Comments on the penalty and interest study.

April 21, 1999

On April 21, 1999, Tax Executives Institute submitted the following comments to the Joint Committee on Taxation and Internal Revenue Service regarding penalty and interest issues in conjunction with a study required by section 3801 of the Internal Revenue Service Restructuring and Reform Act of 1998. TEI's comments were prepared under the aegis of its IRS Administrative Affairs Committee, whose chair is Stephen W. Boocock of Allegheny Teledyne, Inc. Contributing substantially to the Institute's submission were Ben J. Clayton of Philips Petroleum Co., Douglas C. Durham of Allegheny Teledyne, Inc., John S. Estes of Fort James Corporation, Sheldon A. Kimel of Brunswick Corporation, Michael J. Nesbitt of Paychex, Inc., and Terilea J. Wielenga of QAD Inc.

On December 23, 1998, the Joint Committee on Taxation staff and the Internal Revenue Service requested comments on penalty and interest issues in conjunction with a study required by section 3801 of the Internal Revenue Service Restructuring and Reform Act of 1998, Pub. L. No. 105-206, 112 STAT. 782. The IRS's request (Notice 99-4) was published in the January 19, 1999, issue of the INTERNAL REVENUE BULLETIN (1999-3 I.R.B. 9). The Joint Committee's request was in the form of a letter to TEI.

I. Background

Tax Executives Institute is the preeminent association of business tax executives in North America. Our approximately 5,000 members represent 2,800 of the leading corporations through 52 chapters in the United States, Canada, and Europe. 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 that taxpayers can comply with in a cost-efficient manner.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the Internal Revenue Service and 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 the penalty and interest provisions of the Internal Revenue Code.

In their requests, the Joint Committee staff and the IRS ask for comments on penalty and interest issues, as well as specific recommendations on ways to (i) simplify the current penalty and interest regimes; (ii) make tax administration more efficient; (iii) reduce inequities and burdens on taxpayers; and (iv) deter noncompliance, tax avoidance, and fraud. Comments were specifically requested on 13 penalty and interest issues, including --

* Whether the provisions encourage voluntary compliance;

* Whether the provisions permit taxpayers to generate overpayments or underpayments so that they may take advantage of disparities between commercial borrowing rates and the rates imposed by section 6621;

* Whether IRS communications provide an adequate explanation of why penalties and interest were imposed; and

* Whether the IRS's authority to waive penalties or abate interest should be modified.

TEI is pleased to respond to these requests.

II. Penalties

A. Overview

Ten years ago, Congress completed a major overhaul of the penalty provisions of the Code. The resulting legislation, styled the Improved Penalty and Compliance Tax Act, aimed to revise and streamline several penalty provisions. Congress made the changes because it concluded that --

   [T]he number of different penalties that relate to accuracy of a tax
   return, as well as the potential for overlapping among many of these
   penalties, causes confusion among taxpayers and leads to difficulties in
   administering these penalties by the IRS. Consequently, the [House Ways and
   Means] committee has revised these penalties and consolidated them. The
   committee believes that its changes will significantly improve the
   fairness, comprehensibility, and administrability of these provisions.

H.R. Rep. No. 101-247, 101st Cong., 1st Sess. 1388 (1989).

A decade later, we face the same Sissyphean task -- reforming the Code's penalty provisions. Rather than learning from the past -- that penalties should be simple, fair, and easy to administer -- Congress, sometimes at the IRS's and Treasury Department's urgings, has piled penalty upon penalty, targeting specific areas such as transfer pricing and corporate tax shelters in perhaps well-intentioned, but mishandled efforts to encourage compliance. Rather than being simple, direct, and effective, penalties have become almost as complicated as the underlying provisions they seek to enforce. Dangerously, too, the enactment of new or racheting up of existing penalties deprives the system of proportionality while representing a politically expedient way of raising revenues without increasing "taxes."

Tax Executives Institute believes that in order to achieve a penalty framework that is comparatively fair, simple, and easy to administer, the first step is to affirm the proper role of penalties in the tax system. The issue is not whether taxes or interest are due and owing. Rather, the focus is only whether a penalty should be imposed owing to a taxpayer's failure or inability to report the correct tax liability or file an accurate information return. TEI believes that four principles should drive the establishment of an effective and fair penalty regime that encourages voluntary compliance.

First and foremost, penalties should be used to punish intentional or negligent noncompliance -- essentially purposeful acts -- not inadvertent errors or omissions. The current structure does not effectively distinguish between the two, putting taxpayers who unintentionally fail to meet some requirement in the same category with those who willfully decide not to comply. The taxpayer's history of compliance with the tax laws should therefore be considered in determining whether to impose a penalty.

