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House Ways and Means Committee testimony: interest and penalty provisions of the Internal Revenue Code.

November 9, 1999

On November 5, 1999, Tax Executives Institute submitted the following statement to the Oversight Subcommittee of the House Committee on Ways and Means in connection with a planned November 9 hearing on proposed changes to the interest and penalty provisions of the Internal Revenue Code. The hearing, which was scheduled following the release of separate studies by the staff of the Joint Committee on Taxation and the Department of the Treasury, was postponed owing to the press of other legislative business, but will likely be rescheduled in 2000. The Institute's testimony, which was to have been presented by TEI President Charles W. Shewbridge, III, was prepared under the aegis of the IRS Administrative Affairs Committee, whose chair is Robert J. McDonough, Jr. of Wang Global, Inc. Earlier this year, TEI submitted comments to the Joint Committee staff and the Treasury Department in response to their requests. Those earlier comments are reprinted in the May-June 1999 issue of The Tax Executive.

Good afternoon. I am Charles W. Shewbridge, III, Chief Tax Executive for BellSouth Corporation in Atlanta, Georgia. I appear before you today as the President of Tax Executives Institute, the preeminent group of corporate tax professionals in North America. The Institute is pleased to provide the following comments on the Internal Revenue Code's interest and penalty provisions, with particular focus on the recommendations recently made by the staff of the Joint Committee on Taxation and the Department of the Treasury. See Staff of the Joint Committee on Taxation, Study of Present-Law Penalty and Interest Provisions as Required by section 3801 of the Internal Revenue Service Restructuring and Reform Act of 1998 (Including Provisions Relating to Corporate Tax Shelters) (JCS3-99) (July 22, 1999) (hereinafter cited as the "Joint Committee Study"); Office of Tax Policy, U.S. Department of the Treasury, Report to the Congress on Penalty and Interest Provisions of the Internal Revenue Code (October 1999) (hereinafter cited as the "Treasury Report").

I. Background

Tax Executives Institute was established in 1944 to serve the professional needs of in-house tax practitioners. Today, the Institute has 52 chapters in the United States, Canada, and Europe. Our 5,000 members are accountants, attorneys, and other business professionals who work for the largest 2,800 companies in the United States and Canada; they are responsible for conducting the tax affairs of their companies and ensuring their compliance with the tax laws. TEI members deal with the tax code in all its complexity, as well as with the Internal Revenue Service, on almost a daily a basis. Most of the companies represented by our members are part of the IRS's Coordinated Examination Program, pursuant to which they are audited on an ongoing basis. TEI is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. Our background and experience enable us to bring a unique and, we believe, balanced perspective to the subject of the Internal Revenue Code's interest and penalty provisions.

TEI has long believed that the Code's interest and penalty provisions are unduly complex and inequitable. The interest provisions can operate in an unfair manner and are difficult to administer, especially when taxpayers have overlapping periods of under- and overpayments. In many cases, the provisions have served as an inappropriate penalty (such as with the estimated tax penalty), rather than as recompense for the time value of money.

Moreover, the calculation of interest itself -- with its restricted interest provisions and requirements for compounding and netting -- is inordinately difficult and leads to errors by both the government and the taxpayer. Almost every TEI member can recount a protracted tale, if not a horror story, of convoluted, complicated, and ultimately incorrect interest calculations. For good reason, taxpayers doubt the IRS's ability to compute interest accurately, and they frequently incur significant expense in hiring outside consultants to review interest charges -- often without the benefit of a print-out of the IRS calculations. We recognize that much of the cause of the problem lies in the IRS's computer system (which is in the process of being replaced), but we believe the IRS can take immediate steps to assist taxpayers now -- for example, by providing copies of interest calculations.(1)

Moreover, the unfairness and complexity of the Code's interest rules have been exacerbated by the delay in issuing guidance. For example, the Internal Revenue Service Restructuring and Reform Act of 1998 mandates the use of interest netting when there are overlapping periods of under- and overpayments. A transition rule permits taxpayers to apply the ameliorative rules retroactively, but to avail themselves of this relief, taxpayers must file elections by the end of the year. Even though less than two months remain to qualify for transitional relief, the IRS and Treasury Department have not yet issued guidance on the mechanics of the election (e.g., what information must be included, especially in respect of the level of detail required). The delay in issuing the procedure is regrettable and feeds the perception that the IRS and Treasury continue to resist interest netting notwithstanding Congress's mandate.

