Tax controversy and risk management review

Spring 2014
Tax controversy and risk
management review
In this issue:
2 IRS practice and procedure
New IDR process announced
LB&I issues FY14 Field Focus Guide
To Pre-CAP or not to Pre-CAP: that is the question
10 Transfer pricing enforcement trends
LB&I issues new “Roadmap” for transfer pricing audits
16 Penalty corner
Expansion of the IRS program to systemically assess penalties for Forms 5471
and 5472 filed with late-filed returns, including late-filed Forms 1065, makes it
even more imperative that taxpayers file timely returns
18 Courts
• Court holds that fraudulent items on partnership return do not automatically keep
open the statute of limitations for partners
• Supreme Court update
22 Legislative, regulatory and other guidance
• The use of statistical sampling for mitigating tax risk
24 TEFRA corner
Duties of a tax matters partner under TEFRA procedural rules
29 Ernst & Young LLP adds new controversy talent
IRS practice and procedure
New IDR process
By Pat Chaback, Executive Director,
Tax Controversy and Risk Management
Services, Ernst & Young LLP
LB&I issued a third directive regarding
the IDR process, providing further
clarification of issuance requirements
and the enforcement process.
On 28 February 2014, the Internal
Revenue Service’s (IRS) Large Business
and International (LB&I) Division issued a
new directive (LB&I-04-0214-004, the New
Directive) with updated guidance clarifying
Information Document Request (IDR)
issuance requirements and enforcement
procedures. The New Directive incorporates
and supersedes LB&I’s two prior IDR
directives, with changes intended to help
examiners and taxpayers understand the new
procedures, particularly with regard to the
timing of enforcement.
The initial LB&I directive attempting to
revamp the IDR process was issued on
18 June 2013 (LB&I-04-0613-004, the
June Directive), and covered IDR issuance
requirements. These include the need for
IDRs to be issue-focused (i.e., they must
identify the issue that led to the request) and
for examiners to discuss the IDR with the
taxpayer prior to issuance and determine
an agreed-upon reasonable time frame for
response (see EY Tax Alert 2013-1509).
LB&I issued a second directive on
4 November 2013 (LB&I-04-1113-009,
the November Directive), focused on the
IDR enforcement process that is initiated
when a taxpayer has failed to timely respond
to an IDR issued in accordance with the
requirements stated in the directive. The
three-step IDR enforcement process begins
with a Delinquency Notice, followed by a PreSummons Letter and finally the issuance of a
summons (see EY Tax Alert 2013-2109).
New IDR issuance requirements
The New Directive clarifies the June Directive
and includes Attachment 1, Requirements
for Issuing IDRs. The most important item
requires the examiner or specialist, before
issuing the IDR, to discuss the issue with the
taxpayer and why the requested information
is relevant. The taxpayer must receive a draft
of the IDR, and generally, the discussion
regarding its contents should be completed
within the following 10 business days.
Additionally, the examiner or specialist, in
the interest of clarity, is to prepare one IDR
for each issue.
The New Directive also includes an explicit
exception to the “issue-focused” IDR
requirement: the requirement does not
apply to IDRs issued at the beginning of an
examination that requests “basic books and
records and general information about a
taxpayer’s business.” All other IDRs issued
subsequently must be relevant to a specific
issue to be examined.
Importantly, the New Directive makes it
mandatory for the examiner or specialist,
when determining the taxpayer’s response
date to the IDR, to commit to a date by which
the examiner or specialist will review the
information and documentation provided by
the taxpayer and respond to the taxpayer
as to whether the information received
satisfies the IDR request. That response date
is included on the IDR. This requirement is
designed to ensure that if the taxpayer timely
responds, then the information provided will
be timely reviewed.
Tax controversy and risk management review
This new IDR
enforcement process,
effective beginning 3
March 2014, applies
only to IDRs issued in
accordance with the
requirements of the
New Directive.
New IDR enforcement process
The New Directive incorporates and
supersedes the IDR enforcement procedures
included in the November Directive, providing
details of the three-step enforcement
process. This new IDR enforcement process,
effective beginning 3 March 2014, applies
only to IDRs issued in accordance with the
requirements of the New Directive. IDRs not
meeting those requirements must be reissued with a new response date. To “ensure
a smooth transition,” the New Directive
states that no Delinquency Notices should be
issued under the new enforcement process
prior to 3 April 2014. The New Directive
includes, as Attachment 2, the enforcement
process for IDRs issued in accordance with
the requirements included in Attachment 1.
An important addition in the New Directive
gives limited extension authority to
examiners and specialists, permitting them
to grant taxpayers an extension of up to
15 business days before the enforcement
process begins. The New Directive provides
two scenarios under which an extension can
be granted by examiners and specialists: (1)
taxpayer fails to respond to the IDR and (2)
taxpayer provides an incomplete response.
The New Directive instructs the examiner
or specialist to discuss the cause of the
taxpayer’s failure to respond or the cause of
the incomplete response with the taxpayer
within five business days of the IDR due date.
In either case, the examiner or specialist may
grant an extension of up to 15 business days
if warranted by the taxpayer’s explanation.
The IDR enforcement process begins as of
the extended due date or, if no extension was
granted, the date that determination was
communicated to the taxpayer.
Step 1: Issuing the Delinquency Notice
The first step, issuing the Delinquency
Notice signed by the IRS team manager,
should be discussed with the taxpayer to
ensure the taxpayer understands the next
steps. The Delinquency Notice should be
issued to the taxpayer within 10 business
days of the application of the enforcement
process and should include a response date
that is generally no more than 10 business
days from the date of the Delinquency
Notice. The IRS territory manager must
approve any request by the taxpayer to
respond to the Delinquency Notice beyond
the 10 business days.
Step 2: Sending the Pre-Summons Letter
If the taxpayer does not provide a complete
response to the IDR by the Delinquency Notice
due date, the examiner or specialist must
follow the procedures set forth in the second
step of the enforcement process. Specifically,
the examiner or specialist must discuss the
taxpayer’s failure to provide a complete
response to the Delinquency Notice with the
examiner’s or specialist’s management chain
and assigned counsel and must then prepare
the Pre-Summons Letter for signature by the
appropriate territory manager.
The territory manager must discuss the
Pre-Summons Letter and the process
regarding the issuance of that letter with the
taxpayer to ensure understanding of the next
steps. The Pre-Summons Letter must be sent
within 10 business days from the Delinquency
Notice due date and include a response
due from the taxpayer that is generally 10
business days from the date of the letter.
The director of field operations (DFO) must
approve any response date beyond 10
business days. The Pre-Summons Letter
is addressed to the taxpayer management
official who is above the level of the official
that received the Delinquency Notice.
Step 3: Issuing the summons
If the taxpayer does not provide a complete
response to the Pre-Summons Letter by the
date indicated, then the examiner or specialist
must proceed to Step 3 of the enforcement
process and obtain the summons for issuance
to the taxpayer.
If, during the discussion of an IDR, a taxpayer
indicates that the requested information will
not be provided without a summons, the IDR
enforcement procedures do not apply, and
the IRS should move directly to the issuance
of a summons.
Know and understand the new
IDR process to avoid a summons
The New Directive clarifies the IDR process
and provides taxpayers with a specific time
frame that LB&I examiners and specialists
must follow during the enforcement
process. This guidance allows examiners
and specialists limited discretion in granting
extensions for responding to the IDRs.
However, taxpayers should not rely on this
possibility in discussing and determining the
mutually agreed-upon response time during
the early stages of the IDR process.
Knowing what is expected in fulfilling the
IDR requests and how long it is reasonably
expected to take for the taxpayer to respond
remains critical. Given that the revised IDR
procedures delineate each step’s specific
requirements, taxpayers should expect LB&I
to follow these rules and appropriately object
if the guidelines are not being followed. On
their face, these rules are relatively strict.
Since this process is new, taxpayers have had
little experience in how the examiners and
specialists will deal with them. Therefore,
taxpayers should closely monitor their IDR
activity to avoid finding themselves in the
unfortunate position of having to respond to
a summons.
The New Directive gives limited extension authority
to examiners and specialists.
Tax controversy and risk management review
l IRS practice and procedure l
LB&I issues FY14
Field Focus Guide
By Pat Chaback, Executive Director,
Tax Controversy and Risk Management
Services, Ernst & Young LLP
Taxpayers should be familiar
with LB&I’s Field Focus Guide
and plan accordingly
Every year, the LB&I Division of the IRS
outlines its strategic goals and priorities
for the fiscal year in its internal Field Focus
Guide. Taxpayers should be aware of the
current year’s goals and priorities as they
plan interactions with LB&I.
Many of this year’s focus areas reflect LB&I’s
goal to become more efficient and effective
and to deploy strategic thinking around how
and where to best apply limited resources.
The areas of emphasis include:
Deploying resources to those areas that
have the greatest compliance impact and
the highest compliance risk
Implementing new LB&I exam processes
setting forth the road map for an
examination that is professionally executed
and issue-focused throughout planning,
execution and resolution. (To date, LB&I
has released only the Transfer Pricing
Practice (TPP) part of the road map.)
