U.S. GOVERNMENT PRINTING OFFICE

66–992 CC WASHINGTON : 2001

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

(

For sale by the U.S. Government Printing Office

Superintendent of Documents, Congressional Sales Office, Washington, DC 20402

ii

COMMITTEE ON WAYS AND MEANS

BILL ARCHER, Texas, Chairman

PHILIP M. CRANE, Illinois

BILL THOMAS, California

E. CLAY SHAW, JR., Florida

NANCY L. JOHNSON, Connecticut

AMO HOUGHTON, New York

WALLY HERGER, California

JIM MCCRERY, Louisiana

DAVE CAMP, Michigan

JIM RAMSTAD, Minnesota

JIM NUSSLE, Iowa

SAM JOHNSON, Texas

JENNIFER DUNN, Washington

MAC COLLINS, Georgia

ROB PORTMAN, Ohio

PHILIP S. ENGLISH, Pennsylvania

WES WATKINS, Oklahoma

J.D. HAYWORTH, Arizona

JERRY WELLER, Illinois

KENNY HULSHOF, Missouri

SCOTT MCINNIS, Colorado

RON LEWIS, Kentucky

MARK FOLEY, Florida

CHARLES B. RANGEL, New York

FORTNEY PETE STARK, California

ROBERT T. MATSUI, California

WILLIAM J. COYNE, Pennsylvania

SANDER M. LEVIN, Michigan

BENJAMIN L. CARDIN, Maryland

JIM MCDERMOTT, Washington

GERALD D. KLECZKA, Wisconsin

JOHN LEWIS, Georgia

RICHARD E. NEAL, Massachusetts

MICHAEL R. MCNULTY, New York

WILLIAM J. JEFFERSON, Louisiana

JOHN S. TANNER, Tennessee

XAVIER BECERRA, California

KAREN L. THURMAN, Florida

LLOYD DOGGETT, Texas

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.

iii

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

(1)

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:]

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ADVISORY

FROM THE COMMITTEE ON WAYS AND MEANS

FOR IMMEDIATE RELEASE CONTACT: (202) 225–1721

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

3

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.

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3. A witness appearing at a public hearing, or submitting a statement for the record of a public hearing, or submitting written comments in response to a published request for comments

by the Committee, must include on his statement or submission a list of all clients, persons,

or organizations on whose behalf the witness appears.

4. A supplemental sheet must accompany each statement listing the name, company, address,

telephone and fax numbers where the witness or the designated representative may be reached.

This supplemental sheet will not be included in the printed record.

The above restrictions and limitations apply only to material being submitted for

printing. Statements and exhibits or supplementary material submitted solely for

distribution to the Members, the press, and the public during the course of a public

hearing may be submitted in other forms.

Note: All Committee advisories and news releases are available on the World

Wide Web at ‘http://www.waysandmeans.house.gov’’.

The Committee seeks to make its facilities accessible to persons with disabilities.

If you are in need of special accommodations, please call 202–225–1721 or 202–226–

3411 TTD/TTY in advance of the event (four business days notice is requested).

Questions with regard to special accommodation needs in general (including availability of Committee materials in alternative formats) may be directed to the Committee as noted above.

***NOTICE

f—CHANGE IN TIME***

ADVISORY

FROM THE COMMITTEE ON WAYS AND MEANS

FOR IMMEDIATE RELEASE CONTACT: (202) 225–1721

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

Chairman A

The Chair invites all of our guests to take seats.

–14, dated October 26, 1999.)

RCHER. The Committee will come to order.

f 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

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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

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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

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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 

fraises $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.

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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.

9

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

10

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 highpriced 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.

11

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.

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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 (§ 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 (§ 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 (§ 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 (§ 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 (§ 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.

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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 be- lieve 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 (§ 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 

Chairman ARCHER

‘em out.

. Again, the Chair

’’

f’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

14

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

15

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

16

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 indicaVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00020 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
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tion 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 repVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00021 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
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resentative 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 chairVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00022 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
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man 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.

