Tax Executives Institute--IRS Large and Mid-Size Business Division liaison meeting: February 5, 2002.

On February 5, 2002, Tax Executives Institute held its annual liaison meeting with representatives of the Internal Revenue Service's Large and Mid-Size Business Division. The agenda for the meeting was published in the January-February 2002 issue of The Tax Executive. The minutes follow.

On behalf of the Large and Mid-Size Business (LMSB) Division of the Internal Revenue Service, Commissioner Larry R. Langdon welcomed TEI President Robert L. Ashby and the other members of the delegation from Tax Executives Institute to the liaison meeting. LMSB's and TEI's delegations to the liaison meeting are set forth below.

1. Opening Comments

Mr. Langdon expressed appreciation to the Institute for its promotion of the LMSB "bonus" sessions that will be held at the Renaissance Hotel immediately following the conclusion of the Institute's Midyear Conference at the Grand Hyatt Washington. He also thanked the Institute for its letter to Commissioner Charles O. Rossotti, which commends the IRS for various taxpayer-relief notices issued in the aftermath of the September 11 terrorist attacks, for the changes in the research credit regulations, and for other matters. TEI thanked Mr. Langdon for the reply from the Commissioner expressing appreciation for TEI's efforts in promoting awareness among its members of the need to brief IRS field agents on company safety and evacuation procedures.

2. LMSB Updates

A. Industry Issue Resolution (IIR) Program. TEI commended the IRS for developing new issue-management techniques that provide taxpayers and IRS personnel with more timely, focused guidance. TEI observed, however, that taxpayer- and industry-specific guidance is no substitute for generic guidance. TEI invited LMSB to provide an update on the Industry Issue Resolution (IIR) program, including whether additional issues (particularly in the international area) have been selected for resolution.

Mr. Langdon said that, because of the success of the pilot IIR program, LMSB would recommend that IIR be made permanent. He said that an announcement to that effect may be released soon. Mr. Ng provided a summary of the IIR pilot program. Of seven items accepted for IIR, four matters have been resolved with formal guidance issued. In addition, supplemental guidance has been issued to the field on those items. Guidance on the other three issues selected for the pilot program is expected to be issued by the end of March. LMSB is enthusiastic that the process can be used to resolve contentious issues and is in the process of refining both the PFA and IIR programs. In order to evaluate the program and issue resolution process, the IRS is gathering feedback through a questionnaire posted on its website.

TEI inquired whether the IRS will accept new issues for IIR. In order to ensure a level playing field for all taxpayers, Mr. Langdon said, the IRS will follow a procedure similar to that employed when the IIR pilot was announced. Specifically, taxpayers will be invited to submit proposed issues and IRS will decide which issues to accept; a public announcement will follow with all interested parties being accorded an opportunity to submit comments. The IRS will likely accept issues in the "gray areas" of the law where no formal guidance currently exists, but for which it will not be a "stretch" to reach a resolution of the issue.

TEI inquired whether there is a mechanism to measure how many taxpayers have elected the resolution proffered in the IIR guidance. Mr. Ng said that the IRS is still developing measures of the compliance effects for all of the pre-filing issue resolution products. Anecdotal evidence suggests that pre-filing agreements (PFA) have a substantial effect on taxpayer compliance. He acknowledged that it is more difficult to measure the effect of IIR on compliance because the number of taxpayers affected by a particular issue is not easy to discern. Another unknown factor is the degree of uniformity or consistency of taxpayers' treatment of a tax issue before or after IIR guidance released. If an issue is not being raised as a proposed adjustment by the field, that is significant evidence that taxpayers are adopting the treatment prescribed by the IIR. Mr. Ng said that once the feedback on the pilot is complete, LMSB will draft a permanent IIR provision.

B. Post-Filing Design Team. In November, TEI representatives met with the IRS Post-Filing Design Team to explore ways to improve the post-filing process. The first phase of the project was completed in December 2001. TEI's recommendations for improving the process include: (i) focusing on specific material issues (perhaps through better use of the Schedule M), rather than auditing the entire return; (ii) not revisiting issues that were audited with little or no change during the prior audit cycle; (iii) increasing the use of statistical sampling techniques; and (iv) increasing the use of electronic communication.

Mr. Langdon said that the post-filing project is a key LMSB initiative to go beyond traditional compliance approaches. The Post-Filing Design Team is in phase II (Design and Blueprint) of its project and recently completed a focus group discussion in Santa Clara. During the next two to three months, the team will develop and refine its processes and will seek a means to test its procedures. TEI volunteered to serve as a resource for the IRS as it moves forward.

C. Fast-Track Appeals Process. TEI noted that LMSB has issued Notice 2001-67, which LMSB Commissioner Larry Langdon has described as a "field-based" approach to resolve conflicts arising from audits. Under the procedure, taxpayers and IRS examiners work with an Appeals Officer to resolve their differences within 120 days. The procedure requires taxpayers to waive their ex parte protections. Once resolved, the resulting agreements could be applied to subsequent and prior periods. Some issues, TEI noted, have been resolved within a week.

