Unclaimed Property Audits Targeting Japanese-Owned U.S. Corporations – Deadline Approaching for Delaware's New Voluntary Disclosure Program 

While the word "unclaimed property" is not very familiar to many Japanese, state governments in the U.S. are fully utilizing the unclaimed property regime to generate revenues to help balance the states' tight budgets. In fact, private audit firms retained by the state governments on a contingent fee basis are aggressively targeting, and assessing large amounts on, U.S. companies headquartered in Japan and Korea where there is no comparable unclaimed property regime.  This article will serve as a reminder about the importance of compliance with the states' unclaimed property laws and will also introduce the new Voluntary Disclosure Program being administered by the State of Delaware's Secretary of State which can greatly reduce the high risks to many Japanese-owned U.S. corporations of being selected for unclaimed property audits.

 

Introduction

Imagine you are the controller of Company A, a U.S. subsidiary of a Japanese company, and are reviewing the balance sheet of the company and notice the following items:

 

  • A payroll check issued to an employee who left the company over three years ago has not been cashed.
  • Several gift certificates sold more than 2 years ago have not been redeemed.
  • The accounts receivable balance for one of the customers has a large credit balance that hasn't been used by, or refunded to, the customer for several years.
  • A deposit has not been returned to a customer with whom the company has not done business for a few years.

 

As the controller, you feel that you should get rid of these old items as soon as possible in order to clean up the balance sheet. Who cares how? You know the auditors won't comment on these items because they are immaterial for the audit. You tell one of your staff accountants to eliminate these items by crediting "miscellaneous income."

 

This may be a familiar action for many companies who are not aware of unclaimed property laws. However, such actions are unlawful acts under the unclaimed property laws. In fact, because these balances on your balance sheet indicate that you owed something to someone, eliminating these items into income essentially means that you are depriving someone of his or her rights and claims to their asset without any notice.

 

If this action is incorrect, then what is the correct way to handle these items in accordance with the states' unclaimed property laws?  The answer is that the entries need to remain on your company's balance sheet, perhaps as credit entries to "cash" instead of to "miscellaneous income," since you will have to report the items as unclaimed property and remit their cash values to state governments if you cannot return the items to their rightful owners.

 

What is Unclaimed Property?

As shown in the example above, unclaimed property laws require that the holder of the property submit the property to state governments if the property cannot be returned to the owner for any reason. The regime is said to have its origin in medieval England where it was believed that a property whose owner is unknown should be returned to the King and may not be taken and enjoyed privately by a common person. Japan currently does not have a comparative regime but some suggested that dormant bank account balances should be submitted to the national government so the funds can be utilized for such purposes as the recovery from the Great East Japan Earthquake.

 

Currently, in the U.S., all 50 states and the District of Columbia adopted the unclaimed property laws, based on which the state governments accept unclaimed properties from holders and return to owners as appropriate. However, because a relatively small number of owners claim the property, and also because the states actually collect unclaimed property deemed to exist even where there would be no identifiable owners, as discussed later, unclaimed property has become a source of revenue for the state governments.

 

There is a website1 where you can search for unclaimed property held by state governments on your behalf.  As you enter your last name, first name, and your state of residence, the website returns a list of properties that may possibly belong to you. We hear stories that some people found a large sum of money by searching their rich relative's name but it has also been pointed out that it is not easy to claim an unclaimed property and actually receive the funds back from the state governments.

 

Any amount owed to another party which may not be returned by the holder to the owner becomes an unclaimed property once the "prescribed dormancy period" passes. The prescribed dormancy period differs depending on the type of property and the state having the jurisdiction over the property. For example, according to the unclaimed property laws of New York, an uncashed payroll check becomes an unclaimed property and needs to be turned over to the state after it remains uncashed for three years, while according to the unclaimed property laws of California, an uncashed payroll check becomes an unclaimed property and needs to be turned over to the state after it remains uncashed for one year. As a recent trend, many states have enacted laws to shorten the prescribed dormancy periods in order to accelerate collection of unclaimed properties and increase revenues for the states.

 

Which State Has the Jurisdiction?