Next, each penalty should be capable of being abated within the IRS subject to a reasonable cause standard. In other words, there should be no automatic, strict liability, or mechanically imposed penalties. Penalties -- such as those for the failure to pay estimated tax penalties under sections 6654 (individuals) and 6655 (corporations), to comply with the reporting requirements under sections 6038A and 6038C (relating to foreign corporations), or to comply with the transfer pricing documentation rules under section 6662(e) -- should be revised to include a reasonable cause exception. The IRS should also be given the discretion to waive any penalty in appropriate circumstances. In addition to considering the taxpayer's history of compliance in determining whether a penalty should be imposed, the IRS should weigh the effect of the lack of guidance on an issue and the taxpayer's size and sophistication.

Third, penalties should encourage disclosure. As a general matter, no penalty should be asserted where the taxpayer has fully disclosed the item or transaction. Some penalties -- such as the corporate tax shelter penalty of section 6662(d)(2)(C)(iii) -- actually discourage disclosure of return positions. These provisions should effect a waiver of the penalty where the position is fully disclosed. In addition, more provisions such as the "qualified amended return" rule set forth in Treas. Reg. [sections] 1.6664-2(c)(3) -- providing that errors detected and corrected before the IRS contacts the taxpayer will not result in an accuracy-related penalty -- should be adopted.

Finally, penalties should not be used to raise revenue. This principle is closely linked to the first, i.e., that penalties should be used solely to punish intentional misconduct. Hence, penalties should be structured, interpreted, and applied to encourage voluntary compliance and facilitate the orderly administration of the tax laws (e.g., by encouraging disclosure); legislation implementing penalties should not be revenue-based. Moreover, penalties should not be used as "bargaining chips" in audit negotiations. To do so undermines taxpayer belief in the fairness of the tax system.

TEI's comments on specific aspects of the current penalty regime follow. The comments focus on current law and do not discuss issues such as the proposed corporate tax shelter penalties set forth in the Clinton Administration's FY2000 Budget. The issues raised by these proposals will be addressed in a separate submission.

B. Clear Standard of Conduct

Penalties should not be imposed where the required standard of conduct is not clearly defined or communicated. Both Congress and the IRS bear responsibility in this area. Congress has the responsibility for enacting legislation that clearly defines what is required of taxpayers. The IRS also bears responsibility for defining requirements and, perhaps more important, for communicating these requirements to taxpayers in a simple, timely, and understandable manner.(1) Consistent with its new mission, the IRS should continue to seek to inform taxpayers of their tax obligations through a variety of means, including the posting of guidance on the IRS's website. The IRS's efforts in this latter regard are commendable.

The IRS's recent actions regarding the Electronic Federal Tax Payment System (EFTPS) provide an example of how the IRS should work cooperatively with taxpayers to achieve compliance (rather than simply punish). Because the requirements were not well known and because of problems encountered by taxpayers in striving to comply, the IRS has repeatedly delayed the imposition of penalties for failing to use EFTPS. It opted instead for outreach programs to better educate the public. This approach encourages voluntary compliance.

C. Encouraging Voluntary Compliance

The current penalty regime may well discourage voluntary compliance by subjecting any error or omission, intentional or not, to a penalty. We need to move away from a regime where penalties are proposed for every error, followed by a cumbersome waiver or abatement process. TEI sincerely believes that if taxpayers knew that they could correct errors without the risk of penalty, more errors would be corrected. If penalties were imposed only where there is some evidence of intentional disregard or willful neglect, taxpayers would be more likely to resolve omissions caused by oversights and failure to understand the requirements.(2)

D. Consistent Application of Penalty Standards

Our members' experience has shown that the standards for imposing penalties are not applied consistently (e.g., in respect of the failure-to-deposit penalty) across the IRS's Service Centers. What is accepted as reasonable cause by one center may be rejected by another, though the facts are substantially identical. To further the goal of consistency, TEI recommends that some form of coordinated review of penalty application be established, perhaps in conjunction with the new IRS business units.

E. Specific Penalties

(i) Substantial Understatement Penalty. Section 6662(a) imposes a 20-percent penalty on the portion of an underpayment attributable to any of the following: (i) negligence or disregard of rules or regulations; (ii) a substantial understatement of income tax; (iii) a substantial valuation overstatement; (iv) a substantial overstatement of pension liabilities; or (v) a substantial estate or gift tax valuation understatement. The accuracy-related penalty was enacted in 1989 to replace several other penalties, including the negligence, substantial understatement, and valuation overstatement penalties. The penalty is generally not imposed with respect to any portion of the underpayment for which there is reasonable cause if the taxpayer acted in good faith. I.R.C. 6664(c)(1).