Mr. Black expressed his thanks to TEI for its receptivity to the Fast-Track appeals process. He said that 52 Case Leaders (GS-15) in Appeals have been trained in the process, and Appeals' direct involvement with the LMSB field team is critical. Five cases have been closed under the process within an average of 74 days. Fourteen more cases are under active consideration with an average of 40 days of elapsed time. The IRS is considering accepting 15 more cases; 11 cases have been declined. Cases are usually declined where the request is made after the field issued its 30-day letter. He said that all five LMSB industry groups have participated in the process. One question about Fast-Track Appeals that has been raised by the LMSB Industry Directors is whether Appeals has the resources to resolve the cases in a timely fashion. Mr. Black said that it does. Mr. Black invited TEI to provide feedback on the process.

One member noted that her company used mediation recently to resolve an issue and that she was impressed with the Appeals Officer's mediation and technical skills. Mr. Black said that the Appeals Division frequently employs mediation to successfully reach agreements in the Small Business/Self Employed Division but does not anticipate high demand for formal mediation in LMSB Appeals.

TEI inquired whether there is buy-in to the Fast-Track Appeals process at the field level. Mr. Black said that there is strong interest in Appeals, especially at the GS-15 level. The GS-14 Appeals Officers initially seemed less enthused, but became more open to the process after receiving their training. He encouraged TEI to bring any "pockets of resistance" at the field level to his attention. Mr. Brazzil said that the field agents are very enthusiastic about the process because of the opportunity to participate in the decision-making and settlement process. Ms. Burke explained that in order to make Fast-Track work, there has to be a balance between the incentives for taxpayers and the field. As a result, the procedure was very challenging to draft. In most cases, she said, key process issues were resolved in favor of taxpayers in order to provide a perception that the process is fair. TEI said that it will work to increase taxpayer awareness and interest.

D. Pre-Filing Agreement (PFA) Program. TEI reiterated that it has supported the IRS's PFA initiative from the outset. In Rev. Proc. 2001-22, the IRS made the PFA initiative permanent and expanded it to international issues. In a report last summer, the Treasury Inspector General for Tax Administration (TIGTA) found that the pilot program offered taxpayers a successful process by which to resolve specific issues on tax returns not yet filed. TIGTA also found, however, that significant challenges remain before the pilot program can be converted into an effective operational program. TEI invited LMSB to provide a status report on the PFA program, including its relationship to the IIR program.

Mr. Ng said that, despite press reports to the contrary, the PFA program is alive and well and is actively being used to resolve factual issues. He said that LMSB invited TIGTA to comment on the PFA initiative in order to ensure an independent evaluation of the process. Mr. Ng said that TIGTA's principal concerns were (i) whether taxpayer demand for the PFA process justified the resources devoted to the program and (ii) in responding to specific taxpayer requests for PFAs, whether IRS is limiting the resources available for examinations. LMSB's response to TIGTA's report acknowledges the resource constraints, but LMSB believes that substantial long-range benefits will be reaped by investing resources in the PFA process. By taking fact- and record-intensive issues off the table before returns are filed, LMSB believes it will be able to achieve a higher rate of compliance with fewer resources devoted to examining contentious issues, thereby freeing up resources for examination of other taxpayers.

Mr. Ng said that there have been 29 applications for PFAs, of which 16 were accepted, 5 are pending, and 8 were declined. As more taxpayers become aware of the benefits of the process, he added, more issues will likely be submitted for resolution. He said that LMSB is encouraging agents to engage taxpayers in a discussion of issues that can potentially be resolved through PFAs. One of the principal side benefits of undertaking a PFA, reported by agents and taxpayers alike, is that the audit relationship improves significantly. Taxpayers and agents, he said, develop a higher degree of trust since both sides focus on the issues to be resolved, identify the records required for review and substantiation, and identify and commit the necessary taxpayer and government personnel. Also critical to achieving the PFA, he said, is an aggressive time frame for issue resolution and effective management oversight of the process. Where both sides commit to making the process work, they share common, rather than conflicting, objectives.

Ms. Burke noted that one criticism of a PFA is that it is limited to resolving a single issue in a single year. Taxpayers have questioned whether the PFA can be extended to apply on a multi-year basis as is the case with Advance Pricing Agreements. A limited Delegation Order, she said, will likely not be made available to the field. Only representatives of Chief Counsel's office can enter into closing agreements that address the tax treatment of issues in unfiled years. Ms. Burke asked whether a change in the PFA process to permit a multi-year agreement would encourage more taxpayers to participate. TEI agreed that such a change would likely promote participation. Ms. Burke said that other tools, such as determination letters, are available to the field to address filed and unfiled future years, but the question is whether taxpayers will insist on a closing agreement? Closing agreements would likely require National Office involvement, whereas the PFA is designed to be field driven. TEI said that taxpayers may prefer a closing agreement to ensure the treatment of an item in subsequent years' returns, but will likely consider using the PFA process even without closing agreements. TEI suggested the process could be made to work even without a delegation order. TEI analogized the process to the informal issue resolution that taxpayers and some IRS teams employ to resolve subsequent open years without resorting to IRS counsel or making use of formal procedures such as Accelerated Issue Resolution. Ms. Burke agreed that there may be a way to address both taxpayer and IRS concerns.

