Discussion, Analysis and Legislative Proposals

Department of the Treasury

July 1999
1

 Lawrence H. Summers, "A Better Tax Service and a Better Tax System," Tax

Executives Institute, March 22, 1999.

2

Id.

Nonetheless, the Administration in its Fiscal Year 2000 Budget proposed several generic

remedies, focused on certain identified common characteristics, to curb the growth of corporate

tax shelters. As Deputy Secretary Lawrence Summers recently stated, the Administration's

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 - 'merchants' of abusive tax shelters,

their customers, and those who facilitate the transactions."1

The Treasury Department recognizes that this more generic approach to corporate tax

shelters raises certain concerns. In particular, critics have suggested that the definition of "tax

avoidance transaction," upon which many of the Administration’s Budget proposals rely, is too

broad or may create too much uncertainty and thus may inhibit otherwise legitimate transactions. 

The Treasury Department has never intended to inhibit legitimate business transactions.

Since the release of the Administration’s Budget in February, the Treasury Department

has had intensive and extensive dialogue with practitioner groups -- the tax bar, the accounting

profession, and corporate tax executives -- to hear their comments and their criticisms and

hopefully to develop common understandings of the norms of appropriate behavior in this area. 

The Treasury Department has also analyzed the comments raised by others in testimony presented

to the two tax-writing committees, as well as in recent articles by practitioners and academics. 

This report on corporate tax shelters is intended to discuss more fully the reasoning underlying the

Budget proposals relating to corporate tax shelters, to provide an analysis of how the practitioner

comments relate to this rationale, and to provide refinements to the original Budget proposals in

light of these comments and in keeping with the underlying rationale. 

We look forward to continuing to work closely with the tax-writing committees and other

interested parties to adopt proposals that effectively cultivate a "culture of compliance in which

corporate tax shelters are more seldom created,"2 without inhibiting legitimate business

transactions. 
SHELTERS .................................................. .25

B. EVIDENCE OF GROWTH IN CORPORATE TAX SHELTERS ......... . 31

IV. PRESENT LAW CONCERNING TAX AVOIDANCE TRANSACTIONS ........ . 34

A. STATUTORY AND REGULATORY RESPONSES TO TAX SHELTERS . . 35

B. JUDICIAL RESPONSES TO TAX SHELTERS ...................... . 46

C. PROCEDURAL APPROACHES .................................. .59

V. ANALYSIS OF ADMINISTRATION’S BUDGET PROPOSALS .............. . 78

A. INCREASING DISCLOSURE .................................... .80

B. MODIFYING THE SUBSTANTIAL UNDERSTATEMENT PENALTY ... . 87

C. DISALLOWING TAX BENEFITS ................................ .95

D. PROVIDING INCENTIVES FOR ALL PARTICIPANTS .............. . 107

VI. ALTERNATIVE APPROACHES ...................................... .115

A. THE ROADS NOT TAKEN .................................... .115

B. EXPERIENCES OF OTHER COUNTRIES ........................ . 121

C. IMPROVING THE EXISTING “TARGETED RESPONSE” SYSTEM ... . 131

D. PROCEDURAL CHANGES .................................... .133

APPENDIX A -- DESCRIPTION OF SELECTED CORPORATE TAX SHELTERS .... . 136

APPENDIX B -- PROPOSALS IN THE ADMINISTRATION’S FY 2000 BUDGET

RELATING TO CORPORATE TAX SHELTERS ......................... . 148

APPENDIX C -- PROPOSED DEFINITION OF TAX AVOIDANCE TRANSACTIONS . . 159
1

 Statement of Stefan F. Tucker, on behalf of the Section of Taxation, American Bar

Association, before the Committee on Ways and Means, March 10, 1999, at 5 [hereinafter ABA

Ways and Means].

2

 Statement of Harold R. Handler, on behalf of the Tax Section, New York State Bar

Association, before the Committee on Finance, April 27, 1999, at 1 [hereinafter NYSBA].

3

James P. Holden, 1999 Erwin N. Griswold Lecture Before the American College of Tax

Counsel: Dealing with the Aggressive Corporate Tax Shelter Problem, 52 Tax Lawyer 369

(Winter 1999).

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large corporate taxpayers of tax 'products' that have little or no purpose

other than the reduction of Federal income taxes," and its concern at the

"blatant, yet secretive marketing" of such products.1

• The New York State Bar Association, in testimony before the Senate

Finance Committee, 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 leads us to believe that it is likely to be quite

significant.”

2

• In the 1999 Erwin N. Griswold Lecture before the American College of Tax

Counsel, former ABA Tax Section president James Holden stated: "Many

of us have been concerned with the recent proliferation of tax shelter

products marketed to corporations...the marketing of these products tears at

the fabric of the tax law. Many individual tax lawyers with whom I have

spoken express a deep sense of personal regret that this level of Code

gamesmanship goes on."3
4

 Statement of Lester D. Ezrati, on behalf of the Tax Executives Institute, before the

Committee on Finance, April 27, 1999, at 6.

5

 Janet Novack and Laura Saunders, The Hustling of X Rated Shelters, Forbes, Dec. 14,

1998 at 198, 203.

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a major accounting firm who described the development and highly

selective marketing of "black box" strategies for tax avoidance that can save

its purchasers from tens of millions to hundreds of millions of dollars at the

expense of other U.S. taxpayers.

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.

II. Evidence from Recent Shelters

A number of large aggressive corporate tax shelters have been identified by the Congress,

the Treasury Department, and the IRS. As a result, several types have been shut down by

statute or administrative action. As more fully discussed in Appendix A, some of these

shelters involved tax reductions in the billions of dollars.

• Corporate-owned life insurance (COLI). In 1996 and 1997, two

provisions were enacted to prevent the tax abuse of corporate-owned life

insurance. 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
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 (January 31,

1997) [hereinafter 1997 Airlie House Transcript].

- iii -

down the scheme with a notice and proposed regulations. 

• Liquidating REITs. This transaction allowed banks and other financial

institutions to purportedly create a permanent tax exclusion for certain

interest income through the confluence of two incongruent Code sections. 

The Treasury Department’s Office of Tax Analysis estimated that

legislation enacted last year to eliminate the use of liquidating real estate

investment trusts (REITs) would save the tax system approximately $34

billion over the next ten years.

• LILO. Through circular property and cash flows, lease-in, lease-out

transactions, or so-called “LILO” schemes, like COLI, offered participants

hundreds of millions of dollars in tax benefits with no meaningful economic

substance.

• 357(c). On June 25, 1999, President Clinton signed a bill that eliminates the

ability of taxpayers to exploit the concept of “subject to” a liability when

transferring property in order to "create" bases in assets far in excess of the

assets’ value. 

III. Reasons for Concern

There are several reasons to be concerned 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. 
7

 NYSBA, supra note 2, at 2.

- iv -

unfairness. A view that well-advised corporations can and do avoid their

legal tax liabilities by engaging in these tax-engineered transactions may

cause a "race to the bottom." If unabated, this could have long-term

consequences to our voluntary tax system far more important than the shortterm revenue loss we are experiencing.

• The New York State Bar Association recently noted the “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.”

7

Complexity

• Piecemeal legislative remedies complicate the Code and call into question

the viability of common law tax doctrines. In the past few years alone,

nearly 30 narrow statutory provisions have been adopted responding to

perceived abuses. 

Uneconomic use of resources

• Significant resources, both in the private sector and the Government, are

currently being wasted on this uneconomic activity. Private sector

resources used to create, implement and defend complex sheltering

transactions could be better used in productive activities. 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.
8

 ACM Partnership v. Commissioner 73 T.C.M. (CCH) 2189, aff’d in part, rev’d in

part, 157 F.3d 231 (3d Cir. 1998), cert. denied, 119 S.Ct. 1251 (1999). 

9See Tom Herman, Tax Report, Wall St. J. at A-1 (Feb. 10, 1999). 

- v -

IV. Characteristics of Corporate Tax Shelters

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."9

This definition highlights one of the most important characteristics common to most

corporate tax shelters -- the lack of any significant economic substance or risk to the

participating parties. Through hedges, circular cash flows, defeasements and the like, the

participant in a shelter is insulated from any significant economic risk.

Inconsistent financial accounting and tax treatments -- There is a current trend among

public companies to treat corporate in-house tax departments as profit centers that strive

to keep the corporation’s effective tax rate (i.e., the ratio of corporate tax liability to book

income) low and in line with that of competitors. Accordingly, in most 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 “taxindifferent” 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.
10

 See section 6111(d); see also Section II.A.2. of the Report.

11

 ASA Investerings Partnership v. Commissioner, 76 T.C.M. (CCH) 325 (1998).

- vi -

discovery of the idea by the Treasury Department and the IRS. In the past, promoters

have required prospective participants to sign a non-disclosure agreement that provides

for million dollar payments for any disclosure of the “proprietary” advice. The 1997 Act

addressed this feature to some extent.10

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 ASA11 case ($24,783,800) were approximately

26.5 percent of the purported tax savings (approximately $93,500,000).

V. Present Law Applicable to Shelters

The tax consequences of a particular business transaction generally are determined

through the application of mechanical rules (primarily Code and regulatory provisions). 

However, certain standards under current law may be invoked to challenge the legitimacy

of a transaction where a literal application of the mechanical rules to the facts produces

technical tax results that are unreasonable or unwarranted. In addition, certain procedural

provisions generally enacted in response to the individual tax shelters of the 1970s and

1980s apply. 
12 David Hariton, 1997 Airlie House Transcript, supra note 6. (“I think the anti-abuse rules

are a terrific accomplishment of the Administration’s first four years. A day doesn’t go by without

my telling somebody that they can’t do that because of the swap anti-abuse rule, the OID antiabuse rule, or whatever.”)

- vii -

granting the Secretary of the Treasury broad authority to reallocate income and

deductions to require the proper reflection of income. These grants of broad authority

were considered necessary by Congress to empower the Secretary to curb inappropriate

activities. These include:

• section 269, which grants authority to disallow certain acquired losses;

• section 446, which prescribes a change of method of accounting if

necessary to clearly reflect income;

• section 482, which grants authority to reallocate income, deductions etc.,

between related entities if necessary to prevent evasion of tax or clearly to

reflect income; and

• section 7701(l), which grants authority to prescribe regulations

recharacterizing any multiple-party financing transaction as a transaction

directly among any two or more parties where the Secretary determines that

such recharacterization is appropriate to prevent avoidance of tax.

Judicial doctrines -- Courts have created, developed and re-interpreted various broad

common law doctrines to address unreasonable or unwarranted tax benefits, including:

• Substance-over-form -- Under the substance-over-form doctrine, the IRS

and the courts may recharacterize a transaction in accordance with its

substance, if “the substance of the transaction is demonstrably contrary to
13 Michael S. Powlen and Raj Tanden, Corporate Tax Shelters or Plus Ca Change, plus

C’est la Meme Chose, 431 Tax Strategies for Corporate Acquisitions, Dispositions, Spin-Offs,

Joint Ventures, Financings, Reorganizations & Restructurings (PLI) 1003, 1013 (1998).

14 David P. Hariton, Sorting Out the Tangle of Economic Substance, 52 Tax Lawyer

235, 239 (Winter 1999) [hereinafter Hariton].

15

 Gregory v. Helvering, 293 U.S. 465 (1935). 

16 293 U.S. at 469.

- viii -

doctrine, formally separate steps may be treated as one transaction for tax

purposes (rather than giving tax effect to each separate step), if integration

more accurately reflects the underlying substance.

• Business purpose -- The business purpose doctrine requires that a taxpayer

have a business reason -- other than the avoidance of federal taxes -- for

undertaking a transaction or series of transactions. In the Supreme Court’s

decision in Gregory v. Helvering,

15 the Court articulated the doctrine: “The

legal right of the 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. But the question for determination is whether what was

done, apart from tax motive, was the thing which the statute intended.”

16

• Economic substance -- Under this doctrine, tax benefits may be denied if 

the tax benefits arise from a discrete set of transactions that do not

meaningfully alter the taxpayer’s economic position. The economic

substance doctrine can be applied by comparing the taxpayer’s pre-tax

profit to its tax benefits from a transaction. Many commentators believe
17

 See, e.g., Hariton, supra note 14, at 235.

18

 See ABA Ways and Means, supra note 1; Statement of Stefan F. Tucker, on behalf of

the Section of Taxation, American Bar Association, before the Committee on Finance, April 27,

1999; Statement of David A. Lifson, on behalf of the Tax Division, American Institute of Certified

Public Accountants, before the Committee on Finance, April 27, 1999; NYSBA, supra note 2;

New York State Bar Ass’n Tax Section, Report on Corporate Tax Shelters of New York State

Bar Association Tax Section, 83 Tax Notes 879 (May 10, 1999); and New York State Bar Ass’n

Tax Section, Report on Certain Tax Shelter Provisions (June 22, 1999).

- ix -

(2) increasing and modifying the penalty relating to the substantial understatement

of income tax,

(3) changing substantive law to disallow the use of tax benefits generated by a

corporate tax shelter, and 

(4) providing consequences to all the parties to the transaction (e.g., promoters,

advisors, and tax-indifferent, accommodating parties).

The American Bar Association (ABA), American Institute of Certified Public

Accountants (AICPA), and the New York State Bar Association (NYSBA) have

commented on the Administration’s proposals and made proposals of their own in

testimony filed with the tax-writing committees.18 This Report considers those comments

and suggests refinements to the Administration’s proposals based on those comments and

the comments of others.

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
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Disclosure should be limited to the factual and legal essence of the transaction to avoid

being overly burdensome to taxpayers.

• Administration’s FY 2000 Budget. The penalty rate on substantial

underpayments of income tax attributable to corporate tax shelters would be

increased from 20 percent to 40 percent if the taxpayer does not adequately

disclose the shelter. For this purpose, adequate disclosure would mean (1)

filing appropriate documents describing the tax shelter transaction with the

National Office of the IRS within 30 days of the closing of the transaction,

(2) attaching a statement with the corporation’s return verifying that the

disclosure described in (1) had been made, and (3) highlighting on the tax

returns any book/tax differences resulting from the corporate tax shelter.

• The Budget also generally would deny tax benefits from transactions where

taxpayers report tax items relating to a transaction with a tax-indifferent

party inconsistent with the form of their transaction, unless they disclose

that they are reporting the item inconsistent with its form (i.e., in

accordance with the transaction’s substance). The proposal is designed to

restrict the ability of corporate taxpayers to arbitrage tax and regulatory

laws (and in some cases whipsaw the Government) by entering into

transactions where the substance of the transaction is inconsistent with its

form and to permit the Treasury Department and the IRS to consider

whether the claimed tax benefits flowing from the transaction should be

allowed.

• ABA. The ABA believes that many corporate tax shelters and supporting

opinions are based upon dubious factual settings. Thus, they would require

clear disclosure on the return of various matters regarding the true nature

and economic objectives of certain “large tax shelters,” including (1) a

detailed description of the facts, assumptions of facts and factual

conclusions; (2) a description of the due diligence to ascertain the accuracy

of these matters; and (3) copies of written materials provided by a third
- xi -

to be useful to the IRS. The AICPA also supports requiring corporate

officers or representatives to aver to the appropriate facts, assumptions, or

conclusions with respect to a transaction. Any new disclosure requirements

should be coordinated with section 6111 and other current-law disclosure

provisions. 

• NYSBA. The NYSBA strongly supports the Administration’s disclosure

proposal relating to the substantial understatement penalty because it

believes the prospect of disclosure will deter taxpayers from entering into

questionable transactions and will help the IRS uncover corporate tax

shelters. According to the NYSBA, disclosure should be made within 30

days after entering into certain large transactions and again with the filing

of the return, on a short form to avoid the problem of overdisclosure. 

Taxpayer Penalties

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. 

• Administration’s FY 2000 Budget. The substantial understatement penalty

would be increased from 20 percent to 40 percent for a substantial

understatement of tax resulting from a transaction meeting the definition of

a “corporate tax shelter.” However, the penalty would be reduced to 20

percent if, as discussed above, adequate disclosure is made. The 40- or 20-

percent penalty could not be avoided through the “reasonable cause”

exception (i.e., the penalty would be subject to “strict liability.”)

• ABA. While the ABA proposals focus primarily on disclosure, they

acknowledge that an expanded penalty structure may be necessary in order

to provide the appropriate incentives and disincentives for certain types of
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not apply to transactions that (1) were undertaken for reasons germane to

the conduct of the corporation’s business, (2) were expected to produce a

pre-tax return that is reasonable in relation to the costs incurred, and (3) is

reasonably consistent with the legislative purpose for which the provision

was enacted. The AICPA disagrees with the application of a strict liability

standard for corporate tax shelters, and does not suggest any changes to the

current application of the reasonable cause standard.

• NYSBA. In an approach similar to the Administration’s Budget proposal,

the NYSBA proposes that a penalty of at least 10 percent should apply to

corporate tax shelters for which the taxpayer provides disclosure and a

penalty at least 20 percentage points higher (and perhaps more) should

apply to undisclosed corporate tax shelters. Moreover, the NYSBA

supports the elimination of the reasonable cause exception from the penalty,

because they believe that most transactions that would reasonably be

viewed as corporate tax shelters will be subject to at least one “more likely

than not” or stronger tax opinion rendered by a law or accounting firm. 

While a favorable tax opinion does not technically provide “reasonable

cause” by itself, the NYSBA notes that such an opinion makes it

significantly more difficult for the IRS to impose current-law penalties.

Disallow Tax Benefits of Corporate Tax Shelters 

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, which encourages the most aggressive taxpayers

to pick and choose among the most favorable court opinions. 
- xiii -

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. Stated another way, a

significant understatement penalty will have little deterrent effect if there is no

understatement.

• Administration’s FY 2000 Budget. The Secretary of the Treasury would be

granted the authority to disallow a deduction, credit, exclusion, or other

allowance obtained in a tax avoidance transaction. The term “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). In addition, a tax

avoidance transaction would be defined to cover transactions involving the

improper elimination or significant reduction of tax on economic income. 

The proposal would not apply to any 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).

• ABA. The ABA would clarify that, where the economic substance doctrine

applies, the nontax considerations must be substantial (i.e., more than de

minimis or nominal) in relation to the potential tax benefits. According to

the ABA, many current corporate tax shelters rely upon literal

interpretations of mechanical rules of the Code but are not supportable

under common law principles. Thus, the ABA seeks to make the economic

substance doctrine more transparent by calling upon Congress to adopt

statutorily the standard enunciated in the best of the case law. This

approach is similar to the first prong of the Administration’s budget

proposal -- weighing potential tax benefits against potential economic
19 ABA Ways and Means, supra note 1, at 7.

- xiv -

rule out the eventual need for such a proposal. While not endorsing a

change in substantive law, the NYSBA believes that definitions of

corporate tax shelters could be developed by analyzing the different types

of transactions that are troubling from a tax policy perspective and tailoring

the definition thereby. For example, they suggest that one possible approach

would focus on “loss generators;” that is, transactions lacking in pre-tax

economic substance that are designed to create a tax benefit that the

corporation would not itself possess absent the transaction. They also

suggest that a separate substantive provision could be developed to

encompass corporate financings that otherwise have economic effect but are

difficult to analyze under general tax shelter legislation. 

Consequences to Other Parties (e.g., promoters and advisors, and tax-indifferent

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.”

19

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 should be enacted tailored to

corporate tax shelters. 
- xv -

to such person. To ensure that a tax is paid, all corporate participants

would be made jointly and severally liable for the tax. Thus, to the extent

that the tax-indifferent person is immune from U.S. tax, the tax otherwise

owed would be collected from other participants who are subject to U.S.

tax. For purposes of the proposal, a “tax-indifferent person” would include

a foreign person, a Native American tribal organization, a tax-exempt

organization, and domestic corporations with a loss or credit carryforward

that is more than three years old.

• The Budget also proposes to impose a 25-percent excise tax upon (1) the

fees earned by promoters and advisors with respect to a corporate tax

shelter transaction and (2) the total tax benefits anticipated from a corporate

tax shelter transaction, to the extent such benefits are subject to an unwind

agreement, recission clause, or insurance or other arrangement guaranteeing

such benefits. In addition, the Budget proposes to disallow the deduction

for promoter and advisor fees with respect to a corporate tax shelter

transaction. 

• ABA. In recognition of the role that promoters, tax advisors and taxindifferent parties play in corporate tax shelters, the ABA proposes that if

the substantial understatement penalty applies to a taxpayer with respect to

a tax shelter, the penalty should also be imposed on outside advisors,

promoters and tax-indifferent parties that actively participated in the tax

shelter. Special procedural rules would be provided to assure due process

to such parties, similar to current-law rules applicable to tax return preparer

penalties.

• AICPA. The AICPA believes that all parties to a tax shelter transaction

should have an incentive to ensure the soundness of the transaction. They

favor the Administration’s recommendation that Congress address

exploitation of the tax system by the use of tax-indifferent parties, but offer

no specific proposal for addressing this issue. The AICPA does not support
- xvi -

• NYSBA. The NYSBA does not propose sanctions on tax shelter

participants other than the corporate taxpayer itself. The NYSBA believes

that penalizing additional parties, while probably producing some marginal

increase in deterrence, creates significant complexity, coordination issues

and potential for unfairness. However, the NYSBA acknowledges that the

growth of corporate tax shelters can be attributed, at least in part, to certain

tax advisors and promoters (primarily, national accounting firms, multi-city

law firms and major investment banks) that have significant planning

resources, mass-marketing capabilities, and extensive client lists.

VII. Refinement of Budget Proposals

Increased Disclosure

The Treasury Department and almost all commentators believe that disclosure is an

important component of proposals to address corporate tax shelters. 

• In response to concerns that the definition of corporate tax shelter is too

vague for purposes of triggering a reporting requirement, the Treasury

Department would modify the disclosure requirement of the

Administration’s proposal. Disclosure would only be required if a

transaction has some combination of the following characteristics: a

book/tax difference in excess of a certain amount; a recission clause,

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 agreement; the

offering of the transaction to multiple parties; a difference between the form

of a transaction and the way it is reported, etc. These filters are based on

the objective characteristics identified by the Treasury Department and

others as common in many corporate tax shelters.
- xvii -

• Disclosure with the tax return will provide an examining IRS agent with

information necessary to discover and determine the nature of a sheltering

transaction.

• The form would require the taxpayer to describe which of the filters apply

to the transaction, and a brief description of certain information relating to

the transaction, as proposed by the ABA. Failure to meet the disclosure

requirement would subject the taxpayer to a significant fixed-amount

penalty ($100,000 for each failure), regardless of whether the transaction in

question is ultimately determined to be a corporate tax shelter.

• As proposed by the ABA and AICPA, the form would 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.

• The disclosure requirement would be an important component of the

Treasury Department’s modified substantial understatement penalty

proposal, described below. 

• As the AICPA suggests, because this proposal requires taxpayers to

disclose transactions subject to a confidentiality agreement, the section

6111(d) disclosure requirement for confidential corporate tax shelter

arrangements would be modified or eliminated. 

• Promoters would be required to make similar disclosures no later than 30

days after the first offering of the tax shelter. 

• The Treasury Department continues to believe that taxpayers should be

encouraged to disclose transactions that are reported differently from their

form. The original proposal included in the Budget would be modified to
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• The Treasury still believes that the penalty structure set forth in the

Administration's FY 2000 Budget is appropriate. However, consideration

could be given to providing a strengthened reasonable cause standard that

would cause the substantial understatement penalty to be reduced or

eliminated, in situations where the taxpayer also properly disclosed the

transaction in question. This limited exception would encourage disclosure

and would alleviate some taxpayer concerns with respect to the definition

of corporate tax shelter. Under this version, the following sanctions could

apply to substantial understatements of income tax attributable to corporate

tax shelter transactions:

-- If there was no disclosure by taxpayer, the resulting underpayment would

be subject to the increased 40-percent penalty, with additional fixed-amount

penalties for failure to disclose.

-- If there was disclosure by taxpayer, the resulting underpayment would

be subject to the 20-percent penalty, unless the taxpayer met the

strengthened reasonable cause standard, in which case the penalty could be

avoided. 

Disallow Tax Benefits of Corporate Tax Shelters

As stated above, the Treasury Department believes that a substantive change is necessary

to address corporate tax shelters. Such change should embody the adoption of coherent

standards rather than narrow, mechanical rules.

• The centerpiece of the substantive law change should be the codification of

the economic substance doctrine first found in seminal case law such as
20

 Gregory v. Helvering, 293 U.S. 465 (1935). 

21

 ACM Partnership v. Commissioner, 73 T.C.M. (CCH) 2189, aff’d in part, rev’d in part,

157 F.3d 231 (3d Cir. 1998), cert. denied, 119 S.Ct. 1251 (1999). 

- xix -

be more objective. It would apply to transactions that do not lend

themselves to a pre-tax profit comparison; most notably, financing

transactions. 

• Concerns that the IRS might abuse its broader authority would be 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 model for the type of proposal discussed in the above three paragraphs

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.

• In addition, legislative, regulatory, and administrative steps could be taken

to ensure consistent resolution of corporate tax shelter issues and to address

concerns that the IRS might abuse its broader authority.

-- As part of the IRS’s restructuring, IRS personnel reviewing

potential corporate tax shelters will be centralized in the new IRS

corporate group. This centralization will facilitate training and

coordination among agents, their supervisors and Chief Counsel.

Increased coordination by the IRS would increase consistency and

efficiency in dealing with complex tax shelter issues. 

-- A corporate tax shelter task force, modeled after the current

Industry Specialization Program and the Abusive Tax Shelter
- xx -

-- Special rules also could be developed that would allow a taxpayer 

to receive an expedited ruling from the National Office of the IRS as

to whether a contemplated transaction constituted a corporate tax

shelter for purposes of the substantial underpayment penalty.

Consequences to Other Parties (e.g., promoters and advisors, and tax-indifferent

parties)

Promoters and advisors

• With respect to promoters and advisors, the Treasury Department believes

that the most direct way to affect their economic incentives is to levy an

excise tax upon the fees derived by such persons from the corporate tax

shelter transaction. The Treasury Department would modify and clarify the

Administration’s proposal regarding such excise taxes by (1) providing that

only persons who perform services in furtherance of the corporate tax

shelter would be subject to the proposal, and (2) providing appropriate due

process procedures for such parties with respect to an assessment. 

• The Treasury Department recognizes that the proposed excise taxes on

promoter and advisor fees operates in the same manner as a penalty. In this

regard, consideration could be given to amending the current-law penalties

(that were enacted to address the individual tax shelters of the 1970s and

1980s) to be more responsive to corporate tax shelters in lieu of such excise

taxes.

• The Treasury Department proposes to eliminate the Administration’s

original proposals that would (1) disallow deductions for promoter and

advisor fees, and (2) impose a 25-percent excise tax on recission

agreements, unwind provisions, and insurance arrangements. 
- xxi -
1

 Statement of Stefan F. Tucker, on behalf of the Section of Taxation, American Bar

Association, before the Committee on Ways and Means, March 10, 1999, at 5 [hereinafter ABA

Ways and Means].

2

 Statement of Harold R. Handler, on behalf of the Tax Section, New York State Bar

Association, before the Committee on Finance, April 27, 1999, at 1 [hereinafter NYSBA].

3

 James P. Holden, 1999 Erwin N. Griswold Lecture Before the American College of Tax

Counsel: Dealing with the Aggressive Corporate Tax Shelter Problem , 52 Tax Lawyer 369 (1999)

[hereinafter Holden].

Committee, noted its "growing alarm [at] the aggressive use by large corporate taxpayers

of tax 'products' that have little or no purpose other than the reduction of Federal income

taxes," and its concern at the "blatant, yet secretive marketing" of such products. 1

• The New York State Bar Association, in testimony before the Senate Finance Committee,

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 leads us to believe that it is likely to be quite significant.”

2

• In the 1999 Erwin N. Griswold Lecture before the American College of Tax Counsel,

former ABA Tax Section president James Holden stated: "Many of us have been

concerned with the recent proliferation of tax shelter products marketed to

corporations...the marketing of these products tears at the fabric of the tax law. Many

individual tax lawyers with whom I have spoken express a deep sense of personal regret

that this level of Code gamesmanship goes on." 3

• The Tax Executives Institute recently testified before the Senate Finance Committee: "TEI

is not among those who believe no problem exists. But the problem confronting the tax

system is not simple, and care must be taken to ensure that the solutions are measured and
4

 Statement of Lester D. Ezrati, on behalf of the Tax Executives Institute, before the

Committee on Finance, April 27, 1999, at 6 [hereinafter TEI].

5

 Janet Novack and Laura Saunders, The Hustling of X Rated Shelters, Forbes, Dec. 14,

1998 at 198, 203 [hereinafter Forbes].

6

 Letter to the Editor from Joseph Bankman, 83 Tax Notes 1813 (June 21, 1999). See also

Airlie House Transcript, intra note 9 (Kenneth Kies questioning those who claimed "the actual

level of corporate receipts...tells us there is nothing to worry about.")

7

 As Peter Cobb, former Deputy Chief of Staff of the Joint Committee on Taxation

recently stated: "You can’t underestimate how many of America’s greatest minds right now are

being devoted to what economists would all say is totally useless economic activity."

- 3 -

corporate tax revenues have been rising. As Professor Joseph Bankman points out, however, this

is not in and of itself "inconsistent with a burgeoning market in corporate tax shelters. In a boom

economy, it is possible for tax revenues to rise, and tax savings from shelter usage to rise even

faster..."6 In fact, 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. Similarly, the effective tax rate, the ratio of tax to profits,

has declined during the 1990s. Some of this decline may be due to tax shelter activity.

Reasons for Concern. Corporate tax shelters breed disrespect for the tax system -- both

by the people who participate in the tax shelter market and by others who perceive unfairness. A

view that well-advised corporations can and do avoid their legal tax liabilities by engaging in these

tax-engineered transactions may cause a "race to the bottom." If unabated, this will have longterm consequences to our voluntary tax system far more important than the revenue losses we

currently are experiencing in the corporate tax base. Also, significant resources -- both in the

private sector and the Government -- are currently being wasted on this uneconomic activity. 7

Private sector resources used to create, implement and defend complex sheltering transactions are

better used in productive activities. Similarly, the Congress (particularly the tax-writing
8

 Pub. L. No. 104-191, § 501 (1996); Pub. L. No. 105-34, § 1084 (1997)

9

 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) [hereinafter 1997 Airlie House Transcript].

10 Pub. L. No. 105-277, § 3001(a) (1998).

11 Rev. Rul. 99-14, 1994-14 I.R.B. 3.

12 Pub. L. No. 106-___, § 3001 (1999). The bills containing the amendment to section

357(c) are H.R. 435, 106th Cong. (1999) and S. 262, 106th Cong. (1999).

- 4 -

corporate-owned life insurance (COLI). 8 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.”

9

• 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.”

10 The

Treasury Department’s Office of Tax Analysis estimated that eliminating this one tax

shelter product alone would save the tax system approximately $34 billion over the next

ten years.

• The recent IRS ruling11 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 in tax benefits with no real economic substance or risk. 

• Legislation signed into law June 25, 1999 aimed at section 357(c) basis creation abuses. 12

In these transactions, taxpayers exploited the concept of “subject to” a liability and
13 Prop. Reg. § 1.7701(l)-3.

14

 See Notice 98-5, 1998-3 I.R.B. 49.

15 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).

16 76 T.C.M. (CCH) 325 (1998).

17 Lawrence H. Summers, "A Better Tax Service and a Better Tax System," Tax

Executives Institute, March 22, 1999.

- 5 -

• The Government’s victories in two important corporate tax shelter cases -- ACM

Partnership v. Commissioner15 and ASA Investerings Partnership v. Commissioner .

16

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

incomplete. There will always be transactions that are unidentified or not addressed by the

legislation. As Deputy 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." 17

Second, legislating on a piecemeal basis complicates the Code. In the past few years

alone, Congress has passed numerous provisions to prevent specific tax shelter abuses. 

Third, such a legislative strategy seemingly 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 transactional

legislation approach to corporate tax shelters may embolden some promoters and participants to
18 Corporations are free to reduce their taxes as the law allows. See Gregory v.

Helvering, 293 U.S. 465, 469 (1935) ("The legal right of a taxpayer to decrease the amount of

what would otherwise be his taxes, or altogether avoid them, by means which the law permits,

cannot be doubted."), aff’g, 69 F.2d 809, 810 (2d Cir. 1934) ("Anyone may so arrange his affairs

- 6 -

including historic Congressional and Administrative substantive and procedural responses to tax

shelters and the development of judicial anti-avoidance doctrines. Part V provides an analysis of

the Administration’s budget proposals and recommends modifications to the original proposals. 

Part VI discusses other proposals to limit the growth of corporate tax shelters, including options

that we considered but did not propose, anti-abuse approaches adopted in other countries, and

improving the targeted response system. Finally, the Report includes three Appendices. 

Appendix A describes some specific recent corporate tax shelters. Appendix B describes in detail

the corporate tax shelter proposals in the Administration's FY 2000 Budget. Appendix C

discusses in detail the proposed definition of corporate tax shelter.

A. GOAL AND METHODOLOGIES OF CORPORATE TAX SHELTERS

Although corporate tax shelters take many forms, they all share a single goal -- the

reduction of corporate income tax liability. To achieve this goal, participants engineer

transactions that generate tax losses, exclude income from taxation, defer recognition of income

into a later year, or convert income into a different, lower-taxed form. As discussed in Part

II.A.3. below, these transactions typically rely on one or more discontinuities of the tax law. 

These discontinuities can arise in the basic structure of the Federal income tax system or in

specific provisions of the Code and regulations. The development of sophisticated financial

instruments, such as derivatives, has facilitated the exploitation of these tax law discontinuities.

1. Reducing Corporate Income Tax Liability

The primary goal of a corporation is to maximize shareholder value. As corporate

earnings comprise the primary source of shareholder value, corporations continually seek to

create or increase earnings. This can be done either by increasing revenues or decreasing costs. 

Because taxes represent one of a corporation’s most significant costs, corporations seek to

minimize their tax liability. 18 
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."). It should be noted

that the taxpayer in Gregory lost in both the Second Circuit and the Supreme Court.

19 See, e.g., New York State Bar Ass’n (Tax Section), Report on Corporate Tax Shelters

of New York State Bar Association Tax Section , 83 Tax Notes 879 (May 10, 1999) [hereinafter

NYSBA, Report]; Joseph Bankman, The New Market in Corporate Tax Shelters, 83 Tax Notes

1775 (June 21, 1999) [hereinafter Bankman].

20 See also Bankman, supra note 19, at 1784 ("At the same time, perhaps part of a general

trend of greater management responsiveness to shareholder concerns and returns, and perhaps

due to greater management sophistication, tax departments are now looked at in some companies

as profit centers.”); 1997 Airlie House Transcript, supra note 9 (Don Longano stated that: “I

think many corporate tax departments find themselves under a considerable amount of pressure to

add value to the company... I don’t think corporate tax departments generally get points for filing

an accurate return or no typos. Most tax departments report not through the general counsel of

the company, but through the CFO.”). 

21 Forbes, supra note 5, at 200.

- 7 -

and they were embarrassed,' says one accountant. 21
22 The effective tax rate is the ratio of corporate tax liability to book income. For

purposes of determining a corporation’s effective tax rate, a corporation’s tax liability includes

not only taxes currently payable, but deferred taxes as well. Thus, corporate tax shelters that

create timing differences between book and taxable income lower the corporation’s actual tax

liability, but do not reduce the corporation’s effective tax rate. Sophisticated users of financial

statements can discern the benefits of a corporation’s deferred taxes through an examination of

other information in the financial statements reserve. In addition, tax benefits may be reflected in

other areas of the corporation’s income statement or balance sheet. For example, tax benefits

related to leverage leases are reflected as part of the overall investment and not the tax reserves of

the corporation. Permanent differences generally reduce a corporation’s effective tax rate. 

However, a corporation may not fully reflect anticipated permanent tax benefits to be derived

from a corporate tax shelter for fear that the benefits may not survive IRS scrutiny. In such cases,

the corporation will establish a reserve against such benefits that can be reversed at a later time

when it appears more likely that the benefits will be realized ( e.g., when statute of limitations with

respect to the year in question is closed or when the IRS has challenged similar benefits of other

taxpayers but has lost in court). 

23 A lower effective tax rate may lead to a higher stock price and more satisfied

shareholders. See Charles W. Swenson, Increasing Stock Market Value By Reducing Effective

Tax Rates, 83 Tax Notes 1503 (June 7, 1999).

24 See discussion infra, at notes 49-55. 

25

 See, e.g., Jt. Comm. on Tax’n, Tax Reform Proposals: Tax Shelters and Minimum Tax,

at 2 (Aug. 7, 1985).

- 8 -

Corporate tax liabilities can be reduced if income is not taxed, is taxed at a later time, or is

taxed at a rate lower than the prescribed rate for that category of income.25 These classic

hallmarks of tax shelters -- exclusion, deferral, and conversion -- are discussed in section A of

Part IV of this Report. 

