Evaluating Aggressive Tax Strategies: A Methodology in Light of New Court Cases
Peter L. Faber
McDermott, Will & Emery
New York, NY
December 6, 2000
Peter L. Faber is a partner in McDermott, Will & Emery, where he heads the New York tax practice. He specializes in corporate and business tax planning and federal, state, and local tax litigation. He has assisted many companies in reviewing and defending tax-oriented investments.
Mr. Faber served as Chairman of the American Bar Association Section of Taxation, an organization of 25,000 tax lawyers that is the principal spokesman of the American legal community on tax issues. He is a former Chairman of the Section�s Committee on Corporate Taxation. He has testified before Congress on numerous occasions and has served as a consultant to Congressional committees on corporate tax matters. He is a fellow of the American College of Tax Counsel and a member of the Tax Advisory Group of the American Law Institute.
Mr. Faber is active in New York State affairs. He formerly served as Chairman of the Tax Section of the New York State Bar Association and as a member of the Governor�s Council on Fiscal and Economic Priorities. He is a member of the Taxpayer Advisory Committees of the New York State Department of Taxation and Finance, the New York City Department of Finance, and the State and City Tax Appeals Tribunals, and has assisted the Legislature in drafting several tax statutes.
Mr. Faber is the author of over ninety articles on corporate taxation. He has lectured on tax matters at tax institutes around the country.
Mr. Faber is a member of the Board of Directors and the Executive Committee of the New York City Partnership and Chamber of Commerce, Inc. and chairs its Committee on Taxation and Public Revenue. He graduated from Swarthmore College with high honors and from Harvard Law School cum laude. He lives in New York City.
EVALUATING AGGRESSIVE TAX STRATEGIES:
A METHODOLOGY IN LIGHT OF NEW COURT CASES
A case study: the contingent installment sale transaction.
- Recent years have seen an increasing number of tax "products" that are being sold by accounting and investment banking firms that have decided that this is the way to make substantial profits from the tax business. The promoter seeks a fee based on the value of the product, often expressed as a percentage of the tax savings.
- Many of the "products" are extremely aggressive and involve attempts to use provisions of the laws and administrative regulations to achieve results that the drafters did not contemplate and would not have allowed if they had thought about them.
- Judges do not like what they regard as tax avoidance schemes. They often apply the "smell test" and transactions that they feel flunk it are vulnerable. To combat these techniques, the IRS has been using principles that the courts have developed over the years to deal with situations in which the statutory law has led to results that the judges regarded as inappropriate:
- the economic substance doctrine;
- the business purpose doctrine; and
- the step transaction doctrine.
- Tax managers have to evaluate tax-oriented investments critically.
- Will they withstand attack in court?
- Will they result in penalties?
- Will they result in bad publicity?
- Will the benefit be shut down by legislation?
- Expenses of defending the technique.
- The transaction as designed by the promoters.
- The transaction.
- A (a foreign bank), B (a corporation in need of a tax loss), and C (a promoter affiliate) form the ABC Partnership, making cash contributions of $75, $24, and $1 respectively.
- ABC invests $100 in short-term securities.
- One month later, ABC sells the securities to X, an unrelated party, for approximately $100 (which is still their fair market value).
- ABC receives $70 in cash.
- ABC receives an installment note providing for six semiannual payments, each one being equal to a notional principal amount multiplied by the LIBOR rate at the start of the six-month period. The principal to be paid over the note�s term cannot be predicted accurately at the outset but is estimated to be about $30.
- ABC uses the $70 down-payment and the first installment payment to redeem A�s interest in the partnership, leaving B and C as the remaining partners.
- The remaining proceeds of the installment notes are invested in marketable securities.
- The anticipated tax treatment.
- Under the Treasury�s temporary regulations dealing with contingent payment installment sales, ABC applies its basis in the short-term notes against the sale proceeds evenly over the four-year term, or $25 a year. Regs. � 15a.453-1(c).
- In the year of sale (assuming no installment payments are received in that year), ABC has a $45 gain ($70-$25), most of which is allocated to A, which, as a foreign bank, pays no US tax on it.
- In the next three years (assuming installment payments of $30 are received), ABC has a $45 loss (basis of $75-$30), almost all of which is allocated to B (A is no longer a partner). B uses the loss to eliminate tax on gains from other sources.
