Printer Friendly

TEI comments on proposed Schedule M-3 of Form 1120: June 7, 2004.

On June 7, 2004, Tax Executives Institute filed the following comments to the Internal Revenue Service's Large and Midsize Business Division on the design and implementation of proposed Schedule M-3. The comments were prepared under the aegis of the Institute's Federal Tax Committee, whose chair is Neil D. Traubenberg of Storage Technology Corporation.

The following comments summarize Tax Executives Institute's discussions with LMSB and Treasury concerning the design of proposed Schedule M-3 and accompanying instructions, and other matters related to them.

Tax Executives Institute

Tax Executives Institute is the preeminent association of business tax executives in North America. Our more than 5,400 members represent 2,800 of the leading corporations in the United States, Canada, and Europe. TEI represents a cross-section of the business community, and is dedicated to developing and effectively implementing 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. As a professional association, TEI is firmly committed to maintaining a tax system that works--one that is administrable and with which taxpayers can comply in a cost-efficient manner.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by proposed Schedule M-3 to Form 1120.


Proposed draft form Schedule M3, Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million or More, for use by certain corporate taxpayers filing Form 1120, U.S. Corporation Income Tax Return, would expand the current Schedule M-1, and has a goal of increasing the transparency of corporate tax return filings. Schedule M-1 reconciles a corporation's financial accounting income or loss with taxable income or loss reported on Form 1120.

In releasing the draft of the proposed form on January 29, 2004, the Treasury Department announced that it will be finalized for use with federal income tax returns for tax years ending on or after December 31, 2004. In describing the proposal, it was stated:

* Schedule M-1 (and the related instructions) do not provide a uniform reporting requirement for "net income per books" on line 1 of Schedule M-1. As a result, taxpayers may provide information for (i) the worldwide group, (ii) the U.S. consolidated tax group, or (iii) something in between.

* Similarly, Schedule M-1 (and the related instructions) do not provide uniform disclosure requirements for reporting differences between financial accounting net income and taxable income. The lack of requirements prevent efficient comparisons among taxpayers and from year to year for the same taxpayers, thus making assessment of the risk of noncompliance associated with an issue or a taxpayer more difficult.

Goals of Schedule M-3

* Increase transparency while minimizing overall taxpayer burden.

* Reduce the time required to examine tax returns and be in a position to examine the most recent tax returns filed.

* Provide consistent reporting among taxpayers and from year to year for each taxpayer....

* Periodically modify the form to highlight emerging issues, identify trends, and adapt to future changes encountered by large and mid-size corporations....

* Facilitate the use of Limited Issue Focused Examination (LIFE) audits through greater transparency. (1)

General Comments

TEI shares the goal that the Treasury and IRS adopt methods to reduce the time required to examine tax returns and be in a position to examine the most recent tax returns filed much sooner than in the past. However, TEI has significant concerns about certain aspects of the proposed Schedule M-3 that should be addressed before it is adopted. TEI recommends a delay of a year in the effective date of the filing requirement. Most importantly, TEI recommends a longer transition period before the requirements of column (A) of Parts III and IV are imposed upon taxpayers. (Column (D) is also problematic in similar ways for some taxpayers. See, e.g., the discussion below in regard to accrued liabilities included on Line 31 of Part IV.) During that time, the IRS and Treasury could review the data reported in columns (B) and (C) and make a more informed evaluation of whether column (A) (and, for that matter, column (D)) would be required. Given the cost of the changes necessary to complete the section, TEI submits the better course is to abandon column (A) of the Schedule.

TEI understands that the IRS intends the new Schedule M-3 to increase the currency and efficiency of audits by permitting a focused review within a relatively brief period (e.g., ninety days) of the filing of a return. The data presented in the new Schedule M-3 are intended to identify high risk issues so that it might be possible to make a decision whether to audit one or more issues in the return, or to forgo review of the return altogether, within that analytical process and timeframe. The process clearly can have mutual benefits. Just as the IRS hopes these enhancements may make it possible to conclude audits on a more timely basis by focusing on fewer issues and then reallocating audit resources to the returns of other taxpayers, taxpayers are similarly hopeful the changes will enable a more expeditious closure of their tax return examinations, thereby reducing aggregate taxpayer burdens. In particular, the new process will optimally eliminate the need to file Form 8886 for book-tax differences over $10 million as mostly redundant, and similarly anticipate that the additional time required to prepare the new Schedule M-3 will reduce the time required to produce information relative to Schedule M-1 during the subsequent audit. If these savings are not fully realized, the new filing requirement will in most cases represent a substantial net increase in taxpayer resource requirements necessary to meet filing requirements. Accordingly, TEI urges the IRS and Treasury to consider amelioratory changes to the Schedule as discussed in the balance of this letter.