In respect of the Code's penalty provisions, TEI believes that they should be simple, fair, and easy to administer. Unfortunately, we have moved away from this concept in the last decade where penalty has been piled upon penalty to target specific areas such as transfer pricing and corporate tax shelters. Rather than being straightforward, direct, and effective, penalties have become almost as complicated as the underlying provisions they seek to enforce. Dangerously, too, the enactment of new or racheting up of existing penalties deprives the system of proportionality while representing a politically expedient way of raising revenues without increasing "taxes."

We seem to have lost track of the concept that penalties should be applied only in cases of intentional (or volitional) noncompliance, and not for every error or omission. The current structure does not effectively distinguish between the two, but instead places taxpayers who unintentionally fail to meet some requirement in the same category with those who willfully decide not to comply.

It is clearly time for an in-depth review of the Code's interest and penalty provisions. TEI commends Chairman Houghton and the Oversight Subcommittee for scheduling this hearing to determine the effectiveness of the current interest and penalty regime and to consider recommendations for reform.(2) The Institute believes that such a comprehensive review of the provisions will invariably lead to the following conclusions (among others):(3)

* The interest-rate differential should be repealed and the interest charged on under- and overpayments should be equalized.

* The rate of interest on under- and overpayments should equal the applicable federal rate plus two or three percentage points.

* The estimated tax penalty should be converted to an interest charge and a safe harbor should be created for all taxpayers.

* The Internal Revenue Service's ability to abate interest should be expanded.

* The Code's penalty regime should encourage disclosure by taxpayers. The standards for imposing penalties should be harmonized and consistently applied, and there should be a realization that certainty and fairness of application play a bigger role in encouraging compliance than reflexively increasing penalty rates.

* The pension-related penalties should be consolidated for enforcement purposes under a single government agency.

TEI would be pleased to assist the Oversight Subcommittee in effecting these changes.

II. Interest Provisions

A. Elimination of the Interest-Rate Differential

Section 6621 of the Code establishes the rate of interest to be paid on over- and underpayments of tax. The rate on overpayments of tax by a corporation is the federal short-term rate plus two percentage points; the underpayment rate is the federal short-term rate plus three percentage points.(4) "Large corporate underpayments" are subject to an interest equal to the federal short-term rate, plus five percentage points (the so-called hot interest provision).(5) Thus, the rate of interest the government charges corporate taxpayers on tax deficiencies is higher than the rate of interest the government pays on refunds.(6)

The different interest rates for over- and underpayments, coupled with the differences for large corporations, have spawned a major complexity in the tax law -- interest netting. The situation arises when taxpayers both owe money to and are owed money by the government (but the debts bear interest at different rates) and is a common occurrence for large corporations that may have overpayments and underpayments of different taxes for several years as the result of multi-year and overlapping audits. (An IRS determination, say in Year 8, that a taxpayer should have deducted an expense in Year 1 instead of Year 2 could trigger an adjustment owing to the interest-rate differential, even though the taxpayer was a net creditor of the government during the entire period.)

In the IRS Restructuring Act, Congress established a net interest rate of zero where interest is payable on equivalent amounts of over- and underpayments of tax.(7) Taxpayers must affirmatively request and -- at least at present -- calculate the adjustments needed to achieve a zero net interest rate. Although this provision ameliorates the inequity caused by the difference in interest rates, it does not provide a full measure of relief. It is also an extremely complex provision to administer.