If you have an item of unclaimed property, you need to find out the state to which you should report the unclaimed property. It is important to note that unclaimed property is not a tax. Thus, the state tax nexus rules are irrelevant in determining your unclaimed property filing obligations. According to the 1965 U.S. Supreme Court decision, jurisdiction over unclaimed property is determined in accordance with the following:

 

  • First Priority - State of the last known address of the owner of the property
  • Second Priority - State of incorporation or commercial domicile of the holder of the property

 

Some states adopted a third priority rule that the state where the transaction giving rise to the property occurred can claim jurisdiction if the state of incorporation does not accept the property, but this state rule is in conflict with the federal priority rules established by the U.S. Supreme Court decision and has not been upheld by the courts.

It should be noted that "state of incorporation" is listed as the second priority. For various tax and non-tax legal reasons2, many U.S. corporations including those that are Japanese-owned, are incorporated in Delaware. For this reason, Delaware has jurisdiction over unclaimed property in many cases and is aggressively conducting unclaimed property audits throughout the U.S., using the private audit firms on a contingent fee basis. In fact, the state of Delaware collects over $400 million of unclaimed property each year, and unclaimed property is the third largest source of revenue for the state3. Nationally, state governments are holding over $32 billion of unclaimed property4. Of this amount, New York holds approximately $12 billion, while California holds approximately $6 billion.

 

Risks and Issues of Being Audited

The biggest problem in complying with the unclaimed property laws is the fact that there is no statute of limitations in the majority of states. For income taxes, the statute of limitations normally expires in a certain number of years (e.g., 3 years in case of federal income tax) following the filing of a tax return. However, unclaimed property audits can go back to 1981 in most states, including Delaware, regardless of whether unclaimed property reports have been filed or not.

 

However, since many companies have policies to discard books and records after seven years in consideration of the income tax statute of limitations5, these companies have no means to prove that there was no unclaimed property during the period for which no documents are retained.  In cases where a company was acquired by stock or whole business purchase, unclaimed property liabilities from the pre-acquisition period continue to exist and are acquired by the purchaser, but it is often difficult to obtain records prior to the acquisition to prove no unclaimed property existed.

 

The private audit firms retained by the states on a contingent fee basis conduct audits aggressively knowing that the companies do not have records to establish that there was no unclaimed property for the period from 1981 until the year where actual records still exist, which are typically only the most recent years, although a few states do limit the lookback period to 10 years or so. For those periods where the company was unable to establish non-existence of unclaimed property because of the lack of accounting records and supporting documents, assessments are made based on estimation where the auditors calculate an error ratio based on the periods for which records are available and applying the error ratio to the company's financial figures, such as annual revenues, for the periods prior to the records existing. As there are no true owners for the unclaimed properties collected based on estimation, these audit assessments become windfalls of revenue to the state.  Many of the private audit firms hired by the states on a contingent fee basis also conduct audits of companies on behalf of multiple states.

 

It appears that some states and private audit firms may be targeting U.S. companies headquartered in Japan or Korea, countries where no comparable unclaimed property regimes exist. For example, most if not all U.S. consumer electronics companies, almost all which have Japanese or Korean Parent companies, that issued consumer rebate coupons have been subjected to unclaimed property audits in recent years. When significant assessments are made as a result of an unclaimed property audit, it may negatively impact the business relationship with vendors, customers, and employees, and could also hurt the company's reputation as many articles have been in the U.S. newspapers like the Wall Street Journal and New York Times about the unclaimed property audits of U.S. companies by the states.

 

According to a survey6 on unclaimed property audits conducted among the 55 largest U.S. corporations yielded the following results:

 

Survey Question

% Answering "Yes"

Did the audits require involvement by ten or more company personnel?

53%

Were the audits performed utilizing 20+ years of lookback period?

32%

Were the audits conducted by private audit firms on a contingent fee basis?

64%

Did the audits include estimation and extrapolation of assessments for periods with no or incomplete books and records?

71%

 

How are Actual Unclaimed Property Audits Conducted?

