PwC alternatives alert, February 12, 2010

IRS proposes new tax return disclosure of uncertain tax positions: Potential impact for fund managers

Introduction

On January 26, 2010, the IRS released Announcement 2010-9, which states that the Service is considering a requirement that business taxpayers disclose uncertain tax positions (UTPs) as part of their tax return. The IRS is developing a schedule to attach to the tax return. For taxpayers who prepare their financial statements under US GAAP, the schedule would include all UTPs for which a reserve has been recorded under ASC 740-10 (FIN 48). Taxpayers not subject to FIN 48 would be required to disclose the UTPs for which a reserve has been recorded based upon other applicable accounting standards (e.g., International Financial Reporting Standards [IFRS]). In addition, disclosure would be required for any UTP for which a reserve was not established, either because the taxpayer expects to litigate the position or because the taxpayer has determined that the IRS has a general administrative practice not to examine the position.

Taxpayers will be required to disclose UTPs which may be reflected in their own books and records or financial statements, or in the books and records or financial statements of a related domestic or foreign entity. The new disclosure requirement would apply to business taxpayers with assets totaling more than $10 million. The proposed effective date would apply to tax returns filed after the release of the new schedule. We understand, however, that the IRS will provide that the requirement will not apply to 2009 tax returns.

Affected taxpayers would be required to provide a concise description of each UTP and the maximum potential federal tax liability attributable to each uncertain tax position. This disclosure would be made on the schedule and filed with Form 1120, US Corporation Income Tax return, or other business tax return. The Service has requested comments on the disclosure initiative. Comments are due by March 29, 2010.

Potential Impact to Fund Managers

The Announcement as released is generally geared toward corporate tax return filers. Given the predominant use of partnerships in the asset management industry, it is not entirely clear to what extent the disclosure requirements would apply, as partnerships do not pay federal income tax. In addition, fund managers utilize different structures with varied legal entities (e.g., fund vehicles, feeder entities, management companies, special purpose entities) that may have separate tax returns and disclosure requirements. As a result, the application may impact individual asset managers differently. The following Q&As provide some insight into the issues that may affect the application of the disclosure requirement.

Q: Does the requirement for disclosing UTPs apply to partnerships?

A: We believe so, though to what extent the requirement applies is not clear. The Announcement specifically refers to corporate tax returns and "other business tax returns." We expect that the disclosure requirements will apply to partnerships at least to the extent such entities have UTPs with respect to their possible federal income tax liability (e.g., if there was an exposure related to publicly traded partnership issues).

It is still unclear whether uncertain tax positions that impact only an owner's tax return (e.g., timing of an item of income or deduction, or write-off of a worthless security) will also be required to be disclosed in the partnership tax return or the owner's tax return; this is an area that will likely be the subject of comment letters and future guidance by the IRS. Partners are currently challenged in gathering information on UTPs for FIN 48 purposes, which are not provided for at the partnership level; partners may have the added challenge of gathering information the IRS requires as disclosure. Similar challenges may be faced by funds of funds.

Q: Does the Announcement affect UTPs related to non-income based taxes, state taxes, or foreign taxes?

A: The Announcement only refers to positions that affect US federal income tax liability; non-income based taxes (e.g., excise or payroll withholding taxes) are not included. A taxpayer filing a US tax return would not need to disclose UTPs related to state or foreign income taxes unless the position impacted some element of the taxpayer's federal tax liability (such as foreign tax credits or deductions). Some states may decide to add disclosure requirements, in order to obtain similar information being provided to the IRS, in the same manner that certain state taxing authorities developed reportable transaction requirements similar to the IRS required disclosures.

Q: What positions will need to be disclosed on the required schedule?

A: Announcement 2010-9 requires disclosure for all UTPs for which a reserve was established by the taxpayer. In addition, disclosure is required for UTPs that do not have a reserve established either because the IRS has an administrative practice not to raise an issue on examination, or because the taxpayer expects to litigate the issue if needed. We would expect these two additional categories to apply in limited and unusual circumstances.

