Actions Are Needed to Ensure Corporations Receive Intended Tax Benefits for Reinvesting Foreign Earnings in the United States

 

September 2005

 

Reference Number:  2005-30-150

 

This report has cleared the Treasury Inspector General for Tax Administration disclosure review process and information determined to be restricted from public release has been redacted from this document.

 

September 23, 2005

 

 

MEMORANDUM FOR COMMISSIONER, LARGE AND MID-SIZE BUSINESS

                                         DIVISION

 

FROM:                            Pamela J. Gardiner /s/ Pamela J. Gardiner

                                         Deputy Inspector General for Audit

 

SUBJECT:                     Final Audit Report - Actions Are Needed to Ensure Corporations Receive Intended Tax Benefits for Reinvesting Foreign Earnings in the United States  (Audit # 200530008)

 

This report presents the results of our review of the Internal Revenue Service’s (IRS) implementation of Provision 422 of the American Jobs Creation Act of 2004 (AJCA).[1]  The overall objective of this review was to determine whether the IRS effectively completed the planned actions to implement this Provision of the AJCA regarding the incentives to reinvest foreign earnings in the United States (U.S.). 

In summary, actions are needed to ensure corporations receive intended tax benefits for reinvesting foreign earnings in the U.S.  The IRS developed and provided priority guidance and established controls related to the implementation of Provision 422.  The IRS provided much of the required guidance on issues identified by external and internal stakeholders in multiple notices, fact sheets, and a draft of the required Form 8895[2] from January through May 2005.  The date of enactment of the AJCA gave the IRS limited time to issue complete guidance to taxpayers.

Although the IRS developed and provided priority guidance, it did not issue all of the necessary guidance in sufficient time for some taxpayers to determine their dividends received deduction and elect the most beneficial taxable year.  Also, the required tax form to compute the dividends received deduction was not timely provided to taxpayers, even though the IRS’ initial guidance directed taxpayers to use the form.

Two factors hindered the issuance of timely and complete guidance:  (1) the complexity of the law combined with the short implementation period and (2) certain issues needing technical corrections that were pending enactment by Congress.

Because guidance was not always complete or timely, some taxpayers were at a greater risk of being unable to determine the correct dividends received deduction and to choose between 2 taxable years as the most beneficial taxable year in which to bring the foreign earnings into the U.S.  Certain unresolved issues may have prevented many companies from completing their dividend distribution plans or claiming millions of dollars in dividends received deductions.  Without the required tax form and related instructions, there was a greater risk of taxpayers incorrectly computing their allowable dividends received deductions.  Taxpayers could either understate or overstate their deductions and be subjected to a substantial tax (up to 35 percent) on dividends received deductions that would have otherwise been taxed at a rate of 5.25 percent.  In addition, there is a greater probability that amended returns would be necessary because taxpayers did not have complete instructions and the required Form 8895 was not available. 

We recommended the Commissioner, Large and Mid-Size Business (LMSB) Division, evaluate the impact of insufficient guidance on hindering taxpayers from taking the deduction in the earlier of the 2 taxable years or both taxable years and coordinate with the Office of Chief Counsel to elevate this matter to the Department of the Treasury.  A determination needs to be made as to whether legislation is necessary to extend the time needed to ensure corporate taxpayers have complete guidance to enable them to appropriately plan and receive the intended tax benefits for reinvesting foreign earnings in the U.S.  Also, we recommended the Commissioner, LMSB Division, coordinate with responsible officials to ensure the required Form 8895 and related instructions are issued as soon as possible and provide guidance regarding the filing of amended returns to assist taxpayers in complying with Provision 422, when the deductions have already been improperly taken or computed.

Management’s Response:  The Commissioner, LMSB Division, disagreed with our evaluation regarding the timeliness of the relevant guidance, form, and instructions.  The IRS believes its extraordinary efforts to expedite guidance, and issue the relevant form and instructions, met the challenge of facilitating compliance under a complex statute in an exceedingly short time.  The IRS indicated that extending the Internal Revenue Code Section 965 election[3] for an additional year would have significant revenue implications that undoubtedly were already part of Congress’ consideration in enacting Provision 422.  Also, the IRS indicated the final Form 8895 and its related instructions were forwarded to IRS multimedia on August 18, 2005, for release to the public.  In addition, the IRS indicated that complete guidance and instructions have already been provided to taxpayers in three priority notices and the instructions for Form 8895, with regard to filing amended returns or other information for purposes of complying with Internal Revenue Code Section 965.  Management’s complete response to the draft report is included as Appendix IV.