Further, compiling the specific information required by the proposed Schedule M-3 (together with a proposed effective date tied to tax years ending on or after December 31, 2004) will impose a substantial burden on taxpayers that must make substantial adjustments to their accounting and information technology systems to comply. As we explained at our January 23, 2004 meeting (during which several members described their companies' accounting systems and roll-up procedures), the process for accumulating the required information and transferring it to the appropriate lines on the Schedule is not simple and instituting and mandating changes in that process should be very carefully weighed against the associated costs. Many taxpayers have already begun their processes for 2004 under current rules and requirements, and consequently the proposed effective date for Schedule M-3 has a clear retroactive effect.

To be sure, a substantial amount of the desired information can be accumulated in automated systems, but effecting necessary changes in those systems, particularly in general ledger systems and company-wide charts of accounts will, notwithstanding significant investments of dollars and time, be difficult and in some cases even impracticable or perhaps impossible. Further, minimizing the amount of manual processing of information by tax department personnel in the interface between company financial accounting systems and tax return preparation software (e.g., data accumulation, preparation of reclassification and consolidating journal entries, and preparation of Schedule M adjustments), is important to reduce the significant amounts of personnel and other costs associated with the data accumulations, especially in large enterprises.

As explained in our meetings, the process involves much more than simply mapping information transfers from a general ledger account, if it currently exists, to particular inputs in tax preparation software. Taxpayers would be required to modify and redesign their compliance processes from gathering and analyzing book income/loss information to computing and describing book tax-differences to fit within the line item categories of the proposed form. For the data to be correctly mapped to the Schedule, accounting and ledger systems will have to undergo a significant transformation so that the desired information is gathered into a discrete location that can then be mapped to the Schedule. Then, every time there is a new item added to the Schedule, similarly expensive and time-consuming systems reconfigurations would be required. For the tax software to generate the correct form, all book accounts and tax adjustments would need to be remapped into the software. Implementing major changes within a tax return software system adds incremental cost, requires a significant amount of resources and effort, and usually takes multiple return cycles to perfect. Again, the 2004 effective date greatly exacerbates the problems as many taxpayers are currently mapping data into extant data modules and software, and by the time these requirements are set, there will be very little time to make necessary transitions.

These problems are particularly acute with respect to the entries that must be made in Schedule M-3, Parts III and IV, column (A). Completing column (A) may in many cases be very difficult because, in addition to other factors, taxpayers currently categorize book income and deductions in the line item categories of Form 1120, page 1, which are very different from the line item categories included in the proposed form.

The current practice for preparation of certain lines of the tax return may in some cases be to simply reverse the gross balance of a particular book general ledger account and input the manually computed taxable amount into the return. The simple difference is a Schedule M-1 adjustment. In others, detailed tax ledgers are kept, for example, with depreciable assets, so that more complex computations can be made with regard to specific assets and transactions.

In contrast, to provide the information required by the lines in column (A) in an efficient manner, the book account balances must contain the specific information requested. That is, an account must be specifically provided for the needed information because if it is amalgamated with other transactions that may be similar for business purposes but that carry different tax treatments, the difficulty of extracting the information from the mass of transactions in the ledgers of many business units and subsidiaries becomes extraordinarily time-consuming and difficult. Many of the line items of income and expense in the Schedule are not currently included in separate general ledger accounts. In order to electronically (or manually) identify the income statement amounts of these items, taxpayers would need to set up separate ledger accounts and instruct numerous people regarding their proper use. Since these accounts would only have significance for tax return purposes, adherence to the instructions may be inconsistent. For example, in regard to Part III, lines 2 and 5, non-tax company personnel and outside contractors would have no idea whether dividends were previously taxed or not.

Although many companies have a common chart of accounts for consolidated financial reporting purposes, determining the specific book income/loss that relates to the line item categories required on the proposed form would require analysis at the transaction level using the underlying general ledger transaction system. The more complex an organization in terms of structure and acquisition activity, the more likely that there will be multiple general ledger and accounting systems and charts of account. For companies with operating units on multiple general ledger systems that do not use uniform account numbers and descriptions, the process of amending those accounting systems and accumulating the necessary information for preparation of column (A) would require a very significant amount of incremental effort. Further, it is not clear why these accumulations of specific book income data would be helpful, since they are compiled on the basis of accounting rules for disclosure in public financial statements and management reports that are not necessarily relevant to the determination of taxable amounts.

One of the described goals of the Schedule is to "[p]eriodically modify the form to highlight emerging issues, identify trends, and adapt to future changes encountered by large and mid-size corporations." This is understandable since the principal use of the form is to allow an informed decision on audit functions and resources to be devoted to it. Given the problems that taxpayers face in adapting their systems to provide the required information, however, it is absolutely necessary that the design of Parts III and IV of the Schedule be done with careful thought and attention to the issues to be examined and, perhaps more important, that changes occur only infrequently and with similar attention to the consequences of such actions.