Tax Executives Institute supports elimination of the interest-rate differential. When the differential was enacted, two reasons were given for having different rates for under- and overpayments: (i) financial institutions do not borrow and lend money at the same rate, and (ii) the differential between the tax interest rate and the market rate might cause taxpayers either to delay paying taxes or to overpay them, depending upon the rate of interest accruing. H.R. Rep. No. 99- 426, 99th Cong., 1st Sess. 849 (1985) (hereinafter cited as "1985 House Report"); S. Rep. No. 99-313, 99th Cong., 2d Sess. 184 (1986) (hereinafter cited as "1986 Senate Report"). Contrary to the views expressed in the Treasury Report (at 121), TEI submits that these reasons -- even if valid in 1986 -- are no longer applicable. Taxpayers do not deliberately "lend" money to the government. If such practices ever occurred, they were effectively put to an end by the amendments to the calculation of the rate since 1982.(8) Moreover, returning to one rate of interest for both under- and overpayments will greatly reduce or eliminate the need for netting, thereby significantly simplifying the law. Finally, the proposed amendment would address the inequities arising from the "same taxpayer" rule, pursuant to which under- and overpayments by related entities (such as with the foreign sales corporation and related supplier adjustments) do not result in an overall increase in tax liabilities, but because of the different rates on over- and underpayments, interest may be owed.

Thus, the Institute believes that the elimination of the interest-rate differential would complete the reform effort Congress undertook in 1998. See Joint Committee Study at 73. Equalizing the rates would "provide a better mechanism for achieving the equivalent effective interest rate goal than the net zero interest rate approach of current law." Id. at 76. It would also make the benefits of the equivalent effective interest rates available to all taxpayers, not just those capable of preparing the complicated calculations.

TEI therefore recommends that the interest-rate differential be eliminated for all taxpayers.

B. Rate of Interest

Equalizing the interest rates on under- and overpayments raises an issue concerning the appropriate rate of interest to be charged. Current law imposes various rates of interest ranging from the short-term applicable federal rate (AFR) plus 0.5 (for overpayments) to five (for underpayments) percentage points. The two studies recommend equal rates of AFR plus five percentage points (Joint Committee Study at 73) or an underpayment rate of AFR plus two or three percentage points (Treasury Report at 8).

A rate of AFR plus 5 percentage points (essentially 10 percent in today's market) is equivalent to the "hot interest" rate that applies to large corporate underpayments. We question whether this high rate is appropriate for all or even any taxpayers. As the Joint Committee Study notes (at 76), large corporations are generally able to borrow money at a much lower rate. For example, a corporate taxpayer with an "AA" credit rating can borrow money today in the commercial paper market at 5.35 percent for 30 days -- an amount comparable to the short-term AFR. The current interest rate system -- with its provisions for above-market interest and "hot" interest -- acts essentially as a penalty. We recognize that a blended rate is necessary for ease of administration. We also recognize that, from a tax policy standpoint, an argument can be made that interest rates should be skewed, if anything, to encourage overpayment.(9) Nevertheless, we submit the goal should be to approximate a market rate of interest (which does nothing more than reflect the time value of money), and respectfully suggest that a rate of AFR plus 2 or 3 percent would be closer to reality.

C. Abatement of Interest

Under section 6404(e) of the Code, the Treasury Secretary is granted the discretion to abate the assessment of all or any part of interest due for any period on (i) a deficiency attributable in whole or part to any unreasonable error or delay by an IRS officer or employee acting in an official capacity when performing a ministerial or managerial act, or (ii) a tax payment, to the extent that any unreasonable error or delay in such payment is attributable to an IRS employee or officer acting in an official capacity being erroneous or dilatory in performing a ministerial or managerial act. An error or delay may be taken into account only if no significant aspect of such error or delay can be attributed to the taxpayer involved, and after the IRS has contacted the taxpayer in writing with respect to such deficiency or payment. There is also limited authority to abate interest in respect of erroneous refunds or reliance on erroneous written advice of IRS personnel.

Both the Joint Committee staff and the Treasury Department agree that the IRS's authority to abate interest should be expanded, although Treasury's recommendation is more circumscribed.(10) The Joint Committee staff recommends that the IRS be permitted to abate interest in cases of gross injustice. Joint Committee Study at 91-92. Although the "gross injustice" standard sets a high threshold, this marks the first time abatement would be permitted on general equitable grounds. TEI believes that the recommendation should be adopted, but suggests that the IRS's administration of this standard be monitored to determine whether the threshold should be lowered.