For corporations, an understatemerit for any taxable year is substantial if it exceeds the greater of $10,000 or 10 percent of the tax required to be shown on the taxpayer's return. I.R.C. [sections] 6662(d)(1).(3) An exception to the penalty is provided for items in respect of which there is substantial authority for or adequate disclosure of the taxpayer's position. For this purpose, "authority" includes statutes, regulations (final, temporary, and proposed), court decisions, revenue rulings and procedures, private letter rulings, technical advice memoranda, actions on decisions, general counsel memoranda, information or press releases, notices, and tax treaties and their official explanations. Legislative history (including committee reports and floor statements by the bill's managers) is also authority, as is the general explanation of tax legislation prepared by the staff of the Joint Committee on Taxation. Substantial authority does not, however, include a treatise, though the authorities listed in the treatise may satisfy the substantial authority test.

The rules for determining whether an authority is "substantial" are fraught with ambiguity. For example, Treas. Reg. [sections] 1.6662-4(d)(3)(ii) requires a taxpayer to be able to effectively critique the legal analysis of different courts of law in determining whether there is "substantial authority" for a return position. The regulation states that a court opinion simply stating a conclusion is to be given less weight than one reaching its conclusion by cogently relating the applicable law to pertinent facts. Thus, an appeals court decision may arguably not support a taxpayer's position where a different conclusion has been reached by a district court or the Tax Court, depending upon the quality of the opinion and the depth of its analysis. The regulations thus place a premium on the ability to assess the legal analyses and conclusions of different courts. These uncertainties reduce the effectiveness of section 6662(d) in encouraging voluntary compliance. Taxpayers should be permitted to rely on all court opinions, especially courts of appeal, without engaging in the complicated weighing of all authorities.

Additional confusion is created by Treas. Reg. [sections] 1.6662-4(d)(3)(iv)(B), which provides that the applicability of district court cases to the taxpayer by reason of the taxpayer's residence in a particular jurisdiction is not taken into account in determining whether there is substantial authority for the tax treatment of an item. Stated bluntly, this does not make sense in a jurisdiction where the authority supports the taxpayer's position, especially since the focus here is not the correctness of the taxpayer's treatment of an item (whether the taxpayer owes additional tax), but whether the taxpayer should be penalized for adopting the position that a federal judge in the taxpayer's community has ruled is correct. Hence, if a taxpayer resides in a jurisdiction in which a tax issue has been favorably decided, the taxpayer should be able to cite that decision as substantial authority, even if district courts in other jurisdictions have reached a contrary conclusion.(4)

In addition, in the absence of other guidance, taxpayers should be permitted to rely on well-known treatises (such as Bittker & Eustice, Federal Income Taxation of Corporations & Shareholders; Peel, Consolidated Tax Returns; or McKee, Nelson & Whitmire, Federal Taxation of Partnerships & Partners).

(ii) Tax Shelter Penalties.(5) The Taxpayer Relief Act of 1997 amended section 6662(d)(2)(C)(iii) of the Internal Revenue Code to provide a new definition of "tax shelter" for purposes of the substantial understatement penalty.(6) Under this definition, a tax shelter includes any entity, investment, plan, or arrangement with a significant purpose of avoiding or evading federal income tax. Under prior law, a plan was a tax shelter only if tax avoidance or evasion was a principal purpose. The change is effective in respect of transactions entered into after August 5, 1997. The definition also affects the scope of section 6111(d)(1)'s registration requirements for confidential corporate tax shelters, which was also addressed by the 1997 legislation. (The registration provision becomes effective after promulgation of final Treasury Regulations.)

TEI appreciates Congress's desire to discourage abusive tax-motivated transactions. Whether amending the section 6662 penalty and extending the section 6111 registration provisions were the most efficacious way of accomplishing this goal, however, is open to debate. In our view, too many penalties combined with too vague substantive standards are a recipe not for enhanced compliance but for uncertainty and frustration by both taxpayers and IRS personnel. Moreover, because disclosure of the tax shelter item does not insulate a taxpayer from assertion of the section 6662 penalty, the statute has the perverse effect of discouraging taxpayers from disclosing aggressive tax-planning positions on their returns. Thus, we question whether an additional penalty for tax shelters is appropriate or effective.

If the penalty is retained, however, we recommend a return to the "principal" purpose standard. The significant purpose standard of current law is so broad that it threatens to reach legitimate tax planning. Taxes are always a significant consideration for any corporation evaluating a transaction. Indeed, companies and tax directors ignore the tax law at their peril. The significant purpose test is too nebulous and should be discarded.(7)

(iii) Information Reporting Penalties. Current law typically provides that information-reporting penalties will not be imposed if the error is due to reasonable cause and not due to willful neglect. See, e.g., I.R.C. [sections] 6652. Too often, the latter part of that standard ("not due to willful neglect"), which should be incorporated in the interpretation of reasonable cause, is ignored.

