Corporate tax shelter regulations: disclosure of reportable transactions.

June 5, 2000

On June 5, 2000, Tax Executives Institute submitted the following comments to the Internal Revenue Services on proposed regulations relating to the disclosure of certain "reportable transactions" under section 6011 of the Internal Revenue Code. The regulations, which were the subject of a public hearing on June 20, 2000, were issued as part of the IRS's efforts to address so- called corporate tax shelters. TEI's comments were prepared under the aegis of the Institute's Corporate Tax Shelter Task Force, whose chair is Philip G. Cohen of the New York Chapter. Mr. Cohen, who is also 1999-2000 chair of TEI's Federal Tax Committee, also represented TEI at the June 20 public hearing, as did TEI Tax Counsel Jeffery P. Rasmussen.

On February 28, 2000, the Treasury Department and Internal Revenue Service issued a plethora of guidance aimed at identifying and curbing tax-motivated transactions. Specifically, the government issued temporary and proposed rules (T.D. 8876, REG-110311-98) requiring the registration of "confidential corporate tax shelters," temporary and proposed rules (T.D. 8877, REG-103735-00) requiring taxpayers to report their participation in certain "reportable transactions," and temporary and proposed rules (T.D. 8875, REG-103736-00) requiring tax shelter promoters to maintain lists of investors in "potentially abusive shelters."(1) The rules were published in the FEDERAL REGISTER (65 Fed. Reg. 11205) and in the Internal Revenue Bulletin (2000-11 I.R.B. 747). A hearing on the temporary and proposed rules will be held on June 20, 2000. In addition to the temporary and proposed rules, the government released Rev. Rul. 2000-12 (curbing certain transactions in debt straddle instruments), Notice 2000-15 (identifying 10 categories of "listed" transactions for purposes of Temp. Reg. [sections] 1.6011-4T(b)(2) and Temp. Reg. [sections] 301.6111-2T(b)(2)), and Announcement 2000-12 (announcing the formation of the IRS Office of Tax Shelter Analysis and describing the government's overall anti-tax-shelter strategy).

Background

Tax Executives Institute is the preeminent association of business tax executives in North America. Our more than 5,000 members represent 2,800 of the leading corporations in the United States, Canada, and Europe. TEI represents a cross-section of the business community, and 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 cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which taxpayers can comply.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the package of rules released by the government to address tax-motivated transactions. TEI members know all too well that the inherent complexity and nebulous provisions of the Internal Revenue Code make drawing the line between sound tax reduction strategies, on the one hand, and tax shelters, on the other, difficult.(2) Since TEI does not represent tax shelter promoters or their advisers, our comments relate primarily to the temporary regulations under section 6011(a), relating to the requirement that corporate taxpayers file statements with their returns disclosing "reportable transactions." Thus, our comments on the registration regulations (T.D. 8876, REG-110311-98) and the investor list regulations (T.D. 8875, REG-103736-00) are limited in scope.

Overview

Under Temp. Reg. [sections] 1.6011-4T(a), every taxpayer that files a corporate tax return that has participated directly or indirectly in a reportable transaction as defined in Temp. Reg. [sections] 1.6011-4T(b) is required to attach a disclosure statement to its return for each taxable year affected by its participation in the transaction. In addition, a copy of the disclosure statement for the first taxable year for which disclosure is required must be filed with the National Office of the IRS. Under Temp. Reg. [sections] 1.6011-4T(b)(1), a reportable transaction is any transaction described in either paragraph (b)(2) or (b)(3) that meets one of the projected tax effect tests of paragraph (b)(4). The regulations define two categories of reportable transactions. The first category set forth in paragraph (b)(2) ("listed" transactions) includes transactions identified by the Treasury and IRS as "tax avoidance" transactions. The second category in paragraph (b)(3) ("other reportable transactions") includes transactions warranting scrutiny because they possess at least two of six characteristics or factors deemed common in corporate tax shelters.

Tax Executives Institute has consistently said that the proper approach to addressing corporate tax shelter transactions is to enhance tax return disclosures. By identifying and targeting the indicia of transactions that are characteristic of "confidential corporate tax shelters" and requiring enhanced disclosure of such transactions, the IRS can properly focus its examination resources on questionable transactions. Hence, we commend the government for taking the steps necessary to effectuate the tax shelter registration rules of section 6111 that Congress authorized in the Taxpayer Relief Act of 1997. In addition, we commend the Treasury and IRS for their creative use of section 6011, the general rules governing the filing of returns and statements, to craft new disclosure rules compelling taxpayers to highlight transactions that the government may wish to scrutinize. Moreover, we commend the government for largely eschewing pejorative labels in setting forth the new disclosure requirements. References to "listed" and "reportable" transactions are less likely to taint the examination process than references to "confidential tax shelters" or "potentially abusive tax shelters."(3)