Office of Audit Comment:  Congressional intent for Provision 422 was to allow taxpayers to choose between 2 years (either Tax Years 2004 or 2005) to bring foreign earnings back into the U.S.  Since it took the IRS up to 10 months to issue needed guidance after enactment of the legislation, certain Calendar Year 2004 filers and fiscal year filers through August 19, 2005, did not have all the guidance necessary to choose the most beneficial tax year.  Our report has recognized factors outside the IRS’ control that contributed to this delay. 

However, in the interest of ensuring corporate taxpayers receive tax benefits as intended, there are several reasons why the IRS should evaluate the impact of the insufficient guidance provided during the initial 10 months after enactment of Provision 422 on October 22, 2004.  From news releases and other online services, it was clear that taxpayers were affected as a result of waiting for the IRS’ position before developing their reinvestment plans.  It was recognized that the lack of timely guidance and many unanswered questions caused some taxpayers to choose the later of the 2 allowable years.  The issuance of 3 separate notices in January, May, and August 2005, in excess of 150 pages and containing interrelated instructions, had to affect the taxpayers’ ability to choose the election and accurately calculate the amount of foreign earnings to be brought into the U.S. and the allowable dividends received deductions.  Instructions issued in three intervals could have caused additional confusion and multiple amended returns.

In addition, to assist taxpayers in complying with Provision 422, the instructions regarding filing amended returns should have been more extensive and care should have been given to instructing taxpayers on filing amended returns once complete guidance was provided.  In January and May 2005, guidance was provided to taxpayers indicating they could file amended returns.  However, needed guidance concerning computation of the dividends received deduction and the related form needed for the computation were not issued until August 2005.  As a result, there was a greater risk of errors in computations and application of the law.  In three separate notices, taxpayers were advised that they could file amended returns with regard to specific limited situations, potentially causing multiple amended returns to be filed.    

Copies of this report are also being sent to the IRS managers affected by the report recommendations.  Please contact me at (202) 622-6510 if you have questions or Curtis Hagan, Assistant Inspector General for Audit (Small Business and Corporate Programs), at (202) 622-3837.

 

Table of Contents

Background

The Internal Revenue Service Provided Priority Guidance and Established Controls Related to Implementation of Provision 422

Some Taxpayers Were Not Timely Provided With All of the Guidance Necessary to Determine Their Dividends Received Deduction and to Elect the Most Beneficial Taxable Year

Recommendation 1:

Taxpayers Were Not Timely Provided With the Required Tax Form to Compute Their Dividends Received Deduction

Recommendations 2 and 3:

Appendix I – Detailed Objective, Scope, and Methodology

Appendix II – Major Contributors to This Report

Appendix III – Report Distribution List

Appendix IV – Management’s Response to the Draft Report

 

Background

On October 22, 2004, President Bush signed the American Jobs Creation Act of 2004 (AJCA).[4]  Among the provisions of this Act, Provision 422, Incentives to Reinvest Foreign Earnings in the United States (U.S.), provides that certain dividends received by a U.S. corporation from controlled foreign corporations are eligible for an 85 percent dividends received deduction.  It was intended that this deduction and the related reduction in U.S. taxes afforded these taxpayers will stimulate the U.S. domestic economy by triggering the reinvestment of foreign earnings into the U.S. that otherwise would have remained abroad.[5]

At the taxpayer’s election, this deduction is available for dividends received during either the taxpayer’s first taxable year beginning on or after the date of enactment of the Act (October 22, 2004) or the taxpayer’s last taxable year beginning before such date.  Dividends received after the election period will be taxed in the normal manner under present law.  The deduction applies only to cash dividends.

Income earned by a domestic parent corporation from foreign operations conducted by foreign corporate subsidiaries generally is subject to U.S. tax when the income is distributed as a dividend to the domestic corporation.  Until such distribution, the U.S. tax on the income generally is deferred. 

The Large and Mid-Size Business (LMSB) Division was the operating division assigned the primary responsibility for implementation of Provision 422.  The LMSB Division’s actions to implement Provision 422 involved multiple action items, including providing training and guidance to Internal Revenue Service (IRS) employees and taxpayers, coordinating extensively with various IRS components, creating and revising forms and publications, and generally taking the necessary actions to effectively implement this Provision.

This audit was conducted during the period February through June 2005 at the IRS office in Holtsville, New York, covering the LMSB Division’s responsibility in implementing Provision 422.  The audit was conducted in accordance with Government Auditing Standards.  Detailed information on our audit objective, scope, and methodology is presented in Appendix I.  Major contributors to the report are listed in Appendix II.

The Internal Revenue Service Provided Priority Guidance and Established Controls Related to Implementation of Provision 422

The timing of enactment of the legislation involving Provision 422 gave the IRS limited time to issue complete guidance to taxpayers that would benefit from taking the dividends received deduction. 