There remain a number of questions about how the new form will interface with Schedule L of Form 1120. References to Schedule L note that the balance sheet numbers should correspond to the taxpayer's financial statement amounts used for the Schedule M-3 not the tax-basis balance sheet amounts, and presumably include full consolidation accounting rather than a combination approach to aggregating the numbers. Particularly for those taxpayers that qualify for special accounting methods for tax purposes (e.g., under section 448), using a method other than that used to prepare the tax return will be very cumbersome and will not be as easy to reconcile or tie out. TEI suggests that companies be allowed to elect to complete Schedule L using the same overall accounting method that they use to file their tax returns (e.g., use of combined tax-basis books) or using the basis upon which their financial statements are prepared. To do otherwise would be unnecessarily burdensome to taxpayers without apparent benefit to the IRS. Further, the Schedule should be limited to companies in the consolidated group. Auditors are accustomed to balance sheet based examinations, and including non-consolidated entities may be confusing and result in numerous unnecessary questions and Information Document Requests.

In summary, TEI commends LMSB for its efforts to achieve currency in audits of corporate taxpayers and to focus its resources on those issues of most concern to the government while minimizing taxpayer burden. Proposed Schedule M-3 has the potential to advance these goals, but its design and implementation must take into account a number of issues before it will be effective and before it should be adopted. This may in fact be a first step toward fundamental refinement and updating of Form 1120 itself, with Schedule M-3 possibly becoming the operative form (by reconciling worldwide book income to consolidated book income and then adjusting that amount by book-tax adjustments to obtain taxable income, followed by a tax calculation).

Specific Comments and Questions on Draft Schedule M-3

TEI has engaged in an ongoing series of discussions with IRS and Treasury in regard to the development of proposed Schedule M-3. In the course of these discussions, individual TEI members have made comments more fully discussed in the balance of this letter.

Part I:

Question 1. Source of net income.

The Schedule and instructions should clarify that the top parent in the consolidated return is the one the taxpayer should look to for the hierarchy of book income. For example, what is the starting point if the consolidated group consists of a U.S. parent company with audited financials, a US subsidiary with an SEC Form 10-K, and another U.S. subsidiary with audited financials. Does it make a difference if the subsidiary with the Form 10-K is the largest company in the consolidated return in terms of operations, revenues, income, or assets?

For foreign-owned U.S. companies, the form and instructions should similarly make it clear that the financial statements would be those of the U.S. parent company of the U.S. consolidated group. Thus, the instructions should include an example in which the worldwide group has U.S. GAAP financial statements and confirm that the worldwide financial statements would not be the point of reference; instead, the financial statements of the U.S. parent would be the only ones considered. It is also likely that many foreign owned companies will not have U.S. financial statements for their U.S. operations, such that the "best" income statement may be a reporting package that goes to the foreign parent or simply the U.S. books and records. The Schedule and accompanying instructions should address these other situations.

The instructions should also clarify whether one Schedule M-3 is prepared for the consolidated group or whether all members of the consolidated group must complete their own Schedule M-3 (Parts III and IV only). (2) The instructions currently refer to a supporting schedule. Does this mean that the consolidated numbers are shown on the Schedule M-3 and there is simply a consolidating supplemental schedule? This would be the preferred approach.

Furthermore, several corporations in the affiliated group may be required to file their own SEC Form 10-K (e.g., for debt covenants). The instructions should specify that only one consolidated Schedule M-3 need be prepared using the parent company's SEC Form 10-K.

Regulated industries, including utilities and financial companies like banks and insurance companies, present a number of special issues. For example, insurance subsidiaries are regulated by the state insurance departments and file a separate statutory Annual Statement (STAT) in the states where the insurance company is licensed. The STATs are prepared in accordance with National Association of Insurance Commissioners (NAIC) statutory accounting principles. Consolidated STATs for all life and property and casualty insurance companies in the affiliated group are not required by the NAIC. Non-insurance subsidiaries of the consolidated group prepare their financial statements on a GAAP basis.

Further, insurance companies report taxable income on special tax forms. Property and casualty insurance companies use Form 1120PC, and life insurance companies use Form 1120L. There are substantial differences between these forms and Form 1120. Because of these differences, some companies currently perform a "bottom line" consolidation of taxable income because the income statement lines are not consistent between forms. In addition to the mismatch of income statement lines, adjustments result from the consolidated return rules that limit the offsets of income and deductions between life and non-life companies.

