Coordinating State and Federal Income Tax Audits

Transcription

1 Leah Robinson, Partner Scott Wright, Partner May 21, 2015 Coordinating State and Federal Income Tax Audits 1

2 State Tax Exam Issues Coordinating Disclosure of Information to IRS and State Tax Authorities Reporting Federal Adjustments to State Tax Authorities Extending the State Statute of Limitations for Assessment Addressing Conflicting Positions 2

3 Case Study: Coordinating Federal and State Tax Positions and Reporting Company A is a widget manufacturer with 50 subsidiaries that conduct regular business operations in 30 states Company A is a highly leveraged business with $500 million in debt owed to third-party lenders Company A owns a Holding Company that is located in a low tax state; this Holding Company lends to its operating affiliates Company A has engaged in what may be deemed a reportable transaction for federal tax purposes Company A is under audit by IRS and State X 3

4 Coordinating the Disclosure of Information and Documentation to IRS and State Tax Authorities 4

5 Coordinating the Disclosure of Information and Documentation Federal and State Tax Audit Efforts Must Be Coordinated Information sharing agreements have increased the dissemination of sensitive and confidential tax information among tax authorities Memorandum of Understanding between IRS and state tax authorities (and the Multistate Tax Commission) will increase information sharing State and municipal tax authorities share information (and conduct joint audits), such as: New York State and New York City Pennsylvania and Philadelphia Ohio and Regional Income Tax Agency 5

6 Coordinating the Disclosure of Information and Documentation Federal and State Tax Audit Efforts Must Be Coordinated State tax authorities seek to exchange information directly with IRS State tax authorities request information which taxpayers have provided to IRS State IDRs request responses to IRS IDRs relating to a transaction, issues or tax years State tax authorities use information-sharing agreements as the basis for information databases 6

7 Coordinating the Disclosure of Information and Documentation Federal Tax Audit Group Should Consult With State Tax Audit Group Regarding the Disclosure of Information and Documentation State tax audits may be negatively impacted by responses provided to IRS Disclosure to IRS will waive attorney-client privilege protection Oversimplified responses can be problematic for state tax purposes Characterization or resolution of a transaction may not have federal tax consequences but may create state tax issues 7

8 Example Company A has received an lor from the IRS Company A is preparing a response to the lor that addresses the intercompany lending arrangement Intercompany lending arrangement is inconsequential for federal consolidated return purposes IDR indicates that intercompany lending arrangement was "set up for state tax planning purposes" State tax audit group receives an lor from State X to produce any "information or documentation provided to the IRS regarding the intercompany transaction" 8

9 Coordinating the Disclosure of Information and Documentation State Tax Audit Group Should Coordinate With Federal Tax Audit Group Regarding the Disclosure of Information and Documentation Perception that state tax audits are conducted after the federal tax audit is not always accurate State tax audit may proceed in advance of federal tax audit because of state initiatives to accelerate revenue, including: Voluntary compliance programs Aggressive audit schedules State tax audit group may not be aware of potential federal tax issues/consequences 9

10 Coordinating the Disclosure of Information and Documentation State Tax Audit Group Should Consult With Federal Tax Audit Group To Preserve Federal Tax Positions State tax audit group must coordinate review of responses that potentially affect the federal treatment Defending state tax issues during a state audit Preserve federal tax positions while defending a state tax audit Characterization of a transaction at the state level may be inconsistent with the federal treatment Defending federal tax issues during a state audit State tax authorities have become more aggressive about auditing federal tax positions (auditing above-the-line) Coordinate the defense of such a challenge with the federal tax audit group 10

11 Example Company A participated in California's Voluntary Compliance Initiative to avoid double penalties Company A is audited by the California FTB on the tax position based on reporting under the VCI State tax audit group defends the tax position without consulting with the federal tax audit group FTB shares the information obtained in conducting the state tax audit with IRS Federal tax audit group receives from IRS the information the state tax audit group provided to the FTB 11

