Comments on Rev. Proc. 97-27, relating to rules for obtaining consent to change accounting methods.

On February 4, 1998, Tax Executives Institute filed comments with Commissioner of Internal Revenue Charles O. Rossotti concerning IRS Rev. Proc. 97-27, which relates to the conditions and procedures for obtaining the Commissioner's consent for a change in a taxpayer's method of accounting for federal tax purposes. The new procedure substantially revises and replaces the predecessor guidance, Rev. Proc. 92-20. The Institute's comments were prepared under the aegis of TEI's Federal Tax Committee, whose chair is David L. Klausman, and coordinated by TEI's Federal Tax Subcommittee on Tax Accounting Periods, Methods, and Financial Reporting, whose chair is Larry J. Newsome of Echelon International. Margaret A. Curry of General Motors Corporation contributed substantially to the development of TEI's comments.

This letter is in response to the release of Rev. Proc. 97-27, relating to the conditions and procedures for obtaining the Commissioner's consent for a change in a taxpayer's method of accounting for federal income tax purposes. The new procedure revises, and generally improves, the predecessor guidance, Rev. Proc. 92-20, by adopting a number of changes recommended in public comments submitted in response to Notice 96-40. We are pleased to provide following comments on Rev. Proc. 97-27.

Background

Tax Executives Institute is the principal association of corporate tax executives in North America. Our more than 5,000 members represent the 2,700 leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which taxpayers can comply.

Members of TEI are responsible or managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by Rev. Proc. 97-27, relating to the rules for changing accounting methods with the consent of the Commissioner.

Overview of Rev. Proc. 97-27

In Rev. Proc. 97-27, the ERS has set forth revised procedures that a taxpayer must employ in order to obtain the consent of the Commissioner to a change in a method of accounting for federal income tax purposes. The purpose of the procedure is to provide incentives to taxpayers to encourage prompt voluntary compliance with proper tax accounting principles and to simplify many of the complex rules and requirements set forth in Rev. Proc. 92-20.

Generally, TEI commends the IRS for improving and simplifying the procedures for securing consent for changes in accounting method. Indeed, many of the significant revisions summarized in section 1.03 of the procedure comport with recommendations in public comments submitted in response to Notice 96-40, including those made by TEL Specifically, the new procedure simplifies the requirements for obtaining the consent of the Commissioner, stream lines the filing process, and eliminates much complexity. One example of a major simplification and improvement is the elimination of the Category A, Category B, Designated A, and Designated B classifications for methods of accounting. In addition, the adoption of a generally uniform period for spreading the section 481 adjustment to prevent omissions or duplications from taxable income will, we believe, substantially enhance voluntary compliance by simplifying the process even though, depending on the taxpayer's facts and circumstances, there will likely be "winners and losers."

We have reservations, however, about some aspects of the new procedure. Indeed, a number of deficiencies identified under Rev. Proc. 92-20 have been carried over into Rev Proc. 97-27. Moreover, the new procedure adopts a novel and, to our mind's eye, unwarranted expansion of the definition of what constitutes a change in accounting method.

Change In "Character" of an Item as a Change in Method of Accounting

Section 2.01(3) of the procedure states in part:

A change in the characterization 

of an item may also constitute a

change in method of accounting if the

change has the effect of shifting

income from one period

to another. For example, a

change from treating an item

as income to treating the

item as a deposit is a change

in method of accounting.

[Citing Rev. Proc. 91-31,

1991-C.B. 566 as authority

for the statement.]

TEI believes that this new language injects a significant new issue in determining whether a taxpayer must seek the consent of the Commissioner to change the treatment of an affected item. More important, by distending established legal authority, the IRS is seemingly making improper use of a revenue procedure to expand the definition of a method of accounting.

A. IRS Position Distends Existing Legal Authority

1. Regulations. In defining a change in method of accounting, Rev. Proc. 97-27 incorporates the standard set forth in Treas. Reg. [sections] 1.446-1(e). The regulations provide that

[a] change in the method of

accounting includes a change

in the overall plan of accounting

for gross income or deductions

or a change in the treatment

of any material item used in

such overall plan....A material

item is any item which involves

the proper time for the inclusion

of the item in income or the

taking of a deduction....Also,

a change in method of accounting

does not include adjustment of

any item of income or deduction

which does not involve the proper

time for the inclusion of the

item of income or the taking

of a deduction.

