    [House Hearing, 106 Congress]
    [From the U.S. Government Publishing Office]

                             CORPORATE TAX SHELTERS

    =======================================================================

                                    HEARING

                                   before the

                          COMMITTEE ON WAYS AND MEANS
                            HOUSE OF REPRESENTATIVES

                           ONE HUNDRED SIXTH CONGRESS

                                 FIRST SESSION

                                   __________

                               NOVEMBER 10, 1999

                                   __________

                                 Serial 106-85

                                   __________

             Printed for the use of the Committee on Ways and Means

                        U.S. GOVERNMENT PRINTING OFFICE
    66-992 CC                   WASHINGTON : 2001

    _______________________________________________________________________
                For sale by the U.S. Government Printing Office
    Superintendent of Documents, Congressional Sales Office, Washington, DC
                                     20402

                          COMMITTEE ON WAYS AND MEANS

                          BILL ARCHER, Texas, Chairman

    PHILIP M. CRANE, Illinois            CHARLES B. RANGEL, New York
    BILL THOMAS, California              FORTNEY PETE STARK, California
    E. CLAY SHAW, Jr., Florida           ROBERT T. MATSUI, California
    NANCY L. JOHNSON, Connecticut        WILLIAM J. COYNE, Pennsylvania
    AMO HOUGHTON, New York               SANDER M. LEVIN, Michigan
    WALLY HERGER, California             BENJAMIN L. CARDIN, Maryland
    JIM McCRERY, Louisiana               JIM McDERMOTT, Washington
    DAVE CAMP, Michigan                  GERALD D. KLECZKA, Wisconsin
    JIM RAMSTAD, Minnesota               JOHN LEWIS, Georgia
    JIM NUSSLE, Iowa                     RICHARD E. NEAL, Massachusetts
    SAM JOHNSON, Texas                   MICHAEL R. McNULTY, New York
    JENNIFER DUNN, Washington            WILLIAM J. JEFFERSON, Louisiana
    MAC COLLINS, Georgia                 JOHN S. TANNER, Tennessee
    ROB PORTMAN, Ohio                    XAVIER BECERRA, California
    PHILIP S. ENGLISH, Pennsylvania      KAREN L. THURMAN, Florida
    WES WATKINS, Oklahoma                LLOYD DOGGETT, Texas
    J.D. HAYWORTH, Arizona
    JERRY WELLER, Illinois
    KENNY HULSHOF, Missouri
    SCOTT McINNIS, Colorado
    RON LEWIS, Kentucky
    MARK FOLEY, Florida

                         A.L. Singleton, Chief of Staff

                      Janice Mays, Minority Chief Counsel

    Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public
    hearing records of the Committee on Ways and Means are also published
    in electronic form. The printed hearing record remains the official
    version. Because electronic submissions are used to prepare both
    printed and electronic versions of the hearing record, the process of
    converting between various electronic formats may introduce
    unintentional errors or omissions. Such occurrences are inherent in the
    current publication process and should diminish as the process is
    further refined.

                                C O N T E N T S

                                   __________

                                                                       Page

    Advisories announcing the hearing................................     2

                                   WITNESSES

    U.S. Department of the Treasury, Jonathan Talisman, Acting
      Assistant Secretary for Tax Policy.............................    24
    Joint Committee on Taxation, Lindy Paull, Chief of Staff.........    37

                                     ______

    American Bar Association, and Orrick, Herrington & Sutcliffe,
      Paul J. Sax....................................................    60
    American Institute of Certified Public Accountants, David A.
      Lifson.........................................................    68
    BellSouth Corporation, and Tax Executives Institute, Inc.,
      Charles W. Shewbridge, III.....................................    73
    Doggett, Hon. Lloyd, a Representative in Congress from the State
      of Texas.......................................................     8
    Hariton, David P., Sullivan & Cromwell...........................   124
    Kansas City Southern Industries, Inc., Danny R. Carpenter........   135
    New York State Bar Association, Harold R. Handler................    86
    PricewaterhouseCoopers, Kenneth J. Kies..........................   101
    Tax Analysts, Martin A. Sullivan.................................   126

                           SUBMISSIONS FOR THE RECORD

    Association of the Bar of the City of New York, Andrew H.
      Braiterman, letter and attachment..............................   152
    Massachusetts Mutual Life Insurance Company, Springfield, MA,
      statement......................................................   160
    Millman, Stephen L., New York, NY, and Steven C. Salch, Houston,
      TX, Fulbright & Jaworski L.L.P., statement.....................   161
    Washington Counsel, P.C., and Tax Fairness Coalition, statement..   166

                             CORPORATE TAX SHELTERS

                                  ----------

                          WEDNESDAY, NOVEMBER 10, 1999

                              House of Representatives,
                                   Committee on Ways and Means,
                                                        Washington, DC.
        The Committee met, pursuant to call, at 11:00 a.m., in room
    1100, Longworth House Office Building, Hon. Bill Archer
    (Chairman of the Committee) presiding.
        [The advisories announcing the hearing follow:]

    ADVISORY

    FROM THE COMMITTEE ON WAYS AND MEANS

                                                    CONTACT: (202) 225-1721
        FOR IMMEDIATE RELEASE

        October 26, 1999

        FC-14

               Archer Announces Hearing on Corporate Tax Shelters

        Congressman Bill Archer (R-TX), Chairman of the Committee on Ways
    and Means, today announced that the Committee will hold a hearing on
    corporate tax shelters. The hearing will take place on Wednesday,
    November 10, 1999, in the main Committee hearing room, 1100 Longworth
    House Office Building, beginning at 10:00 a.m.

        Oral testimony at this hearing will be from both invited and public
    witnesses. Invited witnesses will include representatives of the U.S.
    Department of the Treasury and the Joint Committee on Taxation. Also,
    any individual or organization not scheduled for an oral appearance may
    submit a written statement for consideration by the Committee or for
    inclusion in the printed record of the hearing.

    BACKGROUND:

        Section 3801 of the Internal Revenue Service (IRS) Reform and
    Restructuring Act (P.L. 105-206) required the Joint Committee on
    Taxation and the Treasury to each conduct a separate study reviewing
    the interest and penalty provisions of the Internal Revenue Code, and
    make any legislation and administrative recommendations deemed
    appropriate to simplify penalty administration and reduce taxpayer
    burden, by July 22, 1999. On July 1, 1999, the Treasury released a
    ``white paper'' on corporate tax shelter penalties and related issues,
    but did not deliver the broader penalty and interest study. The Joint
    Committee on Taxation issued its recommendations on penalties and
    interest and corporate tax shelters on July 22, 1999. On July 13,
    Chairman Archer announced his intention to hold a hearing on corporate
    tax shelters after the Treasury had completed its penalty and interest
    study. That study, including additional recommendations which could
    affect corporate tax shelters, was received yesterday. There is little
    agreement as to the definition or extent of corporate tax shelters, or
    the proper governmental response to them. The hearing will address the
    various policy issues related to corporate tax shelters as well as
    possible administrative or legislative responses.
        In announcing the hearing, Chairman Archer stated: ``This hearing
    is the latest in the Committee's efforts to stop abusive tax shelters.
    Due to actions taken by Congress since 1995, we have stopped $50
    billion in tax abuses. The IRS has won case after case in tax court
    using the very tools Congress already provided. Now, our challenge is
    to focus efforts on stopping abuses while properly restraining new
    blanket authorities for the IRS that might chill legitimate business
    transactions. This hearing continues the Committee's efforts to strike
    the proper balance in addressing the problems presented by corporate
    tax shelters.''

    FOCUS OF THE HEARING:

        The hearing will focus on (1) the nature and scope of the perceived
    corporate tax shelter problem, (2) the manner in which the IRS and the
    courts are currently addressing corporate tax shelters, (3) additional
    steps the Administration could take under current law to address such
    shelters, (4) additional legislation which might be necessary to
    address corporate tax shelters, and, (5) procedures the Administration
    has in place or could adopt, or that the Congress could enact, to
    ensure that new or existing enforcement tools brought to bear on
    corporate tax shelters do not interfere with legitimate business
    transactions or make more difficult the application of an already
    complex income tax.

    DETAILS FOR SUBMISSIONS OF REQUESTS TO BE HEARD:

        Requests to be heard at the hearing must be made by telephone to
    Traci Altman or Pete Davila at (202) 225-1721 no later than the close
    of business, Wednesday, November 3, 1999. The telephone request should
    be followed by a formal written request to A.L. Singleton, Chief of
    Staff, Committee on Ways and Means, U.S. House of Representatives, 1102
    Longworth House Office Building, Washington, D.C. 20515. The staff of
    the Committee will notify by telephone those scheduled to appear as
    soon as possible after the filing deadline. Any questions concerning a
    scheduled appearance should be directed to the Committee staff at (202)
    225-1721.

        In view of the limited time available to hear witnesses, the
    Committee may not be able to accommodate all requests to be heard.
    Those persons and organizations not scheduled for an oral appearance
    are encouraged to submit written statements for the record of the
    hearing. All persons requesting to be heard, whether they are scheduled
    for oral testimony or not, will be notified as soon as possible after
    the filing deadline.

        Witnesses scheduled to present oral testimony are required to
    summarize briefly their written statements in no more than five
    minutes. THE FIVE-MINUTE RULE WILL BE STRICTLY ENFORCED. The full
    written statement of each witness will be included in the printed
    record, in accordance with House Rules.

        In order to assure the most productive use of the limited amount of
    time available to question witnesses, all witnesses scheduled to appear
    before the Committee are required to submit 300 copies, along with an
    IBM compatible 3.5-inch diskette in WordPerfect 5.1 format, of their
    prepared statement for review by Members prior to the hearing.
    Testimony should arrive at the Committee office, room 1102 Longworth
    House Office Building, no later than Monday, November 8, 1999. Failure
    to do so may result in the witness being denied the opportunity to
    testify in person.

    WRITTEN STATEMENTS IN LIEU OF PERSONAL APPEARANCE:

        Any person or organization wishing to submit a written statement
    for the printed record of the hearing should submit six (6) single-
    spaced copies of their statement, along with an IBM compatible 3.5-inch
    diskette in WordPerfect 5.1 format, with their name, address, and
    hearing date noted on a label, by the close of business, Wednesday,
    November 24, 1999, to A.L. Singleton, Chief of Staff, Committee on Ways
    and Means, U.S. House of Representatives, 1102 Longworth House Office
    Building, Washington, D.C. 20515. If those filing written statements
    wish to have their statements distributed to the press and interested
    public at the hearing, they may deliver 200 additional copies for this
    purpose to the Committee office, room 1102 Longworth House Office
    Building, by close of business the day before the hearing.

    FORMATTING REQUIREMENTS:

        Each statement presented for printing to the Committee by a
    witness, any written statement or exhibit submitted for the printed
    record or any written comments in response to a request for written
    comments must conform to the guidelines listed below. Any statement or
    exhibit not in compliance with these guidelines will not be printed,
    but will be maintained in the Committee files for review and use by the
    Committee.

        1. All statements and any accompanying exhibits for printing must
    be submitted on an IBM compatible 3.5-inch diskette in WordPerfect 5.1
    format, typed in single space and may not exceed a total of 10 pages
    including attachments. Witnesses are advised that the Committee will
    rely on electronic submissions for printing the official hearing
    record.

        2. Copies of whole documents submitted as exhibit material will not
    be accepted for printing. Instead, exhibit material should be
    referenced and quoted or paraphrased. All exhibit material not meeting
    these specifications will be maintained in the Committee files for
    review and use by the Committee.

        3. A witness appearing at a public hearing, or submitting a
    statement for the record of a public hearing, or submitting written
    comments in response to a published request for comments by the
    Committee, must include on his statement or submission a list of all
    clients, persons, or organizations on whose behalf the witness appears.

        4. A supplemental sheet must accompany each statement listing the
    name, company, address, telephone and fax numbers where the witness or
    the designated representative may be reached. This supplemental sheet
    will not be included in the printed record.

        The above restrictions and limitations apply only to material being
    submitted for printing. Statements and exhibits or supplementary
    material submitted solely for distribution to the Members, the press,
    and the public during the course of a public hearing may be submitted
    in other forms.

        Note: All Committee advisories and news releases are available on
    the World Wide Web at `http://www.waysandmeans.house.gov''.

        The Committee seeks to make its facilities accessible to persons
    with disabilities. If you are in need of special accommodations, please
    call 202-225-1721 or 202-226-3411 TTD/TTY in advance of the event (four
    business days notice is requested). Questions with regard to special
    accommodation needs in general (including availability of Committee
    materials in alternative formats) may be directed to the Committee as
    noted above.

                          ***NOTICE--CHANGE IN TIME***

    ADVISORY

                   FROM THE COMMITTEE ON WAYS AND MEANS

                                                    CONTACT: (202) 225-1721
    FOR IMMEDIATE RELEASE

    ,November 5, 1999

    No. FC-14-Revised

                   Time Change for Full Committee Hearing on

                         Wednesday, November 10, 1999,

                           on Corporate Tax Shelters

        Congressman Bill Archer (R-TX), Chairman of the Committee on Ways
    and Means, today announced that the full Committee hearing on corporate
    tax shelters, previously scheduled for Wednesday, November 10, 1999, at
    10:00 a.m., in the main Committee hearing room, 1100 Longworth House
    Office Building, will begin instead at 11:00 a.m.

        All other details for the hearing remain the same. (See full
    Committee press release No. FC-14, dated October 26, 1999.)

        Chairman Archer. The Committee will come to order.
        The Chair invites all of our guests to take seats.
        This morning's hearing continues on the ongoing efforts of
    the Ways and Means Committee since 1995 to address issues
    relating to corporate tax shelters and any possible abuses in
    the Code.
        Over the past several years, the Congress has enacted a
    number of changes to prevent abusive corporate tax shelters,
    and those changes have included specific provisions addressing
    at least $50 billion of known abuses. They also included
    general changes requiring the registration of corporate tax
    shelters and enhancing the substantial understatement penalties
    for such shelters.
        I have been disappointed that the Treasury Department has
    failed to implement the corporate tax shelter registration
    provisions that it requested in its own budget. I personally
    believe this failure is inexcusable and has contributed to the
    perception that the government doesn't care about aggressive
    corporate tax shelters, and that is simply not the case.
        There are a number of other steps that Treasury and the IRS
    could take under current law to address the problems of
    corporate tax shelters, and I look forward to a discussion of
    those options. I also look forward to discussion of potential
    legislative proposals.
        The primary focus of this Committee in considering
    legislation and addressing corporate tax shelters will be to
    ensure that any new laws we enact do not end up interfering
    with legitimate business transactions or making substantive
    changes in tax law that have not been adequately considered
    through hearings and, furthermore, that we should make every
    effort not to make the Code more complex.
        Now, maybe that is an oxymoron relative to any income tax
    code, I am not sure, but we should make every effort to do
    that.
        With that, I recognize Mr. Rangel for any opening statement
    that he might like to make.
        Mr. Rangel. Thank you, Mr. Chairman.
        I am still one of those faithful believers that at some
    point before we end this session that we are going to pull the
    IRS Code up by the roots. The last 5 years we have heard a lot
    of talk about how complicated this system is. And I think you
    have to agree with me that no matter what you want to call
    these provisions that we are studying today, that in no small
    part they are responsible for much of the complexity that we
    find in the Tax Code, which is merely treating people
    differently because of our desire to have an outcome which we
    direct by the way we give credits and deductions.
        Now I know that Treasury has not done all that it can do.
    It is never the case that they do. But we have had
    recommendations to stop abusive corporate tax shelters made by
    the Treasury Department and recommendations by the American Bar
    Association. We have had magazine articles. And we have
    certainly had Congressman Doggett, who has brought to the
    attention of the Congress and the Nation the fact that we have
    a lot of things in our Tax Code that should be removed such as
    tax shelters.
        I have a letter here from the National Association of
    Manufacturers saying that we should attack illegitimate
    corporate tax loopholes. And so this is the eleventh hour. I
    don't know what we can accomplish between now and Christmas,
    but there must be a reason why we are having this hearing so
    late in this year.
        We did have an opportunity with the $792 billion tax cut to
    reform the system as we decorated the Christmas tree, but it
    wasn't done then. So I don't know what this hearing is going to
    do except to painfully point out what we haven't done. But
    being a faithful soldier, I follow your leadership and
    congratulate the Chairman for recognizing that within our
    corporate tax structure we have tax shelters that should not
    exist.
        I believe you when you say that we are not going to make
    dramatic changes without hearings and finding out what impact
    tax changes would have. When we will do this, I don't know. But
    I am here to find out and to welcome our colleague, Mr.
    Doggett, and to thank you for having the hearing before we
    adjourn tonight.
        Thank you, Mr. Chairman.
        [The opening statement of Mr. Rangel follows:]

    Statement of Hon. Charles B. Rangel, a Representative in Congress from
    the State of New York

        1. The Committee is finally meeting to discuss the huge
    problem of abusive corporate tax shelters.
         Unfortunately, this important issue is being
    addressed by a hearing--not a markup-at the time the Congress
    is preparing to adjourn.
         Obviously, Republicans don't consider corporate
    tax shelters a serious problem. If they did, they would have
    acted by now or at least have a plan.
         There is no question that corporate tax shelter
    abuse is a widespread and major problem and could have been
    solved months ago.
        2. Just last week it was reported that corporate tax
    shelters may be having a substantial negative impact on
    corporate tax receipts.
         Corporate tax receipts for fiscal year 1999 were
    approximately $4 billion less than for fiscal year 1998--even
    though corporate profits for 1999 were approximately $20
    billion higher than in 1998.
         The decline in corporate tax receipts in fiscal
    year 1999 was the first decline in recent history that was not
    caused by explicit congressional reductions in corporate taxes
    or declines in the overall economy.
         Corporate tax receipts as a percentage of
    corporate profits have steadily declined in recent years from
    approximately 26.6% in 1994 to 21.8% in 1999.
         This decline has occurred despite the corporate
    rate increase in the 1993 budget act and despite net corporate
    tax increases enacted since 1994.
         If corporate receipts had remained constant as a
    percentage of corporate profits since 1994, corporate tax
    receipts in fiscal year 1999 would have been at least $40
    billion higher.
         High among the list of suspected causes for the
    decline in corporate tax receipts is the increased use of
    aggressive corporate tax shelters.
        3. Congressman Doggett (the first witness) should be
    commended for his continued leadership in highlighting the
    corporate tax shelter abuse problem and for proposing a
    meaningful solution.
         His bill, H.R. 2255, the ``Abusive Tax Shelter
    Shutdown Act of 1999'' would disallow tax benefits from
    transactions without substantial economic substance and
    increase the penalty for substantial tax understatements.
         His bill is based on the recommendations made by
    the Treasury Department and the American Bar Association. While
    the details of their proposals may vary, their goal is the
    same.
        4. Over the past six months, Republicans have refused to
    consider or support corporate tax shelter reforms.
         Some (Archer) have said that Congress needed ``to
    wait" for Treasury's overall study on interest and penalty
    reform (released in October 1999.) This was just an excuse for
    doing nothing.
         In fact, Treasury's October interest and penalty
    report does not address corporate tax shelter abuse.
         Moreover, in July 1999, Treasury issued a
    comprehensive report on corporate tax shelter abuse. The Joint
    Committee on Taxation issued their report on interest,
    penalties and tax shelters at the same time. Both reports make
    recommendations for legislative action, yet nothing has been
    done.
         Rather than consider H.R. 2255, or the other
    proposals made by the tax community professionals, the
    Republicans have chosen to invent ridiculous revenue raising
    proposals--such as delaying payment of the Earned Income Tax
    Credit--which would hit hardworking Americans who pay highly
    regressive payroll taxes.
         Obviously it is easier for the Republicans to hit
    on the working guy, rather than to attack corporate tax abuse
    and the peddlers of tax shelter transactions. (The Republicans
    say they don't know how EITC beneficiaries spend their money
    and that those working families need help managing their
    financial affairs-maybe it's time that the Republicans help
    corporate lawyers and accountants in ethically managing their
    affairs.)
         For the first time in Committee history, failure
    to act on tax shelters has left the tax community criticizing
    the Committee for not acting expeditiously to stamp out
    aggressive, abusive corporate tax loopholes.
        5. It is unfortunate that we will hear little today about
    the real facts and players--who the marketeers of abusive tax
    shelters are, the effectiveness of their marketing techniques,
    the purpose and goal of the deals they cut, the outrageousness
    of the transactions being ``peddled,'' how they get away with
    it, and the ``big bucks'' at stake.
         The recent Forbes magazine cover story titled
    ``The Hustling of X Rated Shelters'' documents how the ``Big
    Five'' accounting firms and major law firms are competing
    aggressively to bring the next corporate tax scheme to market.
         Tax professionals are ``cold calling'' potential
    corporate clients, offering tax shelter schemes for 10% of the
    tax savings, and requiring pledges of ``confidentiality.''
         For example, we understand that a company received
    unsolicited offers for a tax shelter scheme after the press
    reported that the company would have large capital gains that
    year.
         The ``peddling'' of abusive tax breaks to
    corporations is not only unethical, but also threatens the
    heart of our tax system.
        6. Under current law, there is a court-developed doctrine
    that requires transactions to have economic substance in order
    to be respected for tax purposes.
         H.R. 2255, introduced by Congressman Doggett,
    codifies the judicial ``economic substance" doctrine so that
    transactions must have potential for profit/risk of loss and
    potential profit must be significant in relationship to the tax
    benefits.
         The ABA, NY State Bar Association, and Treasury
    support this reform.
        7. Also, current law includes an ``accuracy-related''
    penalty for tax understatements equal to 20%. The penalty does
    not apply where the taxpayer has reasonable cause (such as
    having a legal opinion) to justify the transaction.
         H.R. 2255 would increase the substantial
    understatement penalty from 20 to 40 % for transactions without
    substantial economic substance.
         The bill would not allow an easily-obtained legal
    opinion to protect a sham transaction or avoid sanctions.
        8. The provisions of H.R. 2255 have been used as a revenue
    offset in Democratic ``substitutes'' to the 1999 tax cut bill,
    managed care reform bill, and tax extenders package.
         JCT estimates that the bill raises $10 billion
    over 10 years.

        Chairman Archer. I thank the gentleman for his statement.
        I am constrained to respond briefly by saying that the
    gentleman refers as to his desire to tear the income tax out by
    the roots and join me in that effort, and the Chair waits with
    anticipation for the gentleman's endorsement of any plan to do
    that, even conceptually, which the Chair has not yet heard. But
    I hope that that day will come where the gentleman from New
    York will endorse some conceptual plan at least, if not in
    statutory language, in order to accomplish that, and we will
    welcome him joining me in that effort.
        As far as not knowing when we will begin to address the
    corporate tax shelter problem, that is precisely what the
    Committee is about today. The when is now.
        The Chair is happy not to welcome, because the gentleman is
    here almost every day as he is regular in his attendance at
    Committee meetings, but to have as our first witness my fellow
    colleague from the State of Texas, Mr. Doggett, to tell us
    about his proposal to address the corporate tax shelter
    problem.
        Mr. Doggett, we are happy to receive your testimony.

       STATEMENT OF THE HON. LLOYD DOGGETT, A REPRESENTATIVE IN
                    CONGRESS FROM THE STATE OF TEXAS

        Mr. Doggett. Mr. Chairman, thank you very much for your
    Texas hospitality and your continual courtesy to me as a brand
    new member of this Committee.
        Mr. Rangel and members of the Committee, I appreciate the
    opportunity this morning to focus some attention specifically
    on H.R. 2255, the Abusive Tax Shelter Shutdown Act, that I
    introduced back in June, I believe. It is the only legislative
    proposal pending in Congress concerning this matter.
        And I would simply summarize my written testimony about it
    and request that that written testimony be made a part of the
    record.
        I sincerely believe, Mr. Chairman, that the rampant spread
    of corporate tax shelters and our inattention to it in this
    Congress represents one of our major shortcomings. The
    proliferation of abusive corporate tax shelters is costing the
    Federal treasury literally billions of dollars.
        A professor named Michael Graetz defined a tax shelter in
    terms that I could understand it, as saying it is a deal done
    by very smart people that, absent tax considerations, would be
    very stupid.
        And when one of these apparently stupid schemes gets shut
    down, more seem to blossom, and I think that is not by
    accident. One Big Five accounting firm reportedly requires its
    very smart staffers to come up with at least one of these
    economically foolish but tax wise corporate tax dodge ideas
    each week.
        The literal hustling of improper tax shelters is so
    commonplace that one representative of a major Texas-based,
    multinational corporation reported to my office recently that
    he gets a cold call every day from someone hawking these
    shelters. Some are even called black box proposals. They are
    kept under wraps and not even generally discussed with anyone
    other than just a few of the select corporate clients.
        As a partner at one of these national firms boasted, ``A
    whale can't get harpooned unless it surfaces for air.'' To me,
    that is a rather whale-sized bit of arrogance toward the
    ordinary taxpayer, corporate and noncorporate, who is out there
    trying to comply with the tax law and honestly file their tax
    return.
        I believe that these taxpayers, businesses and individuals,
    get hit in two ways by our failure to address this problem.
    First, they end up having to make up the revenues that those
    who cheat on their taxes don't provide; and, second, they have
    to pay for the very expensive law enforcement necessary to try
    to seek compliance.
        One of these tax shelter cases that was won this summer
    cost the public about $2 million for victory. Amazingly, though
    we have had some success, and though this Committee prior to my
    coming on it has acted in this area, the fact that there is a
    victory here or there doesn't seem to slow the process of new
    tax shelters. It seems to me that these tax shelters get
    repackaged and remarketed with creative titles not unlike the
    sequel to a bad movie. Within months of the Treasury shutting
    down LILO transactions, we had something called ``Son of
    LILO,'' and I wouldn't be surprised if we didn't have ``Cousin
    of LILO'' already on the drafting board.
        I have been a member of this Committee, of course, only for
    a few months. And I am not a tax lawyer, and I certainly
    haven't mastered all of the various revenue rulings, circulars
    and tax court decisions. But since being contacted by an Austin
    constituent back in the spring on this problem, what has
    impressed me most, other than the size of the problem, is the
    fact that there really seems to be not so much disagreement but
    rather a consensus that has been voiced by just about all
    observers that there is a problem, and that the Congress needs
    to act now, because it affects confidence of both of our
    corporate and our noncorporate citizens in the tax system.
        We are going to hear today from the same people that have
    expressed in letters to the Committee their growing alarm,
    their disappointment that we haven't addressed this issue, and
    the serious challenge that this poses. I believe that the only
    folks that object to taking prompt legislative action are the
    tax hustlers, who are earning millions of dollars from these
    schemes, and perhaps a few of the tax dodgers.
        I am not here to glorify H.R. 2255. I believe all of you
    have copies of it. I doubt that it is the final word on this
    matter, and I hope that from some of the questions and
    discussions today it can be perfected further. But what it
    basically seeks to do is to focus on the economic substance of
    a transaction, and is based on testimony we received back in
    March and the Senate received in April.
        If I can be indulged for just about another minute to quote
    you and to do so favorably.
        Chairman Archer. The gentleman will certainly have adequate
    time for his presentation.
        Mr. Doggett. Thank you. I will rush through these and then
    respond to questions.
        But I do want to join with some of the comments that you
    made in the opening. There is also, other than Section 3, which
    focuses on the economic substance rule, Section 4, though it
    involves some drafting work, is not original to me. I tried to
    copy as closely as I could the recommendations that were made
    to this Committee back in the spring and to the Senate Finance
    Committee, regarding the disclosure requirements by the
    American Bar Association's tax section, which are somewhat
    similar to the disclosure requirements of the New York State
    Bar Tax Association.
        In Section 4, we also increased and tightened the penalties
    for tax dodging, an issue that the Joint Tax Committee has also
    addressed, to deal with the reasonable cause opinion letter
    excuse which I think has been a loophole to escape penalties.
    And then also we deal with this question of normal business
    transactions, and that is where I said I would quote the
    chairman.
        I believe when you opened our hearing back on March the
    10th you indicated that this area merited review and that we
    are going to try to eliminate every abuse that circumvents the
    legitimate needs of the Tax Code. But you added, as you have
    this morning, we are not going to cast a net that will snare
    everyone. And I just want to indicate to you, Mr. Chairman, and
    to our colleagues, that my objective is to have that same kind
    of net. I am interested in snaring every hustler and cheat.
        I am not interested in impairing legitimate business
    transactions, in invading ordinary tax planning. And I think
    that one of the ways that I do this in the proposal called H.R.
    2255 is to have a section there at pages 6 and 7 concerning
    normal business transactions. That has been reviewed and
    received some favorable comment from at least one of the
    officers from the American Bar Association Tax Section.
        And I think that, while the purpose of this legislation is
    to be anti corporate tax dodger, it is not intended to be anti
    corporation or anti business. Indeed, the idea is to level the
    playing field. Many of our smaller businesses don't get offered
    some of these high-priced tax shelter packages.
        And, finally, I think the chairman has recognized again
    this morning, as you did in March, that we ought not to accord
    the tax enforcers unlimited discretion. And that is why I tried
    to focus in, instead of defining tax shelter broadly, on the
    economic substance doctrine which we already have some
    experience with, at the same time that we strive for more
    certainty in the law, so that a taxpayer will know what is
    required of him or her.
        It is important that we not merely provide such a strict
    and narrow change in the law that we are according only a road
    map for tax cheats. I believe that this Abusive Tax Shelter
    Shutdown Act, while certainly not a panacea, would provide some
    help as it is perfected here in the Committee to law
    enforcement to close some of the loopholes, eliminate sham
    transactions and stop the hustlers.
        That is my objective, Mr. Chairman; and I thank you for
    providing me with this chance.
        Chairman Archer. Thank you for your testimony, Mr. Doggett;
    and, without objection, any entire written statement that you
    have will be inserted in the record.
        [The prepared statement follows:]

    Statement of Hon. Lloyd Doggett, a Representative in Congress from the
    State of Texas

        Mr. Chairman, Mr. Rangel and fellow Committee members, I
    appreciate the opportunity to testify today on corporate tax
    shelters. In June, I introduced HR 2255, the Abusive Tax
    Shelter Shutdown Act, along with my colleague Mr. Stark and
    other Members of the House. This represents the lone proposal
    targeting abusive shelters filed during this Congress.
        As we gather here on what the House Leadership recently
    indicated would be the last day of this session, I believe that
    inattention to the rampant spread of abusive corporate tax
    shelters represents one of the major failures of this Congress.
    The proliferation of abusive corporate tax shelters is costing
    the federal treasury billions of dollars.
        Professor Michael Graetz recently defined a tax shelter as
    ``a deal done by very smart people that, absent tax
    considerations, would be very stupid.'' It is true that many
    such abusive tax shelters are already illegal. The problem is
    that every time we shut down one scheme, tax dodgers come up
    with more. And that is not by accident. One Big Five accounting
    firm reportedly requires its very smart staffers to come up
    with at least one of these economically stupid but tax wise
    corporate tax dodge ideas per week.
        The literal `hustling' of improper tax shelters is so
    commonplace that one representative of a major Texas-based,
    multi-national corporation recently indicated that he gets a
    cold call every day from someone hawking such shelters. Some
    are even called ``black box'' proposals, kept under wraps and
    only offered to a select few clients to avoid public notoriety.
        As a partner at one national firm boasted, ``A whale can't
    get harpooned unless it surfaces for air.'' I would call that a
    whale-sized gulp of arrogance toward honest taxpayers
    everywhere who dutifully file returns every April 15 and have
    to make up for the taxes that some improperly dodged.
        Similarly, Stefan Tucker as Chair of the American Bar
    Association Tax Section, a group comprised of 20,000 tax
    lawyers across the country, told the Senate Finance Committee
    on April 27 that:
        [T]he concerns being voiced about corporate tax shelters
    are very real; these concerns are not hollow or misplaced, as
    some would assert. We deal with corporate and other major
    taxpayer clients every day who are bombarded, on a regular and
    continuous basis, with ideas or ``products'' of questionable
    merit.
        Complicated tax dodging schemes impact ordinary taxpayers
    in at least two ways. They must both make up for the revenues
    that tax cheats fail to provide, and they must pay more for
    enforcement. In one prominent tax shelter case, the cost of a
    federal victory this summer, after prolonged litigation, was
    over two million dollars. Amazingly, some actually rely upon
    such law enforcement successes as justification for opposing
    reform. Ad hoc remedies achieved through years of litigation
    have not prevented the steady growth in abusive practices.
    Indeed, the creativity and speed with which new and more
    complicated tax shelters are devised is remarkable. Following
    judicial and administrative rulings, tax shelters are
    repackaged and remarketed with creative titles like sequels to
    bad movies. Within months of Treasury shutting down the LILO
    transactions, products are now being sold as the ``Son of
    LILO.'' Probably ``Cousin of LILO'' is already being drafted.

                                 I. The Problem

        The dimensions of this problem were first brought to my
    attention by a constituent in Austin, who urged me, as a new
    Member of this Committee, to focus some attention on abusive
    corporate tax shelters. As I have done so, Mr. Chairman,
    beginning with preparation for a hearing before this Committee
    on March 10, I have been impressed not by the discord or
    disagreement but with the near consensus of all observers
    regarding the troubling extent of the problem, its damaging
    impact on citizen confidence in our tax system, and the need
    for this Congress to act legislatively now.
        Among those who have recognized the serious need to address
    these abusive and bogus loopholes are experts from whom we will
    hear again today:
         With this Congress having ignored their March and
    April testimony calling for prompt action, on September 9, the
    American Bar Association Tax Section again wrote to the Chairs
    of the tax writing Committees expressing a ``growing alarm with
    the aggressive marketing of tax `products' that have little or
    no purpose other than the reduction of Federal income taxes.''
         With a similar experience and concern, the New
    York State Bar Association Tax Section on September 14 wrote,
    ``We were disappointed to see that after all this study and
    testimony and the Administration and Joint Committee reports,
    the [Republican tax bill] did not contain any provision dealing
    with this subject. Once again, we express our concern as to the
    negative and corrosive effect that corporate tax shelters have
    on our system of taxation and again call for Congressional
    action on this subject.''
         The Joint Committee on Taxation reported on July
    22, ``The Joint Committee staff is convinced that present law
    does not sufficiently deter corporations from entering into
    arrangements with a significant purpose of avoiding or evading
    Federal income tax...The corporate tax shelter phenomenon poses
    a serious challenge to the efficacy of the tax system. An
    obvious concern is the extent of the loss of tax
    revenues....The proliferation of corporate tax shelters causes
    taxpayers to question the fairness of the tax system.''
         The Treasury Department, in a report released in
    July said, ``The proliferation of corporate tax shelters
    presents an unacceptable and growing level of tax avoidance
    behavior.''
        About the only people who openly object to prompt
    legislative action are the tax hustlers, who are making
    millions from the schemes they concoct, and perhaps a few of
    the tax dodgers themselves.

                              II. The Legislation

        As filed, HR 2255 represents an attempt to stop at least
    some of the more egregious corporate tax shelters. The findings
    and purpose clause contained in Section 2 is very important; it
    seeks to send a clear and unequivocal message not only to the
    shelter hustlers and tax dodgers, but also to the courts and
    the Administration that Congress wants this mess cleaned up.
    A. Economic Substance Test

        Tax shelters hustlers offer their corporate clients complex
    deals that promise substantial, near risk-free tax avoidance
    without any significant possibility of actual profit or loss.
    HR 2255 says look at the substance of the entire deal--was it
    done to earn a profit or only to achieve a tax rip-off.
        HR 2255 codifies the judicially-developed economic
    substance test, which would disallow transactions where the
    profit potential is insubstantial compared to the tax benefits.
    This test, which courts have been applying for many years,
    prohibits transactions lacking any legitimate business purpose
    ginned up to obtain a loss, credit, or deduction for the
    purpose of dodging taxes. As commentator Lee Sheppard wrote in
    Tax Notes recently, this represents ``an objective and easily
    administered test.''
            The test is, after all, just the sort of mathematical analysis
            that the promoters and their customers sit down and do when
            they reach an understanding about the customer's tax benefits
            and cash flow. [It] would deny tax benefits when the present
            value of the reasonably anticipated pretax profits is
            insignificant relative to the present value of the claimed tax
            benefits.
        As you see, Section 3 at pages 4-5 (Sec. 7701(m)(3)) creates a
    rebuttable presumption that a transaction has no economic substance
    when the tax transaction is not reflected on the books or records (no
    financial reporting) or when the transaction allocates the income or
    gain to a tax-indifferent party such as a tax-exempt entity but retains
    the tax benefit for the taxpayer.
        As reflected on page 6 of HR 2255 (Sec. 7701(m)(5)(B)),
    complicated, multi-step transactions will be collapsed, and each step
    must meet the economic substance test. This provision represents a
    codification of the common law step-transaction doctrine of taxation,
    and the objective is to preclude shelters that have been hidden in
    separate but very related transactions that have no economic meaning
    and that are merely designed to create tax benefits.
        On page 7 (Sec. 7701(m)(5)(E)), certain tax incentive programs,
    such as the Low Income Housing Tax Credit, which have been defined in
    statute by Congress, are excluded from application of the economic
    substance test.

    B. Disclosure

        Section 4 at pages 10-12 (Sec. 6662(i)(3)) advises a company that
    thinks it has a proper shelter to provide complete, clear and concise
    disclosure. These disclosure provisions closely track the thoughtful
    commentary of tax practitioners from the American Bar Association Tax
    Section and are similar to those of the New York State Bar Association
    Tax Section. Disclosure includes among other things a detailed
    description of the facts, as verified by a corporate financial officer,
    including fees paid to promoters and existing warranties. What I seek
    is for a responsible corporate officer to disclose in clear and concise
    language the legitimate business purposes of a suspect transaction.

    C. Penalties

        Section 4 at pages 8-9 (Sec. 6662(i)) increases and tightens the
    penalty for tax dodging. The Substantial Underpayment Penalty for
    transactions held to be lacking economic substance shall be increased
    from 20% to 40%, with no exceptions for ``reasonable cause.'' However,
    if a sheltering corporation fully and adequately discloses this
    shelter, as described in the previous section, then the 20% existing
    penalty rate shall apply. By increasing the penalties, corporations
    will be discouraged against setting up the shelters in the first place,
    rather than taking the limited risk that if caught later, they would
    owe the same tax and a little interest.
        The ``reasonable cause'' opinion letter excuse has allowed
    taxpayers to escape all penalties, and has operated as a huge loophole.
    Taxpayers need only shop around the barest of facts on a shelter in
    order to get an opinion that their sketchy description is ``more likely
    than not'' legal. Getting some downtown lawyer to bless what some tax
    hustler has cooked up will not save the corporation from penalties
    anymore if it has clearly stepped over the line with an abusive tax
    shelter. As Harold Handler, chair of the New York State Bar Association
    Tax Section, testified on April 27 to the Senate Finance Committee in
    favor of eliminating the opinion excuse:
            Consequently, corporate taxpayers would be forced to assume a
            real risk in entering into these transactions, and advisers
            would be induced to supply balanced and reasoned analysis
            rather than supplying `reasonable cause' as under current law.

       III. Reasonable Standards Preserving Normal Business Transactions

        In closing, Mr. Chairman, let me indicate that I share the
    views expressed by you in opening this Committee's March 10
    hearing:
            The area of corporate tax shelters is one that merits review. .
            . .We are going to try to eliminate every abuse that
            circumvents the legitimate needs of the tax code. . . .We're
            not going to cast a net that'll snare every one.
        I want to cast my net the same way to snare only every
    hustler and cheat. I believe that we can curtail abuses without
    impairing legitimate business transactions, that we can slow
    the tax hustlers without precluding ordinary tax planning. One
    of the ways HR 2255 seeks to further this objective is by the
    inclusion of a rule at pages 6-7 (Sec. 7701(m)(5)(C)) entitled
    ``Normal Business Transactions,'' which provides:
            In the case of a transaction which is an integral part of a
            taxpayer's trade or business and which is entered into in the
            normal course of such trade or business, the determination of
            the potential income from such transaction shall be made by
            taking into account its relationship to the overall trade or
            business of the taxpayer.
        Ronald Pearlman, the vice chair for government relations at
    the American Bar Association Tax Section has praised this
    provision of HR 2255 as it ``takes the pressure off''
    legitimate business transactions. This legislation is not
    directed to normal business but to the abnormal activity that
    concerned the Tax Section in the testimony to this Committee on
    March 10:
            The aggressive tax shelters that concern us do not overuse tax
            benefits consciously granted by Congress (such as accelerated
            depreciation or credits) nor are they tax-favored methods of
            accomplishing a business acquisition or financing. They are
            transactions that the parties themselves would generally
            concede have little support in sound tax or economic policy,
            but are, the parties assert, transactions not clearly
            prohibited by existing law.
        While this legislation is anti-corporate tax dodger, it is
    certainly not anti-corporation. Indeed, it should be
    characterized as pro-business, and particularly pro-small
    business. This bill levels the playing field for small
    businesses, which are not offered the dodges available to some
    of their large competitors.
        Additionally, I share the view that tax collectors should
    not be accorded unlimited discretion. That is one reason why I
    chose to rely on the well-established economic substance
    doctrine. Similarly, the law should be clear enough to inform
    taxpayers and their advisors of what is necessary to assure
    compliance. What must be avoided, however, is a law that avoids
    reasonable standards in favor of a narrow list of prohibitions.
    Rather than stopping abuses, this approach would only provide a
    roadmap for tax cheats. As the testimony on behalf of the
    American Bar Association Tax Section before this Committee on
    March 10 indicated:
            [T]otal certainty is impossible where complex transactions are
            involved. This is particularly true when the parties seek to
            avoid judicial principles developed to deny tax benefits to
            overly tax-motivated transactions. Taxpayers and their advisors
            know that relative certainty can easily be achieved in
            legitimate business transactions by steering a safer course and
            staying in the middle of the road. The more clearly the
            transaction stays within established judicial and
            administrative principles, the more certainty is assured. When
            they venture to the outer edge, certainty cannot be assured,
            nor should it be; the parties who consciously risk going over
            the edge should clearly understand there are severe
            consequences for doing so.
        Today there are many inequities and injustices associated
    with the federal tax code. Some of the worst arise from those
    who use abusive tax shelters to exploit tax loopholes. The
    Abusive Tax Shelter Shutdown Act is not the final answer; it is
    certainly not a panacea, but it will help law enforcement to
    close some loopholes, eliminate sham transactions, and stop
    these hustlers. As we might say in Texas, ``shut `em down, and
    move `em out.''

        Chairman Archer. Again, the Chair's desire from the
    beginning of taking the chairmanship of this Committee is to be
    sure that we eliminate unjustified abuses in the Tax Code. But
    so often it is difficult to separate the wheat from the chaff.
        And it is not just the complexity of the Tax Code that has
    concerned me over the years, it is the administrative cost and
    red tape to taxpayers in the private sector, which has been
    estimated to be anywhere from $250 billion a year to $600
    billion a year, depending on whose estimates you want to take.
        So the concern I think should be what we are putting on our
    entire economic system from the standpoint of administrative
    burdens. We need to work our way through that and try to find a
    way to separate the wheat from the chaff.
        The Joint Committee on Taxation, as you know, has issued a
    report on penalties and interests. And they stated in their
    analysis of your proposal that the way it is currently drafted
    could affect not only tax shelters but legitimate business
    transactions. And you have appropriately stated that you don't
    want to affect legitimate business transactions, so we have got
    to find a way to work through that.
        As I said, your currently drafted proposal, you deny every
    deduction, loss or credit under the tax law, unless the
    taxpayer can prove that it meets the test contained in the
    bill, the tests of which are not completely specific, but are,
    to some degree, vague.
        How can a taxpayer show that the present value of
    reasonably expected potential income from the transaction and
    the taxpayer's risk of loss from the transaction are
    substantial in relation to the tax benefits claimed? Are we
    back into the mode of putting a burden on the taxpayer to prove
    innocence which we attempted to reform in the IRS reform
    efforts of the Committee? How is a taxpayer going to be
    expected to satisfy that burden?
        Mr. Doggett. Thank you, Mr. Chairman.
        First, with reference to your comment about the Joint Tax
    Committee comment, I think that that particular reference which
    has been cited by a lobby group in a letter to the Committee
    was not to my proposal. They may feel that way, but what they
    were writing about was a proposal that the Treasury discussed
    back at the time of our March hearing, which I also had some
    problems with, and that is why I tried to narrow in on the
    economic substance doctrine.
        But even when you narrow in on the economic substance
    doctrine, as your question suggests, there is a question of how
    much certainty is it appropriate to accord in order to
    separate, which can be challenging, the wheat from the chaff.
        I have used the term ``substantial'' at one point on page
    4, ``meaningful'' at another point on page 4. The way the Joint
    Tax Committee, in its penalty recommendation that you referred
    to, it uses similar terms that are not 100 percent specific. It
    uses the terms ``significant'' and ``insignificant'' in its
    analysis, I believe that is over on about page 234 of the Joint
    Tax Committee recommendation from the staff back in July.
        But let me indicate why I think there has to be some
    flexibility in those terms. And, again, they are terms that I
    didn't dream up by myself. They came right out of the testimony
    that this Committee got in March from the tax law experts and
    that the Senate heard, too.
        If you have a taxpayer who has purchased a shelter from one
    of these tax hustlers and perhaps has paid several million
    dollars for it and they paid several hundred thousand dollars
    to a tax lawyer for an opinion, they are not going to come into
    law enforcement and say, I did this deal to cheat on my taxes
    and tough luck for you. They are paying for all that high-
    priced advice to dress up the transaction in a way to make it
    appear to be something that it is not; to make it appear that
    they took on some real risk, and that this was a legitimate
    business transaction.
        And so there is a need I think in Section 3, in looking at
    this, to suggest that if there was only a very modest,
    insubstantial change in the taxpayer's position, that that will
    not suffice.
        And I believe in saying that, as far as the burden on the
    taxpayer, it is not my desire to increase the burden on the
    taxpayer over what I believe the existing better law is of the
    tax decisions. I think that is what the current doctrine of
    economic substance already requires. I believe it is
    appropriate to demonstrate that the change in the real economic
    position of the taxpayer is not dwarfed by these claimed tax
    benefits; that it is not a thousand dollars of potential
    benefit with a million dollars of tax loss.
        Chairman Archer. Would it not be appropriate, if the
    Committee chose to implement this type of proposal, to provide
    that the IRS has to prove that the tests contained in this bill
    are not met in order to deny a deduction, rather than to say
    that every deduction, loss or credit under the tax law is
    denied unless the taxpayer proves? Would it not be more
    appropriate to put the proof on the IRS in the same sort of
    context that our IRS reform proposal did to address the
    concerns of taxpayers all over this country that they are put
    in a position of having to prove their innocence rather than to
    be put in a position of the IRS proving guilt?
        Mr. Doggett. Of course, I supported your provision to do
    just that with reference to our Taxpayer Bill of Rights. And I
    think that reference to this kind of tax hustling, I would want
    to hear from the Treasury Department on their feeling about how
    that burden of proof is placed.
        Chairman Archer. Okay. Just one last follow-up question.
    Then we will recognize other members of the Committee.
        Mr. Doggett. Sure.
        Chairman Archer. Does your bill define the term
    substantial? What is the definition of substantial? What is the
    definition of reasonably expected potential income? And what is
    the definition of risk of loss?
        Mr. Doggett. It is more than de minimis, more than nominal,
    more than just enough to pay the bill of the tax hustler that
    got you into the tax shelter in the first place. But there is
    no attempt to define this really in any way other than the true
    dictionary definition of these terms.
        Does it have meaning? Is it real? Or is it some circular
    sham like some of these town hall leasing arrangements that
    have been disapproved? And it does allow for some discretion,
    just like the recommendations of the Joint Tax Committee, using
    terms like significant and insignificant, allows for some
    discretion. And I don't know any other way to do it without
    writing a road map that is so narrow that it allows hustlers to
    immediately write around it.
        Chairman Archer. There would be a concern on the part of
    the chairman as to giving the IRS greater gray areas to pursue,
    which has been one of the real complaints in the Tax Code
    today, where the discretion is in the eye of the beholder and
    the IRS's discretion will put significant additional litigation
    into play. And I just think we need to work through that.
        Mr. Rangel.
        Mr. Rangel. Let me agree with you, Mr. Chairman.
        I think that we are finding many different groups that
    recognize your leadership in this area, the American Bar
    Association, the Treasury Department, the IRS, and the Joint
    Committee on Taxation. No one wants to be retroactive. No one
    wants to disrupt legitimate business transactions.
        Have you discussed your bill with Treasury and asked their
    advice as to how we best proceed without causing additional
    problems to the IRS?
        Mr. Doggett. I have discussed it with Treasury. And I
    believe, following the hearing that we had where this Committee
    had the first discussion of this particular bill, H.R. 2255,
    when you incorporated it, Mr. Rangel, into the democratic
    substitute on the extender's bill, there was some discussion in
    the Committee about why the Committee had not acted. We heard
    from Ms. Paull about the interest and penalties report. And so
    I sought to inquire of them about the bill, how it would work,
    and whether there was any reason for the course not to proceed
    to adopt a measure of this sort.
        I think they will speak for themselves today, but that they
    basically embrace the approach taken by this bill. I am sure,
    just like members of the Committee who support the bill or have
    questions about the bill, it is not without perhaps the need to
    do some perfecting here and there. But the basic approach I
    have taken I believe has been embraced by the Treasury
    Department.
        Mr. Rangel. I think that is a good beginning.
        You have pointed out areas of concern about tax shelters.
    The IRS has an opportunity to agree or disagree with you. Where
    they do agree, I think the IRS has a responsibility to share
    with this Committee how we can best carve this cancer out of
    the Tax Code. Then, with the help of the Joint Committee on
    Taxation, I think we can move forward.
        I just don't know in terms of the timetable of this
    Committee when reform will happen because, Mr. Chairman, I
    would agree with you that this should occur when we are pulling
    up the Code by the roots. And I have been trying to get on the
    buses to go around to see how you intended to do this, but so
    far there doesn't seem to be a majority plan to do this. If you
    are waiting for me to come up with a plan----
        Chairman Archer. If the gentleman would yield. I would be
    happy to receive your contender in this arena, because I know
    you are interested in tearing the income tax out by its roots.
    You talk about it all the time. And I would be pleased to know
    what concept you support to do that, because I have made my
    support of the conceptual way to do that, very, very clear, so
    I hope we can work together on that.
        Mr. Rangel. I hope so, Mr. Chairman. We can start with
    hearings, I would think, and then we can see which concept best
    suits this Committee.
        Mr. Doggett. Mr. Chairman, if I may just respond to part of
    Mr. Rangel's comments that I would view as a query. If you turn
    even to today's Wall Street Journal, on the front page there is
    an indication that one of our later witnesses, Mr. Sax,
    representing the American Bar Association Tax Section, has said
    that shelters are increasing, are attracting big, not only
    multinational companies but also midsized businesses and
    wealthy individuals.
        It was only a few weeks ago that another member--another
    prominent tax lawyer in the same column, Mr. Michael Schler
    with Cravath, Swaine & Moore said there is not going to be much
    left of the corporate income tax the way things are going. He
    said the capital gains tax for corporations is essentially
    elective these days, because of the growing proliferation of
    tax-saving techniques.
        My concern, there may be a day when we will all be
    gardeners and rip out the income tax system by its roots and
    substitute the more sales tax approach that I have heard you
    comment on, that I have heard some other people in Texas
    comment on. But, until we do, I just believe that every
    business entity and taxpayer, be they big with access to these
    tax hustlers or be they a midsize company that doesn't have
    that access yet--but, as Mr. Rangel says, it is a cancer
    corrupting the system, and they may well in the future--that
    they all play on a level playing field and we enforce the law
    equitably.
        And I believe that is not too far from the objective that
    the chairman expressed, though we may have a little bit
    different means of getting there.
        Chairman Archer. Does any other member? Mr. Hulshof.
        Mr. Hulshof. Thanks, Mr. Chairman.
        Welcome, Mr. Doggett. It is interesting to have you on the
    other side.
        I note from your written statement and your oral testimony
    you used the terms hustlers, arrogance, tax cheats and tax-
    dodging schemes, and I want to thank the gentleman for toning
    done his rhetoric today. And, in seriousness and candor, do you
    have a fundamental belief, Mr. Doggett, that businessmen and
    women have a desire to cheat on their taxes?
        Mr. Doggett. No, I don't think so. The term tax hustler is
    also not original to me. It came from, as you know, from
    hearing some of my comments on it, a cover story in Forbes
    Magazine, known as The Capitalist Tool, not some ultraliberal
    publication.
        But I do think, and I believe your question really goes to
    the heart of it, and Mr. Rangel's use of the term cancer. If
    you know your competitor is taking advantage of one of these
    outlandish tax shelter packages and they are getting away with
    it, then even the most honest, good-faith operating business
    and tax department is encouraged to do the same thing. And I
    think it drives the whole standard down, and I think it has the
    same effect on the tax attorneys themselves, and that is one of
    the reasons they have been coming to the Committee saying,
    please move quicker, because we can see what this is doing to
    our profession and to our clients.
        Mr. Hulshof. Were you present, and I forget the date,
    earlier this year when we had various representatives--and the
    one that specifically comes to my mind was a representative of
    Daimler Chrysler. And I remember--Mrs. Johnson is not here
    today, but I remember the questioning, the line of questioning
    that she had. And I don't want to put words or mischaracterize
    the testimony of the representative from Daimler Chrysler, but
    I heard that representative intimate that the reason that the
    corporate headquarters moved from the United States to another
    country was because of the complexity of the Tax Code.
        Now, do you believe that were your bill, H.R. 2255, were to
    be enacted, do you think that that would be more business
    friendly or less business friendly?
        Mr. Doggett. I was here for that testimony, and I think it
    would be more business friendly.
        And let me say again, your question really cuts to the core
    of this problem. Because while the Daimler Chrysler people were
    talking about where this business was located, one of the worst
    aspects of these shelters is using offshore entities, of
    running the loss to the company that is based in America and
    hiding the gain in some offshore entity that can never be
    taxed.
        And that is the kind of transaction, this focusing offshore
    dodging taxes in an improper way, that I think the terms like
    tax hustler are exactly the right terms.
        Mr. Hulshof. Treasury we will hear from a little later, but
    I know in an earlier paper, a White Paper issued regarding--
    just on corporate tax shelters, that a major source of
    discrepancy between book income and tax income is depreciation
    that is claimed on taxpayer investments. Do you intend to deny
    or reduce depreciation deductions that are provided under tax
    law and capital equipment purchased by our Nation's business,
    and does your bill have guidance regarding depreciation and
    expensing?
        Mr. Doggett. I believe that the bill does have adequate
    guidance to deal with this problem in the normal business
    transaction section. It is not my desire to interfere with
    depreciation, but let me point to one exception in that regard,
    an even clearer normal business transaction is rent. I
    certainly don't intend to interfere with rent or a purchase of
    property.
        But if the rental, as was the case with the Swiss town
    hall, the business is not in the business of renting properties
    in Switzerland, and it goes out and it rents a Swiss town hall
    that it never has a meeting in, never intends to use for rental
    and immediately turns around and rents it back to the Swiss, it
    can claim its rental payments as a loss and defers the income.
    If it is doing a nonsubstantive kind of transaction, then, yes,
    it does have to meet the economic substance test.
        It is conceivable that some depreciation scheme that was
    not substantive, that was truly circular, might require that
    analysis. But it is not my intent to interfere with
    depreciation.
        Mr. Hulshof. As the gentleman knows, my time is about to
    expire, and I think this is a fairly simple yes or no answer to
    the chairman's previous point. As your bill is drafted, isn't
    it a fact that every deduction loss or credit is denied unless
    the taxpayer or in this case the corporate entity proves or
    meets the test that you put in the bill? Isn't that the essence
    of your bill, that everyone is denied unless they can prove
    that it is a legitimate expense?
        Mr. Doggett. So long as it has economic substance. So long
    as it is a real deal. That is all they have to show. If it gets
    off the line--to go back to the testimony of the American Bar
    Association to this Committee, if it gets way off the line,
    then they have to demonstrate economic substance. And my
    suggestion to the chairman earlier was that we inquire further
    of Treasury concerning the way that the burden of proof would
    work on this issue.
        Mr. Hulshof. Thank you.
        Thank you, Mr. Chairman.
        Chairman Archer. The gentleman's time is expired.
        Mr. Foley.
        Mr. Foley. Thank you very much, Mr. Chairman.
        A lot of us point fingers and call things abuses; and,
    obviously, I think we have to probably look in the mirror. As
    Members of Congress, we write the Tax Code. And we have done
    so, whether it is been brilliantly or poorly, we have to take a
    lot of the burden ourselves.
        I look back at the 1980s and think about some of the unique
    things that were offered citizens as investments, oil and gas
    partnerships, real estate investments, where you would have
    excessive depreciation, but it was provided for under the Code.
    And you would sell this based on the return, not necessarily on
    a cash-flow basis, but you would use the depreciation as a way
    to shelter other ordinary income, but that was provided for by
    the Congress. Was that abusive and should that have been ruled
    abusive?
        Mr. Doggett. I think the Congress looked at that and made
    some changes in the tax laws to deal with those problems.
        My focus here has been on corporate shelters. But as I
    mentioned in the Wall Street Journal story from today and other
    testimony we are hearing about, these are beginning to spread
    into other areas.
        I am not sure that this bill as drafted would adequately
    deal with some of the problems with individual tax shelters. My
    focus has just been on where the problem started, but I think
    if we don't stop it where it started, it will spread and get
    back to some of the abuses that this Committee long before you
    and I got on it decided were sufficient problems to outlaw.
        Mr. Foley. How does your by bill, though, treat a
    legitimate transaction? I understand there is an enactment
    date, but what happens in the event that somebody invested in a
    shelter such as a real estate limited partnership? They find at
    the end, because of a change in the Tax Code which occurred in
    1986, which basically put the real estate market on the skids,
    which the change of the Tax Code then resulted in the FDIC
    having to bail out numerous S&Ls and banks because of the
    throwback of properties that no longer have value because they
    unwound the depreciation--now, obviously, there was a time when
    they invested based on the economic return or, more
    importantly, based on the tax aspects. We unraveled that in
    1986--or those who were here. Would this bill then look at that
    as the new enactment date and claim that abuse and then file
    this bill accordingly?
        Mr. Doggett. This bill is written to be prospective in
    effect and not to reach back. But I think some of those
    transactions under the judge made law that I try to codify here
    in the economic substance test may already be suspect, and
    those people may have a problem if they get picked for an
    audit.
        But this particular bill, H.R. 2255, would be prospective
    in nature and not retroactive.
        Mr. Foley. That is a concern. And I know a lot of taxpayers
    who invested assuming they were going to make their retirement
    a little bit rosier based on projections by speculators, and
    ultimately not only did they lose their capital but they--the
    IRS came in calling for excess depreciation recapture. And so
    they had--the IRS was due for their recapture, and so they
    found themselves not only out of cash from their original
    investment, but now they found themselves further owing the IRS
    monies, because they accelerated depreciation.
        I think there are problems in the Tax Code, but my bigger
    concern is are we, in fact, not or shouldn't we be speaking to
    ourselves and not the corporate community? If, in fact, the tax
    law allows some of these loopholes or, in fact, creates
    creative accounting gimmicks, then it is our job, not
    necessarily simply by enacting a law, to say corporations are
    ripping off the taxpayers. It may be given the guidance by the
    U.S. Congress to do so.
        Mr. Doggett. I think it is our job, and I agree with you
    fully on that.
        I think that is the irony of the situation we find
    ourselves in this year. I believe that sometime in the past,
    before you and I joined the Committee, the Committee had been
    very critical of some aspect of the tax-paying community or
    particularly of the tax advisers, the bar. Here is a situation
    where the people who represent 20,000 tax lawyers across the
    country that have to deal with all the problems you just
    mentioned are coming, telling the Committee that they are
    alarmed because we haven't dealt with this problem yet.
        And so I think it is strange, that it is a time when those
    who are out there having to deal with these problems day in and
    day out are saying to us, as members of this Committee, please
    come in and change the law to help us in upholding the
    standards of our profession and providing competent tax
    planning advice to clients that want to comply with the law,
    rather than corrupting the system with the cancer that is
    beginning to spread and will eventually affect individuals.
        The kind of tax shelters that we have today that I say are
    being hustled, that made the cover of Forbes, cost more, I
    believe, than most wealthy taxpayers are paying in their total
    tax bill.
        Mr. Foley. Would you support a flat tax or a sales tax in
    order to end the ambiguity?
        Mr. Doggett. I am not prepared to do it today. But I will
    tell you that I haven't totally ruled out in my own mind some
    of the ideas that have been advanced by the chairman and others
    to change the system. Because even from the few months I have
    been on the Committee I can see what some of the pressures are
    and how these tax bills are written.
        So I am not prejudging the final answer, if we are down to
    looking at alternatives to pulling the system out by its roots.
    Today, I would be inclined to stick with trying to perfect the
    system that this most powerful nation in the world has relied
    upon for the last many decades.
        But I won't rule out considering alternatives in the
    future. I am just saying, in the meantime, let us be sure that
    everybody is playing by the rules and paying their fair share
    of taxes so we don't shift the burden to the few who can't
    afford a tax hustler.
        Chairman Archer. The gentleman's time has expired.
        There is a vote on the floor, and the Chair will recess the
    Committee for us to vote.
        When we come back, Mr. Jefferson will be recognized to
    inquire.
        [Recess.]
        Mr. McCrery. [presiding.] The Committee will come to order.
        Mr. Doggett, we appreciate your sticking around for a few
    more questions; and I believe the chairman had said that Mr.
    Jefferson was next to inquire. Mr. Jefferson.
        Mr. Jefferson. Thank you, Mr. Chairman.
        Mr. Doggett, I want to ask a question about the whole
    purpose of this discussion we are having here today. Most
    reports say that corporate profits are increasing, yet our
    corporate taxes are apparently lower than they should be, given
    the rise in corporate profits.
        We use the Tax Code for a lot of different things which are
    collateral to its real purpose. We use it to incentivize
    various activities, to rebuild communities and for housing
    construction and all sorts of things and research and
    development, which I will follow up with you on in a minute.
    But, ultimately, isn't the real purpose of the Tax Code to
    collect taxes from the regular economic activity of the public?
        And I want to ask you, in regard to that, whether you think
    the lower corporate taxes that are being collected can be
    attributed in any way to the proliferation of tax shelters and,
    if so, to what extent? And how much are we actually
    experiencing is losses in the government treasury as a result
    of these schemes you talked about today?
        Mr. Doggett. Well, as I told the Committee earlier, I don't
    hold myself out as a tax expert. All I can really do is look at
    what those who are experts have been saying. I have used in
    some of my presentations on this the $10 billion per year
    figure that Professor Joseph Bankman of Stanford Law School has
    used. I couldn't find the precise basis for that. I expect it
    is an estimate. I have had other people who are experienced in
    this field tell me he is off by one zero, and it is larger than
    that.
        We will hear testimony later today looking at the way
    corporate profits have increased and corporate tax receipts
    have not kept pace, suggesting that the shortfall might be $13
    to $24 billion a year, though there may be some other factors
    at play. Those who know the most about how much money is being
    avoided improperly here keep it to themselves. Obviously, they
    keep it secret.
        I do think, and this may or may not be responsive to your
    question, but I am trying to be, that to those who say, well,
    as I saw one set of lobby groups did, you are proposing a $10
    billion tax increase. It is not my objective to increase taxes.
    It is to see that all those who are paying a current level of
    taxes pay their fair share on the same even playing field.
        And it seemed to me that, responding to the tax increase
    argument, not me and not a Democrat but our Republican
    colleague Charlie Norwood got it right on this issue about a
    tax increase when, in defending this same proposal, H.R. 2255,
    before the House Rules Committee here a couple of months ago,
    he said, and I quote, ``There is a large difference in what you
    call a tax increase and stopping bogus tax shelters. That is
    really two different things. They aren't just asking them to
    pay more taxes. We are trying to keep them from cheating the
    system.''.
        And that is my objective, to stop the cheats, whether the
    figure is $1 billion, which is what my bill has been scored on
    in raising over a year, or whether it is $10 billion or $100
    billion or somewhere in between.
        Mr. Jefferson. When taxpayers send us here and say take
    care of waste, fraud and abuse, and that is an answer to some
    of the revenue issues we have here, as far as you see it, they
    are really right. And this is an area we can attack some of
    these problems by pursuing the course that you are talking
    about today.
        Let me ask you something else, and Mr. McCrery may have a
    more detailed question about it as we discuss in what area
    where you have some difficulty in framing exactly what is a
    shelter and what is not. And is any research and development
    area, which I mentioned to you as we were walking out--that is
    an area where we are doing a lot in the Tax Code. We are trying
    to get it to have--because of the latest technology and thus
    the strength of our economy, to give companies opportunities to
    engage in further research and development, many of which
    enterprises result in virtually nothing of economic value, and
    they involve large expenditures that we permit them to write
    up. How does your bill deal with that sort of an issue?
        Mr. Doggett. This does relate to a question that I think
    Mr. McCrery has focusing more on the oil industry. The research
    and development tax credit, as you have heard me say in this
    Committee, is very important in central Texas to our technology
    companies, as it is to many other parts of the American
    economy.
        It is never mentioned in this bill. And it is not mentioned
    because I don't believe that it is one of the economic return
    enhancements where this Congress has specifically said, and you
    mentioned, the low-income housing credit. We said, with low-
    income housing tax credits, we think this is so important that,
    while it may be viewed as not having economic substance for the
    companies and individuals that take advantage of the low-income
    housing tax credit, that we are providing a special economic
    return enhancement, as I defined it on page 7 of the bill, to
    encourage that.
        And I have attempted to identify those. I may not have
    every one that there is. That was my objective,and I provided a
    catch-all to pick it up, so that Treasury could pick any up
    that I had omitted that were properly done through regulations.
        But the research and development tax credit is part of
    normal business operations like rent, like paying executives,
    like other investments. It has economic substance. The business
    engages in it to earn more profits. It is not a circular kind
    of an arrangement that is done just to dodge taxes.
        Mr. McCrery. Mr. Doggett, I do have a question about the
    oil industry. Before I get to that, though, I want to say that
    you are to be commended for looking into this area. I don't
    think any of us want corporate entities or individuals to be
    abusing provisions of the Tax Code to shelter income that we
    don't intend to be sheltered. And I also appreciate your
    willingness, as stated earlier, to work with us in Treasury and
    Joint Tax and perhaps members of the private sector to more
    carefully craft some of the provisions in your legislation to
    make sure that we don't paint with too broad a brush here.
        And one of the broad brush strokes that I see in your bill
    that gives me some concern are lack of definitions in the
    terms. For example, one of the tests that a taxpayer has to
    pass to claim as tax benefit is the present value of the
    reasonably expected potential income from the transaction, and
    then it goes on. And the example I gave you as we were walking
    over to the House was the independent oil guy that has a
    wildcatter and goes out and drills a well, knowing full well
    that there is a 90 percent chance that he won't get any profit
    from that endeavor. So what is the reasonably expected profit
    that he would have to meet under that test?
        It just seems to me that it causes some potential problems
    as we try to define those terms. Have you thought about that?
        Mr. Doggett. Yes. And with reference to the wildcatter, of
    course, in your part of the country and in mine, without
    someone willing to take that substantial risk, we wouldn't have
    much of the energy resources that have fueled our country, and
    it is important to preserve the incentives for doing that.
        I feel that in most instances the wildcatter is never going
    to get to this test, because we have a section of the bill
    called normal business transactions. The wildcatter is in the
    business of searching for oil. This is his normal business
    transaction, to engage in high-risk propositions. It might be a
    little different if some company that had nothing to do with
    wildcatting took all the loss and gave a nontaxable entity all
    the gain. That is my first answer.
        The second one is to focus your attention--and this was a
    little of my response about the research and development tax
    credit which is so important to me that Mr. Jefferson asked
    about. You will see that on page 7 of the bill, at (e),
    treatment of economic return enhancements, that the very first
    one--it may or may not be obvious, but the very first one deals
    with what I understand is called the tight sand credit, where
    Congress has set up a special standard. Some might say that the
    tight sand credit wouldn't justify the tests that I have in
    here.
        But I identified that as one that shall be treated as an
    economic return, a real return and not a tax benefit. And if
    there are others that affect the oil and gas industry like that
    and we are concerned Treasury might not recognize them, we
    should itemize them in the bill.
        Mr. McCrery. Well, I appreciate that. I think that is one
    thing that we would want to do in any legislation of this type,
    is try to identify specific transactions that we know might not
    meet a rather vague test and say this is one--this is an
    example of a transaction that we think is justified and should
    be honored under the Tax Code.
        So I think we need to thoroughly examine the Tax Code for
    other examples like the tight sands credit to make sure those
    are not thrown out with these kinds of reforms.
        Mr. Doggett. I appreciate your comments. It gets us back to
    the discussion that the chairman raised initially in this
    hearing, is we want enough certainty for a good-faith
    wildcatter or small business person or Fortune 500 corporation
    to know what it takes to comply with the law.
        If, however, we define such a narrow list of prohibitions
    and we give no discretion to the courts under the economic
    substance doctrine, we are going to find the same tax hustlers
    that have written around prior work that this Committee under
    Chairman Archer has done to deal with tax shelters and keep
    coming up with new ones, like sequels to the bad movies. They
    will just be given a road map as to how to write around the
    law. And I think we have to try to define that balance between
    the desire for certainty and enough flexibility to really
    prohibit these tax hustlers from doing what they have been
    doing. Thank you very much.
        Mr. McCrery. I am glad to hear you say you are willing to
    try and find that balance and not go too far either way.
        Any other member of the Committee wishing to inquire?
        If not, thank you very much, Mr. Doggett.
        Mr. Doggett. I thank you very much.
        Mr. McCrery. Our next panel is Mr. Talisman from the
    Department of Treasury and Ms. Paull from the Joint Committee
    on Taxation.
        Mr. Talisman, you are listed first, so I am going to call
    on you to begin. Please know that your written testimony will
    be entered into the record in full.
        Mr. Talisman. Thank you very much.
        Mr. McCrery. You may proceed.

    STATEMENT OF JONATHAN TALISMAN, ACTING ASSISTANT SECRETARY FOR
              TAX POLICY, U.S. DEPARTMENT OF THE TREASURY

        Mr. Talisman. Mr. Chairman and members of the Committee, it
    is a pleasure to speak with you today about the problem of
    corporate tax shelters and the administration's proposals to
    address this important problem.
        Mr. Chairman, in 1986 the Congress cured with almost
    instant results the corrosive effect of tax shelter activities
    that were eating away the individual income tax base, swamping
    the IRS and the Tax Code with controversies and causing a
    cynical attitude toward the tax law among many Americans. Today
    we are addressing a similar problem affecting the integrity of
    the tax system, the proliferation of corporate tax shelters,
    that merits immediate attention.
        When we started working on our White Paper late last year,
    our first goal was to raise awareness there was a problem and
    to explore the nature of the problem. Now it is clear that
    there is widespread agreement and concern among tax
    professionals that the corporate tax shelter problem is large
    and growing.
        For example, in a prior appearance before this Committee,
    the American Bar Association noted its growing alarm at the
    aggressive views by large corporate taxpayers of tax products
    that have little or no purpose other than the reduction of
    Federal income taxes and its concern about the blatant, yet
    secretive, marketing of such products.
        The staff of the Joint Committee, the New York State Bar,
    TEI and others have echoed their concern over the proliferation
    of shelters. Thus, we have moved from whether there is a
    problem to what to do to solve the problem. With your help, we
    hope to curtail the development, marketing and purchase of
    corporate tax shelters frequently sold as products off the rack
    to produce a substantial reduction in a corporation tax's
    liabilities.
        Why are we concerned? First, corporate tax shelters erode
    the corporate tax base. As Chairman Archer noted in his press
    release for this hearing, Congress has passed several
    provisions in the past few years alone to prevent specific tax
    shelter abuses which collectively would have cost the tax
    system over $50 billion.
        Second, as the New York State Bar Association recently
    noted, the corrosive effect of tax shelters breeds disrespect
    for the tax system, encouraging responsible corporate taxpayers
    to expect this type of activity to be the norm and to follow
    the lead of other taxpayers who have engaged in tax advantaged
    transactions. This race to the bottom, if unabated, will have
    long-term consequences to voluntary compliance, far more
    important than the short-term revenue loss we are currently
    experiencing.
        Finally, significant resources both in the private sector
    and the government are currently being wasted on this
    uneconomic activity. To date, most of the attacks on corporate
    tax shelters have been targeted at specific transactions and
    have incurred on an ad hoc, after-the-fact basis through
    legislative proposals, administrative guidance and litigation.
        For example, recently the Congress passed two provisions to
    prevent the abuse for tax purposes of corporate-owned life
    insurance, which were scored in the tens of billions of
    dollars, the elimination of the ability to avoid corporate
    level tax through the use of liquidating REITs, which passed
    late last year, and that provision was estimated by itself to
    have saved the tax system upwards of $30 billion over 10 years,
    and legislation passed this year aimed at section 357 basis
    creation abuses.
        Mr. Chairman, we very much appreciate these efforts and
    that members of this Committee have promptly addressed specific
    corporate tax shelters that we or others have brought to your
    attention. At the same time, the Treasury and the IRS have
    taken a number of administrative actions to address corporate
    tax shelters.
        On the regulatory front, we have issued guidance on
    stepdown preferred stock, lease trips and foreign tax credit
    abuses. Most recently, we have brought to light lease-in,
    lease-out tractions or so-called LILO schemes.
        These transactions, through circular property and cash
    flows, purportedly offered participants millions in tax
    benefits with no real economic risk. The notion of a U.S.
    multinational leasing of a town hall from a Swiss municipality
    and then immediately leasing it back to the municipality is
    surely out on its face.
        Finally, we have recently won several important cases, ACM,
    ASA, Compaq, Winn-Dixie and others, after many years of
    litigation. What you find over time, however, is that
    addressing the tax shelter's transaction by transaction is like
    attempting to slay the mythological Hydra. You kill off one
    over here, and two or three more appear over there. Already
    this year we have shut down so-called chutzpah trusts, which
    were similar to a structure shut down by Congress in 1997, and
    we are now hearing about ``Son of LILO'' and derivations on the
    section 357 seed product.
        Promoters like computer hackers will continue to search for
    defects in the Code to exploit, and taxpayers with an appetite
    for tax shelters will simply move from those transactions that
    are specifically prohibited by the new legislation to other
    transactions, the treatment of which has not been definitively
    prescribed.
        Legislating on a piecemeal basis further complicates the
    Code.
        Finally, using a transaction legislative approach to
    corporate tax shelters may embolden promoters and participants
    to rush shelter products to market on the belief that reactive
    legislation will be applied perspectively.
        What we have done at Treasury is identify the common
    sources and characteristics of shelters and incorporated these
    identified shelters into our budget proposals so that we may
    address these abusive tax-engineered transactions in a more
    global manner, hopefully preventing most from occurring. We
    must change the tax shelter cost-benefit analysis in a manner
    that is sufficient to deter these artificial transactions.
        The Treasury Department believes this global solution
    should include four parts--first, increasing disclosure of
    corporate tax shelter activities; two, increasing and modifying
    the penalty relating to the substantial understatement of
    income tax; third, codifying the economic substance doctrine;
    and, fourth, providing consequences to all the parties to the
    transaction, for example, promoters, advisers and tax-
    indifferent, accommodating parties.
        These proposals are intended to change the dynamics on both
    the supply and demand side of this market, making it a less
    attractive one for all participants. All the participants to a
    structured transaction should have an incentive to assure that
    the transaction comports with the established principles.
        I would like to emphasize a few key points. First, there is
    widespread agreement that increased disclosure and changes to
    the penalty regime are necessary to uncover transactions and
    change the cost-benefit analysis of entering into corporate tax
    shelters. However, we do not believe that these procedural
    remedies alone are enough. We believe the economic substance
    doctrine must be codified, thus requiring taxpayers to perform
    a careful analysis of the tax effect of a potential transaction
    before they enter into it.
        Let me be clear, the centerpiece of the substantive law
    proposal is not a new standard but rather is intended as a
    coherent articulation of the economic substance doctrine first
    found in seminal case law such as Gregory v. Helvering and most
    recently utilized in ACM, Compaq, IES and Winn-Dixie.
        The economic substance doctrine requires a comparison of
    the expected pretax profits and expected tax benefits.
    Codification of the doctrine would create a consistent standard
    so that taxpayers may not pick and choose between conflicting
    decisions to support their position.
        Second, there are substantial similarities between the
    Treasury Department's proposals and other proposals to curb
    corporate tax shelters. For example, the staff of the Joint
    Committee on Taxation agrees that there should be increased
    disclosure by participants, increased penalties on
    understatements attributable to undisclosed transactions and
    tightening of the reasonable cause exception.
        Finally, H.R. 2255, as introduced by Mr. Doggett, contains
    an approach similar to the administration's proposal, including
    the codification of the economic substance doctrine. I would
    like to thank Mr. Doggett for his leadership in this area and
    the others who have contributed to this important debate.
        Finally, the proposed legislation would be inadequate
    without effective enforcement. The Internal Revenue Service is
    undergoing a substantial restructuring. This restructuring will
    concentrate IRS resources relating to corporate tax shelters,
    enabling it to identify, focus on and coordinate its efforts
    against corporate tax shelters in a more efficient manner while
    instituting and maintaining appropriate taxpayer safeguards.
        The enactment of corporate tax shelter legislation,
    combined with this effort, will deter abusive transactions
    before they incur and uncover and stop those transactions to
    the extent they continue to occur. We are working closely with
    Commissioner Rossetti to develop the best overall approach to
    address corporate tax shelters and the restructured IRS.
        Let me assure you, however, that the Treasury Department
    does not intend to affect legitimate business transactions and
    looks forward to working with the tax writing Committees in
    refining the corporate tax shelter proposals. Our White Paper
    already made substantial revisions to our original broad budget
    proposals in response to comments we received.
        Further, to prevent interference with legitimate business
    transactions, the IRS and we are considering whether to require
    examining agents to refer corporate tax shelter issues to a
    centralized office for consideration. Such a referral process
    might be similar to that used with respect to the partnership
    antiabuse rules.
        The IRS also is considering whether to establish a
    procedure whereby a taxpayer could obtain an expedited ruling
    from the IRS as to whether a contemplated transaction
    constitutes a corporate tax shelter.
        Mr. Chairman, the proliferation of corporate tax shelters
    presents an unacceptable and growing level of tax avoidance by
    wasting economic resources, reducing tax receipts and
    threatening the integrity of the tax systems. This morning we
    have laid out before you the rationale for a suggested approach
    for combatting this important problem and discussed why we
    believe that existing law does not provide sufficient tools to
    combat this behavior. I look forward to working with you and
    the members of the Committee to address this problem as we have
    in the past to curb specific abuses.
        Thank you very much.
        Mr. McCrery. Thank you, Mr. Talisman.
        [The prepared statement follows:]

    Statement of Jonathan Talisman, Acting Assistant Secretary for Tax
    Policy, U.S. Department of the Treasury

        Mr. Chairman, Mr. Rangel, and distinguished Members of the
    Committee:
        Thank you for giving me the opportunity to discuss the
    problem of corporate tax shelters with you today. The Committee
    on Ways and Means has reacted quickly with legislation as
    specific corporate tax shelters come to light. As you
    mentioned, Mr. Chairman, the Committee in recent years has
    acted to close down about $50 billion in tax shelters.
    Unfortunately, based on all the indications we see, there is an
    increasing number of avoidance transactions being undertaken,
    despite your willingness to enact legislation to stop
    particular schemes as they are uncovered. Consequently, we are
    here before you today in support of legislation to deter
    corporate tax shelter activity on a more comprehensive, before-
    the-fact basis.
        The Treasury Department, in addition to many others,
    including the American Bar Association, the New York State Bar
    Association and the staff of the Joint Committee on Taxation,
    has expressed concerns about the proliferation of corporate tax
    shelters. These concerns range from the short-term revenue loss
    to the tax system, to the potentially more troubling long-term
    effects on our voluntary income tax system. In its FY 2000
    Budget, released in February of this year, the Administration
    made several proposals to inhibit the growth of corporate tax
    shelters.
        In July of this year, the Treasury Department issued its
    White Paper, The Problem of Corporate Tax Shelters: Discussion,
    Analysis and Legislative Proposals. This report discussed more
    fully the reasoning underlying the Budget proposals relating to
    corporate tax shelters, provided a description and analysis of
    the comments on the Budget proposals, and provided refinements
    to those proposals.
        Since the issuance of our White Paper, there have been some
    important developments regarding corporate tax shelters,
    including the issuance of the staff of the Joint Committee on
    Taxation's study of present-law penalty and interest
    provisions, as well as some important court decisions. With
    these developments in mind, I would like to emphasize the
    following points in my testimony today.
        First, corporate tax shelters continue to be a substantial
    and ongoing problem. While Congress, the Treasury Department
    and the Internal Revenue Service take action to stop particular
    transactions as they are uncovered, many abusive transactions
    remain undiscovered and numerous new transactions are created
    all the time.
        Second, the current ad hoc and piecemeal approach to
    addressing corporate tax shelters is inadequate. The current
    system is costly and inefficient. Admittedly, recent court
    decisions \1\ denying the purported tax benefits of certain
    shelter transactions are important. However, these decisions
    are after-the-fact actions against shelters--they do not
    prevent the design, marketing, and implementation of new and
    different shelters. Furthermore, even though Congress has
    enacted certain legislative changes curbing certain types of
    shelters, these statutory prohibitions can sometimes be avoided
    by making certain adjustments to a transaction to avoid the
    impact of the revised statutory provisions. A global
    legislative solution is needed to prevent abusive, tax-
    engineered transactions before they occur. The Treasury
    Department believes this global solution should include four
    parts: increased disclosure, changes to the substantial
    understatement penalty, codification of the economic substance
    doctrine and sanctions on other parties to the transaction.
    ---------------------------------------------------------------------------
        \1\ See, e.g., Compaq Computer Corp. v. Comm., 113 T.C. No. 17
    (1999); IES Industries v. U.S., No. C97-206 (N.D. Iowa 1999); Winn-
    Dixie Stores, Inc. v. Comm., 113 T.C. No. 21 (1999); Saba Partnership
    v. Comm., T.C. Memo 1999-359 (1999).
    ---------------------------------------------------------------------------
        Third, while increased disclosure and changes to the
    penalty regime are necessary to uncover transactions and change
    the cost/benefit analysis of entering into corporate tax
    shelters, these remedies are not enough. Accordingly, the
    Treasury Department continues to believe that it is necessary
    to codify the economic substance doctrine, thus requiring
    taxpayers to perform a careful analysis of the pre-tax effects
    of a potential transaction before they enter into it. The
    Treasury Department's proposed substantive provision is
    intended to be a coherent standard derived from the economic
    substance doctrine as enunciated in a body of case law to the
    exclusion of less developed, inconsistent decisions.
    Codification of the doctrine, while not creating a new
    doctrine, would create a consistent standard so that taxpayers
    may not choose between the conflicting decisions to support
    their position. Codification would isolate the doctrine from
    the facts of the cases so that taxpayers could not simply
    distinguish the cases based on the facts.
        Fourth, there are substantial similarities between the
    Treasury Department's proposals and other proposals to curb
    corporate tax shelters. For example, the staff of the Joint
    Committee on Taxation agrees that there should be increased
    disclosure by participants, increased penalties on
    understatements attributable to undisclosed transactions and
    tightening of the reasonable cause exception, and sanctions on
    other parties to the transaction. As discussed more fully in
    the White Paper, the American Bar Association and the New York
    State Bar Association proposals contain several elements
    similar to those in the Administration's proposal. Finally,
    H.R. 2255, introduced by Mr. Doggett, also contains an approach
    similar to the Administration's proposal, including the
    codification of the economic substance doctrine. We commend Mr.
    Doggett for his leadership.
        Fifth, the proposed legislation would be inadequate without
    effective enforcement. The Internal Revenue Service is
    undergoing a substantial restructuring. This restructuring will
    concentrate IRS resources relating to corporate tax shelters,
    enabling it to identify, focus on, and coordinate its efforts
    against corporate tax shelters in a more efficient manner,
    while instituting and maintaining appropriate taxpayer
    safeguards. The enactment of corporate tax shelter legislation,
    combined with the efforts of the restructured IRS, will deter
    abusive transactions before they occur and uncover and stop
    these transactions to the extent they continue to occur.
        The balance of my testimony will elaborate on these points.