We were advised that, after enactment of Provision 422, the IRS designated guidance for this Provision as a top-priority item and made a significant staffing commitment, including having officials at the highest levels begin a coordinated outreach to both external and internal stakeholders in meetings, conferences, correspondence, and telephone calls for purposes of identifying and prioritizing issues needing guidance under the new Provision.

The IRS focused on addressing those priority issue areas and addressing them in the priority order that had been established in the course of its outreach to external and internal stakeholders.  Thus, the IRS targeted the issuance of three priority notices:  the first primarily addressing domestic reinvestment plans and investments in the U.S., the second primarily addressing the effects of mergers and acquisitions, and the third primarily addressing computational issues. 

On January 13, 2005, approximately 3 months after enactment of Provision 422, the IRS issued Notice 2005-10 as well as a Fact Sheet.  It addressed multiple issues, including adoption, content and compliance for domestic reinvestment plans, the kinds of investments in the U.S. for which the distributed dividends may be used under this program, definitions of terms, and a description of how taxpayers can elect to apply this section to the taxable year.  This Notice was made available to major national and tax media and was included on the IRS web site (IRS.gov).

On May 10, 2005, the IRS issued detailed guidance in Notice 2005-38, for the second in a series of notices to provide much-anticipated direction on the effects of mergers, acquisitions, and reorganizations in calculating the amount of eligible dividends.  It included detailed explanations of new rules on qualifying dividends, maximum repatriations,[6] and related-party indebtedness.

On May 12, 2005, the IRS posted to the Draft Forms web site a draft of One-Time Dividends Received Deduction for Certain Cash Dividends from Controlled Foreign Corporations (Form 8895).[7]  We were informed that, in accordance with standard procedure, the timing of this issuance was coordinated with the guidance in process so the draft Form 8895 was as close as possible to what is anticipated to be the final version of the Form.  The IRS believed this should enable interested parties to have confidence that the product would be substantially similar to the final version that is anticipated to be released in August 2005.  

In August 2005, the third priority notice was anticipated to be issued[8] to address important computational issues relating to the foreign tax credit, allocation of deductions, currency translation, and the alternative minimum tax. 

As part of the IRS’ outreach effort, the LMSB Division, through the Office of Prefiling and Technical Guidance, established a joint IRS/stakeholder working group to handle issues related to the implementation of Provision 422 and Internal Revenue Code (I.R.C.) Section (§) 965.[9]  In addition to LMSB Division employees, the group is comprised of members of the American Bar Association, the American Institute of Certified Public Accountants, the Manufacturers Alliance Product Innovation, and the Treasury Executives Institute.  The Office of Associate Chief Counsel (International) addressed the new I.R.C. § 965 through an International Network News release on January 21, 2005, which was sent to international personnel within both the Office of Chief Counsel and the LMSB Division.

The LMSB Division created for its employees an AJCA web page for its web site that contained links to the notices, news releases, fact sheets, and other existing technical guidance relating to the AJCA.

In addition, the IRS has the Legislative Implementation Tracking System (LITS), which is an IRS Intranet-based planning and monitoring system for implementation of tax legislation.  It is designed to enable the responsible offices to monitor legislation that has a significant impact on the IRS.  The web site has the required actions with estimated due dates and indicates the functions responsible for taking the necessary actions to implement the provisions. Also, the web site shows which action items are on time or running behind schedule. 

Some Taxpayers Were Not Timely Provided With All of the Guidance Necessary to Determine Their Dividends Received Deduction and to Elect the Most Beneficial Taxable Year

Although the IRS developed and provided priority guidance and established controls related to implementation of Provision 422, some taxpayers were not provided with sufficient guidance.

Provision 422 was enacted on October 22, 2004, which gave the IRS a very short window of opportunity for ensuring all aspects needed to successfully implement this Provision of the law were completed.  Initial guidance was issued in January 2005, followed by more detailed guidance and the draft Form 8895 in May 2005, with the need for still additional guidance.  In August 2005, a third notice was anticipated to be issued to address remaining priority issues, and the final Form 8895 and instructions were scheduled to be released. 

This new Provision is a “1-year only” opportunity.  At the taxpayer’s election, the deduction is available for dividends received during the taxpayer’s first tax year that begins during the 1-year period beginning on October 22, 2004, or during the taxpayer’s last tax year beginning before October 22, 2004.  Therefore, these 2 options generally allow taxpayers to take this deduction in 1 of 2 taxable years.

