Tax Executives Institute--U.S. Department of Treasury liaison meeting: February 6, 2002.

On February 6, 2002, Tax Executives Institute held its annual liaison meeting with the Office of Tax Policy of the U.S. Department of Treasury. The agenda for the meeting was published in the January-February 2002 issue of The Tax Executive. The minutes follow:

I. Introductory Comments

On behalf of the U.S. Treasury Department's Office of Tax Policy, Assistant Secretary Mark A. Weinberger welcomed TEI President Robert L. Ashby and the other members of the delegation from Tax Executives Institute to the liaison meeting. Mr. Weinberger observed that the Treasury Department often derives more benefit from its meetings with TEI than the Institute does. Liaison meetings are only part of the dialogue, he noted, adding that Treasury benefits from and is always open to TEI comments. TEI thanked the Treasury representatives for meeting with the Institute. The delegations for the Treasury Department and TEI at the liaison meeting are set forth below.

II. Legislative Priorities

Mr. Weinberger discussed the fiscal outlook for the upcoming year. The Administration's recent budget presents a different economic picture from prior years, he stated, reflecting the events of September 11 and the uncertainty among consumers. Even with the 2002 tax cut, he added, the government's collection of taxes as a percentage of GDP is at an all-time high (19 percent).

Mr. Weinberger explained that the Administration supports enactment of the economic stimulus legislation to spur economic growth, adding the proposed two-year extension of the expiring tax provisions is not long enough. The legislation would speed up the recovery, he said, noting that the Administration views the package as an "insurance policy." We were lucky last year that the arrival of the tax rebate checks and the reduced withholding softened some recessionary effects, he concluded.

TEI referred to the recent testimony of Treasury Secretary Paul O'Neill, which addressed a renewed interest in pension reform and legislation dealing with so-called tax havens. What is the potential for legislation in these areas?

Mr. Weinberger explained that several bills have been introduced to address the retirement security issues relating to the Enron situation. The situation raises tough issues, including diversification of assets, disclosure, blackout periods, and education of employees. Although Congress is considering the establishment of caps on employee-held stock, the Administration is more interested in ensuring adequate disclosure, education, and choices for employees. The objective is to provide sufficient rights to the employees without unduly restricting their ability to hold employer stock or causing the employer to withdraw benefits, he stated.

Mr. Weinberger noted that Enron's use of off-shore partnerships and the number of entities in the Cayman Islands have also raised concerns. The Senate Finance Committee is reviewing the situation, he stated, adding that hearings will be held.

III. Regulatory Guidance

A. 2002 Priorities. Mr. Weinberger remarked on the need for general guidance for both the IRS and taxpayers. With the appointment of B. John Williams as IRS Chief Counsel, he stated, we have an opportunity to consider how the guidance process should be revised. Messrs. Williams and Solomon and Ms. Olson will be working together on the guidance plan. TEI's input is vital to the process, Mr. Weinberger stated, adding that a notice requesting comments on the 2002 guidance priority list will be issued soon.

Mr. Weinberger stated that Treasury has redoubled its efforts to obtain tax information exchange agreements with other countries. Such agreements are a high priority in the government's anti-tax shelter campaign, he said. The government is working with the Organization for Economic Cooperation and Development to emphasize information exchange among countries rather than harmful tax competition. Mr. Weinberger noted that the United States has reached agreements with the Cayman Islands, Antigua and Barbuda, and the Bahamas, which will provide information to the government from large financial centers. TEI commended the Treasury Department for shifting the emphasis of the OECD project.

TEI also commended Treasury for its efforts to provide timely and administrable guidance, citing the government's response to the September 11 attacks, the re-proposed research credit regulations, the notice on capitalization issues, and, most recently, the notice on the Rite Aid decision (dealing with the loss disallowance rules). Referring to Mr. Solomon's recent speech setting forth guidance principles before the ABA Tax Section in New Orleans, TEI suggested including the principles in the guidance notice to help taxpayers shape t, heir comments. The Institute invited the Treasury representatives' comments on emerging issues that could be part of the 2002 business plan.

B. FSC/ETI Regime. The Assistant Secretary referred to the WTO's recent appellate decision concerning the validity of the Extraterritorial Income Exclusion regime. The United States will comply with its WTO obligations, he asserted, adding that compliance could take several forms including the repeal of the ETI provisions, adoption of fundamental tax reform, or negotiation of a safe harbor exception. There may be winners and losers in the ultimate resolution, and Treasury needs TEI's assistance to ensure a fair solution. Please stay involved because there are many competing interests.

TEI inquired about the measure of damages to be determined. Ms. Angus stated that the arbitration proceeding concerning damages has resumed. There is an issue about the appropriate level of damages. The European Union is reviewing the size of the tax expenditures, she said, adding that there is little WTO precedent for determining the amount.

C. Simplification. TEI asked about the prospect for long-term reform of the tax law. Mr. Weinberger stated that, building upon the efforts of the staff of the Joint Committee on Taxation, Treasury is undertaking a massive simplification project. The first phase will consider ways to simplify the current system. Treasury is reviewing the recent Joint Committee recommendations, as well as those emanating from TEI's joint project with the ABA and AICPA. The issue is whether any changes must be revenue neutral, he explained. In the long term, Secretary Paul O'Neill has expressed interest in fundamental tax reform. This project has been delayed because of the September 11 attacks and other priorities, Mr. Weinberger added. TEI noted that there are some changes that could be effected without revenue offsets.

