Registration, listing and disclosure of potentially abusive corporate tax shelters.

• Author: Sawyers, Roby B.

The Treasury issued temporary regulations mandating registration, listing and disclosure of tax shelters and certain other tax-motivated transactions, in an attempt to recoup an annual revenue loss estimated at anywhere from $3.3 billion to $30 billion. The AICPA testified before the Senate on the corporate tax shelter issue and submitted written comments on the regulations. This article explains the new rules and the AICPA's perspective.

EXECUTIVE SUMMARY

* Corporate tax shelters have been the subject of highly publicized, intense and emotional debate over the last few years.

* The temporary regulations address three areas: registration of corporate tax shelters; requirements to maintain lists of investors; and tax shelter disclosure statements.

* The Treasury and JCT white paper recommendations hinge on additional disclosure requirements and increased penalties.

Earlier this year, Treasury issued three sets of temporary and proposed regulations (under Secs. 6011, 6111 and 6112) on corporate tax shelters.(1) As described by Treasury, "the three regulations are designed to provide the Service with better information about tax shelters and other tax-motivated transactions through a combination of registration and information disclosure by promoters and tax return disclosure by corporate taxpayers."(2)

The regulations are the latest round in the continuing debate among Treasury, Congress and the practitioner community (as represented by the AICPA, the American Bar Association (ABA) Section of Taxation, Tax Executives Institute (TEI) and others) concerning the "problem" of corporate tax shelters and the best approach to addressing them.

Backgound

In February 1999, the Clinton administration offered 16 proposals aimed at shutting down abusive tax shelters, as part of the revenue provisions in the President's fiscal year 2000 budget.(3) Congressional hearings on the issue were held in March and April 1999. In July 1999, Treasury and the Joint Committee on Taxation (JCT) each issued "white papers" addressing the issue, followed by another round of Congressional hearings in the fall. Throughout 1999, the issue was hotly debated in the press, Congressional hearings and other forums by the ABA, the New York State Bar Association, the AICPA, TEI and the "Big Five" accounting firms. The debate has continued into 2000; Treasury released regulations and the Senate Finance Committee held hearings. In late May, the Senate Finance Committee staff released a discussion draft, recommending increased penalties on corporations that engage in corporate tax shelters and enhanced disclosure by corporations and promoters, and prohibiting tax opinion writers from providing opinions on transactions in which they participate or otherwise have an interest.(4)

What Is a Corporate Tax Shelter?

Under current law, an arrangement is treated as a corporate tax shelter under Sec. 6111 (c) if it has as a significant purpose the avoidance or evasion of Federal income tax. Although difficult to define, Treasury's white paper identified a number of common characteristics of tax shelters, including lack of economic substance, inconsistent financial accounting and tax treatment, use of tax-indifferent parties (including foreign entities and tax-exempt entities), active marketing by promoters, use of confidentiality agreements by promoters, use of contingent fees or insurance arrangements and high transaction costs.(5)

In addition, a number of transactions have been determined by Treasury to be "tax avoidance transactions."(6) Examples include transactions involving contingent installment notes (CINs), lease-in, lease-out arrangements and debt straddles.

Extent of the Problem

It is difficult to quantify the extent of the tax shelter problem. In a report, the JCT stated that "although economic information concerning the cost of tax shelters is largely anecdotal, some believe that the resulting revenue loss may be in excess of $10 billion a year."(7) Using evidence from three recent high-profile shelter cases(8) and 123 known related cases, the JCT estimates that over $7 billion of disputed tax dollars is at stake.(9) Based on an analysis of decreases in the ratio of corporate taxes to corporate profits from 1994-1999, others have estimated the shortfall to range from $13 billion-$24 billion.(10) Using another approach based on estimated tax shelter fees paid to promoters, the annual revenue loss has been estimated between $3.3 billion and $30 billion.(11)

Some argue that current law is sufficient to address abuses(12) and that the IRS's recent victories in court evidence that. However, most agree that corporate tax shelters are a serious problem, current law is inadequate to address it and a viable solution must extinguish shelters before they are entered into, rather than relying on detection through current means or legislation that attempts to attack specific transactions.

Treasury and JCT Proposals

The Treasury and JCT white paper recommendations hinge on additional disclosure requirements and increased penalties. Both would effectively codify the economic substance doctrine by requiring a comparison of the present values of expected pre-tax profits and tax benefits in determining whether an arrangement has as a significant purpose the avoidance or evasion of Federal income tax.

Disclosure

Disclosure of transactions to the IRS should make detection easier and alert the IRS and Treasury to potential questionable transactions early. According to the JCT, "disclosure should function as an `early warning device' providing notice to Treasury of a potential gap or inconsistency in the tax law that warrants attention."(13) Treasury argues that greater disclosure to the IRS should also discourage corporations from entering into questionable transactions, by changing the cost/benefit analysis.(14)

Both the Treasury and JCT proposals call for advance disclosure to the IRS--pre-return disclosure by the taxpayer or promoter and/or disclosure on the taxpayer's return. The proposals differ as to which transactions would trigger disclosure, and on disclosure form and timing. The JCT recommends disclosure of transactions meeting certain "indicators," including those (1) causing permanent book-tax differences, (2) involving contingent fee or tax indemnity arrangements, (3) involving a tax-indifferent party, (4) failing a pretax profits test (i.e., expected pre-tax profits are insignificant compared to expected net tax benefits) and (5) in which the corporate participant incurs little additional economic risk.

Treasury's proposal recommends the use of "filters" that a transaction must meet to require disclosure, including a combination of book/tax differences in excess of certain thresholds; a recision clause or unwind provision; insurance or similar arrangements for the anticipated tax benefits; involvement of a tax-indifferent party; adviser fees in excess of certain amounts; contingent fees; confidentiality agreements; offering of a transaction to multiple corporations; and a difference between the form of a transaction and how it is reported. Both proposals recommend that any disclosure by the taxpayer be signed by a senior financial officer or another corporate officer having knowledge of the facts.

Penalties

Under current law, tax adviser opinions obtained or issued by a tax shelter promoter are used by taxpayers to avoid 20% substantial underpayment penalties under the "more likely than not" standard. Due to ambiguities in the law and the subjective nature of the standard, it is relatively easy for shelter promoters to write these opinions to meet the more-likely-than-not standard or to obtain them from others (sometimes even "opinion shopping" to more than one CPA or law firm).(15)

In general, the Treasury and JCT white paper proposals would increase underpayment penalties to 40%, with a reduction to 20% for disclosure and "substantial authority" or "more likely than not" support. Treasury would eliminate the 20% penalty with disclosure and a strengthened reasonable cause standard; the JCT would repeal the current reasonable cause exception and replace it with a disclosure requirement and a 75% "highly confident" likelihood that the tax treatment would be sustained on its merits. The Treasury and JCT recommendations also provide for enhanced or new penalties on other parties (e.g., promoters, advisers and tax-indifferent parties) and recognize the need to amend Circular 230(16) to expand its scope and provide more meaningful enforcement measures.

AICPA Reaction

The AICPA reacted to the Treasury and JCT proposals in Senate Finance Committee testimony on March 9, 2000.(17)

Disclosure Provisions

As to disclosure requirements, the AICPA agreed that "reportable transactions" subject to tax-return disclosure...