A Calendar Year taxpayer would have had fewer than 3 months in 2004 (October 22 to December 31, 2004) to take the dividends received deduction, without having any guidance.  For approximately one-half of Calendar Year 2005, complete guidance had not been provided to taxpayers.[10]  We determined approximately 67 percent of corporate filers are calendar year filers and 33 percent are fiscal year filers. 

Also, the filing of an extension to file after the due date of the return will give the taxpayer more time to file a tax return.  However, it would not increase or change the time required to bring the cash dividends into the U.S. or allow more time to review and consider any additional or newly issued guidance, to determine the amount of dividends to bring in or claim as a deduction.  Taxpayers would also have to anticipate the amount of tax due and make the necessary payment at the time the extension is filed. 

IRS and Department of the Treasury officials commented publicly, in news articles and in Notices 2005-10 and 2005-38, that additional notice(s) are expected to provide guidance regarding the implementation of Provision 422.

Issues identified in the Fact Sheet and related Notice 2005-38 by the IRS as still needing additional notice(s) included:

·         The impact of Provision 422 on a corporation’s computation of its tax liability.

·         The use of foreign tax credits and the deduction of certain expenses to offset the nondeductible portion of the dividends received deduction.

Management indicated these issues will be addressed in the third priority notice anticipated to be issued in August 2005. 

The following factors have hindered the issuance of timely guidance regarding Provision 422:

·         The complexity of the law combined with the short implementation period made it difficult to timely issue complete guidance. 

·         Certain issues needing technical corrections are still pending enactment by Congress.

The complexity of the law combined with the short implementation period made it difficult to timely issue complete guidance

Provision 422 is so complex that approximately 100 pages of clarification have already been issued by the IRS, and it is still not adequate.  The Department of the Treasury and IRS indicated they still need to issue additional notice(s) to answer all of the unresolved issues.

The last guidance, Notice 2005-38 (Section 965 – Limitations on dividends received deduction and other guidance) issued May 10, 2005, was over 50 pages and contained 15 sections, which demonstrates the complexity of Provision 422.  The issues covered by Notice 2005-38 included:

·         General principles that apply in determining the amount of cash dividends received by a U.S. shareholder that is considered extraordinary for purposes of I.R.C. § 965(b)(2).[11]

·         General principles that apply in determining the maximum amount of dividends eligible under I.R.C. § 965(b)(1)[12] to be taken into account under I.R.C. § 965(a).[13]

·         The taxable year to which I.R.C. § 965 applies.

·         The effects of certain transactions on the determination of a U.S. shareholder’s limitations.

·         Guidance and principles for determining under I.R.C. § 965(b)(3)[14] the amount of related-party indebtedness that reduces the amounts taken into account under I.R.C. § 965(a), including special adjustments made as a result of certain transactions. 

·         Guidance regarding the impact of certain transactions on domestic reinvestment plans.

·         Other issues arising under I.R.C. § 965, including the application of I.R.C. § 78,[15] the expenses disallowed under I.R.C. § 965(d)(2),[16] and the computation of the alternative minimum tax.

·         Transition rules that apply to certain taxpayers that, prior to the issuance of this Notice, either adopted a domestic reinvestment plan or filed a tax return for a taxable year to which I.R.C. § 965 applies.

Notice 2005-38 also contained over 40 case examples (with individual sets of facts, results, and alternative facts) to aid in understanding the guidance being provided.

Certain issues needing technical corrections are still pending enactment by Congress

The IRS and Congress have recognized the need for technical corrections and, on November 19, 2004, the Tax Technical Correction Act of 2004 was introduced to correct and clarify previous tax laws.[17]  The bill includes technical corrections to provisions in the AJCA. 

On March 17, 2005, a letter was sent to the Acting Deputy Assistant Secretary (Tax Policy) by the Chairman, Committee on Finance; the Chairman, Committee on Ways and Means; and the Ranking Member, Committee on Finance.  The letter specifically indicated:

We are particularly aware that certain technical corrections may be necessary to carry out the intent of [S]ection 965 of the Internal Revenue Code, which provides a temporary dividends received deduction for a portion of the dividends received by a U.S. corporation from a controlled foreign corporation.  These technical corrections would, among other things:

  1. Clarify that the disallowance of expenses in [S]ection 965(d)(2) applies only to expenses that are “directly allocable” to the deductible portion described in [S]ection 965(d)(1) [18] and
  2. Clarify that [S]ection 78 does not apply to any tax which is not allowable as a credit under [S]ection 901[19] by reason of [S]ection 965(d).

We anticipate introducing a technical corrections bill at the earliest opportunity in the 109th Congress, and we anticipate that the above two technical corrections will be introduced in that bill.  We trust that this letter provides sufficient clarification so that appropriate guidance may be issued reflecting our intention. 

