Can a big corporation work hand-in-hand with its perennial adversary, the Internal Revenue Service? Since 2005, the taxman has offered more than 140 of America’s largest companies membership in a select and little-known club called the Compliance Assurance Process. Under the program, if a company is unsure whether the IRS will allow a particular claim on its tax return, it can get a decision from the agency before actually filing the return. Even in an atmosphere of mutual distrust, researchers find the program works because it offers benefits to both sides.
In a handful of advanced economies — including the Netherlands, South Korea, and Australia — tax authorities have launched “enhanced relationship” tax compliance programs. CAP is the American version. Under such programs, a business and a tax authority agree to try to resolve tax questions in a timely manner, as an alternative to adversarial audits that can drag on for years.
There is a key deal at the core of CAP and kindred programs: Before a corporation files a tax return, it discloses to the IRS tax positions that it’s uncertain will pass muster. The IRS gives a thumbs-up, a thumbs-down, or works out a compromise. Once a particular issue is resolved, the IRS essentially pre-clears that part of the tax return. If the agency later decides to audit the return, it agrees not to audit the positions it’s already allowed.
When McCombs Assistant Accounting Professor Jeri Seidman first heard of CAP, she wondered why the IRS would give a taxpayer so much leeway. The corporation gets to pick and choose what it discloses and what it hides, which means it can still try to slip weak claims past auditors. In conversations with IRS agents, Seidman confirmed that some firms are less than transparent in what they tell the agency. But none has ever been asked to leave the program “My first thought was, ‘This is crazy,’” she says.
She teamed up with McCombs alumnus Richard Sansing (BBA ’79, Ph.D. ’90), now a professor of accounting at Dartmouth, and then-McCombs graduate student Lisa De Simone, currently an assistant professor at Stanford, to analyze the program more closely. They used game theory, a concept that researchers have employed since the 1980s to model many different types of strategic relationships, including the one between taxpayer and taxman. Under the model, the researchers write, “the taxpayer’s reporting decision and the tax authority’s audit decision are each best responses to the other player’s choice.”
In the cat-and-mouse game of corporate tax filings, the researchers’ model analyzes all possible positions of the cat and the mouse. In most scenarios, it shows, CAP offers benefits for both players.
For the cat — the IRS — the program can make audits less expensive, more productive, and more focused. Normally, the agency has to audit a questionable item before it can find out what facts the company has to support it. Under CAP, the IRS can get a lot of the facts up front, without having to audit. Says Seidman, “They don’t end up spending time and money looking at lines that don’t end up giving them additional taxes.”
Instead, tax agents can focus on lines in the return for which the company hasn’t made disclosures. Because companies know such lines may draw extra scrutiny, they’re less likely to make risky claims that are supported by weak facts.
The program can also help the mouse, the researchers find. A company runs less risk of being sucked into a drawn-out audit, which could potentially hold up business deals. Additionally, Seidman says, “In our model, the taxpayer confers with the IRS in a collaborative rather than combative manner on uncertain positions supported by facts. Both sides benefit when such positions are not the subject of disputes.”
Another motivation for companies to join CAP is that, over the past decade, the IRS has gotten stronger at detecting questionable corporate tax claims. Seidman points to two rules in particular that have shifted the balance of power towards the government:
- The IRS now requires firms to provide far more informative disclosures on the differences between the income they report on their books and the income on which they pay taxes. A decade ago, the current three-page form was one-third of a page.
- The Securities and Exchange Commission now requires public companies to tell investors how much they set aside in reserves for uncertain tax positions — extra taxes they might have to pay after an audit. “The more you have to disclose about those positions,” says Seidman, “the less likely you are to take them. The CAP program allows a taxpayer to resolve uncertainty more quickly and avoid these additional disclosures.”
Over nine years, more than 140 companies have joined CAP, and Seidman expects the program to continue growing. Candidates include many of the 1,500 or more large firms the IRS keeps under continuous audit. The IRS stations agents at their corporate offices and audits them every year.
To such firms, CAP offers a possible escape hatch. First, though, they have to resolve all outstanding audits. Says Seidman, “Many firms are interested in joining CAP, and we have seen firms say they’re trying to get audits resolved more quickly in order to do so.”
The program offers another carrot: anonymity. The IRS doesn’t publicly disclose member firms, and only a handful have revealed their participation, including Kellogg’s, Estée Lauder, Abbott Laboratories, and Qualcomm.
CAP offers that rarest of prizes in the corporate tax game: a win-win proposition. “Overall, it frees up the IRS to use its resources in a more productive way” says Seidman, “and it frees up a company to use its resources in a more productive way, as well.”