Posted with permission from the July 5, 1999 issue of Legal Times
Treasury Leads Charge Against Corporate Tax Avoidance
The proliferation of "abusive corporate tax shelters" has received much attention of late in the popular press. In response, Congress and the administration have devoted valuable resources to examining the phenomenon. Now the administration is lobbying Congress to enact comprehensive tax shelter legislation.
The blueprint for such legislation, initially set forth in the administration's revenue proposals for the fiscal year 2000 budget, was modified in a white paper released late last week. See Department of the Treasury, General Explanations of the Administration's Revenue Proposals 95-118 (Feb. 1999) and The Problem of Corporate Tax Shelters: Discussion, Analysis and Legislative Proposals (July 1999).
Numerous factors have been cited as fueling the perceived growth of the corporate tax shelter market. On the "promoter" side, there is severe competition for the high-margin tax consulting business. On the "buyer" side, there is an alleged increase in corporations' willingness to accept tax risk in order to manage profits more effectively. Finally, Treasury considers past anti-abuse legislation, as well as its own anti-abuse rule-making authority, as inadequate to discourage corporate participation in such tax-motivated transactions.
The most recent proposals set forth in the white paper maintain the thrust of the multifaceted attack conceived in Treasury's original proposals: Relegate broad substantive authority to Treasury to identify corporate tax shelter activity; mandate disclosure of such activity; and penalize those engaged in marketing, selling, advising, and consuming corporate tax shelters.
Treasury is frustrated in its efforts to effectively combat shelters, in part, because many "engineered" transactions literally comply with the Internal Revenue Code. The department's view is that the typical compliance tools, such as disclosure and penalties, are meaningless as long as there is no real threat of a tax deficiency. Thus, the operative core of the proposals (and their most contested aspect) is the adoption of a substantive rule defining a corporate tax shelter in generic terms. The provision would operate as an overlay to technical rules in the code.
Under the proposals, a corporate tax shelter would include any entity, plan, or arrangement in which a direct or indirect corporate participant attempts to obtain a tax benefit in a tax avoidance transaction. The broad scope of this provision lies in the definitions of tax benefit and tax avoidance transaction.
The term tax benefit includes any reduction, exclusion, avoidance, or deferral of tax or any increase in the taxpayer's refund not "clearly contemplated" by the applicable code provision. However, only those benefits obtained in a tax avoidance transaction will trigger application of the proposals.
There is a twofold definition of the term tax avoidance transaction--an objective test and a second definition for transactions not susceptible to an objective test analysis. The current proposals abandon the earlier, highly criticized catch-all definition, which included any transaction involving the improper elimination or significant reduction of tax on economic income.
The proposed objective test arises out of the practical difficulties faced by the IRS in proving a taxpayer's subjective intent to avoid tax. Instead, the objective test attempts to assess whether the taxpayer had an ascertainable profit motive for entering the transaction. More specifically, a tax avoidance transaction would exist if the reasonably expected pretax profit (determined on a present value basis after expenses) was insignificant relative to the reasonably expected net tax benefits (also determined on a present value basis).
Since the very essence of an "engineered transaction" is that it lacks any real business substance, Treasury feels justified in establishing lack of verifiable economic substance or profit motive as the litmus test for distinguishing abusive shelter activity. In fact, Treasury is supported in this view by the American Bar Association and the courts. See, e.g., ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998), aff'g in part, rev'g in part, 73 T.C.M. (CCH) 2189 (1997).
A second definition would be developed for other arrangements in which no profit/tax benefit comparison would be possible, such as in a financing arrangement where the borrower is not necessarily earning a profit. Treasury suggests that other tax abusive transactions involving employee compensation and business dispositions and liquidations may also fall into this category.
ARSENAL OF PENALTIES
Once a transaction is determined to constitute a corporate tax shelter, the IRS would be empowered with a substantial arsenal of penalties, which it could levy not only on the participants but on the promoters and advisers, as well. Although the penalties under the current proposals are substantial, they are significantly less onerous than the original proposals.
Under the original proposals, the cost to the participant for engaging in a corporate tax shelter was not limited to the tax (and interest) associated with any loss of the anticipated tax benefits. The corporate participant was also denied a deduction for fees paid to promoters and advisers. The participant could also suffer a 25 percent excise tax on the maximum value of any tax benefit protection arrangement employed to hedge the economic downside and tax risk of the transaction. Treasury has now abandoned the latter two provisions.
However, the current proposals do retain a provision that would impose on all corporate participants joint and several liability for the tax attributable to the income of a "tax indifferent" party facilitating a tax shelter. Tax-indifferent parties include those persons or entities that would have no U.S. tax liability for their portion of the income attributable to a tax shelter arrangement (e.g., a foreign person not subject to U.S. tax, a domestic corporation with expiring net operating losses, a Native American tribal organization, or a tax-exempt entity). The provision attempts to eliminate the difficult task under current law of attacking or recharacterizing the participation of tax-indifferent parties in tax abusive transactions. The current proposals clarify that the provision would be applied only to tax-indifferent parties trading on their tax-exempt status. Presumably, this would limit the application to third party "straw men" and exclude tax-exempt participants that do have an economic interest in the transaction.