While the technical corrections bill was still pending and is not limited to the two technical corrections mentioned above, IRS Notice 2005-38 did contain some guidance on these two issues.

Taxpayers may be adversely affected

Because guidance was not complete or timely, some taxpayers were at a greater risk of being unable to determine the correct dividends received deduction and choose between 2 allowable taxable years as the most beneficial taxable year in which to bring the foreign earnings into the U.S. in order to take the deduction.  Also, many unresolved issues may have prevented companies from completing their dividend distribution plans until it is clearer how the unresolved issues affect them.  For example:

·         Some taxpayers will be unable to plan for or take advantage of the dividends received deduction in Tax Year 2004 because complete guidance was not issued.

An article prepared by one of the leading accounting firms in New York[20] indicated:

Given the complexities and the nature of the analysis that has to be done to optimize the benefits, as well as the many unanswered questions that awaited IRS guidance—a great many of which still remain—it appears that virtually all potential beneficiaries will choose to apply the temporary Section 965 DRD[21] in 2005.

This article further indicated:

In addressing the requirements of a domestic investment plan and providing much needed details as to what investments are permitted uses, Notice 2005-10 might provide some companies with enough information to allow them to develop a strategy for implementing Section 965.  On the other hand, companies that expect to have significant base period issues, that have undertaken mergers, acquisitions, or divestitures during the past several years or that need to understand the direction that [the Department of the] Treasury will take in implementing the related party anti-abuse provision to be set forth in the coming technical corrections bill—to name just a few—will no doubt prefer to await additional guidance from the IRS before moving forward on Section 965 planning.

The IRS indicated that, subsequent to this article, Notice 2005-38, issued in May 2005, addressed these issues, and the remaining priority issues will be addressed in the third notice anticipated in August 2005.

·         Some taxpayers may be unable to claim the deduction because they could not choose the preferred taxable year (2004 or 2005) due to guidance not being available.

One large data processing company reported to the Securities and Exchange Commission in a quarterly report ending December 31, 2004,[22] that “The Company has started an evaluation of the effects of the repatriation [P]rovision; however, the Company does not expect to be able to complete this evaluation until Congress acts on the pending Technical Corrections Bill and Treasury Department [sic] provides additional clarifying language on key elements of the [P]rovision.”  The company further indicated it could repatriate between $0 and $500 million, with the related potential range in income tax between $0 and $35 million.

Recommendation

The Commissioner, LMSB Division, should:

1.      Evaluate the impact of insufficient guidance on hindering taxpayers from taking the deduction in the earlier of the 2 taxable years or both taxable years and coordinate with the Office of Chief Counsel to elevate this matter to the Department of the Treasury.  A determination needs to be made as to whether legislation is necessary to extend the time needed to ensure corporate taxpayers have complete guidance to enable them to appropriately plan and receive the intended tax benefits for reinvesting their foreign earnings in the U.S.

Management’s Response:  Management disagreed with our recommendation, indicating it was based on the assumption that taxpayers have not been provided timely and sufficient guidance.  The IRS explained in its response that relevant guidance, form, and instructions were provided timely and on a priority basis.  Moreover, extending the I.R.C. § 965 election for an additional year would have significant revenue implications that undoubtedly were already part of Congress’ consideration in enacting Provision 422.

Office of Audit Comment:  Although management had provided guidance to help taxpayers take advantage of the dividends received deduction, the fact remains that, from October 22, 2004, through August 19, 2005 (10 months), the IRS did not provide all taxpayers with complete or timely guidance.  There are multiple reasons why the IRS should evaluate the impact of the insufficient guidance provided during the initial 10 months after the enactment of Provision 422.  From news releases and other online services, it was clear that taxpayers were affected because they were waiting for the IRS’ position before developing their reinvestment plans.  It was recognized that the lack of timely guidance and many unanswered questions caused some taxpayers to choose the later of the 2 allowable years.  The issuance of 3 separate notices in January, May, and August 2005, in excess of 150 pages and containing interrelated instructions, had to affect the taxpayers’ ability to choose the election and accurately calculate the amount of foreign earnings to be brought into the U.S. and the allowable dividends received deductions.  Instructions issued in three intervals could have caused additional confusion and multiple amended returns.  Errors in calculations could cost taxpayers millions of dollars. 

Also, the Congressional intent for Provision 422 was to allow taxpayers to choose between 2 years (either Tax Years 2004 or 2005) to bring foreign earnings back into the U.S.  Since it took the IRS up to 10 months to issue needed guidance, certain Calendar Year 2004 filers and fiscal year filers through August 19, 2005, did not have all the guidance necessary to choose the most beneficial tax year.  Our report has recognized factors outside the IRS’ control that contributed to this delay. 