The regulations provide examples of items not involving the proper time for inclusion in or deduction from income. Specifically, the correction of an item deducted as interest or salary, but which is properly treated as a payment of dividends, does not affect timing. In addition, the disallowance of items deducted as business expenses that actually constitute personal expenses do not involve a method of accounting. In other words, these items do not involve a determination of when an item should be included in income or taken as a deduction. Rather, these items involve whether the item should at any time be included in income or taken as a deduction.

Rev. Proc. 97-27 provides that a change in the characterization of an item may constitute a change in method of accounting if the change has the effect of shifting income from one period to another. Hence, the procedure directs taxpayers and revenue agents to focus exclusively on whether a timing difference occurs and without regard to the character of the item. In contrast, the examples in the regulations illustrate that items that are recharacterized from taxable to non-taxable or from deductible to non-deductible do not involve timing issues and, hence, do not involve methods of accounting. Consequently, the revenue procedure is over broad and inconsistent with the regulations from which the Commissioner derives the authority to issue Rev. Proc. 97-27.

2. Case Law. In stating that a change in character of an item may constitute a change in method of accounting, the IRS has ignored a substantial body of case law to the contrary. Generally, courts have concluded that the "recharacterization" of an item involves answering the question whether a particular item is includible or not includible in gross income. By contrast, issues that invoke the rules for a proper method of accounting depend upon a determination of when an item is included in income or deducted therefrom. That is to say, whether an item is taxable or not turns on the determination of the character of the item, not the proper method of accounting or time for reporting an item. In addition, in making the distinction between the "character" of an item and the "method" of accounting for it, the courts have recognized that, although there may be a timing effect from the recharacterization of an item, that consequence is a result of the recharacterization and does not, in and of itself, constitute a change in method of accounting within the meaning of section 446.

3. Rev. Proc. 91-31. Rev. Proc. 97-27 cites Rev. Proc. 91-31 in support of the proposition that a change in characterization of an item may constitute a change in method of accounting the item. Rev. Proc. 9131 was issued following the Supreme Court's decision in Commissioner v. Indianapolis Power & Light Co., which rejected the IRS's litigating position that customer deposits given to electric utilities are taxable income upon receipt. In other words, the IRS issued Rev. Proc. 91-31 in order to (i) facilitate an orderly transition of all utility company taxpayers to the same tax treatment and (ii) afford equitable relief to taxpayers that had acquiesced to the IRS position ultimately rejected in Indianapolis Power. Without such relief, taxpayers that had erroneously acceded to the IRS position may not have been able to obtain refunds of taxes paid in respect of deposits received and reported in statute-barred years. Hence, taxpayers who complied with the IRS's erroneous position would have been worse off than those who challenged (or ignored) it.

Regardless of the genesis of Rev. Proc. 91-31, citing that procedure as authority for the proposition that a change in character may be a change in method of accounting represents nothing more than the IRS's bootstrapping its own authority. TEI questions whether the courts will support the IRS's view of Rev. Proc. 91-31 because it would in effect mean that the IRS can deny (through its control over procedures governing accounting method changes) taxpayers the right to conform to a tax treatment (exclusion from income) explicitly sanctioned by the Supreme Court. If an item is not includible in income as a matter of law and a taxpayer discontinues reporting the item as income (thereby conforming its treatment to the Supreme Court's decision in Indianapolis Power), that change in reporting constitutes a permanent change to the taxpayer's lifetime reported income. Thus, that change in tax reporting cannot be viewed as a change in method of accounting because there is no issue in respect of the proper time for inclusion. Hence, notwithstanding the broader statements in Rev. Proc. 91-31 that taxpayers may only change the treatment of deposits pursuant to the consent granted by that procedure (or through a change in method of accounting obtained in the traditional fashion), we submit that there is clear authority for taxpayers to change the treatment of items involving character without securing the consent of the Commissioner. As a result, the IRS's assertion in section 2.01 of Rev. Proc. 97-27 that a change in character may be a change in method is unsupportable. We recommend that the IRS delete the statement.

