1990 act compliance provisions may affect corporate litigation strategies.
During the 1980s, Congress focused much of its attention in the tax compliance area on tax shelter investors. In an effort to make playing the audit lottery more painful for them, Congress adopted a series of increasingly severe penalties and applied an enhanced interest rate to tax deficiencies attributable to tax-motivated transactions.
The tax shelter era was brought to an abrupt halt by the enactment of the passive activity loss provisions, and certain other provisions, in 1986. Consequently, in recent years Congress has had to look to new sources to fill its compliance revenue targets. Publicized reports of foreign corporations paying little tax on their U.S. earnings and U.S. corporations stripping out their earnings through transactions with related foreign entities have resulted in corporations succeeding tax shelter investors as the compliance revenue sources of the 1990s.
The Revenue Reconciliation Act of 1990 (1*) embodied a number of new provisions designed to encourage corporate tax compliance. The 1990 Act also included provisions making it more expensive to dispute a proposed deficiency and easier for the Internal Revenue Service to gain access to information on audit. This article discusses some of the more significant new compliance provisions and suggests areas in which new audit or litigation strategies might be considered.
II. Enhanced Rate of Interest
on Large Underpayments
In 1986, individual taxpayers under audit suffered a blow when Congress amended section 163 to provide for the disallowance of the deduction for interest paid by noncorporate taxpayers on tax deficiencies. The disallowance of such "personal interest" was phased in over several years. (2) By 1990, when 90 percent of "personal interest" was no longer deductible, certain members of Congress averred that corporations similarly should not be allowed to deduct interest on their tax deficiencies. The allowance of the deduction in effect reduced the relative cost of paying interest. The Budget Summit Agreement (3) included a provision to deny deductions for interest paid by C corporations to the IRS on federal income taxes (and other federal taxes, if necessary to meet revenue targets). In the face of some stiff opposition from taxpayers and their advisors, the interest-disallowance provisions were dropped. Instead, the final 1990 tax bill took a different approach: increasing the rate of interest payable by C corporations on "large corporate underpayments." The new provision, in section 6621(c) of the Code, was patterned after the previous section 6621(c), which applied an increased interest rate to underpayments attributable to tax-motivated transactions. (Old section 6621(c) was repealed with respect to returns the due date for which, determined regardless of extensions, was after December 31, 1989.)
Under new section 6621(c), interest on an underpayment of any federal tax that constitutes a "large corporate underpayment" will carry interest at a rate (the "enhanced rate") that is two percentage points higher than the regular floating rate of interest on tax deficiencies (the "regular rate"). (4) The enhanced rate can only apply for periods beginning after December 31, 1990. For the first quarter of 1991, the regular rate of interest on tax deficiencies is 11 percent per annum. (5) Thus, if section 6621(c) applies, the annual enhanced rate of interest will be 13 percent during that quarter.
A. "Large Corporate Underpayment"
A "large corporate underpayment" is defined as an underpayment of a tax by a C corporation for any taxable period if the amount of such underpayment exceeds $100,000. (6) On December 19, 1990, proposed and temporary regulations that elaborate on this definition were issued. (7) Temp. Reg. [section] 301.6621-3T(b)(2)(i) defines an "underpayment of a tax" as the excess of a tax imposed by the Code over the amount of such tax paid on or before the last date prescribed for payment. Thus, if a deficiency in tax is determined during an audit, that deficiency is an underpayment. Similarly, if tax is simply paid late (e.g., the tax shown on a late-filed income tax return is paid at the time of filing or a timely-filed return is not accompanied by the tax shown as due), the amount of tax paid late is also an underpayment. For purposes of this definition, Temp. Reg. [section] 301.6621-3T(b)(2)(i) provides that an underpayment of tax on which section 6621(c) interest is imposed includes tax, previously accrued interest, additions to tax, and penalties. There is substantial doubt, however, whether the regulations can provide for the accrual of section 6621(c) interest on additions to tax and penalties; litigation on this question should be expected.