TEI inquired whether, following the release of the proposed research credit regulations, the IRS anticipates more requests for PFAs on such issues. Mr. Ng said that IRS has received some inquiries and is amenable to accepting research credit issues for PFAs when the proposed regulations are final. TEI inquired whether Counsel is involved in every PFA. Mr. Ng said that it is up to the field to decide whether to involve Counsel in a case and how extensive that involvement should be. During the pilot program, Counsel was part of every team and reviewed all closing agreements. But, he said, concerns have been expressed about the time required to review a PFA, and LMSB is currently reviewing the process. Ms. Burke said that every PFA request is screened by Counsel, which will make a recommendation, but LMSB decides whether to accept an issue for the PFA process or to accept the PFA issue resolution. Mr. Ng added that the PFA is a field-driven process. In some cases, the LMSB Team Manager may invite field counsel to participate in the initial and subsequent conferences to discuss the PFA. Mr. Brazzil said that field counsel are helpful in expediting resolution of issues.

In response to a question, Mr. Ng said that during the pilot program only one application was submitted that related to an international tax issue. After a "healthy" internal discussion, he said, LMSB determined that it might not reach timely agreement on the case because it was not a "clean," concise issue. Mr. Ng explained that in the international arena, stand-alone issues are rare. Frequently, multiple, interrelated issues are present and must be resolved concurrently. There is a high degree of interest among international examiners in using PFAs, however, because they believe many issues are ripe for resolution. Ms. Burke said that even if an issue is not accepted for a PFA or IIR, taxpayers should not assume that no guidance will be forthcoming. Indeed, issues that surface in the PFA or IIR process may result in an item being added to the IRS/Treasury Priority Guidance Business Plan.

E. Role of Counsel. Ms. Burke referred to a presentation entitled Guidelines for Interactions by the Office of Chief Counsel LMSB Division. She said that there were many areas where Counsel will provide assistance to the field. She said that Counsel will engage in discussions with a taxpayer when asked to do so by the Team Manager.

3. TEI Updates

A. TEI Testimony Before IRS Oversight Board. TEI President Robert L. Ashby testified before the IRS Oversight Board on January 29, 2002. Mr. Ashby was on a panel devoted to reducing taxpayer burden. The Institute's testimony addressed the need for currency in audits, the use of statistical sampling, the need for record retention agreements, the increased use of electronic technology, the need for prompt and effective guidance, the need for adequate funding of the IRS, and the need to simplify the tax law. Mr. Langdon thanked TEI for its consistent support for IRS funding.

B. TEI-LMSB Liaison Relationship

1. Effectiveness of Liaison Relationship. Mr. Brazzil said that TEI has been the strongest organization providing support for LMSB in the field. He expressed his thanks for making his job easier. At the chapter and regional levels, he said, TEI and the IRS have established strong and effective points of contact facilitating liaison between the two organizations. He characterized the liaison activities at the industry level as "uneven" and agreed that adding Senior Industry Advisers (SIA) as an additional contact point would facilitate industry-level communication and coordination. The LMSB Industry Directors, he said, have been urged to nurture the relationship with TEI and the SIAs will assume responsibility for ensuring better communication between the IRS Industry groups and TEI. TEI said that the Industry Directors should remain a point of contact for liaison efforts and agreed that adding SIAs as a point of contact will facilitate day-today communications.

2. Industry Meetings. Mr. Brazzil noted that, during the past year, TEI chapters in New York, Detroit, and Cincinnati have sponsored industry-specific forums on financial services, heavy manufacturing, and retail industry issues, respectively. He said the programs are intended to be technical in order to provide continuing professional education credit to the participants. He said that the IRS finds them useful as a means of disseminating information to field agents and taxpayers and intends to continue them, but there are questions within LMSB about the best approach to institutionalize the process and structure future meetings. Feedback from TEI participants at the three industry meetings, he said, indicates that IRS should ensure that the speakers are strong presenters in addition to being technically proficient. Also, there should be an opportunity for networking between taxpayers and IRS personnel, perhaps at a reception held the evening before the technical sessions. He said that LMSB is interested in holding a similar meeting soon for the pharmaceutical industry and it has been approached by an industry trade organization willing to act as a sponsor.

