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March 30, 2011

In theory, the relationship between Congress, the Internal Revenue Service and corporate taxpayers is relatively simple. Congress enacts tax legislation, corporate taxpayers apply the Internal Revenue Code to their operations, and the IRS enforces compliance with Congress’ rules. Since the ratification of the 16th amendment authorizing the federal income tax in 1913, corporate taxpayers and the IRS have not always interpreted the Code — or, more specifically, the application of the Code to a corporate taxpayer’s particular facts — in the same way. Industries have employed lobbyists, and throughout history Congress has enacted special-interest tax legislation to encourage particular investments by certain taxpayers or industries. At the same time, the IRS has promulgated regulations and issued rulings attempting to define its interpretation of Congressional intent embodied in the Code. To round out the picture, the courts have refereed disputes between corporate taxpayers and the IRS, sometimes in conflicting ways. All this has led to a complex fabric of Code, regulations, administrative rulings and court opinions that Senator Kent Conrad (D-ND), chair of the Senate Budget Committee, described recently as a “Chinese riddle” that only a “contortionist” could deal with.

A review of corporate income tax receipts shows that, as a percentage of U.S. gross domestic product (GDP), tax receipts have been dropping since the early 1950s. Many in government have lamented that there is a “tax gap” created by noncompliant taxpayers, including corporations, who contribute to the reduction in corporate income tax collections by the U.S. Treasury. For its part, the IRS has taken various administrative steps to require corporate taxpayers to be more transparent in reporting the tax effects of their transactions.

In recent times, the IRS has been busy introducing additional reporting requirements for corporate taxpayers. In response to tax shelter legislation in the early 2000s, the IRS began requiring tax shelter registration reporting and the disclosure of certain transactions, known as reportable transactions. Additionally, the IRS introduced Schedule M-3 in 2004 to require corporate taxpayers to disclose more information about the differences between book and taxable income. This year, corporate taxpayers are required to file Form UTP with their income tax returns disclosing all their uncertain tax positions. (See Tax Advisory Weekly, Special Edition, “” January 27, 2010; Issue 25, “” June 22, 2010; Issue 37, “” September 16, 2010; and Issue 46, “” November 16, 2010.) The revamping of the penalty provisions has also led to more disclosure requirements for corporate taxpayers.

The courts have also played a significant role in changing the landscape for corporate taxpayers. Last year, the Supreme Court denied certiorari in U.S. v. Textron, passing on an opportunity to address the debate over claims that tax accrual workpapers contain information protected by the work product doctrine. (See Tax Advisory Weekly, Issue 22, “” June 1, 2010; Issue 13, “” April 1, 2009; and Issue 37, “” September 17, 2009.) While the Supreme Court took a pass in Textron, the D.C. Circuit decided a case involving a claim that meeting notes taken by the company’s financial statement auditors may contain information protected by the work product doctrine, ordering the lower court to perform a review of the meeting notes for such information (U.S. v. Deloitte, 610 F.3d 129, D.C. Cir. 2010). And, in a widely discussed ruling, the Tax Court rendered a scathing opinion last August in Canal Corp. v. Comm’r, 135 T.C. No. 9 (August 5, 2010), rejecting the taxpayer’s claim that it relied reasonably and in good faith on an opinion of its Big 4 accounting firm addressing the tax treatment of a particular transaction found by the court to be a disguised sale of a partnership interest (see Tax Advisor Weekly, Issue 32, “” August 12, 2010).

These recent moves by the IRS, Congress and the courts are arguably delayed attempts to curb perceived abuses by corporate taxpayers and their advisors to circumvent the Code. Indeed, the Commissioner of the IRS stated last year during discussions about Form UTP that one of the form’s purposes was to reduce the tax gap. A more pessimistic view of these developments is that the government perceives corporate taxpayers and their tax advisors as the real cause of the tax gap. Indeed, President Obama gave credence to this theory in his State of the Union address when he noted that “a parade of lobbyists has rigged the tax code to benefit particular companies and industries” and that those companies with “accountants or lawyers to work the system can end up paying no taxes at all.”

Time will tell whether the IRS’s initiatives for more transparency in corporate tax reporting are successful. In response to the proposed Form UTP, many commentators argued last year that the IRS’s previous attempts at disclosure (reportable transaction disclosure, penalty disclosure and Schedule M-3) generated massive amounts of information at great administrative cost to taxpayers, but without any noticeable increase in tax collections or assessments by the IRS. But there can be no doubt that any true closure of the tax gap rests in the hands of Congress.