- The Colgate-Palmolive case. ACM Partnership v. Commissioner, T.C. Memo. 1997-115, aff�d in part and rev�d in part, 157 F.3d 231 (3d Cir. 1998), cert. denied, 119 S.Ct. 1251 (1999).
- The facts.
- The promoter approached Colgate with the installment sale technique.
- Colgate�s tax people expressed concerns, feeling that the proposed transactions lacked a non-tax business purpose and that the tax benefits would not be achieved.
- Colgate and the promoter then developed a modified transaction in which, after the installment sale, the partnership would buy Colgate debt, thereby enabling Colgate to manage its debt more effectively and to reduce its exposure to interest rate fluctuations.
- The modified transaction was implemented. The promoter arranged for Algemene Bank Nederland N.V. ("ABN"), a major Dutch bank, to participate.
- The Tax Court opinion (Judge Laro).
- The Court held that Colgate�s loss was not deductible. It said that the transaction lacked "economic substance," but it defined "economic substance" in subjective terms.
- It said that a taxpayer should not be able to get a tax benefit that was not intended by Congress from a transaction that had no economic purpose other than to generate a tax benefit.
- It made a factual finding that Colgate did not enter into the transactions to manage its debt and that Colgate�s only purpose was to create a tax deduction.
- It said that the purchase and sale of the notes was intended to manipulate the tax laws to create a loss that was not "economically inherent" in the transaction. The notes had been sold a month after their purchase for a price that was substantially the same as their purchase price.
- It said that Colgate (and the partnership) did not reasonably expect to make an economic profit above transaction costs.
- Analysis of case law.
- The Court found support for its economic substance analysis in the business purpose language in Gregory v. Helvering, 293 U.S. 465, 469 (1935), although that case arguably is more appropriately analyzed in terms of the substance v. form doctrine. See, Faber, "Business Purpose and Section 355," 43 The Tax Lawyer 855, 862-67 (1990).
- It cited Goldstein v. Commissioner, 364 F.2d 734 (2d Cir. 1966), as standing for the proposition that a transaction that has some economic consequences will be disregarded if those consequences are insignificant when compared to the tax benefits.
- The taxpayer�s arguments on appeal to the U.S. Court of Appeals for the Third Circuit.
- The transactions actually happened. Property and money changed hands. They had economic substance.
- The tax consequences that the IRS doesn�t like result from the IRS�s own regulations.
- Taxpayers should be able to rely on IRS regulations. They should not have to read the IRS�s mind as to what it really intended if the literal language of a regulation is clear.
- The IRS should be required to follow its own regulations. If it doesn�t like them, its proper remedy is to change them and not to get the courts to apply them to some taxpayers but not to others. Woods Investment Co. v. Commissioner, 85 T.C. 274 (1985).
- Taxpayers can structure transactions so as to reduce their tax liabilities. There is no reason why a sale cannot be designed in a tax-efficient manner. Gregory v. Helvering, 293 U.S. 465, 468 (1935).
- A reversal will not open the floodgates to massive tax avoidance. The IRS can address its concerns by amending the installment sale regulations, and the partnership anti-abuse regulations may already have closed down this particular technique if it is deemed to be abusive. Regs �1.701-2.
- The Third Circuit opinion.
- The Third Circuit affirmed the Tax Court, with one dissent.
- The majority opinion (Judge Greenberg).
- The Court adopted the Tax Court�s economic substance theory.
- The Court said that the courts had applied the economic substance doctrine to disregard transactions "which, although involving actual transactions disposing of property at a loss, had no net economic effect on the taxpayer�s economic position."
- The Court seemed to say that some economic effect was not enough to cause a transaction to be recognized if it was inconsequential in relation to the tax benefits. The economic consequences in the transaction before it resulting from changes in interest rates and values during the month that the partnership owned the notes could not have been material and could not have justified the transaction costs.
The court noted, however, that a transaction that had real economic consequences would not be disregarded merely because it was "motivated by tax considerations."
- The Court said that the installment sale regulations are merely accounting regulations that are intended to provide a mechanism for reporting gains and deducting "otherwise existing deductible losses."
- To be deductible, a loss "must reflect actual economic consequences sustained in economically substantive transactions."
- The regulations cannot be used "to bifurcate a loss component of a transaction from its offsetting gain component to generate an artificial loss which, as the Tax Court found, is �not economically inherent� in the transaction."
- The Court separated the transactions involving the notes from the partnership�s professed debt management objectives.