TEI noted that, because of chapter resource constraints, future industry meetings should generally be held in cities where there are strong chapters with an industry presence, for example, Detroit for heavy manufacturing or New York for financial services. Where the forums address technical issues in a timely fashion, TEI members derive substantial benefit and TEI will not only co-sponsor meetings but assist in identifying speakers and promoting awareness and participation by members. In order to ensure proper communication and coordination in respect of regional and national symposia, TEI urged LMSB to include the TEI staff (or the appropriate Institute level point of contact) in the discussions before the meetings are organized. This is so even where a TEI chapter approaches LMSB directly about sponsoring a possible meeting. Coordination with the staff will help TEI better manage its calendar and resources and minimize confusion about the meeting's purposes and sponsor.

TEI said that it would welcome the participation of other organizations as sponsors or co-sponsors of industry meetings, but said the ground rules of co-sponsorship should be addressed. Mr. Brazzil agreed that industry liaison efforts cannot be achieved exclusively through TEI and said that the IRS would welcome other organizations as sponsors or cosponsors. He then explained that LMSB industry approach to its training needs is evolving and there are a number of different types of industry and sub-industry meetings being planned. Some meetings, he said, are to provide CPE training for agents and team managers but may include invited experts from industry. Other sessions will be devoted to internal purposes and focus on either common industry or strategic management issues. Hence, as in the past, some meetings or sessions will be open to TEI members and some will be closed. To avoid misunderstandings, he said, members should be aware of the purpose and scope of the meeting before accepting an invitation to participate.

3. Use of CEOs in IRS Training Programs. TEI referred to a request from an SIA for TEI members to identify CEOs willing to participate in IRS training programs. TEI observed that, given the number of demands on a CEO's time, members would be reluctant to approach their CEO to invite them to spend a day or two traveling to and participating in IRS training sessions. Mr. Langdon said that one objective of LMSB's training is to bring in industry experts to provide perspective to the field and provide a framework for consideration of the tax issues. He said that the title of the expert is not the determining factor; LMSB will invite anyone knowledgeable about specific industry issues and practices, including trade association executives. Mr. Langdon acknowledged the members' concerns about approaching their CEOs or CFOs and invited TEI to submit suggestions on how to provide agents with industry-based training. He said that IRS frequently hears the complaint that, if agents understood the industry better, they would be more efficient and practical. LMSB's goal is to ensure that agents understand the business setting and what drives the decision-making and accounting. With a better industry background, agents will be able to spot emerging issues and improve their audit efficiency. TEI suggested that investor relations personnel might be able to provide the industry perspective. Mr. Langdon acknowledged that investor relations representatives are generally good communicators.

Ms. Linden noted that a group of TEI representatives -- Messrs. Ash by, Bernard, McDonough, McCormally, and Murray -- have been invited to a meeting of the IRS LMSB Management team on February 28 to discuss ways to continue the ongoing dialogue between TEI and LMSB. Former TEI Executive Director, Michael J. Murphy, has also been invited so that the "group of 38" can properly recognize his contributions to the IRS as an employee and while with TEI.

4. Technical Issues

A. Tax Shelter Disclosure Initiative. TEI referred to Announcement 2002-2, an initiative designed to encourage taxpayers to disclose tax shelter transactions and other items to which accuracy-related penalties may apply. TEI commended the IRS and Treasury Department for taking a practical approach to the disclosure of corporate tax shelters and said it is still reviewing the announcement. One question that has arisen is whether the requirement that taxpayers disclose all legal opinions or analyses relied upon in entering into or reporting such transactions is overbroad and, hence, will inhibit disclosure. TEI suggested that taxpayers are likely unwilling to waive their right to assert attorney-client privilege especially for opinions evaluating the merits of a transaction.

Mr. Langdon said that disclosure of opinions should not get in the way of disclosure of transactions. As a result, he said, Ms. Burke is working on a template that would permit a limited subject matter waiver of attorney-client privilege for certain opinions. He added that if the return is prepared on the basis of advice rendered in an opinion, that opinion likely is not privileged. The IRS, he said, must be able to understand the thought process that went into the preparation of the return; if it cannot, it will not be able to assess whether the taxpayer acted in good faith and with reasonable cause in the position taken on the return. Ms. Burke explained that under section 6662, disclosure of a "tax shelter" transaction is sufficient to establish that a taxpayer acted in good faith in respect of its position but disclosure is insufficient to establish that the taxpayer acted with "reasonable cause" to avoid the imposition of an understatement penalty. In order to assess whether the taxpayer had reasonable cause for entering into and reporting a transaction, she said, the IRS must have access to the opinion. Sometimes the relevant opinion on which the taxpayer relies is prepared after the return is filed. She said that the IRS is trying to balance the information it needs in order to assess the taxpayer's reasonable cause with the taxpayer's right to attorney-client privilege. Consultations with counsel, she said, are healthy and the IRS does not wish to impinge unnecessarily on the attorney-client privilege. The IRS will soon release a template for limited subject-matter waiver of privilege for such opinions. She cautioned that the waiver will only bind the IRS. If taxpayers anticipate litigating a tax shelter transaction, the Department of Justice may not view the subject-matter waiver of privilege as limited. [Note: On February 19, 2002, the IRS subsequently released the draft agreement for limiting the assertion of subject-matter waiver of attorney-client privilege.]