Taxpayers Were Not Timely Provided With the Required Tax Form to Compute Their Dividends Received Deduction

Four different business tax returns[23] directed taxpayers to use Form 8895[24] for Tax Year 2004 to elect to take the dividends received deduction.  A draft Form 8895, without the related instructions, was posted on the IRS Draft Forms web site on May 12, 2005.  A statement was posted with the draft Form that cautioned taxpayers that the Form was subject to change and approval before being released.  Also, it requested comments concerning the Form for the IRS’ consideration, to be sent within 30 days of the posting of the Form.  Management anticipated that the final Form 8895 and instructions would be available in August 2005.[25] 

Notice 2005-10[26] states that, if a taxpayer files its tax return for the taxable year in which it intends to elect I.R.C. § 965, but the prescribed Form 8895 has not been issued or published by the IRS, the election must be made on a statement that is attached to its timely filed tax return (including extensions) for such taxable year.  However, this guidance did not provide the specific information that should be included on the statement that is to be attached to the return.  The Form 8895 or statement was supposed to support the line item relating to “Dividends from foreign controlled corporations subject to the 85% deduction (Attach Form 8895).”

The action item on the LITS relating to coordinating the implementation of Provision 422 with the Tax Forms and Publications Division was shown as being completed as of December 31, 2004, while Form 8895 and related instructions have not been issued to the public.

A factor contributing to the inability of the IRS to provide the Form 8895 to the public is that complete guidance was not issued timely with regard to the issues related to computing the dividends received deduction.  We were informed that the dates for the issuance of the final Form 8895 and instructions were pushed back to a time that coincides with the issuance of guidance contained in the next priority notice. 

The draft Form 8895 developed by the IRS included information that could assist filers in computing their dividends received deduction.  Parts of the Form provided a guide to taxpayers through the steps needed to:

·         Determine the amount of their gross cash dividends that qualify for the deduction. 

·         Compute the proper amount of dividends to report on their corporate returns and help them determine their nondeductible dividends.

·         Determine their regular tax liability for each of the business credits they may be entitled to claim. 

·         Compute an additional limitation that must be considered for separate foreign tax categories with nondeductible dividends.

·         Compute their average base period repatriation level.

The draft Form 8895 also asked taxpayers to include information as to how they qualify for the deduction, to list all of the gross cash dividends they received from all controlled foreign corporations during the tax year, and to specifically identify the dividends that qualify for the deduction and those that are I.R.C. § 965(a)(2) amounts.  

Since this draft Form was not scheduled to be finalized and published with instructions for taxpayers’ use until August 2005, calendar year taxpayers for 2004 and fiscal year taxpayers through August 2005 that decided to claim the deduction did so without the guidance, information, and instructions for the Form 8895. 

Without the Form 8895 and related instructions to facilitate computation of the basis for the allowable dividends received deduction, there is a greater risk of computing the allowable dividends received deduction incorrectly (i.e., taxpayers could either understate or overstate their deductions and be subjected to a substantial tax (up to 35 percent) on dividends received deductions that, in most cases, could exceed millions of dollars and would have otherwise been taxed at a rate of 5.25 percent).[27]  In addition, there is a greater probability that amended returns would be necessary because of errors caused by the absence of the Form 8895. 

 

Recommendations

The Commissioner, LMSB Division, should coordinate with responsible officials to ensure:

2.      Form 8895 and related instructions are issued as soon as possible.

Management’s Response:  The final Form 8895 and its related instructions were forwarded to IRS multimedia on August 18, 2005, for release to the public. 

3.      Guidance and instructions are provided with regard to filing amended returns to assist taxpayers in complying with Provision 422, when dividends received deductions have already been improperly taken or computed.

Management’s Response:  Complete guidance and instructions have already been provided to taxpayers in three priority Notices and the instructions for Form 8895 with regard to filing amended returns or other information for purposes of complying with I.R.C. § 965. 

Office of Audit Comment:  To assist taxpayers in complying with Provision 422, the instructions regarding filing amended returns should have been more extensive and care should have been given to instructing taxpayers on filing amended returns once complete guidance was provided.  In January and May 2005, guidance was provided to taxpayers indicating they could file amended returns.  However, needed guidance concerning computation of the dividends received deduction and the related form needed for the computation were not issued until August 2005.  As a result, there was a greater risk of errors in computations and application of the law.  In three separate notices, taxpayers were advised that they could file amended returns with regard to specific limited situations, potentially causing multiple amended returns to be filed. 