Tax shelters take two forms to accomplish those goals: “(1) those that provide tax savings

with respect to other, unrelated income of the shelter investor, and (2) those that provide
26 Kenneth W. Gideon, Mrs. Gregory’s Grandchildren: Judicial Restriction of Tax

Shelters, 5 Va. Tax Rev. 825, 849 (1986).

27 See NYSBA, Report, supra note 19, at 884. The individual tax shelters of the 1970s

and 1980s were usually of this type. Typically, in those shelters, individuals invested in limited

partnerships that, through nonrecourse indebtedness and overvaluations of property, generated

tax losses that could offset other income (often, earned income) of the individuals. For a more

complete discussion of the individual tax shelters of the 1970s and 1980s, see Part IV(C) of this

Report.

28

 NYSBA, Report, supra note 19, at 884.

29

 See generally Michael S. Powlen and Raj Tanden, Corporate Tax Shelters or Plus Ca

Change, plus C’est la Meme Chose, 431 Tax Strategies for Corporate Acquisitions, Dispositions,

Spin-Offs, Joint Ventures, Financings, Reorganizations & Restructurings (PLI) 1003, 1009

(1998) [hereinafter Powlen and Tanden] ("What are the fundamental aspects of the system that

create the opportunity for tax shelters? First, our tax system, perhaps of necessity, incorporates

certain basic principles that: (i) require arbitrary line drawing that can be manipulated, (ii) are

generally not followed on an internally consistent basis, (iii) often exist simultaneously with

antithetical principles, and (iv) ultimately do not give rise to authentically meaningful models of

real income.").

- 9 -

exploiting an unintended discontinuity in the tax law (“exclusion shelters”). A recent example of

an exclusion shelter is the liquidating REIT transaction, also described in Appendix A.

3. Exploiting Tax Law Discontinuities

Corporate tax shelters typically rely on some type of discontinuity in the tax law that treats

certain types or amounts of economic activity more favorably than comparable types or amounts

of activity. 29 Discontinuities exist in the tax law for several reasons. Most importantly, the Code
30 In an ideal income tax, all items of income or deduction would be measured and treated

equally. Under the Haig-Simon definition of income, income is defined as the sum of the market

value of rights exercised in consumption and the change in the value of the store of property

rights between the beginning and the end of the period in question. Such a definition would lead

to the accurate measure of income but has never been fully adopted in the Code. See Haig, The

Concept of Income-Economic and Legal Aspects and H. Simons, Personal Income Taxation,

discussed in Boris I. Bittker and Lawrence Lokken, 1 Federal Taxation of Income, Estates and

Gifts, ¶3.1 (3d ed. 1999) and George Cooper, The Taming of the Shrewd: Identifying and

Controlling Income Tax Avoidance , 85 Col. L. Rev. 657, 660-63 (1985).

31 NYSBA, Report, supra note 19, at 882.

32

 See Woodsam Associates, Inc. v. Commissioner, 198 F.2d 357 (2d Cir. 1952)

(borrowing against appreciated position is not a realization event).

33 For example, prior to the enactment of the Taxpayer Relief Act of 1997, a taxpayer

holding an appreciated stock position could effectively sell the position without recognizing

current taxable gain by entering into a short-against-the-box transaction or a similar economic

transaction. Because the taxpayer had not sold the position, i.e., no realization event had

occurred, taxable gain could be deferred to a future year (or could be avoided altogether if the

taxpayer died holding the securities, as the basis of the stock would be stepped up to fair market

value under section 1014). See, e.g., Rev. Rul. 73-524, 1973-2 C.B. 307. Section 1001(a) of the

Tax Reform Act of 1997 adopted Section 1259, which requires gain recognition with respect to

so-called "constructive sales transactions,” including short-against-the-box transactions.

34 NYSBA, Report, supra note 19, at 882 (“[I]n the context of corporate tax planning, the

unintegrated structure of the corporate tax system places a significant premium on fitting financial

instruments into the optimal cubbyhole of debt or equity.”) 

- 10 -

There are several other discontinuities in the tax law that provide sheltering opportunities. 

For instance, the Code contains a number of distinctions that can be manipulated, such as the

distinction between capital gains and ordinary income, and the distinction between debt and

equity.34 In addition, Congress has used the Code to provide tax benefits to induce taxpayers to
35 Budget of the United States Government, Analytical Perspectives, 105 (Fiscal Year

2000).

36 Subchapter C corporations are subject to tax on their earnings. Subchapter S

corporations and partnerships generally are not. Trusts are subject to a variety of tax rules. Real

estate investment trusts (REITs) and regulated investment companies (RICs) are taxed as

subchapter C corporations, but can reduce or eliminate their taxable income by making deductible

distributions. Similarly, different tax rules apply to owners of these entities. 

37

 See Notice 98-5, 1998-3 I.R.B. 49, Examples 4 and 5.

38

 See, e.g., the description of the fast pay stock transaction in Appendix A, which

attempted to exploit differences with respect to the taxable status of parties, debt and equity, and

forms of entity. 

39

 See Appendix A for descriptions of the ACM transaction and the fast-pay stock

transaction, both of which exploited rules designed to accelerate taxable income.

40

 See Testimony of Donald C. Lubick, Assistant Secretary of the Treasury (Tax Policy),

before the Senate Finance Committee (April 27, 1999).

- 11 -

different tax results. 36 Discontinuities can also arise from the existence of different tax treatments

for the same transaction in different tax jurisdictions. 37 These different tax treatments can and

have been arbitraged to produce corporate tax shelters. 38

Finally, certain provisions of the Code and regulations have been designed with a bias

toward accelerating taxable income. Ironically, over time, tax practitioners have developed

techniques to exploit these rules to create corporate tax shelters. 39

B. CHARACTERISTICS OF CORPORATE TAX SHELTERS

Corporate tax shelters "appear in the guises of Proteus," 40 taking many different forms and

utilizing many different structures. For this reason, a single, comprehensive definition of
41 It is important to note that these characteristics, while common in corporate tax

shelters, may be found in other transactions as well.

42

 See Tom Herman, Tax Report, Wall St. J. at A-1 (Feb. 10, 1999). 

43

 See, e.g., ACM Partnership v. Commissioner, 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). The

transaction at issue in ACM is discussed more fully in Appendix A of this Report.

44

 See, e.g., Friendship Dairies, Inc. v. Commissioner, 90 T.C. 1054 (1988) (leasing

transaction lacked economic substance; court refused to treat investment tax credit as a substitute

for or component of economic profit; in the absence of investment tax credit, taxpayer had no

possibility of economic profit even under the taxpayer’s most optimistic assumptions concerning

the residual value of the leased equipment).

45 For a more complete discussion of this transaction, see Appendix A of this Report.

- 12 -

this definition highlights one of the most important characteristics common to most corporate tax

shelters -- the lack of significant pre-tax economic substance or risk to the participating parties. 

See Part IV.B, of this Report for a discussion of judicial doctrines that highlight this factor and

Part V.C for a discussion of the Administration’s proposals to limit corporate tax shelter activity. 

Often, in corporate tax shelters, a corporate participant purportedly makes a significant

investment. In most cases, however, this investment is illusory. Through hedges, circular cash

flows, defeasements and similar devices, the participant in a shelter is insulated from virtually all

economic risk.43 Transactions with little or no economic risk typically generate little or no pretax return. As Professor Graetz notes, in light of the expectation of little or no pre-tax profit, no

one rationally would participate in such transactions without significant tax benefits. After

factoring in expected tax benefits, however, a negligible pre-tax profit is transformed into a

significant after-tax return. 44 

A recent example of this is the so-called lease-in, lease-out (or “LILO”) type of

transaction. 45 In a typical LILO transaction, a U.S. taxpayer leases property from a foreign
46 Rev. Rul. 99-14, 1999-14 I.R.B. 3. Other shelters have been held to lack economic

substance because the reasonably expected pre-tax profit was insignificant relative to the claimed

tax benefits. See Notice 98-5, 1998-3 I.R.B. 49. See also Sheldon v. Commissioner, 74 T.C.

738, 768-69 (1990) (in the context of an individual tax shelter, the court stated that the economic

gain in question was "infinitesimally nominal" and "vastly insignificant" in relation to the claimed

tax benefits and could not, in and of itself, support a finding of economic substance).

47 In certain shelters, the corporate taxpayer may have a purpose other than profit for

engaging in the transaction. For example, the transaction may be a financing, where the corporate

taxpayer’s purpose is to procure the lowest-cost financing possible. 

48 NYSBA, Report, supra note 19, at 895.

- 13 -

used to shelter other income) followed by net income inclusions many years later. The Treasury

Department understands that in some lease-in, lease-out transactions, the claimed after-tax return

could exceed 18 percent. The Treasury Department and the IRS recently issued a revenue ruling

stating that these transactions lack economic substance and therefore do not generate the tax

benefits they are alleged to create. 46

Corporate tax shelters can arise even in transactions that produce more than a negligible

amount of pre-tax economic profit. As discussed above, exclusion shelters are designed to reduce

or eliminate corporate income tax on the pre-tax economic profit. 47 In addition, a taxpayer may

attempt to disguise the tax avoidance nature of the transaction by placing high-grade, incomeproducing financial instruments in a corporate tax shelter. 48
49 Private companies are less concerned with reported book earnings and thus may be

more willing than public companies to engage in tax shelters that have favorable tax consequences

but also have an impact on book earnings. 

50 This characteristic is consistent with the observation that corporate tax shelters

generally do not have any underlying economic substance other than tax savings. If the

transaction had economic substance, the result generally would be reported on the financial

statements.

51 NYSBA, Report, supra note 19, at 882.

52

 See the discussion in section A.1. of this Part II.

53 It should be noted, however, that, by participating in corporate tax shelters that reduce

the corporation’s effective tax rate for one reporting period, the corporation may be under

pressure to continue to engage in corporate tax shelters in order to meet market expectations of

maintaining the low rate.

- 14 -

results in either a deduction without a financial accounting charge

or financial accounting revenue without the concomitant imposition

of tax can be viewed as a real coup by the tax manager. 51

The emergence of book-tax disparities as a hallmark of recent shelters is consistent with

the trend to treat corporate in-house tax departments as profit centers, 52 and the pressure to

increase shareholder value and remain competitive. Corporate managers are placing greater

emphasis on keeping 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. 

A successful shelter with a book-tax disparity is Elysium for a corporation; it not only

reduces the corporation’s tax liability, but also reduces its effective tax rate. 53 For example,

assume a corporation subject to a 35-percent tax rate has both taxable income and book income

of $1,000. In this case, the corporation’s pre-shelter effective tax rate is 35 percent (35 percent

of $1,000/$1,000). If the corporation engages in a sheltering transaction that permanently
54 Bankman, supra note 19, at 1780.

55 This reconciliation is reported on schedule M-1 of Form 1120 and Part IV of Form

1120A and in the footnotes to financial statements filed with the Securities Exchange

Commission.

56 See Statement of Stefan F. Tucker, on behalf of the Section of Taxation American Bar

Association, to Senate Finance Committee, April 27, 1999 [hereinafter ABA], at 4. (“The tax

shelters that concern us generally have the following features ... one party to the transaction is

frequently what the Treasury refers to as “tax indifferent.”).

57

 73 T.C.M. 2189.

58

 ASA Investerings Partnership v. Commissioner , 76 T.C.M. (CCH) 325 (1998).

- 15 -

and GAAP purposes, the amount of detail required is limited and provides the IRS with little

evidence concerning the existence of corporate tax shelters. 55 Financial statement disclosure is

limited to items of materiality. Tax return disclosure is not limited to corporate tax shelters, but

rather applies to all book-tax differences, of which there are many. Thus, book-tax differences

attributable to shelters often remain hidden, and corporations have no incentive to expose the

existence and nature of their shelters voluntarily. 

3. Presence of Tax-indifferent Parties

Another significant characteristic found in many, but not all, corporate tax shelters is the

participation of tax-indifferent parties. 56 Recent examples of shelter transactions that relied on the

use of tax-indifferent parties include (as described more fully in Appendix A) the fast-pay

preferred stock transactions, the LILO transactions, and the contingent installment sales

transactions that were litigated in ACM57 and ASA.

58

 

Tax-indifferent parties are accommodation parties who are paid a fee or an above-market

return on investment for the service of absorbing taxable income or otherwise “leasing” their tax-
59 In this connection, the shelters typically are structured so that the accommodation party

bears little or no economic risk from the transaction.

60 Trafficking in losses has a long history. In 1943, Congress enacted the predecessor of

section 269 to combat the sale of shell corporations with net operating loss carryovers. Unlike

other tax-indifferent parties, the losses in question may be legitimate economic losses that the loss

corporation may eventually be able to use to offset its own income. In this case, the sale of the

losses accelerates their use and results in a timing benefit to the loss corporation. In contrast, if

the loss corporation could never fully utilize its losses, the benefits arising from the sale would

result in a permanent loss to the system.

61 For example, in a recently publicized transaction, certain hedge fund investors have

attempted to convert their short-term capital gains that flow through from the hedge fund into

long-term capital gains by entering into a derivatives transaction with a mark-to-market taxpayer.

See, e.g., E.S. Browning & Laura Jereski, Tax Plan Could Hurt Hedge Play, Wall St. J., Feb. 1,

1998, at C1. Under the arrangement, the mark-to-market taxpayer acquires a direct interest in the

hedge fund (because it is indifferent to whether gains realized by the hedge fund are short-term or

long-term) and agrees to pay an amount that replicates the return of the hedge fund to the

investor. Because the derivative is not settled before one year after it is entered into, the

transaction is intended to allow the hedge fund investor to defer income and to convert his hedge

fund income into a long-term capital gain. Many investment banks, that create and promote

corporate tax shelters, are required to be on the mark-to-market accounting method. Thus, these

banks may play two roles (as promoters and as a tax-indifferent party) in a corporate tax shelter.

The Administration, in its FY 2000 Budget, and Congressman Neal (D. Mass.) both have

proposed legislation that would eliminate the purported conversion benefits from engaging in the

derivatives transaction. See Department of the Treasury, General Explanation of the

Administration’s Revenue Proposals (February 1999) [hereinafter Treasury Explanation], at 122;

and H.R. 1703, 106th Cong. (1999) (introduced May 5, 1999).

- 16 -
62

 See, e.g., Edward D. Kleinbard, Equity Derivative Products: Financial Innovation’s

Newest Challenge to the Tax System , 69 Tex. L. Rev. 1319 (1991); Alvin C. Warren, Jr.

Financial Contract Innovation and Income Tax Policy , 107 Harv. L. Rev. 460 (1993).

63

 Id.

64

 See, e.g., Merton H. Miller, Financial Innovation: The Last Twenty Years and the

Next, 21 J. Fin. and Quantitative Analysis 459, 461 (1986) ("The income tax system of virtually

every country that is advanced enough to have one seeks to maintain. . .different rates of tax for 

different sources (and uses) of income. . . At the same time, modern finance theory assures us, as

practitioners have long known, that securities can be used to transmute one form (or use or

recipient) of income into another -- in particular, higher taxed forms to lower taxed ones.") .

65

 See, e.g., Michael S. Knoll, Financial Innovation, Tax Arbitrage, and Retrospective

Taxation: The Problem With Passive Government Lending, 52 Tax L. Rev. 199 (1997) ("Many

of these financial products were designed and marketed to exploit inconsistencies in the law,

especially the tax law.").

- 17 -

to facilitate the exploitation of tax law inconsistencies. Financial innovation is growing rapidly

and the tax law has not kept pace. 62 Many of the rules governing financial instruments were

developed in the early part of the century to deal with the common financial instruments of the

day, i.e., plain vanilla stock, debt, and short-term options. New sophisticated financial products

do not fit neatly into the existing regimes. 63 Consequently, taxpayers have been able to exploit the

uncertainty regarding the taxation of these instruments to create, among other things, the

economic equivalence of a traditional investment without the unfavorable tax consequences. 64

Once inconsistencies are identified, they can be, and are, manipulated.65 

The use of a complex structure may also be used as a device to cloak the tax shelter

transaction from detection. According to one commentator, some of this may be “psychological”: 

A client may simply be unwilling to pay millions for a clever reading

of the tax law -- even if the shelter around which the idea is built

can save the client many times that fee... ‘You can have the greatest
66 Bankman, supra note 19, at 1781.

67 This latter characteristic of corporate tax shelters is similar to a characteristic prevalent

in the tax shelters of the 1970s and 1980s: the failure to exercise normal due diligence prior to

making an investment. See, e.g., Friendship Dairies, Inc. v. Commissioner, 90 T.C. 1054 (1988)

(corporate taxpayer lacked a profit motive for engaging in a leasing transaction; taxpayer’s

knowledge of the computer industry was minimal and its evaluation of the leasing transaction in

question was, in the court’s words, "anything but business-like," because the taxpayer relied on

questionable advice regarding the residual value of property); Rice’s Toyota World Inc. v.

Commissioner, 752 F.2d 89 (5th Cir. 1985) (sale-leaseback of computer found to be a sham

because the Tax Court found that the taxpayer, who knew virtually nothing about computers, did

not seriously investigate whether the computer would have sufficient residual value at the end of

the lease to enable the taxpayer to earn a profit on its purchase and seller-financed leaseback.);

Rose v. Commissioner, 868 F.2d 851, 854 (6th Cir. 1989) (The purchase of "reproductions" of

paintings found to be a sham, as the taxpayer failed to obtain any information on the commercial

viability of the reproductions; rather, the taxpayer relied on the exaggerated claims of the

promoter.).

68 The partnership was purportedly formed to permit Colgate to repurchase its debt

surreptitiously in an off-balance sheet transaction. The proffered reason for this was to avoid

making Colgate a more attractive take-over target. As the court noted, the purchase and sale of

the Citicorp notes were unnecessary to achieve this business purpose. The sale of these notes was

necessary solely to achieve the claimed tax benefits. See ACM Partnership v. Commissioner, 73

T.C.M. at 2217-29.

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As discussed in Part IV.B., a taxpayer generally must evince a business purpose for

entering into a transaction (or series of transactions) in order to sustain the claimed tax results. In

many cases, however, certain steps are undertaken solely to obtain the desired tax benefits, and

are not necessary for the taxpayer to achieve the purported business purpose. For example, in

ACM, several steps were undertaken that were unnecessary to achieve the taxpayer’s stated

business purpose.68 Similarly, in fast-pay preferred stock transactions, the use of the REIT

structure was unnecessary to the corporate participant’s business purpose of obtaining financing. 
69 For a more complete discussion of this transaction, see Appendix A.

70 In 1998, governments, tax-exempt institutions, and foreign persons held 38.7 percent of

U.S. corporate equities and 39.7 percent of net debt of nonfarm nonfinancial corporations. Flow

of Funds Accounts for the United States, Annual Flows and Outstandings, June 11, 1999. 

71 For example, it is understood that many of the liquidating REIT transactions described

in Appendix A of this Report were undertaken by financial institutions.

- 19 -

469, which generally disallow losses and credits to be claimed against an individual’s salary or

other earned income if he or she does not materially participate in the activities generating the tax

benefits.

Some corporate tax shelters may also involve new activities for the corporate participant. 

Many corporate tax shelters involve leasing transactions, novel financing arrangements,

transactions with tax-indifferent parties, or the use of entities ( e.g., REITs) that the corporate

participant has not, in the past, been a party to or used. On the other hand, some corporate tax

shelters involve activities that fall within the corporation’s normal business operations. Many

participants are publicly traded conglomerates that are involved in a host of diverse activities. In

addition, many corporate tax shelters involve financing transactions and all business entities need

to finance their activities. Tax-indifferent parties, particularly pension plans and foreign persons,

are a major source of corporate finance.70 Some corporations that are active in the trade or

business of financial intermediation (e.g., banks or insurance companies) also participate in tax

shelters involving financing transactions. Thus, the fact a transaction is not “novel” for the

taxpayer is not necessarily determinative of whether it is a corporate tax shelter. 71

6. Promotion or Marketing

[T]ax advisors are no longer just devising specific strategies to deal with a

client’s tax needs as they arise, as in the past. Today’s shelter hustlers parse the

numerous weaknesses in the tax code and devise schemes that can be pitched as

'products' to corporate prospects. Then they sell them methodically and

aggressively, using a powerful distribution network not unlike the armies of
72 Forbes, supra note 5, at 200. See also Holden, supra note 3, at 369 (citing concern of

many tax lawyers “with the recent proliferation of tax shelter products marketed to

corporations”). 

73 See ACM Partnership, 73 T.C.M. at 2115 ("ACM is one of 11 partnerships. . . formed

over a 1-year period from 1989-1990 by the Swap Group at Merrill Lynch & Co. Inc."); see also

Randall Smith, Collection Drive, Wall St. J., May 3, 1996, at A1 (stating that Merrill Lynch

formed similar partnerships for several corporations in addition to Colgate).

74 See Jacob M. Schlesinger & Anita Raghvan, U.S. Bars Certain Tax-Free Stock Deals,

Cutting Off Billions in Planned Issues, Wall St. J., Feb. 28, 1997, at A4; Bankman, supra note 19,

at 1781 (“Investments in step-down preferred were reported in excess of $10 billion, generating

well over $100 million dollars of fees to Bear Stearns & Co. in a matter of months.”)

75 Forbes, supra note 5, at 202.

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Big Five accounting firm maintains two databases of about 1,000 "mass market" tax savings

ideas.75 

There are various ways in which promoters become aware of corporations who have an

appetite for shelter transactions. First, some corporations that generate significant profits are

known to have an interest in transactions that reduce the tax liability on such profit. Second,

promoters may work with corporations in other capacities, such as underwriters, legal advisors or

auditors, and learn of events, such as the possible sale of a subsidiary for a significant gain, that

would suggest a need for a corporate tax shelter. Using this knowledge, the advisors can

communicate the needs of their clients to other members of the firm who may have expertise in

designing corporate tax shelters.

In addition, new technologies have greatly increased the distribution and marketing of

shelters. In the past, it may have taken weeks or months to distribute a corporate tax shelter

nationwide; now it takes a matter of minutes.

7. Confidentiality
76 Calvin H. Johnson, Corporate Tax Shelters, 1997 and 1998, 80 Tax Notes 1603, 1609

(Sept. 28, 1998) [hereinafter Johnson] (“The owner with a proprietary right to exclude others

from free use of the idea will be able to charge a price for the idea and thus will have an incentive

to improve or perfect the idea, and market it as to maximize the output from the idea.”).

77 See Bankman, supra note 19, at 1781. See also Kenneth W. Gideon, Assessing the

Income Tax: Transparency, Simplicity, Fairness, Fourth Annual Laurence Neal Woodworth

Memorial Lecture (Nov. 23, 1998) ("There is often a confidentiality letter to protect the

'proprietary' golden idea."), reprinted in Tax Law Works Best When the Rules are Clear, 98 TNT

225-71.

78 See Bankman, supra note 19, at 1781 (“Notwithstanding confidentiality agreements...,

the details of any successful tax shelter soon reach the promoter community,... with more than

one promoter offering identical or at least similar shelters.”).

79 Section 6111(d). See Jt. Comm. on Tax’n, General Explanation of Tax Legislation

Enacted in 1997, at 222-23 (1997) ("The Congress concluded that the provision will improve

compliance with the tax laws by giving the Treasury Department earlier notification than it

generally receives under present law of transactions that may not comport with the tax laws. In

- 21 -

and their advisors. 77

Before pitching prospective participants with their tax shelter idea, promoters may require a nondisclosure agreement that provides for million dollar payments for any disclosure of their

“proprietary” advice. These arrangements limit, but do not preclude, the expropriation of the idea

by other promoters. 78

Confidentiality serves another essential purpose for the promoter -- it protects the efficacy

of the idea by preventing or delaying discovery of the idea by the Treasury Department and the

IRS. In part, out of concern that confidentiality agreements were hindering the ability of the

Treasury Department and the IRS to uncover corporate tax shelters in a timely fashion, Congress

expanded the tax shelter registration requirements in 1997 to cover “confidential” corporate tax

shelters.79 One of three conditions for registration is that “some promoter other than the taxpayer
addition, the provision will improve compliance by discouraging taxpayers from entering into

questionable transactions.").

80 See Johnson, supra note 76, at 1609. The other two conditions for registration under

section 6111(d) are that the promoters may receive aggregate fees in excess of $100,000 and the

arrangement “has a significant purpose” of tax avoidance or evasion. 

81See Bankman, supra note 19, at 1789 (“It would allow members of the tax bar to discuss

shelters in public forum and in informal conversations with Treasury Department or legislative

staff. The elimination of confidentiality would also make it slightly less profitable to devote

resources to developing new shelters by decreasing the time it takes for a given shelter to come to

the attention of a competitor.”).

82 Forbes, supra note 5, at 208 ("Clients know that if they blab, they won’t see the next

hot deal.").

83 1997 Airlie House Transcript, supra note 9 (Edward Kleinbard stating that there are

investment bankers who say “we won’t show the rest of the deal unless you agree to hire the law

firm we’ve selected for you, or one of three law firms we’ve selected for you, and you can’t talk

to anyone else.”).

- 22 -

already are relying on tacit understandings, 82 or other arrangements ( e.g., requiring a prospective

participant to use the law firm selected by the promoter), 83 to protect their proprietary interest and

reduce the risk of detection. 
84

 See, e.g., ACM, 73 T.C.M. at 2195 ("Colgate’s management understood that most, if

not all, of these [transaction] costs would be borne by Colgate because all the liability

management and tax benefits of the partnership transactions would enure to Colgate. They

believed that the costs, though high in absolute terms, were reasonable in relation to the benefits

that Colgate expected to received from the partnership."). 

85

 See ASA Investerings Partnership v. Commissioner , 76 T.C.M. (CCH) 325, 332

(1998).

86

 See, e.g., ASA, 76 T.C.M. at 326 ("Merrill Lynch representatives further explained that

the proposal was a package deal. Merrill Lynch would serve as the partnership’s financial adviser

and, for a $7 million fee, recruit the foreign partner and arrange for the issuance and sale of the

PPNs and LIBOR notes. To ensure a market for such issuance and sale, Merrill Lynch would

structure and enter into the requisite swap transactions. Merrill Lynch would also serve as the

partnership’s financial intermediary, earning an additional $1,060,000 to $2,130,000 on the PPN

sale and $212,000 to $425,000 on the LIBOR note sale. The foreign partner, for its participation

in the transaction, would charge AlliedSignal the greater of $2,850,000 or 75 basis points (b.p.)

on funds advanced to the partnership. In addition, AlliedSignal would pay all of the partnership’s

expenses. Merrill Lynch estimated that AlliedSignal’s total expenses for the entire venture would

be between $11,300,000 and $12,600,000.").

87 In one recent deal observed by the Treasury Department, prospective participants were

offered a choice of fees, either an up-front payment of 25 percent of taxes saved, or a contingent

fee of 50 percent of taxes saved, with no payment if the advice was overturned on audit. See also

Forbes, supra note 5, at 202 ("Depending on the product and its originality

PriceWaterhouseCoopers may ask customers for a contingency fee equal to 8 percent to 30

percent of their tax savings.").

- 23 -

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

receives a portion, as much as one-half, of any tax savings realized by the corporate participant. 87

If no tax savings are realized, the promoter gets nothing. Although tax return preparers are
88 See 31 C.F.R. sec. 10.28(b) (Standards of practice before the IRS prohibiting

contingent fees for preparation of an original return, but not for preparing amended returns or

claims for refund).

89

 But see AICPA Code of Professional Conduct Rule 302 (ET Section 302) which

prohibits CPAs from providing attest services for clients for which they have provided certain

services on a contingent fee basis.

- 24 -

rescission arrangement, the parties to the transaction agree to unwind the transaction if the

purported tax benefits are not realized. Often, there is a so-called "trigger" event, such as a

change in law or an IRS audit that is determined by an independent third party to constitute a

significant risk to the tax benefits of the transaction. If the trigger event occurs, the transaction is

unwound. The unwind may take the form of the liquidation of any entity formed for purposes of

the tax shelter, the redemption of any securities issued pursuant to the shelter or the termination

of any contractual agreements. In this way, the corporate participant is not burdened with any

complex or costly financial or legal structures that were part of the design of the suddenly defunct

tax shelter. For example, fast-pay preferred stock transactions provided for the tax-free unwind

of the REIT structure through liquidation of the REIT.
90 See, e.g., NYSBA, Report, supra note 19, at 883 (“Based on our collective experience,

however, we are quite certain that a substantial number of large corporate taxpayers have been

persuaded to participate in one or more of these [corporate tax shelter] transactions, and the

incentives and impetus are there for the frequency of such transactions to increase substantially. 

Indeed, as more aggressive corporate taxpayers continue to exploit the tax law to increase aftertax earnings, other corporate taxpayers will undoubtedly feel greater pressure to engage in the

same tax-driven transactions.”)

91 The rate reduction was phased-in over two years. The maximum corporate tax rate was

subsequently raised to 35 percent in 1993. I.R.C. § 11(b).

92 See, e.g., Robert S. McIntyre and Robert Folen, Corporate Income Taxes in the Reagan

Years; A Study of Three Years of Legalized Tax Avoidance , Citizens for Tax Justice (1984). 

The 1986 Act appears to have succeeded in this regard, as corporate tax payments increased

sharply in the late 1980s. See National Income and Product Accounts, Volume 1, Table 1.16

(Apr. 1998) [hereinafter NIPA].

- 25 -

This part discusses qualitative factors that have contributed to the growth of corporate tax

shelters and evaluates the evidence from tax returns and the experience of experts in the field.

A. THE CHANGING COST-BENEFIT CALCULUS OF CORPORATE TAX SHELTERS

1. Greater Incentive to Use Tax Shelters

The principal benefit of a corporate tax shelter is tax savings. The Tax Reform Act of

1986 (1986 Act) reduced the attractiveness of tax shelters in one respect by lowering marginal tax

rates from 46 percent to 34 percent. That rate reduction meant that a $1.00 reduction in

corporate taxable income was worth 12 cents less in 1988 than it was in 1986. 91 The 1986 Act

also eliminated or reduced a host of corporate tax preferences, most notably accelerated

depreciation and the investment tax credit. These changes were motivated, in part, by a

perception that many large companies were paying little or no tax in the early 1980s, despite

having substantial economic income. 92 On balance, the corporate base broadening more than

offset the rate reduction, meaning that the average tax rate of corporate income increased, even
93

 See NYSBA, Report, supra note 19, at 882.

94 U.S. Treasury, Integration of Individual and Corporate Tax Systems: Taxing Business

Income Once, Washington, D.C.: U.S. Government Printing Office, 1992, pp. 5-11 and pp.

115-116.

95 In 1989, LBOs accounted for 27 percent of the value of mergers and acquisitions. By

1997, they were less than 1 percent of the total. Mergers and Acquisitions (May/June 1991) and

(March/April 1998).

96 See NIPA, supra note 92.

97 NYSBA, Report, supra note 19, at 882-883.

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such as accelerated cost recovery allowances. 94 That concern has abated for several reasons. 

Leveraged buyouts (LBOs), commonly thought to be an important vehicle for increases in

corporate leverage during the 1980s, have all but disappeared. 95 Net interest paid by nonfinancial

corporations has become progressively less important in the 1990s. By 1997, it equaled only 14

percent of total capital income of nonfinancial corporations, down by 60 percent compared with a

35-percent share of capital income at the beginning of the decade. 96 

Part of the reduction in net interest may be due to the decline in the corporate statutory

tax rate, a decline that reduced the tax benefit of the deduction for interest paid. Other factors,

such as the fall in interest rates in the 1990s, undoubtedly have also been important. As a result of

all those changes, firms have a stronger incentive to look elsewhere in the Code in search of

techniques for reducing their taxes.

2. The Reduced Cost of Corporate Tax Shelters

A myriad of factors have reduced the cost of corporate tax shelters. 97 

a. Increased financial sophistication. Tax and financial advisers have become much

more sophisticated about engineering transactions to avoid tax -- which means that the cost of
98 NYSBA, Report, supra note 19, at 882.

99 See, e.g., Powlen & Tanden, supra note 29, at 1009.

100 See Andrew A. Samwick, Tax Shelters and Passive Losses after the Tax Reform Act of

1986, in Martin Feldstein and James M. Poterba, eds., Empirical Foundations of Household

Taxation, National Bureau of Economic Research Project Report series, University of Chicago

Press (1996), at 193-226.

- 27 -

boggling array of products and creating the possibility to engineer new financial assets at very low

cost. As discussed in Part II.B. of the Report, those products provide the engine for some

sophisticated corporate tax shelters.

As in other technology-driven enterprises, the growth of the market for corporate tax

shelters lowers the cost of implementing existing shelter schemes and of developing new ones, as

participants in the market learn from their experiences . Employees who move from one firm to

another take their knowledge and expertise with them and disseminate it. Business schools have

been offering increasingly sophisticated finance programs, teaching cutting-edge mathematical

techniques and advanced computer technologies. All these factors help breed corporate tax

shelter development. 

b. Increased supply of tax shelter specialists. The supply of tax shelter experts has

increased, producing competitive pressures to lower the cost and expanding the array of

sheltering schemes. By clamping down on individual tax shelters, the 1986 Act may have boosted

the supply of corporate tax shelter specialists. As discussed more fully in Part IV.C. of the

Report, the 1986 Act addressed individual tax shelters by reducing marginal tax rates, eliminating

the investment tax credit, eliminating the tax preference for capital gains, and enacting the passive

loss rules. By most accounts, it was quite successful in reducing individual tax shelters .

100 But

the elimination of those tax shelters may have freed up a supply of knowledgeable and willing tax

practitioners and shelter promoters, who have turned to corporate tax shelters as a source of

employment in the 1990s. Thus, at the same time that the 1986 Act helped boost demand for

corporate tax reductions, it created a supply of those who are expert in seeking out novel ways to

reduce taxes.
101 See Bankman, supra note 19, at 1784; Forbes, supra note 5, at 198; NYSBA, Report,

supra note 19.

102 See Richard Meyer, Running for Shelter: Tax Shelters and the American Economy,

Washington, D.C.: Public Citizen (February, 1985).

103 See Joel Slemrod and Varsha Venkatesh, Public Attitudes About Taxation and the

2000 Presidential Campaign, 83 Tax Notes 1799 (June 21, 1999); and Joel Slemrod and Jon

Bakija, Taxing Ourselves: A Citizen’s Guide to the Great Debate Over Tax Reform , The MIT

Press, Cambridge: MA (1996), at 5.

104 See David Weisbach, Formalism in the Tax Law, 66 Chi. L. Rev. ___ (1999)

[hereinafter Weisbach].

105 See Bankman, supra note 19, at 1784; Forbes, supra note 5, at 200.

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A similar phenomenon may be happening now. Many reports in the popular press, and the

results of many polls, suggest that taxpayers increasingly view the current tax system as unfair. 103

Taxpayer resentment of the U.S. tax system may be fueled by the complexity and perceived

arbitrariness of the tax law. Some taxpayers and practitioners may feel that given the level of

complexity of the Code and the seemingly limitless layering of rules, whatever is not proscribed is

allowable. Other taxpayers and practitioners may feel that because the Congress and the Treasury

Department enact and promulgate Code provisions and regulations that are “one-sided” or “antitaxpayer,” the taxpayer is free to develop tax shelters that balance the effect of those seemingly

unfair provisions.104 In such an environment, some corporations may be more willing to take

aggressive tax positions .

At the same time, as discussed more fully in Part II.A.2 of the Report, corporate officers

are paying greater attention to the effect of taxes on their reported earnings. Corporations

increasingly view their tax departments as profit centers, rather than as general administrative

support facilities.

105 Effective tax rates may be viewed as a performance measure, separate from
106 IRS Annual Reports, various years.

107

 See Jeremy Holmes, TRAC Says IRS Data Show Decline in Audit, Fraud Prosecution

Activities, Daily Tax Report (Apr. 12, 1999), at GG-6.

108 NYSBA, Report, supra note 19, at 883.

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d. Reduced audit risk from aggressive tax shelters. Taxpayers may be more likely to

take aggressive tax positions because they perceive the risk of audit to be low. Audit rates for

large corporations (those with assets greater than $100 million) have fallen dramatically over the

past several years. For example, in 1980, 77 percent of companies with assets above $100 million

were audited. By 1990, the audit rate for those companies had fallen to 59 percent, and in 1997

only 35 percent of those companies were audited. 106

Part of this decline is due to the growth in the number of large companies, which occurs

naturally because of real economic growth and inflation. Thus, a $100 million company in 1980

would be much larger in real terms than a $100 million company in 1997. But the overall audit

rate for corporate tax returns also has declined, from 2.9 percent in 1992 to 2.0 percent in 1998,

suggesting a decline in enforcement intensity. 107 The number of audits declined over the same

time period. Although the audit rate is an imprecise guide to enforcement activity, corporate tax

departments perceive that detection is less likely now than in the past. 108

3. Other Factors

Various other factors have spurred the proliferation of corporate tax shelters. Increased

complexity in the Code creates more of the discontinuities that spawn tax shelters. A global

marketplace for both products and capital creates opportunities that would not exist without

trade. And finally, the merger boom of the 1980s and 1990s may have created some new avenues

for tax shelter activity.

a. Complexity. The more complex is the tax law, the more likely it is that aggressive

taxpayers will be able to find and exploit discontinuities. Thus, a recent increase in complexity

may have contributed to the boom in corporate tax shelters. Certain specific tax changes may be
109

 See, e.g., Notice 98-5, 1998-3 I.R.B. 49.