- It said that the investment in the notes impeded the debt management function.
- It said that the installment sale of the notes that created the loss was independent of, and did not further, the debt management function.
- The Court reversed the Tax Court in part and allowed a deduction of actual economic losses (resulting primarily from transaction costs).
- The dissenting opinion (Judge McKee).
- The dissent rejected the economic substance concept. It cited the language in Gregory v. Helvering to the effect that a taxpayer can structure transactions in a tax-efficient manner. 293 U.S. 465, 468 (1935).
- The dissent argued that there was an actual sale of property and that goods and money changed hands, citing Cottage Savings Association v. Commissioner, 499 U.S. 554 (1991) (allowing a loss on an exchange of mortgage pools to be deducted). The majority opinion distinguished Cottage Savings because that case involved the sale of assets that the taxpayer had acquired for non-tax business purposes.
- The dissent said that the parties had followed the IRS�s own regulations and that the IRS�s proper remedy was to change the regulations or to seek Congressional relief. It noted the adoption of the partnership anti-abuse regulations.
- The Allied Signal case. ASA Investerings Partnership v. Commissioner, T.C. Memo. 1998-305, aff�d, 201 F.3d 505 (D.C. Cir. 2000)
- Allied Signal apparently adopted the basic transaction. It did not vary it to achieve a separate business purpose.
- The Tax Court held for the IRS on a different theory from the economic substance theory used by the courts in ACM. Judge Foley held that there was no real partnership. He ignored the promoter affiliate and found that the foreign bank (ABN, once again) was a mere lender to Allied Signal.
- The parties did not adhere to the partnership agreement.
- ABN received interest on its investment through a preferred return, despite a provision in the partnership agreement that no interest was to be paid on capital contributions.
- ABN did not share in losses on the sale of the notes despite an agreement that they were to be shared pro rata.
- Allied Signal paid for all of the partnership�s expenses despite an agreement that they were to be shared pro rata.
- Allied Signal made all of the partnership�s management decisions.
- Allied Signal did not care who the foreign bank partner was. ABN was recruited by the promoter.
- ABN had no economic risk because it hedged against losses from the transaction. Although the hedging transactions took place outside the partnership, they were part of an integrated investment strategy of which the partnership investment was a part.
- The D.C. Circuit affirmed.
- The court said that a partnership would not be respected unless it had a business purpose other than merely securing tax benefits.
- It acknowledged that hedging risks outside a transaction did not justify setting aside the transaction, but here it felt that all of ABN�s risks were hedged so that it could not be viewed as an equity participant.
- The Brunswick case. Saba Partnership v. Commissioner, T.C. Memo. 1999-359.
- Brunswick adopted the basic transaction. It did not vary it to achieve a separate business purpose. It formed two separate partnerships.
- The Tax Court held for the IRS because it said that the transaction lacked economic substance, relying heavily on the ACM Partnership case. It did not address the partnership status theory relied on by the Court in ASA Investerings.
- Application of the economic substance test.
- The Court considered the relative size of the tax benefits and the non-tax economics. It said that any economic profits that might have been realized would have been insignificant relative to the tax benefits.
- The fact that the partnerships might have retained the notes was irrelevant. The transaction was "scripted well in advance" and all parties knew that the notes would only be held for a month.
- The test is whether the transaction is the kind that a person would enter into for reasons other than the tax benefits.
- The Court quoted language from Frank Lyon Co. v. U.S., 435 U.S. 561, 583-84 (1978), to the effect that a transaction should be "imbued with tax-independent considerations" and should not be "shaped solely by tax-avoidance features."
- The Court rejected the taxpayer�s argument that the economic substance doctrine applies only when the statute expressly requires a business purpose.
- Business purpose analysis.
- The Court was influenced by what it felt was a lack of a non-tax business purpose.
- It did not believe testimony that Brunswick�s purpose was to tie up funds that otherwise might become available to a hostile raider.
- It relied on internal memoranda from Brunswick and its advisors.
- A memorandum prepared by in-house counsel at Brunswick summarizing a meeting with the promoter at which the tax aspects of the plan were emphasized. (The Tax Court rejected an argument that this was privileged.)
- A memorandum from Arthur Andersen, LLP saying that "the only reason Brunswick formed the partnership was to maximize the after tax earnings and cash flow" from the sale of other businesses.
- In evaluating aggressive tax strategies, consider the availability of privilege. The IRS will use discovery in litigation to the extent that it is available.