Notwithstanding TEI's support in principle for administrative rules to assist taxpayers in disclosing transactions that the IRS may wish to examine, we believe the temporary rules depend in too many cases on vague and nebulous terms. Moreover, even without the added uncertainty of vague terminology, the regulations are overbroad. Specifically, whereas the scope of "listed transactions" that must be disclosed under Temp. Reg. [sections] 1.6011-4T(b)(2), as supplemented by Notice 2000-15, is reasonably concise, the definition of "other reportable transactions"-- i.e., those meeting the two-of-six factor test of Temp. Reg. [sections] 1.6011-4T(b)(3) -- is excessively broad. Moreover, the exceptions to disclosure under the regulations are too narrow to provide meaningful relief for taxpayers and guard against over-disclosure. Hence, we believe the disclosure rules may well sweep in many ordinary transactions, compelling disclosure of more transactions than the IRS's Office of Tax Shelter Analysis can timely review, analyze, and provide beneficial guidance for.

More specific comments elaborating about the overbroad triggers for the required disclosures, and the attendant uncertainty thereby engendered for compliant taxpayers, follow. TEI's overarching concern with these regulations is the potential they pose for paralyzing the day-to-day administration and resolution of cases. Where a taxpayer discloses one or more transactions under these rules, examining agents may likely feel compelled to examine every aspect of the transactions and emboldened to challenge them. Notwithstanding the helpful statement in Temp. Reg. [sections] 1.6011- 4T(a) that filing a disclosure statement for a reportable transaction does not affect the legal determination whether the benefits claimed are allowable, the visceral reaction of revenue agents may regrettably be to set up a high-profile issue and let someone "higher up" decide whether the benefits are allowable. Moreover, it is unclear who -- case managers, territory managers, Directors of Field Operations, officials in the Office of Tax Shelter Analysis, Appeals, Counsel, et al. -- will judge the legitimacy of the disclosed transactions. If each is to play a role in the decision-making process, the questions become how quickly and how judiciously the IRS, or the Treasury Department, will respond. In our view, it is unclear whether the OTSA (or the Large & Mid-Size Business Division) will have the resources or expertise to routinely inject itself into all large-case examinations involving disclosures under these regulations. The high-profile and sensitive nature of the issues, however, may necessitate an active, hands-on response. If that is the case, it is imperative that the regulations be revised to circumscribe the number of required disclosures -- especially if the government intends to enact legislation revising the penalty standards for nondisclosure of reportable transactions.

Definition of Reportable Transaction

Under Temp. Reg. [sections] 1.6011-4T(b)(1), the term "transaction" "includes all of the factual elements necessary to support the tax benefits that are expected to be claimed with respect to any entity, plan, or arrangement, and includes any series of related steps carried out as part of a prearranged plan and any series of substantially similar transactions entered into in the same taxable year." With the exception of the italicized language in the foregoing quotation, the definition of "transaction" in Temp. Reg. [sections] 1.6011-4T(b)(1) is identical to the definition of "transaction" in Temp. Reg. [sections] 301.6111-2T(a)(3) for purposes of defining a "confidential corporate tax shelter" transaction. TEI questions whether the italicized language adds anything to the definition. If a transaction involves "a series of substantially similar transactions" it would seem to constitute a "reportable transaction" in its own right. We recommend that the IRS delete the italicized language or add an example explaining it.

In addition, there is some uncertainty about the meaning of the phrase "series of related steps carried out as a part of a pre-arranged plan." The drafters presumably intend the phrase to encompass one or more variations of the step-transaction doctrine, especially the decisions that address transactions where the result is essentially "wired" from the first step to the last in a series of interdependent and contractually agreed steps. Where there are independent, intervening steps that are not agreed at the outset, however, -- or there are steps that require subsequent, independent arm's length negotiations or involve transactions with independent legal or economic effects -- then the authority and scope of the regulation are questionable.(4) Hence, we recommend that the IRS clarify the scope of the "prearranged plan" rule. Otherwise, revenue agents will operate with hindsight to argue that whatever events and transactions subsequently transpire were part of a "pre-arranged plan."

Listed Transactions

Under Temp. Reg. [sections] 1.6011-4T(b)(2), a transaction is a "listed transaction" if the transaction is the same as or substantially similar to one of the types of transactions that the IRS has determined to be an avoidance transaction identified by notice, regulation, or other form of public guidance as a listed transaction for purposes of section 6011. Coincident with the publication of the temporary regulations, the IRS issued Notice 2000-15, identifying 10 listed transactions that must be disclosed if the transaction affects the taxpayer's liability in a tax return filed after February 28, 2000. Except for the inherent difficulty of determining what transactions are "substantially similar" to the listed transactions, TEI believes the concept of requiring disclosure for specifically identified transactions is workable. That approach remains sound, however, only if the IRS updates the list of tax avoidance transactions on a timely basis.

