Model recordkeeping and retention regulation: January 10, 1997.

On January 10, 1997, Tax Executives Institute submitted the following comments to the Multistate Tax Commission on the Model Recordkeeping and Retention Regulation that had been developed by the Electronic Data Interchange Audit and Legal Issues Task Force of the Federation of Tax Administrators. TEI was pleased to have several representatives serve on the FTA Task Force (and its workgroups), who participated in the development of the model regulations. The comments were developed under the aegis of the Institute's State and Local Tax Committee whose chair is Christopher W. Baldwin of Gannett Co., Inc. Among the members of the Institute contributing to the comments were Barbara Barton of Electronic Data Services Corporation, Mark D. Loftis of Northern Telecom, Inc., Barbara A. Timek of AT&T, Charles Wooding of First National Bank of Chicago, Bill Zornes of Western Auto Supply Company (who chairs TEI's Tax Information Systems Committee), Robert E. Dobie of AFG Industries, Inc., and Fred H. Montgomery of Sara Lee Corporation.

Tax Executives Institute (TEI) is pleased to provide support for its members who have participated in the Federation of Tax Administrator's Task Force on Electronic Data Interchange (EDI) Audit and Legal Issues (hereinafter the "Task Force"). The Task Force's working groups and steering committees, consisting of business tax professionals and state tax administrators, have been seeking common ground and approaches to adapt existing state tax rules to emerging issues, particularly in the application of electronic data interchange to business transactions. Among the Task Force's first accomplishments is the Model Recordkeeping and Retention Regulation, which was the subject of the December 10, 1996, hearing by the Multistate Tax Commission.

Background

Tax Executives Institute is a professional association of nearly 5,000 accountants, lawyers, and other tax executives who are responsible for managing the tax affairs of their companies. TEI members must contend daily with the interpretation, application, and enforcement of business tax laws. We represent a cross-section of the business community across North America and are dedicated to the development and effective implementation of sound tax policy. We are similarly committed to 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. TEI believes that the diversity, training, and experience of its members enable it to bring a unique and balanced perspective to the policy and administrative issues raised by the Model Recordkeeping and Retention Regulation.

General

In March 1996, the Steering Committee of the Task Force on EDI Audit and Legal Issues (consisting of representatives from the Committee on State Taxation, Federation of Tax Administrators, Institute of Property Taxation, Multistate Tax Commission, and Tax Executives Institute), released a two-part report: Appendix A sets forth a model state regulation to govern the retention of taxpayer records, particularly those generated or retained electronically; Appendix B contains an explanation and commentary on the regulation. Because EDI records are so intertwined with other information systems and cannot be addressed in isolation from general recordkeeping requirements, the scope of the Regulation is broader than EDI transaction records. As a result, adoption of the Regulation will permit state tax administrators and the Multistate Tax Commission (MTC) to update state recordkeeping regulations to address electronic recordkeeping requirements generally while providing taxpayers with guidance on evolving technologies affecting business transactions and recordkeeping.

In general, the Regulation attempts to balance the divergent and competing needs of taxpayers and state tax administrators. Under the Regulation, the responsibility for maintaining books and records to support reported tax liabilities is placed on taxpayers, affording them flexibility to manage the manner in which the records are created or retained. In some areas, the Regulation manifests the desire of state administrators to maintain access to "all" records -- whether paper ("hard-copy" in the parlance of the Regulation) or machine-sensible -- relevant to verifying taxpayers' reported transactions and tax liabilities. In other areas, the Regulation reflects the desire to avoid imposing new or unnecessary burdens on taxpayers.

In many cases, the working groups and Steering Committee of the Task Force agreed readily on the objective of certain provisions (e.g., fair and cost-efficient examinations of the taxpayer's records) but reached an impasse on the language to achieve conflicting goals. In such cases, differing views were reconciled by deleting proposed provisions, inserting illustrative examples in the Regulation, adding counterbalancing provisions elsewhere in the Regulation, or inserting explanations in the commentary. As a result, the Model Regulation and commentary should be viewed, and judged, as an entire package. Appendix B of the Task Force report, which sets forth explanations for some of the Task Force's deliberations -- including important compromises, concessions, and agreements on how the diverse needs and concerns of state tax administrators and taxpayers were to be reconciled -- is an integral part of the report and the Regulation. Hence, we are concerned that the MTC is seemingly only considering the adoption of Appendix A (or modifications to Appendix A) without considering the context provided by Appendix B of the Steering Committee's Report. We recommend that the MTC adopt the Regulation and the commentary as an entire package.