                              Reasons for concern

        First, corporate tax shelters are designed to, and do,
    substantially reduce the corporate tax base. Moreover,
    corporate tax shelters breed disrespect for the tax system--
    both by the parties who participate in the tax shelter market
    and by others who perceive unfairness. A view that well-advised
    corporations avoid their legal tax liabilities by engaging in
    tax-engineered transactions may cause a ``race to the bottom.''
    The New York State Bar Association recently noted this
    ``corrosive effect'' of tax shelters: ``The constant promotion
    of these frequently artificial transactions breeds significant
    disrespect for the tax system, encouraging responsible
    corporate taxpayers to expect this type of activity to be the
    norm, and to follow the lead of other taxpayers who have
    engaged in tax advantaged transactions.'' If unabated, this
    will have long-term consequences to our voluntary tax system
    far more important than the revenue losses we currently are
    experiencing in the corporate tax base.
        Finally, significant resources--both in the private sector
    and the government--are currently being wasted on this
    uneconomic activity.\2\ Private sector resources used to
    create, implement and defend complex sheltering transactions
    are better used in productive activities. Corporations distort
    their business decisions to take advantage of tax shelter
    opportunities. Similarly, the Congress (particularly the tax-
    writing Committees and their staffs), the Treasury Department,
    and the IRS must expend significant resources to address and
    combat these transactions.
    ---------------------------------------------------------------------------
        \2\ As Peter Cobb, former Deputy Chief of Staff of the Joint
    Committee on Taxation recently stated: ``You can't underestimate how
    many of America's greatest minds right now are being devoted to what
    economists would all say is totally useless economic activity.''
    ---------------------------------------------------------------------------

               Corporate tax shelters and the corporate tax base

        Some have argued that the growth of corporate income tax
    receipts demonstrates that corporate tax shelters cannot be a
    problem. Of course, the size of the problem is not indicated by
    the amount of corporate tax receipts, which vary over time for
    a number of reasons, but by the difference between actual tax
    payments and those that would be remitted absent corporate tax
    shelters. That difference is impossible to measure directly,
    but the increasing difference between the income taxpayers
    report on their corporate tax forms (taxable income) and the
    income they report to shareholders (book income) appears to be
    consistent with the increasing use of corporate tax shelters.
        One feature of many tax shelters is that they reduce
    taxable income and taxes without reducing book income.
    Corporate taxpayers report their book income on Schedule M-1 of
    Form 1120. Such data show that the difference between book
    income and taxable income for large corporations (average
    assets greater than $1 billion) increased between 1991 and
    1996.\3\ Current income reported on corporate tax returns
    (total receipts less total deductions) represented a much
    smaller share of book income (calculated as book income after
    tax, plus Federal taxes, less tax-exempt income) in 1996 than
    in the early 1990s. (See Figure 1.) Thus, even though corporate
    income reported on tax returns has increased markedly in the
    1990s, book income has increased even faster. It is unclear how
    much of the divergence between tax and book income reflects tax
    shelter activity, but the data are clearly consistent with
    other evidence that the problem is significant.
    ---------------------------------------------------------------------------
        \3\ All estimates are based on a balanced panel of 811 corporations
    with mean asset size in excess of $1 billion, in 1992 dollars, over the
    years 1991 through 1996. Corporate tax data are only available through
    1996. We did not use data before 1991 for this comparison because
    depreciation data from Schedule M-1 are not available before 1991. In
    addition, the detailed book data from before 1991 seem inconsistent
    with the post-1990 data, perhaps because of an accounting method
    change.
    [GRAPHIC] [TIFF OMITTED] T5744.006

        Book and tax measures of income can diverge for many
    reasons that are unrelated to tax shelters. For example,
    increases in the rate of new investment can cause book and
    taxable income to diverge because tax depreciation is
    accelerated compared with book depreciation. But depreciation
    does not seem to be a significant factor. Figure 2 shows that
    the difference due to depreciation has declined over the last
    several years while the difference between book and tax income
    continues to climb. Hence, removing the depreciation
    discrepancy would actually make the proportional gap between
    the two income measures larger in recent years.\4\
    ---------------------------------------------------------------------------
        \4\ Other factors contribute to the gap between book and tax
    measures of income, including 1) the differential impact of the
    business cycle on the two measures, 2) increases in foreign based
    income that are reflected in book but not tax income and 3) differences
    in accounting treatment for stock options and their increased
    importance as a component of executive and employee compensation.
    [GRAPHIC] [TIFF OMITTED] T5744.007

    ---------------------------------------------------------------------------
    Need for legislation

        To date, most attacks on corporate tax shelters have
    targeted specific transactions and have occurred on an ad hoc,
    after-the-fact basis--through legislative proposals,
    administrative guidance, and litigation. In the past few years
    alone, Congress, the Treasury Department and the IRS have taken
    a number of actions to address specific corporate tax shelters.
    These include:
        1. Two provisions enacted in 1996 and 1997 to prevent the
    abuse for tax purposes of corporate-owned life insurance
    (COLI).\5\ Collectively, these two provisions were estimated by
    the Joint Committee on Taxation to raise over $18 billion over
    10 years. As the then Chief of Staff of the Joint Committee on
    Taxation stated: ``When you have a corporation wiring out a
    billion dollars of premium in the morning and then borrowing it
    back by wire in the afternoon and instantly creating with each
    year another $35 million of perpetual tax savings, that's a
    problem. . . . I think we were looking at a potential for a
    substantial erosion of the corporate tax base if something
    hadn't been done.'' \6\
    ---------------------------------------------------------------------------
        \5\ Pub. L. No. 104-191, Sec.  501 (1996); Pub. L. No. 105-34,
    Sec.  1084 (1997)
        \6\ Kenneth Kies, Transcript of Federal Bar Association's Fourth
    Invitational Biennial Conference on the Tax Legislative Process,
    reprinted in 97 Tax Notes Today 21-38 (Jan. 31, 1997).
    ---------------------------------------------------------------------------
        2. Legislation enacted late last year to eliminate the
    ability of banks and other financial intermediaries to avoid
    corporate-level tax through the use of ``liquidating REITs.''
    \7\ The Treasury Department's Office of Tax Analysis (OTA)
    estimated that eliminating this one tax shelter product alone
    would save the tax system approximately $34 billion over the
    next ten years.
    ---------------------------------------------------------------------------
        \7\ Pub. L. No. 105-277, Sec.  3001(a) (1998).
    ---------------------------------------------------------------------------
        3. The recent IRS ruling \8\ addressing so-called lease-in,
    lease-out transactions, or ``LILO'' schemes. Like COLI, these
    transactions, through circular property flows and cash flows,
    offered participants millions of dollars in tax benefits with
    no real economic substance or risk. Based on the transactions
    we have been able to identify to date, OTA estimates that
    eliminating this tax shelter saved $10.5 billion over ten
    years.
    ---------------------------------------------------------------------------
        \8\ Rev. Rul. 99-14, 1994-14 I.R.B. 3.
    ---------------------------------------------------------------------------
        4. Legislation signed into law on June 25, 1999, aimed at
    section 357(c) basis creation abuses.\9\ In these transactions,
    taxpayers exploited the concept of ``subject to'' a liability
    and claimed increases in the bases of assets that resulted in
    bases far in excess of the assets' values.
    ---------------------------------------------------------------------------
        \9\ Pub. L. No. 106-36, Sec. 3001 (1999).
    ---------------------------------------------------------------------------
        5. Proposed regulations \10\ addressing fast-pay preferred
    stock transactions. These financing transactions purportedly
    allowed taxpayers to deduct both principal and interest. It was
    reported that one investment bank created nearly $8 billion of
    investments in a few months.
    ---------------------------------------------------------------------------
        \10\ Prop. Reg. Sec. 1.7701(l)-3.
    ---------------------------------------------------------------------------
        6. Notice 98-5 \11\ dealing with foreign tax credit abuses.
    ---------------------------------------------------------------------------
        \11\ 1998-3 I.R.B. 49.
    ---------------------------------------------------------------------------
        7. The Government's victories in several important
    corporate tax shelter cases--ACM Partnership v. Commissioner
    \12\ and ASA Investerings Partnership v. Commissioner,\13\ and
    those cases mentioned in footnote one of this testimony.
    ---------------------------------------------------------------------------
        \12\ 73 T.C.M. (CCH) 2189 (1997), aff'd in part, rev'd in part, 157
    F.3d 231 (3d Cir. 1998), cert. denied, 119 S.Ct. 1251 (1999).
        \13\ 76 T.C.M. (CCH) 325 (1998).
    ---------------------------------------------------------------------------
        Addressing corporate tax shelters on a transaction-by-
    transaction, ad hoc basis, however, has substantial defects.
    First, because it is not possible to identify and address all
    (or even most) current and future sheltering transactions, this
    type of transaction-by-transaction approach is inadequate.
    There will always be transactions that are unidentified or not
    addressed by the legislation. As Treasury Secretary Lawrence H.
    Summers said: ``One is reminded of painting the Brooklyn
    Bridge: no sooner is one section painted over, than another
    appears needing work. Taxpayers with an appetite for corporate
    tax shelters will simply move from those transactions that are
    specifically prohibited by the new legislation to other
    transactions the treatment of which is less clear.'' \14\
    ---------------------------------------------------------------------------
        \14\ Lawrence H. Summers, ``A Better Tax Service and a Better Tax
    System,'' Tax Executives Institute, March 22, 1999.
    ---------------------------------------------------------------------------
        Second, addressing tax shelters on a piecemeal basis
    complicates the tax law. In the past few years alone, Congress
    has passed numerous provisions to prevent specific tax shelter
    abuses. The layering of provision upon provision may lead one
    to believe that there is a rule for every situation and thus
    what is not specifically proscribed is, by negative inference,
    allowed. In time these specific rules themselves are used in
    unintended ways to create corporate tax shelters.\15\
    ---------------------------------------------------------------------------
        \15\ So far this year, we have shut down so-called ``chutzpah
    trusts'' which were similar to a structure shut down by Congress in
    1997 and we are now hearing about ``son of LILO'' transactions and
    permutations of the section 357(c) product.
    ---------------------------------------------------------------------------
        Third, a legislative strategy that deals with tax shelter
    transactions on a piecemeal basis calls into question the
    viability of current rules and standards, particularly the
    common law tax doctrines such as sham transaction, business
    purpose, economic substance and substance-over-form. Finally,
    reliance on a transaction-by-transaction legislative approach
    to corporate tax shelters may embolden some promoters and
    participants to rush shelter products to market on the
    assumption that any Governmental reaction would be applied only
    on a prospective basis.
        We believe that a more comprehensive approach to corporate
    tax shelters is needed. In developing such an approach in the
    President's FY 2000 Budget and the Treasury Department's White
    Paper, we examined characteristics of known corporate tax
    shelters.

    Common characteristics

        Because corporate tax shelters take many different forms
    and utilize many different structures, they are difficult to
    define with a single formulation. A number of common
    characteristics, however, can be identified that are useful in
    crafting an approach to solving the corporate tax shelter
    problem.
        Lack of economic substance--Professor Michael Graetz
    recently defined a tax shelter as ``a deal done by very smart
    people that, absent tax considerations, would be very stupid.''
    \16\ This definition highlights one of the most important
    characteristics common to most corporate tax shelters--the lack
    of any significant economic substance or risk to the
    participating parties. Through hedges, circular cash flows,
    defeasements and the like, the participant in a shelter is
    insulated from any significant economic risk.
    ---------------------------------------------------------------------------
        \16\ See Tom Herman, Tax Report, Wall St. J. at A-1 (Feb. 10,
    1999).
    ---------------------------------------------------------------------------
        Inconsistent financial accounting and tax treatments--There
    is a current trend among public companies to treat corporate
    in-house tax departments as profit centers that strive to keep
    the corporation's effective tax rate (i.e., the ratio of
    corporate tax liability to book income) low and in line with
    that of competitors. Accordingly, in many recent corporate tax
    shelters involving public companies, the financial accounting
    treatment of the shelter item has been inconsistent with the
    claimed Federal income tax treatment.
        Tax-indifferent parties--Many recent shelters have relied
    on the use of ``tax-indifferent'' parties--such as foreign or
    tax-exempt entities--who participate in the transaction in
    exchange for a fee to absorb taxable income or otherwise
    deflect tax liability from the taxable party.
        Marketing activity--Promoters often design tax shelters so
    that they can be replicated multiple times for use by different
    participants, rather than to address the tax planning issues of
    a single taxpayer. This allows the shelter ``product'' to be
    marketed and sold to many different corporate participants,
    thereby maximizing the promoter's return from its shelter idea.
        Secrecy--Similar to marketing, maintaining secrecy of a tax
    shelter transaction helps to maximize the promoter's return
    from its shelter idea--it prevents expropriation by others and
    it protects the efficacy of the idea by preventing or delaying
    discovery of the idea by the Treasury Department and the IRS.
    In the past, many promoters have required prospective
    participants to sign a non-disclosure agreement that provides
    for large payments for any disclosure of the ``proprietary''
    advice.
        Contingent or refundable fees and rescission or insurance
    arrangements--Corporate tax shelters often involve contingent
    or refundable fees in order to reduce the cost and risk of the
    shelter to the participants. In a contingent fee arrangement,
    the promoter's fee depends on the level of tax savings realized
    by the corporate participant. Some corporate tax shelters also
    involve insurance or rescission arrangements. Like contingent
    or refundable fees, insurance or rescission arrangements reduce
    the cost and risk of the shelter to the participants.
        High transaction costs--Corporate tax shelters carry
    unusually high transaction costs. For example, the transaction
    costs in the ASA Investerings Partnership case ($24,783,800)
    were approximately 26.5 percent of the purported tax savings
    (approximately $93,500,000).

    Administration proposals

        In its FY 2000 Budget, the Administration made several
    proposals designed to inhibit the growth of corporate tax
    shelters. These proposals build upon the common characteristics
    of corporate tax shelters described above and focus on the
    following areas:
        (1) increasing disclosure of corporate tax shelter
    activities,
        (2) increasing and modifying the penalty relating to the
    substantial understatement of income tax,
        (3) codifying the economic substance doctrine, and
        (4) providing consequences to all the parties to the
    transaction (e.g., promoters, advisors, and tax-indifferent,
    accommodating parties).

    Increasing disclosure

        Greater disclosure of corporate tax shelters would aid the
    IRS in identifying corporate tax shelters and would therefore
    lead to better enforcement by the IRS. Also, greater disclosure
    likely would discourage corporations from entering into
    questionable transactions. The probability of discovery by the
    IRS should enter into a corporation's cost/benefit analysis of
    whether to enter into a corporate tax shelter.
        In order to be effective, disclosure must be both timely
    and sufficient. In order to facilitate examination of a
    particular taxpayer's return with respect to a questionable
    transaction, the transaction should be prominently disclosed on
    the return. Moreover, because corporate tax returns may not be
    examined for a number of years after they are filed, an ``early
    warning'' system should be required to alert the IRS to tax
    shelter ``products'' that may be promoted to, or entered into
    by, a number of taxpayers. Disclosure should be limited to the
    factual and legal essence of the transaction to avoid being
    overly burdensome to taxpayers.
        Disclosure would be required if a transaction has certain
    of the objective characteristics identified above that are
    common in many corporate tax shelters. The Treasury Department
    believes that two forms of disclosure are necessary. Disclosure
    would be made on a short form separately filed with the
    National Office of the IRS. Promoters would be required to file
    the form within 30 days of offering the tax shelter to a
    corporation. Corporations entering into transactions requiring
    disclosure would file the form by the due date of the tax
    return for the taxable year for which the transaction is
    entered into (unless the corporation had actual knowledge that
    the promoter had filed with respect to the transaction) and
    would include the form in all tax returns to which the
    transaction applies. The form would require the taxpayer to
    provide a description of the characteristics that apply to the
    transaction and information similar to the information in the
    ABA disclosure proposal. The form should be signed by a
    corporate officer who has, or should have, knowledge of the
    factual underpinnings of the transaction for which disclosure
    is required. Such officer should be made personally liable for
    misstatements on the form, with appropriate penalties for fraud
    or gross negligence and the officer would be accorded
    appropriate due process rights.
    Substantial understatement penalty

        In order to serve as an adequate deterrent, the risk of
    penalty for corporations that participate in corporate tax
    shelters must be real. The penalty also must be sufficient to
    affect the cost/benefit analysis that a corporation considers
    when entering into a tax shelter transaction.
        The Treasury Department believes that the substantial
    understatement penalty imposed on understatements of tax
    attributable to corporate tax shelters should be greater than
    the penalty generally imposed on other understatements. This
    view is shared by the staff of the Joint Committee on Taxation,
    the ABA, the NYSBA and others. Thus, to discourage the use of
    shelters, the Treasury Department would double the current-law
    substantial understatement penalty rate to 40 percent for
    corporate tax shelters. To encourage disclosure, the penalty
    rate would be reduced to 20 percent if the taxpayer files the
    appropriate disclosures.
        In the original Budget proposal, the Administration
    provided that the rate could not be further reduced below 20
    percent or eliminated by a showing of reasonable cause (i.e.,
    the penalty would be subject to a strict liability standard).
    Although one may rhetorically question whether there ever is
    any reasonable cause for entering into a corporate tax shelter
    transaction, many commentators have criticized the proposed
    elimination of the reasonable cause exception for corporate tax
    shelters. These commentators cited the potentially vague
    definitions of corporate tax shelter and tax avoidance
    transaction,\17\ the allowance of a reasonable cause exception
    for other penalties, and basic fairness for opposing a ``strict
    liability'' penalty. The Treasury Department still believes
    that the penalty structure set forth in the Administration's FY
    2000 Budget is appropriate. However, in light of the comments
    received, the Treasury Department believes that consideration
    should be given to reducing or eliminating the substantial
    understatement penalty where the taxpayer properly discloses
    the transaction and the taxpayer has a reasonable belief that
    it has a strong chance of sustaining its tax position. In
    addition, because many commentators believe that taxpayers are
    either ignoring or circumventing the requirements of Reg.
    Sec. 1.6664-4 as to what constitutes reasonable cause, these
    requirements would be codified to heighten visibility and
    strengthened to the extent necessary.
    ---------------------------------------------------------------------------
        \17\ These criticisms were addressed by the Treasury Department by
    modifying the definition of these terms.
    ---------------------------------------------------------------------------
        Under the Treasury Department's modified approach, a
    strengthened reasonable cause standard could be used to reduce
    or eliminate the substantial understatement penalty if the
    taxpayer also properly disclosed the transaction in question,
    even if the transaction ultimately is deemed to be a corporate
    tax shelter. This limited exception would encourage disclosure
    and would alleviate some taxpayer concerns with respect to the
    definition of corporate tax shelter.
        Finally, as discussed below, fears that the IRS may abuse
    the potential availability of increased substantial
    understatement penalties would be addressed by establishing
    procedures that would enhance issue escalation and facilitate
    consistent and centralized resolution of such matters.

    Codify the economic substance doctrine

        As evidenced by the comments from the ABA, AICPA, NYSBA,
    and others, corporate tax shelters are proliferating under the
    existing legal regime. This proliferation results, in part,
    because discontinuities in objective statutory or regulatory
    rules can lead to inappropriate results that have been
    exploited through corporate tax shelters. Current statutory
    anti-abuse provisions are limited to particular situations and
    are thus inapplicable to most current corporate tax shelters.
    Further, application of existing judicial doctrines has been
    inconsistent over time, which encourages the most aggressive
    taxpayers to pick and choose among the most favorable court
    opinions.
        The current piecemeal approach to addressing corporate tax
    shelters has proven untenable, as (1) policymakers do not have
    the knowledge, expertise and time to continually address these
    transactions; (2) adding more mechanical rules to the Code adds
    to complexity, unintended results, and potential fodder for new
    shelters; (3) the approach may reward taxpayers and promoters
    who rush to complete transactions before the anticipated
    prospective effective date of any reactive legislation; and (4)
    the approach results in further misuse and neglect of common
    law tax doctrines. Thus, the Treasury Department believes that
    a codification of the economic substance doctrine is necessary
    in order to curb the growth of corporate tax shelters. While
    increased disclosure and changes to the penalty regime are
    necessary to escalate issues and change the cost/benefit
    analysis of entering into corporate tax shelters, these
    remedies are not enough if taxpayers continue to believe that
    they will prevail on the underlying substantive issue.
        The centerpiece of the substantive law proposal is the
    codification of the economic substance doctrine first found in
    seminal case law such as Gregory v. Helvering \18\ and most
    recently utilized in ACM Partnership \19\ and the cases in
    footnote one. The economic substance doctrine requires a
    comparison of the expected pre-tax profits and expected tax
    benefits. This test is incorporated in the first part of the
    Administration's proposed definition of ``tax avoidance
    transaction.'' Under that test, a tax avoidance transaction
    would be defined as any transaction in which the reasonably
    expected pre-tax profit (determined on a present value basis,
    after taking into account foreign taxes as expenses and
    transaction costs) of the transaction is insignificant relative
    to the reasonably expected net tax benefits (i.e., tax benefits
    in excess of the tax liability arising from the transaction,
    determined on a present value basis) of such transaction. In
    addition, the economic substance doctrine would apply to
    financing transactions (that do not lend themselves to a pre-
    tax profit comparison) by comparing the tax benefits claimed by
    the issuing corporation to the economic profits derived by the
    person providing the financing.
    ---------------------------------------------------------------------------
        \18\ 293 U.S. 465 (1935).
        \19\ ACM Partnership v. Comm., 73 T.C.M. (CCH) 2189, aff'd in part,
    rev'd in part
    ---------------------------------------------------------------------------
        A tax benefit would be defined to include a reduction,
    exclusion, avoidance or deferral of tax, or an increase in a
    refund. However, the definition of tax benefit subject to
    disallowance would not include those benefits that are clearly
    contemplated by the applicable Code provision (taking into
    account the Congressional purpose for such provision and the
    interaction of the provision with other provisions of the
    Code). Thus, tax benefits that would normally meet the
    definition, such as the low-income housing credit and
    deductions generated by standard leveraged leases, would not be
    subject to disallowance.
        The above definition of a tax-avoidance transaction is a
    modification of the Administration's original FY 2000 Budget
    proposal. The modifications address commentators' concerns
    about the potential vagueness of the original proposal.
    Concerns that the IRS might abuse the authority indicated in
    the original Budget proposal are addressed by a more concrete
    definition of tax avoidance transaction. In addition, the tax
    attribute disallowance rule would apply by operation of law,
    rather than being subject to the discretion of the Secretary.
        A similar approach to that discussed above can be found in
    H.R. 2255, the ``Abusive Tax Shelter Shutdown Act of 1999,''
    introduced by Messrs. Doggett, Stark, Hinchey and Tierney on
    June 17, 1999.
        The Treasury Department continues to believe that it is
    necessary to codify the economic substance doctrine, thus
    requiring taxpayers to perform a careful analysis of the pre-
    tax effects of a potential transaction before they enter into
    it. The Treasury Department's proposed substantive provision is
    intended to be a coherent standard derived from the economic
    substance doctrine as enunciated in a body of case law to the
    exclusion of less developed, inconsistent decisions.
    Codification of the doctrine, while not creating a new
    doctrine, would create a consistent standard so that taxpayers
    may not choose between the conflicting decisions to support
    their position. Codification would isolate the doctrine from
    the facts of the cases so that taxpayers could not simply
    distinguish the cases based on the facts.

    Consequences to other parties

        Proposals to deter the use of corporate tax shelters should
    provide sanctions or remedies on other parties that participate
    in, and benefit from, a corporate tax shelter. These remedies
    or sanctions would reduce or eliminate the economic incentives
    for parties that facilitate sheltering transactions, thus
    discouraging those transactions. As the ABA stated in its
    recent testimony: ``All essential parties to a tax-driven
    transaction should have an incentive to make certain that the
    transaction is within the law.'' With respect to corporate tax
    shelters, the ``other parties'' generally are promoters,
    advisors, and tax-indifferent parties that lend their tax-
    exempt status to the shelter transaction to absorb or deflect
    otherwise taxable income.
        When Congress was concerned with the proliferation of
    individual tax shelters in the early 1980s, it enacted several
    penalty and disclosure provisions that applied to advisors and
    promoters. These provisions were tailored to the types of
    ``cookie-cutter'' tax shelter products then being developed.
    Similar provisions could be enacted that are tailored to
    corporate tax shelters.
        Alternatively, with respect to promoters and advisors of
    corporate tax shelters, the Treasury Department proposed to
    affect directly their economic incentives by levying an excise
    tax of 25 percent upon the fees derived by such persons from
    the corporate tax shelter transaction. Only persons who perform
    services in furtherance of the corporate tax shelter would be
    subject to the proposal, and appropriate due process procedures
    for such parties with respect to an assessment would be
    provided.
        A tax-indifferent party often has a special tax status
    conferred upon it by operation of statute or treaty. To the
    extent such person is using this status in an inappropriate or
    unforeseen manner, the system should not condone such use.
    Imposing a tax on the income allocated to tax-indifferent
    parties could deter the inappropriate rental of their special
    tax status, limiting their participation in corporate tax
    shelters, and thus reducing other taxpayers' use of shelters
    that utilize this technique.
        The Treasury Department proposes to require tax-indifferent
    parties to include in income (either as unrelated business
    taxable income or effectively connected income) income earned
    in a corporate tax shelter transaction. To the extent such
    parties are outside the U.S. tax jurisdiction, such liability
    would be joint and severable with the U.S. corporate
    participant. The proposal would apply only to tax-indifferent
    parties that are trading on their special tax status and such
    parties would have appropriate due process rights.

    JCT Report

        The staff of the Joint Committee on Taxation (JCT), in its
    study and report on penalty and interest provisions of the
    Code, also analyzes corporate tax shelters. The JCT staff
    concluded that there ``is evidence that the use of corporate
    tax shelters has grown significantly in recent years'' and
    ``that present law does not sufficiently deter corporations
    from entering into arrangements with a significant purpose of
    avoiding or evading Federal income tax.'' In this regard, the
    staff made certain legislative recommendations.
        The proposals made by the JCT staff are quite similar to
    those made by the Administration. The JCT staff proposal would
    require increased disclosure, increase the substantial
    understatement penalty on undisclosed transactions and tighten
    the reasonable cause standard, and provide sanctions on other
    parties to shelter transactions. The major difference between
    the two sets of recommendations is that the JCT would not
    codify the economic substance doctrine. However, the JCT
    proposal does incorporate a version of the economic substance
    doctrine similar to that of the Administration's proposals in
    identifying corporate tax shelters.

    Compaq and other recent decisions

        Since we last testified before this Committee on the
    problem of corporate tax shelters, the IRS has won some
    significant tax shelter cases, including Compaq, IES
    Industries, Winn-Dixie, and Saba Partnership. The courts in
    these cases applied an economic substance analysis in denying
    tax benefits that purportedly met the black letter of the
    applicable Code provisions.
        These cases are helpful as part of an overall approach to
    address corporate tax shelters. First, the cases stand for the
    proposition that both the economic substance doctrine and the
    role of penalties are important components in the fight against
    corporate tax shelters. Some may argue that these cases
    demonstrate that the IRS currently has all the tools it needs
    to combat corporate tax shelters and that further legislation
    is unnecessary. Such an assertion ignores the realities of the
    litigation process and is premised on a misunderstanding of the
    intent of the Administration's legislative proposals.
        Reliance on judicial decisions, which taxpayers may attempt
    to distinguish, is not the most efficient means of addressing
    corporate tax shelters. Litigation is expensive and time-
    consuming, both for the government and taxpayers, and
    frequently does not provide a coherent set of rules to be
    applied to subsequent transactions. Tax Court Judge Laro,
    speaking on his own behalf before the Tax Executives Institute
    last month,\20\ acknowledged that the courts have provided
    little guidance on the amount of economic substance or business
    purpose sufficient for a transaction to be respected. He stated
    that such concepts ``may require further development in the
    case law,'' but highlighted the difficulty with such an
    approach when he said that judges ``decide cases one at a
    time...and don't make tax policy.''
    ---------------------------------------------------------------------------
        \20\ BNA Daily Tax Report (Oct. 28, 1999), G-2.
    ---------------------------------------------------------------------------
        The Treasury Department strongly believes that the economic
    substance doctrine upon which these recent cases have been
    decided should be codified. The doctrine has been a part of the
    fabric of our tax system since the seminal case of Gregory v.
    Helvering, but has, until recently, been eroded by some
    admittedly confusing and conflicting case law that has led to a
    lack of respect for the doctrine on the part of some taxpayers
    and tax practitioners. The economic substance doctrine is the
    most objective, most understandable, and most easily applied of
    all the judicially created doctrines. We believe that it is
    appropriate for the Congress to elevate this standard by
    codifying it, rather than waiting and hoping that the case law
    evolves in a more coherent and understandable manner.
        The Administration's corporate tax shelter proposals,
    including enactment of the economic substance doctrine, attempt
    to change the outcome of the cost-benefit analysis undertaken
    by taxpayers in deciding whether or not to engage in a
    questionable transaction. Taxpayers should be encouraged to
    apply these principles before the fact, rather than playing the
    audit lottery. The Administration's proposals provide a level
    playing field between overly aggressive taxpayers and compliant
    taxpayers and between overly aggressive taxpayers and their
    advisors and the government by ensuring that all parties are
    playing by the same objective rules, encouraging timely
    disclosure of potentially questionable transactions, and
    providing appropriate sanctions to parties that ``cross the
    line.''

    IRS administrative actions

        The IRS currently is undergoing a substantial
    restructuring. The IRS will be reorganized into divisions based
    on types of taxpayers. Because the Treasury proposals generally
    apply to large corporate transactions, the IRS personnel
    focusing on corporate shelters probably will be located in the
    IRS's new Large and Mid-Size Business Division, which will be
    fully operational in 2000.
        The restructuring of the IRS will enhance its ability to
    deal with corporate tax shelters. Centralization of IRS
    resources focusing on corporate tax shelters will facilitate
    training and coordination among IRS agents, IRS litigators,
    their supervisors and Chief Counsel. The IRS also is
    considering methods to centralize and coordinate the
    formulation of strategy regarding corporate shelters generally
    and particular shelter transactions.
        Further, to prevent interference with legitimate business
    transactions, the IRS is considering whether to require
    examining agents to refer corporate tax shelter issues to a
    centralized office for consideration. Such a referral process
    might be similar to that used with respect to the partnership
    anti-abuse regulations. The IRS is also considering whether to
    establish of a procedure whereby a taxpayer could obtain an
    expedited ruling from the IRS as to whether a contemplated
    transaction constitutes a corporate tax shelter.
        The Treasury Department will work closely with the IRS to
    create appropriate systems and procedures to centralize review
    and analysis, to ensure fair, consistent, and expeditious
    consideration of corporate tax shelter issues.

    Conclusion

        Mr. Chairman, the proliferation of corporate tax shelters
    presents an unacceptable and growing level of tax avoidance
    behavior by wasting economic resources, reducing tax receipts,
    and threatening the integrity of the tax system. This morning
    we have laid out the rationale for our suggested approach for
    combating this problem, and discussed why we believe that
    existing law does not provide sufficient tools to combat this
    behavior. We look forward to working with you and the members
    of the Committee to address this important problem, as we have
    in the past to curb specific abuses.
        [The Attached July 1999 ``White Paper'' by the U.S. Department of
    the Treasury, Entitled, ``The Problem of Corporate Tax Shelters:
    Discussion, Analysis and Legislative Proposals,'' is Being Retained in
    the Committee Files, and is also available at WWW.USTREAS.GOV/
    TAXPOLICY/LIBRARY/CTSWHITE.PDF.]

        Mr. McCrery. Ms. Paull.

     STATEMENT OF LINDY PAULL, CHIEF OF STAFF, JOINT COMMITTEE ON
                                TAXATION

        Ms. Paull. Thank you, Mr. Chairman, members of the
    Committee. I am pleased to present the testimony of the staff
    of the Joint Committee on Taxation today.
        My testimony focuses on the staff's recommendations that
    were made in the penalties and interest study that was released
    in July. That study was mandated by the IRS Reform Act and
    included, in addition to corporate tax shelter recommendations,
    recommendations on other penalties and interest provisions of
    the Tax Code which I hope the Committee will have the
    opportunity to look at in the near future.
        Attached to my testimony today are two documents. One, the
    first attachment, is a compilation of some data with respect to
    income tax receipts--broken down by individual, corporation and
    total receipts as well as GDP for the period, so that the
    Committee can have our data on these matters. And, in addition,
    we have a second table in that first attachment that provides
    some information on corporate income during the last decade
    basically.
        The second attachment to our testimony is a very lengthy
    document. I apologize to the Committee for not providing it
    earlier. It is difficult to come to closure on some of these
    documents. In this document, we attempted to compile all of the
    concerns raised with respect to both the Treasury proposals,
    Mr. Doggett's proposals, and, in the interest of fair play, the
    Joint Tax Committee staff's recommendations.
        So we hope this will be a useful document as the Committee
    gives further consideration to this issue, because there are
    lots of issues as you go about trying to deal with this very
    complicated matter.
        In conducting our study, we did a very comprehensive review
    of the substantive laws under the Tax Code, the various common
    law doctrines that the courts used to evaluate potentially
    abusive transactions and the standards of practice that apply
    to the tax advisers that participate with the investors in
    these transactions.
        We spent a considerable amount of time meeting with people,
    analyzing the various proposals, and trying to sort out the
    best we can where we are on this particular issue. We believe,
    as is stated in our report and in our testimony, that there is
    a problem with corporate tax shelters. We believe it is a
    growing problem, and we have to say that we don't have hard
    data on that.
        I don't think anybody has any hard data on that. Much of
    the evidence dealing with this kind of a subject is anecdotal
    that we get all the time from tax practitioners, corporations
    across the country talking to us about transactions, so it is
    that source of anecdotal testimony discussions that our staff
    gets. And all the kind of groups that have been testifying
    before Congress this year have indicated there is a growing
    problem with corporate tax shelters--I think it would be hard
    to ignore that there is a growing problem here.
        Although we have provided you with our income tax receipt
    data, we would caution you about the use of it and pointing to
    it, saying that this is evidence of corporate tax shelter
    activity. I don't think anybody, the Treasury Department or our
    staff, would be able to tell you that that data tells you very
    much. We don't have a good, comprehensive analysis of what the
    data means. And I think that it is only fair to say that there
    are a lot of factors at play here. There is a growing use of
    subchapter S corporations and other types of pass-through
    entities that could well be significant in looking at corporate
    receipts.
        On the other hand, if you do look at the corporate income
    tax receipts that are shown in the table, table 1 of attachment
    1, you will see that corporate receipts are basically flat over
    the last couple of years. In fact, the most recent reports
    indicates they have gone down slightly, when we have a growing
    economy.
        So there is an issue there. We don't have any hard data
    that would tell you what is causing the decline in corporate
    income tax receipts. I would caution you on the use of
    macroeconomic statistics in going about analyzing this problem.
        As Mr. Talisman said, there have been some recent court
    cases that dealt with some very aggressive transactions, and we
    have been trying to get as much information as we can about
    other similar cases that might be in the pipeline, and we have
    provided some data in my testimony about that.
        We believe there are at least eight other cases outstanding
    involving the same kind of issues that are involved in the ACM
    case and the total tax involved, which might span a number of
    years, is roughly in the range of a billion dollars for that
    one issue.
        Another recent case dealt with the Compaq Computer
    Corporation. We believe that there is at least 15 other cases
    outstanding involving the same issue there and possibly quite a
    few more. Those 15 cases might involve about approximately $60
    million in taxes.
        And Winn-Dixie, another very recent case that dealt with
    corporate-owned life insurance, we believe there is as many as
    100 similar cases outstanding dealing with similar issues which
    may involve about $6 billion in taxes.
        So if you add up those three transactions that were the
    subject of recent court cases where the courts held that the
    transactions that were entered into basically do not have any
    economic substance or they were possibly a sham in one
    instance, you will see over a short period of time about $7
    billion in play, according to our statistics, and we believe
    they are conservative statistics. So while we don't have hard
    evidence about what is happening to corporate income tax
    receipts, we do have some evidence about questionable
    transactions that are in the pipeline and in controversy at the
    current time.
        Those cases are early 1990 cases. What we have been hearing
    from practitioners and from corporate insiders is that the
    activity with respect to these type of aggressive transactions
    has been occurring more and more in recent years. So there is a
    disconnect here between that kind of data, which involves
    transactions that date back to the early 1990s, and what is
    happening now.
        All I can say is I think the Treasury Department and our
    staff will be monitoring and trying to provide the best data we
    can provide to the Committee as we get it during this process.
        With respect to the reason why a corporate tax shelter
    problem exists, we identified the penalty regime as a real
    problem under current law. We don't think the chances of
    getting hit with a penalty are very great.
        Again, we have taken a look at the most recent data on how
    much penalties in the nature of underpayment penalties or
    negligence penalties are paid by corporations. They are
    extremely small compared to the dollars that are outstanding in
    controversy and the dollars that are paid after a tax return is
    filed by corporations. So we believe there is a significant
    problem here with respect to the penalty regime. Because when a
    corporation or anybody enters into a business transaction, the
    analysis they do is a cost-benefit analysis: What is the costs
    of doing the transaction and what benefits am I going to derive
    from the transaction?
        And, right now, we believe that the cost-benefit analysis
    is tilted in favor of going forward with more aggressive
    transactions because the downside is very low. Very rarely will
    there be a penalty. You only have to pay the tax if you get
    caught on audit, so you play the audit lottery with these
    transactions. And it may take a long time to come to a
    resolution. If you have to go to court, it could take 4 or 5
    years to resolve the issue. During that period, you have the
    use of the money.
        So the real downside is that you might pay some interest on
    this money that you end up paying if you get caught. So we
    think, after quite a bit of analysis, that the proper way to
    approach the corporate tax shelter problem is to look at the
    penalty regime and see if you can address the issue of
    increasing the stakes and the costs of these types of
    transactions.
        Mr. Houghton. [presiding.] Ms. Paull, how much longer do
    you think you will be?
        Ms. Paull. I think I need about 4 more minutes.
        Mr. Houghton. All right.
        Ms. Paull. We have really struggled with the notion of
    trying to codify the court cases on this subject. And that, of
    course, is one of the approaches the Treasury Department has
    taken and Mr. Doggett in his legislation tries to take.
        You know, when you try to codify those cases, you end up
    having to go down the road, I think, of exempting out various
    transactions or investments. In the case of the Treasury
    Department, they put in this notion of clearly contemplated by
    the Tax Code. Your transaction might be in trouble unless it is
    clearly contemplated by the Tax Code.
        Mr. Doggett's legislation says your transaction might be in
    trouble unless you are on the good list, so to speak. He
    provides a list of some good items in the Tax Code and then
    allows the Treasury Department to add to the list. This is the
    most difficult thing you will need to focus on here is what is
    a corporate tax shelter. It is not susceptible, in our view, of
    an easy definition.
        We do attempt to identify the indicators of the modern day
    corporate tax shelter for purposes of beefing up the penalty
    regime.
        But for purposes of determining your underlying tax
    liability, this is a very, very difficult thing to do. And I
    would caution the Committee on that in that regard. And as I
    said before, we have more fully presented those kinds of issues
    in this document that is before you today, appendix number 2.
        If I might just briefly summarize the specific
    recommendations that the Joint Committee staff did in its
    report this summer. We believe the current penalty regime
    should be strengthened. In order to do that, you have to come
    to some grips with what is the kind of transaction that you
    want to hit with a strengthened penalty. So we have set forth
    some indicators of a corporate tax shelter, which I will not go
    into now, but I would be happy to discuss with anybody.
        We also would modify the penalty so there would be no
    requirement that there is a substantial understatement. For a
    large corporation, the current penalty regime gives, in essence
    a fudge factor of 10 percent of the taxes that should be known
    on a return.
        We would also elevate the standards for getting out of the
    penalty, and we would ask that the penalty be increased from 20
    to 40 percent.
        In addition, we have a series of proposals that are
    directed at advisors or other participants in the transactions.
    And we also have a series of disclosure and registration
    requirements not unlike in the other bills.
        So with that, I would welcome the opportunity to answer any
    questions you may have and look forward to working with you as
    you try to grapple with this very difficult issue.
        Mr. Houghton. We do, too, and thanks very much, Ms. Paull.
        [The prepared statement follows:]

    Statement of Lindy Paull, Chief of Staff, Joint Committee on Taxation

        My name is Lindy Paull. As Chief of Staff of the Joint
    Committee on Taxation, it is my pleasure to present the written
    testimony of the staff of the Joint Committee on Taxation (the
    ``Joint Committee staff'') at this hearing before the House
    Committee on Ways and Means concerning corporate tax
    shelters.\1\
    ---------------------------------------------------------------------------
        \1\ This testimony may be cited as follows: Joint Committee on
    Taxation, Testimony of the Staff of the Joint Committee on Taxation
    Before the House Committee on Ways and Means (JCX-82-99), November 10,
    1999.
    ---------------------------------------------------------------------------
        My testimony today focuses on recommendations made by the
    Joint Committee staff with respect to corporate tax shelters,
    which are contained in Part VIII of the study prepared by the
    Joint Committee staff regarding the present-law penalty and
    interest provisions.\2\ Two attachments supplement my
    testimony. The first attachment provides data on Federal income
    tax receipts and corporate income.\3\ The second receipt
    attachment is our staff's further analysis of the issues
    presented by corporate tax shelter proposals and
    recommendations.\4\
    ---------------------------------------------------------------------------
        \2\ Joint Committee on Taxation, Study of Present-Law Penalty and
    Interest Provisions as Required by Section 3801 of the Internal Revenue
    Service Restructuring and Reform Act of 1998 (Including Provisions
    Relating to Corporate Tax Shelters) (JCS-3-99), July 22, 1999 (``;Joint
    Committee staff study'').
        \3\ Joint Committee on Taxation, NIPA and Federal Income Tax
    Receipts Data (JCX-83-99), November 10, 1999.
        \4\ Joint Committee on Taxation, Description and Analysis of
    Present-Law Tax Rules and Recent Proposals Relating to Corporate Tax
    Shelters (JCX-84-99), November 10, 1999.
    ---------------------------------------------------------------------------

                                 I. Background

        Section 3801 of the Internal Revenue Service Restructuring
    and Reform Act of 1998 directed the Joint Committee on Taxation
    and the Secretary of the Treasury to conduct separate studies
    of the present-law interest and penalty provisions of the
    Internal Revenue Code (``;Code'') and to make any legislative
    or administrative recommendations to the House Committee on
    Ways and Means and the Senate Committee on Finance that are
    deemed appropriate to simplify penalty and interest
    administration or reduce taxpayer burden. The Joint Committee
    staff study makes a number of recommendations with respect to
    non-corporate tax shelter penalties and interest that will be
    the subject of a separate hearing by the Subcommittee of
    Oversight of the House Committee on Ways and Means.
        The Joint Committee staff recommendations regarding
    corporate tax shelters were the product of an extensive review
    and analysis of the present-law system of penalties and
    interest in the Code. The Joint Committee staff study focused
    on sanctions in the Code that relate to the collection of the
    proper amount of tax liability, such as penalties relating to
    payment of the proper amount of tax, reporting of income, and
    failure to provide information returns or reports.
        The penalty provisions reviewed by the Joint Committee
    staff relating to tax shelters include the following:

            (1) The accuracy-related penalty imposes a 20 percent penalty
            on any substantial understatement of income tax that, among
            other things, is attributable to corporate tax shelters.\5\
    ---------------------------------------------------------------------------
        \5\ Code section 6662.
    ---------------------------------------------------------------------------
            (2) Income tax return preparers may be liable for a penalty
            with respect to an understatement of a taxpayer's
            liabilities.\6\
    ---------------------------------------------------------------------------
        \6\ Code sections 6694 and 6695.
    ---------------------------------------------------------------------------
            (3) Penalties may be imposed on those who aid and abet a
            taxpayer with respect to a return that results in an
            understatement of tax liability.\7\
    ---------------------------------------------------------------------------
        \7\ Code section 6701.
    ---------------------------------------------------------------------------
            (4) Penalties may be imposed on those who promote abusive tax
            shelters.\8\
    ---------------------------------------------------------------------------
        \8\ Code section 6700.
    ---------------------------------------------------------------------------
            (5) Registration requirements apply with respect to tax
            shelters \9\ and penalties are imposed for failing to comply
            with the registration requirements.\10\
    ---------------------------------------------------------------------------
        \9\ Code sections 6111 and 6112.
        \10\ Code sections 6707 and 6708.
    ---------------------------------------------------------------------------
        The Joint Committee staff concluded after reviewing the
    above provisions that a comprehensive study of the present-law
    penalty provisions of the Code relating to tax shelters was
    appropriate.

                                II. Methodology

        The Joint Committee staff conducted a comprehensive review
    of the penalty and interest rules applicable to corporate tax
    shelters and evaluated their effectiveness in dealing with
    modern-day corporate tax shelter transactions. As part of the
    review process, the Joint Committee staff analyzed:

            (1) The substantive laws in the Code that are designed to,
            among other things, deter tax-shelter transactions \11\ and
            their interaction with the penalty and interest rules,
    ---------------------------------------------------------------------------
        \11\ Code sections 269, 446, 482 and 7701(l).
    ---------------------------------------------------------------------------
            (2) The various common-law doctrines used by the courts to
            evaluate and potentially disallow tax benefits claimed in tax
            shelter transactions \12\ and the imposition of penalties with
            respect to these transactions, and
    ---------------------------------------------------------------------------
        \12\ The common-law doctrines include the sham transaction
    doctrine, the economic substance doctrine, the business purpose
    doctrine, the substance over form doctrine, and the step transaction
    doctrine.
    ---------------------------------------------------------------------------
            (3) The standards of practice that affect certain advisors in
            connection with tax shelter activity and which are intended to
            have certain deterrent and punitive aspects.\13\

        \13\ See regulations found in Title 31, Part 10 of the Code of
    Federal Regulations. In addition, the Joint Committee staff reviewed
    various standards of practice and rules of professional conduct of the
    American Bar Association, the American Institute of Certified Public
    Accountants, and general state licensing authorities.
    ---------------------------------------------------------------------------
        The Joint Committee staff spent considerable time analyzing
    a variety of recent transactions that have given rise to recent
    Congressional or Administrative responses. The Joint Committee
    staff economists analyzed the economic considerations that
    affect corporate taxpayers' decisions with respect to engaging
    in tax shelter activity. The Joint Committee staff consulted
    with representatives of the Treasury Department, and reviewed
    various comments and proposals that have been put forward with
    regard to corporate tax shelters, including:

            (1) The Administration's proposals that were included in the FY
            2000 Budget, as supplemented by the Treasury White Paper on
            corporate tax shelters,
            (2) H.R. 2255, The Abusive Tax Shelter Shutdown Act of 1999,
            introduced on June 17, 1999 by Congressman Doggett and others,
            (3) Comments and recommendations submitted by various groups to
            this Committee and the Senate Committee on Finance, including
            groups such as the Tax Executives Institute, the American Bar
            Association Section of Taxation, the New York State Bar
            Association Tax Section, and the American Institute of
            Certified Public Accountants, and
            (4) Comments that were submitted to the Joint Committee staff
            in connection with the Joint Committee staff study.

                                 III. Analysis

        In analyzing the effectiveness of the present-law penalty
    provisions with respect to corporate tax shelters, the Joint
    Committee staff first addressed two fundamental questions. The
    first question is whether there is, in fact, a corporate tax
    shelter problem. If there is a corporate tax shelter problem,
    the second question is why such a problem exists.

    A. The Corporate Tax Shelter Problem

        The Joint Committee staff believes that there is a
    corporate tax shelter problem--more corporations are entering
    into arrangements principally to avoid tax. The Joint Committee
    staff believes the problem is becoming widespread and
    significant.
        Some commentators and interested parties question whether
    there is a corporate tax shelter problem. They contend that the
    heightened scrutiny the issue has received this year is mostly
    attributable to recent press reports. These commentators cite
    the lack of economic data showing a decline in corporate tax
    receipts as an indication that no problem exists.
        Admittedly, much of the evidence in this area is anecdotal,
    as one might expect, but the importance of this evidence should
    not be discounted. The parties involved in developing,
    marketing, or implementing a tax shelter generally benefit by
    keeping its existence confidential. For example, some firms
    intentionally limit the sale of a corporate tax shelter that
    involves tens of millions of dollars in tax savings to only a
    few taxpayers in an attempt to shield the arrangement from
    scrutiny by the Congress and the Treasury Department. The
    existence of the tax shelter is revealed only when a potential
    customer or a competitor anonymously disclosed the arrangement
    to a government official.
        Recent data would suggest that corporate tax receipts are
    not keeping pace with a growing economy. Data just released
    shows that for fiscal year 1999, corporate income tax receipts
    actually fell by approximately $4 billion, representing a
    decline of approximately two percent, from the prior fiscal
    year.\14\ The last year in which there was a decline in
    corporate tax receipts was in fiscal year 1990, a period in
    which the economy was softening and entering the brief
    recession which began in the last half of 1990.
    ---------------------------------------------------------------------------
        \14\ Monthly Treasury Statement regarding Budget Results for Fiscal
    Year 1999, Department of the Treasury (October 27, 1999).
    ---------------------------------------------------------------------------
        Commentators and interested parties have relied on
    macroeconomic data to reach differing opinions regarding
    whether there is a corporate tax shelter problem. The Joint
    Committee staff believes that the data are not sufficiently
    refined to provide a reliable measure of the corporate tax
    shelter activity. Many tax shelter transactions distort the
    reported measure of corporate profits in a manner similar to
    their impact on the corporate tax base. Other factors include
    year-to-year changes in corporate economic losses and the
    increased use of non-corporate entities.
        The Joint Committee staff believes that direct measurement
    of corporate tax shelter activity through macroeconomic data is
    not possible. Instead of focusing on macroeconomic data, a more
    instructive approach is to analyze specific tax shelter
    transactions that have come to light and evaluate their effect
    on corporate receipts. Because this approach only considers a
    few of the corporate tax shelter transactions, it necessarily
    understates the size of the corporate tax shelter problem. This
    approach, nonetheless, provides a useful reference point for
    consideration of the size of the problem. In the past two
    years, the courts have disallowed tax benefits in several high-
    profile corporate tax shelter cases. For example, in ACM
    Partnership v. Commissioner,\15\ the Third Circuit Court of
    Appeals disallowed a capital loss claimed in 1991 from a
    partnership arrangement because the arrangement lacked economic
    substance. The amount of the tax savings with respect to this
    case was approximately $30 million. The Joint Committee staff
    understands that there are at least eight other cases which
    raise issues similar to those described in the ACM case. The
    Joint Committee staff further understands that the amount in
    controversy from these cases (which may span several tax
    years), when added to the tax benefit at issue in ACM, would
    total approximately $1 billion in taxes.
    ---------------------------------------------------------------------------
        \15\ 157 F.3d 231 (3d Cir. 1998), aff'g 73 T.C.M. (CCH) 2189
    (1997).
    ---------------------------------------------------------------------------
        A second recent corporate tax shelter case is Compaq
    Computer Corp. v. Commissioner.\16\ In the Compaq case, the Tax
    Court disallowed a foreign tax credit claimed in 1992 with
    respect to a dividend from stock in a foreign corporation. The
    taxpayer bought and sold the stock within one hour in an
    arrangement that was structured to eliminate the taxpayer's
    economic risk from owning the stock. The disallowed tax credit
    in the Compaq case would have resulted in a tax benefit of
    approximately $3 million. The Joint Committee staff understands
    that there may be at least 15 other cases which raise issues
    similar to those described in the Compaq case. The Joint
    Committee staff further understands that, when added to amount
    at issue in the Compaq case, the total amount in controversy
    with respect to these cases, which may span several tax years,
    is approximately $60 million in taxes.
    ---------------------------------------------------------------------------
        \16\ 113 T.C. No. 17 (September 21, 1999).
    ---------------------------------------------------------------------------
        A third recent corporate tax shelter case is Winn-Dixie
    Stores, Inc. v. Commissioner.\17\ In the Winn-Dixie case, the
    Tax Court disallowed the interest deductions attributable to
    the taxpayer's 1993 leveraged corporate-owned life insurance
    (``COLI'') program on the grounds that it lacked both economic
    substance and business purpose. The amount of purported tax
    savings in the Winn-Dixie case was approximately $1.6 million
    for one year of an arrangement that was intended to yield tax
    benefits annually over a 60-year period. The Joint Committee
    staff understands that there may be as many as 100 cases in
    controversy which raise issues similar to those described in
    the Winn-Dixie case. The Joint Committee staff also understands
    that the amount in controversy with respect to these cases,
    which may span several tax years, is expected to approach
    approximately $6 billion in taxes.
    ---------------------------------------------------------------------------
        \17\ 113 T.C. No. 21 (October 19, 1999).
    ---------------------------------------------------------------------------
        Looking only at the three arrangements that were at issue
    in these cases, it is estimated that these cases represent over
    $7 billion in unpaid corporate taxes (approximately $1 billion
    from ACM and similar cases, approximately $60 million from
    Compaq and similar cases, and approximately $6 billion from
    Winn-Dixie and similar cases). Although these cases represent
    different tax years, this amount most likely represents a
    fraction of the corporate tax that the Federal government is
    not collecting because of corporate tax shelters. In many
    cases, the corporation that claims the tax benefits from a tax
    shelter escapes audit, or the tax shelter arrangement goes
    undetected during an audit. Even when the corporation is
    audited and the transaction is discovered, the hazards of
    litigation, the complexities of these transactions, and other
    factors are such that the IRS often may opt for a negotiated
    settlement. Only a fraction of tax shelter activity actually
    results in a judicial determination. In addition, as the these
    cases illustrate, several years may pass before a judicial
    determination is made with respect to a corporate tax shelter
    transaction, during which time similar transactions go
    undeterred. Thus, even though the outcome of the recent cases
    generally is favorable to the government, the case law (1)
    cannot be viewed to be representative of the full magnitude of
    the problem, and (2) cannot be considered as evidence that the
    corporate tax shelter problem is being contained.
        An additional observation regarding the effect of tax
    shelters on corporate tax receipts bears discussion. The
    magnitude of the problem, be it a $10 million loss or a $10
    billion loss, is in some respects a secondary issue.
    Practitioners indicate they are spending more of their time
    advising corporate clients regarding arrangements that are
    highly suspect, and tax executives complain they are getting
    ``pitched'' more and more ``aggressive'' transactions from
    promoters and advisors that are solely motivated to reduce the
    corporation's effective tax rate without any relation to a
    nontax business purpose or economic substance. Practitioners
    and corporate tax executives feel pressured to participate in
    such transactions, particularly when it appears that the
    corporation's competitor is doing a similar transaction and
    getting professional advice that such a transaction can avoid
    penalties because the professional advisor is willing to opine
    that the transaction is ``more likely than not'' to succeed.
    The perception of potentially becoming competitively
    disadvantaged by others engaging in a tax-motivated transaction
    could result in more corporations and tax advisors engaging in
    these types of transactions. If one corporation is permitted to
    claim an unwarranted tax benefit that its competitors are
    reluctant to claim, then, in essence, the corporations (and
    their advisors) that ``play by the rules'' are being penalized.
        Many prominent professional associations, such as the
    American Bar Association, the New York State Bar Association,
    the American Institute of Certified Public Accountants, and the
    Tax Executives Institute, have voiced their concerns with the
    growing presence of corporate tax shelters and their
    potentially harmful effects on the Federal income tax system.

    B. Why a Corporate Tax Shelter Problem Exists

        Critical to a corporation's decision of whether to enter
    into a tax shelter arrangement is a comparison of the expected
    net tax benefits with the expected costs of the arrangement.
    Such a ``cost-benefit'' analysis takes into account a corporate
    participant's economic risks in the event the expected net tax
    benefits fail to materialize. The imposition of a penalty
    should be a significant feature of the ``cost'' side of the
    equation, and the Joint Committee staff focused on the cost-
    benefit analysis in determining the effectiveness of the
    present-law penalty regime.
        The Joint Committee staff believes present law does not
    provide sufficient disincentives to engaging in these types of
    transactions.\18\ The cost-benefit analysis is skewed in favor
    of investing in corporate tax shelter transactions. There are
    significant potential benefits from entering into a corporate
    tax shelter transaction with little corresponding cost. The
    chances of a corporation being subject to a penalty from a
    corporate tax shelter are small. The Joint Committee staff
    believes that the cost of entering into abusive tax
    arrangements should be increased to deter this type of
    activity.\19\ The most effective means of realigning the cost-
    benefit calculus is to clarify and enhance the present-law
    penalty regime.
    ---------------------------------------------------------------------------
        \18\ The Joint Committee staff study identified other factors that
    have contributed to the increasing trend of corporate tax shelter
    activity. These factors are: (1) the emerging view of a corporate tax
    department as a profit center; (2) the relatively insufficient risk of
    penalties or other significant deterrents for entering into such
    transactions; (3) the role of tax advisor opinions in mitigating any
    risk of penalties; and (4) the insufficiency of standards of practice
    and the lack of enforcement of such standards.
        \19\ Corporations do not act alone in designing ways to avoid
    paying their fair share of taxes. Many other parties act in concert
    with the corporate taxpayer to facilitate such devices. As a result,
    the Joint Committee staff study recommends that the stakes (and
    standards) should be raised for these other participants as well, and
    disclosure should be required of promoters of corporate tax shelter
    activity.

    ---------------------------------------------------------------------------
    C. Clarifying and Enhancing the Present-Law Penalty Regime

        Although the present-law penalty regime includes certain
    specific provisions aimed at corporate tax shelters, the Joint
    Committee staff believes that the present-law structure is
    ineffective at deterring inappropriate corporate tax shelter
    activity. Nevertheless, the present-law penalty regime provides
    a useful framework from which refinements and improvements can
    be made. Moreover, because the policy considerations that gave
    rise to enactment of that framework in the first place (i.e.,
    deterrence of tax shelter activity) is just as true today, the
    present-law penalty regime appears to be the appropriate
    starting point in addressing the undesirable corporate shelter
    activity. The Joint Committee staff recommendations therefore
    focus on clarifying and enhancing the present law corporate tax
    shelter penalty regime. A meaningful penalty regime would alter
    the cost-benefit analysis of corporate participants in a manner
    that will discourage abusive transactions without interfering
    with legitimate business activity.

    D. Alternative Responses

        Maintaining the status quo

        Some argue that no legislative response to the corporate
    tax shelter problem is necessary; the present-law penalty
    regime would be effective in deterring corporate tax shelter
    activity if only (1) the Treasury Department would issue long-
    overdue guidance with respect to the penalty regime, and (2)
    the IRS would enforce the existing rules. The Joint Committee
    staff believes the present-law penalty structure contains a
    number of structural weaknesses that significantly undermine
    its effectiveness. Some of the weaknesses may be attributable
    to a lack of statutory guidance with respect to recent
    legislation regarding corporate tax shelters. For example, the
    Taxpayer Relief Act of 1997 amended the definition of a
    corporate tax shelter to cover any entity, plan or arrangement
    entered into by a corporate participant if a ``significant
    purpose'' is the avoidance or evasion of Federal income tax.
    However, there appears to be much uncertainty, both in the
    Treasury Department and in the business community, as to what
    constitutes a ``significant purpose'' and no guidance has been
    issued by the Treasury Department. At the same time, the lack
    of statutory guidance could subject any regulatory guidance to
    criticism for exercising too much discretion and exceeding
    statutory authority in resolving these issues.
        In addition, it appears that penalties are rarely collected
    in connection with tax shelters. The lack of imposition of
    present-law penalties may be, in part, a result of a lack of
    statutory guidance. For example, the facts and circumstances
    necessary to satisfy the reasonable cause exception to the
    substantial understatement penalty attributable to corporate
    tax shelters\20\ is widely disputed. Some tax professionals
    believe an opinion from a tax advisor is all that is necessary.
    Others believe that if the test in the regulations were
    enforced, few taxpayers would ever avoid this penalty. Given
    the wide range of interpretations, it is not surprising that
    the IRS generally waives the imposition of this penalty
    whenever a corporate taxpayer produces a favorable opinion
    letter from a professional tax advisor.
    ---------------------------------------------------------------------------
        \20\ Treas. Reg. sec. 1.6664-4(e).
    ---------------------------------------------------------------------------
        Another shortcoming of the section 6662 penalty for
    corporate tax shelters is that the penalty generally applies
    (in the absence of negligence) only if the understatement of
    tax is ``substantial.'' For a corporation, an understatement is
    substantial only if it exceeds 10 percent of the tax that is
    required to be shown on the return (or if greater, $10,000). A
    corporation therefore can engage in corporate tax shelter
    activities knowing that it will not be subject to an
    understatement penalty provided that the tax benefit does not
    exceed this 10 percent threshold. For a large corporation, this
    can represent a significant amount. In addition, the penalty
    applies only if there is an overall underpayment of income tax
    for the taxable year, regardless of whether the tax return
    understates taxable income with respect to a specific
    transaction. As a result, a taxpayer could use overpayment
    items to offset the underpayment from a corporate tax shelter
    and thereby avoid a penalty.
        Maintaining the status-quo also results in greater pressure
    to address each specific tax shelter transaction separately.
    Although in recent years there has been a flurry of legislative
    activity aimed at specific corporate tax shelters, such ad-hoc
    responses, by their very nature, rarely are enacted in a timely
    manner. These responses typically do not occur until after
    there has been significant loss in revenue. Also, because
    legislative changes generally apply on a prospective basis,
    corporations that engage in this activity early during the
    ``life cycle'' of a corporate tax shelter often retain the
    inappropriate tax savings. When the changes are not entirely
    prospective, a fairness concern is raised insofar as taxpayers
    may not have sufficient notice that the legislative changes
    will have affected their transaction. And as a realistic
    matter, the government may never become aware of some
    transactions that would be considered as abusive corporate tax
    shelters.
        Changing the cost-benefit calculus should deter taxpayers
    from entering into corporate tax shelters. While it is true
    that the IRS has won several recent tax shelter cases,
    litigation is an inefficient deterrent (because of the
    uncertainties of the audit process, the costs and hazards of
    litigation, delays in resolution, and similar reasons
    previously discussed), and the status quo does not provide
    sufficient disincentives for taxpayers to engage in tax shelter
    transactions.
        The problems with the present law penalty regime extend
    beyond taxpayer sanctions. There is little guidance and
    enforcement of standards for tax shelter opinions. If an
    advisor provides an opinion to protect a taxpayer from penalty,
    there is little or no risk of sanction to the advisor if the
    opinion is later determined to be improper. The American Bar
    Association Tax Section recently suggested changes to the
    standards of practice before the IRS, known as Circular 230,
    which imposes some standards on tax shelter opinions. These
    suggestions are a good first step. However, the ABA Tax
    Section's suggestions are predicated on the present-law ``more
    likely than not'' standard, which the Joint Committee staff
    believes should be raised.\21\ The Joint Committee staff study
    includes recommendations on how the current rules under
    Circular 230 should be revised to regulate the conduct of
    practitioners as it relates to corporate tax shelters.
    Unfortunately, the IRS Director of Practice recently stated
    that, although the IRS could be proposing changes to Circular
    230 next spring, these proposals are unlikely to tackle any
    ``controversial issues'' such as modifications to tax
    shelters.\22\ Such a noncommittal response illustrates that
    Congress should provide the IRS with strong guidance on how to
    address the tax shelter issue.
    ---------------------------------------------------------------------------
        \21\ Joint Committee staff study includes a recommendation that
    would eliminate the substantial understatement penalty attributable to
    corporate tax shelters only if the corporate participant is ``highly
    confident'' (i.e., reasonably believes that there is at least 75-
    percent chance that the tax treatment would be sustained on the
    merits). In addition, the Joint Committee staff recommends raising the
    minimum standards for tax return positions for both taxpayers and tax
    preparers.
        \22\ See Barton Massey, ``Circular 230 Changes Unlikely to Address
    Shelters or Practice of Law,'' 1999 TNT 206-5, (Doc 1999-34521),
    October 26, 1999.

    ---------------------------------------------------------------------------
    A substantive law change

        Some believe that clarifying and strengthening the penalty
    rules would be insufficient unless changes are also made to
    substantive tax law. The Joint Committee staff believes the
    substantive rules, including the common law doctrines, provide
    a sufficient, well-developed body of law for corporations to
    consider when evaluating tax shelter arrangements. The problem
    is not that the IRS lacked the necessary tools to challenge the
    transaction, nor can it be said that each taxpayer was unaware
    of the common-law doctrines. For example, the courts in each of
    the cases previously discussed--the ACM case, the Compaq case,
    and the Winn-Dixie case--relied on well-known, long-standing
    common-law doctrines to disallow the claimed tax benefits. The
    problem is that, from an economic (i.e., cost-benefit)
    perspective, the taxpayer concluded that it had little (if any)
    financial risk by going forward with the transaction. One only
    needs to look at the imposition of penalties in the cases.
    Neither the ACM case nor the Winn-Dixie case makes reference to
    penalties.\23\ In the Compaq case, the Tax Court imposed a
    negligence penalty under section 6662, though the facts are
    somewhat unusual in that the taxpayer did not seek an opinion
    of counsel, and the court noted how the corporate officer did
    little due diligence (and shredded the spreadsheet). In other
    words, there seems to be sufficient, well-developed case law
    that is flexible and adaptable to address the substantive issue
    of whether a tax shelter exists. What is lacking is a
    meaningful penalty structure that would significantly alter the
    cost-benefit calculus.
    ---------------------------------------------------------------------------
        \23\ The imposition of penalties may be a continuing issue in the
    ACM case.
    ---------------------------------------------------------------------------
        Another important concern with enacting a substantive rule
    is the inherent difficulty of crafting a rule that is sensitive
    to the tax system's reliance on objective, rule-based criteria
    while at the same time does not impede legitimate business
    transactions from going forward. A substantive law change
    should be precise so as to target abusive transactions but not
    affect legitimate business transactions. The difficulty lies in
    crafting a definition of a ``tax shelter.'' There can be
    significant disputes as to whether a particular transaction is
    a tax shelter. This is why the Joint Committee staff study
    identifies certain common characteristics of corporate tax
    shelter arrangements, referred to as ``tax shelter
    indicators,'' \24\ which, if present in an arrangement, would
    result in an understatement penalty only after a determination
    that the arrangement caused an understatement of the corporate
    participant's tax liability. Thus, it is not enough that the
    arrangement appears to be a tax shelter; there must be a
    determination that the tax treatment was improper and the
    taxpayer must have had less than a high level of confidence
    that the tax treatment was proper in order for a penalty to be
    imposed. This relieves much of the pressure of crafting a
    precise definition of a corporate tax shelter, which would
    exist if a substantive law change was adopted.
    ---------------------------------------------------------------------------
        \24\ The Joint Committee staff study identified five common
    characteristics of modern corporate tax shelter transactions. These
    characteristics are: (1) an arrangement in which the reasonably
    expected pre-tax profit is insignificant when compared with the
    expected tax benefits; (2) the involvement of a tax-indifferent
    participant; (3) the use of guarantees, tax indemnities and similar
    arrangements, including contingent fee structures; (4) a difference
    between tax reporting and financial statement reporting, especially
    where permanent differences arise; and (5) the lack of any appreciable
    change in economic position, particularly when a corporation does not
    take on any additional economic risk. Any corporate transaction which
    exhibits one of these characteristics (``;tax shelter indicator'')
    should be considered to have a significant purpose of avoiding or
    evading Federal income tax for purposes of an understatement penalty.

    ---------------------------------------------------------------------------
    E. Summary

        In summary, the cost-benefit analysis should be altered to
    discourage corporations from entering into abusive transactions
    without affecting legitimate business transactions. An enhanced
    penalty structure with more detailed disclosure requirements
    and more stringent standards for other participants in the
    corporate tax shelter would strike the appropriate balance and
    alter the cost-benefit analysis in a manner that would provide
    a sufficient deterrent effect.

                          IV. Specific Recommendations

        Consistent with its analysis and conclusions, the Joint
    Committee staff recommends the following with respect to
    corporate tax shelters.

        Recommendations that affect corporations which participate
    in corporate tax shelters

        A. Clarify the definition of a corporate tax shelter for
    purposes of the understatement penalty with the addition of
    several ``tax shelter indicators.'' This recommendation builds
    on the present-law definition of a corporate tax shelter found
    in section 6662 (the accuracy related penalty). Under that
    definition, a tax shelter exists if a significant purpose of a
    partnership, or other entity, plan, or arrangement is the
    avoidance or evasion of Federal income tax. The recommendation
    expounds upon that definition by providing certain
    ``indicators'' that if present will cause a partnership, or
    other entity, plan or arrangement in which a corporation is a
    participant to be considered to have a significant purpose of
    avoidance or evasion of Federal income tax.
        The indicators were developed from what we found to be
    common characteristics of corporate tax shelters. At the same
    time, so as to ensure that there will be no interruption to
    legitimate business activity, the list excludes many common
    characteristics and is narrowly tailored to avoid any
    overreaching. Most importantly, the indicators themselves do
    not cause a penalty to be created. The penalty is imposed only
    if an understatement exists--meaning that a determination has
    been made (for example, by losing in court) that the tax
    benefits related to a transaction were improper an not
    permitted under present law. The indicators are:

            (1) The reasonably expected pre-tax profit from the arrangement
            is insignificant relative to the reasonably expected net tax
            benefits.
            (2) The arrangement involves a tax-indifferent participant, and
            the arrangement (1) results in taxable income materially in
            excess of economic income to the tax-indifferent participant,
            (2) permits a corporate participant to characterize items of
            income, gain, loss, deductions, or credits in a more favorable
            manner than it otherwise could without the involvement of the
            tax-indifferent participant, or (3) results in a noneconomic
            increase, creation, multiplication, or shifting of basis for
            the benefit of the corporate participant, and results in the
            recognition of income or gain that is not subject to Federal
            income tax because the tax consequences are borne by the tax-
            indifferent participant.
            (3) The reasonably expected net tax benefits from the
            arrangement are significant, and the arrangement involves a tax
            indemnity or similar agreement for the benefit of the corporate
            participant other than a customary indemnity agreement in an
            acquisition or other business transaction entered into with a
            principal in the transaction.
            (4) The reasonably expected net tax benefits from the
            arrangement are significant, and the arrangement is reasonably
            expected to create a ``permanent difference'' for U.S.
            financial reporting purposes under generally accepted
            accounting principles.
            (5) The reasonably expected net tax benefits from the
            arrangement are significant, and the arrangement is designed so
            that the corporate participant incurs little (if any)
            additional economic risk as a result of entering into the
            arrangement.

        B. An entity, plan, or arrangement can still be a tax
    shelter even though it does not display any of the tax shelter
    indicators, provided that a significant purpose is the
    avoidance or evasion of Federal income tax.
        C. Modify the penalty so that, with respect to a corporate
    tax shelter, there would be no requirement that the
    understatement be substantial.
        D. Increase the understatement penalty rate from 20 percent
    to 40 percent for any understatement that is attributable to a
    corporate tax shelter. The IRS would not have the discretion to
    waive the understatement penalty in settlement negotiations or
    otherwise for corporate tax shelters.
        E. Provide that the 40-percent penalty could be completely
    abated (i.e., no penalty would apply) if the corporate taxpayer
    establishes that it satisfies certain abatement requirements.
    Foremost among the abatement requirements is that the corporate
    participant believes there is at least a 75-percent likelihood
    that the tax treatment would be sustained on the merits.
    Another requirement for complete abatement involves disclosure
    of certain information that is certified by the chief financial
    officer or another senior corporate officer with knowledge of
    the facts.
        F. Provide that the 40-percent penalty would be reduced to
    20 percent if certain required disclosures are made, provided
    that the understatement is attributable to a position with
    respect to the tax shelter for which the corporate participant
    has substantial authority in support of such position.
        G. Require a corporate participant that must pay an
    understatement penalty of at least $1 million in connection
    with a corporate tax shelter to disclose such fact to its
    shareholders. The disclosure would include the amount of the
    penalty and the factual setting under which the penalty was
    imposed.

    Recommendations that affect other parties involved in corporate
    tax shelters

        A. Increase the penalty for aiding and abetting with
    respect to an understatement of a corporate tax liability
    attributable to a corporate tax shelter from $10,000 to the
    greater of $100,000 or one-half the fees related to the
    transaction.
        B. Expand the scope of the aiding and abetting penalty to
    apply to any person who assists or advises with respect to the
    creation, implementation, or reporting of a corporate tax
    shelter that results in an understatement penalty if (1) the
    person knew or had reason to believe that the corporate tax
    shelter could result in an understatement of tax, (2) the
    person opined or advised the corporate participant that there
    existed at least a 75-percent likelihood that the tax treatment
    would be sustained on the merits if challenged, and (3) a
    reasonable tax practitioner would not have believed that there
    existed at least a 75-percent likelihood that the tax treatment
    would be sustained on the merits if challenged.
        C. Require the publication of the names of any person
    penalized under the aiding and abetting provision and an
    automatic referral of the person to the IRS Director of
    Practice.
        D. Clarify the U.S. government's authority to bring
    injunctive actions against persons who promote or aid and abet
    in connection with corporate tax shelters.
        E. Include the explicit statutory authorization for
    Circular 230 in Title 26 of the United States Code and
    authorize the imposition of monetary sanctions.
        F. Recommend that, with respect to corporate tax shelters,
    Treasury amend Circular 230 generally to (1) revise its
    definitions, (2) expand its scope, and (3) provide more
    meaningful enforcement measures (such as the imposition of
    monetary sanctions, automatic referral to the Director of
    Practice upon the imposition of any practitioner penalty,
    publication of the names of practitioners that receive letters
    of reprimand, and automatic notification to state licensing
    authorities of any disciplinary actions taken by the Director
    of Practice).

                    Disclosure and registration obligations

    A. Corporate taxpayer disclosure

        (1) 30-day disclosure.--Arrangements that are described by
    a tax shelter indicator and in which the expected net tax
    benefits are at least $1 million would be required to satisfy
    certain disclosure requirements within 30-days of entering into
    the arrangement.

         The 30-day disclosure would include a summary of
    the relevant facts and assumptions, the expected net tax
    benefits, each tax shelter indicator that describes the
    arrangement, the analysis and legal rationale, the business
    purpose, and the existence of any contingent fee arrangements.
         The chief financial officer or another senior
    corporate officer with knowledge of the facts would be required
    to certify, under penalties of perjury, that the disclosure
    statements are true, accurate, and complete.

        (2) Tax-return disclosure.--Arrangements that are described
    by a tax shelter indicator (regardless of the amount of net tax
    benefits) would be required to satisfy certain tax-return
    disclosure requirements.

             The tax-return disclosure would include a copy of any
            required 30-day disclosure.
             The tax-return disclosure also would identify which
            tax shelter indicators describe one or more arrangements
            reflected on the return.

    B. Tax shelter registration

        (1) Modify the present-law rules regarding the registration
    of corporate tax shelters by (1) deleting the confidentiality
    requirement, (2) increasing the fee threshold from $100,000 to
    $1 million, and (3) expanding the scope of the registration
    requirement to cover any corporate tax shelter that is
    reasonably expected to be presented to more than one
    participant.
        (1) Require additional information reporting with respect
    to the registration of tax shelter arrangements that are
    described by a tax shelter indicator. The additional
    information would include the claimed tax treatment and summary
    of authorities, the tax shelter indicator(s) that describes the
    arrangement, and certain calculations relating to the
    arrangement.

                                 V. Conclusion

        The Joint Committee staff believes that a corporate tax
    shelter problem exists, and the problem is becoming widespread
    and significant. The Joint Committee staff further believes
    that increasing the penalties for engaging in corporate tax
    shelters would sufficiently alter the cost-benefit analysis
    with respect to engaging in such transactions and would provide
    a measured response to the corporate tax shelter problem. The
    Joint Committee staff's analysis and specific recommendations
    are discussed in more detail in the Joint Committee staff
    study.
        I thank the Committee for the opportunity to present the
    Joint Committee staff recommendations on corporate tax
    shelters, and I would be happy to answer any questions the
    Committee may have at this time and in the future.
        [Attachments are being retained in the Committee files.]

