Failure to comply with tax shelter disclosure regulations: what's at stake?

• Author: Shurberg, David

As part of its ongoing efforts to curb the use of corporate tax shelters, on February 28, 2003, the Department of the Treasury promulgated final tax shelter disclosure regulations. These regulations adopt the comprehensive definitions proposed in October 2002, requiring disclosure of six broad categories of transactions. Although the final regulations have considerably narrowed the scope of these categories, many non-abusive commercial transactions will be required to be disclosed, presenting serious compliance challenges for taxpayers.

This article summarizes the disclosure requirements under the recently issued final regulations, highlighting the breadth and ambiguous scope of several of the categories of reportable transactions. Next, it outlines the administrative, regulatory, and statutory penalties that the Internal Revenue Service, Treasury, and Congress have proposed or announced for taxpayers that fail to comply with such regulations. Finally, the article considers the compliance challenges facing corporate tax executives and tax departments under this expanded disclosure regime. Any compliance strategy will need to be broad in its approach, because compliance with the tax shelter disclosure regulations will require the cooperation, support, and input of personnel from the treasury, legal, information technology, and other departments within a corporation.

The final tax shelter disclosure regulations are applicable to transactions entered into on or after February 28, 2003, and may, at the taxpayer's option, be applied to transactions entered into on or after January 1, 2003, and prior to February 28, 2003. Because the final regulations generally contain narrower disclosure requirements than the temporary regulations, most taxpayers will find it beneficial to elect to apply the final regulations to all transactions entered into on or after January 1, 2003.

1. Disclosure Regulations

   1. History and Requirements of the Corporate Tax Shelter Disclosure Provisions

      To address concerns about the perceived proliferation of corporate tax shelters, in February 2000 the Treasury issued temporary regulations under section 6011 requiring disclosure of participation in certain tax shelter transactions by corporate taxpayers. (1) From the IRS's perspective, these temporary regulations proved ineffective. The IRS believed that taxpayers narrowly construed the five factors requiring disclosure and broadly construed the regulatory exceptions. Dissatisfied with the paucity of disclosures, the Treasury comprehensively amended the regulations in October 2002. Prior to release of the Treas. Reg. [section] 1.6011-4 on February 28, 2003, (2) the temporary regulations had been amended four times (3) as the Treasury and IRS strove to balance a number of competing goals, including (1) creating definitions that are broad enough to require disclosure of known abusive tax shelters; (2) having clear and objective definitions that minimize the uncertainty and controversy about what transactions are subject to disclosure; and (3) crafting definitions that minimize the number of non-abusive transactions entered into in the ordinary course of business that must be disclosed by taxpayers.

      The final regulations, like the October 2002 temporary regulations, represent a fundamental rethinking of the balance between over-inclusiveness and clarity struck in the original temporary regulations issued in February 2000 and subsequent amendments. Earlier versions generally attempted to avoid over-inclusiveness by providing exceptions for, among other things, transactions entered into in the ordinary course of business in a form consistent with customary commercial practice where there was a generally held understanding that the tax benefits were available. (4) Applying these exceptions, however, required a high degree of subjective judgment. Taxpayers often were frustrated that they could not achieve a high degree of confidence that an exception applied, and the government became frustrated when taxpayers often resolved the resulting uncertainties in their favor. Furthermore, despite IRS statements that disclosure of a transaction would not affect the merits of a transaction, many taxpayers and practitioners feared that failure to avail oneself of this exception could be viewed as an admission against interest on the merits.

      Both the October 2002 and the final regulations attempt to avoid these interpretational issues by using broad, objectively defined categories of transactions to be disclosed. Because these categories are not defined in terms of specific tax abuses, this approach will require the disclosure of many non-abusive transactions entered into by taxpayers in the ordinary course of business. This over-inclusiveness may be a cost of a more objective regime, even though the final regulations contain numerous objectively defined exceptions to key categories of reportable transactions. The Treasury and IRS appear to have determined that avoiding uncertainty and controversy over which transactions must be disclosed is more important than minimizing the number of disclosures.

