Federal, State, and International Tax Audits in the Alternative Investments Industry

Transcription

1 Federal, State, and International Tax Audits in the Alternative Investments Industry April 2013

2 Contents Introduction...1 The audit landscape... 2 The audit process... 3 Managing the audit... 6 Being prepared... 7 Conclusion... 8 Contact information... 9 Federal, State, and International Tax Audits in the Alternative Investments Industry

3 Introduction Federal and local governments are under increased fiscal pressure; many tax jurisdictions are operating in a deficit and are looking to raise capital from all sources, thereby increasing the number of audits they perform, particularly in the asset management industry. Investors are no longer passively sitting on the side lines. They are demanding transparency, focused on risk assessments and don t want to be surprised with adverse news. As a follow-up to our webcast on October 18, 2012 regarding Tax Audits in the Alternative Investments Industry, below is a summary of the issues that PwC addressed. Federal, State, and International Tax Audits in the Alternative Investments Industry 1

4 The audit landscape How has the IRS world changed in recent years? In the past three years the IRS has started a new examination group called the Managed Funds Group, which has spent the last several years studying the complex tax issues the Alternatives industry is facing. This highly specialized group is focused on auditing venture capital, private equity, real estate and hedge funds and is made up of technical advisors, IRS specialists and IRS counsel. These members of the IRS team are experts in partnerships, financial products and TEFRA issues. In many cases the Service comes fully prepared with specialists and counsel to direct the focus of the audit. Another initiative that the IRS more recently established is the Global High Wealth Industry (GHWI). This program starts with the audit of a key partner, usually an individual within an alternative investment fund, and then the audit is expanded to include several entities from which the individual derives income (including the management company in many instances). While this initiative is relatively newer, the Service has signaled that this initiative will continue to expand. Have state and local governments been increasing their focus on audits as well? Yes. As states continue to experience significant budget shortfalls, they have also begun to focus heavily on funds and fund managers. California, Illinois, Massachusetts, New York State and New York City have increasingly targeted funds given the large population of asset managers headquartered in those jurisdictions. However, in the race for tax revenue, other states such as Connecticut, Michigan, Ohio, Pennsylvania and Washington State have also become aggressive with respect to asset managers. Not only are states questioning state specific items, they are also sometimes questioning federal tax items as well. How about on the international front? In today s global economy countries are in search of increasing their tax revenues and reducing their budget deficiencies. This, in combination with political pressure to seek additional tax revenue and additional sources of revenue, has created a shift by countries to focus more on non-resident investors and particularly investment funds. International governments have also focused heavily on assuring entities have sufficient substance if relying on treaty benefits. How is an audit of a partnership different from that of a corporation? In the world of partnerships, partners come in and out, and the entity is not static. In addition, each partner has its own unique tax footprint and issues which add complexities. On the other hand, an audit of a corporation is conducted on the corporate level and there is less concern with who the shareholders are for the period under audit. Further, it is easier to assess the impact of any adjustments because you are only dealing with one taxpayer, whereas, in a partnership, an adjustment that may be a good result for one partner may negatively affect another and is more difficult to manage. Federal, State, and International Tax Audits in the Alternative Investments Industry 2

5 The audit process What is the process for federal audits? Federal audits are governed by special provisions in the Internal Revenue Code. Under the Tax Equity and Fiscal Responsibility Act of 1982, commonly referred to as TEFRA which applies solely to partnerships 1, a TEFRA audit is rigid and poses many challenges. For example, the rules require you to keep investors informed from the onset of the audit thereby possibly creating investor relation concerns even before an adjustment is made. When the IRS is ready to begin an audit of a partnership, the Revenue Agent notifies the Tax Matters Partner, known as the TMP that the partnership has been selected for an audit and that an opening conference is requested. This process of notification is done with an appointment letter followed with the initial Information Document Request (IDR). Usually at the opening conference (or shortly thereafter), the Revenue Agent will give the TMP or its representative a Notice of Beginning of Administrative Adjustment (NBAP). Once an NBAP has been issued the Service has 45 days (this includes all holidays and weekends) to determine whether a full examination is warranted or not. If the agent determines that an examination is not warranted within 45 days of issuing the NBAP, none of the partners of the partnership have to be notified. However, if the Service continues with an examination past the 45 day window all notice partners will have to be notified that an audit has commenced. Although an NBAP is usually issued at the time of the opening conference, such timing can also possibly be negotiated. If an examination is warranted, the IRS sends out notice letters to notice partners. 2 When the examination is under way, the IRS then sends IDRs to the TMP. When examination is complete, IRS issues a summary report to the TMP. The IRS TEFRA procedures are time consuming and arduous. It can take at least 12 months once a Revenue Agent closes a TEFRA examination for an ultimate investor to be notified that the IRS has made an adjustment that will affect their individual tax liability. 1 TEFRA Partnerships are all partnerships, except 1) Small Partnerships (See Treas. Reg (a)(1)-1), 2) 10 or less partners, all of which are individuals or C- corporations. 2 If a partnership has 100 or fewer partners, then all partners are notice partners. If there are 101 or more partners in a partnership, only partners having a 1 percent interest or higher are notice partners. Partners that get together to form a Notice Group representing at least 5% interest are entitled to notice as well. Federal, State, and International Tax Audits in the Alternative Investments Industry 3