20

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 playVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00024 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
21

ing 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,

22

‘‘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

23

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

24

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 shelVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00028 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
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ters. 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 socalled 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 socalled chutzpah trusts, which were similar to a structure shut

26

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, inVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00030 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
27

creased 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 ap- proach similar to the administration’s proposal, including the codi- fication 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 ef- fective 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 trans- actions, 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

28

1See, 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).

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.

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.

29

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.’’ 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.

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.

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.

30

4Other 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.

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

31

5Pub. L. No. 104–191, § 501 (1996); Pub. L. No. 105–34, § 1084 (1997) 6Kenneth 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). 7Pub. L. No. 105–277, § 3001(a) (1998). 8 Rev. Rul. 99–14, 1994–14 I.R.B. 3. 9Pub. L. No. 106–36, § 3001 (1999). 10Prop. Reg. § 1.7701(l)–3.

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

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.

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.

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.

5. Proposed regulations 10 addressing fast-pay preferred stock transactions. These

financing transactions purportedly allowed taxpayers to deduct both principal and

32

11 1998–3 I.R.B. 49. 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). 14Lawrence H. Summers, ‘‘A Better Tax Service and a Better Tax System,’’ Tax Executives

Institute, March 22, 1999. 15So 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. 16See Tom Herman, Tax Report, Wall St. J. at A–1 (Feb. 10, 1999).

interest. It was reported that one investment bank created nearly $8 billion of investments in a few months.

6. Notice 98–5 11 dealing with foreign tax credit abuses.

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.

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

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

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-bytransaction 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.

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.

33

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.

34

17These criticisms were addressed by the Treasury Department by modifying the definition

of these terms.

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. § 1.6664–4 as to what constitutes reasonable cause, these requirements

would be codified to heighten visibility and strengthened to the extent necessary.

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 shelVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00038 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
35

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

ters, 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. 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 lowincome 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, Hin- chey 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 taxdriven transaction should have an incentive to make certain that the transaction

is within the law.’’ With respect to corporate tax shelters, the ‘‘other parties’’ gen- erally 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 ‘‘cookiecutter’’ tax shelter products then being developed. Similar provisions could be en- acted 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

36

20 BNA Daily Tax Report (Oct. 28, 1999), G–2.

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.’’

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

37

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. M

STATEMENT OF LINDY PAULL, CHIEF OF STAFF, JOINT

CCRERY. Ms. Paull.

fCOMMITTEE 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

38

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

39

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 enVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00043 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
40

ters 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 corVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00044 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
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1This 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. 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. 5 Code section 6662.

poration, 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

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

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

42

6 Code sections 6694 and 6695.

7 Code section 6701.

8 Code section 6700.

9 Code sections 6111 and 6112.

10 Code sections 6707 and 6708. 11 Code sections 269, 446, 482 and 7701(l). 12The 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.

13See 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.

(2) Income tax return preparers may be liable for a penalty with respect

to an understatement of a taxpayer’s liabilities.6

(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

(4) Penalties may be imposed on those who promote abusive tax shelters.8

(5) Registration requirements apply with respect to tax shelters 9 and penalties are imposed for failing to comply with the registration requirements.10

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,

(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

(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

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

43

14Monthly Treasury Statement regarding Budget Results for Fiscal Year 1999, Department

of the Treasury (October 27, 1999). 15 157 F.3d 231 (3d Cir. 1998), aff’g 73 T.C.M. (CCH) 2189 (1997). 16 113 T.C. No. 17 (September 21, 1999). 17 113 T.C. No. 21 (October 19, 1999).

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.

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.

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.

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

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18The 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.

(‘‘COLI’’) program on the grounds that it lacked both economic substance and busi- ness 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. 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 signifiVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00048 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
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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. 20Treas. Reg. sec. 1.6664–4(e).

cant 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.

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 presentlaw 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 shelters20 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.

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

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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. 22See Barton Massey, ‘‘Circular 230 Changes Unlikely to Address Shelters or Practice of

Law,’’ 1999 TNT 206–5, (Doc 1999–34521), October 26, 1999. 23The imposition of penalties may be a continuing issue in the ACM case.

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.