Mr. Langdon said that the disclosure initiative is part of a two-track strategy. In respect of Notice transactions (e.g., LILO transactions), the IRS is consolidating all of the cases and using the Fast-Track Appeals process in pursuit of a coordinated settlement for all taxpayers. The IRS, he said, learned several lessons from its experience in litigating corporate-owned life insurance (COLI) cases. Specifically, early resolution of the cases is better from a tax administration standpoint than case-by-case trench warfare, in part because it will ensure that taxpayers who settle now will achieve a better resolution than those who decide to pay later. In non-Notice transactions, the Treasury Department and IRS are considering issuing "yellow light" notices to alert taxpayers to transactions that the government has not taken a position on but that it would like to review. Adding this type of notice would bring more transparency so that taxpayers can understand the government's decision-making.

TEI questioned whether, outside of COLI transactions, the number of taxpayers involved in tax shelter transactions is significant. Mr. Langdon noted that for some companies, abusive shelter transactions are highly addictive. He added that five tax shelter transactions constitute the bulk of known tax shelter activity. Ms. Burke said that the inventory of known transactions and number of taxpayers involved in such transactions expands with IRS training activities. She said that prior to a recent training class, LMSB knew of approximately 30 cases where a particular transaction is present on corporate tax returns. Following a training session for 150 agents, the number of cases where the transaction is a known issue more than doubled. Mr. Ng said that the IRS has indicators suggesting that many taxpayers did not disclose listed transactions on their returns. Part of the strategy underlying the two-prong approach of the Announcement, he said, is to encourage disclosures for previously filed returns. TEI noted that its pitch to members as well as to the government is that effective yet measured disclosure is the key to resolving the tax shelter issue because disclosure will permit the IRS to evaluate the propriety of the transactions. TEI said that it will continue to bring matters to the attention of the IRS in order to promote awareness of issues that might be barriers to disclosure. Mr. Langdon said that LMSB believes it has made progress on the tax shelter issue and the most abusive transactions have been flushed out. The ultimate targets, he said, are the promoters who can push the transactions to companies not generally represented by TEI.

TEI inquired whether the field is using a standardized IDR at the outset of examinations in order to identify tax shelter transactions. Mr. Ng acknowledged that a standardized IDR has been prepared for teams to use but might not be used in connection with every audit. The taxpayer's return is reviewed and then a determination is made whether to issue the standardized IDR. The agents, he added, may not have the ability to identify the issues in all cases, so the IDR is appropriate to provide order and structure to what the field is doing. Mr. Langdon said that he is no fan of standardized IDRs, but this may be one area where it is necessary.

B. Audit Process. TEI noted that its testimony to the IRS Oversight Board stated that progress on the IRS's goal of changing the agency focus to pre-filing activities will require improvements in the currency of IRS audits, and said more needs to be done to address the backlog of cases. In addition, despite the many improvements, new initiatives, and LMSB policies, many TEI members report that the message is not getting down to the field concerning the need to involve taxpayers in planning the audit. TEI invited LMSB to provide an update on audit planning and currency initiatives.

Mr. Brazzil said that LMSB has seen a significant movement to improve audit currency. Some measures are now in place and others are being developed in order to drive how time is spent on audits and reduce the time spent in coordinated industry case (CIC) examinations. He said that the right questions are being asked at all levels: What is the scope of the audit? Why has an issue been selected? What are the IRS's concerns? He said LMSB's focus is on measuring risk analysis and audit currency. As new audits are initiated, the new approaches and measures will become more visible to taxpayers. He said that IRS will be looking for prompt responses on IDRs and will seek to avoid claims being filed late in the audit. The agents, he said, will focus on key issues rather than auditing every issue that might be in the return. He concluded by saying that agents realize that something new is happening and that they do not have to audit every issue in a return.

Mr. Langdon said that the cultural shift that LMSB is striving to effect in the field remains a work in progress. During his monthly review with Commissioner Rossotti, there is a set, discussion of the number of cases closed and how audit time is being used. In addition to an audit currency measure, he said, there are issue measures. In his monthly one-on-one meetings with the Industry Directors and with Mr. Jones, Mr. Langdon stresses the same measures that he discusses with the Commissioner. The process is driven from the top down. TEI noted that timely closing a case frequently hinges on the resolution of a single contentious issue. If that issue is not timely addressed, the entire process will slow down. In order to clear up the backlog of cases, TEI suggested that, once an issue is resolved, agents should be encouraged to apply the approach to resolve the issue in subsequent years without re-auditing the same issue. Mr. Langdon said that the LMSB management initiatives, performance measures, and issue management tools are beginning to move the field away from its traditional ways of doing business, but it may take awhile before all have adopted the new approach.

