Codification of the economic substance doctrine and tax shelter penalty proposals: August 5, 2003.

On August 5, 2003, Tax Executives Institute submitted the following comments to the Chairmen of the Senate Finance and House Ways and Means Committees on the proposal to codify the economic substance doctrine and otherwise amend the rules relating to tax shelters.

On behalf of Tax Executives Institute, I submit the following comments on provisions relating to codification and clarification of the economic substance doctrine and penalties related to reporting of tax shelter transactions that have been included in recent tax legislation. TEI is pleased that H.R. 2896, the "American Jobs Creation Act of 2003," introduced by Chairman Thomas on July 25, 2003, does not include the proposal to codify the economic substance doctrine and includes a modified version of the tax shelter penalty provisions. Given the concerns raised by these provisions and their continuing presence in other bills pending in Congress, however, TEI asks your consideration of the following points.

From the outset, TEI has acknowledged that certain inappropriate tax-advantaged products have been marketed. The Institute firmly believes that the key to stopping such abuses is the effective administration of the tax law. Effective administration of the law, in turn, depends upon the ability of IRS agents to identify and analyze transactions, and, where necessary, to challenge them. The IRS must do more to challenge and curtail questionable transactions, including raising practitioner standards and, where appropriate, asserting currently available penalties. For this reason, the Institute supported the creation of the IRS's Office of Tax Shelter Analysis to identify, quantify, and develop comprehensive approaches to dealing with tax shelters (including the issuance of needed substantive guidance). Moreover, TEI has consistently urged the Congress and the Treasury Department to focus on disclosure-based approaches to address tax shelters.

The proposal to codify the economic substance doctrine adopts a much different approach to the tax shelter issue, which TEI opposes for the following reasons:

* The provision is too broad in scope, ensnaring many wholly legitimate transactions.

* Taxpayers cannot adequately define "meaningful" changes to economic position, "substantial" non-tax purpose or "reasonable" means of accomplishing such purpose.

* 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.

* Granting the Treasury Department regulatory authority to clarify the above issues will only postpone the difficult decisions, will likely make tax administration more complicated, and also raises troublesome tax policy issues.

Further, some of the penalty provisions contained in pending bills, including S. 476, the CARE Act of 2003, the counterpart bill of which is scheduled to be marked up by the Ways and Means Committee on September 4, raise serious concerns:

* The use of strict liability penalties will not accomplish their intended purpose.

* There is no evidence that raising the penalty rate above an already high 20 percent would increase the efficacy of the current penalty regime.

As elaborated on below, we urge Congress to abandon the economic substance proposal and move cautiously in enacting new penalties.

Tax Executives Institute

Tax Executives Institute was established in 1944 to serve the professional needs of business tax professionals. Today, the Institute has 53 chapters in the United States, Canada, and Europe. Our more than 5,300 members are accountants, attorneys, and other business professionals who work for 2,800 of the leading companies in North America and Europe. As a professional organization, the Institute is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the costs and burdens of administration and compliance to the benefit of taxpayers and government alike. The Institute is committed to maintaining a system that works--one that builds upon the principle of voluntary compliance and is consistent with sound tax policy, one that taxpayers can comply with, and one in which the IRS can effectively perform its audit function without unduly burdening taxpayers.

These goals can only be achieved through our members' adherence to the highest standards of professional competence and integrity. To ensure compliance with the law, TEI's Standards of Conduct exhort the members to "present the facts required in tax returns and all the facts pertinent to the resolution of questions at issue with representatives of the government imposing the tax." As important, the members "recognize an obligation to make an affirmative contribution to the sound administration of the tax laws, and to the adoption of sound tax legislation, by cooperation and consultation with the persons charged with those functions, having due regard for the interests of society, as well as the interests of the company and its employees." In short, a balance must be struck between public duty and private right.