Implementing and deploying process
changes that LB&I initiated in FY13:
Improvements to the industry case
(IC) exam process — moving away
from the coordinated industry case
(CIC) designation toward an issuedriven, risk-based model focused on
the nature and complexity of issues
regardless of entity type or size
Advancements in the knowledge
management area, including the Issue
Practice Groups (IPGs), encompassing
domestic issues and the International
Practice Networks (IPNs), which
address international tax issues
Clarification of the Information
Document Request (IDR) process,
including stricter IDR management
and enforcement (see “New IDR
process announced” in this issue)
FY14 LB&I priorities
Knowledge management — Enhance
and leverage LB&I programs and tools
designed to capture expertise, identify
training needs and opportunities for
guidance, disseminate best practices
and increase collaboration and
knowledge-sharing across the division
Tax controversy and risk management review
Initiate and maintain frequent communication throughout the
planning, execution and resolution stages of an examination to
ensure a full understanding of:
Information Document Requests —
Implement the new process through
IDRs that are issue-focused with clear
explanations of the information being
requested, agreed-upon time frames for
responses and, if time frames are not
met, swift enforcement
Which issues have been risk assessed and selected
for examination?
Why were the issues selected for examination?
What information and documentation are necessary to
ensure a thorough factual development and understanding
of the return positions taken?
Issue focus — Select, audit, provide
guidance on and allocate resources to
issues that will have the broadest impact
on compliance regardless of entity type
or size
What legal determinations are being applied by the IRS to
reach its conclusions?
Role of specialists — Pilot and test new
approaches for maximizing effective
deployment of limited specialist resources
(e.g., the engineering program, which
has experienced a near 20% decline in
technical staff from FY13 levels)
LB&I examination process — Implement
the road map for an LB&I examination
that is professionally executed and
issue-focused throughout the planning,
execution and resolution phases of
the examination
New LB&I exam
processes will set forth
the road map for an
issue-focused process.
Tips to taxpayers for maintaining good relationships
with LB&I
Exam re-engineering — Continue
using Lean Six Sigma to identify and
implement improvements to the current
IC examination process, moving away
from the CIC designation toward an issuedriven, risk-based model
FATCA — Continue leading the design
and implementation of the foreign
financial institution (FFI) registration
and intergovernmental data exchange
Offshore compliance — Continue strategic
enforcement efforts and parallel voluntary
disclosure programs, which have given
US taxpayers with undisclosed offshore
assets or income opportunities to comply
with the US tax system, pay their fair
share and avoid potential criminal charges
Get to know and engage with all the team members
assigned to the examination and become familiar with the
chain of command and team members’ respective levels
of accountability
Understand the rules of engagement regarding IPGs and
IPNs on issues, which will enable a clear line of sight as to
who is influencing the issue development and the conclusions
being reached
Tax controversy and risk management review
l IRS practice and procedure l
To Pre-CAP or not
to Pre-CAP: that is
the question
Is inclined to want to achieve IRS
examination currency for given tax
years and to minimize the need to file
numerous amended state tax returns.
Through Pre-CAP and CAP, it is possible
to accelerate closing the books on the
company’s tax reserves.
By Pat Chaback, Executive Director,
and Ned Connelly, Senior Manager,
Tax Controversy and Risk Management
Services, Ernst & Young LLP
Would like to minimize the issues faced in
reporting uncertain tax positions (Schedule
UTP). By completing Pre-CAP — prior to
acceptance into CAP — the company could
resolve those issues sooner and greatly
reduce post-filing examination activity.
Pre-CAP is the gateway to the Compliance
Assurance Process (CAP), through which
a company could significantly increase the
certainty of its tax liability by the due date of
its tax returns.
Anticipates potential post-filing exam
controversy relative to significant
federal tax transactions and matters
that will undoubtedly be selected for
audit. Participation in Pre-CAP as
a prelude to CAP could provide the
company with quicker guidance on
complex tax issues.
Pre-CAP could be a good move
if a company believes that its
tax department:
Is intrigued by what’s been said about
CAP and would like to experience a
limited-issue scope examination in
a highly condensed time frame. The
process allows a company to engage
with the IRS in a cooperative and
transparent environment with no
obligation to progress to CAP unless
it is a good fit for all involved.
Could collaborate with the IRS in providing
information and documentation. CAP
can help a company progress toward
real-time resolution of significant federal
tax matters on completed transactions.
Strives to complement its corporate
governance and accountability
responsibilities. The various phases
of CAP will enhance tax reserve integrity.
Consequently, the company benefits
from improved financial statement
reporting, support for compliance with
Sarbanes-Oxley and enhanced public/
investor confidence that tax issues are
settled. Participating taxpayers can
note the benefits achieved through
participation in Pre-CAP and CAP in their
financial statements.
On 31 March 2011, the IRS announced that
CAP would become a permanent program
available to taxpayers and expanded the
program to include Pre-CAP and CAP
Compliance Maintenance phases.
Pre-CAP provides interested taxpayers
with a clear road map for gaining entry
into CAP (see Internal Revenue Manual
[IRM] The Pre-CAP action plan is
Under CAP, participating taxpayers act
jointly with an IRS team to identify and
resolve potential tax issues before the tax
return is filed each year. Ideally, all major
potentially controversial tax issues are largely
settled prior to filing, thereby subjecting
taxpayers to a shorter and narrower postfiling examination.
CAP is a method of contemporaneously
identifying and resolving tax issues
through open, cooperative and transparent
interaction between the IRS and LB&I
Division taxpayers prior to filing that year’s
return. CAP allows taxpayers to better
manage tax reserves, ensure more precise
reporting of earnings on financial statements
and minimize the need to amend multiple
state tax returns.
Pre-CAP description:
Takes place in a traditional post-file
environment and is conducted
by a team coordinator, not a CAP
account coordinator
Aims to develop an action plan
to close all transition years
occurring within an agreed
(usually accelerated) amount of
time, except for one open and one
unfiled year
Requires taxpayer to meet CAP
eligibility criteria (see IRM cited
earlier in this article)
Allows taxpayers to apply for
Pre-CAP at any time
Pre-CAP takes
place in a traditional
post-file environment.
jointly developed by the examination team
coordinator and the taxpayer and presents a
time frame for closing all the transition years
required to establish CAP eligibility.
Pre-CAP requirements:
Taxpayer works with the exam
team to develop an action plan
to prepare for CAP
Taxpayer signs a Pre-CAP
Memorandum of Understanding
Taxpayer and team will work
in an open and collaborative
Taxpayer exhibits the
transparency and cooperation
needed to progress to CAP
Taxpayer agrees to identify issues
within transaction(s) and provide
information in a timely manner to
resolve outstanding issues
Taxpayer will be eligible for CAP
if all transition years are closed
except for one open filed year and
one unfiled year
If these scenarios apply to your company,
then the answer to, whether to Pre-CAP
or not to Pre-CAP is most likely — yes!
Tax controversy and risk management review
Tax controversy and risk management review
l IRS practice and procedure l
Getting into CAP through Pre-CAP
Taxpayers who meet Pre-CAP eligibility
requirements must complete Form 14234
and mail or fax the application to:
Internal Revenue Service
Attn: LB&I: PFTG: Pre-CAP
The Mint Building
1111 Constitution Avenue, NW
Washington, DC 20224
Fax: +1 202 283 8313
Taxpayers who have ongoing examinations
on filed tax returns (other than the most
recently filed tax return) can apply for
participation in Pre-CAP. Once accepted
into Pre-CAP, the IRS and the taxpayer
work to resolve ongoing examinations on
the intervening filed tax returns so that
the taxpayer may become eligible for CAP.
Taxpayers who do not have an examination
open for any tax year may bypass Pre-CAP
and apply directly for CAP.
Pre-CAP eligibility — taxpayers must meet the
following criteria:
If a taxpayer meets the eligibility criteria,
LB&I Pre-Filing and Technical Guidance
(PFTG) forwards the application to the
LB&I industry director who has jurisdiction
over the taxpayer for an evaluation of the
application and to determine the taxpayer’s
suitability for Pre-CAP. If the taxpayer’s
Pre-CAP application is approved by the IRS,
the taxpayer will be notified in writing by the
territory manager assigned to the taxpayer.
After approval and prior to acceptance
into Pre-CAP, taxpayers must execute a
standardized Pre-CAP MOU that outlines the
Pre-CAP requirements and establishes an
agreement to meet the requirements. The
Pre-CAP MOU is effective for the first PreCAP year and will continue for all years until
one of the following occurs:
Have assets of $10 million or more
Be a publicly held entity with a legal
requirement to prepare and submit
Forms 10K, 10Q, 8K or 20F or other
disclosure forms to the Securities and
Exchange Commission (SEC) or equivalent
regulatory body or, if privately held, agree
to provide to the IRS certified, audited
financial statements on a quarterly basis
or equivalent documentation
Not be under investigation by, or in
litigation with, the IRS or other federal
or state agency that would limit the IRS’s
access to current corporate tax records
The transition years are closed and the
taxpayer fulfills the CAP selection criteria
The taxpayer is terminated from Pre-CAP
The taxpayer voluntarily withdraws
from Pre-CAP
Tax controversy and risk management review
Both parties are held
to a higher standard of
proactive engagement
throughout the process
to ensure success.