12 Coordinating the Disclosure of Information and Documentation 12 Two-Way Transparency in State Taxation Under UTP and Other Disclosure Requirements State tax authorities to request information not previously required by a corporate income tax return Taxpayers are making greater use of FOIA requests for state guidance State Tax Reportable Transaction Statutes Attempt to identify suspect or sham-like transactions (based on similar federal rule finalized in 2003) First version adopted by California in 2003 MTC model adopted in 2006; refers to transactions that lack "economic substance" State statutes may notify states of federal or state reportable or listed transactions State statutes also generally provide for underreporting or other penalties

13 Coordinating the Disclosure of Information and Documentation Attorney-client privilege does not apply to tax accrual workpapers because of the use of outside accountants; see, e.g., Commissioner of Revenue v. Comcast Corp., 453 Mass. 293 (2009) U.S. v. Textron, Inc., 577 F.3rd 21 (1 st Cir. 2009), cerl. denied, - -S.Ct.---, 2010 WL (May 24, 2010): the "work product doctrine does not protect such workpapers so the IRS can request these documents because they are prepared for nonlitigation regulatory purposes Tax audit process is not considered to be the equivalent of litigation En bane decision reverses prior decision by the First Circuit Compare Comcast where the work product doctrine was held to protect tax planning memos prepared by an outside accounting firm 13

14 Reporting Federal Adjustments to State Tax Authorities 14

15 State Reporting Requirements Reporting Federal Adjustments to State Tax Authorities Requirement to Report Federal Adjustments Time Frame to Report Federal Adjustments Determining Which Legal Entity Must Report Reporting Noncompliance Penalty Uniformity 15

16 State Reporting Requirements If a taxpayer disagrees with the assessment in the RAR, the IRS issues a "thirty day letter," which describes the adjustment and sets forth the taxpayer's options. The taxpayer can: Sign Form 870, pay the tax, and then sue for refund in the U.S. District Court or the Court of Federal Claims Ignore the letter, wait for a notice of deficiency, and then appeal to the U.S. Tax Court Submit additional information in a formal protest and request a conference with the IRS Appeals Division 16

17 State Reporting Requirements Requirement to Report Federal Adjustments Assessment by IRS Does it trigger a state filing requirement? Do intermediate determinations trigger a reporting requirement? Which entity is assessed? Is the entity a taxpayer? Does the assessment affect state taxable income? 17

18 State Reporting Requirements Requirement to Report Federal Adjustments Amended Federal Return Does it trigger a state filing requirement? Impact of requesting a refund versus reporting a greater amount of tax due If requesting a refund, at what point do you file amended state return? Reporting responsibilities if federal refund request is rejected? 18

19 State Reporting Requirements Requirement to Report Federal Adjustments Settlement with IRS What gets reported to IRS for final settlement purposes? Does it trigger a state filing requirement? Do intermediate determinations trigger a reporting requirement? Is it possible to structure the settlement to minimize state reporting requirements? Is it possible to structure the settlement to minimize state tax? 19

20 State Reporting Requirements Requirement to Report Federal Adjustments Competent Authority Agreements ("CAAs") Do CAAs trigger a state filing requirement? If CAA does not require taxpayer to amend federal tax return, no requirement to amend state tax returns If CAA requires an amended federal tax return, and normal federal/state statutes of limitations, then the normal amended return rules apply 20

21 State Reporting Requirements Time Frame to Report Federal Adjustments State tax laws provide that a taxpayer must report such federal changes in a relatively short amount of time 30 days 60 days 90 days Taxpayers often have difficulty meeting the deadlines for reporting federal changes Some taxpayers use consultants to facilitate the reporting of federal changes 21

22 State Reporting Requirements What Legal Entity Must Report Nonconformity to federal consolidated return provisions complicates the reporting of federal adjustment at the state level Separate company state reporting may not reflect the adjustments to federal taxable income because of additional tax or benefit Combined or consolidated returns may not include the same affiliated entities as included in the federal consolidated group 22