Q: What information needs to be disclosed on the required schedule?

A: The taxpayer will need to provide a brief, clear description of each UTP and the maximum amount of potential US federal income tax liability attributable to each. The amount is to be determined without regard to the taxpayer's risk analysis regarding the likelihood of sustaining the position or reserved amount. The description must contain the following:

a) The Code sections potentially implicated by the position
b) A description of the taxable year or years to which the position relates
c) A statement that the position involves an item of income, gain, loss, deduction, or credit against tax
d) A statement that the position involves a permanent inclusion or exclusion of any item, the timing of that item, or both
e) A statement defining whether the position involves a determination of the value of any property or right
f) A statement regarding whether the position involves a computation of basis

Q: If an entity files a protective return with the IRS, is disclosure of UTPs required?

A: A foreign entity in a fund group may file a Form 1120-F protective return to initiate the statute of limitations. The return also will protect the entity's ability to take deductions against US-sourced income if the IRS successfully asserts that the entity is engaged in a trade or business in the US and subject to US tax. The Announcement does not specifically address disclosure of UTPs on a protective return, but appears to require such disclosures.

Q: How will the disclosure requirement apply in the context of related entities? Will the same disclosure need to be included in each return?

A: The Announcement appears to require multiple disclosures if the same UTP impacts federal tax liability in several related-party tax returns.

Q: Does the disclosure apply only to permanent differences, or to both permanent and temporary differences? If the permanent or temporary difference is recurring, does the disclosure cover only the year for which the return is being filed, or all years?

A: The Announcement indicates that all UTPs, whether permanent or temporary, must be disclosed. If a FIN 48 liability is established on a deferred item, it would appear that the UTP would not be disclosed until it impacts a current tax liability. The IRS has requested comments regarding whether the disclosure of the maximum tax adjustment should relate solely to the tax period for which the return is filed or to all tax periods the position references.

Q: Is disclosure required for UTPs that are identified in a subsequent tax year after the item was reported on a tax return?

A: The Announcement does not specifically address this issue. The IRS has requested comments on how the new schedule should address taxpayers who initially did not record a reserve for an issue but in later years do record a reserve.

Q: What if a foreign feeder does not file financial statements on a US GAAP basis?

A: The Announcement refers to FIN 48, IFRS, and "country-specific generally accepted accounting standards." Thus, disclosure would be required of uncertain US federal tax positions, whether or not the taxpayer files financial statements on a US GAAP basis. IFRS does not contain the term "UTP" and does not have a direct equivalent of FIN 48. IFRS, however, does contain a broadly applicable standard covering accounting for income taxes, which would seem to fall within the scope of the Service's required disclosures. It is unclear whether the disclosure requirements would apply if an entity does not prepare financial statements or does not prepare them in accordance with GAAP (e.g., cash basis or tax basis).

Q: Will the IRS request tax-accrual work papers in every examination?

A: While the Service has proposed requiring disclosure of UTPs with business tax returns, it has stated that the long-standing "policy of restraint" will otherwise remain in force. The Service believes it has the authority to compel taxpayers to turn over tax-accrual work papers during an examination, but will only do so in specific circumstances, such as failing to disclose participation in a tax-shelter transaction.

Conclusion

The proposed disclosure requirements relating to UTPs in Announcement 2010-9 could substantially increase the amount of time taxpayers spend preparing their business tax returns. Taxpayers should consider the potential impact of the requirement on their operations, investment decisions, and tax accounting and reporting processes. The Service is also evaluating additional options or sanctions to be imposed when a taxpayer fails to file or fails to make adequate disclosure of the required information regarding UTPs. Among the options the IRS is exploring is new legislation to ensure compliance. We encourage you to consult your PwC tax advisor or engagement partner if you have further questions regarding this Announcement.