Considering the complexity of the tax rules and the rapid pace at which changes are made, errors will undoubtedly occur, particularly with the increased reliance on automated processes. Automation allows taxpayers to accomplish a variety of routine compliance tasks efficiently. Unfortunately, this efficiency sometimes comes at a price, as subtle design flaws in the program may produce errors that are not always detected in testing. This could result in a taxpayer missing a filing or payment deadline, with the errors not being discovered until the first notice is received from the IRS. Such an error hardly rises to the level of "willful neglect." For this reason, penalties should not be proposed automatically in every situation where a taxpayer fails to comply with an information reporting requirement. The IRS should respond to errors with an initial notice describing the problem and explaining how to correct and prevent it. Repeated failures to comply could then be deemed willful neglect.

Such an approach is similar to the process used in many states (such as Texas, Wisconsin, and Connecticut). In many cases, when a state conducts an audit, an assessment for tax will be issued along with an interest assessment to compensate for the use of money. Although the auditor has the discretion to do so, penalties will generally not be proposed. Penalties are only applied where the taxpayer has taken some action that clearly shows the noncompliance was intentional. Such a standard should be applied to federal penalties as well.

This approach would reduce the administrative burden not only on taxpayers -- who must respond to penalty notices -- but also on the government -- which must process the notices and the requests for waivers.

(iv) Tiered Penalty Structure. Several areas within the current penalty regime use some form of tiered penalty structure, under which the rate of penalty increases the longer the infraction goes uncorrected. For example, the penalty imposed for failure to deposit taxes under section 6656 imposes a 2-percent penalty if the deposit is 1-5 days late, a 5-percent penalty if the deposit is 6-15 days late, a 10-percent penalty if the deposit is more than 15 days late. Although the tiered system may make conceptual sense, its compressed time period prevents it from operating equitably. Hence, the 10-percent penalty for a payment that is three weeks late is equivalent of an annual interest rate of more than 200 percent -- an excessive penalty we suggest. Such a result is inequitable and does not encourage compliance.

TEI recommends that the tiered system be based not merely on the passage of time but on the number of instances of errors within a given time frame. For example, under the failure-to-deposit penalty structure, if a taxpayer had complied with the deposit requirements within, say, the last year, no penalty would be imposed on the taxpayer's first failure in the current year. A second failure, however, might trigger a penalty at a low rate, if the taxpayer's actions warranted it. The rate of penalty would increase for additional failures, since this might indicate an intentional disregard of the requirements. For this purpose, a group of failures occurring at the same time for the same reason would be regarded as a single error. Thus, if a taxpayer attempts to upgrade its computer system (perhaps to become Y2K compliant), but a programming error prevents the timely filing of its information returns, the taxpayer's history of compliance should be considered in determining whether a penalty should be imposed.

A tiered structure with penalty rates that increase with the frequency of failures would encourage voluntary compliance and punish those taxpayers who make little or no effort to meet the filing requirements. No penalty should be imposed on the first one or two failures.

(v) Cascading Failure-to-Deposit Penalties. Under current rules, if a taxpayer makes a tax deposit that is less than the amount required, the IRS will make up the shortfall by applying funds from the next deposit. For employment tax deposits that are made frequently, a single underdeposit within a return period can affect all future deposits as each subsequent deposit has a portion applied to the previous one. This causes the taxpayer to incur a penalty for multiple deposits, though the error occurred in respect of only one.

Recognizing this problem, the IRS Restructuring Act contained provisions permitting taxpayers to specify the application of deposits to specific periods upon receipt of a penalty notice. In addition, after 2001, the IRS will automatically apply all deposits to the most recent period, then apply any excess to prior periods. This equitable change to the application of deposits should be made as soon as possible, rather than waiting to 2002. This would eliminate a significant amount of unnecessary work on the part of taxpayers and the IRS in resolving the proper application of deposits and prevent taxpayers from being penalized for what, in essence, is a single error.

F. Miscellaneous Issues

(i) Clarity of Notices. Notices of proposed penalties can be significantly improved. All notices should clearly indicate the type of penalty, the reason for its proposed imposition, and, most important, the actual calculation. This information is critical to permit taxpayers to determine the validity of the proposed assessment and to identify the cause of the problem. While the IRS has a mandate to begin providing this information for notices issued after 2000, this change should be implemented as soon as possible.

(ii) Prompt Processing of Taxpayer Responses. The IRS must improve the timeliness of its processing of taxpayer responses to penalty notices. In some cases, taxpayers will submit a written response to a notice within the required time frame, but the response is not processed timely, generating a second notice and a second taxpayer response. This is inefficient and places an unnecessary burden on taxpayers.

(iii) Third-Party Responses to Penalty Notices. More and more, businesses are outsourcing functions to third parties. In these cases, the third party may have the most relevant information regarding the cause of any failure that generated a proposed penalty. The third party may be a service bureau completing certain functions on behalf of its clients or a reporting agent authorized to file based on Form 8655. This makes the third party the appropriate entity to respond to the penalty notice, a process that the IRS prefers to have take place by telephone rather than in writing.