        Mr. Houghton. Mr. Hulshof.
        Mr. Hulshof. Thanks, Mr. Chairman.
        Mr. Talisman, does the Treasury Department endorse Mr.
    Doggett's bill in its current form?
        Mr. Talisman. There are a number of similarities between
    Mr. Doggett's bill and our bill, including codification of the
    economic substance doctrine, increasing disclosure and
    increasing the substantial understatement penalty. We agree
    with that approach. We obviously had a slightly different
    manner of codifying the economic substance doctrine and would
    be happy to work with Mr. Doggett and the rest of the tax
    writing staff as we do in crafting the correct language to
    codify the economic substance.
        Mr. Hulshof. So the answer is yes and no.
        Mr. Talisman. I think it is largely yes.
        Mr. Hulshof. In a letter that the Treasury wrote, I think
    maybe you penned to Mr. Doggett, you indicated that it was the
    Treasury's belief that his bill would not--and I am
    paraphrasing--would not unduly interfere with legitimate
    business transactions. Should we be considering anything that
    interferes at all with legitimate business transactions?
        Mr. Talisman. Well, in order to identify corporate tax
    shelters, the disclosure provisions will be crafted in a way
    that uses particular filters to ensure that the transactions
    are disclosed. Some transactions that will be disclosed will be
    legitimate business transactions. At that point the Service
    will apply the economic substance doctrine in a manner that
    would not, we believe, either unduly or duly affect legitimate
    business transactions because it is merely--again, our approach
    and Mr. Doggett's approach are merely codifications of the
    current economic substance doctrine which already applies.
        Mr. Hulshof. Again, I guess what I think we have to guard
    against, we, all of us, is legislating based on hyperbole or
    legislating based on the bad case. My law school tax professor
    told me that bad cases make bad law. And it is one thing for us
    on this side to rail against $450 bottles of cabernet and
    whether the meal allowance deduction is proper, when, in fact,
    information from the Treasury Department, as Mr. McCrery
    pointed out yesterday, is that the average business meal costs
    $11.61.
        So the other thing I wanted to ask you about is do you
    believe right now that Treasury has insufficient antiabuse
    tools available? And while you are munching on that, let me
    just specifically point out--and I wasn't here in 1995, but
    this Committee talked about and proposed requiring registration
    of corporate tax shelters. That was included in the measure
    that the President eventually vetoed. But finally, I think, in
    the Treasury's green book that accompanied the President's
    fiscal year budget for fiscal year 1997 said that requiring
    registration of corporate tax shelters would be something very
    useful. So as a result of that, this Committee and the House
    and Senate included that. It was signed into law by the
    President on August 5th of 1997.
        So, here's something that Treasury requested, Congress
    acted, in an effort to crack down on these illegitimate
    corporate tax shelters, and yet Treasury has, to my knowledge,
    as yet to issue any guidance necessary to make that those rules
    take effect. Is that the present state of affairs?
        Mr. Talisman. That is correct. However, that legislation
    had as part of the registration requirements three conditions
    for registration, one of which was issuance under conditions of
    confidentiality. It is our understanding that the tax shelter
    promoters are now not relying on conditions of confidentiality
    in large part because of the potential application of those
    rules, and that they are relying more on tacit understandings
    or other agreements to maintain the confidentiality of the
    regs.
        Also, given that we were requesting additional guidance
    with respect to the definition of corporate tax shelter, the
    current definition actually in that legislation is a
    significant purpose of tax avoidance, which is a very broad
    standard and actually has been interpreted by some to include
    all business transactions. We were concerned about, when we
    were looking for a narrower approach, codifying the economic
    substance doctrine to issue guidance that would either have
    been considered too broad or too narrow depending on one's
    view, and that when we were coming to Congress looking for
    additional tools to attack corporate tax shelters, to come out
    with guidance that might set us back.
        Obviously we are looking at--certainly in the context of
    looking at the prospect for legislation. We will review that
    decision in the upcoming months.
        Mr. Hulshof. I would ask the Chairman to indulge me just as
    a final comment, and, Ms. Paull, I didn't have a chance to
    inquire, but you mentioned beefing up the penalty scheme,
    which, again, this Committee did in 1997 in a couple of
    different areas. You mentioned the specific cases by name that
    I think clearly those that are interested, of course, read
    those opinions very carefully in determining how aggressive
    they want to be in marketing these types of shelters. I would
    suggest to you Circular 230, which would be another vehicle
    that Treasury could use to help implement and guide those
    practitioners.
        I mean, we all want to get to the same place. And I guess
    the question that I am asking myself is do we need to go
    further than--and we want to provide you the tools available,
    but the tools we provided, I am not sure they have been
    aggressively used in an effort to crack down. So I appreciate
    your work on this, and, Ms. Paull, yours as well.
        With that, I see my time has expired. I would yield back.
    Thank you.
        Mr. Houghton. Thank you very much.
        Mr. Doggett.
        Mr. Doggett. Thank you, Mr. Chairman.
        Ms. Paull, I am sure that the additional materials you
    submitted will be useful and that I will learn from them. I
    would like to focus on those that you filed back in July, the
    report and your oral comments, because I find a number of areas
    of agreement. First you indicate today that this is not only a
    serious problem, but it is a growing problem as you see it and
    as your staff there on the Committee sees it.
        Ms. Paull. That is correct.
        Mr. Doggett. I believe you indicated in the July 22nd
    report that the--to use your words--that this corporate tax
    shelter phenomenon poses a serious challenge to the efficacy of
    our entire tax system.
        Ms. Paull. That is correct. I believe the Treasury
    Department reiterated that today.
        Mr. Doggett. And given the very serious nature of this
    problem, though you and I may have slightly different ways of
    trying to get at the problem, wouldn't you agree that it would
    be a very serious mistake for this Congress not to address
    legislatively the shelter hustlers?
        Ms. Paull. This Congress? You are not suggesting today,
    right?
        Mr. Doggett. I don't mean tomorrow or Saturday, but during
    the course of this particular Congress, perhaps the second
    session.
        Ms. Paull. I do believe that it is urgent. I also would
    have to acknowledge that it is a very complicated issue, and
    that we hope that this appendix will help you focus on the
    kinds of issues that we and others have identified.
        Mr. Doggett. I sure agree with you on that.
        And as far as the remedies that you have advocated, one of
    them is, I believe, on page 9 of your July 22nd report,
    disclosure obligations. And there are some additional
    disclosures that you think would be appropriate for corporate
    tax shelters. I am not going to go through them line by line,
    but the idea of some additional disclosure, somewhat different
    perhaps than that that I provide in HR 2255, you think would be
    helpful?
        Ms. Paull. I do think disclosure would be helpful, but I
    don't think it is a panacea.
        Mr. Doggett. I concur with you on both.
        Is it your belief that it is possible to have some
    additional disclosure requirements that will neither unduly nor
    duly interfere with the operation of legitimate business?
        Ms. Paull. I do think it would be useful for some
    additional disclosure. I think you have to be realistic about
    the disclosure, though, because certainly if you are going to
    take the approach of your bill or the Treasury approach where
    you have put a cloud over a variety of transactions, and then
    you ask people to come forward and self-confess to those
    transactions, it is a lot more difficult to get that kind of
    disclosure. On the other hand I can see a tremendous benefit if
    we could get some early warning disclosure for aggressive
    transactions somehow. And so there is a tension there between
    the kinds of proposals that you move forward.
        Mr. Doggett. You certainly would disagree with someone who
    would come forward and say it is a myth that we can't have
    reasonable disclosure requirements to deal with this problem?
        Ms. Paull. I think you can have reasonable disclosure
    requirements.
        Mr. Doggett. Then with reference to the penalty provisions,
    although we address it in a slightly different way, you and I
    agree that we need to have heightened penalties.
        Ms. Paull. Correct.
        Mr. Doggett. That is the principal focus of the joint tax
    report, I believe.
        Ms. Paull. That is correct.
        Mr. Doggett. I believe we also--though we deal with it in a
    slightly different way, we also agree that there is a problem
    with the opinion letter, what I call the excuse letter, that
    happens at present, and that, again, you think you can heighten
    the standard for it, but that it is not satisfactory to leave
    the law as it is now with reference to these opinion letters
    that perhaps the same tax hustler that provided the tax shelter
    recommends the law firm that is going to say it is okay.
        Ms. Paull. We feel strongly that the standards for
    preparing opinion letters should be elevated, and let me just
    point out we also feel strongly that with respect to other
    kinds of penalties outside of the corporate tax shelter area,
    that the standards filing tax returns and getting out of
    penalties ought to be elevated as well. And that is also
    covered in our study, but not the subject of this hearing,
    because it is a corporate tax shelter hearing.
        Mr. Doggett. With regard to this tension between trying to
    have enough certainty for a taxpayer to be able to rely and
    comply versus not providing a road map for hustlers to avoid
    the law, you have used in some of your recommendations terms
    that aren't all that different from "substantial" and
    "meaningful" in different contexts, haven't you?
        Ms. Paull. This is the most difficult thing to deal with is
    how you define the corporate tax shelter. For our
    recommendations, we defined it for purposes of determining a
    penalty after you have applied the common law doctrines and you
    found an understatement of tax.
        Mr. Doggett. You are aware that one of our later witnesses
    Mr. Hariton thinks your definitions are more vague than he
    thinks my definitions are vague.
        Ms. Paull. Well, this is one of the most difficult parts of
    this exercise.
        Mr. Doggett. Mr. Chairman, I have got other questions for
    Mr. Talisman, but perhaps after some other witnesses.
        Mr. Houghton. Okay. Thanks very much.
        Mr. Tanner.
        Mr. Tanner. Thank you, Mr. Chairman.
        I would like to follow up. I am sorry I was late, but your
    testimony, I have heard, has been enlightening from the
    standpoint that all of us desire a clear--as clear a standard
    as we can have, both from the practitioner standpoint as well
    as the company as well as our standpoint and, I assume, yours.
        And the, I think, common concern shared by all who approach
    this problem is to what extent this bill or these proposals
    impede unnecessarily on the legitimate pursuit of prudent
    business practices as it relates to the Tax Code as it may be
    written now or in the future.
        Is it your position that--let me back up. I realize, as you
    said, this is a--there is no easy definition, and it is
    probably a moving target as innovations take place, as they
    normally do in the marketplace of ideas, which makes it more--
    all the more complicated. What I guess my question is to what
    extent have you thought about the proposals impacting
    negatively on legitimate transactions when there is this
    acknowledged vagueness as it relates to the standard? Could you
    finish your comment that you were making to Mr. Doggett on
    that, please?
        Ms. Paull. Sure. Well, as I said, it is very difficult to
    define or corporate tax shelter. Mr. Doggett's testimony quoted
    Michael Graetz from Yale, defining it to be a deal done by very
    smart people that, absent tax considerations, would be very
    stupid. Now, that is a nice way to look at it, but you--when
    you are crafting rules of law, you need to have rules of law
    that are susceptible to some interpretation. I think this is
    really where you have a tension. Do you attempt to codify a
    very flexible set of court-made law into the Code? We come down
    against that. Mr. Doggett and the Treasury Department come down
    in favor of it. And I would just have to say Mr. Doggett's
    formulation of those standards is elevated over the common law,
    court-made law.
        Mr. Tanner. So you say the threat----
        Ms. Paull. That is where you get into the legitimate
    business transactions. Transactions that might pass muster
    today under court-made law will have more difficulty passing
    muster under Mr. Doggett's standard, I would just point that
    out. That is one of the principal reasons why our estimate of
    Mr. Doggett's bill is higher than the Treasury proposal. Mr.
    Doggett's bill goes further and also picks up individuals.
    There are another smaller factors as well.
        I hope that is somewhat responsive. If you are going to try
    to codify the common law, then you must rely on things like
    what Mr. Doggett does and the Treasury Department does in terms
    of exemptions from it. You have got to go down that road, and
    that becomes very political. You must develop list of good
    things.
        I do have a series of common business transactions I could
    go over with you to show, they don't pass muster under the
    basic tests under these bills. Then you have to rely on the
    Treasury Department adding to Mr. Doggett's list of good
    transactions, or getting out under this very vague standard of
    ``clearly contemplated by the law.'' What does that mean?
    Because I will tell you, we went back and looked at the low-
    income housing tax credit. That is intended for people to make
    an investment that they would not otherwise make. The tax
    breaks make that an economic investment for the most part. When
    you look at the written legislative history behind that tax
    credit, you can't find that notion in there. So does that mean
    it wasn't clearly contemplated by the law that this tax credit
    is going to make up the difference to make it an economic
    investment? This is really a difficult area that the Committee
    is going to have to grapple with.
        Mr. Tanner. Do you have a comment?
        Mr. Talisman. Yes. I believe, first of all, from our
    standpoint codification of the economic substance doctrine is
    necessary because it ensures the taxpayers are applying the
    right economic substance doctrine at a level that is
    appropriate to these transactions. We obviously would build in
    mechanisms to protect against inappropriate application of the
    doctrine.
        As I talked about, an expedited ruling process, the
    centralization of the IRS review process and coordination at
    the national office would all protect against application to
    transactions that are legitimate ordinary-course-of-business
    transactions. But companies need to be discouraged from
    engaging in engineered transactions that have no relation to
    their core business.
        And so we think that the codification of that doctrine will
    ensure that they will apply it to each transaction before the
    fact rather than after the fact and wait for judge-made law
    many years after the fact to shut down these transactions, and
    that is our concern.
        I also think that it is appropriate to point out that the
    recent cases have used the standard comparison of pretax profit
    to the expected tax benefits, which is the standard we are
    applying. And the ABA has a similar approach in their testimony
    where they say any time the economic substance doctrine would
    apply, you would use effectively the standard, which is the--
    what we think is sort of the articulation of the best of the
    case law.
        Mr. Tanner. Well, I have another, but I see my time has
    expired, Mr. Chairman, and I am very aware of the Chairman's
    appreciation of time. So I will yield back.
        Mr. Houghton. Okay. Thanks very much.
        Mr. Becerra.
        Mr. Becerra. Thank you, Mr. Chairman.
        Ms. Paull, Mr. Talisman, let me ask you a question with
    regard to what Treasury has currently in place. It seems at
    this point the testimony we have heard speaks to the issue of
    tax shelters and the need to perhaps increase penalties. There
    seems to be full agreement on that. There seems to be
    disagreement on how far you need to go beyond beefing up
    penalties and the like.
        Let me ask you about your particular shop within Treasury.
    To what degree could this whole issue--and if you want to
    define it as a problem--this whole issue or problem be
    addressed simply through more aggressive enforcement by IRS of
    these concerns with tax shelters?
        Mr. Talisman. Well, again, I think aggressive enforcement
    is certainly an appropriate response to these shelter
    activities. I don't think it is a panacea to the problem. We
    have already, as we have discussed, one case recently in the
    Tax Court and cases elsewhere applying the economic substance
    doctrine to cases. However those cases occurred in the 1990s,
    early 1990s, and promoters and participants have moved on to
    other transactions which arguably do not meet the facts of the
    cases to which the taxpayers lost previously.
        We also have aggressively sought legislation to shut down
    shelters of which we are aware and also, when appropriate, used
    our authority to address specific shelters either by ruling or
    regulation. Recently we issued a regulation dealing with the
    so-called Chutzpah Trust, son of Accelerated Charitable
    Remainder Trust. In 1997, Congress passed legislation shutting
    down accelerated--abuse of uses of accelerated charitable
    remainder trusts, and so this was a similar device. So it shows
    that taxpayers are willing to move on to the next product
    whenever they can.
        Mr. Becerra. If you were to try to enhance your enforcement
    activity or accelerate it, would one of the net results be you
    would end up being more intrusive, you would have to engage in
    more intrusive behavior to try to ferret out any abusive
    activity in tax shelter activities that occur?
        Mr. Talisman. I believe that identification, up front
    identification of these transactions is important, and
    certainly something that I believe all the parties, certainly
    the joint Committee, Mr. Doggett, and us have all proposed. We
    hope that will help limit the intrusion. And frankly, one of
    the reasons we came forward--and we actually have modified our
    original proposal to provide objective filters, more objective
    filters based on the characteristics of corporate tax shelters
    that we have identified to try and limit the intrusiveness, to
    focus on those transaction most likely to be tax-engineered
    abusive transactions.
        Mr. Becerra. Ms. Paull, if we were to not take any action
    in the near term and rely only on what we have in place, if we
    were to try to have greater success in trying to diminish the
    use of these shelters, would it not lead us to having to go
    towards more aggressive enforcement and, based on what Mr.
    Talisman has said, probably more intrusive behavior in trying
    to reduce the amount of tax shelter abuse that might occur?
        Ms. Paull. Well, certainly one would hope the IRS would be
    prioritizing the corporate tax shelter items at this point in
    time after all that has been said before Congress this year. So
    that is number one. I mean, clearly enforcement is an issue,
    and the IRS ought to be going after these transactions. I think
    you will be faced, no matter what you do here, with
    transactions in the future that you will review and have to
    legislate on, just like you have done in the past. I don't
    think that whatever you do here will avoid that kind of thing.
        Mr. Becerra. But short of providing yourself with
    additional tools to try to go at this problem, you probably
    have to be more aggressive with the tools you have in place.
        Ms. Paull. As I said in my testimony, we really think the
    penalty regime is flawed and should be beefed up considerably.
    We think disclosure would be helpful, but we ought to be
    realistic about what you can get in a disclosure regime.
        Mr. Becerra. Thank you.
        Thank you, Mr. Chairman.
        Chairman Archer. Mr. Talisman, before we release you, as it
    were, today, and Mrs. Paull also, I hope this question has not
    been asked. If it has, you can briefly respond. Are you
    satisfied that you and the IRS are aggressively implementing
    all of the powers that the Congress has already given you in
    this field?
        Mr. Talisman. Mr. Chairman, we are certainly working with
    the IRS to aggressively pursue this issue with all available
    opportunities. I previously spoke to the issue of the 6111
    registration requirements, which may be the basis for your
    question. We were concerned about issuing those regulations at
    a time when we were seeking additional powers, given the broad
    standard that was present in those regulations, a significant
    purpose of tax avoidance. We also understand from the
    marketplace that one of the requirements for application of
    those registration requirements, conditions of confidentiality,
    is basically now not a condition of these corporate tax
    shelters; therefore, we do not expect by issuing the regulation
    that we would get very many registrations. And so we wanted to
    wait and see what the Congress--and listen to the testimony and
    the comments based on the White Paper to make sure that we were
    properly structuring any response in this area.
        Chairman Archer. Well, the Congress has given you fairly
    broad powers to get at this problem. If you feel that there is
    still a big problem, why would you not take advantage of all of
    these powers so that we could get the benefit of what the
    results might be before we contemplate doing something else?
        Mr. Talisman. I believe the Treasury Department has been
    very aggressive in pursuing the corporate tax shelters of which
    we are aware. And we have exercised our anti-abuse authority in
    appropriate circumstances to the extent it is applicable. For
    example, we just exercised our anti abuse authority under
    section 643 dealing with the son of Accelerated Charitable
    Remainder Trust, or so-called Chutzpah Trust. Commissioner
    Rossotti has just announced an initiative to go and pursue,
    again aggressively, corporate tax shelters of which we are
    aware. The IRS has won a series of cases recently that
    demonstrate that they were aggressively pursuing corporate tax
    shelters that arose on audit, but most of those cases arose in
    the early 1990s. So the effect of those cases, those
    transactions, are largely--have largely vanished from the
    marketplace, and we are onto new and different tax shelters.
        So our problem is we are always playing a game of catch up.
    While we can use our anti-abuse authority and our specific
    authority to address particular shelters as they come--as we
    become aware, the problem is that we are not aware of all the
    shelters, and what we need to do is change the dynamics so that
    taxpayers apply an appropriate cost-benefit analysis and don't
    engage in artificial tax-engineered transactions before the
    fact rather than after the fact.
        Chairman Archer. Ms. Paull, do you agree with that? Does
    the joint Committee analysis show that the Treasury is
    effectively and aggressively using all of the powers which have
    already been granted to them by the Congress?
        Ms. Paull. Well, I would have to say that we have done a
    survey, in essence, through conversations with the IRS and the
    Treasury Department on what they are doing. I think that, like
    anything, you can do more. I think enforcement ought to be a
    high priority within the Service. And as far as we know, that
    is what the Commissioner has committed to recently.
        Chairman Archer. But that commitment--I don't want to read
    between the lines, and I want to get this direct. If I read
    between the lines, I would infer from what you said that that
    has not yet been fully implemented to where we can see the
    effectiveness of it and make a judgment. The commitment may be
    there, but has the actual implementation to fulfill that
    commitment occurred so that we have empirical data to make a
    judgment on how effective it is?
        Ms. Paull. Right. We have been inquiring within the IRS,
    and we along with the Treasury Department hope that we are
    going to get more data from them on what enforcement activities
    they have been undergoing. My testimony includes some data
    relating to specific cases the IRS recently won. We have
    preliminary data on that, and we know there are some other big
    transactions in the pipeline.
        I think that this is just the kind of thing that there is
    always going to be a time lag in trying to evaluate how
    effective the enforcement is. But I would agree with Mr.
    Talisman that the current law on corporate tax shelters, both
    registration requirements and the penalty regime, is not
    effective and needs to be worked on.
        Chairman Archer. Okay. But the penalties are independent of
    whether or not there is an abuse. Those are what would be
    levied in the event that there is an abuse found. They do not
    set the criteria for the abuse.
        Ms. Paull. That is correct. But you do have to come up with
    some sort of definition of an abusive transaction that would be
    hit, if you wanted to elevate and strengthen the penalty.
        Chairman Archer. That leads me to another question for Mr.
    Talisman which relates to the inquiry that he made of Mr.
    Doggett. I am concerned about shifting the burden of proof onto
    the taxpayers because we are trying to work away from that in
    tax reform. And where it says in the bill that every deduction
    or loss or credit under the tax law will be denied unless the
    taxpayer can prove that it meets whatever the tests are, which
    I think may be a little vaguer than what we ought to be having
    in the law, that is my own personal opinion, but to just speak
    to what is in the bill denies every deduction loss or credit
    under the tax law unless the taxpayer can prove that it meets
    the tests under the bill.
        Does the Treasury think in today's time when we are trying
    to shift the burden back to the government that that is an
    appropriate way to address this problem?
        Mr. Talisman. Mr. Chairman, in our legislation what we did
    was codify what we believe is the best of the economic
    substance doctrine. And in response to comments we got with
    respect to our original proposals where we said that the
    Secretary has authority to deny benefits based on an
    application of the economic substance doctrine, people were
    concerned that that would give undue discretion to the
    Secretary's determination. So when we issued the White Paper,
    we actually removed the Secretary having authority to deny and
    made it a level playing field in that with the taxpayer it
    would be a court review of whether the pretax benefits were
    significant relative to the tax benefits and the pretax profits
    are insignificant relative to the tax benefits, and that we
    believe that that would put an even balance certainly with
    respect to our application.
        Chairman Archer. So let me be sure I understand your
    answer. Your answer, as I understand it, is that it would not
    be wise to adopt the terminology in this bill that a taxpayer
    could only get a deduction loss or credit if they proved that
    they had met certain tests; is that a fair analysis of your
    statement, that you do not agree with that approach that is in
    this bill?
        Mr. Talisman. I believe that we have to put in place
    appropriate protections for legitimate business transactions,
    and one aspect of that would be looking at the burden of proof
    issue.
        Chairman Archer. Okay. So does that mean that you do not
    agree with the approach that is in this bill?
        Mr. Talisman. As I have commented before, I think we agree
    largely with the approach in Mr. Doggett's bill.
        Chairman Archer. This particular aspect of the bill. I
    can't accept your answer other than to also say you are not
    categorically in support of this approach, you have a different
    approach; therefore ,you do not support the approach that is in
    this bill. Why is it to so difficult to say that?
        Mr. Talisman. I believe that I am comfortable with our
    approach.
        Chairman Archer. You do not support the approach that is in
    this bill. You believe there is another approach that would be
    better?
        Mr. Talisman. Which is our approach, yes, sir.
        Chairman Archer. So you do not support the approach that is
    in this bill. Thank you.
        Mr. Doggett. Mr. Chairman.
        Chairman Archer. Mr. Doggett.
        Mr. Doggett. I have not yet inquired of Mr. Talisman, if I
    could pick up where you left off.
        Chairman Archer. You are recognized to inquire.
        Mr. Doggett. Thank you.
        With reference to the burden of proof and the provisions of
    HR 2255, which I know you and your staff have looked at, is it
    your understanding that this bill doesn't establish a burden of
    proof independent of however the burden of proof applies in
    other IRS cases?
        Mr. Talisman. I believe that is correct.
        Mr. Doggett. And that the criticism that the Joint Tax
    Committee had that has been now twisted and directed not by the
    Chairman, but by a lobby group against my bill, was with
    reference to the so-called super 269 provision that was going
    to allow an administrative determination, which did raise a
    burden of proof problem?
        Mr. Talisman. That is also correct.
        Mr. Doggett. And with reference to the letter that you sent
    to me, my colleague Mr. Hulshof dealt with this earlier, but I
    want to focus attention on it because it bothered me also. You
    indicated in the letter that because my bill and your earlier
    recommendation was targeted toward transactions with little or
    no economic substance, that it did not unduly interfere with
    legitimate business transactions. My objective is not to either
    duly or unduly interfere with legitimate business transactions,
    and I wonder if you might amplify on that sentence.
        Mr. Talisman. It may have been a poor choice of words in my
    letter, but what we were trying to articulate was that our and
    your disclosure provisions might require legitimate
    transactions to be disclosed. However, because what we are both
    doing is codifying the existing economic substance doctrine, we
    don't believe that that aspect of the provision, of either
    provision, would interfere with legitimate business
    transactions.
        Mr. Doggett. Is it your belief that simply changing or
    heightening the penalty alone as recommended by Joint Tax will
    not be sufficient to resolve this problem and keep tax hustlers
    from doing what they have been doing and are doing today?
        Mr. Talisman. I do not believe so. And, in fact, I think,
    as the joint Committee has stated, the penalties are a very
    critical element of this. But there are two reasons why under
    current law the penalties are not being applied. One is the
    reasonable cause exception, which the joint Committee and
    others have suggested be made stronger. The second reason is
    you have to first have a substantial understatement to be
    subject to the penalty, and if you are not applying the
    economic substance doctrine up front, you may not believe you
    have a substantial understatement and therefore may not believe
    you are subject to penalty.
        Mr. Doggett. Is it also your belief that with reference to
    the administrative authority that you currently have, that
    whether you are talking about that which you have already
    utilized, as you have described it today, or that which you
    have not yet utilized because of one reason or another, that
    the existing administrative authority is not sufficiently broad
    to resolve promptly this problem of abusive corporate tax
    shelters?
        Mr. Talisman. We would not be before the Committee today if
    we did not believe that.
        Mr. Doggett. Lastly I have used terms in my testimony here
    and on other occasions such as tax cheat, hustler, sleazy, back
    door, black box, underhanded. What I want to ask you is in your
    experience at the Department, have you seen transactions that
    you think that those words are fairly applied to with reference
    to abusive corporate tax shelters?
        Mr. Talisman. I believe there are artificial abusive tax-
    engineered transactions that we see at our Department.
        Mr. Doggett. Thank you very much.
        Thank you, Mr. Chairman.
        Chairman Archer. Are there any other questions for this
    panel? If not, thank you very much.
        Our next panel is Mr. Paul Sax, who is the chairman of the
    Section of Taxation, American Bar Association; David Lifson,
    American Institute of Certified Public Accountants; Charles
    Shewbridge, chief tax executive for BellSouth; and Harold
    Handler, chair of the New York State Bar Association. If you
    gentlemen would come to the witness table we will be prepared
    to receive your testimony.
        Welcome. Mr. Sax, would you lead off? And if each of you at
    the beginning of your testimony would identify yourselves and
    whom you represent for the record, you may proceed.
        Chairman Archer. Mr. Sax.

    STATEMENT OF PAUL J. SAX, CHAIR, SECTION OF TAXATION, AMERICAN
     BAR ASSOCIATION, AND PARTNER, ORRICK, HERRINGTON & SUTCLIFFE,
                       SAN FRANCISCO, CALIFORNIA

        Mr. Sax. Good morning, Mr. Chairman.
        Chairman Archer. As usual, without objection, your entire
    written statement will be inserted in the record, and we would
    encourage you to summarize in your verbal statement.
        Mr. Sax. Thank you, Mr. Chairman.
        Good morning, Mr. Chairman and members of the Committee. My
    name is Paul Sax. I am a partner in the law firm of Orrick,
    Harrington and Sutcliffe in San Francisco and currently serve
    as chair of the Section of Taxation of the American Bar
    Association. Thank you for the opportunity to testify today.
    Last spring my predecessor Stefan Tucker presented testimony
    before this Committee's Subcommittee on Oversight and the
    Senate Finance Committee on corporate tax shelters. My
    testimony today is consistent. Our message is the same. The Tax
    Section views itself as counsel to the tax system, and this
    generation of corporate tax shelters seriously threatens that
    system.
        Certainly revenue loss is a major issue, but perhaps more
    important is the potential for lost confidence in the tax
    system. We believe that if you do not act now, when the
    taxpaying citizenry learns what large corporations were allowed
    to do, it will be portrayed as a corporate raid on the
    Treasury, and that will have a seriously detrimental effect on
    the willingness of individuals to pay their taxes.
        The reason this large corporate shelter activity is so
    threatening is that the promoters are selling a new product.
    That product is well-calculated defiance of the tax collector.
    The promoters explain that the chance of audit detection and
    successful challenge is minuscule; the penalties are small and
    usually avoidable. The resulting arithmetic of the odds
    favoring a multimillion-dollar tax saving is simply compelling.
    Whether the deal would withstand scrutiny is not relevant.
    Recent judicial decisions do not materially change these odds.
    The game has become catch me if you can.
        Why have we heard so little about this? A veil of what-is-
    the-problem nonchalance is a very sophisticated defense. The
    press are frustrated by claims of confidentiality. This
    activity is too new to be seen in tax return data. The fall-off
    in corporate tax revenue quite possibly could have any number
    of explanations, and the usual defenders of the tax system, the
    big five and some large law firms, are among the principal
    promoters. This year end season is worth millions, even
    billions, to them.
        Lawyers have been a part of that problem. We have now
    addressed that. Less than 2 weeks ago we proposed regulations
    under Circular 230 that would outlaw the practice of giving
    penalty protection tax opinions based on hypothetical or false
    facts. A copy of that submission is attached to our testimony.
    We submit to you today our legislative proposal. The key to our
    proposal is disclosure.
        Large tax shelters, we use 10 million, must disclose the
    facts and the basis for their tax saving. Failure to disclose
    would be backed by a new penalty based solely on failure to
    disclose. Because the only consequence to legitimate
    transactions would be disclosure, the effect to legitimate
    business would be minimal. After all, there is no right to hide
    facts from the tax collector. A key provision would elevate the
    visibility within the company, requiring the chief financial
    officer to attest to the facts. This would preclude the
    practice of circumventing the tax director who signs the tax
    return. The existing understatement penalty would be extended
    to the aider and abettor circle, the promoters, tax and
    different parties and the tax professionals. Last, the economic
    substance test now applied by the courts would be codified so
    that promoters could not contrive ambiguity in the sales
    effort. Nontax benefits would have to be substantial relative
    to tax benefits.
        Mr. Chairman, if you do this, we believe the current threat
    to the tax system will be averted. If you do not, we fear the
    reaction of individual taxpayers when they later learn what was
    allowed to happen.
        Thank you again. That concludes my remarks. As counsel to
    the tax system, we would be pleased to help. Do not hesitate to
    call upon us. I would be pleased to respond to your questions.
        Chairman Archer. Thank you, Mr. Sax.
        [The prepared statement and attachment follow:]

    Statement of Paul J. Sax, Chair, Section of Taxation, American Bar
    Association and Partner, Orrick, Herrington, Sutcliffe, San Francisco,
    California

        My name is Paul J. Sax. I appear before you today in my
    capacity as Chair of the American Bar Association Section of
    Taxation. This testimony is presented on behalf of the Section
    of Taxation. It has not been approved by the House of Delegates
    or the Board of Governors of the American Bar Association and,
    accordingly, should not be construed as representing the policy
    of the Association.
        The Section of Taxation appreciates the opportunity to
    appear before the Committee today to discuss the very important
    subject of corporate tax shelters.\1\ Our testimony will use
    the term ``corporate tax shelters'' in discussing the very
    aggressive tax transactions currently being marketed.\2\
    However, the Committee should understand that this phenomenon
    is not limited to large, multinational corporate taxpayers;
    indeed, it is not limited to corporations. Increasingly, tax
    shelter products are also being marketed to unincorporated
    business taxpayers, including middle market businesses, and
    wealthy individuals.
    ---------------------------------------------------------------------------
        \1\ The Section of Taxation has testified regarding corporate tax
    shelters on two prior occasions this year. On March 10, 1999, the
    Section testified before the Subcommittee on Oversight, and on April
    27, 1999, the Section testified before the Senate Finance Committee.
    Our testimony today is consistent with this prior testimony.
        \2\ We also refer to these shelters as ``transactions,'' although
    recognizing that the taxpayer's investment in a financial or other tax
    shelter product, or other taxpayer action, may not fit the traditional
    description of a transaction. We believe all such actions need to be
    addressed by any legislation.
    ---------------------------------------------------------------------------
        My testimony today contains three parts: (1) a brief
    reference to Circular 230, (2) a description of the Tax
    Section's corporate tax shelter legislative recommendations,
    and (3) an amplification of certain aspects of our legislative
    recommendations. But first, I want to say something about the
    corporate tax shelter problem.

    The Corporate Tax Shelter Problem

        We are aware that you may be told that there is no
    corporate tax shelter problem and that Congress does not need
    to take any action. Mr. Chairman, make no mistake about it.
    There is a serious problem, and it needs to be dealt with if we
    are to maintain any semblance of public confidence in the tax
    system. In the 1970's and early 1980's, when individual tax
    shelters were in vogue, the vast majority of American people
    justifiably became outraged when they learned through the press
    that certain high-income taxpayers were eliminating or
    substantially reducing their tax liabilities by means of
    uneconomic and frequently artificial transactions.
        Today, transactions that have little or no economic
    substance, that are designed solely to defer or permanently
    eliminate tax liability, and that are premised on opinions that
    recite very questionable facts are being marketed to businesses
    of all sizes and to wealthy individuals. These transactions are
    not based on Congressionally mandated tax incentives, such as
    the low-income housing credit, but instead apply aggressive
    interpretations of the law in situations where the transactions
    would be dismissed out of hand by the taxpayers if it were not
    for the tax avoidance benefits of the transactions.
        We are not in a position to estimate the impact on Federal
    revenues of the corporate tax shelter activity of the past
    several years. However, our experience as tax practitioners
    suggests that the level of tax shelter activity is very
    substantial. Many of the shelter transactions involve purported
    tax savings of tens of millions of dollars. As these
    transactions spread in the economy to smaller businesses and
    individual taxpayers, the level of activity will continue to
    grow. Should Congress fail to take appropriate legislative
    action, taxpayers and their advisors will be emboldened and
    become even more aggressive. At some point, after the
    inevitable publicity, the American people may justifiably ask
    their elected representatives why action was not taken to stop
    this tax avoidance activity when the abuses were brought to the
    Congress' attention.

    Circular 230

        I would like to refer to what I believe is a very important
    recent action by the Tax Section in proposing amendments to
    Circular 230, the rules promulgated by the Treasury Department
    that seek to regulate the conduct of practitioners who
    represent taxpayers before the Internal Revenue Service. Less
    than two weeks ago, on October 29, the Tax Section transmitted
    to the Treasury Department and the Internal Revenue Service
    proposed amendments to Circular 230 intended to impose a higher
    standard of conduct on lawyers and other practitioners who
    render certain opinions in connection with corporate tax
    shelters. Copies of our recommendations were sent to you, Mr.
    Chairman, to Mr. Rangel, and to the appropriate tax staffs, and
    a copy of our recommendations is attached to this statement.
        Our recent action, recommending amendments to Circular 230,
    reflects a long-standing view of the Tax Section that the
    professions, including the legal profession, must do what they
    reasonably can to assure appropriate conduct of their members.
    We are confident that if the Treasury Department adopts our
    recommended changes to Circular 230, we will see a higher
    standard of conduct by all tax practitioners who render
    corporate tax shelter opinions affected by the recommended
    amendments.

    Legislative Recommendations

        Although we consider the revision of Circular 230 to be an
    important step in addressing the corporate tax shelter problem,
    it is not the only step. In addition, the Internal Revenue
    Service must audit these transactions and make clear to
    taxpayers, tax practitioners, and marketing organizations that
    it is prepared to assert both civil and criminal penalties
    where appropriate. We are pleased that Deputy Treasury
    Secretary Eizenstat and Commissioner Rossotti recently have
    stated publicly their concern with corporate tax shelters and
    their intention to take appropriate actions to curb this
    potentially harmful activity.
        But, Mr. Chairman, there is a limit on what the Internal
    Revenue Service can do. Under the best of circumstances, it
    cannot detect all questionable transactions, it cannot devote
    audit resources to challenge all transactions it does detect,
    and it cannot litigate all of the cases that should be
    litigated. If the marketing of aggressive tax shelter
    transactions is to be constrained, it is vitally important to
    put added pressure on the marketing process.
        The marketing of these transactions is predicated on the
    odds favoring success. Promoters understand that the IRS is
    unlikely to detect and challenge more than a small fraction of
    transactions. They also view applicable penalties as relatively
    minor and usually avoidable. They put these factors together to
    make a compelling case that the transaction makes economic
    sense, even though the transaction would not withstand judicial
    scrutiny. Corporate tax managers often believe that they have
    nothing to lose by entering into an aggressive tax shelter.
    Even if the claimed benefits are disallowed, they believe that
    they will be able to settle out the penalties and will be no
    worse off than they would have been if they had not entered
    into the transaction.
        Our legislative recommendations are intended to accomplish
    four objectives. First, to encourage the private sector--
    taxpayers, tax advisors, and those who market corporate tax
    shelters--to carefully scrutinize the facts and the legal
    analysis of proposed transactions and consider carefully the
    appropriateness of the transactions under the law. Second, to
    level the audit playing field by assuring that the largest and
    most aggressive of these transactions are disclosed to the
    Internal Revenue Service on the tax return. Third, to make it
    clear to the Internal Revenue Service that Congress places
    emphasis on the audit of and challenge to questionable
    transactions. Fourth, to legislatively endorse a reasonable
    interpretation of the economic substance doctrine--an
    interpretation that we believe constitutes present law. We
    think these four objectives may be furthered by the following
    legislative actions.

            1. Require specific, clear reporting for a ``large tax
            shelter.''

        We recommend the enactment of a new Section 6115 of the
    Internal Revenue Code that would require the following tax
    return disclosure for a ``large tax shelter,'' as defined.

            a) A detailed description of the facts, assumptions of facts
            and factual conclusions (including conclusions regarding the
            business or economic purposes or objectives of the transaction)
            that are relied upon to support the manner in which the
            transaction is reported on the tax return;
            b) A description of the due diligence performed to ascertain
            the accuracy of such facts, assumptions and factual
            conclusions;
            c) A statement signed under penalties of perjury by the
            taxpayer's chief financial officer or comparable senior
            corporate officer with a detailed knowledge of the business or
            economic purposes or objectives of the transaction that the
            facts are true and correct as of the date the return is filed,
            to the best of such person's knowledge and belief. If the
            actual facts varied materially from the facts, assumptions or
            factual conclusions relied upon, the statement would need to
            describe such variances;
            d) Copies of any written material provided in connection with
            the offer of the tax shelter to the taxpayer by a third party;
            e) A full description of any express or implied agreement or
            arrangement with any advisor, or with any offeror, that the fee
            payable to such person would be contingent or subject to
            possible reimbursement if the anticipated tax benefits are not
            obtained; and
            f) A full description of any express or implied warranty from
            any person with respect to the anticipated tax results from the
            tax shelter.

        In the event a taxpayer fails to satisfy the Section 6115
    disclosure requirements for a ``large tax shelter,'' a new
    Section 6716 would impose a $50,000 penalty. If the
    nondisclosure were determined to be willful, criminal penalties
    also would apply. The penalty should be a no-fault penalty
    relating solely to the failure to disclose information on the
    tax return. Neither the amount of the new Section 6716 penalty
    nor its applicability should be dependent on whether or not the
    transaction in issue results in a tax deficiency. Moreover, the
    nondisclosure penalty would be totally unrelated to any penalty
    to which the taxpayer might be subject under Section 6662.
        We believe the proposed Section 6716 penalty should be
    subject to a reasonable cause exception permitting abatement of
    the penalty if the taxpayer establishes that it exercised due
    diligence in attempting to accurately report the relevant
    information (e.g., that it had appropriate fact-gathering
    procedures in place and that it did its best to follow them).

        2. Broaden the substantial understatement penalty to cover
    outside advisors, promoters and ``tax indifferent parties.''

        In any situation in which the substantial understatement
    penalty of existing law is imposed on the taxpayer, a penalty
    also should be imposed on any outside advisors who rendered
    favorable tax advice or opinions used in the promotion of the
    tax shelter, and promoters who actively participated in the
    sale, planning or implementation of the tax shelter. The same
    type of penalty should also be imposed on any ``tax indifferent
    party,'' unless any such party can establish that it had no
    reason to believe the transaction was a tax shelter with
    respect to the taxpayer. The penalty should not be imposed on
    advisers who rendered opinions that comply with our proposed
    Circular 230 amendments.
        Such penalties should be set at levels commensurate with
    the fees or benefits such parties stood to realize if the
    transaction were successful. In addition, separate procedural
    rules should be provided to assure such parties of due process,
    similar to the rules applicable in the case of penalties on tax
    return preparers.

        3. Define ``large tax shelter'' for purposes of proposed
    disclosure requirement.

        The definition of ``tax shelter'' presently contained in
    section 6662(d)(2)(C)(iii) should be retained. The term ``large
    tax shelter'' would be defined as any tax shelter involving
    more than $10 million of tax benefits in which the potential
    business or economic benefit is immaterial or insignificant in
    relation to the tax benefit that might result to the taxpayer
    from entering into the transaction. In addition, if any element
    of a tax shelter that could be implemented separately would
    itself be a ``large tax shelter'' if it were implemented as a
    stand-alone event, the entire transaction would constitute a
    ``large tax shelter.''

        4. Clarify that, where the economic substance doctrine
    applies, the non-tax considerations must be substantial in
    relation to the potential tax benefits.

        Most courts, as well as careful tax advisors, apply the
    economic substance doctrine by weighing the potential tax and
    non-tax results of a contemplated transaction. We think this is
    entirely consistent with long-standing congressional intent.
    Codification of this rule would provide a clear statement of
    the standard generally applied by courts under the economic
    substance doctrine, and would prevent reliance on unclear or
    conflicting judicial articulations of that standard in
    rendering opinions on tax-driven transactions. Any such
    codification would not, however, displace current law where the
    business purpose test is currently applied without a weighing
    of the tax and business objectives, such as the business
    purpose rules applied in the context of section 355 and in most
    tax-free corporate acquisitions.

        5. Articulate a clear Congressional policy that existing
    enforcement tools should be utilized to stop the proliferation
    of large tax shelters.

        Congress should make clear its view that examination of
    large tax shelter transactions by the Internal Revenue Service
    should be considered a tax administration priority. This should
    include the application of both civil and criminal penalties
    when appropriate.

    Amplification of Certain Legislative Recommendations

                         Return Disclosure Requirement

    a) Rationale.

        We seek to achieve two objectives in proposing enactment of
    a ``large tax shelter'' return disclosure requirement. The
    first objective is to reduce the incentive to engage in
    transactions that would not withstand scrutiny on the ground
    that the likelihood of detection is small. Many tax shelter
    products and transactions are comprised of purportedly separate
    transactions or steps, often intended to obscure the overall
    transaction and frequently involving steps both within and
    outside the United States. As such, these transactions are
    extremely complex and often impossible to detect through
    information contained in a tax return, even by an experienced
    revenue agent. We believe Congress should mandate specific tax
    return disclosure obligations that will lessen the significant
    role that the likelihood of escaping detection currently plays
    in the corporate tax shelter equation. On the assumption that a
    return disclosure system is designed to be compliance friendly,
    as we believe it can, the argument that legitimate transactions
    may be affected should be considered with a healthy dose of
    skepticism. Whether legitimate in the eyes of the taxpayer or
    not, we would ask what is inappropriate about fair disclosure
    in a tax return context, even if the transaction is legitimate?
        The second objective of the proposed return disclosure
    requirement is to encourage taxpayers and their advisors to pay
    careful attention to the actual facts underlying the proposed
    transaction prior to its consummation. We remain concerned, as
    we have previously testified, that often the facts assumed in
    analyzing the tax shelter are not the facts that actually
    occur. We believe the return disclosure requirement will
    underscore the importance of the actual facts of the
    transaction and encourage the taxpayer and its advisors to more
    carefully scrutinize the transaction in advance.

    b) Certification by the chief financial or other senior
    officer.

        We believe the proposed chief financial officer
    certification is an extremely important component of the return
    disclosure requirement for two reasons. First, the chief
    financial officer, because of his or her position in the
    company, can be certain that the business people within the
    organization who likely were involved in implementing the
    transaction, and, thus, who likely are most familiar with the
    actual facts, will be involved in preparation of the
    certification.\3\ It will be in the direct interest of the
    chief financial officer to assure such involvement, and there
    will be much less risk that the taxpayer's return preparation
    personnel are isolated from the actual facts.
    ---------------------------------------------------------------------------
        \3\ Some businesses that will be subject to the reporting
    requirement may not have an employee denominated as the chief financial
    officer. Moreover, if the business is unincorporated, it may have no
    officers at all. Thus, it will be important for the legislation, or the
    legislative history, to make it clear that in such circumstances the
    certification must be executed by the person with responsibilities
    comparable to those of a chief financial officer.
    ---------------------------------------------------------------------------
        Second, because these transactions by definition are large
    (we suggest a $10 million reporting threshold) and because they
    are very aggressive, we think it is appropriate to encourage
    the taxpayer's senior management to personally consider the
    proposed transaction. If the chief financial officer knows that
    he or she will be required to execute the certification, we
    expect the officer will be much more interested in being
    personally advised of the transaction and of its risks before
    it is consummated.
        Because of the potentially serious civil and criminal
    penalties that could result to a corporate officer who commits
    perjury by executing an inaccurate certificate, the legislation
    should provide appropriate separate administrative and judicial
    procedures that will accord the officer full due process. To
    this end, procedures should be established for reviewing
    officer certification issues that are independent of the audit
    process.
        Mr. Chairman, the Tax Section attaches particular
    importance to the proposed large tax shelter return disclosure
    requirement because we believe it has the potential to
    accomplish two important objectives: (1) reduce the incentive
    to hide the ball from the IRS and (2) encourage a more careful
    factual and legal analysis of the transaction on the front end,
    before the transaction is consummated. If the disclosure
    requirement has this effect in even a fraction of the corporate
    tax shelter schemes currently on the market, it will make a
    significant contribution to tax administration and the American
    people's confidence in the tax system.

                   Affirmation of Economic Substance Standard

        We are aware that certain advisors take the position that
    any amount, even a de minimis amount, of risk, profit or other
    economic return is sufficient to satisfy the judicial economic
    substance doctrine. While we believe this view does not reflect
    present law, it is important to foreclose such assertions. It
    is for this reason that we make the relatively modest
    suggestion that Congress legislatively affirm that when a court
    determines the economic substance doctrine applies, the
    taxpayer must establish that the non-tax considerations in the
    transaction were substantial in relation to the potential tax
    benefits.
        Our recommendation does not require the Congress to adopt a
    definition of economic substance or specify the particular
    circumstances in which the doctrine is relevant. We think both
    of these matters are best left to the courts where judicial
    discretion can be applied on a case-by-case basis. However, we
    think it is appropriate and important for the Congress to
    affirm what we believe to be current law, namely, that the non-
    tax considerations in the transaction must be substantial in
    relation to the potential tax benefits. It would also be
    helpful if Congress would make it clear that in evaluating the
    non-tax aspects of a transaction, such as potential economic
    profit, all of the costs associated with the transaction,
    including fees paid to promoters and advisors, should be taken
    into account.

                                   Conclusion

        One of the arguments that we expect the Committee will
    continue to hear from opponents of corporate tax shelter
    legislation is that the Internal Revenue Service already has
    the tools to deal with corporate tax shelters on its own,
    without legislation. For example, the Committee may be told
    that recent court decisions in the Commissioner's favor prove
    this point. We urge the Committee not to fall for this
    assertion. In spite of these recent decisions, we have observed
    no slowdown in the sales of tax shelter products; indeed, as we
    have indicated, we see a broadening of the market to smaller
    businesses and wealthy individuals. In addition, it is
    impossible to expect the Internal Revenue Service, even under
    the best of circumstances, to audit, let alone litigate, all of
    these transactions. Ours is a self-assessment system. It works
    best when taxpayers are motivated to take their return
    reporting obligations seriously. We think the only reasonable
    way to meaningfully impact the current corporate tax shelter
    phenomenon is to seek to modify the behavior of taxpayers,
    their tax advisors and those involved in the marketing of tax
    shelters through an improved self-policing system. Changes to
    Circular 230 will help. Increased audit activity by the
    Internal Revenue Service is very important. But, Congress also
    has a responsibility. We urge the Committee to take the lead by
    adopting legislation along the lines we recommend. As you
    proceed in your deliberations, please know that members of the
    Tax Section are prepared to lend a helping hand.
        Mr. Chairman, thank you for the opportunity to appear
    before the Committee today. I will be pleased to respond to any
    questions.

    Section of Taxation Report to Amend 31 C.F.R. Part 10, Treasury
    Department Circular 230, to Deal With ``More Likely Than Not'' Opinions
    Relating to Tax Shelter Items of Corporations

        This Report with proposed amendments to Circular 230 has
    not been approved by the House of Delegates or the Board of
    Governors of the American Bar Association and, accordingly,
    should not be construed as representing the position of the
    Association.

                                     Report

        Treasury Department Circular 230, set forth at 31 C.F.R.
    part 10, provides rules for persons who practice before the
    Internal Revenue Service. Section 10.33 of Circular 230 deals
    with tax shelter opinions that are designed to be included or
    described in tax shelter offering materials that are publicly
    distributed. The rules in section 10.33 do not apply
    specifically to practitioners who provide ``more likely than
    not'' opinions to corporate taxpayers directly for possible use
    as legal justification in the event of an accuracy-related
    penalty assertion with respect to a ``tax shelter item'' as
    that term is defined in Treas. Reg. Sec. 1.6662-4(g)(3). We
    recommend the addition of a new section 10.35 to fill this gap.
    The text of the proposed amendment to Circular 230 is attached.
        New section 10.35 would provide minimum standards for
    practitioners who are asked to furnish their corporate clients
    with ``more likely than not'' opinions under section 6664(c)
    and Treas. Reg. Sec. 1.6664-4(e) for the purpose of
    establishing the reasonable cause and good faith defense to an
    accuracy-related penalty by providing legal justification for
    the tax treatment of a tax shelter item. Because the possible
    application of section 6664 necessarily arises in audit
    proceedings before the IRS, Circular 230 should provide rules
    of practice with respect to such ``more likely than not''
    opinions.
        New section 10.35 provides that a practitioner providing a
    more likely than not opinion to establish a taxpayer's legal
    justification for the tax treatment of a corporate tax shelter
    item is required to evaluate and take account of all relevant
    facts; to relate the applicable law to those facts; to
    consider, to the extent relevant and appropriate, both the
    substance and the purpose of the plan or arrangement;\4\ to
    identify and discuss all material tax issues; to identify and
    discuss the relevance and persuasiveness of the legal authority
    pertinent to the facts and material tax issues; and to contain
    a reasoned analysis of whether applicable authority supports
    the position taken by the taxpayer. The opinion must conclude
    unambiguously that there is a greater than 50-percent
    likelihood that the tax treatment of the tax shelter item would
    be upheld if challenged by the IRS.
    ---------------------------------------------------------------------------
        \4\ The substance and purpose requirement comprehends appropriate
    consideration of the judicial doctrines of substance versus form,
    economic substance, and business purpose on a generalized basis,
    without implying that any of these doctrines is exclusive of the others
    or more relevant than the others for opinion purposes.
    ---------------------------------------------------------------------------
        The opinion must not be based on any unreasonable factual
    or legal assumptions. Assuming, rather than determining through
    reasonable inquiry, that a material fact exists would be
    considered unreasonable. Assuming, rather than analyzing and
    concluding, that a material legal issue would be resolved
    favorably would also be considered unreasonable. By way of
    example, it would be unreasonable for a practitioner merely to
    assume the existence of a business purpose for a transaction if
    business purpose is a material fact. It would also be
    unreasonable for a practitioner who establishes the existence
    of a business purpose to assume, rather than to analyze and
    conclude, that such a business purpose supports the transaction
    in question.
        Except as provided below, a practitioner providing an
    opinion described in new section 10.35 must be knowledgeable in
    the relevant aspects of the Federal tax law at the time the
    opinion is rendered. The practitioner may not rely on an
    analysis of the Federal tax law prepared by another person with
    respect to any aspect of the taxpayer's treatment of the same
    tax shelter item, unless the practitioner is not sufficiently
    knowledgeable to render an informed opinion on a particular
    aspect of the Federal tax law. In such a case, the practitioner
    may rely on an analysis prepared by another practitioner who is
    knowledgeable with respect to that particular aspect of the
    law. For example, a practitioner giving advice as to the effect
    of a transaction in which the taxpayer will purchase an
    interest in a securitization trust holding a municipal bond may
    rely on the opinion of bond counsel that interest on the bond
    is exempt from Federal income tax under section 103.
        A more likely than not opinion provided with respect to a
    corporate tax shelter item that does not state that it is being
    provided as legal justification for the treatment of such item
    on a tax return shall be presumed not to have been intended for
    such purpose. The Section of Taxation recommends that the
    Treasury Department consider the addition of a similar
    presumption to the regulations under Sec. 6664.
        This recommendation is made in a policy environment of
    increased attention to corporate tax shelter activities. See
    Treasury Department, White Paper, The Problem of Corporate Tax
    Shelters: Discussion, Analysis, Legislative Proposals, released
    July 1, 1999; Joint Committee on Taxation, Staff Penalty and
    Interest Study, released July 22, 1999. The Section believes
    there is a consensus among practitioners that the practice of
    giving more likely than not opinions that are intended to
    provide legal justification for the tax treatment of corporate
    tax shelter items should be addressed as a matter of proper
    practice as a supplement to continuing reform of underlying
    substantive law. See, e.g., James P. Holden, 1999 Griswold
    Lecture before the American College of Tax Counsel, Dealing
    with the Aggressive Corporate Tax Shelter Problem, 52 Tax
    Lawyer 369 (1999), making many points similar to this report
    and a recommendation from which the proposed amendment draws
    heavily.
        The Section recommends the amendment of Circular 230 by
    adoption of the following amendments:

                  Draft of Proposed Amendments to Circular 230

    Add a new Sec. 10.35 to read as follows:

        Sec. 10.35. ``More likely than not'' opinions.-- (a)
    Application of section This section prescribes minimum
    standards for a practitioner who provides a ``more likely than
    not'' opinion for the stated purpose of establishing the legal
    justification of a corporate taxpayer under 26 C.F.R. 1.6664-
    4(e)(2) for the tax treatment of a ``tax shelter item,'' as
    defined in 26 C.F.R. 1.6662-4(g)(3). This section also
    necessarily applies to opinions prepared for such a purpose
    that express a higher level of confidence than ``more likely
    than not.''
        (b) Requirements for ``more likely than not'' opinion. A
    practitioner who provides an opinion to a corporate client for
    the stated purpose of establishing that, at the time a return
    is filed, the client reasonably believed that the tax treatment
    of a tax shelter item as reflected on the client's return was
    more likely than not the proper treatment, must, as of the time
    the opinion is rendered and subject to paragraph (b)(9), be
    knowledgeable in the relevant aspects of Federal tax law and
    must comply in good faith with each of the following
    requirements:
            (1) Evaluate all relevant facts. The practitioner must make
            inquiry as to all relevant facts and circumstances and be
            satisfied that the opinion takes account of all such facts and
            circumstances. The opinion should not be based, directly or
            indirectly, on any unreasonable factual assumptions (e.g., an
            assumption of a fact that is material to the analysis, such as
            an assumption that the transaction had a business purpose or an
            assumption with respect to the profitability of the transaction
            apart from tax benefits, or an assumption of a fact made by a
            valuation expert in connection with an appraisal).
            (2) Reliance on representations. The practitioner may, where
            the circumstances indicate that it would be reasonable to do so
            taking into account the practitioner's prior experience with
            the client, rely upon factual representations by persons that
            the practitioner considers to be responsible and knowledgeable.
            If the information so represented appears to be incorrect,
            incomplete or inconsistent in any material respect, the
            practitioner must make further inquiry.
            (3) Relate law to facts. The opinion must relate the applicable
            law to the relevant facts.
            (4) Consider substance and purpose. The opinion must take into
            account, to the extent relevant and appropriate under
            applicable law, both the substance and the purpose of the
            entity, plan or arrangement that gives rise to the tax shelter
            item in question.
            (5) Identify all material tax issues. The opinion must identify
            and discuss all material tax issues unless the opinion is
            provided solely with respect to a specific tax issue, as
            described by paragraph (b)(9).
            (6) Evaluate authorities. The opinion must identify and discuss
            the relevance and persuasiveness of the legal authority
            pertinent to the facts and material tax issues.
            (7) Analysis. The opinion must contain a reasoned analysis of
            whether applicable authority supports the position taken by the
            taxpayer. Such analysis shall be made in the manner described
            in 26 C.F.R. 1.6662-4(d)(3). The opinion must not assume the
            favorable resolution of any legal issue material to the
            analysis.
            (8) More likely than not assessment. The opinion must
            unambiguously conclude that there is a greater than 50-percent
            likelihood that the tax treatment of the item would be upheld
            on the merits if challenged.
            (9) Reliance on analysis of others. A more likely than not
            opinion may not rely on an analysis of the Federal tax law
            prepared by another person that relates directly or indirectly
            to any aspect of the taxpayer's treatment of the same tax
            shelter item, unless such analysis is limited to a specific tax
            issue (e.g., whether interest on a municipal bond is exempt
            from Federal income tax under section 103) with respect to
            which the practitioner is not sufficiently knowledgeable to
            render an informed opinion. In such a case, the practitioner
            may rely on the analysis of another practitioner who is
            sufficiently knowledgeable regarding such issue, but the
            practitioner must ensure that the combined analysis, taken as a
            whole, satisfies the requirements of this section.
        (c) Presumption. A more likely than not opinion provided
    with respect to a corporate tax shelter item that does not
    state that it is for the purpose of providing the taxpayer with
    legal justification for the treatment of such item on a tax
    return shall be presumed not to have been intended for such
    purpose.
        (d) Effect of opinion that meets these standards. An
    opinion of a practitioner that meets the above requirements
    will satisfy the practitioner's responsibilities under this
    section. The persuasiveness of the opinion with regard to the
    tax issues in question and the taxpayer's good faith reliance
    on the opinion will be separately determined under applicable
    provisions of the law and regulations.

    Amend Sec. 10.52(b) as follows:

        A practitioner may be disbarred or suspended from practice
    before the Internal Revenue Service for any of the following: *
    * *
        (b) Recklessly or through gross incompetence (within the
    meaning of Sec. 10.51(j)) violating Sec. 10.33, Sec. 10.34 or
    Sec. 10.35of this part.

        Chairman Archer. Mr. Lifson.

     STATEMENT OF DAVID A. LIFSON, CHAIR, TAX EXECUTIVE COMMITTEE,
           AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

        Mr. Lifson. Thank you, Chairman Archer. My name is David
    Lifson, and I am the chair of the Tax Executive Committee of
    the American Institute of Certified Public Accountants.
        Corporate tax sheltering is posing a problem for the tax
    system, and one we stand ready to help you address. While you
    are sure on the right track here, I just hope you get on the
    right train. We strongly oppose the undermining of our tax
    system by complex, convoluted and confusing tax sophistry.
    Clearly there are abuses, and they must be dealt with
    efficiently.
        We also strongly believe that taxpayers should be entitled
    to structure transactions to take advantage of intended
    incentives and to pay no more tax than is required by the law.
    Clearly the difficulty comes in when trying to draw a delicate
    balance in determining when the character of tax planning
    transactions morphs from legitimate to abusive.
        The system is currently responding, but perhaps not fast
    enough for you as legislators. Recent court cases are evidence
    for this observation. The IRS is clearly responding, too, with
    their announcement of a new operational unit, and they will be
    even more effective in the future with the changes made by you
    through the restructuring act.
        Because of the lack of consensus on the correct approach to
    legislation, we strongly urge a careful examination of the
    conflicting, often confusing proposals you are considering.
    After all, no one likes seeing the tax system gamed. No one
    likes feeling that some taxpayers are not paying their fair
    share. On the other hand, when you develop complex rules in
    highly technical areas that could affect Main Street, the
    yellow caution flag needs to be waved. I can foresee many
    businesses having to do uneconomic transactional analysis on
    normal business acquisitions to assure the government they are
    not subject to this special regime that is proposed by some.
        This result would serve no one well. We urge continued
    focus on the objectives stated by the Chair in announcing these
    hearings, to quote you, Chairman Archer, to stop abuses while
    properly restraining new blanket authorities for the IRS that
    might chill legitimate business transactions. To this end we
    encourage the use of exceptions for transactions that have a
    business purpose or are consistent with the legislative intent
    of the law. None of the proposals before you contain such
    exceptions. If the government wants to place a greater
    responsibility on large gray-area transactions, it should enact
    clear rules to provide for enhanced disclosures, high standards
    for legal support, and higher penalties on failures in certain
    defined situations.
        Call these reportable transactions, something a responsible
    corporate officer will freely disclose or decide not to engage
    in; not tax shelters that imply guilt. Encourage compliance,
    not disrespect for the system. Voluntary compliance is the
    cornerstone of our system. Use it. Use the de minimis
    exception; exempt smaller transactious, say, those involving
    less than 10 million in tax or 1 million in advisory fees, as
    the ABA has suggested.
        We support a more effective disclosure regime both in
    advance and with return filings. We support higher penalties on
    reportable transactions that are not disclosed. We support a
    penalty regime that provides incentives for disclosure, the use
    of objective indicators to identify transactions the government
    wants to scrutinize, and evidence of due diligence by corporate
    officials in signing the return disclosure, as well as high
    standards for tax opinion letters that apply to all tax shelter
    opinions. And we support effective penalties on third parties,
    some of whom are not currently subject to the rules of Circular
    230.
        We are very concerned about and cannot support a super 269
    approach, a disclosure regime that requires the taxpayer and
    numerous third parties to disclose at the time a transaction is
    offered, or, in particular, a disclosure requirement that
    requires a 75 percent likelihood standard in the penalty
    regime.
        In conclusion, we stand ready to continue our work in this
    area, to meet with your staffs to discuss and refine our
    proposals, and to try to improve the system to benefit the
    American people. Thank you for your consideration.
        Chairman Archer. Thank you, Mr. Lifson.
        [The prepared statement follows:]

    Statement of David A. Lifson, Chair, American Institute of Certified
    Public Accountants

        My name is David Lifson, and I chair the Tax Executive
    Committee of the American Institute of Certified Public
    Accountants (AICPA). The AICPA is the national professional
    association for CPAs, and our more than 330,000 members are
    from firms of all sizes, and from business, education, and
    government. Our members work regularly with the tax laws that
    you write, and we have a strong interest in making the tax law
    fair, simple, and administrable.
        I am pleased to present our testimony on ``corporate tax
    shelters.'' For the last year, we have had a task force working
    hard on the issues that the Treasury and Joint Tax Committee
    staff studies have attempted to address. We have discussed the
    issues with our leadership and membership; we have met with
    representatives of the American Bar Association Tax Section and
    Tax Executives Institute to identify areas of consensus; and we
    have met with Treasury Department and Congressional staff.
    While we have made progress, there are still significant areas
    of difference and a lack of consensus on key issues. We are all
    concerned about the misuse of our tax system, but we are also
    concerned that legislation to curtail this activity not be so
    overly broad, vague, and punitive as to have a chilling effect
    on normal transactions of average business taxpayers. We urge
    restraint in legislating solutions until discussions can build
    a greater consensus on the best approach to the difficult and
    complex problem of narrowly but effectively targeting abusive
    corporate transactions, while leaving intact a taxpayer's
    ability to plan regular commercial transactions without fear of
    draconian sanctions.
        In addressing corporate tax shelters legislatively, we
    encourage you to keep in mind that the system must work
    efficiently, so that taxpayers and practitioners can understand
    and the IRS can enforce the rules. The tax system works through
    compliance and enforcement, based on the broad powers that
    Congress has already given the IRS to curb abuses. Not every
    perceived abuse requires new legislation with its concomitant
    new regulations and rulings. Indeed, the government has
    prevailed in several very recent tax cases based on present law
    (Compaq Computer Corp., 113 TC No. 17 (September 21, 1999); IES
    Industries, Inc. v. U.S., No. C97-206 (N.D. Iowa Sept. 22,
    1999); Winn-Dixie Stores, Inc., 113 TC No. 21 (October 19,
    1999); and Saba Partnership, Brunswick Corporation, Tax Matters
    Partner, TC Memo 1999-359 (October 27, 1999)), following last
    year's decisions in ACM Partnership v. Commissioner (157 F2d
    231 (3d Cir. 1998, affg. in part T.C. Memo. 1997-115)) and ASA
    Investerings Partnership (1998-305 TCM).
        We are also pleased with the recent announcement by the IRS
    that it is forming an operational group to target corporate tax
    shelter transactions. As we have stated in prior testimony on
    this subject, some of the problem is lack of enforcement of
    existing rules rather than the need for new rules. As the
    government becomes more successful in identifying and
    prosecuting tax shelter cases, taxpayers and shelter promoters
    will be curtailed from abusive transactions. Nevertheless, we
    do support efforts to raise the standards required of ``more
    likely than not opinions'' through changes to Circular 230, and
    believe the practices of those not currently subject to
    Circular 230 must be subject to meaningful penalties as well.
        We specifically reject the imposition of a new ``super
    269'' approach that is included in some proposals. Such a new
    regime would be imposed over and above current law requirements
    and would deny deductions, losses, or credits unless a complex
    analysis demonstrates an appropriate level of pre-tax profit.
    This approach, combined with a presumption of non-economic
    purpose, is overly broad in targeting abuses, and would
    adversely affect many normal business transactions at a minimum
    by injecting a high level of uncertainty and requiring
    documentation of an analysis for tax purposes that has no other
    meaning or business purpose.
        My comments today supplement and refine those we provided
    last Spring to the House Ways and Means Committee and Senate
    Finance Committee when we were addressing the President's
    budget proposals related to corporate tax shelters. I have
    attached our statement from the Senate Finance Committee
    hearing on April 27, 1999.

    Disclosure of Corporate Transactions

        We continue to strongly support an effective disclosure
    mechanism to advise the government of corporate transactions
    that warrant review. Structuring an effective disclosure regime
    requires balancing the amount of detail, the timing of
    disclosure, and the burden of disclosure on taxpayers and
    advisers.
        Disclosure should provide enough information to the IRS to
    be helpful, but should not include excessive detail that will
    make their review difficult. For tax return disclosure, we
    would encourage the use of Form 8275, which contains a concise
    statement of the legal issues or nature of the controversy.
    This form could be adapted for corporate tax shelter issues,
    possibly with check boxes for indicators of transactions that
    the government might wish to review, such as the involvement of
    a tax indifferent party, indemnities for the benefit of the
    corporate participant in a transaction, or other
    characteristics that the Committee determines are appropriate.
        While advance disclosure (that is, before the return is
    filed) would help the government in some cases, it could be
    burdensome and should be limited to those situations where it
    would be most useful to the government. For both advance and
    return disclosure, we suggest care be used to identify what the
    IRS can actually make use of at each point in time. Disclosure
    requirements for advance and return filing should be specific
    as to what is required, when, and by whom.
        We recommend placing the burden of advance disclosure on
    the promoter, advisor, opinion-writer, or salesman, rather than
    the taxpayer. Requiring both the taxpayer and these third
    parties to disclose a transaction is burdensome and provides
    redundant information to the IRS. Advance disclosure by the
    third parties will be more helpful to the IRS in the timely
    identification of problem areas and will be more effective in
    curtailing abuses by these third parties at an early point in
    time. We suggest that each of the ``responsible'' third parties
    involved be responsible for the reporting, unless there is
    agreement that one of them will take responsibility. This will
    create the necessary tension between the parties to insure
    disclosure.
        For disclosures in advance of filing, we encourage you to
    modify Section 6111 (registration of tax shelters). We suggest
    a ``reportable transactions'' regime as a substitute for the
    ``tax shelter'' transactions convention currently in place
    under Section 6111 to identify targets for pre-return
    disclosures. This approach would be more focused, less
    subjective, less laden with emotion, and would encourage
    disclosure.
        In defining transactions to be disclosed on the return or
    in advance, we believe there is merit in the approach of
    developing fairly objective ``indicators'' of the sorts of
    transactions to which the government wants to give special
    attention. However, both Treasury and the Joint Committee
    staffs have suggested some indicators that we believe would
    sweep in many ordinary business transactions. For example, the
    proposed indicator of a permanent book/tax accounting
    difference, would include key-man insurance, purchased
    intangibles, and the use of stock options as employee
    compensation. Another proposed indicator would look at the
    economic substance of a transaction, using a pre-tax profits
    analysis that would result in a number of ordinary transactions
    being classified as ``tax shelters.'' For example, many
    incentives that Congress enacted to encourage taxpayers to
    undertake transactions that are not susceptible to this bottom-
    line analysis, like the research credit or even charitable
    contributions, would have to be reported or be specifically
    excluded from this test in legislation. It would be impossible
    to compare the pre-tax profits with expected tax benefits in
    many ordinary transactions because the economic return is
    unknown, such as stock purchased on margin or real estate
    purchased with non-recourse debt. Other normal business
    transactions, such as leasing, financing or advertising, are
    not susceptible to an analysis which requires a determination
    of the expected pre-tax return from the transaction. Indeed,
    the Treasury Department's study pointed out that the courts
    have been reluctant to employ this kind of analysis in testing
    the vitality of transactions for tax purposes.
        We are particularly concerned that the five tax shelter
    indicators in the Joint Committee staff recommendations would
    automatically deem a transaction to constitute a tax shelter
    defined under current law as having ``a significant purpose''
    of avoiding or evading Federal income tax. Defining a corporate
    tax shelter by reference to having a ``significant purpose'' of
    tax avoidance or evasion has not proved helpful in determining
    the proper target, and even Treasury has not yet been able to
    produce regulations after two years. We believe the Joint
    Committee staff approach of using more objective indicators is
    better, but they should be used as a substitute for the current
    law standards of ``tax shelters.'' These factors should be
    objective and could be adjusted as more information becomes
    available and new trends are identified. Also, the Joint
    Committee staff recommendation contains a double jeopardy--if a
    transaction does not fall within one of these indicators, the
    IRS could still argue that a significant purpose of the
    transaction is the prohibited avoidance or evasion, and thus
    subject to additional disclosure requirements and higher
    penalties. In short, from the government's perspective, it's
    ``heads, I win; tails, you (may well) lose.''
        We urge consideration be given to developing a more neutral
    approach, such as our suggested ``reportable transactions''
    regime. The results may well be the same: the need for
    disclosure and a potentially higher penalty structure, but the
    judgmental tone is removed and the issue becomes one of
    mechanical reporting, not of emotion. If a transaction
    satisfies an indicator, it is subject to a disclosure and
    enhanced penalty structure; if it does not, it should be
    subject to the normal penalty regime (including disclosure as
    an abating criterion).
        Some of the proposals before you try to avoid affecting
    normal business transactions resulting from overly-broad
    indicators by exempting specific types of transactions. We
    recommend a different approach. If a broad economic purpose
    test is retained, we believe the best way to reach the
    Chairman's stated objective of not adversely impacting normal
    business and financial transactions is to provide exceptions
    for defined categories of transactions. Our categories would
    include transactions that meet a business purpose test, are
    consistent with the legislative intent of the applicable
    provision, or are expected to produce returns that are
    reasonable in relation to the cost and risk of the transaction.
        Finally, there should also be a de minimis level below
    which transactions do not need to meet additional disclosure
    requirements or be subject to extraordinary penalties, and we
    agree with the American Bar Association's proposals for a
    minimum of $1 million in professional fees or $10 million in
    tax benefits. This will avoid application of this regime to
    smaller taxpayers and less-sophisticated practitioners. We note
    that some proposals offered would apply to individual
    taxpayers. We suggest that any higher penalties and disclosure
    requirements should apply to corporate taxpayers initially, and
    expanded to other taxpayers, if necessary, only after the
    reportable transaction regime is well established.

    Penalties

        We believe that the ``reportable transactions'' regime for
    disclosure could be carried over into the substantive penalty
    area under Section 6662(d).\1\ A reportable transaction would
    have to be disclosed on the tax return or the taxpayer would
    face heavier penalties. Disclosure will help the IRS identify
    problem issues, and, coupled with penalties where a position
    taken does not have sufficient merit, will provide a strong
    deterrent against abusive transactions. For reportable
    transactions that are disclosed but that lack substantial
    authority and lack a sound opinion concluding ``more likely
    than not'' on the merits, the 20% penalty of current law should
    apply. A somewhat higher penalty on reportable transactions
    that are not disclosed would provide an economic incentive for
    disclosure as would our suggestion in earlier testimony that
    where the requisite standard is met and disclosure has been
    made, there should be no penalty.
    ---------------------------------------------------------------------------
        \1\ In Short, our recommendation is not intended to layer another
    regime for ``reportable transactions'' on top of those in current law,
    but to stimulate consideration of a means to restructure and simplify
    the substantial understatement penalty for certain transactions, and to
    better coordinate those with the disclosure requirements.
    ---------------------------------------------------------------------------
        We do not support the Joint Committee staff's proposed 75%
    likelihood standard. The current more-likely-than-not standard
    is comprehensible in application where the practitioner and
    taxpayer have to determine that they have the preponderance of
    authority. Even this is not easy in situations where little
    guidance or case law exists. Determining the degree of
    certainty to a specific percentage is virtually impossible, and
    will be difficult for the IRS and courts to apply. It would
    also set a higher standard than would be required to prevail on
    the merits of a case.
        We do not believe there should be a penalty on the taxpayer
    for failure to disclose on a tax return where there is no
    understatement of tax. Although we understand the intent of
    this proposal, a flat-dollar amount would not act as a
    deterrent, and other formulations of the penalty are too
    complex for the potential benefit that might be provided.
    Similarly, we do not support any strict liability penalties,
    believing that the IRS should have the ability to waive
    penalties when justified.
        We believe that a standard must be established under
    Circular 230 for all tax shelter opinion letters. The current
    rules should be expanded to cover ``tax shelter'' opinions
    outside the third party context and should be better
    coordinated with the existing penalty rules. There are other
    aspects of Circular 230 that can also be brought to bear on
    abusive tax shelters, and we will work with the bar, enrolled
    agents, and the Treasury to improve Circular 230. Within the
    AICPA, we are reviewing the ethical conduct of practitioners
    involved in corporate tax shelter cases, and are determined to
    maintain the highest level of responsibility of our members.
        Most individuals who practice before the IRS are
    responsible professionals who have nothing to do with abusive
    tax shelters. Unfortunately, many individuals involved in
    developing, advising, and selling of tax shelters are not
    professionals who are subject to Circular 230 (that is, not an
    attorney, CPA, or enrolled agent). The penalties for aiding and
    abetting the understatement of tax liability could be expanded
    to include these third parties. Also, promoter and advisor
    penalties should be imposed for failure to disclose when
    transactions are developed and sold, and these could be
    fashioned along the lines of Section 6707, as a percentage of
    fees, and could be expanded to apply to investment bankers,
    opinion writers, insurance companies, and others who are
    involved in such transactions. For practitioners governed by
    Circular 230, sanctions can include suspension from practice
    before the IRS or disbarment, and we would encourage tough
    penalties for others who engage in abusive conduct.

    Due Diligence by Corporations

        We have been told that a common problem with abusive tax
    shelters is that tax opinions on certain transactions often do
    not match the actual facts. This has led to proposals that
    corporate officers be required to be more diligent in their
    examination of positions taken in tax returns. We support the
    requirement of a ``corporate officer attestation'' on the
    return, disclosing reportable transactions. Our suggestion is
    that a corporate official having knowledge of the facts, rather
    than one having a position with a particular title within the
    corporation, would be required to sign the attestation. The
    legislative report should make clear that the official could
    reasonably rely on expert opinions as to the tax law,
    valuations, etc., and on other responsible corporate personnel
    as to factual matters. We do not believe that attestation
    should carry personal liability, as this extreme sanction may
    not be appropriate for the conduct of the corporate official.
    Also, large companies frequently insure their officials against
    liability so that personal liability would often be deflected.

    Conclusion

        We strongly oppose the undermining of our tax system by
    convoluted and confusing tax sophistry. Clearly, there are
    abuses and they must be dealt with effectively. However, we
    have a complex tax system and believe that taxpayers should be
    entitled to structure transactions to take advantage of
    intended incentives and to pay no more tax than is required by
    the law. Drawing this delicate balance is at the heart of the
    issue we are addressing today. We urge you to continue the
    difficult discussions that develop from today's hearings until
    a greater consensus can be reached as to the best possible
    legislative approach. We offer our ideas and assistance in
    developing an effective and efficient approach to curtailing
    abusive tax shelters.
        [An attachment is being retained in the Committee files.]

        Chairman Archer. Mr. Shewbridge.

     STATEMENT OF CHARLES W. SHEWBRIDGE, III, CHIEF TAX EXECUTIVE,
      BELLSOUTH CORPORATION, ATLANTA, GEORGIA, AND PRESIDENT, TAX
                       EXECUTIVES INSTITUTE, INC.

        Mr. Shewbridge. Thank you, Mr. Chairman.
        Mr. Chairman, I am Chuck Shewbridge, chief tax executive
    for BellSouth Corporation in Atlanta, Georgia. I am here today
    as president of Tax Executives Institute, the preeminent group
    of in-house tax professionals in North America. Our 5,000
    members represent the 2,800 largest corporations in the United
    States and Canada. We appreciate the opportunity to testify
    because this subject is of vital importance to the tax system.
        Rather than summarizing my entire testimony, I wish to
    highlight two important issues.
        Mr. Chairman, TEI's perspective differs from that of other
    organizations represented on this panel. The Institute does not
    represent the so-called tax shelter promoters and developers
    who either sell or facilitate the transactions, and we do not
    represent the professional advisers who opine on the legitimacy
    of the arrangements. Rather, TEI members work directly for the
    corporations that enter into business transactions that require
    an analysis of their tax benefits and burdens. In other words,
    TEI members are in the thick of it. We, along with the
    government, have the most at stake in trying to craft a
    workable solution to this challenge.
        Before proceeding, Mr. Chairman, I want to endorse a
    comment that Congressman Doggett made last week. He recommended
    that both sides avoid immoderate rhetoric, which I interpret as
    meaning we should act on facts and not on feelings. Thus, I
    think it is both unfair and inaccurate to make blanket
    statements about the cause and scope of the tax shelter
    problem. And if I might, I wish to register my particular
    disagreement with the comment in the ABA's written statement
    that ``corporate tax managers often believe they have nothing
    to lose by entering into an aggressive tax shelter.'' Yes,
    there may be so-called bad actors in the tax community who
    promote, opine on and otherwise facilitate, or participate in
    aggressive transactions. I believe, however, that we must guard
    against overstatement.
        I have been a tax professional for nearly 30 years and have
    been employed by BellSouth for half of that period. As the
    company's senior tax official, I am ultimately responsible for
    the 40,000 Federal, State, local and foreign returns we file
    annually. BellSouth's 1998 Federal income tax return, which I
    signed earlier this year, reflects aggregate tax payments of
    more than $1.6 billion. Given the size of those numbers, and
    given the fact that I sign BellSouth's tax returns under
    penalties of perjury, it should go without saying that I take
    my job, including my responsibility to the tax system,
    seriously. So do my colleagues at TEI.
        Although I question some of the rhetoric that has been used
    discussing tax shelters, I think it is very important to note
    significant areas of agreement. We agree that over aggressive
    tax-advantaged products are being marketed. We agree that the
    IRS must do more to challenge and curtail these transactions,
    including raising practitioner standards and, where
    appropriate, asserting penalties more frequently. And we agree
    that better, fuller disclosure, including early warning
    disclosure by promoters, lies at the heart of successfully
    dealing with the situation.
        Where we disagree, Mr. Chairman, is in very important
    details. First, as an organization of women and men who will
    have to comply with whatever disclosure regime is enacted, TEI
    does not believe that concerns about the definition of a
    corporate tax shelter can be cavalierly dismissed. It has been
    suggested that a tax shelter is any transaction where the
    potential business or economic benefit is immaterial or
    insignificant, in relation to the tax benefit. With three
    decades experience, I think I know what is meant by the words
    ``material'' and ``insignificant,'' and I strongly believe that
    BellSouth has engaged in no abusive tax shelters. But I am very
    much concerned that some time in the future a revenue agent may
    disagree with me. At that point the issue will be joined as
    both sides may be forced to engage experts to argue over the
    meaning of ``significant'' and ``material'' and, in the case of
    the ABA's proposal, whether the $10 million disclosure
    threshold has been crossed.
        Mr. Chairman, TEI believes it is critical to know what we
    are talking about. The definition of ``tax shelter'' must be as
    objective as possible. Thus, we look forward to working with
    the Treasury and the congressional staffs and our colleagues in
    the practitioner community in refining the definition of
    corporate tax shelters.
        The second issue I wish to discuss is the proposal that the
    chief financial officer or another senior officer be required
    to certify that the facts disclosed about a tax shelter
    transaction are true and correct. TEI believes the proposal
    misses the mark. It misapprehends the role of the tax
    department as well as the CFO, it impugns the integrity and
    professionalism of both, and it ignores how the provision would
    adversely affect the examination process.
        The proposal is flawed because it proceeds from the faulty
    premise that companies unknowingly enter into major
    transactions, and that the people who prepare and sign billion
    dollar corporate returns do so lightly. I certainly do not. It
    is totally without basis to say that a company's senior
    officers would permit abusive transactions to go forward but
    for the sanctions that would flow from the proposal.
        TEI's concerns, however, go beyond the proposal's attack on
    the professionalism of corporate tax directors. It poses a
    serious threat to tax administration. If enacted, the proposal
    could lead to focus not on the underlying transaction, but on
    the CFO's statement. Hence the key would not be whether a
    transaction passes muster under the law, but rather ``what did
    the senior officer know and when did he know it.'' We regret
    that the proposal could easily spawn suspicion and distrust
    comparable to that which existed in the 1970s concerning
    questionable payments to foreign persons.
        In conclusion, TEI supports meaningful action in this area,
    but before legislation is enacted, the proposal must be
    refined. We look forward to working with the Committee to this
    end. Thank you.
        Chairman Archer. Thank you, Mr. Shewbridge.
        [The prepared statement follows:]

    Statement of Charles W. Shewbridge, III, Chief Tax Executive, BellSouth
    Corporation, Altanta, Georgia, and President, Tax Executives Institute,
    Inc.

        I am Charles W. Shewbridge, III, Chief Tax Executive for
    BellSouth Corporation in Atlanta, Georgia. I appear before you
    today as the President of Tax Executives Institute, the
    preeminent group of corporate tax professionals in North
    America. The Institute is pleased to participate in the
    Committee's hearing on corporate tax shelters and to provide,
    among other things, comments on the proposals and
    recommendations offered by the staff of the Joint Committee on
    Taxation and the Treasury Department.\1\
    ---------------------------------------------------------------------------
        \1\ See Staff of the Joint Committee on Taxation, Study of Present-
    Law Penalty and Interest Provisions as Required by Section 3801 of the
    Internal Revenue Service Restructuring and Reform Act of 1998
    (Including Provisions Relating to Corporate Tax Shelters) (JCS-3-99)
    (July 22, 1999); Office of Tax Policy, U.S. Department of the Treasury,
    The Problem of Corporate Tax Shelters: Discussion, Analysis and
    Legislative Proposals (July 1999).
    ---------------------------------------------------------------------------
        Mr. Chairman, this subject is a very important one to TEI
    members, to the tax community generally, and to the tax system
    as a whole. In the press release announcing this hearing,
    Chairman Archer identified the following five issues for
    consideration:
         The nature and scope of the perceived corporate
    tax shelter problem;
         The manner in which the IRS and the courts are
    currently addressing corporate tax shelters;
         Additional steps that the Administration could
    take under current law to address such tax shelters;
         Additional legislation that might be necessary to
    address corporate tax shelters; and
         Procedures the Administration has in place or
    could adopt, or that Congress could enact, to ensure that new
    or existing enforcement tools brought to bear on corporate tax
    shelters do not interfere with legitimate business transactions
    or make more difficult the application of an already complex
    income tax.
        After providing background on Tax Executives Institute and
    my own experience as a tax executive, I will address each of
    these issues.

