Tax Executives Institute--Internal Revenue Service Large and Mid-Size Business Division liaison meeting; February 5, 2002.

On February 5, 2002, Tax Executives Institute met with Larry R. Langdon, Commissioner of the IRS's Large and Mid-Size Business Division, and other representatives of LMSB. TEI President Robert L. Ashby led the Institute's delegation to the meeting. The agenda for the meeting is reprinted below. Minutes of the meeting will be published in a future issue of the magazine.

1. Introduction

2. LMSB Updates

a. Industry Issue Resolution Program

* TEI commends the IRS for developing new techniques to provide taxpayers and IRS personnel with more timely, focused guidance. We are concerned, however, that the IIR process not place audits on "hold" while issues are being developed and that the process not replace the issuance of more generic guidance.

* We invite LMSB to provide an update on the IIR program, including whether additional issues (particularly in the international area) have been selected for resolution.

b. Post-Filing Design Team

* In November, TEI representatives met the IRS Post-Filing Design Team to explore ways in which the post-filing process can be improved. 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.

* We invite LMSB to provide an update of the project.

c. Fast-Track Appeals Process

* LMSB has issued Notice 2001-67, which LMSB Commissioner Larry Langdon has described as a "field-based" way to resolve conflicts arising from audits. Under the procedure, taxpayers and IRS examiners work with an Appeals team 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 have been resolved within a week.

* We invite LMSB to provide a status report on the project.

d. Pre-Filing Agreement Program

* TEI has been a supporter of the pre-filing agreement 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 found that the pilot program offered taxpayers a successful process by which to resolve specific issues on tax returns not yet filed. The TIGTA also found, however, that significant challenges remained before the pilot program can be converted into an effective operational program.

* We invite LMSB to provide a status report on the PFA program, including its relationship to the IIR program.

e. Role of Counsel

* During last year's liaison meeting, LMSB Division Counsel Linda Burke discussed the development of "rules of engagement" for Division Counsel. We invite the IRS to provide a status report on the rules and their implementation.

* We also invite a discussion of the need for training of Counsel personnel.

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.

b. TEI-LMSB Liaison Relationship

i. Effectiveness of Liaison Relationship. TEI and the IRS have established points of contact to facilitate liaison between the two organizations. Most recently, it was suggested that the Senior Industry Advisers should be added as contacts for the various industry groups, in addition to the Industry Directors.

ii. Industry Meetings. During the past year, TEI chapters have sponsored forums in New York, Detroit, and Cincinnati on specific industry issues (respective financial services, heavy manufacturing, and retail). Are future meetings in the works?

iii. Use of CEOs in IRS Training Program. Senior Industry Adviser Robert Adams of the Heavy Manufacturing and Transportation Industry Group has requested TEI's help in identifying CEOs or CFOs who would be willing to participate in IRS training programs to discuss how business operates.

4. Technical Issues for Discussion

a. Tax Shelter Disclosure Initiative

In Announcement 2002-2, the IRS announced a disclosure initiative to encourage taxpayers to disclose the tax treatment of tax shelters and other items to which the section 6662 accuracy-related penalty may apply. Disclosures must be made before the issue is raised on audit or April 23, 2002, whichever is earlier.

The IRS and Treasury Department are to be commended for taking a practical approach to the disclosure of corporate tax shelters. Permitting taxpayers to come forward with information -- while preserving their rights on the merits of the transaction -- can advance tax administration by pinpointing suspect transactions and further defining what is (and is not) a tax shelter.

TEI is still reviewing the announcement. One issue that has arisen is the effect of the disclosure of legal opinions or analyses on the assertion of the attorney-client privilege. We understand that LMSB is open to establishing bright-line tests concerning the disclosure of privileged documents. We invite a discussion of this issue.

b. Audit Process

i. Currency

* Additional progress on the IRS's goal of changing the agency focus to pre-filing activities will require improvements in the currency of IRS audits. Both the taxpayer and the IRS have a common goal of completing the audit in a fair, timely, and efficient manner. Several innovative procedures -- such as Fast Track Mediation and Settlement, Accelerated Issue Resolution, and Early Referral Authority -- have been introduced to improve the examination process and promote currency. More needs to be done, however, to address the backlog of cases. Further, it is important that the use of resources in pre-filing activities not, by itself, increase the overall time devoted to particular LMSB taxpayers.

* Field agents must be trained in, and encouraged to use, alternative dispute resolution (ADR) techniques. Balanced performance measures for IRS examiners also need to be developed that stress efficiency and the use of ADR techniques.

* Agents should receive more training in how to approach an audit. Many auditing teams examine issues that have been raised and resolved in prior audits. When a closing agreement has been reached and the facts and circumstances have not changed, it makes sense to use that agreement as the basis for resolving issues in later audits.

* The lack of currency in audits also creates recordkeeping burdens for taxpayers. If taxable years are closed in a timely manner, there is less need to retain records relating to those years. Absent that, the IRS should make better use of records retention agreements. The IRS should revise Rev. Proc. 98-25 to minimize recordkeeping burdens especially in respect of so-called legacy systems.

ii. Planning of audits

* Despite many advances in LMSB policies, many TEI members report that the message is not getting down to the field concerning the involvement of the taxpayer in planning the audit.

