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

                         CORPORATE TAX SHELTERS

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

                                HEARING

                               before the

                      COMMITTEE ON WAYS AND MEANS
                        HOUSE OF REPRESENTATIVES

                       ONE HUNDRED SIXTH CONGRESS

                             FIRST SESSION

                               __________

                           NOVEMBER 10, 1999

                               __________

                             Serial 106-85

                               __________

         Printed for the use of the Committee on Ways and Means

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

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

                      COMMITTEE ON WAYS AND MEANS

                      BILL ARCHER, Texas, Chairman

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

                     A.L. Singleton, Chief of Staff

                  Janice Mays, Minority Chief Counsel

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

                            C O N T E N T S

                               __________

                                                                   Page

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

                               WITNESSES

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

                                 ______

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

                       SUBMISSIONS FOR THE RECORD

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

 
                         CORPORATE TAX SHELTERS

                              ----------                              

                      WEDNESDAY, NOVEMBER 10, 1999

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

ADVISORY

FROM THE COMMITTEE ON WAYS AND MEANS

                                                CONTACT: (202) 225-1721
    FOR IMMEDIATE RELEASE

    October 26, 1999

    FC-14

           Archer Announces Hearing on Corporate Tax Shelters

    Congressman Bill Archer (R-TX), Chairman of the Committee on Ways 
and Means, today announced that the Committee will hold a hearing on 
corporate tax shelters. The hearing will take place on Wednesday, 
November 10, 1999, in the main Committee hearing room, 1100 Longworth 
House Office Building, beginning at 10:00 a.m.
      
    Oral testimony at this hearing will be from both invited and public 
witnesses. Invited witnesses will include representatives of the U.S. 
Department of the Treasury and the Joint Committee on Taxation. Also, 
any individual or organization not scheduled for an oral appearance may 
submit a written statement for consideration by the Committee or for 
inclusion in the printed record of the hearing.
      

BACKGROUND:

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

FOCUS OF THE HEARING:

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

DETAILS FOR SUBMISSIONS OF REQUESTS TO BE HEARD:

      
    Requests to be heard at the hearing must be made by telephone to 
Traci Altman or Pete Davila at (202) 225-1721 no later than the close 
of business, Wednesday, November 3, 1999. The telephone request should 
be followed by a formal written request to A.L. Singleton, Chief of 
Staff, Committee on Ways and Means, U.S. House of Representatives, 1102 
Longworth House Office Building, Washington, D.C. 20515. The staff of 
the Committee will notify by telephone those scheduled to appear as 
soon as possible after the filing deadline. Any questions concerning a 
scheduled appearance should be directed to the Committee staff at (202) 
225-1721.
      
    In view of the limited time available to hear witnesses, the 
Committee may not be able to accommodate all requests to be heard. 
Those persons and organizations not scheduled for an oral appearance 
are encouraged to submit written statements for the record of the 
hearing. All persons requesting to be heard, whether they are scheduled 
for oral testimony or not, will be notified as soon as possible after 
the filing deadline.
      
    Witnesses scheduled to present oral testimony are required to 
summarize briefly their written statements in no more than five 
minutes. THE FIVE-MINUTE RULE WILL BE STRICTLY ENFORCED. The full 
written statement of each witness will be included in the printed 
record, in accordance with House Rules.
      
    In order to assure the most productive use of the limited amount of 
time available to question witnesses, all witnesses scheduled to appear 
before the Committee are required to submit 300 copies, along with an 
IBM compatible 3.5-inch diskette in WordPerfect 5.1 format, of their 
prepared statement for review by Members prior to the hearing. 
Testimony should arrive at the Committee office, room 1102 Longworth 
House Office Building, no later than Monday, November 8, 1999. Failure 
to do so may result in the witness being denied the opportunity to 
testify in person.
      

WRITTEN STATEMENTS IN LIEU OF PERSONAL APPEARANCE:

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

FORMATTING REQUIREMENTS:

      
    Each statement presented for printing to the Committee by a 
witness, any written statement or exhibit submitted for the printed 
record or any written comments in response to a request for written 
comments must conform to the guidelines listed below. Any statement or 
exhibit not in compliance with these guidelines will not be printed, 
but will be maintained in the Committee files for review and use by the 
Committee.
      