        I. Background: The Perspective of the In-House Tax Professional

        Tax Executives Institute was established in 1944 to serve the
    professional needs of in-house tax practitioners. Today, the Institute
    has 52 chapters in the United States, Canada, and Europe. Our 5,000
    members are accountants, attorneys, and other business professionals
    who work for the largest 2,800 companies in the United States and
    Canada; they are responsible for conducting the tax affairs of their
    companies and ensuring their compliance with the tax laws. Hence, TEI
    members deal with the tax code in all its complexity, as well as with
    the Internal Revenue Service, on almost a daily a basis.\2\ TEI is
    dedicated to the development and effective implementation of sound tax
    policy, to promoting the uniform and equitable enforcement of the tax
    laws, and to reducing the cost and burden of administration and
    compliance to the benefit of taxpayers and government alike. Our
    background and experience enable us to bring a unique and, we believe,
    balanced perspective to the subject of corporate tax shelters.
    ---------------------------------------------------------------------------
        \2\ Most of the companies represented by our members are part of
    the IRS's Coordinated Examination Program (CEP), pursuant to which they
    are audited on an ongoing basis.
    ---------------------------------------------------------------------------
        Put another way, TEI's perspective differs from that of other
    organizations that have commented on this issue. The Institute does not
    represent the so-called tax shelter promoters and developers (including
    investment bankers) who either sell or facilitate the transactions. We
    do not represent the professional advisers (be they attorneys or
    accountants) who opine on the legitimacy of the arrangements. Rather,
    TEI's members work directly for the corporations that regularly enter
    into business transactions that require an analysis of their tax
    benefits and burdens. These companies have professional staffs
    dedicated to minimizing their tax liability while ensuring compliance
    with the law. To this end, these companies evaluate particular
    transactions (whether developed by their own staffs or brought to the
    companies by outside advisers or promoters), decide whether or not
    these offerings pass muster--not only in terms of the substantive
    requirements of the tax law but, importantly, in terms of their own
    business needs and corporate culture--and, if they proceed, report the
    transactions on their tax returns and defend them on audit. Ultimately,
    of course, these companies face potential exposure to sanctions (and
    public opprobrium) should their analysis of a transaction not be
    sustained. In other words, TEI's members are in the thick of it. We
    along with the government have the most at stake in trying to craft an
    equitable tax system that is administrable.
        Although I am here today on TEI's behalf, I wish to provide some
    context for my testimony about my role as Chief Tax Executive for
    BellSouth Corporation. I have been a tax professional for nearly 30
    years, and have been employed by BellSouth for half of that period. As
    the company's senior tax official, I am ultimately responsible for
    40,000 federal, state, local, and foreign returns that BellSouth files
    each year. The company's 1998 federal income tax return, which I signed
    earlier this year, reflected an aggregate federal income tax liability
    of more than $1.6 billion.
        Given the size of that number, it should go without saying that I
    take my job seriously. In discharging my duties, I oversee a staff of
    more than 100 people. We see our job as twofold--first, to ensure
    BellSouth's compliance with the state, local, federal, and
    international tax laws and, second, to serve the company's shareholders
    by ensuring that we pay only the taxes required by law. This second
    facet of the job is not new and it is not something that we shrink from
    defending. Concededly, those who seek to influence the debate by the
    language they use pejoratively describe today's tax department as a
    ``profit center,'' \3\ but the desire to reduce--and the legitimacy of
    reducing--one's tax liability is as old as the Rosetta Stone \4\ and as
    legitimate as seeking shelter from the cold or rain.\5\ With due
    respect, TEI suggests that those who wish to consign corporate tax
    departments to the role of scriveners, filling out tax returns,
    fundamentally misunderstand the historical, and we submit wholly
    proper, role of in-house tax professionals. Similarly, those who
    proceed on the assumption that tax executives neither understand nor
    willingly embrace our professional and legal responsibility to ensure
    our companies' compliance with the tax laws do us, our companies, our
    shareholders, and--equally important--the tax system a disservice. To
    be sure, there may be taxpayers who willfully or inadvertently cross
    over the line, just as there may be practitioners, promoters, revenue
    agents, government lawyers, and others who do the same. It would be a
    mistake, however, without sufficient empirical evidence to suggest that
    the problem is pandemic.\6\ Let there be no mistake: TEI supports
    reasonable administrative, judicial, and legislative steps to address
    the tax shelter issue, but the steps must be measured, targeted, and
    based on fact, not feeling. Thus, we take to heart Congressman
    Doggett's statement last week that ``immodest rhetoric'' has no place
    in this debate. We regret, however, that such rhetoric seemingly
    emanates more often from those seeking to enact legislation than from
    those who seek to clarify its scope and effect. While we agree that if
    the tax system does not respond to noncompliance or to sham
    transactions, public confidence in the fairness of the system will be
    diminished, we also believe that public confidence can be equally
    impaired by the enactment of overreaching and overbroad legislation.
    ---------------------------------------------------------------------------
        \3\ The Bureau of National Affairs recently reported that a senior
    Treasury Department official had said that so-called abusive shelters
    ``have arisen at a time when the culture of corporate tax departments
    has changed from one in which compliance was its primary function to
    one in which it is expected to generate money-saving opportunities.''
    ``Piecemeal Solutions to Tax Shelter Problems Contribute to Growth,
    Treasury Officials Says,'' BNA Daily Tax Report No. 210, at G-8
    (November 1, 1999).
        \4\ Charles Adams, For Good and Evil: The Impact of Taxes on the
    Course of Civilization 15-25 (1993).
        \5\ That tax planning by itself violates no moral code or
    substantive provision of the tax law has long been confirmed by the
    courts. Perhaps the most famous formulation of this axiom is Judge
    Learned Hand's: ``[A]nyone may so arrange his affairs that his taxes
    shall be as low as possible; he is not bound to choose that pattern
    which will best pay the Treasury; there is not even a patriotic duty to
    increase one's taxes.'' Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir.
    1934), aff'd, 293 U.S. 465 (1935) (``;The legal right of a taxpayer to
    decrease the amount of what otherwise would be his taxes, or altogether
    avoid them, by means which the law permits, cannot be doubted.'').
        \6\ While recognizing that the precise level of noncompliance owing
    to so-called tax shelter activity may be difficult to quantify, TEI has
    been very much concerned about broad statements of the enormity of the
    problem without empirical support. We are pleased that the IRS recently
    announced its intention to attempt to identify the scope of the
    problem. Assuming the methodology of the IRS's initiative is sound (and
    does not rely on revenue agents and others self-defining tax shelters
    as any transaction that produces a tax benefit they disagree with), it
    should meaningfully contribute to the process.
    ---------------------------------------------------------------------------

    II. What is the Nature and Scope of the Perceived Corporate Tax Shelter
                                    Problem?

        Before enacting expansive legislation dealing with
    corporate tax shelters, Congress is well advised both to ask
    and to answer the question ``What is meant by the term
    `corporate tax shelter'?'' It is not a question whose answer
    can be assumed. It is likewise not a question whose answer can
    be put off indefinitely. Whether you view the solution as lying
    in increased disclosure, the enactment of an economic substance
    doctrine or business purpose test, the imposition of new
    penalties, or ``just'' the racheting up of the IRS's
    enforcement activities, the definition must be both knowable
    and known. At this junction, TEI questions whether it is.
        Thus, the Treasury Department and the staff of the Joint
    Committee on Taxation have both issued substantial and serious
    studies that provide much food for thought on the subject of
    corporate tax shelters. Both have devoted considerable
    resources to identifying the scope of the problem from their
    perspectives and to crafting proposed substantive definitions
    of ``corporate tax shelter'' that attempt to measure the tax
    benefits of a transaction against its economic substance.
    Although we greatly respect the expertise and good faith of
    those involved--although we very much appreciate their efforts
    to date to respond to taxpayer and tax practitioner concerns
    and to refine their approaches--we remain concerned that the
    proposals rely too much on amorphous and unworkable concepts
    that pose challenges to tax administration and may well sweep
    into the ``tax shelter'' net many legitimate transactions for
    the simple reason that they produce a tax benefit to the
    taxpayer.
        Indeed, we are disappointed that some believe that lack of
    clarity is a virtue. Thus, the Treasury Department has
    previously framed the issue as between ``rules'' and
    ``standards'' (the latter being more general) and has recently
    suggested that what is necessary is a simple ex ante standard
    basically providing ``Thou Shalt Not Abuse the Tax Code.'' \7\
    TEI is concerned, however, that such a hortative approach to
    the Nation's heretofore rules-based tax system could be
    counterproductive, ultimately disrupting routine business
    transactions by emboldening revenue agents or others to
    challenge any tax planning idea or transaction as a corporate
    tax shelter.
    ---------------------------------------------------------------------------
        \7\ E.g., ``Piecemeal Solutions to Tax Shelter Problems Contribute
    to Growth, Treasury Officials Says,'' BNA Daily Tax Report No. 210, at
    G-8 (November 1, 1999) (remarks of Joseph M. Mikrut, Treasury's Tax
    Legislative Counsel).
    ---------------------------------------------------------------------------
        In other words, unless the definition is clear--or, at
    least, considerably clearer than it currently is--there will
    remain too great a possibility that the vague label ``tax
    shelter'' will be invoked as a shibboleth to cut off debate. To
    be sure, the effect of such a broad-brush approach may be to
    prevent certain abusive transactions, but it may also be to
    vitiate a taxpayer's right to minimize its tax obligations
    without first examining the facts and circumstances of a
    particular transaction and then assessing how its business
    purpose and economic substance comport with the explicit
    provisions of the Internal Revenue Code.\8\ Thus, TEI submits
    that any legislative action addressing abusive or over-
    aggressive transactions must acknowledge the role of legitimate
    tax planning to minimize corporate tax expense. Legitimate tax
    planning can include transactions undertaken solely for tax
    reduction purposes, such as financing a company with the
    issuance of debt rather than equity,\9\ and a taxpayer should
    not have to proceed through litigation to validate legitimate
    tax planning.
    ---------------------------------------------------------------------------
        \8\ Stated differently, we fear that without clear limits,
    ``corporate tax shelter''might become little more than the word
    ``glory'' in Through the Looking Glass: meaning whatever a revenue
    agent, like Humpty Dumpty, says it means. Lewis Carroll, Through the
    Looking Glass 186 (Signet Classic 1960) (`` `When I use a word
    [`glory'], Humpty Dumpty said, in a rather scornful tone, ``it means
    just what I choose it to mean--neither more nor less.' '').
        \9\ The need to recognize that actions can be wholly motivated by
    tax considerations and still be proper is illustrated by the following,
    concededly simplistic example: A woman is walking down the street and
    comes upon a homeless person, asking for money so he can buy something
    to eat. If the woman pulls a five-dollar bill out of her pocket and
    hands it to the man, she has effected a transaction that has an
    economic cost to her but no favorable tax consequences. Now assume she
    walks the man across the street to a homeless shelter that has secured
    tax-exempt status. As the homeless man enters the soup line, the woman
    writes a check for a tax-deductible contribution to the shelter. She
    has engaged in essentially the same economic transaction but has taken
    additional steps, arguably only to secure the tax benefits of writing
    the check to the charity running the homeless shelter. Should she be
    denied a tax deduction for her contribution to a charity--in the
    nomenclature of the day, a tax-indifferent party--because her
    motivation for the action generating the deduction was solely to reduce
    her tax liability?
    ---------------------------------------------------------------------------
        We have gone on at some length about the definitional
    problems not because we seek to staunch any meaningful action
    by the Treasury Department, IRS, and Congress, but rather
    because we take seriously our obligation to help improve the
    system. TEI agrees that the current situation cannot be
    ignored. As tax executives, we see the challenge to the tax
    system every day. The unrelenting complexity of the law breeds
    opportunity.\10\ The interaction of various intricate
    provisions of the Internal Revenue Code leads to uncertainty
    for taxpayers about the proper limits of tax planning and the
    line between legitimate and illegitimate transactions.
    Moreover, the uncertainty encourages some--especially those who
    stand to reap substantial fees and rewards with little or no
    risk of loss--to abuse or game the system. While the evidence
    is only anecdotal, TEI is very much concerned that abusive
    products or transactions are being developed, marketed, and
    purchased. In our view, this phenomenon poses a challenge to
    the efficacy of the tax system. If the problem of abusive
    products is not addressed, the integrity of the tax system may
    be weakened or, at a minimum, the perception of the tax
    system's fairness impaired. Hence, action is required.
    ---------------------------------------------------------------------------
        \10\ TEI believes it is necessary to recognize the part that
    Congress, the Treasury Department, and the IRS each play in creating an
    environment in which so-called corporate tax shelters can flourish.
    Each of the government players, too, bears responsibility--for how the
    law reads (warts, ``discontinuities,'' and all), how it is interpreted,
    and how it applies. Thus, TEI must acknowledge its frustration that the
    Administration has not sought to address either the complexity that
    characterizes the tax law or the unfair, one-sided provisions that,
    while crafted for a ``pro-government'' purpose, are often turned on
    their head by taxpayers in what is later deemed to be a tax shelter.
    For example, the contingent payment regulations that the taxpayer
    invoked in the ACM case were drafted by the government in a manner to
    be used against taxpayers; the taxpayers in that case simply tried to
    utilize the rules for their own benefit. An evenhanded rule would not
    have presented even the opportunity for abuse.
    ---------------------------------------------------------------------------
        At the same time, the problems with the current proposals
    can likewise not be ignored. There is no simple, easy solution
    to the corporate tax shelter ``problem.'' The key is
    realistically assessing the causes of the problems and then
    designing measured, balanced approaches to dealing with them
    without adding even more complexity to the already overburdened
    tax law. In the final analysis, rules must be developed that
    encourage all participants to exercise self-restraint.
    Ultimately, it is the corporation that is responsible for what
    is reported on its tax return, but in our view it is wrong to
    suggest that the problem lies only with taxpayers themselves
    and that the solutions should be directed only at them.
    Accordingly, TEI is pleased that the Treasury Department, the
    staff of the Joint Committee on Taxation, and others have
    concluded that attention must be paid to both the promoters of
    tax-advantaged products and to the outside advisers whose
    opinions facilitate the marketing of such products. We are
    certainly not claiming that sophisticated taxpayers are
    ``victims,'' but in our view the solutions must reach the
    organizations and advisers who put unduly aggressive
    ``products'' into play.\11\
    ---------------------------------------------------------------------------
        \11\ TEI also believes that, since the problem extends beyond
    corporate taxpayers (with some of the suspect products' being sold to
    partnerships and individuals), any solution crafted by Congress should
    not be confined to corporations.
    ---------------------------------------------------------------------------

    III. The Manner in which the IRS and Courts Have Addressed Tax Shelters

        When the Ways and Means Committee held its first hearing on
    the Administration's tax shelter proposals last spring, several
    witnesses testified that while the Department of the Treasury
    and the Internal Revenue Service had several tools at their
    disposal to combat ``abusive'' corporate transactions, the
    agencies had failed to make appropriate use of those tools.
    Perhaps more fundamentally, it was questioned whether the
    Treasury had sufficiently demonstrated that the provisions of
    the current tax code are inadequate to staunch the perceived
    growth of tax shelters. TEI agrees that there is a powerful
    array of tools available to address abuses--from substantive
    provisions already in the tax code, to the authority to issue
    notices and regulations to halt specific abuses, to the ability
    to target transactions for litigation using one or more common-
    law anti-abuse doctrines.
        Experience teaches that these tools can be and have been
    successfully invoked to curb several questionable transactions.
    For example, there have been a number of cases in which the
    courts have upheld the IRS's challenge to the business purpose
    or economic substance of a transaction that generated
    significant tax benefits. See, e.g., ACM Partnership v.
    Commissioner, 73 T.C.M. 2189 (1997), aff'd in part, rev'd in
    part, 157 F.3d 231 (3rd Cir. 1998), cert. denied, 119 S. Ct.
    1251 (1999); ASA Investerings Partnership v. Commissioner, 76
    T.C.M. 325 (1998), on appeal to Fed. Circuit; United Parcel
    Service of America, Inc. v. Commissioner, T.C. Memo No. 268
    (1999); Compaq Computer Corporation v. Commissioner, 113 T.C.
    No. 17 (Sept. 21, 1997); IES Industries v. United States, No.
    C97-206 (N.D. Iowa, Sept. 22, 1999); Winn-Dixie Stores, Inc. v.
    Commissioner, 113 T.C. No. 21 (Oct. 19, 1999); and Saba
    Partnership v. Commissioner, T.C. Memo. 1999-359 (Oct. 27,
    1999). Indeed, the last five of these government-favorable
    decisions were issued in the past three months. Let me be
    clear, Mr. Chairman: TEI does not necessarily subscribe to the
    view that all of these decisions involved ``corporate tax
    shelters,'' even assuming the government's challenge to the
    transactions at issue were properly sustained. We do believe,
    however, that the cases illustrate the arguments and
    resources--and power--the IRS can successfully bring to bear
    when it concludes that taxpayers have engaged in improper
    transactions.
        In addition, the Treasury Department and the IRS have not
    been reticent to issue regulations, rulings, and announcements
    challenging the purported tax benefits of certain transactions.
    Most recently, the IRS issued Rev. Rul. 99-14, 1999-13 I.R.B.
    3, which addresses so-called lease-in/lease-out (LILO) real
    estate transactions, which often involve the leasing of
    property by a foreign party, often a municipality, to a U.S.
    taxpayer, followed by the sublease of the same property by the
    U.S. taxpayer to the foreign party. Explaining that the
    transactions are structured to produce significant tax benefits
    based on the deduction of prepaid rent with little or no
    business risk, the ruling states that the IRS will scrutinize
    LILO transactions for lack of economic substance and, where
    appropriate, recharacterize these transactions for tax purposes
    based on their substance.\12\
    ---------------------------------------------------------------------------
        \12\ Some examples of the Treasury Department's and the IRS's using
    their regulatory power to challenge certain classes of transactions
    include the partnership anti-abuse regulations (Treas. Reg. Sec.
    1.701-2), the anti-conduit financing regulations (Treas. Reg. Sec.
    1.881-3 and Prop. Reg. Sec. 1.7701(l)-2), and recently proposed
    regulations concerning fast-pay stock (Prop. Reg. Sec. 1.7701(l)-3).
    Moreover, the Treasury Department and the IRS have acted to pre-empt
    many transactions by formally announcing an intention to issue
    regulations attacking transactions with which they disagree. Examples
    of such administrative notices include those involving fast-pay stock
    (Notice 97-21, 1997-1 C.B. 407), foreign tax credit transactions
    (Notice 98-5, 1998-3 I.R.B. 49), and transactions involving foreign
    hybrid entities (Notice 98-11, 1998-6 I.R.B. 13). The Treasury has on
    occasion made its notices retroactive, which by itself dissuades
    taxpayers from undertaking transactions that the government might deem
    abusive. The foregoing list is not exhaustive, but it does illustrate
    the Treasury's and the IRS's willingness and ability to challenge
    abusive transactions without new legislation.
    ---------------------------------------------------------------------------
        Finally, the Treasury has proven effective in persuading
    Congress to act to amend the Internal Revenue Code where
    legislation is necessary to prevent taxpayers from receiving
    unintended benefits. Thus, as the Chairman noted when calling
    this hearing, ``since 1995, (Congress has) stopped $50 billion
    in tax abuses.'' An example of such legislation is the
    amendment earlier this year of section 357(c) to prevent the
    artificial creation of basis. See Sec. 3001 of H.R. 435
    (enacted June 25, 1999).
        Nonetheless, TEI believes that more can and should be done
    to encourage the IRS to employ--within the bounds of sound
    administrative practices and the exercise of managerial
    discretion and congressional oversight--its current statutory
    and common law substantive and administrative tools to curb
    transactions that are perceived as tax shelters. This includes
    the assertion of existing penalties in appropriate cases. The
    IRS must identify its workload requirements in order to
    determine staffing needs. To our knowledge, this has not yet
    occurred. Accordingly, we believe that the IRS's current
    initiative to identify and quantify potentially troubling
    corporate transactions is commendable.
        Moreover, Congress must bear up to its responsibilities and
    ensure that the IRS is consistently well-funded with
    appropriations. To be effective, the IRS must have a well-
    trained workforce, and nowhere is this more true than with
    respect to the complex transactions that have been challenged
    as corporate tax shelters. Congress should ensure that the IRS
    has stable funding to meet its ongoing training needs.

    IV. Additional Steps that the Administration Can Take Under Current Law

        Before enacting new legislation, the Ways and Means
    Committee is right to ask whether there are additional steps
    that can be taken under current law. TEI believes there are.
    More fundamentally, we believe that there are administrative
    and regulatory steps the Treasury Department and the IRS must
    take even if legislation is enacted to enhance the disclosure
    of questionable transactions or otherwise address the tax
    shelter issue. Stated differently, the tax shelter problem is
    not one that Congress alone can cure. There is no legislative
    panacea, no single step or series of steps that Congress can
    take and thereby relieve the Treasury and the IRS of their
    ongoing responsibility. The Treasury and the IRS must continue
    to play their roles and if they fail to do so, they should be
    held accountable.
        For example, in 1997 Congress enacted a provision relating
    to the registration of corporate tax shelters. Section 6111(d)
    of the Code was intended to help the IRS obtain useful
    information about corporate transactions at an early stage in
    order to identify transactions that should be audited and then
    take additional action--through enforcement proceedings,
    regulatory changes, or targeted legislative action. The
    provision, however, does not become effective until the
    issuance of Treasury regulations, and to date no such
    regulations have been issued. It may be that section 6111(d) is
    flawed (for example, because it is keyed to the use of
    confidentiality agreements and an excessively broad
    ``significant purpose'' test), but if the Treasury proves no
    more willing or able to act under any new legislation than it
    has been under current law, we believe it is reasonable to
    question why new legislation should be enacted.
        Section 6111(d) does not stand as the only provision that
    has not been effectively used by the Treasury Department and
    the IRS. Questions could also be asked about the government's
    use of section 7408, which gives the government the authority
    to enjoin tax shelter promoters, and section 7609(f),
    concerning the issuance of so-called John Doe summonses to
    promoters. There is also a question about the Treasury's and
    IRS's not toughening the rules of conduct that govern return
    preparers and other practitioners. Perhaps more important, some
    have questioned whether the IRS has made adequate use of
    section 269, which authorizes the IRS to disallow tax benefits
    in respect of acquisitions made to evade or avoid income tax.
    Surely before enacting a greatly expanded section 269 to
    disallow deductions, credits, exclusions, or other allowances
    obtained in tax shelter transactions, the Treasury Department
    and the IRS should be called into account for its current use--
    or disuse--of section 269. Similarly, we suggest that before
    Congress acts on proposals to double the accuracy-related
    penalty, it should receive testimony from the IRS on both how
    frequently the current 20-percent penalty has been asserted
    (and sustained by the courts) and whether there is any evidence
    that the level of the penalty is insufficient to encourage
    compliance.\13\
    ---------------------------------------------------------------------------
        \13\ It may well be that compliance is affected more by the
    certainty (or uncertainty) of application than by the level of the
    penalty.
    ---------------------------------------------------------------------------
        Stated simply, TEI believes that there can be no substitute
    for an effective enforcement program by the IRS. No statute or
    series of statutes, no single or group of ex ante
    pronouncements, can eliminate the need for a well-trained
    workforce that has the financial resources and the managerial
    will to get the job done. In other words, the Institute
    believes the Administration should utilize all appropriate
    enforcement tools currently at its disposal, including the
    wider use of focused information document requests and the
    assertion of penalties in appropriate cases.\14\ The Treasury
    Department should also consider whether an amendment to the
    applicable penalty regulations--most notably, Treas. Reg.
    1.6664-4(c), relating to a taxpayer's ability to rely on an
    adviser's opinion in establishing its eligibility for the
    reasonable cause exception--are appropriate.\15\
    ---------------------------------------------------------------------------
        \14\ Coincidentally with the controversy about corporate tax
    shelters, the IRS has built an impressive track record in cases it
    perceives as abusive. See, e.g., Jacobs Engineering Group, Inc. v.
    United States, 97-1 U.S.T.C. para. 50,340, at 87,755 (C.D. Cal. 1997),
    aff'd, 99-1 U.S.T.C. para. 50,335, at 87,786 (9th Cir. 1999); The
    Limited, Inc. v. Commissioner, 113 T.C. No. 13 (Sept. 7, 1999), as well
    as the cases listed on page 11 of this testimony. What was missing was
    the IRS's willingness and ability to successfully assert penalties
    against sophisticated taxpayers. Significantly, the IRS has begun to
    assert and the courts sustain penalties against large corporate
    taxpayers. See Compaq Computer Corp. v. Commissioner, 113 T.C. No. 17
    (1999) and United Parcel Service of America v. Commissioner, T.C.M. No.
    268 (1999). This is a significant development, for it not only
    underscores the continuing vitality of the common law business purpose
    requirement but cannot help but prompt otherwise aggressive taxpayers
    to modify their behavior.
        \15\ For example, revised regulations could provide that a taxpayer
    may not rely on the opinion of a professional adviser that fails to
    contain a complete and accurate description of the facts underlying the
    transaction.
    ---------------------------------------------------------------------------
        Lastly, Mr. Chairman, we believe that the Treasury
    Department and the IRS (as well as Congress) can alter the
    environment in which so-called corporate tax shelters can
    flourish by working to simplify the law and to apply it in an
    evenhanded manner. As previously stated, we believe many of
    today's so-called tax shelters are attributable to one-sided
    rules that were crafted for a ``pro-government'' purpose but
    subsequently turned on their head.

       V. Additional Legislation that Might be Necessary to Curb Shelter
                 Activity--And Legislation that Is Ill-Advised

        To the extent Congress determines legislation is necessary,
    TEI believes that it must be measured and restrained. Any
    response must carefully balance the benefit of any legislative
    proposal against the possible adverse consequences, including
    the likelihood that the provision would unduly interfere with
    routine business transactions and legitimate tax planning,
    impose needless complexity, and inevitably operate as a tax
    increase. It is imperative that Congress not overreact and
    enact a general anti-abuse rule (sometimes referred to as a
    ``super section 269'' provision) that would permit IRS agents
    to disallow transactions based solely on a subjective finding
    that the taxpayer had a significant purpose of tax avoidance in
    entering into a transaction. Such a provision would be
    exceedingly disruptive to ordinary business transactions and
    tax planning.\16\
    ---------------------------------------------------------------------------
        \16\ It is clear from the recent IRS victories in court that when
    the IRS becomes aware of a potentially abusive transaction, judicial
    doctrines including those relating to sham, economic substance,
    business purpose, substance over form, and step transaction--especially
    when coupled with existing statutes such as sections 446, 482, 7701(l),
    and 269--provide the IRS with significant tools to ensure that the
    system works. We are concerned that attempting to codify the common law
    doctrines could further complicate and confuse the system and undermine
    legitimate tax planning.

    ---------------------------------------------------------------------------
    A. The Focus Should Be on Meaningful Disclosure

        Disclosure of information to the IRS is a most effective
    element of tax enforcement. Corporations are already required
    to reconcile their book and taxable incomes on Schedule M-1 of
    the tax return.\17\ Indeed, the examination of corporate
    taxpayers generally centers around the book and tax differences
    disclosed on that schedule. During the course of an
    examination, taxpayers must expend considerable resources
    explaining, justifying, and supporting the differences. As a
    result, it is odd that the Treasury and Joint Committee staff
    both focus on book-tax differences as an indicator of a
    corporate tax shelter. These differences are not so much
    ``indicators'' as they are an unavoidable byproduct of the
    Internal Revenue Code that Congress--often with Treasury's
    direct support--has crafted. Mr. Chairman, I do not believe my
    company had any corporate tax shelters on the 1998 tax return
    that was just filed in September. But I do know that we had
    more than 125 separate items disclosed on our company's
    Schedule M-1 reconciling book and tax income.
    ---------------------------------------------------------------------------
        \17\ Under section 6662, disclosure can have the effect of
    immunizing taxpayers from the accuracy-related penalty, but disclosure
    will not have this effect if a tax-shelter item is involved.
    Ironically, then, current law has the perverse effect of discouraging
    disclosure of such items.
    ---------------------------------------------------------------------------
        The country's largest 1,700 companies are subject to
    continual audit by the IRS as part of the CEP program, but
    proponents of legislation downplay the significance of this.
    Hence, the Joint Committee staff's study states that ``audits
    of large corporations typically follow an agreed agenda of
    issues that is negotiated by the IRS and the corporate
    taxpayer'' and both the Treasury Department and the Joint
    Committee staff refer repeatedly to the ``audit lottery.''
    Taxpayers do strive to work cooperatively with the IRS, but
    they certainly are not capable of ``walling off'' some issues
    from examination. In practice, it is the IRS audit team that
    determines what transactions will be scrutinized. It is the IRS
    audit team that determines what information it needs. And it is
    the IRS audit team that ultimately determines what adjustments
    to propose. Any implication that large corporate taxpayers can
    win the ``audit lottery'' by narrowing the scope of the audit
    does not reflect the realities of the examination process. Mr.
    Chairman, you and the Committee may be assured that when large
    taxpayers have a new, non-routine Schedule M-1 item on their
    return, it will be examined.

    B. Possible Expansion of Disclosure Requirements

        One deficiency in the current system is the lack of
    downside risk to those who promote corporate tax shelters.\18\
    This shortcoming could be addressed by imposing a disclosure
    requirement on promoters of particular types of
    transactions.\19\ Indeed, promoter disclosure could effectively
    operate as an ``early warning'' system that enables IRS and the
    Treasury Department to evaluate products and issue guidance--
    whether in the form of notices, rulings, or regulations--
    shutting down transactions that are perceived as ``abusive''
    before they proliferate. This will also enable the IRS to
    marshal its resources and focus on examining transactions,
    including those undertaken by non-CEP taxpayers (individuals
    and middle-market and small companies) for whom the perception
    of the risk of detection is skewed by the ``audit lottery.''
    TEI believes that an effective system will impose the
    obligation for early disclosure on the promoter.\20\ Because
    taxpayers will be required to make a detailed disclosure on
    their tax returns in order to avoid penalties, we do not
    support the imposition of a duplicate early disclosure
    requirement on taxpayers. As previously suggested, for early
    disclosure to have the intended salutary effect, the IRS and
    the Treasury must undertake to analyze and take appropriate
    action on the disclosed transactions.
    ---------------------------------------------------------------------------
        \18\ Thus, TEI agrees with the Joint Committee staff and Treasury
    Department that the tax system may require adjustments to better
    balance the cost-benefit analysis undertaken by promoters. Otherwise, a
    promoter may have little incentive to stop marketing abusive products.
    We note that some have argued that promoter fees are the ``oxygen''
    vital to the fire of tax shelter products and they have therefore
    proposed that promoter penalties should be as much as 50 percent of the
    fees earned on the product and, further, that they be crafted so that
    the promoters cannot avoid the incidence of the penalty by passing on
    the risk to clients. While TEI believes that these proposals may merit
    consideration, the Institute has not yet taken a formal position on
    them. We do believe, however, that should new promoter penalties be
    enacted, they should afford promoters an independent review process
    that is separate from the examination of the taxpayer's return.
    Moreover, any legislation should make it clear that where a taxpayer
    implements a sound tax planning idea in an abusive manner, penalties
    should not be imposed on promoters.
        \19\ While section 6111(d), once operative through the issuance of
    regulations, will require registration of more transactions, that
    provision may not work as intended.
        \20\ TEI believes that a key to an effective early warning system
    involving promoters is the development of clear ``triggers'' for
    disclosure. Hence, we suggest that a promoter's disclosure could be
    tied to (1) the receipt of a minimum level of fees by the promoter and
    (2) the presence of other ``indicators'' or ``filters'' in a
    transaction. One possible approach would require the promoter to file a
    statement with the IRS no later than 30 days after the receipt of
    $100,000 or more in fees from two or more taxpayers in respect of that
    product (or a substantially similar product). At a minimum, two or more
    tax shelter ``indicators'' or ``filters'' would be required (promoter
    fees plus some other indicator) for a tax shelter transaction to be
    found. The disclosure statement filed by the promoter would fully
    describe the product, the amount of fees collected, the name and
    employer identification number of the clients, and which indicators
    were triggered. Consideration should be given to affording promoters
    the opportunity to obtain an advance ruling on whether a product should
    be registered. The purpose of the disclosure is to alert the IRS that
    it might wish to examine the transaction. Whether through this or other
    means, taxpayers with transactions meeting two or more ``indicators''
    should be required to provide complete and meaningful disclosure with
    their returns. While alerting the examiner to a potential problem area,
    TEI strongly believes that the indicators should be used exclusively to
    trigger promoter disclosures. Hence, any legislation should confirm
    that no inference should be drawn concerning the proper treatment of a
    transaction that is subject to early disclosure by a promoter.
    ---------------------------------------------------------------------------
        In addition, TEI believes steps can be taken to enhance the
    value of return disclosures by taxpayers themselves. One means
    of ensuring that IRS examiners will not miss issues, even in
    respect of CEP taxpayers, is to require a taxpayer to attach a
    copy of the promoter's disclosure notice to the taxpayer's
    return. Furthermore, the specific types of information that
    must be disclosed on the return in respect of certain
    transactions could be specified, either by Congress in the
    statute or in regulations.

    C. The Senior Corporate Officer Attestation Proposal Should Be
    Rejected

        It has been proposed that Congress require the Chief
    Financial Officer or another senior officer to certify that the
    facts disclosed (or reported on a return) about a tax-shelter
    transaction are true and correct. Indeed, some proponents of
    legislation have characterized such an attestation requirement
    as a ``linchpin'' in any successful effort to curb abusive tax
    shelters. Even if enhanced disclosure is appropriate, we regret
    that this attestation proposal misses the mark. It
    misapprehends the role of the tax department as well as the
    CFO, it impugns the integrity and professionalism of both, and
    it ignores how an attestation provision would adversely affect
    the examination process. TEI strongly opposes its enactment.
        Stated bluntly, the senior officer attestation proposal
    obfuscates the issue because it proceeds from a faulty premise
    that companies do not enter into major transactions knowingly
    and that the people who prepare and sign billion-dollar
    corporate returns do so cavalierly. Corporate tax returns are
    already filed under penalties of perjury, and while I will not
    presume to speak for all my peers, I defy the proponents of
    this proposal to identify a sufficient number of corporate tax
    directors who take their return-signing duty so lightly as to
    justify the attestation requirement. As one commentator wrote
    recently in Tax Notes: ``[I]f the corporate tax manager does
    not have full knowledge of the facts of the corporation's tax-
    motivated transactions, why is he signing the return? And if he
    does not know what is going on, why is anyone's signature on
    the extra form necessary, except for show? '' \21\ Equally
    important, it is totally without basis for proponents to say
    that a company's CFO and the other senior officers who might be
    subject to the attestation provision would permit abusive
    transactions but for the sanctions that might flow from the
    proposal.
    ---------------------------------------------------------------------------
        \21\ Lee Sheppard, ``Slow and Steady Progress on Corporate Tax
    Shelters,'' Tax Notes, July 12, 1999, at 194. Some proponents of the
    attestation requirement have previously expressed surprise at TEI's
    opposition to the proposal, suggesting that the requirement would take
    in-house tax professionals ``off the hook'' by transferring
    responsibility to the CFO or another senior corporate officer. Whether
    short sighted or not, we take our professional responsibility to our
    companies and to our systems too seriously to support such a ``pass the
    buck'' strategy.
    ---------------------------------------------------------------------------
        Mr. Chairman, TEI's objections to the attestation proposal
    go beyond its denigration of the professionalism of corporate
    tax directors. The proposal poses a serious threat to the
    efficient operation of corporate tax return preparation and,
    especially, the examination processes. If enacted, the proposal
    could lead to focusing not on the underlying transaction but on
    the attestation. Hence, the key would not be whether a
    transaction passes muster under the law, but rather ``what did
    the senior officer know and when did he know it?'' Such
    inquiries could well result in intrusive or threatening
    examination practices that the IRS Restructuring and Reform Act
    was enacted to prevent.\22\ Indeed, the proposal could easily
    spawn suspicion and distrust about the entire return
    preparation and examination process comparable to that which
    existed during the era of the infamous ``Eleven Questions''
    (relating to facilitation payments to foreign persons) in the
    1970s.
    ---------------------------------------------------------------------------
        \22\ Specifically, we are concerned that revenue agents might use
    the possible assertion of penalties against the CFO as a lever in their
    negotiation of the underlying tax treatment with the corporate tax
    director. Thus, the discussion could go, as follows: ``If you don't
    concede the merits of this transaction, I am going to refer your boss's
    attestation to the criminal investigation division.'' Although
    according the attesting officer due process rights in respect of any
    penalty assertion is important, we question whether that alone will
    ensure the provision is not used improperly. Similar concerns make us
    less than sanguine about requiring companies to publicly disclose tax
    penalties above a certain dollar threshold in their financial
    statements.
    ---------------------------------------------------------------------------
        For the foregoing reasons, we urge Congress to reject the
    senior officer attestation proposal.
    D. Changes to the Code's Penalty Structure Must Be Measured

        Although TEI believes that the primary focus of Congress
    should be ensuring meaningful and timely disclosure of
    transactions, we recognize that a comprehensive approach to
    this subject requires an examination of the Code's penalty
    provisions, including most particularly the accuracy-related
    penalty and the multitude of standards governing taxpayers, tax
    practitioners, and tax-return preparers. In proceeding, we urge
    Congress to keep in mind the following:
        1. We cannot help but comment on the complexity of the
    proposed penalty regime set forth in the Joint Committee Study.
    Although seeking to consolidate and simplify the various
    standards to which taxpayers, preparers, and promoters are
    subject, the Joint Committee staff was forced to create an 11 x
    5 matrix to explain the proposal. Concededly, one of the
    columns was devoted to listing current law, but it remains that
    the proposal is highly complicated and supposes a level of
    mathematical precision that does not exist in respect of what
    in many cases are essentially judgment calls--does a
    transaction legitimately reduce taxes?
        2. TEI is very much concerned about proposals to increase
    the accuracy-related penalty in respect of certain tax shelter
    transactions to 40 percent. Indeed, we suggest that a
    fundamental problem with the administration of the current 20-
    percent penalty is that it is so high that it is rarely
    asserted against corporate taxpayers. Where penalties are
    disproportionate compared with the conduct involved, agents may
    be inhibited from asserting such penalties. Witness, for
    example, the penalty for errors involving qualified plans
    before the intermediate sanction rules were enacted. Because
    the stated penalty--revocation of exempt status--was uniformly
    considered too harsh, agents rarely ever asserted it.\23\ Thus,
    while steps should be taken to address the certainty of
    application, we do not at this time believe the level of the
    accuracy-related penalty should be increased.
    ---------------------------------------------------------------------------
        \23\ A collateral effect of the excessive pension plan penalty was
    to discourage taxpayers from disclosing and correcting errors for fear
    that the action could result in disqualification. With the advent of
    the employee plans compliance resolution system and its graded rewards
    and penalties (i.e., intermediate sanctions and penalties), taxpayers
    are much more willing to voluntarily disclose errors for administrative
    resolution.
    ---------------------------------------------------------------------------
        3. TEI believes that taxpayers should generally not be
    subject to penalties if they make a complete and meaningful
    disclosure about a product or transaction in the tax return and
    satisfy the applicable standard (see comment 5 below). If the
    taxpayer fails to disclose a transaction that is subsequently
    deemed to be a tax shelter and the taxpayer does not prevail on
    the merits, the taxpayer should be subject at most to a 20-
    percent understatement penalty where it has substantial
    authority for its treatmentpercent of an item. On the other
    hand, if a taxpayer fails to disclose apercent transaction that
    should be disclosed because it meets objective
    disclosurepercent criteria and the taxpayer prevails on the
    merits of the issue, it may be appropriate to impose an
    information-reporting type penalty on the taxpayer, the rate of
    which should not generally be linked to tax benefits at issue.
        4. Given the complex nature of the tax law, TEI believes
    the enactment of a strict liability penalty is wholly
    inappropriate. Penalties should be designed either to punish
    purposeful misbehavior or to provide an incentive to behave
    properly. Accordingly, we support the retention of the
    reasonable cause exception. We do, however, believe the scope
    of the exception should be clarified. Hence, TEI believes that
    opinion standards should be revised for purposes of the
    reasonable cause exception. Before relying on an adviser's
    opinion to avoid a penalty, the taxpayer must be able to
    demonstrate that the opinion is based on the actual facts of
    the taxpayer's transaction and not an assumed set of facts.
        5. Although TEI believes that some adjustment to and
    harmonization ofs taxpayer, practitioner, and preparer
    standards may be appropriate tos encourage the filing of more
    accurate returns, we have concerns abouts proposals to raise
    the standards, in respect of both shelter and non-s shelter
    items. Let there be no mistake: The multitude of standards nows
    contained in the Code--more likely than not, realistic
    possibility ofs being sustained, substantial authority,
    reasonable basis, not frivolous--is undeniably confusing. The
    multiple standards have reduced taxpayers,s practitioners, and
    preparers to assigning mathematical probabilities tos each
    standard and then divining (to the extent possible) whether a
    proposed return position meets or exceeds the applicable
    standard. The clarity suggested by the use of such mathematical
    probabilities, however, is a false one, for the tax law is
    marked by many things, but mathematical precision is rarely one
    of them.
        Regrettably, the false clarity of current law would be
    exacerbated under the Joint Committee staff's proposal to
    engraft a ``highly confident'' standard on the Code, which the
    staff defines as a 75-percent or greater likelihood of success
    on the merits if challenged. At one level, we are concerned
    that the combination of the ``highly confident'' and ``more
    likely than not'' standards may unleash a torrent of
    disclosures that consumes valuable IRS resources and distracts
    revenue agents from issues more worthy of their scrutiny.
    Equally important, we are concerned the imposition of higher
    standards will leave taxpayers facing penalties where, several
    years after they grappled with the vagaries and interstices of
    the tax law, a revenue agent or court concludes--with the
    benefit of hindsight--that the taxpayer erred in concluding its
    position was ``at least probably right'' (under the ``more
    likely than not standard'') or ``highly confident.'' \24\ This
    concern is especially pronounced in light of the Joint
    Committee staff's recommendation that the reasonable cause
    exception of current law be repealed. (See comment 4 above.)
    ---------------------------------------------------------------------------
        \24\ It should also be recognized that the person making the
    decision whether the taxpayer was ``at least probably right'' or
    assessing the correctness of the taxpayer's ``highly confident'' claim
    (i.e., revenue agent, Appeals officer, or court) would not even reach
    that question until concluding that the taxpayer was wrong on the
    merits.
    ---------------------------------------------------------------------------
        6. Congress should not make changes in this area in a
    vacuum and should resist the temptation to make ad hoc changes
    in the Code's penalty provisions. A comprehensive overhaul of
    the provisions, as was presaged at yesterday's hearing of the
    Subcommittee on Oversight, is preferable.

       VI. Steps to Ensure that Legitimate Business Transactions Are Not
                                    Impeded

        Mr. Chairman, in announcing this hearing you expressed a
    desire to explore the procedures the Administration has in
    place or could adopt, or that Congress could enact, to ensure
    that new or existing enforcement tools brought to bear on
    corporate tax shelters do not interfere with legitimate
    business transactions or make more difficult the application of
    an already complex income tax. We agree that this should be a
    primary consideration of the Committee. If legislation is
    enacted that is overbroad or unclear--if it does an
    insufficient job of defining what is acceptable and what is
    unacceptable--it is the corporate community as a whole that
    will suffer.
        TEI believes that the recommendations contained throughout
    this testimony address this issue, but in summary we offer the
    following:
         The definition of corporate tax shelter cannot be
    assumed. It must be known. Thus, while we agree that there will
    not be as much ``pressure'' on the definition if a disclosure-
    based proposal is adopted (as opposed to changes to the Code's
    substantive provisions), the problems do not disappear. Unless
    the ``indicators'' or ``triggers'' are objective or relatively
    easy to apply, there will be a likelihood not only of massive
    are objective or disclosures (``just to be safe'') but of
    potential abuse by revenue agents or courts using hindsight to
    impose penalties. Neither of these developments would be good
    for tax administration.
         To the extent a broad disclosure regime is
    adopted, any requirementts agents for ``early warning''
    disclosure should be imposed on promoters rather than
    taxpayers. This would ensure that promoters of tax shelters
    will have a rather thanective or incentive not to market
    abusive transactions, without unduly burdeninge aather
    thanective or taxpayers. Taxpayers, however, should be subject
    to more meaningful return or disclosure requirements.
         Congress should reject the Siren's song of senior
    corporate office attestation. So, too, should it reject the
    allure of doubling penalty rates. The IRS and Treasury would be
    better advised to develop effective audit strategies and to
    build the case for the appropriate assertion of a penalty.
         The standards for taxpayers, preparers, and
    advisers should be harmonized.
         Last but not least, neither Congress nor the
    Treasury should shrink from their obligation to improve and
    simplify the substantive provisions of the tax law.

                                VII. Conclusion

        Mr. Chairman, as evidenced by these comments, there are no
    magical solutions to the corporate tax shelter phenomenon. TEI
    believes the keys are (1) encouraging clear and meaningful
    disclosure by tax-shelter promoters and taxpayers; (2)
    substantially changing the risk-reward profile for tax-shelter
    promoters; and (3) clarifying that tax ``opinions'' based on
    assumed facts and circumstances unrelated to the taxpayers'
    will not be sufficient to excuse taxpayers from disclosure or
    understatement penalties. Solutions to the tax shelter dilemma
    must be carefully targeted and should not exacerbate the
    problem by adding further complexity to the Internal Revenue
    Code or by transforming a putatively neutral IRS examination
    process into an adversarial--even prosecutorial--search for
    ``bad actors.''
        Tax Executives Institute appreciates this opportunity to
    present its views on the corporate tax shelter problem. Any
    questions about the Institute's views should be directed to
    either Michael J. Murphy, TEI's Executive Director, or Timothy
    J. McCormally, the Institute's General Counsel and Director of
    Tax Affairs. Both individuals may be contacted at (202) 638-
    5601.

                Tax Executives Institute, Inc.

                                     Charles W. Shewbridge, III
                                                              President

        Chairman Archer. Mr. Handler.

     STATEMENT OF HAROLD R. HANDLER, CHAIR, TAX SECTION, NEW YORK
                         STATE BAR ASSOCIATION

        Mr. Handler. Thank you, Mr. Chairman. My name is Harold
    Handler. I appear in my capacity as chair of the Tax Section of
    the New York State Bar Association. Earlier this year we
    presented two reports on proposals relating to the phenomenon
    known as corporate tax shelters. In these reports we indicate
    our belief that there are serious and growing problems with
    aggressive, sophisticated and we believe in some cases
    artificial transactions designed particularly to achieve a tax
    advantage.
        The problem with these transactions is twofold. There is,
    of course, revenue loss. But there is a second corrosive
    effect. The constant promotion of these frequently artificial
    transactions breeds significant disrespect for the tax system.
        We believe there are several related steps in dealing with
    this phenomenon. First, the Service must increase its audit
    efforts and intensify scrutiny of these transactions, but
    diligent litigation alone will not, in our opinion, be
    sufficient to deter these transactions. Litigation is
    expensive, time-consuming and uncertain as to result. It fails
    to--and we believe it fails to catch a sufficiently large
    portion of these transactions to assure adequate deterrence.
        There must be further steps taken to change the risk-for-
    reward ratio. The only downside risk at present, given the
    availability of reasonable cause opinions today which provide
    protection under the current law from any penalty, is some
    additional interest, but the possibility of benefit by avoiding
    tax completely is substantial. We believe this equation must be
    changed. If a taxpayer is considering a tax shelter
    transaction, the elements to be considered must include the
    likelihood of significant penalty if the claimed tax treatment
    is disallowed. Under a strict liability regime, taxpayer's
    reliance on professional tax opinion would no longer have the
    effect of eliminating the risk of the penalty. Corporate
    taxpayers would be forced to assume a real risk in entering
    into these transactions, and advisors would be induced to
    supply balanced and reasoned analysis rather than merely
    supplying reasonable cause as under current law.
        There have been a number of proposals recently addressing
    this problem which we believe are significant positive steps in
    the right direction, and we support these efforts. These
    include H.R. 2255, the Treasury White Paper, and the joint
    Committee study in July. Of these three approaches to
    reasonable cause opinions, we prefer the H.R. 2255 approach,
    which would prohibit the ability of corporate taxpayers to rely
    on such opinions. As our reports indicate, increased disclosure
    is an essential corollary to any of these increased penalty
    provisions, but more than disclosure is required. We believe it
    important for Congress to adopt as proposed in H.R. 2255 a
    strict liability approach to the accuracy-related tax shelter
    penalties by eliminating the reasonable cause exception to the
    imposition of such penalties for proscribed tax-motivated
    transactions.
        We acknowledge the strict liability approach to accuracy-
    related penalties will put considerable pressure on defining
    appropriate cases. We have concluded on balance that it is
    acceptable to live with the effects of such strict liability
    when the imposition of the penalty, one, depends on the
    taxpayer's position ultimately not being sustained as a matter
    of current law; two, the amount of the penalty would be reduced
    if the transaction is properly disclosed; and three, that the
    penalties are targeted at corporate tax shelters as
    appropriately defined.
        The critical element is therefore to define these suspect
    transactions in a manner that distinguishes artificial
    transactions designed to produce a tax benefit only from
    legitimate corporate tax planning, which we clearly believe is
    appropriate.
        Our report includes a definition of the type of transaction
    which we believe should be subject to these penalties. Many of
    the elements of our proposal are also contained in H.R. 2255,
    the "white paper," and also the Joint Committee Study and we
    would be pleased to work with the administration and Congress
    to clarify this approach and reconcile any differences.
        Mr. Chairman, thank you for the opportunity of appearing
    today.
        [The prepared statement follows:]

    Statement of Harold R. Handler, Chair, Tax Section, New York State Bar
    Association

        Mr. Chairman and Members of the Committee:
        My name is Harold R. Handler and I appear in my capacity as
    Chair of the Tax Section of the New York State Bar Association.
    The Section has 3,000 tax professionals as members, and through
    its Executive Committee, prepares and disseminates between 25
    and 40 analytic reports a year on various topics relating to
    Federal, state and local taxation.
        Earlier this year, we presented two reports on proposals in
    the President's Fiscal Year 2000 Budget Proposals relating to
    the phenomenon known as corporate tax shelters. In these
    reports, we indicate our belief that there are serious, and
    growing, problems with aggressive, sophisticated and, we
    believe in some cases, artificial transactions designed
    principally to achieve a particular tax advantage. A good
    example is the transaction recently the subject of a Tax Court,
    and a Third Circuit decision in ACM Partnership vs.
    Commissioner. But this is not the only example, and our report
    attempts to detail a number of abusive corporate tax shelter
    transactions.
        Tax shelter transactions take many complex forms, but
    typically include some if not all of the following elements:
    lack of business purpose other than tax reduction, absence of
    meaningful economic risk or reward, exploitation of uneconomic
    aspects of the tax code, and shifting of income to tax-exempt
    parties. Consider, for example, the ``lease-in lease-out'' (or
    ``LILO'') transaction described in a revenue ruling issued last
    spring (Rev. Rul. 99-14, 1999-13 I.R.B. 3). A US taxpayer
    purports to ``lease'' an asset (perhaps a town hall or a
    trolley system) from a foreign municipality, and to
    ``sublease'' the asset back to the municipality. The US
    taxpayer ``prepays'' and deducts the ``rent'' under its lease,
    funded by a non-recourse loan which is collateralized by the
    municipality depositing this prepayment with the lending bank
    to secure its obligation to make ``sublease rent'' payments
    over a term of years. The transaction serves no discernable
    business purpose, involves no meaningful risk to either party
    because of the circular flow of cash, and is intended to
    exploit uneconomic differences in accounting for the ``lease''
    and the ``sublease'' so as to create ``income'' to the tax-
    exempt municipality and deductions for the US taxpayer during
    the initial part of the transaction.
        Some might suggest that all is well now that the particular
    accounting rules that the taxpayer sought to exploit in the
    LILO transaction described in the Revenue Ruling have been
    changed by the promulgation this spring of final regulations
    under Section 467 of the Code. There are rumors abroad,
    however, of ``son of LILO'' transactions. Whether or not these
    particular rumors are true, it is undoubtedly the case that
    misguided creativity is being applied to concoct other tax
    avoidance transactions that have as little substance as the
    LILO transaction that the Ruling describes.
        The problem with these transactions is two-fold. There is
    obviously an effect on revenue. While we are unable to estimate
    the amount of this revenue loss, anecdotal evidence and
    personal experience leads us to believe it is likely quite
    significant. But there is a second corrosive effect. The
    constant promotion of these frequently artificial transactions
    breeds significant disrespect for the tax system, encouraging
    responsible corporate taxpayers to expect this type of activity
    to be the norm, and to follow the lead of other taxpayers who
    have engaged in tax advantaged transactions.
        There are no simple solutions to the problems posed by the
    corporate tax shelter phenomenon. We believe there are several
    related steps to dealing with this phenomenon. First, the
    Service must increase its audit efforts and intensify the
    scrutiny of these transactions. As an example, the recent
    government success in ACM and similar cases is a positive
    development. But audit scrutiny and diligent litigation alone
    will not, in our opinion, be sufficient to deter these
    transactions. In the first place, litigation is expensive, time
    consuming, and uncertain as to result. Moreover, we are
    convinced that it fails to catch a sufficiently large enough
    portion of these transactions to assure adequate deterrence.
        There must be further steps taken to change the risk/reward
    ratio. The current equation is all too simple. Even responsible
    corporate financial officers, when faced with the choice of
    paying tax on some item of gain or other income may choose to
    engage in artificial transactions designed to eliminate the tax
    they otherwise would pay. The only downside risk at present,
    given the availability of ``reasonable cause'' opinions today,
    which provide protection under current law from any penalty, is
    some additional interest, which is likely to be at a somewhat
    higher rate than they would otherwise pay from more
    conventional lending sources. But the possibility for benefit
    by avoiding the tax completely is substantial, and far greater
    than the risk of somewhat greater interest cost.
        We believe this equation must be changed. If a taxpayer is
    considering a tax-shelter transaction, the elements to be
    considered must include the likelihood of a significant penalty
    if the claimed tax treatment is disallowed. Under a strict-
    liability regime, a taxpayer's reliance on professional tax
    opinions would no longer have the effect of eliminating the
    risk of a penalty being imposed on corporate taxpayers engaging
    in corporate tax shelter transactions. Consequently, corporate
    taxpayers would be forced to assume a real risk in entering
    into these transactions, and advisers would be induced to
    supply balanced and reasoned analysis rather than supplying
    ``reasonable cause'' as under current law.
        In our view, even if substantially greater resources were
    devoted to attacking corporate tax shelters under current law,
    the structure of our current penalty system ultimately would
    not provide adequate deterrence of corporate tax shelter
    activity. For this reason, we strongly support the approach of
    the Administration's proposal to increase accuracy-related
    penalties for defined corporate tax shelter transactions to
    encourage disclosure and deter risk taking by taxpayers. There
    have been a number of proposals recently addressing this
    problem, which we believe are significant positive steps in the
    right direction, and we support these efforts. H.R.2255
    proposes a statutory definition of ``non-economic tax
    attributes,'' which uses many of the same attributes that were
    included in our proposed definition in our April Report and
    eliminates the ability to rely on a ``reasonable cause''
    opinion. The Treasury ``white paper'' in July proposed imposing
    additional penalties unless there was disclosure as well as a
    ``strong'' opinion supporting the validity of the transaction,
    The Joint Committee study in July also proposed a definition of
    tax shelter, and would provide a ``reasonable cause'' abatement
    of penalty only with disclosure coupled with an opinion
    concluding a 75% likelihood of success, but also proposed to
    expand the ``aiding and abetting'' penalty to the issuer of
    such a 75% likelihood opinion if a ``reasonable tax
    practitioner'' would not have issued such an opinion. Of these
    three approaches to ``reasonable cause'' opinions, we prefer
    the H.R.2255 approach which would prohibit the ability of
    corporate taxpayers to rely on such opinions.
        As our Reports indicate, increased disclosure is an
    essential corollary to any of these increased penalty
    provisions. Disclosure will be helpful on several counts.
    First, proper disclosure will change the odds of the audit
    lottery, and the need to disclose will itself act as a
    deterrent. In addition, to the extent taxpayers actually
    report, a disclosure regime will act as an early warning system
    to allow the Treasury and the Service to respond quickly to new
    developments on this front.
        But more than disclosure is required. As we have noted, to
    address the insufficient deterrent effect of current law, we
    believe it important for Congress to adopt, as proposed in
    H.R.2255, a ``strict liability'' approach to the accuracy-
    related tax-shelter penalties by eliminating the reasonable
    cause exception to the imposition of the accuracy-related
    penalties for prescribed tax-motivated transactions.
        We acknowledge a strict-liability approach to accuracy-
    related penalties will put considerable pressure on defining
    appropriate cases subject to the provision, and may increase
    significantly the leverage of Internal Revenue Service agents
    in some audits of corporate taxpayers. Because we believe it
    crucial to increase the risk associated with entering into
    corporate tax shelters, we have concluded that, on balance, it
    is acceptable to live with these effects of H.R.2255 when the
    imposition of the penalty (i) depends on the taxpayer's
    position ultimately not being sustained as a matter of current
    law, (ii) the amount of the penalty is reduced if the
    transaction is disclosed on the taxpayer's return, and (iii)
    the penalties are targeted at corporate tax shelters, as
    appropriately defined.
        The critical element is therefore to define these suspect
    transactions in a manner that distinguishes artificial
    transactions designed to produce a tax benefit only, from
    legitimate corporate tax planning which we believe is clearly
    appropriate. Our report includes a definition of the type of
    transaction we believe should be subject to these penalties.
    Many of the elements of our proposal are also contained in
    H.R.2255 and we would be pleased to work with the
    Administration and Congress to clarify this approach and
    reconcile any differences.
        Mr. Chairman, thank you for the opportunity to appear
    before the Committee today. I will be pleased to answer your
    questions.

        Chairman Archer. The Chair is grateful to all four of you
    for taking your time to come help us try to work our way
    through this very complicated process, and each one of you has
    an expertise from your own personal activities that can be very
    helpful to the Committee as we try to resolve this issue in the
    right way. So we do look forward to having your help as we work
    through this.
        There are many, many questions that I guess can be asked
    and I will try to break the ice a little bit. And I am sure
    other members will want to add to that. I think all of us
    should agree with the basic foundation that we want to get at
    abusers and we don't want to get at people who are legitimate.
    How do we finally accomplish that?
        Mr. Shewbridge, there was an allusion by some witnesses
    that the corporate tax base has been eroded by corporate tax
    shelters. And I am curious: Has the corporate tax base been
    eroded? What are the tax revenues coming from corporations in
    the aggregate today as compared to 5 years ago, for example, or
    10 years ago?
        Mr. Shewbridge. I really don't know what the absolute
    dollar amounts are. I have not seen any empirical data that
    suggests that corporate tax shelters are eroding the tax base.
    I did hear Ms. Paull's comments earlier on the Joint
    Committee's efforts to quantify how much certain transactions
    might involve after they worked their way through the legal
    system, but I cannot speak to their correctness.
        Chairman Archer. Well, I should have directed this question
    to Mr. Talisman, and I overlooked doing that. But the Committee
    does need to have information as to what has actually happened
    to the revenues from corporations in the last 5 to 10 years.
        Mr. Shewbridge. That has been one of our concerns. There
    really has not been any empirical data with respect to what is
    happening with respect to corporate tax shelters.
        Chairman Archer. The preliminarily ad hoc information that
    I have as corporate tax revenues have gone up--and maybe other
    witnesses who will come before us today can testify to that.
        I will ask you one other additional question. As a
    financial officer of a corporation, are you not under a
    fiduciary responsibility to keep your taxes as low as possible,
    as are legitimately related to your business transactions?
        Mr. Shewbridge. Yes, I think I would say I am under
    requirement to pay only those taxes that I am absolutely
    required to under the law. And I think we do that to the best
    of our ability.
        Chairman Archer. I hope we don't ignore that fiduciary
    responsibility as we go through this process, because taxes are
    a cost of doing business.
        Mr. Shewbridge. Absolutely.
        Chairman Archer. And legitimate operations can design their
    transactions in a way to keep their taxes as low as possible
    and/or under a fiduciary responsibility to do that, are they
    not?
        Mr. Shewbridge. Yes, sir, they are. And I make no excuse
    for doing so.
        Chairman Archer. Mr. Handler, I have got a couple more
    questions. In your opinion, will there be more or less
    litigation if this Doggett bill is enacted compared to current
    law?
        Mr. Handler. I think as I say in my formal testimony with
    respect to the strict liability approach, that I think the
    Doggett bill proposes and that we endorse, I think there will
    be less litigation; and I think there will be less litigation
    because I think our corporate financial officers, such as Mr.
    Shewbridge, will know that the risk of entering any of these
    transactions will create a far greater penalty in terms of loss
    than the benefit that would be ultimately sustained by success.
    That would, I think, eliminate the frequency of these
    transactions, and I would hope eliminate litigation.
        Chairman Archer. I assume, as both you and Mr. Sax will be
    retained by a number of people to advise them as to how to work
    their way through this process irrespective of what the
    legislative result is, and I don't want to imply that you may
    get more business because people will come to you and say, how
    in the world do we deal with all of these new vague tests and
    all of these very new reporting requirements and how can we be
    sure that we are safe and how can we know that we are not going
    to get into the penalty situation?
        And I will put that aside for the moment as any possible
    special interest that you might have. But you certainly will be
    asked by your clients to defend them in the event that the IRS
    comes after them.
        Mr. Handler. Absolutely.
        Chairman Archer. That is your appropriate role, both you
    and Mr. Sax in our system. How would you argue on behalf of
    your client as to the definition of "substantial"?
        Mr. Handler. Well, that is obviously a relative term, and
    the litigation is only one aspect of the nature of the work
    that we do in New York and Mr. Sax and the ABA does nationwide.
    We represent--our organization has 3,000 tax professionals, and
    what is remarkable about the testimony that I have heard both
    here and at the Senate Finance Committee is that the
    professionals, the tax professionals, are cautioning Congress
    in the fact that they want more limitation imposed on the
    ability to deliver the kinds of opinions that are now being
    delivered.
        I think we both are moving in that direction in different
    ways. That is one major element of what we as tax professionals
    do for a living. And what we are asking Congress to do is to
    give us some additional support in carefully analyzing
    transactions and describing the risks that are available to our
    corporate taxpaying clients. At the moment, as I said in my
    testimony, the risk at the moment is merely just additional
    interest, if the taxpayer loses and we have to advise the
    taxpayer of that, and when it comes time to litigation, the
    issue of substantial versus nonsubstantial is a function of the
    question of substantive law that might exist at that moment.
        But what is remarkable is that our group and, I believe,
    Mr. Sax's group are basically asking for a further limitation
    on the kind of opinions that we would be asked, we are being
    asked to deliver today.
        Chairman Archer. Well, is substantive law adequately
    specific to where you know what the term ``substantial'' means,
    or would you perhaps take a different position from the IRS?
        Mr. Handler. Our view is that we don't----
        Chairman Archer. Defending one of your clients.
        Mr. Handler. I am sorry I thought you meant in terms of the
    litigation.
        Chairman Archer. You won't defend the IRS, I don't think.
        Mr. Handler. I am on the other sides of those issues.
        Chairman Archer. Your involvement will be on behalf of the
    private client that is being contested by the IRS.
        Mr. Handler. And I would argue----
        Chairman Archer. How would you define on behalf of your
    client the term "substantial"?
        Mr. Handler. I would marshal all of the information that
    exists with respect to the transaction and try to demonstrate
    that the benefit that was achieved by the client as a business
    matter was substantial.
        Chairman Archer. And is it possible the IRS would take a
    different position?
        Mr. Handler. Yes, it is very possible, and that is what
    courts are for. The court would ultimately decide whether or
    not--which of us was right in that dispute.
        Chairman Archer. Is it a precise term, or is it something
    that is going to always be left to the courts to make the
    subjective decision in every instance?
        Mr. Handler. I don't think you can define "substantial"
    with precision. I think it has to be something which is the
    subject of ultimate dispute resolution.
        Chairman Archer. That is the point I wanted to get at. Your
    job as shepherds and stewards of the Tax Code is to try to make
    it as specific as possible so that there will be a degree of
    certainty for the people in this country to know what they can
    and cannot do.
        And I am a little bit concerned about what you have just
    told me compared to what your general testimony to this
    Committee was that you strongly support this. Because it will
    create clearly from your final answer a very nonspecific
    provision in the Code, which we already have tremendous
    problems with the IRS and the implementation of our system in
    these gray areas.
        We find that our tax system in many instances is not
    determined by the law, but determined by the ability to
    negotiate. That is a bad tax system. No one taxpayer, because
    they have a better ability to negotiate with the IRS, should
    get a better result than another taxpayer in the very same
    situation. And now you are telling us this is an uncertain
    term, and there will be different results. That bothers me as
    someone who is trying to make the tax system more specific.
        Now, let me ask Mr. Lifson. My colleague and friend, Mr.
    Doggett--and we are friends, we can disagree without losing our
    friendship----
        Mr. Lifson. Been there.
        Chairman Archer. --and we do disagree significantly on a
    lot of issues--has said and has repeated today that people
    within your industry, and I suppose also, Mr. Sax, people
    within your profession, are sleazy, are underhanded, are
    hustlers. Do you know those people?
        Mr. Lifson. I suspect I do.
        Chairman Archer. I don't think he is referring to anybody
    else. I think he is referring to consultants in either the CPA
    profession or the legal profession. And I am just curious if
    you know any of them.
        Mr. Lifson. Well, I am not sure I would use those words to
    describe them, but I could see why some people might use them.
    I don't have any as close associates, but I read about them the
    same way Mr. Doggett does.
        Chairman Archer. Mr. Sax.
        Mr. Sax. We have chosen quite deliberately not to employ
    those words in our descriptions.
        Chairman Archer. So you don't know of any people in your
    profession that fit that description?
        Mr. Sax. I wouldn't go so far as to say that, no.
        Chairman Archer. Well, what percent would you say there
    are?
        Mr. Sax. I would be pleased to respond to that. I am
    pleased to say that I believe it is very, very, very low, much
    lower than in the general population.
        Chairman Archer. Oh, okay; 1 percent maybe?
        Mr. Sax. I mean, I don't have statistical data, Mr.
    Chairman, of course, but I do----
        Chairman Archer. Less than 10 percent?
        Mr. Sax. I do take great pride in being a member of the
    bar. I take that honor and role as an officer of the court
    seriously. I believe on the whole, lawyers are very good people
    and try to take their mission seriously and do the right thing.
    And, yes, as with the general population and every other
    population, there will be bad apples.
        Chairman Archer. Okay. I happen to be a lawyer myself, and
    I don't think it is a dishonorable profession. I agree with
    you, it is an honorable profession; sometimes dishonored by
    some of our own members of the profession, but in itself an
    honorable profession. Why is it that the Bar Association, if it
    knows about sleazy, underhanded hustlers doesn't disbar them
    and solve the problem?
        Mr. Sax. That is a very good question, Mr. Chairman. I
    think it arises principally from the fact that the organized
    bar is not very organized. It is balkanized into the bars of 50
    States, often underfunded, often with very little by way of
    resources and very little ability to detect, much less punish
    the things that should be detected and punished.
        Chairman Archer. Well, maybe we ought to try, you and I
    together ought to try shore up our association and see that it
    does a better job.
        Mr. Lifson, what about the CPAs?
        Mr. Lifson. I think the road from accusation to conviction
    is a very long road indeed in all professions. And I do know
    that the AICPA is investigating and is continuously
    investigating various acts of bad behavior, including
    involvement with tax shelters. And it will continue to do so.
        Chairman Archer. Mr. Doggett said in his testimony that one
    of your members, one of the Big 5, according to his testimony,
    requires its very smart staffers to come up with at least one
    economically stupid, but taxwise corporate tax dodge idea per
    week. Which one would that be?
        Mr. Lifson. I am not exactly sure, since I come here
    representing 40,000 practice units and 330,000 CPAs. So if one
    of those 40,000 practice units in fact does do that, then that
    would be something or that would be a matter for study. But I
    have a feeling that is a matter of characterization of activity
    rather than reality in the way that activities really work in
    that firm or any other firm.
        Chairman Archer. Okay. Let me go back over what he said; he
    did not say one of the 40,000, he said one of the Big 5. Which
    one would that be?
        Mr. Lifson. I can't say for sure. I don't know.
        Chairman Archer. Okay. Do you have any sort of intimation
    as to which one it might be?
        Mr. Lifson. I don't know.
        Chairman Archer. And if so, would your association be
    willing to take action against them?
        Mr. Lifson. If, in fact, anybody had those sort of
    policies, one would first have to determine whether that was a
    person's policy or a firm's policy. I am sure that this is a
    much more complicated issue than the surface of the headline or
    the surface of an accusation.
        Chairman Archer. Do you believe that is possible? I mean,
    this is just an allegation obviously, but do you believe it is
    possible?
        Mr. Lifson. I am a very open-minded person, I believe
    anything is possible.
        Chairman Archer. Okay, I thank the gentleman for enduring
    my questioning.
        Mr. Doggett.
        Mr. Doggett. Thank you, Mr. Chairman.
        Mr. Shewbridge, it is my understanding from your testimony
    that while we might have a different perspective on what
    belongs in legislation to address this problem, that you agree
    that the Congress should take legislative steps to address this
    problem; is that correct?
        Mr. Shewbridge. Well, I really think it is a little bit
    broader than that. Some action in legislation may be needed,
    but it needs to be done in concert with additional enforcement,
    effective use of the tools that are already available to the
    IRS, and more faster guidance from the Treasury Department.
        Mr. Doggett. I thank you for that.
        And, Mr. Lifson, I understand the same to be true with
    reference to your testimony. You think it would be a mistake
    for this Congress not to act legislatively to address this
    problem, though you have a different view than I do about what
    the most appropriate legislative action is?
        Mr. Lifson. I think it would be fair to say we do not think
    it would be inappropriate to act.
        Mr. Doggett. Do you think that the Congress needs to
    address this problem legislatively or not?
        Mr. Lifson. I believe in many respects the problem may
    well, through publicity and enhanced enforcement, solve itself;
    but the speed with which the problem may be solved may be of
    concern to this Congress.
        Mr. Doggett. Giving the brevity of the questioning period I
    have, I would ask if you would submit to the Committee if you
    are aware of your association having ever disciplined or
    removed or barred any member or any individual accountant for
    peddling any type of corporate tax shelter. With reference to
    your comment that no one likes to see the tax system scammed, I
    agree with you, and certainly some of the tax shelters that you
    know have subsequently been outlawed were scamming the system,
    weren't they?
        [The information follows:]
                                                      February 15, 2000

    The Honorable Lloyd Doggett
    328 Cannon Office Building
    U.S. House of Representatives
    Washington, DC 20515

    Dear Congressman Doggett:
        This letter responds to your request at the House Ways and Means
    Committee hearings on November 10, 1999 for information about AICPA
    sanctions against members involved in ``corporate tax shelters.'' As we
    stated at the hearings, we are determined to maintain the highest
    ethical standards for our members, and the AICPA and the state CPA
    societies participating in the Joint Ethics Enforcement Program are
    committed to protecting the public interest. The AICPA supports efforts
    to curtail ``abusive tax shelters,'' and our only concern about
    legislation in this area is that it be carefully crafted to avoid both
    burdensome disclosure requirements and harsh penalties for average
    taxpayers with normal transactions.
        Our Professional Ethics Division investigates each allegation of
    unprofessional or unethical conduct by an AICPA member that is brought
    to its attention by another AICPA member, a state CPA society, a
    client, a member of the public, or any other source. We are proactive
    in obtaining such information, and monitor media reports, including
    local and national newspapers, professional publications, and
    government reports. Many of our investigations are based on referrals
    received from government agencies, and we review the IRS Internal
    Revenue Bulletin for sanctions imposed by the IRS Director of Practice.
    We encourage IRS and other government officials to report individuals
    involved in abusive conduct to help us maintain the high standards of
    our profession.
        All sanctions involving suspension or expulsion from membership,
    and guilty findings of the Joint Trial Board are published in The CPA
    Letter which is broadly distributed, including to all 338,000 AICPA
    members, state CPA licensing boards, various government agencies,
    various trade and consumer publications, and others. We are also in the
    process of providing this information on the AICPA's website. In
    addition to affecting the reputation of the CPA involved, distribution
    to state licensing boards could potentially result in the loss of his
    or her license to practice. We take these matters very seriously, as do
    our members.
        During the five-year period from 1994 through 1998, we investigated
    approximately 1,720 members, resulting in 258 being either suspended or
    expelled; 391 being given letters of required corrective action; and 60
    being disciplined by the Joint Trial Board. While these cases include
    members who have an alleged involvement with a tax scam or fraud, we
    are not able to tell you specifically how many of these are related to
    ``corporate tax shelter'' issues. The AICPA Professional Ethics
    Division is developing a new database that will be able to capture the
    type of information you have requested in the future, but our present
    system is over ten years old and does not allow us to search in the way
    you have requested. Also, the term ``corporate tax shelter'' has yet to
    be well-defined, and has only been used in the sense that you have used
    it since the end of 1998. The statistics for 1999 have not yet been
    compiled, but they will be derived from the present database system.
        I hope this information is helpful, and would be happy to provide
    any follow-up information.

                Sincerely,

                                                David A. Lifson
                                                                  Chair
                                          AICPA Tax Executive Committee

        Mr. Lifson. I am not sure what the definition of a tax
    shelter is, but there certainly are some arrangements.
        Mr. Doggett. How about the renting of Swiss Town Hall and
    renting it right back; wasn't that scamming the system?
        Mr. Lifson. Yes, it is, but I just am not sure about what a
    tax shelter is.
        Mr. Doggett. Thank you.
        Mr. Handler, isn't the calculation that is contemplated in
    the HR 2255, as I proposed it, essentially the same calculation
    that a corporation that you might represent would have to make
    in deciding whether to buy one of these tax shelter products
    that some hustler calls them with a cold call and says they
    ought to undertake?
        Mr. Handler. I am not sure I understand what you mean by
    "calculation," Congressman, but----
        Mr. Doggett. In deciding whether the tax shelter product is
    worth getting, whether it exposes them to too much risk,
    whether they will have any real gain or whether they will have
    tremendous tax advantages with no real risk.
        Mr. Handler. I think the typical analysis that is done,
    appropriately done, in making corporate decisions of these
    types, is what is a risk-reward analysis; what do I gain by
    taking--by doing a transaction, what do I risk by doing it?
        Mr. Doggett. Isn't that essentially what the economic
    substance test calls for?
        Mr. Handler. Yes.
        Mr. Doggett. It is a little more complicated than that, I
    know.
        Mr. Handler. It is a quite a bit more complicated, but it
    is basically the same series of equations in terms of deciding
    whether it is a worthwhile transaction to undertake.
        Mr. Doggett. Do I understand your testimony to be that
    there is a limit, as important as it is to have precision in
    the Code so you can advise your client what the law is, there
    is some limit as to how far that precision can go and it is
    necessary to have certain terms like "substantial" and
    "meaningful," and this is not the only part of the Internal
    Revenue Code where we find them, isn't it?
        Mr. Handler. That is true.
        Mr. Doggett. Mr. Sax, I want to commend you and Mr.
    Handler. I think your statement is to be praised, not only for
    its succinct eloquence, but for the fact it takes a certain
    amount of courage for you and Mr. Handler and other members of
    the bar to come to this Committee. After all, the same
    corporations that are being tempted with these cold calls and
    these tax hustlers are the same people that are the clients of
    many of your members. And I think it does take courage to come
    forward and speak out about the need to resolve this issue.
        Now, I know you might not use the same terminology that I
    do about this. But when you see the cover of Forbes Magazine
    about tax shelter hustlers, and you hear about these problems
    from the 20,000 members of your profession, are there good
    people in some cases doing bad things because of the pressure
    of tax hustlers? And in addition, let me just ask you to
    respond to the point in my testimony earlier that I had a
    multinational major Texas company come and tell me that their
    tax department was getting about one cold call a day with some
    tax shelter proposal.
        Does that fit with what you have been hearing about this
    problem?
        Mr. Sax. Yes, it does, Congressman. We do agree that we are
    confronting a situation of good people doing bad things. We
    have tried to address that portion of the issue that we can
    directly deal with within the bar, by proposing the amendment
    to Circular 230 to upgrade the quality of tax opinion-giving,
    figuring that is one thing we can do immediately, and we have
    sought to do that.
        Mr. Doggett. But that by itself won't get the job done, as
    your testimony indicates?
        Mr. Sax. That is absolutely correct.
        Mr. Doggett. Could you just--we have all talked--I have
    used the Swiss Town Hall example. But can you give us an
    example that won't cause our eyes to glaze over, of what some
    of these corporate tax shelters that you are hearing about,
    what they basically involve?
        Mr. Sax. There is a side of me that says I can't give you
    an example that won't cause your eyes----
        Mr. Doggett. That is part of the problem, isn't it? They
    are so complex no one can understand them.
        Mr. Sax. One of the common denominators is complexity used
    to obfuscate.
        Mr. Doggett. Exactly.
        Mr. Sax. You often hear it said that no agent can ever
    understand or unravel this. So one of the predicates is the
    complexity that makes it almost impossible for me to give you a
    short description of one. One fundamental concept is to bring a
    built-in loss in from offshore and marry it up with a gain that
    is about to happen onshore, using either a partnership or
    corporation to mix the two up.
        Now, that is not done in a few words, that is done in
    several hundred pages of documents. That is the gist of one
    type.
        Mr. Doggett. By offshore, you mean some foreign entity that
    is not subject to United States taxation, they get the gain or
    the income, but the loss is here to be a benefit to someone who
    is a U.S. taxpayer?
        Mr. Sax. That's correct, Congressman. And the fundamental
    of that is to take a transaction that has a gain side and a
    loss side and put the gain side in a place that doesn't pay
    tax, whether it is a domestic nontaxpayer, a domestic taxpayer
    with offsetting losses or a foreign taxpayer, and put the loss
    side in the hands of someone who will use it to reduce taxes in
    this country.
        Mr. Doggett. I thank all four of you.
        Chairman Archer. Mr. McCrery.
        Mr. McCrery. Thank you, Mr. Chairman.
        Gentlemen, I appreciate the testimony that all of you have
    provided. And I have heard from others before the Committee
    today that basically while there are tools that the IRS has to
    use today to combat illegal tax shelters, you think that there
    is more that is needed legislatively to give the IRS or the
    government better tools to fight this kind of activity.
        And I am not sure how much further we need to go to give
    more tools to the government. But assuming that we do need to
    give more tools, do any of you see a danger in going too far
    the other way, in terms of inhibiting legitimate economic
    activity? I know you are not economists, but you have some
    familiarity with what we are talking about. Do any of you have
    any fears of that?
        Mr. Sax. Congressman, I can respond to that by saying that
    we are very concerned about inhibiting legitimate business
    activity, and it is for that reason that we have confined the
    essence of our proposal to disclosure, figuring that if the
    worst thing that can happen is that facts have to be disclosed
    by the taxpayer, that is not too terrible. That is an
    acceptable burden to place on taxpayers who come close to the
    line.
        Mr. Lifson. I think that my statement emphasizes the
    importance, not of law enforcement, but of self-assessment. And
    by making large gray areas, areas that responsible corporate
    officers must disclose, a responsible corporate officer knows
    the difference between a business start-up that produces losses
    and a tax shelter. They know what they have been working with
    and how they have worked and generated those numbers. So by
    having that gray area simply disclosed with higher standards
    and so on, you create a self-policing system.
        Mr. McCrery. Mr. Shewbridge, how do you respond to that?
        Mr. Shewbridge. I don't disagree at all with the disclosure
    proposals. The books and records of corporate taxpayers, and
    their tax returns are open, and I don't think they mind
    disclosing.
        I would say, though, that with respect to corporate tax
    shelters, the only way that we can disclose is to know what the
    animal is. We need a very clear, concise definition of what a
    corporate tax shelter is in order to know what to disclose.
    Also, we think that the promoters ought to be disclosing.
        Mr. McCrery. Mr. Handler.
        Mr. Handler. Mr. McCrery, in the report I referred to in my
    testimony, we have a great concern about legitimate corporate
    transactions being subject to this kind of legislation. And in
    fact one of the things we comment on in our report is that we
    do not agree with what has been called by Mr. Lifson and others
    as super 269 provisions or new substantive rules that would
    potentially attract corporate transactions. We believe, as
    others on this panel do, that disclosure is one element; but we
    also believe, as I said earlier, that the reasonable cause
    opinion which does not allow for significant risks to a
    corporate taxpayer who wishes to undertake one of these
    transactions has got to be strengthened.
        Mr. McCrery. In 1997, the Congress enhanced the substantial
    understatement penalty related to corporate tax shelters. Given
    the standard lag in the audit cycle, should we wait to assess
    the impact of that change in the law on this kind of activity,
    or do you think it is going to have any substantial impact?
        Mr. Shewbridge. I think you are seeing some activity in
    that right now, with many recent court decisions. Taxpayers are
    certainly going to be looking at those cases and making
    decisions as to what risks they want to take going forward. So,
    yes, I think a waiting period is probably in order.
        Mr. McCrery. Anybody else?
        Mr. Handler. As Ms. Paull said earlier in the earlier
    panel, one of the problems with the existing understatement
    penalty is the ability to avoid it. And it is relatively easy
    to avoid in today's world by reason of the kinds of opinions I
    have discussed. I think it would be appropriate for Congress to
    consider that element of the understatement regime.
        Mr. McCrery. And one last question, especially for you, Mr.
    Handler, in your testimony, you say that you favor increasing
    penalties on taxpayers that are engaging in corporate tax
    shelters. Would you also favor increasing penalties on advisers
    who issue opinions to corporate tax shelters, to corporate tax
    executives on tax shelters?
        Mr. Handler. At the risk of sounding self-serving, our view
    is that the proper party to whom these penalties should apply
    is the taxpayer undertaking them. In my experience, with the
    members of my group, and we represent, remember, 3,000
    professionals, the issue of proper analysis and the kinds of
    risks that are associated with these transactions is a function
    of what the law requires.
        At the moment, the law only requires a more likely than not
    opinion, which, because of the ambiguity of some provisions in
    the laws, is a relatively easy standard to satisfy. That is why
    we proposed strict liability and allow professionals like
    myself to advise clients that there is a risk of penalty in
    transactions where a properly-defined tax shelter might fit
    this particular transaction.
        Mr. McCrery. I want to thank you. I am a lawyer, too. And I
    appreciate Mr. Sax defending our profession. I know a lot of
    lawyers and I know some of them who are good and some of them
    who are bad. I know a lot of doctors, some of them are good and
    some are bad. I know a lot of lobbyists, most of them are good.
        But, you know, I am tired of this name calling and trying
    to classify people according to their profession or according
    to somebody's perception of them. I wish we would get away from
    that. There are good people and bad people in all professions
    and I think generally about the same percentage in all the
    professions are good and bad. And we ought to just accept that
    and move on.
        Thank you, gentlemen.
        Chairman Archer. Would my friend from Louisiana include
    Members of Congress in that?
        Mr. McCrery. Yes, sir.
        Chairman Archer. Gentlemen, I would like to follow up for
    just a moment, if I may, because we do want to work through
    this and we do want to find the right answer. I myself believe
    it is important that we have as much specificity as possible in
    the standard that we ultimately enact.
        And I am very, very concerned about that. But this entire
    concept is promoted, in a sense, by allusion to promoters and
    those who call you on the phone, those who come to your office,
    those who are going to charge you a fee because they have got a
    tax shelter plan and they are going to urge you to adopt it.
    And clearly, I don't think any of us are sympathetic to that.
        And if there is a way to ferret that out and address that,
    then that is something we ought to try to pursue, if possible.
    But as I read this bill, it goes far beyond that. I mean, the
    promotion of the bill is on the basis that there are outside
    promoters coming in and that they are--they are literally
    prospering on the tax system by getting good people to do
    wrong.
        But the reality of this bill is, it is far, far more than
    that. It is anybody who undertakes any deduction, any
    deduction, any tax credit, internally generated, because you
    are under the fiduciary responsibility to reduce your tax
    burden legally as much as you can as a cost of doing business.
    It hits you, not just the promoters, not just people who come
    in from the outside.
        And I am concerned about that, particularly when there is
    not a specificity as to standard, because I think it gets over
    into everything, it gets over into your borrowing, it gets over
    into the underwriting of new stock issues, the investment
    brokerage houses. Every aspect that has any relationship to the
    Tax Code is covered by this in a very broad sweeping way. And
    so we need your help to help us work through this and to get to
    the right answer.
        I am curious before you leave, I would like to know what
    each of you feels--we have listened to you and I think we have
    an understanding of where you are. But what I want to hear is
    whether any one of you endorses H.R. 2255, the Doggett bill
    that we are having a hearing on today.
        Does any one of you endorse that bill and that approach
    specifically to the problem?
        Mr. Handler. Mr. Chairman, as I indicate in my testimony,
    our group endorses the repeal of the reasonable cause exception
    to the understatement penalty. And that is a key provision of
    the Doggett bill.
        Chairman Archer. But it goes far beyond that.
        Mr. Handler. I agree it goes far beyond it.
        Chairman Archer. So the record should show that there is
    not a one of you that endorses the complete H.R. 2255?
        Mr. Sax. That is true, Mr. Chairman, but the disclosure
    provisions of H.R. 2255 and our disclosure provisions are for
    all practical purposes the same, so we very much endorse and
    embrace the disclosure provisions of that section of the bill.
        Chairman Archer. But let me reiterate, this bill goes far
    beyond the provision that you endorse and the provision that
    Mr. Handler endorses, so if the Committee's decision must be to
    embrace this bill or to embrace nothing, what would be your
    position in its entirety now? You know, I don't mean to pick
    and choose one section. You say, okay, I agree with this
    section, you have got to look at the bill in its entirety.
        Mr. Handler. May I speak to that for a second?
        Chairman Archer. Yes, please, sir.
        Mr. Handler. Someone earlier at one of the--perhaps it was
    yourself indicated there are many approaches to this issue and
    many ways of getting at a solution to these problems.
    Provisions in the Doggett bill, including the definition of a
    noneconomic attribute, pick up and include a number of items
    that we would include in a different form of approach to the
    problem in trying to define transactions that would be subject
    to a nonstrict liability penalty.
        In that respect, I think that the Doggett bill is
    absolutely correct. It has picked up a number of the attributes
    of the tax shelter proposals that are floating around, not all
    of them, but many of them, the taxing different party issues
    and the other aspects, which I believe and our group believes
    should be included in an appropriate definition of a tax
    shelter to which strict liability would apply.
        Now, that is not the same approach as Congressman Doggett's
    approach. We do not agree with a substantive provision that is
    like a 216 or a super 269, which is akin to what Congressman
    Doggett approach would provide. But that doesn't mean that we
    disagree with the elements of the Congressman's proposal.
        Chairman Archer. Thank you for explaining that.
        Mr. Doggett, do you want to follow up?
        Mr. Doggett. Since my name is invoked, I do want to follow
    up just a little bit.
        Mr. Sax, let me begin with you. I believe you made clear
    that as far as this bill, which only has about 4 or 5 sections,
    section 4 on disclosure, you believe follows almost verbatim
    the recommendations that the ABA has made?
        Mr. Sax. That is correct.
        Mr. Doggett. With reference to section 3, while I
    understand you don't embrace section 3 as it is written today,
    the idea of having the courts rely on a codified economic
    substance rule, which your section has not yet proposed with
    specificity, but that idea is something that we share in common
    with reference to section 3, is it not?
        Mr. Sax. There is a commonality.
        Mr. Doggett. And there is a difference?
        Mr. Sax. And there is a difference. We propose that where
    the courts choose to apply to the economic substance doctrine
    there be a weighing of tax and nontax benefits. I might note
    that we don't view that as complicating matters. As the
    economic substance doctrine stands, there is no standard
    whatever and it is very complicated because there is simply no
    guidance. Adding the word ``substantial'' is imperfect but it
    is better than nothing at all, and certainly clearer.
        Mr. Doggett. If the word ``substantial'' is used in the
    right way, it adds more clarification than our current law has?
        Mr. Sax. That is our position.
        Mr. Doggett. And Mr. Handler, I believe the New York State
    Bar Association disclosure provisions are somewhat different
    than the American Bar Association's disclosure requirements, is
    there some variation?
        Mr. Handler. We are very close.
        Mr. Doggett. Very close. So as to the disclosure
    requirements and the provisions concerning the reliance on what
    is called the ``excuse letter,'' you are in agreement with the
    bill?
        Mr. Handler. Yes, absolutely.
        Mr. Doggett. And is your position somewhat similar to Mr.
    Sax's with reference to the use of the economic substance test;
    you believe that the Congress should codify it, but you would
    do that in a somewhat different way than I have done in section
    3?
        Mr. Handler. That is correct.
        Mr. Doggett. And generally the findings and purpose clause,
    which is section 2, it seems to me to read pretty close to some
    of the testimony as you have given here.
        Mr. Handler. That is correct, Congressman.
        Mr. Doggett. Thank you very much for your testimony.
        Chairman Archer. Gentlemen, again, thank you. And we will
    be looking forward to having further input from you as we move
    through this process. Thank you very much.
        Mr. Sax. Thank you.
        Mr. Handler. Thank you.
        Mr. Lifson. Thank you.
        Chairman Archer. Our next panel, Mr. Kenneth Kies, Mr.
    David Hariton, Mr. Martin Sullivan, and Mr. Danny Carpenter.
    Please come to the witness table.
        Welcome, gentlemen. As usual, your entire written
    statement, without objection, will be inserted in the record.
    And if you will make your verbal testimony as concise as
    possible, the Committee would appreciate it.
        And if each of you will identify yourself and the entity
    that you represent before giving your testimony, that will be
    good for the record.
        Mr. Kies, would you begin?