TEI members are responsible for conducting the tax affairs of their companies and ensuring their compliance with the tax laws. TEI members deal with the tax code in all its complexity, as well as with the Internal Revenue Service, on almost a daily basis. Most of the companies represented by our members are part of the IRS's Coordinated Industry Case program, pursuant to which they are audited by a team of IRS agents on a continuing basis.

As a professional association of in-house tax executives, TEI offers a different perspective on tax shelters from other organizations. The Institute does not represent tax shelter promoters and developers (including investment bankers) who either sell or facilitate the transactions. Nor do we represent the professional advisers (be they attorneys or accountants) who opine on and hence assist in the development, promotion, and implementation of the arrangements. Rather, TEI's members work directly for the corporations that routinely enter into business transactions that require an analysis of their tax benefits and burdens. These companies have professional staffs dedicated to ensuring compliance with the law while minimizing their tax liability. We, along with the government, have the most at stake in trying to craft an equitable tax system that is as administrable and efficient as possible.

Codification of the Economic Substance Doctrine

TEI urges the Congress to reject proposals to codify and clarify the economic substance doctrine such as that contained in the Senate amendment to H.R. 2, the Jobs and Growth Tax Relief Reconciliation Act of 2003. We also recommend that the correlative proposal to establish an essentially non-waivable 40-percent penalty for understatements attributable to transactions lacking economic substance be dropped.

In describing the economic substance doctrine, the Joint Committee on Taxation has stated:

  The Internal Revenue Code ... provides
  specific rules regarding
  the computation of
  taxable income, including the
  amount, timing, source, and
  character of items of income,
  gain, loss and deduction.
  These rules are designed
  to provide for the computation
  of taxable income in a
  manner that provides for a
  degree of specificity to both
  taxpayers and the government.
  Taxpayers generally
  may plan their transactions
  in reliance on these rules to
  determine the federal income
  tax consequences arising from
  the transactions. (1)

The specificity provided by these rules in turn provides for a necessary and correlative degree of certainty as well.

The judicially created doctrine operates as a "backstop" to the Code's specific rules and becomes applicable, and a judicial remedy is warranted, where a taxpayer seeks to claim tax benefits by means of transactions that serve no economic purpose other than tax savings and those benefits are unintended by Congress. (2) Thus, currently the doctrine does not apply if the court determines that the benefits were intended by Congress In other words, doctrine is utilized by courts where tax benefits are suspect because the court concludes that allowing the benefits would be contrary to the intent of the drafters, and not as an independent rule of positive law.

The proposal is not a simple clarification of existing law as its title suggests. The proposed regime does not define an abusive tax shelter and then disallow the tax benefits that flow from the transaction in question. Instead, the current system would be turned on its head, with specific statutory provisions potentially being "trumped" by a vague, amorphous override provision. Regardless of what particular Code provisions may otherwise allow, such provisions may be ignored unless a taxpayer proved both a meaningful change in economic position and a substantial non-tax purpose for a transaction. Every provision of the Code, and every transaction consummated by a taxpayer, must satisfy its requirements.

Simply stated, the proposal would, in TEI's view, substantially impair rather than improve the tax system.

First, the statute itself leaves open to question many important issues that are necessary to its application. For example, how is "meaningful" change in economic position to be determined? Will it be possible to meet required levels of profit in the transaction?(5) How is the "transaction" to be defined?(6) Must there be contemporaneous evidence showing the relevant facts and subjective intentions before every transaction is consummated and, therefore, must all taxpayers carefully document all transactions beforehand? Who determines whether the transaction is a reasonable means of accomplishing a substantial non-tax purpose and when should the taxpayer's determination be allowed to stand? What broad standards could apply to the diversity of transactions that occur every day in the economy?