The IRS will generally not discuss any matter with anyone other than the taxpayer without a valid power of attorney (Form 2848) on file. Obtaining a power of attorney simply to clarify a matter of which the third party clearly has know]edge can be time consuming, burdensome, and many times difficult to coordinate. In other cases, the IRS insists the caller be an officer of the company, not simply an employee. In large companies, officers are generally far removed from the day-to-day operations and may have little, if any, knowledge of the facts surrounding a specific penalty. Requiring an officer to respond personally to a notice is an exercise in futility in many instances.

The reasons underlying the IRS's current rules are laudable -- preserving taxpayer confidentiality -- but the current rules are time-consuming and burdensome. A mechanism is needed to identify third parties who can provide an oral response to the IRS and receive information in return. Based on reports from our members, TEI understands that at least one District Office has experimented with including a unique identifying number on each notice of proposed penalty. If a caller responds to the notice and provides the name and employer identification number (EIN) of the taxpayer and the identifying number, the IRS assumes the caller is authorized to discuss the matter, eliminating the need for a power of attorney and providing a swift resolution of any questions. TEI recommends that such a procedure be implemented permanently and universally.

Moreover, a mechanism should be developed to identify on the return the third party authorized to respond to questions. For example, at least one state income tax return asks the taxpayer whether information contained in the return can be discussed with the designated paid preparer. This statement is signed by the taxpayer when the return is filed. A similar mechanism at the federal level would allow the IRS to discuss information submitted with the parties having the knowledge about how the information was developed.(8)

(iv) TIN Verification System. One key to proper information reporting is to ensure the payee's name and identification number match IRS and Social Security Administration records. This process could be significantly improved with a system to verify taxpayer identification numbers (TIN) for large-volume filers. Some programs currently exist, but they do not easily handle verification of large numbers of TINs from a single filer at one time.

A TIN verification system was in place on a pilot basis several years ago at the Martinsburg, West Virginia, Service Center. Unfortunately, the equipment supporting the process was destroyed by fire and has never been replaced. Congress and the IRS should heed taxpayers' calls and allocate sufficient funds to create a TIN verification system for large-volume filers as soon as possible.

III. Interest

A. Interest Rate Differential

Section 6621 of the Code establishes the rate of interest to be paid on over and underpayments of tax. The rate on overpayments of tax by a corporation is the federal short-term rate plus two percentage points; the underpayment rate is the federal short-term rate plus three percentage points. "Large corporate underpayments" are subject to an interest equal to the federal short-term rate, plus five percentage points (the so-called "hot interest" provision).(9) Thus, the rate of interest the government charges corporate taxpayers on tax deficiencies is higher than the rate of interest the government pays on refunds. TEI submits that the provision is both inequitable to taxpayers and ill-advised. The interest rate differential for corporations should be eliminated. (The IRS Restructuring and Reform Act of 1998 eliminated the differential in respect of individual taxpayers.)

The legislative history of the interest rate differential states that the provision was necessary because "[f]ew financial institutions, commercial operations, or other entities, borrow and lend money at the same rate." H.R. Rep. No. 99-426, 99th Cong., 1st Sess. 849 (1985) (hereinafter cited as the "1985 House Report"); S. Rep. No. 99-313, 99th Cong., 2d Sess. 184 (1986) (Pub. L. No. 99-514) (hereinafter cited as the "1986 Senate Report"). There was also a concern that the differential between the tax interest rate and the market rate might "cause taxpayers either to delay paying taxes as long as possible to take advantage of an excessively low rate or to overpay to take advantage of an excessively high rate." 1985 House Report at 849; 1986 Senate Report at 184.

TEI believes that the statements of congressional intent evidence a misapprehension of the reasons taxpayers overpay their taxes and a lack of appreciation for the effect of legislative changes that were made in the 1980s. Perhaps more fundamentally, we believe the differential reflects a congressional proclivity to use interest provisions as a penalty or a disguised tax to raise revenue -- policy decisions that in our view have spawned disrespect for the fairness of the tax system.

When the tax interest rate was determined only once every two years (as was the case before the Economic Recovery Tax Act of 1981 was enacted), it was quite possible -- especially in times of frequent and substantial interest rate fluctuations -- that the spread between the section 6621 rate and the market rate would be substantial. With the changes made first by ERTA (requiring the annual adjustment of the rate and the daily compounding of interest), then by the Tax Equity and Fiscal Responsibility Act of 1982 (requiring the semi-annual adjustment of the rate), and finally by the Tax Reform Act of 1986 (requiring quarterly adjustments), the potential for any significant differential was limited. Indeed, inasmuch as TEFRA also changed the rules relating to when interest on refunds would commence running, the limited ability of taxpayers to "overpay to take advantage of an excessively high rate" was essentially eliminated. Thus, contrary to the implication in the congressional reports, taxpayers do not deliberately "lend" money to the government. If such practices ever occurred, they were effectively put to an end by the amendments since 1982.