     STATEMENT OF KENNETH J. KIES, CO-MANAGING PARTNER, WASHINGTON
           NATIONAL TAX SERVICES, PRICEWATERHOUSECOOPERS LLP

        Mr. Kies. Yes, Mr. Chairman, and thank you, I am Ken Kies,
    co-managing partner of PricewaterhouseCoopers, Washington tax
    practice. The U.S. and Canadian tax practice of the worldwide
    firm has more than 6,500 professionals.
        Today I would like to focus my comments on what I believe
    to be specific myths surrounding the debate over corporate tax
    shelters. Also I have submitted extensive written testimony
    that I appreciate the Chairman including in the record.
        The first myth I would like to discuss concerns corporate
    revenues. Advocates of sweeping change will tell you that
    corporate tax shelters are eroding the corporate tax base.
    There is no evidence that supports this view. Yet the Treasury
    Department and others continue to cite an unsubstantiated claim
    by Joseph Bankman, a part-time teacher at Stanford University,
    that $10 million in tax revenues are lost each year from
    corporate tax shelter activities.
        Mr. Bankman is not an economist and has had limited
    experience with tax issues in private practice. He tells us in
    his Internet chat room that this $10 billion figure is and, I
    quote, ``obviously just an estimate.'' Yet this $10 billion
    figure keeps being repeated by government officials as if it
    was somewhat a fact or the result of an authoritative study; it
    is not.
        The facts are as follows, as reflected on the charts in
    front of you. First, corporate income tax revenues since 1992
    have grown by more than 80 percent. By contrast, the economy
    has grown by only 44 percent. Second, corporate income tax
    revenues over the past 4 years have been at the highest levels
    as a percentage of GDP than at any time since 1980. These
    statistics suggests an extremely vibrant corporate income tax,
    not a system being eroded.
        Myth number 2 is that the corporate tax shelter proposals
    advanced by Treasury Department and others would not hinder
    legitimate business transactions. Treasury's John Talisman in a
    letter to Mr. Doggett has stated that the shelter proposals
    would not unduly interfere with legitimate transactions.
    Frankly, it is not okay to interfere with legitimate
    transactions. In reality, the shelter proposals would cast
    considerable doubt on the continued legality of a wide range of
    legitimate transactions.
        The UK earlier this year abandoned a proposal very similar
    to the corporate tax shelter proposals before us because of
    concerns over the uncertainties that proposals would have
    created for UK corporations seeking to move forward with
    legitimate transactions.
        You should also look to the U.S.-Italy income tax treaty.
    As proposed, this new treaty included a so-called main purpose
    test that would have given tax administrators the authority to
    disregard the tax rules as written, if they believed tax
    reduction was a motivation behind a transaction.
        In other words, this test looks a lot like the definitions
    of a corporate tax shelter before us. The Joint Committee in
    testimony this month rightfully criticized this treaty
    provision, calling the main purpose test vague and subjective
    and noting that it can, and I quote, ``create planning
    difficulties for legitimate business transactions.'' Precisely
    the same arguments apply to the corporate tax shelter proposals
    before us. The Senate has now stripped this test from the
    Italian treaty.
        Myth number 3 is that the IRS lacks sufficient tools under
    law to combat abuse; a string of recent court victories by the
    IRS directly refutes this argument.
        Myth number 4 is that new disclosure requirements would not
    be burdensome. The broad disclosure requirements proposed would
    force corporate taxpayers to generate mountains of paperwork
    describing a multitude of transactions. The UK abandoned its
    proposed legislation in significant part due to concerns over
    the ability to handle the extensive disclosure that would have
    been required.
        Myth number 5 is that a consensus has somehow formed around
    new policies to address perceived shelters. The fact is that
    there are considerable differences of opinion. The Joint
    Committee does not support Treasury's proposed expansion of
    section 269. Moreover, Treasury itself isn't sure what the
    right answer is. Treasury's July ``white paper,'' released just
    before the July 4th recess, made significant modifications to
    the shelter proposals included in the administration's own
    budget released just months earlier. This uncertainty over
    policy throws into question the remaining proposals that
    Treasury continues to promote.
        In closing, I would simply say that proponents of sweeping
    corporate tax shelter legislation have not met the burden of
    proof necessary to justify enactment of changes as sweeping and
    radical as the proposals before us. The fact of the matter is
    that corporate taxes are inherently complex, as are corporate
    transactions themselves, and the relationship between the IRS
    and taxpayers is naturally adversarial. As a result, there are
    going to be differences of opinion over application of the tax
    law. These realities will not be changed by the proposals
    before us.
        Before I close, I would like to say that we at
    PricewaterhouseCoopers take very seriously our professional
    responsibility as tax advisers. We are concerned about the
    perception that has arisen that corporate tax planning is
    growing increasingly abusive. We do not believe abuses are
    pervasive; however, we do believe there are practitioners who
    engage in questionable activities. We believe this calls for a
    targeted and measured response.
        Toward this end, we commend the Joint Committee for its
    proposal to strengthen Circular 230 and regulations that govern
    the professional conduct of tax practitioners. We are prepared
    to work with the tax-writing Committees in considering this
    issue. And I thank you very much for your time.
        Chairman Archer. Thank you, Mr. Kies, and you carefully
    prepared your remarks to finish exactly at the 5-minute level.
        [The prepared statement follows:]

    Statement of Kenneth J. Kies, Co-Managing Partner, Washington National
    Tax Services, PricewaterhouseCoopers, LLP

                                I. Introduction

        PricewaterhouseCoopers appreciates the opportunity to
    submit this written testimony to the Committee on Ways and
    Means on the subject of ``corporate tax shelters.''
        PricewaterhouseCoopers, the world's largest professional
    services organization, provides a full range of business
    advisory services to corporations and other clients, including
    audit, accounting, and tax consulting. The firm, which has more
    than 6,500 tax professionals in the United States and Canada,
    works closely with thousands of corporate clients worldwide,
    including most of the companies comprising the Fortune 500.
    These comments reflect the collective experiences of many of
    our corporate clients.
        Doing something about ``corporate tax shelters'' has a
    certain rhetorical appeal, stoked by the press, that threatens
    to overwhelm principles of sound tax policy and administration.
    Concerns have been expressed that large corporations routinely
    are avoiding taxes by undertaking complex tax-motivated
    transactions. The Treasury Department and others claim--without
    supporting evidence--that the corporate income tax base is
    eroding and will continue to erode absent sweeping tax-law
    changes and new restrictions on corporate tax executives.
        In this testimony, we provide a detailed, reasoned analysis
    of the asserted ``corporate tax shelter'' problem and the
    proposed remedies, taking into account actual experiences of
    corporate taxpayers rather than theoretical speculation. We
    analyze budget and economic data to determine whether there is
    empirical evidence supporting the view that the corporate
    income tax base is being eviscerated. We explore the efficacy
    of tools already available to the Treasury Department and the
    Internal Revenue Service (IRS)--and to the Congress--to address
    abusive transactions. Finally, we consider the potential impact
    of proposals that have been advanced to date by Treasury \1\ ,
    the staff of the Joint Committee on Taxation (JCT) \2\ , and
    others.
    ---------------------------------------------------------------------------
        \1\ The Problem of Corporate Tax Shelters, Department of the
    Treasury, July 1999; General Explanations of the Administration's
    Revenue Proposals, Department of the Treasury, February 1999.
        \2\ Study of Present-Law Penalty and Interest Provisions as
    Required by Section 3801 of the Internal Revenue Service Restructuring
    and Reform Act of 1998 (Including Provisions Relating to Corporate Tax
    Shelters), Staff of the Joint Committee on Taxation, July 22, 1999
    (JCS-3-99) [hereinafter JCT study].
    ---------------------------------------------------------------------------
        We conclude that no justification has been presented that
    would support enactment of such sweeping tax policy changes at
    this time. Economic data does not suggest any systemic erosion
    of the corporate income tax base. Current-law administrative
    tools, if used properly, are more than adequate to detect and
    penalize tax avoidance. The legislative proposals that have
    been advanced are at odds with sound tax policy principles and
    administration, would threaten legitimate tax-planning
    activities undertaken by corporate tax professionals, and would
    exacerbate the complexity of the tax code.

                     II. Arguments Against Sweeping Changes

    A. The Myth of the Eroding Corporate Income Tax Base

        Both the Treasury Department and the JCT staff have cited
    as justification for their proposals a possible erosion of
    corporate income tax revenues attributable to ``corporate tax
    shelters.'' Neither has presented any evidence to support this
    concern. Rather, both have cited--as their only reference--
    statements made Joseph Bankman of Stanford University that
    corporate tax shelters are responsible for $10 billion in lost
    corporate income tax revenues each year. Bankman essentially
    admits he has no data supporting his $10 billion figure in his
    Internet tax policy chatroom,\3\ where he answers a question
    from a reader as to the references for his $10 billion figure
    as follows: ``The $10 billion figure that I am quoted on is
    obviously just an estimate.'' This unsubstantiated claim hardly
    represents the type of serious economic analysis that should be
    undertaken before adopting sweeping tax policy changes of the
    scope envisioned by Treasury and the JCT staff.
    ---------------------------------------------------------------------------
        \3\ http://www.law.nyu.edu/bankmanj/federalincometax
    ---------------------------------------------------------------------------
        An analysis of actual data shows no evidence of a loss of
    corporate income tax revenues attributable to shelter
    activities. Since 1992, corporate federal income tax payments
    have grown by more than 80 percent, from $100.3 billion in
    fiscal 1992 to $184.7 billion in fiscal 1999 (see Appendix 1).
    By point of comparison, GDP has grown by 44 percent over this
    period. Over the fiscal 1993-1999 period, corporate tax
    payments averaged 2.1 percent of GDP; only once in the
    preceding 1980-1992 period were corporate income tax payments
    higher in percentage terms (in 1980).
        Despite the high level of tax payments in the post-1992
    period, some commentators have pointed to a two-percent drop in
    federal corporate tax payments in fiscal 1999, as compared to
    the prior year, as possibly indicating corporate tax shelter
    activity.\4\ This claim has been made despite the fact that, at
    2.1 percent of GDP in fiscal 1999 (through June), corporate tax
    payments remain higher than the average for the 1980-1999
    period (1.9 percent).
    ---------------------------------------------------------------------------
        \4\ See, Martin A Sullivan, ``Despite September Surge, Corporate
    Tax Receipts Fall Short,'' 85 Tax Notes 565 (Nov. 1, 1999).
    ---------------------------------------------------------------------------
        A possible explanation for this drop is a relative decline
    in corporate profits attributable to depreciation deductions
    associated with increased equipment investment and the increase
    in employee compensation relative to corporate profits.\5\ The
    Congressional Budget Office in its mid-session review in July
    noted these as among the factors putting downward pressure on
    corporate profits.\6\ It also should be noted that the slight
    falloff in corporate profits was not unforeseen--the Office of
    Management and Budget (OMB) at the beginning of this year
    projected that corporate income tax payments would fall in FY
    1999, before rising again in FY 2000.\7\ It should be further
    noted that actual corporate income tax payments for FY 1999
    exceeded the January forecast by more than $2 billion.
    ---------------------------------------------------------------------------
        \5\ See, New York Times, September 21, 1999, ``When an Expense is
    Not an Expense.'' This article points to rising compensation paid in
    the form of stock options as a possible explanation. An increase in
    employee compensation increases personal income tax (at the employee
    level) at the expense of corporate income tax, because employee
    compensation generally is deductible in computing corporate income tax
    and includable in computing personal income tax.
        \6\ Congressional Budget Office, The Economic and Budget Outlook:
    An Update, July 1, 1999.
        \7\ The Administration's FY 2000 budget projected that corporate
    income revenues would total $182.2 billion in FY 1999, or $2.5 billion
    less than actual.
    ---------------------------------------------------------------------------
        In this section of the statement, we examine whether the
    recent dip in corporate income tax payments provides any
    evidence that ``corporate tax shelter'' activity is
    proliferating. After a thorough review of the data, including
    data from the IRS, the Bureau of Economic Analysis (BEA), and
    corporate financial statements, we find no basis for assertions
    that increased shelter activity has caused corporate tax
    burdens to fall.

    1. Corporate tax liability and the timing of tax payments

        Corporate tax payments received by the IRS during a given
    year fail to reflect that year's tax liability for several
    reasons. First, large corporate taxpayers frequently have five
    to ten ``open'' years for which final tax liability has not
    been determined. Thus, current corporate tax payments may
    include deficiencies (plus interest and penalties) for a number
    of prior tax years. Similarly, current corporate tax payments
    may be reduced by refunds arising from overpayments of
    corporate tax in a number of prior tax years. In addition,
    current tax payments may be reduced by previously unused net
    operating losses and tax credits that are carried forward from
    prior years. Thus, current data on corporate income tax
    payments received by the IRS are not a reliable indicator of
    current year tax liability; rather, current year tax receipts
    reflect a blend of current and past year tax liabilities, and
    are reduced by carryforwards of unused losses and credits from
    prior years.

    Corporate tax payments

        Monthly information on receipts of corporate income taxes
    by the U.S. Government is published by the Financial Management
    Service of the U.S. Treasury Department. \8\ The Treasury
    defines net corporate receipts in any month as gross receipts
    less refunds. Net corporate tax receipts were $185 billion in
    calendar year 1998, and are estimated to remain flat (at $184.6
    billion) in 1999, based on annualized results for the first
    nine months (see Appendix 2). Gross corporate tax receipts in
    1998 were $213.5 billion, and based on the first nine months of
    1999, gross receipts are estimated to increase by more than one
    percent to $216.4 billion. The slight dip in net corporate
    receipts over the last two years is almost entirely due to an
    increase in refunds. Refunds can increase as a result of
    overpayments of estimated tax (which may occur when profits
    turn out to be lower than expected) or as a result of
    amendments to prior year tax returns (for example, when current
    year losses or credits are carried back to a prior tax year).
    Until the IRS tabulates tax return data for 1998 and 1999, it
    is not possible to determine the reason for the recent increase
    in refunds.
    ---------------------------------------------------------------------------
        \8\ U.S. Dept. of the Treasury, Monthly Treasury Statement of
    Receipts and Outlays of the United States Government.

    ---------------------------------------------------------------------------
    Corporate tax liability

        For purposes of the National Income and Product Accounts,
    BEA makes current estimates of corporate tax liability based on
    IRS and other data. The IRS calculates annual corporate income
    tax liability by tabulating corporate tax returns (before
    audit). The most recent publicly available corporate income tax
    return information is for IRS years 1996 (i.e., tax years
    ending after June 1996 and before July 1997).\9\
    ---------------------------------------------------------------------------
        \9\ See, IRS, Statistics of Income Bulletin, Winter 1998/1999.
    ---------------------------------------------------------------------------
        In summary, it is important to distinguish between
    corporate tax liability and corporate tax receipts. Because
    corporate tax receipts are a mix of estimated tax payments for
    the current year as well as adjustments (both up and down) to
    taxes paid with respect to prior years, a drop in corporate tax
    receipts does not imply a drop in corporate tax liability. For
    example, in 1985, corporate tax receipts increased over the
    prior year at the same time that corporate tax liability
    decreased (see Appendix 2).

    2. Effective Tax Rates: Commerce Department Data

        Corporate tax liability can be broken down into two
    components: (1) a reference measure of profits arising in the
    corporate sector; multiplied by (2) the effective tax rate
    (which is equal to corporate tax divided by reference profits).
    A decline in corporate tax liability can occur as a result of
    lower profits or, alternatively, as a result of a lower
    effective tax rate. A decline in corporate tax liability due to
    a fall in real corporate income is not, of course, evidence of
    tax shelter activity. By contrast, a decline in the effective
    tax rate may warrant investigation to determine if there is tax
    avoidance not intended by lawmakers.
        Calculation of the effective corporate tax rate requires a
    measure of corporate income tax liability as well as a
    reference measure of corporate profits. Two data sources are
    used in this analysis: (1) the National Income and Product
    Accounts (NIPA) published by the U.S. Commerce Department; and
    (2) data from audited financial statements of public companies
    filed with the Securities and Exchange Commission (SEC) on Form
    10K. Effective tax rate calculations based on NIPA data are
    described in this section; calculations based on SEC data are
    described in the following section.
        One of the items used by BEA to calculate GDP is
    ``corporate profits before tax.'' \10\ This concept of profits
    includes income earned in the United States (whether by U.S. or
    foreign corporations) and excludes income earned outside the
    United States. For purposes of calculating an effective tax
    rate, several adjustments are made to ``corporate profits
    before tax": (1) profits of the Federal Reserve Banks are
    subtracted; (2) profits of subchapter S corporations are
    subtracted; (3) payments of State and local income tax are
    subtracted; and (4) corporate capital gains are added. These
    adjustments follow the methodology developed by CBO to estimate
    ``taxable corporate profits.'' \11\ BEA estimates that
    corporate profits before tax, as adjusted, increased from $587
    billion in calendar 1998 to $603 billion in 1999 (see Appendix
    3).\12\ As a percent of GDP, pre-tax corporate profits are
    estimated to have reached a post-1980 high of 7.0 percent in
    1996, with a dip to 6.9 percent in 1997-1998, and a further dip
    to 6.8 percent in the first half of calendar 1999 on an
    annualized basis.
    ---------------------------------------------------------------------------
        \10\ BEA makes two adjustments to this measure of corporate profits
    in determining GDP: (1) BEA uses an ``economic'' measure of
    depreciation rather than tax depreciation (i.e., the ``capital
    consumption adjustment''); and (2) BEA removes inventory profits
    attributable to changes in price (i.e., the ``inventory valuation
    adjustment'').
        \11\ See, Congressional Budget Office, The Shortfall in Corporate
    Tax Receipts Since the Tax Reform Act of 1986, CBO Papers, May 1992.
    The first adjustment reflects the fact that the Federal Reserve system
    is not subject to corporate income tax; the second adjustment is made
    because S corporations generally do not pay corporate level tax (rather
    the income is flowed through to the shareholders); the third adjustment
    is made because state and local income taxes are deductible in
    computing federal income tax; and the fourth adjustment is necessary
    because corporations are taxed on capital gains while GDP excludes
    capital gains.
        \12\ 1999 data are annualized based on the first six months of the
    year, seasonally adjusted.
    ---------------------------------------------------------------------------
        Based on adjusted NIPA data, the effective corporate tax
    rate, measured as federal corporate tax liability divided by
    corporate profits before federal income tax, is projected to be
    32.7 percent in 1999, higher than the 31.2 percent rate in 1998
    and higher than the 32.6 percent average for the 1993-1999
    period (see Appendix 3). Thus, based on the National Income and
    Product Accounts, there is no evidence of a decline in the
    effective rate of corporate income tax.

    3. Effective Tax Rates: SEC Data

        Corporate effective tax rates also can be estimated from
    the audited financial statements that publicly traded companies
    are required to file with the SEC. This method was used by the
    General Accounting Office in its 1992 study of corporate
    effective tax rates.\13\ Following the GAO methodology, the
    effective corporate tax rate is measured by dividing the
    current provision for federal income tax into reported U.S.
    operating income, reduced by the current provision for State
    and local income tax. U.S. operating income is determined by
    subtracting foreign operating income from total operating
    income net of depreciation, based on geographic segment
    reporting.
    ---------------------------------------------------------------------------
        \13\ See, General Accounting Office, ``1988 and 1989 Company
    Effective Tax Rates Higher Than in Prior Years,'' GAO/GGD-92-11, August
    1992.
    ---------------------------------------------------------------------------
        Standard & Poors publishes SEC 10K data in its Compustat
    database, which is updated monthly.\14\ Based on the August
    1999 Compustat data release, effective corporate tax rates were
    calculated for the 1988-1998 period using information from
    every corporation in the database that supplied all of the
    necessary data items. Recognizing that the results for 1998
    might not be comparable to prior years due to the limited
    sample size, the effective tax rates for 1996 and 1997 were
    recomputed using information from the same companies as in the
    1998 sample.
    ---------------------------------------------------------------------------
        \14\ Financial statements for companies with fiscal years ending
    after May of 1998, and before June of 1999, are classified as 1998
    statements in Compustat. Because there is a lag between the end of a
    company's fiscal year and the time it files Form 10K, and another lag
    between the time the form is filed and the time it is processed by
    Standard & Poors, information for Compustat's 1998 year was incomplete
    as of August 1999.
    ---------------------------------------------------------------------------
        For purposes of this analysis we excluded publicly traded
    corporations and partnerships that are not generally taxable at
    the corporate level (i.e., mutual funds and real estate
    investment trusts). Separate calculations were made for
    companies that reported foreign activity (multinationals) and
    for companies that reported no foreign activity (domestics). A
    multinational's current provision for U.S. tax may include U.S.
    tax on foreign source income; consequently, measured relative
    to domestic income, the effective tax rate of U.S.
    multinationals may be higher than for comparable domestic
    firms. In theory, U.S. tax on foreign source income should be
    removed from the numerator of a domestic effective tax rate
    calculation; however, this adjustment cannot accurately be made
    with financial statement data.
        The results of this analysis are shown in Appendix 4. For
    1997, the most recent year for which annual reporting is
    complete, companies included in the Compustat sample report $78
    billion of current federal income tax liability, accounting for
    over 40 percent of federal corporate tax liability in the
    National Income and Product Accounts. The Compustat sample of
    firms excludes private companies and public companies that do
    not report all of the items necessary to calculate the
    effective tax rate. While the average firm in Compustat is much
    larger than the average corporate taxpayer, the main purpose of
    our analysis is to examine the trend in effective corporate tax
    rates over time. We have no reason to believe that there is a
    systematic difference in trend effective tax rates between
    companies in Compustat and other corporate taxpayers. Indeed,
    if there were a proliferation of corporate tax shelter
    activity, we might expect to see indications of this first
    among the largest and most sophisticated corporations, of the
    type included in the Compustat sample.
        In general, we find that the effective tax rates calculated
    from financial statement data are lower than those calculated
    from the National Income and Product Accounts. One reason for
    this is that the profit definition used for the NIPA
    calculations is based on tax depreciation, while the profit
    definition used for the financial statement calculations is
    based on book depreciation. Another reason is that the income
    element of nonqualified stock options is deductible for tax
    purposes when the option is excercised (and included in the
    employee's income), but is not treated as an expense against
    income for financial statement purposes. We also find that, on
    average, over the 1988-1998 period, effective federal tax rates
    are higher for multinational corporation than for domestic
    corporations.
        Based on financial statement data, the corporate effective
    tax rate for all corporations (domestic and multinational) was
    higher in 1997 (19.9 percent) than the average over the ten-
    year period 1988-1997 (18.5) percent, and for the sample of
    companies reporting financial results for 1998, the effective
    tax rate increased between 1997 (19.4 percent) and 1998 (20.7
    percent).\15\
    ---------------------------------------------------------------------------
        \15\ These results also generally hold up when effective tax rates
    are measured relative to U.S. assets or U.S. revenues. Among domestic-
    only firms, however, income has grown more slowly than either assets or
    revenues since 1995, with the result that the ratio of tax liability to
    either assets or revenues has declined slightly for companies without
    foreign operations.
    ---------------------------------------------------------------------------
        In summary, based on audited financial statements, there is
    no evidence for a decline in the effective corporate tax rate.
    This is consistent with our findings using National Income and
    Product Account data.

    4. Corporate capital gains

        One category of corporate ``tax shelter'' that has received
    recent attention is the use of transactions designed to avoid
    tax on capital gains. Indeed, one commentator believes these
    transactions are so prevalent that the tax on corporate capital
    gains has essentially been rendered ``elective.''\16\ If this
    assessment of the corporate income tax system were accurate, we
    would expect to see a marked decline in corporate capital gain
    realizations in recent years.
    ---------------------------------------------------------------------------
        \16\ Michael Schler, as quoted in the September 1, 1999, Wall
    Street Journal ``Tax Report,'' A1.
    ---------------------------------------------------------------------------
        The IRS data, however, do not support the view that
    corporations easily can avoid tax on capital gains. Excluding
    mutual funds, net corporate gain on capital assets increased by
    54 percent from $53 billion in 1992 to $82 billion in 1996 (the
    most recent year for which IRS data is available)--an average
    annual increase of 11.5 percent per year (see Appendix 5). In
    short, notices of the death of the corporate capital gains tax
    are premature.

    5. Conclusion

        If unusually high levels of corporate tax shelter activity
    have been occurring over the last few years, we would expect to
    see a drop in corporate tax liability relative to normative
    measures of pre-tax corporate income. To test this hypothesis,
    we measure corporate effective tax rates using data from the
    National Income and Product Accounts and audited financial
    statements. Neither measure shows a suspicious drop in tax
    liabilities relative to corporate income; to the contrary, both
    measures show flat or rising corporate effective tax rates over
    the last five years. Moreover, if corporate capital gains tax
    was easily avoidable using tax shelter techniques, we would
    expect to see little or no growth in net capital gains reported
    on corporate tax returns. Again, the data disprove this
    hypothesis, showing instead a robust rate of increase over the
    most recent four-year period for which data are available.

    B. Efficacy of Current-Law Tools

        Proponents of extensive new legislation to address
    ``corporate tax shelters'' overlook the formidable array of
    tools currently available to the government to deter and attack
    transactions considered as abusive. In our view, the tools
    described below are more than sufficient to achieve compliance
    with the corporate income tax. That is, these tools enable the
    IRS and courts to ensure that corporations pay the corporate
    income tax liability that results from application of the
    Internal Revenue Code.

    1. Threat of penalties

        As an initial matter, the tax Code includes significant
    disincentives to engage in potentially abusive behavior.
    Present law imposes 20-percent accuracy-related penalties under
    section 6662 in the case of negligence, substantial
    understatements of tax liability, and certain other cases. In
    considering a proposed transaction that may turn on a debatable
    reading of the tax law, a corporate tax executive must weigh
    the potential for imposition of these penalties, which could
    have a negative impact on shareholder value and on the
    corporation.
        Furthermore, it should be noted that Congress, in the 1997
    Taxpayer Relief Act, strengthened the substantial
    understatement penalty as it applies to ``tax shelters.'' Under
    this change, which was supported and encouraged by the Treasury
    Department, an entity, plan, or arrangement is treated as a tax
    shelter if it has tax avoidance or evasion as just one of its
    significant purposes.\17\ The Congress believed that this
    change, coupled with new reporting requirements that Treasury
    has failed to activate, would ``improve compliance by
    discouraging taxpayers from entering into questionable
    transactions.'' \18\ Although this change is effective for
    current transactions, the IRS and Treasury have not yet issued
    regulations providing guidance on the term ``significant
    purpose.''
    ---------------------------------------------------------------------------
        \17\ Section 6662(d)(2)(C)(iii). Prior law defined tax shelter
    activity as an entity, plan, or arrangement only if it had tax
    avoidance or evasion as the principal purpose.
        \18\ General Explanation of Tax Legislation Enacted in 1997, Staff
    of the Joint Committee on Taxation, December 17, 1997 (JCS 23-97).
    ---------------------------------------------------------------------------
        The 1997 Act changes have made it even more important for
    chief tax executives to weigh carefully the risks of penalties
    and even more difficult to determine which transactions might
    trigger penalties. At this time, there is no demonstrated
    justification for making these penalties even harsher.

    2. Anti-abuse rules

        The Code includes numerous provisions that arm Treasury and
    the IRS with broad authority to prevent tax avoidance, to
    reallocate income and deductions, to deny tax benefits, and to
    ensure taxpayers clearly report income.
        These rules long have provided powerful ammunition for
    challenging tax avoidance transactions. For example, section
    482 authorizes the IRS to reallocate income, deductions,
    credits, or allowances between controlled taxpayers to prevent
    evasion of taxes or to clearly reflect income. While much
    attention has been focused in recent years on the application
    of section 482 in the international context, section 482 also
    applies broadly in purely domestic situations. Further, the IRS
    also has the authority to disregard a taxpayer's method of
    accounting if it does not clearly reflect income under section
    446(b).
        In the partnership context, the IRS has issued regulations
    under subchapter K aimed at arrangements the IRS considers as
    abusive.\19\ The IRS states that these rules authorize it to
    disregard the existence of a partnership, to adjust a
    partnership's methods of accounting, to reallocate items of
    income, gain, loss, deduction, or credit, or otherwise to
    adjust a partnership's or partner's tax treatment in situations
    where a transaction meets the literal requirements of a
    statutory or regulatory provision, but where the IRS believes
    the results are inconsistent with the intent of the Code's
    partnership tax rules.
    ---------------------------------------------------------------------------
        \19\ Treas. Reg. Sec.  1.701-2.
    ---------------------------------------------------------------------------
        The IRS also has issued a series of far-reaching anti-abuse
    rules under its legislative grant of regulatory authority in
    the consolidated return area. For example, under Treas. Reg.
    Sec. 1.1502-20, a parent corporation is severely limited in its
    ability to deduct any loss on the sale of a consolidated
    subsidiary's stock. The consolidated return investment basis
    adjustment rules also contain an anti-avoidance rule.\20\ The
    rule provides that the IRS may make adjustments ``as
    necessary'' if a person acts with ``a principal purpose'' of
    avoiding the requirements of the consolidated return rules. The
    consolidated return rules feature several other anti-abuse
    rules as well.\21\
    ---------------------------------------------------------------------------
        \20\ Treas. Reg. Sec.  1.1502-32(e).
        \21\ E.g., Treas. Reg. Sec.  1.1502-13(h) (anti-avoidance rules
    with respect to the intercompany transaction provisions) and Treas.
    Reg. Sec.  1.1502-17(c) (anti-avoidance rules with respect to the
    consolidated return accounting methods).
    ---------------------------------------------------------------------------

    3. Common-law doctrines

        Pursuant to several ``common-law'' tax doctrines, Treasury
    and the IRS can challenge a taxpayer's treatment of a
    transaction if they believe the treatment is inconsistent with
    statutory rules and the underlying Congressional intent. For
    example, these doctrines may be invoked where the IRS believes
    that (1) the taxpayer has sought to circumvent statutory
    requirements by casting the transaction in a form designed to
    disguise its substance, (2) the taxpayer has divided the
    transaction into separate steps that have little or no
    independent life or rationale, (3) the taxpayer has engaged in
    ``trafficking'' in tax attributes, or (4) the taxpayer
    improperly has accelerated deductions or deferred income
    recognition.
        These broadly applicable doctrines--known as the business
    purpose doctrine, the substance over form doctrine, the step
    transaction doctrine, and the sham transaction and economic
    substance doctrine--give the IRS considerable leeway to recast
    transactions based on economic substance, to treat apparently
    separate steps as one transaction, and to disregard
    transactions that lack business purpose or economic substance.
    Recent applications of those doctrines have demonstrated their
    effectiveness and cast doubt on Treasury's asserted need for
    additional tools.
        The recent decisions in ACM v. Commissioner \22\ and ASA
    Investerings v. Commissioner \23\ illustrate the continuing
    force of these long-standing judicial doctrines. In ACM, the
    Third Circuit, affirming the Tax Court, relied on the sham
    transaction and economic substance doctrines to disallow losses
    generated by a partnership's purchase and resale of notes. The
    Tax Court similarly invoked those doctrines in ASA Investerings
    to disallow losses on the purchase and resale of private
    placement notes. Both cases involved complex, highly
    sophisticated transactions, yet the IRS successfully used
    common-law principles to prevent the taxpayers from realizing
    tax benefits from the transactions.
    ---------------------------------------------------------------------------
        \22\ 157 F.3d 231 (3d Cir. 1998). See also Saba Partnership, T.C.M.
    1999-359 (10/27/99).
        \23\ T.C.M. 1998-305.
    ---------------------------------------------------------------------------
        More recent examples of use of common-law doctrines by the
    IRS are the Tax Court's decisions in United Parcel Service v.
    Commissioner \24\ (8/9/99), Compaq Computer Corp. v.
    Commissioner \25\ (9/21/99), and Winn-Dixie v. Commissioner
    \26\ (10/19/99). In United Parcel Service, the court agreed
    with the IRS's position that the arrangement at issue--
    involving the taxpayer, a third-party U.S. insurance company
    acting as an intermediary, and an offshore company acting as a
    reinsurer--lacked business purpose and economic substance. In
    Compaq, the court agreed with the IRS's contention that the
    taxpayer's purchase and resale of certain financial instruments
    lacked economic substance and imposed accuracy-related
    penalties under section 6662(a). In Winn-Dixie, the court held
    that an employer's leveraged corporate-owned life insurance
    program lacked business purpose and economic substance.
    ---------------------------------------------------------------------------
        \24\ T.C.M. 1999-268.
        \25\ 113. T.C. No. 17.
        \26\ 113. T.C. No. 21.
    ---------------------------------------------------------------------------
        This recent line of cases and the IRS's increasingly
    successful use of common-law doctrines in these cases argue
    against any need for expanding the IRS's tools at this time or,
    as the Treasury Department has suggested, codifying such
    doctrines.

    4. Treasury action

        Treasury on numerous occasions has issued IRS Notices
    stating an intention to publish regulations that would preclude
    favorable tax treatment for certain transactions. Thus, a
    Notice allows the government (assuming that the particular
    action is within Treasury's rulemaking authority) to move
    quickly, without having to await development of the regulations
    themselves--often a time-consuming process--that provide more
    detailed rules concerning a particular transaction.
        Recent examples of the use of this authority include Notice
    97-21, in which the IRS addressed multiple-party financing
    transactions that used a special type of preferred stock;
    Notice 95-53, in which the IRS addressed the tax consequences
    of ``lease strip'' or ``stripping transactions'' separating
    income from deductions; and Notices 94-46 and 94-93, addressing
    so-called ``corporate inversion'' transactions viewed as
    avoiding the 1986 Act's repeal of the General Utilities
    doctrine. \27\
    ---------------------------------------------------------------------------
        \27\ The General Utilities doctrine generally provided for
    nonrecognition of gain or loss on a corporation's distribution of
    property to its shareholders with respect to their stock. See, General
    Utils. & Operating Co. v. Helvering, 296 U.S. 200 (1935). The General
    Utilities doctrine was repealed in 1986 out of concern that the
    doctrine tended to undermine the application of the corporate-level
    income tax. H.R. Rep. No. 426, 99th Cong., 1st Sess. 282 (1985).
    ---------------------------------------------------------------------------
        Moreover, section 7805(b) of the Code expressly gives the
    IRS authority to issue regulations that have retroactive effect
    ``to prevent abuse.'' Although many Notices have set the date
    of Notice issuance as the effective date for forthcoming
    regulations,\28\ Treasury has used its authority to announce
    regulations that would be effective for periods prior to the
    date the Notice was issued.\29\ Alternatively, Treasury in
    Notices has announced that it will rely on existing law to
    challenge abusive transactions that already have occurred.\30\
    ---------------------------------------------------------------------------
        \28\ See, e.g., Notice 95-53, 1995-2 CB 334, and Notice 89-37,
    1989-1 CB 679.
        \29\ See, e.g., Notice 97-21, 1997-1 CB 407.
        \30\ Notice 96-39, I.R.B. 1996-32.
    ---------------------------------------------------------------------------

    5. Targeted legislation

        To the extent that Treasury and the IRS may lack rulemaking
    or administrative authority to challenge a particular type of
    transaction, one other highly effective avenue remains open--
    that is, enactment of legislation. In this regard, over the
    past 30 years dozens upon dozens of changes to the tax code
    have been enacted to address perceived abuses. For example,
    earlier this year Congress enacted legislation (H.R. 435)
    addressing ``basis-shifting'' transactions involving transfers
    of assets subject to liabilities under section 357(c).
        These targeted legislative changes often have immediate, or
    even retroactive, application. The section 357(c) provision,
    for example, was made effective for transfers on or after
    October 19, 1998--the date House Ways and Means Committee
    Chairman Bill Archer introduced the proposal in the form of
    legislation. Chairman Archer took this action, in part, to stop
    these transactions earlier than would have been accomplished
    under the effective date originally proposed by Treasury (the
    date of enactment).

    C. Adverse Impact of Proposals

        The Treasury, JCT staff, and similar proposals addressing
    ``corporate tax shelters'' would impose additional uncertainty
    and burdens on corporate tax executives. As discussed below,
    each turns on a vague and subjective definition of ``corporate
    tax shelter'' that would threaten to sweep in legitimate
    transactions undertaken in the ordinary course of business,
    such as financing transactions, capital restructuring
    transactions, corporate reorganizations, and other
    transactions. Businesses already are confronted by a
    complicated, ever-changing, and in many instances, arcane and
    outdated tax system comprised of an intricate jumble of
    statutes, case law, regulations, rulings, and administrative
    procedural requirements. Rather than providing clearer and more
    precise rules defining transactions viewed as abusive, the
    proposals would add new layers of complexity and
    uncertainty.\31\
    ---------------------------------------------------------------------------
        \31\ Treasury Department Acting Assistant Secretary (Tax Policy)
    Jonathan Talisman, in an October 4 letter to Rep. Lloyd Doggett (D-TX)
    states that the Administration's proposals would not ``unduly''
    interfere with legitimate business transactions.
    ---------------------------------------------------------------------------
        Some commentators have suggested that the broad sweep of
    the ``corporate tax shelter'' proposals can be justified as
    representing a balance between ``objective'' rules and
    ``flexible'' concepts to ensure appropriate behavior by
    corporations. We disagree, believing that the vast majority of
    corporations abide by rules of appropriate planning and that
    the extremely broad and vague concepts introduced by the
    proposals severely would hamper legitimate business planning.
    Faced with the regime of draconian sanctions proposed by
    Treasury and the JCT staff, taxpayers would find it difficult
    to make business decisions with any certainty as to the tax
    consequences. This would be particularly true since
    classification as a ``tax shelter'' could result not from
    taking an incorrect position under the tax code, but merely
    because ``significant'' tax benefits resulted from certain
    vaguely defined types of arrangements.
        Like individual taxpayers,\32\ corporations have the right
    legitimately to seek minimization of tax liabilities, i.e., to
    pay no more in taxes than the tax law demands. Indeed,
    corporate executives have a fiduciary duty to preserve and
    increase the value of a corporation for its shareholders. Some
    commentators decry this responsibility, termed ``profit center
    activity'' in current management parlance, as wrong. We
    disagree. Responsible minimization of taxes in conjunction with
    the business activity of a corporation is one important
    function of corporate executives seeking to enhance
    profitability, and one that long has been viewed as consistent
    with sound policy objectives.\33\
    ---------------------------------------------------------------------------
        \32\ Individual taxpayers often undertake actions to obtain
    favorable tax treatment, but this alone is not considered a reason
    simply to disallow the benefits. For example, an individual holding an
    appreciated security may decide to hold it for sale until a particular
    date solely to obtain long-term capital gain treatment. Also, an
    individual may take out a home-equity loan to pay off credit-card debt
    because interest on the home loan can be tax deductible. As another
    example, an individual renting a home may decide to purchase it,
    viewing the tax benefits as a principal purpose for entering into the
    transaction. In such cases, Congress has not been concerned that the
    taxpayer acted out of tax motivations; the tax benefits still are
    allowed.
        \33\ Judge Learned Hand wrote: ``Over and over again courts have
    said that there is nothing sinister in so arranging one's affairs as to
    keep taxes as low as possible. Everybody does so, rich or poor; and all
    do right, for nobody owes any public duty to pay more than the law
    demands: taxes are enforced extractions, not voluntary contributions.''
    Comm'r v. Newman, 159 F.2d 848, 850-851 (2d Cir. 1946) (dissenting
    opinion).
    ---------------------------------------------------------------------------
        In a broad sense, the proposals overlook the significant
    responsibilities shouldered by corporate tax executives in
    collecting and remitting corporate income taxes, withholding
    taxes, and an array of excise taxes.\34\ In addition to these
    duties as a significant private administrator of the U.S. tax
    code, a chief corporate tax executive must understand
    management's business decisions and planning objectives, and
    provide reasoned advice to management on the tax consequences
    of various possible business decisions and on appropriate ways
    to minimize tax liabilities. Once these business decisions are
    made, the tax executive must implement them by supervising the
    formation of applicable entities, creating systems for
    capturing tax-related information as it is generated from the
    business, and implementing procedures for the calculation and
    remittance of taxes, information returns, and additional
    documentation necessary for compliance. The collective effect
    of the Treasury and JCT staff ``shelter'' proposals would be to
    penalize these responsible tax executives by adding to their
    burden and increasing complexity and uncertainty in determining
    the tax consequences of business decisions.
    ---------------------------------------------------------------------------
        \34\ Of the $1.7 trillion in tax revenue collected by the federal
    government in FY 1998, corporations either remitted directly or
    withheld and remitted more than 50 percent, vastly reducing the
    compliance burden on the IRS and individuals.
    ---------------------------------------------------------------------------
        Ironically, the proposed ``corporate tax shelter''
    definitions strongly resemble a test included in the new U.S.-
    Italy Income Tax Treaty and the new U.S.-Slovenia Income Tax
    Treaty that drew strong criticism from the JCT staff. ``Main
    purpose'' tests in the proposed treaties would have denied
    treaty benefits (e.g., reduced withholding rates on dividends)
    if the main purpose of a taxpayer's transaction is to take
    advantage of treaty benefits. The JCT staff correctly raised
    policy objections to this proposed test:

            The new main purpose tests in the proposed treaty present
            several issues. The tests are subjective, vague and add
            uncertainty to the treaty. It is unclear how the provisions are
            to be applied. . . . This uncertainty can create planning
            difficulties for legitimate business transactions, and can
            hinder a taxpayer's ability to rely on the treaty. . . . This
            is a subjective standard, dependent on the intent of the
            taxpayer, that is difficult to evaluate. . . . It is also
            unclear how the rule would be administered. . . . In any event,
            it may be difficult for a U.S. company to evaluate whether its
            transaction may be subject to Italian main purpose
            standards.\35\

        \35\ ``Explanation of Proposed Income Tax Treaty and Proposed
    Protocol between the United States and the Italian Republic,'' October
    8, 1999 (JCS-9-99); see also, ``Testimony of the Staff of the Joint
    Committee on Taxation before the Senate Committee on Foreign Relations
    Hearing on Tax Treaties and Protocols with Eight Countries,'' October
    27, 1999 (JCX-76-99).
    ---------------------------------------------------------------------------
        The Senate approved these treaties on November 5. In light
    of concerns raised by the JCT staff and the Senate Foreign
    Relations Committee, the Senate approved the treaties subject
    to a ``reservation'' that has the effect of eliminating the
    ``main purpose'' test.
        These very same objections--``vague,'' ``subjective,''
    ``difficulties for legitimate business transactions''--have
    been raised by businesses with respect to the Treasury's and
    the JCT staff's ``corporate tax shelter'' proposals. Any
    distinction between the ``main purpose'' test and the
    ``corporate tax shelter'' tests is extremely fine. Like the
    ``main purpose'' test, these proposals would give tax
    administrators broad authority to disregard the application of
    written rules where they believe they see tax considerations
    playing too important a role in structuring transactions.

    D. Worldwide Experience with Anti-Avoidance Rules

        Recent experiments with ``anti-avoidance'' tax legislation
    undertaken by other major industrialized countries provide
    useful case histories for U.S. policymakers contemplating the
    Treasury and JCT staff proposals.

    Sweden

        Sweden repealed its ``general anti-avoidance rule'' (GAAR)
    in 1993 following ``some dissatisfaction with its
    performance.'' \36\
    ---------------------------------------------------------------------------
        \36\ Graeme S. Cooper, Tax Avoidance and the Rule of Law, IBFD
    Publications BV, 1997, p. 10.

    ---------------------------------------------------------------------------
    Canada

        Canada in 1988 adopted a GAAR disregarding transactions
    resulting in reductions of tax unless the transaction is
    carried out primarily for non-tax purposes. Regarding the
    practical impact of the Canadian GAAR, one commentator has
    noted that ``very few transactions that would have been carried
    out before the introduction of the rule have not been carried
    out since its introduction.'' \37\ While withholding final
    judgment on the GAAR, the commentator has noted that ``the
    courts could make the rule into an overly broad weapon that
    discourages legitimate commercial activity.'' \38\ This
    commentator also notes that the Canadian GAAR was enacted after
    the Canadian Supreme Court had rejected judicial approaches to
    fighting tax-avoidance--this absence of judicial activism is
    hardly the case in the United States, as the recent ACM, United
    Parcel Service, and Winn-Dixie decisions clearly show. As one
    observer has noted, in the United States, ``robust judicial
    doctrines have served in the place of a GAAR.'' \39\
    ---------------------------------------------------------------------------
        \37\ Brian Arnold, ``The Canadian General Anti-Avoidance Rule,''
    Tax Avoidance and the Rule of Law, ed. Graeme S. Cooper, IBFD
    Publications BV, 1997, p. 241.
        \38\ Ibid. p. 244.
        \39\ Cooper, supra p. 10.

    ---------------------------------------------------------------------------
    Australia

        Australia reinstituted a GAAR in 1981, following the
    failure of earlier GAAR provision. The new GAAR continued to
    draw criticism. As one commentator has noted, ``If we are
    concerned about the philosophical questions as to the rule of
    law in a complex society and not just about revenue collection,
    we should as a result have concerns about the present GAAR
    operative in Australia.'' \40\
    ---------------------------------------------------------------------------
        \40\ Jeffrey Waincymer, ``The Australian Tax Avoidance Experience
    and Responses: A Critical Review,'' Tax Avoidance and the Rule of Law,
    ed. Graeme S. Cooper, IBFD Publications BV, 1997, p. 306.

    ---------------------------------------------------------------------------
    United Kingdom

        The United Kingdom's recent experience with a GAAR is
    particularly noteworthy. In the 1997 Labor Party budget
    submission, U.K. Chancellor of the Exchequer Gordon Brown
    proposed creation of a GAAR to counter perceived tax avoidance
    in the corporate sector. The U.K. Inland Revenue was directed
    to review this area and consider how such a GAAR might be
    framed.
        A ``consultative document'' \41\ published by Inland
    Revenue in October 1998 provided a rough draft for a GAAR.
    Inland Revenue would be given authority to ignore ``tax-driven
    transactions'' or to substitute the tax results that would have
    been produced by a ``normal'' commercial transaction. A ``tax-
    driven transaction'' would be defined as a transaction one of
    whose main purposes is ``tax avoidance.'' ``Tax avoidance''
    would defined as: \42\

        \41\ ``A General Anti-Avoidance Rule for Direct Taxes: Consultative
    Document,'' U.K. Inland Revenue, October 1998.
        \42\ Id., at 6.5.2.
    ---------------------------------------------------------------------------
            (a) not paying tax, paying less tax, or paying later than would
            otherwise be the case,
            (b) obtaining repayment or increased repayment of tax, or
            obtaining repayment earlier than would otherwise be the case,
            or
            (c) obtaining payment or increased payment by way of tax
            credit, or obtaining such payment earlier than would otherwise
            be the case.

        The draft plan also discussed a safe harbor for
    ``acceptable tax planning,'' which Inland Revenue sketchily
    defined as ``arranging one's affairs so as to avoid tax in a
    way that does not conflict with or defeat the purpose of the
    legislation.''
        Businesses responded that the proposal, with its lack of
    any objective test, would raise significant uncertainties over
    the tax treatment of transactions undertaken in the normal
    course of business. The draft plan itself envisioned that
    taxpayers would need some sort of quick ``clearance,'' before
    undertaking a transaction, that Inland Revenue would not seek
    to apply the GAAR to the transaction. However, following
    issuance of the draft, concerns mounted at Inland Revenue that
    the agency might lack the resources to process clearance
    applications on a timely basis. In light of problems that had
    been identified calling into question whether a GAAR could work
    in practice, Chancellor Brown in March 1999 announced that the
    U.K. government would not be proceeding with plans to implement
    the GAAR.
        The U.K. experience with the GAAR proposal parallels the
    current U.S. ``corporate tax shelter'' proposals. Both
    initiatives would rely on subjective terminology and would give
    broad discretion to the taxing authorities, raising concerns
    from the business sector that legitimate transactions would be
    affected. For U.S. policymakers, the U.K. experience with the
    GAAR presents a clear picture of the dangers and difficulties
    associated with overly broad anti-avoidance rules. As with the
    U.K. experience, the IRS would not be able to provide effective
    and timely advance approval of a multitude of transactions
    submitted for clearance; also taxpayers would incur substantial
    costs in applying for approval.
        We respectfully urge Congress to reach the same conclusion
    regarding Treasury's and the JCT staff proposals that prudent
    decisionmakers in the United Kingdom ultimately reached in
    rejecting the GAAR proposal.

              III. Analysis of ``Corporate Tax Shelter'' Proposals

    A. Treasury Department Proposals

        The Treasury Department's ``corporate tax shelter''
    proposals were advanced in the Administration's FY 2000 budget
    and revised in a ``White Paper'' published July 1, 1999.\43\
    The following are brief summaries of the Treasury proposals as
    revised, followed by our comments: \44\
    ---------------------------------------------------------------------------
        \43\ Treasury dropped proposals to eliminate completely the
    reasonable cause exception in the case of ``corporate tax shelters,''
    to disallow deductions for fees paid to tax shelter promoters and
    advisors, and to impose a 25-percent excise tax on tax benefits subject
    to rescission or insurance provisions.
        \44\ These comments supplement analysis provided in testimony
    presented by PricewaterhouseCoopers in conjunction with the House Ways
    and Means Committee's March 10, 1999, hearing on the revenue proposals
    in the Administration's FY 2000 budget.
    ---------------------------------------------------------------------------

    1. Disallowance of tax benefits

    Summary

        The proposal would disallow deductions, credits,
    exclusions, or other allowances obtained in a ``tax avoidance
    transaction.'' This would be defined generally as any
    transaction in which the reasonably expected pre-tax profit of
    the transaction is insignificant relative to the reasonably
    expected net tax benefits of such transaction. The proposal
    also would deny tax benefits associated with financing
    transactions where the benefits are in excess of the economic
    return of the counterparty to the transaction.

    Comment

        The proposal would expand the current-law section 269 rules
    to deny deductions or other tax allowances flowing from a ``tax
    avoidance transaction,'' an entirely new and vague concept.
    While the first prong of Treasury's definition of this term is
    styled as an objective test, the inclusion of subjective or
    unexplained concepts in the equation precludes such a
    characterization. The proposal raises significant questions of
    policy and practicality. As an initial matter, what constitutes
    the ``transaction'' for purposes of this test? Next, what are
    the parameters for ``reasonable expectation'' in terms of both
    pre-tax economic profit and tax benefits? Further, where is the
    line drawn regarding the significance of the reasonably
    expected pre-tax economic profit relative to the reasonably
    expected net tax benefits?
        Under this ill-defined proposal, even though a taxpayer's
    transaction may have economic substance and legitimate business
    purpose, the tax savings could be denied to the taxpayer if
    another route of achieving the same end result would have
    resulted in the remittance of more tax. The proposed expansion
    of section 269 would create uncertainty for corporate taxpayers
    that engage in prudent tax planning to implement business
    objectives.

    2. Substantial understatement penalty

    Summary

        The substantial understatement penalty imposed on corporate
    tax shelter items generally would be increased to 40 percent
    (reduced to 20 percent if the taxpayer satisfies certain
    disclosure requirements). The reasonable cause exception would
    be retained, but narrowed with respect to transactions deemed
    to constitute a corporate tax shelter--for these transactions,
    taxpayers would have to have a ``strong'' probability of
    success on the merits and to meet disclosure requirements. A
    ``corporate tax shelter'' would be defined as any arrangement
    (to be determined based on all the facts and circumstances) in
    which a direct or indirect corporate participant attempts to
    obtain a tax benefit in a tax avoidance transaction.

    Comment

        This proposal is overbroad, unnecessary, and inconsistent
    with the goals of rationalizing penalty administration and
    reducing taxpayer burdens. Here again, the penalty would
    introduce the vague concept of ``tax avoidance transaction.''
        Second, sharp restrictions on the reasonable cause
    exception would result in situations where a revenue agent may
    feel compelled to impose a punitive 40-percent penalty even
    though the agent determines that (1) there is substantial
    authority supporting the return position taken by the taxpayer,
    and (2) the taxpayer reasonably believed (based, for example,
    on the opinion or advice of a qualified tax professional) that
    its tax treatment of the item was more likely than not the
    proper treatment. It is doubtful that agents would accept a
    taxpayer's argument against application of the penalty based on
    having had a ``strong probability of success,'' an undefined
    term setting an unrealistically high threshold.
        Rather than serving as a deterrent to undertaking
    questionable transactions, the virtually automatic proposed
    penalty would penalize--at a harsh 40-percent rate--taxpayers
    for entering into arrangements that they reasonably believed to
    be proper and supported by substantial authority.

    3. Disclosure

    Summary

        The Treasury proposal would require disclosure of
    transactions that have a combination of ``some'' of the
    following characteristics: a book/tax difference in excess of a
    certain amount; a rescission clause, an unwind provision, or
    insurance or similar arrangement for the anticipated tax
    benefits; involvement with a tax-indifferent party; advisor
    fees in excess of a certain amount or contingent fees; a
    confidentiality arrangement; and the offering of the
    transaction to multiple corporations.
        Disclosure would be required of corporations and promoters.
    Corporations entering into transactions having these
    characteristics would be required to file a disclosure form
    with the IRS National Office by the due date of the tax return
    for the taxable year for which the transaction is entered into.
    The corporation also would have to attach the form to all tax
    returns to which the transaction applies. Promoters would be
    required to file the disclosure form within 30 days of offering
    the transaction.
        The form would require information regarding the
    transaction characteristics discussed above and the nature and
    business or economic objective of the transaction. For
    corporations, it would have to be signed by a corporate officer
    who has knowledge of the factual underpinnings of the
    transaction for which disclosure is required; the officer would
    be ``personally liable'' for misstatements on the form. The
    corporation would not be required to file the form if it had
    specific knowledge that the promoter had disclosed the
    transaction. A ``significant'' monetary penalty would apply for
    failure to disclose.
        Taxpayers also would be required to disclose on the return
    transactions reported differently from their form if the tax
    benefits exceed a certain threshold amount.

    Comment

        This proposal represents another example of Treasury
    overreaction aimed at perceived ``shelter'' transactions,
    imposing further burdens on corporate taxpayers. The existing
    tax shelter registration rules--which Treasury has yet to
    implement--and the existing penalties provide Treasury with
    ample tools to address situations of perceived abuse.
        This proposal would create considerable uncertainties for
    taxpayers determining whether disclosure is required. Consider,
    for example, the requirement to disclose transactions that are
    reported differently from their form. Does ``form'' refer to
    the label given to the transaction or instrument, or does it
    refer to the rights and liabilities set forth in the
    documentation? For example, if an instrument is labeled debt,
    but has features in the documentation typically associated with
    an equity interest, is the form debt or equity? What if the
    taxpayer reasonably believed that it was reporting the
    transaction in accordance with its ``form,'' but later
    interpretations of ``form'' suggested that it had not so
    reported the transaction?
        It appears that the proposal would require disclosure for a
    number of other common and legitimate corporate business
    transactions. For example, the requirement to disclose
    transactions and arrangements with a significant book/tax
    difference would sweep in a wide range of non-abusive
    transactions. (See also our comments, below, on the JCT staff's
    disclosure requirements.)

    4. Promoters

    Summary

        The proposal would impose a 25-percent excise tax on fees
    received in connection with promoting or rendering tax advice
    related to corporate tax shelters. Treasury also notes that an
    alternative might be to amend current-law penalties applicable
    to promoters and advisors under sections 6700, 6701, and 6703.

    Comment

        The imprecise definition of a corporate tax shelter
    transaction contained in this and related Treasury proposals
    would make it difficult for professional tax advisers to
    determine the circumstances under which this provision would
    apply. The substantive burdens of interpreting and complying
    with the statute and the administrative problems that taxpayers
    and the IRS would face cannot be overstated. The creation of
    the new excise tax would subject tax advisers to an entirely
    new and burdensome tax regime that again shifts the focus away
    from the substantive tax aspects of the transaction to
    unrelated definitional issues.

    5. ``Tax-indifferent'' parties

    Summary

        Treasury would retain its proposal to tax income allocable
    to a ``tax-indifferent'' party with respect to a corporate tax
    shelter, but notes that certain modifications would be
    necessary to narrow the scope of its proposal.

    Comment

        Treasury itself now concedes that its proposal ``may be
    difficult to administer and may only represent an additional
    penalty on the corporate participant (because the tax-
    indifferent party is not subject to U.S. taxing jurisdiction).
    . . .'' \45\
    ---------------------------------------------------------------------------
        \45\ The Problem of Corporate Tax Shelters, supra n.1, at 114.
    ---------------------------------------------------------------------------
        This overreaching Treasury proposal cannot be justified on
    any tax policy grounds. The proposal ignores the fact that many
    businesses operating in the global economy are not U.S.
    taxpayers, and that in the global economy it is increasingly
    necessary and common for U.S. companies to enter into
    transactions with such entities. The fact that a tax-exempt
    person earns income that would be taxable if instead it had
    been earned by a taxable entity surely cannot in and of itself
    be viewed as objectionable.
        Moreover, as it applies to foreign persons in particular,
    the proposal is overbroad in two significant respects. First,
    treating foreign persons as tax-indifferent ignores the fact
    that in many circumstances they may be subject to significant
    U.S. tax, either because they are subject to the withholding
    tax rules, because they are engaged in a U.S. trade or
    business, or because their income is taxable currently to their
    U.S. shareholders. Second, limiting the collection of the tax
    to parties other than treaty-protected foreign persons does not
    hide the fact that the tax-indifferent party tax would
    constitute a significant treaty override.

    B. Joint Committee on Taxation Staff Recommendations

        JCT staff proposals on ``corporate tax shelters'' were
    included in a 300-page study reviewing the interest and penalty
    provisions of the Code.\46\ The following are brief summaries
    of the JCT staff proposals, followed by our comments:
    ---------------------------------------------------------------------------
        \46\ 46. JCT study, supra, n.2.
    ---------------------------------------------------------------------------

    1. Definition of ``corporate tax shelter''

    Summary

        The JCT staff recommends ``clarifying'' the definition of a
    corporate tax shelter for purposes of the understatement
    penalty with the addition of several ``tax shelter
    indicators.'' A partnership or other entity, a plan, or an
    arrangement would be considered (with respect to a corporate
    participant) to have a significant purpose of avoidance or
    evasion of federal income tax if it is described by at least
    one of the following indicators:
         The reasonably expected pre-tax profit from the
    arrangement is insignificant relative to the reasonably
    expected net tax benefits.
         q The arrangement involves a ``tax-indifferent
    party,'' and the arrangement (1) results in taxable income
    materially in excess of economic income to the tax-indifferent
    participant, (2) permits a corporate participant to
    characterize items of income, gain, loss, deductions, or
    credits in a more favorable manner than it otherwise could
    without the involvement of the tax-indifferent participant, or
    (3) results in a noneconomic increase, creation,
    multiplication, or shifting of basis for the benefit of the
    corporate participant, and results in the recognition of income
    or gain that is not subject to federal income tax because the
    tax consequences are borne by the tax-indifferent party.
         The reasonably expected net tax benefits are
    significant, and the arrangement involves a tax indemnity or
    similar agreement for the benefit of the corporate participant
    other than a customary indemnity agreement in an acquisition or
    other business transaction entered into with a principal in the
    transaction.
         The reasonably expected net tax benefits are
    significant, and the arrangement is reasonably expected to
    create a ``permanent difference'' under GAAP.
         The reasonably expected net tax benefits from the
    arrangement are significant, and the arrangement is designed so
    that the corporate participant incurs little (if any)
    additional economic risk as a result of entering into the
    arrangement.
        Under the JCT staff proposal, an entity, plan, or
    arrangement still could be treated as a tax shelter even if it
    does not display any of the tax shelter indicators, provided
    that a significant purpose is the avoidance or evasion of
    federal income tax.

    Comment

        Rather than ``clarify'' the existing definition of a
    corporate tax shelter for purposes of the penalty, the JCT
    staff recommendation would layer on top of that already vague
    definition a test based on the existence of any one of five so-
    called ``indicators''--each of which itself would introduce
    new, subjective tests. The first indicator, for example, would
    require the taxpayer (and the IRS) to analyze whether the
    ``reasonably expected'' pre-tax profit from a transaction is
    ``insignificant'' relative to the ``reasonably expected'' net
    tax benefits--and these determinations, in turn, must be based
    on ``reasonable assumptions and determinations.''
        A multitude of common, legitimate corporate business
    transactions that do not have a significant purpose of tax
    avoidance nevertheless would be treated as corporate tax
    shelters if deemed to exhibit just one of the five
    ``indicators.'' Conversely, even if an arrangement has no
    indicator of shelter status, it still could be treated as a
    shelter under the existing ``significant purpose'' definition.
    The five indicators raise a number of concerns and questions:
         The ``profit vs. benefit'' indicator, which uses
    such vague terms as ``reasonably expected,'' ``arrangement,''
    and ``insignificant,'' could taint as tax shelters many types
    of inherently risky corporate ventures, such as wildcat oil-
    drilling, basic research partnerships where profit projections
    necessarily are uncertain, and some real estate investments by
    REITs, as well as investments encouraged by the tax law that do
    not produce profits, such as cleanups of brownfield sites.
         The ``tax-indifferent party'' indicator ignores
    the fact that to compete in a global economy, U.S. businesses
    must engage in arrangements with foreign entities. Subjecting
    these transactions to an economic profit test would further
    complicate U.S. tax-law treatment of cross-border transactions.
         The ``indemnity agreement'' indicator would punish
    a corporation that prudently engages a tax practitioner to
    analyze a planned transaction where the practitioner is
    confident enough to stand behind the opinion with an indemnity
    or similar agreement.
         The ``permanent difference'' indicator could call
    into question transactions that the Code explicitly seeks to
    encourage, e.g., through augmented charitable deductions for
    certain contributions of inventory property, on the ground that
    there would be a permanent difference under GAAP.
         The ``economic risk'' indicator seems to taint
    ordinary business decisions as to operating structures as
    ``shelter'' activities merely because the business decision
    results in lower ultimate tax liability than alternative
    choices. These types of decisions, such as choosing a form of
    business or organizing tiers of subsidiaries, may not involve
    economic risk.
        As a result of these layers of complexity, businesses and
    their tax advisors would be unable to determine with any
    confidence whether transactions entered into for strategic
    business reasons could trigger harsh penalties if later viewed
    as having either just one ``indicator'' of shelter status or a
    ``significant'' tax avoidance purpose. This problem would be
    aggravated by the JCT staff recommendation to eliminate the
    reasonable cause exception to the understatement penalty.

    2. Substantial understatement penalty

    Summary

        The understatement penalty rate would be increased from 20
    percent to 40 percent for any understatement that is
    attributable to a corporate tax shelter. The 40-percent penalty
    would be reduced to 20 percent if certain required disclosures
    are made, provided the taxpayer had substantial authority in
    support of its position. The JCT staff proposal also would
    eliminate the present-law reasonable cause exception and
    prohibit the IRS from waiving the penalty.
        The 40-percent penalty could be abated completely if (1)
    the taxpayer establishes that it was at least 75 percent sure
    that its tax treatment would be sustained on the merits and (2)
    the taxpayer discloses certain information (discussed further
    below) that is certified by the chief financial officer or
    another senior corporate officer with knowledge of the facts.
        A corporate participant that must pay an understatement
    penalty of at least $1 million in connection with a corporate
    tax shelter would be required to disclose the penalty payment
    to its shareholders, including the facts causing imposition of
    the penalty.

    Comment

        The stunning complexity of the JCT staff penalty
    recommendations can be seen in the JCT staff's own chart
    (attached hereto as Appendix 6) seeking to explain the various
    permutations and combinations of factors that can result in
    penalty rates of zero, 20 percent, and 40 percent.
        The JCT staff recommendations include eliminating the
    present-law reasonable cause exception. Treasury itself already
    has backed away from its original proposal to eliminate the
    exception. The narrow abatement procedure proposed by JCT staff
    would be available only where a business could establish that
    it had been ``highly confident'' (75 percent) of prevailing in
    its position that any reliance on a third-party opinion was
    ``reasonable,'' that no ``unreasonable'' assumptions were made
    in the opinion, and that the transaction had a ``material''
    nontax business purpose. Thus, the new 40-percent penalty rate
    could apply (absent satisfying the proposed disclosure
    requirements) even if a taxpayer established that it had
    substantial authority for its position, that it had a greater
    than 50 percent (but not at least 75 percent) likelihood of
    prevailing, and that it had reasonable cause. It is unclear how
    a taxpayer would be able to support a 75-percent degree of
    confidence with respect to a transaction successfully
    challenged by the IRS. The JCT staff proposals are inconsistent
    with the acknowledged purpose of tax code penalties, namely, to
    encourage voluntary compliance by taxpayers rather than to
    serve as a punitive weapon wielded by the IRS.
        The JCT staff recommendation that companies must disclose
    to shareholders payment of shelter penalties of $1 million or
    more--given the factors mentioned above--would be a highly
    inappropriate use of the tax statute. It is noteworthy that the
    proposal would require disclosure of a payment even if the
    company is challenging the penalty assessment in court.

    3. Disclosure

    Summary

        For arrangements that are described by one of the ``tax
    shelter indicators'' and in which the expected net tax benefits
    are at least $1 million, corporations would have to satisfy
    certain disclosure requirements within 30 days of entering into
    the arrangement. This disclosure would have to include a
    summary of the relevant facts and assumptions, the expected net
    tax benefits, the applicability of any tax shelter indicator,
    the arrangement's analysis and legal rationale, the business
    purpose, and the existence of any contingent fee arrangements.
    The CFO or another senior corporate officer with knowledge of
    the facts would be required to certify, under penalties of
    perjury, that the disclosure statements are true, accurate, and
    complete.
        Disclosure of tax shelter arrangements also would be
    required on the company's tax return, regardless of the amount
    of net tax benefits.

    Comment

        The recommended double disclosure requirements (at the time
    of the transaction and in the taxpayer's return) would be
    onerous and unnecessary. This flood of documents under the 30-
    day requirement would defeat the cited ``early warning''
    purpose, since under the vague definitions of the proposal the
    IRS would receive so many documents it would have great
    difficulty processing and identifying those transactions it
    might want to examine. The proposed exceptions for certain
    arrangements already reported on specific forms would apply
    only after regulations are issued--given that Treasury has yet
    to publish regulations under the 1997 tax shelter registration
    provision, the exceptions might never be triggered.
        The breadth of the JCT staff's shelter recommendations can
    be seen by its statement that a mere purchase or sale of one
    asset, in and of itself, does not constitute an
    ``arrangement.'' This statement is indicative of the
    overwhelming volume of guidance that would be necessary to
    implement and administer this proposal. These determinations
    would plunge businesses and their tax advisers deeper into an
    abyss of unfathomable terminology and complexity.

    4. ``Promoter'' provisions

    Summary

        The JCT staff document includes a number of recommendations
    affecting other parties involved in ``corporate tax shelters,''
    including an expansion of the aiding and abetting penalty.

    Comment

        Having proposed a 75-percent likelihood-of-success
    threshold for avoiding the 40-percent penalty rate in certain
    situations--thereby virtually forcing businesses to obtain
    outside tax advice as to the proper treatment of transactions--
    the JCT staff recommendation next proposes imposing an ``aiding
    and abetting'' penalty on the practitioner giving the opinion
    if an understatement results and a so-called ``reasonable
    practitioner'' would have rendered a different opinion. No
    definition of a ``reasonable practitioner'' is provided.
        The JCT staff proposal would allow the practitioner being
    penalized a ``meaningful opportunity'' to present evidence on
    his or her behalf. Should this evidence not sway the IRS, the
    practitioner would be penalized in an amount equal to the
    greater of $100,000 or one-half his or her fees, the
    practitioner's name would be published by the IRS, and the IRS
    would forward the practitioner's name to State licensing
    authorities ``for possible disciplinary sanctions.'' These
    harsh provisions seem aimed at thwarting companies from seeking
    tax opinions as to the appropriate treatment of business
    transactions and arrangements, while also penalizing them if
    they do not.

    5. Tax shelter registration requirements

    Summary

        The JCT staff recommends modifying the present-law rules
    regarding the registration of corporate tax shelters by (1)
    deleting the confidentiality requirement, (2) increasing the
    fee threshold from $100,000 to $1 million (in this respect,
    loosening the present-law requirement), and (3) expanding the
    scope of the registration requirement to cover any corporate
    tax shelter that is reasonably expected to be presented to more
    than one participant. Additional information reporting would be
    required with respect to arrangements covered by a tax shelter
    indicator.

    Comment

        The JCT staff recommendations would modify a legislative
    provision requiring registration that was enacted in 1997, but
    that has not become effective because Treasury has not issued
    implementing regulations. Before recommending further changes
    to the law relating to registration issues, Treasury should
    issue guidance on the existing registration requirements, which
    were enacted in 1997.

    C. ``Abusive Tax Shelter Shutdown Act of 1999''

        Rep. Lloyd Doggett (D-TX) introduced on June 17, 1999, the
    ``Abusive Tax Shelter Shutdown Act of 1999'' (H.R. 2255), which
    includes several proposals that essentially follow Treasury's
    initial recommendations to disallow tax benefits for
    ``corporate tax shelters'' and to increase the substantial
    understatement penalty.
        Our comments above on Treasury's proposals apply with equal
    force to H.R. 2255. If anything, the H.R. 2255 proposal
    disallowing ``noneconomic tax attributes'' would introduce even
    greater uncertainty by using terms such as ``meaningful
    changes,'' ``economic position,'' and ``substantial value.''
    This proposal would create tremendous uncertainty for companies
    following prudent tax planning in implementing business
    strategies in a global marketplace. Similarly, the H.R. 2255
    penalty proposals (like those of Treasury) are overbroad,
    unnecessary, and punitive.

                                 IV. Conclusion

        It is respectfully submitted that Congress should reject the broad
    legislative proposals regarding ``corporate tax shelters'' that have
    been advanced by the Treasury Department, the JCT staff, and others.
        The revenue and economic data indicate no need for these radical
    changes. Further, the proposals are completely unnecessary in light of
    the array of legislative, regulatory, administrative, and judicial
    tools available to curtail perceived abuses. Finally, these proposals
    would create an unacceptably high level of uncertainty and burdens for
    corporate tax officials while potentially imposing penalties on
    legitimate transactions undertaken in the ordinary course of business.
    Proponents of this type of sweeping legislation have not demonstrated
    that these proposals are necessary or advisable in our corporate tax
    system.

                                   Appendix 1

                                       Corporate Income Tax Receipts, FY 1980-1999
                                              [Billions of current dollars]
    ----------------------------------------------------------------------------------------------------------------
                                                                                          Federal
                                                                                         corporate     Corporate tax
                               Fiscal year                                  GDP         income tax     receipts as a
                                                                                         receipts     percent of GDP
    ----------------------------------------------------------------------------------------------------------------
    1980............................................................          $2,719           $64.6            2.4%
    1981............................................................          $3,048           $61.1            2.0%
    1982............................................................          $3,214           $49.2            1.5%
    1983............................................................          $3,423           $37.0            1.1%
    1984............................................................          $3,819           $56.9            1.5%
    1985............................................................          $4,109           $61.3            1.5%
    1986............................................................          $4,368           $63.1            1.4%
    1987............................................................          $4,609           $83.9            1.8%
    1988............................................................          $4,957           $94.5            1.9%
    1989............................................................          $5,356          $103.3            1.9%
    1990............................................................          $5,683           $93.5            1.6%
    1991............................................................          $5,862           $98.1            1.7%
    1992............................................................          $6,149          $100.3            1.6%
    1993............................................................          $6,478          $117.5            1.8%
    1994............................................................          $6,849          $140.4            2.1%
    1995............................................................          $7,194          $157.0            2.2%
    1996............................................................          $7,533          $171.8            2.3%
    1997............................................................          $7,972          $182.3            2.3%
    1998............................................................          $8,404          $188.7            2.2%
    1999............................................................          $8,851          $184.7            2.1%
    Period averages:
      1980-99.......................................................        $5,529.9          $105.5            1.9%
      1980-82.......................................................        $2,993.7           $58.3            1.9%
      1983-85.......................................................        $3,783.7           $51.7            1.4%
      1986-89.......................................................        $4,822.5           $86.2            1.8%
      1990-92.......................................................        $5,898.0           $97.3            1.6%
      1993-99.......................................................        $7,611.6          $163.2            2.1%
    ----------------------------------------------------------------------------------------------------------------
     AASources: Congressional Budget Office, Historical Budget Data, The Economic and Budget Outlook: Fiscal Years
      2000-2009, released January 1999.
     AACongressional Budget Office, The Economic and Budget Outlook: An Update, July 1999. U.S. Treasury Department,
      Monthly Treasury Statement, October 1999 and earlier issues.

                                   Appendix 2

                                 Federal Corporate Tax Liability and Receipts, 1980-1999
                                                  [Billions of dollars]
    ----------------------------------------------------------------------------------------------------------------
                                                       Federal corp.         Federal corp. income tax receipts
                      Calendar year                    tax liability -----------------------------------------------
                                                            \1\            Gross          Refunds           Net
    ----------------------------------------------------------------------------------------------------------------
    1980............................................           $58.6           $72.0            $8.6           $63.4
    1981............................................           $51.7           $75.1           $13.4           $61.7
    1982............................................           $33.9           $63.5           $19.5           $44.0
    1983............................................           $47.1           $64.6           $22.7           $41.9
    1984............................................           $59.1           $75.5           $16.9           $58.6
    1985............................................           $58.5           $78.7           $16.1           $62.6
    1986............................................           $66.0           $84.1           $17.8           $66.3
    1987............................................           $85.5          $105.2           $18.0           $87.2
    1988............................................           $93.6          $114.4           $16.0           $98.5
    1989............................................           $95.5          $113.9           $14.1           $99.8
    1990............................................           $94.4          $112.9           $15.9           $96.9
    1991............................................           $89.0          $112.9           $16.6           $96.4
    1992............................................          $101.8          $119.7           $16.6          $103.1
    1993............................................          $122.3          $137.3           $13.7          $123.6
    1994............................................          $136.2          $158.9           $14.7          $144.2
    1995............................................          $155.9          $180.4           $17.9          $162.5
    1996............................................          $172.9          $191.8           $19.8          $172.1
    1997............................................          $189.5          $211.1           $19.8          $191.3
    1998............................................          $183.2          $213.5           $28.5          $185.0
    1999 \2\........................................          $198.0
    1999 \3\........................................                          $216.4           $31.8          $184.6
    ----------------------------------------------------------------------------------------------------------------
    \1\ Determined from the National Income and Product Accounts as profits before tax (domestic basis) minus
      profits of the Federal Reserve Banks minus state and local income taxes. See text for details.
    \1\ Figure is seasonally adjusted at an annual rate based on first six months of the year.
    \3\ Figures are seasonally adjusted at annual rates based on first nine months of the year.
     AASources: U.S. Commerce Dept., Bureau of Economic Association, Survey of Current Business, October, 1999.
     AAU.S. Treasury Department, Monthly Treasury Summary, October 1999 and earlier issues. PwC calculations.