Under the Internal Revenue Code, insurance companies are required to use Annual Statement statutory income as net income per the books in computing taxable income. The consolidated net income per income statement on line 1 of Part II, Schedule M-3 will be based on the SEC Form 10-K for publicly traded corporations, prepared in accordance with GAAP. However, the net income per the income statement for insurance companies is based on the STAT. Therefore, the aggregate of the net income per books for insurance companies and non-insurance affiliates will be a combination of STAT and GAAP income statements. The IRS should clarify whether individual insurance companies must prepare a Schedule M-3 and if so, must revise the Form 1120L and 1120PC tax returns accordingly. In addition, the instructions should clarify whether differences between GAAP net "income and STAT net income for each insurance company, commonly referred to as GAAP to STAT adjustments, need to be reflected in the Schedule M-3 reconciliation to the parent company's Form 10-K. One suggestion is that GAAP to STAT adjustments be reported on line 7 of Schedule M-3, Part II. Since each insurance company can have numerous GAAP to STAT adjustments, it is strongly recommended that a single GAAP to STAT adjustment be computed for each insurance company on line 7.

The balance sheets on Form 1120 and 1120PC are identical, but GAAP numbers may be reported for noninsurance members and statutory numbers for insurance subsidiaries. Schedule L on Form 1120L requires the use of tax basis of all assets except real property and stock where fair market value is to be used. Liabilities and the capital section of the balance sheet are reported using statutory accounting values. Needless to say, the 1120L balance sheet does not "balance."

Question 3. Restatements.

Restatements of financial statements are now commonplace due to acquisitions, dispositions, and other like events. Unless this information is also intended to be developed from the responses, question 3 should be revised to apply only to situations where restatement is required due to mistake, fraud, or other similar circumstances.

Affirmative responses to Question 3 are to be accompanied by attached details. Is attaching a copy of disclosure from the appropriate section of Forms 10-Q or 10-K sufficient for this purpose?

Different Book and Tax Years.

The form and instructions should clarify how the information should be recorded on the lines in this section for companies with book years that differ from tax years. It would seem to make more sense to add X months or subtract X months of full data and then pull out foreign amounts and other adjustments separately from the initial 12-month amounts and then to do the same for the months being added or subtracted.

Part II:

Excluded and Unconsolidated Companies.

It appears that the entire income of excluded companies is included on lines 2 and 3, and then the minority interest is backed out on Line 5. Does this approach make the reconciliation more complicated than it needs to be? What supporting data must be included? To what degree is netting permitted?

Will the financial statement income of unconsolidated U.S. affiliates with different income statement and tax years be backed out on line 3 based on its income statement year or will such income be backed out based on its tax year (which can then be traced to its separate return) with an appropriate adjustment made on line 6?

Top-side adjustments.

Line 7 will include all top-side adjustments. These adjustments often record book reserves for plant closings, business disposals, etc., which have no tax effect in the current year. In subsequent years, when the events actually take place and become reportable for tax purposes, the entire loss is currently reported via Schedule M in a lump sum. How would these amounts be allocable to particular lines in column (A) of new Schedule M-3? Would they instead be shown as an adjustment in Part II?

Parts III and IV:


TEI strongly encourages consideration be given to whether a concept of materiality (either by dollar amount or percentage of income, assets, etc.) could be applied to determine the items which should be separately reported on Schedule M-3, Parts III and IV. Such a rule might allow the administrative simplification of allowing some netting of smaller schedule M adjustments, for example, on lines for "other" items.

Lines 7, 26, 29, and 30 of Part III and Marketable Securities Portfolios.

The instructions for lines 1 through 8 require taxpayers to provide the payor's name, Employer Identification Number (EIN), and amount of the item of difference for each corporation. This may be more appropriate for business affiliates and subsidiaries than for passive investment assets. For a corporate taxpayer with a large portfolio of marketable securities, these requirements may necessitate the accumulation of significant amounts of new information that is not currently collected for such short-term investment assets. Some subsidiaries may account for dividend income on the cash method for tax reporting and on the accrual method for books. This method difference will require a Schedule M-3 adjustment. This instruction requires the taxpayer to attach a schedule listing the amount of this adjustment, along with the EIN, for each corporate payor.

The GAAP calculation of discount amortization on marketable securities simply takes into account the difference between purchase cost and maturity value. It makes no difference whether that discount arose at issue or because of changes in market interest rates. Original issue discount on line 26 is strictly a tax concept. Some accounting systems do not break out this number on a GAAP basis, and the computation of it may be difficult.

Lines 29 and 30 require gross capital gain and loss information. Some large portfolios of marketable securities are accounted for on a purchase lot level and thousands of lots are sold each year. The investment system may sort book-tax differences by sale lot for purposes of producing Schedule M items. For example, such a system may analyze each lot sold to capture each element constituting the overall book-tax basis difference for that particular lot: amortization methods, nontaxable exchanges, and so on. Each element of difference for each lot would be reported in a separate Schedule M-1 adjustment. The adjustment for book-tax difference in the method of computing premium amortization would include a detailed listing of each lot sold with such a basis difference. The same would be true for all lots that were the subject of nontaxable exchanges, etc. All lots would be summed and reported as an overall debit or credit adjustment. To comply with Schedule M-3, the taxpayer would first have to separate the debits and credits according to whether there is a gross gain or a gross loss on the transaction. If a security sale were a loss for financial reporting but a gain for tax reporting, the taxpayer would have to do reclassification entries to get all the amounts on the correct lines. If a security sale were a loss for financial reporting but a gain for tax reporting, does the financial reporting capital gain go on line 27, all book to tax differences on line 28 (whether debits or credits since there is an overall tax loss), and then a reclassification entry is shown on both lines 27 and 28 to arrive at the correct gross tax loss? In a multi-billion dollar portfolio, these changes are not simple to accomplish and do not change the tax result.

