Codification of the economic substance doctrine in A.B. 1601 and S.B. 614: August 29, 2003.

On August 29, 2003, Tax Executives Institute sent the following letter to the California Senate's and Assembly's Committees on Appropriation. The letter highlights TEI's concerns in respect of codification of the economic substance doctrine and extreme penalties. The letter was prepared under the aegis of the Institute's State and Local Tax Committee, whose chair is Barbara Barton of Electronic Data Systems Corp. TEI's letter to Congress regarding the same issues-at the federal level-was enclosed; this letter is reprinted beginning on page 398 of this issue.

As president of Tax Executives Institute, I am writing to commend the recent decision to significantly modify provisions relating to codification of the economic substance doctrine in A.B. 1601 and S.B. 614. (1) TEI is the preeminent organization of business tax professionals, and our members--including more than 600 in California--had grave concerns about the initial proposals, which were modeled after pending federal legislation. While we are heartened by recent changes to sharpen the focus of the legislation, TEI continues to oppose the penalty provisions that remain in the bills.

As initially proposed, the provision in each bill codifying economic substance presented the same difficulties as the federal proposal:

* The proposal was 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.

* Current law permits taxpayers to enter transactions lacking economic substance if the resulting tax benefits were intended by Congress. The proposal seemingly made all tax benefits from transactions that lack economic substance open to challenge even where taxpayers are engaging primarily in the behavior Congress intended.

* Granting regulatory authority to clarify the above issues would only postpone the difficult decisions, would likely make tax administration more complicated, and raise troublesome tax policy issues.

* In sum, the proposal would create intolerable uncertainty that would substantially impair the ability of taxpayers to conduct ordinary business transactions.

The amended provisions, relying on current case law and adjudication of business purpose and disregarded entities, ameliorate some of these difficulties. Still troubling, however, is the draconian penalty regime in relation to tax shelter transactions, particularly the 40-percent "hammer" penalty.

TEI recently elaborated on the difficulties engendered by the federal legislation in the enclosed letter. TEI firmly believes that 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. Key to this process is the ability to identify and analyze such transactions, and TEI has consistently urged both government leaders and tax administrators to focus on disclosure-based approaches to address tax shelters.

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, including 5 in California. 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.

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 who either sell or facilitate the transactions. Nor do we represent the professional advisers 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 federal, state, and local governments, have the most at stake in trying to craft an equitable tax system that is as administrable and efficient as possible.

40-Percent Penalty Provision

Amending A.B. 1601 and S.B. 614 to delete provisions codifying the economic substance doctrine is a positive development. TEI is concerned, however, that the correlative proposal establishing a 40-percent penalty for understatements attributable to transactions lacking economic substance remains in the legislation.

We understand that proposed code section 19774, the "hammer" penalty, has been retained. TEI submits that a 40-percent penalty devoid of any administrative discretion--the non-delegable authority to compromise this penalty resides solely with the Chief Counsel of the Franchise Tax Board--is wholly misguided. 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. TEI believes that consistency and certainty in the application of penalties play a bigger role in deterring noncompliance than viscerally increasing the amount of them.

We are also concerned because a disproportionate penalty could well exacerbate taxpayer-auditor relations, prolong and disrupt the audit process, and even prove counterproductive to the provision's goals. Indeed, some field agents may refrain from delving into a transaction to avoid the punitive result otherwise exacted by the proposal. Because administrative review is essential to ensuring the fairness of a penalty regime, TEI believes substantially limiting administrative discretion is unwarranted. Additionally, doubling the already stern penalty for undisclosed transactions may effectively compel prudent taxpayers--wanting to avoid the "hammer"--to disclose myriad legitimate business transactions that are otherwise unremarkable, undermining the goal of highlighting troublesome transactions, and also greatly complicating tax administration.

TEI urges California to abandon the 40-percent penalty and invites careful consideration of the enclosed letter in respect of the other proposed penalties contained in A.B. 1601 and S.B. 614.

Conclusion

Eliminating a complex, subjective anti-abuse statutory rule in favor of relying on judicial and administrative authority to determine the economic substance of transactions is a substantial improvement to A.B. 1601 and S.B. 614. Eliminating the overly harsh 40-percent penalty would be a further improvement, which would not diminish the efficacy of the Voluntary Compliance Initiative contained the bills.

We would be happy to present our views on these subjects or have the opportunity to discuss them further. Any questions about the Institute's views should be directed to Fred F. Murray, TEI's General Counsel and Director of Tax Affairs, at 202.638.5601, or me, at 408.765.1193.

(1) Our understanding is that the provisions for a codified economic substance doctrine in these bills will be modified so that a transaction will be respected unless an entity disregarded as lacking economic substance is involved or a taxpayer does not have a valid California nontax business purpose for entering into the transaction.