Walking the tightrope: the new tax shelter disclosure regulations - Tax Executives Institute

Tax Executive, The, July, 2000 by McGee Grigsby, Jack F. Harrison

In February of this year, the Internal Revenue Service issued temporary and proposed regulations aimed at curbing what the Treasury Department perceives as the most serious compliance issue threatening the American tax system -- corporate participation in tax shelters.(1) Similarly, in May of this year, the Senate Finance Committee released a draft of proposed legislation that would also target corporate tax shelters.(2) The new regulations and draft legislation evidence increasing concern among government officials that billions of dollars a year are being lost to corporate tax-avoidance schemes.(3)

The new tax shelter disclosure (TSD) regulations do not alter substantive tax rules, but rather attack the problem by requiring persons participating in corporate tax shelter transactions to create, maintain, and provide to the IRS certain information about the transactions and persons associated with the transactions.

The first of the TSD regulations, Temp. Reg. [sections] 1.6011-4T, outlines new reporting requirements for corporate taxpayers that engage in tax shelter transactions. The second set of the TSD regulations, Temp. Reg. [sections] 301.6111-2T, requires promoters and advisers to register corporate tax shelters. The third set, Temp. Reg. [sections] 301.6112-1T, requires promoters to collect and maintain information regarding investors who purchase interests in corporate tax shelters.

It is obvious that the Treasury Department hopes the TSD regulations will provide the IRS with more current and more complete information about tax-motivated transactions. The regulations require corporations to attach a special form to the first return upon which a tax motivated transaction affects the corporate tax liability.(4) Registration of tax shelters is required currently with the marketing of the product, and investor lists are to be made available for inspection without a summons within ten calendar days of a request.

If the tax shelter problem is as pernicious as perceived, these are laudable objectives. Unfortunately, the TSD regulations are overbroad in scope, may impose disproportionate burdens with respect to routine transactions, and create substantial uncertainty regarding their actual requirements.

CORPORATE REPORTING

Temp. Reg. [sections] 1.6011-4T(5) requires corporate taxpayers to file a statement with their tax return disclosing their participation in reportable transactions. As defined in the regulations, reportable transactions fall into two categories: (1) listed transactions, and (2) other reportable transactions.

Listed Transactions

A listed transaction is any transaction the IRS has identified through published guidance as a tax-avoidance transaction or a transaction that is substantially similar to a listed transaction. Along with the new regulations, the IRS also published Notice 2000-15,(6) detailing 10 listed transactions.

Other Reportable Transactions

The second category consists of other reportable transactions. A transaction will be an other reportable transaction if it possesses at least two of the following six characteristics:

1. The taxpayer has participated in the transaction under conditions of confidentiality.

2. The taxpayer has obtained contractual protection against the possibility that all or part of the intended tax benefits from the transaction will not be allowed.

3. The taxpayer's participation in the transaction was promoted, solicited, or recommended by one or more persons who are expected to receive fees or other consideration with an aggregate value in excess of $100,000.

4. The expected treatment of the transaction for federal tax purposes is expected to differ by more than $5 million from the treatment of the transaction for purposes of determining book income as taken into account on the schedule M-1 (or comparable schedule) on the taxpayer's federal tax return for the same period.

5. The transaction involves the participation of a person that the taxpayer has reason to know is in a federal income tax position that differs from that of the taxpayer (such as a tax-exempt entity or foreign person), and the participation of such person allows the taxpayer to receive more favorable federal tax treatment.

6. The expected characterization of any significant aspect of the transaction for federal tax purposes differs from the expected characterization of the same aspect of the transaction for purposes of taxation of any party to the transaction in a foreign country.

The characteristics and thresholds in the regulations present a number of problems. As a general matter, the two-of-six-factor test is excessively broad and sweeps in many ordinary transactions. Several of the six characteristics are often present in ordinary business transactions. For example, the $5 million of book/tax difference, the participation of a tax-exempt entity or foreign person, and incurring an aggregate of $100,000 in fees can occur with some frequency.

In comments to the IRS, Tax Executives Institute stressed that the Internal Revenue Code is replete with provisions creating book/tax accounting differences; thus, it is somewhat paradoxical that the more scrupulous a taxpayer is in complying with the tax law (i.e., reporting book/tax differences), the greater the likelihood of having to file additional disclosure. Large corporations generally disclose scores of Schedule M items on tax returns, and the book/tax differences for these items frequently exceed $5 million in a single tax year. Consequently, for a large corporation, the regulation's book/tax characteristic will almost invariably be present, and the two-of-six-factor test will in practice be more akin to a one-in-five-factor test.(7)