Furthermore, the Joint Committee staff recommends that abatement occur for periods attributable to any unreasonable IRS error or delay. Joint Committee Study at 91-92. This provision thus eliminates the managerial or ministerial acts requirement, which creates complex factual issues that can lead to audit disputes and litigation The legislative history of the interest-abatement provision confirms that Congress did not intend the provision to be used routinely to avoid payment of interest, but rather that the provision should operate in instances where the denial of abatement would be widely perceived as grossly unfair. 1985 House Report at 844-45; 1986 Senate Report at 208-09. There may well be instances where the denial of an abatement request may be unfair, but the situations do not meet the standards now set forth in the statute.

TEI therefore supports the Joint Committee staff's recommendations in respect of the abatement of interest and suggests that consideration be given to expanding its reach.

D. Dispute Reserve Account

In general, interest on under- and overpayments continues to accrue during the period that a taxpayer and the IRS dispute a liability. Under section 6404(g) of the Code, the accrual of interest on an underpayment is suspended if the IRS fails to notify an individual taxpayer in a timely manner, but interest will begin to accrue once the taxpayer is properly notified. No similar suspension is available for other taxpayers.

Taxpayers that are unable to promptly resolve their disputes with the IRS face limited choices. The taxpayer can continue to dispute the amount owed and risk paying a significant amount of interest, it can pay the disputed amount and claim a refund, or it can make a deposit in the nature of a bond.

The Joint Committee staff recommends that taxpayers be permitted to deposit amounts in a special "dispute reserve account" within the Treasury Department. Joint Committee Study at 97. Access to the account would be permitted upon notice to the IRS. According to the study, the account "would allow taxpayers to better manage their exposure to underpayment interest without requiring them to surrender access to their funds or requiring them to make a potentially indefinite- term investment in a non-interest bearing account." Id. at 99. It would also preserve the taxpayer's access to the U.S. Tax Court while encouraging the prepayment of disputed amounts. Interest paid on the account would be set at a rate that would provide reasonable compensation to the taxpayer for the use of its money, but should not encourage the use of dispute reserve accounts as an alternative to investment in other short-term instruments. Id. at 100.(11)

The Joint Committee staff's recommendation is a significant improvement over the cash bond requirement of current law and should be adopted. Moreover, TEI recommends that interest accrue on amounts deposited in the account at the rate established for under- and overpayments of tax.

III. Estimated Tax Penalty

A. Penalty in Lieu of Interest

Under section 6655 of the Code, corporate taxpayers are subject to a penalty if they fail to estimate their tax liability and make quarterly deposits equal to either (i) 100 percent of their actual tax liability, or (ii) 100 percent of their prior year's tax liability. The "prior year's tax" option is generally not available to for so-called large corporations -- roughly, corporations whose taxable income is $1 million or more in any of the preceding three years. The estimated tax penalty is imposed in lieu of an interest charge on the underpayments of tax.

Because of the effective lack of a safe harbor, the large corporate taxpayer generally faces a choice:

* paying a penalty for underestimating its liability, or

* overpaying its taxes (in order to avoid the penalty).(12)

The second option -- which large corporations are generally required to choose not only by internal business conduct policies but by the desire to avoid penalties -- does not come without cost. The cost is the effective denial of interest on the amount of the compelled overpayment by operation of section 6611(e), which provides that interest on an overpayment will not begin to run until the filing of a claim for refund.(13) The rules thus act as a "non-penalty" penalty for corporations.

TEI agrees with the recommendation that the estimated tax penalty be converted to an interest charge at the rate provided under section 6621 of the Code, which would make the interest deductible by corporate taxpayers. See Joint Committee Study at 114-15.(14) The estimated tax penalty is, in reality, a charge for the time value of money and the law should reflect this fact. It is simply bad tax policy to disguise an interest charge as a penalty.

TEI therefore supports the Joint Committee staff's recommendations. We also agree with the recommendation (at 118-19) that, in the interest of simplification, the interest rates should be aligned so that, for any given estimated tax underpayment period, only one interest rate would apply, i.e., the interest applicable on the first day of the quarter in which the due date arises.

