I am pleased to reproduce below a guest post from my friend and colleague, David S. De Berry. Dave is an attorney and CEO of Concord Specialty Risk, a series of a Delaware limited liability companies owned by RSG Specialty Group, LLC. I want to emphasize that while Dave and I are now colleagues as a result of the common ownership of our two firms, I welcome guest post submissions from any responsible contributor. Dave’s topic is in an area not typically covered on this blog, but I still thought readers would find it of interest. Here is Dave’s post.


Companies could be facing a significant new exposure as a result of a new reporting requirement that goes into effect for tax returns that must be filed this year. The new reporting requirement expands beyond existing accounting requirements for tax uncertainty. The result is that tax liabilities not requiring a reserve for financial statement purposes may be directly disclosed to the IRS. This article discusses the new reporting requirements, the potential impact on securities litigation and the variety of insurance solutions available to address these issues.


The Requirement to "Confess & Rank"

The IRS now requires "large" corporations to "confess and rank" their uncertain tax positions when filing tax returns. Specifically, the IRS is now requiring corporations with (worldwide, gross) assets that exceed $100 million to provide the IRS with a "concise description" of all of their uncertain tax positions and to rank those positions by size of tax reserve, or by amount at issue (if not reserved), and to denote whether the position relates to transfer pricing. The information must be included in their 2010 U.S. income tax returns (generally filed on or before September 15, 2011 for calendar year taxpayers) under a new IRS form, Schedule UTP, which stands for "uncertain tax positions." The Schedule UTP form can be found here.


And the requirement to "confess and rank" to the IRS is slated to extend to all corporations as Schedule UTP phases in over the next five years. Corporations with total assets of $100 million or more must file Schedule UTP starting with 2010 tax years. Starting with 2012 tax years, the total asset threshold will be reduced to $50 million. Starting with 2014 tax years, it will be reduced to $10 million.  The IRS stated that it will consider whether to extend the Schedule UTP reporting requirement to other taxpayers—such as pass-through entities or tax-exempt organizations—for 2011 or later tax years. The instructions for Schedule UTP can be found here.


The Dramatic Extension Beyond Current U.S. – GAAP

Companies reporting their financial statements in accordance with US-GAAP have recently had to follow a set of rules known as "FIN 48" when accounting for tax uncertainty. Essentially, FIN 48 requires that all tax positions be identified and evaluated in a two-step process: (1) the recognition step, which asks whether each tax position would more likely than not prevail under existing law – if not, then none of the tax benefits associated with the position are "recognized" (i.e., the entire amount at risk is charged or reserved and provisions for accruing interest and perhaps penalties must also be set forth in the financial statements); if the position is likely to prevail under existing precedent or authority, then the second (measurement) step is taken to determine how much of the tax benefits may be recognized for financial statement purposes and (2) the measurement step, which asks, as to each recognized position, how much of the position is more likely than not going to be allowed in a final resolution (via settlement or adjudication) with the taxing authority assuming the position were challenged and it would be settled on its own merits (no trading of positions for settlement purposes). The official publication of FIN 48 can be found here.


Schedule UTP is a dramatic divergence from the measurement step used in FIN 48 for accounting purposes. Under FIN 48, if a company believes (i.e., convinces its financial statement auditors) that it would never settle a tax position with the IRS and would more likely than not prevail in the adjudication of that position, no FIN 48 reserve is required. Under Schedule UTP, however, each such position must be disclosed and given a priority ranking as part of the corporate tax return filed with the IRS.


The Impact on Companies

The impact that Schedule UTP will have on securities class actions and derivative actions remains to be seen. The impact on corporate cash, balance sheets and income, however, is expected to be significant.For example, in a report by Credit Suisse dated May 18, 2007, entitled "Peeking Behind the Tax Curtain", Credit Suisse analyzed just 361 companies in the S&P 500 and found a total of $141 billion in unrecognized tax benefits for uncertain tax positions identified pursuant to FIN 48. A copy of an abstract of that repot can be found here.