    1. All statements and any accompanying exhibits for printing must 
be submitted on an IBM compatible 3.5-inch diskette in WordPerfect 5.1 
format, typed in single space and may not exceed a total of 10 pages 
including attachments. Witnesses are advised that the Committee will 
rely on electronic submissions for printing the official hearing 
record.
      
    2. Copies of whole documents submitted as exhibit material will not 
be accepted for printing. Instead, exhibit material should be 
referenced and quoted or paraphrased. All exhibit material not meeting 
these specifications will be maintained in the Committee files for 
review and use by the Committee.
      
    3. A witness appearing at a public hearing, or submitting a 
statement for the record of a public hearing, or submitting written 
comments in response to a published request for comments by the 
Committee, must include on his statement or submission a list of all 
clients, persons, or organizations on whose behalf the witness appears.
      
    4. A supplemental sheet must accompany each statement listing the 
name, company, address, telephone and fax numbers where the witness or 
the designated representative may be reached. This supplemental sheet 
will not be included in the printed record.
      
    The above restrictions and limitations apply only to material being 
submitted for printing. Statements and exhibits or supplementary 
material submitted solely for distribution to the Members, the press, 
and the public during the course of a public hearing may be submitted 
in other forms.
      

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

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

                                

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

ADVISORY

               FROM THE COMMITTEE ON WAYS AND MEANS

                                                CONTACT: (202) 225-1721
FOR IMMEDIATE RELEASE

,November 5, 1999

No. FC-14-Revised

               Time Change for Full Committee Hearing on

                     Wednesday, November 10, 1999,

                       on Corporate Tax Shelters

    Congressman Bill Archer (R-TX), Chairman of the Committee on Ways 
and Means, today announced that the full Committee hearing on corporate 
tax shelters, previously scheduled for Wednesday, November 10, 1999, at 
10:00 a.m., in the main Committee hearing room, 1100 Longworth House 
Office Building, will begin instead at 11:00 a.m.
      
    All other details for the hearing remain the same. (See full 
Committee press release No. FC-14, dated October 26, 1999.)

      

                                

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

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

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

                                

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

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

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

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

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

                             I. The Problem

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

                          II. The Legislation

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

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

B. Disclosure

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

C. Penalties

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

   III. Reasonable Standards Preserving Normal Business Transactions

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

                                

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

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

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

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

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

                          Reasons for concern

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

           Corporate tax shelters and the corporate tax base

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

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

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Need for legislation

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

Common characteristics

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

Administration proposals

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

Increasing disclosure

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

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

Codify the economic substance doctrine

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

Consequences to other parties

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

JCT Report

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

Compaq and other recent decisions

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

IRS administrative actions

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

Conclusion

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

                                

    Mr. McCrery. Ms. Paull.

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

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

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

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

                             I. Background

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

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

                            II. Methodology

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

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

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

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

                             III. Analysis

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

A. The Corporate Tax Shelter Problem

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

B. Why a Corporate Tax Shelter Problem Exists

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

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

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

D. Alternative Responses

    Maintaining the status quo

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

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

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

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

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

                      IV. Specific Recommendations

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

    Recommendations that affect corporations which participate 
in corporate tax shelters

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

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

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

Recommendations that affect other parties involved in corporate 
tax shelters

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

                Disclosure and registration obligations

A. Corporate taxpayer disclosure

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

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

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

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

B. Tax shelter registration

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

                             V. Conclusion

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

                                

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

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

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

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

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

The Corporate Tax Shelter Problem

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

Circular 230

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

Legislative Recommendations

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

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

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

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

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

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

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

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

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

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

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

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

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

Amplification of Certain Legislative Recommendations

                     Return Disclosure Requirement

a) Rationale.

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

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

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

               Affirmation of Economic Substance Standard

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

                               Conclusion

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

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

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

                                 Report

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

              Draft of Proposed Amendments to Circular 230

Add a new Sec. 10.35 to read as follows:

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

Amend Sec. 10.52(b) as follows:

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

                                

    Chairman Archer. Mr. Lifson.

