Study of taxpayer confidentiality.

October 21, 1999

On October 21, 1999, Tax Executives Institute filed the following comments with the staff of the Joint Committee on Taxation and the Department of the Treasury relating to the confidentiality of tax returns and tax return information. The comments were prepared under the aegis of TEI's IRS Administrative Affairs Committee, whose chair is Robert J. McDonough, Jr. of Wang Global, Inc.

The Internal Revenue Service Restructuring and Reform Act of 1998, Pub. L. No. 105-206, 112 STAT. 782, instructs the staff of the Joint Committee on Taxation and the U.S. Department of Treasury to prepare studies pertaining to the confidentiality of tax returns and tax return information. On August 17, 1999, the Joint Committee staff invited comments with respect to this subject, and on October 8, 1999, the Treasury Department issued a similar request. The reports are due to be submitted to Congress by January 22, 2000.

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 taxpayer confidentiality provisions of the Internal Revenue Code.

The Joint Committee staff and Treasury Department have requested comments on issues relating to the confidentiality of tax returns, including --

* The adequacy of present-law protections governing taxpayer privacy;

* The interrelationship of the taxpayer confidentiality provisions in the Internal Revenue Code (primarily section 6103) with the Freedom of Information Act, the Privacy Act, and section 6110 of the Code;

* The need, if any, for third parties, including those presently authorized under the Code, to use tax return information; and

* Whether greater levels of voluntary compliance can be achieved by allowing the public to know who is legally required to file tax returns but does not do so.

TEI is pleased to respond to these requests.

II. Adequacy of Present Law

For all its flaws, the U.S. tax system generally works well. Each year, millions of individuals and businesses voluntarily self-assess and pay the billions of dollars necessary to fund the military, the Social Security and Medicare programs, and other government programs. In the tax returns they file annually with the Internal Revenue Service, U.S. taxpayers lay bare not only their souls but also their personal and business lives. The level of detailed information required by the Internal Revenue Code is at once daunting and extraordinarily sensitive, and the willingness of taxpayers to disclose confidential information is largely attributable to assurances that their privacy interests will be safeguarded by the government.

Before 1977, tax returns were "public records" subject to disclosure under Treasury Department regulations approved by the President or by presidential order. In the aftermath of the Watergate scandals, however, Congress acted to strengthen taxpayers' privacy rights, reflecting public reaction to a wide range of governmental intrusions into private life well beyond the tax area. Consider, for example, the comments of the U.S. Privacy Protection Study Commission:

   Effective disclosure policy must make special provision for the
   confidentiality of the records of particular Federal agencies through
   enactment of statutes that set disclosure policy for a single agency, or
   for the records generated in a particular type of relationship an
   individual may have with one or more agencies. Records that contain a great
   amount of detail about individuals or that must be held in strict
   confidence if individuals are to be induced to participate in a government
   undertaking deserve special attention in this regard.

The Internal Revenue Service and the records it maintains about taxpayers represent such a special case. Although the taxpayer volunteers most of the information the IRS needs, his disclosures to it cannot be considered voluntary because the threat of criminal penalties for failure to disclose always exists. The fact that tax collection is essential to government justifies an extraordinary intrusion on personal privacy by the IRS, but it is also the reason why extraordinary precautions must be taken against misuse of the information the Service collects from and about taxpayers. U.S. Privacy Protection Study Commission, Personal Privacy in an Information Society 537 (1977).

Thus, in 1976, Congress provided that tax returns and tax return information are confidential and not subject to disclosure, except in 13 limited circumstances. In these areas of allowable disclosure, Congress attempted "to balance the particular office or agency's need for the information involved with the citizen's right to privacy, as well as the impact of the disclosure upon the continuation of compliance with our country's voluntary tax assessment system." Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1976, 94th Cong., 2d Sess. 315 (1976). Embodied in section 6103 of the Code, these rules define the protected area ("returns" and "return information") in detail, establish a basic rule of confidentiality, and prescribe different rules for disclosure to each of three groups -- private persons, government taxing authorities, and other government agencies.