* Milestones should be included in the audit plan to measure and review the progress of an audit. Both taxpayers and the IRS need to adhere to time deadlines.

c. Research Tax Credit

i. TEI Reaction

* 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 believes that the proposed regulations conform more closely with congressional intent to provide a salutary incentive for research activities. Moreover, properly administered, the new rules should diminish the scope, number, and degree of audit controversies about qualified research activities.

* The proposed regulations have beneficially refined the process of experimentation tests set forth in T.D. 8930 that, in effect, limited qualified research to "white coat" research projects. Another improvement is that, depending on the facts and circumstances, a process of experimentation may include the appropriate design of a business component. We also applaud the elimination of the requirement to create credit-specific documentation at the inception of a research project; the proposed regulations instead require that taxpayers satisfy the general standard of section 6001 and maintain records sufficient to substantiate the amount of the claimed credit.

* TEI will provide detailed comments in our formal submission on the proposed regulations. Areas of concern where clarification or changes may be necessary include:

* The breadth of the: (1) 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.

* 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 "patent-able" products.

ii. Administration of Research Credit Claims

* TEI understands that the IRS is considering centralizing the processing of claims in a single service center, permitting the IRS to better assess its staffing and training needs. TEI recognizes that the IRS has an interest in determining how many claims it must address, how many R&D specialists it may need to process them, and thus how it can deal with the challenge to tax administration posed by a significant change in the law.

* In addition, TEI has forwarded to LMSB a sample of comments from members reacting to a proposal to require the filing of a Form 1120X to claim research credits under the revised regulations. We do not understand the administrative utility of this change, especially since the informal claims process has worked well. If the IRS believes the circumstances dictate a departure from prior practice, consideration should be given to developing an 1120XEZ or 1120XR&D that limits the jurat to the subject of the claim.

iii. Training

* The key to administering the research tax credit is training -- or retraining -- LMSB agents and Appeals officers in the new rules. We invite a status report on its R&D training efforts.

iv. Recordkeeping Requirements

* The proposed regulations eliminate the requirement to create and retain credit-specific documentation at the outset of the research project. To address ongoing research credit documentation issues, the IRS and Treasury Department propose to use pre-filing processes, including industry issue resolution, pre-filing agreements, determination letters, and record retention agreements to provide certainty to taxpayers and to ensure the availability to the IRS of records necessary to facilitate examinations.

* The recordkeeping agreements must be flexible enough to adapt to the taxpayer's evolving system needs. Few taxpayers report success in securing record retention agreements generally under Rev. Proc. 98-25. To be effective, record retention agreements relating to research claims must be completed expeditiously and with a minimum of burden on taxpayers.

d. Accounting Issues

i. Capitalization Issues

* 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). The Institute has consistently encouraged the issuance of bright-line rules to quell the frequent disputes that have arisen since the INDOPCO decision. Hence, we are pleased that the IRS and Treasury have announced the advanced notice of proposed rulemaking.

* 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. We invite a discussion of whether the IRS would consider expanding the de minimis concept to apply to tangible as well as intangible assets.

For financial accounting purposes, taxpayers expense nominal value assets because the value of the assets is insignificant when compared with the administrative cost of tracking them. Moreover, nominal value assets are often short-lived and frequently replaced. Hence, the adoption of a de minimis asset "expensing" rule would likely meet the "clear reflection of income" standard under a "regular and recurring" exception to capitalization. In addition, there is a natural tension between increasing the nominal value asset threshold to maximize administrative convenience and limiting the nominal asset threshold to avoid understating income and to retain asset management and control purposes. The IRS should consider adopting a safe harbor permitting taxpayers to deduct the cost of nominal value purchases and to rely on the business determination of what constitutes a "nominal" value asset.

ii. IRS-Initiated Changes to Improper Methods of Accounting

* It has been nearly four years since the IRS issued Notice 98-31, relating to IRS-initiated changes in accounting methods. TEI requests a status report on this issue. We also request an update on whether the IRS is considering any changes to Rev. Proc. 97-27, relating to the procedures for obtaining the Commissioner's consent for taxpayer-initiated accounting method changes.

e. International Issues

i. Revisions to Forms 1139 and 5471

In light of the economic recession, many companies will file applications for tentative refund claims (Form 1139) for carrybacks of net operating and capital losses and unused business credits. In many cases, obtaining an expeditious refund of the cash will be vital to the continued viability of the claimants. The IRS should act to verify the tentative claims and process the refund checks as expeditiously as possible. Indeed, we urge the IRS to adopt a goal of processing submitted claims in no less than 30 days.

* The instructions to Form 1139 (Rev. Sept. 2000) are misleading. The face of the form and the related instructions state that whenever a loss carryback releases foreign tax credits (FTCs), the taxpayer is precluded from filing a Form 1139. Instead, the instructions mandate that the claimant file its loss claim on Form 1120X. The additional steps involved in processing the Form 1120X will substantially delay the vital cash infusion that the tentative carryback claim provides.