"Other" Reportable Transactions

In addition to reporting "listed transactions," taxpayers must report transactions where two or more of six characteristics or factors set forth in subparagraphs (A) through (F) of Temp. Reg. [sections] 1.6011-4T(b)(3)(i) are present. The preamble notes that the identified characteristics are common in corporate tax shelters and, hence, warrant scrutiny.

a. Book/Tax Difference Exceeding Certain Dollar Thresholds

Temp. Reg. [sections] 1.6011-4T(b)(3)(D) states that one characteristic that will, when present in combination with one other characteristic, require disclosure of the transaction is that

   [t]he expected treatment of the transaction for Federal income tax purposes
   in any taxable year differs or is expected to differ by more than $5
   million dollars 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 corporate income tax return
   for the same period.

Regrettably, the Internal Revenue Code is replete with provisions creating book/tax accounting differences. Hence, it is somewhat a paradox that the more scrupulous taxpayers are in complying with the underlying tax law (in reporting those book/ tax differences), the greater the likelihood of having to file an additional disclosure statement. Corporations that participate in the IRS's Coordinated Examination Program (CEP) generally disclose hundreds of Schedule M items on their returns and the difference in the book and tax amount frequently exceeds $5 million.(5) As a result, we believe the two-of-six-factor test of Temp. Reg. [sections] 1.6011-4T(b)(3) will in practice likely become a one-in-five-factor test. That is to say, the book/tax difference test will almost invariably be satisfied.(6) If this factor is to be retained as a characteristic, the IRS should consider revising the standard for "other reportable" transactions to require two-of-five characteristics, plus the requisite book-tax difference.(7) Alternatively, in order to focus the IRS's examination resources on truly large corporate transactions, we recommend increasing the dollar threshold to at least $10 million. Finally, if the current dollar threshold and two-of-six-factor test are retained, the IRS should consider focusing on requiring disclosure only for permanent book and tax accounting differences rather than requiring an additional disclosure of all differences (including timing).

b. Expected Foreign and U.S. "Characterization" of Transaction Differ

According to Temp. Reg. [sections] 1.6011-4T(b)(3)(F), another characteristic that warrants scrutiny is present where "[t]he expected characterization of any significant aspect of the transaction for Federal income tax purposes differs from the expected characterization of such aspect of the transaction for purposes of taxation of any party to the transaction in another country." The meaning of "expected characterization" of a transaction is undefined. Presumably, the drafters have in mind the tax attributes of timing, character, source, and amount of a transaction, but that is far from clear. We recommend that the regulations be clarified.

Even with that clarification, the question remains how to determine what a "significant aspect" of a transaction is. For example, is a "significant aspect" of a transaction a difference in legal interpretation or effect? Is a "significant aspect" measured in quantifiable terms, for example, on the basis of gross income, pre-tax profit, the overall tax cost, a comparison of the pre-tax profit from a transaction to the tax benefits of the transaction (as in the Temp. Reg. [sections] 301.6111-2T(b)(3)), or on some other basis? Where there are alternative forms of structuring the same transaction, all of which have the same U.S. tax effect but differing foreign tax consequences (for example, as a result of the use of a hybrid entity), is the use of such a hybrid entity itself a "significant aspect"?

In many cases, large intercompany transactions in multinational corporate groups will result automatically in a "reportable transaction" because (i) there is likely a significant book/tax difference in excess of $5 million and (ii) there is very likely a difference in the foreign and U.S. tax treatment of some "significant aspect" of the transaction. For example, any transaction involving a check-the-box hybrid (or reverse hybrid) entity could result in a different U.S. and foreign country tax treatment. Other frequently recurring transactions that may well be swept automatically into the net of reportable transactions include:

   * Redemptions of shares of a controlled foreign corporation, considered a
   distribution of earnings and profits under U.S. rules but a sale or
   exchange under the foreign country rules. (The foreign country may or may
   not tax the transaction.)

   * A dividend fully taxable under U.S. rules but treated as a nontaxable
   repatriation of exempt surplus under foreign country rules.

   * Payments of "interest" on intercompany "loans" treated as debt under U.S.
   rules and equity under foreign country rules.

The foregoing examples illustrate that the vagueness of this characteristic will likely compel disclosure of many more transactions than necessary (or manageable by either taxpayers or the IRS). At a minimum, we recommend that the government clarify these rules. More properly, we believe the government should, in light of the controversy surrounding Notice 98-11 and the proper role and scope of the Subpart F rules, consider deleting this characteristic or revising it to confirm that saving foreign taxes through asymmetries between foreign and U.S. tax laws does not make the transaction a reportable transaction for U.S. tax purposes.

c. Participants with Different Tax Posture

Under Temp. Reg. [sections] 1.6011-4T(b)(3)(i)(E), another characteristic of a reportable transaction is "the participation of a person that the taxpayer knows or 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 a foreign person)" and the taxpayer knows or has reason to know that the participation is necessary to permit the transaction to be structured to confer the tax benefits on the taxpayer.