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

47

24The 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.

whether a tax shelter exists. What is lacking is a meaningful penalty structure that

would significantly alter the cost-benefit calculus. Another important concern with enacting a substantive rule is the inherent dif- ficulty 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 dis- putes 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.

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

48

characterize items of income, gain, loss, deductions, or credits in a more favorable manner than it otherwise could without the involvement of the taxindifferent 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 taxindifferent 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 ac- cepted 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 sancVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00052 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
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tions, 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. H

Mr. HOUGHTON

ULSHOF. Thanks, Mr. Chairman.

. Mr. Hulshof.

f 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

50

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.

51

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?

52

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

53

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

54

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.

55

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 aggresVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00059 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
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sive 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 socalled Chutzpah Trust. Commissioner Rossotti has just announced

an initiative to go and pursue, again aggressively, corporate tax

57

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

58

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.

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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

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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

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1The 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.

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-theproblem 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 aggresVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00065 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
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2We 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.

sive 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. 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 Amer- ican 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 longstanding 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

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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 cor- porate tax shelters—to carefully scrutinize the facts and the legal analysis of pro- posed 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 informaVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00067 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
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tion (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, pro- moters 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?

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3Some 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.

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.

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.

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4The 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.

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. § 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. § 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.

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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 § 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 § 10.35 to read as follows:

§ 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).

68

(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 § 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 § 10.51(j))

violating 

Chairman A

§ 10.33, §

RCHER

10.34 or 

. Mr. Lifson.

§ 10.35of this part.

f 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.

69

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

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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 ap- proach, 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 Amer- ican 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 comVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00074 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
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plex 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 gov- ernment 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 (reg- istration of tax shelters). We suggest a ‘‘reportable transactions’’ regime as a sub- stitute 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 nonrecourse 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

72

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.

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 objec- tive 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 trans- actions 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 ad- versely 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 car- ried 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.

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

73

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.

f 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 inhouse tax professionals in North America. Our 5,000 members repVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00077 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
74

resent 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.

75

1See 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,

Continued

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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1999); Office of Tax Policy, U.S. Department of the Treasury, The Problem of Corporate Tax

Shelters: Discussion, Analysis and Legislative Proposals (July 1999). 2Most 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.

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.

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

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3The 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). 5That 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.’’). 6While recognizing that the precise level of noncompliance owing to so-called tax shelter activ- ity 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-defin- ing tax shelters as any transaction that produces a tax benefit they disagree with), it should

meaningfully contribute to the process.

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 sug- gests 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, judi- cial, 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.

II. WHAT IS THE NATURE AND SCOPE OF THE PERCEIVED CORPORATE TAX SHELTER

PROBLEM?

Before enacting expansive legislation dealing with corporate tax shelters, Con- gress 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 ap- preciate 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 adminisVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00081 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
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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). 8Stated 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.’ ’’). 9The 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? 10TEI 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.

tration 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.

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.

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

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11TEI 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. 12Some 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

Continued

or, at a minimum, the perception of the tax system’s fairness impaired. Hence, action is required.

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

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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(Treas. Reg. § 1.701–2), the anti-conduit financing regulations (Treas. Reg. § 1.881–3 and Prop.

Reg. § 1.7701(l)–2), and recently proposed regulations concerning fast-pay stock (Prop. Reg.

§ 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 fastpay stock (Notice 97–21, 1997–1 C.B. 407), foreign tax credit transactions (Notice 98–5, 1998–

3 I.R.B. 49), and transactions involving foreign hybrid entities (Notice 98–11, 1998–6 I.R.B. 13).

The Treasury has on occasion made its notices retroactive, which by itself dissuades taxpayers

from undertaking transactions that the government might deem abusive. The foregoing list is

not exhaustive, but it does illustrate the Treasury’s and the IRS’s willingness and ability to

challenge abusive transactions without new legislation.