Temp. Reg. [section] 301.6621-3T(b)(2)(ii) provides that, in order for section 6621(c) to apply, there must be a "threshold underpayment of a tax" (excluding interest, additions to tax, and penalties) exceeding $100,000 for a single taxable period. In any event, once there is a large corporate underpayment, the enhanced rate applies to the full underpayment, not just amounts in excess of $100,000. In the case of income taxes, the taxable period is a single taxable year; for FICA taxes, it is the calendar quarter. (8)
Under Temp. Reg. [section] 301.6621-3T(b)(2)(ii), different types of taxes (such as income tax and FICA tax) and amounts that relate to different taxable periods of the same tax are not added together in determining whether the $100,000 threshold is met. (9) Different underpayments of the same type of tax for the same period, however, are aggregated. Thus, based on Example 2 under Temp. Reg. [section] 301.6621-3T(d), if a corporation determines that it has an income tax liability for 1990 of $60,000, but pays the entire $60,000 late and the IRS later determines an additional income tax deficiency for 1990 of $50,000, there is an aggregate underpayment of $110,000 and section 6621(c) applies to the entire $110,000 tax underpayment, plus all accrued interest, additions to tax, and penalties thereon, to the extent not previously paid.
B. "Applicable Date"
Section 6621(c)(1) applies only to interest accruing on the underpayment after an "applicable date." Where the regular deficiency procedures apply, section 6621(c)(2)(A) provides that the applicable date is the 30th day after the earlier of -
(1) the date on which the IRS first sends a letter of
proposed deficiency allowing for IRS Appeals Office
review (commonly known as a "30-day letter"), or
(2) the date on which it sends a notice of deficiency
(commonly known as a "90-day letter").
Under Temp. Reg. [section] 301.6621-3T(c)(3), where such deficiency procedures do not apply, the applicable date is 30 days after the IRS first sends a letter or notice that notifies the taxpayer of an assessment or proposed assessment of tax. One common example where the deficiency procedures do not apply is adjustments made to a corporation's distributive share of partnership items. (10) Such items are adjusted through partnership-level procedures, which typically involve the issuance of a notice of proposed adjustment with respect to the partnership's items, followed later by a notice of final partnership administrative adjustment. (11) The latter notice may be contested in court. (12) Only after the partnership items are finally determined at the partnership level does the IRS calculate and assess the tax effect of the adjustment to a corporate partner. At that time, it sends the corporate partner, under separate cover, a copy of its tax computation and a collection notice demanding payment of the tax and interest the IRS has computed and assessed. (13) Neither the statute nor the regulations make clear which of the notices in a partnership proceeding trigger the applicable date. The structure of section 6621(c) suggests, however, that the applicable date should be triggered only by the collection notice sent to corporate partners.
Other common situations in which the deficiency procedures do not apply are notices of corrections of mathematical errors (14) and notices demanding payment of tax reported on a return but not yet paid. In these cases, the first letter to a taxpayer is almost invariably a collection notice, the date of sending of which will be considered the applicable date.
In order to encourage prompt payment of proposed small deficiencies and collection notices, a letter or notice does not trigger the applicable date if the taxpayer makes a payment equal to the amount of tax, interest and penalties shown as due in the letter or notice within 30 days after the IRS sends it. (15) This is a very important exception, as the following example - based on Examples 2 and 4 in Temp. Reg. [section] 301.6621-3T(d) - illustrates:
Assume a corporation receives a 30-day letter proposing
a $25,000 tax deficiency arising from unreported
income. The corporation does not pay the
amount proposed in the 30-day letter, but seeks IRS
Appeals Office consideration. The matter is settled
at Appeals six months later for a payment of $15,000.
A year later, the IRS issues a notice of deficiency
proposing a $750,000 tax deficiency based on additional
unreported income and disallowed losses. The
taxpayer pays the $750,000 plus regular interest 20
days after the notice of deficiency is mailed. Despite
having promptly paid the notice of deficiency in full,
section 6621(c) interest is computed on the entire
$750,000 tax deficiency plus interest from a date
which is 30 days after the 30-day letter was issued!
Had the taxpayer paid the $25,000 tax deficiency
plus interest thereon within 30 days after the 30-day
letter was issued, however, the enhanced rate under
section 6621(c) would never have applied because no
applicable dates would have been triggered.