The Joint Committee candidly acknowledged these concerns:

  The proposal would not
  provide specific definitions
  regarding what constitutes
  a "change in a meaningful
  way" or "substantial non-tax
  purpose." Defining these
  terms in the Code could
  prove problematic, be an
  inadequate deterrent, and
  could hinder valid business
  transactions, because a codified
  definition likely could not
  properly address the variety
  of circumstances in which
  the economic substance doctrine
  should be applied. For
  example, requiring a pretax
  profit test as part of an
  economic substance analysis
  could raise concerns with
  respect to certain customary
  leveraged lease transactions,
  financing arrangements in
  general, and transactions
  where the tax benefits are
  both intended by Congress
  and significant, but the
  transaction itself is expected
  to yield little (if any) profit.
  For this reason, the proposal
  would grant the Treasury
  Department the authority
  to further define these terms
  to carry out the purposes of
  the proposal.... The proposal
  would provide that a taxpayer's
  non-tax purpose for
  entering into a transaction
  must be "substantial," and
  that the transaction must
  be "a reasonable means" of
  accomplishing such purpose.
  A single, statutory definition
  of what is "substantial" or
  what constitutes "a reasonable
  means" could not
  adequately address the various
  situations in which the
  purported business purpose
  of the transaction may be
  examined under the economic
  substance analysis. (7)

A more significant problem is that the proposal would engender significant and intolerable uncertainty. Taxpayers can live with some uncertainty, but the vague definition of prohibited tax avoidance contained in these rules will be disruptive and provide no comfort. The answer to a simple question that would be answered by a specific provision of law would become a matter of subjective opinion varying from person to person. Taxpayers should not be expected to operate their businesses on such a basis.

It is difficult to take much comfort from the committee report:

  If the tax benefits are clearly
  contemplated and expected by
  the language and purpose of
  the relevant authority, it is
  not intended that such tax
  benefits be disallowed if the
  only reason for such disallowance
  is that the transaction
  fails the economic substance
  doctrine as defined in this
  provision.

H.R. CONF. REP. No. 108-26, at 35 n.52 (2003) (hereinafter "Conference Report") (emphasis added), describing the Senate amendment. For example, could the new rules operate to disallow commonplace--and previously clearly acceptable--deferral planning with respect to international operations of multinational companies?

  Example 1: USCO is a
  domestic corporation that
  wishes to set up a new factory
  outside of the United
  States. While it could have
  chosen to operate in branch
  form from a local tax and
  legal perspective, USCO
  decides to establish a foreign
  subsidiary ("FSub") to
  operate this new factory in
  order to achieve deferral of
  U.S. tax on the income from
  its non-U.S, manufacturing
  operations.

  Example 2: USCO is a domestic
  corporation that currently
  conducts operations in
  branch form in one or more
  foreign countries. USCO
  decides to establish one or
  more foreign
  subsidiaries
  ("FSubs"), and
  contributes
  its foreign
  business operations
  to
  the FSubs in
  a section 351
  exchange,
  in order to
  achieve deferral
  of U.S. tax
  on the income
  from its non-U.S.
  business
  operations.

Under current case law, the economic substance doctrine would not and should not apply to either of these transactions. Indeed, the tax-free incorporation of a business operated in branch form is sanctioned in section 351 of the Code, and the incorporation of a foreign branch is expressly permitted by section 367(a) (3). Finally, according to the legislative history to section 367(d), Congress intended to continue to allow foreign branch incorporations even though certain transfers intangibles were to be made taxable. Although the statute does not expressly provide for deferral, the existence of subpart F indicates that Congress intended for taxpayers operating a foreign business through a foreign corporate subsidiary to enjoy the benefit of tax deferral Inasmuch as tax-free contributions and tax deferral are benefits that Congress intended to confer upon taxpayers, a statutory economic substance test should not apply to the described transactions even if the sole purpose of the transaction is to enjoy the tax benefits in question. But how would one know in advance of completing such transactions that the tax benefits are clearly contemplated and expected by the language and purpose of the relevant authority, or to the contrary, when they are not?