Finally, the Treasury has proven effective in persuading Congress to act to amend the Internal Revenue Code where legislation is necessary to prevent taxpayers from

receiving unintended benefits. Thus, as the Chairman noted when calling this hearing, ‘‘since 1995, (Congress has) stopped $50 billion in tax abuses.’’ An example of such legislation is the amendment earlier this year of section 357(c) to prevent the

artificial creation of basis. See § 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 com- mon 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 cor- porate 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 socalled 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

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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. 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. ¶ 50,340, at 87,755 (C.D. Cal. 1997), aff’d, 99–1 U.S.T.C. ¶

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. 15For 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. 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 cou- pled 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. 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.

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

Stated simply, TEI believes that there can be no substitute for an effective en- forcement 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

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

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

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18Thus, 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. 19While section 6111(d), once operative through the issuance of regulations, will require reg- istration of more transactions, that provision may not work as intended. 20TEI believes that a key to an effective early warning system involving promoters is the de- velopment 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.

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. 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 corpora- tions 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 Com- mittee staff refer repeatedly to the ‘‘audit lottery.’’ Taxpayers do strive to work coop- eratively 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 en- ables 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

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21Lee 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. 22Specifically, 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.

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.

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 taxshelter 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.

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.

For the foregoing reasons, we urge Congress to reject the senior officer attestation

proposal.

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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 volun- tarily disclose errors for administrative resolution.

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 con- sidered 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. 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 tax- payer, 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 tax- payers,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

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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 con- cluding that the taxpayer was wrong on the merits.

confident’’ and ‘‘more likely than not’’ standards may unleash a torrent of disclo- sures 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 con- cluding 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.)

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 com- prehensive 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 ad- dress 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 rev- enue 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 understate- ment 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.

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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

f 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 inVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00090 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
87

creased 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.

88

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-shel- ter 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

89

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 taxshelter 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.

taking your time to come help us try to work our way through this

Chairman ARCHER. The Chair is grateful to all four of you for

f 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.

90

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 repVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00094 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
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resent—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.

92

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

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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.

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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.

95

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

fAICPA 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.

96

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

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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 selfpolicing 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.

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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

99

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?

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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 comVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00104 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
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plicated 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, comanaging 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.

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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.

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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 un- certainty over policy throws into question the remaining proposals

that Treasury continues to promote. In closing, I would simply say that proponents of sweeping cor- porate 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

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1The Problem of Corporate Tax Shelters, Department of the Treasury, July 1999; General Ex- planations of the Administration’s Revenue Proposals, Department of the Treasury, February

1999. 2Study 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]. 3http://www.law.nyu.edu/bankmanj/federalincometax

4See, Martin A Sullivan, ‘‘Despite September Surge, Corporate Tax Receipts Fall Short,’’ 85

Tax Notes 565 (Nov. 1, 1999). 5See, 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.

7The 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.

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.

We conclude that no justification has been presented that would support enact- ment 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 eco- nomic analysis that should be undertaken before adopting sweeping tax policy

changes of the scope envisioned by Treasury and the JCT staff. 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).

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 Manage- ment 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

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8 U.S. Dept. of the Treasury, Monthly Treasury Statement of Receipts and Outlays of the

United States Government. 9See, IRS, Statistics of Income Bulletin, Winter 1998/1999.

be further noted that actual corporate income tax payments for FY 1999 exceeded

the January forecast by more than $2 billion.

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.

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

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.

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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’’). 11See, 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. 13See, General Accounting Office, ‘‘1988 and 1989 Company Effective Tax Rates Higher Than

in Prior Years,’’ GAO/GGD–92–11, August 1992. 14Financial 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.

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 ‘‘cor- porate 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.

Based on adjusted NIPA data, the effective corporate tax rate, measured as fed- eral 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. Standard & Poors publishes SEC 10K data in its Compustat database, which is

updated monthly.14 Based on the August 1999 Compustat data release, effective cor- porate 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. For purposes of this analysis we excluded publicly traded corporations and part- nerships 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

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15These 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. 16Michael Schler, as quoted in the September 1, 1999, Wall Street Journal ‘‘Tax Report,’’ A1.

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 multi- national corporation than for domestic corporations.

Based on financial statement data, the corporate effective tax rate for all corpora- tions (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

In summary, based on audited financial statements, there is no evidence for a de- cline 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. 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

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17Section 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. 18General Explanation of Tax Legislation Enacted in 1997, Staff of the Joint Committee on

Taxation, December 17, 1997 (JCS 23–97). 19Treas. Reg. § 1.701–2. 20Treas. Reg. § 1.1502–32(e).