110 NYSBA, Report, supra note 19, at 881.

111 See Forbes, supra note 5, at 200; Powlen and Tanden, supra note 29, at 1009;

Bankman, supra note 19, at 1784.

112

 See Appendix A for a description of these transactions.

113 M&A Almanac, 1992

114 M&A Almanac, 1998

115

 See Alan Auerbach and David Reishus, The Effect of Taxation on the Merger

Decision, NBER Working Paper No. 2192, Cambridge MA: National Bureau of Economic

Research (March 1987); Taxes and the Merger Decision: An Empirical Analysis, NBER Working

- 30 -

b. Globalization and financial innovation. Several commentators have cited the

increasing sophistication and globalization of financial markets as a partial explanation .

111 Many

tax shelters that have come to light involve complicated financial transactions, sometimes

involving foreign parties (examples include ACM, fast-pay preferred stock, LILOs, and 357 basis

shifting involving foreign corporations). 112 Such transactions may have been facilitated by

technological advance in financial product development, and by the globalization of world capital

markets. Globalization has increased the ability for taxpayers to arbitrage differences between tax

systems of different countries through cross-border transactions.

c. Merger booms of the 1980s and 1990s. In the middle and late 1980s, the United

States experienced a booming market in mergers and acquisitions. For example, in 1983, merger

and acquisition activity involving U.S. companies totaled less than $50 billion. By 1986, such

transactions reached $201 billion, and remained high throughout the 1980s. 113 After falling in the

early 1990s, merger and acquisition activity has rebounded to reach new heights. In 1997, merger

activity involving U.S. companies totaled $791 billion, over 300 percent larger than in 1993. 114

Those merger booms, although unlikely to be tax driven, may create tax planning opportunities. 115
Paper No. 1855, Cambridge MA: National Bureau of Economic Research (March 1986).

116 Most notably in 1986, Congress repealed the General Utilities doctrine, which allowed

taxpayers to receive a tax-free step-up in acquired assets. Most recently, Congress eliminated the

use of the Morris Trust transaction, making it more difficult for a conglomerate to dispose of

unwanted subsidiaries on a tax-free basis.

117 See Forbes, supra note 5; Bankman, supra note 19; NYSBA, Report, supra note 19.

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are not required to identify shelters. In fact, the whole point of tax shelters is to hide income from

the tax authority. It is very hard to measure an absence of income. At the same time that we

believe tax shelters have proliferated, the economy has been booming and interest rates have been

falling, causing taxable corporate income to increase. At issue, however, is whether the rate of

taxable income increase has kept pace with the growth in corporate profits.

As already discussed, experts in the field are convinced based on their own experience that

corporate tax shelters are very significant. Forbes magazine and others have conjectured that

corporate tax shelters might cost the U.S. Treasury $10 billion annually, and that this number is

growing dramatically. 117 The conjecture is based on unscientific evidence, but it reflects the

widespread agreement that the tax shelter phenomenon is important and growing.

In specific cases, there is direct evidence of how corporate tax shelters can grow like

wildfire. One corporate tax shelter, liquidating REITS, was virtually invisible in the data until

1996. Liquidating REITS generally involved the use of closely held mortgage REITS that were

created solely to be liquidated within a year or two for tax reasons. The value of mortgages in

closely held REITS soared by over 1,100 percent from 1995 to 1997, from $9 billion in 1995 to

$111 billion in 1997, as word of the tax-sheltering technique spread rapidly. The Treasury

Department estimated in 1998 that liquidating REITS reduced corporate tax receipts by $0.5

billion in 1997, and were likely to reduce corporate tax receipts by over $13 billion over the

following five years. Based on more recent data, those estimates probably significantly

understated the magnitude of the problem. The liquidating REIT tax shelter was closed as part of

the Tax and Trade Relief Extension Act of 1998.
118 See Lillian F. Mills and Kaye J. Newberry, The Relation Between Reporting Incentives

and Firms’ Book-Tax Earnings Conformity: Further Evidence of Earnings Management ,

unpublished working paper, University of Arizona (January 1999). See also Lillian F. Mills,

Book-Tax Differences and Internal Revenue Service Adjustments, 36 Journal of Accounting

Research 343-56 (Autumn 1998) (Mills finds evidence that the IRS is more likely to assert

deficiencies on firms with large book-tax disparities, indicating that such disparities are correlated

with aggressive tax planning). 

119 Note that this ratio is extremely volatile. For example, in 1989 it was 1.23, fell to 1.08

in 1990, jumped up to 1.20 in 1991, and fell again to 1.09 in 1991.

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taxable income has increased recently. The ratio of pre-tax book income to taxable income was

1.82 in 1995 and 1.86 in 1996, substantially above its average of 1.25 during the 1990-1994

period, and considerably higher than at any time since (at least) 1985. 119

Figure 1 shows the discrepancy between book income and taxable income for corporations

with assets over $1 billion, in 1992 dollars. The difference has clearly been growing since 1992.
- 33 -

87 88 89 90 91 92 93 94 95 96

Year

100

200

300

400

500

600

700

(in Billions of 1992 Dollars)

Pre-tax book income is defined as after-tax book income plus federal taxes, as reported on lines 1 and 2 of Schedule M.

Book Income

Taxable Income
120 Stanley Surrey, Complexity and the Internal Revenue Code: The Problem of the

Management of Tax Detail, 34 Law & Contemp. Probs. 673 (1969).

121 Weisbach, supra note 104.

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doctrines discussed below, serve several essential functions in our rule-based system. First, their

mere existence allows the rules to be simpler and less complete then they otherwise would need to

be. As Stanley Surrey observed some thirty years ago: “It is clear that [various anti-avoidance

provisions in the law at that time] save the tax system from the far greater proliferation of detail

than would be necessary if the tax avoider could succeed merely by bringing his scheme within the

literal language of substantive provisions written to govern the everyday world.”

120

Second, a system of rules backed up by standards can more accurately measure income

than a system of rules alone.121 When the rules by themselves produce results that are unintended

or inappropriate, the application of a standard can defeat a literal interpretation of the rules,

thereby providing a more reasonable result. For example, the business purpose requirement in

corporate transactions performs this function, allowing the courts to disregard formalities and

recharacterize transactions in certain cases. 

Finally, standards reduce the level of certainty in the system as a whole. This reduction

cuts both ways. In one sense, it acts as a powerful brake on the most egregious forms of taxmotivated activity. If the possible application of an overriding standard makes the tax

consequences of a tax shelter uncertain, risk-averse taxpayers may not engage in the shelter. At

the same time, however, too much uncertainty can inhibit or “chill” legitimate commercial

transactions.

The standards that overlay the Code can be roughly grouped into three categories. First,

under certain regulatory “anti-abuse” rules, the IRS may recharacterize the tax results of

transactions that, while designed to meet the literal requirements of a particular Code or

regulatory section, clearly frustrate the purpose of the relevant Code or regulatory section. 

Second, the Code provides various broad grants of authority to the Secretary to clearly reflect

income and to prevent avoidance of tax. Finally, even in the absence of an explicit grant of

authority in the Code or regulations, the tax benefits arising from a transaction may be disallowed
122 For GAAP purposes, income tax expense includes both current tax expense (taxes

actually paid to the government for the year) and deferred tax expense (taxes paid in a later year). 

123 See supra note 22.

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a significant amount of income. In the past, Congress and the Treasury Department have

responded by either amending the provisions or creating a system to overlay the provisions to

ensure that they may only be applied as intended. 

a. Deferral. Deferral is the postponement of tax with respect to income that has

economically accrued. Because the taxpayer must eventually pay the tax liability postponed

through a deferral transaction, deferral generally provides the taxpayer with an interest-free loan

from the Government. For GAAP purposes, deferred taxes are treated as an expense for the year

in which the related income is reported for book purposes 122 and cumulative deferred taxes are

accounted for in a liability account known as a deferred tax reserve. 123 

Deferral can arise in a number of ways. Some provisions of the Code and regulations

specifically sanction deferral (e.g., the realization principle, the reorganization provisions and the

cash method of accounting). Deferral also can arise from taxpayers’ manipulations of the tax law. 

For instance, taxpayers often attempt to structure transactions that accelerate deductions in the

early years of the transaction (which can be used to shelter other income of the taxpayer), and

defer the income until later years. A recent example of this type of transaction is the LILO

transaction, discussed more fully in Appendix A. 

Section 1281 illustrates a Congressional response to deferral. Prior to the enactment of

section 1281, taxpayers using an accrual method of accounting could purchase short-term

obligations that mature shortly after the taxpayer’s tax year ends. If the taxpayer borrowed to

fund the purchase, the taxpayer could accrue an interest deduction in the first year while deferring

all of the economically offsetting interest income until it was received in the second year. Section

1281 was enacted in response to this problem, by requiring taxpayers that use an accrual method

of accounting to accrue interest income on short-term obligations, thereby matching in time their

accrued interest income with accrued interest expense.
124 If a corporation enters into a tax shelter that it or its auditors believe may be

challenged by the IRS, the corporation may establish a reserve for all or a part of such contingent

tax liability. Such reserve may be reversed or reduced ( i.e., increase book income) when the

corporation feels that such threat has subsided ( e.g., because the IRS did not challenge the issue,

another taxpayer successfully litigated the issue, etc.). 

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reserves need not be established). 124 Corporate tax shelters may be designed to provide the same

benefits as exclusion by creating inflated deductions, basis, or other tax attributes the use of which

shelter from tax otherwise taxable income (as discussed in subsection d., below). The liquidating

REIT transaction is a recent example of an exclusion-based tax shelter, as discussed more fully in

Appendix A. 

c. Conversion. Conversion occurs when taxpayers are able to transmute one form or

source of income into a tax-preferred form or source. For example, taxpayers may manipulate the

different tax rules applicable to ordinary and capital items to convert income or loss from one

form into another. Although there is no capital gains rate differential for corporations,

corporations are subject to the capital loss limitation rules, and thus generally prefer income to be

characterized as capital gain, and losses to be characterized as ordinary losses. 

For example, prior to the enactment of section 1258 in 1993, taxpayers could agree to sell

property forward for a fixed price. Although the gain from the sale related entirely to the time

value of money (i.e., was in the nature of interest income), the seller would claim that the gain

from the sale was capital gain. Section 1258 precludes taxpayers from converting what is

ordinary income into capital gain through the use of these types of financial transactions (that is,

financial transactions generally consisting of two or more positions taken with regard to the same

or similar property).

Conversion also occurs in connection with the source of income. In general, U.S.

taxpayers have an incentive to characterize items of income or gain as foreign source and items of

deduction or loss as U.S. source. A U.S. taxpayer can shelter foreign source income from a

residual U.S. tax with foreign taxes paid on that income (or by cross-crediting foreign taxes paid

with regard to other income in excess of the U.S. rate if such income is in the same category of

income under section 904). A foreign source loss, on the other hand, may not be of much value
125 For an example of this type of conversion in the context of a corporate tax shelter, see

Appendix A.

126 For a more complete discussion of this type of arbitrage, see discussion of taxindifferent parties, supra, at Part II.B.3.

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opportunities have been found by taking advantage of the use of entities that enjoy tax-exempt

status or that employ different methods of accounting. 126

Other arbitrage opportunities exist by using Code provisions in combinations to obtain a

tax benefit from a transaction that may be uneconomic absent tax considerations. For example,

assume that a taxpayer in the 30 percent marginal tax bracket can borrow $10,000 at seven

percent interest to buy bonds yielding five percent interest. On its face, this transaction is

uneconomic because the taxpayer would appear to be losing $200 a year ($500 interest received

less $700 interest paid). However, if the interest on the five-percent bonds is tax exempt and the

interest on the borrowing deductible, the taxpayer would be $10 ahead ($500 interest received

less $700 interest paid plus $210 tax benefit from deductible interest). In this transaction, the

taxpayer is arbitraging the tax-exempt status of the five-percent bonds and the tax-deductible

status of the seven-percent borrowing to achieve a tax benefit. Congress has responded to such

opportunities, for example, with the enactment of section 265, which disallows a deduction for

interest payments on debt “incurred or continued to purchase or carry” tax-exempt obligations. 

(For a discussion of another recent tax shelter transaction structured to obtain such arbitrage, see

the discussion of company-owned life insurance in Appendix A.)

Corporate taxpayers have also found tax arbitrage opportunities in transactions structured

to take advantage of the exclusion provided by the dividends-received deduction (“DRD”). The

DRD was designed to mitigate the taxation of corporate earnings distributed to another

corporation. At times, however, taxpayers have applied the DRD rules in ways not contemplated, 

which have led to responses by Congress. For example, transactions have been structured to shift

ownership of dividend-paying stock temporarily to a corporate taxpayer eligible for the DRD

immediately before the dividend payment date. Also, transactions have been structured so that a

corporate taxpayer holds both short and long positions in stock over the dividend payment date to

deduct the amount of the dividend paid to the lender of the short stock and report only a small
127 For example, under section 246(c), the DRD is denied if the stock is not held for more

than forty-five days (or ninety days in the case of certain preferred stock), and the holding period 

is tolled if the taxpayer substantially diminished its risk of loss from holding the stock.

128

 See Weisbach, supra note 104.

129 1997 Airlie House Transcript, supra note 9 (David Hariton commented, “I think the

anti-abuse rules are a terrific accomplishment of the Administration’s first four years. A day

doesn’t go by without my telling somebody that they can’t do that because of the swap anti-abuse

rule, the OID anti-abuse rule, or whatever.”).

130 Treas. Reg. § 1.701-2.

131 Treas. Reg. § 1.1275-2(g).

132 T.D. 8588 (Dec. 29, 1994), amended by T.D. 8592 (Apr. 12, 1995).

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of targeting specific transactions. They also help limit the need for even more complicated rules

that otherwise would be necessary to address all potential fact situations. 128 One commentator

has declared that anti-abuse rules potentially are “a path towards a coherent solution” to the

problem of tax shelters. 129

 For example, as a result of numerous transactions structured to take advantage of a literal

reading of the partnership provisions of the Code and regulations, the Treasury Department

promulgated final regulations providing for a partnership anti-abuse rule. 130 As another example, 

the final regulations providing rules for the timing and amount of original issue discount (OID)

contain an anti-abuse rule that applies if a debt instrument is structured or engaged in with “a

principal purpose” to achieve a result that is unreasonable in light of the purposes of the

provisions. 131

a. Partnership anti-abuse rule. On December 29, 1994, the Treasury Department

issued final regulations providing an anti-abuse rule under subchapter K of the Code. 132 These

regulations were issued in response to an increasing number of transactions that attempted to use
133

 See PS-27-94 (May 12, 1994), reprinted at 1994-1 C.B. 832, 833.

134

 See, e.g., Notice 94-48, 1994-1 C.B. 357 (partnership structure used to provide

issuing corporation tax benefits of issuing debt even though corporation actually issues stock).

135 Treas. Reg. § 1.701-2(a).

136 For a detailed discussion of these doctrines, see infra Part IV.A.2. (clear reflection of

income), Part IV.B.1. (substance over form), and Part IV.B.2.(business purpose). 

137

 Treas. Reg. § 1.701-2(a).

138

 Treas. Reg. § 1.701-2(a)(3); see also Treas. Reg. § 1.701-2(d), Ex. 6 (relating to value

equals basis rule in Treas. Reg. § 1.704-1(b)(2)(iii)( c)); Ex. 9 (relating to election under section

754 to adjust basis of partnership property); and Exs. 10 & 11 (relating to basis in distributed

property under section 732).

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intended to foster. The regulations incorporate established legal doctrines, such as business

purpose, substance over form and clear reflection of income, 136 in combination with an analysis of

the purposes of subchapter K.

The regulations begin by setting forth certain requirements that are implicit in the intent of

subchapter K. These requirements are that (1) the partnership is bona fide and each partnership

transaction has a substantial business purpose; (2) the form of each partnership transaction is

respected under substance-over-form principles; and (3) the tax consequences under subchapter K

generally must properly reflect the partners’ economic agreement and the partner’s income. 137 In

recognition of the fact that certain provisions of subchapter K were adopted to promote

administrative convenience and other policy objectives and thus, in some circumstances, tax

results may not clearly reflect income, the regulations provide that the clear reflection of income

requirement will be met if requirements (1) and (2) above are met and the tax results of the

transaction were “clearly contemplated” by the subchapter K provision. 138
139 Treas. Reg. § 1.701-2(b).

140 Treas. Reg. § 1.701-2(e)(1).

141 Announcement 94-87, 1994-27 I.R.B. 124.

142

 See, e.g., Treas. Reg. §§1.1502-13 (intercompany transactions); 1.1502-20 (loss

disallowance); 1.1502-32 (investment adjustments); 1.1502-90T through 99T (application of

section 382).

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thereunder.140

In an effort to ensure that the regulations are applied only in appropriate situations, all

issues affected by the regulation in an examination must be coordinated with both the Issue

Specialist on the Partnership Industry Specialization Program team and the IRS National Office. 141

b. Original issue discount (OID) anti-abuse rule. In general, the OID rules (sections

1271 through 1275 of the Code) provide for the calculation of accrued, but unpaid interest with

respect to a debt instrument on an economic yield-to-maturity basis. Holders and issuers of OID

instruments take OID into account on an accrual basis, regardless of the taxpayer’s overall

method of accounting. The OID regulations contain a number of highly mechanical rules to

calculate economic yield on a debt instrument. As a result, it is possible for taxpayers to structure

transactions that literally meet the requirements of these mechanical rules but that produce results

that are unreasonable in light of the broad principles underlying the OID provisions. To address

these situations, the Treasury Department proposed in 1994, and finalized in 1996, the OID antiabuse rule of §1.1275-2(g). This rule authorizes the Commissioner to apply or depart from the

OID rules, as necessary, to prevent taxpayers from achieving results that are “unreasonable” in

light of the purposes of the OID statutory provisions.

c. Consolidated return anti-abuse rules. The consolidated return regulations issued

under the authority of section 1502 of the Code are characterized by a large number of highly

complex mechanical rules.142 Because even more complicated rules would be required to address

every conceivable (and unanticipated) fact pattern, the regulations contain a series of general anti-
143 CO-11-91, 1994-1 C.B. 724.

144 T.D. 8597, 1995-2 C.B. 147.

145 See, e.g., Treas. Reg. §§1.1502-13(h) (“[i]f a transaction is engaged in or structured

with ‘a principal purpose’ to avoid the purposes of this Section (including, for example, by

avoiding treatment as an intercompany transaction), adjustments must be made to carry out the

purposes of this Section”); 1.1502-19(e) (“[i]f any person acts with ‘a principal purpose’ contrary

to the purposes of this Section, to avoid the effect of the rules of this Section or apply the rules of

this Section to avoid the effect of any other provision of the consolidated return regulations,

adjustments must be made as necessary to carry out the purposes of this Section”); 1.1502-

21T(c)(2)(iv) (“[t]he members composing a SRLY subgroup are not treated as a SRLY subgroup

if any of them is formed, acquired, or availed of with ‘a principal purpose’ of avoiding the

application of, or increasing any limitation under, this paragraph (c)”); see also Treas. Reg.

§§ 1.1502-32(e), 1.1502-33(g), and 1.1502-76(b)(3) (all to similar effect). For other formulations

of anti-abuse rules in the consolidated return regulations, see Treas. Reg. §§ 1.1502-17(c)

(addressing activities acquired or engaged in with “the principal purpose” to avail the group of

certain accounting methods); 1.1502-20(e) (addressing a taxpayer who “acts with a view to avoid

the effect of the rules of this Section . . .”).

146

 See Woods Investment Co. v. Commissioner, 85 T.C. 274 (1985), acq. 1986-2 C.B. 1. 

In this case, the Tax Court stated 

[i]f respondent believes that his regulations and section 312(k)

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The typical consolidated return anti-abuse rule requires that adjustments must be made to

carry out the purposes of the underlying regulation if a transaction is structured or undertaken

with “a principal purpose” of avoiding those purposes. 145

Prior to the promulgation of the anti-abuse rules, courts interpreted the consolidated

return regulations literally, and would not allow the IRS to recast transactions that met the rules

as drafted even if respecting such transactions led to inappropriate results. 146
together cause petitioner to receive a ‘double deduction,’ then

respondent should use his broad power to amend his regulation. 

Since respondent has not taken steps to amend his regulations, we

believe his apparent reluctance to use his broad power in this area

does not justify judicial interference in what is essentially a

legislative and administrative matter. 

Id. at 282.

147 Treas. Reg. § 1.446-1(a)(1). The legislative history of the 1924 Act explained the clear

reflection of income authority as follows: 

[A]uthority is granted to the Commissioner to allow or require

deductions and credits to be taken as of a year other than that in

which ‘paid’ or ‘accrued’ when, in his opinion, it is necessary in

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shareholders, and the principal purpose for such acquisition is evasion or avoidance of Federal

income tax by securing the benefit of a deduction, credit, or other allowance, the Secretary may

disallow such tax benefit either in whole or in part to the extent necessary to eliminate such

evasion or avoidance of income tax. For purposes of this rule, control means the ownership of 50

percent of the corporation’s stock (by vote or value). The rule applies also in the case of a

qualified stock purchase by one corporation of another corporation, in the event that the acquiring

corporation does not elect to treat the stock purchase as an asset acquisition, and where the

acquired corporation is liquidated pursuant to a plan of liquidation adopted not more than two

years after the acquisition date, the principal purpose of which is to secure the benefit of a

deduction, credit, or other allowance. Section 269 was originally enacted in 1943 to deter the

growing practice of purchasing loss corporations to serve as a shell to offset the profits of the

purchasing corporation’s businesses.

b. Section 446. If the Secretary determines that a taxpayer’s regular method of

accounting does not clearly reflect income, the Secretary may prescribe a method of accounting to

be used in computing a taxpayer’s taxable income that, in the Secretary’s opinion, does clearly

reflect income.147 This authority is not limited to a taxpayer’s overall method of accounting, but
order to clearly reflect income. ... The necessity for such a

provision arises in cases in which a taxpayer pays in one year

interest or rental payments or other items for a period of years. If

he is forced to deduct the amount in the year in which paid, it may

result in a distortion of his income which will cause him to pay

either more or less taxes than he properly should. 

H.R. Rep. No. 68-179, at 10-11 (1924).

148 Treas. Reg. § 1.446-3 prescribes the proper timing of income and loss arising from a

swap transaction. The regulation arose as a result of taxpayers utilizing swaps to improperly

accelerate taxable income. See Notice 89-21, 1989-1 C.B. 651.

149 RLC Indus. Co. v. Commissioner, 98 T.C. 457, 491 (1992), aff’d, 58 F.3d 413 (9th Cir.

1995); Capitol Fed. Sav. & Loan Assoc. v. Commissioner, 96 T.C. 204, 209 (1991); Prabel v.

Commissioner, 91 T.C. 1101, 1112 (1988), aff’d, 882 F.2d 820 (3rd Cir. 1989).

150 RLC Indus., 98 T.C. at 491; RECO Indus., Inc. v. Commissioner, 83 T.C. 912, 920

(1984); Peninsula Steel Products & Equip. Co. v. Commissioner, 78 T.C. 1029, 1044 (1982).

151 Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 532-533 (1979) (quoting Lucas

v. American Code Co., 280 U.S. 445, 449 (1930) and Lucas v. Structural Steel Co. , 281 U.S.

264, 271 (1930)).

152 See Pacific Enterprises v. Commissioner, 101 T.C. 1, 13 (1993); RLC Indus. Co., 98

T.C. at 489.

153 Ford Motor Co., v. Commissioner, 102 T.C. 87 (1994), aff’d, 71 F.3d 209 (6th Cir.

1995). In Ford, the taxpayer purchased single premium annuity contracts to fund a series of

payments required under settlements with tort claimants. The cost of the annuity contracts did

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the Secretary may set aside a taxpayer’s method of accounting that is otherwise sanctioned by the

Code or regulations where he determines that the method does not clearly reflect income. 153 
not exceed the present value of the settlement obligations to the tort claimants. Ford claimed a

deduction for the full amount of all future payments it was obligated to make to the tort claimants

under the terms of the settlement agreements. Although Ford claimed that the deduction of the

full amount was permitted under the all events test in the regulations, the Court found that Ford’s

method of accounting for its obligations under the settlement agreements did not clearly reflect

income and that the Commissioner had not abused her discretion in requiring Ford to deduct only

the cost of the annuity contracts. In its analysis, the Court stated that: 

the statute does not limit the Commissioner’s discretion under

section 446(b) by the taxpayer’s mere compliance with the methods

of accounting generally permitted under section 446(c). To the

contrary, section 446 provides that the use of an accounting method

is conditioned upon the method clearly reflecting income ‘in the

opinion of the Secretary.’ In short, the statute clearly provides that

the taxpayers may use an accrual method so long as it clearly

reflects income.

Id. at 99.

154 See Lee A. Sheppard, What Should We Do About Corporate Tax Shelters? , 81 Tax

Notes 1431, 1434 (December 14, 1998) (citing Judge Laro’s observation in ACM Partnership

that the IRS could have used its section 446(b) clear reflection of income authority to deny the

benefits of the installment sale regulation to the taxpayer). 

155 H.R. Rep. No. 70-2, at 16-17 (1928).

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tax liability.”

155

d. Section 7701(l). Congress enacted section 7701(l) in 1993, which gave the

Secretary authority to prescribe regulations recharacterizing any multi-party financing transaction

as a transaction directly among any two or more parties when such recharacterization is

appropriate to prevent avoidance of any tax. Section 7701(l) was considered necessary so that

the Secretary could issue guidance consistent with the courts’ focus on the substance of a
156 H.R. Conf. Rep. No. 103-213, at 654 (1993).

157 See, e.g., Aiken Industries, Inc. v. Commissioner, 56 T.C. 925 (1971). In Aiken, a

domestic corporation (D) borrowed $2,250,000 from a related person (F1), a resident of a

country not having a treaty with the U.S., in exchange for a note bearing interest at four percent. 

F1 assigned D’s note to a related party (F2), a resident in a country having a treaty with the U.S.

that eliminated the 30-percent withholding tax on interest payments from a U.S. person to a treaty

country resident, in exchange for nine notes in the aggregate amount of $2,250,000 bearing

interest at four percent. The Tax Court held that interest payments from D to F2 (which now held

D’s note) did not qualify for the treaty exclusion. Under the Court’s reasoning, F2 did not receive

the interest for its own account ( i.e., it did not have complete dominion and control over the

interest) because it was "committed to pay out exactly what it collected, and it made no profit on

the acquisition of [D’s] note in exchange for its own." 56 T.C. at 934. In this case, F2 was

"merely a conduit" for the passage of interest payments from D to F1. Id.; see also Rev. Rul.

84-152, 1984-2 C.B. 381, declared obsolete , Rev. Rul. 95-56, 1995-2 C.B. 322; Rev. Rul.

84-153, 1984-2 C.B. 383, declared obsolete , Rev. Rul. 95-56, 1995-2 C.B. 322; Rev. Rul. 87-89,

1987-2 C.B. 195, declared obsolete , Rev. Rul. 95-56, 1995-2 C.B. 322; Tech. Advice Mem.

9133004 (May 3, 1991).

158 H.R. Rep. No. 103-111, at 729 (1993) ("The committee intends that the provision

apply not solely to back-to-back loan transactions, but also to other financing transactions.").

159 Treas. Reg. § 1.881-3.

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investments, structured to avoid tax. 158 

In accordance with this broad grant of regulatory authority, the Treasury Department has

already used section 7701(l) to address specific types of multiple-party financing transactions that

permit taxpayers to avoid tax. For example, the Treasury Department promulgated regulations to

prevent the use of an intermediary to avoid tax under section 881, which imposes tax on certain

U.S. source income of a foreign corporation. 159 Also, proposed regulations under section 7701(l)

have been issued to address lease stripping transactions, which are intended to allow one party to

realize income from a lease or similar agreement and another party to report deductions (such as
160 Prop. Reg. § 1.7701(l)-2 (addressing "obligation shifting transactions" such as lease

stripping transactions).

161 Notice 97-21, 1997-1 C.B. 407; Prop. Reg. § 1.7701-3 (recharacterizing fast-pay

stock transactions).

162 For example, under long-standing authorities, a “repo” of securities, although formally

documented as a sale and repurchase, is treated for tax purposes as a secured borrowing. See,

e.g., Rev. Rul. 74-27, 1974-1 C.B. 24. In this case, the formal tax result is based on the

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way in which the taxpayer has presented the facts belies their real substance and, as a result, the

taxpayer is applying the wrong set of mechanical rules in reaching its purported tax consequences. 

Second, the IRS may argue that, while the facts are as the taxpayer has represented, the technical

tax results produced by a literal application of the law to those facts are unreasonable and

unwarranted, and therefore should not be respected. This second line of argument, which

encompasses long-standing principles of business purpose and economic substance, is an

important and essential gloss on our generally mechanical system of determining tax liabilities.

Application of these doctrines to a particular set of facts is often uncertain. Typically, in

the cases in which the IRS has been successful, the IRS has argued that the taxpayer’s transaction

was in some sense artificial--that the taxpayer undertook the transaction in a particular way (even

though economically equivalent avenues were available to the taxpayer) to achieve an

unreasonable or unwarranted tax benefit. Often, it is clear that, if tax savings had not been an

issue, the taxpayer would have used a more straight-forward (and more heavily-taxed) route. 

 

1. Substance Over Form Doctrine

a. In general. As a practical matter, taxpayers, not the IRS, are in control of the

facts. Taxpayers choose the transactions they undertake and, thereby, choose their tax

consequences. Generally, the tax results arising from a transaction (or series of transactions) are

obvious, uncontroverted, and based on the “form” of the transactions the taxpayer has chosen. In

some rare (but important) cases, however, the “substance” of a particular transaction produces

tax results that are inconsistent with its “form” as embodied in its underlying documentation. 162
substance of the underlying transactions, not its formal documentation.

163 Joseph Isenbergh, Musings on Form and Substance and Form in Taxation, 49 Chi. L.

Rev. 859, 866 (1982) [hereinafter Isenbergh].

164 Powlen & Tanden, supra note 29, at 1013.

165 Notice 94-48, 1994-1 C.B. 357.

166 David P. Hariton, Sorting Out the Tangle of Economic Substance , 52 Tax Law, 235, 

239 (1999) [hereinafter Hariton]. Although not really a limitation on the taxpayer’s ability to

choose the facts, it is also clear that the IRS has the ability to dispute the facts themselves. In a

number of cases (often referred to as “factual sham” cases), the IRS has succeeded in arguing that

the facts as represented by the taxpayer did not, in fact, exist. A good example of a factual sham

is Knetsch v. United States, 364 U.S. 361 (1960). In that case, the taxpayer sought to arbitrage

the fact that income on a single-premium deferred annuity savings bond was includible in income

only when paid, while interest on a borrowing to purchase the bond was currently deductible. 

The taxpayer purported to purchase a bond by borrowing the bulk of the purchase price from the

seller of the bond. The Supreme Court held that the taxpayer could not claim the tax benefits of

the purported transaction because the transaction itself never existed--it was a sham.

167 293 U.S. 465 (1935).

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and thereby secure an interest deduction. 165 As one commentator recently has written,

“[s]tandards must govern the factual characterization of relationships and arrangements to some

extent, and the Commissioner must have the ability to challenge the taxpayer’s description of the

relevant facts -- otherwise the taxpayer’s advantage would be insurmountable.”

166

The substance-over-form doctrine has its roots in Gregory v. Helvering.

167 In that case,

the taxpayer wanted to extract appreciated securities from her wholly-owned corporation in a

manner that avoided taxation as a dividend. Accordingly, the distribution of securities was done

in three steps (all within six days): (1) formation of a new subsidiary capitalized with the

appreciated securities; (2) a spin-off of the new subsidiary to the taxpayer; and (3) liquidation of
168 430 F.2d 1185 (5th Cir. 1970), cert. denied, 401 U.S. 939 (1971).

169 89 T.C. 1086 (1987), acq. in result in part 1988-2 C.B. 1. As another example of the

uncertain application of the substance-over-form doctrine, compare Commissioner v. Court

Holding Co., 324 U.S. 331 (1945) (holding that distributions of property to shareholders followed

by their prearranged sale of the distributed property could be recharacterized as a sale directly by

the distributing corporation), with Esmark v Commissioner, 90 T.C. 171 (1988), aff’d per

unpublished order, 886 F.2d 1318 (7th Cir. 1989)(refusing to recharacterize Mobil’s purchase of

Esmark shares followed by a redemption of those shares in exchange for an appreciated asset as a

sale of the appreciated asset by Mobil to Esmark). As one commentator puts it, “[t]he efforts to

‘tease’ out what the taxpayers did wrong in [the Court Holding line of cases] and distinguish them

from what taxpayers did right in other cases have been wholly inscrutable.” Hariton, supra note

166, at 240.

170 I.R.C. § 243.

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wholly-owned subsidiary for $3.5 million because it would have realized a significant gain. (At

the time, its basis in the stock of the subsidiary was $700,000). Instead, prior to the sale,

Waterman caused the subsidiary to distribute a $2.8 million dividend in the form of a note. The

dividend was tax-free to Waterman. 170 Waterman then sold the subsidiary for its reduced value of

$700,000, and reported no gain. Shortly thereafter, the new owner of the subsidiary lent it $2.8

million, which the subsidiary used to pay off the note to Waterman. The Tax Court respected the

transaction as the parties had structured it. The Court of Appeals for the Fifth Circuit reversed

the Tax Court, and found that in substance the transaction should be treated as Waterman’s sale

of the subsidiary for $3.5 million.

Litton involved a transaction almost identical to that in Waterman. It differed only in that

there was no specific buyer for Litton’s subsidiary at the time it paid the dividend note to Litton,

and the sale of the subsidiary occurred about six months after the dividend. The Tax Court found

these differences significant enough to decline to apply the substance-over-form doctrine, and
171

 See also Uniroyal, Inc., v. Commissioner, 66 T.C.M. (CCH) 2690 (1993).

172

 See supra note 169 for a discussion of Esmark.

173 Lee A. Sheppard, Colgate’s Corporate Tax Shelter Showdown , 71 Tax Notes 1284,

1284 (June 3, 1996); see also, Lee A. Sheppard, Substance Over Form in Subchapter C, 44 Tax

Notes 642, 645 (August 7, 1989) (“After Esmark and other cases, the IRS is worried about the

continuing viability of the substance over form doctrine.”); Robert W. Wood, Is the StepTransaction Doctrine Still a Threat for Taxpayers? , 72 J. Tax’n 296 (1990) (“It seems safe to

conclude that the step-transaction doctrine, and the related one of substance over form, may now

be easier for taxpayers to overcome than at any time in the past.”). 

174 76 T.C.M. (CCH) 325 (1998).

175

 See supra notes 212-214 and accompanying text for a discussion of ACM.

176 76 T.C.M. at 326 (“We must look to the substance of the transactions rather than the

form. When the formalities are stripped away, ABN [the foreign “partner”] is in substance a

lender.”(citation omitted)). At least one commentator has been highly critical of the Tax Court’s

reliance in ASA on the substance-over-form doctrine, rather than the economic substance

doctrine. See Hariton, supra note 166, at 58-59. Thus, under this commentator’s line of

reasoning, ACM, which involved similar facts to those at issue in ASA, was more properly

decided because it invoked the economic substance doctrine to disallow the purported losses.

177 King Enterprises, Inc. v. United States, 418 F.2d 511 (Ct. Cl. 1969), stating that “the

central purpose of the step transaction doctrine [is] to assure that the tax consequences turn on

the substance of the transaction, rather than on its form.”

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actually a lender and reallocated the partnership’s gains to the U.S. partners. 176

b. Step transaction doctrine. The step transaction doctrine is a relatively common

application of the substance-over-form doctrine. 177 Under the doctrine, formally separate steps

may be treated as one transaction for tax purposes (rather than giving tax effect to each separate
178

 See Bittker & Lokken, supra note 30, at ¶ 4.3.5. See also Randolph Paul & Philip

Zimet, Step Transactions, in Selected Studies in Federal Taxation, 200 (2d Series, 1938)

[hereinafter Paul & Zimet]; Seymour S. Mintz & William T. Plumb, Jr., Step Transactions in

Corporate Reorganizations , 12 N.Y.U. Inst. on Fed. Tax’n. 247 (1954); Joshua D. Rosenberg,

The Step Transaction Doctrine in Corporate Tax , 1986 N.Y.U.. Inst. On Corp. Tax Plan. 280.