- Implications of the contingent installment sale litigation.
- The cases have raised serious issues as to when taxpayers can rely on IRS regulations and other pronouncements. It is not clear that the "economic substance" test as applied by the courts in ACM is an appropriate way of addressing transactions that judges feel flunk the "smell test."
- In ACM Partnership and ASA Investerings Partnership the judges indicated that the economic bona fides of the transactions was cast into doubt because the taxpayers hedged against the risk of the transactions in separate transactions. This raises serious questions about the tax effect of hedging transactions generally. The D.C. Circuit in ASA said that the problem was that all of one partner�s risks were hedged so that it could not be viewed as an equity participant.
- The litigation involving the contingent installment sale transactions is not over.
- Several more companies have cases pending involving the issue.
- The dissent in the Third Circuit in ACM and reports that several Tax Court judges were uncomfortable with the economic substance analysis in that case suggest that there may be some division in the judicial ranks.
III. Another case study: the BOSS transaction.
- This technique was developed by a Big-5 accounting firm to create a tax loss.
- The general structure.
- The taxpayers create a partnership with a minimal capital contribution of 8.
- The partnership borrows 100 from a bank.
- An investment fund controlled by the accounting firm borrows 107 from a bank.
- The partnership and the investment fund form a Cayman Islands LLC.
- The LLC is treated as a corporation under the default rules of the IRS check-the-box regulations.
- The partnership contributes 108 and gets a common interest in the LLC.
- The investment fund contributes 109 and gets a preferred interest in the LLC.
- The LLC borrows 100 from a bank and buys a portfolio of securities for 101 that are secured by the loan.
- The LLC buys other securities for 213.
- The LLC distributes the first securities portfolio to the partnership.
- The distribution is valued at 1 (value of securities of 101 less lien of 100).
- A and B are treated as becoming secondarily liable on the loan.
- The LLC elects to be treated as a partnership, triggering a constructive liquidation under I.R.C. section 331.
- A and B realize a large loss on the liquidation because their basis in the partnership includes the debt on the distributed securities as well as their initial bank loan and capital contributions.
- The IRS acted quickly to shut down the BOSS transaction. Notice 99-59.
- It said that losses were deductible only if they were bona fide and reflected actual economic consequences. Here, "[t]hrough a series of contrived steps, taxpayers claim tax losses for capital outlays that they have in fact recovered. Such artificial losses are not allowable for federal income tax purposes."
- The IRS warned that penalties might be imposed on taxpayers, return preparers, and promoters.
IV. Other recent cases
- Corporate-owned life insurance (COLI). Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C. ___ No. 21 (October 19, 1999).
- Winn-Dixie was denied a deduction for interest on COLI.
- Winn-Dixie purchased COLI on the lives of 36,000 employees. It was the owner and beneficiary of the policies. Projections showed that it would have a substantial pre-tax cash flow loss in each year of the 60 years for which projections were made but that it would have a substantial after-tax profit in each year because of the interest deduction. Winn-Dixie adopted a "zero cash" strategy in which it borrowed to pay the first three years� premiums and used the cash values to pay the premiums for the next four years. When the Internal Revenue Code was amended to eliminate the deduction for COLI interest, the Company dropped the program.
- The Court tested the transaction for both economic substance and business purpose, describing them as "related factors."
- Economic substance.
- The Court said that interest was not deductible unless the overall transaction of which the debt was a part had economic substance.
- The Court said that the economic substance test involved an "objective evaluation of changes in economic position of the taxpayer (economic effects) aside from tax benefits."
- The Court rejected the taxpayer�s argument that it could realize large pre-tax benefits if there were a catastrophe and many employees died unexpectedly. It said that "this was so improbable as to be unrealistic and therefore had no economic significance." The large number of employees covered (36,000) meant that the actuarial projections were reliable.
- The Court said that "the only function of the plan was to produce tax deductions in order to reduce petitioner�s income tax liabilities." Therefore, it had no economic substance.
- Business purpose.
- The taxpayer argued that it entered into the plan to finance other employee benefits.
- The Court rejected this argument on two grounds.
- The connection was not proved.
- Even if this was the purpose, the plan would have lost money and have failed to accomplish this purpose without the tax benefits. The use to which the benefits are put is irrelevant under the business purpose test.