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’’ over- look 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 trans- actions, the IRS and Treasury have not yet issued regulations providing guidance

on the term ‘‘significant purpose.’’ 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 avoid- ance 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.

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

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21 E.g., Treas. Reg. § 1.1502–13(h) (anti-avoidance rules with respect to the intercompany transaction provisions) and Treas. Reg. § 1.1502–17(c) (anti-avoidance rules with respect to the

consolidated return accounting methods). 22 157 F.3d 231 (3d Cir. 1998). See also Saba Partnership, T.C.M. 1999–359 (10/27/99). 23T.C.M. 1998–305. 24T.C.M. 1999–268. 25 113. T.C. No. 17. 26 113. T.C. No. 21.

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

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.

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 corporateowned life insurance program lacked business purpose and economic substance.

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 NoVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00113 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
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27The 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). 28See, e.g., Notice 95–53, 1995–2 CB 334, and Notice 89–37, 1989–1 CB 679. 29See, e.g., Notice 97–21, 1997–1 CB 407. 30 Notice 96–39, I.R.B. 1996–32. 31Treasury Department Acting Assistant Secretary (Tax Policy) Jonathan Talisman, in an Oc- tober 4 letter to Rep. Lloyd Doggett (D–TX) states that the Administration’s proposals would

not ‘‘unduly’’ interfere with legitimate business transactions. 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

tices 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

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 effec- tive 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

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

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.

111

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). 34Of 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.

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).

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

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.

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

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

112

36Graeme S. Cooper, Tax Avoidance and the Rule of Law, IBFD Publications BV, 1997, p.

10.37 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. 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.

41 ‘‘A General Anti-Avoidance Rule for Direct Taxes: Consultative Document,’’ U.K. Inland

Revenue, October 1998. 42 Id., at 6.5.2.

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

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 taxavoidance—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

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

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

(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

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43Treasury 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. 44These 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.

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

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

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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?

115

45The Problem of Corporate Tax Shelters, supra n.1, at 114. 46 46. JCT study, supra, n.2.

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

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:

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:

116

• 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 taxindifferent 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 treat- ed 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 ‘‘rea- sonably 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.

117

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 arrangeVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00121 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
118

ments 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.

119

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]

Fiscal year GDP

Federal corporate

income tax receipts

Corporate tax receipts as a 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]

Calendar year Federal corp. tax

liability 1

Federal corp. income tax receipts

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

120

Federal Corporate Tax Liability and Receipts, 1980–1999—Continued

[Billions of dollars]

Calendar year Federal corp. tax

liability 1

Federal corp. income tax receipts

Gross Refunds Net

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]

Calendar year GDP

Corp. profits

before tax

(BEA adj.1

Federal corp.

tax liability

(BEA adj.)

Federal corp.

tax liability

(BEA adj.) as

a percent of

corp. profits

before tax

Corp. profits

before tax

(BEA adj.) as

a percent of

GDP

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%

121

Effective Corporate Tax Rate, NIPA, 1980–1999—Continued

[Billions of dollars]

Calendar year GDP

Corp. profits

before tax

(BEA adj.1

Federal corp.

tax liability

(BEA adj.)

Federal corp.

tax liability

(BEA adj.) as

a percent of

corp. profits

before tax

Corp. profits

before tax

(BEA adj.) as

a percent of GDP

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]

Item 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 96Aug 97Aug 98A

A. Companies with foreign operations

U.S. fed. inc. tax liability 1 ............................................................................................................................ $25 $24 $25 $23 $23 $27 $34 $41 $42 $48 $19 $22 $

U.S. oper. inc. after state inc. tax ................................................................................................................ $127 $144 $138 $123 $128 $149 $181 $222 $231 $234 $89 $103 $1U.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 $1,0U.S. revenues ................................................................................................................................................. $1,063 $1,212 $1,313 $1,371 $1,423 $1,373 $1,529 $1,745 $1,794 $1,770 $736 $817 $8U.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% 22.6U.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% 2.2U.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

