Autumn arrives: TEI urges house of commons to shed LCT tax, U.S. and California not to codify economic substance doctrine: also recommends narrowing tax shelter filters, addresses Virginia initiatives.

Although John Keats waxed poetic about Autumn as the "season of mists and mellow fruitfulness," the change of seasons at TEI brought a not-so-mellow flurry of technical activities. During the waning days of summer, the Institute's committees focused on Canada's pre-budget deliberations, challenged the proposed codification of the economic substance doctrine at the federal and state levels, recommended a narrowing of the filters in the corporate tax shelter disclosure regulations, and offered comments on a variety of several tax initiatives in the Old Dominion state.

In a written statement filed with the House of Commons Standing Committee on Finance in early September, the Institute urged Canada to accelerate the phase-out and repeal of the Large Corporations Tax. Calling the tax "counterproductive," TEI endorsed the government's position that capital taxes, including the LCT, are a significant impediment to investment in Canada. TEI recommended that the LCT tax rate for 2004 for all corporations be reduced to 0.1 percent and that the tax be eliminated in 2005.

The Institute also urged the Finance Committee to abandon the draft legislation in respect of Foreign Investment Entities and Non-Resident Trusts. If perceived abuses of the Income Tax Act cannot be addressed by Canada Customs and Revenue Agency under current law, TEI stated, narrower, more targeted remedies should be adopted.

"The Government has been fine-tuning the proposed legislation for more than three years," the Institute observed. "Given its mind-numbing complexity, taxpayers need time to digest and understand the legislation and, where possible, modify company information systems to capture and report the additional required information." TEI thus urged that the proposed January 1, 2003, effective date be postponed to give compliant taxpayers the opportunity to understand the provisions and ensure that legitimate business operations are not inadvertently caught up in the legislation.

The Institute also recommended the adoption of a loss transfer system (or group loss relief rules) for corporate groups and recommended other improvements in the administration of the Income Tax Act, such as repealing the withholding tax imposed on cross-border services, including binding arbitration provisions in Canada's tax treaties, and streamlining the reporting obligations of Canadian taxpayers in respect of their foreign affiliates.

TEI's written statement formed the basis of oral testimony presented to the House Standing Committee on September 30. TEI was represented at the hearing by Mario Tombari, TEI regional vice president, and Monika Siegmund, chair of TEI's Canadian Income Tax Committee. The Institute's written statement is reprinted in this issue, beginning on page 398.

Economic Substance Doctrine

On August 5, the Institute urged the tax-writing committees of Congress to reject codification of the economic substance doctrine. In a letter from TEI president Ray Rossi to Senator Charles Grassley and Congressman Bill Thomas, TEI opposed efforts to codify the judicial doctrine, asserting that the provision is too broad in scope, ensnaring many wholly legitimate transactions.

"Taxpayers cannot adequately define 'meaningful' changes to economic position, 'substantial' nontax purpose or 'reasonable' means of accomplishing such purpose," Mr. Rossi stated.

In addition, TEI's president noted that current law permits taxpayers to enter transactions lacking economic substance if the resulting tax benefits were intended by Congress. "The proposal would seemingly make all transactions that lack economic substance open to challenge even where taxpayers are engaging in primarily the behavior Congress intended," he said.

Granting the Treasury Department regulatory authority to clarify these issues will only postpone the difficult decisions, the Institute's president said. It will also make tax administration more complicated and raise troublesome tax policy issues.

Finally, TEI stated that the penalty provisions contained in pending bills raise serious concerns. "The use of strict liability penalties will not accomplish their intended purpose," Mr. Rossi explained, and there is "no evidence that raising the penalty rate above an already high 20 percent would increase the efficacy of the current penalty regime." He concluded by urging Congress to abandon the economic substance proposal and move cautiously in enacting new penalties.

On August 29, TEI reiterated its doubts about the codification of the economic substance doctrine at the state level. Commenting on two legislative proposals pending in California, the Institute expressed concern that "the proposal would create intolerable uncertainty that would substantially impair the ability of taxpayers to conduct ordinary business transactions."

"The key to stopping abusive tax shelters is the effective administration of the tax law, recognizing that tax administrators must do more to challenge and curtail questionable transactions, including raising practitioner standards and, where appropriate, asserting currently available penalties," the Institute said. Key to this process is the ability to identify and analyze such transactions. TEI has consistently urged both government leaders and tax administrators to focus on disclosure-based approaches to address tax shelters, the organization concluded.

TEI's August 5 letter to the federal tax-writing committees is reprinted in this issue, beginning on page 402, and its August 29 letter to state officials is reprinted, beginning on page 388.

Narrowing the Tax Shelter Filters

In its August 8 comments to the U.S. Department of Treasury and the Internal Revenue Service, TEI offered improvements to the final regulations relating to the disclosure of confidential transactions under the reportable transaction regulations.

Noting that the Treasury Department of IRS have acknowledged the need to sharpen and narrow the regulations' focus, the Institute recommended the adoption of one or more of the following approaches:

* Limiting the required waiver of confidentiality to transactions where a promoter, consultant, or material adviser subject to sections 6111 or 6112 is the beneficiary of the confidentiality restriction.

* Narrowing the waiver of confidentiality language authorizing taxpayers to disclose the tax structure of a transaction by clarifying that waiver is limited to disclosure of the tax structure to the IRS or other government agencies and to independent tax advisers.

* Issuing a revenue procedure to carve out specific types of non-disclosure agreements from the confidential transaction category of the reportable transaction regulations.

"The first two recommendations provide general rules for narrowing the scope of the definition of reportable confidential transactions," TEI explained, while the "angel list" approach described in the third item would narrow the scope of taxpayer reporting obligations. More comprehensive rules will be easier and more efficient for taxpayers and the IRS to apply, the organization averred.

TEI suggested that an "angel list" would be useful either as a supplement to comprehensive revision of the regulations or, if broader rules limiting unnecessary reporting cannot be formulated, as an alternative to obviating disclosure of many routine day-to-day transactions, TEI stated.

The Institute also recommended changing the time at which the disclosure of merger and acquisition agreements must be permitted by eliminating the "earlier of three events" rule of Treas. Reg. [section] 1.6011-4(b)(3)(ii)(B). The tax organization suggested substituting a rule that permits taxpayers to disclose an M&A transaction "no later than 30 days following consummation of such a transaction." In addition, TEI proposed a revision of the definition of confidential transactions to eliminate transactions entered into by controlled foreign corporations for the purpose of reducing foreign or state and local taxes.

The Institute's comments are reprinted in this issue, beginning on page 390.

Virginia Tax Initiatives

In September, the Institute' Virginia Chapter filed comments with the state Department of Taxation on five legislative proposals. In a September 22 letter to Commissioner Kenneth Thorson, Chapter president Win Ryan expressed general support for the proposals, with the exception of the proposal to place rulings of the Tax Commissioner on an equal level with regulations in any proceeding relating to interpretation and enforcement of the tax laws.

Commenting that the proposal is at odds with current Virginia law and the treatment afforded agency pronouncements at the federal level, TEI explained that it is "appropriate to distinguish between regulations, which have been vetted through a formal notice-and-comment process designed to provide due process for all concerned stakeholders, and a Tax Commissioner's ruling, which is merely the Department's view of the law."

"The proposed change would not be in the best interest of either taxpayers or tax administrators," the comments concluded.

The Chapter submission is reprinted in this issue, beginning on page 396.