C. Research Tax Credit

1. TEI Reaction. TEI said that the recently re-proposed regulations on qualified research activities represent a commendable and bold change in course for the IRS and Treasury. By eliminating the "discovery test" and aligning the definition of qualified research more closely with the requirements of section 174, the government has taken a significant step to ease the process for claiming the credit. TEI said that it would provide detailed comments in its formal submission on the proposed regulations. Areas of concern where clarification or changes may be necessary include the breadth of: (1) the definition of gross receipts, especially the retrospective effect that essentially requires taxpayers to restate base period amounts in order to comply with the consistency rule; (2) the per se exclusion for "debugging" activities; and (3) the per se exclusion of "trial production runs" as a possible research activity.

In addition, TEI said, to be effective, the patent safe harbor should be expanded. Where a taxpayer obtains a patent on product or business component, that fact should be presumptive evidence that all the qualification tests for research activities are satisfied. The safe harbor should also cover "patentable" products. The real key to achieving effective research credit regulations, however, lies in the training of field personnel and proper administration of the issues.

2. Administration of Research Credit Claims. Mr. Ng said that the IRS recognizes the sensitivity of research credit issues and said that it began to re-examine its approach to research credit examinations in connection with the issuance of the final regulations. That process has continued and now the IRS has refocused its attention on the proposed regulations. LMSB activities, he said, fall into three areas: (1) training, (2) issuing guidance to the field and taxpayers, and (3) developing efficient audit plans. Mr. Davis explained that the new IRS audit process and the philosophy underlying the new regulations are key components of its current training program for research credit claims. Moreover, in order to centralize the IRS's resources, there will likely be changes in the way taxpayer claims are handled. Currently all taxpayers file amended return claims with the service center where the original return is filed and IRS is consolidating return processing for LMSB taxpayers in the Ogden, Utah, Service Center. Hence, all original and amended returns as well as applications for tentative carryback adjustments for LMSB taxpayers will be filed in Ogden. The purpose of consolidating return processing, he said, is to focus LMSB expertise and resources. The IRS is working on a process to move all affected taxpayer files to Ogden and would welcome TEI comments in that respect. The discussions within LMSB about possibly requiring taxpayers to file amended research credit claims at the Ogden Service Center are based on the same premise: to permit LMSB to focus its resources and expedite processing of the claims.

TEI said that there were two issues with the proposals. The first is whether taxpayers should be required to file a formal claim on an amended return (Form 1120X). The second is the IRS resource issue. TEI said that it recognizes the IRS's legitimate interest in determining how many claims it must address, how many R&D specialists it may need to process them, and thus determine the resources necessary to address the change in the law. TEI questioned, however, whether a formal claim is necessary since in CIC cases the informal claim process has generally been effective.

Mr. Davis said that when a CIC taxpayer prepares a Form 1120X for a research credit claim, it can submit a copy to the IRS examination team at the same time it files the claim with the service center. Centralized filing of all claims at the service center will enable the IRS to spot industry issues and trends permitting the IRS to address issues sooner. Currently, he said, the IRS's only tool for gathering data on pending but unprocessed claims is to undertake a manual survey of field agents. That process is inefficient and unreliable in identifying industry issues and trends. As a result, compliance issues and trends are often spotted only after proposed adjustments are issued and entered into the IRS's database. By centralizing research credit claims, IRS will spot issues much earlier. In addition, the informal claim process is only available to taxpayers and the IRS where a taxpayer is under examination. The IRS said that it believes that many taxpayers that are not under examination will submit claims under the new research credit regulations. TEI noted that in nearly every CIC case, adjustments are made to claims for errors, omissions, and adjustments discovered after the return is filed. Mr. Davis acknowledged that the IRS is less concerned about ordinary, run-of-the-mill adjustments that arise on audits, but it is concerned about the potential the regulations pose for spawning many potentially large claims for refunds. Mr. Ng said that the IRS is sensitive to the issue of compelling taxpayers to file claims where an audit team is currently on-site auditing a taxpayers' research credit, but questions have been raised about how to ensure consistent and fair treatment of mid-market and smaller taxpayers that are not subject to continuing audit. Those taxpayers, he said, must file an amended return claim. All claims filed at the service center will be scrutinized, he said, but the taxpayers themselves will not necessarily be audited.

TEI noted that a key part of the IRS's training of agents in the new regulations will be to ensure that agents do not fall back on old principles such as the "discovery" test -- or create variations on that test -- in order to disallow research credit claims. Mr. Langdon said that the IRS is spending up to 25 percent of its time auditing research credit issues, which is far too much. He acknowledged the challenge of training up to 1,500 agents in the new regulations but said that the IRS is doing a good job of forcing a cultural change.