23 State Reporting Requirements Requirement to Report Federal Adjustments Indiana If a taxpayer's federal income tax liability for a taxable year is modified due to the assessment of a federal deficiency or the filing of an amended federal income tax return, then the date by which the department must issue a proposed assessment under section 1 of this chapter for tax imposed under IC 6-3 is extended to six (6) months after the date on which the notice of modification is filed with the department by the taxpayer. Indiana Code (g). Oklahoma The period of time prescribed in Section 223 of this title, in which the procedures for the assessment of income tax may be commenced by the Tax Commission, shall be tolled and extended until the amount of taxable income for any year of a taxpayer under the Internal Revenue Code has been finally determined under applicable federal law and for the additional period of time hereinafter provided in this subsection. Okla. Stat H.1 23

24 State Reporting Requirements Requirement to Report Federal Adjustments Oregon 24 The department may mail a Notice of Deficiency at any time within two years after the department receives notification of a change or correction contained in: Kentucky a federal revenue agent's report; the audit report of another state's taxing authority; or the written report filed by the taxpayer as required by ORS (2)(a) Or. Reg (3) "Conclusion of the federal audit" means the date that the adjustments made by the Internal Revenue Service to net income as reported on the taxpayer's federal income tax return become final and unappealable; and "Final determination of the federal audit" means the revenue agent's report or other documents reflecting the final and unappealable adjustments made by the Internal Revenue Service. Kentucky Rev. Stat (2)( d)

25 Example 25 Company A reaches an agreement with IRS on several audit issues The agreement on the audit issues generates additional federal taxable income for companies with state tax reporting responsibilities Company A and IRS agree that a few issues will be set aside for appeals Issues that remain subject to challenge only affect 5 of the 50 companies Federal changes for remaining 45 entities for the tax year are final Two years later taxpayer and IRS settle the remaining outstanding issues

26 State Reporting Requirements Reporting Method No uniform method for reporting federal changes to the various state tax authorities Taxpayer may (depending on its nexus with various states) have to file adjustments in every state with a net income tax based on a single federal adjustment Actual amended returns Some states require taxpayers to manually stamp an original tax return "amended" while other states provide amended returns to be completed Schedule of changes Some states require a schedule with each and every change from the line items on the state return while other states only ask for the changed line items 26

27 State Reporting Requirements Reporting Noncompliance Penalty Financial penalties Treated as a failure to file a return Unlimited extension of the statute of limitations to assess additional tax based on the failure to report Provisions place the burden on the taxpayer to report the federal changes to begin running of the statute of limitations for assessment 27

28 State Reporting Requirements Uniformity In State Reporting The lack of uniformity is an issue that every state tax director can agree is truly a problem Specific provisions that need uniformity: Time frame for reporting federal changes Method of reporting federal changes Eliminate intermediary reporting requirements Limited extension of the statute of limitations 28

29 Extending the State Statute of Limitations for Assessment 29

30 State Statute of Limitations State tax laws extend the state statute of limitations for assessment upon the reporting of federal changes Limited: Some states' laws limit the state tax authority to assess additional tax solely on the reported federal change Broad: Some states' laws permit the state tax authority to assess additional tax on any aspect of the state return (i.e., no limitations) An agreement between the taxpayer and IRS to extend the federal statute of limitations on assessment will likely extend the state statute of limitations on assessment 30

31 State Statute of Limitations State Statutory Provisions - Limited Maryland tax law provides a limited extension of the statute of limitations on tax assessments solely related to the federal changes Specifically, the law provides: If a report of federal adjustment is filed within the time required under Section of this title, the tax collector shall assess the financial institution franchise tax, public service company franchise tax, income tax, or estate tax within 1 year after the date on which the tax collector receives the report... An assessment of income tax under paragraph (1) of this subsection shall be related to changes made by the amended items in the return. Md. Code (c) 31