Under Pre-CAP, the IRS and taxpayer
work together to develop an action plan to
complete all required examination activity
within an established time frame. Taxpayers
must identify transactions, material items
and steps within the transactions, and other
tax return items and positions taken on their
filed returns and provide relevant information
within the established time frames. The
taxpayer’s disclosures described in this
paragraph should be in writing. The IRS
and the taxpayer will jointly determine the
scope of the Pre-CAP examination, including
materiality thresholds. However, the ultimate
decisions for identifying transactions
and issues for examination remain at the
discretion of the IRS.
CAP is a valued mechanism for LB&I to
achieve exam currency and maximize the
use of the division’s extremely limited
resources. Additionally, taxpayers accepted
into the program are viewed favorably for
their willingness to be proactive in their
tax administration. There is a heightened
level of commitment to succeed in getting a
taxpayer prepared and eligible for the CAP
program. A successful CAP relationship is
founded on the principles of cooperation
and transparency with the LB&I examination
team, where the battle lines have not yet
been drawn. This is a welcome change from
the often controversial and antagonistic
relationships of the past.
Pre-CAP provides an opportunity for
taxpayers to significantly change the
dialogue and the dynamics of their working
relationship with LB&I. Pre-CAP allows
taxpayers to exhibit the transparency and
cooperation required to be considered for
the CAP program. Since the goal of PreCAP is to help taxpayers meet the selection
criteria for entry into CAP, both parties
are held to a higher standard of proactive
engagement throughout the process to
ensure success.
The ultimate answer to the “To Pre-Cap or
not to Pre-CAP” question is … it depends.
When taxpayers are deciding whether the
benefits of choosing Pre-CAP outweigh the
risks, the real question should be, “Why not
Pre-CAP provides an opportunity for
taxpayers to significantly change the
dialogue and the dynamics of their working
relationship with LB&I.
Transfer pricing enforcement trends
LB&I issues new
“Roadmap” for transfer
pricing audits
By Loren Ponds, Manager, International Tax
Services — Transfer Pricing, John DiIorio
and Matthew Cooper, Senior Managers,
Tax Controversy and Risk Management
Services, Ernst & Young LLP
On 14 February 2014, Transfer Pricing
Operations (TPO) of the IRS’s LB&I Division
issued the long-awaited Transfer Pricing
Audit Roadmap (the Roadmap).1 As noted in
the Roadmap, it was created to “… provide
the transfer pricing practitioner, whether
employed in TPO or International Business
Compliance (IBC), with the audit techniques
and tools to assist with the planning,
execution and resolution of transfer pricing
examinations.” With the Roadmap’s external
publication, the taxpayer is afforded very
specific insight as to the TPO’s view of how a
transfer pricing audit should be conducted.
The Roadmap provides best practices
and helpful reference materials for LB&I
employees regarding the administration
of transfer pricing audits. It is organized
around a 24-month audit timeline —
separated into three phases: planning,
execution and resolution — under the rubric
of the IRS’s Quality Examination Process
(QEP) (Figure 1). The Roadmap represents
an institutional effort to formalize the
continuous involvement of transfer pricing
specialists in transfer pricing audits, from
inception to completion. Overall, the
Roadmap emphasizes coordination within
LB&I, including the exam team and transfer
pricing specialists and the taxpayer, and it
encourages constant communication among
all three stakeholder groups. Further, opening
with the statement that “Transfer pricing
cases are usually won and lost on the facts,”
the Roadmap seems to emphasize factgathering to build a case not only for exam
but for successful litigation. Accordingly,
taxpayers are well advised to ensure that
their transfer pricing documentation is robust
and presents a factual picture consistent with
their tax returns and financial statements.
Knowing how the TPO is organized is
important to understanding the Roadmap’s
more structured approach to transfer pricing
audits. TPO is headed by Director Sam
Maruca and encompasses both the Advance
Pricing and Mutual Agreement (APMA)
Program and the Transfer Pricing Practice
(TPP). The TPP is a team of transfer pricing
specialists — including economists, lawyers,
international examiners and other experts
— that began assisting the field exam teams
with transfer pricing enforcement in the fall
of 2012. Specifically, the TPP was designed
to bring together these specialists in an
effort to better select issues to pursue and
effectuate consistency with audit results. In
the past, transfer pricing cases were handled
primarily by international examiners, who
were trained in more general international
tax issues and typically did not have in-depth
knowledge of US transfer pricing rules.
The absence of advanced international
tax technical skills frequently resulted in
inconsistency in how transfer pricing cases
were resolved.
In a recent public forum, Director Maruca
commented that the Roadmap was part of
TPP’s plan to “… educate our people to up
their game.”2 Maruca also commented that
TPP has a SharePoint-accessible system
designed to maintain certain information on
each transfer pricing case: a summary and
status of the case, who is working on it and
the relevant issues. Not every case will have
heightened scrutiny, but with this database,
TPP members have a view of what is going
on with every transfer pricing case and can
choose to become involved if they see a need.
Quality Examination Process (QEP)
QEP Phases
Planning phase:
pre-examination analysis
1. Preliminary assessment
Figure 1: Quality Examination Process (QEP)
Transfer pricing audit stages and timeline
Cycle time in months
Non-cycle time
1st to 2nd
7th to 15th
20th to 23rd
Pre-examination analysis
Opening conference,
transfer pricing orientation
Preparation of initial
risk analysis, exam plan
and key milestones
Fact-finding and additional IDRs, functional analysis
Mid-cycle risk
Issue development
and preliminary
The Roadmap emphasizes
coordination within
LB&I, including the
exam team and transfer
pricing specialists and
the taxpayer, and it
encourages constant
communication among all
three stakeholder groups.
The examiner prepares the mandatory
Information Document Request (IDR) for the
taxpayer’s transfer pricing documentation
and initial examination contact letter, which
are issued simultaneously.3 Finally, in the
description of this phase, the Roadmap
makes the first of many references to TPP
involvement throughout the document,
noting that a TPP member and/or an
economist will participate in the preliminary
assessments. The level of involvement of a
TPP member can range from advisor to
lead examiner.
Final NOPA and
case closing
TP Roadmap
The initial planning phase can last up to six
months and starts before the 24-month audit
cycle begins. Examiners are instructed to
review the taxpayer’s returns with emphasis
on Forms 5471, 5472, 8833, 8858, 8865
and 926, as well as Schedules UTP and M-3.
Examiners are also encouraged to familiarize
themselves with the taxpayer’s business
operations (e.g., 10-K) and to perform
preliminary economic analyses (e.g., key
financial ratio analysis). This exam phase
involves reviewing the information already at
the IRS’s disposal, including prior audit cycle
results, reports and Appeals Case Memoranda
(ACM), as well as the use of IRS tools to
conduct industry analyses.
The TPO is national in scope and is divided into three territories: East, Central and West.
Comments of Sam Maruca, 2014 Conference of the USA branch of the International Fiscal Association — San Francisco, 27 February 2014.
Tax controversy and risk management review
Taxpayers are required to respond within 30 days from receipt of the initial examination contact letter regarding the transfer pricing documentation.
Tax controversy and risk management review
l Transfer pricing enforcement trends l
2. Internal Revenue Code (IRC) Section
6662(e)4 documentation review
Examiners review and analyze the Section
6662(e) documentation and note areas that
require further development, confirmation
or inquiry. Examiners determine whether
the documentation provided meets the
requirements established in the regulations
and are instructed to coordinate with
the economist and the TPP on the initial
assessment and working hypothesis.
3. Planning meetings
Along with discussing general items,
such as time frames and key milestones,
the preliminary planning meeting is an
opportunity for examiners to identify the key
taxpayer personnel who will be responsible
for assisting the exam team with the transfer
pricing audit and to request data and records
relevant to the transfer pricing audit.
The Roadmap also instructs TPP members to
discuss the IDR process (e.g., response times,
taxpayer input) with the taxpayer during this
meeting and mandates APMA notification
with regard to challenged transactions
involving treaty partners. Taxpayers should
also be aware of the three directives recently
issued by LB&I dealing with the issuance
and enforcement of IDRs.5 Although the
Roadmap has specific guidance with respect
to IDRs issued in connection with a transfer
pricing audit, the IDR directives have
overarching application, and all examiners
and specialists, including those in the TPP,
should abide by those directives. Accordingly,
taxpayers should hold the examiners and
specialists to the rules and guidelines stated
in both the IDR directives and the Roadmap
when dealing with IDRs.6
the intangible services and/or tangible goods;
and gain an understanding of the taxpayer’s
transfer pricing methodology.
4. Opening conference
6. Preparation of initial risk analysis and
audit plan
The opening conference, which kicks off
the 24-month audit cycle, provides a forum
for the exam team to discuss the general
aspects of the audit process (e.g., review
of the Roadmap as applied to the case, IDR
response time and delays, Notice of Proposed
Adjustment (NOPA) issues and resolution
processes) with the taxpayer.