 

Appendix I

 

Detailed Objective, Scope, and Methodology

 

The overall objective of this review was to determine whether the Internal Revenue Service (IRS) effectively completed the planned actions to implement the provision of the American Jobs Creation Act of 2004 (AJCA)[28] regarding the incentives to reinvest foreign earnings in the United States (U.S.).  To accomplish this objective, we:

I.        Evaluated whether the IRS had identified and scheduled the actions necessary to implement Provision 422. 

A.    Reviewed tax legislation created by the AJCA regarding incentives to reinvest foreign earnings in the U.S.

B.     Reviewed statistics regarding the volume of tax returns filed by business taxpayers who may be affected by AJCA Provision 422 and the volume of U.S. corporations with controlled foreign corporations. 

C.     Determined what actions have been taken by the IRS to implement AJCA Provision 422.

1.      Reviewed and monitored the Legislative Implementation Tracking System (LITS)[29] to identify planned actions to implement this Provision, due dates and related statuses of completion, owners and co-owners of the actions, and indications of whether the statuses were updated. 

2.      Contacted the Large and Mid-Size Business (LMSB) Division to identify the steps planned and taken to identify actions still needed from each function to fully implement this Provision. 

3.      Identified potential indications of the IRS’ inability to meet completion dates and obtained information with regard to any completion dates that may appear questionable in successfully implementing this Provision in Fiscal Year 2005.

4.      Determined from a review of the LITS and inquiries with IRS management whether interim measures were being considered in instances in which there were problems in meeting due dates or when dates have been revised to later dates.

II.     Determined whether policies and procedures were established to ensure the IRS timely provided the necessary guidance to business taxpayers and practitioners to enable taxpayers to successfully comply with the tax law.

A.    Obtained information from IRS management with regard to the process or procedures developed to ensure necessary guidance and information were provided to taxpayers and/or practitioners.  We determined whether the IRS can identify U.S. corporations that can or have received certain dividends from controlled foreign corporations that would be eligible for the 85 percent dividends received deduction.

B.     Reviewed the two issued Notices (Notices 2005-10 and 2005-38) and related Fact Sheets that provided guidance for the reinvestment of foreign earnings in the U.S.

C.     Reviewed the Practitioners’ Guide to the Filing Season, Tax Talk Today, and the IRS E- News for Practitioners to determine whether information is being provided by the IRS to practitioners to enable them to ensure taxpayers are successfully complying with AJCA Provision 422.

D.    Reviewed News Releases from the “In the News” section of the IRS web site (IRS.gov) on a daily basis regarding Provision 422 to identify any trends related to the guidance being provided.

III. Determined whether the IRS timely developed and revised forms, schedules, instructions, or publications, when necessary.

A.    Contacted the Tax Forms and Publications Division and obtained the potential list of forms, instructions, and publications affected by the AJCA. 

B.     Identified the affected forms, instructions, and publications related to AJCA Provision 422.

C.     Identified the stated changes required to the affected documents and the status of these changes.

D.    Obtained and reviewed affected forms, instructions, and publications from the IRS web site to determine whether they were available on the web site and the stated required changes had been made to the affected documents.  If forms were not available, we monitored the IRS web site to determine when the forms became available.

E.     Contacted the IRS forms toll-free number, 1-800-829-3676, to request the tax forms affected by AJCA Provision 422.  We determined whether the forms were available or needed to be “back ordered.”

F.      Contacted LMSB Division management to determine the status of the draft One-Time Dividends Received Deduction for Certain Cash Dividends from Controlled Foreign Corporations (Form 8895), proposed contents, status, and expected date of issuance.

 

Appendix II

 

Major Contributors to This Report

 

Curtis Hagan, Assistant Inspector General for Audit (Small Business and Corporate Programs)

Richard J. Dagliolo, Director

Robert K. Irish, Audit Manager

Michael D. Luongo, Lead Auditor

W. George Burleigh, Senior Auditor

Philip Peyser, Senior Auditor

 

Appendix III

 

Report Distribution List

 

Commissioner  C

Office of the Commissioner - Attn:  Chief of Staff  C

Deputy Commissioner for Services and Enforcement  SE

Commissioner, Wage and Investment Division  SE:W

Deputy Commissioner, Large and Mid-Size Business Division  SE:LM

Deputy Commissioner, Wage and Investment Division  SE:W

Chief Counsel  CC

National Taxpayer Advocate  TA

Director, Office of Legislative Affairs  CL:LA

Director, Office of Program Evaluation and Risk Analysis  RAS:O

Office of Management Controls  OS:CFO:AR:M

Audit Liaisons:

Commissioner, Large and Mid-Size Business Division  SE:LM

Commissioner, Wage and Investment Division  SE:W

 

Appendix IV

 

Management’s Response to the Draft Report

 

The response was removed due to its size.  To see the response, please go to the Adobe PDF version of the report on the TIGTA Public Web Page.