179

 See supra note 167.

180

 See, e.g., Penrod v. Commissioner, 88 T.C. 1415 (1987).

181 The binding commitment test was first articulated by the Supreme Court in

Commissioner v. Gordon, 391 U.S. 83 (1968). In Gordon, a corporation distributed 57 percent

of the stock of its wholly-owned subsidiary to its shareholders, and notified its shareholders that it

intended to distribute the remaining 43 percent within the next few years. Two years later, it

distributed the remaining 43 percent. The taxpayer argued that the two distributions ought to be

stepped together, and that therefore the overall transaction was a tax-free divisive reorganization

under section 355. The Court rejected this argument, stating that “if one transaction is to be

characterized as a 'first step' there must be a binding commitment to take the later step.” Id. at 96.

Cf. Redding v. Comissioner, 630 F.2d 1169 (7th Cir. 1980), cert. denied, 450 U.S. 913 (1981)

(court rejected taxpayer’s argument that receipt and exercise of warrants were tax-free under

section 355 under step-transaction analysis where more than 80 percent of subsidiary stock was

issued to warrant-holders and underwriters within two weeks after warrants were issued).

182

 See Rosenberg, supra note 178, at 406-07; Martin D. Ginsburg and Jack S. Levin,

Mergers, Acquisitions, and Buyouts, § 608.1 (Mar. 1998 ed.)[[hereinafter Ginsburg & Levin]. 

183

 See King Enterprises., Inc. v. United States, 418 F.2d 511, 517 (Ct. Cl. 1969);

Kanawha Gas & Utils. Co. v. Commissioner, 214 F.2d 685, 691 (5th Cir. 1954); Atchinson,

Topeka & Santa Fe R.R. Co. v. United States, 443 F2d 147, 151 (10th Cir. 1971); Associated

Wholesale Groceries, Inc. v. United States , 927 F2d 1517, 1523 (10th Cir. 1991). See also

- 50 -

separate steps will be combined into one transaction if the steps are part of a single scheme or

plan intended from the outset to achieve a specific result. 183 Because the end result test focuses
Stephen S. Bowen, The End Result Test, 72 Taxes 722 (1994).

184

 See Rosenberg, supra note 178, at 407-08.

185

 American Bantam Car Co. v. Commissioner, 11 T.C. 397 (1948), aff’d per curiam,

177 F.2d 513 (3d Cir. 1949), cert. denied, 339 U.S. 920 (1950). See also Paul & Zimet, supra

note 178, at 254.

186 Rosenberg, supra note 178, at 409.

187 Ginsburg & Levin, supra note 182, at § 608.1.

188

 See, e.g., Ronald H. Jensen, Of Form and Substance: Tax-Free Incorporations and

Other Transactions Under Section 351, 11 Va. Tax Rev. 349, 359-67 (1991) (describing similar

cases applying each of the three tests); Ginsburg & Levin, supra note 182, at § 608.1

(“Notwithstanding years of litigation and hundreds of cases, the exact contours of the step

transaction doctrine, and even its proper formulation, are still the subject of intense debate.”).

189 Ginsburg and Levin, supra note 182, at § 608.1.

190

 See generally Boris I. Bittker & James S. Eustice, Federal Income Taxation of

Corporations and Shareholders, ¶ 12.61[3] (6th ed. 1997)[hereinafter Bitker & Eustice]; Ginsburg

& Levin, supra note182, § 608.4. 

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The step transaction doctrine is an amorphous concept. Often,

application of the doctrine hinges on whether a court finds that a

particular series of transactions runs counter to a significant tax

policy.189

Despite the somewhat inconsistent application of these three tests, the step transaction

doctrine has been an effective anti-avoidance tool, particularly in the area of tax-free

reorganizations and incorporations. 190 
191 See, e.g., Higgins v. Smith, 308 U.S. 473, 477 (1940); U.S. v. Morris & E.R. Co., 135

F.2d 711, 713 (2d Cir. 1943), cert. denied, 320 U.S. 754 (1943). Under a related doctrine, when

the form and substance of a transaction are consistent, the taxpayer may not argue that the tax

consequences of the transaction should be determined by the tax consequences that would flow

from an economically similar transaction in which the taxpayer did not engage. See

Commissioner v. National Alfalfa Dehydrating & Mill & Co., 417 U.S. 134, 149 (1974) ("The

Court has observed repeatedly that, while a taxpayer is free to organize his affairs as he chooses,

nevertheless, once having done so, he must accept the tax consequences of his choice, whether

contemplated or not, and may not enjoy the benefit of some other route he might have chosen to

follow but did not." [citations omitted]). 

192

 Estate of Weinert v. Commissioner, 294 F.2d 750, 755 (5th Cir. 1961).

193

 Danielson v. Commissioner, 378 F.2d 771, 775 (3d Cir. 1967), cert. denied, 389 U.S.

858 (1967).

194

 Ullman v. Commissioner, 264 F.2d 305 (2d Cir. 1959) (applying the strong proof

rule). See also Illinois Power Co. v. Commissioner, 87 T.C. 1417 (1986) (discussing both the

strong proof and Danielson rules); Estate of Durkin v. Commissioner, 99 T.C. 561 (1992) (Tax

Court indicates that, in order to satisfy the strong proof rule, a taxpayer must, at a minimum,

establish that (i) the taxpayer reported the transaction in accordance with its substance, (ii) the

taxpayer’s reports and actions show an honest and consistent respect for the substance of the

transaction, (iii) the taxpayer does not change its position upon challenge, and (iv) the parties are

aware of the substance of the transaction and the taxpayer would not be unduly enriched at the

other party’s expense by relying upon the substance of the transaction).

- 52 -

jurisdictions merely require strong proof (something more than a preponderance of the evidence

but something less than the Danielson rule) that the substance of the transaction should be

followed.194 

Taxpayers are put to an exacting burden of proof when trying to recharacterize their

transactions because of concerns over unjust enrichment, post-transactional tax planning, and the

potential for the IRS to be whipsawed by the parties taking inconsistent positions with respect to
195

 See, e.g., Danielson, 378 F.2d at 771; Insilco Corp. v. United States, 53 F.3d 95 (5th

Cir. 1995) (taxpayer precluded from recharacterizing six years later a transaction originally

structured as a sale). See also Michael Baillif, When (and Where) Does the Danielson Rule Limit

Taxpayers Arguing ‘Substance Over Form?, 82 J. Tax’n 362 (1995); Robert Thornton Smith,

Substance and Form: A Taxpayer’s Right to Assert the Priority of Substance , 44 Tax Law. 137,

144-46 (1990); William S. Blatt, Lost on a One-Way Street: The Taxpayer’s Ability to Disavow

Form, 70 Or. L. Rev. 381 (1991).

196

 Danielson, 378 F.2d at 771.

197 The amount that a purchaser pays to a seller for a covenant not to compete in

connection with the sale of a business generally is ordinary income to the seller and is amortizable

by the purchaser.

198

 Danielson v. Commissioner, 44 T.C. 549 (1965), vacated and remanded, 378 F.2d 771

(3d Cir. 1967), cert. denied, 389 U.S. 858 (1967).

- 53 -

had in effect produced strong proof that the covenant not to compete was not realistically

bargained for by the parties and that the amount allocated in the agreement to the covenant was,

in reality, part of the purchase price for the stock. 198

On appeal, the IRS argued in Danielson that the taxpayer should not be permitted to

attack its agreement, as the agreement spelled out the precise amount to be paid for a covenant

not to compete, except in cases of fraud, duress, or undue influence. The Third Circuit agreed,

finding that the prohibition on permitting one party to attack the agreement was necessary to

prevent unjust enrichment (as the presumed tax consequences could have affected the

determination of the purchase price, as it did in this case), would negate the reasonably

predictable tax consequences of the agreement to the parties, and would cause administrative

problems for the IRS in seeking to collect the proper amount of tax from the parties.
199

 See, e.g., Strick Corp. v. United States , 714 F.2d 1194 (3d Cir. 1983) (limiting

Danielson rule to cases where its underlying policy considerations are implicated).

200 Section 1060(a) provides that if, in connection with an applicable asset acquisition, the

transferor and transferee agree in writing as to the allocation of any consideration, or as to the fair

market value of any of the assets, such agreement shall be binding on both the transferee and

transferor unless the Secretary determines that the allocation (or fair market value) is not

appropriate. See H.R. Rep. No. 101-881, at 350 (1990) (extending the existing reporting and

allocation rules "may diminish some of the 'whipsaw' potential that results when the parties’

allocations for tax reporting purposes are inconsistent").

201 H.R. Rep. No. 102-716, at 3 (1992). See also 138 Cong. Rec. H7165-66 (daily ed.

August 3, 1992) (statement of Rep. McGrath) ("[Section 385(c)] will help prevent an illegal tax

avoidance scheme known among practitioners as the debt-equity whipsaw. Issuers of stock or

bonds and the holders of those interest classify their interests differently to maximize tax

advantages.").

202 Bittker & Eustice, supra note 190, at ¶ 14.47[1]. One commentator has described the

business purpose doctrine as follows:

In another class of cases what was done apparently falls within the statute, but results in a

bad thing. . . . Many bad things, however, are precisely what they purport to be, and

therefore cannot be swept aside as shams. Here the inclination of one who feels strongly

is to invoke some more general feature of the law, for example the “intent” (or perhaps

nowadays the “deep structure”) of the statute, to conclude that the bad thing ought not to

- 54 -

was concerned that issuers and holders may have been taking inconsistent positions with respect

to the characterization of a corporate instrument as debt or equity. 201 

2. Business Purpose Doctrine

The business purpose doctrine requires that a taxpayer have a reason--other than the

avoidance of federal taxes--for undertaking a transaction or series of transactions. 202 Like several
be. 

Isenbergh, supra note 163, at 866. 

203 293 U.S. 465 (1935). The business purpose doctrine has since been made a

requirement in a variety of corporate transactions, including divisive reorganizations, acquisitive

reorganizations in general, tax-free incorporations, dividends, and the acquisition of control of a

corporation. See, e.g., Basic Inc. v. United States, 549 F2d 740 (Ct. Cl. 1977) (requiring

business purpose for payment of a dividend).

204 293 U.S. at 469. 

205 364 F.2d 734 (2d Cir. 1966), cert. denied, 385 U.S. 1005 (1967).

206

 Id. at 741.

- 55 -

example, in Goldstein v. Commissioner,

205 Mrs. Goldstein, the winner of the Irish sweepstakes,

attempted to shield some of her winnings from tax by borrowing $945,000 at four percent annual

interest and purchasing $1 million in Treasury securities paying two percent annual interest. She

prepaid interest of $81,396 on the borrowing, and deducted this amount against her $140,000

sweepstake winnings. The court disallowed the interest deduction on the grounds that the

borrowing transaction had “no substance or purpose aside from the taxpayer’s desire to obtain the

tax benefit of an interest deduction.”

206

The business purpose doctrine also was used to challenge the individual tax shelters of the

1970s and 1980s. These shelters typically took the form of partnerships that engaged in activities-

-such as real estate development or motion picture production--that generated net losses in their

early years of operation. The partnerships’ individual investors used their share of losses to

shelter other, unrelated income. Although these shelters were attacked on a variety of grounds,
207

 See, e.g., Sochin v. Commissioner, 834 F.2d 351 (9th Cir. 1988), cert. denied, 488

U.S. 824 (1988); Lukens v. Commissioner, 945 F.2d 92 (5th Cir. 1991).

208 Goldstein v. Commissioner, 364 F.2d 734 (2d Cir. 1966), cert. denied, 385 U.S. 1005

(1967).

209 Id. at 741.

210 94 T.C. 738 (1990). See also Paul J. Donahue, The Rule of Sheldon v. Commissioner:

Is It an Economically Efficient Evolution of the Sham Transaction Doctrine? , 13 Va. Tax Rev.

165 (1993).

- 56 -

A number of economic substance decisions have focused on the presence of offsetting

obligations and circular cash flows that limit the economic consequences to the taxpayer while

preserving the taxpayer’s purported tax benefits. For example, in Goldstein v. Commissioner,

208

the taxpayer sought to exploit the different tax treatment for borrowing transactions involving

prepaid interest and lending transactions that do not involve prepaid interest. By borrowing to

purchase Treasury securities and by prepaying much of the interest on the borrowing, the taxpayer

sought to secure a large interest deduction in the year of the borrowing. This deduction would be

effectively reversed in later years by interest and gain on the Treasury securities. Aside from the

purported tax benefits, the simultaneous lending and borrowing transactions produced little net

economic consequence for the taxpayer. Despite the circular nature of the transactions, the court

concluded that the transactions did, in fact, take place and therefore could not be ignored as

“shams.” The court nevertheless went on to hold against the taxpayer on the grounds that the

transaction had “no substance or purpose aside from the taxpayer’s desire to obtain a tax

benefit.”

209

Similarly, in Sheldon v. Commissioner,

210 the economic substance doctrine was used to

disallow the tax benefits resulting from the leveraged purchase of debt instruments. In Sheldon,

the taxpayer bought Treasury bills that matured shortly after the end of the tax year and funded

the purchase by borrowing against the Treasury bills. The taxpayer accrued the majority of its

interest deduction on the borrowings in the first year while deferring the inclusion of its

economically offsetting interest income from the Treasury bills until the second year. As was the
211 The London Metals Exchange cases were heard in the Tax Court as a single case--

Glass v. Commissioner, 87 T.C. 1087 (1986). There were heard by several circuits on appeal. 

The appellate decisions include Yosha v. Commissioner, 861 F.2d 494 (7th Cir. 1988), and

Lerman v. Commissioner, 939 F.2d 44 (3d Cir. 1991), cert. denied, 502 U.S. 984 (1991).

212 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). See also Steven M. Surdell, ACM Partnership: A

New Test for Corporate Tax Shelters? , 75 Tax Notes 1377 (June 9, 1997).

213 157 F.3d at 250.

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were designed to create ordinary loss in the first year and capital gain in the second year. Because

these transactions naturally offset each other (typically, a taxpayer would be both “long” and

“short” on the same commodity at the same time), the transactions, while producing large “paper”

gains and losses, produced minimal net economic consequences. For this reason, the transactions

were found to lack economic substance. 

More recently, the economic substance doctrine has been applied to deny a taxpayer the

purported tax benefits from a near-simultaneous purchase and sale of property. In ACM

Partnership v. Commissioner,

212 the taxpayer purchased privately-placed debt instruments and

sold them 24 days later for consideration equal to their purchase price. Taken together, the

purchase and sale “had only nominal, incidental effects on [the taxpayer’s] net economic

position.”

213 The taxpayer claimed that despite the minimal net economic effect, the transaction

had a large tax effect resulting from the application of the installment sale rules to the sale. The

Tax Court held, and the Third Circuit affirmed, that because the transaction lacked any

meaningful economic consequences other than the creation of tax benefits, the taxpayer was not

entitled to the purported tax benefits of the transaction. As the Third Circuit opinion explained:

Viewed according to their objective economic effects rather than

their form, [the taxpayer’s] transactions involved only a fleeting and

economically inconsequential investment in and offsetting

divestment from the [debt instruments]. . . . The transactions with

respect to the [debt instruments] left the [taxpayer] in the same
214

 Id.

215 94 T.C. at 769.

216 Hariton, supra note 166, at 235 (1999).

- 58 -

for small net economic consequences could not support a finding of economic substance. In the

words of the court, the potential for gain was “nominal” and “insignificant” when considered in

comparison to the claimed deductions. 215

As is the case with other judicial anti-avoidance doctrines, predicting when the economic

substance doctrine will be applied is difficult. One commentator has suggested that the test

actually has three components: “(1) the benefits arise from a set of ‘discrete’ tax-motivated

transactions; (2) these transactions do not meaningfully alter the taxpayer’s net economic

position; and, (3) most important, the tax benefits themselves are unreasonable and unwarranted

in light of the objective rules which give rise to them.”

216

C. PROCEDURAL APPROACHES

1. Tax Shelters of the 1970s and 1980s

This is not the first time that the tax system has been confronted with a significant assault

in the form of tax shelters. In the 1970's and 1980's, there was an explosion of tax shelters that

threatened not only the revenue of the fisc, but also general taxpayer confidence in the fairness

and effectiveness of the tax system.

Unlike the corporate tax shelters of today, the tax shelters of the 1970's and 1980's were

aimed primarily at high-tax bracket individuals. Many of these shelters were "cookie-cutter" deals

that were mass-marketed to the taxpaying public. Often, these deals were accomplished using

limited partnerships, which afforded the investors the benefits of limited liability and the ability to

obtain tax benefits generated by the partnership without actively participating in the business of

the entity.
217

 See generally Jt. Comm. on Tax'n, Tax Reform Proposals: Tax Shelters and Minimum

Tax (Aug. 7, 1985). 

218

 See generally Caplin, Tax Shelter Disputes and Litigation with the Internal Revenue

Service: 1987 Style, 6 Va. Tax Rev. 709 (1987).

219 Pub. L. No. 91-172, 83 Stat. 487.

220 Pub. L. No. 94-455, 90 Stat. 1520.

221 Pub. L. No. 95-600, 92 Stat. 2763.

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deductions and formed the basis of many of these early-era tax shelters. 

Congress recognized the danger posed by these tax shelters and enacted various forms of

legislation to combat the shelters. 218 The first step (albeit a small one) in the assault on tax

shelters came in the Tax Reform Act of 1969.219 There, Congress enacted a minimum tax on

specified tax preference items, including excess investment interest, percentage depletion, long

term capital gains, and other items. 

The first comprehensive action against tax shelters came in the Tax Reform Act of

1976.220 As part of this legislation, at-risk rules were enacted which limited loss deductions to a

non-corporate taxpayer's actual investment with respect to certain activities (although, in a

significant exception, the rules did not apply to real estate). In addition, deductibility of prepaid

interest was required to be spread over the life of a loan, and a number of changes were made to

the partnership provisions in order to limit syndication abuses. Finally, a number of additional

provisions were added to curb abuses relating to (1) holding, producing, and distributing motion

picture films, (2) certain types of farming, (3) equipment leasing, and (4) oil and gas exploration

and exploitation.

In the Revenue Act of 1978,221 the at-risk rules were extended to a broader array of

activities (although still not real estate) and to closely-held corporations. The Economic
222 Pub. L. No. 97-34, 95 Stat. 172.

223 Pub. L. No. 97-248, 96 Stat. 324.

224 Pub. L. No. 98-369, 98 Stat. 494.

225 Pub. L. No. 99-514, 100 Stat. 2085.

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IRS in attacking large tax shelters, centralized procedures for audits and litigation with respect to

large partnerships were implemented so that the various procedural rules relating to such audits

and litigation would apply at the partnership rather than the partner level.

The Deficit Reduction Act of 1984224 contained numerous provisions aimed at tax shelters. 

For the first time, it became necessary to register tax shelters with the IRS, which was designed to

help the IRS locate and evaluate tax shelters. Organizers and sellers of "potentially abusive tax

shelters" also were required to maintain a list of investors in such shelters. Certain penalties were

significantly strengthened, and rigorous standards for appraisals relating to charitable

contributions of appreciated property were instituted. In addition, the Treasury Department was

given authority to bring disciplinary actions against appraisers who appear before the IRS or the

Treasury Department.

While significant progress had been made in the tax shelter battle by this time, the Tax

Reform Act of 1986225 was viewed by most as the death knell of the individual tax shelter industry

that had grown up in the 1970's and 1980's. Among the provisions contained in this act were the

following: (1) limitations on passive activity losses and credits, (2) application of the at-risk rules

to real estate, (3) elimination of the investment tax credit, (4) less favorable depreciation

deductions, (5) elimination of the capital gains preference, (6) adoption of uniform capitalization

rules, (7) more restrictive limits on investment interest deductions, (8) denial of personal interest

deductions (with an exception for home mortgage interest), and (9) a more rigorous alternative

minimum tax for individuals and a new alternative minimum tax for corporations. 

2. Procedural Provisions Aimed at the Tax Shelters of the 1970s and 1980s
226 See Jt. Comm. on Tax'n, General Explanation of the Revenue Provisions of the Deficit

Reduction Act of 1984, at 475 (1984) [hereinafter 1984 Blue Book].

227 I.R.C. § 6111(a)(1).

228 I.R.C. § 6111(a)(2).

229 I.R.C. § 6111(b)(1).

230 I.R.C. § 6111(b)(2).

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a. Tax shelter registration requirements. As part of the Deficit Reduction Act of

1984, Congress enacted Code sections 6111 and 6112 to require the registration of tax shelters

and maintenance of lists of shelter investors. Prior to this time, there was no requirement that tax

shelters register with the IRS. As a result, the IRS lacked complete and systematic information on

which to base its decisions about which shelters should be audited. 226

More specifically, section 6111 requires any tax shelter organizer to register a tax shelter

with the Secretary no later than the day upon which the first offering for sale of interests in such

shelter occurs. 227 The registration is to include (1) information identifying and describing the

shelter, (2) information describing the tax benefits represented (or to be represented) to investors,

and (3) any other information prescribed by the Secretary.228 Any person who sells or transfers an

interest in a tax shelter also is required to furnish each investor who purchased or otherwise

acquired an interest in such shelter an identification number. The identification number is to be

assigned by the Secretary. 229 This registration number is to be shown on the tax return of any

person who claimed a deduction, credit or other tax benefit by reason of the registered tax

shelter.230 Section 6112 requires, in certain cases, that organizers or sellers of "potentially abusive
231 Prior to enactment of this provision, when the IRS identified an abusive tax shelter, it

would be able to identify taxpayers who invested in the shelter only through enforcement of

summornses. See H.R. 98-861, at 977 (1984).

232 I.R.C. § 6111(c)(1). The "tax shelter ratio" is defined as the aggregate amount of

deductions and 350 percent of the credits represented to be potentially allowable for any year

divided by the investment base. The "investment base" generally means the amount of money and

adjusted basis of other property (reduced by liabilities to which the property is subject)

contributed by the investor. I.R.C. § 6111(c)(2), (3).

233 The legislative history states that the requirement that securities be registered with

either the SEC or a state agency applied to many tax shelters. 1984 Blue Book, supra note 226,

at 475. As a general rule, the legislative history's description of the tax shelter ratio and definition

of a tax shelter reflects the salient features of many shelters of this era. See generally 1984 Blue

Book, supra note 226, at 477-79. 

234 I.R.C. § 6111(c)(4).

235 I.R.C. § 6112(b).

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sale of securities, or (3) a substantial investment. 233 An investment is defined to be "substantial" if

there are expected to be five or more investors and the aggregate amount that was offered for sale

exceeds $250,000.234 For purposes of section 6112, a "potentially abusive tax shelter" is defined

as any tax shelter under section 6111 for which registration is required or any entity, investment

plan or arrangement or other plan or arrangement of a type determined by regulations as having

potential or tax avoidance or evasion. 235 

A tax shelter "organizer" means the person principally responsible for organizing the

shelter or, if there is no organizer under this definition, any other person who participated in the
236 I.R.C. § 6111(e). The legislative history states in this regard that 

in many cases, the tax shelter organizer will be the tax shelter

promoter. The tax shelter organizer need not, however, be the

promoter or general partner. . . . If the person principally

responsible for organizing the tax shelter fails to register the shelter

as required, then any person who participates in the organization of

the shelter must register the shelter. . . .Ordinarily, the rendition of

professional advice by an unrelated attorney or accountant would

not constitute the organization of a tax shelter. However, if, for

example, the attorney=s or accountant=s fee is based, either in part

or in whole, upon the number or value of units sold, the [IRS]

might reasonably conclude that the attorney or accountant is an

organizer, promoter, or seller of a tax shelter, since he participates

in the entrepreneurial risk born by other promoters.

 1984 Blue Book, supra note 226, at 477.

237 I.R.C. § 6707(a)(2) (as enacted).

238 I.R.C. § 6707(b). The penalty for failure to include the identification number on a

return could be abated for reasonable cause.

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1986 to be the greater of $500 or one percent of the aggregate amount invested in the shelter

(i.e., the $10,000 maximum was eliminated). A penalty also is imposed for failure to furnish a tax

shelter identification number in the amount of $100 for each such failure. Failure to include the

identification number on a return was originally subject to a penalty of $50 for each such failure,

which amount was increased by the Tax Reform Act of 1986 to $250.238 Failure to maintain lists

of investors in potentially abusive shelters is subject to a penalty of $50 for each person with

respect to which there was such failure, up to a maximum of $50,000, which maximum was

increased to $100,000 by the Tax Reform Act of 1986. 
239 S. Rep. No. 98-469, at 425 (1984). The legislative history goes on to state that

promoters know that

even if a tax scheme they marketed was clearly faulty, some

investors= incorrect returns would escape detection and many others

would enjoy a substantial deferral of tax while the Treasury

searched for their returns and coordinated its handling of similar

cases. Also, Congress believed that registration will provide the

[IRS] with basic information that will be useful in detecting trends

in tax shelter promotions at an early date. 

 1984 Blue Book, supra note 226, at 475.

240

 Id.

241 I.R.C. §§ 6653(a) & (b) (1954). The negligence penalty was 5 percent if an

understatement was attributable to a careless, reckless, or intentional failure of the taxpayer to

comply with the rules and regulations, while a 50 percent fraud penalty applied if an

understatement was due to a knowingly false material representation by a taxpayer. 

- 64 -

promoter). Further, it was more efficient to handle the situations of individual investors in a

single shelter simultaneously and uniformly. Lists of investors allowed the IRS to identify the

participants for this purpose. Likewise, the definition of a tax shelter for purposes of this

registration requirement reflected the fact that such shelters generally were promoted through

offering materials, to multiple investors, through sale of interests in the shelter, and with tax

benefits that exceeded by a multiple the investment in the shelter. Similarly, the penalties for

failure to register or maintain lists of investors in potentially abusive shelters were not onerous in

amount, but could accumulate if the aggregate investment was large or if there were numerous

investors in a shelter for whom lists had to be maintained or identification numbers furnished.

c. Accuracy-related penalty. Prior to 1982, penalties existed for negligent and

fraudulent understatements of tax. 241 The expectation of nonfraudulent and nonnegligent

reporting positions had its analog in ABA Formal Opinion 314 (1965), which imposed a
242 See Jt. Comm. on Tax'n, General Explanation of the Revenue Provisions of the Tax

Equity and Fiscal Responsibility Act of 1982, at 216 (1982) [hereinafter 1982 Blue Book]; J.

Kurtz and Panel, Questionable Positions, 32 Tax Law. 13 (1978).

243 In the Economic Recovery Tax Act of 1981, the negligence penalty was increased by

adding a supplemental penalty of 50 percent of the interest attributable to the portion of a

deficiency out of which the penalty arose. A negligence penalty also was added that

presumptively applied to certain unreported straddles and a penalty that applied to individuals and

certain corporations making valuation overstatements. The Tax Equity and Fiscal Responsibility

Act of 1982 added a supplemental penalty to the fraud penalty similar to that adopted for the

negligence penalty.

244 See 1982 Blue Book, supra note 242, at 216.

245 I.R.C. §§ 6661(a) & (b).

246 I.R.C. § 6661(b)(2)(B). Congress did not believe a penalty was appropriate where

substantial authority existed and taxpayers and the government reasonably differed over the tax

laws, but did believe that a penalty was appropriate for undisclosed questionable positions. See

1982 Blue Book, supra note 242, at 216-17.

247 1982 Blue Book, supra note 242, at 217.

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of the 'borrowing.'"244

As originally enacted in section 6661, the substantial understatement penalty applied a

penalty of 10 percent to any underpayment attributable to an understatement of tax if the

understatement exceeded the greater of 10 percent of the correct tax required to be shown on the

return or $5,000 ($10,000 for corporations). 245 The penalty generally could be avoided either by

adequately disclosing the relevant facts or by establishing that there was “substantial authority”

for the taxpayer’s position. 246 Special rules, however, applied to tax shelters because "Congress

believed that taxpayers investing in tax shelters should be held to a higher standard of care in

determining the tax treatment of items arising from the shelter or risk a significant penalty." 247 A
248 I.R.C. § 6661(b)(2)(C)(ii)(as enacted)(emphasis added). Regulations subsequently

defined "the principal purpose" to mean a purpose that "exceeds any other purpose." Treas. Reg.

§ 1.6662-4(g)(2). 

249 I.R.C. § 6661(b)(2)(C)(i).

250 I.R.C. § 6661(c).

251 The interest rate for tax motivated transactions was raised to 120 percent of the

otherwise applicable rate and the valuation penalty was broadened through the addition of section

6660.

252 The fraud penalty was increased to 75 percent and valuation penalties were broadened

to encompass pension matters with the addition of section 6659A. The negligence penalty was

extended to all taxes and the definition of negligence was changed to include "any failure to make

a reasonable attempt to comply with the provisions of the Code."

253 Thus, for example, a charitable deduction for donated property in excess of the

property's value could subject a taxpayer to the negligence, substantial understatement and

substantial overvaluation penalties for the same underpayment of tax. When Congress enacted

major reform of the tax penalty regime in 1989, the legislative history indicated that “ the number

of different penalties that relate to accuracy of a tax return, as well as the potential for

overlapping among many of these penalties, causes confusion among taxpayers and leads to

difficulties in administering these penalties.@ H.R. Rep. No. 101-247, at 1288 (1989).

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A result of this legislative activity, however, was the existence of several separate (and

potentially cumulative) accuracy-related penalties encompassing negligence, substantial

understatement of tax, and various types of valuation overstatements or understatements. 253 The

Improved Penalty Administration and Compliance Tax Act of 1989 consolidated these penalties

into a single accuracy-related penalty under Code section 6662 for five different types of

misconduct: (1) negligence or disregard of rules or regulations; (2) substantial understatement of

income tax; (3) a substantial valuation misstatement for income tax purposes; (4) a substantial
254 However, a 40-percent penalty applies under section 6662(h) in the case of certain

“gross valuation misstatements.” 

255 The legislative history states that the enactment of a single reasonable cause exception

was intended to permit taxpayers to more readily understand the behavior that is required, to

simplify administration of the penalties, to lead the IRS to consider fully whether imposition of the

penalty is justified, and to provide greater scope for judicial review. H.R. Rep. No. 101-247, at

1392-93 (1989).

256 Prior to enactment of section 6700, the Code contained no penalty provisions

specifically directed toward promoters of abusive tax shelters and other abusive tax avoidance

schemes. In appropriate cases, the promoter might be subject to civil or criminal penalties for

false or fraudulent return preparation or willful attempts to evade tax. See S. Rep. No. 97-494, at

266 & 268 (1982). 

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were directed specifically toward promoters and sellers of tax shelter transactions. These are (1)

the penalty for promoting abusive tax shelters (Code section 6700) and (2) the penalty for aiding

and abetting an understatement of tax (Code section 6701). In addition, Code section 7408 was

enacted which provided authority for the Secretary of the Treasury to seek injunctions against tax

shelter promoters. These penalties were directed toward the more egregious types of conduct

engaged in by promoters in the 1970s and 1980s, i.e., where the transaction was a sham, involved

gross overvaluations, or otherwise involved false or fraudulent misrepresentations to potential

investors of the purported tax benefits.

 

In 1982, Congress imposed a new penalty for promoting "abusive tax shelters" under

section 6700. Consistent with the purpose underlying the registration requirements and the

promoter penalty, this penalty was intended to attack tax shelters at their source, "the organizer

and salesperson," rather than through enforcement actions against investors. 256 Consequently, the

section 6700 penalty is imposed on to organizers or sellers of interests in partnerships or other
257 The legislative history stated in this regard that "the promoter penalty was viewed as

particularly equitable because the promoter, professional advisor or salesman of a tax shelter

generally is more culpable than the purchaser who may have relied on their representations as to

the tax consequences of the investment." 1982 Blue Book, supra note 242 , at 211.

258 The legislative history clarifies that the addition of "has reason to know" is intended to

permit the IRS to rely on objective evidence of the knowledge of the promoter or salesperson to

prove that a false or fraudulent statement was deliberately furnished. H.R. Conf. Rep. No.

97-760, at 572 (1982). Several courts have held that the Aknow or has reason to know @ standard

i.e., specific intent. U.S. v. Campbell, 897 F.2d 1317 (5th Cir. 1990); U.S. v. Kaun, 827 F.2d

1144 (7th Cir. 1987). False statements of fact or statements regarding the purported tax benefits

that are contrary to established law generally have been held to be false or fraudulent. See, e.g.,

U.S. v. Buttorf, 761 F.2d 1056 (5th Cir. 1985); United States v. Estate Preservation Services , 38

F. Supp.2d 846 (E.D. Ca. 1998). In determining whether the promoter knew or had reason to

know of the false or fraudulent statement, relevant factors include the promoter's familiarity with

the tax laws, level of sophistication and education, and whether the opinion of knowledgeable

professionals was obtained. Id.

259 S. Rep. No. 97-494, at 267 (1982).

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material matter. Material matters are described in the legislative history as those matters which

would have a substantial impact on the decision-making process of a reasonably prudent investor

and include matters relevant to the availability of a tax benefit. 259
260 Prior to enactment of section 6701, there was no civil penalty for aiding and abetting in

the preparation of false or fraudulent documents. A criminal penalty was provided for willfully

aiding in the preparation or presentation of a false or fraudulent return or other document,

punishable by a fine up to $5,000 or 3 years imprisonment. Section 6701 was intended to be a

civil penalty analogous to the preexisting criminal penalty for conduct that Ashould be penalized@

but that was "not so abhorrent as to suggest criminal prosecution." 1982 Blue Book, supra note

242, at 220. 

261 I.R.C. § 6701(c).

262 Mattingly v. Commissioner, 924 F.2d 785 (8th Cir. 1991); Gard v. United States, 92-1

U.S.T.C. (CCH) ¶ 50,159 (N.D. Ga. 1992). The legislative history states that knowledge was

intended to limit the penalty to "cases involving willful attempts to accomplish an understatement

of the tax liability of a third party." 1982 Blue Book, supra note 242, at 221.

263 The penalty as originally enacted was the greater of $1,000 or 10 percent of the gross

income derived from the activity, which was modified by the Deficit Reduction Act of 1984 to be

the greater of $1,000 or 20 percent of the gross income derived from the activity. The current

penalty amount was enacted in the Omnibus Budget Reconciliation Act of 1989.

264 I.R.C. § 6700(a). This provision was added by the Omnibus Budget Reconciliation Act

of 1989.

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Both the section 6700 abusive tax shelter penalty and the section 6701 aiding and abetting

penalty are monetary penalties. The penalty for promoting an abusive tax shelter presently is the

lesser of $1,000 or 100 percent of the gross income derived from the activity. 263 The penalty for

aiding and abetting is $1,000 per document ($10,000 for corporations). Reflecting the massmarketing of cookie-cutter shelters in the 1970s and 1980s to high-bracket individuals, however,

the penalties were framed such that multiple activities (e.g., sales) or misleading representations to

more than one taxpayer can be separately penalized. Thus, the penalty for promotion of abusive

shelters provides that activities with respect to each entity or arrangement or each sale are treated

as separate activities. 264 The aiding and abetting penalty may be imposed in relation to no more
265 I.R.C. § 6701(b)(3).

266 1982 Blue Book, supra note 242, at 213.

267 The injunction may enjoin the conduct subject to penalty or "any other activity subject

to penalty under section 6700 or 6701." I.R.C. § 7408(b). Generally, where injunctions have

been issued that reach beyond the specific conduct before the court, the injunction was applied to

any tax avoidance scheme with characteristics similar to those of the particular scheme before the

court. See, e.g., U.S. v. Campbell, 897 F.2d at 1323. 

268 Circular 230 is found at Part 10 of Title 31 of the Code of Federal Regulations. 

269 Section 10.2(e). Section 10.32, however, qualifies that the regulations should not be

construed as authorizing persons not members of the bar to practice law.

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States to be brought in federal district court enjoining any person from further engaging in

conduct subject to penalty under sections 6700 or 6701. The action must be brought in a district

court for the district in which the shelter promoter resides, has his or her principal place of

business, or has engaged in the conduct subject to penalty. Injunctive relief may be awarded if the

court finds that the promoter’s conduct is subject to penalty under section 6700 or 6701 and that

injunctive relief is appropriate to prevent recurrence of the conduct. 267

e. Standards of Practice. The Treasury Department promulgates regulations

governing practice before the IRS, referred to as Circular 230. 268 These standards cover "all

matters connected with a presentation to the Internal Revenue Service" relating to a client's rights,

privileges, or liabilities under the internal revenue laws. This includes the preparation and filing of

documents, correspondence and communications with the IRS, and representing clients at

conferences, hearings, and meetings.269 

In response to the proliferation of tax shelters in the 1970s and 1980s, in 1985 the

Treasury Department promulgated specific standards in Circular 230 relating to tax shelter
270 Section 10.33. Circular 230 also contains standards for return preparers. See section

10.34.