Do lines 29 and 30 include the net section 1231 gain amount? The determination of the tax character of section 1231 sales can only be done after all the separate returns are completed. Literally hundreds of individual sales will be included in this category. Accounting systems may not segregate such sales by gain or loss. To do so when there is a net section 1231 gain will require a re-analysis and rerun of the return information for every member of the consolidated group that has a section 1231 sale.

Lines 9 and 10 and Partnership Income.

Lines 9 and 10 of Part III create questions on how to report partnership items. Is there to be a new Schedule M-3 for filing with Form 1065? How would the reporting for this line be coordinated with the more detailed reporting for partnerships? Would it be appropriate to postpone the requirements of these lines until the requisite partnership schedules are completed? This would be especially appropriate if it is intended that the taxpayer report on the underlying partnership items (i.e., a look-through approach).

Column (A) would presumably show the amount of partnership income reported in the taxpayer's book income, if any. The next two columns request the temporary and permanent tax adjustments. The detail of a partner's proportionate share of a partnership's temporary and permanent tax adjustments may not be available to the partner. The instructions should be clarified to explain how to report the differences on columns (B) and (C) if sufficient detail is not available to determine whether the differences are temporary or permanent. In addition, there may be multiple temporary differences and multiple permanent differences. The instructions should indicate whether all temporary differences should be added together to be reported in column (B) and all permanent differences added together to be reported in column (C). Additionally, if the partnership's book income has not yet been reported for book purposes by the partner or if there are special allocations of book income/expenses, how should such items be reported (e.g., as temporary differences)?

If a look-through approach is adopted, is it intended that a partner's proportionate share of identified line items like depreciation be moved to line 29 of Part IV rather than netted on lines 9 and 10 of Part III?

Line 15 and Like-Kind Exchanges.

If a corporation separately reports a sale and a purchase for financial statement purposes and a portion of the transaction qualifies for like-kind exchange treatment for federal income tax purposes, is a taxpayer expected to bifurcate the financial reporting gain and report a portion in column (A) of line 15 with the balance in column (A) of line 29? Separately, is it intended that a taxpayer only use line 15 in the year in which the transaction closes or in all subsequent years where depreciation or amortization differences attributable to a prior year like-kind exchange continue to affect the current year?

Line 20 and Form 8886.

Line 20, Part III requires taxpayers to attach details even though a Form 8886 is already required to be provided for reportable transactions and provides the detail needed. Discussion in our meetings talked of using a questionnaire to address specific information in the Form and emerging issues. Will Schedule M-3 be further expanded to encompass these requirements?

Comparable entries in column (A).

The proposed form requires book income (loss) to be captured and reported in categories defined by tax law. By default, many of these tax concepts do not exist for book purposes. The new instructions clarify what is required on Part III, lines 2-5. However, Part III, lines 14, 15, 16, 17, 21, 23, and 26-32, and Part IV, lines 14, 15, 26, 27, 31, and 33, do not have related financial statement categories. Taxpayers might attempt to compute an amount for column (A) or might enter zero. This would compromise consistency and comparability.

Inventory valuation adjustments.

Lines 18, Part III and 34, Part IV, are both described as inventory valuation adjustments. What should be reported on these lines? Inventory valuation adjustments might be a number of things including obsolescence reserves, lower of cost or market reserves, or other differences between book and tax. What is intended to be reflected here?

Income tax expense.

Part IV of the form is similar to Part III except it relates to expenses. Lines 1-6 will add significant complexity and time to the tax return process. While it is true that companies break out their income tax expense between current and deferred at the top disclosure level for the SEC filings, they do not always break it out on a company-by-company basis. Nor do they always break it out among state, foreign and federal tax expenses at the separate company trial balance level. Many companies put their combined income tax expense on their detailed trial balances and separate company income statements. They disallow this entire amount on the tax return and then deduct only the accrued or paid state income taxes. As proposed, lines 1-6 of the Schedule M-3 add considerable work to identify these items for each separate entity and the utility of the information is not clear.