6 What is an Information Document Request IDR and what is typically included in an IDR? An IDR is a request for information regarding a T axpayer s books and records. IDRs issued by the IRS Managed Funds Group have recently become more specialized. In addition to requesting information regarding books and records, IDRs currently being issued are now focused on industry practices, issues and procedures. For example, Taxpayers have been asked for information regarding financial transactions such as wash sales, IRC 1256 transactions, qualified dividend income, swaps, and worthless securities deductions. IDRs have also recently begun to focus on the processes and procedures for reporting and trueing up Schedule K-1s received by the T axpayer. Assuming there is an adjustment by the IRS, are partners required to amend their prior years returns? The IRS will automatically make the adjustment to the partners returns and will bill them for their portion of an underpayment of tax. However, partners may be required to amend their state and local tax returns. What happens when a fund is audited by a state and local jurisdiction? How are these audits generally handled and are there similar administrative challenges to a federal audit? Unlike an IRS audit which is very rigid, states are not as regimented and do not follow as specific procedures. The auditors will come for a field visit and issue an information request, however, it may be several months before the auditor contacts the fund again. Due to this time lag, state and local jurisdictions are taking much longer to complete an audit than in previous times, averaging between 18 to 24 months for completion. What are things to consider when going through a state audit? State auditors still do not understand the fund industry and are often trying to audit for issues applicable to corporations or operating partnerships that have property, payroll and sales. States are diverting audit resources from the traditional multinational corporation audits to focus on partnership audits, especially on asset managers. Similar to the federal aspects, some of the audits of the funds seem to be training audits whereby the states are trying to understand how funds operate and the assets they trade. As such, much time is often spent educating the auditors on fund specific state and local tax issues. Federal, State, and International Tax Audits in the Alternative Investments Industry 4

7 What are things to consider when going through an international audit? The type of audits that are being conducted in non-us jurisdictions depend on a country-by-country basis. For instance, in some countries a local tax return may trigger follow-up questions from the tax authorities which may then result in an audit. In other countries, local tax authorities may review an industry, such as the asset management industry, and send questionnaires. Upon review of the questionnaires, the tax authorities may investigate a taxpayer further. Another triggering event for an audit is obviously the media. Articles, interviews, etc. may result in a tax audit. Overall, similar to the US, tax authorities are trying to understand the bigger picture and the industry. With the globalization of markets and mobility of investment professionals, asset managers should have guidelines in place on what investment activities their professionals can or cannot undertake while travelling, to manage a permanent establishment exposure. This is not only relevant for the management company, but also for the fund it manages as well as the individuals themselves. What is a closing agreement? A closing agreement is an agreement between the taxpayer and IRS that essentially by-passes the final closing TEFRA audit process of flowing up the adjustments tier by tier to the appropriate individual partners. The use of a closing agreement is still evolving and being tested in various audits and locations throughout the country and is not widely used. There are many advantages and disadvantages of a closing agreement for both the IRS and the partnership under audit and must be carefully considered. One of the advantages of having a closing agreement is that rather than flowing an adjustment up through the layers of partners, any adjustments made where additional tax is due can possibly be paid by the partnership or the GP of the partnership under audit. Such payments are typically called compliance payments and are used to make the government whole. Because the closing agreement is an evolving process, not all audit teams across the country are aware of their use in a TEFRA audit, nor is this procedure uniformly used by IRS audit teams. A closing agreement is not suitable for every audit. For example, a compliance payment from the partnership or GP may not be suitable with respect to a capital loss that the Service disallows in the year under audit if the current partner make-up is different from the partners that were in the partnership for the year under audit. Due to the fact that the IRS issues a no change report, there is technically no obligation to notify any state of an IRS adjustment. Hence, there shouldn t be any adjustment on the state level. However, how states view this is an open question. Federal, State, and International Tax Audits in the Alternative Investments Industry 5