Other more or less routine transactions pose similar questions. For example, assume a corporation that owns slightly less than 80 percent of the shares of a second corporation decides to purchase a few shares held by another shareholder to reach the required threshold of 80 percent so that a consolidated return may be filed and significant tax advantages would accrue. What if that purchase is at a significant premium? There would seem to be no reasonable expectation of economic profit apart from a tax motive. The same question is raised by provisions in the Code that require a maximum number of shareholders to file a subchapter S return, or that require a minimum ownership to take other actions like a section 332 liquidation. What if a corporation that owns several subsidiaries, acting in accord with the principles of Rev. Rul. 74-79 (8) and section 355, liquidates a subsidiary that is not engaged in a trade or business to avoid the holding company test so that the remaining subsidiaries qualify under the 5-year trade or business test for a spin off? Again, depending on one's perspective, these transactions may not be considered to produce a meaningful change in the taxpayer's economic position apart from the tax consequences and there would seem to be no substantial non-tax motive for the transactions in question, yet they are considered permissible under current law.

While the targets of the proposal are taxpayers that engage in abusive tax shelters, all taxpayers would be required to live in this world; they would have to deal with the uncertainty and complexity and, hence, the possibility that adherence to the Code's literal requirements may not be enough. Notwithstanding what a particular Code provision provides, it may be ignored unless the requirements of the subjective overlay have been satisfied. The nature of our tax system and voluntary compliance would be fundamentally changed in a well-intentioned attempt to staunch a limited number of troublesome transactions.

As the Joint Committee has suggested, one answer to these concerns is to leave the enforcement of the standards to administrative discretion. That is to say, legitimate transactions would be separated from proscribed ones by the issuance of administrative guidance. This would seem to be a very difficult task, perhaps even an impossible one. The time involved just to consider and issue the guidance would operate as a drag on many legitimate transactions, and produce a significant burden on the staff resources of the Treasury. More fundamentally, such a broad grant of administrative authority is troubling. Most changes in rules require the active consent if not participation of Congress. Is the Congress fully prepared to delegate so much of its authority to the Treasury Department and the IRS?

TEI submits that the penalty provisions associated with the basic proposal evoke concerns with respect to basic fairness and due process. In the complex economic environment in which businesses must currently operate, it is difficult to accurately assess the net economic effects of a transaction in advance of its implementation. As a result, many business transactions, if not arguably every business transaction, would potentially be subject to a risk of a 40-percent penalty. It would be difficult for a taxpayer to know in advance of engaging in a transaction, particularly in advance of the promulgation of specifically applicable Treasury guidance, whether or not doing so would subject the taxpayer to the penalty. Given the strict liability aspects (9) of the proposal, this would lead to particularly harsh results.

As both a substantive change to the Code and a separate basis for a penalty for noncompliance, the proposals would mark a significant departure from our rules-based system, apply to an extraordinarily broad range of transactions (including many not considered "tax shelters"), and involve the application of vague subjective tests. They would make it extremely difficult for taxpayers to enter into their everyday business decisions with necessary clarity and certainty, and for the IRS to examine their returns in an even-handed, objective, and consistent manner. Adopting such rules will prove at once both over-inclusive (ensnaring and severely punishing taxpayers for wholly legitimate transactions) and under-inclusive (failing to catch some abuses that should be stopped).

Tax Shelter Penalty Provisions

Sections 702, 703, 704, 705, 716, and 717 of S. 476, the CARE Act of 2003 (10), would make significant use of increased accuracy-related penalty rates (as noted above, as high as 40 percent), impose stringent standards for avoidance of penalties and waiver of them (which in many cases essentially impose a form of strict liability that affords no discretion in their application), and impose other punitive provisions on taxpayers that would deny interest deductions on underpayments, extend statutes of limitations, levy fines, and require disclosures in filings with the Securities and Exchange Commission. TEI recommends that these provisions be abandoned.

In the past two decades, Congress has significantly raised the penalties for under-reporting or inaccurately reporting income. Yet the apprehension remains that more must be done to enhance voluntary compliance by strengthening the penalty system. There is no evidence, anecdotal or otherwise, that the efficacy of the current penalty regime would be increased by raising the rate above an already high 20 percent. (11) TEI believes that consistency, certainty, and fairness in the application of penalties play a bigger role in deterring noncompliance than viscerally increasing the amount of them.

