Procedure & Administration

Global Harmonization of Taxation

The European Union (EU) was a catalyst for the acceptance of international financial reporting standards (IFRS) in Europe. The EU and the International Organization of Securities Commissions (IOSCO) adopted IFRS in 2002, the U.S. Securities and Exchange Commission (SEC) anticipates IFRS acceptance by 2009, and the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) continue to worktoward common standards. Will there bespillover effects of financial accountingharmonization on taxation? Tax globalization efforts include international cooperation, the European Common Consolidated Corporate Tax Base (CCCTB), and U.S. tax reform to meet today’s global business environment.

This item begins with a review of nongovernmental organization (NGO)and government tax policy involvement. It then looks at tax globalization efforts. Finally, it considers an international tax organization and harmonization.

NGOs

OECD: The Organisation for Economic Co-operation and Development (OECD) creates international recommendations to promote global economic progress. It is headquartered in Paris and currently includes 30 democratic member countries (see Exhibit 1). The OECD has taken a primary role in circumventing harmful tax practices around the globe by issuing the Model Tax Convention. The Convention is used by the OECD member and nonmember countries as the basis for negotiating, applying, and explaining tax treaties. It is also used to harmonize OECD member countries’ tax conventions and to mitigate double taxation.

In 1998, the OECD issued a report titled “Harmful Tax Competition: An Emerging Global Issue” (www.oecd.org/dataoecd/33/0/1904176.pdf). Harmful tax competition thwarts free trade and investment; it usually manifests itself as a special tax incentive. The report’s major objective was to change the Model Tax Convention. Now, under the Convention, a country cannot refuse to provide information that is unnecessary for its own tax purposes and cannot use bank secrecy laws to justify its failure to provide information.

The OECD has some weaknesses. Since its recommendations are not legally enforceable, success hinges on voluntary participation and/or legal enforcement by other organizations (e.g., the World Trade Organization). Subsequent to the 1998 report, the OECD’s lack of representation for developing countries (countries with a low standard of living and gross domestic product) has been under attack.

The 1998 report noted that the key characteristic of harmful tax competition is the lack of effective information exchange—timely availability (via legal means) of reliable information. The OECD created the Tax Information Exchange Agreement (TIEA) model to continue addressing the effective exchange of tax information. The TIEA applies to tax information for income, capital, inheritance, estate, or gift taxes and under the agreement, the information is exchanged only on request.

In 2000, the OECD identified tax havens around the world, describing them as “non-cooperative countries andterritories” and demanding that they sign letters of commitment ending harmful tax practices. The commitment letter required each jurisdiction to fulfill transparency disclosure requirements. The OECD perceives a transparent tax system as one that applies laws on a consistent basis among similar taxpayers and has information in place for taxing authorities to determine a taxpayer’s position. The OECD believed each jurisdiction would comply, and some did willingly, but many changed the language of the letter before signing.

In response to these requirements, the International Tax and Investment Organisation (ITIO) was formed in March 2001. The ITIO consists of 15 small and developing countries (see Exhibit 2). The ITIO was created to establish a level playing field and confront the OECD. During 2001 and 2002, the ITIO challenged the OECD repeatedly, drawing attention to what the ITIO calls an ongoing double standard for OECD member and nonmember states. For example, the ITIO suggested that the OECD targeted small states in its initiative against corporate crime while overlooking or excusing problems of its member states.

The OECD’s 2005 annual Global Forum, comprising OECD and non-OECD members, focused on leveling the playing field by promoting tax transparency and information exchange. The OECD released “Tax Co-operation: Towards a Level Playing Field—2007 Assessment by the Global Forum on Taxation” on October 12, 2007 (www.oecd.org/document/29/0,3343,en_2649_33745_39473821_1_1_1_1,00.html). The OECD reports increased participation in TIEAs (including access to bank information).

ECOSOC: The United Nations (UN) Economic and Social Council (ECOSOC) discusses international economic and social issues and formulates policy recommendations for its member countries. The UN became more active in international tax matters in 1980 when it produced the UN Model Income Tax Treaty and ECOSOC created the Ad Hoc Group of Experts on International Cooperation in Tax Matters. In 2004, the Ad Hoc Group was renamed the UN Committee of Experts on International Cooperation in Tax Matters. The Experts meet annually and are responsible for reviewing and updating the Model Tax Treaty; providing a framework for dialogue to improve and promote international tax cooperation; monitoring, assessing, and providing recommendations on new and emerging international cooperation issues; and providing recommendations and technical assistance to developing countries.