271 Section 10.33(c)(3). One commentator has noted that, as a consequence, the standards

are Anot easily adapted for application to practitioners who advise prospective purchasers in a

one-to-one relationship.@ Holden, supra note 3, at 374.

272 Section 10.33(a)(1). This subsection of Circular 230 also contains further refinements

of the standards to be followed by practitioners in ascertaining facts, including valuations of

property or financial projections.

273 Section 10.33(a)(2).

274 Section 10.33(a)(3). A Amaterial@ tax issue includes any Federal income or excise tax

issue relating to a tax shelter that would make a significant contribution toward sheltering from

Federal taxes income from other sources by providing deductions in excess of income from the

tax shelter investment in any year, or tax credits available to offset tax liability in excess of the tax

attributable to the tax shelter in any year. It also includes any other Federal income or excise tax

issue that could have a significant impact (either beneficial or adverse) to a tax shelter investor

under any reasonably foreseeable circumstance. It also includes the potential applicability of

penalties, additions to tax, or interest charges that could be reasonably asserted. The

determination of what is material is to be made by the practitioner in good faith based on

information available at the time the offering materials are circulated.

275 Sections 10.33(a)(4) & (5). 

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the IRS are fully and fairly addressed.274 

The tax shelter opinion standard requires that the practitioner, where possible, render an

opinion whether it is more likely than not that an investor will prevail on the merits of each

material tax issue, and on the material tax benefits in the aggregate, if there is a reasonable

possibility of challenge by the IRS. Where such an opinion cannot be rendered, the opinion

should fully describe the reasons for the inability to make such an evaluation. 275 A favorable
276 Section 10.33(a)(5)(i).

277 Section 10.51(j).

278 IR 85-49 (May 17, 1985).

279 I.R.M., Audit, 42(17)1, MT 4200-574 (Nov. 22, 1989) (Tax Shelter Program --

General).

a prospective client by oral or written solicitation. Circular 230 provides a number of examples of

disreputable conduct, including (1) the giving of a false tax opinion, (2) knowingly, recklessly, or

through incompetence, giving an opinion that is intentionally or recklessly misleading, or (3) a

pattern of providing incompetent opinions on tax questions. 277

After the tax shelter opinion standards were promulgated, the IRS announced that it

planned strict enforcement of these standards where practitioners were connected with abusive

tax shelters. 278 It stated that violations of the standards would be referred to the Director of

Practice. Practitioners who would be considered for referral were those who had violated the

requirements of section 10.33, against whom penalties for promoting abusive tax shelters had

been assessed, who had been enjoined from promoting abusive tax shelters, who had been

penalized for giving bad advice that created an understatement of tax, or who had not complied

with the registration requirements. The IRS also stated that referrals would be made regardless of

whether penalties were assessed if the situation indicated that the practitioner had failed to follow

the rules of practice. As a practical matter, however, enforcement of these standards was largely

preempted by the shutting down of shelter activity in the mid-1980s with passage of the passive

loss rules. 

3. Tax Shelter Program of the 1980's

In the early 1980's, the IRS established a program to identify, investigate, and address

abusive tax shelters that coordinated a multitude of functions, including technical, examination,

criminal investigation, and litigation. The primary goal of the program was to identify, examine,

and investigate abusive tax shelters that utilized improper or extreme interpretations of the law or

the facts to secure for the investors substantial tax benefits clearly disproportionate to the

economic reality of the transaction. 279 Once an abusive tax shelter was identified and investigated,
280 Under the direction of a District Director, pre-filing notification letters were sent to

investors if there was evidence that the shelter assets were overvalued or if the promotional

materials contained false or fraudulent statements concerning a material matter. Rev. Proc. 83-

78, 1983-2 C.B. 595, at § 6.01, modified by, Rev. Proc. 84-84, 1984-2 C.B. 782. The pre-filing

notification letters advised the investors that, based on a review of the shelter, the IRS believed

that the purported tax benefits were not allowable. Id. at § 6.02. It also advised them of the

consequences if they filed their tax returns claiming the shelter benefits and of the possibility of

amending their returns if they had already filed them. Id. After the letters were issued, the

District forwarded a list of the investors to the appropriate service centers so that the affected

returns could be examined. Id. at § 7. See also Rev. Proc. 84-84, 1984-2 C.B. 782, at § 3.02

("Returns in which pre-filing notification letters have been issued for the current or prior year will

automatically be selected for review.").

281 As of December 31, 1985, the inventory of tax shelter cases included approximately

413,665 returns under examination; approximately 31,072 cases in appeals; and approximately

30,000 cases docketed with the Tax Court. Robert R. Ruwe, Tax Shelter Outline, in Tax Shelter

1986 Style: The IRS Speaks (Law & Business, Inc., 1986).

282 Rev. Proc. 83-78, 1983-2 C.B. 595, modified by Rev. Proc. 84-84, 1984-2 C.B. 782. 

The Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. 97-248, permitted the IRS to

attack abusive shelters at their source by authorizing injunctive relief and penalties against the

promoters of such shelters. I.R.C. §§ 6700 & 7408.

283 Rev. Proc. 84-84, 1984-2 C.B. 782. This revenue procedure arose because of

concerns about an increase in abusive tax shelters that generated refunds for taxpayers. Id. at §

2.01. Paying out refunds attributable to losses, deductions, or credits when the available

information indicated that those losses, deductions, or credits were attributable to an abusive tax

shelter and were likely to be excessive imposed a heavy burden on the collection resources of the

IRS. To meet this concern, the IRS developed procedures at the service centers to identify

potential abusive tax shelter returns and certain claims for credit or refund during initial front-end

processing before any refunds were paid.

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284 I.R.C. § 6111(d).

285 I.R.C. § 6111(d)(1).

286 I.R.C. § 6111(d)(2).

287 See I.R.C. § 6111(d)(3).

288 I.R.C. § 6707(a)(3). A similar penalty is imposed on participants who are required to

register the shelter but do not, but only to the extent of fees paid by that participant. The penalty

is increased to 75 percent of fees paid in the case of an intentional failure or act.

289 P.L. No. 103-465, 108 Stat. 4809.

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In the last few years, Congress has modified the existing registration and substantial

understatement penalty provisions to respond to the proliferation of corporate tax shelters. The

Taxpayer Relief Act of 1997 extended the registration provisions to corporate tax shelters

promoted under conditions of confidentiality. 284 This registration requirement is effective for tax

shelter interests offered to potential participants after guidance is issued with respect to the

registration requirement (which guidance has not yet been issued). Under this provision, certain

arrangements are treated as tax shelters for a corporate participant, specifically: (1) where “a

significant purpose” of the structure is tax avoidance or evasion, (2) which is offered under

conditions of confidentiality, and (3) where promoter fees may exceed $100,000 in the

aggregate. 285 A promoter is defined as any person or any related person (within the meaning of

section 267 or 707) who participates in the organization, management, or sale of the tax shelter. 286

In certain cases, persons other than the promoter are required to register the corporate tax

shelter.287 The amount of the penalty for failure to register or for registering false or incomplete

information also was increased in the case of confidential arrangements. The penalty is the

greater of 50 percent of the fees paid to all promoters of the tax shelter with respect to offerings

made before the date such shelter is registered or $10,000. 288

Changes also were made to the substantial understatement penalty in the context of

corporate tax shelters, beginning with the Uruguay Round Agreements Act of 1994. 289 The ability
290 The legislative history indicates Congressional concern that the substantial

understatement penalty may not have been effective enough to deter corporations from entering

into aggressive tax shelter transactions. “[T]he intent of the provision is that the standards

applicable to corporate shelters be tightened; consequently, in no instance would this modification

result in a penalty not being imposed where a penalty would be imposed under prior law.” H.R.

Rep. No. 103-826, at 198 (1994). 

291 Johnson, supra note 76, at 1604. The 1997 Act also provided that in no event would a

corporation have a reasonable basis for the tax treatment of an item attributable to a multi-party

financing if the treatment did not clearly reflect income. I.R.C. § 6662(d)(2)(B). 

292 Treas. Reg. § 1.6664-4(e)(1).

293 Treas. Reg. § 1.6664-4(e)(2)(i)(A).

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least one commentator has asserted that the current law definition of a tax shelter as one having

tax avoidance as a significant purpose potentially encompasses all types of corporate tax

planning.291

Thus, under current law, a substantial understatement penalty of 20 percent can be

imposed on any underpayment attributable to a corporate tax shelter item unless reasonable cause

under section 6664(c) is demonstrated. A "tax shelter" is any partnership, entity, investment plan

or other plan or arrangement "a significant purpose" of which is the avoidance or evasion of tax. 

Regulations issued under section 6664(c) provide that, with respect to tax shelter items of

corporations, the determination of whether a corporate taxpayer acted with reasonable cause and

in good faith must be made on the basis of all pertinent facts and circumstances. 292 The

regulations set forth minimum requirements to establish reasonable cause. The corporate

taxpayer must satisfy both an authority and belief requirement. The authority requirement is

satisfied only if there is substantial authority for the tax treatment of the item. 293 The belief

requirement is satisfied only if, based on all the facts and circumstances, the corporation

reasonably believed at the time the return was filed that the tax treatment of the item is more likely

than not the proper treatment. This latter requirement can be satisfied if the corporation either (1)

analyzes the pertinent facts and authorities and, in reliance upon that analysis, reasonably
294 Treas. Reg. § 1.6664-4(e)(2)(i)(B).

295 Id.

296 Treas. Reg. § 1.6664-4(e)(2)(i).

297 Treas. Reg. § 1.6664-4(e)(4).

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The regulations further provide, however, that satisfaction of the minimum requirements is

not necessarily dispositive of reasonable cause and good faith. Reasonable cause and good faith

nonetheless may be found lacking if the taxpayer's participation in the tax shelter lacked significant

business purpose, if the claimed tax benefits are unreasonable in comparison to the taxpayer's

investment in the shelter, or if there is a confidentiality agreement between the taxpayer and the

organizer or promoter. 297 
298 See, e.g., TEI, supra note 4, at 8-9.

299 See, e.g., NYSBA, Report, supra note 19, at 881-83; ABA, supra note 56, at 4-6.

300 See, e.g., NYSBA, Report, supra note 19, at 881; Holden, supra note 3, at 369.

301 See NYSBA, Report, supra note 19, at 882-83.

302 The litigation in ACM Partnership v. Commissioner, 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), for

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However, like the individual tax shelter problem of the 1980s, legislation is necessary to

address current corporate tax shelters, and in this regard, the Administration has put forth several

proposals in its FY 2000 Budget. These proposals have generated a great deal of interest and

commentary. Some commentators have asserted that any deficiency in current law is reflective of

a need for greater enforcement of existing rules and sanctions rather than changes in the rules or

sanctions themselves. 298 Conversely, others have asserted that the current regime requires further

modification in light of the realities of today’s marketplace and the correlative pressures brought

to bear on the various parties engaged in corporate tax shelter activity. 299 The commentators,

however, have almost uniformly recognized the existence of a serious and growing problem and

their analysis of the underpinnings of the problem is substantially similar.

First, there appears to be a consensus that the corporate tax shelter transactions of

concern have several common characteristics, as described in this Report. These characteristics

are distinguishable in a number of respects from the salient characteristics typically found in the

shelters of the 1970s and 1980s. Second, corporate tax shelters threaten the integrity of the tax

system, due to lost revenue and other negative collateral effects including breeding of disrespect

for the tax system and nonproductive use of resources. 300 Third, the Treasury Department and the

IRS cannot handle this phenomenon solely through the issuance of regulations and notices; it is a

perennial game of “catch up” in a realization-based system that spawns “an almost infinite variety

of tax planning.”

301 Litigation is a time-consuming and resource-intensive process that produces a

definitive outcome long after the transaction was accomplished and promoters have moved on to

other products. 302 Fourth, the corporate sector appears to be placing a premium on tax savings
example, took several years and cost the IRS several million dollars. 

303 See Bankman, supra note 19, at 1784; NYSBA, Report, supra note 19, at 882.

304 See Forbes, supra note 5, at 200 & 202.

305 See ABA, supra note 56, at 6.

306 Treasury Explanation, supra note 61, at 95-105. The descriptions of these proposals

are reproduced in Appendix B.

307 This Report focuses on the comments of these organizations because they not only

provide an analysis of the relative strengths and weaknesses of the corporate tax shelter proposals

put forth by the Administration in its FY 2000 budget, they also provide, to varying degrees,

alternative or supplemental proposals of their own. In developing this Report, the Treasury

Department has considered all comments submitted by interested parties, even if not cited herein.

308 H.R. 2255, 106th Cong. (1999). This bill was introduced by Messrs. Doggett, Stark,

Hinchey, and Tierney on June 17, 1999. 

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Association (ABA), American Institute of Certified Public Accountants (AICPA), and the New

York State Bar Association (NYSBA). 307 This analysis also examines the relevant provisions of

H.R. 2255, the “Abusive Tax Shelter Shutdown Act of 1999,” provisions of which reflect

portions of the Administration’s Budget proposals as well as comments made by the practitioner

groups.308 Finally, this Part of the Report provides potential modifications to the Administration’s

original Budget proposals to address certain concerns raised by commentators. 

To inhibit the growth of corporate tax shelters, the FY 2000 Budget proposals 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) changing

substantive law to disallow the use of tax benefits generated by a corporate tax shelter, and (4)

providing incentives to all the parties to the transaction ( i.e., corporate participants, promoters

and advisors, and tax-indifferent, accommodating parties) to insure that it comports to established
309

 See, e.g., Johnson, supra note 76, at 1606-07.

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Greater disclosure of corporate tax shelters would have two closely related ameliorative

effects. First, it could lead to greater enforcement efforts by the IRS. Before the IRS can combat

a corporate tax shelter, they must find it. As discussed in Part III.A., not all corporations are

audited annually and those corporations that are frequently audited often have voluminous and

complex tax returns. Because corporate tax shelters typically involve complex transactions and

may generate deductions or credits that corporate taxpayers typically claim on a tax return, the

existence of the shelter is not readily apparent from an initial examination of the corporation’s tax

return. As discussed in Part II.B., the reconciliation of book and taxable income on Schedule M-1

and published financial statements is not sufficiently detailed to expose corporate tax shelters. 

Clearly, sheltering taxpayers have incentives not to reveal questionable transactions to the IRS

and, under current law, there are no mechanisms that adequately reverse these incentives. Indeed,

disclosure cannot reduce the substantial understatement penalty with respect to a corporate tax

shelter under section 6662 of current law. 

Second, and more importantly, greater disclosure could 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. 309 In fact, a

corporation may develop and implement strategies to discourage the discovery of its tax shelter. 

For example, one part of the transaction may be undertaken by one entity in the affiliated group

while another offsetting position that eliminates the economic substance of the transaction is

undertaken by another member of the group. In addition, corporate tax shelters may be

structured through partnerships, the procedural rules for which may inhibit discovery and

assessment. An effective increase in the disclosure of corporate tax shelters will change the

cost/benefit analysis of entering into such transactions and will deter the use of shelters by

taxpayers. 

1. Administration Proposals
310 Treasury Explanation, supra note 61, at 95. 

311 To be effective, the disclosure would have to be made on a timely filed original Federal

income tax return for the taxable year that includes the date the transaction is entered into.

312

 Such examples may include sale-repurchase and sale-leaseback transactions. For the

treatment of sale-repurchase transactions, see generally American National Bank of Austin v.

U.S., 421 F.2d 442 (5th Cir. 1970), cert. denied, 400 U.S. 819 (1970) and Union Planters

National Bank of Memphis v. U.S., 426 F.2d 115 (6th Cir. 1970), cert. denied, 400 U.S. 827

(1970). For the treatment of sale-leaseback transactions, see generally Helvering v. F.R. &

Lazarus & Co., 308 U.S. 252 (1939) and Frank Lyon Co. v. U.S., 435 U.S. 561 (1978).

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such differences exist.

Second, the Budget contains a proposal designed to curtail the ability of corporate

taxpayers to arbitrage tax and regulatory laws (and in some cases whipsaw the Government) by

entering into transactions where the substance of the transaction is inconsistent with its form. 

Corporate taxpayers would be denied the tax benefits from such transactions unless they disclosed

that they were reporting consistent with the substance of the transaction on their returns. 311 By

encouraging disclosure, the proposal would permit the Treasury Department and the IRS to

consider whether the claimed tax benefits flowing from the transaction should be allowed and, if

not, what actions to take ( e.g., proposing legislation, promulgating regulations, or pursuing

litigation) to prevent taxpayers from claiming such benefits. Appropriate exceptions would be

provided from the disclosure rules for transactions that have historically involved taxpayers taking

positions inconsistent with the form 312 and transactions for which the Treasury Department and

IRS explicitly require taxpayers to report the substance of the transaction.

2. Commentaries

Many of the ABA proposals relate to disclosure. The ABA believes that many corporate

tax shelters and supporting opinions are based upon dubious factual settings. Thus, they believe

that there should be a clear disclosure of the true nature and economic impact of specified classes

of transactions. Under the ABA approach, a question would be added to the corporate tax return
313

 See, the discussion in Part V.C., below, for a discussion of the use of a similar

economic substance test in the Administration’s proposal. 

314

 Cf. H.R. 2255, 106th Cong., § 4 (1999) (bill contains these same requirements;

requirements relate to decreases in the substantial understatement penalty applicable to

noneconomic tax attributes).

315 ABA, supra note 56, at 9-10.

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in support of the return position; 

(2) a description of the due diligence to ascertain the accuracy of the above; 

(3) a statement signed by one or more corporate officers with detailed knowledge of the

business or economic purposes or objectives of the transaction that the facts, assumptions of facts

and factual conclusions relied upon in reporting the transaction are true and correct as of the date

the return is filed to the best of the signer’s knowledge and belief, with any material differences

explained; 

(4) copies of written materials provided in connection with the offer of the tax shelter by a

third party; 

(5) a full description of any express or implied agreement or arrangement of any

contingent or reimbursable fees with any advisor or any offeror with respect to the shelter; and 

(6) a full description of any express or implied warranty from any person with respect to

the anticipated tax results from the shelter. 314 

The answers should be clear and accurate and not contain voluminous material that might

obfuscate the true nature of the transaction. The statement provided by the corporate officer

regarding the accuracy of the factual underpinnings of the transaction should impose personal

accountability. Specific penalties for non-compliance are not provided. However, the ABA

suggests an approach by which there would be a reduction of the penalty rate for tax shelters for

which there is proper disclosure. 315

The AICPA strongly supports an effective mechanism to advise the IRS of the essence of

transactions reported on a return. In their view, to be effective, disclosure must (1) provide

taxpayers with an incentive to disclose transactions of interest to the IRS and (2) be in a form and
316 AICPA, supra note 316, at 19-20.

317 NYSBA, Report, supra note 19, at 894.

318 ABA, supra note 56, at 4.

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The NYSBA strongly supports the disclosure provision of the Administration’s penalty

proposals relating to the substantial understatement penalty because they believe the prospect of

disclosure will deter taxpayers from entering into questionable transactions. In addition, the

NYSBA views disclosure as a potentially important tool in the IRS’s effort to uncover corporate

tax shelters. According to the NYSBA, disclosure should (1) be made within 30 days after

entering into the transaction and again with the filing of the return, (2) be made on a one or two

page form to avoid the problem of overdisclosure, and (3) not apply to small transactions ( e.g.,

those involving tax of less than $1 million). Disclosure should reveal a brief description of the

transaction, an enumeration of the key tax issues and the taxpayer’s position thereto, the amount

of tax at issue, and an identification of all other filings made by the taxpayer that raise issues

substantially similar to those raised by the filing. The NYSBA also suggests considering whether

SEC disclosure requirements should be modified to require the footnotes of a taxpayer’s financial

statements to disclose the aggregate amount of tax covered by the taxpayer’s disclosure

statements. 317 

3. Analysis and Possible Modifications to Administration Proposals

As all the commentators agree, statutory rules mandating disclosure are essential if the

Treasury Department and the IRS are to have the ability to detect and respond in a timely manner

to aggressive transactions. One frequently cited impetus for aggressive planning is the assumption

that the Treasury Department and the IRS will not be able to detect a fraction of the aggressive

transactions that are being done and that any legislative or regulatory response will be

prospective. 318 A related concern is that detection during the course of an audit by revenue agents
319 NYSBA, Report, supra note 19, at 883; Johnson, supra note 76, at 1606. One

commentator has suggested that these audit constraints may operate with less force with respect

to large corporate taxpayers, who are routinely audited under the IRS’s Coordinated Examination

Program. Holden, supra note 3, at 371 n.1. However, the IRS audits approximately 1600 large

corporations under this program. The audits are complex and time consuming; often more than

one tax year is included in a single audit cycle. Especially when constrained by the three-year

statute of limitations, examining agents may encounter difficulty in identifying and analyzing the

complex financial and structural arrangements that typify corporate tax shelters.

320 See ABA, supra note 56, at 6-7; Bankman, supra note 19, at 1788-89.

321 See, e.g., I.R.C. § 6111(a)(2) (registration requirements).

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into by, a number of taxpayers, disclosure could be required soon after the transaction is

promoted or completed. Such “early warning” disclosure could be made by the participating

corporation or the promoter. 321 Disclosure will be more effective if it is limited to the factual and

legal essence of the transaction. Disclosure of all items and documents with respect to a

transaction may be misleading or may overwhelm the IRS such that it could not ascertain the

substance of the transaction in a timely manner. Overdisclosure will inhibit the ability of the IRS

to sift through the reported transactions for those with shelter characteristics. Thus, the required

disclosure should be calibrated to avoid massive disclosures of routine corporate transactions

among which are buried the transactions that should be scrutinized. Finally, disclosure should not

be overly burdensome to taxpayers, particularly taxpayers not engaged in questionable

transactions. 

The Treasury Department continues to believe that disclosure is an important element in

the effort to discourage the use of corporate tax shelters. In order to be effective, disclosure must

be coupled with a sufficient penalty for the failure to disclose and must be in a form that is usable

by the government. Consistent with the views expressed by the ABA, AICPA and NYSBA, the

Treasury Department believes that the format of disclosure should be relatively short so as not to

overburden both the IRS and taxpayers and should be limited to cases that cause the most

concern. In this regard, a form could be developed that requires short answers, centering on the

information being sought. 
322 The proposal would not apply to customary representations and warranties found in

transactions other than corporate tax shelters.

323 H.R. 2255 also requires a dual filing to avoid the increased substantial understatement

penalty -- once within 30 days of the transaction and again with the tax return.

324 Different filters may be required for purposes of disclosure by promoters.

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known); a difference between the form of a transaction and how it is reported, etc.

The Treasury Department believes that two forms of disclosure are necessary. 323

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. 324 Corporations entering into transactions that meet the filters described above

would file the form by the due date of the tax return for 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 filters 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. 

A filing nearly contemporaneous with the sheltering transaction should be made to the

National Office of the IRS in order to provide the Government with an early warning of the types

of transactions being promoted and implemented. This early warning will allow the IRS, the

Treasury Department and, to the extent necessary, the Congress sufficient time to react to and

stop the spread of the latest fad in the corporate tax shelter genre. In addition, disclosure must be

made with the tax return to provide the examining IRS agent in the field the information necessary

to discover and determine the nature of a sheltering transaction. 
325 A significant criticism of the current-law registration rules is that the requirement of a

confidentiality arrangement is overly limiting. Commentary on this requirement suggests that the

response of purveyors of corporate tax shelters to its enactment in 1997 has simply been

avoidance of confidentiality arrangements.

326 Disclosure would be required whether or not the transaction was with a tax-indifferent

party.

327 The penalty is increased to 40 percent under section 6662(h) for certain gross valuation

misstatements.

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modified or eliminated.325

The Treasury Department continues to believe that taxpayers should be encouraged to

disclose transactions that are reported differently from their form. The original proposal included

in the Budget would be modified to provide that any transaction 326 over a certain threshold

amount (say, with tax benefits over $1 million) for which the taxpayer does not follow its form

must be separately disclosed on the taxpayer’s return. Exceptions would be provided for certain

transactions that have historically involved taxpayers taking positions inconsistent with their form. 

A significant penalty (say, $100,000) would apply for each failure to disclose.

B. MODIFY SUBSTANTIAL UNDERPAYMENT PENALTY

The imposition of a significant penalty traditionally is one method to deter persons,

including taxpayers, from engaging in inappropriate behavior. As more fully discussed in Part

IV.C., potentially the most significant penalty currently applicable to corporate tax shelters is the

section 6662 accuracy-related penalty. Section 6662 imposes a 20-percent penalty on the portion

of an underpayment attributable to, among other things, negligence or disregard of rules or

regulations and any substantial understatement of income tax. 327 Special rules apply to tax shelter

items. For this purpose, a tax shelter is defined as a partnership or other entity, 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 provision was

modified to its current form in 1997. Prior to 1997, an item was not a tax shelter item unless the
328 Some have commented that higher penalty rates may inhibit enforcement, as the IRS

may be less willing to impose significant penalties in all but the most egregious cases.

329 See generally NYSBA, Report, supra note 19, at 892-93.

330 Whether penalties alone are sufficient as a deterrent is discussed below with respect to

substantive changes.

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or (4) penalties alone are not a sufficient deterrent. 330 Anecdotal and other information seemingly

refute the first hypothesis. Several tax practitioners and corporate tax executives informally have

told the Treasury Department that the likelihood of liability for a significant penalty will deter a

corporate tax shelter transaction and a 20-percent or greater penalty is significant. Thus, merely

raising the section 6662 penalty rate, alone, likely will not have much effect upon corporate tax

shelter activity.

As discussed in Part V.A. with respect to disclosure, in order to assess a penalty, the IRS

must discover the questionable transaction. Thus, issues of disclosure and penalties are

interrelated. In addition, even if the taxpayer believes the IRS were to discover a questionable

transaction, the section 6662 penalty is an effective deterrent only if it can be applied to a

substantial understatement. If there is a defect in the underlying substantive law such that the

claimed tax benefits are not disallowed and concomitantly no understatement is created, the

penalty alone will not be an effective deterrent. 

In addition, many commentators note that the substantial underpayment penalty is not an

effective method to address current corporate tax shelter activity because the reasonable cause

exception, despite the amendments made in 1994, has become an almost fool-proof escape hatch

from the penalty regime. It is telling that two of the major organizations that represent tax

professionals --the ABA and the NYSBA-- point to a perceived deterioration in tax opinion

writing standards as a facilitating cause in the availability of the reasonable cause exception and in

the rise of corporate tax shelters, and have suggested remedies (described below) that are

intended to narrow or, in the case of the NYSBA, even eliminate this escape hatch. 
331 For this purpose, a corporate tax shelter would be defined as any entity, plan, or

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. (See

the discussion below for the definition of tax avoidance transaction.)

332 A separate proposal in the Administration’s Budget would modify application of the

substantial understatement penalty to the lesser of $10,000,000 or 10 percent of the tax required

to be reported. This proposal would apply whether or not the understatement arose with respect

to a corporate tax shelter. 

333 H.R. 2255 would make similar amendments to section 6662 with respect to tax benefits

disallowed from certain noneconomic transactions.

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reduced to 20 percent if, as discussed above, adequate disclosure also is made. The penalty could

not be avoided through the reasonable cause exception of section 6664 ( i.e., the penalty would be

subject to “strict liability”). 333

The budget also contains several penalty-like sanctions in the form of excise taxes upon

other participants in, and features of, corporate tax shelters. These proposals are discussed in

Part V.D. below.

2. Commentaries

The ABA proposals primarily focus on disclosure. However, the ABA acknowledges that

an expanded penalty structure may be necessary to provide the appropriate incentives and

disincentives for certain types of behavior and makes some suggestions regarding the substantial

understatement penalty. The ABA proposes that the current-law definition of corporate tax

shelter of section 6662 (as modified in 1997) be retained, and that increased disclosure be

required for “large tax shelters.” For this purpose, a large tax shelter would be one that involves

more than $10 million of tax benefits in which the potential business or economic benefit is

immaterial or insignificant to the tax benefits. The ABA also suggests that it may be appropriate

to develop and impose new penalties upon taxpayers that fail to disclose required information
334 ABA, supra note 56, at 9-10.

335 AICPA, supra note 316, at 15-17.

336 NYSBA, Report, supra note 19, at 897.

337

 Id. at 894-97.

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reasonably consistent with the legislative purpose for which the provision was enacted. The

AICPA disagrees with the application of a strict liability standard for corporate tax shelters, and

does not suggest any changes to the current application of the reasonable cause standard. 335

The NYSBA would leave it to Congress to determine the appropriate level of penalties

applicable to corporate tax shelters. They suggest that a penalty of at least 10 percent should be

applied to corporate tax shelters for which the taxpayer provides disclosure and a penalty of at

least 20 percentage points higher apply to undisclosed corporate tax shelters and that this latter

penalty rate be greater than the current-law 20-percent rate. 336

Moreover, the NYSBA supports the elimination of the reasonable cause exception from

the penalty. The NYSBA assumes that most transactions that would reasonably be viewed as

corporate tax shelters will be subject to at least one “more likely than not” or stronger tax opinion

rendered by a law or accounting firm. They note that although a favorable tax opinion does not

technically trigger the reasonable cause exception by itself, the receipt of such an opinion by the

taxpayer makes it significantly more difficult for the IRS to impose penalties. The NYSBA is

concerned that removal of the reasonable cause exception will increase the leverage of the IRS in

audits and believes that it is important that the IRS administer the penalty in a fair and evenhanded way. The penalty would be imposed even if the IRS and the Treasury Department were

to issue favorable regulations or other guidance with respect to a transaction unless the taxpayer

disclosed the transaction. 337

3. Analysis of Administration Proposals
338

 See TEI, supra note 4, at 11; AICPA, supra note 316, at 15-16. 

339 The notable exception to this statement is a taxpayer that has a recission or other

arrangement that covers 100 percent of its anticipated tax benefits from the tax shelter. 

340 A 40-percent penalty applies under section 6662(h) to certain gross valuation

misstatements.

341 See NYSBA, Report, supra note 19, at 892.

342 The “a significant purpose” standard was added by the Taxpayer Relief Act of 1997. 

Prior to the 1997 Act, the applicable standard was “the principal purpose,” which generally is

interpreted as the primary or most important purpose. “A significant purpose” generally is

interpreted as a lesser standard and could include any important purpose.

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taxpayer. It is the later imposition of a penalty that places the noncompliant taxpayer in a worse

financial position than a compliant taxpayer. Second, the various 25-percent excise taxes would

be applied to amounts (e.g., promoter fees) that generally would be less than the amount upon

which the substantial underpayment penalty applies. 339 In addition, the liability of some of these

excise taxes rests on parties other than the corporate participant. Finally, current-law section

6662 already provides a 40-percent penalty in sufficiently egregious cases. 340

Complaints about the level of penalties for corporate tax shelters also appear to result

from the perceived broadness or vagueness of the definition of corporate tax shelter. Larger

penalties generally are more acceptable if taxpayers have greater certainty as to the intended

target of the penalty. 341 The definition of corporate tax shelter in the Administration’s proposal

largely turns on the definitions of “tax benefit” and “tax avoidance transaction” and is discussed in

detail in Part V.C. below. It should be noted, however, that the current law definition of “tax

shelter” under present-law section 6662 is generally thought to be far broader than the definition

proposed by the Administration. It defines a “tax shelter” as any partnership, entity, plan or

arrangement that has as “a significant purpose” the avoidance or evasion of tax. 342 Commentators

on this 1997 Act change to section 6662 have suggested that the current-law definition of
343

 See Johnson, supra note 76, at 1604; Holden, supra note 3, at 371. Some have

criticized the Administration for proposing changes to the current law penalties when the

Administration has not used the current tools available to it. As an example, they cite the lack of

regulations under the 1997 Act changes to section 6662. See Kenneth J. Kies, A Critical Look at

the Administration’s Corporate Tax Shelter Proposals , 83 Tax Notes 1463, 1465 (June 7, 1999)

[hereinafter Kies]. This analysis ignores the fact that the 1997 Act changes to section 6662

(passed while Mr. Kies was chief of staff of the Joint Committee on Taxation) applied to

transactions entered into after August 5, 1997 and was self-effectuating. That is, the provision

applies as drafted by Congress and is not dependent upon the issuance of enabling regulations. If

the standard of “a significant purpose” is as broad as reasonably interpreted by some, one must

ask why tax shelter activity persists after August 5, 1997. 

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taxpayer’s investment in the shelter, or that involve confidentiality arrangements. When that is

combined with potentially being subject to a broader definition of “tax shelter” ( i.e., transactions

with “a significant purpose” of tax avoidance), countervailing factors must be operating currently

to mitigate their deterrent effects. For example, some may believe that, if the transaction is

backed by a “more likely than not” opinion, the IRS and courts will be disinclined to impose

penalties regardless of the literal requirements of the regulations. 

Thus, perhaps the strongest rationale for elimination of the reasonable cause exception lies

in transparency, i.e., dispelling any notion at the time the transaction is being evaluated by the

taxpayer that a “more likely than not” opinion is a mechanism for penalty insurance. As the

NYSBA recently stated:

The current structure of penalties has, in our experience, often had

a perverse impact on the discussion engaged in by corporations in

considering whether to enter into such a transaction - what may be

called the “tax dialogue.” A dominant fact discussed in such

situations simply becomes whether an opinion will be rendered or

not. For corporate tax shelter transactions to be deterred, the tax

dialogue must shift to a nuanced consideration of whether the tax

benefits are likely to be sustained in court and whether the
344 NYSBA, Report, supra note 19, at 893. See also Johnson, supra note 76, at 1606. (“A

20 percent penalty imposed automatically if the corporation loses in a substantial tax case is a very

good idea. The corporate behavior you want to encourage is reporting and paying over the

amount of tax that is due as finally determined by a court. The behavior you want to discourage

is reporting and paying over less than the amount that is ultimately determined to be due. Giving

a corporation an immunity from penalty if it has a reasonable basis or substantial authority for its

reporting position will mean that the corporation will not try hard enough to predict real

outcomes of the case. Giving the corporation credit for reasonable basis or substantial authority

is a bit like scoring football games by the number of good tries or reasonable efforts. Scoring by

touchdowns accomplished seems to encourage each side to try harder.”).

345 See generally NYSBA, Report, supra note 19, at 883.

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risks if the transaction is challenged. This is particularly true in the context of corporate tax

shelters where sophisticated corporate taxpayers are intent on managing their effective tax rates. 

Practitioners may be placed in the unenviable position of either turning away existing or

prospective corporate clients, or writing an aggressive opinion to provide “penalty insurance.” 

Even if receipt of a favorable opinion does not technically preclude application of the substantial

understatement penalty, receipt of such an opinion makes it significantly more difficult for the IRS

to successfully assert the penalty which, in turn, makes its deterrent value less certain. 345

Corporate taxpayers themselves must be deterred from entering into corporate tax

shelters. This requires that such taxpayers perceive a real risk of penalty if the transaction

ultimately is not upheld, one that is not perceived to be mitigated on the basis of a “more likely

than not” opinion. 

Another concern expressed by commentators is that elimination of the reasonable cause

exception will vest too much discretion in IRS revenue agents to assert the penalty. However, as

discussed in detail in Part V.C. below, it is possible to institute review procedures to mitigate this

concern. Some amount of judgment will always be necessary in the assertion of penalties and,

ultimately, the courts are the final arbiter. Even under present law, revenue agents must bring

judgment to the task of evaluating the taxpayer’s assertion of reasonable cause. At least one

commentator has concluded that “these negative consequences of adoption of a strict liability
346

 See id.

347 1982 Blue Book, supra note 242, at 218-19.

348 See TEI, supra note 4, at 9-13; AICPA, supra note 316, at 15-17. Conversely, as

discussed above, other commentators, notably the NYSBA, support elimination of the reasonable

cause exception for corporate tax shelters. NYSBA, Report, supra note 19, at 880.

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The Treasury Department continues to believe 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 ABA, the

NYSBA and others. Thus, to discourage the use of shelters, the Treasury Department would

retain the Budget proposal to double the current-law substantial understatement penalty rate to 40

percent for corporate tax shelters. As in the Budget, 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. 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 cite the potentially

vague definitions of corporate tax shelter and tax avoidance transaction, the allowance of a

reasonable cause exception for other penalties, and basic fairness for opposing a “strict liability”

penalty.348 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 (as

discussed in Part V.A. above) 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 section 1.6664-4 as to what constitutes
349 See ABA, supra note 56, at 4-6; NYSBA, Report, supra note 19, at 892-94; Holden,

supra note 3, at 373. For example, no reliance could be placed on an advisor’s opinion if the

transaction in question is subject to a confidentiality agreement, the advisor is compensated by a

promoter, the advisor worked with a promoter in developing the transaction, the advisor is being

compensated on a contingent or other non-traditional basis, the opinion does not satisfy the

standards of Circular 230 and applicable professional ethics or practice standards, the opinion fails

to identify all the material facts of the transaction, the opinion does not set out the due diligence

performed by the advisor, the opinion does not identify or consider the application of judicial

doctrines, the opinion assumes a business purpose, or other such qualifications.