In enacting section 6103(a), Congress made confidentiality the general rule: "Returns and return information shall be confidential, and except as authorized by this title [federal officers, employees, and certain other persons shall not] disclose any return or return information." "Return information" is defined, in part, under section 6103(b)(2)(A), as follows:

   [A] taxpayer's identity, the nature, source, or amount of his income,
   payments, receipts, deductions, exemptions, credits, assets, liabilities,
   net worth, tax liability, tax withheld, deficiencies, overassessments, or
   tax payments, whether the taxpayer's return was, is being, or will be
   examined or subject to other investigation or processing, or any other
   data, received by, recorded by, prepared by, furnished to, or collected by
   the Secretary with respect to a return or with respect to the determination
   of the existence, or possible existence, of liability (or the amount
   thereof) of any person under this title for any tax, penalty, interest,
   fine, forfeiture, or other imposition, or offense.

Courts repeatedly have confirmed the broad scope of this statutory language. E.g., Branch Ministries, Inc. v. Richardson, 970 F. Supp. 11, 18 (D.D.C. 1997) ("[t]his language is extremely broad ...."); Lehrfeld v. Richardson, 954 F. Supp. 9, 13 (D.D.C. 1996), aff'd, 132 F.3d 1463 (D.C. Cir. 1998) ("`return information' is defined broadly to include almost any information compiled by the IRS in connection with its determination of a taxpayer's liability"). Section 6103 is the type of statute that exempts information from disclosure under the Freedom of Information Act (FOIA) because it is nondiscretionary or establishes "particular criteria" for withholding information within the meaning of FOIA Exemption 3. Church of Scientology of California v. IRS, 792 F. 2d 146, 150 (D.C. Cir. 1986), aff'd en banc, 792 F. 2nd 153 (1986), aff'd, 484 U.S. 9 (1987).(1)

So important is protecting taxpayer confidentiality and maintaining taxpayer confidence in the integrity of the tax system that the Internal Revenue Code contains a three-tier system of sanctions for those who violate section 6103. First, section 7431(a) accords aggrieved taxpayers a civil cause of action and provides for damages in the case of unauthorized disclosures. Second, section 7213(a)(1) makes the unauthorized disclosure of taxpayer returns and return information a felony. Finally, the law mandates the firing of any federal employee convicted of unauthorized disclosure. I.R.C. [sections] 7213(a)(1). The enactment of civil and criminal penalties demonstrates the importance of the taxpayer confidentiality provisions.

Section 6103's ban on disclosure is not, however, absolute. In addition to the 13 limited exceptions, Congress has provided under section 6110 for the disclosure of "written determinations," which are defined as "a ruling, determination letter, technical advice memorandum, or Chief Counsel advice." Background file documents relating to written determinations -- defined as any written material submitted in support of the request -- are also subject to disclosure. These documents include any communications between the IRS and persons outside the IRS concerning such written determination that occur before the IRS issues the determination. Thus, at the same time it enacted section 6103, Congress enacted section 6110 to require the disclosure of private letter rulings and technical advice memoranda because the "secrecy surrounding" those written determinations "has generated suspicion that the tax laws are not being applied on an evenhanded basis." S. Rep. No. 94-938 (Part 1), 94th Cong., 2d Sess. 305 (1976).

Over the years, disputes have arisen concerning what constitutes a "written determination" under section 6110. See, e.g., Tax Analysts v. IRS, 117 F. 3d 607 (D.C. Cir. 1997) (relating to the application of FOIA Exemption 3 and section 6110 to field service advice memoranda). Thus, a tension exists between section 6103's general rule of confidentiality and section 6110's policy of public access.

