Coordinating State and Federal Income Tax Audits

Coordinating State and Federal

Income Tax Audits

Leah Robinson, Partner Scott Wright, Partner May 21, 2015

State Tax Exam Issues

• Coordinating Disclosure of Information to IRS and

State Tax Authorities

• Reporting Federal Adjustments to State Tax

Authorities

• Extending the State Statute of Limitations for

Assessment

• Addressing Conflicting Positions

Case Study: Coordinating Federal and

State Tax Positions and Reporting

• Company A is a widget manufacturer with 50

subsidiaries that conduct regular business operations

in 30 states

• Company A is a highly leveraged business with $500

million in debt owed to third-party lenders

• Company A owns a Holding Company that is located

in a low tax state; this Holding Company lends to its

operating affiliates

• Company A has engaged in what may be deemed a

reportable transaction for federal tax purposes

Coordinating the Disclosure of

Information and Documentation

to IRS and State Tax Authorities

Coordinating the Disclosure of

Information and Documentation

• Federal and State Tax Audit Efforts Must Be

Coordinated

 Information sharing agreements have increased the

dissemination of sensitive and confidential tax information among tax authorities

 Memorandum of Understanding between IRS and state tax authorities (and the Multistate Tax Commission) will

increase information sharing

 State and municipal tax authorities share information (and conduct joint audits), such as:

 New York State and New York City

 Pennsylvania and Philadelphia

Coordinating the Disclosure of

Information and Documentation

• Federal and State Tax Audit Efforts Must Be

Coordinated

 State tax authorities seek to exchange information directly with IRS

 State tax authorities request information which taxpayers have provided to IRS

 State IDRs request responses to IRS IDRs relating to a transaction, issues or tax years

 State tax authorities use information-sharing agreements as the basis for information databases

Coordinating the Disclosure of

Information and Documentation

• Federal Tax Audit Group Should Consult With State

Tax Audit Group Regarding the Disclosure of

Information and Documentation

 State tax audits may be negatively impacted by responses provided to IRS

 Disclosure to IRS will waive attorney-client privilege protection

 Oversimplified responses can be problematic for state tax purposes

 Characterization or resolution of a transaction may not have federal tax consequences but may create state tax issues

Example

• Company A has received an lOR from the IRS

• Company A is preparing a response to the lOR that

addresses the intercompany lending arrangement

• Intercompany lending arrangement is inconsequential

for federal consolidated return purposes

• IDR indicates that intercompany lending arrangement

was "set up for state tax planning purposes"

• State tax audit group receives an lOR from State X to

produce any "information or documentation provided

to the IRS regarding the intercompany transaction"

Coordinating the Disclosure of

Information and Documentation

• State Tax Audit Group Should Coordinate With

Federal Tax Audit Group Regarding the Disclosure of

Information and Documentation

 Perception that state tax audits are conducted after the federal tax audit is not always accurate

 State tax audit may proceed in advance of federal tax audit because of state initiatives to accelerate revenue, including:

 Voluntary compliance programs

 Aggressive audit schedules

 State tax audit group may not be aware of potential federal tax issues/consequences

Coordinating the Disclosure of

Information and Documentation

• State Tax Audit Group Should Consult With Federal

Tax Audit Group To Preserve Federal Tax Positions

 State tax audit group must coordinate review of responses that potentially affect the federal treatment

 Defending state tax issues during a state audit

 Preserve federal tax positions while defending a state tax audit

 Characterization of a transaction at the state level may be inconsistent with the federal treatment

 Defending federal tax issues during a state audit

 State tax authorities have become more aggressive about auditing federal tax positions (auditing above-the-line)

 Coordinate the defense of such a challenge with the federal tax audit group

Example

• Company A participated in California's Voluntary

Compliance Initiative to avoid double penalties

• Company A is audited by the California FTB on the

tax position based on reporting under the VCI

• State tax audit group defends the tax position without

consulting with the federal tax audit group

• FTB shares the information obtained in conducting

the state tax audit with IRS

• Federal tax audit group receives from IRS the

information the state tax audit group provided to the

FTB

Coordinating the Disclosure of

Information and Documentation

• Two-Way Transparency in State Taxation Under UTP and Other

Disclosure Requirements

 State tax authorities to request information not previously required by a corporate income tax return