The interest rate differential is not only grossly unfair, but counterproductive. By giving the government an unfair advantage insofar as its obligation to pay corporate taxpayers interest, the provision undermines efforts to restore faith in the integrity and fairness of the tax system. Adequate safeguards are now in place to prevent manipulation of payments.

To suggest that a differential interest rate is justified because "financial institutions" and "commercial operations" borrow and lend money at different rates is to miss the point: the government should neither view itself nor strive to be viewed by taxpayers as a financial institution. Taxpayers have no freedom to negotiate interest rates and terms with the government, as they might with a commercial lender (or borrower). References to financial institutions and to arm's-length negotiations are simply not appropriate.

As previously explained, the IRS Restructuring and Reform Act eliminated the interest rate differential for individuals, but not corporations. The rates on corporate over- and underpayments should be uniform. Any difference in rate acts as a penalty and should be scrupulously avoided.

B. Interest Netting

The current regime of differential interest rates for overpayments and underpayments, coupled with the differences for large corporations, is chiefly responsible for recent enactment of legislation permitting interest netting. The situation arises when taxpayers both owe money to and are owed money by the government (but the debts bear interest at different rates) and is a common occurrence for large corporations that may have overpayments and underpayments of different taxes for several years as the result of multi-year and overlapping audits. (An IRS determination, say in Year 8, that a taxpayer should have deducted an expense in Year 1 instead of Year 2 could trigger an adjustment owing to the interest-rate differential, even though the taxpayer was a net creditor of the government during the entire period.) In 1998, Congress passed legislation, establishing a net interest rate of zero where interest is payable on equivalent amounts of overpayments and underpayments of tax.(10)

Returning to one rate of interest -- which approximates the "real world" market rate -- for both under- and overpayments would greatly reduce or eliminate the need for netting. In the absence of such a change in the law, we believe that the IRS should institute the most comprehensive netting system possible. Regrettably, the IRS's most recent guidance on the issue, Rev. Proc. 99-19, signals an intent to deny taxpayers a full measure of relief.(11) For example, although it is possible to interpret the rules to permit netting when the statute of limitations is open for either the year of the overpayment or the underpayment, the revenue procedure requires the statutes of limitations for both the underpayments and overpayments be open in order to qualify for transitional relief. Such an approach continues the inequity of the current law and should be eschewed. If a taxpayer-favorable interpretation under the current law is not possible, the IRS and Treasury should seek a legislative solution.

C. Computation of Interest

The complexity of the Code's interest provisions hinders efficient administration. One way to simplify the calculations would be to provide for the use of simple, rather than compound, interest.

In addition, under current law, errors in calculation by the IRS are common, especially where the taxpayer has executed a waiver on assessment of the deficiency (Form 870 or 4549). For example, the IRS commonly fails to recognize a waiver date and allows interest to accrue to the assessment date. The IRS may also fail to recognize a payment made, especially a cash bond or similar payment. The IRS's computer system also leads to errors and delays in computations.

For this reason, taxpayers mistrust the IRS's interest calculations and frequently incur significant expense in hiring outside consultants to review interest charges -- often without the benefit of a print-out of the IRS calculations. Although we recognize that the IRS is working to replace its computer system, it can assist taxpayers in the meantime by providing copies of interest calculations.(12)

D. Abatement of Interest

Under section 6404(e) of the Code, the IRS is granted the discretion to abate the assessment of all or any part of interest due for any period on (i) a deficiency attributable in whole or part to any unreasonable error or delay by an IRS officer or employee acting in an official capacity when performing a ministerial or managerial act, or (ii) a tax payment, to the extent that any unreasonable error or delay in such payment is attributable to an IRS employee or officer acting in an official capacity being erroneous or dilatory in performing a ministerial or managerial act. An error or delay may be taken into account only if no significant aspect of such error or delay can be attributed to the taxpayer involved, and after the IRS has contacted the taxpayer in writing with respect to such deficiency or payment. There is also limited authority to abate interest in respect of erroneous refunds or reliance on erroneous written advice of IRS personnel.

TEI believes that IRS's authority to abate interest is too circumscribed. The "unreasonable errors or delay" and "ministerial or managerial" language creates complex factual issues that can lead to audit disputes and litigation. The legislative history of the interest-abatement provision indicates that Congress did not intend the provision to be used routinely to avoid payment of interest, but rather in instances where the denial of abatement would be widely perceived as grossly unfair. 1985 House Report at 844-45; 1986 Senate Report at 208-09. There may well be instances where the denial of an abatement request may be unfair, but the situations do not meet the standards now set forth in the statute. We therefore recommend that the IRS seek and be granted the authority to abate interest on equitable grounds and in respect of all taxes (including employment taxes).