B. Safe Harbor

TEI is disappointed that neither Joint Committee Study nor the Treasury Report mentions the need for a safe harbor for corporate taxpayers. Because they are not permitted to utilize the prior year's tax rule, large corporations must base their quarterly deposits on estimates of their current year's tax liability. Estimating taxes is not an exact science. The existing task is literally impossible in light of the complexity of the tax laws, the rapidity with which they have been changed in recent years, and the fact that the numerous adjustments to financial income can accurately be done only annually.

TEI submits that there is no valid tax policy reason for denying large corporations the availability of the prior year's tax rule under section 6655. We therefore recommend that a safe harbor, based on a percentage of the prior year's (or the average of a group of years') liability, be established for large corporate taxpayers.

V. Penalties

A. Accuracy-Related Penalties

The Code imposes a hodgepodge of penalties to ensure that a taxpayer's return is accurate. These penalties employ a variety of standards, ranging from "more likely than not" (section 6662(d)(2)B)(i)) and "reasonable basis" (section 6662(d)(2)(B)(ii)) for taxpayers to "realistic possibility of being sustained" (section 6694(c)) and "not frivolous" (section 6694(a)) for return preparers. The lower standards are generally applicable for positions that are disclosed on a return. See Joint Committee Study at 152, Table 7 ("Summary of Existing Standards for Tax Return Positions").

Section 6662(a) imposes a 20-percent penalty on the portion of an underpayment attributable to any of the following: (i) negligence or disregard of rules or regulations; (ii) a substantial understatement of income tax; (iii) a substantial valuation overstatement; (iv) a substantial overstatement of pension liabilities; or (v) a substantial estate or gift tax valuation understatement. The accuracy-related penalty was enacted in 1989 to replace several other penalties, including the negligence, substantial understatement, and valuation overstatement penalties. The penalty is generally not imposed with respect to any portion of the underpayment for which there is reasonable cause if the taxpayer acted in good faith. I.R.C. [sections] 6664(c)(1).

For corporations, an understatement for any taxable year is substantial if it exceeds the greater of $10,000 or 10 percent of the tax required to be shown on the taxpayer's return. I.R.C. [sections] 6662(d)(1). An exception to the penalty is provided for items in respect of which there is substantial authority or adequate disclosure of the taxpayer's position.(15)

The Code also imposes a two-tiered penalty on tax return preparers in respect of positions not having a realistic possibility of being sustained on the merits. Specifically, if the position will result in an understatement, a penalty will be imposed unless the preparer takes steps to ensure the disclosure of the position and the position is "not frivolous." I.R.C. [subsections] 6694 (a) & (c).

The Joint Committee staff and Treasury Department both recommend that the standards be consistent, although they approach the issue in two different ways. Their reports focus on two issues:

* The appropriate standard imposed on taxpayers and tax return preparers.

* The appropriate standard imposed for disclosed and undisclosed return positions.

The Joint Committee staff recommends that, for both taxpayers as well as preparers, the minimum standard for each undisclosed position on a tax return be that the taxpayer or preparer must reasonably believe that the tax treatment is "more likely than not" the correct tax treatment under the Code. Joint Committee Study at 153. For disclosed positions, the Joint Committee staff would require both substantial authority and adequate disclosure and would eliminate the reasonable cause exception of section 6664(c)(1). Joint Committee Study at 154-155, Table 8 ("Proposed Standards for Tax Return Positions"). Thus, under the Joint Committee staff's proposal, the statute would move from the disjunctive (substantial authority or disclosure) to the conjunctive (substantial authority and disclosure).

In contrast, the Treasury Department would retain the "substantial authority" standard for undisclosed positions and raise the standard for disclosed items to a "realistic possibility of success" for both taxpayers and tax return preparers. Treasury Report at 108.

The multitude of standards now contained in the Code -- more likely than not, realistic possibility of being sustained, substantial authority, reasonable basis, not frivolous -- is undeniably confusing and has reduced taxpayers, practitioners, and preparers to assigning mathematical probabilities to each standard and then divining (to the extent possible) whether a proposed return position meets or exceeds the applicable standard. The clarity suggested by the use of such mathematical probabilities, however, is a false one, for the tax law is marked by many things, but mathematical precision is rarely one of them.