We suggest that a fundamental problem with the administration of the current penalty is that the rate is already so high that it is rarely asserted against corporate taxpayers. Where penalties and their consequences are disproportionate to the conduct involved, revenue agents may be inhibited from asserting such penalties. Witness, for example, the penalty for errors involving qualified plans before the intermediate sanction rules were enacted. Because the stated penalty--revocation of exempt status--was uniformly considered too harsh, agents rarely asserted it. (12)

As previously noted, certain aspects of the proposal were seemingly designed to take the decision out of the hands of the examiners. (13) This would not advance good tax administration. Indeed, the perverse effect of this approach is that it puts not only the penalty imposition at risk, but the underlying tax as well, because field agents may decide not to challenge the underlying return position itself given the harsh and unavoidable consequences. Thus, while administrative review is often helpful in strengthening the fairness and certainty of application of penalties, TEI believes diminishing the agent's discretion is unwarranted. Moreover, we continue to believe that increasing the penalty rate--and compelling the public disclosure of any penalty (regardless of materiality)--would be counterproductive.

Further, proposed strict liability regimes stand in marked contrast to current law where, under section 6664(c) (1) of the Code, no accuracy-related penalty will be imposed in respect of any portion of the underpayment for which there is reasonable cause if the taxpayer acted in good faith. Strict liability penalties for underpayments or nondisclosure will invariably produce harsh and disproportionate results. There is no evidence to suggest that the in terrorem effect of a no-fault penalty regime would have a positive effect on compliance. Indeed, those who propose that Congress enact a strict liability regime seem to have forgotten that part of the essence of recent reforms to the Code's interest and penalty provisions was not to punish foot faults.

Conclusion

Overlaying the Internal Revenue Code with a complex, subjective anti-abuse rule would add significantly to the overall complexity of the tax system, significantly reduce the certainty of application of its rules, make voluntary compliance difficult for many taxpayers, and perhaps even frustrate future efforts to combat abusive transactions.

The economic substance doctrine was developed by the courts to complement, or provide a backstop to, the Internal Revenue Code's substantive provisions. When abuses occur, the courts have demonstrated their willingness to utilize existing doctrine or to create new ones to prevent abuse. Regrettably, codifying the economic substance doctrine would further complicate and confuse the system and undermine not only legitimate tax planning but the courts' willingness and ability to apply this and other judicial doctrines. Accordingly, TEI urges Congress to reject these provisions.

A strict liability regime will ultimately lead to the imposition of penalties in cases of inadvertent noncompliance. Finally, TEI submits that the standard of authority required for avoiding understatement penalties for an undisclosed transaction, combined with the new penalty provisions, would effectively compel cautious taxpayers to disclose myriad legitimate business transactions that otherwise do not meet the definition of a reportable transaction, undermining the goal of highlighting troublesome transactions to the IRS. We urge you to rethink these proposals.

Any questions about the Institute's views should be directed to either Timothy J. McCormally, TEI's Executive Director, or Fred F. Murray, the Institute's General Counsel and Director of Tax Affairs. Both individuals may be contacted at 202.638.5601.

(1) Technical Explanation of H.R. 5095 ("The American Competitiveness Act of 2002"), Staff of the Joint Committee on Taxation, JCX-78-02, July 19, 2002, at 2 (emphasis added) (hereinafter "JCX-78-02").

(2) ACM Partnership v. Commissioner, T.C. Memo 1997-115 at 723, aff'd in part, rev'd in part, 157 F.3d 231 (3d Cir. 1998), cert. denied, 526 U.S. 1017 (1999). See also Helvering v. Gregory, 69 F.2d 809 (2d Cir. 1934), aff'd, Gregory v. Helvering, 293 U.S. 465 (1935).