5. Taxpayer orientation
Within 30 days of the opening conference,
there will be a financial statement/books and
records orientation meeting. The goal is to
address all financial topics and can include,
inter alia, a reconciliation from geographical
trial balance to the consolidated financial
statement in the 10-K; review of segmented
financial statements and roll-ups to the
consolidated financial statement; mapping
from the tax return to trial balance to general
ledgers; reviewing workpapers for book/tax
differences; and gaining an overview of the
taxpayer’s accounting practices and policies.
A transfer pricing orientation meeting
should follow soon after the financial
statement/books and records orientation
meeting. The examiner’s goal is to, inter
alia, gain more insight into the taxpayer’s
intercompany transactions; determine the
functions performed, assets employed and
risks assumed among controlled parties;
identify who is responsible for tax planning;
understand the value chain(s) associated with
The last step of the planning phase includes
preparing the risk analysis and audit plan,
both of which are approved internally and
then provided to the taxpayer. This period
also serves as an opportunity to request
additional information from the taxpayer.
Execution phase: fact-finding
The execution phase typically spans 14
months. This phase comprises two main
steps: (1) fact-finding and informationgathering and (2) issue development.
1. Fact-finding and information-gathering
This part of the process occurs during
months 3 to 17 of the audit cycle. Factfinding involves the issuance of any
necessary additional IDRs in accordance with
the LB&I directives on IDRs and the use of
the IDR enforcement process if necessary to
secure the requested information, interviews
of relevant taxpayer employees, and plant
tours and site visits. The goal is to give
the exam team the ability to perform an
in-depth functional analysis, identifying all
significant economic activities connected to
the transactions under review. The examiner
should also perform a comparability analysis.
The Roadmap instructs the exam team
to meet with the taxpayer to confirm
the material facts developed during
the examination. Particularly, a written
statement summarizing the material facts
from the exam team’s perspective should
be provided to the taxpayer, and the
taxpayer should be requested to provide
a written confirmation or explanation of
differences between its position and the
IRS’s. This interactive process is expected to
significantly affect case resolution.
The exam team is required to perform a midcycle risk assessment during the 12th month
of the audit cycle. At this time, the team
should update timelines and milestones as
necessary, secure the appropriate approvals
and discuss its findings with the taxpayer —
again highlighting the need for continuous
communication with the taxpayer.
As an important side note, the Roadmap
also directs exam teams to coordinate any
discrete legal issues found with field counsel,
Associate Chief Counsel International (ACCI),
the TPP and the International Practice
Network (IPN).7
2. Issue development
The economist on the case performs
an economic analysis consistent with
the working hypothesis. This is done in
consultation with various team members,
including the examiner, the TPP member
and field counsel. In addition to a strong and
coherent economic analysis, an effective
presentation of the position is required,
including an explanation of the background
and facts used in developing the hypothesis.
This write-up, along with the preliminary
economist’s report, will form the basis of the
draft NOPA. The exam team shares this with
the taxpayer and discusses any inaccuracies
and points of disagreement. The ultimate
goal is to have an agreed-upon set of facts
in the final NOPA. The Roadmap notes that
the process can be iterative, with possible
repeated rounds of receiving the taxpayer’s
input and then redrafting. During this phase,
the exam team should also consider the
applicability of Section 6662 penalties and
prepare a Mutual Agreement Procedure
(MAP) report, if applicable.
Resolution phase
The last part of the audit is the resolution
phase, which usually occurs during the
last seven months of the audit cycle. This
phase consists of three main steps: (1) issue
presentation, (2) issue resolution and (3)
case closing/revenue agent’s report (RAR).
1. Issue presentation
Prior to finalizing the NOPA, the exam team
meets with the taxpayer to discuss the
Government’s findings on all transactions
at issue. The exam team should work
to understand the taxpayer’s position,
determine whether the taxpayer agrees with
the facts established by the exam team and
determine whether the taxpayer would agree
to any issues. At this point, the exam team
assesses the strengths of its position and
any risks associated with taking the issue
forward, then determines the best approach
for presenting its position. Presumably, this
will be an opportune time for taxpayers to
persuade the exam team to proceed toward
the next step: issue resolution.
2. Issue resolution
Four months prior to the end of the proposed
two-year time period, the exam team and
the taxpayer meet to determine whether a
resolution is possible. The Roadmap notes
that the intent of these meetings in part is to
understand the nature of the disagreements
(either factually or legally) and specifically
requires the exam team to “[c]onsider the
taxpayer’s input for resolution purposes.”
The Roadmap also suggests discussing preAppeals resolution opportunities for issues
left unresolved at the examination level. Once
all issues are fully developed and resolution
efforts have been concluded, a final NOPA
is issued. For all agreed-upon issues, a
discussion of Revenue Procedure 99-32 and
its ramifications is appropriate.8
3. Case closing/RAR
If there are open issues, the last step is for
the exam team to prepare and issue the
RAR/30-day letter for all unresolved issues.
Once the taxpayer protests the proposed
adjustments, the exam team will prepare
the rebuttal and attend the Appeals preconference meeting. Finally, if the issues
are settled at Appeals, the exam team will
attend the post-Appeals meeting so that
it understands Appeals’ rationale for the
settlement. The exam team will also review
and analyze the Appeals Case Memorandum
(ACM) and, importantly, consider the impact
of the settlement on subsequent year(s)
risk assessment(s).
All Section references are to the US Internal Revenue Code of 1986, as amended, unless otherwise stated. The Regulations promulgated thereunder are
referred to as “regulations” and cited as “Treas. Reg. Section.”
Directive LB&I-04-0613-004 (18 June 2013); Directive LB&I-04-1113-009 (4 November 2013); and Directive LB&I-04-2014-004 (28 February 2014).
See “New IDR process announced” in this issue.
Tax controversy and risk management review
To help develop in-house transfer pricing experts, the IRS has established internal knowledge management tools, including internal communication networks
in which examiners and other personnel can exchange their experiences and observations. One of these networks is the IPN, a knowledge development network
for international issues, including transfer pricing.
Revenue Procedure 99-32 discusses the IRS’s position regarding adjustments that may be made to conform the accounts of taxpayers to reflect allocations
made under Section 482 and avoid the tax consequences that might otherwise result from those conforming adjustments.
Tax controversy and risk management review
l Transfer pricing enforcement trends l
The Roadmap is a toolkit for conducting
transfer pricing audits, from the identification
of issues, to the formulation of a working
hypothesis, to issue resolution. The
process relies heavily on open and active
communication between the taxpayer and
the exam team.
With an emphasis on the involvement of TPP
members at every step, taxpayers should be
prepared for scrutiny by professionals with
sophisticated transfer pricing knowledge.
Further, having robust documentation of
transfer pricing methodologies is paramount,
as the Roadmap itself approaches the audit
with the maxim that cases are “won and lost
on the facts.” Therefore, it is reasonable to
expect that the meticulously detailed steps
set forth in the Roadmap could be designed
to generate reports, notes and stipulated
facts that could form the basis of case
development for litigation, if issues are not
resolved at the Exam or Appeals levels.
The Roadmap points out that transfer
pricing audits can take as long as two to
three years; accordingly, it is constructed
on a two-year framework. Timeline
notwithstanding, the Roadmap seems to
emphasize issue development over currency.
When approaching a transfer pricing
The process relies
heavily on open and
active communication
between the taxpayer
and the exam team.
audit, taxpayers can use the Roadmap
information to their advantage, especially
with regard to the activities the exam team
is recommended to undertake and the
emphasis on “continuous communication”
and cooperation among various groups
within LB&I and with the taxpayer. Coupled
with LB&I’s new IDR directives, taxpayers
should have the opportunity to frame their
transfer pricing methodology in a compelling
manner, clearly addressing the basis for their
business decisions and the resulting financial
outcomes and effective tax impact.
Tax controversy and risk management review
Tax controversy and risk management review
Penalty corner
Expansion of the IRS
program to systemically
assess penalties for Forms
5471 and 5472 filed
with late-filed returns,
including late-filed Forms
1065, makes it even more
imperative that taxpayers
file timely returns
By Elvin T. Hedgpeth, Executive Director,
Tax Controversy and Risk Management
Services, Ernst & Young LLP
For several years the IRS has been
automatically assessing certain penalties
for late filing of returns and certain required
international information reporting forms.
This process first caught the eye of the tax
community when, in 2009, the IRS started
this automatic assessment process with
the penalty under IRC Section 6038(a) for
Form 5471 (Information Return of U.S.
Persons With Respect To Certain Foreign
Corporations), which is filed with a delinquent
Form 1120 (U.S. Corporation Income Tax
Return). In 2013, the IRS expanded its
systemic automatic assessment process
to Forms 5472 (Information Return of a
25% Foreign-Owned U.S. Corporation or a
Foreign Corporation Engaged in a U.S. Trade
or Business) filed with delinquent returns.
Starting in January 2014, the IRS also
implemented the systemic penalty process
for a late-filed Form 5471 attached to a Form
1065. In response to the Treasury Inspector
General for Tax Administration (TIGTA) report
of September 2013,9 relating to this process,
the IRS stated that it will study whether to
expand the automated penalty program to
other international information reporting
forms, causing more taxpayers concern
about timely filing their returns with all of the
needed forms and statements attached.