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(1) Transaction held to be a corporate tax shelter, no disclosure by taxpayer: The

resulting underpayment would be subject to the increased 40-percent penalty, with additional

fixed-amount penalties for failure to disclose.

(2) Transaction held to be a corporate tax shelter, disclosure by taxpayer: The resulting

underpayment would be subject to the 20-percent penalty, unless the taxpayer had a reasonable

belief that it had a “strong” probability of success on the merits.

(3) Transaction held not to be a corporate tax shelter, no disclosure by taxpayer: The

resulting underpayment would be subject to the current-law 20-percent penalty, subject to the

current-law substantial authority exception, with additional fixed-amount penalties for failure to

disclose.

(4) Transaction held not to be a corporate tax shelter, disclosure by taxpayer: The

resulting underpayment would be subject to the current-law 20-percent penalty, unless the

taxpayer met the current-law reasonable basis exception.

Finally, fears that the IRS may abuse the potential availability of increased substantial

understatement penalties would be addressed by promulgating procedures that would enhance

issue escalation and facilitate consistent and centralized resolution of such matters. Such

procedures are discussed below in Part V.C.

C. DISALLOW TAX BENEFITS OF CORPORATE TAX SHELTERS
350 Treasury Explanation, supra note 61, at 97.

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challenges and in doing so, have created, developed, and reinterpreted the concepts of sham

transaction, substance over form, step transaction, business purpose, and economic substance. 

The application of these standards varies necessarily from court to court. Because the application

of these common law standards is inherently subjective and courts have applied them unevenly, a

great deal of uncertainty exists as to when and to what extent these standards apply, how they

apply, and how taxpayers may rebut their assertions. 

The current state of the law presents a strong case that a substantive law change is

necessary to address corporate tax shelters. Resolving these issues by legislation rather than court

decisions has other advantages as well. Litigation is costly and time consuming. Often, by the

time a judicial determination with respect to a transaction is made, Congress or the Treasury

Department has changed the underlying operating rules, or the transaction is otherwise obsolete. 

This is particularly true of corporate tax shelters that traditionally have had short “shelf-lives,” in

part, to help avoid detection by the IRS. The promulgation of tax rules generally rests with the

Congress in enacting statutory provisions and in the Secretary of the Treasury in issuing

regulatory guidance. Unlike judicial decisions, both of these forums are subject to public scrutiny

and comment and can be formulated to apply to a wide variety of fact patterns, rather than only

the case at bar.

It is clear that amendments to the objective operating rules of the Code upon which

existing shelters rely will not stop unidentified transactions (and may, in fact, provide a breeding

ground for new shelters). To the extent coherent standards could be developed to supplement

existing judicial doctrines, the self-assessment system would be enhanced and inappropriate

results limited. 

1. Administration Proposals

The Administration’s FY 2000 Budget would provide the Secretary of the Treasury the

authority to disallow a deduction, credit, exclusion, or other allowance obtained in a tax

avoidance transaction. 350 
351

 See, e.g., Treas. Reg. § 1.6662-4(g)(2)(ii) (list of tax benefits explicitly provided by

the Code). See also H.R. 2255, 106th Cong. (1999), which provides an explicit list of credits not

subject to disallowance under the bill.

352 The tax benefits generated by leveraged leasing activity requires careful analysis as to

whether such benefits are clearly contemplated. Leveraged leasing has existed for decades

primarily as a means of transferring tax benefits among parties. Both the Congress and the

Administration have implicitly and explicitly allowed leveraged leases to stand undisturbed,

subject to certain tolerances ( see, e.g., Rev. Proc. 75-21, 1975-1 C.B. 367). This is not to say,

however, that all leveraged leasing transactions are not tax avoidance transactions. See, e.g.,

Rice’s Toyota World Inc. v. Commissioner, 752 F.2d 89 (5th Cir. 1985); Rev. Rul. 99-17,

1999-14 I.R.B. 3. 

353 A detailed discussion of the first part of the proposed Administration definition can be

found in Appendix C.

354

 See Hariton, supra note 166, at 241 & 252.

355

 See supra discussion in section II.B.

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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 351 and deductions generated by standard

leveraged leases, 352 would not be subject to disallowance.

The proposed definition of tax avoidance transaction has two parts. The first part

incorporates the economic substance doctrine found in case law. 353 The economic substance

standard generally is thought to be the most objective of the common law doctrines, primarily

because it does not rely on the taxpayer’s intent. 354 In addition, the first part of the definition

incorporates a significant characteristic of current excess-benefits corporate tax shelters -- the

existence of tax benefits that are vastly disproportionate relative to the economic benefits of the

transaction. 355 
356 AICPA, supra note 316, at 16.

357 ABA, supra note 56, at 5-6 & 11.

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definitions of “corporate tax shelter” or “tax avoidance transaction” upon which a substantive

change may be based. The AICPA disagrees with the need to expand the Secretary’s authority to

expand the disallowance regimes of the Code and would provide safe harbors with respect to any

corporate tax shelter definition. 356

Rather than adopt the Administration’s disallowance rule, the ABA would clarify that,

where the economic substance doctrine applies, the nontax considerations must be substantial

(i.e., more than a de minimis or nominal) in relation to the potential tax benefits. The ABA

provides this proposal in response to their belief that many current corporate tax shelters rely

upon literal interpretations of mechanical rules of the Code but are not supportable under

common law principles. In this regard, the ABA seeks to make the economic substance doctrine

more visible by calling upon Congress to adopt it statutorily. In addition, the ABA proposal is

intended to overrule interpretations of case law that would suggest that even a de minimis or

insignificant amount of pre-tax profit is sufficient to give tax significance to a transaction. 357 

In many respects, this ABA proposal is similar to the Administration’s budget proposal to

change substantive law. Both proposals deal with the economic substance doctrine, which, as

explained in Part IV.B., generally involves the weighing of expected tax benefits with expected

pre-tax economic income from a transaction in order to determine the validity of the transaction

for tax purposes. The Administration’s proposal would elevate the standard to apply to all

corporate tax avoidance transactions and would specifically provide how the doctrine would apply

(i.e., by using a present value analysis). Although not adopting a formalistic approach, the ABA

would similarly provide that nontax considerations must be substantial in relation to the claimed

tax benefits. However, the ABA would provide that the economic substance doctrine should

apply only in cases where it currently applies and would not mandate a present value analysis. 

Presumably, the ABA would leave it to the courts to determine when and how to make such

determinations. 
358 NYSBA, Report, supra note 19, at 899-900.

359

 Id. This section of the paper focuses on the first two approaches suggested by the

NYSBA. The third approach -- providing the Treasury Department a grant of regulatory

authority to address troubling transaction -- is not discussed herein because it does not have an

analog to the Administration’s original proposed definition. 

360

 See Appendix A for descriptions of these and other “loss generator” transactions.

361 As one anonymous tax professional has commented, “If somewhere in the planning for

a transaction you have to ask, ‘What is our business purpose?,’ you know you have a tax shelter.” 

362 499 U.S. 554 (1991). The Cottage Savings decision involved a thrift institution that

sold interests in a pool of mortgages with built-in losses to other thrift institutions and, at the

same time, acquired interests in substantially identical mortgages from the other institutions. The

Supreme Court upheld the taxpayer’s deduction for a loss on the disposition of its mortgages

even though its economic position had not changed because of the acquisition of the new

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other than tax savings, and (4) an insubstantial economic effect upon the parties in relation to the

tax benefits. The definition would not apply to tax benefits that are “clearly contemplated” by

applicable statutory or regulatory provisions, administrative authority or a substantial body of case

law. In some respects, a definition built on these elements is similar to those proposed by the

Administration and the ABA. 

This NYSBA definition raises elements not found in the Administration and ABA

definitions --accrued losses, motive and business purpose. As discussed above, the

Administration’s proposed definition does not look to motive or business purpose, as these

concepts are viewed as subjective and potentially subject to taxpayer manipulation. 361 

However, the Administration’s proposed definition is silent as to whether a tax avoidance

transaction would encompass the use by a taxpayer of a tax attribute that it already possesses, but

could not readily access but for some extraordinary transaction. Thus, it is unclear how the

decision in Cottage Savings Association v. Commissioner 362 would be resolved under the
mortgages.

363 NYSBA, Report, supra note 19, at 899-900. The provision would also apply to

dispositions of assets.

364

 See AICPA, supra note 316, at 16; TEI, supra note 4, at 11.

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and which are not. In any event, the issues presented by the Cottage Savings case and other

“close calls” does not mean that a substantive legislative change should be abandoned. Rather,

the definition should be tailored appropriately to address these concerns.

The adoption of the second NYSBA approach would address perceptions of vagueness in

the second part of the Administration’s proposed definition. They suggest that a separate

substantive provision could be developed to encompass corporate financings that otherwise have

economic effect but are difficult to analyze under general tax shelter legislation. In such cases, the

purported tax benefits could be disallowed if there was (1) a significant distortion in the timing of

income or the elimination or reduction of income or a reduction of tax on income and (2) such

distortion, timing or elimination was plainly contrary to Congressional intent under applicable

statutory provisions or the purpose or structure of existing Treasury regulations. 363

3. Analysis of Administration Proposals

The criticisms of the Administration’s proposal to grant the Secretary the authority to

disallow certain tax benefits derived in a tax avoidance transaction can be summarized as follows:

(1) a change in the substantive law is not necessary to address current tax shelters; (2) the

proposed definition of tax avoidance transaction is too vague and (3) the proposal provides the

IRS with significant authority that may be subject to abuse. 364 These issues, and an analysis of

H.R. 2255, are provided below.

a. Why a substantive change in law is necessary. Many, if not most, current

corporate tax shelters “might work” under the applicable objective mechanical rules of the Code,

but “shouldn’t work” under either the more subjective common law doctrines developed by the

courts or under general notions of tax policy. A recent example of a “might work, but shouldn’t”
365

 See Appendix A for a detailed description of the transaction.

366 Kies, supra note 343, at 1478-79.

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mechanical rules to the Code adds to complexity, unintended results, and potential fodder for new

shelters; (3) the approach may rewards 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. 

Corporate tax shelters flourish under the existing legal regime. As discussed in Part II.B.,

discontinuities in objective statutory or regulatory rules can lead to inappropriate results that have

been exploited through corporate tax shelters. More general anti-abuse provisions ( e.g., sections

269, 446, 482, and 7701(l)) are limited to particular situations. Reliance upon the courts to police

such transactions with common law tax standards has proved to be somewhat unsatisfactory. As

discussed above, court decisions are often conflicting, creating confusion in an area of law that

generally relies upon objective rules. An efficient tax system places great reliance on selfassessment, requiring taxpayers and their advisors to apply the law to report taxable income

properly. Self-assessment is frustrated by conflicting, incoherent decisions and encourages the

most aggressive taxpayers to pick and choose among the most favorable cases.

To properly address corporate tax shelters, a broader approach is necessary. Much of the

discussion with respect to corporate tax shelters has centered upon the broader common law

doctrines discussed in Part IV.B. Some have suggested that these tools are sufficient in order to

address corporate tax shelters and no other substantive changes are necessary. 366 This argument

ignores the fact that corporate tax shelters thrive today despite the presumptive applicability of

these doctrines. Several reasons can be offered as to why these common law doctrines are

ineffective in curbing tax shelters. First, taxpayers (and their advisors) may be simply ignoring the

doctrines. Alternatively, taxpayers may be cognizant of the doctrines, but have decided that they

do not apply because the facts of their transaction are distinguishable from the facts in the case. 

Finally, because judicial interpretations of these doctrines is uneven, taxpayers may be relying on

decisions that are more favorable to the result they desire, while ignoring (or distinguishing)

decisions that are less favorable (the “least common denominator” factor). 
367 See, e.g., TEI, supra note 4, at 9-10; AICPA, supra note 316, at 15.

368 Some have suggested that courts in analyzing questionable transaction apply such

visceral tests and then disallow the tax benefits under the rubric of one of the enumerated

common law doctrines. See, e.g., ACM Partnership v. Commissioner, 157 F.3d 231, 265 (3d Cir.

1998) (McKee dissenting), cert. denied, 119 S.Ct. 1251 (1999). 

369

 See Knetsch v. U.S., 364 U.S. 361 (1971); ACM Partnership v. Commissioner, 73

T.C.M. (CCH) 2189, aff’d in part, rev’d in part, 157 F.3d 231 (3d Cir. 1998), cert. denied, 119

S.Ct. 1251 (1999). See generally Hariton, supra note 166. 

370

 See Frank Lyon Co. v. U.S., 435 U.S. 561 (1978); Horn v. Commissioner, 968 F.2d

1289 (D.C. Cir. 1992).

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benefits derived from a tax avoidance transaction. Criticisms of this approach generally focus on

the vagueness of the definition of tax avoidance transaction. 367 Vagueness is inherent in any

standard. In a sense, a corporate tax shelter could be defined as a transaction that “might work,

but shouldn’t,” is “too good to be true,” or doesn’t “pass the smell test.” These definitions

represent visceral reactions to shelter transactions; are difficult to translate into legislative,

regulatory or judicial language; and are truly subjective. 368 For the reasons described in this

report, the Treasury Department believes that its proposed definition of tax avoidance transaction

is more objective (than those contained in much of case law), and that perceptions of vagueness

are overstated. However, as discussed below, modifications can be made to the definition to

address certain causes of concern.

As described in detail above and in Appendix C, the first part of the Administration’s

proposed definition is intended to be a coherent standard derived from the economic substance

doctrine as espoused in a body of case law 369 to the exclusion of less developed, inconsistent

decisions.370 In addition, the definition incorporates a common characteristic of current corporate

tax shelters -- the lack of economic substance relative to purported tax benefits. Any definition of

corporate tax shelter should encompass this characteristic and, accordingly, take into account the

taxpayer’s expected tax benefits and the expected economic consequences to be derived from the

transaction. While the incorporation of this characteristic into the definition of corporate tax
371 Some have suggested substituting a “clear reflection of income” standard for this part

of the definition.

372 Of course, a financing may have nexus to a larger transaction that has a profits

component.

373 Other situations where profit may not be relevant could include cases involving

employee compensation and liquidations or dispositions of businesses.

374

 See, e.g., TEI, supra note 4, at 10; AICPA, supra note 316, at 15.

375

 See, e.g., NYSBA, Report, supra note 19, at 896. See also, supra, Part IV.B. for a

discussion of the use of a similar standard in the partnership anti-abuse regulation.

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This second part of the Administration’s proposed definition is intended to apply primarily

to financing transactions. In straight financing arrangements, the borrower is not "making a

profit" in an economic sense -- although the borrower may be reducing its costs relative to other

forms of capital financing -- but rather is raising capital in order to enter into profit-making

transactions. 372 In this instance, and others, 373 a comparative profits test may be inapposite. 

Corporate taxpayers, however, should not be free in these situations to enter into transactions that

produce unintended and unreasonable tax results, and this branch of the definition of corporate

tax shelter is intended to preclude corporate taxpayers from realizing such benefits. However, as

described below, the second part of the Administration’s proposal may be modified to be more

objective, targeted and consistent with the economic substance standard of the first part of the

proposed definition. 

The disallowance of tax benefits generated by tax avoidance transactions would not apply

to tax 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.) Some commentators have suggested that this exception to the proposed

definition also is too vague because it is often difficult to discern Congressional intent. 374 Others

believe this to be an important feature of any definition. 375
376

 See AICPA, supra note 316, at 16; TEI, supra note 4, at 11.

377

 See NYSBA, Report, supra note 19, at 894.

378 As described supra in Part V.B., H.R. 2255 also contains provisions similar to the

Administration’s original Budget proposal to modify the substantial understatement penalty of

section 6662.

379 Specifically, the following tax benefits would not be subject to disallowance: the credit

relating to producing fuel from nonconventional sources of section 29, the low-income housing

credit of section 42, the credit relating to electricity produced from renewable resources of section

45, the credit relating to qualified zone academy bonds of section 1397E, and any other tax

benefit as provided in regulations.

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4. Description and Analysis of H.R. 2255

H.R. 2255 contains several elements of the Administration’s proposal to modify

substantive law to disallow certain unwarranted tax benefits derived in corporate tax shelter

transactions. 378 In addition, H.R. 2255 reflects comments made by the ABA and NYSBA. 

Specifically, with respect to a substantive change in the law, section 3 of the bill would amend

section 7701 to provide for the disallowance of noneconomic tax attributes which would be

defined as any deduction, loss or credit claimed from any transaction unless (1) the transaction

changed in a meaningful way (apart from Federal income tax consequences) the taxpayer’s

economic position and (2) either (a) the present value of the reasonably expected potential income

from the transaction (and the taxpayer’s risk of loss from the transaction) are substantial in

relationship to the present value of the tax benefits claimed or (b) in the case of financing

transactions, the deductions claimed by the taxpayer for any period are not significantly in excess

of the economic return realized by the person providing the capital. Disallowance would not

apply to the realization of built-in losses or deductions that the taxpayer had economically borne

prior to the transactions or to certain specified tax benefits. 379 Certain transactions that do give

rise to meaningful book/tax differences or are entered into with tax-indifferent parties would be

presumed to be noneconomic transactions. 
380

 But see TEI, supra note 4, at 15; ABA, supra note 56, at 5 (suggesting that any antishelter provisions should apply equally to corporations and other taxpayers).

- 103 -

if such benefits are significantly in excess of the economic return of the counterparty to the

transaction. This rule of H.R. 2255, in essence, uses the economic substance test also found in

the first part of the Administration’s original proposed definition (and in the first part of the H.R.

2255 test), but applies it in a practical way to financing transactions. In this regard, H.R. 2255 is

more objective than the second part of the Administration’s original proposal and the NYSBA's

suggested modification for financing transactions (which is similar to the “improper elimination of

tax on economic income” test). 

H.R. 2255 would resolve the Cottage Savings issue discussed above in a manner similar to

that suggested by the NYSBA (i.e., disallowance would not apply to built-in losses of the

taxpayer). The Administration’s proposal and the NYSBA suggestion would not apply to tax

benefits that were contemplated by the Congress; H.R. 2255 would supply a definite list of certain

exempt credits and allow other tax benefits to be exempt pursuant to regulations. The

presumption that certain transactions are subject to disallowance and the application of the

disallowance rules to taxpayers other than corporations are other features of H.R. 2255 not found

in the Administration’s original proposal. 380

5. Proposed Modifications to Administration Proposals

The Treasury Department continues to believe that a substantive change in the law is

necessary to address corporate tax shelter transactions. However, in order to address legitimate

concerns regarding the vagueness of the definition and the potential abuse of discretion, the

Treasury Department proposes certain modifications.

First, the definition of tax avoidance transaction would remain a two-part definition, with

the first part based on the economic substance doctrine as originally proposed. However, to more

narrowly target the second part of the definition and to make it more consistent with the first part,

the Treasury Department proposes to substitute its original “improper elimination of tax” test with

a test focused specifically on financing transactions to that of H.R. 2255. 
381

 But see TEI, supra note 4, at 15 (any proposals that are adopted into law should also

apply to taxpayers other than corporations). 

382 Several commentators have observed that to be effective, any corporate tax shelter

provisions must be supported by proper enforcement on the part of government. See, e.g., ABA,

supra note 56, at 11.

383 Announcement 94-87, 1994-27 I.R.B. 124.

384 Notice 98-31, 1998-23 C.B. 9. 

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coordination by the IRS would increase consistency and efficiency in dealing with complex tax

shelter issues. 382 

Additional legislative and regulatory steps could be taken to further ensure proper and

consistent resolution of corporate tax shelter issues. For example, any corporate tax shelter issue

raised by an examining agent could be automatically referred to the National Office of the IRS for

further processing or resolution. Similar procedures currently are provided with respect to the

partnership anti-abuse regulation 383 and in the proposed procedures for involuntary accounting

method changes.384 Special rules also could be developed that would allow a taxpayer to receive

an expedited ruling from the National Office as to whether a contemplated transaction constituted

a corporate tax shelter for purposes of the section 6662 penalty. Taxpayers currently have the

opportunity to request private letter rulings with respect to the determination of the proper

substantive tax treatment of a transaction. Due to the complex factual and legal nature of many

corporate transactions, these rulings often cannot be provided on an expedited basis. 

Finally, an approach similar to that of H.R. 2255 should be adopted to further address

concerns of abuse of discretion. As described above, the Administration’s proposed substantive

rule vests authority in the Secretary to disallow unwarranted tax benefits; the substantive rule in

H.R. 2255 is self-executing. The difference between the two approaches is that, should an issue
385

 For instance, the Secretary generally is shown substantial deference when he uses his

authority under section 446 to challenge a method of accounting as not clearly reflecting income. 

See supra Part IV.A. for a discussion of section 446. 

386 Such a scenario is unlikely, however, in the current environment.

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As discussed in Part II.B., there are many parties that may participate in, and benefit from,

a corporate tax shelter other than the corporate participant. Proposals to deter the use of

corporate tax shelters could provide sanctions or remedies on these parties as a penalty for

engaging in inappropriate behavior. More importantly, such remedies or sanctions would lessen

or eliminate the economic incentives for these parties to participate in sheltering transactions, thus

having a dampening effect on the transactions themselves to the extent they are facilitated by the

participation of these parties. Finally, the potential for remedies or sanctions on all participating

parties will multiply the number of eyes that will scrutinize a transaction for its integrity.

Different remedies or sanctions may be fashioned for different types of participating

parties, requiring an identification of the parties and their respective roles in a corporate tax

shelter. It should be noted that remedies or sanctions on participants other than the corporation

itself will not, alone, put an end to corporate tax shelters. Not all corporate tax shelters use taxindifferent parties. Likewise a corporate tax shelter can be devised and implemented by a

corporation’s in-house personnel without the aid of outside promoters or advisors. 386 Moreover,

sanctions on tax advisors and promoters may merely raise the cost of the tax shelter transaction

and does not totally eliminate the incentive to enter into the transaction. Thus, enactment of

sanctions on promoters, advisors, and tax-indifferent parties must be at least accompanied by

significant sanctions on the corporate participant as well. 

a. Promoters and advisors. Many corporate tax shelters are designed and promoted

by individuals that are not employees of the corporate participant. These individuals may be

employed by investment banks, accounting firms, law firms or tax shelter boutiques whose

primary activity is the development and promotion of tax shelter products. Other independent

parties involved in a sheltering transaction include those who provide technical tax advice and

analysis, those who provide tax opinions, those who prepare or review tax returns or financial
387 NYSBA, Report, supra note 19, at 893.

388 See, e.g., U.S. v. Buttorf, 761 F.2d 1056, 1063 (5th Cir. 1985) (injunctive relief

appropriate against actions “denounced as wrongful by positive, public law”); U.S. v. Campbell,

897 F.2d 1317, 1321 (5th Cir. 1990) (debt without monetary correction for rapidly declining value

of foreign currency “did not comport with standard commercial practice” and rendered notes

virtually worthless compared to purported value). 

389

 See, e.g., Buttorf, 761 F.2d at 1062 (“the fact that appellant counseled his clients not

to seek separate opinions from lawyers or accountants” demonstrates “that appellant knew or had

reason to know that his representations to his customers regarding the tax benefits of his trust

- 106 -

provided on a contingent basis based on a percentage of the anticipated or realized tax benefits.

Congress previously has addressed the role of promoters and advisors of tax shelters. The

abusive shelter promotion and aiding and abetting penalties were enacted by TEFRA during the

height of the individual tax shelter activity of the 1980s. Rightly, they focus on the promoter or

salespersons hyping the shelter and other participants making representations as part of the

offering materials because those shelters typically had many investors and it was more effective to

target the promoter and associated individuals than to take enforcement action against each

investor. The level of misconduct that is subject to penalty, however, is egregious misconduct of

a variety not difficult for courts to discern, i.e., false or fraudulent statements or the preparation of

documents that knowingly will result in an understatement of tax. These standards reflect a basic

attribute of the tax shelter activity of the 1970s and 1980s, that is, that the typical investor was a

high-bracket individual without any detailed knowledge of the tax laws and potentially susceptible

to promotional claims that did not withstand close scrutiny by those skilled in the tax laws. 

Usually, the participant offering the opinion did so at the behest of the promoter and had no

relationship to the investors in the shelter. Consequently, the penalties were intended to protect

such third-party investors from the activities of such promoters and other participants. The cases

that have been brought under these standards reflect their basic orientation toward these types of

shelters, where the representations involved were plainly at odds with the economic substance of

the transaction or established principles of tax law or economics 388 and under circumstances where

knowledgeable advice was not sought by the promoter. 389 
package were false and misleading”); U.S. v. Estate Preservation Services , 38 F. Supp.2d 846,

854 (E.D. Cal. 1998) (promoter consulted with professionals but acknowledged that some of

those professionals disagreed with him as to propriety of specific representations; promoter

ignored those opinions and instead “associated with individuals who unquestioningly agreed to

further his scheme”).

390 See Forbes, supra note 5, at 202.

391 With respect to foreign persons who engage in a trade or business within the U.S.,

income that is effectively connected to such U.S. trade or business is subject to tax in the same

manner and at the same rates as income of U.S. persons. I.R.C. §§ 871(b) & 882. Certain U.S.

source income that is not effectively connected to a U.S. trade or business is subject to a 30-

percent gross basis tax, collected through withholding. I.R.C. §§ 871(a) & 881(a). U.S. source

income subject to the 30 percent withholding tax generally includes interest, dividends, rents, and

other fixed or determinable annual or periodic income. In addition, there are a number of

statutory exclusions. For example, so-called "portfolio interest" is not subject to the 30 percent

withholding tax. I.R.C. §§ 871(h) & 881(c). The withholding tax may be reduced by an

applicable treaty.

392 I.R.C. §§ 501(a) (exemption from tax) & (b) (tax on UBIT).

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b. Tax-indifferent parties. As discussed in Part II.B. of this Report and described in

Appendix A, the operation of many corporate tax shelter transactions are dependent upon the

participation of parties who are indifferent to tax consequences, e.g., foreign persons, tax-exempt

organizations, Native American tribal organizations, and otherwise taxable persons with expiring

tax attributes such as loss or credit carryovers. Foreign persons (nonresident aliens and foreign

corporations) are subject to U.S. Federal income tax only on income that is sourced in the United

States. 391 Tax-exempt organizations (including pension plans and charitable organizations) are

subject to federal income tax only on income that is unrelated to the organization’s exempt

purpose (UBIT).392 States, municipalities or political subdivisions thereof are not subject to
393 I.R.C. § 115.

394 See, e.g., Rev. Rul. 94-65, 1994-2 C.B. 14; Rev. Rul. 94-16, 1994-1 C.B. 19; Rev.

Rul. 81-295, 1981-2 C.B. 15; Rev. Rul. 67-284, 1967-2 C.B. 55.

395

 See, e.g., I.R.C. §§ 269 & 382.

396 Treasury Explanation, supra note 61, at 104.

397 If corporate participants were not jointly and severally liable, the tax could be easily

avoided. For example, the parties could organize a special purpose foreign entity to absorb the

income and then liquidate to avoid the proposed penalty. In addition, the joint and several liability

proposal would avoid questions concerning the limitations on the taxing jurisdiction of U.S.

- 108 -

tax system should not condone it. Imposing a tax on the income allocated to tax-indifferent

persons could be used to eliminate the inappropriate rental of their special tax status, eliminate

their participation in corporate tax shelters, and thus eliminate the use of shelters that arbitrage

their tax-preferred treatment. Trafficking of tax status also is inconsistent with the many

provisions of the Code that seek to limit the trafficking of tax attributes, such as net operating

losses.395

2. Administration proposals

Under the Administration’s FY 2000 Budget proposal, any income received by a taxindifferent person with respect to a corporate tax shelter would be taxable to such person. 396 To

ensure that a tax is paid, all corporate participants would be made jointly and severally liable for

the tax.397 For purposes of the proposal, a tax-indifferent person would be defined as a foreign

person, a Native American tribal organization, a tax-exempt organization, and domestic

corporations with a loss or credit carryforward that is more than three years old. The proposal

would characterize the income to achieve taxable status. For example, in the case of a tax-exempt

organization, the income would be characterized as UBIT. In the case of a foreign taxpayers, any

income not otherwise treated as U.S. source income would be treated as effectively connected

income.
398 Treasury Explanation, supra note 61, at 99.

399

 Id. at 100.

400

 Id. at 99.

401 ABA, supra note 56, at 10.

402

 Id.

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3. Commentaries

The ABA believes that promoters and tax advisors have played a role in the proliferation

of corporate tax shelters. They also recognize that one feature of many corporate tax shelters is

the participation of a tax-indifferent party. In recognition of the role that these parties play in

corporate tax shelters, the ABA proposes that if the substantial understatement penalty applies to

a taxpayer with respect to a tax shelter, the penalty should also be imposed on outside advisors,

promoters and tax-indifferent parties that actively participated in the tax shelter. These penalties

would be set at levels commensurate with the fees and benefits such parties stood to realize if the

transaction was successful. Special procedural rules would be provided to assure due process to

such parties, similar to the rules applicable to tax return preparer penalties. 401

The ABA would also expand the scope of potential participants subject to penalty with

respect to corporate tax shelters to officers of the corporation who must attest to the disclosure

requirements proposed by the ABA regarding the nature of the transaction. The ABA would

impose personal accountability upon such officer for the accuracy of the factual underpinnings of

the transaction. The nature of such penalty is not discussed. 402

The AICPA agrees that present law should be changed to ensure that all parties to a tax

shelter transaction have an incentive to ensure the soundness of the transaction. They favor the

Administration’s recommendation that Congress address exploitation of the tax system by the use
403 AICPA, supra note 316, at 14.

404

 Id. at 20-21

405 NYSBA, Report, supra note 19, at 882-85. 

406 New York State Bar Ass’n (Tax Section), Report on Certain Tax Shelter Provisions

(June 22, 1999).

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Circular 230, while acknowledging that certain parties ( e.g., investment bankers) are not subject

to these provisions. 404

The NYSBA acknowledges that the growth of corporate tax shelters can be attributed, at

least in part, to certain tax advisors and promoters --primarily, national accounting firms, multicity law firms and major investment banks-- that have significant planning resources, mass

marketing capabilities, and extensive client lists. 405 However, the NYSBA does not support the

penalties and excise taxes proposed by the Administration with respect to parties other than the

corporate participant and believes the principal emphasis should initially be placed on deterring

corporations themselves from entering into questionable transactions. 406

4. Analysis and Possible Modifications to Administration Proposals

The Treasury Department believes that the current “nothing ventured, nothing gained”

attitude, coupled with little downside risk to many participants has, in part, led to the proliferation

of corporate tax shelters. The Treasury Department believes that, to foster a "culture of

compliance," it is important that all parties that facilitate a questionable transaction have a

personal stake in determining the appropriateness of the transaction. In order to develop this

personal stake, current law must be modified to change the financial incentives of participants in

corporate tax shelter transactions.

The proposals in the Administration’s Budget attempt to change these financial incentives.

With respect to promoters and advisors, the Treasury Department believes that the most direct

way to affect their economic incentives is to levy a penalty excise tax upon the fees derived by
407 Thus, a tax professional who advised a client that a transaction was not supportable

under current law or who cautioned a client not to enter into the transaction would not be subject

to the penaltyexcise tax with respect to fees charged for such advice.

408 As described in Part IV.C., sections 6700, 6701 and 6703 were enacted in response to

the individual tax shelters of the 1970s and 1980s and have little applicability to corporate tax

shelters today.

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Denying the deduction for costs of certain services effectively raises the cost of such

services. Because this sanction is directly imposed on the corporate participant, it only has an

indirect effect on promoters and advisors. In addition, unlike deductions generated by tax

avoidance transactions, fees paid to outside promoters and advisors represent actual out-ofpocket costs to corporations. Because the Treasury Department believes that the other sanctions

proposed with respect to the corporate participant are sufficient, the Treasury Department

proposes to eliminate its original proposal regarding the deductibility of promoter and advisor

fees. 

As a further deterrent to certain services currently being provided to participants in

corporate tax shelters, the Administration’s original Budget proposed a 25-percent excise tax

upon the tax benefits subject to an unwind provision, recission agreement, or insurance or similar

arrangement. The Treasury Department believes it is inappropriate for promoters and others to

"guarantee" tax benefits arising from corporate tax shelters. However, because this sanction

represents yet another burden on the corporate participant and would be difficult to administer,

the Treasury Department proposes to eliminate this proposal. However, the Treasury Department

proposes that the existence of an unwind provision, recission agreement, or insurance or similar

arrangement should a special type of “filter” that automatically triggers disclosure. 

Finally, the Treasury Department remains concerned about the participation of taxindifferent parties in corporate tax shelters. At a minimum, the Administration’s original Budget

proposal to tax income earned by such persons with respect to corporate tax shelters should be

modified by (1) providing appropriate due process procedures for such parties with respect to any

assessment, (2) providing that only tax-indifferent parties that are trading on their tax exemption
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409 S. Rep. No. 99-313, at 714 (1986).

410

 Id. at 715.

411

 Id.

412

 Id.

413

 See, e.g., NYSBA, supra note 19, at 900.

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significant administrative and compliance burdens. 412 Accordingly, Congress chose a more limited

path: addressing the symptoms rather than the cause.

Existing corporate tax shelters could be limited if some of the basic principles and rules

underlying the Federal income tax system that are contributing to the existence of such shelters

are changed or modified.413 Alternatively, as was done with respect to individual tax shelters in

the 1980s, the symptoms could be addressed. For example, various limitations could be imposed

on the amount of tax benefits a taxpayer could receive or use under the income tax. Examples of

the latter type of limitation include the alternative minimum tax and the passive loss rules of

section 469. Applying such rules in response to corporate tax shelter transactions casts a wide

net–one that would catch both taxpayers that engage in sheltering transactions as well as those

that do not. This section discuss alternatives for addressing corporate tax shelters, including

options that we considered but did not propose, anti-abuse approaches adopted in other countries,

and improving the targeted response system.

A. THE ROADS NOT TAKEN

1. Fundamental Tax Reform or Integration

This Report is focused on curbing corporate tax shelters within the Federal income tax

system. The Treasury Department recognizes, however, that in light of the increased avoidance

of corporate income taxes through the use of tax shelters, some may call for the replacement of

the corporate income tax with a new tax regime, or integration of the corporate and individual
414 Dept. of the Treas., Integration of The Individual and Corporate Tax Systems (January

1992).

415

 See, e.g., Bankman, A Market Value Based Corporate Income Tax , 68 Tax Notes

1347 (Sept. 11, 1997).

416

 See, e.g., Jt. Comm. on Tax’n, Impact on Manufacturing, Energy, and Natural

Resources of Replacing the Federal Income Tax (1996) (discussing sources of complexity and

potential manipulation in alternative tax systems).

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corporate tax systems. 414 The primary goal of integration would be to tax corporate income once

and reduce or eliminate the economic distinctions arising under the current two-tiered system. 

The report examines in detail several different integration prototypes to stimulate debate on the

desirability of integration. With respect to publicly traded corporations, some have argued for a

form of integration that would replace the corporate income tax with an annual tax on

shareholders measured by the market value of the corporation’s stock. 415

In the case of fundamental tax reform and integration, a corporation would still be

required to determine a tax base, albeit under the new system, to determine its tax liability or the

tax allocable to its shareholders. Under any system, corporations and their shareholders would

continue to have an interest in minimizing their collective tax liabilities. For example, even if the

corporate and individual income taxes were integrated, shareholders (and, correspondingly,

corporations) would have an interest in postponing the payment of taxes attributable to corporate

earnings. In addition, a fundamentally new tax regime would have sufficiently unclear or complex

areas that could result in a significant avoidance of tax. 416

2. Floor on Taxable Income

In 1969, Congress enacted the minimum tax to reduce the advantages derived from tax

preferences and to make sure that those receiving such preferences also pay a share of the tax
417 S. Rep. No. 91-552 (1969), reprinted in 1969-3 C.B. 423, 495 ("The present treatment

which permits individuals and corporations to escape tax on certain portions of their economic

income results in an unfair distribution of the tax burden. This treatment results in large variations

in the tax burdens placed on taxpayers who receive different kinds of income.").

418 S. Rep. No. 99-313, at 518 (1986).

419

 Id. Congress also believed that the ability of high-income individuals and highly

profitable corporations to pay little or no tax undermined respect for the tax system and was

inherently unfair. Id.

420

 Id. at 520.

421

 Id. Given the conservatism of financial accounting (i.e., it is designed to err on the

side of understating, rather than overstating income), "alternative minimum taxable income

generally should not be lower than book income for any substantial period of time, absent tax

preferences that have not been separately identified." Id. at n. 4.