D. Corporate Tax Shelters. Mr. Weinberger stated that the Treasury Department is considering ways to address the issue of abusive corporate tax shelters. The government is reviewing the current regulations and determining whether the filing requirements for promoters and taxpayers are adequate. If additional authority is needed, Treasury will work with Congress to obtain it, he stated. TEI's guidance on any proposed legislation is important, Mr. Weinberger said.

TEI referred to Announcement 2002-2, which announced an 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. One issue that has arisen is the effect of the disclosure of legal opinions or analyses on the assertion of the attorney-client privilege. The announcement could be interpreted as requiring the production of post-filing legal advice.

Ms. Olson stated that the government wants the disclosure initiative to succeed. Treasury believes it struck the correct balance, she said, but it is aware of the privilege issue. The IRS is reviewing the issue and is moving to allay concerns. A notice should be issued soon, she stated.

E. Rev. Proc. 98.25. TEI referred to Rev. Proc. 98-25, which addresses retention requirements in respect of computer-generated records. Few taxpayers report success in securing agreements under the procedure, which should be updated to keep pace with the rapid changes in record systems.

TEI noted the long delays in having the IRS revise the procedure. If it is not on the business plan, it is less likely to receive attention and resources. The current procedure does not serve the interests of tax administration. TEI also said that the problem with records retention decreases when audits become more current.

F. Research Tax Credit Regulations. TEI called the recently reproposed regulations on qualified research activities a step in the right direction. TEI is studying the regulations and will supply detailed comments in our formal submission. For the time being, TEI identified two areas of concern:

* The broad definition of gross receipts, especially the retrospective effect that essentially requires taxpayers to recalculate base period amounts in order to comply with the consistency rule. Many taxpayers have employed a definition of gross receipts based on line 1(c) of Form 1120 (sales, less returns and allowances) and excluded unrelated passive investment income or other receipts reported below that line.

* The patent safe harbor, which should be expanded. The current safe harbor establishes only that the taxpayer has conclusively engaged in research activity intended to discover information. Where a taxpayer obtains a patent on a product or business component, that fact should be presumptive evidence that all the qualification tests for research activities are satisfied. In addition, the safe harbor should apply to activities that are capable of being patented, even if a patent is not sought.

TEI also suggested that the per se exclusions for debugging activities and trial production runs be rethought. These processes are basic to the R&D process.

The Institute noted that the elimination of the requirement to create and retain credit-specific documentation at the outset of the research project is a good approach. Under section 6001, taxpayers must still prove that the research qualifies through the use of normal business documents.

TEI stated that the IRS is considering centralizing the processing of research tax credit claims in a single service center, permitting the agency to better assess its staffing and training needs. In addition, the IRS is considering a proposal to require the filing of a Form 1120X to claim research credits under the revised regulations. In TEI's view, there are three areas that need to be considered: (i) a taxpayer that files a claim for refund but is not under examination; (ii) a taxpayer whose examination is within the 15-day period after the start of its examination; and (iii) a taxpayer whose examination is past the 15-day period. In the first case, there is no question that some type of filing is required, but in the other two cases the informal claim process has worked well. A formal claim seems unnecessarily burdensome. An alternative could be filing a new form or providing a Form 6765 to the audit team with a copy to the service center. TEI said it recognized that the government is concerned with the fairness of requiring smaller taxpayers to file a formal claim while permitting larger companies to use an informal process, but the smaller companies are not continually under examination with an IRS team on site. [Note: The Institute's comments on the research tax credit were filed on March 6, 2002.]

G. Capitalization Issues. TEI referred to the recent advance notice of proposed rulemaking concerning capitalization issues. When issued, the proposed rules will clarify the treatment of costs incurred in acquiring, creating, or enhancing intangible assets and benefits. TEI applauded the bright-line tests set forth in the notice, inquiring which areas should be the focus of the institute's comments.

Mr. Weinberger stated that capitalization issues top the list for consumption of taxpayer and government resources. Ms. Olson explained that the first notice addresses the treatment of intangibles. Other areas to be considered include the use of de minimis rules and the treatment of repairs. The advance notice set forth the principles Treasury will follow, she said, adding that any assistance TEI could provide in this area will be appreciated.

TEI suggested extending the de minimis rules to tangible assets as well as intangible ones. For the sake of simplification, internal company procedures for tracking assets for financial reporting purposes should be used for tax purposes.

Ms. Olson requested comments on items that were not covered in the notice, particularly standards that could be used. Ms. Cohen stressed the need to balance the clear reflection of income principle with simplification measures, asking whether any standards discussed in the notice create more problems than they solve. TEI suggested that if the struggle is between clearly reflecting income and simplification, the rules should err on the side of simplification.