To provide meaningful guidance, this characteristic requires elaboration. For example, how is the taxpayer to determine whether the counterparty's tax position and participation in the transaction are pivotal in effecting the advantageous tax result for the taxpayer? The status of the counterparty as a foreign person or tax exempt entity does not automatically mean that the taxpayer will obtain a tax benefit from the other parties' participation. For example, foreign persons may be subject to U.S. tax on effectively connected income and tax-exempt entities are subject to unrelated business income tax. To illustrate the issues and concerns further, assume that a "tax-indifferent" party participates in the taxpayer's transaction and that participation has two effects: a lower overall federal tax bill on the transaction (when compared with the participation of an alternative counterparty) and a lower overall non-tax cost of the transaction. Is the presence of the economic savings a sufficient business purpose to employ the tax-indifferent party? Or must the tax benefits be compared with the lower overall non-tax transaction costs? If the tax and non-tax benefits must be compared, is there some ratio or amount by which the non-tax benefits must exceed the tax benefits?

To be sure, the purpose of the temporary rule seems clear in the context of a classic tax shelter transaction where the promoter makes its pitch in a series of slides, laying out the roles and tax status of each party and how that tax status drives the result in a tax-motivated product. In the context of an arm's-length agreement between the taxpayer and a counterparty, however, the effects of the counterparty's tax status and the corresponding obligation on the taxpayer to disclose a transaction become less manifest. For example, U.S. corporate taxpayers frequently have differing tax attributes and, hence, in the course of negotiating a transaction may discover a means to structure a transaction that provides tax benefits to both parties. The ordinary course exception for the acquisition, disposition, or recapitalization of a business recognizes this possibility and exempts such transactions from additional disclosures. There are likely other forms of directly negotiated transactions that do not involve promoters and hence should not require disclosure (or registration or maintenance of investor lists for that matter). We urge the government to provide additional examples.

d. Confidentiality as a Characteristic

Under Temp. Reg. [sections] 1.6011-4T(b)(3)(i)(A), a taxpayer that enters a transaction under conditions of confidentiality, as defined in Temp. Reg. [sections] 1.6111-2T(c), satisfies one of the characteristics. This characteristic will be satisfied in many ordinary course transactions. For example, before negotiating a significant business transaction, taxpayers often sign "mutual nondisclosure agreements." To avoid sweeping in myriad such transactions, the regulations should be narrowed. Where there is no "promoter" working for a fee, the regulations should not compel companies to choose between maximizing protection of intellectual property (i.e., the structure of the transaction between the two companies) and the risk of exposure to the tax disclosure regime.

e. Fee Threshold as a Characteristic

Under Temp. Reg. [sections] 1.6011-4T(b)(3)(i)(C), one characteristic of a reportable transaction is that the taxpayer's participation in the transaction is promoted, solicited, or recommended by persons who will receive fees in excess of $100,000, and "such persons' entitlement to such fees or other consideration was contingent on the taxpayer's participation in the transaction." The rule is seemingly derived from the amendments to section 6111(d), relating to the registration of a confidential corporate tax shelter. Read literally, the rule applies wherever an outside adviser receives a fee of more than $100,000, the adviser recommends a course of action, and the entitlement to the fees is contingent on the taxpayer's participating in the transaction. Thus, the rule encompasses advice or recommendations from an external tax adviser where the fee paid exceeds $100,000, even where the advice or recommendations promote compliance. Arguably too, the rule applies to transfer-pricing or cost-sharing documentation studies, E&P studies, and investment basis studies that assist the taxpayer in reporting its proper tax liabilities. We doubt such a broad rule is intended and recommend that the regulation be narrowed to circumstances where the receipt of the fees is contingent on the taxpayer achieving a specific tax result or a specific dollar threshold of tax benefits from the transaction.

Moreover, we note that the relatively low fee threshold, when combined with conditions of confidentiality -- and nearly all tax planning is undertaken under conditions of confidentiality -- means that any transaction satisfying the projected tax effect test will be automatically subject to disclosure.(8)

f. Number of Characteristics Present Irrelevant to Tax Treatment

Temp. Reg. [sections] 6011-4T(a) states that "[t]he fact that a taxpayer files a disclosure statement for a reportable transaction shall not affect the legal determination whether the tax benefits claimed with respect to the transaction are allowable." TEI commends the IRS for including the statement in the regulations. We regret, however, that "listed" transactions are presumed to be "tax avoidance" or "tax shelter" transactions for purposes of the temporary rules relating to registration and investor list maintenance. Scrutiny of such transactions will likely be heightened because of the loaded terms used in the related regulations. TEI is concerned that agents will presume that the "tax avoidance" assumption inherent in listed transactions also inheres in transactions possessing two or more of the characteristics that trigger disclosure. Hence, we recommend that the IRS reinforce the message that disclosure of "other reportable transactions" is independent of the determination whether the tax benefits are allowable. Specifically, Temp. Reg. [sections] 1.6011-4T(b)(i) should be revised to include a statement that: the mere presence of two or more characteristics in a reportable transaction shall not affect the determination whether the tax benefits claimed with respect to the transaction are allowable. Similarly, the presence of multiple characteristics should not create a presumption that the tax benefits are disallowed. Whereas an increasing number of characteristics may be cause for heightened scrutiny, they should not, by themselves, be evidence that the tax benefits should be disallowed. We also urge the IRS to emphasize in its training manuals that the determination of the benefits of a transaction is independent of disclosure.

