Proposed amendment of the substantial understatement penalty.

• Position: Tax Executives Institute's IRS Administrative Affairs Committee

Tax Executives Institute opposes the proposal in pending GATT funding legislation that would amend the substantial understatement penalty to provide that the amount of any corporate understatement may not be reduced to the extent attributable to a "tax shelter." The proposal is misguided and discriminatory, and should be rejected.

Background

In 1989, Congress enacted the Improved Penalty Administration and Compliance Act, which was intended to strip the Internal Revenue Code of irrational, unfair, and duplicative penalties. IMPACT was the result of a comprehensive, bipartisan, government-private sector initiative to improve the tax system and to restore balance to a penalty regime that was badly out of whack.

Although Congress has enacted amendments to the penalty provisions of the Code since 1989 (in particular, in respect of transfer pricing adjustments under section 482), the basic structure and philosophy of IMPACT remain intact. As the principal association of corporate tax executives in North America,(1) Tax Executives Institute was pleased to participate in the process that led to the enactment of IMPACT. The legislation not only brought a measure of rationality to the Code's penalty provisions, but it also restored fairness and promised stability. Regrettably, that rationality, fairness, and stability would be significantly eroded by the GATT penalty proposal.

Under current law, a 20-percent accuracy-related penalty will be imposed, in the absence of reasonable cause, in respect of substantial understatements of income tax. (I.R.C. [sections][sections] 6662(a), (d).) The amount of any understatement, however, is to be reduced to the extent it is attributable to (i) an item that is adequately disclosed on the taxpayer's return or (ii) an item in respect of which the taxpayer's treatment is supported by substantial authority. (I.R.C. [sections] 6662(d)(2).)(2) More stringent rules already apply in respect of tax shelters. Specifically, section 6662(d)(2)(C) provides that disclosure of an item on the taxpayer's return will not insulate the taxpayer from a penalty and, further, that the substantial authority exception will be available in respect of tax shelter items only if the taxpayer reasonably believed that the tax treatment of the item was "more likely than not" the proper tax treatment. For purposes of the penalty, section 6662(d)(2)(C)(ii) defines a tax shelter as--

(I) a partnership or other enti- ty, (II) any investment plan or ar- rangement, or (III) any other plan or arrange-

ment,

if the principal purpose of such

partnership, entity, plan, or ar-

rangement is the avoidance or

evasion of Federal income tax.

Although the language of the proposal has not been released and, indeed, the description of its terms remains vague,(3) it appears that the proposal would amend section 6662(d)(2) to provide, as follows: Where an understatement of federal income tax by a corporation is attributable to a tax shelter, the 20-percent penalty will automatically and unconditionally be...