An unclaimed property audit can last for several years. As the audit prolongs, it would entail increased internal and external costs. In an actual unclaimed property audit, the following information is typically requested for each of the years back to 1981:

 

  • Organizational charts, Form 851s (a tax form showing all companies included in the federal consolidated tax return), Form 1120s (federal corporate income tax returns), trial balances, chart of accounts, and financial statements.
  • General ledger details for any accounts suspected to hold entries related to unclaimed property, such as unapplied or unidentified cash, write-offs, suspense accounts, and miscellaneous income.
  • Quarterly or monthly bank statements, bank reconciliations, outstanding check lists, and voided check lists.
  • Accounts Receivable aging reports showing aged credit balances and details of any credit balances written off to income.

 

It is important to ensure that the staff accountants interviewed by the auditors fully understand the issues so they do not give any inappropriate answers. However, no matter how well you are prepared, you should expect that the auditors will try to identify any suspicious items as unclaimed properties and impose a very high burden of proof on the company to refute the assessments. If the auditors perceive that you lack knowledge and experience with unclaimed property matters, they tend to take aggressive positions on items not clearly defined by law.  Many companies engage technical specialists in the area of unclaimed property to protect the companies from auditors taking advantage of the company personnel's lack of technical knowledge in this area.

 

Penalties and Interest

If unclaimed property assessments are made as a result of an audit, penalties and interest are often added to the assessments by the states. The 1995 Uniformed Unclaimed Property Act set the following guidelines:

 

  • Interest: 12 percent per year.
  • Late filing of reports: $200 penalty per day up to $5,000 maximum.
  • Willful failure to submit a report: $1,000 penalty per day up to a $25,000 maximum.
  • Submission of a false report: $1,000 per day, up to a maximum of $25,000, plus an additional 25% of the value of the property.

 

Actual penalties and interest provisions vary from state to state, for example, as follows:

 

 

Delaware

New York

California

Penalties

Base

Amount of unclaimed property reported late for each report year

Period of willful failure to file reports

Period of failure to file reports

Willful refusal to deliver property

Rate

60% per report year (5% per month)

$100 per day

$100 per day

$5,000 per property

Maximum

50% of the value of the property due in each report year

N/A

$10,000

$50,000

Interest

Base

Value of the property plus penalties in each report year

Value of the property in each year for each year late

Value of the property in each year for each year late

Rate  per year

6%

10%

12%

Maximum

50% of the value of the property plus penalties due in each report year

N/A

N/A

 

Preparing for Audits

Since most states' unclaimed property audits will cover all the years back to 1981, the longer a company waits to come into compliance, the more years that will be included when the company is eventually selected for an audit. For this reason, it is imperative to start addressing the unclaimed property issues to come into compliance with the states' laws on a voluntary basis and prepare for selection for audits as soon as possible.  Some of the basic steps to mitigate the risks include the following:

 

  • Educate management about the risks of non-compliance
  • Address gaps in the compliance process
  • Develop policies and procedures that are tailored to the specific business' accounting processes
  • Quantify the company's exposure by entity, property type, state, year
  • Develop a compliance strategy
  • File reports timely
  • Maintain the detailed documentation that supports the reports filed
  • Train personnel involved in unclaimed property compliance
  • Develop process to stay abreast of law changes and current audit trends

 

It should be noted that, as mentioned above, a statute of limitations for income taxes starts running once the return is filed but the filing of an unclaimed property report does not cause a statute of limitations to run or shorten the lengthy audit period going back many years. Accordingly, it is not recommendable to file unclaimed property reports as a matter of formality without carefully formulating strategies as to how to address the risks incurred in the past years because doing so could trigger selection for an audit.

 

In fact, if you have identified that your company has had issues in the past with unclaimed property, the best cause of action may be to take advantage of the Voluntary Disclosure Agreement ("VDA") programs offered by various states. In short, under these programs, if you step forward voluntarily before being selected for an audit, you may be able to settle the issues with relatively favorable terms. However, some of the VDA programs offered by the states are only offered for limited periods of time so it is best to perform a review of your company's unclaimed property exposure as soon as possible so you can take advantage of the available programs.  In general, by participating in VDA programs instead of being audited, you can:

 

  • Save substantial amounts of time and costs;
  • Prepare well in advance and be in control of the process;
  • Develop and offer reasonable estimations and avoid aggressive estimation techniques used by states and private audit firms;
  • Reduce the lookback period in accordance with the terms of the program (most VDA lookback periods are ten years); and
  • Obtain abatement of interest and penalties.