 Taxpayers are making greater use of FOIA requests for state guidance

• State Tax Reportable Transaction Statutes

 Attempt to identify suspect or sham-like transactions (based on similar federal rule finalized in 2003)

 First version adopted by California in 2003

 MTC model adopted in 2006; refers to transactions that lack "economic substance"

 State statutes may notify states of federal or state reportable or listed transactions

 State statutes also generally provide for underreporting or other penalties

Coordinating the Disclosure of

Information and Documentation

• Attorney-client privilege does not apply to tax accrual

workpapers because of the use of outside accountants; see, e.g.,

Commissioner of Revenue v. Comcast Corp., 453 Mass. 293

(2009)

• U.S. v. Textron, Inc. , 577 F.3rd 21 (1 st Cir. 2009), cerl. denied,

--S.Ct.---, 2010 WL 2025148 (May 24, 2010): the "work product “ doctrine does not protect such workpapers so the IRS can

request these documents because they are prepared for nonlitigation regulatory purposes

 Tax audit process is not considered to be the equivalent of litigation

 En bane decision reverses prior decision by the First Circuit

 Compare Comcast where the work product doctrine was held to protect tax planning memos prepared by an outside accounting firm

Reporting Federal Adjustments to

State Tax Authorities

State Reporting Requirements

• Reporting Federal Adjustments to State Tax

Authorities

 Requirement to Report Federal Adjustments

 Time Frame to Report Federal Adjustments

 Determining Which Legal Entity Must Report

 Reporting Noncompliance Penalty

State Reporting Requirements

• If a taxpayer disagrees with the assessment in the

RAR, the IRS issues a "thirty day letter," which

describes the adjustment and sets forth the taxpayer's

options. The taxpayer can:

 Sign Form 870, pay the tax, and then sue for refund in the U.S.

 District Court or the Court of Federal Claims

 Ignore the letter, wait for a notice of deficiency, and then appeal to the U.S. Tax Court

 Submit additional information in a formal protest and request a conference with the IRS Appeals Division

State Reporting Requirements

• Requirement to Report Federal Adjustments

 Does it trigger a state filing requirement?

 Do intermediate determinations trigger a reporting requirement?

 Which entity is assessed?

 Is the entity a taxpayer?

State Reporting Requirements

• Requirement to Report Federal Adjustments

 Does it trigger a state filing requirement?

 Impact of requesting a refund versus reporting a greater amount of tax due

 If requesting a refund, at what point do you file amended state return?

 Reporting responsibilities if federal refund request is rejected?

State Reporting Requirements

• Requirement to Report Federal Adjustments

 What gets reported to IRS for final settlement purposes?

 Does it trigger a state filing requirement?

 Do intermediate determinations trigger a reporting requirement?

 Is it possible to structure the settlement to minimize state reporting requirements?

 Is it possible to structure the settlement to minimize state tax?

State Reporting Requirements

• Requirement to Report Federal Adjustments

 Do CAAs trigger a state filing requirement?

 If CAA does not require taxpayer to amend federal tax return, no requirement to amend state tax returns

 If CAA requires an amended federal tax return, and normal federal/state statutes of limitations, then the normal amended return rules apply

State Reporting Requirements

• Time Frame to Report Federal Adjustments

 State tax laws provide that a taxpayer must report such federal changes in a relatively short amount of time

 30 days

 60 days

 90 days

 Taxpayers often have difficulty meeting the deadlines for reporting federal changes

 Some taxpayers use consultants to facilitate the reporting of federal changes

State Reporting Requirements

• What Legal Entity Must Report

 Nonconformity to federal consolidated return provisions complicates the reporting of federal adjustment at the state level

 Separate company state reporting may not reflect the

adjustments to federal taxable income because of additional tax or benefit

 Combined or consolidated returns may not include the same affiliated entities as included in the federal consolidated

group

State Reporting Requirements

• Requirement to Report Federal Adjustments

 Indiana

 If a taxpayer's federal income tax liability for a taxable year is modified due to the assessment of a federal deficiency or the filing of an

amended federal income tax return, then the date by which the

department must issue a proposed assessment under section 1 of this chapter for tax imposed under IC 6-3 is extended to six (6) months after the date on which the notice of modification is filed with the department by the taxpayer. Indiana Code § 6-8.1-5-2(g).