We have described the current taxpayer confidentiality regime in some detail because we believe that, in general, taxpayers and the public have been well served during the 23 years since the enactment of sections 6103 and 6110. We recognize that at times the IRS may have invoked section 6103 to prevent information from becoming disclosed, as, for example, a litigating tactic or perhaps in an attempt to save itself from embarrassment. TEI believes, however, that on the whole taxpayer confidentiality must remain paramount and, therefore, that no fundamental changes should be effected. We suggest, however, that the law should be updated to take into account IRS programs that have developed since section 6103 was enacted. (Specifically, as discussed in the next section, advance pricing agreements should be considered "tax return information" and excluded from disclosure under section 6103.) In addition, the limited exceptions to section 6103 should be clarified in respect of third-party access to tax returns and return information to ensure that unrelated parties do not have access to confidential information.

III. Interaction with FOIA

In general, section 6103 and FOIA have operated in tandem to reasonably balance the public's interest in protecting taxpayer privacy against the public's right to have access to certain information. Thus, FOIA (and, later, section 6110) has resulted in the publication of private letter rulings (PLRs), technical advice memoranda (TAMs), general counsel memoranda (GCMs), IRS actions on decision (AODs), and, most recently, field service advice (FSAs). The release of these documents -- subject to appropriate redaction -- has served to keep the public abreast of IRS positions on issues, often well before official "published" guidance is released. Thus, written determinations, such as PLRs and TAMs, have provided much needed guidance in transition periods while more formal guidance is being prepared. This is not to say, however, that there have not been some hiccups. One of the problem areas involves the IRS's advance pricing agreement (APA) program.(2)

The APA program is designed to forestall contentious and expensive transfer pricing disputes between taxpayers and the IRS. A voluntary venture, the APA program represents one of the IRS's success stories of the 1990s, for it furthers the goals of reducing taxpayer burdens and minimizing disputes between the IRS and taxpayers. Under the program, the taxpayer submits detailed and confidential financial information, business plans, and projections to the IRS for consideration. Resolution involves an extensive analysis of the taxpayer's functions and risks. Since its inception in 1991, the APA program has produced more than 180 APAs, and approximately 195 APA requests are pending.

An APA effectively resolves transfer pricing disputes before they arise. Each APA specifies a methodology negotiated between the specific taxpayer and the IRS (and, at times, one or more foreign countries) for the taxpayer to use in determining its intercompany pricing and thereby ensure compliance with section 482 of the Internal Revenue Code. The information set forth in an APA is highly fact specific and involves sensitive financial and commercial information. By reducing taxpayer burdens and enhancing taxpayer certainty, the APA program strengthens the competitiveness of participating U.S. businesses and facilitates the more efficient use of IRS resources.

Although the IRS had treated APAs as subject to section 6103 from the inception of the program, earlier this year it stipulated that APAs were "rulings" and therefore "written determinations" for purposes of section 6110. This concession, which was made in the course of litigation to force the disclosure of APAs, BNA v. IRS, Nos. 96-376, 96-2820, & 96-1473 (D.D.C.), was in TEI's view erroneous.

As a professional association dedicated to the development and implementation of sound tax policy, TEI is fully aware of the policy concerns underlying the Freedom of Information Act. Unless the proper balance is struck between the public's interest in safeguarding taxpayer privacy and the principles underlying "government in the sunshine," however, irreparable harm may be done to the tax system and, more particularly, the APA program. TEI is concerned that the release of APAs and supporting materials, even in redacted form, will adversely affect the program. Taxpayers submitted the pricing information to the IRS with the understanding that the information would be subject to the same confidentiality restrictions as tax returns. Companies' legitimate privacy interests would be compromised by the release of the APA background files and their ability to compete effectively in the marketplace could be harmed. In addition, releasing APAs and their background files could well diminish the willingness of taxpayers -- and our treaty partners -- to participate in the program.