Mr. Davis said that training in the research credit regulations will begin with 60 key managers, agents, and engineers, who will help train nearly all other agents and engineers. Training will commence with teams assigned to the cases where the largest amount of research credit is claimed. The IRS will reinforce the live training sessions with videotaped training exercises. In addition, a website will be developed with a frequently asked questions section that will be devoted to research credit issues. Other guidance will be developed to assist agents in applying the regulations and, to the extent current coordinated issue papers are inconsistent with the new regulations, new guidance issued.

TEI encouraged the IRS to issue guidance indicating whether or when CIC taxpayers should file a formal rather than an informal claim. Where a taxpayer is under examination, TEI said, the IRS should consider permitting taxpayers to file its claim with the field agents and have them forward the claim to the service center. Mr. Ng said that the IRS is controlling the issues very closely because of the high visibility and sensitivity. He noted that the regulations are still in proposed format and that the proper administration of the claims is still being discussed. Questions raised by TEI and by IRS internally will be addressed soon. In addition, LMSB wishes to provide guidance to the field on computational matters and invited TEI to comment on these matters as well as other procedural issues. He noted that comments about the administration of research credit claims could be filed with LMSB before or after the March 6 deadline for comments on the proposed regulations.

TEI said that, in addition to compelling the taxpayer to report changes related to non-research- credit-related issues, the requirement to file a formal claim would impose administrative burdens, including possibly a requirement to file amended state income tax returns. TEI inquired whether the IRS would, in lieu of requiring a Form 1120X to be filed, consider issuing a new subject-matter limited form say, an 1120X-R&D. Alternatively, TEI noted that since there are three possible administrative scenarios -- taxpayers that are not under audit, taxpayers where the audit is still within the 15-day "qualified amended return" window at the inception of an audit, and taxpayers that are in mid-audit -- the IRS should consider developing and issuing a standardized template for capturing the data that it wishes to enter into its centralized database of research credit claims. The template could be modeled after Form 6765, Credit for Increasing Research Activities. Ms. Burke said that it is easier for the IRS to work with formal claims.

TEI noted that the change in recordkeeping requirements should help streamline audits because they require only that the taxpayer establish under the general books and records standard of section 6001 that it is entitled to the amount of the credit claimed. Mr. Langdon said that IRS will continue to study the recordkeeping requirements for research credit claims. The IRS is concerned that contingent claims prepared by outside consultants for taxpayers often depend upon a post-filing review of taxpayers' books and records. He said that the characterization of research activity in records prepared contemporaneously with a return should be entitled to greater weight than post-return contingent claims.

D. Capitalization Issues. TEI observed that the IRS and Treasury Department recently issued an Advance Notice of Proposed Rulemaking (REG-126538-01). The Notice acknowledges that the scope of controversies over capitalization issues has increased in the wake of the decision in INDOPCO v. United States, 503 U.S. 79 (1992). To reduce administrative and compliance costs, the IRS is considering adopting safe harbors and simplifying assumptions, including an exception for de minimis amounts of less than $5,000 paid in connection with certain transactions. TEI inquired about; the effect of the Notice on LMSB's operations pending the release of the promised regulations, especially since LMSB acknowledges devoting more than 25 percent of its audit resources to capitalization issues.

Mr. Langdon said that LMSB is interested in developing administrable rules and actively worked with Chief Counsel and Treasury in developing the Notice. Mr. Ng said that LMSB will be issuing guidance to the field on what the announcement means and will coordinate that guidance with the SB/SE Division. Mr. Ng said that the Notice solicits comments in a number of areas. Areas of concern to LMSB include recordkeeping requirements as well as possibly extending the rules of administrative convenience to tangible costs. Ms. Burke cautioned that the Advance Notice of Proposed Rulemaking only indicates matters that the IRS is considering issuing guidance on; the Notice does not constitute authority for a position. She said that the LMSB will be looking closely at developing rules that are administratively feasible.

E. International Issues

1. Revisions to Forms 1139 and 5471. TEI said because of the downturn in the economy many companies will be filing Applications for Tentative Refunds on Form 1139. Obtaining a prompt refund of the taxes will be vital to the continuing vitality of the companies. Hence, TEI said, the IRS should consider adopting a goal of processing tentative refund claims within 30 days. In addition, the instructions to Form 1139 (Rev. Sept. 2000) are seemingly misleading. TEI suggested that the IRS should revise the instructions along the lines of the May 1999 version of the Form.

Mr. Hedgpeth said that the IRS will consider adopting TEI's goal of processing Form 1139 within 30 days. He invited TEI to provide feedback to the IRS if the claims require longer than that to process. In respect of the Form 1139 instructions, Mr. Hedgpeth was unable to determine whether the forms are in error because the Chief Counsel attorney who would address the issue was unavailable.