Overview of penalty for late filing
of Forms 5471 and 5472
Penalties are often harsh for a simple failure
to timely file an information return or form.
Section 6038(a) requires that each US
taxpayer submit certain specified information
regarding each foreign business entity it
controls (e.g., controlled foreign corporation
(CFC)). Treas. Reg. Section 1.6038-2(f)
provides that the following information needs
to be included on a Form 5471 filed for each
CFC with the taxpayer’s Form 1120: certain
identifying information, stock, shareholder,
earnings and profits, and financial
information about the foreign corporation,
as well as transactions between the
foreign corporation, the filer, certain other
shareholders, and entities related to the filer
or the foreign corporation. Section 6038(b)
prescribes a penalty of $10,000 for each
annual accounting period in which there was
a failure to submit such information. That
penalty increases at a rate of $10,000 per
30 days, where the failure to file continues
for more than 90 days after the IRS notifies
the taxpayer of its compliance failure.
Similarly, Section 6038A requires a US
person to make a separate annual information
return for a domestic corporation that is 25%
foreign owned. Section 6038C also requires
foreign corporations engaged in US business
to make an annual information return.
Generally, this information is to be provided
on a Form 5472, which is to be filed with the
corporation’s income tax return by the due
date of that return. Sections 6038A(d) and
6038C(c) authorize a $10,000 penalty for
each failure to comply with the provisions of
Sections 6038A and 6038C. That penalty
also increases in the same manner as the
Section 6038(b) penalty if the delinquency
Significantly, the penalties in Sections
6038(a), 6038A and 6038C for late-filed
Forms 5471 and Forms 5472 apply even if
no tax is due on the returns to which they are
attached. These penalties for late-filed forms
can, however, be waived if the taxpayer can
show reasonable cause for the delinquency.
The systemic assessment of
late-filed information forms
expanded in 2013 to include
late-filed Forms 5472, and
further expansion is intended
Based primarily on a recommendation
in a 2006 TIGTA report10 regarding the
penalty-setting process for information
returns related to foreign operations and
transactions, the IRS established the
systemic automatic assessment process
to ensure that it is assessing late-filed
penalties for delinquent returns and required
international information returns and forms.
As noted above, the IRS rolled out this
program in stages. In January 2009, Forms
5471 that are attached to a late-filed Form
1120 or Form 1120-F were included in this
automatic assessment process. At that time
there was speculation that the IRS would
extend this automatic assessment process to
other late-filed information returns.
The goals of this automatic process are to
provide revenue enhancement and improve
taxpayer filing compliance. According to the
2013 TIGTA report, the process is working,
as the IRS is meeting these goals. However,
in that same report, TIGTA criticized the
IRS for abating penalties without proper
documentation and management approval
and recommended improvements in that
latter process. TIGTA also recommended
that the IRS study whether to expand the
automatic process for assessing late-filed
penalties for information returns and that the
Commissioner, LB&I Division, “[c]onduct a
study to determine if the automated penaltysetting process should be expanded to
other types of income tax and international
information reporting returns.”
The IRS agreed with TIGTA’s
recommendations and noted in its
response to those recommendations
that the LB&I Division of the IRS had
already begun to take actions to expand
the systemic penalty assessments with
respect to other types of income tax and
international information reporting returns,
including Form 1120-S11 (U.S. Income
Tax Return of an S Corporation), Form
104012 (Individual Income Tax Return) and
Form 1065 (U.S. Return of Partnership
Income). With respect to Form 1065,
systemic assessment of penalties for late
filed Forms 5471 is scheduled to begin in
2014. Consequently, the same automatic
assessment of penalties process as is
currently working for the Form 1120 should
be in place for late-filed Forms 1065 with
attached Forms 5471.
Of note are changes made to the IRS Penalty
Handbook in March 2013, regarding the
automatic systemic assessment of penalties.
The Penalty Handbook provides instructions
for IRS personnel in determining and
processing penalties against taxpayers.
Part of the Penalty Handbook
provides specific directions for IRS personnel
processing penalties when Forms 5471 are
attached to late-filed Forms 1120 and Forms
1065.13 Part of the Handbook
now includes directions for systemically
assessing penalties for Forms 5472 that were
attached to late-filed Forms 1120.
The IRS administration of this penalty
program has received a large amount
of criticism. While improvements have
been made since its inception, obtaining
abatement at any level of the IRS can be a
challenge. Taxpayers may be able to avoid
these penalties if reasonable cause exists for
the failure to timely file the Forms 5471 or
5472. In addition, such penalties assessed
for omissions of, or errors with respect to,
information contained in otherwise timely
filed Forms 5471 or 5472 may be avoided if
the taxpayer can show substantial compliance
with the information reporting requirements.
Given that these penalties are assessed for
a late filing, we would encourage greater
diligence with respect to the filing of Forms
7004 requesting an extension of time to file
the return to which these forms are attached.
Incorrect or missed extensions have
frequently been the cause of the automated
penalty being assessed. We would anticipate
that not unlike what occurred with Forms
5471, many businesses will find themselves
the subject of penalties relating to late-filed
Forms 5472. We believe this may prove
especially true for inbound businesses.
Since 2009, many businesses have received
penalty notices generated by the automated
Form 5471 penalty program. Obtaining
abatement of the penalty has frequently
been difficult. Part of the difficulty is due to
the penalty being an immediately assessable
penalty, generally requiring payment before a
business can appeal the assessment.
Nevertheless, professionals in the Tax
Controversy and Risk Management Services
group have extensive experience with these
penalty programs and can help taxpayers
contest penalty notices and reasonable cause
requests where a penalty has been assessed
for the failure to timely file their appropriate
international information reporting forms.
TIGTA Report — Reference No. 2013-30-111, 25 September 2013, Systemic Penalties on Late-Filed Forms Related to Certain Foreign Corporations Were
Properly Assessed, but the Abatement Process Needs Improvement.
TIGTA Report — Reference No. 2006-30-075, May 2006, Automating the Penalty — Setting Process for Information Returns Related to Foreign Operations and
Transactions Shows Promise, but More Work is Needed.
Tax controversy and risk management review
With respect to Form 1120-S, the IRS has systemically assessed penalties to late filing of Forms 5471 since 2009.
With respect to Form 1040, the IRS is pursuing changes to Form 1040, Schedule B that would require identification of the number of Forms 5471
attached to the return.
In the current version of the IRS Penalty Handbook, there are no instructions for systemically assessing late-filing penalties for a Form 8865
(Return of U.S. Persons With Respect to Certain Foreign Partnerships) attached to a late-filed Form 1065 (U.S. Return of Partnership Income).
Tax controversy and risk management review
Court holds that fraudulent
items on partnership return
do not automatically
keep open the statute of
limitations for partners
By Matthew Cooper, Senior Manager,
Tax Controversy and Risk Management
Services, Ernst & Young LLP
There is now a difference in
interpretations of the various
courts that have considered
this issue
In October 2013, the US Court of Federal
Claims issued a significant opinion dealing
with the statute of limitations during
which the IRS can assess taxes against
the members of a Tax Equity and Fiscal
Responsibility Act (TEFRA) partnership. In
BASR Partnership v. United States, No. 1:10cv-00244 (Fed. Cl. 30 September 2013,
opinion revised on 29 October 2013), the
US Court of Federal Claims addressed, in
the context of a partnership subject to the
TEFRA procedural rules, whether fraudulent
items appearing on a partnership return
create an unlimited assessment period when
none of the partners in the partnership
personally intended to evade tax. The court
held that fraud by the outside counsel who
structured the fraudulent transaction for
the partners was not enough on its own to
indefinitely extend the assessment statute
under Sections 6229(c)(1) and 6501(c)(1)
as against the partners. The court disagreed
with prior opinions addressing this issue from
the Tax Court and the Court of Appeals for
the Second Circuit.
Transaction and examination
An attorney at a law firm advised the tax
matters partner (TMP) of a partnership
and the TMP’s accountant regarding the
tax consequences of the sale of a business
owned by the TMP, his wife and their sons.
The tax advice provided for the sale to
take place through the creation of BASR
Partnership, which included the contribution
of cash and short positions in US Treasury
notes by each of BASR’s partners. In 2000,
the TMP filed the BASR Partnership returns
for the tax years ending 12 June 1999 and
12 December 1999; the individual and trust
returns for each of the partners also were
filed in 2000.
The partnership returns included fraudulent
items as a result of the tax plan developed
by the attorney. The IRS initiated an audit of
the partnership returns in 2006 and issued
a Notice of Final Partnership Administrative
Adjustment (FPAA) in 2010, well beyond
the normal three-year period of limitations
for assessment of tax in Section 6501(a),
and beyond the period of limitations for
the assessment of partnership items and
affected items in TEFRA proceedings under
Section 6229(a).
Tax controversy and risk management review
The law
Section 6226(a) of the TEFRA rules permits
judicial review of an FPAA in the Tax Court,
the district court for the district in which the
partnership has its principal place of business
or the US Court of Federal Claims. The
partner filing for such review does not have
to pay the adjustments determined in the
FPAA before bringing the action, although
the partner does have to deposit the amount
by which the partner’s tax liability would
be increased if the proposed adjustments
were sustained.
