Disclosure of confidential transactions: August 8, 2003.

On August 8, 2003, Tax Executives Institute filed comments with the Treasury Department and the IRS urging the government to narrow the scope of the confidential transactions category of reportable transaction regulations. The comments were prepared under the aegis of TEI's Federal Tax Committee whose 2002-2003 chair was Mitchell S. Trager of GeorgiaPacific Corporation. Contributing substantially to the development of TEI's comments were William J. Sample of Microsoft Corporation and Robert M. Gordon of BP America, Inc. Also contributing were Alice A. Smith of Eaton Corporation, David F. Nitschke of Amerada Hess Corporation, and Neil D. Traubenberg of Storage Technology Corp. Mr. Traubenberg is the 2003-2004 chair of TEI's Federal Tax Committee.

On behalf of Tax Executives Institute (TEI), I am pleased to submit the following comments on the disclosure of confidential transactions under the reportable transaction regulations. Final regulations requiring disclosure of a taxpayer's participation in reportable transactions were issued on February 27, 2003. In public remarks since the rules were issued, Treasury Department and IRS officials have expressed willingness to modify Treas. Reg. [section] 1.6011-4 to sharpen and, to the extent possible without undermining their purpose, narrow their focus to better target disclosure of abusive transactions.

We believe the confidential transaction regulations would be improved by adopting one or more of the following approaches:

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

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

* Issuing a revenue procedure to carve out specific types of nondisclosure agreements (NDAs) from the confidential transaction category of the reportable transaction regulations.

The first two recommendations provide general rules for narrowing the scope of the definition of reportable confidential transactions. The "angel list" approach described in the third bullet point would also narrow the scope of taxpayer reporting obligations, but more comprehensive rules will be easier and more efficient for taxpayers and the IRS to apply. An "angel list" would be useful either as a supplement to TEI's suggested comprehensive revisions or, if broader rules limiting unnecessary reporting cannot be formulated, as an alternative approach to eliminate disclosure of many routine day-to-day transactions.

In addition, we recommend:

* Changing the time at which the disclosure of merger and acquisition (M&A) agreements must be permitted by eliminating the "earlier of three events" rule of Treas. Reg. [section] 1.6011-4(b)(3)(ii)(B) and substituting a rule that permits taxpayers to disclose an M&A transaction "no later than 30 days following consummation of such a transaction."

* Revising the definition of confidential transactions to eliminate transactions entered into by controlled foreign corporations (CFCs) for the purpose of reducing foreign or state and local taxes.

Background

Tax Executives Institute is the preeminent association of business tax executives in North America. Our more than 5,300 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.

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 laws, and to the adoption of sound 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, TEI members agree that a balance must be struck between public duty and private right.

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 of the Internal Revenue Code makes drawing the line between sound tax reduction strategies, on the one hand, and "tax shelters," on the other, difficult.

The regulations released on February 27, 2003, finalize temporary and proposed disclosure regulations released in October 2002. In our view, the final disclosure regulations will--as TEI noted in respect of the temporary and proposed regulations--cause the reporting of substantially more transactions than necessary. The overbroad nature of the disclosure regulations as a whole--and the confidential transaction category in particular--remains our principal concern. These comments, which relate solely to the confidential transaction category of reportable transactions, elaborate on the comments in our submission of January 28, 2003, relating to the temporary and proposed regulations.

Overview

Final regulations requiring disclosure of a taxpayer's participation in certain "reportable transactions" (the "disclosure regulations") were issued on February 27, 2003. (1) Their purpose is to ensure that transactions possessing characteristics indicative of tax shelter transactions are reported to the IRS. Under Treas. Reg. [section] 1.6011-4(b), the six categories of "reportable transactions" include: (1) those identified by the IRS as tax shelters ("listed transactions"), (2) confidential transactions, (3) transactions with contractual protection (i.e., transactions where the fees paid in respect of the transaction are refundable if the desired tax result is not obtained), (4) "loss transactions" exceeding certain dollar thresholds, (5) transactions resulting in book-tax differences exceeding $10 million, and (6) transactions involving a brief asset holding period.

Treas. Reg. [section] 1.6011-4(b)(3) defines a confidential transaction as a transaction that is offered under conditions of confidentiality. Conditions of confidentiality exist if there is an express or implied limitation on the taxpayer's disclosure of the tax treatment or tax structure of a transaction for the benefit of any person making a "statement" to the taxpayer about the potential tax consequences of a transaction. Thus, the regulations require disclosure of a transaction if the taxpayer (1) has a binding obligation or a non-binding understanding with another party not to disclose any tax aspects of a transaction and (2) claims a tax benefit on its return in respect of the transaction. There are limited exceptions to the disclosure rule for securities law purposes and for certain merger and acquisition agreements. In addition, Treas. Reg. [section] 1.6011-4(b) (3)(iii) affords taxpayers a presumption that a transaction will not be considered offered under conditions of confidentiality if every person who makes or provides a statement, oral or written, to the taxpayer (or for whose benefit a statement is made or provided to the taxpayer) about the potential tax consequences that may result from the transaction provides express written authorization for disclosure to the taxpayer at the specified time and in the precise form prescribed by the regulation. (2)

