New Rules for Reporting Book-Tax Differences

By Paul Carman

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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 corporation (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 book-tax differences by eliminating overlap between the reportable transaction regulations and Schedule M-3, many corporations that were not required to report book-tax 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.

Other entities that do not file a Form 1120 (e.g., S corporations) and are subject to the disclosure requirements of transactions with significant book-tax differences may also use the alternative reporting method on the new Schedule M-3.

To satisfy the alternative reporting requirements for reportable transactions on the new Schedule M-3, the taxpayer must disclose each item of income, gain, loss, deduction, or credit for which the difference between the amount included in the taxpayer’s financial statement net income for the tax year and the amount included in taxable income is greater than $10 million (a “reportable transaction”). If a taxpayer is filing Schedule M-3 only to satisfy the reporting requirements of reportable transactions, each difference of more than $10 million must be separately stated and adequately disclosed. Taxpayers should recognize, however, that satisfying the alternative reporting requirements for transactions with a significant book-tax difference will not satisfy the requirements if the transaction is reportable because it also qualifies as some other category of reportable transaction. In addition to transactions with significant book-tax differences, a transaction may be a reportable transaction if it is—

• a transaction described in IRS guidance (listed transaction) or one that is the same or substantially similar to such;
• a transaction offered under conditions of confidentiality;
  n a transaction with contractual protection against the loss of tax benefits;
• a transaction resulting in a specified minimum annual or cumulative loss; or
• a transaction involving a brief holding period.

Some taxpayers may prefer the alternative disclosure method on Schedule M-3 to Form 8886, used to satisfy the general requirements for reportable transactions. The advantage, however, may be lost, because a copy of Schedule M-3 must be filed with the Office of Tax Shelter Analysis if the schedule is being used to satisfy the alternative reporting requirements.

If a taxpayer is required to file Schedule M-3, there is no threshold for the differences that must be separately stated and adequately disclosed. Differences for the same item must generally be netted together.

Differences for separate items, however, must not be netted together. If a single reportable transaction results in more than one book-tax difference, each difference must be separately stated and adequately disclosed on a supporting schedule that references the specific, identified reportable transaction.

The first year that a corporation is required to file Schedule M-3, it is only required to complete Part I [financial information and net income (loss) reconciliation] and columns B and C of Part II [reconciliation of net income (loss) per income statement of includable corporations with taxable income per return].

For a member of a consolidated group, whether an item of difference exceeds $10 million is based on the separate activity of that group member, not the consolidated group. For consolidated groups, Part I must be completed once, with the consolidated information, but Parts II and III [reconciliation of net income (loss) per income statement of includable corporations with taxable income per return—expense/deduction items] must be completed separately for each member of the consolidated group.

Exceptions and Effective Date

Schedule M-3 is not currently required to be filed by real estate investment trusts (REIT) or property, casualty, or life insurance companies. The Treasury Department has indicated that Schedule M-3 will be adapted for partnership returns, S corporation returns, and returns for insurance companies. The new Schedule M-3 is effective for taxable years ending on or after December 31, 2004. Taxpayers, however, may rely upon the new rules for the purposes of the alternative disclosure of reportable transactions occurring after January 1, 2003.

Although the IRS stated that the new schedule was developed to reduce duplication, its dropping of the threshold to $10 million of assets and eliminating the exclusions provided by the revenue procedure means that many corporations will face significant new compliance burdens in preparing and filing the Schedule M-3.