The UN Secretary General’s August 2007 report on the International Conference on Financing for Development suggests that the UN should be more involved in international tax cooperation (www.un.org/esa/ffd). The report recommends that the Experts be more diligent in combating tax evasion via taxation of services and natural resources, as well as tax administration. The report highlights an underlying difference between the OECD and the UN tax models. The OECD model gives more rights to the investor’s country of residence and the UN model gives more rights to the source country where the activities take place.

EU: In 2003, the EU ratified the Tax Directive, an agreement to share tax and cross-border interest payment information among EU members. The Tax Directive consists of three items: a code of conduct to eliminate harmful business tax regimes (i.e., environments that perpetuate harmful tax competition), legislation to ensure a minimum level of taxation on savings income (to ensure capital market efficiency and reduce tax evasion), and legislation to eliminate taxes on cross-border payments of interest and royalties between related companies. The EU believes that the Tax Directive will diminish harmful competition (e.g., tax benefits reserved for nonresidents, tax advantages granted in the absence of real economic activity). One way it plans to meet this objective is by sharing all tax information. The EU agreement requires every member state withholding taxes to execute the exchange of information by 2010. The Tax Directive was effective January 1, 2004, with the exception of the Directive on Taxation of Savings, which became effective January 1, 2005.

Cooperation

Countries are under pressure to conform to international tax initiatives to create greater transparency through the exchange of information. International cooperation could be a catalyst for international tax harmonization. This would be analogous to the adoption of international accounting standards and harmonization among global economies.

It appears that the current global tax environment reflects tax cooperation—e.g., eliminating double taxation (OECDmodel treaty), sharing information (OECD, TIEA, and EU Tax Directive)—rather than harmonization. However, the EU is working on a Common Consolidated Corporate Tax Base, which evokes harmonization because it would result in a common tax base across all member states. Nevertheless, different countries exhibit different levels of cooperation.

Switzerland: Switzerland has shown a strong resistance to converging to international tax information exchange standards and has obstructed the process in Europe. Switzerland is not a member of the EU and refuses to comply with the 1998 OECD report. It also refuses to share information automatically as the OECD TIEA model requires. Switzerland is considered a tax haven and has low personal (11.5% top rate) and corporate (flat 8.5%) tax rates. The country’s low tax rates may impede the end of harmful tax competition within Europe.

However, in 2003 Switzerland and the United States signed an agreement to respond to information requests for investigations into civil or criminal matters. Also, Switzerland has compromised and has agreed to the EU Savings Directive. There are four elements to the EU agreement with Switzerland: (1) withhold 15% tax on interest earned in Switzerland, transferring 75% to the EU citizen’s country of residency and retaining 25% for Switzerland (where the income was produced); (2) exchange information on request for investigations of criminal or civil fraud cases; (3) review the agreement a minimum of once every three years; and (4) if non-Swiss source income is voluntarily disclosed to the taxpayers’ resident country, the withholding tax will not be applied. In April 2007, Switzerland reported that it would pay 402.5 million Swiss francs ($333 million) to the member states, satisfying its withholding tax agreement on interest payments.

United States: The United States has published its own model treaty and is making strides to conform to the OECD. In June 2006, Hal Hicks, Treasury Tax Counsel, suggested that the United States would revise its treaty to be more in line with the OECD Model Convention. The revised treaty was completed on November 15, 2006.

Hicks also commented that the United States and OECD do not promote bureaucracy or high tax rates. Rather, promoting information exchange and transparency are their primary interests, since information exchange is fundamental to the enforcement of tax laws and full collection of taxes is the best approach to keeping tax rates low.

European Commission: In 2001, the European Commission proposed short-term and long-term goals to resolve cross-border EU economic activities. The plan is to remove tax obstacles to cross-border activities and investment. The short-term goals are to eliminate double taxation, prevent nontaxation, and reduce compliance costs. The long-term goal is to harmonize the corporate tax base via the CCCTB. Some EU member states prefer the short-term coordination (e.g., via double tax conventions), fearing that tax base harmonization would lead to a common tax rate that might diminish revenues. Certain member states believe that direct taxes should be determined at the member level rather than the European Community level because of the members’ vested interest in their own revenues. KPMG reported similar results in a fall 2007 survey. The survey suggests that 78% of respondents support the CCCTB development process, while only 34% would unconditionally agree to use it (i.e., before seeing the details).