Taking advantage of this TEFRA rule and
presumably to avoid the adverse precedent
in the Tax Court, the TMP filed a complaint in
the US Court of Federal Claims challenging in
a motion for summary judgment the issuance
of the FPAA as invalid due to the expiration
of the relevant assessment statutes. Section
6501(a) generally requires the IRS to assess
the amount of any tax within three years
after the return was filed, although Section
6501(c)(1) provides that the tax may be
assessed at any time in the case of a false
or fraudulent return with the intent to
evade tax.
For purposes of Section 6501(a) the term
“return” means the return required to be
filed by the taxpayer and does not include a
return of any person from whom the taxpayer
has received an item of income, gain, loss,
deduction or credit. Section 6229(a)(1)
also provides that any tax attributable to
any partnership item (or affected item) for a
partnership year needs to be assessed before
three years after the date the partnership
return was filed.
Holding of Court of Federal Claims
Under Section 6229(c)(1), however, if
any partner has, with the intent to evade
tax, signed or participated in preparing a
partnership return that includes a false or
fraudulent item, the tax attributable to any
partnership item (or affected item) may
be assessed at any time against partners
who signed or participated in preparing the
return. In this case, the US Government
argued that the fraudulent items included in
the partnership returns created an unlimited
period under both Sections 6229(c)(1) and
6501(c)(1), even though the Government
admitted that the partners themselves did
not possess an intent to evade tax. The
Government relied heavily on favorable case
law in the Tax Court (Allen v. Commissioner,
128 T.C. 37 [2007]) and Second Circuit
(City Wide Transit, Inc. v. Commissioner,
709 F.3d 102 [2d. Cir. 2013]) providing for
unlimited assessment periods under Section
6501(c)(1) in instances where the fraud was
committed solely by the taxpayers’ preparers
acting as their agents.
The court initially addressed the taxpayer’s
argument that Section 6229 is a separate
period of limitations on assessment that
controls in a TEFRA proceeding. The court
found, consistent with the prior precedent in
the Federal Circuit, that the three-year period
of limitations in Sections 6229 and 6501
must be read together in TEFRA proceedings
(see AD Global Fund, LLC v. United States,
481 F.3d 1351 [Fed. Cir. 2007]). In other
words, for TEFRA partnerships, Section
6229(a) provides a minimum period for
assessment of partnership items, although
this minimum period may expire before
or after the maximum period provided in
Section 6501 (Id. at 1354) (see Andantech
L.L.C. v. Commissioner, 331 F.2d 972
[D.C. Cir. 2003]).
There is one assessment period
Fraudulent intent of individual
partners required
Notwithstanding this initial finding, the court
agreed with the taxpayer’s position that the
assessment period was closed under both
Sections 6229 and 6501. Although the
For TEFRA partnerships, Section 6229(a) provides
a minimum period for assessment of partnership
items, although this minimum period may expire
before or after the maximum period provided in
Section 6501.
Tax controversy and risk management review
court found that there was no question that
the partnership returns contained false or
fraudulent items, the unambiguous meaning
of the relevant provisions limits these
exceptions to instances when the taxpayer
personally has the requisite intent to commit
fraud. In reaching this conclusion, the court
relied upon the definition of “return” in
Section 6501(a), which is “the return to be
filed by the taxpayer (and does not include
a return of any person from whom the
taxpayer received an item of income gain,
loss, deduction or credit).”
The court determined that because the
language of Section 6501(a) is expressly
limited to a return filed by the “taxpayer,”
the fraudulent intent referenced in Section
6501(c) is by implication limited to fraud
by the taxpayer despite different prior
interpretations by the Tax Court and Second
Circuit. The court also concluded that this
interpretation was consistent with the plain
language in Section 6229(c)(1) requiring
that “any partner has, with the intent to
evade tax, signed or participated directly or
indirectly in the preparation of a partnership
return which includes a false or fraudulent
item” to extend the assessment period for
tax attributable to partnership items. Thus,
notwithstanding any valid policy reasons
raised by the Government regarding the
practical impediments to the discovery of
tax fraud, the court held that the relevant
assessment period for all of the partners was
already closed, and any adjustments in the
FPAA were untimely.
l Courts l
It is likely that the
Government will continue
to push for unlimited
assessment statutes
based on fraud of the
taxpayers’ agents in
future cases.
It remains unclear whether the IRS will be
able to examine taxpayers’ returns well
beyond the three-year period (or six-year
period for substantial omissions of gross
income) based on the fraud of the taxpayers’
agents. Although this case arose in the
context of a TEFRA partnership, the court’s
analysis could apply equally to both TEFRA
and non-TEFRA matters, and there is now
a difference in interpretations among the
various courts that have considered the issue.
The Government has filed a notice of appeal,
and the taxpayer has cross-appealed. We
can only speculate on whether the Circuit
Court will affirm the lower court or when an
opinion will be issued on the appeal.
It is likely, that the Government will continue
to push for unlimited assessment statutes
based on fraud of the taxpayers’ agents in
future cases. Until more appellate courts
or the Supreme Court address this issue,
taxpayers should be cautious in assuming that
they are no longer subject to examination by
the IRS and additional tax liability, even well
after the normal three-year limitations period,
if there is any potential for the IRS to argue
fraud by the taxpayers’ agents, including their
preparer, CPA or attorney. For now, taxpayers
contesting FPAAs with this issue should
consider bringing actions in the Court of
Federal Claims or other district courts outside
the Second Circuit until the Federal Circuit
and other appellate courts address this issue.
The court’s analysis could apply equally to both
TEFRA and non-TEFRA matters, and there is now
a difference in interpretations among the various
courts that have considered the issue.
Tax controversy and risk management review
Supreme Court update
By Matthew Cooper, Senior Manager, Tax Controversy and Risk
Management Services, Ernst & Young LLP
The US Supreme Court agreed to accept three federal tax cases during
its 2013 term, which runs from October 2013 through June 2014. This
is a shift from recent times when the Court rarely reviewed more than
one federal tax case per term. Here is a brief summary of the cases:
United States v. Woods — The Court heard oral arguments on 9 October
2013, and delivered its opinion on 3 December 2013 (United States
v. Woods, 134 S. Ct. 557 [2013]). In a 9-0 Government-favorable
decision, the Court held that the 40% accuracy-related penalty for
gross valuation misstatements applies to a transaction subsequently
disregarded for lack of economic substance. The Court also held that
the TEFRA procedural rules confer jurisdiction in a partnership-level
proceeding for a court to determine the applicability of the 40% penalty
arising from a misstatement of a partner’s outside basis.
United States v. Quality Stores, Inc. — The Court heard oral arguments
on 14 January 2014, and delivered its opinion on 25 March 2014
(United States v. Quality Stores, Inc. [Docket No. 12-1408]). In an 8-0
Government-favorable decision, the Court held that supplemental
unemployment benefit payments paid to involuntarily terminated
employees as a result of a plant closure or reduction in force are subject
to FICA taxes.
United States v. Clarke — The Court granted the Government’s
petition for writ of certiorari on 10 January 2014, in United States
v. Clarke (Docket No. 13-301). The question presented is whether an
unsupported allegation that the IRS issued a summons for an improper
purpose entitles an opponent of the summons to an evidentiary hearing
to question IRS officials about their reasons.
The case is to be argued on 23 April 2014.
Tax controversy and risk management review
Legislative, regulatory and other guidance
The use of statistical
sampling for mitigating
tax risk
By Mary Batcher, Executive Director;
Ed Cohen, Senior Manager; and
Nicole Miller, Manager, Quantitative
Economics and Statistics group (QUEST),
Ernst & Young LLP
Statistical sampling can mitigate
tax risk for the taxpayer under audit
Given the instability of the global economy
and the ever-changing tax environment,
companies are more risk averse. Statistical
sampling, which can enable companies to
take advantage of federal tax credits and
deductions that bring much-needed cash,
can help mitigate tax risk.
What is sampling?
The review of an organization’s business
records to estimate an anticipated tax
burden, credit or deduction can be
overwhelming and expensive. Statistical
sampling enables a company to review only a
small number of its records and to estimate
accurate results acceptable to federal and
state taxing authorities. For example, in a
population of 5,000 potentially qualifying
research and development projects, a sample
of only 30 to 100 projects might be needed
to estimate the total amount qualifying for
the tax credit and would be close to the
actual total qualifying amount had all 5,000
projects been reviewed.
domestic manufacturing deduction,
cost segregation, Uniform Capitalization
(UNICAP), and transfer pricing to establish
arm’s-length pricing. Oftentimes, more than
one tax year can be sampled at once.
The IRS typically
reviews only the
records selected in a
taxpayer’s sample as
opposed to selecting an
independent sample.
The IRS issued guidance to taxpayers
regarding using and evaluating statistical
samples in Revenue Procedure 2011-42,
2011-37 I.R.B. 318. It also provides specific
guidance in the use of statistical sampling to
its own personnel in Part of the IRS
Internal Revenue Manual (IRM): “This IRM
provides guidelines and procedures for the
Computer Audit Specialist (CAS) to follow
when conducting an examination involving a
statistical sample.” For federal tax purposes,
the statistical sampling and estimation
methodologies followed by EY are the same
as those outlined by the IRS. Sampling can be
used for non-tax purposes as well.