 

New Delaware VDA Program

As discussed above, while many Japanese-owned corporations are incorporated in Delaware, Delaware is one of the states that have been performing unclaimed property audits most aggressively. The state's Escheator's Office has been offering a VDA program which limits the lookback to 1991 instead of 1981 and provides for abatement of penalties and interest if the holders come forward before receiving an audit notice. However, since the State Escheator's Office is also in charge of auditing companies for unclaimed property and engaging third party audit firms to audit companies on a contingent fee basis, and as the applicants to this program tend to be treated in a similar manner as being audited, only a limited number of holders have been willing to participate in the program.

 

Delaware's state legislators enacted a law recently to offer a new VDA program administrated by the Secretary of State, instead of the State Escheator's Office, for a limited time period. Under the new VDA program:

 

  • Property holders that request participation prior to June 30, 2013, and remit full payment (or commit to a payment plan) prior to June 30, 2015, will not be required to report property issued prior to 1996.
  • Property holders that request participation between July 1, 2013 and June 30, 2014, and remit full payment (or commit to a payment plan) prior to June 30, 2015, will not be required to report property issued before 1993.
  • If participating companies file unclaimed property reports with Delaware for the three years immediately following the periods covered by the VDA will be closed to future audits by the State.

 

As once you receive an audit notice from the Delaware State Escheator's Office, you are not eligible for the new VDA program, you need to act as quickly as possible. In order to encourage participation in the new program, the state suspended issuance of audit notices by the State Escheator's Office until early February and the Secretary of State sent letters to various corporations' CFOs and other officers to introduce the new program and encourage companies to participate. It is very likely that many of the companies which received the letter from the Secretary of State that do not request participation in the VDA Program will receive an audit notice from the State Escheator's Office in the near future since the State Escheator is aggressively looking for companies to target for audits.

 

Summary

Japanese-owned U.S. corporations tend to overlook the importance of complying with the unclaimed property laws because of the lack of a similar system in the home country. Knowing this, some states, including Delaware, where many of these corporations are incorporated, are targeting these Japanese-owned U.S. corporations and auditing them aggressively using the private audit firms on a contingency fee basis, resulting in large assessments in some cases. Action needs to be taken urgently to protect your company from selection for an unclaimed property audit. The new limited-time VDA program offered by Delaware's Secretary of State is a rare and excellent opportunity to eliminate the unclaimed property issues in the jurisdiction potentially with the highest risks for many.  Accordingly, those Japanese-owned U.S. corporations incorporated in Delaware, which have not addressed the issues concerning unclaimed property in the past, are urged to take an immediate action to meet the June 30th deadline for requesting participation in Delaware's VDA Program.

 

*****

 

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

 

The views and opinions are those of the author and do not necessarily represent the views and opinions of KPMG LLP. All information provided is of a general nature and is not intended to address the circumstances of any particular individual or entity.

 

1. MissingMoney.com. This is a website run by the National Association of Unclaimed Property Administrators.

 

2. Frequently-cited reasons for incorporating in Delaware include: 1) incorporation procedure is relatively simple; 2) corporate maintenance fee (so-called Franchise Tax) can be as low as $75 per year (in case where authorized shares are 5,000 or less); 3) No income tax filing is required unless the corporation actually conduct business activities in Delaware; 4) shareholders' rights are relatively weak so that the management has more discretion in making corporate decisions especially in case of public companies; and 5) predictability in terms of corporate law issues is high because many case laws are available thanks to the large number of corporations incorporated in Delaware due to all the reasons stated above.

 

3. State Financial Report for the fiscal period ended June 30, 2012.

 

4. National Association of Unclaimed Property Administrators.

 

5. While the normal federal income tax statute of limitations is 3 years following the filing of a return, it is extended to 6 years if 25% or more of the gross income is omitted. Thus, many companies are adopting the 7-year document retention period based on the maximum 6-year federal statute of limitations.

 

6. A survey conducted jointly by KPMG and the Conference Board Council during February and March 2010.

Author

Makoto Nomoto

 

Makoto Nomoto

Partner, Tax

KPMG LLP

mnomoto@kpmg.com