CCCTB

Why is the CCCTB being pursued? Currently, EU member states operate under separate accounting standards. Specifically, corporations account for earnings and profits in each location in which they operate, and related-party transactions require pricing via an arm’s-length method (transfer pricing rules per OECD guidelines and Sec. 482). These standards result in double taxation and in most countries losses cannot be offset against subsidiary earnings in another member state. To establish the CCCTB, participating countries must agree on the definition of taxable income (common tax base), the definition of the consolidating group and loss offsetting rules, and the income apportionment formula.

Where do the IFRS fit in the CCCTB scheme? Some suggest that the IFRS are the starting point for developing the common tax base (via common language and definitions). Others believe the tax base should be independent of the IFRS since not all companies are required to use those standards (i.e., they could use domestic accounting rules), and the CCCTB involves tax accounting. The CCCTB Working Group has made some strides in the tax base definition and has proposed three apportionment options. One of those options—formulary apportionment—mimics U.S.state apportionment rules (property, payroll, and sales). The Working Group proposes that the CCCTB be optional because it is supposed to help companies rather than countries, noting that many companies do not operate across borders. The CCCTB should be completed by 2011.

U.S. Tax Reform

In June 2007, the Brookings Institution’s Hamilton Project released policy papers on U.S. tax reform. Part of the proposed policy change was to make multinational corporations more compliant. The project highlighted the fact that foreign income has become a major source of tax avoidance for firms operating in global environments. For example, one paper notes that the United States has the second highest statutory tax rates among OECD members, yet revenue collections are the fourth lowest (as a percentage of gross domesticproduct) (Furman, Summers, and Bordoff,“Achieving Progressive Tax Reform
in an Increasingly Global Economy”(Brookings Institution, June2007), p. 17).

Another paper highlights how corporations exploit tax planning. U.S. multinational profit allocation does not represent economic reality since the top three source countries do not align with multinational jobs. The top three source countries for U.S. multinational profits are the Netherlands, Ireland, and Bermuda, with statutory rates of 5.3%, 6.1%, and 1.7%, respectively (Clausing and Avi-Yonah, “Reforming Corporate Taxation in a Global Economy” (Brookings Institution, June 2007), p. 8). Two themes (formulary apportionment and business tax reform) to improve multinational compliance emerged from the policy papers.

Clausing and Avi-Yonah’s proposal recommends formulary apportionment based only on sales (i.e., equivalent of U.S. state tax allocation) since it is simple to administer. The proposal suggests that an apportionment system should mitigate tax decisions made for avoidance purposes and should result in either lower corporate rates or increased revenues. An alternative recommendation (Kleinbard, “Rehabilitating the Business Income Tax” (Brookings Institution, June 2007)) suggests a business enterprise income tax (BEIT) that would permit corporations to deduct the cost of capital and require investors to pay tax on the accrued normal (risk-free) returns of the investment, eliminating double taxation. Business investments would be taxed only on risky returns and rents. These changes would simplify the tax system and mitigate the use of tax shelters. Moreover, harmonization of tax rates on different business forms, financing, and investing should occur.

ITO and Harmonization

Vito Tanzi, retired head of the International Monetary Fund’s Fiscal Department, addressed the need for an international tax organization (ITO) as early as 1996. (See Tanzi, “Is There a Need for a World Tax Organization?,” in Razin and Sadka, eds., The Economics of Globalization: Policy Perspectives from Public Economics (Cambridge University Press, 1999), pp. 173–86.) A decade ago he noted that globalization was creating cross-border tax issues that defied the territoriality principle. Tanzi’s major theme is that tax competition is eroding tax revenues and increasing administrative costs. Specifically, his concerns were capital flight to jurisdictions with lower tax rates (including tax havens) or more generous tax incentives; income shifting (via transfer pricing) to lower tax jurisdictions; and lack of information exchange and the use of complex financial instruments (both leading to income underreporting or evasion).