On the whole, TEI supports the MTC's objective of providing a Model Recordkeeping Regulation, which if adopted by a substantial majority of the States, will advance a longstanding goal of the Institute -- administrative and procedural uniformity among the States. Hence, TEI recommends that the MTC substitute the Model Regulation for its existing Recordkeeping Regulation. Adoption of the Model Regulation by the MTC will provide an important imprimatur and will likely increase the number of States that adopt the Regulation. Notwithstanding our support for the MTC's adoption of the Regulation, we have several comments and recommendations that we believe will improve the Regulation.

Specific Comments

1. The MTC should consider rephrasing the requirement contained in section 3.1 that "a taxpayer shall maintain 'all' records that are 'necessary' to the determination of the 'correct' tax liability under..." as "a taxpayer shall maintain books and records sufficient to establish its tax liability under..." The determination of the "correct" liability is a complex process involving the interpretation of numerous provisions of law, an understanding of the facts of a transaction, as well as many computations on the return as filed by the taxpayer, carryovers from different tax years, adjustments proposed by the State or amended returns filed by the taxpayer, appeals of proposed adjustments, and, ultimately, either litigation or a settlement that represents a compromise view of the "correct" tax liability. At any point in the process, the taxpayer and the State may well have different, though good faith, views of the "correct" amount of tax liability. Hence, at a minimum, we recommend deleting the word "correct" from section 3.1.

As important, the requirement in section 3.1 to maintain "all" records "necessary" is overbroad. Indeed, a state auditor may misinterpret the requirement to keep "all" records "necessary" as a requirement to keep "any" or "every" record. A broad requirement to keep "all" records -- untethered by a relevance standard or untempered by a recognition of the burden imposed on taxpayers by recordkeeping rules generally -- would undermine provisions of the Model Regulation that afford taxpayers discretion to manage their records and fulfill their recordkeeping obligations in the most prudent and efficient manner. (See, e.g., section 4.1.1, second sentence, providing in respect of machine-sensible records that "a taxpayer has discretion to discard duplicated records and redundant information provided its responsibilities under the Regulation are met.). Hence, we recommend that the MTC consider either deleting the word "all" from section 3.1 or adding the word "material" immediately after the word "all."

Finally, the amount of documentary evidence "necessary" to support a taxpayer's reported tax liability should be based, as has traditionally been the case, on a civil law standard of a preponderance of evidence. TEI's recommended language incorporates the preponderance of evidence standard by stating that taxpayers are required to provide "sufficient" evidence (i.e., there is "enough" evidence) to support their reported tax liability without imposing a higher evidentiary standard that taxpayers must also disprove that the correct tax liability is higher (or lower) than reported. The recommended change will not undermine the taxpayer's fundamental obligation to provide records to substantiate and verify its reported tax liability.

2. Section 4.1.2 requires a taxpayer to convert all machine-sensible records to a "standard record" format without defining what that standard record format is or should be. We believe the provision was conceived originally to permit the retrieval of "standard record formats" in EDI transactions where the trading partners generally must follow standards prescribed by the American National Standards Institute (ANSI) for EDI transactions. As the scope of the Regulation expanded to address all recordkeeping requirements, however, the provision was retained on the justification that States should be permisted to invest in, or use, currently available software packages in their examination of taxpayers.(1)

The Model Regulation was developed because of a perception among taxpayers and state tax administrators that current state recordkeeping regulations should be updated to address EDI specifically and electronic recordkeeping requirements generally. Current state recordkeeping regulations have either become dated by the shift to electronic recordkeeping or, in some cases, may have inhibited adoption of new forms of doing business or maintaining records based on evolving electronic technologies, such as EDI or document imaging. While the Model Regulation addresses the current need for updated rules, the Regulation may itself be rendered passe by subsequent technological advances. More important, we believe the States should foster, rather than inhibit, technological advances that will make both business and government recordkeeping practices more efficient. Hence, we believe section 4.1.2 in the Model Regulation should be modified.