 Oklahoma

 The period of time prescribed in Section 223 of this title, in which the procedures for the assessment of income tax may be commenced by the Tax Commission, shall be tolled and extended until the amount of taxable income for any year of a taxpayer under the Internal Revenue Code has been finally determined under applicable federal law and for the additional period of time hereinafter provided in this subsection. Okla. Stat. § 2375.H.1

State Reporting Requirements

• Requirement to Report Federal Adjustments

 Oregon

 The department may mail a Notice of Deficiency at any time within two years after the department receives notification of a change or

correction contained in:

 a federal revenue agent's report;

 the audit report of another state's taxing authority; or

 the written report filed by the taxpayer as required by ORS 314.380(2)(a) Or. Reg.§ 150.314.410(3)

 Kentucky

 "Conclusion of the federal audit" means the date that the adjustments made by the Internal Revenue Service to net income as reported on the taxpayer's federal income tax return become final and

unappealable; and

 "Final determination of the federal audit" means the revenue agent's report or other documents reflecting the final and unappealable

adjustments made by the Internal Revenue Service. Kentucky Rev. Stat. 141.21 0(2)( d)

Example

• Company A reaches an agreement with IRS on

several audit issues

• The agreement on the audit issues generates

additional federal taxable income for companies with

state tax reporting responsibilities

• Company A and IRS agree that a few issues will be

set aside for appeals

• Issues that remain subject to challenge only affect 5

of the 50 companies

• Federal changes for remaining 45 entities for the tax

year are final

State Reporting Requirements

• Reporting Method

 No uniform method for reporting federal changes to the various state tax authorities

 Taxpayer may (depending on its nexus with various states) have to file adjustments in every state with a net income tax based on a single federal adjustment

 Actual amended returns

 Some states require taxpayers to manually stamp an original tax return "amended" while other states provide amended returns to be completed

 Schedule of changes

 Some states require a schedule with each and every

change from the line items on the state return while other states only ask for the changed line items

State Reporting Requirements

• Reporting Noncompliance Penalty

 Treated as a failure to file a return

 Unlimited extension of the statute of limitations to assess additional tax based on the failure to report

 Provisions place the burden on the taxpayer to report the federal changes to begin running of the statute of limitations for assessment

State Reporting Requirements

• Uniformity In State Reporting

 The lack of uniformity is an issue that every state tax director can agree is truly a problem

 Specific provisions that need uniformity:

 Time frame for reporting federal changes

 Method of reporting federal changes

 Eliminate intermediary reporting requirements

 Limited extension of the statute of limitations

Extending the State Statute of

Limitations for Assessment

State Statute of Limitations

• State tax laws extend the state statute of limitations

for assessment upon the reporting of federal changes

 Limited: Some states' laws limit the state tax authority to assess additional tax solely on the reported federal change

 Broad: Some states' laws permit the state tax authority to assess additional tax on any aspect of the state return (i.e., no limitations)

• An agreement between the taxpayer and IRS to

extend the federal statute of limitations on

assessment will likely extend the state statute of

limitations on assessment

State Statute of Limitations

• State Statutory Provisions - Limited

 Maryland tax law provides a limited extension of the statute of limitations on tax assessments solely related to the

federal changes

 Specifically, the law provides:

 If a report of federal adjustment is filed within the time required under Section 13-409 of this title, the tax

collector shall assess the financial institution franchise tax, public service company franchise tax, income tax, or estate tax within 1 year after the date on which the tax collector receives the report ... An assessment of income tax under paragraph (1) of this subsection shall be

related to changes made by the amended items in the return. Md. Code § 13- 1101(c)