Most of these issues have surfaced within the OECD, ECOSOC, the EU/EC, and the United States, and some progress has been made via bilateral agreements. However, bilateral agreements (cooperation) do not match his appeal for an international organization that supervises and influences tax developments that have transnational effects (harmonization). Tanzi advocates a board (representing all member countries) that would recommend changes to mitigate negative tax effects and give developing countries a greater role in setting standards.

Conclusion

The CCCTB goals should reduce tax compliance costs for U.S. multinationals operating in the EU. Will the CCCTB process mimic international financial accounting harmonization? Something in the process is strangely familiar because the IASB/IFRS gained strength via the EU, the IFRS will be recognized by the SEC, and the FASB and the IASB are working toward harmonization. It would be a stretch for the United States to concede to an international tax framework; however, the CCCTB might be viewed as a subset of an ITO. It may be difficult to harmonize international taxes because of cultural and legal differences. Nonetheless, the United States needs to be willing to accept change to ensure its continued economic success.

From Lynn Comer Jones, Ph.D., CPA, University of North Florida, Jacksonville, FL, and Jennifer L. Brown, M. Acc. (Neither Affiliated with CPAmerica International)

Practical Considerations for the New Paid Preparer Penalty Rules and FIN 48

Return preparers have recently become subject to new, higher standards from two sources: Congress and the Financial Accounting Standards Board (FASB). This item compares the new “more likely than not” standard and explores the pitfalls that CPAs may encounter under FIN 48 and the Code.

Preparer Standards Under the Code

The Small Business and Work Opportunity Tax Act of 2007, P.L. 110-28 (SBWOTA), which was signed into law on May 25, 2007, includes a provision that modifies the existing preparer penalty rules. SBWOTA amended Sec. 6694 by making the following changes:

1. It expanded the preparer penalties to apply not only to income tax returns but also to estate and gift, excise, exempt organization, and employment tax returns.

2. It increased the dollar amount of preparer penalties:

3. It modified the standards of conduct that must be met to avoid the imposition of preparer penalties associated with the understatement of a tax liability:

The Service has issued Notice 2007-54, which provides transitional relief from the new preparer penalty rules. This transitional relief will allow return preparers to follow the previous law under Sec. 6694 for income tax returns, amended returns, and refund claims. For all other returns, including estate, gift, and generation-skipping transfer tax returns, employment tax returns, and excise tax returns, the reasonable basis standard set forth in the regulations under Sec. 6662 will be applied in determining whether the IRS will impose a preparer penalty. The Notice 2007-54 relief will apply to all returns, amended returns, and refund claims due on or before December 31, 2007 (determined with regard to any extension of time for filing), to 2007 estimated taxes due on or before January 15, 2008, and to employment and excise tax returns due on or before January 31, 2008. No transitional relief is available where there is willful or reckless conduct, regardless of the type of return prepared.

The “reasonable basis” standard for disclosed positions is defined in Regs. Sec. 1.6662-3(b)(3) to be a relatively high standard of tax reporting—significantly higher than “not frivolous” or “not patently improper.” Under the regulations, a return position that is “merely arguable or that is merely a colorable claim” does not satisfy the reasonable basis standard. If a return position is reasonably based on one or more of the authorities set forth in Regs. Sec. 1.6662-4(d)(3)(iii) (taking into accountthe relevance and persuasiveness of the authorities and subsequent developments), the return position will generally satisfy the reasonable basis standard even though it may not satisfy the substantial authority standard as defined in Regs. Sec. 1.6662-4(d)(2).

The former “realistic possibility of being sustained on its merits” standard for undisclosed positions was defined in Regs. Sec. 1.6694-2(b) as one in which a reasonable and well-informed analysis by a person knowledgeable in the tax law would lead such a person to conclude that the position has approximately a one in three or greater chance of being sustained on its own merits.

Sec. 6694 does not define the new “more likely than not” (MLTN) standard. However, the plain meaning of the term and its interpretation in other instances indicate that it means a greater than 50% possibility.

Note: Circular 230 §10.35(b)(4) describes a reliance opinion as written advice “if the advice concludes at a confidence level of at least more likely than not (a greater than 50 percent likelihood) that one or more significant federal tax issues would be resolved in the taxpayer’s favor.” (The IRS has issued proposed regulations to conform Circular 230 to the new Sec. 6694 MLTN standard; see News Notes, p. 705.)