How can sampling reduce tax
risk under audit?
Sampling can be used in numerous other tax
applications as well, including, but not limited
to, meals and entertainment deductions,
tangible property compliance, litigation
support, capitalization and depreciation,
When using a sample for tax preparation,
the taxpayer not only makes burdensome
tasks manageable and cost-effective, but also
mitigates IRS audit risk in several ways. First,
the IRS typically reviews only the records
Tax controversy and risk management review
selected in a taxpayer’s sample as opposed to
selecting an independent sample. Therefore,
the burden of pulling and substantiating
additional documentation for records
not originally in the sample is virtually
eliminated. The Government is saved time
and audit effort, creating a win-win for the
taxpayer and the IRS.
Second, a taxpayer preparing a sample
significantly reduces the chance that the
IRS will use an improper or unsanctioned
statistical method in the audit. Specifically,
the IRS may extract a sample for audit (if
the taxpayer does not already have one)
in numerous ways, some of which do not
adhere to the sampling procedures outlined
in Revenue Procedure 2011-42. The
examination team might use a judgment
sample as opposed to a random sample,
where the examiner may select any items
he or she wishes to review. This can be a
reasonable approach if used properly.
The examination team
might use a judgment
sample as opposed to
a random sample.
However, occasionally the examiner might
apply the results of the judgment sample to
the entire population. Unfortunately, most
items in the population have no probability
of selection; therefore, the results cannot
be applied across the population. If the
taxpayer consents to the use of the judgment
sample, the potential impact on the exam
might not be fully understood. For example,
the sample selections might be more
heavily weighted toward problematic
items. If the IRS extrapolates the sample
results to the population, an overly large
adjustment could result. It is not statistically
appropriate to extrapolate a judgment
sample, and it is interesting that, historically,
a judgment sample, when used by a taxpayer,
carried serious risk of rejection by the IRS
under audit.
There are benefits to understanding
the process
While taxpayer samples can safeguard
against those potential challenges
presented when the IRS selects a sample,
understanding the general concept of
sampling error and how it should be applied
can also reduce risk under audit. Sampling
error is the degree of inaccuracy of an
estimate due to the fact that a sample
was reviewed as opposed to every item
in a population. The more inaccurate the
estimate (usually due to a small sample size
or inefficient type of sample), the larger the
sampling error.
In a taxpayer sample, a larger sampling
error equates to a larger reduction in the
deduction or credits the taxpayer can claim.
However, if the IRS uses its own sample
under audit, the agency does not always
suffer the effects of the sampling error as the
taxpayer would.
Given the IRS’s own internal sampling
guidance, taxpayers should expect the
IRS to follow the same procedures and
requirements described in the revenue
procedure with only the exceptions noted.
However, this might not always be the case.
The taxpayer who knows the proper use of
statistical sampling and understands the
requirements of the IRS’s own guidance,
Revenue Procedure 2011-42 and the
applicable provisions of the IRM is in the best
position when statistical sampling is either
proposed or used in an IRS examination.
When a taxpayer does not have its own
sample, working with the IRS can have its
benefits. For example, the IRS might reduce
its sample size or agree to fully apply the
sampling error reduction in its adjustment in
order to foster agreement with the taxpayer.
If the two parties cannot reach an agreement,
the sample can be expanded and the
examination continued until a compromise or
an acceptable sampling error is reached.
Statistical sampling by a
taxpayer is a proactive
way to achieve greater
control over an audit.
In addition to sample size, the IRS and the
taxpayer might agree on an appropriate
sampling unit. One such example occurs
with respect to withholding studies where
the IRS and the taxpayer might agree to
review vendors — as opposed to invoices —
which reduces the volume of analysis
for both parties. Lastly, if the taxpayer is
planning to draw its own sample but perhaps
the issue at hand is not well-suited to the
guidelines outlined in Revenue Procedure
2011-42, the taxpayer might seek the IRS’s
approval up front, thereby reducing the
risk of alternative sampling and estimation
methods being disallowed.
Tax controversy and risk management review
Within its Tax practice, EY
supports a specialty practice, the
Quantitative Economics and Statistics
(QUEST) group. This group is an
interdisciplinary team of more than
30 statisticians, data analysts and
economists — with more than 70%
holding an advanced degree (either
a PhD or MS) in statistics, operations
research, economics or a related field.
With more than 15 years of tax
sampling experience, EY has the
premier tax sampling practice in the
country. It includes several former
IRS statisticians who have maintained
positive relationships with the IRS. In
fact, IRS sampling coordinators have
even come to QUEST for sampling
advice as they attempt to use
methods developed by EY. In the more
than 400 samples produced annually
by EY, none have ever been rejected
by the IRS.
Statistical sampling can be a tremendous
asset in minimizing the effort to determine
a tax position, but it is perhaps even more
advantageous in reducing the risk faced
under an IRS examination. Statistical
sampling by a taxpayer is a proactive way
to achieve greater control over an audit and
to protect the taxpayer from agreeing to an
IRS sample without fully understanding the
statistical or financial consequences. When
in doubt, working with the IRS directly can
often be mutually beneficial.
TEFRA corner
Duties of a tax matters
partner under TEFRA
procedural rules
By Alice Harbutte, Executive Director,
and Matthew Cooper, Senior Manager,
Tax Controversy and Risk Management
Services, Ernts & Young LLP
“TEFRA corner,” a new recurring section of
the Tax controversy and risk management
review, addresses hot topics in the area of
the Tax Equity and Fiscal Responsibility Act
(TEFRA). The first installment highlights
the general duties and responsibilities
imposed by the Internal Revenue Code
under TEFRA on a tax matters partner (TMP)
who plays a critical role and has substantial
responsibilities in TEFRA proceedings.
The unified partnership audit and litigation
procedures (otherwise known as the TEFRA
procedural rules) can be complex and difficult
to understand. Both taxpayers and tax
practitioners should be aware of these rules
given the increased use of pass-through
entities subject to TEFRA and the IRS’s
renewed focus on examining these entities.
Moreover, the potential pitfalls relating to
TEFRA have resulted in a significant number
of cases in litigation being decided based
on these procedural rules rather than on
the substantive merits. As an example,
the US Supreme Court raised a TEFRA
jurisdictional issue in the recently decided
case of United States v. Woods, 134 S. Ct.
557 (3 December 2013), which otherwise
involved the applicability of a 40% accuracyrelated penalty to a transaction lacking
economic substance (see also “Court holds
that fraudulent items on partnership return
do not automatically keep open the statute of
limitations for partners” in this issue).
proceeding instead of at the partner level,
and any partnership-level determinations are
binding on all direct and indirect partners
of the partnership.15 Any resulting tax
liability, however, is assessed against the
individual partners after the conclusion of the
partnership-level proceeding.
Overview of TMP and related duties
and responsibilities
The TMP is the partner
designated to act as
liaison of the partnership
in administrative and
judicial proceedings.
TEFRA background
To eliminate the administrative burden caused
by duplicative audits and to provide consistent
treatment of partnership items among the
partners in the same partnership, Congress
enacted the unified audit and litigation
procedures of TEFRA, which are located in
Sections 6221 through 6234 of the Code.14
Pursuant to Section 6221, partnership items
are determined in a single partnership-level
Generally, the TMP is the partner designated
as liaison of the partnership in administrative
and judicial proceedings.16 The rules for
designating a TMP are set forth in Treas.
Reg. Section 301.6231(a)(7)-1. The TMP
is usually a general partner (or a member
manager if the TEFRA entity is an LLC) of
the partnership designated by the partners
and identified in Schedule B of Form 1065
(U.S. Return of Partnership Income). The IRS
has the authority to designate a TMP if the
partnership has not named one. The TMP
determination is made separately for each
partnership taxable year. If several years are
under audit for the same partnership, it is
thus possible for the IRS to have to deal
with a different TMP for each taxable year
being examined.
In connection with its role as a liaison with
the IRS, the TEFRA provisions confer on the
TMP certain rights and responsibilities. The
TMP may extend the period of limitations for
assessing any tax attributable to partnership
items (and affected items)17 and enter into
settlement agreements that bind certain
Under the TEFRA procedures, the TMP
is required to provide copies of certain
documents issued during the examination
of a partnership. Two of the most important
documents that the TMP must provide to
non-notice partners20 are copies of the
Notice of Beginning of Administrative
Proceeding (NBAP) issued by the IRS at
the start of a TEFRA examination of the
partnership and any Final Partnership
Administrative Adjustment (FPAA) issued
by the IRS at the end of the TEFRA
administrative process.21 The NBAP must
be furnished to non-notice partners within
75 days of the date it was mailed by the IRS,
while the FPAA must be furnished to such
partners within 60 days of the date it was
mailed by the IRS.22
Pub. L. 97-248, Section 401, 96 Stat. 648; see H. Conf. Rept. 97-760, at 599-600 (1982), 1982-2 C.B. 600, 662-63; Meruelo v. Commissioner, 132 T.C. 355, 362 (2009).