B. Improper Use of a Revenue Procedure

TEI believes that the IRS is improperly using a revenue procedure to alter the definition of a change in accounting method as set forth in the regulations. Moreover, by systematically citing Rev. Proc. 97-27 (or Rev. Proc. 91-31) for an unproven proposition, the IRS will compound its error and foster a misperception among revenue agents and taxpayers alike. For example, in Rev. Proc. 97-37 (relating to procedures to obtain automatic consent for changes in accounting methods), the IRS invoked section 2.01(3) of Rev. Proc. 97-27 in defining a change in method of accounting. Cited frequently enough, revenue agents will very likely assert the proposition as though it were a settled rule of law and taxpayers may acquiesce to that view. While changing taxpayer behavior may be the IRS's ultimate goal, we question whether the use of revenue procedures to advance a substantive change in the law is a proper use of the IRS's broad grant of authority to ensure compliance with proper accounting methods. If the IRS believes it can and should change the substantive law governing what a change in accounting method is, the proper course is by amending the regulations (pursuant to the notice and comment procedures of the Administrative Procedures Act) or by proposing amendments to section 446.

Window Periods for Taxpayers "Under Examination"

Section 6 prescribes the conditions under, and procedures through, which taxpayers "under examination," before an Appeals officer, or before a federal court may request a change in accounting method. Section 6.01(1) states the general rule that a taxpayer under examination may not request a change in accounting method unless it qualifies under either the 90- or 120-day windows of sections 6.01(2) or (3), respectively, or obtains the consent of the District Director under section 6.01(4). Under section 6.01(2), taxpayers "under examination" for a continuous period of 12 months as of the first day of a taxable year may make an application for a change in accounting method without the consent of the District Director, as long as the application is filed within the first 90 days of the taxable year (the 90-day window). Similarly, taxpayers "under examination" may file an application for change in accounting method within 120 days of the "end of an examination." An examination is deemed to end at different dates depending on whether the examination results in (i) no change, (ii) a fully agreed case, or (iii) an unagreed or partially agreed case.

1. Definition of "Under Examination." Taxpayers are deemed to be under examination as of the first date that the taxpayer is contacted in any manner by a representative of the IRS for the purpose of scheduling an examination. With respect to taxpayers under continuous examination in the Coordinated Examination Program (CEP), TEI believes that an examination should be deemed to "begin" at the conclusion of the 15-day (or longer) period prescribed in Rev. Proc. 94-69, which governs the procedures for disclosure of certain matters under section 6662 in order to avoid substantial understatement penalties. Hence, an examination would "begin" for purposes of accounting method changes on the date that the period for filing a "qualified amended return" in accordance with Rev. Proc. 94-69 closes.

2. Elimination of 90-Day Window at the Inception of an Examination. We regret that, as part of its simplification effort, the IRS has eliminated the 90-day window at the inception of an examination within which taxpayers may initiate requests for accounting method changes and be afforded back-year audit protection. This window was an important opportunity for taxpayers (especially those outside of the CEP program) to review their accounting methods and make appropriate changes. We recommend that the IRS reconsider its decision to eliminate the window period at the inception of an examination.

3. Clarify the "End" of an Examination in Partially Agreed or Unagreed Cases. Where an examination results in a no-change determination or a fully agreed case, the time at which the examination ends is clear, certain, and triggered by definite action undertaken by the IRS or the taxpayer within a prescribed period of time. In respect of an unagreed or partially agreed case, section 3.07(1)(a)(iii) states that an examination is deemed to end on the "earliest of the date the taxpayer . . . is notified . . . that the case has been referred to Appeals from Examination, the filing of a petition in Tax Court, the date on which the period for filing a petition with the Tax Court expires, or the date of notice of claim disallowance."

At the risk of shortening the period within which taxpayers may file a change in accounting method following the "end" of an examination, we recommend that the date an examination is deemed to "end" in an unagreed or partially agreed case be the earliest of when the taxpayer files its protest, when the taxpayer files a petition in Tax Court, the date on which the period for filing a Tax Court petition expires, or the date of a notice of claim disallowance. Regrettably, IRS practice is not consistent across all Districts in sending notification to the taxpayer that Appeals has "accepted the taxpayer's protest" nor is such notice absolutely required under IRS procedures. The IRS arguably may keep an examination open indefinitely by failing to provide taxpayers with the requisite notice, even though Appeals may have initiated discussions on the case with the taxpayer Hence, a taxpayer may be denied the 120-day window by the IRS's inaction. To avoid this result, we believe that the 120-day window period should begin with the date of filing the taxpayer's protest in an unagreed or partially agreed case. Alternatively, the IRS should revise its procedures to require notice (or deemed notice) to the taxpayer of the acceptance of the case by Appeals within a prescribed period, say, 60 days after filing of the protest by the taxpayer.