State Statute of Limitations

• State Statutory Provisions - Broad

 Oklahoma tax law provides a broad extension of the statute of limitations on tax assessments for any aspect of the taxpayer's state return

 Specifically, the law provides:

 In administering the provisions of this subsection, the Tax Commission shall have the authority to audit each and every item of income, deduction, credit or any other matter related to the return where such items or matters relate to allocation or apportionment between the State of Oklahoma and some other state or the federal government even if such items or matters were not affected by revisions made in such final

determination. Where such items or matters do not relate to allocation or apportionment between the State of Oklahoma and some other state or the federal government, the Tax

Commission shall be bound by the revisions made in such final determination. Okla. Stat. § 2375

State Statute of Limitations

• State Statutory Provisions

 Colorado tax law provides that an agreement between the taxpayer and IRS to extend the federal statute of limitations on tax assessments extends the state statute of limitations on tax assessments

 Specifically, the law provides:

 If any taxpayer agrees with the Internal Revenue Service for an

extension, or renewals thereof, of the period for assessing deficiencies or paying refunds in federal income tax or for changing reported federal taxable income of a partnership, limited liability company, or fiduciary for any year or if any taxpayer files a federal income tax refund claim or initiates administrative or judicial proceedings which have the effect of extending said period for any year, the period within which the

executive director may issue a notice of deficiency for any such year shall be four years after the applicable Colorado return was filed, or one year after the date of expiration of the extended period for

assessing deficiencies in federal income tax or changing reported federal taxable income of a partnership, limited liability company, or

Example

• Company A's statute of limitations for assessment of additional

tax has expired for Maryland, Oklahoma and Colorado

• Company A eliminated the unrecognized tax benefits from its

financial statements

• Company A and IRS extended the federal statute of limitations

until the end of the year

• IRS issues an assessment of additional tax to Company A

• Company A's state statute of limitations for assessment of

additional tax is re-opened

• Maryland can only make changes related to the federal changes

• Oklahoma is authorized to re-open the entire state tax return to

audit

• Colorado is authorized to re-open the return because of a federal

extension of the statute of limitations for assessment automatically extends the state statute of limitations

36

Addressing Conflicting Positions

• Accuzip, Inc. v. Director, Division of Taxation; Quark, Inc. v.

Director, Division of Taxation, N.J. Tax Ct. Dkt. No. 005744-2003

(Aug. 13, 2009)

 New Jersey DOT determined that taxpayer did not qualify for the protections of P.L. 86-272 because its sales of

software were not sales of TPP

 New Jersey Tax Court rejected the DOT’s argument

 Federal guidance as well as NJ’s own sales tax

guidance resulting in the software being treated as TPP. State could not take conflicting positions

• Lorillard Licensing Co., LLC v. Director, Division of Taxation, N.J.

Addressing Conflicting Positions

• Lorillard Licensing Co., LLC v. Director, Division of Taxation, N.J.

Tax Ct. Dkt No. 008772-2006 (Aug. 9, 2013)

• New Jersey DOT interpreted the phrase “subject to a tax” one way for nexus purposes (expansively) and another way for Throw Out Rule purposes (narrowly).

• Tax Court (Judge DeAlmeida) required a consistent application of the term.

38

Addressing Conflicting Positions

• Oracle USA, Inc. v. Oregon Dep’t of Rev., Or. Tax Ct. Case No.

TC-MD 070762C (Feb. 11, 2010)

 Taxpayer reported gain from the sale of stock as business income in its domiciliary state California, while classifying the same gain as nonbusiness income under Oregon law

 On audit, the Oregon DOR reclassified the gain as business income asserting that the taxpayer was required to do so under UDITPA

 The Oregon Tax Court held that a corporate taxpayer did not have a duty under UDITPA to uniformly report an item of

income as “business” or “nonbusiness” among MTC states notwithstanding uniform definition

 Rather, the proper classification of income in each state must be determined according to that state’s laws

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