[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
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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.
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\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\
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\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
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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\
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\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\
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\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.''
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\20\ BNA Daily Tax Report (Oct. 28, 1999), G-2.
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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\
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\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.
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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\
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\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.
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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\
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\5\ Code section 6662.
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(2) Income tax return preparers may be liable for a penalty
with respect to an understatement of a taxpayer's
liabilities.\6\
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\6\ Code sections 6694 and 6695.
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(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\
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\7\ Code section 6701.
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(4) Penalties may be imposed on those who promote abusive tax
shelters.\8\
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\8\ Code section 6700.
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(5) Registration requirements apply with respect to tax
shelters \9\ and penalties are imposed for failing to comply
with the registration requirements.\10\
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\9\ Code sections 6111 and 6112.
\10\ Code sections 6707 and 6708.
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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,
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\11\ Code sections 269, 446, 482 and 7701(l).
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(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
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\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.
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(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.
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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.
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\14\ Monthly Treasury Statement regarding Budget Results for Fiscal
Year 1999, Department of the Treasury (October 27, 1999).
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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.
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\15\ 157 F.3d 231 (3d Cir. 1998), aff'g 73 T.C.M. (CCH) 2189
(1997).
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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.
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\16\ 113 T.C. No. 17 (September 21, 1999).
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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.
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\17\ 113 T.C. No. 21 (October 19, 1999).
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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.
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\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.
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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.
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\20\ Treas. Reg. sec. 1.6664-4(e).
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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.
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\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.
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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.
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\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.
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\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.
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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.
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\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.
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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\
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\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).
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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.
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\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.
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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.
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\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.
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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.
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\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).
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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.
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\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?
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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.
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\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\
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\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.
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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\
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\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.
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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\
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\13\ It may well be that compliance is affected more by the
certainty (or uncertainty) of application than by the level of the
penalty.
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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\
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\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.
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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\
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\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.
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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.
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\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.
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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.
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\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.
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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.
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\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.
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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.
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\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.
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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.
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\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.
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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.)
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\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.
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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.
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\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.
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\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\
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\9\ See, IRS, Statistics of Income Bulletin, Winter 1998/1999.
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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.
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\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.
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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.
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\13\ See, General Accounting Office, ``1988 and 1989 Company
Effective Tax Rates Higher Than in Prior Years,'' GAO/GGD-92-11, August
1992.
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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.
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\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.
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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\
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\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.
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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.
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\16\ Michael Schler, as quoted in the September 1, 1999, Wall
Street Journal ``Tax Report,'' A1.
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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.''
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\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).
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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.
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\19\ Treas. Reg. Sec. 1.701-2.
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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\
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\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).
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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.
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\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.
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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.
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\24\ T.C.M. 1999-268.
\25\ 113. T.C. No. 17.
\26\ 113. T.C. No. 21.
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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\
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\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).
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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\
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\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.
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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\
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\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.
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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\
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\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).
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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.
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\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).
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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\
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\36\ Graeme S. Cooper, Tax Avoidance and the Rule of Law, IBFD
Publications BV, 1997, p. 10.
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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\
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\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.
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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.
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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\
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\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.
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\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.
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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.
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\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.
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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'').
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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.
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\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).
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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\
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\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.
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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.
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\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).
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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\
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\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).
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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.
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\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'').
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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.
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\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\
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\6\ Department of the Treasury, The Problem of Corporate Tax
Shelters: Discussion, Analysis and Legislative Proposals (July 1999).
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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\
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\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.
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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:
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\8\ Unless otherwise indicated, all Section references are to
Sections of the Internal Revenue Code of 1986, as amended (the
``Code'').
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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\
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\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).
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\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\
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\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.
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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\
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\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.
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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\
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\14\ Id.
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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\
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\15\ Compare Section 7425 (establishing a confidentiality privilege
for certain taxpayer communications).
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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\
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\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\
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\17\ CBO, Economic and Budget Outlook, Fiscal Year 2000-2009,
January 1999, p. 24.
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CBO also notes that corporate profits will decline
primarily because of a projected increase in gross domestic
product devoted to depreciation.\18\
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\18\ Id. at 27.
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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\
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\19\ Id.
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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.
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\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.
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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\
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\21\ See JCT Press Release, 98-2 (December 21, 1998) (emphasis
added).
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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\
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\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\
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\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).
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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\
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\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.
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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\
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\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.
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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\
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\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).
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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.
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\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.
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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\
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\46\ Helvering v. Gregory, 69 F.2d 809, 810 (2nd Cir. 1934), aff'd
293 U.S. 465 (1935).
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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.
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\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).
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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.
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\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.
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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).
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\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.
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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\
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\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.''
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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\
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\54\ The Doggett Bill also inappropriately targets transactions
involving tax-indifferent parties.
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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.
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\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.''
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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.
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\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.
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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.
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\57\ The Doggett Bill also would require duplicative filings,
within thirty days of closing a transaction and again with the tax
return.
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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.
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\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.
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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.
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\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
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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.
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\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.
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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\
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\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.
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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\
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\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.
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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.
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\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.
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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.
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\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.
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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.
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\65\ See supra footnote 11.
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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.
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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.
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\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.
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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.
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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).
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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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