C. Effective Date
Section 6621(c) interest can only apply to interest accruing on or after January 1, 1991. Nevertheless, it may accrue thereafter on pending proposed deficiencies that have been at IRS Appeals or in litigation for some time. Typically, a 30-day or 90-day letter has been issued in such disputes, so the applicable date has long since been triggered. Thus, the applicable date need not occur on or after January 1, 1991, in order for interest to run at the enhanced rate on or after January 1, 1991.
D. Audit and Litigation Strategy
As of January 1, 1991, section 6621(c) has generally increased the cost of continuing to litigate pending audit and litigation matters without paying. Accordingly, it is wise to reexamine whether all or a portion of a proposed existing tax liability should be paid now. Of course, a corporation should not make such a payment without considering the possible impact that the payment may have on settlement negotiations, the choice of forum for litigation, other litigating strategies, and similar business concerns.
In particular, if a taxpayer fully pays a deficiency proposed in a 30-day letter, it may avoid interest at the section 6621(c) enhanced rate, but it may also preclude having its dispute heard by the U.S. Tax Court. The Tax Court can only hear cases in which the IRS has issued a 90-day letter; (16) but usually no 90-day letter will be issued after the taxpayer has made the payment in full. Such taxpayers will only be able to contest the matter further through filing a refund claim and eventually bringing suit in the local U.S. District Court or the U.S. Claims Court. If the taxpayer would prefer the precedent or less burdensome discovery procedures of the U.S. Tax Court, it should be careful about making full payment.
One strategy a taxpayer might follow to avoid most of the impact of section 6621(c) while preserving its access to the Tax Court would be to pay virtually all, but not all, of the deficiency proposed in a 30-day letter on the assumption that the IRS will, in due course, most likely issue a 90-day letter for the balance. Of course, a taxpayer could ask the IRS for a 90-say letter for the remainder if the IRS does not issue the notice on its own.
Another strategy would be to make a deposit in the nature of a cash bond under Rev. Proc. 84-58, 1984-2 C.B. 501, in the full amount of the proposed deficiency. The deposit will stop any further running of interest, and the IRS will have to issue a 90-day letter in order to assess the tax secured by the deposit. The deposit procedure, however, is not without its potential cost: if the ultimate deficiency is determined to be less than the amount deposited, the taxpayer will receive a refund of the balance of the deposit, but no interest will be paid to the taxpayer on the amount returned. For this reason, in cases involving protracted litigation, the deposit procedure is often inadvisable.
As a practical matter, in cases involving (1) extremely large proposed deficiencies in respect of which the taxpayer expects generally to prevail, (2) proposed smaller deficiencies on issues on which the taxpayer expects ultimately completely to prevail but only after protracted litigation, or (3) taxpayers that are not in solid financial shape, it may make sense to continue to contest matters in the Tax Court, acknowledging the additional economic cost imposed by the enhanced rate of interest under section 6621(c). In cases where no penalties are involved (or, as suggested above, if the temporary regulations imposing interest at the enhanced rate on penalties are invalidated or withdrawn), the economic issue may simply be whether the cost of funds represented by the ultimate interest charge, including the enhanced rate, is acceptable. In cases where the corporation is a regular-tax taxpayer that can avail itself of a current deduction, the additional two-percent interest charge applicable under section 6621(c) will represent an additional after-tax cost of no more than 1.32 percent. (17)
One final observation: The enhanced rate does not apply for purposes of computing the ordinary charge for estimated tax underpayments or under special statutory rules that impose an interest charge on deferred (or deemed-deferred) gain (e.g., under the installment sales rules and on excess distributions from a passive foreign investment company.) (18)
III. Increased Accuracy-Related Penalty
in Certain Section 482 Cases
Prior to the 1990 Act, corporations already had a considerable incentive to use justifiable transfer prices in transactions with related entities and otherwise to avoid the impact of a proposed section 482 allocation by the IRS. At one extreme, pursuant to section 6663, a tax deficiency attributable to a section 482 adjustment could be subject to a fraud penalty equal to 75 percent of the deficiency and interest. In the more usual case, a section 482-related deficiency could result in an accuracy-related penalty equal to 20 percent of the deficiency if it was attributable to (1) negligence or disregard of rules or regulations, (2) a substantial understatement of income tax, or (3) a substantial valuation overstatement for income tax purposes. (19)
For this purpose, a substantial understatement of income tax existed where an understatement of tax not arising from items that were disclosed on the return or for which there was substantial authority exceeded the greater of 10 percent of the tax required to be shown on the return or $10,000. A substantial valuation overstatement for income tax purposes existed if the value or adjusted basis of any property claimed on the return was 200 percent or more of the correct amount. If the valuation overstatement was 400 percent or more, the accuracy-related penalty was increased to 40 percent of the tax deficiency attributable to the overstatement. Under section 6601(e)(2)(B), the accuracy-related penalty bears interest at the regular underpayment rate from the due date of the return to which it relates until the penalty is paid. Temp. Reg. [section] 301.6621-3T(b)(2)(i) provides for interest on such penalty to accrue at the enhanced rate where there is a large corporate underpayment, though there is doubt that this provision could withstand legal challenge.