Exceptions to Reportable Transactions

Under Temp. Reg. [sections] 1.6011-4T(b)(3)(ii), a transaction that possesses two or more of the factors triggering disclosure is not reportable if it satisfies one of four enumerated exceptions. Two of the exceptions relate to transactions undertaken in the "ordinary course of business"; one exception is for transactions where there is "no reasonable basis under Federal tax law for denial of any significant portion of the tax benefits"; and the fourth exception is for transactions identified in published guidance.

a. Ordinary Course Transactions -- General

Under Temp. Reg. [sections] 1.6011-4T(b)(3)(ii)(A), a taxpayer is not obligated to report a transaction where it participates in the transaction "in the ordinary course of its 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 Federal income tax benefits." An exception for transactions in the ordinary course is clearly necessary in order to minimize reporting burdens on taxpayers and minimize the number of disclosures the government must review. Hence, we commend the government for promulgating the "ordinary course" exceptions.

Regrettably, in their current form the exceptions are too narrow and vague to stanch the torrent of disclosures resulting from overinclusive reporting rules. For example, why is it necessary for a taxpayer to demonstrate that a transaction is undertaken in the ordinary course of its historic business practices? If a transaction (say, factoring receivables) otherwise adheres to customary commercial practices, it should not be subject to a heightened disclosure requirement simply because the transaction is novel when viewed from the perspective of the taxpayer's historic business practices.(9) Taxpayers are seemingly precluded from availing themselves of the ordinary course exception for any transaction that represents a change in its business practices, even where the business transactions must be structured to take account of the taxpayer's tax characteristics and attributes. For example, a taxpayer consistently paying alternative minimum tax might decide to change its business practices and lease capital equipment rather than purchase it. The lease rentals could be structured to permit the taxpayer to use accumulated AMT credits. Absent the regulations, the change in business practices would involve tax planning for transactions that the taxpayer would report, but not separately disclose, in its tax return. We do not believe the regulations intend to make the transactions "other reportable transactions," but the regulations suggest that cautious taxpayers should treat any tax planning idea as a potentially reportable transaction.

TEI believes the ordinary course exceptions will likely prove less salutary than the regulation drafters envisioned. Under the ordinary course exception the onus is on the taxpayer to demonstrate that it would have entered into the transaction irrespective of the tax benefits. In nearly all commercial transactions, however, tax benefits are routinely considered. This is especially so where the tax benefits accruing to one or both parties affect the price of an ordinary commercial transaction between them (e.g., leases or other financing transactions and allocations of purchase price). At a minimum, the regulations should permit taxpayers to make financial projections of their ordinary commercial transactions employing assumed tax rates applicable to the income and deductions. The mere use of tax rates and tax-planning assumptions should not be deemed to run afoul of the requirement that the transaction be undertaken "irrespective" of the tax benefits. More broadly, absent unusual facts and circumstances that arise in connection with, or as part of a series of related transactions as the "reportable transaction," a transaction that otherwise comports with customary commercial practice should be accorded a presumption as being in the ordinary course.

b. Ordinary Course Transactions -- Long-Standing and Generally Accepted Understanding of Federal Tax Benefits

Under Temp. Reg. [sections] 1.6011-4T(b)(3)(ii)(B), a transaction is not considered a reportable transaction where the taxpayer participates in the transaction --

   in the ordinary course of business in a form consistent with customary
   commercial practice, and the taxpayer reasonably determines that there is a
   long-standing and generally accepted understanding that the expected
   Federal income tax benefits from the transaction (taking into account any
   combination of intended tax consequences) are allowable under the Internal
   Revenue Code (Code) for substantially similar transactions. (Emphasis
   added.)

While the exception is well-intended, it raises perhaps more questions than it answers. Specifically, the requirement that a tax benefit be "long-standing" to be allowable is a novel -- even pernicious -- concept without support in the Code or the regulations. The legitimacy of the tax benefits of a transaction are independent of the length of time that a transaction structure is available. For example, the first taxpayer to enter into a leveraged lease transaction -- a transaction that Example 3 of Temp. Reg. [sections] 1.6011-4T(b)(5) confirms is sufficiently "long-standing" to warrant the use of the exception -- would not have been able to avail itself of the exception, even though an analysis of the transaction demonstrated that the federal tax benefits of depreciation deductions, etc., should be accorded the transaction. Indeed, any time Congress enacts a new corporate tax incentive, deduction, or exclusion (e.g., the credit for increasing research activities or the deduction under section 170 of the Code for amounts in excess of basis on contributions of certain inventory property), a question will arise whether a tax benefit is "long-standing." Moreover, the scope of many tax provisions is frequently an issue for years. Indeed, it is ironic that the IRS should propose such a test when agents continue to distend the INDOPCO decision and challenge the "long-standing" and "generally accepted understanding" of the tax treatment of many taxpayer deductions for ordinary and necessary business expenses. In its current formulation, this exception to disclosure suggests that the IRS believes that novel tax planning for "ordinary course transactions" that meets the requisite projected tax effect of Temp. Reg. [sections] 1.6011-4T(b)(4) must be disclosed to the IRS for scrutiny. We disagree and urge the IRS to eliminate the reference to "long-standing" tax benefits from Temp. Reg. [sections] 1.6011-4T(b)(3)(ii)(B).