      What's at Stake? If Proposed Legislation Is Enacted: * $200,000 penalty for each undisclosed listed transaction * $100,000 penalty for each undisclosed reportable transaction * Doubling of the statute of limitations from 3 to 6 years * Required SEC disclosure when certain penalties are imposed * 40-percent penalty (for undisclosed) and 20-percent penalty (for disclosed) transactions lacking economic substance * Denial of deduction for interest paid to the IRS * New 30-percent accuracy-related penalty (20percent if transaction was disclosed) * Extremely limited ability to have penalties waived or rescinded According to Recently Announced IRS Policy: * Requirement to provide tax accrual workpapers to the IRS * Inability to participate LIFE program * Inability to rely on an adviser's opinion for penalty protection B. Disclosure and Document Retention Requirements

      A taxpayer that has participated in a reportable transaction must attach Form 8886 to its return for each taxable year (5) in which the taxpayer participates in the transaction. In addition, a copy of Form 8886 must be sent to the IRS Office of Tax Shelter Analysis for the first year a taxpayer participates in the transaction (6) The taxpayer is also required to retain copies of all documents and other records that are relevant to an understanding of the tax treatment of a reportable transaction until the statute of limitations has run (7)

   3. Categories of Reportable Transactions

      The final regulations contain the same six categories of reportable transactions provided in the October 2002 temporary regulations: (1) listed transactions; (2) confidential transactions; (3) transactions providing contractual protection to the participant; (4) section 165 losses that exceed certain dollar thresholds; (5) transactions generating a significant book-tax difference; and (6) transactions generating at least a $250,000 tax credit and involving an asset held briefly. If a transaction is described in any one of these categories, it is a reportable transaction. There follows a description of the six categories, including highlights of changes in the final regulations; most of the changes are favorable to taxpayers.

      1. Listed Transactions

         A listed transaction is a transaction that is the same as or "substantially similar" to one of the transactions that the IRS has determined to be a tax avoidance transaction and identified by notice, regulation, or other form of published guidance as a listed transaction. (8)

         The final regulations do not make any significant modifications to the listed transaction category. The listed transactions regime is intended to give taxpayers notice that the IRS has identified specific transactions as abusive. The success of this regime depends upon the IRS providing "bright line" standards so that taxpayers can decide, on a principled basis, whether a given transaction is the same or substantially similar to a listed transaction. Of the 23 transactions currently on the list, most are defined with a reasonable degree of precision. The definitions of several of the transactions on the list, however, are sufficiently vague to be troubling. It is to be hoped that as the IRS maintains the list and adds transactions to the list, it will identify with precision the specific abuse involved in the listed transaction and clearly articulate why it considers the transaction to be abusive. A clear articulation of the rationale for listing a transaction will help tax executives determine whether a given transaction is "substantially similar" to the listed transaction.

      2. Confidential Transactions

         A confidential transaction is a transaction offered to a taxpayer under conditions of confidentiality. This category of reportable transaction is aimed at advisers seeking confidentiality with respect to the tax aspects of a transaction and not at taxpayers seeking protection for their own commercial information. Thus, disclosure will not be required unless the taxpayer's disclosure of the tax treatment or the tax structure of the transaction is limited in any manner by an express or implied understanding or agreement with any individual that provides tax advice with respect to the transaction. (9)

         The final regulations retain (and expand) the exception in the October 2002 regulations for confidentiality provisions required to comply with securities laws, making it applicable to all securities laws and not merely U.S. federal and state securities laws. (10)

         In response to comments received, the IRS added an important exception for confidentiality agreements with respect to mergers and acquisitions. This exception allows certain mergers and acquisitions to remain confidential and not create a disclosure obligation if the taxpayer is permitted to disclose the tax treatment and tax structure of the transaction no...