These concerns notwithstanding, TEI believes that some adjustment to and harmonization of taxpayer, practitioner, and preparer standards may be appropriate to encourage the filing of more accurate returns. We question, however, whether sufficient attention has been paid to the effect of raising the standard in respect of undisclosed positions to "more likely than not" (as the Joint Committee staff suggests). Such an approach may unleash a torrent of disclosures that consumes valuable IRS resources and distracts revenue agents from issues more worthy of their scrutiny. Thus, although we appreciate the surface appeal of the statement that "`more likely than not' is a simple threshold that is easily understood" (Joint Committee Study at 153), we are concerned about how an "at least probably correct" standard (id.) will be applied in practice. As the Joint Committee staff notes, it is unrealistic to expect taxpayers to file a perfect return, id. at 152, and TEI is concerned that taxpayers may find themselves facing penalties where, several years after they grappled with the vagaries and interstices of the tax law, a revenue agent or court concludes -- with the benefit of hindsight -- that the taxpayer erred in concluding its position was "at least probably right." (This concern is heightened in light of the Joint Committee's recommendation that the reasonable cause exception of current law be repealed.(16) If a taxpayer has substantial authority for a return position -- e.g., if a court decision or regulation supports its position -- no disclosure should be necessary in order to avoid a penalty. See Treasury Report at 108.(17)

Moreover, we do not believe that the case has been made for raising the standard for disclosed positions in respect of taxpayers from a reasonable basis to either a realistic possibility of success standard (as the Treasury proposes) or a substantial authority standard (as the Joint Committee staff proposes). Again, the Institute is concerned that raising the standard would be counterproductive. It may prompt taxpayers, out of an abundance of caution, to laden down their tax returns with myriad disclosure forms, thereby greatly diminishing the value of any particular "needle" in the burgeoning "haystack." Overwhelming the system with disclosures will not aid the administration of the law.(18)

B. Pension Benefit Penalties

Current law imposes several penalties in respect of the failure to file the Form 5500 series (the annual return/report for pension plans). The penalties are imposed by the IRS (under Code section 6652(e)), the Department of Labor (under DOL Reg. [sections] 2560.502(c)-2(d)), and the Pension Benefit Guarantee Corporation (PBGC) (under PBGC Reg. [sections] 4071.3).

The Joint Committee staff recommends the consolidation into one penalty of the present-law penalties imposed by the Internal Revenue Code and ERISA for failure to file the Form 5500 series. Joint Committee Study at 161. The penalty that would result from this consolidation would be no less than the existing ERISA penalty for failure to file. In addition, the staff would designate the IRS as the agency responsible for enforcing the reporting requirements and replace the Labor Department's voluntary compliance program with a similar program administered by the IRS, thereby reducing from three to one the number of government agencies authorized to assess, waive, and reduce penalties for failure to file. Other penalties imposed for the failure to file certain reporting forms would also be eliminated. Id. The Treasury Department also supports consolidation of the penalties, but recommends that the administration of the penalties rest with the Department of Labor. Treasury Report at 141.

In TEI's view, consolidating the penalties would be a marked improvement over current law. It would simplify the Form 5500 series penalty structure, reduce the number of potential penalties for failure to file, strengthen incentives to comply, and encourage voluntary compliance by delinquent filers while retaining the most significant of the present-law penalties for failure to file. On balance, we favor the Joint Committee staff's proposal to have the IRS responsible for administration of the streamlined regime.

C. Administrative Proposals

The Joint Committee staff makes several recommendations concerning the administration of the penalty provisions. First, the staff recommends that the IRS improve the supervisory review of the imposition of penalties as well as their abatement (or waiver). Joint Committee Study at 169. Improving the level of review would improve consistency and combat the perception that penalties are often used as "bargaining chips." As the Joint Committee staff suggests, another way to improve supervisory review would be to institute penalty oversight committees, similar to the one established for administering the transfer pricing penalty.

TEI believes that these suggestions are sound and encourages the IRS to consider whether the penalty oversight committees should be expanded to the review of other penalties, most especially, accuracy-related penalties.

