Industry Director Directive #2 on Section 118 Abuse
LMSB- Control No: LMSB-04-0307-026
Impacted IRM 4.51.5
April 2, 2007
MEMORANDUM FOR INDUSTRY DIRECTORS
DIRECTOR, FIELD SPECIALISTS
DIRECTOR, PREFILING AND TECHNICAL GUIDANCE
DIRECTOR, INTERNATIONAL COMPLIANCE STRATEGY AND POLICY
From: Patricia C. Chaback /s/ Patricia C. Chaback
Industry Director
Communications, Technology and Media
Subject: Tier I Issue: Section 118 Abuse Directive # 2
This Directive is intended to provide field direction on a Tier I Issue relating to Universal Service Fund (USF) programs.
Background/Strategic Importance:
This issue addresses whether amounts received by telecommunication providers from federal and state universal service programs constitute taxable income under section 61 or non shareholder contributions to capital excludable from income under section 118(a). Universal service has long been a cornerstone of federal and state telecommunications policies. The term “universal service” refers to the widespread availability of basic telephone service at affordable rates. Over the years, the Federal Communications Commission (FCC) established various universal service support mechanisms designed to achieve the goal. With the enactment of the Telecommunications Act of 1996, the FCC combined the existing mechanisms with newly established mechanisms under one umbrella called the Universal Service Fund (USF). The USF has four general programs: Low Income (LI) Program, High Cost (HC) Program, Schools and Libraries (S&L) Program, and Rural Health Care (RHC) Program. Under the LI, S&L, and RHC programs, eligible customers pay discounted rates for service supported by the programs, and the carriers providing such services receive subsidies equal to the discount. Under the HC program, customers in high cost areas pay rates that do not cover the carrier’s cost of providing that service, and the carriers providing services to such areas receive subsidies that are intended to cover the excess costs of providing service. For
financial accounting purposes, the FCC requires the carriers to report their universal service support receipts as revenue. States have also developed their own universal service support programs and funding mechanisms.
Since 1998, approximately $44 billion has been paid from the federal USF to telecommunication carriers. In 2006, approximately $7 billion is expected to be paid to telecommunication carriers. In addressing both federal and state USF rate subsidies, the Service has emphasized a consistent tax position that these funds represent payments for services.
Issue Tracking:
Any cases having this issue should use the following UIL and SAIN codes:
UIL
SAIN
Planning and Examination Guidance:
Issue identification:
The issue may be raised either on the original return or through claims. Absent the filing of a claim, the issue may not be readily apparent. Thus an in-depth examination of a taxpayer’s Schedule M entries is required. Specifically, book-tax differences in income and/or depreciation should be analyzed closely.
Other means of identifying the issue include any of the following:
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Key words or phrases used on the tax return such as contribution to capital, inducements, or IRC §118.
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A review of Universal Service Monitoring Reports (located at http://www.fcc.gov/wcb/iatd/monitor.html) will help to determine whether the taxpayer received federal USF support.
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A review of fixed assets for basis reductions.
Planning and Examination Risk Analysis
The issue is a Tier I Compliance Issue and therefore is a mandatory examination item. The field should challenge all arguments by taxpayers who attempt to exclude their receipt of these support payments from gross income. All examination results, whether adjusted or no changed, should be reported to kathleen.g.follis@irs.gov.
Audit Techniques
An audit aide to be used as a guideline for an Information Document Request for the USF issue is available – see attachment for a list of information to request.
Audit Evaluation:
Once it is determined USF support payments were excluded from income the agent should identify the specific USF programs at issue and obtain the taxpayer’s written position paper. In addition, an in-depth review of the correlative section 362(c) adjustment should be completed to determine the actual asset basis(es) that were decreased. The agent should ask the taxpayer to provide a spreadsheet(s) or other schedule(s) that identifies (1) the amount of USF support by state or wire center that each of its subsidiaries received and (2) the cost of assets by state or wire center that each of its subsidiaries added during the tax year.
LMSB Position:
The payments received by telecommunications service providers in exchange for providing universal telecommunications services as defined under the operative federal and state programs do not constitute a capital contribution under section 118(a) and thus fall within the definition of gross income under section 61(a).
The Commissioner’s position on this issue is reflected in the following published materials: Technical Advice Memorandum (TAM) 200332025 (published August 8, 2003) and Coordinated Issue Paper (CIP) (released October 24, 2003). The TAM and the CIP concluded that the payments were gross income under section 61(a) and not non-shareholder capital contributions under section 118(a). Additionally on August 13, 2004, Appeals Settlement Guidelines were issued stating that the litigation hazards to the taxpayer on the USF issue are substantial.
Effect on Other Guidance:
None
Contact:
Kathleen Follis, Telecommunications Industry Technical Advisor, (484)636-0520
This Directive is not an official pronouncement of law, and cannot be used, cited, or relied upon as such.
cc: Commissioner, LMSB
Deputy Commissioner, Operations
Deputy Commissioner, International
Division Counsel, LMSB
Chief, Appeals
Directors, Field Operations
Director, Performance, Quality and Audit Assistance