Finally, section 3.07(1)(b) of Rev. Proc. 97-27 states unequivocally that an examination does not end as a result of an early referral of an issue to Appeals pursuant to Rev. Proc. 96-9. TEI recognizes that the early or "advance" issue resolution procedure is relatively novel and that, as a result, the IRS may cautious resolving the collateral consequences of such referrals. Nonetheless, TEI is concerned that there will be cases where an examination is substantially concluded but for the issue referred to Appeals pursuant to Rev Proc. 969. Assuming that the issue under consideration at Appeals is not an item for which the taxpayer seeks to change its method of accounting, we do not see why the taxpayer should be precluded from availing itself of the 120-day window. TEI acknowledges that only a limited number of taxpayers will likely find themselves in this situation. Nonetheless, just as CEP taxpayers and IRS often are able to agree under Rev. Proc. 94-69 about when an examination begins, there should be a way for the taxpayer and the IRS to agree that an examination has ended (even while Appeals retains jurisdiction of the case), thereby opening the 120-day window.

4. Definition of "Issue Under Consideration." Under section 3.08(1), a taxpayer's method of accounting for an item is an "issue under consideration" for the taxable year under examination "if the taxpayer receives notification (for example, by examination plan, information document request (IDR), or notification of proposed adjustment or income tax examination changes) from the examining agent(s) specifically citing the treatment of the item as an issue under consideration." For the first time, the IRS has added examples to clarify when an accounting method is deemed an "issue under consideration."

We are pleased that the IRS has adopted our recommendation that the procedure include examples to clarify when an accounting method is an "issue under consideration." We regret, however, that the revenue procedure would permit revenue agents to place entire segments of a taxpayer's return in suspense (i.e., off limits) in respect of accounting method changes simply by citing in an examination plan (or IDR) that a particular segment of the return (e.g., LIFO pooling) will be examined. We continue to believe that the taxpayer is not fully apprised of the existence of an issue in respect of its accounting methods -- and hence should be able to initiate a requested change -- until a revenue agent issues a notice of proposed adjustment or a report of examination changes specifically citing the accounting method as improper Notwithstanding our disagreement in respect of the proper time for determining when an accounting method is an "issue is under consideration," we do believe that the addition (in section 3.08(1) of the procedure) of a formal mechanism for national office review of such determinations is a salutary safety valve.

Incomplete Form -- 21-Day Rule

In section 8.09, the IRS provides a general rule that if the Form 3115 is not properly completed in accordance with the instructions on the Form 3115 and Rev. Proc. 97-27, or if supplemental information is needed, the IRS will notify the taxpayer The taxpayer will be permitted 21 days to supply the missing or supplemental information. An additional period, not to exceed 15 days, may be granted following a written request from the taxpayer. Finally, the IRS reserves the right to shorten the 21-day period on additional requests.

TEI acknowledges that the IRS can and should set reasonable guidelines to manage its caseload of accounting method change requests and to expedite the processing of Forms 3115, especially where such requests involve "routine" accounting matters. But determining whether a request for supplemental information is "routine" or imposes a substantial hardship on a taxpayer may not be apparent to the national office personnel requesting supplemental information. Hence, we question whether the time periods the IRS has included in the procedure to govern requests for supplemental information from taxpayers are realistic or even reasonable under the myriad facts and circumstances that might arise. Moreover, where the taxpayer can demonstrate that the supplemental information requested is substantial and not easily retrieved or submitted, we question why national office personnel should not be permitted to grant additional time periods beyond 15 days for the taxpayer to provide supplemental information. Consequently, TEI urges the IRS to reconsider the rigid rules governing requests for supplemental information. At a minimum, the national office personnel (or a supervisor) assigned to review the taxpayer's request for additional time, should have discretion to determine whether the seemingly absolute rules in section 8.09 should be waived in appropriate circumstances.

Conclusion

The Institute's comments were prepared under the aegis of TEI's Federal Tax Committee, whose chair is David L. Klausman. If you should have any questions concerning the comments, please do not hesitate to contact Mr. Klausman at [phone], or Jeffery P. Rasmussen of the Institute's legal staff at [phone].