Equally troubling is the regulation's notion that tax benefits are allowable only where a generally accepted understanding exists. The test injects a subjective element into otherwise objective (albeit vague) transactional characteristics. Specifically, whose understanding of the tax benefits is considered generally accepted? The taxpayer's? The revenue agent's? The IRS Office of Tax Shelter Analysis's? TEI believes the exception will, at best, prove problematic to administer and, at worst, be impossible to apply to either novel facts and circumstances or novel legislation, regulations, or rulings. We recommend that the IRS delete the requirement that the taxpayer "reasonably determine[] ... that there is a `generally accepted understanding' [of] the expected Federal income tax benefits from the transaction...."

c. No Reasonable Basis for the IRS to Deny the Tax Benefit

Under Temp. Reg. [sections] 1.6011-4T(b)(ii)(3), a transaction is subject to disclosure as an other reportable transaction unless "the taxpayer reasonably determines that there is no reasonable basis under Federal tax law for denial of any significant portion of the expected Federal income tax benefits from the transaction." (Emphasis added.) The determination must be based on the entirety of the transaction and not on unreasonable or unrealistic factual assumptions. Stated differently, taxpayers would be precluded from employing the ordinary course of business exception to omit disclosure of otherwise reportable transactions wherever a revenue agent can raise a merely "colorable" claim or argument that the federal tax benefit should be denied. Under current standards for issuing opinions, many commentators believe that the temporary rule would in effect require taxpayers to obtain a "will" opinion from outside advisers in order to come within the scope of this exception.(10) TEI believes that the "no reasonable basis" requirement sets the bar unreasonably high. Indeed, the practical effect of the standard is to require disclosure of nearly all tax planning transactions where the tax treatment is less than absolutely certain. TEI recommends that the regulation be revised to comport more closely with the current rules governing disclosure of transactions or positions in order to avoid substantial understatement penalties under section 6662. Specifically, where a taxpayer concludes that there is not substantial authority (commonly understood to be a 40-per-cent chance of prevailing on the merits) that its tax position will be denied, it should not be required to disclose a transaction under these regulations. Unless the temporary rules' standard for disclosure is revised, the IRS will likely receive a substantial, even overwhelming, number of disclosures for routine expenditures and transactions.

d. Published List of Excepted Transactions

Temp. Reg. [sections] 1.6011-T(b)(3)(ii)(D) states that transactions identified in published guidance are excepted from disclosure under the regulations. We recommend that the IRS use this exception quickly to assure taxpayers that ordinary tax planning is, indeed, acceptable.

Current Treas. Reg. [sections] 1.6662-4(g)(2)(ii) provides support for carving out routine tax planning by excluding from the definition of a tax shelter item, items --

   if the entity, plan or arrangement has as its purpose the claiming of
   exclusion from income, accelerated deductions or other tax benefits in a
   manner consistent with the statute and Congressional purpose. For example,
   an entity, plan or arrangement does not have as its principal purpose the
   avoidance or evasion of Federal income tax as a result of the following
   uses of tax benefits provided by the Internal Revenue Code: the purchasing
   or holding of an obligation bearing interest that is excluded from income
   under section 103; taking an accelerated depreciation allowance under
   section 168; taking the percentage depletion allowance under section 613 or
   section 613A; deducting intangible drilling costs as expenses under section
   263(c); establishing a qualified retirement plan under sections 401-409;
   claiming the possessions tax credit under section 936; or claiming tax
   benefits available by reason of an election under section 992 to be taxed
   as a domestic international sales corporation ("DISC"), under section
   927(f)(1) to be taxed as a foreign sales corporation ("FSC"), or under
   section 1362 to be taxed as an S corporation.

In enacting the 1997 amendments on confidential corporate tax shelters, Congress expressed no dissatisfaction with these common-sense regulations. Hence, TEI urges the IRS and Treasury to publish, and frequently update, a list of transactions excepted from disclosure pursuant to Temp. Reg. [sections] 1.6011-4T(b)(3)(ii)(D). This will be especially important if the ordinary course of business exceptions of Temp. Reg. [subsections] 1.6011-4T(b)(3)(ii)(A) and (B) are not revised.