E. Tax Court Jurisdiction

Section 6404(i) of the Code provides the Tax Court with jurisdiction over actions brought by a taxpayer who meets certain requirements to review the IRS's refusal to abate interest on underpayments of tax. Section 7430(c)(4)(A)(ii) establishes net worth tests for using the procedure. An individual's net worth may not exceed $2 million; all other taxpayers (including corporations) may not have a net worth exceeding $7 million or more than 500 employees.

The ability to litigate an inequitable assessment of interest without first paying the amount should not be limited. All taxpayers are similarly situated in respect of interest on a tax liability and should be permitted to contest their disputes with the IRS in the Tax Court. Therefore, section 6404(i) should be amended to permit the Tax Court to hear the claims of all taxpayers relating to the IRS's refusal to abate interest.

IV. Estimated Tax

A. Safe Harbor

Current law effectively requires large corporations to overpay their estimated taxes, without the benefit of interest, in order to avoid an underpayment penalty under section 6655 of the Code. This Hobson's choice does not confront other taxpayers because they may generally avoid the section 6655 penalty by availing themselves of a statutory safe harbor. The corporate estimated tax rules thus operate as a "non-penalty penalty."

Specifically, under section 6655, corporate taxpayers are effectively subject to a penalty if they fail to estimate their tax liability and make quarterly deposits equal to either (i) 100 percent of their actual tax liability, or (ii) 100 percent of their prior year's tax liability. The "prior year's tax' option is not available to so-called large corporations -- roughly corporations whose taxable income is $1 million or more in any of the preceding three years.

Because they are not permitted to utilize the prior year's tax rule, large corporations must base their quarterly deposits on estimates of their current year's tax liability. The existing task is literally impossible in light of the complexity of the tax laws, the rapidity with which they have been changed in recent years, and the fact that the numerous adjustments to financial income can accurately be done only annually. Consequently, the large corporate taxpayer faces the following choice:

* paying a penalty (under section 6655) for underestimating its liability, or

* overpaying its taxes (in order to avoid the penalty).

The second option -- which large corporations are generally required to choose not only by internal business conduct policies but by the desire to avoid penalties -- does not come without cost. The cost is the effective denial of interest on the amount of the compelled overpayment by operation of section 6611(e), which provides that interest on an overpayment will not begin to run until the filing of a claim for refund.(13)

TEI suggests that a reform of the corporate estimated tax provisions of the Code is long overdue. "Large corporations" should be permitted to use the prior year's tax rule under section 6655.(14) (Alternatively, the government could pay interest on the overpayment of tax.)

B. Foreign Sales Corporations

A related issue involves the "penalty" effect of the estimated tax provisions on foreign sales corporations (FSCs) and their related suppliers. In general, a portion of a FSC's income is exempt from tax if certain conditions are met. The exemption is available with respect to income allocated to the FSC under special transfer-pricing rules based on either optional administrative rules or the arm's-length pricing rules under section 482 of the Code.(15) A decrease in the FSC's taxable income will almost invariably increase the income of its related supplier and vice versa. Thus, any overpayment of tax by a FSC will be offset by an underpayment of tax by its related supplier.

Although FSCs must file U.S. tax returns, as foreign corporations they cannot join their U.S. parent in filing a consolidated return. Thus, a FSC must separately file a corporate tax return. The estimated tax rules effectively operate as a "Catch-22" for FSCs and their related suppliers.

The problems in the FSC estimated tax area are twofold. First, combined taxable income (CTI) is often not susceptible to accurate calculation until after the close of the taxable year, particularly if grouping or marginal costing is used. Temp. Reg. [sections] 1.925(a)-1T(e)(4) permits a FSC and its related supplier to recalculate the amount of foreign trading gross receipts at any time prior to the expiration of the statute of limitations for the taxable year. If this provision is utilized, CTI will obviously change after year-end -- long after estimated tax payments would have been made.

A similar problem exists with respect to the tax payments required to accompany extension of time requests for filing income tax returns. Under Treas. Reg. [sections] 1.6081-3, a taxpayer (including a FSC) may receive an automatic six-month extension to file its tax return, if at least 90 percent of the tax liability is paid by the original due date. Because of the problems inherent in calculating CTI, it is difficult (if not impossible) to accurately determine the amount of tax owed by a FSC by the original due date of the return. Any underpayment of tax by the FSC will invariably be offset by a reciprocal overpayment by its related supplier, and vice versa. There is thus no policy or revenue basis for penalizing the underpaying entity.

TEI believes that the estimated tax provision should be amended so that no estimated tax penalties, failure-to-pay penalties, or interest charges would be imposed if no such penalties and interest would be due on a net basis with respect to FSC commissions when the payments of both the FSC and its related supplier are taken into account.(16)

V. Conclusion

Tax Executives Institute appreciates this opportunity to present our views on Notice 99-4, relating to the IRS's penalty and interest study. If you have any questions, please do not hesitate to call Stephen W. Boocock, chair of TEI's IRS Administrative Affairs Committee, at [phone], or Mary L. Fahey of the Institute's professional staff at [phone].