TEI said that it understands that the IRS Office of International Programs intends to revise Form 5471. Much of the information requested on that form is unnecessary to the determination of tax liability and imposes substantial recordkeeping burdens on taxpayers. Mr. Hedgpeth confirmed that the Office of International Programs is conducting an internal review to determine whether the form asks taxpayers to compile and report unnecessary information. When the internal review is complete, the IRS will invite stakeholders, including TEI to comment. Mr. Langdon observed that some of the information collected on the form is gathered for the IRS's Statistics of Income Bulletin.

2. Treaty Benefit Clearance Procedures. TEI said that claims for exemption under a treaty must be filed with the IRS, which must certify that the taxpayer is a resident of the United States and forward it to the appropriate treaty partner. The amount of time required to shepherd the certification through two countries often lags significantly behind the date of any payment. U.S. taxpayers have successfully worked with the IRS in expediting the clearance process but it would be helpful if the procedures were formally revised and streamlined. Mr. Hedgpeth said that if taxpayers are haying difficulty obtaining a timely certification, they should bring the matter to the attention of his office.

3. Section 482 Service Regulations. Mr. Hedgpeth said that the treatment of stock options under the regulations is a compensation issue rather than an international guidance issue.

F. Compensation-Related Guidance

1. ESPP Payroll Tax Withholding. Notice 2001-14 announced the IRS's intention to clarify the application of FICA and FUTA taxes and income tax withholding to statutory options (incentive stock options (ISOs) and employee stock purchase plans (ESPPs)). TEI submitted comments in July 2001, urging the IRS to reconsider its intent to impose FICA and FUTA taxes on the exercise of statutory stock options. Without restating its previous arguments or the comments it will file in respect of the issue, TEI observed that employers are withholding agents and the burden the regulations would impose is tremendous, especially in respect of former employees.

Mr. Jones said the IRS recognizes the employer burden issue, but explained that the IRS does not believe it can ignore what it believes is a statutory mandate to impose the payroll taxes on options exercised under ESPP and incentive stock option plans. He said that taxpayers can ask Congress to change the employment tax treatment of statutory stock options.

2. Code V Reporting. TEI noted that the IRS issued Announcement 2001-92 in September 2001, extending through 2002 the voluntary status of the requirement to separately report stock option income on Forms W-2 employing the Code V designation. In December 2001, TEI filed comments reiterating its objections to the separate reporting requirement. Mr. Jones encouraged TEI to address its concerns to the Treasury Department because they are insisting on the Code V reporting requirement.

G. Circular 230. Mr. Langdon stated that the responsibility for developing and enforcing Circular 230 is outside of LMSB. He encouraged TEI to meet separately with Michael E. Shaheen, Jr., Senior Counselor to the Commissioner, to discuss its concerns.

5. Conclusion

TEI thanked Mr. Langdon and the LMSB representatives for their participation in the meeting. Mr. Langdon thanked TEI for its preparation for the meeting.

IRS Delegation

Larry R. Langdon, LMSB Commissioner
Linda B. Burke, LMSB Division Counsel
Daniel L. Black, Jr., National Chief, Appeals
Robert E. Brazzil, LMSB Industry Director, Retailers, Food,
  Pharmaceuticals and Healthcare
Arlene Kaye, Director, Quality Assurance / Performance Management
  Innovation
Keith Jones, Director, Field Specialists
Frank Ng, Deputy Director, Pre-Filing and Technical Guidance
Elvin T. Hedgpeth, Deputy Director, International
Dwight L. Davis, Acting Deputy Director, Pre-Filing and Technical
  Guidance
Susan W. Linden, Director, LMSB Communications & Liaison
Matthew Beaulieu, Manager, LMSB Legislative Affairs and Liaison
Chris Neighbor, Senior Program Analyst, LMSB Communications & Liaison
Para Oliveras, Senior Program Analyst, IRS National Office of Public
  Liaison

TEI Delegation

Robert L. Ashby, Nortel Networks, Inc., TEI President
J.A. (Drew) Glennie, Shell Canada Limited, TEI Senior Vice President
Raymond G. Rossi, Intel Corporation, TEI Secretary
Stephen W. Boocock, TEI Treasurer
Michael P. Boyle, Microsoft Corporation, TEI Executive Committee
Robert J. McDonough, Jr., Axcelis Technologies Inc., TEI Executive
  Committee
Nell D. Traubenberg, Storage Technology Corporation, TEI Executive
  Committee
Roger D. Wheeler, General Motors Corporation, TEI Executive Committee
David L. Bernard, Kimberly-Clark Corporation, Chair, TEI IRS
  Administrative Affairs Committee
Mitchell S. Trager, Georgia-Pacific Corporation, Chair, TEI Federal Tax
  Committee
Judith P. Zelisko, Brunswick Corporation, Chair, TEI International
  Tax Committee
Timothy J. McCormally, TEI Executive Director
Fred F. Murray, TEI General Counsel and Director of Tax Affairs
Mary L. Fahey, TEI Tax Counsel
Gregory S. Matson, TEI Tax Counsel
Jeffery P. Rasmussen, TEI Tax Counsel