32 State Statute of Limitations 32 State Statutory Provisions - Broad Oklahoma tax law provides a broad extension of the statute of limitations on tax assessments for any aspect of the taxpayer's state return Specifically, the law provides: In administering the provisions of this subsection, the Tax Commission shall have the authority to audit each and every item of income, deduction, credit or any other matter related to the return where such items or matters relate to allocation or apportionment between the State of Oklahoma and some other state or the federal government even if such items or matters were not affected by revisions made in such final determination. Where such items or matters do not relate to allocation or apportionment between the State of Oklahoma and some other state or the federal government, the Tax Commission shall be bound by the revisions made in such final determination. Okla. Stat. 2375

33 State Statute of Limitations State Statutory Provisions Colorado tax law provides that an agreement between the taxpayer and IRS to extend the federal statute of limitations on tax assessments extends the state statute of limitations on tax assessments Specifically, the law provides: If any taxpayer agrees with the Internal Revenue Service for an extension, or renewals thereof, of the period for assessing deficiencies or paying refunds in federal income tax or for changing reported federal taxable income of a partnership, limited liability company, or fiduciary for any year or if any taxpayer files a federal income tax refund claim or initiates administrative or judicial proceedings which have the effect of extending said period for any year, the period within which the executive director may issue a notice of deficiency for any such year shall be four years after the applicable Colorado return was filed, or one year after the date of expiration of the extended period for assessing deficiencies in federal income tax or changing reported federal taxable income of a partnership, limited liability company, or fiduciary, whichever is later. Co. Rev. Stat (6)( e) 33

34 Example 34 Company A's statute of limitations for assessment of additional tax has expired for Maryland, Oklahoma and Colorado Company A eliminated the unrecognized tax benefits from its financial statements Company A and IRS extended the federal statute of limitations until the end of the year IRS issues an assessment of additional tax to Company A Company A's state statute of limitations for assessment of additional tax is re-opened Maryland can only make changes related to the federal changes Oklahoma is authorized to re-open the entire state tax return to audit Colorado is authorized to re-open the return because of a federal extension of the statute of limitations for assessment automatically extends the state statute of limitations

35 Addressing Conflicting Positions 35

36 Addressing Conflicting Positions Accuzip, Inc. v. Director, Division of Taxation; Quark, Inc. v. Director, Division of Taxation, N.J. Tax Ct. Dkt. No (Aug. 13, 2009) New Jersey DOT determined that taxpayer did not qualify for the protections of P.L because its sales of software were not sales of TPP New Jersey Tax Court rejected the DOT s argument Federal guidance as well as NJ s own sales tax guidance resulting in the software being treated as TPP. State could not take conflicting positions Lorillard Licensing Co., LLC v. Director, Division of Taxation, N.J. Tax Ct. Dkt No (Aug. 9, 2013) 36

37 Addressing Conflicting Positions Lorillard Licensing Co., LLC v. Director, Division of Taxation, N.J. Tax Ct. Dkt No (Aug. 9, 2013) New Jersey DOT interpreted the phrase subject to a tax one way for nexus purposes (expansively) and another way for Throw Out Rule purposes (narrowly). Tax Court (Judge DeAlmeida) required a consistent application of the term. Currently on appeal 37

38 Addressing Conflicting Positions Oracle USA, Inc. v. Oregon Dep t of Rev., Or. Tax Ct. Case No. TC-MD C (Feb. 11, 2010) Taxpayer reported gain from the sale of stock as business income in its domiciliary state California, while classifying the same gain as nonbusiness income under Oregon law On audit, the Oregon DOR reclassified the gain as business income asserting that the taxpayer was required to do so under UDITPA The Oregon Tax Court held that a corporate taxpayer did not have a duty under UDITPA to uniformly report an item of income as business or nonbusiness among MTC states notwithstanding uniform definition Rather, the proper classification of income in each state must be determined according to that state s laws 38

39 Questions? Leah Robinson Partner Scott Wright Partner

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