8 Managing the audit What are some of the investor relations considerations when it comes to managing the audit? The following are some considerations: Partnership agreements should discuss the procedures and requirements of when a fund is audited. If the Fund is considered to be a TEFRA partnership, there should be a discussion in the agreement that discusses TEFRA and how it could impact partners directly. Consider whether the Partnership will allow individual partners to negotiate with the IRS during the audit even though the TMP is the face of the partnership when negotiating with the Service. Funds should be providing a point of contact for investors if they have questions. Consider providing flexibility in your agreements of setting up a reserve. Discuss in the partnership agreement who handles the audit if you have a merger or liquidation of a fund. What are some tips to conducting a successful audit? The key to successfully conducting and resolving any audit is establishing a cooperative working relationship with the IRS, or for that matter, any auditor. This involves reaching an understanding with the audit team on the rules of engagement, e.g., establishing and understanding areas of inquiry, industry areas and how funds operate, trying to develop boundaries to avoid audit creep, and establishing protocols for review of draft IDRs and the timing of responses. At the start of any audit process, it s important to understand your taxpayer rights and responsibilities in order to manage the audit process. For example, the Revenue Agent should at some point early on in the audit discuss the audit plan and what they will be focusing on, including the risk analysis. Most importantly, a fund should be prepared to be able to respond timely and completely with good documentation, making sure responses are responsive to the IDRs and complete, thereby trying to avoid having to respond to follow up IDRs or have the auditor raise new issues based upon uncertainties and ambiguities in your responses. Federal, State, and International Tax Audits in the Alternative Investments Industry 6

9 Being prepared What should funds be doing today to prepare for an audit? Funds should consider the following: Funds should be creating fund profiles by documenting its fund investment strategy, its risk profile, and where they fall on the risk spectrum of industry and general issues being raised by the IRS. Not all issues will be applicable to all funds. Funds should be familiar with the type of information the IRS will request and consider how they would respond to a similar request. Funds need to make sure that documentation is robust enough to be able to respond timely and comprehensively to these requests. Waiting until the fund is under audit can create much undue burden to satisfy the auditors with the documentation required and can be a strain on resources. Archiving your documentation in real time will make it available for you when you need it and allow the partnership to quickly respond to any information request. This is important given the IRS is more closely monitoring IDR response times and getting Counsel and IRS management involved in the IDR process. Creating a Fund profile should be done in real-time and should be embedded in the partnership s tax function. The Fund profile should be reviewed and updated periodically to account for changes in investment strategy which could result in a new set of potential tax risks that need to be managed. Having processes and procedures in place (prior to being selected for audit) with respect to various issues (such as loan origination, withholding, etc.) is important. The IRS is moving towards control based auditing. Therefore, not only having proper policies and procedures in place, but being able to demonstrate the fund has controls in place to assure such policies and procedures are being implemented can reduce the scope of the audit and help alleviate some of the questions posed by the Service. Funds should also make sure they have readily available organizational charts, book to tax reconciliation, financial statements, etc. not just for the current year, but for past years as well. Funds should retain copies of their agreements, election statements and any changes made over the years. One way to prepare for an audit is to perform a mock audit and have a fund or management company reviewed from the perspective of a tax authority. Some of the benefits of such approach are: Reducing the uncertainty of what is in your tax files when being audited; and Determining the resources that need to be allocated within the organization to deal with the tax authorities. Asset managers should review their strategy, existing structures, policies and procedures and corporate governance with a global holistic approach. In addition, when using an investment platform they should have a valid business reason aligning their investment strategy with their tax strategy, have sufficient substance in place and the investment platform should be considered the beneficial owner of the income. Federal, State, and International Tax Audits in the Alternative Investments Industry 7

10 Conclusion Recent activity by the IRS, state and international auditors has shown that their focus on the asset management industry is not transitory. Navigating and negotiating an audit can be tricky, burdensome and costly. Managing the audit process can be as challenging as defending the substantive issues raised on an audit. Real time preparation and, if selected for an audit, aggressive management of the process are key to a successful resolution with the least amount of strain on an organization. Federal, State, and International Tax Audits in the Alternative Investments Industry 8

11 Contact information For more information please contact: Kara Friedenberg Brian Rebhun Alan Biegeleisen Louis Carlow Anthony Russo Daniel Lobatto daniel. Kimberly Schoenbacher Steven Lew Federal, State, and International Tax Audits in the Alternative Investments Industry 9

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