                                   Appendix 3

                                      Effective Corporate Tax Rate, NIPA, 1980-1999
                                                  [Billions of dollars]
    ----------------------------------------------------------------------------------------------------------------
                                                                                              Federal
                                                                                             corp. tax      Corp.
                                                                     Corp.                   liability     profits
                                                                    profits      Federal     (BEA adj.)   before tax
                     Calendar year                       GDP       before tax   corp. tax       as a      (BEA adj.)
                                                                      (BEA      liability    percent of      as a
                                                                    adj.\1\     (BEA adj.)     corp.      percent of
                                                                                              profits        GDP
                                                                                             before tax
    ----------------------------------------------------------------------------------------------------------------
    1980...........................................     $2,784.2       $200.8        $58.6        29.2%         7.2%
    1981...........................................     $3,115.9       $193.6        $51.7        26.7%         6.2%
    1982...........................................     $3,242.1       $142.9        $33.9        23.7%         4.4%
    1983...........................................     $3,514.5       $181.1        $47.1        26.0%         5.2%
    1984...........................................     $3,902.4       $212.3        $59.1        27.8%         5.4%
    1985...........................................     $4,180.7       $215.4        $58.5        27.2%         5.2%
    1986...........................................     $4,422.2       $238.0        $66.0        27.7%         5.4%
    1987...........................................     $4,692.3       $255.9        $85.5        33.4%         5.5%
    1988...........................................     $5,049.6       $305.2        $93.6        30.7%         6.0%
    1989...........................................     $5,438.7       $290.0        $95.5        32.9%         5.3%
    1990...........................................     $5,743.8       $281.1        $94.4        33.6%         4.9%
    1991...........................................     $5,916.7       $287.3        $89.0        31.0%         4.9%
    1992...........................................     $6,244.4       $317.8       $101.8        32.0%         5.1%
    1993...........................................     $6,558.1       $369.5       $122.3        33.1%         5.6%
    1994...........................................     $6,947.0       $399.5       $136.2        34.1%         5.8%
    1995...........................................     $7,269.6       $499.9       $155.9        31.2%         6.9%
    1996...........................................     $7,661.6       $537.6       $172.9        32.2%         7.0%
    1997...........................................     $8,110.9       $559.7       $189.5        33.9%         6.9%
    1998...........................................     $8,511.0       $587.3       $183.2        31.2%         6.9%
    1999 \2\.......................................     $8,873.4       $603.4       $197.5        32.7%         6.8%
    Period averages:
      1980-99......................................     $5,609.0       $333.9       $104.6        31.3%         6.0%
      1980-82......................................     $3,047.4       $179.1        $48.1        26.8%         5.9%
      1983-85......................................     $3,865.9       $203.0        $54.9        27.1%         5.2%
      1986-86......................................     $4,900.7       $272.3        $85.1        31.3%         5.6%
      1990-92......................................     $5,968.3       $295.4        $95.1        32.2%         4.9%
      1993-99......................................     $7,704.5       $508.1       $165.4        32.5%         6.6%
    ----------------------------------------------------------------------------------------------------------------
    \1\ Figures for 1997-1999 are based on CBO fiscal year projections. Because actual corporate capital gains data
      were not available for 1980-82, imputations were used.
    \2\ Figures for 1999 are annualized based on first six months, seasonally adjusted.
     AASources: U.S. Commerce Department, Bureau of Economic Analysis, Survey of Current Business, October 1999.
     AAU.S. Treasury Department, Monthly Treasury Summary, October 1999. PwC Calculations

                                                                                               Appendix 4
                                                             U.S. Corporate Income Tax Liability per Audited Financial Statements, 1988-1998
                                              [Dollar amounts in billions; Tax years ending after May of indicated year, and before July of following year]
    ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                                                                             Avg '88-
                                   Item                                   1988     1989     1990     1991     1992     1993     1994     1995     1996     1997    96Aug    97Aug    98Aug      97
    ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                  A. Companies with foreign operations
    U.S. fed. inc. tax liability \1\..................................      $25      $24      $25      $23      $23      $27      $34      $41      $42      $48      $19      $22      $24      $31
    U.S. oper. inc. after state inc. tax..............................     $127     $144     $138     $123     $128     $149     $181     $222     $231     $234      $89     $103     $105     $168
    U.S. assets.......................................................   $1,408   $1,587   $1,753   $1,904   $1,996   $1,988   $2,310   $2,433   $2,595   $2,494     $905   $1,050   $1,071   $2,047
    U.S. revenues.....................................................   $1,063   $1,212   $1,313   $1,371   $1,423   $1,373   $1,529   $1,745   $1,794   $1,770     $736     $817     $841   $1,459
    U.S. fed. inc. tax liability as % of:
      U.S. oper. inc. after state inc. tax............................    19.9%    16.6%    18.2%    19.1%    18.3%    18.2%    19.0%    18.3%    18.4%    20.7%    21.7%    21.4%    22.6%    18.7%
      U.S. assets.....................................................     1.8%     1.5%     1.4%     1.2%     1.2%     1.4%     1.5%     1.7%     1.6%     1.9%     2.1%     2.1%     2.2%     1.5%
      U.S. revenues...................................................     2.4%     2.0%     1.9%     1.7%     1.6%     2.0%     2.2%     2.3%     2.4%     2.7%     2.6%     2.7%     2.8%     2.2%
    Number of corps...................................................      700      746      806      886      963      820      934    1,057    1,159    1,178      633      633      633      925

                                                                                 B. Companies without foreign operations
    U.S. fed. inc. tax liability \1\..................................      $17      $19      $20      $23      $24      $22      $25      $27      $29      $29      $24      $26      $29      $24
    U.S. oper. inc. after state inc. tax..............................     $106     $116     $118     $123     $136     $115     $130     $149     $157     $157     $131     $144     $150     $131
    U.S. assets.......................................................   $1,332   $1,488   $1,570   $1,658   $1,825   $1,627   $2,061   $2,295   $2,526   $2,676   $2,124   $2,493   $2,907   $1,906
    U.S. revenues.....................................................     $913   $1,016   $1,117   $1,182   $1,286   $1,079   $1,252   $1,398   $1,509   $1,564   $1,214   $1,403   $1,593   $1,232
    U.S. fed. inc. tax liability as % of:
    U.S. oper. inc. after state inc. tax..............................    15.7%    16.3%    17.3%    18.4%    18.0%    19.2%    19.6%    18.2%    18.7%    18.6%    18.1%    18.0%    19.4%    18.1%
      .S. assets......................................................     1.2%     1.3%     1.3%     1.4%     1.3%     1.4%     1.2%     1.2%     1.2%     1.1%     1.1%     1.0%     1.0%     1.2%
      U.S. revenues...................................................     1.8%     1.9%     1.8%     1.9%     1.9%     2.1%     2.0%     1.9%     1.9%     1.9%     2.0%     1.9%     1.8%     1.9%
    Number of corps...................................................    3,681    3,573    3,646    3,731    3,945    3,696    3,847    4,209    4,249    4,052    3,357    3,357    3,357    3,863

                                                                            C. Companies with and without foreign operations
    U.S. fed. inc. tax liability \1\..................................      $42      $43      $45      $46      $48      $49      $60      $68      $72      $78      $43      $48      $53      $55
    U.S. oper. inc. after state inc. tax..............................     $233     $261     $256     $246     $264     $264     $310     $372     $387     $391     $220     $247     $256     $298
    U.S. assets.......................................................   $2,740   $3,075   $3,323   $3,562   $3,821   $3,615   $4,371   $4,727   $5,120   $5,171   $3,030   $3,543   $3,978   $3,952
    U.S. revenues.....................................................   $1,976   $2,228   $2,430   $2,553   $2,709   $2,452   $2,781   $3,143   $3,302   $3,332   $1,950   $2,220   $2,434   $2,691
    U.S. fed. inc. tax liability as % of:
      U.S. oper. inc. after state inc. tax............................    18.0%    16.5%    17.8%    18.8%    18.2%    18.7%    19.2%    18.3%    18.5%    19.9%    19.6%    19.4%    20.7%    18.5%
      U.S. assets.....................................................     1.5%     1.4%     1.4%     1.3%     1.3%     1.4%     1.4%     1.4%     1.4%     1.5%     1.4%     1.4%     1.3%     1.4%
      U.S. revenues...................................................     2.1%     1.9%     1.9%     1.8%     1.8%     2.0%     2.1%     2.2%     2.2%     2.3%     2.2%     2.2%     2.2%     2.0%
    Number of corps...................................................    4,381    4,319    4,452    4,617    4,908    4,516    4,781    5,266    5,408    5,230    3,990    3,990    3,990    4,788
    ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
     AACurrent provision for tax.
     AASource: Standard and Poors, Compustat, September 1999; PwC calculations.

                                   Appendix 5

                                Net Capital Gains for All Active Corporations, 1980-1996
                                         [Excluding RICs in Billions of dollars]
    ----------------------------------------------------------------------------------------------------------------
                                                                                Net gain on capital assets
                                                                     -----------------------------------------------
                                                                                       Net long-term
                                  Year                                Net short-term   gain less net
                                                                       gain less net    short-term       Subtotal
                                                                      long-term loss       loss
    ----------------------------------------------------------------------------------------------------------------
    1980............................................................             1.4            22.1            23.5
    1981............................................................             1.7            25.6            27.3
    1982............................................................             1.9            24.1            26.0
    1983............................................................             2.7            28.4            31.1
    1984............................................................             2.4            35.1            37.6
    1985............................................................             4.3            45.9            50.2
    1986............................................................             8.2            74.2            82.4
    1987............................................................             4.4            54.5            58.9
    1988............................................................             4.0            56.7            60.7
    1989............................................................             6.0            62.5            68.5
    1990............................................................             2.9            43.4            46.3
    1991............................................................             7.1            41.1            48.2
    1992............................................................             7.9            45.1            53.0
    1993............................................................            10.8            53.3            64.1
    1994............................................................             2.4            47.9            50.3
    1995............................................................            10.0            60.9            70.8
    1996............................................................             6.6            75.2            81.8
    ----------------------------------------------------------------------------------------------------------------
    Source: IRS. Corporate Source Book, various issues.

                                   Appendix 6

      Arrangements with a ``Significant Purpose'' of Avoidance or Evasion of Tax and Resulting in an Understatement
                                                 for Corporate Taxpayers
    ----------------------------------------------------------------------------------------------------------------
                                                                        Disclosure                     Penalty under
            Highest standard met          Described by an indicator    requirements    Penalty under       staff
                                                                         satisfied      present law   recommendation
    ----------------------------------------------------------------------------------------------------------------
    Highly Confident...................  Yes........................             Yes               0               0
    Highly Confident...................  Yes........................              No               0             40%
    Highly Confident...................  No.........................         Deemed*               0               0
    More Likely Than Not...............  Yes........................             Yes               0              20
    More Likely Than Not...............  Yes........................              No               0              40
    More Likely Than Not...............  No.........................         Deemed*               0              20
    Substantial Authority..............  Yes........................             Yes              20              20
    Substantial Authority..............  Yes........................              No              20              40
    Substantial Authority..............  No.........................           Yes**              20              20
    Substantial Authority..............  No.........................            No**              20              40
    Less Than Substantial Authority:     ...........................  ..............             20%             40%
     All Cases.
    ----------------------------------------------------------------------------------------------------------------
     AA* Under the Joint Committee staff recommendations, a transaction that is Not described by an indicator is Not
      a ``reportable transaction.'' Therefore, to the extent that a ``more likely than Not'' or higher standard has
      been satisfied, there is No special tax shelter disclosure or general section 6662(d)(2)(B) return disclosure
      required in order to reduce penalties.
     AA** These transactions would Not be ``reportable transactions'' to which the special corporate tax shelter
      disclosures apply. Under the Joint Committee staff recommendations, however, transactions that are Not
      described by a tax shelter indicator nevertheless must satisfy the new, higher section 6662 reporting
      standards that are recommended in Part VII.G., above. Therefore, if the highest standard satisfied by a
      transaction is substantial authority, general tax return disclosure rules (i.e., sec. 6662(d)(2)(B) and Treas.
      Reg. sec. 1.6662-3(c)(2)) must be satisfied in order to abate the penalty, even if the special corporate tax
      shelter disclosure requirements do Not apply. Thus, the disclosure indicated in the boxes accompanying this
      footnote actually refers to the section 6662(d)(2)(B) disclosure and Not corporate tax shelter disclosure.
     AAKey
     AAHighly Confident:--75 percent or greater likelihood of success on the merits if challenged.
     AAMore Likely than Not:--Greater than 50 percent likelihood (but less than highly confident) of success on the
      merits if challenged.
     AASubstantial Authority:--Less than more likely than Not, but greater than reasonable basis.

        Chairman Archer. Mr. Hariton, you may proceed.

     STATEMENT OF DAVID P. HARITON, PARTNER, SULLIVAN & CROMWELL,
                           NEW YORK, NEW YORK

        Mr. Hariton. Thank you very much. I don't have Mr. Kies'
    experience, so I may not time it so perfectly. My name is David
    Hariton. I am a tax lawyer practicing in New York, and my
    practice deals with the taxation of complex business
    transactions. I have done a lot of thinking about these issues.
    I have written about these issues, and I am speaking here
    strictly on my own behalf and for the benefit of the Government
    and the Treasury Department.
        And I say what I am about to say now with the greatest
    appreciation and gratitude for everyone who has spent time
    trying to deal with this problem, especially Representative
    Doggett and his staff. I have concluded that the most
    constructive response that Congress could make would be to
    grant the Commissioner additional financial resources to deal
    with complex business transactions.
        And if we are going to have a statutory response, it really
    can't be one that is based on some definition of abusive tax
    transactions. That is just hopeless. At most, it might be one
    that is designed to shift the balance, like an increase in the
    penalty for understatements arising from corporate tax
    shelters.
        Now, I have already set out in various articles the issues
    that I think would have to be addressed before we could develop
    any sort of coherent language to define corporate tax shelter,
    and I would be glad to assist the government in the effort if I
    was called upon.
        I must tell you frankly, though, that I really think there
    is little to be gained from such language. The law in this area
    is very complex, and the transactions to which the law applies
    are even more complex. And when you are talking about the
    application of the former to the latter, that is as unique and
    case-specific as any particular chess game. That is why we have
    hundreds of pages of a court decision trying to explain a
    particular transaction.
        And any string of words that purports to define bad
    transactions and distinguish them from good ones is going to be
    ignored as functionally meaningless and impossible to apply or
    even comprehend. At most, I think it would cast a shadow of
    confusion over the objective rules that determine tax
    liabilities.
        Besides, to be honest, I am not persuaded that such a
    definition is necessary. I think that the courts have made it
    quite clear that they will not permit sophisticated taxpayers
    to reap the unjust benefits of strictly tax-motivated
    transactions. The Commissioner has enough judicial doctrines at
    his disposal to successfully challenge any taxpayer that seeks
    to take unfair advantage of his rules. The problem really is
    not that the Commissioner has litigated and lost.
        In other words, I don't think this is a job for law. This
    is a job for administration. And an increase in the volume of
    law instead of in the volume and quality of enforcement is not
    going to accomplish very much.
        It is administration, not law, that can apply analytical
    reasoning to specific transactions. Administration, not law,
    can distinguish legitimate transactions from abusive ones. Laws
    don't think, people do; and I think we would be foolish to
    suppose that we could draft a definition to do our thinking for
    us.
        Now, having said that, I must say that I have a great deal
    of sympathy for the Commissioner's complaint that he is
    outmanned and ill-equipped to deal with this problem. In order
    to deal adequately with complex tax motivated transactions, the
    Commissioner has got to be proactive, energetic and efficient;
    yet at the same time, he has got to be fair, judicious,
    reflective, cerebral. How is he supposed to hire a staff to
    accomplish all of these tasks with a limited budget and a
    government salary cap?
        Is it a surprise to learn that he may be losing tens, even
    hundreds of billions of dollars? I have to say, for me at
    least, I think that the way that we are dealing with our own
    Treasury Department may be pennywise and pound foolish.
        Now, I do realize that some people are concerned about the
    problems that the little guy faces in dealing with the IRS. But
    obviously we are not talking about the little guy here. These
    are transactions entered into by large corporations and wealthy
    individuals. Isn't it possible for Congress to grant the
    Commissioner special financial resources and tell them not to
    use them to prosecute the little guy, but rather to deal
    energetically with complex tax motivated transactions?
        And I think you should also find some way to let the
    Commissioner pay his staff more. The Commissioner is not going
    to be able to handle complex business transactions if he can't
    compete with the private sector in hiring the best and the
    brightest. Does it make sense to bind someone who is trying to
    collect our revenue to the salary caps that are designed to
    save the government money?
        Anyway, thank you very much for your time. And I will say
    that I am very glad that you are focusing on the taxation of
    complex business transactions. I just hope that your concern
    will yield up measures that are practical and efficacious, as
    opposed to just ceremonial.
        Chairman Archer. Thank you, Mr. Hariton, and you did very
    well by the time.
        [The prepared statement follows:]

    Statement of David P. Hariton, Partner, Sullivan & Cromwell, New York,
    New York

        As a tax lawyer whose practice deals with complex business
    transactions, I hope to offer a practical view on the problem
    which the Committee is now addressing. I have concluded on
    reflection that the most constructive response that Congress
    could make would be to grant the Commissioner additional
    financial resources to deal with complex business transactions.
    If there is to be a statutory response, it should not be one
    that places significant weight on a statutory definition of
    abusive tax transactions. At most, it should be one designed to
    shift a perceived imbalance, such as an increase in the penalty
    for understatements arising from corporate tax shelters.
        I have already endeavored to assist the government by
    setting out in published articles the issues that must be
    considered in drafting statutory language to better define the
    words ``corporate tax shelter,'' and I would be glad to
    continue that assistance if called upon. I must tell you
    frankly, however, that there is little to be gained by enacting
    legislation that purports to describe bad transactions and
    distinguish them from good ones. The law in this area is
    exceedingly complex, the transactions to which the law applies
    are even more so, and application of the former to the latter
    is as unique and case-specific as any particular chess game.
    Laws which purport to define bad transactions are likely to be
    ignored as functionally meaningless--impossible to apply or
    even comprehend. At most, they will do damage by casting a
    shadow of confusion over the primarily objective rules that
    determine tax liabilities.
        Moreover, I am not persuaded that such laws are necessary.
    A series of recent decisions clearly demonstrates that the
    courts will not permit sophisticated taxpayers to reap the
    unjust benefits of strictly tax-motivated transactions. The
    case law has sufficient judicial doctrines to permit the
    Commissioner to successfully challenge taxpayers that seek to
    take unfair advantage of his rules. The problem is not that the
    Commissioner has litigated and lost.
        In other words, this is not a job for law. This is a job
    for administration. I fear that a decision to increase the
    volume of law instead of the volume and quality of enforcement
    will accomplish nothing constructive. It is administration, not
    law, which can apply analytic reasoning to specific
    transactions and perform the all-important task of
    distinguishing legitimate transactions from abusive ones. Laws
    don't think--people do--and we would be foolish to suppose that
    we could somehow draft laws to do our thinking for us.
        I am highly sympathetic, however, to the Commissioner's
    complaint that he is outmanned and ill-equipped to deal with
    the substantial increase in intellectual resources that the
    private sector is now directing towards complex tax-motivated
    transactions. To deal with the problem, his staff must be
    proactive, energetic and efficient, yet at the same time
    judicious, fair, reflective and cerebral. How can the
    Commissioner muster a staff to accomplish these tasks with his
    hands tied behind his back? Is it any surprise that he is
    losing tens, perhaps hundreds, of billions of dollars? The way
    we are dealing with our own Treasury is, to be frank, penny-
    wise and pound-foolish.
        I understand that some people are concerned about the
    problems that the little guy faces in dealing with the IRS. The
    transactions we are discussing, however, are entered into by
    large corporations and massively wealthy individuals. Surely it
    is possible for Congress to grant the Commissioner special
    resources and direct that he use them not to prosecute the
    little guy, but rather to deal energetically with complex tax-
    motivated transactions.
        I must stress, moreover, that it will not be enough for the
    Commissioner to hire more people. When it comes to complex
    business transactions, the Commissioner must compete with the
    private sector to hire the best and the brightest. Frankly, how
    can he do this if he is bound by the salary caps which
    generally apply to all government workers? Does it come as any
    surprise to learn that the Commissioner's staff has difficulty
    keeping up with people who earn ten times as much in the
    private sector, or that when the Commissioner directs them to
    increase enforcement, they wind up targeting legitimate
    business transactions while the transactions they are really
    trying to stop elude their grasp? We cannot remedy the problem
    if we insist upon being deaf and blind to mundane realities.
        Thank you for your time. As a tax lawyer and an individual
    who recognizes how much revenue is at stake, I hope you grow
    more, not less, concerned with the taxation of complex business
    transactions. I merely hope that your concern will manifest
    itself in measures that are practical and efficacious, as
    opposed to merely ceremonial.

        Chairman Archer. Dr. Sullivan.

        STATEMENT OF MARTIN A. SULLIVAN, PH.D., ECONOMIST, TAX
                     ANALYSTS, ARLINGTON, VIRGINIA

        Mr. Sullivan. Good afternoon, Mr. Chairman, Mr. McCrery,
    Mr. Doggett. It is an honor for me to appear here today. My
    name is Martin Sullivan, I am an economist. Anticipating a
    question from you, everybody in our profession is upright and
    there are no ethical conflicts, on the one hand.
        I work for Tax Analysts, which is a nonprofit, nonpartisian
    organization in Arlington, Virginia. It is best known as the
    publisher of Tax Notes Magazine, which I know you all read
    faithfully every week, and I appreciate that.
        I am honored to be here today. I really am trying to help.
    So let me just go to what I know. Let me just tell you what I
    don't know. I don't know anything about corporate tax shelters.
    It is way too complex for me. In fact, I was trying not to
    learn about them at all and avoid them, because they are too
    hard for a simple-minded economist such as myself. But the data
    at the other end of the telescope, if you will, just made it
    obvious I couldn't avoid it anymore or at least think about it
    a little bit.
        For the fiscal year 1999 that ended on September 30th, the
    Treasury Department collected $184 billion in receipts from the
    corporation income tax. This is down 2.5 percent from the prior
    year. I don't have charts, I just have little pieces of paper.
    If you would like to follow along with me, they are labeled
    chart 1, chart 2 and chart 3 in the testimony.
        The question is, we see that corporate testimony receipts
    have gone down this year. Is that a big deal? Is that something
    we should be concerned about? Well, I don't know definitely,
    but let us just go through what the possibilities might be. Let
    us look at the history. We have never had a decline in
    corporate tax receipts before-- we have only had it two times
    in the last 20 years; the first time was in the early 1980s
    when we had a really big recession and a really big tax cut, so
    that makes senses. The only other time was in 1990, when we had
    a smaller recession so that kind of makes sense.
        But right now we are not in the recession, as we all know
    and are thankful for, and we haven't had any big tax cuts. So
    in fact, profits are up; if anything, we have had legislation
    where corporate receipts are supposed to increase. Even the
    Chairman's press release indicates $50 billion of extra
    receipts from corporations should be expected over the last few
    years. We have had a rate increase from 34 to 35 percent, ill-
    advised in my opinion, but nevertheless there as a result of
    the 1993 act.
        So it is not legislation. It is not a recession. Why are
    corporate tax receipts going down? Well, the next thing to look
    at is profits, d that is what I did. If you look on chart 3, I
    sort of constructed an effective tax rate. And again if you
    just look at the history, it sort of makes sense. 1981, 1982,
    1983, 1984, we had a big recession and we had a big tax cut.
    Corporate profits go down. In 1987, receipts go up as a result
    of the Tax Reform Act of 1987.
        In 1991, 1992, receipts are low, because of the recession.
    But again you have this declining pattern starting around 1994.
    What is it due to? I am not sure. The possibilities are--we
    mentioned legislation. I think it is clearly true that it is
    not legislation.
        The second thing might be an increased investment in plant
    and equipment. Because of the way that the depreciation
    allowances work, tax depreciations are faster than book
    depreciation. That could be a reason. I just saw in the
    Treasury testimony that indicates that it might not be the
    reason. I think that deserves further study.
        The other possible reason might be an increase you have in
    noncorporate entities like S corporations. I don't think that
    is big enough to explain the entire shortfall but it might be
    there.
        Another reason might be an increased use in exercised stock
    options by executives of corporations because they deduct it
    for tax purposes but not for book purposes, and the other
    reason might be some sort of statistical fluke that is in the
    data. These are very complex data. But the other--the reason
    why I am here today is that the other possible reason, it might
    be corporate tax shelters. It might not be.
        The point is I think there clearly is a downward trend
    here. The trend could be as large as 10 or $20 billion a year
    annually.
        But I think, just to conclude, that it would be foolish to
    take this data as gospel. On the other hand, it would be
    foolish to ignore this data at this time.
        Thank you very much. I would be glad to answer any
    questions.
        Chairman Archer. Thank you, Dr. Sullivan.
        [The prepared statement follows:]

    Statement of Martin A. Sullivan, Ph.D., Economist, Tax Analysts \1\

             1. The Recent Decline in Corporate Income Tax Receipts

        For the fiscal year 1999 that ended on September 30th, the
    Treasury Department collected $184 billion in receipts from the
    corporation income tax. This is down 2.5 percent from the prior
    year.
    ---------------------------------------------------------------------------
        \1\ Tax Analysts is a non-partisan, non-profit organization located
    in Arlington, Virginia. It can be accessed on the world wide web at
    www.tax.org. This testimony reflects the views of the author and should
    not in any way be attributed to Tax Analysts. Much of the information
    contained in this testimony is from ``Shelter Fallout? Corporate Taxes
    Down, Profits Up,'' Tax Notes, August 2, 1999 and ``Despite September
    Surge, Corporate Tax Receipts Fall Short,'' Tax Notes, October 25,
    1999.
    ---------------------------------------------------------------------------
        Prior to 1999, there have been two periods over the last
    two decades when corporate income tax receipts declined. First,
    there was a huge drop in corporate tax receipts in the early
    1980s. This was due to the combination of two factors: (1) the
    massive amount of corporate tax relief provided by the Economic
    Recovery Tax Act of 1981 and (2) the 1981-82 recession, the
    deepest business cycle downturn since the 1930s.
        The second period of decline was in 1990 when corporation
    income tax receipts declined by 9.9 percent. This decline
    coincided with a small recession that began in July of 1990 and
    ended in March of 1991.
        Chart 1 shows the annual rate of growth in corporation
    income tax receipts from 1979 though 1999.
        What is striking about the 1999 decline in corporate tax
    receipts is that it does not come in the midst of a recession
    or after legislation including any significant corporate tax
    relief. The U.S. economy is booming. And, if anything, on net
    over the last five years Congress has legislated more income
    tax increases than decreases for U.S. corporations.
        Chart 2 compares the growth rate of real GDP with the
    growth in corporate receipts. Except for the late 1990s,
    percentage changes in corporation income tax receipts have
    generally moved with changes in overall economic growth (as
    measured by changes in real GDP) over the last two decades.
    Since 1995, the growth rate in corporation income tax receipts
    has declined despite strong economic growth.

    2. Do Declining Corporate Profits Explain Declining Corporate Receipts?

        If a recession or legislation cannot explain the recent
    decline in corporate tax receipts, the next most likely
    explanation would be a decline in the amount of profits.
        There is no perfect measure of true economic profits. The
    most widely-cited profit figure is that estimated by national
    income accountants of the Bureau of Economic Analysis of the
    Commerce Department. This data (adjusted slightly to align
    calendar year data with fiscal year data and to provide
    consistency over time) does show that there recently has been a
    decline in the rate of growth corporate profits in the late
    1990s. But the decline in corporate receipts has been
    significantly larger than the decline in profits as measured by
    the Commerce Department.
    [GRAPHIC] [TIFF OMITTED] T5744.008

    [GRAPHIC] [TIFF OMITTED] T5744.009

        One way to explore whether declining receipts are
    attributable to lower profits is to construct a ratio of
    corporate receipts to profits and observe the movement of this
    ratio over time. (Sometimes the ratio of corporation income tax
    receipts to profits is thought of as an ``effective tax
    rate.'')
        Chart 3 shows the ratio of corporation income tax receipts
    to corporate profits as measured by the Commerce Department
    from 1978 through 1999. (Please see the appendix at the end of
    this testimony for explanation and sources of the estimates.)
    [GRAPHIC] [TIFF OMITTED] T5744.010

        Corporation tax receipts were in excess of 30 percent of
    book profits in the late 1970s. As a result of corporate tax
    cuts included in the Economic Recovery and Tax Act of 1981,
    corporate income tax receipts declined dramatically to 18.3
    percent of profits in 1983--the lowest ratio in the two decades
    from 1978 to 1999. Following the 1982 Tax and Fiscal
    Responsibility Act taking effect in 1983, corporate tax
    receipts as a percentage of profits rose to the low twenties
    through 1985. The 1986 Tax Reform Act got the ratio up to the
    middle twenties. The ratio peaked at 26.6 percent in both 1993
    and 1994.
        Despite the increase in the top corporation income tax rate
    from 34 to 35 percent after passage of the 1993 Act, the ratio
    has steadily declined until it reached its twelve-year low in
    1999. The ratio of corporation income tax receipts to
    corporation book profits now stands at 21.8 percent. The
    average ratio for the prior three years prior to 1999 was 23.3
    percent. The average ratio for the five years prior to 1999 was
    24.3 percent. The average ratio for the ten years prior to 1999
    was 24.7 percent. So, depending on one's perspective, the tax-
    to-profit ratio is ``too low'' by 1.4 percent, 2.4 percent, or
    2.8 percent. (See Table B of Appendix for details.)
        How significant are these reductions in the ratio?
    According to the Commerce Department, corporate profits are now
    about $850 billion annually. Therefore, each percentage point
    decline in the ratio of corporate tax represents a loss of
    about $8.5 billion to the Treasury. Depending on what one
    considers to be a ``normal'' ratio of taxes to profits, the
    ``shortfall'' in corporation income tax receipts in 1999 is in
    a neighborhood between $12 and $24 billion.
        Using an average of prior-year ratios is only one standard
    for comparing current levels of corporate taxation. It is
    arbitrary. Nobody can say with authority what level corporate
    profits should be. But whatever measure is used, it is clear
    that there is a decline in corporate profitability in the last
    few years that probably amounts to more than $10 billion
    annually.

             3. Possible Reasons for Declining Effective Tax Rates

        Observing is one thing. Explaining is another. What has
    caused this decline in the taxation in corporate profits over
    the last five years? Here is a list of possible explanations.
        (1) Legislation. Congress has passed a lot of tax laws in
    the last ten years. But there has been relatively little in the
    way of corporate income tax reductions. In 1997, there was a
    significant reduction in the corporate alternative minimum tax,
    but the estimated revenue impact of this change was only about
    $1.5 billion for 1999. Offsetting this has been a fair number
    of small provisions raising corporate taxes. (Extensions of
    expiring provisions are significant but because they are merely
    extensions they would not explain declines in corporate
    revenue.) Perhaps the largest recent corporate tax change was
    the increase in the top corporate tax rate from 34 to 35
    percent enacted as part of the Omnibus Budget Reconciliation
    Act of 1993. This provision increased corporate tax revenue by
    approximately $5 billion annually. In conclusion, if anything,
    the likely impact of recent tax legislation has been to
    increase the ratio of corporate taxes to corporate profits.
        (2) Increased investment in plant and equipment. As a
    result of the 1986 Act, tax depreciation is not nearly as
    accelerated as it had been before 1986. Still, depreciation
    allowances are generally more accelerated for tax purposes than
    for book purposes. Therefore, a rapid increase in investment
    could cause tax depreciation to rise relative to book
    depreciation and therefore tax profits to decline relative to
    book profits. During the five year period from 1994 though
    1999, nonresidential fixed investment in the United States
    increased at an average annual inflation-adjusted rate of 9.9
    percent. During the prior five-year period (from 1989 through
    1993) the corresponding figure was only 1.5 percent. Without
    the availability of a depreciation simulation model, like those
    that are used by the Treasury Department and Joint Tax
    Committee economists, it is difficult to gauge whether
    increased investment can explain the recent decline in
    corporate income taxes.
        (3) Increased use of noncorporate entities. Changes in
    federal and state laws have made use of Subchapter S
    corporations, limited partnerships, and limited liability
    companies increasingly popular by small and mid-size
    businesses. Because these alternative forms are generally not
    an option for the largest U.S. corporations (from whom the vast
    bulk of corporation income tax is collected), there is no
    reason to expect this type of self-help to soon wipe out the
    corporation income tax. But increased use of pass-through
    entities might explain some significant portion of the declines
    in corporation tax in recent years.
        (4) Increase in exercised stock options. An increasingly
    popular method of compensating executives is the use of stock
    options. There are tax and accounting advantages of using stock
    options as compensation. Since 1993, executive salaries in
    excess of $1 million are no longer deductible. But stock
    options can be deductible if they are linked to a firm's
    financial performance. On the accounting side, stock options
    are not considered a cost under traditional accounting rules.
    Stock options are recognized as income (by the executive) and
    deductible (by the firm) when the stock options are exercised.
    Therefore, any increase in executives' exercising stock options
    could reduce corporation income tax receipts without any
    corresponding decline in book profits.
        (5) Possible statistical fluke. Perhaps some statistical
    bias--one way or the other--has seeped into the receipts data
    tabulated by the Treasury or into the profit data tabulated by
    the Commerce Department. (The calculation of profits is a
    complex undertaking explained in a lengthy 1985 Commerce
    Department Report called ``Corporate Profits: Profits Before
    Tax, Profits Tax Liability, and Dividends'' available at
    www.bea.doc.gov/bea/ARTICLES/NATIONAL/NIPA/Methpap/
    methpap2.pdf. Given the large amount of structural change
    recently in the U.S. economy, and given the difficulty that
    statisticians have in tracking these changes, this possibility
    deserves serious consideration as possible explanation of the
    apparent decline in the tax-to-profit ratio.
        (6) Other factors. The drop in corporate tax receipts may
    be due to some other factors not identified here.

              4. Declining Tax Receipts and Corporate Tax Shelters

        Among the other possible explanations of the recent decline
    corporate receipts is the increased use of a variety of
    aggressive tax planning techniques commonly referred to as
    ``corporate tax shelters.'' The charts presented in this
    testimony show a slowdown in the rate of growth of corporate
    receipts in the mid-1990s. This roughly coincides with the
    anecdotal evidence about the timing of the increased use of
    shelters.
        In addition, many knowledgeable commentators suspect that
    tax shelter may be eating into the corporate tax base:
         In its recently released interest and penalty
    study (JCS-3-99, July 22, 1999), the Joint Committee on
    Taxation made the following comment on the amount of corporate
    tax shelter activity: ``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.''
         In testimony before the Senate Finance Committee,
    the New York State Bar Association Tax Section stated: ``We
    believe that there are serious, and growing, problems with
    aggressive, sophisticated and, we believe in some cases,
    artificial transactions designed principally to achieve a
    particular tax advantage. . . . There is obviously an effect on
    revenue. While we are unable to estimate the amount of this
    revenue loss, anecdotal evidence and personal experience lead
    us to believe that it is likely to be quite significant.''
    (``Statement of Harold R. Handler on Behalf of the Tax Section,
    New York State Bar Association, before the Senate Finance
    Committee,'' April 27,1999.)
         In its recent white paper on corporate tax
    shelters (July 1, 1999), the Treasury Department wondered aloud
    about the relationship between declines in this ratio and tax
    shelters: ``While corporate tax payments have been rising,
    taxes have not grown as fast as have corporate profits. One
    hallmark of corporate tax shelters is a reduction in taxable
    income with no concomitant reduction in book income. The ratio
    of book income to taxable income has risen fairly sharply in
    the last few years. Some of this decline may be due to tax
    shelter activity.''
        But it is important to remember that a decline in the ratio
    of tax receipts to profits provides no proof about a
    relationship between corporate tax shelters and aggregate
    corporate tax receipts. Such data are only suggestive. The
    bigger the shortfall, the more suggestive they are.
        The situation in many ways is analogous to the use of low
    profitability of foreign controlled U.S. corporations as
    evidence of transfer pricing abuses by foreign-headquartered
    companies operating in the United States. As in the case of the
    controversy about inbound transfer pricing, finding alternative
    explanations of low taxes--such as high rates of investment--
    lessens suspicion that corporate shelter activity causes of
    lower corporate taxes. On the other hand, if this pattern
    persists and no alternative explanations are borne out, the
    likelihood that tax shelters are the cause of declining
    corporate tax receipts will increase.
        By its nature, the aggregate data can never provide
    conclusive evidence about the relationship between corporation
    income tax receipts and corporate tax shelters. In the end,
    Congress and the Administration must base any decisions it
    makes about tax shelters on uncertain information. Any decision
    based on solely on information presented here would be foolish.
    However, any decision ignoring this information similarly would
    be ill-advised.

                       Appendix: Explanation of the Data

        Historical data on corporate tax receipts are from the
    Office and Management and Budget, ``Budget of the United States
    Government, Fiscal Year 1999, Historical Tables,'' Table 2.1,
    ``Receipts by Source: 1934-2003'' available at
    www.access.gpo.gov/su--docs/budget99/pdf/hist.pdf. The most
    recent data on corporate tax receipts are from the U.S.
    Department of the Treasury, Financial Management Service,
    ``Monthly Treasury Statement,'' October 1999, available at
    www.fms.treas.gov/mts/mts0999.txt. These data are shown in
    Column (2) of Table A below.
        Annual corporate profit data used for calculations in this
    report are from the Commerce Department's Bureau of Economic
    Analysis (BEA) Quarterly historical data are from the BEA's web
    site at www.bea.doc.gov/bea/dn/0898nip3/table4.htm. The most
    recent data are available at www.bea.doc.gov/bea/dn/
    profits.htm. Data on real GDP growth are also from these same
    sources.
        Ideally, in order to match BEA quarterly data with fiscal-
    year data from the Treasury, profit data from four consecutive
    quarters ending with the third quarter of any year would be
    averaged to arrive at an annual figure for that year. For
    example, the average of BEA profit data from the last quarter
    of 1997 and the first three quarters of 1998 is paired with
    receipts data for fiscal year 1998. The entire series is shown
    in Column (3) of Table A below.
        However, the latest profit data available from BEA are for
    second quarter of 1999. In order to derive an estimate for 1999
    that is consistent with estimates for prior years, average
    profit data from four consecutive quarters ending with the
    second quarter was used an approximation of average profit data
    from four consecutive quarters ending with the third quarter.
    For example, the average of BEA profit data from the last two
    quarters of 1997 and the first two quarters of 1998 are paired
    with the corresponding receipts data for fiscal year 1998. The
    entire series is shown in Column (4) of Table A below.
        The ratios cited throughout this testimony and in the chart
    use this profit data and are shown in Column (6). In the
    interests of full disclosure, corresponding ratios for the more
    ideal measure are shown in column (5). Using ratios in column
    (5) do not appreciable change the results.
        Table B shows the calculations used to estimate the
    shortfall in corporate profits in 1999. All data in Table B are
    from, or are computed from, data shown in Table A.

     Table A.--Corporate Profit Data from the Commerce Department, Corporate Income Receipts Data from the Treasury
                               Department, and the Ratio of Receipts to Profits, 1978-1999
    ----------------------------------------------------------------------------------------------------------------
                                                                                 Ratio of     Ratio of
                                                      Corporate    Corporate    Corporate    Corporate     Rate of
                                        Corporation    Profits      Profits    Receipts to  Receipts to  Growth Real
                   Year                  Income Tax     (Year        (Year       Profits      Profits       Gross
                                          Receipts    Ending in    Ending in     (End 3rd     (End 2nd     Domestic
                                                      3rd Qtr.)    2nd Qtr.)   Qtr.) [(2)/   Qtr.[(2)/     Product
                                                                                   (3)]         (4)]
    (1)                                         (2)          (3)          (4)          (5)          (6)          (7)
    ----------------------------------------------------------------------------------------------------------------
    1978..............................        $60.0       $200.2       $195.9        29.9%        30.6%         5.4%
    1979..............................        $65.7       $217.6       $218.1        30.2%        30.1%         2.8%
    1980..............................        $64.6       $191.8       $200.6        33.7%        32.2%        -0.3%
    1981..............................        $61.1       $206.5       $195.9        29.6%        31.2%         2.3%
    1982..............................        $49.2       $186.4       $194.8        26.4%        25.3%        -2.1%
    1983..............................        $37.0       $218.4       $201.8        17.0%        18.3%         4.0%
    1984..............................        $56.9       $280.1       $270.8        20.3%        21.0%         7.0%
    1985..............................        $61.3       $302.0       $294.8        20.3%        20.8%         3.6%
    1986..............................        $63.1       $296.0       $306.4        21.3%        20.6%         3.1%
    1987..............................        $83.9       $316.4       $297.6        26.5%        28.2%         3.5%
    1988..............................        $94.5       $368.5       $359.2        25.7%        26.3%         4.2%
    1989..............................       $103.3       $389.5       $390.9        26.5%        26.4%         3.5%
    1990..............................        $93.5       $392.0       $393.3        23.9%        23.8%         1.7%
    1991..............................        $98.1       $407.0       $400.0        24.1%        24.5%        -0.2%
    1992..............................       $100.3       $416.5       $424.3        24.1%        23.6%         3.4%
    1993..............................       $117.5       $471.2       $442.0        24.9%        26.6%         2.4%
    1994..............................       $140.4       $551.3       $527.0        25.5%        26.6%         4.0%
    1995..............................       $157.1       $649.9       $622.8        24.2%        25.2%         2.7%
    1996..............................       $171.8       $736.9       $722.7        23.3%        23.8%         3.7%
    1997..............................       $182.3       $803.2       $781.8        22.7%        23.3%         4.5%
    1998..............................       $188.7       $824.4       $827.9        22.9%        22.8%         4.3%
    1999..............................       $184.7          N/A       $844.2          N/A        21.9%         3.0%
    ----------------------------------------------------------------------------------------------------------------

        Table B.--Calculations Used to Estimate the 1999 ``Shortfall'' in
        Corporate Tax Receipts under Various Assumptions about ``Normal''
                                    Receipts
    ------------------------------------------------------------------------
                                                                   10-Year
                                       3-Year Avg.  5-Year Avg.      Avg.
    ------------------------------------------------------------------------
    (1) Average of Prior Years.......        23.3%        24.3%        24.7%
    (2) 1999 Ratio...................        21.9%        21.9%        21.9%
    (3) Difference...................         1.4%         2.4%         2.8%
    (4) 1999 BEA Corporate Profits...       $844.2       $844.2       $844.2
    (5) Estimate of ``Shortfall''            $11.8        $20.3        $23.6
     [(3) times (4)].................
    ------------------------------------------------------------------------

        Chairman Archer. Mr. Carpenter, you may proceed.

    STATEMENT OF DANNY R. CARPENTER, VICE PRESIDENT-FINANCE, KANSAS
            CITY SOUTHERN INDUSTRIES, INC., KANSAS CITY, MO

        Mr. Carpenter. Thank you. Good afternoon, Mr. Chairman, and
    members of the Committee. My name is Danny R. Carpenter and I
    am Vice President of Finance of Kansas City Southern Industries
    located in Kansas City, Missouri. It is a pleasure to appear
    today, and I appreciate the opportunity to be here.
        I have been a tax professional for approximately 20 years.
    At this time I have overall responsibility for tax functions at
    Kansas City Southern, but not day-to-day responsibility.
        Over the past several years, I have been approached at
    least four to five times to consider transactions designed
    solely to avoid corporate taxes. I have examined only one of
    those transactions in depth, and the others only briefly. These
    transactions had three common elements, as I saw it. First,
    they were very complex and relied on technical application of
    tax rules to facts that were contrived to produce benefits
    never intended by Congress. Second, the transactions involve
    very sizable fees for professional advisors, investment bankers
    and others. And third, the transactions had little or no
    business purpose or economic substance.
        My company, KCSI, did not participate in any of these
    transactions because of the lack of business and economic
    reality, and also because of concern that a transaction
    designed exclusively to generate tax benefits would not and
    should not succeed.
        I am not suggesting that my company does not wish to save
    taxes where possible. We strive to pay no more taxes than the
    law requires. But we do not believe it is appropriate to engage
    in a significant transaction unrelated to a company's business,
    solely or principally to create tax benefits. Such transactions
    are inconsistent with a self-assessing tax system and should be
    viewed as abusive and eliminated.
        My concern about these transactions also extends to the way
    they have been developed and promoted. They are not presented,
    in my experience, as business transactions with nontax economic
    advantages; rather, they are promoted as transactions to
    provide tax benefits and for which an attempt would be made to
    establish a business purpose.
        In several instances the names of prominent local or
    national companies that had undertaken similar transactions
    were mentioned. Presumably that was to add credibility, but it
    also had the effect of creating competitive pressure,
    especially for companies in similar businesses. Tax
    professionals and accounting and law firms apparently have
    participated in designing these transactions and certainly in
    promoting and executing them. Without dwelling on these points,
    I would just say that especially in a self-assessing tax
    system, we would like to think that tax professionals would
    help police these kinds of transactions, not design and promote
    them.
        Finally, I would like to express my concern about possible
    solutions. Because of difficulties in finding a remedy for each
    individual transaction, there may be a tendency towards broad
    solutions for all such transactions. But broad standards mean
    that implementing regulations take years to complete and
    possible years of litigation will be required to develop
    meaningful rules. Broad solutions also establish traps for the
    unwary, produce unanticipated consequences, and create enormous
    costs and burdens for our tax administration system.
    Accordingly, broad, general solutions and vague standards must
    be avoided.
        While I do not believe the transactions I have seen would
    survive an IRS challenge under existing law, I recognize that
    under our current system, the IRS could easily be overwhelmed
    if there is widespread adoption of abusive techniques, as seems
    to be occurring. Accordingly, I believe congressional action is
    needed, at least to aid in the detection of these transactions
    through additional disclosure requirements, and probably also
    to strengthen existing anti-abuse rules.
        Thank you very much for the opportunity to appear and offer
    comments on a very important issue.
        [The prepared statement follows:]

    Statement of Danny R. Carpenter, Vice President-Finance, Kansas City
    Southern Industries, Inc., Kansas City, Missouri

        Good afternoon Mr. Chairman, Mr. Rangel, and members of the
    Committee. It is my pleasure to appear today in conjunction
    with the Committee's examination of so-called corporate tax
    shelters. I am Vice President-Finance for Kansas City Southern
    Industries, Inc. (``KCSI'').
        I have been a tax professional for approximately 20 years,
    first as an attorney in private practice, and since 1993, with
    Kansas City Southern Industries, Inc. Until May 1995, I served
    as Vice President-Tax and Tax Counsel for KCSI, and I continue
    to have overall (not day-to-day) responsibility for tax
    functions at KCSI.
        Over the past several years, I have been approached on four
    or five occasions to consider transactions that were designed
    simply to avoid corporate taxes. On one occasion I examined the
    proposed transaction relatively thoroughly, and on the other
    occasions, only briefly. In each instance, I found several
    matters of concern:

            1. The transactions were very complex and relied on the
            technical application of normal tax law provisions to facts
            that were contrived to produce tax results never contemplated
            by Congress.
            2. The transactions involved very sizeable fees for
            professional advisors, investment bankers and others who
            promoted the transactions.
            3. The transactions had either no business or economic purpose
            or a business or economic purpose that was dubious.

        KCSI did not participate in any of the transactions
    presented to us, because of the lack of business and economic
    reality to the proposed transactions and our concern that a
    transaction constructed exclusively, or virtually exclusively,
    to generate tax benefits would not achieve such benefits.
        Please do not interpret this statement as an indication
    that our company is not interested in controlling its tax cost
    or otherwise saving taxes where appropriate. In conducting our
    business and engaging in transactions undertaken for
    appropriate business purposes, we, of course, strive to pay no
    more taxes than the law requires and employ outside tax
    professionals to assist in achieving that goal. However, we do
    not believe it is appropriate to engage in a significant
    transaction which is unrelated to a company's business
    principally or solely for the purpose of generating tax
    benefits. Such transactions are inconsistent with a self-
    assessing tax system and should be viewed as abusive and
    eliminated.
        My concern about these transactions extends also to the way
    in which they have been developed and promoted. The
    transactions brought to my attention were not presented as
    business transactions with non-tax economic advantages. To the
    contrary, they were each promoted as a transaction that could
    reduce corporate taxes and for which an attempt would be made
    to find a business purpose. In several instances, the names of
    prominent local or national companies that had undertaken
    similar transactions were mentioned, presumably to add
    credibility to the proposal, but also creating pressure because
    of the increase in earnings a company could achieve through tax
    savings.
        Tax professionals at accounting firms and law firms
    apparently have participated in designing these transactions
    and in promoting and executing them. On several occasions, the
    transactions presented to me were put forth as ``proprietary,''
    and prior to disclosure of the ``proprietary'' information, I
    was asked to agree not to undertake the transaction with other
    advisors. This approach raises other issues not now relevant
    (e.g., an attorney's obligation to use his or her expertise to
    assist each client who could potentially benefit from the
    ``proprietary'' information), but the point here is that tax
    professionals should assist in policing abusive transactions,
    not designing and promoting them to generate substantial fees.
        Despite my belief that so-called corporate tax shelters are
    abusive and should be eliminated, I would like to express one
    significant concern regarding possible solutions to these
    transactions. Because of the nature of our current tax laws,
    these transactions present very complex issues cutting across
    many aspects of the Internal Revenue Code, and solutions aimed
    at specific transactions may be seen as only plugging one hole
    in the dike, while others continue to pop open. On the other
    hand, solutions that use very broad standards often require
    years for the development of regulations and possibly decades
    of litigation before meaningful rules are developed. Such broad
    solutions often establish traps for the unwary, result in
    unanticipated consequences and create enormous costs and
    burdens for our system of tax administration. Accordingly,
    broad, general solutions with vague language must be avoided.
    As I have indicated, we do not think the transactions presented
    to us would survive an IRS challenge under existing law, but I
    recognize that in a self-assessment tax system the IRS could
    easily be overwhelmed if there is widespread adoption of these
    abusive techniques, as seems to be occurring. Thus I think
    Congressional action is needed, at least to aide the Internal
    Revenue Service in detecting the use of such transactions, and
    probably also to clarify the anti-abuse rules now in the Code
    and those employed by the courts.
        Thank you very much for the opportunity to appear before
    this Committee and offer comments on a very complex and
    important tax issue.

        Chairman Archer. My gratitude to all of you gentlemen. Mr.
    Kies, your testimony seems to be different from Dr. Sullivan's,
    and I wonder if you could address the apparent differences
    between Dr. Sullivan's presentation relative to corporate tax
    receipts. Maybe I missed something, but I think there is some
    disparity between your two testimonies.
        Mr. Kies. Mr. Chairman, there is--and, unfortunately, Marty
    and I haven't had a chance to actually explore this, but we
    have identified two very serious flaws in his analysis that I
    think indicate that the conclusion that he reached is factually
    incorrect.
        In defining the corporate effective tax rate, he used
    corporate tax receipts and not the liability of corporations
    being reported year to year. Receipts and liability are two
    very different things. For a particular year, a corporation's
    liability could be a hundred million but there may be a variety
    of adjustments that occur that change the net tax receipts to
    the Federal Government because of receiving refunds from prior
    years or paying deficiencies from other years.
        The other problem that we have identified with Marty's
    analysis is that his denominator includes a number of pieces of
    income that are not subject to the corporate income tax,
    including sub S corporation income, which he did identify,
    profits from Federal Reserve Banks, and also the failure to
    eliminate State or local income tax expense. These are all
    items that the Bureau of Economic Analysis backs out in
    calculating what are corporate profits.
        We redid his numbers with these two adjustments, and what
    it shows is that, for 1999, the effective corporate tax rate is
    32.7 percent. The average for '89 to '98 is 32.5 percent.
    Therefore, it would suggest that the effective rate expected
    for 1999 is well in line with the rate that we have seen over
    the past 10 years. The rate for '94 to '98 was 32.5 as well.
        So our analysis with the modifications and the way we think
    the data should be analyzed suggest that the effective rate for
    this year is very consistent with what we have seen over the
    past 10 years.
        We plan to provide the Committee with this detailed
    information. It wasn't possible to get it done in time for
    today because of how recently his article was published.
        Chairman Archer. We will keep the record open for the
    receipt of that information.
        [The information follows:]
                                                      November 30, 1999

    The Honorable Bill Archer
    United States House of Representatives
    1236 Longworth House Office Building
    Washington, DC 20515

        Dear Mr. Chairman:

        I am writing to respond to a question you posed to me at the
    November 10, 1999, Ways and Means Committee hearing on ``corporate tax
    shelters.''
        At the hearing, I stated that a claim made by Marty Sullivan of Tax
    Analysts regarding corporate effective tax rates was based on a
    seriously flawed methodology. Specifically, Mr. Sullivan testified that
    the corporate effective tax rate in FY 1999 is ``too low by 1.5
    percent, 2.5 percent, or 2.9 percent'' compared to the prior three-,
    five-, and ten-year periods, respectively. You asked me to provide the
    Committee with information that supports my critique of Mr. Sullivan's
    claim.
        Mr. Sullivan's measure of corporate effective tax rates is flawed
    for two main reasons. First, the ``numerator'' in his calculation is
    corporate tax receipts rather than corporate tax liability. The amount
    of corporate tax payments that Treasury receives during the year only
    partially relates to current-year tax liability. Many of the payments
    and refunds during the current year reflect adjustments to prior-year
    tax liability (e.g., audit adjustments, carrybacks of NOLs, etc.).
    Also, companies' tax payments for current-year liability are based on
    estimates, with final tax settlement typically occurring six to nine
    months after the close of the tax year. The proper measure should be
    corporate tax liability, data that is available from the IRS.
        Second, the ``denominator'' in Mr. Sullivan's calculation is
    unadjusted corporate profits before tax, taken from the Commerce
    Department's GDP accounts. This is an inappropriate measure of
    corporate profits for purposes of calculating corporate effective tax
    rates. For purposes of calculating corporate profits, CBO makes four
    adjustments that Sullivan neglected:
        (1) CBO subtracts profits of the Federal Reserve Banks;
        (2) CBO subtracts profits of subchapter S corporations;
        (3) CBO subtracts State and local income tax payments; and
        (4) CBO adds corporate capital gains.
        PricewaterhouseCoopers has calculated corporate effective tax rates
    using the proper methodology. First, the ``numerator'' we use is
    corporate tax liability as reported by the IRS or, for more recent
    years, estimated by the Commerce Department's Bureau of Economic
    Analysis. Second, the ``denominator'' (e.g., corporate profits),
    follows CBO's methodology, with the subtractions and additions
    discussed above. Making these corrections to Mr. Sullivan's work, we
    found that the corporate effective tax rate in 1999 actually exceeds
    the average for the prior three, five, and ten years by between 0.2
    percent and 0.3 percent.

                                              Corporate Effective Tax Rates
    ----------------------------------------------------------------------------------------------------------------
                                                             Sullivan (fiscal years)
                            Year                                     percent            PwC (calendar years) percent
    ----------------------------------------------------------------------------------------------------------------
    1999................................................                          21.8                       32.7 a
    1996-1998...........................................                          23.3                          32.4
    1994-1998...........................................                          24.3                          32.4
    1989-1998...........................................                          24.7                          32.5
    ----------------------------------------------------------------------------------------------------------------
    a Based on first six months, seasonally adjusted.

        In other words, there is no evidence that corporate effective tax
    rates are declining. Rather, the reverse appears to be true.
        The Committee also should note that there is new evidence to
    support the view that the slight drop (2 percent) in net corporate
    income tax receipts in FY 1999 may simply be a statistical aberration,
    as Mr. Sullivan has acknowledged. Specifically, corporate income tax
    receipts in the first month of FY 2000 (October 1999) were nearly 25
    percent higher than the first month of FY 1999 (October 1998). As I
    discussed at the hearing, we will continue to monitor the incoming data
    to weigh whether there is any real evidence to suggest that the
    corporate income tax base is in danger of eroding.
                Sincerely,
                                                Kenneth J. Kies

        Chairman Archer. Dr. Sullivan, you want to make any
    comment?
        Mr. Sullivan. Sure. I appreciate it.
        I freely admit that these calculations are preliminary,
    that there are a lot of difficulties with them. That would only
    apply to my table number 3.
        Tables number 1 and 2--I will talk about table 3. But
    tables number 1 and 2 are still unaffected by Ken's criticism.
        Now let's go to table number 3. There is a--there are just
    a lot of--what I did, just so you know where I was coming from,
    I just chose the most commonly used profit figure. I did not
    fish or look around their search for the one that would produce
    the sexy result.
        I think that this does deserve a lot of study. I think some
    of the shortcomings that Ken mentioned could go either way.
    That is, when you make all the corrections that you would like
    to see, maybe it would show more dramatic change or I think
    some of the shortfalls are not biased.
        But the other factor is--and, again, is that even if it is
    level, that we would expect, with legislation, that it should
    increase. So, you know, it is always hard to know what the
    right answer is. But I just go back to the common sense of the
    first chart where corporate receipts are down, and we are not
    in a recession, and that is very unusual. And that is--
    otherwise, I agree with everything Ken said.
        Mr. Kies. Just by way of clarification, we didn't fish
    around or otherwise for this data. We used what CBO uses as its
    methodology for computing the effective corporate tax rate, and
    we used what the Commerce Department's Bureau of Economic
    Analysis uses for its measure of liability. So, I mean, we used
    what we thought were fairly conventional numbers for purposes
    of making this analysis.
        I would also point out that OMB predicted that corporate
    tax receipts would be down this year earlier this year because
    of the even-handed appreciation that is occurring because of
    significant investment increases that occurred in the past
    couple of years. This was a development that was predicted by
    the experts at both CBO and OMB, and they specifically noted
    that there was a dramatic increase in investment in the middle
    '90s over what had occurred earlier during the recession of the
    early '80s. And those depreciation deductions are now finding
    their way into the corporate revenve data.
        Chairman Archer. Dr. Sullivan.
        Mr. Sullivan. I just want to mention I don't know if I am
    disagreeing with you or not, Ken, but my understanding is that
    CBO predicted a downturn in corporate receipts due to their
    belief that corporate profits would decline, which has not been
    the case this year. So, in effect, they were at least partially
    right for the wrong reasons.
        So, I do agree--I do agree with Ken. That is absolutely
    true that the increase in investment, as I mentioned in my
    article and in my testimony, may account for this. And I
    believe the Treasury in their testimony, they have much bigger
    economic models than I have, addressed that issue, and they
    didn't believe it was a problem.
        Chairman Archer. When can we expect to get the final
    figures on 1999? These are just estimates right now.
        Mr. Sullivan. It is a source of frustration to us. It is--
    it may take 3 years to get final figures on 1999. The numbers
    come cascading in, and they are continuously revised. So we
    each month get new data, and we make new estimates based on
    that.
        Chairman Archer. Thank you very much.
        Mr. Hariton, you mentioned perhaps an exception could be
    carved out for, I believe in your words, the little guy
    relative to whatever we do on tax shelters and that that would
    take care of the compliance costs. I must tell you, I am very
    concerned about the compliance costs of the entire code,
    irrespective of the size of the taxpayer. When we talk about
    spending as much on compliance as we spend on national defense
    each year, that should be a matter of concern for all of us.
    And so the compliance--any additional compliance costs that go
    beyond being able to really address the problem in this area
    would concern me.
        You commented that the Treasury really just needs and the
    IRS just need more resources, and I agree with you on that. Our
    Committee does not set those resources, I am sorry to say, or
    they would have more. But the administration testimony today
    was that they can't administer this even with more resources
    when they don't know what is going on. I think that is pretty
    much what they said. So, if we gave them more resources and
    they come back and say doesn't matter, we don't know what is
    going on, we can't use them, what would your response do that
    be?
        Mr. Hariton. Well, I guess one response I would make is we
    all know that Treasury is saying this in part, and it is only
    natural that they should say it, because the Treasury is
    requesting legislation. But the truth is Treasury is doing a
    marvelous job with the resources it has--excuse me, the IRS is
    doing a marvelous job. It has a string of victories in court.
        I can tell you as a lawyer that those victories are very
    valuable in advising a client the reason Mr. Carpenter's
    company is not investing in these Tax shelters not because it
    is an unusually moral company but rather because the company is
    properly advised, and the proper advice is these transactions
    do not work. And I can tell you that most companies take that
    very, very seriously.
        You hear stories about how the CEO goes golfing with
    somebody that Representative Doggett might describe as a
    shyster, and the shyster tells her that there is some terrific
    deal where she can avoid all of her company's taxes. And of
    course that is incorrect as a matter of law. But none of us can
    stop that CEO from calling up the law firm of Winken, Blinken
    and Nod, if that is whom she wants to take her advice from. But
    the truth is that with decisions like this, it will become more
    and more clear even to that CEO that these transactions don't
    work as a matter of law. But what is clear is that if the IRS
    doesn't litigate these cases, and litigate them in force, and
    litigate them successfully, in effect as a practical matter the
    law has changed, the advice has changed, and then that CEO will
    do them more.
        So I don't see any alternative for the Commissioner and any
    alternative for the Treasury Department but to litigate these
    cases as best they can. And if they succeed, new laws will be
    unnecessary. But if they fail, if they are not going to do it,
    I don't think any law that we put on the books is going to make
    one whit of difference.
        I mean, think about it practically. We publish a definition
    of bad transactions and bad whisperings and it has 19 clauses
    and 3 subparts and 32 exceptions. Is anybody going to be
    walking around the golf course with that, with the CEO trying
    to tell her that the transaction in question does or does not
    fit that definition? No. Enforcement really is the answer of
    how to make sure people are really paying their taxes properly.
        Chairman Archer. Are you saying then we have not yet
    realized the full impact of the remedial action that is already
    under way?
        Mr. Hariton. As a practicing lawyer I can tell you that
    those court decisions have made a difference in the way people
    are behaving in the real world and that they will continue to
    make a difference in the way people are behaving in the real
    world. As I have said in my statement, I don't think that one
    should stop there. I think that Treasury and the IRS should
    have the maximum of resources because the task is two-fold and
    the hardest task is the first one, finding the transactions and
    distinguishing them with judgment and insight from legitimate
    business transactions. That is something that can only be done
    as a matter of administration and then telling these taxpayers
    those transactions don't work.
        The second task is, for the few taxpayers who disagree,
    taking them to court, proving that you mean it, proving that
    the transactions don't work. If that happens on a consistent
    basis, the system will work, and you will find that people will
    not enter into these transactions.
        Chairman Archer. Let me ask one last question which is a
    hypothetical, and first let me ask all of you, have you read
    H.R. 2255? Does each of you have an understanding of what the
    bill does? Doc Sullivan says no, but that is not really what
    his job is here today. I understand that. What about you, Mr.
    Carpenter?
        Mr. Carpenter. I have only looked at a summary.
        Chairman Archer. Mr. Hariton, you have looked at it, I take
    it; and, Mr. Kies, you have looked at it. I will ask the two of
    you this hypothetical question.
        Let's assume this. That an individual has had a family
    corporation for a number of years and finally realized one day
    that their earnings are being double taxed; and they decide,
    hey, this doesn't make any sense. I don't know why I continue
    to have this family corporation. I am now going to have a
    partnership. And the corporation is dissolved so that the
    partnership earnings can flow out singly taxed to the owners
    rather than doubly taxed. Would I in any way be covered by this
    bill by taking that action?
        Mr. Kies. Well, Mr. Chairman, I think you would be covered
    by the general terms of Mr. Doggett's bill which would indicate
    that any deduction exclusion that doesn't change the economic
    condition of the taxpayer could be disallowed. I would expect
    that Mr. Doggett and or the Treasury or IRS would take the
    position that that is something that ought to be covered by a
    specific exception, that is a result that is clearly
    anticipated by the law.
        I think your question highlights a more fundamental point
    and that is that transactions as basic as the one you have
    described would have to be run through that continuous filter
    of are you or are you not a transaction that is contemplated by
    the law. And that is the biggest source of concern to us, that
    is like asking the IRS to completely rewrite the Internal
    Revenue Code through the prism of what is clearly contemplated
    rather than allowing taxpayers to rely on a body of law that
    has been built up over 75 years. And that really is the source
    of greatest concern about the nature of Mr. Doggett's proposal.
        Chairman Archer. But the decision that was made in the
    hypothetical that I gave to you was solely for tax reasons.
    There was no change in the business transactions. It was driven
    solely for tax reasons and no other reason.
        Would there have been a disclosure report required?
        Mr. Kies. Again, I think it would depend upon how
    comfortable you were with either the statutory exceptions
    ultimately included in enactment of the provision.
        Chairman Archer. But is that statutory exception included
    in this bill?
        Mr. Kies. I think that is probably a matter of
    interpretation. But there is, I think, generally an exception
    that is intended to say if it is a result clearly contemplated
    by the Code--certainly, for example, the Treasury Department
    proposal has that exception--that you would be okay.
        Again, it just highlights a more fundamental----
        Chairman Archer. But under the terms of this bill, if you
    were advising me under this situation, would you advise me to
    file any kind of a disclosure?
        Mr. Kies. You know, one would at least have to think about
    that. And if this were ever to be enacted into law, these
    question would be asked thousands of times over. What would
    become the standard of practice is very difficult to predict as
    we sit here with something that is pretty hypothetical, at
    least at this point.
        Chairman Archer. Yeah, but this seems to me to fall exactly
    within the definition. There is no economic gain. This is
    strictly driven by taxes. And does that make it wrong?
        Mr. Kies. Well, I don't think--as a matter of wrong or
    right, hopefully, one would not approach it that way. It would
    be a question if the statute clearly permits you to use your
    business form. And one would, therefore, presume that if you
    wanted to switch from being a C corp to a partnership or a sub
    S entity you should be permitted to do that. But, technically,
    it fits squarely within the general definition of what would be
    a targeted transaction.
        Chairman Archer. Thank you very much.
        And, Mr. Doggett, I am sure you would like to inquire.
        Mr. Doggett. Thank you, Mr. Chairman. I am still seeking
    cosponsors, but you are not at the top of my list right now.
        As far as your example, my answer would be that this
    legislation doesn't cover reorganizations and that the
    transaction you describe does not involve a loss, credit or
    deduction, so we don't even get to the enumerated provisions.
        But I have a few questions for Mr. Kies.
        Welcome back. When you were here on March the 10th, in
    response to questions that I asked, you indicated that you were
    opposed to Congress taking any legislative action on tax
    shelters whatsoever. Is that still your position?
        Mr. Kies. Yes, Mr. Doggett. And I think intervening events
    just firm up that position because of the Tax Court cases that
    have shown----
        Mr. Doggett. I appreciate that and would be glad for you to
    follow up in elaboration as to why. But since my time is
    limited, haven't you voiced the opinion yourself that Congress
    would, in fact, take no legislative action on tax shelters in
    this Congress?
        Mr. Kies. I think what I have said is I didn't expect
    Congress would act this year on this issue.
        Mr. Doggett. Are you familiar with the operations of your
    firm Pricewaterhouse with reference to the promotion of what
    some folks call tax shelter products?
        Mr. Kies. I am familiar with the operations of our firm.
        Mr. Doggett. What do these tax shelter products cost?
        Mr. Kies. There is no specific cost.
        Mr. Doggett. Just give me an idea of the range. The kind of
    tax shelter products that you would market, say, to a Fortune
    500 company, what is the range of the cost of an individual tax
    product?
        Mr. Kies. Mr. Doggett, perhaps you misunderstood my earlier
    answer. I said I am familiar with the type of advice we
    provide. I didn't say anything about marketing tax shelters. So
    if you want to rephrase your question I would be happy to
    answer.
        Mr. Doggett. Are there any tax products that you sell to
    corporations in this country, large corporations, in order to
    permit them to reduce significantly the amount of their taxes?
    And, if so, can you tell me what those kind of products cost?
        Mr. Kies. The costs would be totally dependent on the
    complexity.
        The answer to your first question is, we advise clients
    with respect to ways in which to legitimately reduce their tax
    liability with some things as simple as their capital structure
    in using debt instead of equity, which gives rise to interest
    deductions, and then there are much more complicated
    transactions involving corporate reorganizations. The level--
    the fees involved would be directly related to the complexity.
        Mr. Doggett. Mr. Kies, do you know Mr. Fernando Murias, the
    co-chair, as of 1998, of the firm's Mid-Atlantic and Washington
    national tax practice?
        Mr. Kies. Yes, sir, I do.
        Mr. Doggett. Is he still employed after he gave that Forbes
    interview?
        Mr. Kies. Mr. Morias is still a partner with the firm. That
    is correct.
        Mr. Doggett. Is he still the director of the Mid-Atlantic
    and Washington National Tax Practice?
        Mr. Kies. No, he is not.
        Mr. Doggett. And when did that change?
        Mr. Kies. He took a different position within the last 6 or
    8 months.
        Mr. Doggett. And, as you know because we talked about this
    some when you were here in March, he told Forbes that your
    company has actively promoted about 30 mass market products,
    and for each had prepared a marketing briefing book and
    assigned product managers called ``product champions'' to
    coordinate sales, and that you had 40 newly hired professional
    salesmen helping pitch these ideas to companies that aren't
    current clients. Was he accurate in that regard?
        Mr. Kies. Mr. Doggett, I think the words that Mr. Morias
    chose, which were at a cocktail party, were rather inartful.
    The reality----
        Mr. Doggett. Were they inaccurate?
        Mr. Kies. They were both inartful and inaccurate. What is a
    fact is that the firm does identify planning strategies from
    time to time that may have common application to more than one
    client and under those circumstances it wouldn't be surprising
    that we might share those with potential clients.
        Mr. Doggett. What is the range of the cost of those 30 mass
    market products that he referred to?
        Mr. Kies. I really don't know.
        Mr. Doggett. Would you be able to supply us that
    information?
        Mr. Kies. It is possible.
        Mr. Doggett. Will you make an effort to do so?
        Mr. Kies. Certainly.
        Mr. Doggett. It is a profit center for the company that I
    suppose is growing and is substantial, isn't it?
        Mr. Kies. Not really, Mr. Doggett.
        Mr. Doggett. Since we are on the caution light, let me ask
    you about another comment that he made, that your firm markets
    so-called ``black box'' products. I asked you about that in
    March and you indicated you weren't familiar with it. These, he
    is quoted as saying, ``are complex and unique strategies that
    we do not publicize broadly.'' Each can save a client from tens
    of millions to hundreds of millions of dollars in tax. Has your
    company marketed such products?
        Mr. Kies. Mr. Doggett, again, I think the words Mr. Morias
    used were both inartful--it is certainly true that we have
    planned transactions for clients that may have substantial tax
    savings like doing a tax-free re-organization instead of a sale
    of a subsidiary.
        Mr. Doggett. Never heard of them referred to as ``black
    box'' proposals?
        Mr. Kies. The term black box----
        Mr. Doggett. Do you have some proposals, as he says, that
    you don't publicize broadly and you save for a few select
    clients?
        Mr. Kies. Mr. Doggett, perhaps you could indicate which
    question you would like me to answer.
        Mr. Doggett. The latter one, the one I just asked. Would
    you like me to restate it?
        Mr. Kies. You asked me whether or not we use a black box.
    And then, as I tried to give that answer, you interrupted me.
    Maybe you just tell me which question you would like me to
    answer.
        Mr. Doggett. I would glad to, if the chairman would permit.
        Mr. McCrery. I would indulge the gentleman one last
    question.
        Mr. Doggett. Thank you. It is because of the danger of
    filibuster that I have tried to ask these questions succinctly.
        Let me ask you, sir, if, as one last question only, if your
    company is still promoting the bond and option sales strategy
    that you call the Boss plan, a way to circumvent what this
    Committee did on section 357 in June.
        Mr. Kies. I am not even familiar with that transaction. I
    would be happy to look at it and get back to you.
        Mr. Doggett. I am sure you would. It has got
    PricewaterhouseCoopers on the cover, so I am sure you can find
    out about it when you get back.
        Thank you for your responsiveness, Mr. Kies.
        Mr. Kies. Certainly, Mr. Doggett.
        [The information follows:]
        [The Bond and Option Sales Strategy (Boss) plan is being
    retained in the Committee files.]
                                                      December 20, 1999

    The Honorable Bill Archer
    Committee on Ways and Means
    U.S. House of Representatives
    1102 Longworth House Office Building
    Washington, DC 20515-6348

        Dear Mr. Chairman:

        At the November 10, 1999, Ways and Means Committee hearing, Rep.
    Lloyd Doggett (D-TX) asked me for further information with respect to
    matters regarding my firm, PricewaterhouseCoopers. This letter is my
    response to Rep. Doggett's request, and is being sent to you so that it
    may be included in the printed record for the hearing. I am forwarding
    a copy of this letter to Rep. Doggett.
        Rep. Doggett asked me then if my firm is promoting a so-called
    ``Bond & Option Sales Strategy'' transaction. At the time of his
    question, I was not familiar with this transaction, as I stated at the
    hearing. Since the hearing, I have inquired within my firm about this
    matter. I also requested, and received from Rep. Doggett's office, a
    copy of a summary document apparently generated by
    PricewaterhouseCoopers regarding this hypothetical transaction and a
    draft of an opinion letter regarding the tax consequences of the Bond &
    Option Sales Strategy.
        I have learned the following. First, it is my understanding that
    PricewaterhouseCoopers has not been engaged by any client to assist,
    advise, or otherwise consult on execution of the specific Bond & Option
    Sales Strategy transaction outlined in the draft opinion letter that
    Rep. Doggett provided. Second, we did advise clients with respect to
    transactions similar to the one described in the draft opinion
    involving different economic characteristics. Third, it is the position
    of my firm that we will not issue an opinion on this transaction or
    such similar transactions. Moreover, we have delivered no such opinions
    to any client.
        Rep. Doggett also asked me about the fees charged by
    PricewaterhouseCoopers in conjunction with the tax advice that we
    provide to clients. Specifically, Rep. Doggett asked about the cost of
    the ``30 mass-market products'' that our partner Fernando Murias was
    quoted in the December 14, 1998, edition of Forbes magazine as saying
    my firm offers. Mr. Murias believes that his quoted comments were taken
    out of context and my firm does not believe they accurately portray the
    firm or its practices.
        In response to Rep. Doggett's question, I am not aware, as an
    initial matter, which specific services provided by
    PricewaterhouseCoopers were referred to by Mr. Murias. Even if I was,
    the fees charged by my firm are held confidential with our clients, and
    I would not be in a position to provide any specifics. That said, it is
    true that my firm consults regularly on ways to minimize our clients'
    tax liability consistent with Federal, State and local, and
    international tax laws. It also is true that some of these strategies
    have general applicability across our client base (e.g., reviewing a
    company's tax accounting methods) and in that regard we offer these
    services broadly. Other services we provide are specific to a client's
    unique facts and circumstances (e.g., consulting on a corporate
    reorganization) and thus are not applicable to a ``mass market.'' While
    there are no standard fees charged by my firm with respect to our
    services, in all cases the firm's fees are consistent with fees charged
    by other professional tax advisors and consistent with the expectations
    of our clients.

                                                     Sincerely,
                                                Kenneth J. Kies

        cc: The Honorable Charles Rangel, Ranking Minority Member,
    Committee on Ways and Means, U.S. House of Representatives
        The Honorable Lloyd Doggett, U.S. House of Representatives
        Jim Clark, Chief Tax Counsel, Committee on Ways and Means, U.S.
    House of Representatives
        John Buckley, Minority Tax Counsel, Committee on Ways and Means,
    U.S. House of Representatives
        Lindy Paull, Chief of Staff, Joint Committee on Taxation
        Jonathan Talisman, Acting Assistant Secretary (Tax Policy),
    Department of the Treasury

        Mr. McCrery. Mr. Kies, there were a number of questions
    asked. I would be willing to give you time now to respond to
    those questions if you so choose. If not, I have questions of
    my own.
        Mr. Kies. I would be happy to answer your questions,
    Mr.McCrery.
        Mr. McCrery. Thank you.
        Mr. Hariton, I was most interested in your comments about
    Treasury employees and paying them more because of the
    expertise needed. In fact, I think we could extend that maybe
    to the Ways and Means Committee. We will talk about that later.
    What about disclosure requirements? You didn't seem to be in
    favor of much of anything except letting the courts continue to
    work their magic. What about disclosure requirements? Do we
    need more disclosure requirements?
        Mr. Hariton. We have the same difficulty I fear with
    disclosure requirements that we had with substantive
    requirements which is, in order to have them, we have to figure
    out what a corporate tax shelter is. It is all very easy to
    say, well, disclose anything that is a corporate tax shelter.
    And if you read, for example, the proposals of Mr. Sax at the
    ABA, there is a long and detailed disclosure signed by the CFO
    with a great deal of ceremony. But it turns out, as the
    chairman was suggesting earlier, that when you go to figure out
    what transactions this applies to, it turns out to apply to
    everything and nothing. So that, if properly advised, basically
    we are enacting a rule that says every transaction done in
    America has to be disclosed in detail by the CFO and signed.
        Now--and you might well ask, who is going to write all
    those disclosures? And when they arrive in Washington who is
    going to read them? And what are they going to do with them?
    That might all be rather funny in a way, if it weren't that we
    all understand as practical people that none of that is ever
    going to happen. The minute you enact that law it will be
    ignored and nobody will disclose anything because they can't
    understand what they are supposed to disclose. So what it will
    reduce to is that if and when the IRS enforces a tax-abusive
    transaction, one of the things that they will say is that you
    should have disclosed.
        So to me we might as well go right to the heart of the
    issue and talk about the penalties that are imposed on persons
    who are found to have engaged in corporate tax shelters. I do
    not object, as I said in my statement, or think it would be a
    mistake to propose, for example, to raise the penalty for
    understatements arising from corporate tax shelter transactions
    if Congress feels that the balance is misplaced. I simply do
    not want Congress to enact legislation that on its face, after
    some careful thought, cannot possibly help in any way.
        Mr. McCrery. Why do you think the American Bar Association
    and the New York Bar Association are so seemingly adamantly in
    favor of increased disclosure requirements?
        Mr. Hariton. Well, everybody involved in this process I
    feel means well, and I can't speak to where anybody comes to
    their----
        Mr. McCrery. I am not talking about their motive. I am
    talking about why the difference. Why are such respected
    organizations as the ABA and the New York Bar in favor of
    increased disclosure and you make such compelling arguments
    against it? How do you explain that? What compelled them to
    reach such a different conclusion?
        Mr. Hariton. Well, I cannot--again, it is impossible for me
    to say--I haven't had enough discussions with Mr. Sax, for
    example, to get the full benefit of his reasoning and perhaps I
    should.
        I can tell you myself, based on my 15 years of experience
    in advising about the tax consequences of complex business
    transactions, that it is impossible, as the chairman was
    suggesting earlier, to give anybody any advice about what would
    or would not be disclosable, right down to the fellow who is
    disincorporating to avoid a second-level tax.
        I can tell you, for example, that many of the transactions
    that were done you would not think were tax abusive but were
    shut down by Congress presumably would be picked up--for
    example, Mirror Liquidations in the 1980s or just recently the
    so-called Morris Trust Transaction that was closed down, that
    is a spin-off followed by a merger of one of the companies into
    another company. Were these all disclosable transactions?
        In a sense, the disclosable transactions would really be
    infinite. And I don't understand how we would all function on a
    going-forward basis if we were to take seriously rules that say
    disclose any transaction with a significant purpose of tax
    avoidance. That is what I do for a living, is spend my time
    trying to figure out how to structure transactions so that you
    pay less rather than more tax. I do not want to--I think it
    would be a mistake for Congress to enact a law which, because
    it couldn't be complied with, encourages taxpayers and their
    advisors to ignore the law.
        Mr. McCrery. Is there anything--I will let you add to that
    in just a minute.
        Is there anything that enhanced disclosure requirements
    would offer the IRS that they don't now have access to in an
    audit?
        Mr. Hariton. For practical reasons I honestly don't think
    so. And here is the practical reason: In order to make use of a
    disclosure, one must examine it, ponder, think and analyze.
    There is no machine down here in Washington that can receive
    disclosures and sort them out in a pile, one abusive, nine
    okay, one abusive, nine okay. And this takes time. That is
    administration. That is why administration is the only answer
    to the problem.
        Mr. McCrery. Mr. Kies.
        Mr. Kies. Mr. McCrery, with all due respect to the previous
    panel, it did not appear to me and it does not appear to me
    that either the New York Bar or the ABA tax section have
    actually taken the time to analyze the economic data as to
    whether there is a problem with the erosion of the corporate
    tax base. I think they are operating largely based on anecdotal
    experience.
        If you noted, the last panel couldn't even identify what is
    the current level of corporate revenues. The only number thrown
    out was $120 billion. The current level, as you can see, is
    $180 billion. And I would have to just respectfully say that I
    don't think either one of those organizations have taken the
    time to examine the actual macro-economic data as to where
    corporate revenues have gone over the last 10 years to
    determine whether there is any fundamental erosion of the
    corporate tax base underway.
        We believe that is a threshold question that needs to be
    answered before one is launched off into a lot of statutory
    changes, particularly when you realize that the Service has
    been quite successful in combating problems within the last
    year through a series of Tax Court decisions that have been
    favorable to the government.
        I think Mr. Hariton noted something earlier I would just
    underscore in this regard and that is corporate tax directors
    and corporate professionals are reading those cases quite
    closely, and it is foolish to think that they are not taking
    into account the direction the courts are going in how they
    advise their clients. Because they clearly are.
        Mr. McCrery. Dr. Sullivan, I was somewhat surprised at your
    conclusion that there is a trend of declining corporate tax
    revenues to the Federal Government. And I was surprised because
    I immediately--before listening to your testimony, I read the
    charts provided by Mr. Kies which indicate that, as a percent
    of GDP, corporate revenues have actually increased since the
    early '80s, fairly consistently. And only this year, 1999, did
    we see a decrease from 2.2 percent of GDP to 2.1 percent of
    GDP.
        In light of--first of all, maybe these are wrong, but if
    you don't think they are wrong, then does that change your
    conclusion or do you still stand by your conclusion that we
    have a trend of declining corporate tax revenues?
        Mr. Sullivan. Yes, I do. The reason is that corporate--we--
    just put it simply, we had surging--we haven't noticed this
    trend because the Treasury has been doing so well with so much
    money coming in. And the question is relative to the amount of
    corporate profits we should expect.
        I was surprised to find this result myself. But when you
    look at corporate profits and you look at how much they have
    gone up, you just say receipts haven't gone up commensurate
    with that. And that is what is surprising.
        You look at the order of magnitude, and if you--depending
    on what type of chart you look at, it may look small, but it
    could be--it easily could be a 10 or $20 billion shortfall. It
    could be more than that.
        Again, that is why I think it is important that the
    Committee at least be aware of this with all the uncertainty
    around it that there might be this problem. I wouldn't want to
    you come to me 2 years from now and say, why didn't you tell me
    about this? There is something going on. We are not sure.
        If I may just add, it is very reminiscent of about 10 years
    ago when foreign corporations doing business in the United
    States were not paying any tax. We could clearly see that in
    the data, but we didn't know why. The inference was in transfer
    pricing, and we had a big to-do about transfer pricing. It is
    really the same situation here. We are observing something
    going on, we will never be able to prove it by looking at the
    data, but we just need to keep that in mind as we look at the
    overall situation.
        Mr. McCrery. Mr. Kies, do you have any comment on that?
        Mr. Kies. I would just cite you to our data, which really
    does show, I think rather convincingly, corporate revenues are
    on an up trend. There may be this small downturn for this year,
    which I think is easily explainable because of depreciation.
    But when you look at a number of factors like corporate
    revenues as a percent of GDP, when you look at effective tax
    rates, the effective tax rate for this year is expected to be
    32.7 percent. That is well in line with what we have seen over
    the past 10 years. It is higher than we saw in 1980 when it was
    only 29.2 percent.
        But I would say, consistent with Mr. Sullivan, and that is
    you should continue to watch these numbers to determine whether
    there is some fundamental problem. I guess what we are saying
    is we don't see it in the numbers that we have to date, that
    the corporate revenue base appears to be quite vibrant and has
    been for the past 10 years. But certainly part of the
    Committee's responsibility is to continue to monitor that
    situation.
        Mr. McCrery. Yeah, I have to say I think we should monitor
    them, but I am not inclined to agree with Dr. Sullivan that
    there is a trend out there right now. Maybe if we get another 2
    or 3 years of declining corporate receipts as a percent of GDP
    then we could conclude that there is. But, right now, I am
    inclined to say just watch it.
        Mr. Carpenter, you seem to be saying that there should be
    more focus on the folks advising corporations and individuals
    on tax shelters. Are you suggesting that we ought to consider
    penalties for people who are advising corporations and
    individuals to enter into these illegal transactions?
        Mr. Carpenter. I think that some bolstering of Circular 230
    probably is in order. I am not an expert in the area, but I do
    believe that is appropriate.
        However, I do not believe that going after the promoters or
    the advisors is the ultimate answer. If there are no tax
    shelters to promote, there will be no promoters. So I do
    believe that in some fashion or another there should be an
    effort made to reduce the attractiveness or reduce the
    availability of the so-called corporate tax shelters.
        I think that some further disclosure would be appropriate,
    and think that possibly some changes in the anti-abuse sections
    would be appropriate. Particularly I think that consideration
    could be given to modifying the rules on reasonable cause under
    Section 6664 so that there is an explicit exclusion for certain
    opinions that are faulty or not-well-reasoned tax opinions. I
    know such changes can get into a lot of issues, but I do think
    that there are some possibilities there.
        I think there is also a possibility that one should
    consider making the reasonable cause exception of 6664(c)
    available only to transactions that are disclosed.
        So I do think there are things that can be done that aren't
    massive that would help put a chilling effect on these
    corporate tax shelters. I don't think that actions through the
    courts by themselves will do that, because it takes a long
    time. And the shelters that are being sold now are very
    complex, and they are based, to a certain extent at least, on
    confidentiality and the anticipation that the transaction will
    not be discovered in audit. So that is the reason I think some
    attention of this Committee is appropriate to these matters,
    and hopefully a workable solution can be found.
        Mr. McCrery. Are you not concerned about the costs to your
    company of complying with such disclosure requirements?
        Mr. Carpenter. I am very concerned about it, but I am also
    concerned that the fact that the rates that every taxpayer pays
    are higher if others are avoiding tax in ways that are not
    contemplated by the laws of this country.
        So, yes, I do have some concern about the compliance costs.
    I definitely am concerned about any rules that would require
    taxpayers to do something within 30 days. I think that is a
    very difficult compliance requirement that should not be
    enacted if it is being proposed. Compliance is a very difficult
    process in a large corporation or for any taxpayer, and it is
    difficult enough to pull all of the needed resources together
    to do an annual tax return. But to have various rules requiring
    compliance within a 30-day period after a transaction I think
    definitely should be avoided.
        Mr. McCrery. I know you have said you have only read a
    summary of Mr. Doggett's bill. Would you be so kind as to have
    someone on your staff look at it more carefully and advise us
    of particularly the disclosure section of his legislation and
    see if you think that is a reasonable requirement or if it is
    too onerous or just what your comments would be? I would
    appreciate that.
        Mr. Carpenter. I would be very happy to do that.
        [The information follows:]
                                                      November 30, 1999

    The Honorable Jim McCrery
    United States House of Representatives
    2104 Rayburn House Office Building
    Washington, DC 20515-1804

        Re: Corporate Tax Shelters

        Dear Congressman McCrery:

        This letter responds to your request at the Ways and Means
    Committee hearing on corporate tax shelters held on November 10, 1999.
    Specifically, you requested that I consider the disclosure provisions
    of the ``Doggett Bill'' (H.R. 2255) and offer my perspective about the
    reasonableness of those proposed disclosure requirements. I now have
    had a chance to review the Doggett Bill in full and offer the following
    comments on the disclosure provisions of that bill:
        1. I strongly oppose any disclosure requirement other than a
    disclosure in the tax return of the taxpayer for the year in which the
    transaction takes place. Requiring disclosure within 30 days of a
    transaction is an unnecessary burden on the taxpayer (annual returns
    and quarterly payments are all that should be required), and would be
    useless unless the IRS is given large additional resources to
    scrutinize such disclosures.
        2. The Doggett Bill would require taxpayers to disclose
    ``appropriate documents describing the transaction.'' This requirement
    is vague, thus creating uncertainty for taxpayers attempting to comply
    and also allowing taxpayers great latitude in their disclosures,
    resulting in significant IRS time to analyze the disclosures.
        3. The Doggett Bill also would require very extensive information
    to be filed with the taxpayer's return, which probably is more
    information than the IRS would find useful or economical to analyze at
    that stage. Obviously, all of the details would have to be provided to
    the IRS on audit, but I hope that there could be simpler tax return
    disclosures that would be more useful to the IRS.
        For the initial tax return disclosure, simple disclosure of the
    salient facts would be preferable to the more burdensome Doggett Bill
    disclosure provisions. Because any definition of a corporate tax
    shelter probably should consider the relationship between any economic
    benefits and the anticipated tax benefits from the transaction, a
    simple disclosure requirement could include only (a) a brief
    description of the transaction, (b) a disclosure of the transaction as
    a corporate tax shelter for ease in identification by the IRS, and (c)
    a comparative disclosure of the economic and tax benefits for the tax
    year in question and an estimate of such benefits over the next ten
    years.
        It is a pleasure to have this opportunity to provide a follow-up to
    the November 10 hearing.