For example, outside of EDI transactions, a "standard record" format for machine-sensible records may not exist. Record formats vary from industry-to-industry, taxpayer-by-taxpayer, and State-by-State. Moreover, what is standard in 1997, may well be obsolete as early as the year 2000, especially as companies and governments begin to address the computer code and data-field limitations built into many current computer programs. As a result, we believe the requirement to convert machine-sensible records to a "standard record format" should be limited to EDI transactions governed by ANSI standards. Otherwise, the Regulation will likely stifle innovation and efficiency by imposing stasis on recordkeeping methodologies.

Thus, we recommend that section 4.1.2 be revised as follows: "At the time of an examination, the retained machine-sensible records must be capable of being retrieved. In addition, EDI transactions must be capable of being converted to a standard record format." Our recommended revision will mesh with section 6.2.3 which permits, but does not require, non-EDI machine-sensible records to be converted to a "standard record format" prescribed by the state taxing authority.

3. The Model Regulation is designed to preserve maximum access to all maintained records, whether machine-sensible or paper ("hardcopy documents" in the Regulation). Should the States desire to audit machine-sensible records, they may (see section 3.2); should they wish to audit paper records instead, they may, (see, e.g., section 9.5). In addition, the taxpayer is permitted to demonstrate tax compliance through either traditional paper or machine-sensible records (see section 3.3).

Throughout the deliberations of the Task Force, the need for the States to conduct efficient audits of both paper and machine-sensible records was paramount. Taxpayer and state representatives agreed that efficient auditing practices require the taxpayer and the auditor to agree to determine at the outset of the audit which records -- whether paper or machine-sensible -- are most relevant and accessible. Hence, except for EDI transactions where no paper record may exist, the Regulation is not intended to create a preference or priority of one form of record (or one form of audit) over the other. Thus, notwithstanding the language in section 3.2 that the taxpayer "shall" make machine-sensible records available at the request of the State, the selection of the proper records for audit properly remains a subject of discussion between the taxpayer and the state auditor. We believe that the report of the audit workgroup of the FTA's Task Force will ultimately support this interpretation.

Nonetheless, in order to improve the balance between taxpayers and the States concerning the selection of paper or machine-sensible records for audit, we recommend that the MTC retitle section 6 "Access to Records," add the words "hard-copy or" immediately before the phrase "machine-sensible" in section 6.1, and change the cross-reference to subsection 3.2 contained in subsection 6.1 to cross-reference "subsections 3.1 or 3.2 3.2."(2) In addition, we recommend adding as the first sentence of section 6.2 the following: "In order to minimize disruption of the taxpayer's normal business processing and minimize its costs of retrieval, reproduction, or conversion, [the state taxing authority] will afford discretion to taxpayers concerning the manner in which the taxpayer provides access to machine-sensible records." The balance of section 6.2 (including the current introductory sentence) may remain as examples of the manner in which the taxpayer provides access to machine-sensible records. TEI's proposed revision does not mitigate or undermine the taxpayer's obligation under section 3.2 to provide records in machine-sensible format where requested by the state taxing authority.

Conclusion

TEI is pleased to provide the foregoing comments on the MTC's Model Recordkeeping and Retention Regulation. TEI's comments were prepared under the aegis of its State and Local Tax Committee, whose chair is Christopher W. Baldwin of Gannett Co., Inc. Should you have any questions concerning TEI's comments, you may contact either Mr. Baldwin at [phone], or Jeffery P. Rasmussen of TEI's legal staff at [phone].

(1) The unstated assumption of the Regulation may be that all computer records are currently capable of being converted to a universal standard such as ASCII text files.

(2) The Regulation supplies copious examples of the manner of access to machine-sensible records, but says nothing of the manner in which hard-copy records must be supplied. Presumably hard-copy records must be legible and readable. The omission of any reference to the manner of providing access to hard-copy records is an implicit recognition by the Task Force that, though the audit process is adversarial and at times contentious, it generally works.