team will be given an opportunity to review the information and provide comments to Appeals. The renewed emphasis by Appeals on these procedures is intended to increase efficiencies in the review process as well as potentially prevent unreasonable timeframes during the traditional appeals process. Conclusion While the IRS continues to be in the midst of very challenging times, there is still a focus on the implementation of robust compliance strategies that will affect a wide range of large and midsize corporate taxpayers, partnerships, and pass-through entities. Therefore, it is imperative for taxpayers to be aware of and understand all of the alternative dispute resolution options available. Taxpayers also need to continuously ensure that the IRS is following reasonable examination management practices, such as creating audit timeline agreements, scheduling issue discussions regularly, and agreeing to a process for elevating contentious issues expeditiously. n 160 PRACTICAL TAX STRATEGIES OCTOBER 2014 IRS BUDGET CONSTRAINTS