Walking the tightrope: the new tax shelter disclosure regulations.

• Author: Grigsby, McGee
• Position: Tax Executives Institute

In February of this year, the Internal Revenue Service issued temporary and proposed regulations aimed at curbing what the Treasury Department perceives as the most serious compliance issue threatening the American tax system -- corporate participation in tax shelters.(1) Similarly, in May of this year, the Senate Finance Committee released a draft of proposed legislation that would also target corporate tax shelters.(2) The new regulations and draft legislation evidence increasing concern among government officials that billions of dollars a year are being lost to corporate tax-avoidance schemes.(3)

The new tax shelter disclosure (TSD) regulations do not alter substantive tax rules, but rather attack the problem by requiring persons participating in corporate tax shelter transactions to create, maintain, and provide to the IRS certain information about the transactions and persons associated with the transactions.

The first of the TSD regulations, Temp. Reg. [sections] 1.6011-4T, outlines new reporting requirements for corporate taxpayers that engage in tax shelter transactions. The second set of the TSD regulations, Temp. Reg. [sections] 301.6111-2T, requires promoters and advisers to register corporate tax shelters. The third set, Temp. Reg. [sections] 301.6112-1T, requires promoters to collect and maintain information regarding investors who purchase interests in corporate tax shelters.

It is obvious that the Treasury Department hopes the TSD regulations will provide the IRS with more current and more complete information about tax-motivated transactions. The regulations require corporations to attach a special form to the first return upon which a tax motivated transaction affects the corporate tax liability.(4) Registration of tax shelters is required currently with the marketing of the product, and investor lists are to be made available for inspection without a summons within ten calendar days of a request.

If the tax shelter problem is as pernicious as perceived, these are laudable objectives. Unfortunately, the TSD regulations are overbroad in scope, may impose disproportionate burdens with respect to routine transactions, and create substantial uncertainty regarding their actual requirements.

CORPORATE REPORTING

Temp. Reg. [sections] 1.6011-4T(5) requires corporate taxpayers to file a statement with their tax return disclosing their participation in reportable transactions. As defined in the regulations, reportable transactions fall into two categories: (1) listed transactions, and (2) other reportable transactions.

Listed Transactions

A listed transaction is any transaction the IRS has identified through published guidance as a tax-avoidance transaction or a transaction that is substantially similar to a listed transaction. Along with the new regulations, the IRS also published Notice 2000-15,(6) detailing 10 listed transactions.

Other Reportable Transactions

The second category consists of other reportable transactions. A transaction will be an other reportable transaction if it possesses at least two of the following six characteristics:

1. The taxpayer has participated in the transaction under conditions of confidentiality.

2. The taxpayer has obtained contractual protection against the possibility that all or part of the intended tax benefits from the transaction will not be allowed.

3. The taxpayer's participation in the transaction was promoted, solicited, or recommended by one or more persons who are expected to receive fees or other consideration with an aggregate value in excess of $100,000.

4. The expected treatment of the transaction for federal tax purposes is expected to differ by more than $5 million from the treatment of the transaction for purposes of determining book income as taken into account on the schedule M-1 (or comparable schedule) on the taxpayer's federal tax return for the same period.

5. The transaction involves the participation of a person that the taxpayer has reason to know is in a federal income tax position that differs from that of the taxpayer (such as a tax-exempt entity or foreign person), and the participation of such person allows the taxpayer to receive more favorable federal tax treatment.

6. The expected characterization of any significant aspect of the transaction for federal tax purposes differs from the expected characterization of the same aspect of the transaction for purposes of taxation of any party to the transaction in a foreign country.

   The characteristics and thresholds in the regulations present a number of problems. As a general matter, the two-of-six-factor test is excessively broad and sweeps in many ordinary transactions. Several of the six characteristics are often present in ordinary business transactions. For example, the $5 million of book/tax difference, the participation of a tax-exempt entity or foreign person, and incurring an aggregate of $100,000 in fees can occur with some frequency.

   In comments to the IRS, Tax Executives Institute stressed that the Internal Revenue Code is replete with provisions creating book/tax accounting differences; thus, it is somewhat paradoxical that the more scrupulous a taxpayer is in complying with the tax law (i.e., reporting book/tax differences), the greater the likelihood of having to file additional disclosure. Large corporations generally disclose scores of Schedule M items on tax returns, and the book/tax differences for these items frequently exceed $5 million in a single tax year. Consequently, for a large corporation, the regulation's book/tax characteristic will almost invariably be present, and the two-of-six-factor test will in practice be more akin to a one-in-five-factor test.(7)

   In addition, the Chicago Bar Association has pointed out that the sixth factor outlined in the regulations (i.e., transactions in which the expected characterization of a significant aspect of the transaction for federal income tax purposes differs from its characterization in a foreign country) will often be duplicative of the immediately preceding factor (i.e., participation of a person whose federal income tax position differs from that of the taxpayer).(8) By definition, a foreign person is a person whose federal tax position will usually be different from that of a U.S. taxpayer. Hence, the inclusion of both the fifth and sixth factors in the regulations may have the effect of automatically rendering every transaction that involves a foreign party a reportable transaction.(9)

   Even if factors 5 and 6 are not identical, for multinational corporations, the presence of one of these two characteristics in many transactions is inevitable. Thus, many routine transactions will require disclosure because the book/tax differential will also be a characteristic of these transactions.

   Projected Tax Effects

   In addition to falling into either the listed or other reportable transaction category, a transaction must also satisfy a projected tax effects threshold before reporting is required. For listed transactions, the threshold is satisfied if the transaction reduces the corporation's tax liability by more than $1 million in any single tax year or by a total of more than $2 million for any combination of tax years. For other reportable transactions, the projected-tax-effects thresholds increase to $5 million for any single tax year and $10 million for any combination of tax years.

   Unfortunately, the test for estimating the projected tax effect of a transaction and for determining whether it meets the monetary thresholds requiring disclosure is unclear in its application.(10) For example, how long must a taxpayer analyze a transaction in order to arrive at the $2 million and $10 million thresholds for a combination of tax years? Is it five years, ten years, or more?(11) This is a difficult estimate for corporations involved in complex non-tax motivated transactions that produce ancillary tax savings over a number of years. It seems that under the regulations, disclosure would be required of many transactions with small, but enduring tax savings.(12)

   Exceptions

   In an attempt to exclude nonaggressive tax transactions from the disclosure requirements, the TSD regulations include four exceptions for transactions that would otherwise fall into the other reportable transaction category. Regrettably, the exceptions do not provide meaningful relief for taxpayers swept in by the excessive scope of the two-of-six-factor test. The TSD regulations provide that a corporation does not have to disclose participation if any of the following conditions are satisfied:

1. The taxpayer participated in the transaction during the ordinary course of business, and the taxpayer reasonably determines that it would have participated in the transaction irrespective of the tax benefits.

2. The taxpayer participated in the transaction during the ordinary course of business, and the taxpayer reasonably determines there is a longstanding and generally accepted understanding that the expected tax benefits are allowable under the Code.

3. The taxpayer reasonably determines there is no reasonable basis under federal tax law for the denial of the tax benefits.

4. The transaction is...