To the extent that FIN 48 reserves relate to tax liabilities owed the IRS, Schedule UTP will almost certainly make the FIN 48 reserves a self-fulfilling prophecy. As discussed further below, however, there may be some relief for companies that posted large FIN 48 tax reserves of U.S. income tax liabilities. In cases where the tax position was not recognized, in part or in whole, because the company could not persuade its financial statement auditors with a tax opinion prior to the initial setting of FIN 48 reserves for the position, tax insurance may be available.


But regardless of the amount reserved for FIN 48 purposes, the amount not reserved but yet exposed by Schedule UTP will present a significant challenge to many companies. In certain instances, the discrepancy between tax liabilities reserved for FIN 48 purposes and tax liabilities disclosed to the IRS in Schedule UTP can be very significant. Many companies obtained tax opinions for certain tax positions and argued that they would never settle with (and would prevail over) the IRS to avoid FIN 48 reserves for those tax positions. As noted above, all such positions must now be disclosed in a concise narrative description and given a priority ranking as part of the corporate tax return.


When the discrepancy is material to the company’s financial condition and significant tax liabilities (and/or penalties) that were not reserved arise as a result of Schedule UTP, there may well be grounds for shareholder actions.


The Specter of Securities Class Actions & Derivative Suits

Absent rather extreme circumstances (e.g., Enron), it still seems fairly remote that an adverse, material, final determination of an uncertain tax position(s) not fully reserved in a company’s financial statements but reported on Schedule UTP could expose the company, its directors and officers and/or auditors to liability under securities laws or corporate law.


However, in instances in which the discrepancy between FIN 48 reserves and Schedule UTP exposure is both large (relative to liquidity) and protracted (not remedied over time by either increasing reserves or mitigating the tax risk, as discussed below), and/or if penalties are assessed, the plaintiff’s case becomes easier.


In Overton v. Todman & Co, 478 F.3d 479 (2d Cir. 2008), the Court vacated and remanded the trial court’s dismissal of a securities fraud claim against an accounting firm that purportedly failed to correct its certified opinion after learning that the company’s tax liability had not been correctly stated. (The appeal did not address the more difficult issue of loss causation because the trial judge had dismissed on the basis that the accounting firm had no "duty to speak.") The Court ruled:


Specifically, we hold that an accountant violates the "duty to correct" and becomes primarily liable under  Section  10(b) and Rule 10b-5 when it (1) makes a statement in its certified opinion that is false or misleading when made; (2) subsequently learns or was reckless in not learning that the earlier statement was false or misleading; (3) knows or should know that potential investors are relying on the opinion and financial statements; yet (4) fails to take reasonable steps to correct or withdraw its opinion and/or the financial statements; and (5) all the other requirements for liability are satisfied [i.e., materiality, transaction causation, loss causation and damages]. { Id at pages 486-487.} 


A copy of the decision can be found here.


It would seem that the reasoning in Overton as to an auditor’s duty to correct and speak about an inaccurately disclosed tax liability should extend to corporate "speakers" when any corporate tax directors, CFO’s and the members of an Audit Committee discover a material discrepancy between FIN 48 reserves for U.S. income tax liabilities and Schedule UTP. For purposes of establishing liability under Section 10(b) of the Securities Exchange Act of 1934, a significant discrepancy followed by silence (and no action to mitigate loss or increase reserves) may well be viewed as the basis for establishing corporate scienter (particularly in jurisdictions that follow either a weak or semi-strong theory of corporate scienter) and/or scienter on the part of the CFO and members of the Audit Committee. And the "failure to take reasonable steps" language of Overton could well be applied to a derivative action taken against the Audit Committee that fails to correct or mitigate these discrepancies and subsequently incurs large legal and expert fees and/or penalties.