In order to dampen the active market for corporate tax shelters, penalties would also be imposed on those facilitating "abusive" behavior. Treasury reports that "it is important that all parties that facilitate a questionable transaction have a personal stake in determining the appropriateness of the transaction." Accordingly, a 25 percent excise tax would be imposed on fees received in connection with the purchase and implementation of corporate tax shelters and the rendering of tax advice related to shelters. (This provision would not apply to expenses incurred in representing a taxpayer before the IRS or a court.) Any professional who advised the client against participation in the shelter would be outside the scope of the provision. As an alternative, Treasury would consider amendments to make existing penalty provisions (e.g., I.R.C. Section 6700) applicable to these transactions.
Undoubtedly, this proposal could have a chilling effect on a taxpayer's right to seek competent tax advice. In practice, it may be quite difficult to distinguish between regular tax advice and abusive tax shelter advice. This provision also raises numerous legal and ethical issues for the tax adviser. For example, can the adviser maintain an independent status if there is the potential that the adviser will end up in an adverse relationship with the corporate client in any IRS proceeding?
A key enforcement component of Treasury's proposals is increased disclosure of tax shelter activity. Timely notice to Treasury would enhance the department's ability to identify abusive transactions. Moreover, it is universally agreed that increased visibility likely inhibits the corporate appetite for tax risk.
The proposals would require disclosure with respect to any transaction that contains one or more of certain specified attributes whether or not such transaction constitutes a corporate tax shelter. The specified attributes (generally those characteristic of shelter activity) include involvement of a tax-indifferent party, a tax benefit protection arrangement, a book/tax difference or adviser fees in excess of certain thresholds, a confidentiality agreement, the offering of the transaction to multiple parties, and a tax treatment of a transaction that does not comport with its form (arbitrage). Since the disclosure requirement is based on the existence of certain facts, taxpayer "discretion" as to which transactions to report will be largely limited.
The corporation must file any disclosure statement with its income tax return, and such disclosure must be attested to by a corporate officer. That officer would be held personally accountable (with appropriate penalties for fraud and gross negligence) for any statements submitted in the disclosure--for example, representations of business purpose. Separately, the promoter (or under some circumstances, the reporting corporation) must file contemporaneous disclosure with the national office of the IRS. Failure to make the required disclosure would result in a $100, 000 fixed fee penalty.
In the case of failure to disclose a corporate tax shelter, a 40 percent penalty would apply to any understatement of tax (over certain thresholds). Where the taxpayer properly disclosed the shelter transaction, the understatement penalty could be reduced to 20 percent. Treasury has also agreed to reduce or eliminate the penalty with respect to a disclosed tax shelter if the taxpayer can demonstrate "a reasonable belief that it had a strong probability of success on the merits." However, a corporation's ability to rely on the opinion of an expert tax adviser to establish its reasonable belief may be limited. For example, no reliance would be permitted where the transaction was subject to a confidentiality agreement.
Tax arbitrage, another common attribute of a tax shelter, occurs when a taxpayer determines the federal income tax consequences of a transaction on the basis of its "substance" rather than the form or steps actually consummated. For example, hybrid financial instruments may be treated as equity for foreign law purposes but as debt for U.S. tax purposes. Under the current proposals, the tax benefits associated with any tax arbitrage position would be denied if the tax benefits exceeded a certain threshold (perhaps $1 million) and the taxpayer failed to file the appropriate disclosure. (Contrary to the original proposals, disclosure would be required even if no tax-indifferent party were involved.)
As was expected, the breadth and vagueness of the original proposals in defining the appropriate limits of tax avoidance were lightning rods for criticism. Although the current proposals try to address those criticisms, there is still wide latitude for interpretation. One concern among taxpayers will be the use of such latitude by a local IRS agent. How can Treasury ensure consistency of interpretation and application?
In the white paper, Treasury professes an intent to partner with practitioners and Congress in advancing reform that neither inhibits legitimate business transactions nor negates a taxpayer's legal right "to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits." Nevertheless, concerns about fairness will be a major obstacle in the legislative debate. Ultimately, the battleground may be trust.
These proposals represent the first shot across the bow in Treasury's much anticipated war on corporate tax shelters. Whether Congress will enact the current version of the proposals is uncertain. The budget surplus might be expected to depress the appetite for major tax reform this year. But the apparent consensus in the press and among tax professional organizations about the existence of widespread tax shelter abuse may force Congress' hand.
Giovanna T. Sparagna is a tax partner in the D.C. office of Sutherland Asbill & Brennan, concentrating in the areas of corporate and international tax.
Reprinted with permission of Legal Times, 1730 M St., N.W., Suite 802, Washington, D.C. 20036. Phone: 202-457-0686. Copyright, Legal Times, 1999.