(3) See Cottage Savings Association v. Commissioner, 499 U.S. 554 (1991) (swapped pools of mortgages for the purpose of triggering tax losses). The Supreme Court held that the exchanged mortgages were substantially identical for regulatory and book purposes and had legally distinct entitlements that were material for tax purposes.

The significant estimate of revenue effects calculated by the Joint Committee suggests otherwise [$13.698 billion for Fiscal Years 2003-2013, not including the effects of the associated 40-percent penalty. Estimated Budget Effects of the "Jobs and Growth Tax Relief Reconciliation Act of 2003" Scheduled for Consideration by the Committee on Finance on May 13, 2003," Staff of the Joint Committee on Taxation, JCX-50-03, May 13, 2003, at 1].

The basis for this revenue estimate is not readily apparent, but to reach such a considerable amount, the rules must surely be targeted at identified transactions. If so, it would seem possible to craft more targeted and specific anti-abuse rules. If not, could the revenue estimate instead be based upon a projection of the deterrent effects of the provision? This also seems odd given its amorphous shaping, as it gives little illumination as to the transactions in mind, and given the statement of the staff of the Joint Committee in describing the provision:

  The proposal would not provide
  specific definitions regarding
  what constitutes a "change in a
  meaningful way" or "substantial
  non-tax purpose." Defining these
  terms in the Code could prove
  problematic, be an inadequate
  deterrent, and could hinder
  valid business transactions, because
  a codified definition likely
  could not properly address the
  variety of circumstances in which
  the economic substance doctrine
  should be applied.

Id. Further, the Treasury Department is urged to promulgate rules after enactment to implement the new provision (but without identifying the necessary parameters). As noted, there would be inadequate deterrent effect because there is no notice to taxpayers of the effects of the provision.

(5) The Senate version requires that "[A] taxpayer may rely on factors other than profit potential to demonstrate that a transaction results in a meaningful change in the taxpayer's economic position; the provision merely sets forth a minimum threshold.... If a taxpayer relies on a profit potential, however, the present value of the reasonably expected pre-tax profit must be substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected. Moreover, the profit potential must exceed a risk-free rate of return. In addition, in determining pre-tax profit, fees and other transaction expenses and foreign taxes are treated as expenses. A lessor of tangible property subject to a qualified lease shall be considered to have satisfied the profit test with respect to the leased property. For this purpose, a 'qualified lease' is a lease that satisfies the factors for advance ruling purposes as provided by the Treasury Department." S. REP. No. 108-, at 21 (2003). (Footnote 31 of the report states: "Thus a 'reasonable possibility of profit' will not be sufficient to establish that a transaction has economic substance.") The investor who is willing to assume a high risk for high return (e.g., the wildcatter oil well driller) and who is content with a reasonable possibility (as opposed to the more certain reasonable expectation) of a profit suffers an additional risk of loss through these provisions, i.e., both the risk of economic loss and the risk that the transaction will not be respected for tax purposes (and even the further risk of a 40 percent penalty). Sections 165 and 212 would not seem to impose similar constraints under current law.

Many lessors of tangible property would likely find it difficult to satisfy these requirements, inasmuch as many tax advantaged lease transactions (both those considered "good" transactions, as well as those considered to be abusive) would fail because they do not have a reasonably expected pre-tax return at least equal to a risk-free rate because cash returns are reduced through market pricing to reflect the tax benefits. The current advance ruling requirements for leveraged leases are contained in Rev. Proc. 2001-28, 2001-1 C.B. 1156, and Rev. Proc. 2001-29, 2001-1 C.B. 1160. These guidelines are not intended to fully state current law on leasing transactions; they indicate what the transaction must involve if the IRS is to issue an advance ruling on it, not what IRS will allow if the transaction is reviewed on audit. Many current leases that are otherwise acceptable would not satisfy these tests since many leases depart in material ways from the IRS ruling guidelines. For example, a lessee is often given an option to purchase leased property at a fixed price equal to or greater than the estimated fair market value of the property at the time of exercise. That practice is supported by case law, but not permitted under the guidelines. See JCX-78-02, at 6.