[1] Pub. L. No. 108-357, 118 Stat. 1418 (2004).

[2] One-Time Dividends Received Deduction for Certain Cash Dividends from Controlled Foreign Corporations (Form 8895) was issued in preliminary draft form, without instruction, and posted to the IRS Draft Forms web site on May 12, 2005.

[3] AJCA Provision 422 resulted in adding Section 965, Temporary Dividends Received Deduction, to the Internal Revenue Code.

[4] Pub. L. No. 108-357, 118 Stat. 1418 (2004).

[5] The source of this information is from American Jobs Creation Act of 2004, Laws, Explanation and Analysis, page 217, CCH Incorporated.

[6] The American Jobs Creation Act of 2004 – Conference Report by CCH Incorporated refers to repatriation as follows:  “Income earned by a domestic parent corporation from foreign operations conducted by foreign corporate subsidiaries generally is subject to U.S. tax when the income is distributed as a dividend to the domestic corporation.”

[7] The IRS posted the preliminary draft Form 8895, without the related instructions, to the Draft Forms web site on May 12, 2005. 

[8] The IRS issued the third priority notice, Notice 2005-64 on August 19, 2005.

[9] AJCA Provision 422 resulted in adding § 965, Temporary Dividends Received Deduction, to the I.R.C.

[10] Complete guidance was not issued within the first 7 months (November 2004 through May 2005) of the enactment of Provision 422.  Calendar year taxpayers for 2004 and fiscal year taxpayers with tax years ending in October 2004, November 2004, or January 2005 through whenever complete guidance becomes available are at risk of incorrectly deducting dividends.

[11] This I.R.C. Section relates to the limitations on the dividends that are considered extraordinary.

[12] This I.R.C. Section sets forth the limitations on the amount of dividends that can be taken as a deduction.

[13] This I.R.C. Section generally describes the nature of the dividends received deduction.

[14] This I.R.C. Section relates to the reduction in benefits if there is an increase in related-party indebtedness.

[15] This I.R.C. Section is entitled Dividends Received from Certain Foreign Corporations by Domestic Corporations Choosing Foreign Tax Credit.

[16] This I.R.C. Section generally relates to the denial of certain expenses that are allocated and apportioned to the deductible portions of dividends.

[17] On November 19, 2004, the Chairman of the Committee on Ways and Means introduced H.R. 5395, Tax Technical Corrections Act of 2004.  H.R. 5395 includes provisions that technically correct and clarify the intent of previous tax laws.

[18] This I.R.C. Section generally relates to the denial of certain foreign tax credits.

[19] Taxes of Foreign Countries and of Possessions of the United States.

[20] This article was prepared by James J. Tobin, Esq. (Ernst & Young LLP, New York, New York) and was entitled “An Analysis of the Low-Tax Repatriation Provision Enacted by the American Jobs Creation Act of 2004 and of Notice 2005-10.”  The article was not dated.

[21] DRD is the dividends received deduction.

[22] The source of this statement is the United States Securities and Exchange Commission Form 10-Q, Quarterly Report Pursuant to Section 13 or 15(d) of The Securities Exchange Act of 1934, For the Quarterly Period Ended December 31, 2004, regarding Automatic Data Processing, Inc, Note 15, Income Taxes (Page 16 of 46) secured from the Internet.

[23] U.S. Corporation Income Tax Return (Form 1120), U.S. Life Insurance Company Income Tax Return (Form 1120-L), U.S. Property and Casualty Insurance Company Income Tax Return (Form 1120-PC), and Farmers’ Cooperative Association Income Tax Return (Form 990-C).

[24] One-Time Dividends Received Deduction for Certain Cash Dividends from Controlled Foreign Corporations (draft Form 8895).

[25] On May 12, 2005, draft Form 8895 was posted on the IRS web site without the related instructions.  The draft Form 8895 is an advance proof copy of an IRS tax form that is subject to change and Office of Management and Budget approval.  The draft Form 8895 allows 30 days from the date the draft was posted on the IRS web site for comments and suggestions.

[26] Section 7, Election to Apply Section 965 to a Taxable Year.

[27] The Department of the Treasury initially estimated income to the Federal Government for Provision 422 for Fiscal Year 2005 will be $2.8 billion; however, the net effect over the 10-year period 2005-2014 would be a cost to the Federal Government of $3.3 billion.

[28] Pub. L. No. 108-357, 118 Stat. 1418 (2004).

[29] The LITS is an IRS Intranet-based planning and monitoring system for implementation of tax legislation.  It is designed to monitor legislation that has a significant impact on the IRS.