In fact, transparency regarding tax liabilities has taken center stage in recent corporate governance gatherings. On October 19, 2009, IRS Commissioner Doug Shulman addressed the 2009 National Association of Corporate Directors Governance Conference and urged that companies establish an open dialogue and regular meetings between their Audit Committees and Tax Directors and that directors are legally charged with oversight of their company’s compliance with tax laws. Commissioner Shulman made a number of detailed inquiries that should be undertaken by Audit Committees. The IRS’s suggested inquiries could one day serve as the checklist for proper corporate tax governance by many corporations and/or plaintiff’s counsel prosecuting a derivative action (particularly where penalties have been assessed). A copy of the Commissioner’s remarks can be found here.


Loss Mitigation Techniques

So how does a company protect itself from the risk that it failed to adequately reserve for tax liabilities? As noted above, the traditional approach of obtaining a tax opinion may no longer suffice. There are two major concerns: (1) the opinion will not prevent disclosure under Schedule UTP and (2) the opinion may not, in practice, protect the company against penalties, much less un-accrued taxes and interest.


A "covered" tax opinion that satisfies the standards of Treasury Circular 230 (31 CFR 10.35) is often touted as the company’s defense against penalties. In practice, however, not many corporate taxpayers want to waive their attorney-client privilege and provide the IRS with a tax opinion that (in order to be a covered opinion) develops all relevant legal theories and considers all relevant authorities, support and arguments, both favorable and not favorable for the taxpayer.


Accordingly, tax practitioners may wish to consider advising their clients to consider tax insurance for their material uncertain tax positions. In fact, some tax practitioners already include such advice as a standard provision in any tax opinion. (E.g., "Of course, our opinion is not binding on the IRS and there is a reasonable basis by which the IRS could successfully challenge the tax position. If greater economic certainty around the tax position is desired, tax insurance may be available.")


Moreover, tax return preparers may wish to consider comparing the FIN 48 reserves (and work papers) with the Schedule UTP before filing the tax return and would be well advised to inform their clients that tax insurance may be available for discrepancies, if any, and/or for tax positions that have not been fully recognized.


Tax Insurance Protection: In fact, tax insurance may be available via several alternative (but not mutually exclusive) approaches:


1. Transactional Tax Insurance covering a particular uncertain tax positions (or set of related tax positions) taken in particular tax year(s) against claims made during the policy period (often co-extensive with the statutory period in which assessments can be made).


2. Schedule UTP/FIN 48 Tax Insurance covering the shortfall in FIN 48 reserves for those selected uncertain tax positions set forth on Schedule UTP. The policy period will often be co-extensive with the statutory period in which assessments can be made with respect to the U.S. (federal) corporate income tax return. The difference between Schedule UTP/FIN 48 Tax Insurance and Transactional Tax Insurance is that the scope of uncertain tax positions is expected to be far broader in Schedule UTP/FIN 48 Tax Insurance, with higher limits. Subsequently policies would cover subsequent returns on a non-cumulative basis with respect to tax positions covered under multiple policies (i.e., the full amount of tax exposure may be insured but not more than the full amount will be insured).


3. FIN 48 Tax Insurance – An annual claims-made policy with a one-year policy period covering the adequacy of the FIN 48 reserves with respect to the tax positions covered under the policy. A claim is made when an audit makes inquiry about a covered tax position. Each year, a new set of covered tax positions are covered (subject to underwriting approval) as new tax positions are reported and/or as former tax positions are no longer subject to challenge.


Variations of the above prototypes may also be available. Tax insurance almost always allows the insured to select its tax counsel (subject to consent) and typically contains no more than a few exclusions. It is not, however, available for "reportable transactions."


Because tax insurance provides cash when needed to pay a tax bill, and because its purchase reflects a prudent risk management approach to the inherent complexities of tax planning, reporting and reserving, as Schedule UTP becomes a corporate requirement, so too may tax insurance. The alternative may well be a new wave of shareholder suits.