- The taxpayer argued that section 264 of the Code expressly allowed deduction of COLI interest because of its 4/7 test. The Court said that section 264�s function was to limit deductions that were otherwise available under section 163. Here, the interest was not deductible under section 163 in the first place.
- Quick fix foreign tax credits. Compaq Computer Corporation v. Commissioner, 113 T.C. ___ No. 17 (September 21, 1999).
- Compaq�s attempt to solve a capital gain problem through a device to generate a foreign tax credit (FTC) was rejected on economic grounds.
- Compaq sold a business and realized a substantial capital gain. A representative of Twenty-First Securities Corporation (TFSC) read about the transaction and contacted Compaq, indicating that TFSC had developed several strategies for dealing with capital gains. He met with a representative of Compaq and, after a one-hour meeting with no later examination, Compaq decided to adopt a strategy involving the purchase of American Depository Receipts (ADRs) "cum dividend" (i.e., entitled to receive a declared dividend) and their sale a few days later "ex dividend" (i.e., with the buyer not entitled to the dividend).
- Although the taxpayer received a small pre-tax profit ($1.9 million) on the transaction, the FTC was twice the economic profit and was used to offset tax on Compaq�s other income.
- The Court said that the economic substance test had two components: an objective one and a subjective one.
- The transaction flunked the objective component because Compaq had no economic risk. The purchases and sales of the ADRs were at pre-determined prices and consisted of 23 cross-trades executed one hour apart. The whole process lasted 5 days.
- The transaction flunked the subjective component because Compaq was interested only in the tax benefits.
- It entered into the transaction after a one-hour meeting with TFSC and without investigating the investment quality of the ADRs.
- It reviewed a spreadsheet of the transaction (which it shredded one year later) but did no other analysis.
4. The Court said that it would be acceptable to close out an economically accrued loss or to structure a transaction that the taxpayer would have done anyway in a tax-efficient manner. The problem was in doing a transaction solely to obtain a tax benefit that was created by the transaction itself.
5. The Court imposed accuracy related penalties under section 6662(a) of the Code. The taxpayer did not show reasonable cause. It was negligent in not doing an investment analysis. It was interested only in the tax benefits.
V. State and local tax issues.
- A current problem: nexus for limited partners and limited liability company members.
- A tax planning technique that is being used by many companies to reduce state and local tax liabilities is to do business in states through limited partnerships and limited liability companies.
- Most states do not impose an entity-level income or franchise tax on limited partnerships and LLCs, particularly if they elect flow-through tax treatment under the federal "check-the-box" regulations.
- Many states do not impose income or franchise tax on limited partners or LLC members if they have no nexus with the state other than through their ownership of an interest in the entity. The theory is that taxable nexus should not (and, perhaps, may not under the Constitution) be created by a passive investment.
- Some corporations have been using the following technique.
- Corporation A conducts an active business in State X. It owns a fully-equipped manufacturing plant and related facilities in X.
- A transfers all of its property and operations in X to newly-formed limited partnership LP in exchange for a limited partnership interest in LP that comprises 99% of the value of LP�s equity.
- A�s wholly-owned subsidiary, Corporation B, transfers cash to LP in exchange for a general partnership interest in LP that comprises 1% of the value of LP�s equity.
- The regulations in State X provide that a corporation does not acquire income or franchise tax nexus as a result of being a limited partner in a limited partnership that does business in the State.
- A takes the position that it has left State X�s taxing jurisdiction by interposing LP between A and X.
- Legal authorities.
- Many states have regulations or statutes providing that a limited partner does not have taxable nexus by reason of its limited partnership interest. See, e.g., Texas, 34 TAC � 3.546(c)(12); New Jersey Reg. � 18:7-7.6 (rule does not apply if the corporation is also a general partner in the partnership or otherwise takes an active part in controlling the partnership�s business).
- The Tennessee Department of Revenue held that the transfer of an existing operation in Tennessee to a 99-1 partnership with an affiliate avoided nexus. Letter Ruling No. 97-49 (December 2, 1997). When the Department realized the revenue implications of its position, however, it went to the Legislature and convinced it to impose an entity-level tax, thus eliminating the technique. The Legislature later repealed the entity-level tax as to limited liability companies with a sole corporate owner but imposed nexus.
- Considerations in using this technique.
- Will the tax authorities argue that the regulation was intended for minority interests and not for interests in entities that are effectively controlled by the taxpayer? See the Third Circuit�s dismissal of the installment sale regulations in ACM.