Number of corps. ........................................................................................................................................... 700 746 806 886 963 820 934 1,057 1,159 1,178 633 633 6

B. Companies without foreign operations

U.S. fed. inc. tax liability 1 ............................................................................................................................ $17 $19 $20 $23 $24 $22 $25 $27 $29 $29 $24 $26 $

U.S. oper. inc. after state inc. tax ................................................................................................................ $106 $116 $118 $123 $136 $115 $130 $149 $157 $157 $131 $144 $1U.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 $2,9U.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 $1,5U.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

.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% 1.0U.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

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 3,3

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 $

U.S. oper. inc. after state inc. tax ................................................................................................................ $233 $261 $256 $246 $264 $264 $310 $372 $387 $391 $220 $247 $2U.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 $3,9U.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 $2,4U.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% 20.7U.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% 1.3U.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

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 3,9

AACurrent provision for tax.AASource: Standard and Poors, Compustat, September 1999; PwC calculations.

123

APPENDIX 5

Net Capital Gains for All Active Corporations, 1980–1996

[Excluding RICs in Billions of dollars]

Year

Net gain on capital assets

Net short-term

gain less net

long-term loss

Net long-term

gain less net

short-term loss

Subtotal

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

Highest standard met Described by an indicator

Disclosure requirements satisfied

Penalty under

present law

Penalty under

staff 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: All Cases ... ...................................... ........................ 20% 40%

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:

Chairman A

—Less than more likely than Not, but greater than reasonable basis.

RCHER. Mr. Hariton, you may proceed.

f

124

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.

125

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.

126

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.

STATEMENT OF MARTIN A. SULLIVAN, PH.D., ECONOMIST, TAX

Chairman ARCHER. Dr. Sullivan.

fANALYSTS, 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

127

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

128

1Tax 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.

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.

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.

129

130

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.)

131

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.

132

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.

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(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 rough- ly 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 As- sociation Tax Section stated: ‘‘We believe that there are serious, and growing, prob- lems 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 foreignheadquartered 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

134

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

Year

Corporation

Income Tax

Receipts

Corporate

Profits (Year

Ending in 3rd

Qtr.)

Corporate

Profits (Year

Ending in 2nd

Qtr.)

Ratio of Corporate Receipts to Profits (End 3rd

Qtr.) [(2)/(3)]

Ratio of Corporate Receipts to Profits (End 2nd

Qtr.[(2)/(4)]

Rate of

Growth Real

Gross Domestic Product

(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%

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Table B.—Calculations Used to Estimate the 1999 ‘‘Shortfall’’ in Corporate Tax Receipts under

Various Assumptions about ‘‘Normal’’ Receipts

3-Year Avg. 5-Year Avg. 10-Year 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

STATEMENT OF DANNY R. CARPENTER, VICE PRESIDENT-FI-

(5) Estimate of 

Chairman A

‘‘Shortfall’’

RCHER

 [(3) times (4)] ............................................................ $11.8 $20.3 $23.6

. Mr. Carpenter, you may proceed.

f NANCE, 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 menVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00139 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
136

tioned. 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 solu- tions. 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 socalled 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

137

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.

Kies, your testimony seems to be different from Dr. Sullivan

Chairman ARCHER. My gratitude to all of you gentlemen. Mr.

f ’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.

138

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

139

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

Year Sullivan (fiscal years) 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,

f 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.

140

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

141

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?

142

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 standVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00146 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
143

ard 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.

144

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 socalled ‘‘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

145

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 trans- actions 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 ques- tion 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 othVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00149 Fmt 6633 Sfmt 6621 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
146

erwise 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

asked. I would be willing to give you time now to respond to those

Mr. MCCRERY. Mr. Kies, there were a number of questions

f 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

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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?

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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.

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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.

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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

151

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,

f 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:]

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1This 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.

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

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.

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2See, e.g., the cover story in the December 14, 1998 edition of Forbes. 3See, e.g., Notice 97–21 and Prop. Treas. Reg. § 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).

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 mar- keting 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 regula- tions 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. 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.