Congress was concerned that, in transfer pricing cases, the issue if often the understatement, not an overstatement, of a transfer price, or the case deals with the appropriate value of services, rather than the value of property. Prior to the 1990 Act, the valuation overstatement component of the accuracy-related penalty did not apply in such cases. Further, Congress considered the 20-percent penalty insufficient as a deterrent in very large section 482 cases and cases involving extreme valuation understatements.
Accordingly, in 1990 Congress amended the income tax valuation overstatement component of the accuracy-related penalty to provide that the 20-percent penalty applies where the price for any property or services (or for the use of property) claimed on a return with respect to related-party transactions is 200 percent or more or 50 percent or less of the correct amount determined under section 482. The 20-percent penalty will now also apply where the net increase to taxable income from any section 482 transfer price adjustments for a taxable year exceeds $10 million. If the transfer price valuation misstatement is 400 percent or more or 25 percent or less of the correct amount, or if the section 482 transfer price adjustment for the taxable year exceeds $20 million, the accuracy-related penalty will be 40 percent of the tax deficiency attributable to the misstatements. These amendments are effective for taxable years ending after November 5, 1990. (20) Thus, the new penalty provisions are somewhat retroactive in effect.
The accuracy-based penalty can be avoided by showing that there was reasonable cause for the underpayment and that the taxpayer acted in good faith with respect to the underpayment. (21) As a practical matter, in a section 482 case a taxpayer that can show both substantial legal and factual support for its position may well be able to avoid the negligence, substantial understatement, and valuation misstatement components of the penalty. Well-advised taxpayers already build a substantial legal and factual record before taking a significant section 482 return position. Accordingly, the behavior of many taxpayers will likely not change as a result of the new penalty provisions.
The main practical effect of the amendment, then, will be to raise the penalty stakes to 40 percent in very large section 482 cases and in cases of over-aggressive transfer pricing. By raising the penalty stakes, Congress no doubt hopes to deter taxpayers from taking section 482 return reporting positions that have little or no chance of success if litigated. In large cases, however, extension of the new 40-percent penalty may also provide an added inducement to settle a section 482 dispute without litigation.
IV. Expanded Reporting and Record-Keeping
Requirements for Foreign-Owned U.S.
Subsidiaries and Branches
Under section 6038A, prior to its amendment by the 1990 Act, certain foreign-controlled corporations were required to maintain records and furnish to the IRS on request certain information (on Form 5472) concerning transactions with related parties. Section 6038A, as amended in 1989, also required related foreign persons to appoint a foreign-controlled reporting corporation as their agent for the limited purpose of summons enforcement.