- Will the management activities of the 1% general partner be imputed to the 99% limited partner? (The separate existence of each corporation should be observed and transactions between them should meet arms-length standards if this technique is to work.)
- Does the state have a statute or regulation comparable to section 269 of the Internal Revenue Code?
- How long will the benefit last? Is the state likely to change the regulation? (This technique is not secret. The technique is being widely used.)
- Will state tax authorities regard the technique as dishonest, thus poisoning the atmosphere of future audits?
- Should the taxpayer reserve for potential tax liabilities?
- Is there a risk of penalties if the corporation is complying with the literal language of a regulation?
- The extension of federal common law principles to the state and local tax area.
- State and local tax authorities were slow to apply federal common law principles and state and local tax practitioners for many years operated on the principle that form would prevail over substance.
- State tax departments in recent years have been more aggressive in challenging transactions, however.
- The Massachusetts Department of Revenue has been particularly sensitive to business purpose issues.
- The Department, in an internal memorandum, has instructed its auditors to attack tax-oriented transactions that lack a business purpose, giving examples.
- The Department has successfully challenged intangible holding companies before the Appellate Tax Board on the grounds that the transfer and license-back of intangible property lacked economic substance and a business purpose. The Sherwin-Williams Co. v. Commissioner of Revenue (July 19, 2000); Syms Corp. v. Commissioner of Revenue (September 14, 2000).
- In a recent California case, a last-minute conversion of debt to equity to avoid gain recognition was ignored because it lacked a business purpose. Halvorsen Lumber Products, Inc. (State Board of Equalization, April 22, 1999).
VI. Analyzing tax-oriented investments.
- Apply the "smell test" and be careful if the transaction flunks. Judges are likely to do this (Judge McKee in his dissent in ACM expressly accused the majority of doing this). Be particularly wary of transactions the sole purpose of which is to generate a tax benefit (as contrasted with techniques that involve tax-efficient ways of doing transactions that one would have done anyway).
- Think of theories that could be used to attack the transaction. Analyze their strengths and weaknesses.
- Consider public relations aspects. Would you want your company�s participation in the investment to be publicized? (Colgate�s Tax Court litigation was the feature story on page 1 of the Wall Street Journal.)
- Analyze penalty exposure.
- Expanded penalty exposure under section 6662(d) of the Internal Revenue Code.
- A "tax shelter" is now defined as an investment or arrangement if "a significant" purpose is tax avoidance (formerly "the principal" purpose).
- If an investment is a tax shelter, disclosure will not avoid penalties and the taxpayer must show not only that there was substantial authority for its position but that it reasonably believed that its treatment of the transaction was more likely than not the correct treatment.
- Review state and local penalty provisions.
- Consider whether the technique may be shut down by administrative or legislative action.
- If the technique will be available for only a few years, the possible tax savings that must be balanced against transaction and defense costs and the risk that the technique will not work are reduced.
- If the technique is based on what arguably is an unintended mistake or loophole in the statute or the regulations, it may be shut down retroactively. See Monroe v. Valhalla Cemetery Co., Inc., 749 So.2d 470 (Ala. Ct. Civ. App. 1999), cert. den., ___ S.Ct. ____ (2000) (legislation that retroactively closed loophole under which out-of-state vendors with no nexus in state could deliver goods to in-state buyers by common carrier without sales or use tax liability because of a disconnect between the sales and use tax statutes was constitutional); U.S. v. Carlton, 512 U.S. 26 (1994) (retroactive amendment to Internal Revenue Code to close a loophole that would have permitted massive avoidance of estate tax by selling assets to employee stock ownership plans was constitutional).
- Advise corporate management of the risks, including that of adverse publicity.
VII. Dealing with sellers of tax "products."
- Corporate tax managers are frequently approached by accounting and investment banking firms selling tax "products," which they claim are "proprietary" ideas that will be disclosed only if the corporation signs a "confidentiality agreement."
- The seller typically charges a contingent fee based on a percentage of tax savings. If no savings result, the corporation pays nothing.
- The appeal is that if no savings result there is no cost.
- Corporations should approach these "products" with caution.
- Even if professional fees are contingent, the company may have to do some restructuring or incur other internal costs to implement the plan.
- Some of the products are on the fringe of acceptable tax conduct.
- They involve penalty exposure.
- They can adversely affect the atmosphere of a tax audit.
- They can result in adverse publicity.