MLTN Under FIN 48

FASB Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes, which generally applies to fiscal years beginning on or after December 15, 2006, addresses the recognition and measurement of income tax positions using an MLTN threshold. Under FIN 48, the MLTN threshold means that:

FIN 48 requires a “cumulative probability” approach to recognize the largest amount of a tax benefit that is more than 50% likely to be realized after settlement with a tax authority that has full knowledge of all relevant information.

In practice, FIN 48 will require a business to assess its worldwide tax position using these MLTN criteria in determining the adequacy of its tax reserves and its inventory of temporary differences and the resulting measurement of its deferred tax assets. It will require a great deal of judgment for an enterprise to properly implement FIN 48.

Prior to FIN 48, a business used Statement of Financial Accounting Standards (FAS) No. 5, Accounting for Contingencies, to assess the reasonableness of its tax reserves. Aggressive tax positions were generally recorded as a component of a business’s FAS 5 reserve (also referred to as a company’s tax “cushion”). Under FAS 5, a business identified uncertain tax benefits and determined the likelihood of losing those benefits. A loss contingency was accrued only if the loss was probable and could be reasonably estimated.

A deferred tax asset is generally measured based on all available data readily available and in accordance with FAS No. 109, Accounting for Income Taxes. If management determines, based on the weight of the evidence available, that it is more likely than not (more than 50%) that some portion or all of the deferred tax assets will not be realized, a valuation allowance should be recorded to reduce the deferred tax asset to the amount that is more likely than not to be realized.

Under FIN 48, an additional measurement has been added due to the MLTN measurement criteria requirement to determine the “best estimate” required by FIN 48. As a result, there are three measurements to consider: financial statement basis, “best estimate” tax basis, and the “as filed” tax basis.

Expanded Disclosure Requirements

A controversial issue of FIN 48 is the expanded disclosure requirements. For example, at each annual reporting period, the following disclosures are required:

The obvious concern here is that FIN 48 disclosures and workpapers can provide a great deal of information about a business enterprise’s worldwide tax position. Access to this information would provide an auditor a great deal of insight into the “Achilles heel” of a company’s uncertain tax positions. Historically, under its policy of restraint, the Service has not requested tax accrual workpapers as a standard examination technique. Its current policy is to request them only when a business has been involved in a listed transaction (IRM 4.10.20.3.2).

Recent IRS guidance on FIN 48 gives some insight into the Service’s view of this new accounting pronouncement’s relevance for use in an IRS examination.

Chief Counsel Memorandum AM 2007-0012 (6/8/07): The IRS Chief Counsel’s Office concludes that documents produced by a taxpayer and/or its auditors to document uncertain tax positions according to FIN 48 are treated as tax accrual workpapers (TAWs) as defined by Internal Revenue Manual (IRM) Section 4.10.20.2(2).

Field Examiner’s Guide LMSB-04-0507-045, FIN 48 Implications (May 2007), and LMSB Commissioner Memorandum LMSB-04-0507-044, FIN 48 and Tax Accrual Workpaper (TAW) Policy Update (5/10/07): The field examiner’s guide and LMSB memo say that documents produced by a taxpayer and its auditors to document uncertain tax positions in accordance with FIN 48 are included in the IRS’s interpretation of TAWs and are subject to the Service’s policy of restraint in requesting provision workpapers. The field guide does suggest to IRS auditors that tax footnotes including FIN 48 disclosures should be reviewed as part of the audit planning process, subject to warnings that the IRS’s restraint policy on requesting tax provision workpapers should be
followed.

Chief Counsel Notice 2007-015 (6/20/07): CC-2007-015 concludes that effective tax rate reconciliation workpapers are neither tax accrual workpapers nor audit workpapers. Therefore, they are not included in the documents that the IRS will not routinely request during an audit.

Issues to Consider

CPAs may want to consider the following issues in light of the increased level of scrutiny required under the MLTN criteria by both Sec. 6694 and FIN 48:

Conclusion

The MLTN standard has effectively raised the bar on CPAs who provide tax compliance and tax advisory services for their clients. With the ever-increasing regulatory requirements imposed on the profession coupled with resource constraints, CPAs must be extremely careful and diligent when providing tax services to their clients under the MLTN requirement.

From Anthony P. Vernaglia, CPA, MST, Restivo Monacelli LLP, Providence, RI (Not Affiliated with CPAmerica International)

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