Reporting corporations included domestic corporations as well as foreign corporations engaged in a U.S. trade or business if, in either case, the corporation was owned at least 25 percent (directly or indirectly) by a single foreign person. Related parties included any 25-percent foreign shareholder, a person related (within the meaning of sections 267(b) or 707(b)(1) to the reporting corporation or a 25-percent foreign shareholder, and any other related person (under section 482). Monetary penalties of up to $10,000 per year applied to failures to file a Form 5472 or to maintain required records; additional $10,000 penalties applied for each 30-day penalty period beginning 90 days after notice of noncompliance was sent by the IRS. Furthermore, if (1) no U.S. agent was appointed, (2) the IRS issued an administrative summons for such records or testimony, and (3) the taxpayer did not substantially comply with the summons in a timely manner, the IRS was also authorized, in its sole discretion, to determine the allowable amount of deduction for any amount paid to a related party and the basis of any property acquired from or transferred to the related party. A taxpayer could bring a proceeding in U.S. District Court to quash such a summons, but bringing the proceeding also served to toll the statute of limitations until the proceeding was resolved.
Prior to the 1990 Act, section 6038A's requirements that the reporting corporation maintain certain records and that the related foreign person appoint the corporation as its agent for summons enforcement purposes applied only with respect to tax years beginning after July 10, 1989.
The 1990 Act made several changes to section 6038A and added section 6038C to the Code. Perhaps the most important aspect of the 1990 Act in this context was expansion of the periods covered by amended section 6038A and new section 6038C. The 1990 Act requires the maintenance of records in existence on or after March 20, 1990, and applies the agency-authorization and summons-enforcement rules after November 5, 1990. In addition, by the enactment of section 6038C, Congress extended the rules and procedures of section 6038A to all foreign corporations engaged in a U.S. trade or business (regardless of the existence of any single 25-percent foreign owner). (22)
V. New Designated Summons Procedure
May Extend the Statute of Limitations
Building on section 6038A, Congress decided that no corporation subject to U.S. tax should be able to resist summons enforcement without paying for such resistance through an extension of the statute of limitations while the enforcement proceedings are pending. Accordingly, Congress amended section 6503 to add subsection (k), which provides that the IRS may issue a single "designated summons" in any corporate audit. The designated summons must be issued at least 60 days before the statute of limitations would otherwise expire. Under new section 6503(k), if a designated summons is issued but is not complied with and if, prior to the expiration of the statute of limitations, the IRs or the taxpayer brings suit in U.S. District Court to enforce or quash the summons, the statute of limitations will be tolled while the judicial proceeding is pending. This provision is effective for any tax where the statute of limitations had not expired by November 5, 1990.
The designated summons is a potent new tool for IRS examiners to use against corporate taxpayers that refuse to extend the statute of limitations volutarily. Corporate taxpayers may usually prefer to receive a notice of deficiency based on an incomplete audit, which to that date may have uncovered only minor items, rather thanrisk a notice of deficiency raising large items following a longer audit. In the past, corporations could control the provision of sensitive documents to an auditor so that even if a summons were issued and later enforced, the documents would be produced only after the IRS had been forced to issue a notice of deficiency. If the IRS, based upon these documents, were then to raise an issue not contained in the notice, it would typically bear the burden of proof on that issue in a proceeding in the Tax Court. (23)
By issuing a burdesome designated summons at essentially the last minute and bringing suit to enforce it, the IRS can now unilaterally extend the period of limitations while it completes its audit of all issues (not just those with which the summons is concerned). Whether the IRS will use the designated summons procedure responsibly will bear watching.
Congress has armed the IRS with a number of new tools to make it more painful for corporations to take aggressive transfer pricing positions and even more painful to contest routine tax disputes. These changes will cause corporate taxpayers under audit or in litigation to consider whether their existing strategies continue to make sense.
Furthermore, recent developments in the reporting, record maintenance and production, and appointment of agents in connection with related foreign-party transactions by foreign-owned U.S. corporations and brances are likely to generate significant interest among tax professionals who will have to consider carefully how to deal with them.
(1) The 1990 tax act was enacted as Title XI of the Omnibus Budget Reconciliation Act of 1990, Pub. L. No. 101-508 (enacted November 5, 1990).
(2) I.R.C. [section] 163(h); see Treas. Reg. [section] 1.163-9T(b)(2) (even taxes on business income of noncorporate taxpayers are nondeductible).
(3) The text of the agreement between the President and certain congressional leaders was released by the Office of Management and Budget on September 30, 1990, and is reproduced at pages L-1 through L-12 of the BNA Daily Tax Report (DTR No. 191) of October 2, 1990.
