With big changes taking place in how authorities will examine tax compliance, companies need to take a fresh look at their biggest risks and be sure they can withstand a new kind of scrutiny, both in tax filings and in financial statements.
Funding cuts at the Internal Revenue Service during the Obama years have called into question long-standing practices around how corporate tax returns are examined and audited. The IRS no longer has an army of examiners who can study a broad range of issues in corporate filings, so the strategy is shifting toward digging more deeply into a handful of high-risk issues.
For large business and international filers, the IRS recently announced 13 “campaigns” that it has identified, or areas where examiners will zero in their focus when studying corporate returns. These are tax compliance areas where the IRS has noticed the biggest compliance problems, so it will deploy its limited resources toward those areas. They represent the “first wave” of issues to be explored, according to the IRS release. “More campaigns will continue to be identified, approved, and launched in the coming months,” the IRS says.
Tax experts say companies would be wise to study the 13 campaigns and consider the implications for their own tax risk. “It gives you an indication of what the IRS thinks is the most fertile area in a company,” says Dan Dumezich, managing director at Deloitte Tax. “If I know where they’re going to look, I should look at my exposure in those areas.”
The 13 campaigns should serve as notice to corporate taxpayers on where they have increased audit risk, says Mark Allison, a tax attorney at law firm Caplin & Drysdale, which published an alert on the new issues. “The IRS is going to be focusing on these specific issues and trying to identify taxpayers that fall into these campaigns,” he says.
Companies should even be alert to what their financial statement auditors will examine, says Mark Trivette, managing director at tax services firm Alvarez & Marsal. Companies are required to say in financial statements and in their tax filings where they believe they have taken uncertain tax positions, so even financial statement auditors will be interested in whether companies disclose any heightened tax risk and what documentation they produce to support their tax positions.
“Public company audit firms will take notice and will enhance their audit procedures. That’s really where public companies will feel the first impact. It’s a double-edge sword. The good news is if you can pass the public accounting audit with documentation, you’ll likely be able to stand up to IRS scrutiny as well.”
Mark Trivette, Managing Director, Alvarez & Marsal
“Public company audit firms will take notice and will enhance their audit procedures,” says Trivette. “That’s really where public companies will feel the first impact. It’s a double-edge sword. The good news is if you can pass the public accounting audit with documentation, you’ll likely be able to stand up to IRS scrutiny as well.”
Although the IRS has said little so far about how it will undertake examinations under this new campaign approach, it likely will change the way companies interact with the IRS, says Allison. “This will be almost a joint venture between the IRS and the taxpayer for developing a process for engaging in the audit,” he says. “It will not be a situation where you are sitting back and the IRS is doing the work. It will be a joint fact-finding effort.”
The 13 campaigns identified so far for large and international companies include a number of issues that could be concerns for public companies. Some are narrowly focused, such as a campaign to look at companies that entered then exited a voluntary disclosure program around offshore income or another to examine certain types of entertainment companies that claimed deductions for domestic production activities.
Other campaigns might apply more broadly to public companies, like an intention to study—even more closely than the IRS and even financial statement auditors already have in recent years—transactions among related parties in a given corporate entity. Another campaign that will apply across most public companies is repatriation, or the process by which companies bring into the United States profits that were earned overseas.
The 13 campaigns or areas the division plans to target include:
examinations of the energy credit described in Internal Revenue Code 48C;
declines and withdrawals from the offshore voluntary disclosure program;
repatriation of income from overseas locations;
foreign companies doing business in the United States that are not filing appropriately;
transfer pricing associated with inbound distribution of goods from related parties outside the United States;
deferred variable annuity reserves and life insurance reserves;
basket transactions that seek to treat ordinary income and short-term capital gain as long-term;
micro-captive insurance contracts;
the completed contract method of accounting applied by land developers;
application of the domestic production activities deduction to certain entertainment products;
risks associated with larger, more complex pass-through partnerships; and
losses claimed in excess of basis in S corporations.
Source: Internal Revenue Service
Some of the campaigns are focused on issues the IRS has long regarded as abusive, says Mike Dolan, national director in tax at KPMG and a former deputy commissioner at the IRS. “There are areas here where the IRS has already sent some shots across the bow,” he says.
Those include a campaign around “basket transactions,” or transactions where taxpayers try to treat ordinary income or short-term capital gains as long-term capital gains, and a campaign on micro-captive insurance, where companies have tried to reduce taxable income using contracts that are meant to look like insurance. “I would expect the IRS to have more than a casual interest in trying to find those returns or taxpayers that display those kinds of issues,” says Dolan.
Repatriation and related-party transactions are especially hot areas likely to apply across capital markets as angst has grown over corporate use of various maneuvers to keep foreign-earned income offshore; companies are facing backlash over their attempts to avoid U.S. corporate tax rates that are high relative to many other countries. In the absence of any Congressional action on the issue, the U.S. Treasury Department pushed through new regulations late in 2016 to place heavy new documentation burdens on companies to substantiate cross-border transactions.
“Many companies now operate on an international basis, so intercompany transactions involving U.S. and foreign entities is of utmost importance for tax compliance globally,” says Brian Kittle, a partner at law firm Mayer Brown. Repatriation, related-party transactions, inbound distributor scrutiny, and even the focus on the domestic production deduction all speak to IRS concern about compliance in cross-border activity, he says.
Even companies that have already been subject to IRS exam or audit in the high-risk campaign areas should expect return visits from the IRS, says Kittle. The IRS developed the campaign approach based in part on what its examiners or auditors have seen in the field. “Given that examiners have helped identify these campaigns, they already have in mind taxpayers who have had these issues in the past,” he says. “So if you’ve been examined in the past, take note, that examination may be coming down the pike again.”