Sente Inv. Club P’ship of Utah v. Commissioner, 95 T.C. 243, 247-250 (1990).
See Section 6231(a)(7); Bush v. United States, 101 Fed. Cl. 791, 793 (2011); Conway v. United States, 50 Fed. Cl. 273, 276 (2001).
A partnership item is an item required to be taken into account at the partnership-level (e.g., items of income, gain, loss or deduction), while an affected item is an item to the extent
such item is affected by a partnership item. See Section 6231(a)(3) and (5); Treas. Reg. Section 301.6231(a)(3)-1 and (a)(5)-1.
Tax controversy and risk management review
The regulations under Section 6223 lists
a host of other notices or information that
the TMP is required to furnish to the other
partners, including information regarding
the following:23
non-notice partners (partners who are not
entitled to receive copies of these notices
directly from the IRS).18 In order for the
settlement agreement to be binding against
a non-notice partner, the agreement must
expressly state that the agreement is to
bind the non-notice partner, and the
non-notice partner must not have filed
a statement with the IRS providing
that the TMP does not have authority to
enter into a settlement agreement on the
non-notice partner’s behalf.19
Closing conference with the
examining agent
Proposed adjustments, rights of appeal
and requirements for filing a protest
Time and place of any Appeals conference
Acceptance by the IRS of any
settlement offer
Consent to the extension of the period of
limitations with respect to all partners
Filing of a request for administrative
adjustment (including a request for
substituted return treatment under Treas.
Reg. Section 301.6227(c)-1) on behalf of
the partnership
Filing by the TMP or any other partner
of any petition for judicial review under
Sections 6226 or 6228(a)
Filing of any appeal with respect to any
judicial determination provided for in
Sections 6226 or 6228(a)
Final judicial redetermination
The TMP is the partner
designated to act as
liaison of the partnership
in administrative
proceedings and judicial
See Sections 6229(b)(1)(B) and 6224(c)(3)(A).
Treas. Reg. Section 301.6224(c)-1.
Section 6223(a); Treas. Reg. Section 301.6223(g)-1(a).
See Treas. Reg. Section 301.6223(g)-1(a)(1) for NBAP, Treas. Reg. Section 301.6223(g)-1(a)(2) for FPAA,
and Treas. Reg. Section 301.6223(g)-1(a)(3) for certain exceptions.
Treas. Reg. Section 301.6223(g)-1(b)(1).
Tax controversy and risk management review
l TEFRA corner l
The TMP is required to furnish the
information with respect to the action or
other matter described above within 30 days
from the date the action was taken or the
information received.24 Note that Section
6230(f) provides that if the TMP fails to
provide actual notice of a judicial proceeding
to any partner, the TEFRA proceeding is
nevertheless applicable to that partner.
There is a two-year
period of limitations
to file suit requesting
a court to allow the
adjustments in the
AAR regardless of
whether the IRS
allows or disallows the
adjustments requested
in the AAR.
Tax controversy and risk management review
TMP filing of AAR
The TMP also has the authority to file
an Administrative Adjustment Request
(AAR) on behalf of the partnership under
Section 6227(b). An AAR filed by the
TMP (partnership-level AAR) is a request
by the partnership to the IRS to allow the
amendments to the partnership’s tax return
that are set forth in the AAR. As referenced
above, the regulations under Section 6223
require that within 30 days of filing an
AAR, the TMP must provide information to
the other partners concerning the filing. In
addition to notifying the other partners that
a partnership-level AAR was filed, the TMP
needs to keep the other partners informed
concerning the status of the partnership-level
AAR filing.
For example, there is a two-year period of
limitations to file suit requesting a court to
allow the adjustments in the AAR regardless
of whether the IRS allows or disallows the
adjustments requested in the AAR. This
two-year period to file suit, which may be
extended by agreement, starts from the date
the partnership-level AAR is filed. Thereafter
the IRS has two years to issue a refund to
partners who are entitled to a refund based
on the adjustments in the partnership-level
AAR. If the refund is not paid, the TMP
must file suit asking a court to issue the
refund.25 Unlike the procedures applicable
for claiming a non-TEFRA refund, the filing
of a partnership-level AAR by the TMP
does not toll the period of limitations with
respect to any claim for refund attributable
to the partnership items being adjusted.
Treas. Reg. Section 301.6223(g)-1(b)(3).
Sections 6228 and 6230(d)(2).
Tax controversy and risk management review
l TEFRA corner l
Consequently, if two years is allowed to
lapse after the AAR is filed and refunds
have not been issued, partner-level refunds
attributable to the partnership-level AAR
are barred unless the TMP files suit in one
of three courts: Tax Court, District Court
or Court of Federal Claims. As a result, it is
It is important for the
TMP and the TMP’s tax
advisor to understand
the basics of the TEFRA
procedural rules.
extremely important for the TMP to monitor
the filing and processing of the partnershiplevel AAR to prevent barred partner refunds.
Ernst & Young LLP adds new
controversy talent
It is important for the TMP and the TMP’s
tax advisor to understand the basics of the
TEFRA procedural rules. As the Tax Court has
repeatedly observed, the continual presence
of a TMP to act on behalf of the other
partners is essential to the proper operation
of TEFRA because the execution of the
TMP’s statutory duties will have a substantial
effect upon the rights of all partners in the
partnership.26 In other words, actions that
are taken by the TMP, as identified above,
will impact all of the partners and may
have detrimental consequences, including
a loss of the right to timely take action,
for partners who did not receive proper
information or notification. This is especially
true considering the language in Section
6230(f) providing for the applicability of the
TEFRA rules notwithstanding any failure by
the TMP to provide notice to any partner.
Consequently, it is critical that partners
choose a TMP wisely — one who is reliable
and responsive.
Matthew Cooper joins Ernst & Young LLP to focus on
penalty and TEFRA tax controversy issues
Matthew Cooper
Washington, DC
+1 202 327 7177
Matt Cooper joined the US firm after spending
the previous nine years as an attorney
in the IRS Office of Chief Counsel within
the Procedure & Administration division.
In his most recent role with the IRS, Matt
was a special counsel advising the IRS, US
Department of Justice, tax practitioners and
the public on all aspects of administrative
and judicial tax practice. As special counsel,
Matt coordinated some of the office’s most
high-profile and controversial topics, such
as the economic substance doctrine, the
return preparer initiative and challenges to
the Defense of Marriage Act. He also was one
of the office’s subject-matter professionals
In our next issue, we will explore in more
detail the TMP’s duties and responsibilities
with respect to filing an AAR under TEFRA
and the perils if the TMP neglects those
duties and responsibilities.
See Seneca Ltd. v. Commissioner, 92 T.C. 363, 366 (1989), aff’d. 899 F.2d 1225 (9th Cir. 1990); Computer Programs Lambda v. Commissioner, 90 T.C. 1124 (1988).
Tax controversy and risk management review
with respect to various procedural tax issues,
including penalty, refund, TEFRA, Circular
230, tax shelter and power of attorney issues.
Prior to becoming a special counsel, Matt was
a senior technician reviewer with the IRS and
was responsible for supervising attorneys,
drafting regulations and providing legal advice
and litigation support on penalties, limitation
periods, interest, information reporting
and ethics. Matt has been involved with
multiple guidance projects. Some examples
of published guidance that he reviewed or
drafted are projects relating to reportable
transaction penalties under Sections 6707,
6707A and 6708; employer identification
number updates under Section 6109;
estimated tax penalty relief under Section
6654; and all return preparer and Circular
230 projects issued since 2006.
Tax controversy and risk management review
Tax Controversy and Risk
Management Services:
Ernst & Young LLP team leadership
Rob Hanson,
EY Americas Director
Washington, DC
+1 202 327 5696
Tina Boldt,
Accounts and Interest Group
Dallas, TX
+1 214 969 8476
Frank Cannetti
Pittsburgh, PA
+1 412 644 0571
Pat Chaback
San Francisco, CA
+1 415 894 8231
Richard Fultz
Washington, DC
+1 202 327 6840
Alice Harbutte
Denver, CO
+1 720 931 4011
Elvin Hedgpeth
Washington, DC
+1 202 327 8319
Tom Meyerer,
Employment Tax
Controversy Leader
Washington, DC
+1 202 327 8380
Frank Ng
Washington, DC
+1 202 327 7887
Alan Summers
Portland, OR
+1 503 414 7967
Ned Connelly
Stamford, CT
+1 203 674 3006
Steve Diamond
Houston, TX
+1 713 750 8277
Dolly Park
McLean, VA
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Sharon Kariya
San Francisco, CA
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Mark Mesler
Atlanta, GA
+1 404 817 5236
Maureen Nelson
Washington, DC
+1 202 327 6021
Bill O’Meara
Philadelphia, PA
+1 215 448 5616
Lee Poullard
Los Angeles, CA
+1 213 240 7509
John Risacher
Chicago, IL
+1 312 879 3323
Trevor Wetherington
Detroit, MI
+1 313 628 8439
National leadership
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Please refer to your advisors for specific advice.