422 I.R.C. § 56(f) (repealed). See generally Jt. Comm. on Tax’n, General Explanation of

the Tax Reform Act of 1986, at 434 (1987) [hereinafter 1986 Blue Book] ("Congress concluded

that it was particularly appropriate to base minimum tax liability in part upon book income during

the first three years after enactment of the Act, in order to ensure that the Act will succeed in

restoring public confidence in the fairness of the tax system.").

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income, was necessary in order for the minimum tax regime to be successful. 421 Under the book

income preference adjustment, the alternative minimum taxable income of a corporation was

increased by 50 percent of the amount by which the adjusted net book income of the corporation

exceeded the alternative minimum taxable income for the taxable year (determined without the

book income adjustment and the alternative tax net operating loss deduction). This adjustment

applied only for three years, from 1987 through 1989.422 For years after 1989, the book income
423 I.R.C. §§ 56(c) & (g). According to the Joint Committee on Taxation,

For taxable years beginning after 1989, Congress concluded that

the book income preference should be replaced by the use of a

broad-based system that is specifically defined by the Internal

Revenue Code. Congress intended that this system should

generally be at least as broad as book income, as measured for

financial reporting purposes, and should rely on income tax

principles in order to facilitate its integration into the general

minimum tax system. Congress concluded that the definition of

earnings and profits applying for certain regular tax purposes . . .

provided an appropriate starting point in this regard.

1986 Blue Book, supra note 422, at 435.

424 That is, they reduce the taxes paid by the corporation without a commensurate reduction in

the book earnings of the corporation.

425 Congress created a priority system for determining the applicable financial statement

that would be used to determine book income. The Senate Report provides that

[t]he taxpayer’s applicable financial statement is the statement it

provides for regulatory or credit purposes, for the purpose of

reporting to shareholders or other owners, or for other substantial

nontax purposes. In the case of a corporation that has more than

one financial statement, rules of priority are provided for the

determination of which statement is to be considered as the

applicable financial statement for the purpose of determining net

book income."). 

S. Rep. No. 99-313, at 530 (1986)

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approach obviously would require a determination of the appropriate book income figure. 425
426

 Id. at 532-35.

427

 See Andrew B. Lyons, The Alternative Minimum Tax: Equity, Efficiency, and

Incentive Effects, in Economic Effects of the Corporate Alternative Minimum Tax, at 51-82

(Washington, D.C.: Am. Council for Capital Formation Ctr. for Policy Research 1991).

428 Statement of Financial Accounting Concepts No. 1, Objectives of Financial Reporting

by Business Enterprises (FASB 1978).

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allow sheltering to some extent.

Finally, broadly relying on financial accounting rules for tax purposes may prove

unsatisfactory as financial accounting and tax accounting rules have different purposes and

different sources. The objective of financial accounting is, among other things, to provide

investors and creditors with some of the information useful in making rational investment, credit,

and similar decisions.428 Financial accounting is governed by broad concepts, such as

conservatism and consistency, and by standards (generally accepted accounting principles, or

GAAP) that are generally developed by the Financial Accounting Standards Board (FASB). The

observance of these concepts and rules is determined by certified public accountants and by

regulatory bodies such as the Securities and Exchange Commission (SEC). Their application may

vary among companies, among industries, or depending upon the auditor. The objective of the

Federal income tax is, among other things, to provide revenues for the operation of the

government. Tax accounting rules are determined by Congress, the Treasury Department, and

the courts. If the Congress were to re-enact a book income adjustment, it would be conceding

the determination of a significant portion of the corporate tax base to bodies (the AICPA, FASB

and SEC) other than itself.

3. Scheduler or Basketing System

The Code contains a number of provisions designed to limit the ability of taxpayers to use

tax benefits from one activity to offset income from an unrelated activity. For example,
429 I.R.C. § 1211. In the case of a corporation, net capital losses are not deductible but

generally may be carried back three years and carried forward five years. I.R.C. § 1212(a). In the

case of an individual, a net capital loss of up to $3,000 is deductible against ordinary income. 

I.R.C. § 1211(b).

430 I.R.C. § 904. In addition to an overall limitation on foreign tax credits, separate

limitations apply to discrete categories of income. I.R.C. § 904(d). These "baskets" limit the use

of foreign tax credits generated with respect to highly taxed foreign source income from being

used to offset U.S. resident tax on low-taxed foreign source income (such as, passive income).

431 I.R.C. § 163(d).

432 I.R.C. § 165(d).

433 I.R.C. § 469(a). 

434

 See supra Part II.A.2. for a description of “excess benefit” shelters and “exclusion”

shelters.

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restrict the tax benefits a corporation derives from non-economic transactions. This would

preclude taxpayers from engaging in transactions (so-called “excess benefit transactions” or “loss

generators”) merely to produce tax benefits to offset income from other transactions. Such an

approach, however, would not be effective with respect to so-called “exclusion transactions.”

434

A broad basketing or schedular system limited to corporate tax shelters would be difficult

to design, implement and enforce. Unlike individuals, corporations engage in a wide variety of

activities and often grow and diversify into new activities. Because money is fungible, tracing tax

benefits derived from financing transactions to taxable income from activities for which the

financing is used (and vice versa) would be difficult. Limiting schedular taxation to corporate tax
435 1997 Airlie House Transcript, supra note 9 (quoting Phil Wiesner: “I can live with the

[partnership anti-abuse rules] because I view them like the difference between a root canal with

novacaine versus a root canal without novacaine. There are worse things that could have been

done...like extending the passive loss rules to corporations.”); but see Lee A. Sheppard, Is There

Constructive Thinking About Corporate Tax Shelters? , 83 Tax Notes 782, 783-84 (May 10,

1999) (advocating a scheduler system).

436

 A General Anti-Avoidance Rule for Direct Taxes: Consultative Document (U.K.

Inland Revenue 1998).

437 Id. at § 6.1.1.

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tax law can be overturned or recast by tax administrators and the courts. In many cases, the general

principles employed by a GAAR are similar to the long-standing common law principles employed by

the U.S. courts. Some employ several principles, failure to meet any one of which will trigger the

GAAR, to those that only encompass one test ( e.g., business purpose). 

For example, the U.K. Inland Revenue consultative paper on a GAAR436 identifies four

elements that a GAAR might contain. It would: “require a scheme to be considered as a whole, rather

than on a step-by-step basis;” apply this step transaction rule to steps “merely planned or expected,”

not just those that are preordained; impose a recharacterization “based on the commercial substance of

the transaction;” and “have regard to the purpose of the legislation.”

437 As discussed in Part IV. B.,

judicial doctrines involving step transaction, substance-over-form recasts of transactions, and purposive

interpretation of the statute (where the language of the statute is ambiguous or silent) are wellestablished in U.S. tax jurisprudence.

It is difficult from the experiences of other countries to draw general conclusions about

the efficacy of a GAAR, or its appropriateness for the United States, because tax systems and

systems of jurisprudence differ from country-to-country. For example, a GAAR may have been

introduced in some countries because courts felt unable to develop judicial anti-avoidance

doctrines (similar to those that exist in the United States). The success of a GAAR also may

depend on the extent to which the tax law is based on formalistic mechanical rules, and the extent

to which legislative intent is clearly expressed in an accessible form. If the tax law is highly
438 See, e.g., Australia’s experience with judicial interpretation of section 260 of the

Income Tax Assessment Act, discussed infra at text accompanying notes 444 - 441.

439 Section 260, Income Tax Assessment Act 1936.

440 See, e.g., Mullens & Ors v. FCofT (1976) 135 CLR 290; Slutzkin & Ors v. FCofT

(1977) 140 CLR 314; Cridland v. FCofT (1977) 140 CLR 330.

441 For a discussion of this case, see infra text accompanying notes 459-460 .

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importance on the legal form of the transaction, and ignoring motive. What follows is a brief

examination of three common law countries and their experience (or lack thereof) with a GAAR: 

Australia, which has had a GAAR for several decades; Canada, which recently introduced a

GAAR; and the United Kingdom, which has been considering a GAAR.

a. Australia. Australia has for many years had general anti-avoidance rules in its

income tax legislation, but the history of their application has been mixed. Section 260 of the

Income Tax Assessment Act of 1936 (reenacting a provision originally enacted in 1915), which

was in force until 1981, provided that any contract, agreement or arrangement made with the

purpose or effect of, inter alia, altering the incidence of any income tax or “defeating, evading or

avoiding” any tax liability, would be absolutely void as against the government. 439 

The Australian courts, however, apparently proved very unwilling to apply the statute, and

developed the “choice doctrine” which held that if the legislation provided two explicit choices,

then section 260 could not be used to invalidate the taxpayer’s choice of the more tax efficient

outcome.440 Whether the taxpayer met the provisions of the chosen provision would be

interpreted under the formalistic standards of the Duke of Westminster case.441 The courts also

interpreted the section as giving them no authority to recast transactions; only to completely void

(or “annihilate”) them. Finally, if any specific anti-avoidance rule (however limited) applied, then

section 260 could not.
442 After Part IV A was introduced, in cases on the former section 260, the Australian

courts significantly limited the apparent scope of the “choice doctrine” and so expanded the

potential effect of the former section. See, e.g., FCofT v. Gulland, Watson v. FCofT, Pincus v.

FCofT (1985) 160 CLR 55 (consolidated cases).

443 Sections 177A-177G, Income Tax Assessment Act 1936.

444 (1996) 96 ATC 4663.

445 Id. Judgment of Brennan CJ, Dawson, Toohey, Gaudron, Gummow and Kirby JJ.

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applied even where specific anti-avoidance provisions apply. 443

In FCofT v. Spotless Services Ltd,

444 the Australian High Court considered Part IV A in

relation to a scheme which involved earning interest in a favorable foreign low-tax jurisdiction at a

rate that was lower than the comparable interest rate obtainable in Australia. Because the interest

was claimed to be exempt from Australian taxation, this nevertheless resulted in a higher post-tax

return than the income would have earned if deposited in Australia. The taxpayer argued that it

was simply trying to maximize its post-tax return, which was a business motive rather than a tax

avoidance motive. The lower courts agreed. However, the High Court handed the government a

significant victory, holding that:

A person may enter into or carry out a scheme,

within the meaning of Pt IVA, for the dominant

purpose of enabling the relevant taxpayer to obtain a

tax benefit where that dominant purpose is

consistent with the pursuit of commercial gain in the

course of carrying on a business.445

The High Court also confirmed that the formalistic standards under Duke of Westminster

have no relevance in applying Part IV A. 
446 Gov’t of Austl., Tax Reform: Not a New Tax, a New System 150 (1998). See also,

e.g., Taxation Laws Amendment Act (No. 3) 1998, which introduced a new general antiavoidance provision into Part IV A to target franking credit trading and dividend streaming

schemes where one of the purposes of the scheme (other than an incidental purpose) is to obtain a

franking credit benefit.

447 See Brian Arnold & James Wilson, The General Anti-Avoidance Rule -- Part 1, 36

Can. Tax J. 829 (1988). See also Stubart Investments Ltd. v. The Queen [1984] CTC 294

(SCC). Other commentators, however, disagree. They argue that the Courts were going in the

right direction, but the problem was lax enforcement. See, e.g., David Ward, Tax Avoidance:

Judicial and Legislative Approaches in Other Jurisdictions , in Report of Proceedings of the 40th

Tax Conf. (Can. Tax Found. 1989).

448 Brian Arnold, The Canadian General Anti-Avoidance Rule, [1995] Brit. Tax Rev. 541.

449 Section 245 Income Tax Act, RSC 1952, c. 148. The Canadian Department of Finance

explained:

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b. Canada. A recent example of a common law country introducing a GAAR for the

first time is Canada. In 1988, Canada enacted a GAAR, in response to increasingly aggressive

planning and the perceived unwillingness of Canadian courts to expand common law doctrines. 447 

The GAAR was first proposed in 1987. A white paper was issued, and a period of

consultation followed during which the tax bar almost unanimously opposed the proposed

provision.448 Despite these objections, the Canadian Government moved forward with the

proposal. Several changes were made, however, to reflect some of the comments that had been

received. As passed (in section 245 of the Income Tax Act), the GAAR provides that tax benefits

from a transaction may be denied “unless the transaction may reasonably be considered to have

been undertaken or arranged primarily for bona fide purposes other than to obtain the tax

benefit.” In order to provide “greater certainty,” however, the GAAR “does not apply to a

transaction where it may reasonably be considered that the transaction would not result directly or

indirectly in a misuse of the provisions of this Act or an abuse having regard to the provisions of

this Act, other than this section, read as a whole.”

449

 
New section 245 of the Act is a general anti-avoidance rule which is

intended to prevent abusive tax avoidance transactions or

arrangements but at the same time is not intended to interfere with

legitimate commercial and family transactions. Consequently, the

new rule seeks to distinguish between legitimate tax planning and

abusive tax avoidance and to establish a reasonable balance

between the protection of the tax base and the need for certainty for

taxpayers in planning their affairs. 

Canadian Department of Finance, Explanatory Notes to Legislation Relating to Income Tax

(1988).

450 See, e.g., IC88-2, General Anti-Avoidance Rule (October 21, 1988).

451 Id. at ¶ 2.

452 1998 Report of the Auditor General of Canada, Chapter 5. According to the report (at

5.29), the Committee meets weekly to review GAAR audit and advance ruling issues.

453 Arthur Drache, Seven-Year-Old Law Still a Puzzle , Sec. 2, p. 30, The Financial Post

(June 18, 1996). See also 1996 Report of the Auditor General of Canada, Ch. 11, at 11.40-11.41

(Auditor General suggested that Revenue Canada’s local offices were equally in the dark as to the

GAAR Committee’s reasoning).

454 By late 1998, 300 audit-generated cases had been referred to the GAAR Committee. 

The Committee determined that the GAAR did not apply in 100 cases. Application of the GAAR

was recommended in 200 cases. Among the 200, 130 were reassessed and 45 subsequently

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1989 returns commenced. The GAAR Committee considers both the appropriate assertion of the

GAAR in audit cases as well as its interpretation in advance rulings. 452 While criticized for not

releasing its deliberations to the public, 453 the GAAR Committee has recommended that the

GAAR not be applied in one-third of the cases sent to it by the rulings division and by district

offices in relation to income tax audits. 454 Revenue Canada is attempting to streamline the process
settled. Only 21 were taken to court, and 6 of those were subsequently withdrawn. Vivien

Morgan, Revenue Canada and Finance Round Table, 1998 Annual Tax Conference (Special

Report) Canadian Tax Highlights (Nov. 17, 1998).

455 Robert Couzin, Business Operations In Canada, A-76(1) (1997-98).

456 See generally Brian Arnold, Revenue Canada: 2, Taxpayer: 0, Regarding GAAR, 14

Tax Notes International 1427 (May 5, 1997).

457 John Owen, Statutory Interpretation and the General Anti-Avoidance Rule: A

Practitioner’s Perspective , 46 Can. Tax J. 233, 266-73 (1998).

458 See, Colin Masters, Is There a Need for General Anti-Avoidance Legislation in the

United Kingdom?, [1996] Brit. Tax Rev. 647.

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More cases will need to be decided, however, before judicial treatment of the GAAR can be fully

assessed.

c. United Kingdom. While the United Kingdom has never adopted a GAAR with

respect to its income tax, general anti-abuse rules have been employed, at various times, in

relation to certain specific types of tax ( e.g., the excess profits tax). In applying these broad

provisions, the courts have liberally exercised their powers to approve recasts of transactions by

the Inland Revenue.458 Absent such provisions, however, English courts have traditionally

narrowly interpreted the tax law, looking to discern the plain meaning of the statute and then

determining whether the form of the transaction comports with the language of the statute. In the

leading case, IRC v. Duke of Westminster, Lord Russell of Killowen stated his “disfavour” for the

notion that a court may recast a transaction in accordance with its substance:

I confess that I view with disfavour the doctrine that

in taxation cases the subject is to be taxed if, in

accordance with a Court's view of what it considers

the substance of the transaction, the Court thinks

that the case falls within the contemplation or spirit
459 Commissioners of Inland Revenue v. Duke of Westminster, [1936] AC 1 (HL) (19 Tax

Cases at 524).

460 Id. at 19 Tax Cases 520.

461 Bradford Corporation v. Pickles, [1895] AC 587 at 594 (HL).

462 [1984] STC 153 (HL).

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Lord Tomlin, further stated, in terms reminiscent of Judge Learned Hand, in Gregory:

Every man is entitled if he can to order his affairs so

that the tax attaching under the appropriate Acts is

less than it otherwise would be. If he succeeds in

ordering them so as to secure this result, then,

however unappreciative the Commissioners of

Inland Revenue or his fellow tax-payers may be of

his ingenuity, he cannot be compelled to pay an

increased tax. 460

English Courts have also generally been unwilling to consider questions of motive. In

Bradford v. Pickles, Lord Halsbury stated that: 

If it was a lawful act, however ill the motive might

be, he had a right to do it. If it was an unlawful act,

however good his motive might be, he would have

no right to do it. 461

In recent years, English courts have, on occasion, proved more willing to expand judicial

anti-avoidance doctrines without specific statutory endorsement. For example, the House of

Lords in cases in the 1980s such as Furniss v. Dawson462 (step transaction applied, and transaction
463 [1997] STC 888 (HL).

464 This is not to say that there have not been setbacks for the Inland Revenue. Craven v.

White, [1988] STC 476 (HL), for example, was regarded as a paring back of the principle of

Furniss v. Dawson, as was Fitzwilliam v. IRC [1993] STC 502 (HL).

465 Tax L. Rev. Comm., Tax Avoidance, xi-xii and 31-32, (1997, Inst. for Fiscal Affairs).

466 Id. at xii.

467 See, e.g., Peter Wyman, U.K. Proposed GAAR May Be Counterproductive, 17 Tax

Notes Int. 1160 (Oct. 19, 1998); Adam Blakemore, U.K. Tax Institute Highlights GAAR’s

Hidden Dangers, 17 Tax Notes Int. 1891 (Dec. 14, 1998).

468 George Hardy, U.K. Chancellor Releases 1999 Budget, 18 Tax Notes Int. 1019

(Mar. 15, 1999).

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Second, such a doctrine operates retrospectively, as courts are declaring what the law has always

been (rather than only applying prospectively as a statute, or regulatory guidance might), yet

offers no clear framework within which it will operate or not. The Committee, therefore,

concluded:

We consider that tax avoidance should be countered principally by

legislation rather than by the further development of the current

judicial anti-avoidance doctrine. A statutory rule can attempt to

make good some of the limitations inherent in a judicial rule and

provide a proper framework for the application of a general antiavoidance rule.466

Practitioners and others have raised serious concerns about the introduction of a

GAAR.467 According to recent reports, it appears, following the 1999 budget, that the U.K.

government does not intend to introduce a GAAR immediately. However, the government did

not foreclose the possibility of doing so in the future. 468
469 Gen. Tax Code, § 42.

470 Jorg-Dietrich Kramer, Abuse of Law by Tax Saving Devices, 2 Intertax100 (Feb.

1991). 

471 Various categories of suspect structures have emerged in practice, including sales of

shell corporations with expiring tax attributes, formation of offshore base or holding companies,

interposition of certain partnership holding structures, agreements between family members or

spouses, and arrangements for acceleration of expenses or deferral of income.

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abuse of structures available under the law. If such

abuse occurs, tax will be due as if a legal structure

had been used which is appropriate to the economic

substance of the transaction. 469 

According to one commentator, four factors are necessary for the application of this

provision. First, there is an attempt to circumvent the law by transactions that may not conflict

with the literal language of the statute, but which do conflict with its purpose. Second, there is an

abuse of the legal arrangements in that there are either (a) no economic or other significant

reasons which would justify the legal arrangement adopted by the taxpayer, or (b) the legal

arrangement used by the taxpayer is inappropriate given the economic purposes it claims to seek

to achieve in the transaction. Third, the purpose is to save or avoid tax. Fourth, there is an intent

to circumvent the tax laws. 470

The tax authorities bear the burden of proving circumvention of the tax law under section

42. While the use of an unusual legal structure is not, as such, inappropriate, an objectively

verifiable economic or other reason must exist to justify the use of such a structure. The choice of

such a structure may be considered to be an indication of an intent to circumvent the law, and the

Federal Tax Court has held that a presumption of circumvention exists if the taxpayer cannot

show objectively verifiable economic or other reasons for use of the structure. Moreover, the

Federal Tax Court has also held that a presumption of intent to circumvent the law exists where a

taxpayer uses a structure that has repeatedly been held to be abusive or that has generally been

held to establish intent to circumvent the law. 471
472 David Ward, Abuse of Tax Treaties, 397 at 408 (in Herbert Alpert and Kees van Raad,

eds, Essays on International Taxation: To Sidney I. Roberts, 1993).

473 Book of Fiscal Procedures, Art. L64.

474 Daniel Sandler and Ephraim Fuks, eds., The International Guide to Advance Rulings,

France-17 (IBFD 1997).

475 Claude Gambier and Jean-Yves Mercier, Taxes in France 163-4 (1990).

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provisions giving rise to (a) lower registration duties

or (b) disguising either a realization or a transfer of

profits or income or (c) permitting the avoidance,

either in whole or in part, of payment of turnover

taxes on the transactions carried out pursuant to the

contract or agreement, are not valid against the tax

authorities . . . .473 

Taxpayers may request an advance ruling that Art. L64 does not apply. It is understood

that this process is rarely used because as a technical matter the ruling only protects the taxpayer

against assertion of abuse of law. It is not a ruling on the tax treatment of the transaction as such. 

A taxpayer will be protected against assertion of abuse of law if it acts in reliance either upon a

favorable ruling, or upon the absence of a reply within six months of requesting a ruling. 474

 

A taxpayer who receives an assessment which invokes Art. L64 may ask for the matter to

be referred to a special Committee that considers the application of the anti-abuse rule ( i.e., a

GAAR Committee). Once the Committee has rendered its decision, the burden of proof is on the

party that the Committee held against. If no referral is made to the Committee, then the burden of

proof in any court case is on the government. 475

It appears that the Courts have interpreted this provision fairly narrowly. The courts have

consistently held that Art. L64 may only be successfully invoked in two situations. Either the

transaction is simply fictitious ( e.g., a sham), or the transaction is entered into exclusively with the
476 Id. at 163.

477 Pub. L. No. 104-168, 110 Stat. 1452, 1468, § 1101. See Jt. Comm. on Tax’n, General

Explanation of Tax Legislation Enacted in the 104th Congress , at 44 (1996) (“The Congress

believed that it is generally inappropriate for Treasury to issue retroactive regulations.”).

478 I.R.C. § 7805(b)(1).

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response to the lease stripping tax shelters and the fast-pay preferred tax shelters, the IRS and

Treasury Department initiated regulatory projects that recharacterized the transactions in a way

that eliminated the purported tax benefits of the transactions. The Treasury Department can, and

should, continue to address tax shelters and tax-motivated transactions by proposing these types

of statutory and regulatory changes.

The Treasury Department can also take a number of steps to increase the effectiveness of

these responses. First, the Treasury Department’s Office of Tax Policy and the IRS National

Office can allocate additional employee time and other resources to detecting and responding to

tax-shelter activity. Second, the Treasury Department and IRS could use retroactive forms of

guidance more frequently.

This second point -- retroactive guidance -- deserves some elaboration. Legislative and

regulatory responses by their very nature are generally prospective. When changing the rules,

Congress (in the case of legislation) and the Treasury Department (in the case of regulations)

generally make the changes prospective so that they do not inappropriately affect transactions that

were entered into in reliance on the existing state of the law. In fact, in 1996, Congress generally

limited the ability of the Treasury Department to issue regulations having retroactive effect in the

Taxpayer Bill of Rights (“TBOR”) 2.477 Section 1101 of TBOR 2 amended section 7805(b) of the

Code to provide that temporary and proposed regulations must have an effective date no earlier

than the date of publication in the Federal Register or the date on which any notice substantially

describing the expected contents of the regulation is issued to the public. 478

This limitation on the application of regulations retroactively (hereafter “retroactive

regulations”) is subject to certain exceptions. Regulations filed or issued within 18 months of the
479 I.R.C. § 7805(b)(2).

480 I.R.C. § 7805(b)(3).

481 Anita Baghavan, Wall Street Concocts New Tax-Saving Play; Then It’s Fed’s Turn ,

Wall St. J., Nov. 6, 1997, at A1.

482 Notice 97-21, 1997-1 C.B. 407.

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discourage the creation and implementation of new shelters. While generally effective at

preventing the expansion of known shelters to new participants, prospective regulations do not

discourage the creation and implementation of new shelters because, as noted in Part V, they

encourage tax shelter promoters and participants to “rush to market” the latest abuses in order to

avoid application of the prospective fix. Retroactive regulations do not suffer from this “rush to

market” phenomenon. Of course, retroactive regulations suffer from a drawback not present in

prospective regulations: they create uncertainty as to the ability of taxpayers to rely on existing

law. This uncertainty, however, is limited to cases of abuse. As Congress recognized when it

enacted section 7805(b)(3), the reliance interests of taxpayers engaging in abusive transactions is

outweighed by the interests of the Treasury Department in preventing abusive transactions.

Finally, Congress and the Treasury Department could significantly curtail the “rush-tomarket” attitude of many corporate tax shelter market participants by changing the way preeffective date transactions are “grandfathered.” Traditionally, targeted legislative and regulatory

responses to corporate tax shelters have “grandfathered” transactions that were entered into prior

to the effective date of the statute or regulation. Reportedly, this has led to a rush to market in

cases where the tax shelter community has become aware of planned legislative or regulatory

action.481 More recently, the Treasury Department has grandfathered only the portion of the

transaction occurring before the effective date. 482 This approach, if applied consistently to

targeted legislative and regulatory response should limit the economic incentive to enter into a

transaction before the guidance is issued.

D. PROCEDURAL CHANGES
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1990s. In addition, new tax shelter registration requirements were recently enacted to deter the

use of conditions of confidentiality and potentially to provide an additional tool of detection. 

Recently, the IRS also has achieved success in a few well-publicized litigations of corporate tax

shelter transactions. Notwithstanding the foregoing, it is not apparent that corporate tax shelter

activity has diminished to the point that it has ceased to impose an unacceptable drain on tax

revenues or to foster the negative impression among taxpayers at large that corporate taxpayers

are able through adroit use of the Code and well-paid advisors to avoid paying their fair share of

taxes. 

2. Additional Potential Responses

To successfully attack the problem of corporate tax avoidance transactions may require, as

it did in the 1980s, a multi-prong approach dedicated to detection and penalization of such

transactions. The following are a list of potential actions:

a. Standards of practice.

1. Modify Circular 230 to expand the tax shelter opinion standard to include

the types of corporate tax shelters currently being marketed, and to make clear that the opinion

standards apply whether or not the shelter is marketed to the public. 

2. Modify Circular 230 to expand the definition of practice to include tax

advice on corporate tax shelters, whether or not reflected in a written opinion.

3. Modify Circular 230 to eliminate contingency fee arrangements and

confidentiality arrangements with respect to tax shelters.

4. Institute policy similar to 1985 policy statement regarding referrals and

enforcement of practice standards relating to tax shelters.

5. Encourage ABA and AICPA to consider whether additional guidelines

should be issued with respect to corporate tax shelter advice.
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2. Modify the section 6700 promoter penalty to include making or furnishing

a statement in connection with the organization or sale of a plan or arrangement that the promoter

knows, or has reason to know, would be false, fraudulent, or misleading as to any material matter. 

Modify penalties such that false or fraudulent statements are penalized by loss of the greater of

$1,000 or 100 percent of the gross income derived (or to be derived) from such activity, with a

reduced percentage for misleading statements. 

3. Modify section 7408 injunction action to be limited to knowing aiding or

abetting under section 6701 promoter penalty but to encompass misleading statements under

section 6700 promoter penalty.

c. Enforcement

1. Create IRS task force dedicated to corporate tax shelter audits with

appropriate training to assist revenue agents in identifying and analyzing corporate tax avoidance

transactions. Coordinate audits with registration information filed pursuant to section 6111 to

identify transactions and promoters.

2. Consider development of IRS trial teams dedicated to litigation of

corporate tax shelters. Coordinate through IRS National Office selection of cases for litigation. 

Develop informational data base for use in audit and litigation of promoters.

3. Use summons authority aggressively to obtain lists of potential investors to

whom tax avoidance transactions are promoted or marketed. 

4. Assert penalties where appropriate and make referrals to the Director of

Practice where appropriate.

5. Use section 7408 injunctive action where appropriate.

6. Consider legislation that addresses statute of limitations issues with respect

to corporate tax shelters established in TEFRA partnerships. 
- 133 -
483 The descriptions in this Appendix are for illustrative purposes only. No inference is

intended regarding the proper tax treatment under present or prior law with respect to any

transaction described herein.

484 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).

485 76 T.C.M. (CCH) 325 (1998).

- 134 -

taxpayers, through use of a tax-indifferent party, to have a high and overstated basis in a relatively

liquid asset. When the U.S. corporate taxpayer sells the asset, a tax loss is generated that can be

used to shelter other, unrelated income from tax. In particular, the transaction is designed to

overallocate taxable income to a tax-indifferent participant in the transaction, resulting in a

corresponding underallocation of taxable income to the U.S. corporate taxpayer. 

The IRS successfully challenged the CINS transactions in court. In ACM Partnership v.

Commissioner,

484 the tax benefits of the transaction were denied on economic substance grounds. 

In ASA Investerings Partnership v. Commissioner ,

485 the court recharacterized the transaction in a

manner that eliminated the intended tax benefits of the transaction. 

Detailed discussion

The CINS transaction exploits a mechanical provision in the contingent installment sale

rules that accelerates taxable income. In the basic transaction, a U.S. taxpayer, a tax-indifferent

party, and a promoter create a partnership. The partnership acquires privately-offered notes and,

shortly thereafter, exchanges the notes for cash and contingent notes in a transaction designed to

qualify as a contingent installment sale. Because the contingent installment sale rules limit the

amount of basis that can be allocated to the first year of the sale, the cash consideration received

in the first year produces significant amounts of gain in that year. (The parties, of course, expect

that this gain will be “reversed” by losses in the later years.) Most of this gain is allocated to the

tax-indifferent partner. Shortly after the gain has been allocated, the tax-indifferent partner is

redeemed out of the partnership, leaving the U.S. taxpayer (and the promoter) to benefit from the

expected losses in the later years.
486

 See ACM Partnership, 73 T.C.M. at 2115 ("ACM is one of 11 partnerships. . . formed

over a 1-year period from 1989-1990 by the Swap Group at Merrill Lynch & Co. Inc."); see also

Randall Smith, Collection Drive, Wall St. J., May 3, 1996, at A1 (stating that Merrill Lynch

formed similar partnerships for several corporations in addition to Colgate).

487 1990-2 C.B. 344.

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For tax purposes, however, the contingent installment sale creates gain in the first year. 

Under these rules, the partnership is required to allocate its $1,000 basis pro-rata over the six-year

term of the contingent notes. Thus, the partnership must allocate $167 of basis to each of the six

years. This flat allocation of basis results in significant gain in the first year. At a minimum, the

gain in the first year will be $633 ($800 amount realized in cash less $167 basis). (The amount of

gain recognized in the first year will be higher to the extent a contingent payment is received.) 

This first-year gain is allocated in accordance with the partner’s respective interests in the

partnership; that is, 80 percent to the tax-indifferent party, 19 percent to the U.S. taxpayer, and 1

percent to the promoter. At the end of the first year, the partnership uses the $800 cash on hand

to redeem the partnership interest of the tax-indifferent party. The partnership is then left with an

asset, the contingent note, worth somewhat less than $200 in which it has a basis of $833 ($1,000

- $167). Because its basis is higher than its fair market value, this asset will generate losses over

the remaining five years of the note.

Shortly after the IRS discovered the CINS transactions, 486 the IRS published Notice 90-

56487 indicating that the contingent installment sale regulations would be amended and that the

transactions would be closely scrutinized under principles of existing law such as the economic

substance doctrine. Ultimately, the IRS successfully challenged the CINS transactions in court. 

In ACM, the tax benefits of the transaction were denied on economic substance grounds. In

ASA, the court recharacterized the transaction in a manner that eliminated the intended tax

benefits of the transaction. 

 

LIQUIDATING REIT TRANSACTIONS: EXCLUSION OF ECONOMIC

INCOME FROM TAXABLE INCOME THROUGH TAX LAW “GLITCHES”
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legislation to correct the glitch giving rise to these transactions. That legislation was enacted as part of

the Tax and Trade Relief and Extension Act of 1998 (the "1998 Trade Act") and is effective for

liquidating distributions occurring after May 21, 1998.

The Treasury Department estimates that this transaction, had it not been legislatively

addressed, would have reduced the corporate tax base by approximately $34 billion over a ten-year

period.

Detailed discussion

The liquidating REIT transaction involved the use of a real estate investment trust (a “REIT”)

that was closely held (i.e., at least 80 percent owned) by a corporate shareholder. The transaction was

intended to allow the REIT and the corporate shareholder to avoid all federal income tax on earnings

accrued by the REIT during the liquidation period of the REIT. 

In the basic transaction, a corporation formed a subsidiary corporation that elected to be taxed

as a REIT in its first taxable year. The parent corporation owned all of the common stock of the REIT,

which represented virtually all of the economic interest in the REIT. In order to meet the 100 or more

shareholder requirement for REITs, the REIT issued shares of a separate class of non-voting preferred

stock to 99 other “friendly” shareholders (generally employees of the corporation). Sometime soon

after formation, the REIT adopted a plan of liquidation.

Although REITs are generally taxable as corporations, unlike most other corporations REITS

can reduce or eliminate their taxable income by making dividend distributions and claiming a dividends

paid deduction. These dividend distributions generally are included in the taxable income of the REIT

shareholder.

The benefit to the corporate shareholder in the liquidating REIT transactions arose after the

REIT adopted a plan of liquidation. Section 562(b)(1)(B) provides that, in the case of a complete

liquidation that occurs within 24 months after the adoption of a plan of liquidation, any distribution

during such period made pursuant to such plan will, to the extent of earnings and profits, be treated as

a dividend for purposes of computing the dividends paid deduction. Prior to the 1998 Trade Act, even

where a liquidating distribution qualified for the dividends paid deduction, section 332 generally

provided that a corporation receiving property in a complete liquidation of an 80-percent-owned

subsidiary would not recognize gain or loss as a result of the distribution.
- 137 -

The following hypothetical example illustrates the intended tax results from the liquidating

REIT transaction: A bank transferred a significant portfolio of mortgage loans to a closely-held REIT

on January 1, 1995. For the taxable year ending December 31, 1995, the REIT avoided the payment of

any dividends prior to the end of the year. On December 31, 1995, the REIT adopted a plan of

liquidation and paid out all of its earnings for 1995 (i.e., interest on the mortgage loans) in a

“liquidating” distribution. The REIT also distributed the interest income earned on the mortgage loans

as dividends to the parent bank in 1996 and 1997, with the last distribution being made on December

30, 1997 (the last day of the two-year liquidation period). Under these facts, taxpayers took the

position that the REIT was entitled to a dividends paid deduction for all liquidating distributions (which

include the REIT’s earnings for 1995, 1996, and 1997), and the corporate shareholder avoided

recognition of income upon receipt of all liquidating distributions under section 332. The end result of

the example is that the bank did not pay any corporate-level income tax on interest income earned with

respect to its mortgage loans for the 1995-1997 taxable years.

It was determined that if taxpayers were allowed to continue engaging in this transaction, the

cost to the Federal government in lost tax revenues would be approximately $34 billion over a ten-year

period. The Treasury Department and the tax-writing staffs for Congress worked together to draft a

bill to stop these transactions, and the bill, which added new section 332(c) to the Code, eventually was

enacted as part of the 1998 Trade Act. Section 332(c) provides that where a REIT (or a regulated

investment company) claims a dividends paid deduction with respect to a liquidating distribution, the

corporate parent must include the distribution in income as a dividend. The legislative history of 1998

Trade Act states that no inference was intended regarding the treatment of these transactions under

prior law. The provision was effective for distributions after May 21, 1998.
- 138 -

in the asset must be increased by the entire amount of the secured liability, not just the portion of the

liability that relates to the asset. In effect, the U.S. subsidiary takes an overstated basis in the asset. 

This overstated basis can later be used to shelter income from tax. 

Over the past two years, the Treasury Department and the tax-writing staffs of Congress have

worked on legislation that would deny the purported tax benefits of these transactions. This legislation

was enacted as part of H.R. 435 on June 25, 1999, effective for transfers on or after October 19, 1998.

Detailed discussion

In general, if a shareholder transfers an asset to a corporation and the shareholder’s basis in the

asset is less than the amount of liabilities assumed by the corporation in the transaction, section 357(c)

requires that the shareholder must recognize this difference as gain and that the corporation may stepup its basis in the asset by the amount of this gain. A similar rule applies where the corporation does

not assume the liabilities but, instead, takes the asset “subject to” the liabilities.