                                              Very truly yours,

                                             Danny R. Carpenter

        Mr. McCrery. Mr. Doggett, we have a vote on. Thank you all
    very much for appearing before us today, and we look forward to
    working with all of you to address this situation. Thank you.
        [Whereupon, at 3:20 p.m., the hearing was adjourned.]
        [Submissions for the record follow:]
                                                       November 5, 1999
    The Honorable Bill Archer
    Chair
    House Ways & Means Committee
    House of Representatives
    Washington, DC 20515

    The Honorable William V. Roth, Jr.
    Chair
    Senate Finance Committee
    United States Senate
    Washington, DC 20510

    The Honorable Charles B. Rangel
    Ranking Minority Member
    House Ways & Means Committee
    House of Representatives
    Washington, DC 20515

    The Honorable Daniel P. Moynihan
    Ranking Minority Member
    Senate Finance Committee
    United States Senate
    Washington, DC 20510

    Charles O. Rossotti
    Commissioner
    Internal Revenue Service
    Room 3000
    1111 Constitution Avenue, N.W.
    Washington, DC 20224

    Jonathan Talisman
    Acting Assistant Secretary, Tax Policy
    Department of the Treasury
    Room 3120
    1500 Pennsylvania Avenue, N.W.
    Washington, DC 20220

        Dear Sirs:

        We are writing to express our views on the provisions regarding
    corporate tax shelters contained in the Administration's Fiscal Year
    2000 Budget Proposals (the ``Administration Proposals''), which were
    released in February of this year, along with proposed modifications
    contained in the Treasury Department White Paper on ``The Problem of
    Corporate Tax Shelters: Discussion, Analysis, and Legislative
    Proposals'' (the ``White Paper''), which was released on July 1, 1999.
    Our comments are limited to the proposals relating to ``tax shelters''
    generally, as opposed to the provisions in the Administration Proposals
    addressing specific perceived abuses, such as the proposal to modify
    the anti-abuse rules related to assumption of liabilities in
    transactions under Section 351 of the Internal Revenue Code of 1986, as
    amended (the ``Code'') \1\
    ---------------------------------------------------------------------------
        \1\ This letter also addresses certain similar provisions in H.R.
    2255, the proposed ``Abusive Tax Shelter Shutdown Act of 1999,'' which
    was introduced on June 17, 1999.
    ---------------------------------------------------------------------------
        As discussed in more detail below, we share the Treasury
    Department's concern about the recent proliferation of corporate tax
    shelters and understand the motivation behind the Administration
    Proposals, as modified by the White Paper (as so modified, the
    ``Treasury Proposals''). In this regard, we generally endorse the
    proposals for enhanced disclosure requirements and the increase in the
    ``substantial understatement'' penalty applicable to corporate tax
    shelters. However, we differ from the Treasury Department insofar as we
    believe that all existing tools for enforcement, along with enhanced
    disclosure requirements and penalties, should be utilized before
    attempting to combat these perceived abuses by permitting the Internal
    Revenue Service to disallow tax benefits based upon characterization of
    a transaction as a ``tax avoidance transaction,'' without regard to the
    normally applicable substantive provisions of the Code. We also
    disagree with the provisions in the Treasury Proposals that target not
    just the corporate taxpayers seeking benefits from ``tax shelters,''
    but the advisers and tax-exempt parties involved in these transactions.

    Concerns with the General Approach of the Treasury Proposals To Denying
                 Tax Benefits Associated with ``Tax Shelters''

        The Treasury Proposals would disallow tax benefits
    associated with transactions in which the reasonably expected
    pre-tax benefits are insignificant in comparison to the
    reasonably expected net tax benefits, as well as certain
    financing transactions.
        We agree with the Treasury Department's concerns about the
    aggressive marketing of corporate tax shelters, which has
    resulted in a great deal of publicity not only in the tax
    press, but in the general business press.\2\ Although
    corrective regulations or legislative amendments have been
    proposed to rectify many of the alleged abuses after they have
    come to light,\3\ the Treasury Department apparently fears that
    abusive transactions that have already taken place will be
    grandfathered by specific regulatory and legislative remedies
    and that other transactions will go undetected. As a result,
    the Treasury Department apparently believes that a more general
    anti-abuse rule will give the Internal Revenue Service the
    ability to more effectively prevent and combat abuses.
    ---------------------------------------------------------------------------
        \2\ See, e.g., the cover story in the December 14, 1998 edition of
    Forbes.
        \3\ See, e.g., Notice 97-21 and Prop. Treas. Reg. Sec. 1.7701(l)-3
    (addressing fast-pay stock); Section 3001 of Pub. L. 106-36 (modifying
    applicability of Section 357(c) to asset transfers subject to
    liabilities).
    ---------------------------------------------------------------------------
        We concur with the Treasury Department that heavily
    promoted corporate tax shelters, which often have little or no
    non-tax economic motivation and rely on very aggressive, and
    often dubious, technical interpretations of the Code and
    regulations, pose serious problems for the tax system. Even
    aside from the potential for corporations to realize tax
    savings that are unwarranted from a policy standpoint,
    publicity about these transactions creates a damaging public
    perception that the tax system is unfair.
        Nonetheless, we are not convinced that the approach to
    disallowing tax benefits taken by the Treasury Proposals is
    warranted. This is particularly so in light of what appears to
    be a lack of empirical evidence as to the amount of revenue
    that has been lost by the Treasury due to claimed tax benefits
    that would be disallowed under the Treasury Proposals but are
    otherwise allowable. Our sense is that many of the aggressive
    tax-motivated transactions currently being marketed are
    vulnerable to attack under present law, as a result of which
    many taxpayers that have been approached by investment bankers
    and other promoters have decided against proceeding with these
    transactions. The Internal Revenue Service's potential ability
    under current law successfully to attack abusive transactions
    that actually have been implemented further complicates any
    effort at producing meaningful revenue estimates of the impact
    of the Treasury Proposals.
        The Treasury Proposals, insofar as they would disallow tax
    benefits arising from a broadly defined class of tax avoidance
    transactions, represent a significant departure from current
    law. The proposed anti-tax shelter rules clearly go well beyond
    existing anti-avoidance provisions of the Code and regulations,
    such as Treas. Reg. Sec. 1.1502-13(h), that are limited to
    preventing attempts to avoid the purposes of specific
    substantive rules. The scope of transactions potentially
    covered by the Treasury Proposals is far broader than Section
    269 of the Code, which addresses only limited types of
    acquisitions of corporate control and carryover basis
    acquisitions of assets undertaken with the principal purpose of
    obtaining tax benefits that would not otherwise be available.
    Even the partnership anti-abuse regulations of Treas. Reg.
    Sec. 1.701-2, which are extremely broad and have themselves
    been the subject of substantial criticism, are at least on
    their face limited to transactions that are deemed to be
    inconsistent with the intent of Subchapter K of the Code. By
    contrast, the Treasury Proposals' anti-tax shelter provisions
    are not limited to transactions which are inconsistent with the
    generally applicable substantive rules of the Code and
    regulations or with the intent of such rules. The Treasury
    Proposals also go significantly beyond the existing judicial
    economic substance and business purpose doctrines. These
    doctrines are generally understood to apply only to
    transactions that are devoid of any economic substance or
    business purpose. The Treasury Proposals, on the other hand,
    would require a vaguely defined weighing of tax and non-tax
    motivations.
        Our most fundamental objection to the Treasury Proposals'
    anti-tax shelter provisions is that they would create enormous
    uncertainty and would have a chilling effect on transactions
    that incorporate entirely appropriate tax planning. Tax
    considerations play a major role in many business decisions.
    The U.S. business and financial environment is extremely
    complex, which has inevitably resulted in the development of an
    equally complex set of tax laws. Nonetheless, with sufficient
    effort, it generally is possible to reach a reasonable level of
    confidence as to the tax consequences of a given set of
    actions. This level of certainty, which is extremely important
    to business planning, would be severely undermined by enactment
    of the Treasury Proposals. The anti-tax shelter provisions
    would permit the Internal Revenue Service to override the
    generally applicable substantive tax rules based upon
    inherently uncertain assessments of the likely pre-tax and tax
    benefits to be derived from a transaction or the perceived
    propriety of reductions in income.\4\ As a result, there would
    be a serious risk that legitimate tax planning in the context
    of bona fide business transactions would be frustrated.
    ---------------------------------------------------------------------------
        \4\ This is, of course, a one-way street. Taxpayers would not be
    given a similar right to insist on a deviation from the normal rules
    where they result in some ``unfair'' or ``irrational'' negative result.
    Although taxpayers can often plan their affairs and structure
    transactions in such a way as to avoid these adverse outcomes, this is
    not always possible even for well-advised taxpayers.
    ---------------------------------------------------------------------------
        We believe that abusive tax shelters can be more
    effectively and appropriately combated through a more
    traditional approach along with increased penalties and
    stepped-up enforcement. Addressing specific provisions of the
    Code and regulations ultimately is a more effective way of
    addressing abusive transactions because it produces more
    predictable results. In addition, because many corporate tax
    shelters are designed to take advantage of provisions that, in
    other contexts, can produce results that are unfairly
    detrimental to taxpayers, an approach that corrects the
    distortions that produce these results can enhance the overall
    fairness of the tax system and benefit taxpayers as well as the
    government. Moreover, although we recognize that changes to
    legislation and regulations may not be effective with respect
    to transactions that have already been consummated, many such
    transactions, if they are perceived as abusive corporate tax
    shelters, can be attacked successfully through vigorous
    enforcement of current law.
        Not only can the Internal Revenue Service challenge
    transactions using technical arguments that may be available
    with respect to specific provisions of the Code and
    regulations, under current law it can avail itself of arguments
    such as the business purpose, economic substance, and substance
    over form doctrines and the clear reflection of income
    principle. The government successfully used this approach in a
    number of recent cases, including ACM Partnership v.
    Commissioner, 157 F.3d 231 (3rd Cir. 1998), Compaq Computer
    Corp. v. Commissioner, 113 T.C. No. 17 (1999), Winn-Dixie
    Stores, Inc. v. Commissioner, 113 T.C. No. 21 (1999), and IES
    Industries, Inc. v. United States (N.D. Iowa, No. C97-206,
    1999). These cases are clear examples of effective actions by
    the Internal Revenue Service to combat perceived abuses under
    current law.\5\ Significantly, the Internal Revenue Service in
    all of these cases successfully attacked transactions raising
    issues which had also been effectively addressed on a
    prospective basis by administrative or legislative actions.\6\
    These cases thus cut against the assertion by some advocates of
    the Treasury Proposals that ``piecemeal'' changes in the law
    are inadequate because prior transactions are grandfathered and
    go unchallenged.
    ---------------------------------------------------------------------------
        \5\ In Compaq, the government prevailed not only in disallowing the
    claimed tax benefits, but in assessing a negligence penalty.
        \6\ ACM involved use by the taxpayer of provisions in the
    installment sale regulations which the Internal Revenue Service
    announced in Notice 90-56, 1990-2 C.B. 344, would be amended. Compaq
    and IES Industries involved claims of credits for foreign taxes
    withheld from dividends on stock held for periods that would have
    fallen short of the subsequently enacted holding period requirements of
    Section 901(k) of the Code. Similarly, in Winn-Dixie, the court
    disallowed claimed interest deductions arising from a corporate-owned
    life insurance program of a type that was addressed in post-transaction
    amendments to Section 264 of the Code.
    ---------------------------------------------------------------------------
        The Treasury Department can also reduce the risk that
    corporate tax shelters will go undetected by promulgating
    regulations to implement the 1997 changes to the tax shelter
    registration requirements of Section 6111 of the Code. Perhaps
    more fundamentally, we believe that the Internal Revenue
    Service should be given adequate resources to support its
    enforcement activities. One of the factors weighed by taxpayers
    in deciding whether to enter into aggressive tax-motivated
    transactions is the likelihood of being audited. The better the
    enforcement of existing rules, the higher the likelihood of
    audit, and the less likely taxpayers are to enter into abusive
    transactions. A reversal of the recently reported drop in audit
    activity \7\ would go a long way toward not only combating tax
    shelters, but increasing compliance in non-shelter situations.
    ---------------------------------------------------------------------------
        \7\ See Tax Notes, April 12, 1999, p. 188.
    ---------------------------------------------------------------------------

                  Specific Comments on The Treasury Proposals

        Although the Treasury Proposals have not yet been reduced
    to specific legislative language, their description in the
    ``General Explanations of the Administration's Revenue
    Proposals'' (the ``General Explanation'') and the White Paper
    gives rise to a number of troublesome issues.

    Definition of ``tax avoidance transaction.''

        The Treasury Proposals generally are aimed at ``tax
    avoidance transactions,'' a term that includes two general
    categories of transactions. The first category includes ``any
    transaction in which the reasonably expected pre-tax profit
    (determined on a present value basis, after taking into account
    foreign taxes as expenses and transaction costs) of the
    transaction is insignificant relative to the reasonably
    expected net tax benefits (i.e., tax benefits in excess of the
    tax liability arising from the transaction, determined on a
    present value basis) of such transaction.'' \8\ Under the
    original Administration Proposals, the definition of a tax
    avoidance transaction would also have included certain
    transactions involving ``the improper elimination or
    significant reduction of tax on economic income.'' The White
    Paper would replace this second category of the tax shelter
    definition with an additional category of tax avoidance
    transaction similar to that set forth in H.R. 2255. This new
    second category would encompass financing transactions in which
    the deductions claimed by the taxpayer for any period are
    significantly in excess of the economic return realized by the
    person providing the capital.
    ---------------------------------------------------------------------------
        \8\ H.R. 2255 includes a similar definition of ``noneconomic tax
    attribute,'' which would include any deduction, loss, or credit arising
    from any transaction unless the transaction changes the taxpayer's
    economic position (apart from federal income tax consequences) in a
    ``meaningful way'' and the present value of the reasonably expected
    potential income (and risk of loss) from the transaction is
    ``substantial'' in relationship to the present value of the tax
    benefits claimed.
    ---------------------------------------------------------------------------
        This definition is extremely problematic to the extent that
    it would be employed to disallow otherwise allowable tax
    benefits, thus affecting taxpayers' underlying tax liabilities,
    as opposed to merely serving as a benchmark for the imposition
    of penalties with respect to benefits that are otherwise
    disallowed. At the most basic level, it is totally unclear what
    it means for the reasonably expected pre-tax profit to be
    ``insignificant'' relative to the reasonably expected net tax
    benefits. ``Insignificant'' could mean less than 40 percent,
    less than 25 percent, or even less than 10 percent. Given that
    every dollar of deductible expense in the most straightforward
    transaction results in a thirty-five cent tax savings for top-
    bracket corporate taxpayers, the threshold of
    ``insignificance,'' if set too high, is very quickly met.
    Moreover, in most business transactions, the ``reasonably
    expected pre-tax profit'' is extremely difficult to predict,
    and the relationship between pre-tax profit and net tax
    benefits often is highly dependent upon the success of the
    venture.
        The proposed definition of tax avoidance transaction has
    substantial potential for overbreadth. The economics of many
    straightforward commercial transactions, such as ``plain
    vanilla'' leveraged leases of aircraft to domestic airlines,
    which are heavily dependent upon tax savings and often produce
    returns without regard to tax consequences that are less than
    returns on ``risk-free'' investments in United States
    government obligations, might fall within the first category of
    the definition of a tax avoidance transaction, despite the fact
    that such arrangements generally are not perceived as abusive
    tax shelters. Many internal restructurings of corporate groups
    intended to enhance tax efficiency would also appear to fall
    within the literal terms of the definition, because there often
    is no pre-tax motivation. Similarly, a sale of a high basis,
    low value asset at a loss could produce tax savings
    substantially in excess of any pre-tax economic benefit. The
    Treasury Proposals do provide that a ``tax benefit,'' while
    including ``a reduction, exclusion, avoidance, or deferral of
    tax, or an increase in a refund,'' excludes ``a tax benefit
    clearly contemplated by the applicable provision (taking into
    account the Congressional purpose for such provision and the
    interaction of such provision with other provisions of the
    Code).'' The scope of this exclusion is, however, extremely
    uncertain. It can be argued that any tax benefit expressly
    provided in the Code must have been ``clearly contemplated,''
    but this presumably is not what was intended by the Treasury
    Proposals, because they then would be rendered almost
    completely meaningless. On the other hand, it can equally well
    be argued that very few tax benefits are ``clearly
    contemplated'' in the context of a particular transaction,
    since Congress typically promulgates rules of general
    applicability rather than rules aimed at specific transactions.
    The White Paper attempts to provide some assurance by
    enumerating the low-income housing credit and deductions
    generated by ``standard leveraged leases'' as examples of
    benefits that normally would meet the tax avoidance transaction
    definition but are not subject to disallowance.\9\ Even this
    apparent concession, however, is limited by a statement to the
    effect that tax benefits generated by leveraged leasing
    activity require careful analysis as to whether such benefits
    are clearly contemplated and that some such transactions may
    indeed be tax avoidance transactions.\10\
    ---------------------------------------------------------------------------
        \9\ White Paper, p. 96.
        \10\ Id., n. 35
    ---------------------------------------------------------------------------
        The portion of the definition dealing with financing
    transactions is also troubling. As with the first prong of the
    definition, there is a great deal of pressure on determining
    the ``significance'' of a discrepancy between the taxpayer's
    deductions and the capital provider's economic return. A
    further flaw is that the definition picks up transactions where
    there is a discrepancy for any period rather than looking at
    the life of the transaction. Finally, categorizing a financing
    transaction as a tax avoidance transaction is fundamentally
    unfair where the discrepancy between the taxpayer's deductions
    and the capital provider's economic return results from
    application of tax accounting principles embodied in the Code
    or regulations, especially where the capital provider is a U.S.
    taxpayer and suffers income inclusions that match the
    taxpayer's deductions.
        Finally, it appears that the determination of whether a
    given transaction is a tax avoidance transaction is highly
    dependent on how the transaction itself is defined. This is a
    particularly difficult issue in the case of multi-step
    transactions, which can be viewed either as a single
    transaction or as a series of separate transactions, each of
    which must be separately tested for ``tax avoidance.'' Under
    the latter approach, by separately examining each element of an
    integrated transaction, the Internal Revenue Service could
    effectively require taxpayers to choose the least tax-efficient
    means of achieving a given business objective.\11\
    ---------------------------------------------------------------------------
        \11\ H.R. 2255, by providing that each transaction which is part of
    a series of related transactions and each step in a multi-step
    transaction must be tested both individually and on an overall basis,
    appears to impose a particularly harsh standard in this regard.
    ---------------------------------------------------------------------------
        In a similar vein, it is unclear whether the tax avoidance
    transaction definition is intended to apply, and if so how it
    would be applied, to tax-favored disposition techniques, such
    as the redemption transactions that were the target of the 1997
    amendments to Section 1059 of the Code. In many such cases, the
    decision to dispose of the underlying business is motivated
    almost entirely by non-tax business reasons, whereas the choice
    of a particular disposition structure may be principally tax-
    driven. It is also difficult to see how the comparison of pre-
    tax profit and net tax benefits would be applied to such a
    transaction.
        Because of its inherent uncertainties and dependence upon
    subjective administrative and judicial determinations, the
    ``tax avoidance transaction'' definition as a practical matter
    would likely boil down to an ``I know it when I see it''
    determination, which is by its very nature in the eyes of the
    beholder. As a result, the Treasury Proposals would carry a
    substantial risk of being overinclusive or underinclusive in
    their actual application, making their practical effect
    extremely hard to predict. Because planning to minimize taxes
    is such an integral part of business transactions, transactions
    that most people would not think of as ``tax shelters'' could
    be subject to attack. The possibility of such a result could
    deter risk-averse taxpayers from entering into perfectly
    appropriate, economically motivated but tax advantageous
    transactions.

    Denial of tax benefits in the case of tax avoidance
    transactions.

        The Treasury Proposals would provide for the disallowance
    of any deduction, credit, exclusion or other allowance obtained
    in a tax avoidance transaction. For the reasons discussed
    above, we believe that it is inappropriate for substantive tax
    liability to be determined based upon inherently vague
    definitions of tax avoidance transactions rather than specific
    statutory rules. In addition to our objections, discussed
    above, to the definition of a ``tax avoidance transaction'' in
    the Treasury Proposals, we believe that this provision would
    provide the Internal Revenue Service and ultimately the courts
    with overly broad discretion to determine taxpayers' tax
    liabilities. The original Administration Proposals would have
    given the Secretary authority to disallow tax benefits obtained
    in tax avoidance transactions. Although the White Paper
    proposes to modify the Administration Proposals by providing
    for a self-operative disallowance provision, the Internal
    Revenue Service would still as a practical matter have
    discretion as to whether to seek to apply the provision. The
    White Paper's modification is likely merely to shift the
    ultimate discretionary authority inherent in the disallowance
    provision from the administrative level to the judicial level.
    Once a transaction is classified as a tax avoidance
    transaction, it appears that all associated deductions,
    credits, exclusions, or other allowances otherwise available
    from the transaction, as opposed to only those benefits that
    are viewed as somehow ``inappropriate'' or the net tax savings
    otherwise resulting from a transaction, are subject to
    potential disallowance. In the context of a multi-step
    transaction, this puts further pressure on appropriately
    defining the scope of the ``transaction'' that is determined to
    be a tax avoidance transaction. The determination of the
    taxpayer's tax liability thus appears to become completely a
    matter of administrative and/or judicial discretion.

    Disclosure requirements.

        The Treasury Proposals would require disclosure of
    potential corporate tax shelters, both within 30 days after
    completion of the transaction and on the taxpayer's return. The
    White Paper proposes that the disclosure requirement should be
    triggered by the presence of certain ``filters,'' such as book/
    tax differences, rescission, unwind, or insurance arrangements
    related to tax benefits, confidentiality agreements, and
    contingent fees payable to advisers, that are commonly
    associated with corporate tax shelters.
        As long as the criteria for determining when transactions
    must be disclosed are objective and reasonably well-defined, as
    opposed to being based upon falling within the inherently vague
    definition of ``tax avoidance transaction,'' we are in favor of
    these disclosure requirements. We believe that the proposed
    disclosure requirements would serve two useful functions.
    First, in the case of taxpayers that are not routinely audited,
    disclosure would reduce their ability to successfully play the
    ``audit lottery'' and thereby receive unwarranted tax benefits
    simply because the transaction is never detected. Second,
    requiring prompt disclosure will alert the Internal Revenue
    Service to potentially abusive transactions and enable it to
    respond more promptly through legislative proposals or changes
    in regulations. In this regard, the enhanced disclosure
    requirements greatly diminish the need for the Treasury
    Proposals' provisions that would disallow tax benefits based
    upon characterization of a transaction as a tax avoidance
    transaction without regard to generally applicable principles
    of substantive tax law. It is important, however, that the
    class of transactions subject to the disclosure requirement be
    reasonably narrow in order to ensure that the disclosure
    requirement is limited to transactions that are likely to have
    a potential for tax avoidance. Otherwise, the Internal Revenue
    Service will be flooded with disclosure forms regarding
    transactions with no real abuse potential, and the purpose of
    the disclosure requirements will be largely defeated.
        The Treasury Proposals would also require disclosure of any
    transaction that a taxpayer reports in a manner different from
    its form. Although such transactions potentially involve some
    form of tax arbitrage, abusive tax shelters almost universally
    involve taxpayers reporting transactions in accordance with
    their form in a manner that is inconsistent with their
    substance rather than vice versa. We therefore question whether
    this additional disclosure requirement serves any real purpose.
    Nonetheless, it is possible that the Treasury Department is
    concerned that transactions which are reported differently from
    their form may involve potential for abuse, particularly in
    cross-border situations where taxpayers attempt to take
    advantage of different characterizations of the same
    transaction by different jurisdictions. Accordingly, in cases
    in which the form of the transaction is unambiguous, we do not
    object to this proposal.

    Modifications to substantial understatement penalty for
    corporate tax shelters.

        The Treasury Proposals would redefine corporate tax
    shelters for purposes of the substantial understatement
    penalty. A ``corporate tax shelter'' would be defined as ``any
    entity, plan, or arrangement (to be determined based on all
    facts and circumstances) in which a direct or indirect
    corporate participant attempts to obtain a tax benefit in a tax
    avoidance transaction.'' Unless the taxpayer complies with the
    disclosure requirements, the applicable penalty would be
    doubled from 20 percent to 40 percent, with an additional fixed
    amount penalty for failure to disclose, and the ``reasonable
    cause'' exception would be unavailable. In the case of a tax
    shelter where there is disclosure, the penalty would remain at
    20 percent and the reasonable cause exception would be
    available, but only if the taxpayer had a reasonable belief
    that it had a ``strong'' probability of success on the merits
    (as compared to the current ``more likely than not'' standard
    applicable to tax shelters). Although the White Paper is not
    clear in this regard, we assume that the 20% penalty and
    reasonable cause exception would apply in the case of a tax
    shelter for which disclosure was not required.
        We are in favor of increasing the penalty provided that the
    substantive tax rules are reasonably well-defined and the
    increased penalty can be avoided by complying with objectively
    defined disclosure requirements.\12\ An increased penalty would
    serve as a more effective deterrent to taxpayers that engage in
    overly aggressive transactions in the belief that they may not
    be audited and that, even if they are audited, they will not be
    substantially worse off if their claimed benefits are
    disallowed than they would have been if the benefits had never
    been claimed, particularly in view of taxpayers' expectations
    that they will be able to negotiate a settlement during the
    course of an audit.
    ---------------------------------------------------------------------------
        \12\ In this regard, we object to the approach of H.R. 2255, which
    would impose the increased penalty with respect to any disallowed
    ``noneconomic tax attribute'' which is not disclosed, rather than tying
    the increased penalty to a disclosure requirement based on an objective
    standard.
    ---------------------------------------------------------------------------
        Our concerns with the proposed penalty provision stem
    principally from our concerns, discussed above, about the broad
    substantive discretion given the Internal Revenue Service and
    the courts to disallow tax benefits associated with tax
    avoidance transactions. The proposed tax shelter definition on
    balance is a reasonable one, and its inherent ambiguities are
    much less troubling, to the extent that the definition applies
    only for penalty purposes as opposed to serving as a basis for
    making determinations of underlying tax liability and as long
    as the stricter penalties can be avoided by taxpayers that
    comply with clearly defined disclosure requirements. In fact,
    the proposed definition represents an improvement over the
    current definition of ``tax shelter'' in Section 6662(d), which
    focuses on a ``significant purpose'' to avoid or evade Federal
    income tax. The current definition thus potentially encompasses
    transactions that are motivated primarily by non-tax economic
    considerations but also involve a significant tax planning--and
    hence tax avoidance--purpose.
        As long as the disclosure requirements are triggered by
    bright-line standards that are easily complied with, rather
    than being triggered by the Treasury Proposals' broad
    definition of ``tax avoidance transaction,'' we believe that
    eliminating the reasonable cause exception where the taxpayer
    fails to comply with those requirements is an appropriate
    mechanism for encouraging disclosure.\13\ We believe, however,
    that the reasonable cause exception, which already is very
    narrow in the case of corporate tax shelters, should be
    retained in its current form in cases where the disclosure
    requirements are met. The proposed ``strong probability of
    success'' test would impose a virtually insurmountable bar to
    avoiding the penalty. Under current law, Treas. Reg. Sec.
    1.6664-4(e) provides that tax shelter items of corporations
    satisfy the reasonable cause exception only if the taxpayer's
    position is supported by substantial authority and the taxpayer
    reasonably believed that it was more likely than not to
    prevail; even then, a further inquiry into more subjective
    criteria relating to business purpose and other factors is
    required. It is hard to see how preservation of this narrow
    exception, which imposes a high standard on taxpayers and
    protects only those acting in good faith, would hinder unduly
    the Internal Revenue Service's attempt to combat tax abuse.
    Moreover, if substantial authority exists to support a position
    taken by a taxpayer and the taxpayer has received a ``more
    likely than not'' opinion from a reputable adviser who is fully
    apprised of the relevant facts, it is difficult to perceive how
    that position could be characterized as sufficiently abusive to
    merit a penalty, regardless of the relative magnitude of tax
    benefits as compared to pre-tax profits.
    ---------------------------------------------------------------------------
        \13\ Again, we believe that H.R. 2255 goes too far by eliminating
    the reasonable cause exception even where there is disclosure.

    Taxation of income from corporate tax shelters involving tax-
    ---------------------------------------------------------------------------
    indifferent parties.

        The Treasury Proposals would also impose tax on income
    realized by ``tax indifferent parties'' in connection with
    corporate tax shelters. The intent is to prevent the shifting
    of taxable income to foreign persons, Native American tribal
    organizations, tax-exempt organizations, and domestic
    corporations with expiring loss or credit carryovers. The
    income earned by the tax-indifferent party would be subject to
    tax, although the incidence of the tax would depend upon the
    nature of the tax-indifferent party. In the case of tax-exempt
    organizations, domestic corporations, and foreign persons not
    entitled to treaty protection, the tax would be imposed
    directly on the tax-indifferent party. In the case of Native
    American tribal organizations and foreign persons entitled to
    treaty benefits, on the other hand, the tax would be collected
    only from other participants who are not exempt from tax.
        We do not believe that this provision is appropriate. For
    the most part, tax-indifferent parties to tax shelter-type
    arrangements do not realize benefits that are sufficient to
    justify changing the taxing regime applicable to them. Indeed,
    in many cases, the tax-indifferent party may not have
    sufficient information to assess the tax benefits available to
    the corporate taxpayer and thus to determine whether the
    proposed tax shelter provision would potentially be applicable.
    If a transaction involves an inappropriate shifting of income
    from a taxable corporation to a tax-indifferent party, the
    proper solution would be a reallocation of income to the
    taxable party. In proposing to collect tax on income realized
    by treaty-eligible foreign persons and Native American tribal
    organizations from the taxable corporate participants, the
    Treasury Department appears to recognize the merits of this
    approach in at least limited contexts, although the proposal is
    unclear as to which corporate participants are subject to tax.
        Regardless of the incidence of the tax, the proposed
    provision could result in substantial overkill. Although the
    White Paper would narrow the provision in the original
    Administration Proposals by applying the provision only to tax-
    indifferent parties that are ``trading on their tax
    exemption,'' it appears that all the income earned by such a
    tax-indifferent party, not just income that is artificially
    shifted away from the corporate taxpayer through implementation
    of an abusive tax shelter, would be subject to tax. For
    example, where a tax-indifferent party provides funds as part
    of a transaction, it appears that all of its income from the
    transaction--including the normal rate of return on its
    investment--would be subject to tax. There is no justification
    for effectively changing the basis for taxation of this type of
    income earned by a tax-indifferent party on account of tax
    benefits realized by an unrelated corporate tax shelter
    participant, even if the tax is imposed on the taxable
    corporate participant.
        Finally, we believe that the proposed provision's
    definition of a ``domestic corporation with expiring loss or
    credit carryovers'' that would be treated as a tax-indifferent
    party is overbroad. Loss and credit carryforwards that are more
    than three years old would generally be treated as expiring.
    Aside from the fact that such carryforwards may not be in
    serious danger of expiring, it is not clear from the General
    Explanation that application of the provision is dependent upon
    the carryforwards being available and sufficient to offset the
    income from the transaction in question.

    Imposition of excise tax on certain fees.

        The Treasury Proposals would impose a 25 percent excise tax
    on fees received by promoters and advisers in connection with
    corporate tax shelters. The White Paper proposes to delete a
    provision in the original Administration Proposals that would
    have made the fees non-deductible to the corporate tax shelter
    participant.
        Aside from our general objections to the proposed
    definition of tax avoidance transaction, we believe that
    imposing an excise tax on the recipients of fees is
    inappropriate. The provision appears broad enough to apply to
    underwriting and other fees incurred in connection with a tax
    avoidance transaction, even if the particular services involved
    bear only a tangential relationship to the tax avoidance
    purpose and would have been incurred even without regard
    thereto. For example, a financing transaction with an improper
    tax avoidance purpose could involve underwriting fees no
    greater than, and for services largely no different from, those
    that would have been incurred in a less tax-efficient
    alternative transaction.
        Moreover, promoters typically are rendering a service by
    presenting ideas, the evaluation of which is the responsibility
    of taxpayers and their advisers. It is hard to see why there
    should be a special tax regime applicable to these service
    providers.
        Even if it were appropriate to impose special penalties on
    promoters, there is no justification for imposing an excise tax
    on a taxpayer's outside counsel or other tax adviser, who
    typically is in the position of trying to give an unbiased
    assessment of a proposed transaction and is not receiving a
    contingent fee. The risk of being subject to an excise tax has
    the potential to adversely affect an adviser's ability to give
    objective tax advice. The White Paper states that the penalty
    would not apply to a tax professional that advises a client
    that a transaction is not supportable or cautions the client
    not to proceed with the transaction. It is completely
    inappropriate for the Treasury Department to use the threat of
    a tax penalty on the adviser to influence the advice that the
    adviser gives to his or her clients. It is hard to see how the
    goal of sound administration of the tax system is advanced if
    advisers can only avoid penalties by refusing to provide proper
    and objective tax advice to their clients.
        Imposing an excise tax on fee recipients also would present
    potentially insurmountable procedural problems, because the
    imposition of the tax is dependent upon the outcome of the
    determination of the corporate taxpayer's liability. Not
    permitting the fee recipient to contest and if necessary to
    litigate the underlying tax liability would be a denial of due
    process. Conversely, allowing the fee recipient to participate
    in proceedings against the corporate taxpayer would be unfair
    to the taxpayer and potentially would be a significant
    impediment to settlement of disputes. Although the White Paper
    appears to acknowledge this concern by stating that
    ``appropriate due process procedures'' would be provided, it is
    unclear how this could be effected.

    Effective dates.

        Under the Treasury Proposals, all the provisions discussed
    above would be effective on the date of first Committee action.
    Even if these provisions were appropriate as a general matter
    (which we believe they are not), it is indisputable that they
    represent a major change in current law and require substantial
    refinement. Under those circumstances, we see absolutely no
    justification for a pre-enactment effective date.

    * * *

        If you have any questions regarding the foregoing, please
    feel free to contact the undersigned at (212) 837-6315.

                                        Respectfully submitted,

                                           Andrew H. Braiterman
                                                          Chair
        cc:Lindy L. Paull
        Mark Prater
        Timothy L. Hanford
        John Buckley
        Russ Sullivan

    COMMITTEE ON TAXATION OF BUSINESS ENTITIES

                        Andrew H. Braiterman, Chair \14\

                       Louis H. Tuchman, Vice-Chair \15\

                          Mary B. Flaherty, Secretary

    Statement of the Massachusetts Mutual Life Insurance Company,
    Springfield, Massachusetts

        Massachusetts Mutual Life Insurance Company is the eleventh
    largest life insurance company in the United States, doing
    business throughout the nation. The Company offers life and
    disability insurance, deferred and immediate annuities, and
    pension employee benefits. Through its affiliates,
    Massachusetts Mutual offers mutual funds and investment
    services. The Company serves more than two million
    policyholders nationwide and, with its affiliates, has more
    than $175 billion in assets under management. Massachusetts
    Mutual is very concerned about efforts to categorize business
    life insurance as a corporate tax shelter. This sweeping
    generalization ignores the legitimate uses of business life
    insurance and the fact that Congress has already eliminated the
    potential for businesses to abuse the tax benefits associated
    with cash value life insurance.
        In its revenue proposals for the fiscal year 2000 budget,
    the Administration identified cash value life insurance as a
    tax shelter that provides unjustifiable benefits to business
    policyholders. With recent testimony before this Committee, the
    staff of the Joint Committee on Taxation repeated the charge
    that business life insurance is just another corporate tax
    shelter. In support of this claim, Joint Committee staff cited
    the recent Winn-Dixie decision which denied an interest
    deduction for large-scale borrowing of policy cash values.
    However, there was no mention of the fact that this case
    involved transactions that are no longer viable under the
    Internal Revenue Code.
        A tax shelter has been defined to exclude any ``tax benefit
    clearly contemplated by the applicable provision'' of current
    tax law. Over the past few years, Congress has repeatedly
    examined the tax treatment of business life insurance. The
    current rules are the product of this extensive review.
        Congress weighed the tax benefits for business life
    insurance when it passed amendments to Section 264 of the
    Internal Revenue Code. Congress eliminated the use of life
    insurance for tax arbitrage. There are clear-cut and effective
    rules that now limit the ability of a business to deduct
    interest on debt when it holds cash value life insurance.
    Following amendments enacted in 1996, federal law allows a
    business to take an interest deduction for loans against only
    those insurance policies covering the life of either a 20%
    owner of the business or another key person. No more than 20
    individuals may qualify as key persons and a business can
    deduct interest on no more than $50,000 of policy debt per
    insured life. Policies issued before June 21, 1986 are
    grandfathered from this rule.
        Two years ago, Congress examined the tax treatment of
    general debt where a business also happened to hold cash value
    life insurance. Based on this review, it created a tax penalty
    for businesses that hold life insurance on their debtors,
    customers or any insureds other than their employees, officers,
    directors or 20% owners. Last year, as part of its fiscal year
    1999 budget, the Administration proposed extending the penalty
    to all business life insurance policies other than those
    covering 20% owners. Congress re-examined the treatment of
    unrelated business debt and rejected the Administration's
    proposal last year. Earlier this year, the Administration
    submitted the same proposal, with no better tax policy
    justification than it has offered in the past. However, this
    year, the Administration sought to cloak its proposal as an
    attempt to eliminate a tax shelter.
        Further changes in tax treatment would make cash value life
    insurance prohibitively expensive for all businesses. Business
    life insurance serves many legitimate, non-tax purposes. Life
    insurance provides a means for businesses to survive the death
    of an owner, offering immediate liquidity for day-to-day
    maintenance of the business or the funds to purchase the
    decedent's interest from heirs who are unwilling or incapable
    of continuing the business.
        Businesses purchase life insurance to meet other needs in
    addition to funding business buy-outs. A business must protect
    itself from the economic drain and instability caused by the
    loss of any major asset. The talents of its key personnel
    sustain a business as a viable force in the economy. Life
    insurance provides businesses with the means to protect the
    workplace by replacing revenues lost on the death of a key
    person and by offsetting the costs of finding and training a
    suitable successor. Businesses use life insurance to provide
    survivor and post-retirement benefits to their employees,
    officers and directors. As part of a supplemental compensation
    package, these benefits help attract and retain talented and
    loyal personnel, the very individuals who are crucial to the
    ongoing success of any business. Treating cash value life
    insurance as a tax shelter would penalize a business that tried
    to take reasonable measures to protect itself or to provide
    benefits for its employees.
        The legitimate needs for workplace protection insurance
    have not altered in the past three years. Nor will the business
    need for life insurance simply disappear if business life
    insurance is treated as a tax shelter. However, the resulting
    effect for businesses will be punitive. Term insurance does not
    provide businesses with a reasonable alternative to cash value
    insurance. While often appropriate for temporary arrangements,
    term insurance is both costly and unsuitable for long-range
    needs. Application of the tax shelter stigma to cash value life
    insurance is an exceedingly harsh punishment to impose on a
    business for taking prudent financial measures to protect its
    valuable human assets or to provide benefits for its employees
    and retirees.
        Congress has repeatedly examined the tax treatment of
    business owned life insurance. Amendments it has passed in the
    last several years have effectively curtailed the use of life
    insurance for tax arbitrage. There is no reason to change the
    rules yet again. There is no justification for penalizing
    businesses that purchase cash value life insurance to safeguard
    their own well being or to provide benefits for their
    workforce. Businesses use life insurance for legitimate
    purposes. Like any other taxpayer, a business also needs some
    stability in the tax law in order to make long-term plans for
    its own financial welfare and that of its employees. Congress
    revisit the tax treatment of business life insurance, for the
    fourth time in four years, with the express purpose of removing
    the carefully crafted rules set in the 1996 and 1997 tax acts.

    Statement of Stephen L. Millman, and Steven C. Salch, Fulbright &
    Jaworski L.L.P., Houston, Texas

        Chairman Archer and Members of the Committee:
        Fulbright & Jaworski L.L.P. is a law firm with offices in
    three States, the District of Columbia, and two foreign
    countries. Our Firm is has been in existence for over 80 years,
    and has engaged in federal tax practice for over 70 years. Our
    tax practice extends to all phases of state and federal
    taxation. We are involved with commercial and financial
    transactional planning, documentation, and consummation, and
    defense of taxpayers on examination, during administrative
    appeals, and in litigation. Our clients include individuals,
    corporations, partnerships, trusts, estates, and financial
    institutions, both domestic and foreign. We do not engage in
    the sale of ``tax products.'' However, we have been exposed to
    those ``products'' in the course of representation of clients
    to whom ``products'' have been offered.
    ---------------------------------------------------------------------------
        \14\ Member of the Committee principally responsible for the
    drafting of the letter.
        \15\ Member of the Subcommittee that prepared the letter. Sydney E.
    Unger, the former chair of the Committee, also participated in the
    preparation of this letter. The assistance of Mary B. Flaherty is
    gratefully acknowledged.
    ---------------------------------------------------------------------------
        We appreciate the opportunity to offer this written
    statement for consideration by the Committee members and
    inclusion in the record of this hearing. We have followed the
    evolution of the study of corporate tax shelters from the
    debate concerning the enactment of the confidential corporate
    tax shelter registration provisions, the preservation of those
    provisions in enactment of the federally-authorized tax
    practitioner privilege provisions, the Study done by the Staff
    of the Joint Committee on Taxation \1\ , and the Treasury
    Department White Paper \2\ and Penalty Report.\3\
    ---------------------------------------------------------------------------
        \1\ Study of Present-Law Penalty and Interest Provisions as
    Required by Section 3801 of the IRS Restructuring and Reform Act of
    1998 (Including Provisions Relating to Corporate Tax Shelters) JCS-3-99
    (July 7, 1999) (sometimes hereinafter referred to as the ``Study'' or
    the ``JCT Staff Study'').
        \2\ The Problem of Corporate Tax Shelters--Discussion, Analysis and
    Legislative Proposals (July 1, 1999) (sometimes hereinafter referred to
    as the ``White Paper'' or the ``Treasury White Paper'').
        \3\ Report to Congress on Penalty and Interest Provisions of the
    Internal Revenue Code (October 25, 1999) (sometimes hereinafter
    referred to as the ``Report'' or the ``Treasury Report'').
    ---------------------------------------------------------------------------
        Members of our firm have participated in various capacities
    in the activity of the Section of Taxation of the American Bar
    Association concerning tax shelters since the early 1980's. We
    have defended individuals and entities who have invested in tax
    shelters promoted by others. We also have defended individuals
    and entities whose legitimate tax planning has been challenged
    by the Internal Revenue Service upon examination. Those
    experiences, and the sense of the delicate balance that must be
    maintained to preserve both the integrity of the tax system and
    the perception of taxpayers of the fairness of the tax system
    and tax administration, are the foundation for the comments and
    suggestions in this statement.
        We commend both the Joint Committee Staff and the Treasury
    Staff for the prodigious effort and thoughtful manner in which
    they have approached the issue of corporate tax shelters. Their
    reports provide a solid basis from which to study that problem.
    We also commend Chairman Archer for his recognition that any
    action, legislative or administrative, intended to restrain the
    proliferation of ``abusive corporate tax shelters,'' must be
    carefully and thoughtfully constructed and narrowly focused to
    assure that legitimate business transactions are not chilled or
    opened to challenge.
        We believe the marketing of ``tax product'' including
    ``corporate tax shelters,'' and particularly ``products''
    marketed under confidentiality agreements demanded by, and
    running in favor of, the promoter of such ``products,'' has
    become a substantial problem. There are many reasons for this
    phenomenon. They include: the inefficiency and anticompetitive
    character of the federal corporation income tax; the pressure
    the financial markets exert on domestic businesses to
    constantly grow cash flow and profits; the apparent need of
    some tax practitioners to develop and market ``products'' to
    non-clients, as well as clients, in order to generate
    additional revenue for themselves, and a penalty system that
    penalizes disclosure, rather than rewarding it.
        It is important to approach these issues remembering that a
    taxpayer has no duty to pay the maximum possible amount of tax
    that might be owed. Rather, a taxpayer is free to arrange its
    affairs so that it pays the least amount of tax on the profits
    it derives, consistent with the tax laws. Indeed, the tax law
    affords the taxpayer many options as to form and timing of
    recognition of income or losses. Thus, the first and most
    difficult task in approaching the problems posed by ``abusive
    corporate tax shelters'' is that of defining ``abusive
    corporate tax shelter.''
        We are concerned that the presently proposed definitions of
    ``corporate tax shelter'' are too broad. For example, two
    generally-accepted types of transactions appear to fall into
    the definitions currently under study. One is preferred stock
    which has a dividend rate that is reset periodically and for
    which there is assurance to a corporate holder that at each
    reset, someone will buy out its investment, at par, if it so
    desires. Billions of dollars of this ``remarketed preferred
    stock'' are sold annually, and it is a vital tool for corporate
    financial planning. But the combination of pre-tax yield and a
    dividend received deduction is what makes the shares
    marketable. The pre-tax yield, per se, is inadequate to attract
    buyers. The issues are marketed by investment banks or
    underwriters whose fees are typically stated as a percentage of
    the aggregate par value of, or dollars paid for, the preferred
    shares sold by the issuer. Presumably, some mathematician could
    translate those transaction-size percentage fees to a
    percentage of dividends payable (since the stated dividend rate
    is a percentage of the par value of the preferred). The
    original impetuses for these transactions were proposals by
    investment bankers, backed by tax opinions.
        Leveraged leasing shares most of the same characteristics.
    The tax investor's pre-tax profit is well below standard
    interest rates--it is the tax benefits that make the
    transaction marketable on the economic terms employed. Most of
    the lessees would not be able to use the depreciation if they
    did no leasing; the lessor can, and intermediaries market the
    transactions and take a fee based on the transaction size that
    could, mathematically, be translated into a percentage of
    depreciation deductions available to the lessor. As the JCT
    Staff Study clearly points out, leveraged leasing has been
    distinguished from other transactions by a special set of
    judicially-crafted criteria to determine ownership, and tax
    treatment of the parties.\4\ Leveraged equipment leasing is a
    vital economic tool to many industries, allowing manufacturers
    to increase sales of products by lowering the cost of ownership
    to end users.
    ---------------------------------------------------------------------------
        \4\ See, e.g., Frank Lyon v. U.S., 435 U.S. 561 (1978).
    ---------------------------------------------------------------------------
        Both of these techniques have been blessed by the courts
    and the IRS. However, since they would appear to be ``tax
    shelters'' under most of the presently-proposed definitions, we
    are concerned that the proposed legislation might chill these
    financial planning tools and unnecessarily inhibit evolution of
    future tools that are similar in effect. Thus, we urge the
    Committee to at least except leasing transactions subject to
    the special rules discussed in the JCT Staff Study from the
    ambit of any broad-based definition of ``tax shelter.''
        We believe many of the ``products'' being marketed today
    would disappear from the marketplace if the Treasury Department
    would promulgate implementing regulations for the confidential
    arrangement tax shelter registration provisions of section
    6111(d) of the Internal Revenue Code of 1986, as amended. If
    ``products'' are required to be registered with the Internal
    Revenue Service and taxpayers utilizing products are obligated
    to disclose they are utilizing products, identified by a tax
    shelter registration number assigned by the Internal Revenue
    Service, many of the objectives of the several proposals of the
    Joint Committee Staff and the Treasury Department could be
    accomplished quickly and effectively, without the necessity of
    additional litigation.
        Registration and identification would eliminate any impact
    of confidentiality undertakings on the tax system.
    Registration, promoter recordkeeping, and taxpayer reporting
    should also make it relatively easy for the Internal Revenue
    Service to determine the taxpayers who have employed a
    particular product and protect the statute of limitations while
    examining and evaluating that product. To the extent such
    ``products,'' like vampires, vaporize when exposed to the light
    of day, registration and identification would have a positive
    impact on tax administration.
        We do not know why the Treasury Department has failed to
    promulgate the regulations necessary to effectuate and activate
    section 6111(d). However, to the extent the delay of
    approximately two years is attributable to Treasury's inability
    to develop a definition of ``tax shelter,'' it should alert the
    Congress of the dangers and difficulties inherent in
    endeavoring to develop a legislative definition of ``tax
    shelter'' that does not chill bona fide business transactions
    that possess some features that are common with the
    ``products'' marketed under confidentiality covenants running
    in favor of the promoter.
        On balance, we do not believe major, new legislation of the
    type suggested by the Joint Committee Staff and the Treasury
    Department is necessary or desirable to deal with the
    ``corporate tax shelter'' problem. To the extent that
    implementation of the registration provisions does not
    materially inhibit the mass marketing of abusive ``products,''
    the Internal Revenue Service and the courts have employed
    existing legal tools to impose tax liability and penalty
    liability on corporations employing ``products'' in an effort
    to reduce their federal income tax liability.
        The JCT Staff Study enumerates the judicial doctrines,
    including sham transaction, step transaction, substance over
    form, economic substance, and business purpose that have been a
    part of the fabric of tax law for more than 60 years in some
    cases. They have survived and thrived, without legislative
    definition or delineation, and shown themselves to be
    sufficiently flexible to permit ready adaptation to address the
    particular abusive transaction currently in vogue. We are
    concerned that any effort to define and incorporate those
    judicial doctrines into the Internal Revenue Code would destroy
    their flexibility and inhibit their future utility. Thus, while
    we encourage the Committee, the Congress, and the Treasury
    Department to reaffirm the continuing viability of these
    doctrines and their application to transactions, we
    respectfully urge that you refrain from trying to define them
    by legislation.
        Our concern that legislating these doctrines would be
    counterproductive is premised in part on our perception of the
    effect of excessive delineation of objective standards or
    criteria in the Internal Revenue Code. When Congress enacts a
    tax statute with extreme specificity, some taxpayers and tax
    professionals are encouraged to believe that any variant that
    is completely within a beneficial provision is permitted,
    without regard to whether it has substance or business purpose,
    or conversely, that any transaction that does not fall entirely
    within a statutory prohibition's explicit terms is permitted.
    Neither of those views is completely accurate, but they are the
    seeds of much of the ``product'' presently being marketed to
    taxpayers. Thus, we urge the Committee to permit the
    judicially-developed doctrines to remain a part of the common
    law, rather than endeavoring to explicitly define and
    incorporate them into the Internal Revenue Code of 1986.
        The successes of the IRS in the courts, subsequent to the
    issuance of the JCT Staff study and the Treasury White Paper,
    in employing the judicial doctrines to address transactions
    clearly establishes the viability of the doctrines in their
    present form and their utility to the IRS to cover a broad
    range of transactions from foreign tax credit capture
    transactions \5\ and foreign captive insurance \6\ to corporate
    owned life insurance.\7\ These recent successes, including the
    imposition of penalties in the United Parcel Service and Compaq
    Computer cases, demonstrate that the present system does work
    and is effective. To be sure, it takes time and effort.
    However, that expenditure of time and effort helps assure that
    the IRS is seeking the right answer, rather than crying ``tax
    shelter'' and pursuing a properly motivated transaction that
    has been implemented in a way that minimizes tax liability.
    Also, that time and effort was more than justified by the
    amounts in issue and the impact those decisions are already
    having in the ``product'' marketplace.
    ---------------------------------------------------------------------------
        \5\ Compaq ComputerCorporation v. Commissioner, 113 T.C. No 17
    (September 21, 1999); IES Industries, Inc. v. U.S., No. 97-206 (DCND
    IA, September 22, 1999)
        \6\United Parcel Service of America v. Commissioner, T.C. Memo
    1999-26528 (August 9, 1999).
        \7\ Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C. No. 21
    (October 19, 1999).
    ---------------------------------------------------------------------------
        As the JCT Staff Study and the Treasury White Paper
    observe, ``products'' are frequently marketed under contracts
    in which the promoter endeavors to limit liability to the
    customer in the event the product is unsuccessful and seeks
    compensation from the customer if the customer breaches
    confidentiality or third parties proceed against the promoter.
    Now that the IRS has successfully asserted penalties in
    litigation,\8\ larger customers are refusing to provide
    promoters with those limitation and indemnity agreements and
    are demanding stronger warranties from the promoters. If this
    trend continues, over time the more tenuous ``products'' will
    either be driven from the marketplace or move to smaller
    customers with less bargaining power or sophistication. In the
    latter event, disclosure will become more important to tax
    administration.
    ---------------------------------------------------------------------------
        \8\ See, United Parcel Service of North America, and Compaq
    Computer Corporation, supra.
    ---------------------------------------------------------------------------
        The JCT Staff Study and the Treasury White Paper adopt the
    approach that disclosure of tax return positions is desirable
    for tax administration but should only provide mitigation
    against an enhanced penalty, rather than protection against
    imposition of an accuracy-related or substantial authority
    penalty in tax shelters. The premise for disclosure is to
    assist the IRS in identifying shelter products and the
    taxpayers who have employed them. Both the Study and the White
    Paper comment that the IRS has difficulty identifying tax
    shelter transactions in corporate audits. If that is true, then
    disclosure seemingly would help the IRS. However, to induce a
    taxpayer to disclose a position that potentially would not be
    located by the IRS in the absence of disclosure requires
    something more than the difference between a 20% penalty and a
    40% penalty.
        The Study and the White Paper do not fully appreciate the
    significance of any penalty to a corporate tax professional.
    Imposition of a penalty based on action or inaction is
    frequently grounds for immediate termination and loss of
    employee benefits, such as unexercised stock options. Thus, to
    motivate a corporate employee in such a position to disclose,
    disclosure must afford per se exemption from an accuracy-
    related or substantial authority penalty as long as the return
    position meets a standard that is slightly lower than the
    threshold standard for imposition of a penalty without
    disclosure. In other words, disclosure and a lower standard,
    provide sufficient meaningful reward to induce disclosure. If,
    as under present law, disclosure is effective to provide
    protection against a penalty only if the return position
    satisfies the standard necessary to avoid imposition of a
    penalty on an undisclosed transaction, disclosure not likely if
    imposition of any penalty is a career-ending event. The
    corporate employee is going to play the audit lottery, rather
    than disclose and risk a penalty--whether at a 1% or 40% rate.
        We also recognize the role that ``tax opinions'' are
    playing in the corporate tax shelter product marketing process.
    The only difference we discern from that role and the role
    similar ``opinions'' played in the individual tax shelter craze
    of the late 1970's and early 1980's is the number of taxpayers
    to whom any single ``opinion'' is presented.\9\ From a
    professional perspective the obligations of an attorney to his
    or her client should not change based on the number of clients
    to whom the attorney's opinion is ultimately addressed. Indeed,
    in our experience, many law firms have applied the thrust of
    ABA Formal Opinion 346 (Revised) \10\ in all their tax law
    opinions to their clients--not merely those that fit the
    definition of ``tax shelter'' set forth in that Opinion.
    However, we are aware that not all law firms or lawyers share
    our views or adhere to this principle as a ``best practice.''
    Thus, we support modification of Circular 230 \11\ to clarify
    that the due diligence precepts and preclusion of hypothetical
    fact predicate principles of ABA Formal Opinion 346 (Revised)
    \12\ extend to all tax opinions rendered by those entitled to
    practice before the IRS.
    ---------------------------------------------------------------------------
        \9\ We understand some vendors of ``product'' deliberately limit
    the number of taxpayers to whom a particular ``product'' will be
    offered.
        \10\ ABA Standing Committee on Professional Responsibility (January
    29, 1982).
        \11\ The Treasury Department Regulations Governing the Practice of
    Attorneys, Certified Public Accountants, Enrolled Agents, Enrolled
    Actuaries, and Appraisers before the Internal Revenue Service, codified
    at 31 CFR Subtitle A, Part 10, and reprinted as Treasury Department
    Circular 230 (hereinafter referred to as ``Circular 230'').
        \12\ ``The lawyer should relate the law to the actual facts to the
    extent the facts are ascertainable. The lawyer should not issue an
    opinion which a discusses purely hypothetical facts.'' ABA Formal
    Opinion 346 (Revised) (January 29, 1982).
    ---------------------------------------------------------------------------
        Since the Agency Practice Act of 1965 \13\ entitles every
    individual licensed and in good standing under local law as an
    attorney or a certified public accountant to practice before
    the IRS, the suggested changes to Circular 230, like the 1986
    amendment adopting section 10.33, can be adopted as a principle
    of reputable conduct and due diligence by every lawyer and CPA,
    without regard to whether that lawyer or CPA actually practices
    before the IRS or the ``opinion'' itself is ``practice before
    the IRS,'' within the meaning of section 10.2 of Circular 230,
    and without regard to whether the ``opinion'' is one which the
    CPA is legally authorized to issue under the law of the State
    which has issued his or her CPA license.\14\
    ---------------------------------------------------------------------------
        \13\ Codified at 5 USC Sec. 301.
        \14\ Circular 230, section 10.32, provides, ``Nothing in the
    regulations in this part shall be construed as authorizing persons not
    members of the bar to practice law.'' Note in this regard that the
    Notice of Final Rulemaking that announced promulgation of section 10.33
    specifically noted that the promulgation of section 10.33 did not
    represent a conclusion that the issuance of a ``legal opinion'' by an
    authorized practitioner other than an attorney engaged in the private
    practice of law was permissible.
    ---------------------------------------------------------------------------
        At present a practitioner can be suspended from practice
    before the IRS by reason of a felony conviction for robbery.
    That does not, however, require a finding that the act of
    robbery is ``practice before the IRS,'' within the meaning of
    Circular 230. Under the same rationale, an individual can be
    suspended from practice before the IRS by reason of issuance of
    an improper ``tax shelter opinion'' without necessity of a
    finding that the rendition of the opinion is ``practice before
    the IRS.''
        In certain respects, Circular 230 preempts State law.\15\
    We believe preservation of State law and judicial remedies are
    important when professional conduct is the issue in order to
    protect the rights of taxpayers and the shareholders of
    corporate taxpayers. Their right to pursue State law
    malpractice or derivative actions against promoters of
    ``abusive tax shelters'' who employ inappropriate ``tax
    opinions'' should not be preempted. Indeed, since the ABA Model
    Rules of Professional Conduct contain specific limitations on
    the ability of lawyers to ethically seek advance agreements
    limiting malpractice liability to their client, yet the AICPA
    Code of Professional Responsibility does not, it appears proper
    to amend Circular 230 to provide that it is disreputable for an
    individual eligible to practice before the IRS to seek to limit
    his or her malpractice liability to any client as to any matter
    that relates to federal taxation in advance of either
    performing the service or the assertion by the client of the
    claim to which the attempted limitation would be applicable. To
    the extent that a lawyer, CPA, or enrolled agent presently is
    promoting ``products'' and employing such limitations, this
    modification of Circular 230 would curtail that practice.
    ---------------------------------------------------------------------------
        \15\ Sperry v. Florida, 373 U.S. 379 (1953). See also, Salch,
    Inter-professional Practice Issues: A Debate and Discussion, The
    ``Practice of Tax,'' 50 Major Tax Plan. 5-500, 5-506 (Matthew Bender
    1998).
    ---------------------------------------------------------------------------
        Since our role generally is that of advising our clients
    regarding ``products'' promoted by others, including advising
    our clients not to participate, we appreciate the
    acknowledgement by the Treasury Department in the Treasury
    Report that its proposal to impose an excise tax on the fees
    charged by professionals advising their clients regarding ``tax
    shelters'' would not apply to fees charged by a professional
    advising a client not to participate in a ``tax shelter.''
    However, we are concerned that an excise tax liability
    dependent on the tenor of the legal advice rendered could
    present a conflict of interest between the advisor and the
    client that would necessitate disclosure and waiver of the
    conflict by the client.
        We appreciate the opportunity to submit these comments. The
    principal drafters of these comments were Steven C. Salch (713-
    651-5433) in our Houston office and Stephen L. Millman (212-
    318-3039) in our New York office. Please contact either of them
    if you or your staffs have questions about any of our comments.

    Statement of Washington Counsel, P.C., on behalf of Tax Fairness
    Coalition

    Comments on Corporate Tax Shelter Recommendations Made by the Staff of
     the Joint Committee on Taxation in its Penalty and Interest Study \1\

        This paper sets forth comments on the ``corporate tax
    shelter'' and certain other penalty recommendations made by the
    staff of the Joint Committee on Taxation (``JCT'' or ``Joint
    Committee'') in its penalty and interest study that was
    recently submitted to the House Committee on Ways and Means and
    the Senate Committee on Finance as required by the Internal
    Revenue Service Restructuring and Reform Act of 1998 (the ``JCT
    Study'').\2\
    ---------------------------------------------------------------------------
        \1\ Staff of the Joint Committee on Taxation, 106th Cong., 1st
    Sess., Study of Present-Law Penalty and Interest Provisions As Required
    by Section 3801 of the Internal Revenue Service Restructuring and
    Reform Act of 1998 (Including Provisions Relating to Corporate Tax
    Shelters) JCS-3-99 (July 22, 1999).
        \2\ P.L. 105-206 (July 22, 1998).
    ---------------------------------------------------------------------------

                                I. Introduction

        We commend the JCT for its rejection of proposals made by
    the Administration \3\ and others \4\ to (i) give the Executive
    Branch and IRS agents unfettered discretion to rewrite
    substantive tax rules or (ii) impose explicit tax increases on
    other parties that participate in, and benefit from,
    transactions covered by their recommendations (e.g., levies on
    tax-indifferent parties, disallowed deductions for ordinary and
    necessary business expenses, and excise taxes on fees paid to
    third parties or routine indemnification arrangements). We
    agree that such proposals have no place in the current debate.
    We particularly commend their discussion regarding the
    importance of a ``rules based'' system of taxation.
    ---------------------------------------------------------------------------
        \3\ See United States Treasury Department, General Explanations of
    the Administration's Revenue Proposals (February 1999).
        \4\ In H.R. 2255, 106th Cong., 1st Sess. (1999), Rep. Doggett (for
    himself and Reps. Stark, Hinchey, Tierney, Allen, Luther, Bonior and
    Farr), introduced a proposal to disallow tax benefits claimed to arise
    from transactions without substantial economic substance (the ``Doggett
    Bill'').
    ---------------------------------------------------------------------------
        According to the JCT Study, its recommendations are
    intended to address both current and future corporate tax
    shelter transactions using a balanced approach that does not
    interfere with legitimate tax planning activities and does not
    result in increased complexity or unfair penalties. We embrace
    this objective as a fundamental requirement of any response to
    corporate tax shelters. Not only does such an objective adhere
    to the spirit of the legislation which called for the JCT
    Study,\5\ but it will be essential to ensure the success of any
    legislative changes in their practical application. As detailed
    below, however, we believe that the JCT's recommendations would
    benefit from further analysis.
    ---------------------------------------------------------------------------
        \5\ Section 3801 of the IRS Restructuring and Reform Act of 1998
    required both the Joint Committee and the Treasury Department to make
    recommendations to simplify penalty or interest administration and
    reduce taxpayer burden.
    ---------------------------------------------------------------------------
        The JCT Study proposals are sweeping; they would create a
    new and enhanced web of rules that would have a significant
    effect on taxpayers and tax administration. If enacted, the
    JCT's recommendations would fundamentally change the nature of
    tax compliance. We are concerned that, while thoughtful and
    well-intended, the JCT Study proposals could, in practice, do
    more harm than good. In particular, we are concerned that the
    JCT Study proposals would:
          have the practical effect of creating a strict
    liability penalty regime that would apply to legitimate tax
    planning and routine business transactions and would provide
    IRS agents with new weapons to extract inappropriate
    concessions from taxpayers;
          penalize tax advisors and return preparers on
    more than one hundred percent of their income when their advice
    turns out to be wrong;
          have the practical effect of discouraging
    legitimate tax planning and routine business transactions while
    forcing more and more taxpayers into refund litigation; and
          add another layer of mind-numbing complexity to
    the Internal Revenue Code.
        Moreover, the Congress will find it difficult to reclaim
    any power that it delegates to the Executive Branch because any
    attempts to reverse such actions would be scored as revenue
    losers under current revenue estimating conventions. For these
    reasons, the Congress should not enact the JCT Study proposals,
    or other similar legislation at this time. Rather, the Congress
    should continue to monitor the situation and instruct the IRS
    and Treasury to make use of the tools already at their
    disposal.
        This paper briefly describes the corporate tax shelter
    recommendations set forth in the JCT Study. The paper then
    outlines a general framework for addressing corporate tax
    shelters. Next, the paper provides specific critiques of
    certain of the corporate tax shelter recommendations made by
    the JCT. Although not addressed in detail in this paper, many
    of the comments made herein with respect to the recommendations
    set forth in the JCT Study, particularly the general framework
    for addressing corporate tax shelters, are equally applicable
    to the proposals made by the Treasury Department in its
    recently released white paper on corporate tax shelters (the
    ``White Paper'').\6\
    ---------------------------------------------------------------------------
        \6\ Department of the Treasury, The Problem of Corporate Tax
    Shelters: Discussion, Analysis and Legislative Proposals (July 1999).
    ---------------------------------------------------------------------------

                II. Overview of the Joint Committee's Proposals

        The JCT Study recommends an expansive definition of
    corporate tax shelters that covers a broad range of routine
    business transactions and ordinary tax planning activities
    (hereinafter sometimes referred to as ``Covered
    Transactions''). It also recommends greatly expanding the scope
    of penalties that may be imposed on taxpayers and third parties
    through proposals that are extremely complex. The JCT's
    corporate tax shelter recommendations generally fall into three
    categories: (i) proposals targeted at corporations that
    participate in corporate tax shelters; (ii) proposals targeted
    at other parties involved in corporate tax shelters; and (iii)
    proposals relating to disclosure and registration requirements.
    Following is a brief overview of these proposals.\7\
    ---------------------------------------------------------------------------
        \7\ As described below, a number of the proposals addressing
    corporate tax shelters are embedded in the JCT Study's recommendations
    regarding other penalty provisions.
    ---------------------------------------------------------------------------

                  A. Proposals Targeted at Corporate Taxpayers

        The JCT Study recommends fundamental changes in the
    corporate tax shelter provisions of the Section 6662
    substantial understatement penalty.\8\ Under current law,
    Section 6662 imposes a penalty for a substantial understatement
    of income tax in cases involving tax shelters. For purposes of
    this rule, Section 6662(d)(2)(C)(iii) defines the term ``tax
    shelter'' as:
    ---------------------------------------------------------------------------
        \8\ Unless otherwise indicated, all Section references are to
    Sections of the Internal Revenue Code of 1986, as amended (the
    ``Code'').
    ---------------------------------------------------------------------------
            A partnership or other entity, any investment plan or
            arrangement, or any other plan or arrangement, if a significant
            purpose of such partnership, entity, plan, or arrangement is
            the avoidance or evasion of Federal income tax.
        If the understatement exceeds certain thresholds, then the
    taxpayer is subject to a twenty percent penalty unless the
    taxpayer has substantial authority for the position it is
    taking and reasonably believes that it is more likely than not
    to prevail on the merits if challenged by the IRS.\9\
    ---------------------------------------------------------------------------
        \9\ In this regard, for reasons that will become clear, it is worth
    noting that the IRS has taken the position that mistakes of fact (e.g.,
    an overlooked or misunderstood transaction or document) can never have
    substantial authority.
    ---------------------------------------------------------------------------
        The JCT Study recommends: (i) modifying the ``tax shelter''
    definition; (ii) eliminating the requirement that an
    understatement be ``substantial'' before a penalty is imposed;
    (iii) creating a two-tier (i.e., forty percent/twenty percent)
    penalty rate; (iv) mandating imposition of the penalty unless
    the taxpayer prevails in court; and (v) repealing the
    substantial authority/reasonable cause exception unless the
    taxpayer satisfies certain disclosure requirements and is able
    to establish that it had (A) a greater than seventy-five
    percent certainty of prevailing in litigation and (B) a
    material non-tax business purpose for the transaction.

    1. Modification of ``Tax Shelter'' Definition

        The JCT Study would automatically treat a transaction as a
    tax shelter if it is described by one or more of the following
    five indicators (the ``Tax Shelter Indicators''):
          The reasonably expected pre-tax profits from the
    arrangement are insignificant relative to the reasonably
    expected net tax benefits.
          The arrangement involves a tax-indifferent
    participant, and the arrangement (a) results in taxable income
    materially in excess of economic income to the tax-indifferent
    participant, (b) permits a corporate participant to
    characterize items of income, gain, loss, deductions, or
    credits in a more favorable manner than it otherwise could
    without the involvement of the tax-indifferent participant, or
    (c) results in a non-economic increase, creation,
    multiplication, or shifting of basis for the benefit of the
    corporate participant, and results in the recognition of income
    or gain that is not subject to Federal income tax because the
    tax consequences are borne by the tax-indifferent participant.
          The reasonably expected net tax benefits from the
    arrangement are significant, and the arrangement involves a tax
    indemnity or similar agreement for the benefit of the corporate
    participant other than a customary indemnity agreement in an
    acquisition or other business transaction entered into with a
    principal in the transaction.
          The reasonably expected net tax benefits from the
    arrangement are significant, and the arrangement is reasonably
    expected to create a ``permanent difference'' for U.S.
    financial reporting purposes under generally accepted
    accounting principles.
          The reasonably expected net tax benefits from the
    arrangement are significant, and the arrangement is designed so
    that the corporate participant incurs little (if any)
    additional economic risk as a result of entering into the
    arrangement.
        The list of Tax Shelter Indicators would not be exclusive.
    Accordingly, even if no Tax Shelter Indicator is present with
    respect to a particular transaction, the ``significant
    purpose'' test nonetheless could be met and an entity, plan or
    arrangement could still be a corporate tax shelter (i.e., a
    Covered Transaction) for purposes of the penalties imposed
    under Section 6662.

    2. Elimination of Threshold for Imposing the Penalty

        Because the JCT Study recommends repeal of the requirement
    that the understatement be ``substantial,'' any understatement
    attributable to a Covered Transaction would be subject to the
    penalties imposed under Section 6662.

    Creation of a Two-Tier Penalty Rate

        The JCT Study recommends increasing the understatement
    penalty rate under Section 6662 from twenty percent to forty
    percent for any understatement that is attributable to a
    Covered Transaction. If the IRS decided to challenge the
    claimed tax treatment of what it viewed as a Covered
    Transaction, the IRS would not have the discretion to waive the
    understatement penalty in settlement negotiations or otherwise.
    As a result, the taxpayer could only avoid imposition of the
    penalty by successfully litigating the transaction in court and
    (if unsuccessful on the merits) litigating over whether the
    transaction was a Covered Transaction and the potential
    application of the abatement rules described below.
        a. The forty percent penalty could be completely abated
    (i.e., no penalty would apply) if the corporate taxpayer
    established that it satisfied the following abatement
    requirements: (i) the corporate taxpayer must have analyzed the
    transaction to determine whether any Tax Shelter Indicators are
    present; (ii) if one or more Tax Shelter Indicators exist, the
    corporate taxpayer must have complied with all disclosure
    requirements (as described below); (iii) a chief financial
    officer or other senior corporate official must have certified
    that such disclosure is true, complete and accurate; and (iv)
    at the time the corporate taxpayer entered into the
    transaction, the corporate taxpayer must have been ``highly
    confident'' that it would prevail on the merits if the tax
    treatment for the arrangement was challenged by the IRS.
        The JCT Study prescribes two criteria for satisfying the
    ``highly confident'' standard. First, this standard would be
    satisfied only if a reasonable tax practitioner would believe
    there existed, at the time the transaction was entered into, at
    least a seventy-five percent likelihood that the tax treatment
    would be sustained on the merits based upon the facts and the
    law that existed at that time. In making this determination,
    taxpayers could not take into account the possibility that a
    return will not be audited, that an issue will not be raised on
    audit, or that an issue will be settled. Taxpayers could rely
    on third-party opinions to satisfy the ``highly confident''
    standard, but only if such reliance is reasonable, within the
    meaning of Treas. Reg. Sec.  1.6664-4(c). Second, a corporate
    taxpayer would not be treated as meeting the ``highly
    confident'' standard unless it can establish a material purpose
    germane to its trade or business for the transaction, other
    than the reduction of Federal income taxes (a ``Material Non-
    tax Business Purpose'').
        b. The forty percent penalty could be reduced to twenty
    percent for a Covered Transaction: (i) described by a Tax
    Shelter Indicator if the taxpayer meets the reportable
    transaction disclosure requirements (described below) and meets
    the substantial authority threshold; (ii) that is not described
    by a Tax Shelter Indicator if the taxpayer meets the current
    law more likely than not threshold (without any disclosure) or
    (iii) that is not described by a Tax Shelter Indicator if the
    taxpayer meets the substantial authority (but not the more
    likely than not) standard and if the taxpayer meets the
    generally applicable disclosure requirements of Section
    6662(d)(2)(D).
        c. These proposals should be viewed in light of the JCT
    Study's general recommendations with respect to standards for
    tax return positions applicable to all taxpayers (individual
    and corporate). In general, with respect to the twenty percent
    substantial understatement penalty of Section 6662, these
    recommendations would: (i) raise the threshold for undisclosed
    return positions from substantial authority to more likely than
    not; (ii) raise the threshold for disclosed return positions
    from reasonable basis to substantial authority and (iii)
    subject all taxpayers to a twenty percent penalty on
    understatements if the substantial authority standard is not
    satisfied, without regard to whether the matter is disclosed.

                  Proposals Targeted at Other Involved Parties

        In addition to recommendations with respect to corporate
    taxpayers that participate in Covered Transactions, the JCT
    Study recommends certain penalties and sanctions with respect
    to other parties that participate in the creation,
    implementation or reporting of a Covered Transaction that
    results in an understatement penalty for a corporate
    participant.

    1. Return Preparer Penalty

        The JCT Study recommends raising the standard of conduct
    for income tax return preparers regarding positions on a return
    that result in an understatement of a taxpayer's liability. In
    general, the penalty would apply unless: (i) the tax return
    preparer reasonably believed that the more likely than not
    standard was satisfied (in which case no disclosure would be
    required under Section 6662(d)(2)(B)) or (ii) the substantial
    authority standard was satisfied and the position was
    disclosed. In this regard, the JCT Study would increase the
    substantial authority standard for preparers from the realistic
    possibility of success standard (i.e., the ``one-in-three''
    test) \10\ to a greater than forty percent likelihood of
    success. If the substantial authority standard is not
    satisfied, then the preparer would in all cases be subject to
    the preparer penalty (without regard to whether the item had
    been disclosed).
    ---------------------------------------------------------------------------
        \10\ Treas. Reg. Sec.  1.6694-2(b)(1).
    ---------------------------------------------------------------------------
        The JCT Study recommends increasing the first-tier penalty
    on preparers, under Section 6694(a), from $250 to the greater
    of $250 or fifty percent of the preparer's fee. In addition,
    the second-tier penalty on preparers, under Section 6694(b),
    would be increased from $1,000 to the greater of $1,000 or one
    hundred percent of the preparer's fee.\11\
    ---------------------------------------------------------------------------
        \11\ As a practical matter, such penalties would almost always
    result in levies that exceed one hundred percent of the preparer's net
    after-tax income. For example, if you assume that a preparer's cost of
    doing business is thirty percent of gross receipts and that the
    preparer is subject to a combined federal and state income tax rate of
    forty percent, then the preparer's net after-tax income on a $10,000
    fee would be $4,200. In this example, regardless of whether the fifty
    percent or one hundred percent penalty applies, the amount of the
    penalty will exceed the preparer's after-tax income. Moreover,
    regardless of the preparer's cost of doing business, a one hundred
    percent penalty rate will always exceed the preparer's after-tax income
    because penalties are not deductible under the Code.
    ---------------------------------------------------------------------------
        It is worth noting that these changes would apply to all
    tax return preparers, regardless of the type of taxpayer (i.e.,
    individual or corporate) and regardless of whether any items
    covered by the tax return relate to corporate tax shelters.

    2. Aiding and Abetting Penalty

        The JCT Study recommends several modifications to the
    existing penalty under Section 6701 for aiding and abetting the
    understatement of tax liability.\12\ First, the amount of the
    penalty would be increased from $10,000 to the greater of
    $100,000 or one-half the fees related to the transaction
    received by the person penalized.\13\
    ---------------------------------------------------------------------------
        \12\ This penalty applies with respect to both the preparation of
    tax returns and the presentation of tax returns (i.e., in audits and
    refund claims). Moreover, no actual understatement of liability is
    required for the penalty to apply. Rather, Section 6701 merely requires
    that the return preparer know (or have reason to believe) that an
    understatement would result from the use of the return as prepared.
    See, e.g., Kuchen v. Commissioner, 679 F. Supp. 769 (D. Ill. 1988).
        \13\ As discussed supra, in footnote 11, such penalties would
    almost always result in levies that exceed one hundred percent of the
    third party's net after-tax income.
    ---------------------------------------------------------------------------
        Second, the scope of the penalty would be expanded to apply
    to any person who aids or assists in, procures, or advises with
    respect to the creation, implementation or reporting of a
    Covered Transaction that results in an understatement of tax
    liability of a corporate participant if: (i) the person to be
    penalized knew, or had reason to believe, that the Covered
    Transaction (or any portion thereof) could result in an
    understatement of tax liability of the corporate participant;
    (ii) the person opined, advised, represented or otherwise
    indicated (whether express or implied) that, with respect to
    the tax treatment of the Covered Transaction (or any portion
    thereof), the highly confident standard would be satisfied; and
    (iii) a reasonable tax practitioner would not have believed
    that, with respect to the tax treatment of the Covered
    Transaction (or any portion thereof), the highly confident
    standard would be satisfied.
        The latter requirement appears to establish a standard for
    tax return preparers that is different than that recommended by
    the JCT Study for taxpayers. The difference, which is so subtle
    that it might be unintentional, is that a tax return preparer
    would be liable for the penalty if a reasonable tax
    practitioner would not have believed that the highly confident
    standard would be satisfied, whereas a taxpayer would not be
    liable for the substantial understatement penalty if a
    reasonable tax practitioner would have believed that the highly
    confident standard would be satisfied. Thus, a taxpayer need
    find only one reasonable tax practitioner to agree that it
    meets the standard, while a tax return preparer needs to ensure
    that every reasonable tax practitioner agrees that it meets the
    standard.
        The IRS would be required to publish the names of all
    persons who have been penalized under this provision. In
    addition, such persons would be automatically referred to the
    IRS Director of Practice and the appropriate state licensing
    authority for possible disciplinary sanctions.

    3. Enjoining Promoters

        The JCT Study recommends modifying the authority of Federal
    district courts under Section 7408 to enjoin promoters of
    Covered Transactions or the aiding and abetting of the
    understatement of tax liability. Section 7408 would be amended
    to provide that the traditional equity factors such as
    irreparable injury and likelihood of success on the merits need
    not be considered once the government has satisfied the
    statutory requirements (i.e., that the promoter has engaged in
    conduct subject to penalty under Sections 6700 or 6701 and that
    injunctive relief is appropriate to prevent a recurrence of
    such conduct).