In addition to the examples already listed in Treas. Reg. [sections] 1.6662-4(g)(2)(ii), the regulations or notices should, at a minimum, include the following additional list of examples:(11) using low- income housing tax credits, preservation credits, and energy credits; using three parties in a like-kind exchange; deferring service income under Rev. Proc. 71-21; deferring advance payments for goods under Treas. Reg. [sections] 1.451-5; using a flow-through entity under the check-the-box regime; structuring a transaction to qualify as a tax-free reorganization under Subchapter C; using stock options to provide non-cash compensation, using intercompany loans between foreign affiliates; using studies to identify potentially overlooked tax benefits in areas such as research and experimentation, cost segregation, and FSC transaction-by-transaction pricing calculations. So long as an underlying business transaction serves a business purpose, the use of a tax reduction technique should not reflexively transform a transaction into a reportable transaction.(12)

Finally, the regulations should confirm that the reduction of non-federal taxes remains a legitimate business purpose. For example, under the corporate reorganization provisions, the reduction of non-federal (e.g., state) is a valid business purpose. Treas. Reg. [sections] 1.355-2(b)(2). Similarly, this valid purpose extends to foreign taxes. See Rev. Rul. 89-101, 1989-2 C.B. 67.

Penalties

The temporary regulations do not propose (and perhaps under the Code, the government cannot propose) new penalties to enforce the enhanced disclosure regulations. We agree with that approach. Before crafting new or additional penalties, the government should determine whether the new disclosure rules are having the intended effect on taxpayer behavior. Indeed, given the vague scope of the regulations, the large number of undefined and untested terms, and the excessive scope of transactions likely caught by the expansive rules, the IRS may wish to fine tune its information requirements before revising the penalty standards.

Even though the temporary regulations on disclosure of transactions do not prescribe penalties, the preamble states that, in the event an underpayment is attributable to a reportable transaction and the taxpayer fails to satisfy the disclosure requirements, the nondisclosure may affect the taxpayer's exposure to penalties under sections 6662 and 6663 of the Code because its failure to disclose may affect whether the taxpayer acted in good faith for purposes of the reasonable cause exception of section 6664. In the next paragraph, the preamble states that "the fact that a professional tax advisor has advised the taxpayer that its return position is more likely than not the proper tax treatment is not necessarily sufficient to satisfy the requirements of section 6664(c)(1)." Thus, nondisclosure of a reportable transaction -- even with a "more likely than not" opinion from a reputable tax adviser -- may not, according to the preamble, shield a taxpayer from penalties, "even if the taxpayer's return position has sufficient legal justification to meet the minimum requirements of section 6664(c)(1). In such a case, the determination of whether a taxpayer has acted in `good faith' will depend on all the facts and circumstances, including the reason ... why the taxpayer failed to make the required disclosure." If the IRS believes that a "more likely than not" opinion issued by a reputable tax adviser and based on all the facts and circumstances is, or should be, insufficient to accord taxpayers penalty protection under section 6664(c) and the applicable regulations, we recommend that those regulations be explicitly revised. To effect a change in such a sensitive area through a preamble is not sufficient notice to taxpayers reading the penalty and reasonable cause regulations under sections 6662 through 6664. At a minimum, Treas. Reg. [subsections] 1.6664(b)(1), (c), and (e) should be amended to include cross references, thereby alerting taxpayers that compliance with the new disclosure requirements is a factor affecting the determination of the taxpayer's good faith reliance on a legal opinion that satisfies the minimum legal justification.

Conclusion

Tax Executives Institute appreciates this opportunity to present its views on the temporary and proposed regulations issued under section 6011, relating to disclosure of certain "listed" transactions and "other reportable transactions. The Institute's comments were prepared under the aegis of its Federal Tax Committee, whose chair is Philip G. Cohen. If you have any questions, please do not hesitate to call Mr. Cohen at [phone], or Jeffery P. Rasmussen of the Institute's professional staff at [phone].

(1) For convenience' sake, the temporary and proposed rules will hereinafter be referred to as the temporary rules or temporary regulations and cited as Temp. Reg. [sections].

(2) Subsequent to the amendment of sections 6662(d)(2)(C)(iii) and 6111(d)(1) by the Taxpayer Relief Act of 1997, TEI submitted pre-regulation comments in November 1998 on the definition of a corporate tax shelter. The comments were impelled by TEI's concerns about the change in the definition of a "tax shelter." Prior to the 1997 amendments, a tax shelter involved any partnership or other entity, any investment plan or arrangement, or any other plan or arrangement if a principal purpose of the plan or arrangement was the avoidance or evasion of tax. The amendment changed the test from a principal purpose of tax avoidance or evasion to a significant purpose -- a substantially lesser threshold that unavoidably infringes on day-to-day tax planning in a corporate tax department.