The United States’ budget deficit is staggering — $1.3 trillion for fiscal 2010 alone. That represents about nine percent of GDP. Meanwhile, corporate tax receipts are at their lowest point in 60 years, amounting to about 1.3 percent of GDP in the 2010 budget. Further, the current Internal Revenue Code contains about $1.1 trillion in tax “expenditures,” leading Senate Budget Committee Chairman Conrad to remark during committee hearings on March 9, 2011, that “eliminating or scaling back tax expenditures should be at the heart of any tax reform we consider.”

In December, the President’s bipartisan National Commission on Fiscal Responsibility and Reform (“Fiscal Reform Commission” or “Commission”) issued its report, titled “The Moment of Truth,” wherein the Commission calls for sweeping tax reform to address the mounting budget deficit. In the report, the Commission cites a need to close the tax gap as support for its tax reform proposals. In his State of the Union address on January 25, 2011, President Obama called for an overhaul of the Code. He called on Congress to simplify the tax system, get rid of the loopholes and lower the corporate tax rate to bring it more in line with corporate tax rates around the globe.

The Fiscal Reform Commission, the President and various lawmakers on both sides of the aisle agree that the U.S. corporate tax rate must be reduced to make it more competitive in the global economy. The debate about how to change our system of international taxation continues as this article goes to press. But there seems to be a recognition that corporate tax reform, including international taxation, must include a simplification of the Code, a broadening of the tax base (i.e., an elimination of deductions, credits and incentives) and a lowering of the rate (see Tax Advisory Weekly, Issue 8, “” February 23, 2011). These actions are seen as necessary to close the tax gap and, ultimately, to reduce the budget deficit.

Congressional action to reform our corporate tax system appears more likely with each passing day. We know that tax provisions will be impacted in the period in which any law change goes into effect. (See Tax Advisor Weekly, Issue 8, “” February 23, 2011, for more on the tax provision impacts of tax reform legislative changes.) Corporate taxpayers in net deferred tax asset positions will feel the sting of additional expense if the corporate rate is lowered. And while those corporate taxpayers in net deferred tax liability positions will have a benefit roll through their income statements in the quarter of adoption, the deferred tax assets on the books will turn at a lower rate and be less valuable to the company than before the rate change. So the obvious approach to mitigate the impact of a corporate tax rate drop is to begin planning now to reduce the deferred tax assets in the company’s inventory. Tax directors still have time before Congress acts to reduce the corporate tax rate to revisit tax accounting methods to make sure the company is appropriately treating its various timing items. Of course, each company will have to look at its specific tax attributes to determine a best course of action. Those with large net operating losses sitting in their deferred tax asset inventory may want to look for ways to accelerate income into periods before an enacted rate change. Similarly, corporate taxpayers for whom the IRC Section 199 deduction is significant may want to consider maximizing the deduction now by deferring deductions affecting the IRC Section 199 calculation, since repeal of IRC Section 199 is on the table in the current corporate tax reform discussions. Consideration should also be given to utilizing any tax credits before Congress acts to lower the corporate tax rate, as previous rate reductions have been accompanied by commensurate reduction of credits utilized after the rate reduction goes into effect.

Alvarez & Marsal Taxand Says:

Generally, transparency in corporate tax reporting is a commendable goal. There seems to be an air of hostility in government toward corporate tax directors and their advisors, seen as major contributors to shrinking corporate tax revenues. Closing the tax gap, however, must be accomplished through legislative changes to our tax system. Recent activity in Washington suggests that corporate tax reform is an integral part of addressing our country’s deepening budget deficit. We should not, as so eloquently stated by Senator Tom Coburn (R-OK) in the Fiscal Reform Commission report, “keep kicking the can down the road, and splashing the soup all over our grandchildren.” Any legislative changes that include a corporate tax rate reduction will have immediate impacts for corporate taxpayers, both in computing their cash tax liability and in their financial statements. The time to act to mitigate the impacts of the corporate tax reform proposals is now.

Footnotes

Time Magazine, “Washington Mulls a Corporate Tax Overhaul,” by Steven Gray, March 4, 2011

Disclaimer

As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.

The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.

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Disclaimer

As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.

The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.

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Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisors who are free from audit-based conflicts of interest, and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the U.S., and serves the U.K. from its base in London.

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