VI. Miscellaneous

Recommendations

A. Standards Applicable to IRS Personnel

The Joint Committee staff also makes several recommendations concerning the administration of the tax law by the IRS, including a revision of the standards applicable to IRS personnel under Rev. Proc. 64-22, 1964-1 C.B. 689, which among other things provides that IRS employees should not adopt a strained construction of the Code. As the Joint Committee staff notes, "the standards of conduct applicable to the IRS are an important component of taxpayers' perceptions of the relative fairness of the administration of the tax laws." Joint Committee Study at 167.(19)

TEI agrees that the standards to which IRS employees are held should be clarified. We also agree with the Joint Committee that some employees may have misconstrued the quoted language from Rev. Proc. 64-22 -- which also appears several places in the Internal Revenue Manual (IRM) -- to suggest that a revenue agent's position need not be reasonable, it just cannot be strained. As the Joint Committee's report puts it: "[I]t may appear that an inappropriately low standard of conduct is applicable to the IRS." Joint Committee Study at 167. Thus, the Joint Committee staff recommends that the standards be revised to incorporate a higher standard of behavior by the IRS, similar to that for practitioners.

TEI agrees that a higher standard of conduct for IRS personnel is appropriate and recommends adoption of the Joint Committee staff's recommendation.

B. Failure-to-Deposit Penalty

The Joint Committee staff and Treasury Department make several recommendations concerning the four-tier failure-to-deposit penalty under section 6656(B). Although both suggest that no new legislation be enacted in this area for two years -- in order to give the recent statutory changes time to be evaluated -- the Joint Committee staff further suggests that the Treasury Department consider revising its deposit regulations concerning events that trigger a change in the deposit schedule in a later calendar quarter. This would give the IRS an opportunity to notify the taxpayer of the change in status before it takes effect. It would also give the depositor time to recognize its new obligations and adjust its operating procedures accordingly. Both studies also recommend that the IRS continue to work with payroll service providers to expedite resolution of problems where a single error or mishap may affect multiple taxpayers. Joint Committee Study at 139-140; Treasury Report at 96.

TEI supports these recommendations, but suggests that consideration be given to implementing a mechanism to identify third parties who can provide an oral response to the IRS and receive information in return -- without resorting to the time-consuming method for obtaining a power of attorney. Based on reports from our members, TEI understands that at least one District Office has experimented with including a unique identifying number on each notice of proposed penalty. If a caller responds to the notice and provides the name and employer identification number (EIN) of the taxpayer and the identifying number, the IRS assumes the caller is authorized to discuss the matter, eliminating the need for a power of attorney and providing a swift resolution of any questions. TEI recommends that such a procedure be implemented.

VII. Conclusion

Tax Executives Institute appreciates this opportunity to present its views on the interest and penalty provisions of the Internal Revenue Code. Any questions about the Institute's views should be directed to either Michael J. Murphy, TEI's Executive Director, or Timothy J. McCormally, the Institute's General Counsel and Director of Tax Affairs. Both individuals may be contacted at (202) 638-5601.

(1) Section 6631 of the Code (added by the IRS Restructuring and Reform Act) requires that individual taxpayers be provided with interest calculations after December 31, 2000. This provision should apply to all taxpayers and should be implemented as soon as possible.

(2) These comments do not address recent studies and proposals in respect of corporate tax shelters, which will be the topic of a separate hearing on November 10, 1999.

(3) Both the Joint Committee staff and the Treasury Department make several recommendations concerning the interest and penalty provisions as applied to individual taxpayers. TEI has not addressed these recommendations, but suggests that many of them -- such as the Joint Committee staff's recommendation that overpayment interest not be included in the income of individual taxpayers -- are worthy of consideration.

(4) The IRS Restructuring Act eliminated the differential in respect of individual taxpayers, but not for corporations.