TEI asked whether the Administration would seek any legislative solutions to the problems. Mr. Weinberger stated that Treasury is striving to make the current law work. In the short term, our focus is on issuing regulations, he stated. The mid-term objective is to provide the "easy fixes" and in the long term to consider fundamental reform. Striving for clear reflection of income is the objective for all three proposals, he added.

TEI commented that taxpayers are willing to accept timing differences if there is certainty concerning the year in which the expenditure is to be reported. The problem arises when the changes are proposed 10 years after the return is filed. [Note: The Institute's comments on the advance notice were filed on April 24, 2002.]

H. Changes in Accounting Methods. TEI referred to Notice 9831, relating to IRS-initiated changes in accounting methods, asking whether the government was revisiting the harsh rules set forth in the notice. Ms. Olson noted that consideration of the notice is on Treasury's agenda.

I. Compensation Issues. TEI referred to Notice 2001-14, which announced the government's intent 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--which held that such transactions were exempt from withholding--obsolete.

The administrative challenges of withholding income taxes on a transaction for which the employer makes no payment and to which the employer is not a party, i.e., the disposition of the stock, warrants a regulatory exception from withholding, TEI stated. If the IRS requires withholding, the increased tax liabilities and administrative costs would discourage employee participation and diminish the willingness of businesses to provide or expand the plans.

Mr. Sweetnam explained that Rev. Rul. 71-52 was issued at a time when the FICA wage base was low and the individuals receiving ISOs were the top wage earners. It was administratively easier to exempt the exercise from withholding, he stated. That is not the case now, however, with the increase in the FICA wage base and the more generalized use of stock options. There are statutory impediments to continuing the exemption, he concluded.

TEI inquired whether the January 1, 2003, deadline could be extended to permit taxpayers to seek a legislative solution. Mr. Sweetnam stated that the government has sought to avoid making the rules retroactive and to provide a hiatus to permit time for legislation. Mr. Weinberger added that Treasury is willing to work with taxpayers and Congress to resolve the issue, but is bound by current law to enforce it.

TEI referred to 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. Since the IRS has indicated it does not need the information, what is the policy reason for the change? Mr. Weinberger replied that Treasury is not persuaded that the reporting requirement imposes a huge administrative burden on employers. The budget estimators need the information, he said. TEI asked whether the information could be reported on a company basis. Mr. Kiefer replied that the estimators must have the information broken down by individuals.

J. Circular 230. TEI referred to the proposed regulations revising Circular 230, relating to the standards of practice before the IRS. The proposed revisions were aimed at tax shelter activity by promoters, and it is unclear how they apply to in-house practitioners. TEI suggested that advice rendered by in-house professionals should be exempt from the rules unless the opinion is used to "penalty-proof" the employer.

Mr. Solomon agreed that the rules are unclear and asked about their applicability to opinions by in-house employees on tax shelters. Mr. McDonough stated that if the opinion were drafted to insulate the taxpayer from the penalty under section 6662, it should be covered by the rules. He added that the Institute would address the issue in written comments. [Note: The Institute's comments on Circular 230 were filed on March 6, 2002.]

K. Treaties. TEI asked about the progress of negotiations of the protocol to the U.S.-Canada treaty, particularly the status of the rates of withholding on cross-border payments of interest and dividends. Ms. Angus explained that the current withholding rates are higher than the United States prefers, adding that the government believes it is important to reduce the tax to zero.

TEI noted the lack of an arbitration clause in the recent treaties with the United Kingdom and Australia. Ms. Angus said that the government is interested in speeding the resolution of cross-border issues, but arbitration should not be the exclusive means of making the competent authority process work. We need to look at other methods of reaching agreement, she stated, perhaps by clarifying the substantive areas of the law. For example, the characterization of royalties is our biggest problem. If we can reduce the rate of withholding, there is less at stake and resolution is more likely, she added.

In response to questions, Ms. Angus reported that the United States has begun formal negotiations on a new treaty with Japan and additional rounds are scheduled. No negotiations are currently underway with Brazil.

TEI explained 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 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 the procedures should be streamlined, TEI concluded.

VII. Conclusion

TEI thanked the Treasury Department representatives for their participation in the meeting. On behalf of the Treasury Department, Mr. Weinberger expressed his appreciation for the time and effort the TEI representatives put in to prepare for the meeting and urged the Institute to continue to bring issues to the attention of the Treasury Department.

Department of Treasury Delegation

Mark A. Weinberger, Assistant Secretary (Tax Policy)
Pamela F. Olson, Deputy Assistant Secretary (Tax Policy)
Eric Solomon, Deputy Assistant Secretary (Regulatory Affairs)
Jeffrey H. Paravano, Senior Advisor to the Assistant Secretary
Barbara Angus, International Tax Counsel
William F. Sweetnam, Jr., Benefits Tax Counsel
Donald Kiefer, Director, Office of Tax Analysis
Jodi Cohen, Attorney-Advisor

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
Neil 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
Timothy J. McCormally, TEI Executive Director
Fred F. Murray, TEI General Counsel and Director of Tax Affairs
Mary L. Fahey, TEI Tax Counsel
Jeffery P. Rasmussen, TEI Tax Counsel
Gregory S. Matson, TEI Tax Counsel