§ 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.

§ 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 conVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00157 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
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4This 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. 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. 7See Tax Notes, April 12, 1999, p. 188.

sequences 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.

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), WinnDixie 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 grand- fathered and go unchallenged. 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.

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.

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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. 9White Paper, p. 96.

10 Id., n. 35

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.

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

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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.

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

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 administra- tive 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, cred- it, 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 au- thority 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.

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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.

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, particuVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00161 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
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13 Again, we believe that H.R. 2255 goes too far by eliminating the reasonable cause exception

even where there is disclosure.

larly in view of taxpayers’ expectations that they will be able to negotiate a settlement during the course of an audit.

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. § 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.

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 taxindifferent 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.

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Regardless of the incidence of the tax, the proposed provision could result in sub- stantial 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 jus- tification 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

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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

fB. 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 largescale 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% ownVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00164 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
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14Member of the Committee principally responsible for the drafting of the letter. 15Member 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.

ers. 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 longterm 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

f 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

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1Study 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’’). 2The 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’’).

products.’’ However, we have been exposed to those ‘‘products’’ in the course of representation of clients to whom ‘‘products’’ have been offered.

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

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 pretax 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.

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4See, e.g., Frank Lyon v. U.S., 435 U.S. 561 (1978).

Leveraged leasing shares most of the same characteristics. The tax investor’s pretax 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 equip- ment 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. 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 re- quired 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 un- dertakings 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 regu- lations 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 de- velop 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 trans- action, 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 pre- mised 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

164

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) 6United Parcel Service of America v. Commissioner, T.C. Memo 1999–26528 (August 9, 1999). 7Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C. No. 21 (October 19, 1999). 8See, United Parcel Service of North America, and Compaq Computer Corporation, supra.

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.

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.

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’’

165

9We 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). 11The 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). 13 Codified at 5 USC § 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. 15Sperry 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).

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 pre- clusion 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.

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

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.

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

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1Staff 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).

2P.L. 105–206 (July 22, 1998). 3See 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’’). 5Section 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.

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.

C

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

OMMENTS ON CORPORATE TAX S

fHELTER 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

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.

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.

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;

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6Department of the Treasury, The Problem of Corporate Tax Shelters: Discussion, Analysis

and Legislative Proposals (July 1999). 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. 8 Unless otherwise indicated, all Section references are to Sections of the Internal Revenue

Code of 1986, as amended (the ‘‘Code’’). 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.

• 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

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

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:

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

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

168

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. § 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

169

10Treas. Reg. § 1.6694–2(b)(1). 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 aftertax 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. 12This 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).

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).

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

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

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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. 14 Id. 15 Compare Section 7425 (establishing a confidentiality privilege for certain taxpayer communications).

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

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

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

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 ‘‘ReVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00174 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
171

portable 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 re- ceipts 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 financ- ing 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

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16The 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).

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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17 CBO, Economic and Budget Outlook, Fiscal Year 2000–2009, January 1999, p. 24. 18 Id. at 27. 19 Id.

Corporate Income Tax Receipts

Year Corporate income

tax receipts Total receipts Percent oftotal

Percent of 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

CBO also notes that corporate profits will decline primarily because of a projected

increase in gross domestic product devoted to depreciation.18

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

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 approVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00177 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
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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 taxindifferent parties that participate in corporate tax shelters. 21See JCT Press Release, 98–2 (December 21, 1998) (emphasis added). 22See Section 1028 of the Taxpayer Relief Act of 1997(enacting Section 6111(d)). 23See 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. 24Section 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).

priately 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.

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

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

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

175

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’’). 27Treas. Reg. Section 1.6664–(4). 28 Internal Revenue Service Form 1120, Schedule M–1. 29The 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. 30GAO, ‘‘Tax Administration—Factors Affecting Results from Large Corporations,’’ p. 1, GAO/

GGD—97–62 (Apr. 1997). 31Despite 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.