- The seller of a tax idea who stands to receive a contingent fee if the corporation adopts it cannot be expected to give objective advice on the idea, even if it is a reputable professional services firm. An "opinion" that is offered by a law or accounting firm that has an economic interest in whether the corporation adopts the proposal should be viewed with suspicion. It may be more of a sales document than an objective expression of views. The corporation should have any such proposals reviewed by professionals (in-house or with an outside firm) who have no stake in the outcome.
- Negotiating the agreement with the promoter.
- These agreements are negotiable both as to price (i.e., the calculation of the fee) and as to terms.
- The corporation should find out as much as possible about the product before starting negotiations. Negotiating these agreements can be time-consuming and the process should not be started unless the concept seems generally feasible. The seller will want the deal more than the corporation and will usually be willing to disclose the general concept.
- The agreement should be inoperative if it turns out that the product is already in the public domain (e.g., it has been written about or spoken about) or if the corporation already knows about it. The corporation should not be bound to pay an accounting firm a percentage of tax savings resulting from an idea about which it already knew.
- The term of the period over which tax savings produce a fee should be specified. It should not last forever.
- The jurisdictions covered should be specified. Are state tax savings included? If so, should the deductibility of state taxes for federal tax purposes be taken into account?
- Fees should be refunded with interest if the product is successfully challenged by the tax authorities. Corporations should consider holding back part of the fees until the statute of limitations on assessing tax deficiencies has expired.
- The agreement should become inoperative with respect to future tax savings if the idea becomes part of the public domain after the agreement is signed.
VIII. U.S. Treasury reporting and disclosure regulations (February 28, 2000.)
- Disclosure by corporate taxpayers. Temp. Regs. � 1.6011-4T.
- A corporation that has participated in a "reportable transaction" must disclose it on each tax return that is affected by it.
- Definition of "reportable transaction."
- "Listed transactions" that have been identified by the Internal Revenue Service as "tax avoidance transactions" and that reduce federal income tax liability by more than $1 million in any taxable year or by more than $2 million in all years.
- Other transactions with certain characteristics that are deemed indicative of tax avoidance and that reduce federal income tax liability by more than $5 million in any taxable year or by more than $10 million in all years.
- The transaction must have at least two of the following characteristics.
- The taxpayer participates under conditions of confidentiality.
- The taxpayer is protected by a rescission right, a right to a refund of fees, an indemnity, or similar right if the tax benefits do not materialize.
- The promoter receives more than $100,000 in fees that are contingent on the taxpayer�s participation.
- The tax treatment is expected to differ from the book treatment by more than $5 million in any year.
- The transaction involves the participation of a tax-indifferent person that results in favorable terms for the taxpayer.
- The tax treatment of any significant aspect of the transaction differs from the tax treatment of that aspect for any party in another country.
- Even if at least two of these characteristics are present, the transaction will not be a reportable transaction if any of the following conditions are met.
- The taxpayer participates in the ordinary course of business in a form consistent with customary commercial practice and:
- the taxpayer reasonably determines that it would have participated in the same transaction on substantially the same terms irrespective of the tax benefits; or
- the taxpayer reasonably determines that there is a long-standing and generally accepted understanding that the tax benefits are allowable.
- The taxpayer reasonably determines that there is no reasonable basis for the tax benefits to be denied.
- The transaction is publicly-identified by the Internal Revenue Service as being exempt from disclosure.
- Registration by promoters. Temp. Regs. � 301.6111-2T.
- Confidential corporate tax shelters must be registered by their promoters.
- A confidential corporate tax shelter is an entity, plan, arrangement, or transaction that meets all of the following requirements.
- A significant purpose of the structure is the avoidance or evasion of federal income tax.
- It is offered to any potential participant under conditions of confidentiality.
- The promoters may receive fees greater than $100,000 in the aggregate.
- A promoter is anyone who participates in the organization, management, or sale of a tax shelter (including attorneys, accountants, and investment advisors).
- Investor lists. Temp. Regs. � 301.6112-1T.
- Any person who organizes or sells an interest in a "potentially" abusive tax shelter" must maintain a list showing each investor who buys such an interest.
- A "potentially abusive tax shelter" is one for which a significant purpose of the structure is the avoidance or evasion of federal tax.
- There is no requirement that the shelter be offered to any investor under conditions of confidentiality.
- There is no requirement that promoter fees exceed $100,000.