The section 357(c) basis-shift transaction exploits an ambiguity in the application of section

357(c) to transactions in which multiple assets are secured by a single liability. In these cases, it is

unclear how the liability should be allocated among the assets if some, but not all, of the assets are

contributed to a corporation in a transaction to which section 357(c) applies. In these cases, a number

of taxpayers have interpreted section 357(c) as applying to the full amount of the liability assumed or

taken subject to, even though the liability secures additional assets that were not part of the transfer. In

cases where the transferor is a tax-indifferent person ( e.g., a tax-exempt corporation or foreign

corporation) and the transferee is a U.S. corporation, this interpretation results in the transferee

corporation taking an overstated basis in its assets without a corresponding tax being paid by the taxindifferent party. This excess basis may be recovered through depreciation deductions or may create a

tax loss on the sale of the asset.

For example, consider a foreign parent that has three U.S. subsidiaries and three zero-basis

assets subject to a single $100 liability. If the foreign parent separately transfers to each subsidiary one

asset subject to the same liability, each subsidiary may take the position that it can step-up the basis of

its asset by the full $100 amount of the liability on the theory that each asset is transferred “subject to”

the entire liability.
- 139 -
- 140 -

In early 1997, the Treasury Department became aware of these transactions and on February

27, 1997, the IRS and the Treasury Department published a notice indicating their intent to publish

regulations that would recharacterize the transaction in a manner that eliminated the tax benefit. On

January 6, 1999, the IRS and the Treasury Department published proposed regulations recharacterizing

the transactions, effective for tax years ending after February 26, 1997.

Detailed discussion

In early 1997, the Treasury Department became aware of certain corporate tax shelter

transactions involving so-called “fast-pay stock,” sometimes referred to as “step-down preferred

stock.” These transactions were designed to artificially allocate taxable income to a tax-exempt party

(such as a foreign bank) thereby allowing the U.S. corporate participant in the transactions to avoid tax. 

In the basic fast-pay transaction, a U.S. corporate sponsor (the “sponsor”) forms a closely-held

REIT with accommodating tax-exempt investors (the “exempt participants”). The REIT issues

common stock to the sponsor and fast-pay stock to the exempt participants. The fast-pay stock is

structured to have an above-market dividend rate for a fixed period of time, after which the dividend

rate “steps down” to a de minimis rate. In addition, after the step down, the arrangement generally

gives the sponsor (or the REIT) the right to redeem the fast-pay stock for its then-fair market value, a

small fraction of its issue price. As an economic matter, the fast-pay stock performs much like selfamortizing debt: To the exempt participants, the high periodic dividend payments represent in part

distributions of income and in part returns of capital.

For federal income tax purposes, by contrast, the periodic dividend payments on the fast-pay

stock were entirely distributions of income. This mischaracterization of the dividends (entirely as

income when economically a portion represented a return of capital) effectively allowed the REIT to

overallocate its taxable income to the exempt participants. This overallocation resulted in a

corresponding underallocation to the taxable sponsor. If the sponsor eventually sold its interest in the

REIT, the underallocation would allow the sponsor to defer its economic income from the transaction

to the time of the sale and convert its character from ordinary to capital gain. If the sponsor liquidated
488 The liquidating REIT proposal, discussed supra in this Appendix A, would not have

altered this permanent exclusion.

- 141 -

period, the dividend rate on the fast-pay stock steps down to 1 percent per year. At that time, the REIT

has the ability to redeem the fast-pay stock for its then-fair market value of $100. If the fast-pay stock

is redeemed, the U.S. corporation that owns the corporation can then liquidate the REIT in a section

332 liquidation.

The U.S. corporation expects that it will realize a predictable economic benefit over the

anticipated 10-year term of the transaction without ever incurring any tax liability for that benefit. In

particular, the U.S. corporation anticipates that the dividends-paid deduction on the fast-pay stock will

eliminate the REIT’s income for the initial 10-year period. Immediately after this period, the U.S.

corporation anticipates that the fast-pay stock will be redeemed for $100 and that the REIT will then be

liquidated in a section 332 liquidation. Upon the liquidation, the U.S. corporation will succeed to the

$1,900 cash on hand ($2,000 cash on hand less the $100 payment to redeem the fast-pay stock)

without incurring a tax. Thus, the U.S. taxpayer will have realized a $900 economic benefit ($1,900

amount received less $1,000 initial investment) over the 10-year term of the transaction without ever

incurring a tax on it.

In response to fast-pay transactions, the IRS and the Treasury Department published Notice

97-21 on February 27, 1997. The Notice described the transactions in detail, explained how the

purported tax benefits of the transactions did not reflect their economic substance, and promised

regulations under section 7701(l) (conduit regulatory authority) that would recharacterize these

transactions in accordance with their economic substance. On January 6, 1999, the IRS and the

Treasury Department published proposed regulations under section 7701(l). The proposed regulations

treat the fast-pay stock as if the stock were a security issued by the sponsor, instead of the REIT. 

Consistent with this recharacterization, the regulations treat the fast-pay distributions as if they were

made by the REIT to the sponsor and then by the sponsor to the exempt participants. This

recharacterization ensures that the sponsor is taxed on its economic income from the transaction.
- 142 -

income over the entire term of the transaction, the mismatch of deductions early and income late results

in a significant tax benefit. The value of this deferral benefit is the excess of the present value of the

tax saved (through the early-year deductions) over the present value of the tax owed (as a result of the

later-year income inclusions).

Earlier this year, the IRS and the Treasury Department published a revenue ruling stating that

such LILO transactions lack economic substance and therefore do not produce the intended tax

benefits. As a statement of existing law, the revenue ruling applies to LILO transactions that were

completed prior to its release. In addition, the IRS and the Treasury Department finalized regulations

that alter the way taxpayers must account for prepaid rents on a going-forward basis. These

regulations effectively eliminate the tax benefits that were at the heart of the LILO transaction for

leases entered into after May 18, 1999.

Detailed discussion

The LILO transaction is deliberately designed to exploit a tax rule that mischaracterizes

prepaid rent to produce significant tax benefits with little or no real business risk. Very simply, the

U.S. taxpayer purports to lease a long-lived asset owned by a foreign municipality (under a

“Headlease”). As part of the same transaction, the U.S. taxpayer immediately leases back the asset to

the foreign municipality (under a “Sublease”) and grants the foreign municipality a fixed-price option

to terminate the arrangement at the end of the Sublease term. Thus, at all times, the foreign

municipality maintains title and possession of the asset. 

The tax benefits of the transaction come from the unusual payment structure on the Headlease. 

The Headlease calls for the U.S. taxpayer to prepay its rental obligations. This prepayment purportedly

generates significant net deductions in the early years of the arrangement that will be economically

offset by significant net income in the final year of the arrangement. The early net deductions can be

used to shelter unrelated income of the U.S. taxpayer. 

Although only the Headlease is prepaid, the non-tax economics of the transaction are

minimized through the use of deposit arrangements that economically defease virtually all cash flows

from the transaction. At the inception of the transaction, the foreign municipality uses the majority of

the rent prepayment to fund deposit accounts that economically defease its obligations under the

Sublease and the fixed-payment option. Having defeased its obligations, the foreign municipality

keeps the balance of the Headlease prepayment as its “fee” for participating in the transaction. 
- 143 -
- 144 -

In 1996 and 1997, the Treasury Department and the tax-writing staffs of Congress worked

together on legislation that limits the ability of corporate taxpayers to deduct interest on debt used to

carry COLI. The 1996 legislation eliminated the tax benefit from leveraged purchases of COLI on

large numbers of insured lives where the debt was directly traceable to the purchase of the life

insurance. The 1997 legislation eliminated the tax benefit from leveraged purchases of COLI where

the insured lives were not employees of the corporation, regardless of whether the debt was traceable

to the purchase of the life insurance. 

Detailed discussion

COLI In a basic leveraged COLI transaction, a corporation purchases a number of cash value

life insurance policies on lives of employees and uses borrowed funds to pay some or all of the

premiums. Because the anticipated inside build-up on the policy is offset in whole or part by the

interest expense on the borrowing, there is little net non-tax benefit to the corporation from the policy. 

In fact, the primary benefit to the corporation from the transaction is the tax benefit created by the

timing mismatch -- current deduction for the interest expense, and deferral or exclusion for the inside

build-up.

Although Congress moved to limit a corporation’s interest deduction for indebtedness that was

incurred to purchase or carry COLI in 1986, this legislation only limited interest deductions on

borrowings that exceeded $50,000 per insured life. After 1986, corporations invested in smaller COLI

contracts that were designed to fit under the $50,000 cap. The insured persons under these policies

included many or all of the corporations’ employees. Thus, corporations made up in volume (more

individual contracts) what they lost is size (smaller values per contract). 

In 1996, Congress limited a corporation’s interest deduction on all debt that could be directly

traced to an investment in COLI, with a limited exception for $50,000 of indebtedness with respect to

up to 20 policies.

In 1997, the Treasury Department and Congress learned that some businesses planned to invest

in cash value life insurance policies on the lives of their customers, and to use general business

indebtedness rather than traceable indebtedness to finance these investments. Congress responded by

disallowing interest deductions on non-traceable indebtedness allocable to investments in cash value

life insurance, to the extent that the policies did not insure the lives of the business’ employees. 
- 145 -

plans. In 1997, the Treasury Department testified in support of the proposed legislation to disallow

interest deductions on nontraceable indebtedness of a business that invested in cash value life

insurance, which was later enacted. In 1998 and 1999, the Administration’s budget included a

proposal to extend this prorata disallowance rule to investments in cash value life insurance on the lives

of employees and officers, other than 20 percent or greater shareholders in the business.
- 146 -

aggressive corporate tax shelters. The 1994 modification eliminated, with respect to corporate

taxpayers, the exception to the substantial understatement penalty regarding tax shelter items for which

the taxpayer had substantial authority and reasonably believed that its treatment was more likely than

not the proper treatment. Instead, the substantial understatement penalty applied unless the taxpayer

could demonstrate reasonable cause and acted in good faith with respect to the portion of the

underpayment attributable to the tax shelter item (section 6664(c)). The legislative history stated that a

determination by the taxpayer or a professional tax advisor that the substantial authority and more likely

than not standards were satisfied would be an important factor, but not enough by itself, to establish

that the reasonable cause exception applied. It was the intent of the provision that the standards

applicable to corporate shelters be tightened. In 1997, the statutory definition of a tax shelter was

modified to eliminate the requirement that the tax shelter have as “the principal purpose” the avoidance

or evasion of Federal income tax and required that the tax shelter have only as “a significant purpose”

the avoidance or evasion of tax. 

Reason for Change

Despite the heightened substantial understatement penalty for corporate tax shelters,

there continue to be a significant number of abusive tax shelter transactions involving corporate

taxpayers. The more narrow reasonable cause exception for corporate tax shelters does not appear to

adequately deter such transactions. Accordingly, the standards applicable to corporate tax shelters

should be tightened.

Proposal

The proposal would increase the penalty applicable to a substantial understatement by

corporate taxpayers from 20 percent to 40 percent for any item attributable to a corporate tax shelter. 

The penalty would be reduced to 20 percent if the corporate taxpayer (1) discloses to the National

Office of the Internal Revenue Service within 30 days of the closing of the tax shelter transaction

appropriate documents describing the transaction, (2) files a statement with its tax return verifying that

such disclosure has been made, and (3) provides adequate disclosure on its tax returns as to the

book/tax differences resulting from the corporate tax shelter item for the taxable years in which the tax

shelter transaction applies. The reasonable cause exception of section 6664(c) would be eliminated for

any item attributable to a corporate tax shelter.
- 147 -

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, a tax avoidance

transaction would be defined to cover certain transactions involving the improper elimination or

significant reduction of tax on economic income.

The Secretary may prescribe regulations necessary to carry out the purposes of this

provision.

The proposal would be effective for transactions occurring on or after the date of first

committee action. 
- 148 -

extent necessary to eliminate such evasion or avoidance of income tax. For purposes of this rule,

control means the ownership of 50 percent of the corporation’s stock (by vote or value). The rule

applies also in the case of a qualified stock purchase by one corporation of another corporation, in the

event that the acquiring corporation does not elect to treat the stock purchase as an asset acquisition,

and where the acquired corporation is liquidated pursuant to a plan of liquidation adopted not more

than two years after the acquisition date, the principal purpose of which is to secure the benefit of a

deduction, credit, or other allowance.

Tax benefits also can be disallowed when those benefits are generated in transactions

that lack economic substance and undermine the purposes of the Code. Sheldon v. Comm’r, 94 T.C.

738 (1990). The Treasury Department has exercised its general regulatory authority to promulgate

anti-avoidance rules in specific contexts, including rules incorporating business purpose and economic

substance standards. See, e.g., Treas. Reg. section 1.701-2; Notice 98-5, 1998-3 I.R.B. 3. 

Reasons for Change

The Administration is concerned about the proliferation of corporate tax shelter activity

that allows a direct or indirect corporate participant to obtain a tax benefit that the participant otherwise

did not possess in a tax avoidance transaction. The current law anti-avoidance provision may not be

sufficient to address many current corporate tax shelter schemes. First, the provision only applies to

the acquisition of control of a corporation or the acquisition of carryover basis property. In addition,

although tax evasion or avoidance might be the most significant factor motivating an acquisition or

liquidation, it is difficult from an administrative standpoint to contest a taxpayer’s assertion that the

transaction had another more significant purpose.

Furthermore, some taxpayers take aggressive positions that they are entitled to a tax

benefit even in circumstances in which there is little or no expected pre-tax economic profit from a

structure. The proposal would clarify that tax benefits arising from tax avoidance transactions would

be disallowed. The Administration proposes to expand the anti-avoidance provision to better address

the types of transactions that the Administration believes are abusive.

Proposal

The proposal would expand the scope of the anti-avoidance rule by adding a provision

authorizing the Secretary to disallow a deduction, credit, exclusion or other allowance obtained in a tax
- 149 -
- 150 -

The Administration has become increasingly concerned with the prevalence of

corporate tax shelters and thus wants to impose impediments to the purchase, promotion and sale of

corporate tax shelters. Further, the Administration does not believe that payments made for the

purchase and implementation of corporate tax shelter schemes should be treated as ordinary and

necessary business expenses.

Proposal

The proposal would deny a deduction to the corporate participant in a tax avoidance

transaction for fees paid or incurred in connection with the purchase and implementation of corporate

tax shelters and the rendering of tax advice related to corporate tax shelters. The proposal also would

impose a 25 percent excise tax on fees received in connection with the purchase and implementation of

corporate tax shelters (including fees related to the underwriting or other fees) and the rendering of tax

advice related to corporate tax shelters. This proposal would not apply to expenses incurred with

respect to representing the taxpayer before the IRS or a court. If a taxpayer claims a deduction that

otherwise would be denied under this proposal, the amount of deduction could be subject to the

Administration’s proposed new substantial understatement penalty. For purposes of this proposal,

“corporate tax shelter” would be defined in the same manner as that provided in the Administration’s

proposed new substantial understatement penalty.

The proposal would be effective for fees paid or incurred, and fees received, on or after

the date of first committee action.
- 151 -

unwind the transaction and make the taxpayer whole financially if there is a change in or

clarification of law that interferes with the successful completion of the transaction,

(2) require a guarantee of tax benefits necessitated not by a change or misstatement of

the facts but by a change in or clarification of the law (to distinguish this from a normal

representation and warranty clause), or 

(3) enter into insurance arrangements with third parties to guarantee the tax benefits.

The tax treatment of payments under these arrangements depends upon the nature of

the payments.

Reasons for Change

The Administration has become increasingly concerned with the prevalence of

corporate tax shelters and is concerned that provisions that insulate the purchaser from risk encourage

participation in tax shelter activity. The Administration wants to impose impediments to the purchase,

promotion and sale of corporate tax shelters by taking away the benefit of provisions that insulate the

purchaser from risk.

Proposal

The proposal would impose on the corporate purchaser of a corporate tax shelter an

excise tax of 25 percent on the maximum payment under a tax benefit protection arrangement at the

time the arrangement is entered into. For this purpose, a tax benefit protection arrangement would

include a rescission clause, guarantee of tax benefits arrangement or any other arrangement that has the

same economic effect (e.g., insurance purchased with respect to the transaction). The maximum

payment under the arrangement would be the aggregate amount the taxpayer would receive if the tax

benefits were denied. For example, if a taxpayer purchases for $100 protection against the risk that the

tax benefits derived from a transaction will not be realized and the agreement values the tax benefits at

$10,000, the taxpayer would be subject to an excise tax of $2,500, even if it is later determined that

only $5,000 of the tax benefits from the transaction were denied. For purposes of this proposal,

“corporate tax shelter” would be defined in the same manner as that provided in the Administration’s

proposed new substantial understatement penalty.
- 152 -
- 153 -

tax consequences, taxpayers must meet a relatively high standard of proof. Depending on the

jurisdiction in which the taxpayer resides, the taxpayer will be required to show that the substance of

the transaction is indeed different from its form through either proof that would alter the construction of

the agreement or render it unenforceable (the so-called " Danielson rule") or strong proof (something

more than a preponderance of the evidence and something less than the Danielson rule). See, e.g.,

Ullman v. Commissioner, 264 F.2d 305 (2d Cir. 1959); Danielson v. Commissioner, 378 F.2d 771 (3d

Cir. 1967), cert. denied, 389 U.S. 858 (1967); Illinois Power Co. v. Commissioner, 87 T.C. 1417

(1986). 

Under section 385(c), an issuer’s characterization of an interest in a corporation as debt

or equity is binding on the issuer and all holders of such interests, unless the holder discloses that it is

treating the interest in a manner inconsistent with the issuer’s characterization. Under section 1060(a),

if, in connection with an applicable asset acquisition, the transferor and transferee agree in writing as to

the allocation of any consideration, or as to the fair market value of any of the assets, such agreement

shall be binding on both the transferee and transferor unless the Secretary determines that the allocation

(or fair market value) is not appropriate.

Reasons for Change

Because a taxpayer has control over the form of its transactions, it is appropriate to

impose restrictions on the taxpayer’s ability to argue against the form it has chosen. In addition, many

taxpayers enter into transactions in which the substance is different from the form in order to arbitrage

U.S. and foreign tax and regulatory laws. In transactions involving a taxable and tax-indifferent party,

the taxable party may believe it has even greater freedom to disavow the form of the transaction

because such recharacterization would have no effect upon the tax-indifferent party.

Proposal

The proposal would generally provide that a corporate taxpayer would be precluded

from taking any position (on any return or refund claim) that the Federal income tax treatment of a

transaction is different from that dictated by its form if a tax-indifferent party has a direct or indirect

interest in such transaction. This rule would not apply (i) if the taxpayer discloses the inconsistent

position on a timely filed original Federal income tax return for the taxable year that includes the date

the transaction is entered into; (ii) to the extent provided in regulations, if reporting the substance of the

transaction more clearly reflects the income of the taxpayer; or (iii) to certain transactions (such as
- 154 -

form of its transactions under current law.

The proposal would be effective for transactions entered into on or after the date of first

committee action.
- 155 -

charitable organizations) are subject to Federal income tax only on income that is unrelated (UBTI) to

the organization’s exempt purpose.

Reasons for Change

Many corporate tax shelters involve a timing mismatch or separation of income or

gains from losses or deductions that is exploited through the use of tax-indifferent parties. In these

transactions, the tax-indifferent party absorbs the income or gain generated in the transaction, leaving

the corresponding loss or deductions to the taxable corporate participants. Tax-indifferent parties often

agree to engage in such transaction in exchange for an enhanced return on investment or for an

accommodation fee. Corporate taxpayers should not be entitled to buy the special tax status of taxindifferent parties. Imposing a tax on the income allocated to tax-indifferent parties should limit the

sale of their special tax status and, thus, their participation in corporate tax shelters.

Proposal

The proposal would provide that any income allocable to a tax-indifferent party with

respect to a corporate tax shelter is taxable to such party. The tax on the income allocable to the taxindifferent party would be determined without regard to any statutory, regulatory, or treaty exclusion or

exception. All other participants of the corporate tax shelter ( i.e., any participant other than the taxindifferent party in question) would be jointly and severally liable for the tax. For this purpose, a

corporate tax shelter would be defined in the same manner as that provided in the Administration’s

proposed new substantial understatement penalty. A tax-indifferent party would be defined as a

foreign person, a Native American tribal organization, a tax-exempt organization, and domestic

corporations with expiring loss or credit carryforwards. (For this purpose, loss and credit

carryforwards would generally be treated as expiring if the carryforward is more than 3 years old.)

In the case of a tax-exempt organization, the income would be characterized as UBTI. 

In the case of a domestic corporation with expiring loss or credit carryovers, tax would be computed

without regard to such losses or credits. In the case of a foreign person, tax on the income or gain

allocable to such person would first be determined without regard to any exclusion or exception

(provided in a treaty or otherwise) and any such income or gain that is not U.S. source FDAP would be

treated as ECI, regardless of its source. If the foreign person properly claimed the benefit of a treaty,

however, the tax otherwise owing by such person would be collected from the other participants who

are not exempt from U.S. tax. Similarly, in the case of a Native American tribal organization, the tax
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489

 See generally Powlen & Tanden, supra note 29. In this article, the authors solicit

readers to play the 

tax shelter challenge: (1) Blindfold yourself; (2) Pick up a volume

of the Code; (3) Randomly open it to any page; (4) Take off the

blindfold; (5) Read the provision to which you have turned. We

give you three chances to do this and challenge you to find one of

the three provisions that was not enacted in part to prevent tax

shelter activity and is not a provision enabling an existing tax

shelter (i.e., is not Section 42, which enables low income housing

tax credit tax shelters.

Id. at 1024 (emphasis in original).

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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 are 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, a tax avoidance transaction would be defined

to cover transactions involving the improper elimination or significant reduction of tax on economic

income. 

A tax benefit would be defined to include a reduction, exclusion, avoidance or deferral of tax,

or an increase in a refund, but would not include 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 Administration’s proposal to change substantive law to disallow tax benefits claimed with

respect to a tax avoidance transaction would supplement current authority possessed by the Secretary

in current-law sections 269, 446, 482 and 7701(l). 
490 1998-3 I.R.B. 49. 

491 As discussed in Part IV.B., although the sham transaction doctrine has typically

involved an analysis of both subjective and objective factors, in applying the subjective test of the

doctrine, greater weight is given to what the taxpayer actually (objectively) did rather than what

the taxpayer claims to have actually intended.

492

 See, e.g., ACM Partnership v. Commissioner, 157 F.3d 231, 248 (3d Cir. 1998) ("In

assessing the economic substance of a taxpayer’s transactions, the courts have examined 'whether

the transaction has any practical economic effects other than the creation of tax losses.'"), cert.

denied, 119 S.Ct. 1251 (1999); Sochin v. Commissioner, 843 F.2d 351, 354 (9th Cir. 1988) (The

court’s traditional sham analysis is "whether the transaction had any practical economic effects

other than the creation of income tax losses”); Rose v. Commissioner, 868 F.2d 851, 853 (6th Cir.

1989) ("The proper standard in determining if a transaction is a sham is whether the transaction

has any practicable economic effects other than the creation of income tax losses."). Courts have

defined profit, for purposes of the primary profits test of section 183, as "economic profit,

independent of tax savings." See, e.g., Campbell v. Commissioner, 868 F.2d 833, 836 (6th Cir.

1989) ("'profit' means economic profit independent of tax consequences"), non acq. 1993-1

C.B. 1; Surloff v. Commissioner, 81 T.C. 210, 233 (1983) ("'profit' means economic profit,

independent of tax savings," citing Shapiro v. Commissioner, 40 T.C. 34 (1963)); see also Shapiro

v. Commissioner, 40 T.C. 34, 39-40 (1963) ("the avoidance of taxes hardly qualifies as 'the

production or collection of income' under the statute, either literally or by any implication that is

supported by any relevant legislative history").

493

 See Friendship Dairies, Inc. v. Commissioner, 90 T.C. 1054,1063-67 (1988) (ignoring

investment tax credit but taking into account all economic outlays, including the 10% of

taxpayer’s cost on which the credit was based, for purposes of economic substance analysis). In

the context of non-sham transactions, courts have recognized that foreign withholding taxes are a

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on whether a transaction has any practical economic effects apart from taxes. Thus, the transactions

economic profit absent U.S. tax effects must be calculated, i.e., the U.S. tax effects must be ignored. 

All other economic costs must be taken into account since those costs determine whether, as an

economic matter, a transaction had a potential for economic profit. 493
cost that affects profit. Continental Illinois Corp. v. Commissioner, 998 F.2d 513, 516 (7th Cir.

1993) (changes in the amount of withholding tax on interest payments affect the lender’s rate of

return when the lender bears the foreign tax), cert. denied, 510 U.S. 1041 (1994); Nissho Iwai

American Corp. v. Commissioner, 89 T.C. 765, 769 (1987) (same). 

494 As explained in section B of Part IV, courts have applied a number of different tests in

determining whether a transaction has economic substance, with the most prominent test being an

inquiry into whether the transaction has any practical economic effects other than the creation of

tax benefit.

495

 See Rice’s Toyota World Inc. v. Commissioner, 752 F.2d 89, 91 (5th Cir. 1985);

Sochin v. Commissioner, 843 F.2d 351, 354 (9th Cir. 1988), cert. denied, 488 U.S. 824 (1988). If

such profit is found, and is not de minimis, then the economic substance leg of the sham

transaction could be satisfied. See Sheldon v. Commissioner, 94 T.C. 738, 768 (1990); Estate of

Thomas v. Commissioner, 84 T.C. 412, 440, n.52 (1985) (“Since the potential profit here was

more than de minimis, we are satisfied that petitioners should prevail.”).

496 I.R.C. § 183(a).

497 H.R. Rep. No. 91-172 (1969), reprinted in 1969 U.S.C.C.A.N. 1645; S. Rep. No.

91-552 (1969) reprinted in U.S.C.C.A.N. 2027 & 2133-34.

498 Treas. Reg. § 1.183-2(a).

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define the test as requiring the taxpayer to have an objective of making a profit, not a reasonable

expectation of profit. 498 In determining whether such an objective exists, the regulations provide that a

small chance of making a large profit may be sufficient, even if the expectation of a profit may be
based on all facts and circumstances, with greater weight given to objective factors rather than the

taxpayer’s subjective intent. Relevant factors include: (i) the manner in which the taxpayer

carries on the activity; (ii) the expertise of the taxpayer or his advisors; (iii) the time and effort

expended by the taxpayer in carrying on the activity; (iv) the expectation that the asset used in the

activity may appreciate in value; (v) the success of the taxpayer in carrying on other similar or

dissimilar activities; (vi) the taxpayer’s history of income or losses with respect to the activity;

(vii) the amount of occasional profits, if any, which are earned; (viii) the financial status of the

taxpayer; and (ix) whether there are elements of personal pleasure or recreation in carrying on the

activity. Treas. Reg. § 1.183-2(b).

500

 See, e.g., Krause v. Commissioner, 99 T.C. 132, 168 (1992), aff’d sub nom.,

Hildebrand v. Commissioner, 28 F.3d 1024 (10th Cir. 1994), cert. denied, 513 U.S. 1078 (1995);

Peat Oil and Gas Assoc. v. Commissioner, 100 T.C. 271, 280-83 (1993) (Swift, J., concurring),

aff’d sub nom., Ferguson v. Commissioner, 29 F.3d 98 (2d Cir. 1994). Section 183 is an

allowance, not a disallowance, provision. Expenses that are not deductible under sections 162 or

212 may still be deductible to the extent provided in section 183. Treas. Reg. § 1.183-2(a). See

also Brannen v. Commissioner, 78 T.C. 471, 500, 506-07 (1982), aff’d, 722 F.2d 695 (11th Cir.

1984). Although sections 162 and 212 generally require an inquiry into the taxpayer’s primary

motive for entering into an activity, the courts have not generally applied this standard in cases

involving section 183. See generally Peat Oil and Gas Assoc., 100 T.C. at 279-286 (Swift, J.,

concurring), 287-293 (Ruwe, J., concurring).

501

 See, e.g., Smith v. Commissioner, 937 F.2d 1089, 1096 (6th Cir. 1991) (under the

profit objective test of section 183, "'a reasonable expectation of profit [subjectively] is not

required;' rather we look to 'whether the taxpayer entered into the activity, or continued the

activity, with the objective of making a profit . . . even though the expectation of profit might be

considered unreasonable'" (quoting Bryant v. Commissioner, 928 F.2d 745, 750 (6th Cir. 1991)),

cert. denied, 502 U.S. 1082 (1992). In order to compare the expected economic benefits of a

transaction to the transaction’s expected tax benefits, one must define the scope of the

transaction. In Smith, the Sixth Circuit failed to limit the scope of the transaction with reference

to the parties before the court. As the Tax Court noted in Peat Oil and Gas Associates, the Sixth

Circuit "seemed to give the limited partners the benefit of the possibility that some 'practicable

effects other than the creation of tax losses' might be realized by other persons associated with the

venture." Peat Oil and Gas Assoc., 100 T.C. at 276.

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502

 See Saviano v. Commissioner, 765 F.2d 643 (1985). In this case, the court stated

[t]he freedom to arrange one’s affairs to minimize taxes does not

include the right to engage in financial fantasies . . . The

Commissioner and the courts are empowered, and in fact dutybound, to look beyond the contrived forms of transactions to their

economic substance and to apply the tax laws accordingly. That is

what we have done in this case and that is what taxpayers should

expect in the future.

Id. at 654.

503 As discussed in Part II.B., the corporation’s investment is rarely subject to a significant

risk of loss.

504

 See, e.g., Sheldon v. Commissioner, 94 T.C. 738, 768 (1990). 

505

 Smith, 937 F.2d at 1096 (The determination of whether a transaction has any

practicable economic effects other than the creation of income tax losses must be "conducted

from the vantage point of the taxpayer at the time the transaction occurred, rather than with the

benefit of hindsight"). 

506

 See Brealy & Meyers, Principles of Corporate Finance 66, 85 (2d ed. 1984) (stating

that "wise investment decisions are based on the net present value rule"; a key feature of the net

present value rule is its recognition that " a dollar today is worth more than a dollar tomorrow ,"

and "any investment rule which does not recognize the time value of money cannot be

sensible"(emphasis in original)).

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unnecessary investment into the transaction. Second, comparing profit to tax benefits is consistent with

economic reality and existing case law. 504

In comparing the expected economic benefits to the expected tax benefits, both factors should

be discounted to the time at which the transaction is entered into. 505 A present value comparison best

comports with economic realty. 506 Although a present value analysis requires a projection of expected
507

 Estate of Thomas v. Commissioner, 84 T.C. 412, 440, n.52 (1985) ("Moreover, we do

not feel competent, in the absence of legislative guidance, to require that a particular return must

be expected before a 'profit' is recognizable, the necessary conclusion to be drawn if we were to

discount residual value"); Hilton v. Commissioner, 671 F.2d 316 (9th Cir. 1983) (in commenting

on the Tax Court’s discounting of economic benefit, the Ninth Circuit Court of Appeals stated

that "[w]e deem the six percent rate to be for illustrative purposes only. No suggestion of a

minimum required rate of return is made. Taxpayers are allowed to make speculative investments

without forfeiting the normal tax applications to their actions.") , cert. denied, 459 U.S. 907

(1982). Because tax benefits are typically front-loaded, discounting such benefits will have little

effect. In contrast, because the economic benefits of a transaction are typically backloaded,

discounting will have a significant effect on the relative value of such benefits.

508

 Cf. Treas. Reg. § 1.1275-4(b)(4)(I)(B) (in determining the comparable yield of a

contingent debt instrument with one or more contingent payments not based on market

information when the instrument is part of an issue that is marketed or sold in substantial part to

persons for whom the inclusion of interest is not expected to have a substantial effect on their

U.S. tax liability, the instrument’s comparable yield is presumed to be the applicable Federal rate,

based on the overall maturity of the debt instrument).

509 Courts have been reluctant to apply a relative test because of the perceived inability to

determine at what point tax benefits should be denied. See, e.g., Estate of Thomas, 84 T.C. at

440, n.52 ("Moreover, we do not feel competent, in the absence of legislative guidance, to require

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Congressional mandate, corporations should not be encouraged to enter into transactions that do not

produce a positive net present value. The choice of the appropriate discount rate likely will depend on

the facts and circumstances surrounding the transaction and the identity of the transaction

participants. 508 In some cases, the discount rate may be the average cost of capital for the corporate

participant. In other cases, the discount rate may be the applicable Federal rate, as defined in section

1274(d), commensurate with the expected term of the transaction. Certain presumptions may need to

be developed to determine the appropriate discount rate or a range of acceptable discount rates.

A comparison of the expected economic benefit to expected tax benefits requires a weighing of

relative benefits, which in some cases may be difficult.509 The benefits of the relative test outweigh its
that a particular return must be expected before a 'profit' is recognizable, the necessary conclusion

to be drawn if we were to discount residual value."); Peat Oil and Gas Assoc., 100 T.C. at 285-86

(Swift, J., concurring) ("I would spare us, other courts, the IRS, and the tax bar, the task of

evaluating whether, for example, a $5,000 pre-tax profit when compared to $20,000 of tax

benefits provides a sufficient non-tax profit for one investor but not for another.").

510

 Cf. Treas. Reg. § 1.446-3(g)(6), Exs. (3) and (4) (giving rough guideposts as to when

a swap with significant nonperiodic payments may be recharacterized as two separate

transactions).

511

 But see Sheldon, 94 T.C. at 768 ("The potential for 'gain' here, however, is not the

sole standard by which we judge, and in any event, is infinitesimally nominal and vastly

insignificant when considered in comparison to the claimed deductions").

512

 See, e.g., Sheldon, 94 T.C. at 768 (sale-repurchase transactions lacked economic

substance and a non-tax business purpose, notwithstanding the potential for a profit that the court

characterized as "infinitesimally nominal and vastly insignificant when considered in comparison

with the claimed deductions"). In ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir.

1998), cert. denied, 119 S.Ct. 1251 (1999), the court stated

[l]ikewise, the court found that the interest income generated by the

notes could not have a material effect on ACM’s financial position

because the Citicorp notes paid interest at a rate that varied only

nominally from the rate that ACM’s cash contributions 'were

already earning . . . in . . . deposit accounts before the notes were

acquired,' resulting in only a $3,500 difference in yield over the 24-

day holding period, a difference which was obliterated by the

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expected pre-tax profit is insubstantial relative to the reasonably expected tax benefits, certain

presumptions may need to be developed to determine the outer range of unacceptable ratios. 510 Under

the sham transaction doctrine, courts typically have not balanced profit against tax benefits. 511 Rather,

courts have looked to whether the taxpayer had any realistic possibility of profit. In making this

determination, however, courts have generally ignored profit that is insubstantial or de minimis. 512
for more than a de minimis amount of pre-tax profit), aff’d per curiam, 671 F.2d 316 (9th Cir.

1982), cert. denied, 459 U.S. 907 (1982).

513 The scope of the transaction is important for determining the profit arising from the

transaction as well as the applicable transaction costs.

514

 In James v. Commissioner, 899 F.2d 905 (10th Cir. 1990), the court stated

The only transactions at issue in this case are the purported sales by

the Communications Group to the joint venture. These sales

cannot be legitimized merely because they were on the periphery of

some legitimate transactions. . . The 'bifurcated transaction'

approach does have a basis in established law, however. As the

Fourth Circuit held in Rice’s Toyota, 'a sham transaction may

contain elements whose form reflects economic substance and

whose normal tax consequences may not therefore be disregarded.'

(citations omitted).

Id. at 910; see also Karr v. Commissioner, 924 F.2d 1018 (11th Cir. 1991) ("The activities of the

other entities involved in exploiting the Koppelman process, however, cannot necessarily be

attributed to POGA [the taxpayer]."); Peat Oil and Gas Assoc., 100 T.C. at 276 ("The Court of

Appeals for the Sixth Circuit [in Smith] seemed to give the limited partners the benefit of the

possibility that some 'practicable effects other than the creation of tax losses' might be realized by

other persons associated with the venture."). As stated in note 500, supra, the Sixth Circuit in

Smith defined the transaction in question by considering the practical economic effects of parties

unrelated to the litigants. The court in Smith stated as follows: 

The evidence presented at trial included the following: a report

concluding that the Koppelman process was 'technically,

environmentally, and economically feasible;' a showing that the

taxpayers’ obligations to SFA took the form of full recourse notes;

financial analysis indicating that projected revenues would be 

sufficient to retire the partnership’s notes to FTRD and SciTeck;

and uncontradicted expert testimony stating that the Koppelman

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process did have a reasonable chance of generating profits. These

investments were risky, to be sure, and the taxpayers were

predictably concerned about saving taxes -- but the question is

whether apart from the anticipated tax advantages, the taxpayers’

investment was a sham. On the basis of the evidence present, it

seems obvious to us that the investment was not a sham.

937 F.2d at 1096. 

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