TEI is not alone in recognizing the dangers of releasing APAs. Earlier this year, several members of Congress introduced H.R. 2378 to safeguard taxpayers' rights by ensuring that the submitted information remains confidential. The bill would also require the Treasury Department to issue an annual report on the APA program. This report, which would include information such as a summary of the methodology used in each agreement, would provide taxpayers with valuable insight concerning how the IRS administers the transfer pricing provisions of the Code, as well as the administration of the APA program itself. Consistent with the overall concern for confidentiality, the bill provides that the Secretary's primary concern in preparing the reports shall be to protect the identity and privacy rights of the taxpayer. This provision should balance taxpayers' privacy concerns with the policies underlying the Freedom of Information Act. The annual report should also help promote the APA program by making available information about the scope and benefits of the program. Thus, it would encourage more taxpayers to participate in the APA program without sacrificing taxpayers' legitimate privacy interests. A version of the APA provision was included in H.R. 2488, the Financial Freedom Act of 1999, which was vetoed by President Clinton for reasons unrelated to APAs, and is included in H.R. 2923, the so-called extenders bill awaiting action on the House floor.

TEI believes that the APA program represents the best way for companies to resolve transfer pricing controversies and avoid costly and time-consuming audits and litigation. At a time when the IRS is seeking more efficient, taxpayer-friendly ways of doing business, initiatives such as the APA program should actively be encouraged. Thus, the Institute strongly believes that section 6103 should be amended to protect the confidentiality of APAs and their background files. The Joint Committee's and Treasury Department's studies should address taxpayers' concerns about the APA program and recommend legislation to protect APAs from disclosure.(3)

IV. Third-Party Access to Tax Return Information

Section 6103 contains certain limited exceptions to its bar on the disclosure of confidential information. For example, sections 6103(h)(4)(B) and 6103(h)(4)(C) provide that third-party taxpayer information can be provided in situations where the treatment of an item reflected on the taxpayer's return is directly related to the resolution of an issue in the proceeding in which the information is sought or where there is a direct transactional relationship between the party seeking the information and the taxpayer and that relationship directly affects the resolution of the issue. In light of the important privacy interests underlying section 6103, TEI strongly believes that these exceptions should be narrowly construed.

A recent decision by the United States District Court for the District of Puerto Rico undercuts the privacy protections accorded by section 6103. In Bristol-Myers Barceloneta, Inc., Bristol Caribbean, Inc., and Bristol Laboratories Corp. v. United States, Civil 97-2567CCC, the court ordered that the IRS produce tax return information in respect of unrelated parties. The order grew out of the plaintiffs' efforts to secure information relating to their claim that the IRS had improperly denied them the favorable treatment accorded other taxpayers, and it was resisted by the IRS on section 6103 grounds.(4) The efforts of some affected taxpayers to voice their objections to the disclosure of confidential tax return information -- and to recommend alternative, less-drastic solutions -- proved unsuccessful.(5)

TEI believes that the district court misinterpreted the exceptions under sections 6103(h)(4)(B) and (C), which have generally been limited to situations where there is some relationship between the taxpayers and the third party. Thus, for example, in Davidson v. Brady, 559 F. Supp. 456 (W.D. Mich. 1983), aff'd on other grounds, 732 F. 2d 552 (6th Cir. 1984), the court found that the disclosure of a third party's financial statement submitted to the IRS during a criminal investigation was proper under section 6103(h)(5)(C) because of the debtor-creditor relationship between the two parties. See also Mindell v. United States, 693 F. Supp. 847 (D. Cal. 1988) (IRS permitted under section 6103(h)(5)(B) to disclose taxpayer's return to tax preparer to permit defense against preparer penalty).

Quite simply, tax returns of unrelated parties should not be released to litigants in a pending case.(6) As noted by a federal appellate court in quashing a subpoena from the Commodities Futures Trading Commission for copies of individual traders' tax returns, "Income tax returns are highly sensitive documents." Commodities Futures Trading Comm'n v. Collins, 997 F. 2d 1230 (7th Cir. 1993).(7) The exceptions should be clarified to require a direct relationship between the taxpayer and the third party. The IRS might also be directed to develop alternative means of allowing taxpayers to pursue claims of "disparate treatment" based on the IRS's actions in respect of unrelated parties.

V. Disclosure of Non-Filers

One issue to be addressed in the study is whether the publication of the names of taxpayers who do not file returns would encourage voluntary compliance. The Institute believes that, as a matter of tax policy and administration, such a program would be ill advised.