    4. Regulation of Professional Conduct of Practice

        The JCT Study recommends that explicit statutory
    authorization for Treasury Circular 230 (relating to regulation
    of practice before the IRS) be provided in the Code, including
    authorization for the imposition of monetary sanctions not to
    exceed one hundred percent of the aggregate fees associated
    with the sanctioned conduct.\14\
    ---------------------------------------------------------------------------
        \14\ Id.
    ---------------------------------------------------------------------------
        In addition, the JCT Study recommends numerous
    modifications to Circular 230, which generally are intended to
    reflect the other recommendations made in the JCT Study.
    Perhaps most noteworthy is that the rendering of tax advice in
    connection with a Covered Transaction would be treated as
    practice before the IRS without regard to whether the advisor
    was a return preparer with respect to that matter. Presumably,
    the IRS would be entitled to access to that advice for purposes
    of determining whether the provisions of Circular 230 were
    implicated.\15\
    ---------------------------------------------------------------------------
        \15\ Compare Section 7425 (establishing a confidentiality privilege
    for certain taxpayer communications).
    ---------------------------------------------------------------------------

                    C. Disclosure and Registration Proposals

        The JCT Study includes specific proposals requiring
    disclosure by corporate taxpayers that participate in Covered
    Transactions and registration of such transactions, either by
    the promoter thereof or corporate taxpayers that participate in
    the transaction.

    1. Participant Disclosure

        The JCT Study would require any corporate taxpayer that
    participates in any transaction which is described by one or
    more of the Tax Shelter Indicators (a ``Reportable
    Transaction'') to disclose its participation in such
    transaction within thirty days after the close of the
    transaction (``30-day Disclosure'') and again on the taxpayer's
    Federal income tax return (``Tax Return Disclosure''). As
    indicated above, satisfaction of these disclosure requirements
    would be a prerequisite to partial or complete abatement of the
    penalties that apply to corporate taxpayers in connection with
    Reportable Transactions. Moreover, because the JCT Study would
    define a ``corporate participant'' as any domestic corporation
    with average annual gross receipts in excess of $5 million, it
    appears that this disclosure may be required of any corporate
    taxpayer that participates in the transaction, even if the
    taxpayer does not obtain any tax benefits from the transaction
    (e.g., any bank that provides financing in connection with a
    Reportable Transaction would be required to comply with these
    disclosure requirements).
        a. The 30-day Disclosure requirement would apply to any
    Reportable Transaction in which the reasonably expected net tax
    benefits equal or exceed $1 million. Corporate taxpayers
    participating in such transactions would be required to
    disclose: (i) the relevant facts and assumptions with respect
    to the transaction; (ii) the reasonably expected net tax
    benefits arising from the transaction; (iii) which Tax Shelter
    Indicators describe the transaction; (iv) a summary of the
    taxpayer's rationale and analysis underlying the tax treatment
    of the transaction, including the substantive authority relied
    on to support such treatment; (v) the taxpayer's Material Non-
    tax Business Purpose for the transaction; and (vi) the
    existence of any expressed or implied fee arrangement with a
    third party which is contingent upon or is otherwise to be
    determined based upon the tax consequences of the transaction.
    The chief financial officer or another senior corporate officer
    with knowledge of the facts would be required to certify, under
    penalties of perjury, that the disclosure statement is true,
    accurate and complete.
        b. The Tax Return Disclosure requirement also would apply
    to all Reportable Transactions regardless of the dollar amounts
    involved. This requirement would be satisfied by attaching a
    copy of any required 30-day Disclosure, together with
    disclosure of any material changes in law or facts since the
    time of entering into the transaction, and identifying which
    Tax Shelter Indicators describe the transaction.
        c. Although described by one or more Tax Shelter
    Indicators, certain transactions would be exempt from the
    disclosure requirements outlined above. First, to the extent
    provided by regulations, transactions and arrangements that are
    properly reported on certain forms specifically prescribed for
    arrangements of that type would not be treated as Reportable
    Transactions. In this regard, the JCT Study suggests that such
    regulations would provide exemptions from both the 30-day
    Disclosure and Tax Return Disclosure requirements for taxpayers
    that file Form 1120-FSC (with respect to foreign sales
    corporations), Form 1120-DISC (with respect to domestic
    international sales corporations), Form 8586 (with respect to
    the low income housing credit), Form 1120, schedule K, line 12
    (with respect to tax exempt interest), and Form 8860 (with
    respect to the qualified zone academy bond credit). Second, an
    exception to the 30-day Disclosure requirement--but not Tax
    Return Disclosure--would be automatically provided (regardless
    of regulations) with respect to any leasing transaction within
    the scope of Rev. Proc. 75-21, 1975-1 C.B. 715, to the extent
    that the guidelines set forth in that revenue procedure, or the
    relevant case law thereunder, are satisfied.
        d. Covered Transactions that are not Reportable
    Transactions would be subject to a different set of disclosure
    requirements. The JCT Study recommends that any position taken
    or advised to be taken on a tax return (including with respect
    to Covered Transactions that are not Reportable Transactions)
    must be disclosed unless the reported tax treatment is more
    likely than not the correct tax treatment under the Code.
        e. Finally, the JCT Study would require any corporate
    taxpayer that is required to pay an understatement penalty of
    at least $1 million attributable to a corporate tax shelter to
    disclose that fact to its shareholders. Such disclosure would
    be required to indicate both the amount of the penalty and the
    factual setting under which the penalty was imposed.

    2. Tax Shelter Registration

        The JCT Study also recommends modifying the rules with
    respect to registration of corporate tax shelters. Under
    current law, Section 6111 requires any tax shelter organizer to
    register the tax shelter with the IRS not later than the first
    day on which the first offering for interests in the tax
    shelter occurs. Congress enacted Section 6707 to impose a
    penalty for the failure to timely register tax shelters under
    Section 6111; because the Treasury Department has not yet
    promulgated the implementing regulations, Section 6707 has not
    yet taken effect. When those regulations are promulgated, the
    penalty under Section 6707 for the failure to timely register a
    tax shelter will be equal to the greater of (i) fifty percent
    of the fees paid all promoters of the tax shelter with respect
    to offerings made before the date the tax shelter is registered
    or (ii) $10,000. If the promoter does not register and is not a
    U.S. person, then any potential participant in the tax shelter
    must register within ninety days unless it notifies the
    promoter that it will not participate.
        a. The current standard under Section 6111(d)(1) for
    triggering the tax shelter registration requirements is that
    the tax shelter involve any entity, plan, arrangement or
    transaction: (i) where a significant purpose of the structure
    is the avoidance or evasion of federal income tax for a direct
    or indirect corporate participant, (ii) which is offered to any
    potential participant under conditions of confidentiality and
    (iii) for which the tax shelter promoters may receive fees in
    excess of $100,000 in the aggregate.
        b. The JCT Study recommends modifying this standard in two
    respects. First, the requirement that an arrangement be offered
    under conditions of confidentiality would be replaced with a
    requirement that the arrangement (or the tax analysis
    underlying the arrangement) is reasonably expected to be
    presented to more than one potential participant. Second, the
    threshold for promoter fees would be increased from $100,000 to
    $1 million in aggregate fees expected to be received from the
    specific arrangement and all similar arrangements.
        Because the first criteria set forth in Section 6111(d)(1)
    corresponds to the corporate tax shelter definition provided in
    Section 6662 (i.e., that a significant purpose of the structure
    or arrangement be the avoidance or evasion of federal income
    tax for a direct or indirect corporate participant), it appears
    that the tax shelter registration requirements will apply to
    all Covered Transactions (including, but not limited to,
    Reportable Transactions).
        c. In the case of arrangements that are described by one or
    more Tax Shelter Indicators (i.e., Reportable Transactions),
    the JCT Study would require additional information to be
    disclosed as part of the registration process. This would
    include a description of (i) the claimed tax treatment of the
    arrangement and a summary of the authorities for the positions
    taken; (ii) the calculations for the arrangement under a
    reasonable set of hypothetical facts (including any
    calculations used to determine that the arrangement is
    described by a Tax Shelter Indicator); and (iii) the reasons
    why the arrangement is reasonably expected to be considered a
    tax shelter because of the presence of one or more Tax Shelter
    Indicators.

            General Framework for Addressing Corporate Tax Shelters

        We believe that an appropriate framework for addressing
    corporate tax shelters requires an evaluation of the true scope
    of the perceived problem; the ability of the Treasury
    Department and the IRS to identify imperfections in our tax
    system through the tools it already has at its disposal; and
    the ability of the government to address the problems that it
    does identify, either through the rulemaking process or through
    the courts. Only when the Treasury Department and the IRS do
    not have the necessary tools to address the problems they
    identify, or when the Treasury Department identifies problems
    that it cannot address through its existing regulatory
    authority, should the Congress provide additional tools and
    delegations of authority to the Treasury Department and the
    IRS. To the extent that the Congress determines that such
    additional tools or delegations are necessary, we agree with
    the JCT's conclusions that such tools or delegations should not
    interfere with legitimate tax planning or impose needless
    complexity, and would also suggest that such tools should not
    result in arbitrary or hidden tax increases or violate basic
    notions of fairness and equity.

     A. The First Step of Any Analysis Should Be to Assess The Causes And
      Severity of The Problem And to Ensure That Any Remedy Does Not Risk
                          Causing More Harm Than Good

        The rhetoric and anecdotal press accounts that have
    surfaced surrounding corporate tax shelters suggest that the
    corporate tax base is rapidly eroding and in imminent danger of
    imploding. While we understand that the perception of a problem
    is itself a problem that may require attention, the data we
    have reviewed simply does not support claims that the corporate
    tax base is at risk.\16\
    ---------------------------------------------------------------------------
        \16\ The following table is compiled from data set forth in Office
    of Management and Budget, Historical Tables, Budget of the United
    States Government, Fiscal Year 2000 (February 1999).

                                              Corporate Income Tax Receipts
    ----------------------------------------------------------------------------------------------------------------
                                                         Corporate income                     Percent of  Percent of
                           Year                            tax receipts      Total receipts      total        GDP
    ----------------------------------------------------------------------------------------------------------------
    FY1989............................................       $103,291,000       $991,190,000        10.4         1.9
    FY1990............................................        $93,507,000     $1,031,969,000       119.1         1.6
    FY1991............................................        $98,086,000     $1,055,041,000         9.3         1.7
    FY1992............................................       $100,270,000     $1,097,279,000         9.2         1.6
    FY1993............................................       $117,520,000     $1,154,401,000        10.2         1.8
    FY1994............................................       $140,385,000     $1,258,627,000        11.2         2.1
    FY1995............................................       $157,004,000     $1,351,830,000        11.6         2.2
    FY1996............................................       $171,824,000     $1,453,062,000        11.8         2.3
    FY1997............................................       $182,293,000     $1,579,292,000        11.5         2.3
    FY1998............................................       $188,677,000     $1,721,798,000        11.0         2.2
    ----------------------------------------------------------------------------------------------------------------

        These statistics indicate that, despite the
    Administration's assertions that corporate tax shelters have
    severely eroded the corporate tax base, corporate taxpayers in
    the United States have paid more money to the Federal
    government for each of the past nine years, and that the
    percentage of corporate income tax receipts as compared to both
    total Federal receipts and gross domestic product has remained
    steady over the past decade. Moreover, the Administration's
    estimates for the next five years indicate that this trend will
    continue, with corporate income taxes as a percentage of gross
    domestic product remaining at approximately 2.1 percent for
    each of those years and annual corporate payments continuing to
    trend up. Indeed, the Administration's own revenue estimates
    suggest that the scope of the corporate tax shelter problem is
    limited. The Administration estimates that its six generic tax
    shelter proposals would increase revenues by $1.76 billion over
    five years--less than 0.2% of total projected corporate tax
    receipts over that period. Of this amount, $830 million relates
    to the proposal to tax income attributable to tax indifferent
    parties.
        One of the reasons cited by government agencies and
    officials for surpluses higher than expected over the past
    couple years, and in the future, is a stronger than expected
    economy resulting in higher than expected corporate profits and
    unparalleled job growth, which in turn result in higher than
    expected tax revenue. Domestic businesses have become more
    efficient in their business operations and have been able to
    employ more workers and raise capital to effectively compete in
    the global market place.
        The Congressional Budget Office (``CBO'') notes that
    ``corporate profits are beginning to be squeezed by higher
    labor costs and the inability of firms to raise prices in the
    face of strong opposition from home and abroad.'' \17\
    ---------------------------------------------------------------------------
        \17\ CBO, Economic and Budget Outlook, Fiscal Year 2000-2009,
    January 1999, p. 24.
    ---------------------------------------------------------------------------
        CBO also notes that corporate profits will decline
    primarily because of a projected increase in gross domestic
    product devoted to depreciation.\18\
    ---------------------------------------------------------------------------
        \18\ Id. at 27.
    ---------------------------------------------------------------------------
        CBO predicts that some decline in corporate profits from
    recent levels is ``inevitable'' because of the sensitivity of
    corporate profits to business-cycle fluctuations.\19\
    ---------------------------------------------------------------------------
        \19\ Id.
    ---------------------------------------------------------------------------
        In an era of projected budget surpluses, the size of which
    is due in part to increased employment and corporate profits
    (and taxes thereon), the Congress should require compelling
    evidence of the need for enacting proposals that would restrict
    the ability of corporate taxpayers to operate efficiently and
    respond to changing market conditions. This is especially true
    when CBO is predicting increased pressures on future corporate
    profits.
        As the JCT Study states, no direct measure of loss in tax
    revenues attributable to corporate tax shelters is currently
    available. But, with corporate profits steadily increasing, and
    with corporate income tax receipts likewise accelerating, the
    burden should rest on those who are calling for a new and
    enhanced system to substantiate their claims of an imploding
    revenue base. The burden should not be placed on taxpayers to
    prove that they should be paying even more income taxes in
    order to avoid new penalties. Moreover, as noted above, the
    Congress should act judiciously in this area. Due to the
    current revenue estimating conventions, once the Treasury
    Department and IRS receive new delegations of authority to
    attack corporate tax shelters, any attempt to curb that
    authority would be scored as resulting in a revenue loss.
        Accordingly, Congress should not let anecdotal evidence and
    targeted press accounts attacking various transactions lead to
    legislation that does more harm than good. The threshold for
    enacting legislation in this area remains high. Tax shelters do
    not threaten the corporate tax base. Any responses to the
    problem, when appropriately articulated, should not impose
    complex and overreaching rules that undermine the ability of
    domestic businesses to operate efficiently, and thereby
    undermine the job creation and corporate profits that
    ultimately generate the long-term growth of Federal revenues.

    B. Treasury Has Several Existing Tools to Combat Corporate Tax Shelters
              Which Should Be Evaluated Before Piling on New Ones

        Much of the rhetoric relating to the ``corporate tax
    shelter'' issue suggests that the government needs new tools
    because it is not aware of transactions and tax planning
    arrangements which it might deem inappropriate. That is why the
    Administration proposed numerous specific provisions to attack
    transactions that it does not like, plus the general
    provisions, such as that proposed in the Doggett Bill, in case
    there are others which they have not yet found.\20\ The JCT
    Study, like the White Paper, appears to embrace the notion that
    new tools are required even before undertaking a thorough
    analysis of the existing powers that the Administration has at
    its disposal.
    ---------------------------------------------------------------------------
        \20\ In the White Paper, Treasury recommended (i) significantly
    increased disclosure; (ii) a significantly harsher penalty structure;
    (iii) a substantive change in law such as that proposed in the Doggett
    Bill; and (iv) additional penalties and excise taxes on promoters,
    advisors and tax-indifferent parties that participate in corporate tax
    shelters.
    ---------------------------------------------------------------------------
        The IRS has several existing and some new tools at its
    disposal to identify corporate tax shelters. Before enacting
    new proposals, existing rules and authorities should be
    carefully and thoroughly reviewed. If they do not work or are
    inadequate perhaps they should be repealed and replaced with
    new ones. Adding another layer of penalties and rules to
    overlay existing ones merely creates more complexity and
    potential pitfalls for taxpayers. It is contrary to the intent
    of Congress in mandating the JCT Study and requiring a review
    of the ``administration and implementation by the Internal
    Revenue Service of interest and penalty provisions of the
    [Code] and to make any legislative or administrative
    recommendations the JCT deems appropriate to simplify penalty
    or interest administration and to reduce taxpayer burden.''
    \21\
    ---------------------------------------------------------------------------
        \21\ See JCT Press Release, 98-2 (December 21, 1998) (emphasis
    added).
    ---------------------------------------------------------------------------
        As recently as 1997, the Congress enacted a law that
    expanded the definition of what qualifies as a ``tax shelter''
    for purposes of registering such transactions with the IRS.\22\
    When Treasury proposed the registration provision in February
    1997, it explained that the provision would help get the IRS
    useful information about corporate deals at an early stage to
    help identify transactions to audit and then take appropriate
    action--presumably through enforcement, regulatory changes, and
    requests for legislation when necessary.\23\ The filing
    requirement becomes effective when Treasury Regulations are
    prescribed. To date, such regulations have not been issued. One
    explanation for the delay may be the concern that the 1997
    amendment is limited to transactions offered under conditions
    of confidentiality, and that taxpayers will simply enter into
    transactions without such conditions in order to avoid
    application of the new rules. Nonetheless, there appears to
    have been little effort to assess the effectiveness of existing
    programs,\24\ as expanded in 1997, or to correct any perceived
    flaws in the 1997 amendments, before making wholesale changes
    to these rules.\25\
    ---------------------------------------------------------------------------
        \22\ See Section 1028 of the Taxpayer Relief Act of 1997(enacting
    Section 6111(d)).
        \23\ See the U.S. Treasury Department's General Explanations of the
    Administration's Revenue Proposals, at 81 (February 1997). According to
    Treasury:
          Many corporate tax shelters are not registered with the IRS.
    Requiring registration of corporate tax shelters would result in the
    IRS receiving useful information at an early date regarding various
    forms of tax shelter transactions engaged in by corporate participants.
    This will allow the IRS to make better informed judgments regarding the
    audit of corporate tax returns and to monitor whether legislation or
    administrative action is necessary regarding the type of transactions
    being registered.
        \24\ Section 6111 was added to the Code in the Tax Reform Act of
    1984. In 1989, the Commissioner's task force Report on Civil Tax
    Penalties concluded that ``[v]irtually no empirical data exists'' about
    the Section 6111 penalty (VI-22 and n. 29 (1989)).
        \25\ Commentators view the rules enacted in 1997 as quite
    expansive. See, Mark Ely and Evelyn Elgin, New Tax Shelter Penalties
    Target Most Tax Planning, Tax Notes (December 8, 1997); Sheryl
    Stratton, Restructuring Agreement would Expose Tax Shelter Opinions,
    Tax Notes (June 23, 1998).
    ---------------------------------------------------------------------------
        The expansive definition of tax shelters for purposes of
    the tax shelter registration provision was also carried over to
    Section 6662, the substantial understatement penalty provision.
    Accordingly, the increased exposure to the substantial
    understatement penalty, as a result of the 1997 changes, is
    virtually brand new and has not been assessed.\26\ In this
    case, unlike the registration requirement discussed above,
    there is no requirement that the arrangement involve a
    corporation, a confidentiality agreement or minimum promoter
    fees. As a result, it is worth noting, that under current law a
    corporate taxpayer can fully disclose a position on a tax
    return and can have substantial authority for such position but
    still be subject to penalty if the transaction is considered a
    tax shelter. The only way to avoid a penalty is to establish
    reasonable cause under Section 6664(c) which, by regulation,
    Treasury has already circumscribed so that for example, a
    taxpayer's reasonable belief that it is more likely than not to
    prevail may not be sufficient.\27\
    ---------------------------------------------------------------------------
        \26\ As suggested by the staff of the JCT in its description of the
    Administration's revenue proposals, ``it may be premature to propose
    new measures to deal with corporate tax shelters when provisions have
    already been enacted that are intended to that, but where there has
    been no opportunity to evaluate the effectiveness of those already-
    enacted provisions because they have not yet become effective because
    of the lack of the required guidance.'' Staff of the JCT, Description
    of Revenue Provisions Contained in the President's Fiscal year 2000
    Budget Proposal, JCS-1-99 at 165 (Feb. 22, 1999) (hereinafter the ``JCT
    Report'').
        \27\ Treas. Reg. Section 1.6664-(4).
    ---------------------------------------------------------------------------
        Many have argued that the success of the 1997 changes to
    the substantial understatement penalty rules will turn on how
    artfully the term ``tax shelter'' is defined by the Treasury
    Department and enforced by IRS agents. There is great concern
    in the business community that the expanded definition will
    provide a strong incentive for revenue agents to set up
    penalties as bargaining chips in negotiations. Before
    considering giving these agents more authority, it is important
    to evaluate the effect of these most recent changes. It is
    premature to explore new proposals even before the most recent
    changes take effect.
        Disclosure of appropriate information to the IRS is an
    important element of successful tax enforcement. As indicated
    above, Congress approved enhanced disclosure of tax shelters in
    the Taxpayer Relief Act of 1997 by adopting provisions that the
    IRS and Treasury have not yet implemented. This is on top of
    existing disclosure requirements. In this regard, we note that
    corporate taxpayers generally are required to reconcile their
    book and taxable income on the face of the corporate income tax
    return.\28\ Thus, corporate taxpayers already are required to
    disclose (and must be prepared to explain and justify) the
    book/tax differences that the Administration and the JCT Staff
    view as a key indicator of potential corporate tax shelter
    transactions.\29\ Moreover, the largest 1,700 corporate
    taxpayers are included in the coordinated examination program
    \30\ and are subject to continuous audit by revenue agents who
    routinely work from offices at the taxpayer's headquarters and
    have the time and access to all of the information necessary to
    identify potential corporate tax shelters.\31\
    ---------------------------------------------------------------------------
        \28\ Internal Revenue Service Form 1120, Schedule M-1.
        \29\ The White Paper and the JCT Study both suggest that the
    Schedule M-1 is not a useful audit tool, and that negotiations over
    audit plans allow taxpayers to hide corporate tax shelter issues. This
    is simply not the case. The IRS invariably uses the Schedule M-1 as a
    road-map for conducting its audits, and one of the first requests made
    by the IRS in any audit of a large corporation is a request for a
    detailed explanation of book/tax differences.
        \30\ GAO, ``Tax Administration--Factors Affecting Results from
    Large Corporations,'' p. 1, GAO/GGD--97-62 (Apr. 1997).
        \31\ Despite the assertion made in the JCT Study that ``audits of
    large corporations typically follow an agreed-upon agenda of issues
    that is negotiated by the IRS and the corporate taxpayer,'' in practice
    we have found that the IRS determines which issues will be covered by
    an audit, and that the IRS will continue to raise new issues throughout
    the audit process. Thus, the notion that corporate taxpayers can ``win
    the audit lottery'' by negotiating the initial agenda for an audit does
    not reflect the reality of how the IRS conducts audits.
    ---------------------------------------------------------------------------

    C. The IRS Regularly Identifies Imperfections in Our Tax System Through
                    the Tools It Already Has at Its Disposal

        As a practical matter, when the government does identify
    what it perceives as ``abuses,'' the IRS has often been
    aggressive in challenging those transactions through
    examination and litigation.

    1. Litigation

        Significant cases that the government has won in recent
    years include: Ford Motor Co. v. Commissioner, 102 T.C. 87
    (1994), aff'd 71 F.3d 209 (6th Cir. 1995) (Tax Court limited a
    current deduction for a settlement payment, stating that tax
    treatment claimed by the taxpayer would have enabled it to
    profit from its tort liability); Jacobs Engineering Group, Inc.
    v. United States, 97-1 USTC 87,755 (CCH para.  50,340) (C.D.
    Cal. 1997), aff'd 99-1 USTC 87,786 (CCH para. 50,335) (9th Cir.
    1999) (applying Section 956 to a transaction despite the fact
    that a literal reading of the regulations would not have
    subjected the taxpayer to that provision); ACM Partnership v.
    Commissioner, 73 T.C.M. (CCH) 2189 (1997), aff'd 157 F.3d 231
    (3d Cir. 1998) (not respecting a partnership's purchase and
    subsequent sale of notes, stating that the transaction lacked
    economic substance) cert. denied 119 S. Ct. 1251 (1999); ASA
    Investerings Partnership v. Commissioner, 76 T.C.M. (CCH) 325
    (1998) (applying an intent test to determine that a foreign
    participant in a partnership was a lender, rather than a
    partner, for federal income tax purposes); United Parcel
    Service of America, Inc. v. Commissioner, T.C.M. No. 268 (1999)
    (treating an intragroup restructuring involving a related
    insurance company as a sham, stating that the restructuring was
    primarily motivated by tax considerations); The Limited Inc. v.
    Commissioner, 113 T.C. No. 13 (1999) (holding in favor of the
    IRS on grounds that the principal purpose for organizing a
    foreign subsidiary to purchase certificates of deposit from a
    domestic subsidiary, rather than using a domestic corporation,
    was to avoid the application of Section 956); Compaq Computer
    Corp. v. Commissioner, 113 T.C. No. 17 (1999) (holding that the
    economic substance doctrine applied to deny foreign tax credits
    attributable to the purchase and resale of ADRs when the
    transaction was (i) designed to yield a specific result and
    eliminate all economic risks, (ii) the taxpayer had no
    reasonable possibility of a pre-tax profit and (iii) the
    taxpayer had no non-tax business purpose for the transaction);
    IES Industries, Inc. v. United States, No. C97-206 (N.D. Iowa
    September 22, 1999) (order granting partial summary judgment in
    favor of IRS under facts similar to Compaq); Winn-Dixie v.
    Commissioner, 113 T.C. No. 21 (1999) (holding that a leveraged
    corporate-owned life insurance program lacked economic
    substance and business purpose when the court found that the
    only function of the program was to generate interest and fee
    deductions in order to offset income from other sources); and
    Saba Partnership v. Commissioner, T.C.M. No. 359 (1999)
    (applying economic substance test to disregard partnership
    transactions similar to those addressed in ACM Partnership and
    ASA Investorings Partnership).
        Of particular note is that in UPS and Compaq the IRS
    asserted, and the courts sustained, the imposition of
    meaningful penalties on the taxpayers. This suggests that the
    current law penalty provisions are being used, despite an
    assertion to the contrary in the JCT Study.

    2. Administrative Action

        Likewise, the Administration regularly addresses what it
    perceives as ``abuses'' through notices and regulations. In
    recent years, the Treasury Department has promulgated a number
    of regulations and other rules intended to stop tax planning
    activities that the Treasury Department has viewed as
    inappropriate. These include the partnership anti-abuse
    regulations,\32\ the proposed regulations targeting certain
    partnership transactions involving a partner's stock,\33\ the
    anti-conduit financing regulations,\34\ the temporary
    regulations targeting the improper use of tax treaties by
    hybrid entities,\35\ the recently proposed regulations
    targeting fast-pay stock arrangements,\36\ the recently
    released revenue ruling attacking certain leasing
    transactions,\37\ the recently proposed regulations targeting
    certain transactions involving foreign hybrid entities \38\ and
    the recently proposed regulations targeting certain charitable
    remainder trust arrangements.\39\
    ---------------------------------------------------------------------------
        \32\ Treas. Reg. Sec. 1.701-2.
        \33\ Prop. Treas. Reg. Sec. 1.337(d)-3.
        \34\ Treas. Reg. Sec. 1.881-3; Prop. Treas. Reg. Sec. 1.7701(l)-2.
        \35\ Temp. Treas. Reg. Sec. 1.894-1T.
        \36\ Prop. Treas. Reg. Sec. 1.7701(l)-3.
        \37\ Rev. Rul. 99-14, 1999-13 I.R.B. 3.
        \38\ Prop. Treas. Reg. Sec. 1.954-9.
        \39\ Prop. Treas. Reg. Sec. 1.643(a)-8.
    ---------------------------------------------------------------------------
        Moreover, on a number of occasions in recent years, the
    Treasury Department has issued notices to target specific tax
    planning techniques, typically announcing its intention to
    issue regulations addressing such techniques that will be
    effective as of the date of the notice. Examples of this
    approach include notices attacking certain partnership
    transactions,\40\ inversion transactions,\41\ transactions
    involving the acquisition or generation of foreign tax credits
    \42\ and transactions involving foreign hybrid entities.\43\ On
    several occasions, the regulatory guidance has been issued with
    retroactive effective dates, a practice that is likely to have
    a chilling effect on transactions that taxpayers believe the
    government might find ``abusive.'' \44\
    ---------------------------------------------------------------------------
        \40\ Notice 89-37, 1989-1 C.B. 679.
        \41\ Notice 94-46, 1994-1 C.B. 356.
        \42\ Notice 98-5, 1998-3 I.R.B. 49.
        \43\ Notice 98-11, 1998-6 I.R.B. 13.
        \44\ See Section 7805(b)(3) (authorizing Treasury to issue
    regulations retroactively when necessary to prevent abuse, but only
    with respect to statutory provisions enacted on or after July 30,
    1996).

    ---------------------------------------------------------------------------
    3. Targeted Legislation

        Under the present system, when the Treasury Department
    identifies a perceived ``abusive'' transaction, whether through
    rulemaking or by way of a specific legislative proposal, the
    Congress has not hesitated to enact legislation to curb
    transactions that it perceives as inappropriate. For example,
    last year the Congress eliminated certain tax benefits
    involving the liquidation of a regulated investment company or
    real estate investment trust. In addition, just several months
    ago the Congress enacted a provision to address certain
    transactions involving the transfer of property subject to
    multiple liabilities. While in each case the statute was
    effective as of the date of announcement, the Congress made
    clear (as it does routinely in perceived abuse cases) that the
    IRS was free to attack pre-effective date transactions under
    prior law.
        The events that unfolded over the past eighteen months
    following the release of Notice 98-11,\45\ and the Congress'
    repeated rejection of most of the Administration's proposed
    revenue raisers, highlight another issue that should be
    considered in light of the proposals to provide the IRS and the
    Treasury Department with new ways to combat transactions that
    they view as inappropriate. We respectfully submit that the new
    arsenal of weapons recommended by the JCT Study would
    effectively allow the IRS and Treasury to accomplish what the
    Congress has effectively prevented in the legislative arena.
    Moreover, even when the Congress and the Treasury Department
    agree that a problem exists, they may not agree on the
    appropriate solution.
    ---------------------------------------------------------------------------
        \45\ In Notice 98-11, the IRS and Treasury announced their
    intention to propose regulations targeting certain transactions
    involving foreign hybrid entities. Less than three months after the
    issuance of Notice 98-11, temporary regulations implementing the notice
    were promulgated. As a result of a significant legislative backlash to
    those temporary regulations, which generally focused on whether the
    targeted transactions were in fact inappropriate and whether Treasury
    had the authority to issue the regulations, the IRS and Treasury issued
    Notice 98-35, in which they expressed their intent to revise the
    temporary regulations with a new effective date. Those regulations were
    proposed on July 9, 1999, with a proposed effective date of no earlier
    than 2006.
    ---------------------------------------------------------------------------
        Department agree that a problem exists, they may not agree
    on the appropriate solution.
        We are not suggesting that there are no transactions that
    generate unanticipated and inappropriate tax consequences. To
    the contrary, these results are the inevitable outcome of a tax
    system that is too complex and burdensome. We also recognize
    the obvious--taxpayers and their advisors move quickly to take
    advantage of perceived tax planning opportunities.
    Nevertheless, wholesale new laws with vague and punitive
    components can do more harm than good.

    D. Criteria That Should Be Used in Evaluating Legislative Proposals to
                         Address Corporate Tax Shelters

        To the extent that Congress determines that legislative
    action is required to address corporate tax shelters, such
    action should be commensurate with the problem. Moreover,
    Congress should balance carefully the expected benefit of any
    legislative proposal with the likely adverse consequences of
    enacting such a proposal. In particular, we respectfully
    suggest that no legislative proposal should be enacted that
    would: interfere with mainstream business transactions and
    ordinary tax planning activities; impose needless complexity;
    violate basic notions of fairness and equity or result in an
    arbitrary or hidden tax increase.

    1. Any Legislative Solution Should Not Interfere with
    Mainstream Business Transactions and Ordinary Tax Planning
    Activities

        No legislative solution to the perceived corporate tax
    shelter problem should undermine routine business transactions
    and tax planning. As Judge Learned Hand observed over sixty
    years ago:
            A transaction, otherwise within an exception of the tax law,
            does not lose its immunity, because it is actuated by a desire
            to avoid, or, if one choose, to evade, taxation. Any one may so
            arrange his affairs that his taxes shall be as low as possible;
            he is not bound to choose that pattern which will best pay the
            Treasury; there is not even a patriotic duty to increase one's
            taxes.\46\
    ---------------------------------------------------------------------------
        \46\ Helvering v. Gregory, 69 F.2d 809, 810 (2nd Cir. 1934), aff'd
    293 U.S. 465 (1935).
    ---------------------------------------------------------------------------
        All of the tax policy makers in the current debate on
    corporate tax shelters--including the Chairman of the House
    Committee on Ways and Means,\47\ the Chairman of the Senate
    Committee on Finance,\48\ the Treasury Department \49\ and the
    JCT \50\--agree that legislation should not inhibit legitimate
    business transactions and tax planning activities.
    ---------------------------------------------------------------------------
        \47\ Tax Bill Will Include Extenders, Some Shelter Provisions,
    Archer Says, 1999 TNT 56-1 (March 23, 1999) (quoting Rep. Archer,
    Chairman of the House Committee on Ways and Means, to the effect that
    [Chmn. Archer] ``wants to proceed more cautiously and doesn't want to
    injure taxpayers who are trying to legally reduce their tax liabilities
    in the push to catch those who abuse the system'').
        \48\ Finance Committee to Review Tax Code Penalties, Including
    Corporate Tax Shelter Proposals, News Release from Sen. Roth (July 13,
    1999) (``Corporate tax shelters should be curtailed without affecting
    legitimate business transactions.'')
        \49\ Hearing on the President's Fiscal Year 2000 Budget Before the
    House Committee on Ways and Means, 106th Cong., 1st Sess. (1999)
    (statement of Hon. Donald Lubick, Assistant Secretary (Tax Policy),
    U.S. Department of the Treasury) (``The Treasury Department does not
    intend to affect legitimate business transactions.'')
        \50\ JCT Study at 219 (stating that the tax system must not impede
    taxpayers' ability to conduct business).
    ---------------------------------------------------------------------------
        The question that must be answered is whether the proposals
    contained in the White Paper and the JCT Study impede
    legitimate tax planning (i.e., the activities described by
    Judge Hand as an integral part of our tax system). For the
    reasons set forth below, the answer to this question is yes. It
    is clear that they would have precisely the chilling effect
    that all involved have said they wish to avoid.

    2. Any Legislative Solution Should Not Impose Needless
    Complexity

        When discussing our tax system, there is only one complaint
    that is universally shared--the system is far too complex and
    must be simplified. In this regard, it is important to note
    that complexity can be both substantive and procedural.
    Substantive complexity arises at one extreme when the operative
    definitions and rules are crafted so broadly that they cannot
    be reasonably and uniformly applied; it arises at the other
    extreme when taxpayers are required to navigate a labyrinth of
    rules in order to determine which substantive rules will apply.
    Procedural complexity arises when, for example, taxpayers are
    subject to burdensome reporting or record-keeping requirements,
    or must engage in costly and protracted disputes with the
    government.
        The question that must be answered is whether the proposals
    contained in the White Paper and the JCT Study lead to
    significant substantive procedural complexity. For the reasons
    set forth below, the answer to this question is yes.

    3. Any Legislative Solution Should Not Violate Basic Notions of
    Fairness and Equity

        One of the striking aspects of the proposals to address
    corporate tax shelters is the apparent failure to consider
    standards of basic fairness and equity. These concepts are, of
    course, difficult to define in practice. However, we believe
    that the fairness and equity of the proposals under
    consideration can be addressed by considering questions such as
    the following:
          Do the proposals create a structural bias that
    will cause taxpayers to systematically over-pay their taxes?
          Do the proposals give IRS revenue agents the
    authority to extract inappropriate concessions from taxpayers?
          Do the proposals permit the government to avoid
    accountability for the rules that it writes?
          Do the proposals impose standards on taxpayers
    and third parties that are far more onerous than the standards
    imposed on the government?
        Unfortunately, for the reasons set forth below, the answer
    to each of these questions is likely to be yes. As a result,
    the proposals under consideration do violate basic notions of
    fairness and equity.

    4. Any Legislative Solution Should Not Result in an Arbitrary
    or Hidden Tax Increase

        If the goal of corporate tax shelter legislation is to
    create incentives in our self-assessment system for taxpayers
    to file tax returns that reflect the actual amount of tax
    required to be paid under the law, then any such legislation
    should not be crafted as a tax increase in disguise. If
    Congress wishes to raise taxes, it can do so directly.
        The question that should be asked is whether the proposals
    under consideration would result in an arbitrary or hidden tax
    increase because they:
          create strong structural incentives for taxpayers
    to overpay their taxes;
          give IRS revenue agents weapons that they can use
    to extract inappropriate concessions from taxpayers;
          impose penalties on third parties that would
    likely be borne by corporate taxpayers; and
          impose dead-weight costs in the form of
    substantial compliance and administrative burdens.
        Unfortunately, again for the reasons explained below, the
    answer to these questions is likely to be yes. While presumably
    unintended, the proposals would result in a hidden tax increase
    on corporate taxpayers.

            IV. Specific Comments on the JCT Study's Recommendations

        The JCT Study suffers from two fundamental flaws. First,
    the JCT Study fails to establish a plausible case that the
    Treasury Department and the IRS do not have the necessary tools
    to address the problems that they identify, and accordingly
    presumes the need for the creation of new and enhanced
    penalties. To be sure, the JCT Study provides evidence of the
    perception of a corporate tax shelter problem; however, the
    only real evidence of a problem with the enforcement tools
    already available to the IRS is the JCT's assertion that the
    IRS too often is willing to waive the imposition of
    penalties.\51\ As the recent decisions of the Tax Court in UPS
    and Compaq demonstrate, the IRS does assess, and the courts do
    impose, substantial penalties in the context of ``tax
    motivated'' transactions. Second, even if the Congress were to
    determine that a legislative response is appropriate, the JCT
    Study's recommendations violate the criteria outlined above for
    evaluating proposed statutory changes: they would interfere
    with ordinary tax planning activities, they would result in
    additional complexity, they would result in arbitrary or hidden
    tax increases, and they would violate basic notions of fairness
    and equity.
    ---------------------------------------------------------------------------
        \51\ JCT Study at 220 (citing David C. Garlock, A Tax Executive's
    Guide to Evaluating Tax-Oriented Transactions, 17 Tax Mgmt. Wkly. Rep.
    370 (1998) (noting, without providing any empirical evidence, that the
    IRS routinely threatens penalties and offers to waive them in
    settlements)). Moreover, to the extent that the JCT Study does provide
    statistics with regard to abatement of interest and penalties, those
    statistics do not necessarily portray the whole picture, which is that
    the IRS often ``trades'' penalties in exchange for concessions by
    taxpayers on other issues as part of the settlement process.
    ---------------------------------------------------------------------------
        Following are comments on the specific proposals, and an
    evaluation of those proposals in light of the general framework
    suggested above.

                       A. Comments on Specific Proposals

    The Proposed Definition of Corporate Tax Shelters is Overly
    Broad and Needlessly Complex

        Section 6662(d)(2)(C)(ii) defines the term ``tax shelter''
    for purposes of the substantial understatement penalty as:
            A partnership or other entity, any investment plan or
            arrangement, or any other plan or arrangement, if a significant
            purpose of such partnership, entity, plan, or arrangement is
            the avoidance or evasion of Federal income tax.
        This definition, which turns on the meaning of a ``significant
    purpose,'' is widely viewed as extremely broad and uncertain. Indeed,
    it is arguable that the definition encompasses all matters where tax
    planning is involved because the essence of tax planning is to
    ``avoid'' tax liabilities that would otherwise arise if the transaction
    or activity were structured or conducted in some other way.\52\ Under
    current law, the ramifications of this open-ended definition are
    limited to procedural matters (e.g., the imposition of a twenty percent
    penalty if a substantial understatement results, unless the taxpayer
    has substantial authority for its position and reasonably believed that
    it was more likely than not to prevail on the merits.) Under the JCT
    Study's proposal, however, the uncertainty inherent in the definition
    of a ``corporate tax shelter'' would have far more serious consequences
    (e.g., a taxpayer that engages in a Covered Transaction but
    misapprehends the need to disclose would face a mandatory forty percent
    penalty if the taxpayer loses on the merits).
    ---------------------------------------------------------------------------
        \52\ We recognize that the word ``avoid'' may have negative
    connotations; however, since the time of Judge Hand's assertion in
    Gregory, the ``avoidance'' of taxes is a universally accepted
    description of legitimate tax planning.
    ---------------------------------------------------------------------------
        The breadth of the underlying definition of ``corporate tax
    shelter'' is neither circumscribed nor clarified by the
    addition of the five Tax Shelter Indicators. As explained
    below, the Tax Shelter Indicators are explicitly intended to
    encompass routine tax planning activities and are potentially
    vague and subjective in their application.\53\
    ---------------------------------------------------------------------------
        \53\ The Doggett Bill would create a similar degree of uncertainty
    by retaining the vague definition of current law and adding a new
    definition for ``noneconomic tax attributes.''
    ---------------------------------------------------------------------------
        a. The reasonably expected pre-tax profit from the
    arrangement is insignificant relative to the reasonably
    expected net tax benefits. For purposes of this factor, the JCT
    Study states that the present value of the relevant amounts
    would be determined using a discount rate equal to the short-
    term applicable Federal rate plus one percentage point (100
    basis points). The use of this mandatory discount rate in
    valuing cash flows would mean that many financing and pre-tax
    arbitrage transactions (when the market routinely seeks profits
    measured in less than 100 basis points) could be covered. A
    review of basic data that everyone in the bond market has
    access to supports the conclusion that the proposed discount
    rate does not reflect what goes on in the ``real world.''
    Concerns regarding the potential implications of this rule are
    amplified by the fact that, as noted below, the JCT Study views
    an investment in tax-exempt bonds as a corporate tax shelter,
    presumably based on an application of this mandatory discount
    rate. Indeed, nearly every purchase of preferred stock or tax-
    exempt bonds would be below the yield indicated by the
    mandatory discount rate.
        b. The arrangement involves a tax-indifferent participant,
    and (a) results in taxable income materially in excess of
    economic income to the tax-indifferent participant; (b) permits
    a corporate participant to characterize items in a more
    favorable manner or (c) results in a non-economic increase,
    creation, multiplication or shifting of basis. The use of a Tax
    Shelter Indicator that turns on the participation of a tax-
    indifferent party is troubling for several reasons. First, the
    targeting of transactions that involve categories of taxpayers
    that the Congress has determined are worthy of exemption from
    tax, including Native American tribal organizations and other
    tax-exempt organizations, effectively overrides the tax
    exemptions that such organizations currently enjoy. If the
    Congress determines that there are circumstances in which these
    organizations should be taxed, a more appropriate approach
    would be to either repeal their exemptions or expand the scope
    of the unrelated business income tax. Second, the use of tax-
    indifferent parties in the definition of a corporate tax
    shelter would create a new kind of uncertainty for other
    taxpayers that participate in the transaction, in that such
    participants could wind up subject to deficiencies and
    penalties for the simple reason that they did not know whether
    another party to the same transaction falls within the proposed
    definition of a tax-indifferent participant.\54\
    ---------------------------------------------------------------------------
        \54\ The Doggett Bill also inappropriately targets transactions
    involving tax-indifferent parties.
    ---------------------------------------------------------------------------
        c. The reasonably expected net tax benefits are
    significant, and the arrangement involves a tax indemnity or
    similar agreement for the benefit of the corporate participant
    other than a customary indemnity in an acquisition or other
    business transaction entered into with a principal in the
    transaction. The JCT Study's discussion of ``customary
    indemnity agreements'' fails to consider a host of transactions
    in which a tax indemnity is provided in the ordinary course. A
    few of the many examples include the dividends received
    deduction indemnity that accompanies every private placement of
    preferred stock and the withholding tax indemnity that
    accompanies every cross-border securitization or financing.
    Depending upon how the ``customary'' standard is interpreted,
    this factor could sweep in a large number of routine business
    transactions.
        d. The reasonably expected net tax benefits from the
    arrangement are significant, and the arrangement is reasonably
    expected to create a ``permanent difference'' for U.S.
    financial reporting purposes under generally accepted
    accounting principles. This factor alone would apply to
    numerous routine business activities and transactions,
    including many where corporate tax planning may not be a
    significant consideration.\55\ Some of the more common examples
    involve stock options, tax exempt municipal bonds, the
    dividends received deduction and special tax credits (e.g.,
    low-income housing credit under Section 42). Moreover, by their
    nature, permanent book/tax differences are already disclosed to
    the IRS as part of the Form 1120 Schedule M-1 reconciliation.
    ---------------------------------------------------------------------------
        \55\ Similarly, the Doggett Bill would create a presumption that
    tax benefits should be disallowed when the benefits ``are not
    reflected...on the taxpayer's books and records for financial reporting
    purposes.''
    ---------------------------------------------------------------------------
        e. The reasonably expected net tax benefits from the
    arrangement are significant and the arrangement is designed so
    that the corporate participant incurs little (if any)
    additional economic risk as a result of entering into the
    arrangement. The breadth of this factor is illustrated by the
    fact that, as currently worded, it arguably covers all
    borrowings (because, as commonly understood, the lender is the
    party taking the risk), hedging transactions, defeasance
    transactions, insurance transactions, credit support
    transactions (including guarantees and letters of credit), and
    all transactions among members of an affiliated group
    (including all financing transactions, intercompany
    transactions and arrangements regarding the repatriation of
    dividends). While this may not have been intended, it is a
    straight-forward reading of the proposal--and certainly a
    reading that enterprising IRS agents might assert.
        The extraordinary breadth of the corporate tax shelter
    definition, and the list of Tax Shelter Indicators, is best
    illustrated by example. One starting point is the routine
    corporate tax planning transactions that the JCT Study itself
    acknowledges are Covered Transactions. The JCT Study treats all
    of the following as Reportable Transactions, meaning that they
    are all Covered Transactions described by one or more Tax
    Shelter Indicators:
        All leveraged lease transactions. The JCT Study would
    exempt lease transactions that satisfy the criteria of Rev.
    Proc. 75-21 (or the relevant case law thereunder) from the 30-
    day Disclosure requirement, acknowledging that the volume of
    these transactions is so significant that disclosure would be
    unduly burdensome on both taxpayers and the IRS. Nonetheless,
    the JCT Study apparently views all leveraged leasing
    transactions as ``corporate tax shelters,'' presumably because
    the typical pre-tax profit of one to four percent that
    investors expect in a leveraged lease transaction would fall
    short under the mandatory discount rate that the JCT staff
    recommended, even though one to four percent would be
    significantly more than the de minimis standard of Sheldon v.
    Commissioner, 94 T.C. 738 (1990). Thus, one of the most common
    techniques for raising capital to finance airplane acquisitions
    and acquisitions of heavy equipment by utilities and others--
    transactions that have been expressly sanctioned by the IRS and
    serve an important function in the domestic and international
    capital markets--are tainted with the ``corporate tax shelter''
    label. In this regard, it is also worth noting that numerous
    leveraged lease transactions fail (or arguably fail) to meet
    one or more of the Rev. Proc. 75-21 requirements yet are
    routinely respected as true leases by the IRS. Presumably,
    however, any leveraged lease transaction that does not satisfy
    the criteria of Rev. Proc. 75-21, even if otherwise sanctioned
    as a true lease, could be subject to these reporting
    requirements.
        Investments in low-income housing projects, tax exempt
    bonds, foreign sales corporations (``FSCs'') and Domestic
    International Sales Corporations (``DISCs'') The JCT Study
    recommends that the Secretary be allowed to provide an
    exemption from the 30-Day and Tax Return Disclosure
    requirements for corporate taxpayers that avail themselves of
    these provisions of the Code. Presumably, investments in low
    income housing and tax exempt bonds are Reportable Transactions
    because they fail to satisfy the minimum return standard of the
    first Tax Shelter Indicator. While FSC's and DISC's are Covered
    Transactions, it is not entirely clear why the JCT Study also
    views them as Reportable Transactions. It is also interesting
    to note that the JCT Study did not include corporate
    investments in preferred stock as potentially exempt from the
    Tax Return Disclosure requirements. The volume of these
    transactions is, if anything, greater than the volume of
    leasing and tax exempt bond transactions. By treating tax
    advantaged investments that Congress has specifically
    sanctioned as Covered Transactions, and therefore corporate tax
    shelters per se, the JCT Study demonstrates the breadth of its
    definition. (Indeed, it even goes beyond the White Paper, which
    would presume such investments to be outside the scope of its
    corporate tax shelter proposals.)
        An endless number of ordinary tax planning activities
    arguably are encompassed by the general corporate tax shelter
    definition and the list of Tax Shelter Indicators. As noted
    below, the risk that a transaction may constitute a corporate
    tax shelter--or that a revenue agent may threaten to treat a
    transaction as a corporate tax shelter--triggers a chain of
    events ranging from mandatory filing of additional information
    to the imposition of draconian penalties. These consequences
    will arise routinely in the context of efforts by taxpayers
    ``to arrange [their] affairs so that [their] taxes will be as
    low as possible,'' as Judge Hand observed was permissible, even
    if ``actuated by a desire to avoid . . . taxation.'' A few of
    the many tax planning activities that satisfy Judge Hand's
    definition but would nonetheless be treated as corporate tax
    shelters under the JCT Study include:
        Changes in capital structure. Public companies routinely
    engage in stock buy-back programs, often financed explicitly or
    implicitly with debt. In most instances, the current cash flow
    costs of the debt are greater than the current cash flow
    ``costs'' associated with dividends on the repurchased common
    stock. Such transactions likely would be treated as corporate
    tax shelters under the JCT's recommendations because (i) they
    would be covered by the general definition of a corporate tax
    shelter in that a significant purpose is the ``avoidance of
    tax'' through obtaining a current interest deduction, and (ii)
    they would be described by at least one of the Tax Shelter
    Indicators because the reasonably expected pre-tax profits from
    the stock buy-back program are insignificant relative to the
    reasonably expected net tax benefits.
        Mergers, acquisitions and other corporate transactions.
    There are numerous circumstances where taxpayers engage in
    formalistic steps in the context of mergers, acquisitions and
    other corporate transactions to achieve desired tax objectives
    or to avoid otherwise negative tax consequences. Most of
    Subchapter C is predicated and administered in reliance on
    mechanical rules, and steps that have little or no impact on
    expected pre-tax profits routinely have major tax implications.
    Taxpayers routinely use--and the IRS routinely sanctions--these
    steps despite the fact that their only purpose is to ``avoid''
    taxes that would otherwise be due but for their inclusion in
    the transaction. Examples include the formation of a holding
    company to qualify an acquisition for tax-free treatment under
    Section 351; using transitory entities to effectuate tax free
    reorganizations; using or changing a particular capital
    structure to achieve (or avoid) tax free treatment; and using
    (or avoiding use of) particular consideration to achieve (or
    avoid) tax free treatment. All of these transactions satisfy
    both the generic definition of Covered Transactions and at
    least one of the Tax Shelter Indicators (relating to expected
    pre-tax profits). Depending upon how the standard is
    interpreted, they may also fit within the factor dealing with
    transactions that have no economic risk but confer substantial
    tax benefits.
        Routine transactions among members of an affiliated group
    (foreign, domestic, and cross-border). A number of foreign
    corporate groups establish single holding companies to serve as
    parent companies of their U.S. consolidated tax groups.\56\
    Alternatively, the foreign parent could establish separate U.S.
    corporate chains for each business. Invariably, these choices
    are driven at least in part by consideration of the tax
    benefits and detriments of consolidation. (The same, of course,
    applies to U.S. holding companies.) The decision to create or
    change a consolidated structure would likely satisfy both the
    generic definition of Covered Transactions and at least one of
    the Tax Shelter Indicators (relating to expected pre-tax
    profits). Likewise, ``plans'' relating to the timing and source
    of repatriated earnings and the routine structuring of non-US
    businesses by US taxpayers would satisfy both the generic
    definition and at least one Tax Shelter Indicator.
    Interestingly enough, while inter company pricing decisions are
    arguably not covered by the generic definition (the taxpayer is
    supposed to be looking for the ``right'' answer), inter company
    pricing decisions arguably meet one or more Tax Shelter
    Indicators because the pricing has a significant impact on the
    taxpayer's tax liability but may not have any overall economic
    impact (in terms of profitability or risk) on the consolidated
    enterprise.
    ---------------------------------------------------------------------------
        \56\ In a recent field service advice memorandum, the IRS
    challenged exactly this type of internal corporate restructuring,
    stating that the primary purpose for creating the domestic holding
    company was to reduce taxes. See FSA 1999-26011.
    ---------------------------------------------------------------------------
        Once again, what is important to emphasize is that all of
    the JCT Study's penalty and disclosure recommendations are
    built on the same foundation--the JCT Study's definition of
    corporate tax shelters. That definition encompasses the entire
    range of legitimate tax planning activities which, in the
    corporate context, covers most transactions and many routine
    business operations.
        2. The Registration, Disclosure and Certification
    Requirements Would Impose Significant and Unnecessary Paperwork
    and Administrative Burdens on Taxpayers and Third Parties
        The JCT Study identifies two reasons for their
    registration, reporting and disclosure recommendations: to
    provide the IRS with an effective ``early-warning'' device of
    new transactions that it may wish to address and to assist the
    IRS in the examination of taxpayers. While each of these
    objectives is appropriate, the requirements should be
    consistent with their stated purposes and should not impose
    unnecessary paperwork or administrative burdens on taxpayers
    and third parties involved in their transactions.
        The disclosure recommendations set forth in the JCT Study
    violate these standards in several ways. Again, the starting
    point is the breadth of Covered Transactions. The IRS is
    certain to be inundated with registration forms and disclosure
    documents from ``promoters,'' taxpayers and third parties,
    undermining the stated goal of providing the IRS with a usable
    ``early warning'' system. Moreover, JCT Study mandates ``long-
    form'' registration and disclosure documents, despite
    experience suggesting that this type of information may be far
    less helpful than some type of ``short-form'' disclosure.
    Finally, the 30-Day Disclosure rule for corporate taxpayers is
    entirely superfluous. Particularly given the breadth of the Tax
    Shelter Indicators and the promoter registration requirements,
    it will not further the early warning objective; indeed, it
    will make matters worse for the IRS and Treasury. The 30-day
    Disclosure rule also has nothing to do with the examination of
    the taxpayer, because that same disclosure is required on the
    taxpayer's tax return.
        a. The disclosure requirements on corporate taxpayers are
    unduly burdensome, especially given the breadth of Covered
    Transactions. As a preliminary matter, taxpayers would have to
    determine whether a Covered Transaction was also a Reportable
    Transaction (i.e., described by one or more of the Tax Shelter
    Indicators). For reasons noted above, that determination is
    itself quite complex. Moreover, given the scope of the Tax
    Shelter Indicators, the 30-day Disclosure rule would be
    tantamount to a year-round filing requirement that bears no
    relationship whatsoever to the real world process of return
    preparation. Because many financing transactions undergo
    numerous changes before closing, such a short period during
    which to file a detailed disclosure is impractical. The
    burdensome nature of this requirement is further evidenced by
    the fact that the same information must be provided a second
    time to comply with the Tax Return Disclosure Requirements.\57\
    Finally, by mandating long-form disclosure, the recommendation
    will create mountains of needless paperwork for both the IRS
    and corporate taxpayers in connection with transactions where
    there is no issue or uncertainty whatsoever regarding proper
    tax treatment of the disclosed item.
    ---------------------------------------------------------------------------
        \57\ The Doggett Bill also would require duplicative filings,
    within thirty days of closing a transaction and again with the tax
    return.
    ---------------------------------------------------------------------------
        b. Requiring a senior executive familiar with all aspects
    of a transaction to sign off on corporate tax shelters is
    unnecessary and unduly burdensome. In the first instance, this
    requirement is redundant because the tax director or other
    senior corporate officer already signs the tax return under
    penalties of perjury. Moreover, in light of the breadth of the
    definition of a corporate tax shelter, which would encompass
    routine business transactions and ordinary tax planning
    activities, the requirement would apply to an array of
    transactions that should not concern the Executive Branch or
    the Congress, let alone the chief financial officer or other
    senior executives of a corporate taxpayer. In order to satisfy
    the certification requirements, senior executives outside the
    tax function would be required to devote substantial time,
    effort and money to business activities and tax matters having
    nothing to do with their corporate responsibilities.\58\
    Finally, the broad scope of the underlying disclosure
    requirement makes the certification requirement all that much
    more onerous.
    ---------------------------------------------------------------------------
        \58\ The same problem would obtain under the Doggett Bill, because
    it would require a statement signed by a senior financial officer as to
    the truth of the underlying facts.
    ---------------------------------------------------------------------------
        c. The recommendation in the JCT Study that transactions be
    disclosed to shareholders if the understatement penalty is at
    least $1 million undercuts the materiality standards currently
    used by the SEC. It also continues a peculiar and troublesome
    precedent by giving the tax writing Committees direct
    jurisdiction over disclosures required by the securities laws.
    Moreover, while the JCT Study implies that disclosure would
    deter inappropriate tax planning because management would not
    want to be criticized, the opposite may well be true. In the
    context of a system that imposes penalties on routine tax
    planning, when (as described below) a corporation will be
    penalized even if it has a better than 50-50 chance of
    prevailing, an occasional penalty may be viewed (correctly) as
    evidence that management is properly discharging its fiduciary
    duties to shareholders.
        d. Two other forms of administrative burden are critically
    important but not addressed by either the White Paper or the
    JCT Study. The stakes associated with disclosure and
    certification are quite high. The failure to make proper
    disclosure will trigger a forty percent penalty that cannot be
    waived if the matter involves a Reportable Transaction and the
    taxpayer loses on the merits. The failure to make proper
    disclosure will trigger a twenty percent penalty that cannot be
    waived if the matter involves a Covered Transaction that is not
    a Reportable Transaction if the taxpayer satisfies the
    substantial authority standard but does not satisfy the more
    likely than not standard. The certification requirement is a
    threat that speaks for itself in the hands of a revenue agent.
    Under these circumstances, taxpayers could and would be subject
    to two examinations by the IRS--one regarding the correctness
    of their tax returns and another regarding the question of
    whether each item challenged by the IRS was a Covered
    Transaction, whether each Covered Transaction was a Reportable
    Transaction, and whether the disclosure (if any) satisfied the
    long-form disclosure requirements.
        Not only is this ``second examination'' itself a source of
    substantial administrative burden, but the disclosure
    requirements will also increase burdens associated with the
    examination of the taxpayer's return. This will occur for two
    reasons. First, any time a matter is disclosed, the IRS revenue
    agent will need to review the disclosure and likely feel
    compelled to discuss the matter with the taxpayer. Given the
    breadth of the definition of Covered Transactions, this will
    result in substantial wasted time by taxpayers and the IRS.
    Second, the long-form disclosure requirements can be read to
    require a discussion of all potential theories that the IRS
    could use to attack the transaction, including those that have
    little merit (especially, given the stakes associated with
    inadequate disclosure and the fact that a disclosure may be
    inadequate even if the facts and issues that ultimately
    determine the outcome of the case are fully disclosed).\59\ In
    the real world of IRS audits, revenue agents routinely assert
    any and all theories to support a proposed adjustment,
    including many that are groundless. Under these circumstances,
    the disclosure requirements are a ticket to expensive, time-
    consuming, and needless arguments over theories that should not
    be raised.
    ---------------------------------------------------------------------------
        \59\ Although the JCT Study would require only ``a summary and
    analysis of the corporate participant's rationale and analysis
    underlying the tax treatment of the Reportable Transaction including
    the substantive authority relied upon to support such treatment,'' the
    reality of corporate tax practice and the advice provided corporate
    taxpayers by their tax advisors is that a corporate tax director will
    analyze all of the authorities that potentially apply to the purported
    tax treatment, including any contrary authorities and any authorities
    that an IRS agent might attempt to apply to disregard the purported tax
    treatment. In this regard, it is worth noting that the IRS always
    requires a taxpayer requesting a private letter ruling to identify and
    discuss any contrary authorities. See Rev. Proc. 99-1, 1999-1 I.R.B. 6.

    3. The Proposed Penalty Structure Amounts to a Strict Liability
    ---------------------------------------------------------------------------
    Sanction on Most Tax Planning Activities

        Despite its claim to the contrary, the JCT Study's
    substantial understatement penalty recommendations amount to a
    ``strict liability'' penalty on Covered Transactions.\60\ As a
    preliminary matter, the penalty could not be waived or
    compromised by the IRS. Thus, IRS agents would be obligated to
    assert the penalty on all Covered Transactions when the IRS
    proposes a tax deficiency. As noted above, these
    recommendations, which are based on the JCT Study's definition
    of corporate tax shelters, encompass a range of legitimate tax
    planning activities which, in the corporate context, covers
    most transactions and many routine business operations.
    ---------------------------------------------------------------------------
        \60\ In contrast to the intent of the JCT Study, the Doggett Bill
    intentionally would create a strict liability penalty (i.e., non-
    waivable penalties), with no exceptions for substantial authority or
    reasonable cause.
    ---------------------------------------------------------------------------
        Simply reciting the Joint Committee's proposed rules with
    respect to the ability to abate the substantial understatement
    penalty demonstrates their substantive and procedural
    complexity. To wit:
          If a taxpayer engages in a Covered Transaction
    that is a Reportable Transaction, it would be subject to a non-
    waivable forty percent penalty unless (i) the taxpayer wins on
    the merits or (ii) the taxpayer establishes that: (A) it
    properly disclosed the transaction, (B) it satisfied the
    seventy-five percent standard, and (C) the transaction served a
    Material Non-tax Business Purpose.
          If a taxpayer engages in a Covered Transaction
    that is not a Reportable Transaction, it would be subject to a
    non-waivable forty percent penalty unless (i) the taxpayer wins
    on the merits or (ii) the taxpayer establishes that: (A) it
    satisfied the seventy-five percent standard and (B) the
    transaction served a Material Non-tax Business Purpose.
          If a taxpayer engages in a Covered Transaction
    that is a Reportable Transaction (and does not win on the
    merits), the forty percent penalty would be reduced to a non-
    waivable twenty percent penalty only if the taxpayer can
    establish that (i) the taxpayer properly disclosed the
    transaction and (ii) the taxpayer satisfied the substantial
    authority (forty percent) standard.
          If a taxpayer engages in a Covered Transaction
    that is not a Reportable Transaction (and does not win on the
    merits), the forty percent penalty would be reduced to a non-
    waivable twenty percent penalty only if (i) the taxpayer can
    establish that (A) the taxpayer properly disclosed the
    transaction and (B) the taxpayer satisfied the substantial
    authority (forty percent) standard, or (ii) the taxpayer can
    establish that it satisfied the more likely than not standard.
        What is important to note are the circumstances in which
    taxpayers will be subject to strict liability (i.e., non-
    waivable) penalties if they do not prevail on the merits.
    Following are a few of the many striking examples:
          A corporate taxpayer engages in a Covered
    Transaction (i.e., a transaction that involves tax planning)
    that it fully discloses, under circumstances where it has a
    Material Non-tax Business Purpose and reasonably believes that
    it has a better than fifty percent--but less than a seventy-
    five percent--chance of prevailing in litigation. The
    corporation is subject to a non-waivable penalty unless it wins
    its case in court or obtains a greater than seventy-five
    percent concession from the government.\61\
    ---------------------------------------------------------------------------
        \61\ Presumably, when the IRS concedes more than seventy-five
    percent of an issue, the IRS would also concede that the taxpayer
    satisfied the highly confident standard.
    ---------------------------------------------------------------------------
          A corporate taxpayer engages in a Covered
    Transaction that is a Reportable Transaction under
    circumstances where reasonable tax professionals believe that
    the taxpayer has better than a seventy-five percent chance of
    sustaining the claimed tax treatment, and the taxpayer has a
    Material-Non Tax Business Purpose for engaging in the
    transaction. The taxpayer discloses the transaction, but omits
    certain of the information required by the disclosure rules. If
    the corporation loses the case in litigation, or concedes more
    than twenty-five percent of the issue in settlement, it will be
    subject to a non-waivable forty percent penalty.\62\
    ---------------------------------------------------------------------------
        \62\ Presumably, when a taxpayer concedes more than twenty-five
    percent of an issue, the taxpayer will be hard pressed to convince the
    IRS that it satisfied the highly confident standard.
    ---------------------------------------------------------------------------
          A corporate taxpayer engages in a transaction
    under circumstances where it reasonably believes that it has a
    better than one-in-three chance of prevailing, but less than a
    four-in-ten chance of prevailing, and it fully discloses the
    transaction on its return. If the taxpayer does not prevail in
    litigation, the taxpayer will be subject to a non-waivable
    penalty of at least twenty percent.
          A corporate taxpayer will be subject to a non-
    waivable penalty with respect to Covered Transactions if it
    cannot convince the (undeniably reasonable) judge who has just
    decided the case against it that a reasonable professional
    would believe that the taxpayer had a better than seventy-five
    percent chance of prevailing.
        The last example is one illustration of a more general
    point regarding the highly confident standard. The taxpayer can
    satisfy this standard only if it can establish that ``a
    reasonable tax practitioner'' would believe that the taxpayer
    had at least a seventy-five percent chance of prevailing on the
    merits. As a practical matter, this standard is unworkable. It
    means that the IRS revenue agent would have to conclude that
    proposed adjustment was proper, but that ``reasonable tax
    practitioners'' (including, presumably, the IRS revenue agent
    proposing the adjustment) would believe that the taxpayer had
    at least a seventy-five percent chance of prevailing. Likewise,
    it is difficult to envision an appeals officer settling an item
    by conceding less than seventy-five percent of the issue, yet
    concluding that the taxpayer had a better than seventy-five
    percent chance of prevailing. Finally, a court would have to
    conclude that the taxpayer was wrong on the merits, but that
    reasonable tax professionals (including, presumably, the judge
    hearing the matter) would believe that the taxpayer had a
    seventy-five percent chance of success. While all of this may
    be possible in theory, the practical effect is that the
    taxpayer will be liable for the penalty if the taxpayer loses
    on the merits.
        Once again, the starting point is the breadth of the
    definition of Covered Transactions. These and other examples
    make it clear that the JCT Study's proposal amounts to a strict
    liability penalty on routine tax planning activities, and on
    the inevitable foot faults that will occur in complying with a
    complex set of rules. The fact that this is a strict liability
    standard in the ``real world'' is already acknowledged by the
    IRS: appeals officers are instructed to concede cases when the
    taxpayer has a better than eighty percent chance of success.
        Two other practical implications of this regime are worth
    noting. First, as noted above, the JCT Study proposals would
    distort and undermine the settlement process. More
    fundamentally, while not stated in so many words, the JCT Study
    proposes going to a system where the only way that a corporate
    taxpayer can be certain to avoid penalties with respect to any
    item on its return is to pay taxes with respect to that item,
    file a claim for refund that is denied, and commence litigation
    in District Court or Claims Court.\63\ In essence, the JCT
    Study is saying that when the outcome of a transaction that
    involves tax planning is less than certain, the taxpayer should
    overpay its taxes and sue for a refund.
    ---------------------------------------------------------------------------
        \63\ This assumes that because the taxpayer will not owe additional
    taxes, it will not be subject to penalty--even if the taxpayer's claim
    is substantially or entirely without merit.
    ---------------------------------------------------------------------------
        While the many implications of this regime are beyond the
    scope of this paper, it is obvious that the JCT Study is
    recommending a far-reaching and fundamental change in our
    system of voluntary compliance and dispute resolution.

    4. The Proposed Penalties on Tax Return Preparers, together
    with the Proposed Penalties on Third Parties Involved in
    Covered Transactions, Would Create Fundamental Conflicts of
    Interest Between Taxpayers and their Advisors

        The JCT Study creates fundamental and irreconcilable
    conflicts between a taxpayer and its advisors. Quite simply,
    all return preparers, and all those involved in advising
    corporations regarding Covered Transactions, have an
    overwhelming incentive to make certain that the taxpayer
    overpays its (his or her) taxes.
        a. The JCT Study recommends penalties on tax professionals
    that will routinely exceed their net after-tax income. The JCT
    Study proposes increasing the first tier tax return preparer
    penalty to the greater of $250 or fifty percent of the
    preparer's fee.\64\ The preparer can avoid this penalty only
    if: (i) the item satisfies the more likely than not standard or
    (ii) is properly disclosed and satisfies the 4-in-10 standard.
    It also recommends a penalty equal to the greater of $100,000
    or fifty percent of the tax advisor's fees if the advisor
    directly or indirectly advises the taxpayer that it has a
    better than seventy-five percent chance of prevailing on the
    merits with respect to a Covered Transaction.
    ---------------------------------------------------------------------------
        \64\ The JCT Study also recommends increasing the second tier
    penalty to the greater of $1,000 or one hundred percent of the
    preparer's fees.
    ---------------------------------------------------------------------------
        b. The JCT Study would authorize the IRS Director of
    Practice to impose further penalties on tax professionals,
    including sanctions that could prevent them from continuing to
    represent or advise taxpayers. While it is somewhat cryptic,
    the JCT Study appears to recommend that Congress: (i) provide
    specific statutory authorization for Circular 230; (ii) require
    that the IRS modify Circular 230 to conform to the JCT Study's
    recommendations (including but not limited to the corporate tax
    shelter proposals); (iii) define practice before the IRS to
    include the rendering of tax advice; (iv) require automatic
    referral to the Director of Practice whenever a preparer or
    advisor is subject to a penalty; (v) authorize the Director of
    Practice to impose monetary sanctions of up to one hundred
    percent of the fees received by preparers and advisors with
    respect to sanctioned conduct; (vi) authorize the Director of
    Practice to suspend or revoke the right of the preparer or
    advisor to practice before the IRS (including, the rendering of
    tax advice); and (vii) require the Director of Practice to
    notify the appropriate state licensing authorities if the
    advisor or preparer is subject to any sanction (including, a
    letter of reprimand). While not entirely clear, it appears that
    tax professionals could be liable for both the preparer
    penalties and Circular 230 monetary sanctions in connection
    with the same transaction.
        In other words, the Code-based penalties on preparers and
    advisors could well amount to more than one hundred percent of
    their after-tax income.\65\ Under circumstances where these
    penalties are triggered, the preparer or advisor must be
    referred to the Director of Practice who has the authority to
    impose another penalty equal to more than the preparer's or
    advisor's pre-tax/pre-Code penalty income. Not to mention the
    fact that the Director of Practice can take away the preparer's
    or advisor's future right to make a living as a tax
    professional, and the fact that if the Director so much as
    issues a letter of reprimand, the preparer or advisor must be
    prepared to defend himself or herself before state licensing
    authorities.
    ---------------------------------------------------------------------------
        \65\ See supra footnote 11.
    ---------------------------------------------------------------------------
        With this penalty and sanctions structure as background, it
    is worth revisiting when advisors and preparers will be subject
    to the Code-based penalties and the chain of events that those
    penalties will trigger:
          All return preparers (including those
    representing non-corporate taxpayers, and including those
    representing corporations on matters that are not Covered
    Transactions) are subject to a penalty if the return position
    has a less than forty percent chance of success on the merits.
          All return preparers are subject to a penalty if
    the return position has a forty percent or greater chance of
    success, but less than a fifty percent chance of success,
    unless the item meets the applicable disclosure rules.
          All those involved in advising a corporate
    taxpayer are subject to a penalty if they advise the taxpayer
    with respect to a Covered Transaction (i.e., routine tax
    planning activities) that it satisfies the highly confident
    standard under circumstances where the taxpayer ultimately does
    not prevail on the merits.\66\
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        \66\ The advisor penalty is a strict liability sanction for two
    reasons. First, as noted above, advisors are subject to an even higher
    ``highly confident'' standard than corporate taxpayers (advisors
    apparently fail to satisfy this standard if even one reasonable
    professional would conclude that the taxpayer had less than a seventy-
    five percent chance of succeeding on the merits). Moreover, as noted
    above, there is no realistic possibility that a court would decide
    against the taxpayer and then conclude that all reasonable tax
    professionals believed that the taxpayer had a better than seventy-five
    percent chance of success.
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        When all of these proposals are viewed together, it is
    clear that preparers and advisors have overwhelming incentives
    to: (i) make certain that taxpayers call every close question
    (and most not-so-close questions) in favor of the IRS; (ii)
    make certain that taxpayers disclose questionable items and
    make certain that the disclosure is overly broad; (iii)
    encourage taxpayers to overpay their taxes and sue for refunds;
    and (iv) document their communications with their clients in a
    way that serves their own best interests, and to disclose
    client confidences as a means of defending against penalty
    assertions.

    The JCT Study's Proposals Violate All Four Criteria That Should Be Used
     in Evaluating Legislative Proposals to Address Corporate Tax Shelters

    1. The Recommendations Made in the JCT Study Would Interfere With
    Mainstream Business Transactions and Ordinary Tax Planning Activities

        While the JCT Study sets forth comprehensive and well-intended
    proposals for fundamental reform of the rules governing taxpayer
    compliance, we believe that significant issues exist with these
    proposals and that they would benefit from further review. For a number
    of reasons, the JCT Study's proposal would inhibit routine business
    transactions and customary tax planning activities. Most obvious, of
    course, are the administrative costs, reporting burdens and strict
    liability penalties that would be imposed on corporate taxpayers. The
    underlying definition of Covered Transactions is so broad, and the
    sanctions are so draconian, that taxpayers will minimize their costs
    and their risks by simply not engaging in widely accepted, and entirely
    appropriate, tax planning activities.
        The less obvious, but equally important reason, is that preparers
    and advisors have an overwhelming incentive to discourage tax planning
    under circumstances where their risks are substantially
    disproportionate to their potential benefits. The JCT Study asserts
    that tax professionals have a dual responsibility to their clients and
    the tax system. The practical effect of the JCT Study's recommendations
    is to require that preparers and advisors show single-minded devotion
    to the IRS. It is inevitable that under this regime taxpayers will not
    engage in entirely appropriate tax planning activities--unless they are
    big enough, and have sufficient cash, to internalize the process and
    routinely engage in refund litigation.\67\
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        \67\ As noted above, The JCT Study implicitly stands for the
    proposition that taxpayers can engage in any type of tax planning they
    choose--but only if they are willing to pre-pay their taxes and sue for
    a refund. It seems apparent that this construct will, in the real
    world, materially inhibit legitimate tax planning.
    ---------------------------------------------------------------------------
        The question posed above was whether the White Paper and JCT Study
    recommendations would impede legitimate tax planning. The answer to
    that question is unequivocally yes.

    2. The Recommendations Made in the JCT Study Would Impose Needless
    Complexity

        The rules recommended in the JCT Study are overly complex for a
    multitude of reasons, including the following:
          They raise difficult questions of substantive
    interpretation and application (what is a Covered Transaction, is a
    Covered Transaction a Reportable Transaction, is disclosure required,
    is the disclosure adequate, are the taxpayer's odds of success 74% or
    76%, 49% or 51%, 39% or 41%).
          They codify a two-tier audit system: the correctness of
    the taxpayer's return and the taxpayer's compliance with disclosure
    rules and penalty provisions.
          They create ``cliff'' effects that the tax system should
    avoid (the taxpayer's liability for penalties can fluctuate
    dramatically depending upon a one percent swing in its chances of
    success).
          Given the scope of Covered Transactions, the disclosure
    and certification requirements are extremely burdensome.
          They place a premium on needless documentation of routine
    transactions and activities by taxpayers, preparers and advisors.
          The 30-Day Disclosure requirement is extremely burdensome
    and entirely unnecessary.
          They impose significant practical barriers to the
    settlement of most tax disputes.

    3. The Recommendations Made in the JCT Study Violate Basic Notions of
    Fairness and Equity

        The recommendations made in the JCT Study, which was written in
    response to a congressional request for legislative recommendations to
    simplify penalty or interest administration and reduce taxpayer burden,
    violate fundamental notions of neutrality and fair play in many
    respects.
          For the reasons explained above, they create a structural
    bias that will cause taxpayers to systematically over-pay their taxes.
          They arm IRS revenue agents, appeals officers, and
    attorneys with the weapons to extract inappropriate concessions from
    taxpayers (both directly, and through pressure on taxpayer
    representatives). It is absolutely certain that these weapons will be
    used improperly by some IRS employees (because they don't understand
    the rules or are overzealous).
          The proposals permit the government to avoid
    accountability for the rules that it writes. As both the JCT Study and
    the White Paper acknowledge, many of the transactions targeted by their
    recommendations result from the complexity of the Code and attempts to
    exploit inconsistencies in the tax law.\68\ The White Paper and JCT
    Study proposals reduce any incentive that the government might
    otherwise have to write neutral rules and simplify the tax system.
    ---------------------------------------------------------------------------
        \68\ See JCT Study at 207; White Paper at 17. For example, both the
    installment sale transactions and the transactions involving transfers
    of property subject to liabilities, which are identified as examples of
    corporate tax shelters by the JCT Study and the White Paper, involved
    attempts to exploit inconsistencies in the tax law and the IRS's
    interpretation of complex rules.
    ---------------------------------------------------------------------------
          The proposals impose standards on taxpayers and third
    parties that are far more onerous than the standards imposed on the
    government. The JCT Study and the White paper emphasize the importance
    of the public's confidence in the basic fairness of the tax system. One
    sure way to destroy this confidence is to impose onerous requirements
    on citizens that the government refuses to live by. The White Paper and
    JCT Study proposals violate this fundamental norm of good government.
    To cite a few examples, IRS agents can assert frivolous positions
    against taxpayers with no consequences to the institution or the
    individuals involved. IRS attorneys can advise their IRS clients to
    take frivolous positions against taxpayers with no financial or
    professional consequences to them. The IRS can issue 30-day and 90-day
    letters challenging Covered Transactions that do not include the
    information required of taxpayers in their disclosure statements. The
    District Director is not required to certify under penalties of perjury
    that a 30-day or 90-day letter challenging Covered Transactions is
    true, accurate and complete. The courts are instructed to enjoin the
    marketing of a Covered Transaction even when the IRS has no realistic
    possibility of success on the merits.
        For these and other reasons, the response to the third question is
    also yes. The White Paper and JCT Report do violate basic notions of
    fairness and equity.
        4. The Recommendations Made in the JCT Study Would Result in
    Arbitrary and Hidden Tax Increases
        The White Paper and JCT Study proposals amount to an arbitrary and
    hidden tax increase for all of the reasons noted above. Taxpayers are
    given strong incentives to over pay their taxes, and preparers are
    given stronger incentives to make sure that happens. The IRS is given
    weapons to extract inappropriate concessions from taxpayers, and
    preparers are given incentives to make certain that taxpayers go
    along.\69\ Not only would the proposals result in a tax increase, they
    would result in the worst kind of tax increase--one that is not
    transparent, is not neutral, and can be arbitrarily imposed by
    individual employees of the government.
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        \69\ One way to illustrate this point is to use the JCT Study's own
    assumptions regarding behavior. If the proposals are successful in
    assuring that taxpayers generally take taxpayer-favorable positions
    only when their chances of success are forty percent or greater, and
    generally engage in Reportable Transactions only when their chances for
    success are greater than seventy-five percent, then taxpayers will
    necessarily over pay their taxes. This is especially true under
    circumstances where the IRS can (and routinely does) assert claims when
    it's chances of success range from zero to forty percent.
    ---------------------------------------------------------------------------
        The proposals would also result in a second kind of equally
    troublesome tax increase in the form of increased dead-weight
    compliance costs. While these costs are not technically ``tax
    increases,'' they have the same practical effect.

                                   Conclusion

        There is no evidence that corporate tax shelters are
    severely eroding the corporate tax base. While concerns have
    been expressed, the IRS is pursuing enforcement efforts,
    including the assertion of penalties, and the courts have sided
    with the IRS in a number of well-publicized cases. The Treasury
    Department is issuing regulations (including retroactive rules)
    to address transactions that it finds troublesome.\70\ At some
    point, the IRS and the Treasury Department will implement the
    tax shelter registration legislation that was enacted in 1997.
    The audit cycles for returns filed after the enactment of the
    changes made in 1997 to the penalties with respect to corporate
    tax shelters will begin in the next several years. IRS agents
    are increasingly making use of recent IRS court victories to
    attack transactions on economic substance and similar
    grounds.\71\ These developments are of relatively recent
    vintage, and will likely begin having an impact on taxpayer
    behavior. Under these circumstances, we do not believe that the
    case has been made that more legislation is necessary at this
    time.
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        \70\ Moreover, even when the Treasury Department is not certain
    whether a transaction is troublesome, it increasingly attaches broad
    anti-abuse rules to otherwise objective regulations. See, e.g., Treas.
    Reg. Sec. 1.367(e)-2(d) (establishing broad anti-abuse rule authorizing
    the IRS to require gain recognition on otherwise tax-free liquidations
    ``when a principal purpose of the liquidation is the avoidance of U.S.
    tax'').
        \71\ See, e.g., T.A.M. 199934002 (May 24, 1999) (applying ACM
    Partnership and similar authorities to conclude that the taxpayer's
    nontax motives for securing its promises to pay employee benefits
    lacked sufficient economic substance to cause them to be respected for
    Federal tax purposes).
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        There are some who believe that the pendulum is already
    starting to move in the other direction, and that the primary
    challenge facing IRS executives and the Congress will be
    reining in overzealous enforcement and litigation activity by
    the IRS. In particular, as the courts place more reliance on
    the ``common law'' doctrines described in the JCT Study, there
    is an increased risk that the IRS will move away from the
    ``rules based'' system that the JCT Study endorses. In this
    regard, it is already clear that IRS agents are starting to
    rely on these common law principles in situations that are
    wholly inappropriate and at the expense of the rules that have
    been crafted by the Congress.\72\
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        \72\ See, e.g., FSA 199935019 (June 1, 1999) (IRS National Office
    instructed agent that ACM Partnership and other economic substance
    cases were not applicable to transactions involving contributions to
    capital); T.A.M. 9818004 (December 24, 1997) (IRS National Office
    refusing to revoke a letter ruling allowing the taxpayer to change its
    method of accounting for service contracts, finding that Ford Motor Co.
    was not applicable).
    ---------------------------------------------------------------------------
        Moreover, we believe that legislation would be ill-advised
    because the risks are high that the proposals advanced to date
    would do more harm than good. This concern is compounded by the
    realities of the legislative process. If the Congress enacts
    legislation that leads to the adverse results that we and
    others anticipate, revenue estimating conventions and the
    budget process would prevent the Congress from undoing the
    damage. Indeed, the worse the adverse impact, the more
    difficult it would be to remedy the situation.
        Accordingly, we respectfully recommend that the Congress
    instruct the Treasury Department to promulgate the regulations
    that were required in 1997, and to identify specific areas of
    the substantive tax law in which changes may be necessary.
    Moreover, we recommend that the Congress instruct the IRS to
    develop a system of obtaining statistically valid quantitative
    data to indicate where the IRS should focus its enforcement
    efforts and where there are defects in the tax system that
    require legislative action. In addition, to make certain that
    the IRS has the resources it needs to make use of the tools
    already available to it, Congress should continue to provide
    adequate funding to the IRS (as it already has for the current
    fiscal year).

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