(3) In order to be consistent, however, the title of T.D. 8877 and REG-103735-00 should be changed from "Tax Shelter" Disclosure Statements to "Required" Disclosure Statements. Of more concern is that the disclosure rules are so closely integrated with the confidential corporate tax shelter regulations and the investor list regulations for potentially abusive tax shelter transactions that the value-laden labels of those regulations -- and the baggage of assumptions that accompany those labels -- will tend to diminish the critical analysis necessary to distinguish between proper and improper transactions. The Office of Tax Shelter Analysis (OTSA) will provide the expertise that the field may lack, but without more concise definitions of the transactional characteristics that trigger disclosure, the OTSA's resources may be overwhelmed by voluminous disclosures, thereby leading to a backlog of cases and guidance.

(4) For example, in the Mobil-Esmark transaction that underlies the decision in Esmark, Inc. v. Commissioner, 90 T.C. 171 (1988), aff'd, 886 F. 2d 1318 (7th Cir. 1989), a series of steps were each held to have independent legal and economic significance. The IRS's attempt to collapse the steps was rejected. Would the Mobil-Esmark transaction be considered to fall within these rules?

(5) For frequently recurring items or multiple items of a specific type reflected in a single account, it is unclear whether the $5 million book/tax threshold is to be measured on a per-item (transactional) basis or as an aggregate of all similar items. Consider depreciation. Assume that the taxpayer's depreciation expense arises from two large pieces of equipment and a host of much smaller equipment items. Assume further that one of the two large pieces of equipment produces a $6 million book/tax difference in depreciation expense and the other produces a $5 million book/tax difference. In addition, the aggregate book/tax depreciation difference arising from all other equipment is more than $5 million. How many "reportable transactions" are there if, say, the taxpayer were to engage in multiple lease stripping transactions involving its depreciable equipment? Are the taxpayer's historical financial and tax reporting practices relevant in determining the number of transactions possessing the tainted characteristic? Taxpayer practices in respect of aggregating (or disaggregating) financial accounts or items in the preparation of Schedule M-1 are not uniform. Hence, the same transaction in the same amount reported on different taxpayer returns could trigger different disclosure requirements.

(6) Under the projected tax effect test of Temp. Reg. [sections] 1.6011-4T(b)(4), a transaction that meets the two-of-six- factor test is not subject to disclosure unless the transaction reduces taxes by more than $5 million in a single year or by more than $10 million in multiple years. For large corporations, transactions (including many routine deductions) that satisfy the projected tax test will nearly always satisfy the dollar threshold for the book/ tax accounting treatment characteristic. In effect, a $14.3 million Schedule M-1 item decreasing taxable income is all that is required to satisfy the projected tax effect test. Hence, we believe that many Schedule M items will automatically require disclosure and the two-of-six-factor test is more akin to a one-in-five test.

(7) There are other issues relating the book/ tax difference characteristic and taxpayer reporting practices as well. For example, while the characteristic is not limited to transactions that "reduce" taxable income, the projected tax effect test will likely eliminate the requirement to report transactions giving rise to the taxable income in excess of book income. In some transactions, however, there may be book/tax differences that increase taxable income and others that produce a decrease. Should the taxpayer "net" the differences? That practice would not seem in keeping with the notion of "full disclosure." Indeed, netting items that arise from the same transaction -- even though integrally related -- may violate the projected tax effect test. On the other hand, where in the regulations is the taxpayer accorded the "offset" for timing differences that reverse and increase taxable income? The projected tax effect test seemingly has the effect of cherry-picking those aspects of a transaction that produce a tax benefit and ignoring those that produce a tax detriment.

(8) The investor list regulations are even broader. Since there is no minimum fee threshold under Temp. Reg. [sections] 301.6112-1T, external tax advisers seemingly must maintain a "list" of all communications with clients wherever a tax planning idea is discussed that the IRS may challenge. In this respect, we believe the investor list regulations should be narrowed substantially. Otherwise, the regulations will inhibit taxpayers from seeking advice from outside counsel, which would be counterproductive to compliance.

(9) The ordinary course exception of Temp. Reg. [sections] 1.6011-4T(b)(3)(ii)(B) is formulated slightly differently, but includes identical introductory language. Hence, the same question as discussed in the text arises under that rule: How closely must a transaction comport with the taxpayer's historic business practices in order to qualify for the exception to disclosure?

(10) Under some formulations, this means the taxpayer must obtain an opinion that there is a greater than 80- percent likelihood that the tax benefits of the transaction will be sustained. If, contrary to TEI's recommendation, the "no reasonable basis" requirement is retained, the regulations should, at a minimum, clarify the scope of the opinion that taxpayers must obtain from counsel in order to satisfy that standard. Some commentators believe a strong "should" opinion will be sufficient to satisfy the "no reasonable basis" standard while others suggest that a "will" opinion is necessary. We urge the IRS to clarify the requisite opinion standard.

(11) TEI's list is illustrative and by no means comprehensive. TEI would be pleased to work with the IRS to develop a list of examples that could be incorporated in the regulations or in a Notice.

(12) For example, a sale or exchange of an asset to recognize an economically accrued loss sustained in a non- tax-motivated transaction should qualify.