New Rules for Reporting Book-Tax Differences

CPA Journal, The, May 2005 by Carman, Paul

Over the last several years, the IRS has promulgated extensive new regulations requiring taxpayers to disclose "reportable transactions," in an effort to curb abusive tax shelter activity. One area targeted by the IRS has been transactions that produce a significant book-tax difference.

A significant book-tax difference exists if the treatment of any item for federal income tax purposes differs, or is reasonably expected to differ, by more than $ 10 million on a gross basis (i.e., without netting of offsetting items) from the treatment of the item for book purposes in any tax year. Book income is calculated by applying GAAP to worldwide income.

After an uproar following the initial requirements for disclosing significant book-tax differences, the IRS promulgated several limitations and exceptions to the requirements. First, the disclosure requirements apply only to business entities (and their affiliates) with publicly offered debt or equity in the United States or with at least $250 million in gross assets (after aggregating the assets of all related business entities). In addition, transactions solely between members of a consolidated group are disregarded (where a transaction involves two or more members of a consolidated group and others outside of the group, items are aggregated). In the case of most foreign persons, only U.S. assets and only transactions that give rise to income that is effectively connected with the conduct of a U.S. trade or business are taken into account. In addition, Revenue Procedure 2004-67 lists the following items for which reporting is not required:

* Items generating a book loss or expense before or without a tax loss or expense;

* Items generating tax income or gain before or without a book income or gain;

* Depreciation, depletion, and amortization relating solely to differences in methods, lives, or conventions;

* Bad debts or cancellation of indebtedness income;

* Federal, state, local, and foreign taxes;

* Compensation of employees and independent contractors (including stock options and pensions);

* Charitable contributions of cash or tangible property;

* Tax-exempt interest, including municipal bond interest;

* Dividends, including amounts previously taxed as dividends under the controlled foreign coiporation (CFC) and the potential taxes on foreign investments (PFIC) rules, and deemed dividends under the CFC, the PFIC, and the foreign personal holding company (FPHC) rules;

* Items resulting from involuntary conversions;

* Gains and losses from transactions to which the mark-to-market rules for dealers in securities or marketable PFIC stock apply;

* Adjustments resulting from changes in a taxpayer's method of tax accounting; and

* Items resulting from the treatment as a sale, purchase, or lease for book purposes and as a financing arrangement for tax purposes.

The revenue procedure includes other exceptions as well. Although the limitations and ambiguities in the exceptions continue to cause concern, the exceptions are broad enough so that many common transactions are excluded from the reportable transaction disclosure requirements.

New Schedule M-3

On July 7, 2004, the Department of the Treasury and the IRS released several additional pieces of guidance relating to how book-tax differences are reported, including a new Schedule M-3 for Form 1120.

Although the IRS indicated that its intent in promulgating the new schedule was to streamline the reporting of significant booktax differences by eliminating overlap between the reportable transaction regulations and Schedule M-3, many corporations that were not required to report booktax differences under the reportable transactions regulations will now have to file the new Schedule M-3. If a corporation (or consolidated group) reports on its Form 1120 that it has total assets of $10 million or more, it is required to file Schedule M-3 along with it. The $10 million asset threshold is likely to apply to many taxpayers that did not worry about the $250 million reportable transactions threshold.

On the other hand, for corporations that are SEC registrants or have gross assets of $250 million or more, the new procedures may eliminate some duplication in reporting, while requiring extensive detail. A taxpayer that complies with the new Schedule M-3 will satisfy the requirements of disclosing significant book-tax differences for the purposes of the reportable transaction regulations.

The new Schedule M-3 seeks information on 29 specific income or loss items and 38 specific expense or deduction items, in each case with a catchall "other" category. Unlike the reportable transactions regulations, the exclusions in the revenue procedure for items such as tax-exempt interest and off-balance-sheet financing do not apply to the Schedule M-3 requirements; such items would have to be disclosed on the schedule. If the taxpayer is filing Schedule M-3 solely to satisfy the alternative reporting requirements of reportable transactions, the taxpayer presumably may still rely upon the exclusions provided by the revenue procedure.