As the Privacy Commission found in 1977, "extraordinary precautions must be taken against misuse of the information the Service collects from and about taxpayers." In enacting section 6103, Congress was also concerned about the "impact of disclosure upon the continuation of compliance with our country's voluntary tax assessment system." TEI believes that the concerns leading to the enactment of section 6103 are still valid today.

Assuming that the information published is accurate, revealing the names of non-filers will undoubtedly erode taxpayers' privacy rights. Moreover, should mistakes occur -- as seems highly likely in today's mobile society -- taxpayers will soon lose confidence in the accuracy of the information, thereby defeating the purpose of the provision. In such circumstances, the provision could well hinder, rather than help voluntary compliance.

Finally, the suggestion raises significant administrative questions. How will the provision be implemented? Will the IRS develop a list of who filed a return in one year, compare it with a list of those who filed a return in prior years, and publish a list of names on one list, but not the other? When will the decision be made? Who will be responsible for keeping the list up-to-date? How will changes in names or mergers of companies be handled? How will errors be rectified? Will supposed non-filers have the opportunity to object to their inclusion on the list (before the fact)? What are the consequences of listing the name of a taxpayer who has, in fact, filed a return? TEI believes that the publication could cause more harm than good.

VI. Conclusion

Tax Executives Institute appreciates this opportunity to present our views on issues relating to taxpayer confidentiality. If you have any questions, please do not hesitate to call Robert J. McDonough, Jr., chair of TEI's IRS Administrative Affairs Committee, at [phone] or Mary L. Fahey of the Institute's professional staff at [phone].

(1) FOIA lists categories of information that a federal agency must make available for public inspection. 5 U.S.C. [sections] 552(a). Although the statute sets forth a general presumption that agency records are publicly accessible, there are nine exemptions from public disclosure. For example, Exemption 3 of FOIA provides that an agency is not required to disclose matters that are specifically exempted from disclosure by statute "provided that such statute (A) requires that the matters be withheld from the public in such a manner as to leave no discretion on the issue, or (B) establishes particular criteria for withholding or refers to particular types of matters to be withheld...." 5 U.S.C. [sections] 552(b)(3).

(2) Under section 6110, the IRS is to redact taxpayer information before releasing so-called written determinations -- a process in which the affected taxpayers participate. Although TEI is concerned about the potential for inadvertent disclosure -- especially where voluminous background information is involved -- the safeguards utilized by the IRS work remarkably well.

(3) Contrary to recent criticism of the need for APA confidentiality, the APA program does not permit taxpayers to set their own effective tax rates. The APA program focuses on methodology and acts as a replacement for an audit of a taxpayer's return. Information gathered in the conduct of an audit is considered tax return information and subject to section 6103's confidentiality provisions. APAs should likewise be considered tax return information.

(4) The plaintiffs had sought to change their taxable year to maximize the tax benefits accorded by section 936 of the Code, following Congress's 1993 amendment of that provision. Plaintiffs argued that several similarly situated corporations were successful in their efforts to change their taxable years, and that the disparate treatment accorded them was improper, citing IBM Corp. v. United States, 343 F. 2d 914 (Ct. Cl. 1965). It is the return information of taxpayers filing for a change in taxable year that was the subject of the district court's order. Although the return information was produced in July under conditions of confidentiality, TEI is seriously concerned about the long-term effect of the court's order on taxpayer confidentiality.

(5) Following the district court's initial February 5, 1999, order requiring the IRS to produce the confidential third-party information, the IRS's Chief Counsel notified the affected taxpayers. Several of those taxpayers sought to participate in the case as amici curiae, but their motion -- along with the government's motion for reconsideration -- was denied on May 14, 1999.

(6) Let there be no mistake: TEI believes that the plaintiffs' "disparate treatment" claim is worthy of adjudication. Nevertheless, even a wholly meritorious claim is insufficient reason to vitiate the protections of the Code's privacy provisions.

(7) The court also noted, "The self-reporting, self-assessing character of the income tax system would be compromised were they promiscuously disclosed to agencies enforcing regulatory programs unrelated to tax collection itself."