The prior version of the instructions for Form 1139 (Rev. May 1999) correctly stated the claim procedure taxpayers should employ when foreign tax credits are released by a loss carryback. (File Form 1139 for the loss carryback; file Form 1120X for the released foreign tax credits.) The current form instructions should be corrected.

* In addition, we recommend that the IRS clarify the purpose of question 4 on Form 1139 or eliminate it. An incorrect answer by a taxpayer to Question 4 could lead, at best, to a delay in the processing of its refund claim at the Service Center and, at worst, to its rejection. Pending release of corrected forms and instructions within the next 30 days, the IRS should publish a notice reaffirming the proper procedure for filing loss (or other unused credit) carryback claims when foreign tax credits are released.

* It is TEI's understanding that the IRS Office of International Programs intends to revise Form 5471. Much of the information requested on that form is unnecessary to the computation of a company's tax liability and places substantial recordkeeping burdens on taxpayers. TEI assisted in the development of the form (which replaced several international forms) more than 15 years ago and would be pleased to assist with its revision. We request a status report on efforts to revise the form.

ii. Treaty Benefit Clearance Procedures

* 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 it takes 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.

iii. Section 482 Service Regulations

* At the recent ABA tax section meeting, IRS Associate Chief Counsel John Staples stated that the IRS is grappling to rewrite the 1968 section 482 service regulations concerning whether and in what form the current provision's cost safe harbor should be retained. The safe harbor permits the provider of services to a related party to charge cost, rather than imposing a markup, for services that are not an integral part of its business.

The current regulatory treatment of non-integral services is a practical approach to an area in which accurate accounting is very difficult, costly, and burdensome. The cost chargeback is also consistent with the transfer-pricing policies of many U.S. trading partners. TEI recommends that the cost chargeback for non-integral services be retained in any revised regulations.

* The 25-percent floor for principal activity or substantial services should also be included in the revised regulatory scheme. Indeed, economic changes in recent years suggests that the IRS should consider raising the 25-percent floor. As competition increases, profit margins for many multinationals are decreasing. Thus, a higher percentage may be warranted.

We understand that the IRS is inclined to retain the cost safe harbor. TEI wholeheartedly agrees with this approach.

f. Compensation-Related Guidance

i. 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)). The notice stated that the IRS would not assess FICA and FUTA tax upon the exercise of statutory options exercised before January 1, 2003, and would not treat the disposition of stock acquired pursuant to the exercise of an option as subject to income tax withholding. The notice also declared Rev. Rul. 71-52 -- treated for almost 30 years as the principal guidance holding that such transactions were exempt from withholding -- obsolete.

* 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.

* Under section 421(a), the exercise generates no income subject to tax; while the 1983 legislation permitted the IRS to require FICA and FUTA tax payments on wage amounts that are exempt from income tax withholding, the amendments did not require the IRS to do so.

* The administrative challenges of withholding income taxes on a transaction for which the employer makes no payment and, indeed, to which the employer is not a party, i.e., the disposition of the stock, warrants a regulatory exception from withholding. The IRS should issue guidance stating that this income, while taxable, is not subject to withholding.

* On November 14, 2001, the IRS issued proposed regulations on the application of employment taxes and income tax withholding to statutory options. In addition, the IRS issued Notices 2001-72 and 2001-73 to provide rules of administrative convenience regarding employment taxes and to clarify the application of income tax withholding to dispositions of stock acquired through the exercise of a statutory stock option.

* TEI is preparing comments on the proposed regulations and notices. Notice 2001-72 recognizes the difficulties employers would have implementing such withholding. Employers still face difficulties, however, with the imposition of employment tax withholding on exercises of statutory options. No employment taxes should be imposed, and the proposed regulations should be withdrawn.

ii. Code V Reporting

* In November 2000, the IRS issued Announcement 2000-97, modifying the manner in which the compensatory gain arising from the exercise of employer-provided stock options is to be reported by mandating the separate disclosure of nonqualified stock option income reported by use of code "V" on Form W-2. The change was to have been effective for the 2001 W-2 forms, but Announcement 2001-7 made the requirement voluntary for 2001, though separate reporting was required with respect to all stock options exercised after December 31, 2001.

* In August, 2001, TEI objected to the new requirement. The IRS issued Announcement 2001-92 in September 2001, extending the voluntary status of the requirement through 2002 and requesting comments on cost-effective alternatives for reporting such income. In December 2001, TEI reiterated its objections to the requirement. We continue to believe that the reporting requirement is unnecessary and extremely burdensome.

g. Circular 230

* The IRS is currently reviewing the comments it has received on the proposed revision of Circular 230 and intends to issue re-proposed regulations relating to tax shelter opinions within the next few months.

* TEI is in the process of preparing comments on the proposed revision. During the liaison meeting, we request a status report on the Circular.

5. Conclusion