(4) The regular interest rate on tax deficiencies is determined as the rounded federal short-term rate determined under section 1274(d) plus three percentage point. This rate is adjusted quarterly. I.R.C. [subsection] 6621(a) and (b).
The interest rate on overpayments is only two percentage points over the federal short-term rate. I.R.C. [section] 6621(a)(1). Consequently, if overpayments could be credited against underpayments, the amount of the net interest charged could be minimized. See I.R.C. [section] 6601(f) ("[i]f any portion of a tax is satisfied by credit of an overpayment, then no interest shall be imposed under this section on the portion of the tax so satisfied for any period during which, if the credit had not been made, interest would have been allowable with respect to such overpayments"). Section 6402(a) authorizes the IRS to credit overpayments (and interest on overpayments) against underpayments but does not require such crediting; and section 6402 was not amended by the 1990 tax act. The Conference Report accompanying the enactment of section 6621(c) in the 1990 Act, however, includes the following language: "The Secretary should implement the most comprehensive crediting procedures under section 6402 that are consistent with sound administrative practices." H.R. Rep. No. 101-964, 101st Cong., 2d Sess. 1101 (Oct. 27, 1990).
(5) Rev. Rul. 90-94, 1990-46 I.R.B. 16.
(6) I.R.C. [section] 6621(c)(3).
(7) Temp. Reg. [section] 301.6621-3T.
(8) I.R.C. [section] 6621(c)(3)(B); Temp. Reg. [section] 301.6621-3T(b)(4).
(9) Certain questions are likely to arise concerning what is the same tax - for example, are the employer and employee portions of FICA tax different taxes, and are certain witholding taxes (e.g., backup witholding and foreign-person witholding) considered separately or aggrevated?
(10) I.R.C. [section] 6230(a).
(11) I.R.C. [section] 6223(a); Internal Revenue Manual [section] 4422.3:(2).
(12) I.R.C. [section] 6226.
(13) I.R.C. [sections] 6225, 6230(c), and 6231(a)(6); Internal Revenue Manual [section] 4227.5(11)2:7.
(14) I.R.C. [section] 6213(b).
(15) I.R.C. [section] 6621(c)(2)(B)(ii); Temp. Reg. [section] 301.6621-3T(c)(4). For this purpose, payment does not include making a deposit in the nature of a cash bond under Rev. Proc. 84-58, 1984-2 C.B. 501. See discussion of the cash bond procedure in the text that follows.
(16) I.R.C. [section] 6213(a).
(17) This rate is computed by multiplying 2 percent by the sum of 1.00 minus .34, the regular tax marginal rate. This rate would be reduced further if the interest were deductible for state or local tax purposes. For taxpayers paying alternative minimum tax, the after-tax cost would be 1.58 percent (or 2 percent times [1.00 minus .21, the AMT marginal rate]), again computed before state and local taxes.
(18) See Temp. Reg. [section] 301.6621-3T(b)(iv).
(19) I.R.C. 6662, prior to amendment by the 1990 Act.
(20) I.R.C. [sections] 6662(e) and (h)(2)(A), as amended by the 1990 Act.
(21) I.R.C. [sections] 6662(e)(3)(B) and 6664(c).
(22) On December 10, 1990, the IRS issued proposed regulations under sections 6038A and 6038C. Those regulations were the subject of an article published in the January-February 1991 issue of The Tax Executive. See Cole, Proposed Loss Disallowance Regulations: New Recordkeeping, Information Reporting, Record Production, and Translation Requirements With Respect to Transactions Between a Foreign-Owned U.S. Corporation and Its Foreign Related Parties, 43 Tax Executive 26 (January/February 1991).
(23) Assuming the taxpayer petitioned the Tax Court in response to the notice of deficiency, the IRS could not issue a second notice of deficiency for that year absent fraud. I.R.C. [section] 6212(c)(1). Tax Court Rule 142(a) provides that the IRS has the burden of proof when it raises new matters not contained in the deficiency notice or seeks to increase the amount of the deficiency.
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|Author:||Glicklich, Peter A.|
|Date:||Mar 1, 1991|
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