(1) Such guidance must be readily available to all taxpayers. Many taxpayers, particularly small businesses, lack expertise and sophistication in tax matters. For these taxpayers, the compliance requirements can be extremely difficult, especially if they are unfamiliar with revenue procedures, rulings, or regulations. The lack of knowledge imposes a responsibility on the IRS to issue prompt and clear guidance to taxpayers in a manner that is readily available to all.

(2) This is particularly true for small taxpayers. Consider the self-employed individual who may not learn of a reporting requirement until he meets with his accountant after the close of the taxable year. Does he file the return later and seek a waiver of the penalty or does he continue in his noncompliance in the hope the IRS never notices?

(3) These thresholds can be easily exceeded, especially in respect of taxpayers with substantial net operating losses.

(4) Treas. Reg. [sections] 1.6662-4(d)(3)(iv)(B) does provide that there is substantial authority for the tax treatment of an item if the treatment is supported by controlling precedent of a U.S. court of appeals to which the taxpayer has a right of appeal with respect to the item. This provision is limited, however, to appellate decisions and does not address district court decisions -- a distinction TEI believes should be eliminated.

(5) This section does not discuss the Clinton Administration's recent proposals concerning tax shelters.

(6) The substantial authority and disclosure exceptions provided in the substantial understatement penalty do not apply -- and, hence, the existence of substantial authority or a taxpayer's disclosure has no effect -- in respect of any item attributable to a corporate "tax shelter." Thus, if a corporation has a substantial understatement attributable to a tax shelter item, the penalty applies with respect to that understatement, unless the reasonable cause exception of section 6664(c)(1) is satisfied.

(7) Transactions that the significant purpose test were intended to reach -- such as stepped down preferred stock or liquidating REITs -- would also have been covered under the more established principal purpose test. Thus, we question whether the new standard is necessary to address these transactions.

(8) Taxpayers should receive a copy of all notices sent to third parties.

(9) The higher large corporate underpayment interest rate applies only to periods after the "applicable date." The calculation of the applicable date differs. If the deficiency procedures apply, the applicable date is the 30th day following the earlier of the date on which (a) the first letter of proposed deficiency that allows the taxpayer an opportunity for administrative review in IRS's Office of Appeals, or (b) the statutory notice of deficiency is sent by IRS. If the deficiency procedures do not apply, the applicable date is 30 days after the date on which IRS sends the first letter or notice that notifies the taxpayer of the assessment or proposed assessment.

(10) The provision applies to interest for periods beginning after July 22, 1998. In addition, the provision applies if: (i) the statute of limitations has not expired with respect to either the underpayment or overpayment; (ii) the taxpayer identifies the overlapping periods for which the zero rate applies; and (iii) the taxpayer requests the netting before December 31, 1999.

(11) TEI is in the process of preparing comments on Rev. Proc. 99-19, which will be submitted as soon as possible.

(12) Section 6631 of the Code (added by the IRS Restructuring and Reform Act) provides that individual taxpayers must be provided with interest calculations after December 31, 2000. This provision should apply to all taxpayers and should be implemented as soon as possible.

(13) The filing of a tax return could constitute a claim for refund, but most calendar-year large corporations will not file returns until close to September 15 (the extended due date of their return), though an outstanding tax would have to be paid no later than March 15. Thus, there could be, at a minimum, a six- month period during which no interest would be paid on the amount of the overpayment.

(14) The estimated tax rules provide an annualization method that may be employed to avoid any penalties. Determining annualized tax liability and quarterly estimated payments under section 6655(e), however, remains far from simple. This process effectively requires taxpayers to prepare five "mini" returns for their estimated tax payments plus their final return. By reinstating the prior year's liability safe harbor, Congress could remove the uncertainty associated with the determination of tax liability from the quarterly estimating and payment process.

(15) Under the administrative pricing rules, transfer prices must be set so that the FSC's taxable income will not exceed the greater of (i) 23 percent of the combined taxable income (CTI) of the FSC and its related supplier (generally its U.S. parent) attributable to foreign trading gross receipts derived from the sale of property by the FSC, or (ii) 1.83 percent of the gross receipts derived from the sale of property by the FSC.

(16) We recognize that matching estimated tax payments of FSCs and their related suppliers may complicate the processing of the returns by the IRS. We suggest, however, that a simplified procedure could be developed that would not require the IRS to physically "match" the returns of the FSC and its related supplier. For example, Form 2220 (Underpayment of Estimated Tax by Corporations) could be revised to permit the FSC or supplier to show an overpayment of estimated tax by the other entity.3