coordinating state and federal income tax audits...case study: coordinating federal and state tax...

Coordinating State and Federal Income Tax Audits

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

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©2015 Sutherland Asbill & Brennan LLP

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

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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

• Company A is under audit by IRS and State X

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Coordinating the Disclosure of Information and Documentation to IRS and State Tax Authorities

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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 Ohio and Regional Income Tax Agency

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• 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

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• 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

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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"

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• 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

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• 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

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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

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• 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

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• 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

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Reporting Federal Adjustments to State Tax Authorities

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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 Uniformity

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• 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

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• Requirement to Report Federal Adjustments Assessment by IRS

Does it trigger a state filing requirement? Do intermediate determinations trigger a reporting

requirement? Which entity is assessed? Is the entity a taxpayer? Does the assessment affect state taxable income?

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• Requirement to Report Federal Adjustments Amended Federal Return

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?

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• Requirement to Report Federal Adjustments Settlement with IRS

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?

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• Requirement to Report Federal Adjustments Competent Authority Agreements ("CAAs")

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

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• 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

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• 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

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• 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

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• 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)

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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

• Two years later taxpayer and IRS settle the remaining outstanding issues

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• 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

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• Reporting Noncompliance Penalty Financial penalties

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

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• 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

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Extending the State Statute of Limitations for Assessment

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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

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• 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)

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• 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

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• 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 fiduciary, whichever is later. Co. Rev. Stat. § 39-22-601 (6)( e)

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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

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Addressing Conflicting Positions

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©2015 Sutherland Asbill & Brennan LLP 36


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



• 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.

• Currently on appeal



• 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


Questions?

Leah Robinson

Partner 212.389.5043

[email protected]

Scott Wright Partner

404.853.8374 [email protected]

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