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

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

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

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

Disclosure of Corporate Transactions 

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

Penalties 

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

Due Diligence by Corporations

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

Conclusion 

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

                                

    Chairman Archer. Mr. Shewbridge.

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

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

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

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

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

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

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

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

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

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

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

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

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

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A. The Focus Should Be on Meaningful Disclosure

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

B. Possible Expansion of Disclosure Requirements

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

C. The Senior Corporate Officer Attestation Proposal Should Be 
Rejected

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

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

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

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

                            VII. Conclusion

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

            Tax Executives Institute, Inc.

                                 Charles W. Shewbridge, III
                                                          President
      

                                

    Chairman Archer. Mr. Handler.

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

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

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

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

                                

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

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

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

            Sincerely,

                                            David A. Lifson
                                                              Chair
                                      AICPA Tax Executive Committee
      

                                

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

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

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

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

                            I. Introduction

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

                 II. Arguments Against Sweeping Changes

A. The Myth of the Eroding Corporate Income Tax Base

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

1. Corporate tax liability and the timing of tax payments

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

Corporate tax payments

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

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

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

2. Effective Tax Rates: Commerce Department Data

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

3. Effective Tax Rates: SEC Data

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

4. Corporate capital gains

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

5. Conclusion

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

B. Efficacy of Current-Law Tools

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

1. Threat of penalties

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

2. Anti-abuse rules

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

3. Common-law doctrines

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

4. Treasury action

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

5. Targeted legislation

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

C. Adverse Impact of Proposals

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

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

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

D. Worldwide Experience with Anti-Avoidance Rules

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

Sweden

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

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

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

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Australia

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

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

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

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

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

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

A. Treasury Department Proposals

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

1. Disallowance of tax benefits

Summary

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

Comment

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

2. Substantial understatement penalty

Summary

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

Comment

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

3. Disclosure

Summary

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

Comment

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

4. Promoters

Summary

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

Comment

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

5. ``Tax-indifferent'' parties

Summary

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

Comment

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

B. Joint Committee on Taxation Staff Recommendations

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

1. Definition of ``corporate tax shelter''

Summary

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

Comment

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

2. Substantial understatement penalty

Summary

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

Comment

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

3. Disclosure

Summary

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

Comment

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

4. ``Promoter'' provisions

Summary

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

Comment

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

5. Tax shelter registration requirements

Summary

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

Comment

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

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

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

                             IV. Conclusion

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

                               Appendix 1

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

                               Appendix 2

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

                               Appendix 3

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

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

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

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

                               Appendix 5

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

                               Appendix 6

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

      

                                

    Chairman Archer. Mr. Hariton, you may proceed.

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

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

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

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

                                

    Chairman Archer. Dr. Sullivan.