The income tax expense complexity might be ameliorated by changing line 1 of Part II to start with worldwide net income, and adding new Lines 1a, 1b, 1c, etc., to add back worldwide federal, state, and foreign taxes to come up with a worldwide profit before tax as the final number of line 1. This ending line 1 number could then tie back to the 10K. Lines 2 through 7 then add back profit before tax (PBT) for the respective entities rather than after-tax net income. Line 8 then results in PBT for the consolidated U.S. group. Lines 1 through 7 of Part IV can then be removed. (3)

Partially-deductible expenses.

Clarification for the reporting of costs that have only partial book-tax differences would also be helpful. For example, some meals are fully deductible (like those reported on Form W-2 of a relocating employee) and some are only 50 percent deductible. Would all meals and entertainment expense be reported on Part IV, line 11? Would fully deductible meals and entertainment expenses be reported on Part IV, line 37 and 50 percent deductible meals and entertainment expenses be reported on Part IV, line 11? Separating the expenses into two separate lines on Part III or IV would add complexity for tax return preparation and tax software programming.

Accrued liabilities.

Line 31 of Part IV requires taxpayers to determine the book expense and tax deduction for columns (A) and (D) relating to accrued liabilities. This would be very difficult for the following reasons.

These liabilities are often part of accounts which are partially deductible (e.g., under the 8 1/2 month rule of section 461(h)). It would be difficult to bifurcate the liability and list the non-deductible portion in column (A) (if that is what is expected).

Further, most large taxpayers have a variety of accrued liabilities that are deductible upon payment for tax. The common and simple approach used to compute the book-tax difference for these accrued liabilities is to subtract the ending balance from the beginning balance in the accrued liability accounts. A positive result is a decrease to taxable income and a negative result is an increase to taxable income. This process works because debits to the account would be for payments and credits would be for book accruals. Thus a reduction in the account balance reflects more payments than accruals. An increase in the account indicates more accruals than payments for the year. This balance sheet approach to computing the book-tax difference for accrued liabilities has typically been employed where it is not practical to identify and track the specific book accrual entries, e.g., benefit expenses that are charged to a multitude of different manufacturing expense accounts.

If each accrued liability account had a single dedicated expense account (not used in connection with any other liability account), the book expense and tax deduction related to that liability could be easily determined. Typically, however, the liability account and the expense account do not include exactly the same items. The total book expense for a particular liability may be included in a variety of accounts or is subsumed in a large expense account that is used for a number of liability accounts. In such a situation, a new process for compiling book expense would need to be implemented to capture the amount to be reported for tax adjustments relating to accrued liabilities reported on line 31 of the proposed Schedule.

Unless separate sub-accounts are used to capture the accrued expense versus the payments and other adjustments to an accrued liability account, the only way to compute the expense versus the payments would be to review every transaction (journal entry) that was made to the accrued liability accounts. Most large taxpayers have simplified their account structures, eliminating additional sub-accounts, in an effort to streamline their accounting process. For large taxpayers, depending on the accounting systems used, this might involve reviewing and summarizing hundreds if not thousands of journal entries, which would significantly increase the workload. This additional analysis is typically not required to calculate a proper book-tax difference.

The following examples illustrate the difficulties of completing line 31.

Multiple miscellaneous accrued liability accounts are used in which numerous items are recorded across multiple business units using multiple expense accounts (e.g., manufacturing expense, administrative expense, other deductions). Currently, an information request is sent to the accounting staff asking for a description of the specific items making up both the beginning and ending liability account. (Some additional analysis and inquiry may be done to make sure the items affecting the balances result in a book-tax difference.) The book-tax difference can be computed using those balances. However, the absolute book expense and tax deduction are not separately identified but subsumed in the various expense accounts used. Employee benefit type expenses are accrued in various liability accounts, with many of these expenses being deductible when paid for tax. The expenses could be charged to manufacturing expense, engineering expense, or administrative expense among others. To compute the Schedule M adjustment, the difference between the beginning and ending balances in the liability accounts is used. However, the absolute book expense and tax deduction are not separately identified but subsumed in the various expense accounts used for hourly and salaried benefits. Getting this additional detail could be difficult and be of minimal value in computing an accurate Schedule M adjustment.

Another example is accrued shutdown costs. The beginning and ending balances may provide the Schedule M amount. The actual expenses related to this balance sheet account consists of many items, including salaries, severance, rent, utilities, security, cleaning expenses, supplies, equipment maintenance, inventory disposal costs, and so on.

Inventoriable costs is another area of difficulty in separately identifying book expense and tax deductions. Such costs are included on the ledger and mapped into the tax software without reflecting changes in ending inventory. The portion of a particular expense that is in book or tax inventory is not specifically identified in the accounts and is reflected in an overall inventory adjustment. Moreover, if a standard costing system is used, an over/under absorbed expense account is used to record variances that are not allocated to inventory. Thus having an accurate number for the accrued benefit expense and tax deduction is not possible without significant allocations that, even if affected, would appear to be of little value.

Other income (loss) items with differences.