(5) The higher large corporate underpayment interest rate applies only to periods after the "applicable date." The calculation of the applicable date differs. If the deficiency procedures apply, the applicable date is the 30th day following the earlier of the date on which (a) the first letter of proposed deficiency that allows the taxpayer an opportunity for administrative review in IRS's Office of Appeals, or (b) the statutory notice of deficiency is sent by IRS. If the deficiency procedures do not apply, the applicable date is 30 days after the date on which IRS sends the first letter or notice that notifies the taxpayer of the assessment or proposed assessment.

(6) Under section 6621(a)(1), the interest rate on corporate tax overpayments that exceed $10,000 is only AFR plus 0.5 percentage points, as opposed to AFR plus 2 percentage points. (This provision was enacted in 1994 as part of the Uruguay Round Agreements Act, Pub. L. No. 103-465, 108 STAT. 4809, and accordingly is often referred to as "GATT" interest.) Thus, the potential difference between the interest rate for under- and overpayments for corporations is 4.5 percentage points. Although the GATT interest rate is effective for purposes of determining interest for periods after December 31, 1994, the IRS has applied an unduly narrow interpretation of the statute, applying the lower rate to overpayment interest accruing before the statute's effective date. IRS Service Center Advice Memorandum 1998-014 (April 24, 1997). Indeed, the 1997 memorandum represents a change in position for the IRS, which originally determined that overpayment interest accrued through December 31, 1994, would not be subject to the lower GATT rate. The statutory GATT interest provision and the IRS's narrow interpretation operate to exacerbate the unfairness of the interest-rate differential.

(7) The provision applies to interest for periods beginning after July 22, 1998. In addition, the provision applies if: (i) the statute of limitations has not expired with respect to either the underpayment or overpayment; (ii) the taxpayer identifies the overlapping periods for which the zero rate applies; and (iii) the taxpayer requests the netting before December 31, 1999.

(8) Before 1982, interest rates were adjusted only once every two years; now they are adjusted on a quarterly basis.

(9) That is to say, if the interest rate is to provide an incentive either to overpay or to underpay one's taxes, the incentive should be toward encouraging overpayment.

(10) The Treasury Department recommends that the abatement provision be expanded only in respect of reliance on erroneous written advice from the IRS. Treasury Report at 137.

(11) The Treasury Report does not address this issue.

(12) The estimated tax rules provide an annualization method that may be employed to avoid any penalties. Determining annualized tax liability and quarterly estimated payments under section 6655(e), however, remains far from simple. This process effectively requires taxpayers to prepare five "mini" returns for their estimated tax payments plus their final return. By reinstating the prior year's liability safe harbor, Congress could remove the uncertainty associated with the determination of tax liability from the quarterly estimating and payment process.

(13) The filing of a tax return could constitute a claim for refund, but most calendar-year large corporations will not file returns until close to September 15 (the extended due date of their return), though an outstanding tax would have to be paid no later than March 15. Thus, there could be, at a minimum, a six-month period during which no interest would be paid on the amount of the overpayment.

(14) But see Treasury Report at 81 (recommending retention of current law).

(15) Special rules apply in respect of "tax shelters," where the penalty can be avoided only if the taxpayer establishes that, in addition to having substantial authority, it reasonably believed that the treatment claimed was more likely than not the proper treatment of the item.

(16) It should also be recognized that the person making the decision whether the taxpayer was "at least probably right" (i.e., revenue agent, Appeals officer, or court) would not even reach that question until concluding that the taxpayer was wrong on the merits.

(17) Given the additional recommendation to increase the amount of the preparer penalty -- from a two-tier penalty of $250 or $1000 per return to 50 or 100 percent of the fee (Joint Committee Study at 156) -- TEI wonders whether sufficient attention has been focused on the potential adverse effect of the higher standards.

(18) The Joint Committee Study (at 156) acknowledges that no empirical evidence exists on whether or how effectively the IRS uses the taxpayer disclosures made under current law, and it recommends that the IRS be required to maintain records on its own usage of taxpayer disclosures. TEI supports this recommendation and suggests that, pending the gathering and analysis of information on the effectiveness of current law, Congress not rush to judgment on the need for more detailed disclosures.

(19) The Treasury Report is silent on this issue.
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Publication:Tax Executive
Geographic Code:1USA
Date:Nov 1, 1999
Words:6414
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