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

Many have argued that the success of the 1997 changes to the substantial under- statement 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

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

¶ 50,340) (C.D. Cal. 1997), aff’d 99–1 USTC 87,786 (CCH ¶ 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 PartnerVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00179 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
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32Treas. Reg. § 1.701–2. 33Prop. Treas. Reg. § 1.337(d)–3. 34Treas. Reg. § 1.881–3; Prop. Treas. Reg. § 1.7701(l)–2. 35Temp. Treas. Reg. § 1.894–1T. 36Prop. Treas. Reg. § 1.7701(l)–3. 37 Rev. Rul. 99–14, 1999–13 I.R.B. 3. 38Prop. Treas. Reg. § 1.954–9. 39Prop. Treas. Reg. § 1.643(a)–8. 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.

ship 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

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

177

44See 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). 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.

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

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.

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

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46 Helvering v. Gregory, 69 F.2d 809, 810 (2nd Cir. 1934), aff’d 293 U.S. 465 (1935). 47Tax 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’’). 48Finance 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).

pay the Treasury; there is not even a patriotic duty to increase one’s taxes.46

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

JCT50—agree that legislation should not inhibit legitimate business transactions and tax planning activities. 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 selfassessment 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.

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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. 52We recognize that the word ‘‘avoid’’ may have negative connotations; however, since the

time of Judge Hand’s assertion in Gregory, the ‘‘avoidance’’ of taxes is a universally accepted

description of legitimate tax planning.

The 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 tax- payers; and • impose dead-weight costs in the form of substantial compliance and adminis- trative burdens.

Unfortunately, again for the reasons explained below, the answer to these ques- tions 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. Following are comments on the specific proposals, and an evaluation of those pro- posals 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).

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 exVerDate 20-JUL-2000 13:12 Jan 11, 2001 Jkt 060010 PO 00000 Frm 00183 Fmt 6633 Sfmt 6602 K:\HEARINGS\66992.TXT WAYS1 PsN: WAYS1
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53The 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.’’ 54The Doggett Bill also inappropriately targets transactions involving tax-indifferent parties. 55Similarly, 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.’’

plained below, the Tax Shelter Indicators are explicitly intended to encompass routine tax planning activities and are potentially vague and subjective in their application.53

a. The reasonably expected pre-tax profit from the arrangement is insignificant rel- ative 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 tax- able 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

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., lowincome 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.

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

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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 cor- porations (‘‘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

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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.

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 buyback 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.

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

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57The Doggett Bill also would require duplicative filings, within thirty days of closing a transaction and again with the tax return. 58The 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.

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, es- pecially given the breadth of Covered Transactions. As a preliminary matter, tax- payers 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.

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 disclo- sure requirement makes the certification requirement all that much more onerous.

c. The recommendation in the JCT Study that transactions be disclosed to share- holders 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 occa- sional 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 ad- dressed 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

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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. 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.

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.

3. The Proposed Penalty Structure Amounts to a Strict Liability Sanction on Most

Tax Planning Activities

Despite its claim to the contrary, the JCT Study’s substantial understatement

penalty recommendations amount to a ‘‘strict liability’’ penalty on Covered Transactions.60 As a preliminary matter, the penalty could not be waived or compromised

by the IRS. Thus, IRS agents would be obligated to assert the penalty on all Covered Transactions when the IRS proposes a tax deficiency. As noted above, these

recommendations, which are based on the JCT Study’s definition of corporate tax

shelters, encompass a range of legitimate tax planning activities which, in the corporate context, covers most transactions and many routine business operations.

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

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61Presumably, 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. 62Presumably, 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. 63This 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.

in court or obtains a greater than seventy-five percent concession from the government.61

• 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

• 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.

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

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64The JCT Study also recommends increasing the second tier penalty to the greater of $1,000

or one hundred percent of the preparer’s fees. 65See supra footnote 11. 66The 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.

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.

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.

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

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

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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.

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

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

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68See JCT Study at 207; White Paper at 17. For example, both the installment sale trans- actions 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. 69One way to illustrate this point is to use the JCT Study’s own assumptions regarding be- havior. 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 seventyfive 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. 70Moreover, 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. § 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’’).

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. • 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. The proposals would also result in a second kind of equally troublesome tax in- crease 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

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71See, 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). 72See, 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).

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.

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

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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