The vast majority of Schedule M items would be reported on Part III, line 33, and Part IV, line 36 for many taxpayers. It would require major changes to general ledger accounts to electronically (or manually) identify the income statement amounts of these items. The problem is exacerbated by the fact that some companies are very decentralized and have numerous ledger systems feeding into the consolidated financial statements and tax return. Is it important to identify upfront the income statement amount of various items of income and expense, or is the book/tax difference the important factor in risk analysis?

Specific Comments and Questions on Particular Parts of Draft Instructions to Schedule M-3

Page 1--Specific Instructions for Parts I and II.

Part 1 of the proposed M-3 assumes that the taxpayer is a publicly traded company. However, there are companies filing with the SEC that are not publicly traded. Could the instructions be clarified to confirm that questions 4 and 5 only apply to publicly traded companies?

Page 3--Specific Instructions for Parts III and IV.

The instructions to Schedule M-3 note that Part II of the form does not need to be filled out by each separate corporation in the consolidated return (i.e., it is filled out at the consolidated level). The instructions also note that for Parts III and IV, supporting schedules should be filed for each includible corporation. We suggest that the instructions clarify that the note on the bottom of Part III that indicates that line 37, column (A) amount must equal the amount on Part II, line 8 applies only to the consolidated summary of Part III and does not apply to the separate Part III schedules that are to be completed for each includible corporation.

Page 3--Reporting Differences.

The definition of "item" is unclear. There is very little guidance on what netting of transactions or parts of transactions is allowable. Does it make a difference whether the item is a temporary difference or a permanent difference? Having a "no netting rule" could make the Schedule M-3 unreasonably complex. Consider a taxpayer with a number of asset leasing portfolios. Even though the transactions may be leases for book and tax purposes a number of differences may exist. The Schedule M-1 adjustment would typically be prepared utilizing automated reports generated by the company's leasing software. The software is programmed to appropriately account for the book and tax differences and produces an all-inclusive number for calculating the Schedule M-1 adjustment. The software does a significant amount of "netting" and unbundling the result would be a non-value added task. Note that the IRS audit approach to such an adjustment would likely be a detailed tracing of sample transactions through the system and other testing to confirm that the system is working as stated by the taxpayer. Usually no attempt is made to separate all the adjustments by item.

Page 3--Example 5.

The instruction references the amortization of goodwill for financial statement purposes even though goodwill is no longer amortized for financial statement purposes.

Page 4--Example 7.

How does one "separately state and adequately disclose the amounts "attributable" to the reserves?

The last sentence of the example requires pending litigation reserves and warranty reserves to go on Part IV, line 36 (Other expense/deduction items with differences). Should those items be reported on line 31, accrued non-deductible liabilities?

Page 4--Part III, Reference to lines 1 through 8, Additional Information for each Corporation.

The instructions require a supporting schedule that provides the name, EIN, and the amount of the item of difference for each corporation. Presumably "each corporation" means those paying dividends or for which equity income is being reported and does not mean each "includible" corporation. Otherwise, this would imply that a supporting schedule is not required for each of the lines unless specifically mentioned. Many of the lines from Parts III and IV are not discussed and there are no references to an attached supporting schedule on page 5 for Part IV. (The specific instructions on page 3 require the filling of a supporting schedule for each corporation but do not describe what should be included on the supporting schedule.)

Page 4--Reference to line 1.

The instructions require only an amount in column (A) for income statement income (loss) from any equity method foreign corporation; the instructions also require that any dividends from equity method foreign corporations be reported in column (D) of lines 2 through 4. The instructions do not require anything in columns (B), (C), or (D) of line 1. How does line 1, column (D) have no entry unless something is put in column (B) and (C) to offset the amount required in column (A)?

Page 4--References to lines 2, 3, 4.

The instructions require taxpayers to put amounts in column (D) (and column (A) for line 2) and no other columns. How does an amount get to (D) without entries in columns (B) or (C)?

The instructions for Part III, line 4, indicate that the amount of section 78 gross up should correspond to the total of the amounts reported on Forms 1118 and on all Forms 5471. As a technical point, we are not aware of any section 78 gross up amount being reported on Form 5471.

Page 4--Reference to Line 6.

The instructions require only an amount in column (A) for income (loss) from any equity method U.S. corporation, but also require that any dividends from equity method U.S. corporations be reported in column (D) of line 7. The instructions would have taxpayers put no entry in column (D) of line 6 but also show no entry in columns (B) and (C). How does column (D) have no entry unless something is put in column (B) and (C) to offset the amount in column (A)?

Page 5--Reference to Line 7.

The instructions require U.S. dividends included in taxable income on Form 1120, page 1, line 28, to be included in column (D). The instructions do not require an entry in columns (A), (B), or (C). It would seem that an entry in column (D) should be supported by an entry in columns (B) or (C)? (Although Page 3, General Format of Parts III and IV, discusses the general requirement that columns (B) and (C) be completed when there are differences between columns (A) and (D), the fact that these columns are mentioned in some examples but not in others may lead to confusion.)