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

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

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

         1. The Recent Decline in Corporate Income Tax Receipts

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

2. Do Declining Corporate Profits Explain Declining Corporate Receipts?

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

[GRAPHIC] [TIFF OMITTED] T5744.009

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

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

         3. Possible Reasons for Declining Effective Tax Rates

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

          4. Declining Tax Receipts and Corporate Tax Shelters

    Among the other possible explanations of the recent decline 
corporate receipts is the increased use of a variety of 
aggressive tax planning techniques commonly referred to as 
``corporate tax shelters.'' The charts presented in this 
testimony show a slowdown in the rate of growth of corporate 
receipts in the mid-1990s. This roughly coincides with the 
anecdotal evidence about the timing of the increased use of 
shelters.
    In addition, many knowledgeable commentators suspect that 
tax shelter may be eating into the corporate tax base:
     In its recently released interest and penalty 
study (JCS-3-99, July 22, 1999), the Joint Committee on 
Taxation made the following comment on the amount of corporate 
tax shelter activity: ``Although economic information 
concerning the cost of tax shelters is largely anecdotal, some 
believe that the resulting revenue loss may be in excess of $10 
billion a year.''
     In testimony before the Senate Finance Committee, 
the New York State Bar Association Tax Section stated: ``We 
believe that there are serious, and growing, problems with 
aggressive, sophisticated and, we believe in some cases, 
artificial transactions designed principally to achieve a 
particular tax advantage. . . . There is obviously an effect on 
revenue. While we are unable to estimate the amount of this 
revenue loss, anecdotal evidence and personal experience lead 
us to believe that it is likely to be quite significant.'' 
(``Statement of Harold R. Handler on Behalf of the Tax Section, 
New York State Bar Association, before the Senate Finance 
Committee,'' April 27,1999.)
     In its recent white paper on corporate tax 
shelters (July 1, 1999), the Treasury Department wondered aloud 
about the relationship between declines in this ratio and tax 
shelters: ``While corporate tax payments have been rising, 
taxes have not grown as fast as have corporate profits. One 
hallmark of corporate tax shelters is a reduction in taxable 
income with no concomitant reduction in book income. The ratio 
of book income to taxable income has risen fairly sharply in 
the last few years. Some of this decline may be due to tax 
shelter activity.''
    But it is important to remember that a decline in the ratio 
of tax receipts to profits provides no proof about a 
relationship between corporate tax shelters and aggregate 
corporate tax receipts. Such data are only suggestive. The 
bigger the shortfall, the more suggestive they are.
    The situation in many ways is analogous to the use of low 
profitability of foreign controlled U.S. corporations as 
evidence of transfer pricing abuses by foreign-headquartered 
companies operating in the United States. As in the case of the 
controversy about inbound transfer pricing, finding alternative 
explanations of low taxes--such as high rates of investment--
lessens suspicion that corporate shelter activity causes of 
lower corporate taxes. On the other hand, if this pattern 
persists and no alternative explanations are borne out, the 
likelihood that tax shelters are the cause of declining 
corporate tax receipts will increase.
    By its nature, the aggregate data can never provide 
conclusive evidence about the relationship between corporation 
income tax receipts and corporate tax shelters. In the end, 
Congress and the Administration must base any decisions it 
makes about tax shelters on uncertain information. Any decision 
based on solely on information presented here would be foolish. 
However, any decision ignoring this information similarly would 
be ill-advised.

                   Appendix: Explanation of the Data

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

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

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

      

                                

    Chairman Archer. Mr. Carpenter, you may proceed.

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

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

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

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

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

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

                                

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

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

    Dear Mr. Chairman:

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

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

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

                                

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

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

    Dear Mr. Chairman:

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

                                                 Sincerely,
                                            Kenneth J. Kies

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

                                

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

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

    Re: Corporate Tax Shelters

    Dear Congressman McCrery:

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

                                          Very truly yours,

                                         Danny R. Carpenter
      

                                

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

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

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

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

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

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

    Dear Sirs:

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

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

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

              Specific Comments on The Treasury Proposals

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

Definition of ``tax avoidance transaction.''

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

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

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

Disclosure requirements.

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

Modifications to substantial understatement penalty for 
corporate tax shelters.

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

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

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

Imposition of excise tax on certain fees.

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

Effective dates.

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

* * *

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

                                    Respectfully submitted,

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

COMMITTEE ON TAXATION OF BUSINESS ENTITIES

                    Andrew H. Braiterman, Chair \14\

                   Louis H. Tuchman, Vice-Chair \15\

                      Mary B. Flaherty, Secretary

      

                                

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

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

                                

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

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

                                

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

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

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

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

            II. Overview of the Joint Committee's Proposals

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

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

1. Modification of ``Tax Shelter'' Definition

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

2. Elimination of Threshold for Imposing the Penalty

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

Creation of a Two-Tier Penalty Rate

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

              Proposals Targeted at Other Involved Parties

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

1. Return Preparer Penalty

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

2. Aiding and Abetting Penalty

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

3. Enjoining Promoters

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

4. Regulation of Professional Conduct of Practice

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

                C. Disclosure and Registration Proposals

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

1. Participant Disclosure

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

2. Tax Shelter Registration

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

        General Framework for Addressing Corporate Tax Shelters

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

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

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

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

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

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

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

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

1. Litigation

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

2. Administrative Action

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

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3. Targeted Legislation

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

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

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

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

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

2. Any Legislative Solution Should Not Impose Needless 
Complexity

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

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

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

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

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

        IV. Specific Comments on the JCT Study's Recommendations

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

                   A. Comments on Specific Proposals

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

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

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

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

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

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

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

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

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

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

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

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

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

                               Conclusion

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

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