Further, treating foreign taxes as expenses denies the foreign tax credits otherwise allowed by the Code, and may significantly raise the profit required to satisfy the test.

(6) For example, in ACM Partnership v. Commissioner, 157 F. 3d 231 (3d Cir. 1998), aff'g, T.C. Memo 1997-115 (1997), cert. denied 526 U.S. 1107 (1999), the court looked to a part of the structures employed by the taxpayer in invalidating a marketed investment strategy. The participants in the ACM transaction were Colgate-Palmolive Company (through a special purpose subsidiary), Merrill Lynch (through a special purpose subsidiary), and ABN (a Netherlands bank, through its Curacao affiliate). The ACM partnership served as a vehicle for a "contingent instalment sale" or "CINS" transaction. Under the plan, ACM bought Citicorp notes (designed to be cash equivalents) and sold part of the notes three weeks later for cash and other notes. These new notes (the "LIBOR" notes) called for a series of payments over five years equal to an amount computed by multiplying a notional principal amount by the LIBOR rate. ACM later used the cash sale proceeds and the first instalment payment under the LIBOR notes to redeem ABN's interest in the partnership. The partnership computed its gain on the sale of the Citicorp notes on the instalment method. Under those computations, basis in the notes was spread over five years in equal annual increments, while gain was included in income primarily in the first year when 70% of the proceeds were received. Because of its 83% partnership interest, that gain was allocated principally to ABN, a non-U.S, taxpayer. In the later years, the partnership recognized losses (i.e., 30% of the proceeds were offset by 5/6ths of the basis), and those losses were allocated to Colgate as ABN had been redeemed out by that time. The losses were carried back to offset the gain recognized by Colgate on the sale of a subsidiary. The Tax Court did not accept the taxpayer arguments that hedges and other activities of the partnership in relation to the transaction served a valid business purpose. Colgate's economic substance argument was that the LIBOR notes were a hedge, but the Tax Court held that both parties were fully hedged outside the partnership. The Tax Court framed the "transaction" to be tested, not as Colgate's decision to form a partnership with an unrelated party to repurchase its debt, but as ACM's use of its cash to purchase the Citicorp notes and then immediately sell those notes for cash and contingent instalment notes. The court did not accept Colgate's characterization of the transaction as a more complicated way of repurchasing debt.

(7) JCX-78-02, at 6-8 (internal footnotes omitted) (emphasis added).

(8) 1974-1 C.B. 81.

(9) Once a penalty (regardless of whether the transaction was disclosed) has been included in the Revenue Agent Report, the penalty cannot be compromised for purposes of a settlement without the approval of the Commissioner personally or the head of the Office of Tax Shelter Analysis. Furthermore, the IRS is required to submit an annual report to Congress summarizing the application of this penalty and providing a description of each penalty compromised under this provision and the reasons for the compromise." S. REP. No. 108-, at 32-33 (2003). These requirements were obviously designed to make it difficult to waive the penalty; however, the design essentially makes it almost certain that the penalty would not be waived in a given case.

(10) These provisions are similar to Sections 302, 303, 304, 305, 315, and 316 of the Senate amendment to H.R. 2, recently passed by the Senate but dropped in conference of the bill. See Conference Report, at 38-62.

(11) Those who minimize the deterrent effect of a 20-percent penalty, averring it as merely constituting another "cost of doing business," fail to understand both the mathematics of the situation and the aversion of companies (especially publicly held companies) to having any penalty imposed.

(12) A collateral effect of the excessive pension plan penalty was to discourage taxpayers from disclosing and correcting errors for fear that the action could result in disqualification. With the advent of the employee plans compliance resolution system and its graded rewards and penalties (i.e., intermediate sanctions and penalties), taxpayers are much more willing to voluntarily disclose errors for administrative resolution.

(13) See, e.g., description at n.9 supra.