Page 5--Reference to Line 7.

The instruction does not mention dividends from domestic corporations that may be included in Part II, line 8 and, accordingly, would be required in column (A) of line 7 (e.g., dividends from non-equity method corporations). This line should parallel line 2.

Page 5--Reference to line 11.

Would this include a grantor trust? Many companies do not recognize the trust for financial reporting purposes either, so the elements of income and expense are spread throughout the accounts.

Page 5--Reference to Line 29.

The instruction refers to lines 18 and 34 as lines in which depreciation may be reported elsewhere on Schedule M-3. Lines 18 and 34 are described as inventory valuation adjustments. What type of depreciation would be reported as part of inventory valuation adjustments? Although depreciation may be included in additional costs capitalized into inventory for tax purposes, the depreciation component of the additional costs is typically not segregated and computed separately.


TEI concurs in the importance of Treasury and IRS goals to adopt methods that reduce the time required to examine tax returns and to be in a position to examine the most recent tax returns filed much sooner than in the past. The efforts in recent attempts to "think outside the box" such as the design of new proposed Schedule M3 are significant to the realization of those goals.

Certain aspects of the current proposal, however, continue to be of concern and should be addressed prior to its adoption. Further, TEI has real concerns with the adoption of Schedule M-3 (at least Parts III and IV) this year, inasmuch as that taxpayers will have little or no time for completing the necessary systems changes and that current year data is already being processed in existing systems. Hence, we recommend a delay of a year in the effective date of the filing requirement. At the least, TEI recommends a longer transition period beyond that for the imposition of general filing requirements of Schedule M-3 before the requirements of column (A) of Parts III and IV are imposed upon taxpayers. Column (D) is also problematic in similar ways for some taxpayers. See, e.g., the discussion above in regard to accrued liabilities included on Line 31 of Part IV. During that time, the IRS and Treasury could review the data reported in columns (B) and (C) and make a more informed evaluation of whether column (A) (and, for that matter, column (D)) would be required. This evaluation would compare the IRS' benefits of obtaining this additional data to the taxpayers' costs and burdens involved in making changes to enable them to complete these columns. Given the cost of the changes necessary to complete this portion of the Schedule, TEI would recommend that the requirement for column (A) ultimately be abandoned.

Any questions about the Institute's views should be directed to either Timothy J, McCormally, TEI Executive Director, or Fred F. Murray, the Institute's General Counsel and Director of Tax Affairs, at 202.638.5601.

(1) Press Release, U.S. Treasury Department, Office of Public Affairs, Treasury and IRS Propose New Tax Form for Corporate Tax Returns (January 28, 2004).

(2) During our meetings, IRS staff have referred to the IRS electronic filing program, suggesting that inputs for e-filing may require a "stacked" approach, i.e., a separate Schedule M-3 (Parts III and IV only) for each subsidiary company included in the return. If this is expected, it is important to coordinate those requirements so that taxpayers can address necessary changes in their systems and do so only once.

(3) This suggestion may throw Schedule L into disarray. Using this format a taxpayer would not report net income for the consolidated U.S. group. Net income on the Schedule M-2 would therefore not tie to anything and Schedule L would not have a reference point for Retained Earnings. Should Schedule L be changed to be Form 10-K worldwide numbers rather than the U.S. consolidated group? Tying retained earnings in Schedules L and M-2 to the Form 10-K gives greater consistency.
COPYRIGHT 2004 Tax Executives Institute, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2004, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
Printer friendly Cite/link Email Feedback
Publication:Tax Executive
Date:May 1, 2004
Previous Article:TEI comments on LMSB record retention initiative: April 8, 2004.
Next Article:Tei comments on clarification of PE definition: June 7, 2004.

Related Articles
Canada's foreign affiliate rules.
Proposed check-the-box regulations under Section 7701.
Requiring CEOs to sign corporate tax returns: June 11, 2003.
All VAT and more: TEI responds to the European Commission on place of supply rules for services: also urges Canada to adopt group loss rules and...
Elimination of the federal capital tax: June 19, 2003.
Implementation of a formal loss transfer system: June 20, 2003.
TEI welcomes spring with a shower of technical activities: comments filed on 2004 Act, e-filing mandate, and auditor independence, withholding, and...
CEO declaration in respect of a company's tax return: May 12, 2005.
Tax Executives Institute - U.S. Department of Treasury Office of Tax Policy liaison meeting: February 8, 2006.
Tax Executives Institute-large and mid-size business division-liaison meeting minutes: February 7, 2006.

Terms of use | Privacy policy | Copyright © 2022 Farlex, Inc. | Feedback | For webmasters |