Fundamentally, TEI believes that the confidential transaction prong of the regulations is overbroad. Since the regulations contain no exception for transactions entered into in the ordinary course of business and since all the facts and circumstances surrounding a transaction must be considered in determining whether a transaction is subject to conditions of confidentiality, prudent taxpayers must analyze every single transaction of the thousands of daily transactions that they enter into. Indeed, the regulations require disclosure of far too many routine transactions, engendering substantial administrative costs for taxpayers to report mundane transactions that are of little or no interest to the government.

As important, in order to comply with the regulations taxpayers face a dilemma in protecting their confidential non-tax information: They must incorporate in their nondisclosure agreements (NDAs) the excessively broad waiver of confidentiality language set forth in the regulations, thereby risking potential disclosure of the very information the NDA is employed to protect, or disclose through additional tax return filings all transactions covered by NDAs regardless of how insignificant the tax consequences or structure may be.

Ordinary Commercial Transactions of Limited or No Interest to the IRS Must be Disclosed and Cannot Be Effectively Monitored

The parties to routine, ordinary commercial transactions rarely discuss the tax treatment or structure of a transaction, especially where the tax consequences of the transactions are likewise routine. Even the simplest transactions (e.g., a sale of inventory to a customer), however, have tax consequences and various employees within a large company may well make "a statement" about their tax effects or structure. As a practical matter, a company's tax department cannot possibly monitor all such statements--whether oral, written, or electronic--made by any one of its employees about any particular routine transaction. The large number and scope of transactions that taxpayers engage in will make it difficult--perhaps impossible--for taxpayers to literally and fully comply with the regulations and, as important, demonstrate, if challenged by a revenue agent, that a particular routine transaction was not offered under conditions of confidentiality. (3)

Regulations Require Taxpayers to Weigh Burden of Added Tax Return Disclosures Against Protection of Confidential, Non-Tax Information

Confidentiality is required in many common commercial transactions in order to protect trade secrets, know-how, and other economic and proprietary business advantages. Among the numerous commercial transactions taxpayers desire to keep confidential are routine sales of inventory; licenses of intellectual property and technology-sharing agreements; employee secondments; severance agreements; agreements to settle commercial litigation and disputes; and nonfinancial service agreements, including, for example, payroll, human resources, and data processing services. The IRS is likely uninterested in receiving information about most transactions that fall under such agreements, but if a tax statement is made in the documents or by any person about any of the transactions covered by the NDA, the taxpayer is required to disclose the transaction or transactions.

Theoretically, taxpayers can avert filing additional disclosure statements by obtaining a waiver of confidentiality--in language identical to that set forth in Treas. Reg. [section] 1.6011-4(b) (3)(iii)--from all parties to the transaction. Adopting this approach, however, imposes a considerable administrative burden on taxpayers, especially where a company has hundreds, even thousands, of nondisclosure agreements (NDAs) in place with customers, vendors, employees, and litigants.

More important, adopting the overbroad waiver language set forth in the regulations may permit counterparties to the agreement to disclose material non-tax information that the NDA was designed to protect. (4) As a practical matter, many taxpayers will be unwilling to incorporate the required regulatory language in their NDAs and risk disclosure of the confidential non-tax information. One approach to achieving the government's objective of compelling disclosure of the tax structure or tax consequences of transactions while protecting sensitive non-tax information would be to limit the required waiver of confidentiality to transactions where a promoter, consultant, or "material adviser" subject to the registration provisions of section 6111 or list maintenance rules of section 6112 is the beneficiary of the confidentiality restriction. Taxpayers negotiating with arm's length parties in bona-fide business transactions should not be subject to a disclosure requirement simply because of a mutual exchange of NDAs. Another approach would be to revise the required waiver language set forth in the regulation to clarify that the waiver is limited to disclosure of the tax structure to the IRS or other government agencies and to independent tax advisers (whose corresponding disclosure of the tax structure and consequences must, except for the attorney-client privilege, be similarly unencumbered by restrictions against disclosure). A third approach to narrow the scope of the confidential transaction category would be to issue a revenue procedure similar to Rev. Proc. 2003-24 or Rev. Proc. 2003-25, (5) carving out specified routine NDAs from the confidential transaction prong of the disclosure regulations. We elaborate below on the specific types of NDAS that should be exempted from reporting by taxpayers. The "angel list" might be used to supplement more comprehensive revisions to the rules (such as the approaches recommended by TEI) or, if no comprehensive exclusions can be formulated, as a stand-alone approach.

Standard Nondisclosure Agreements

Companies routinely enter into NDAs in the ordinary course of their business. Typically, NDAs impose reciprocal obligations on the parties to refrain from disclosing non-public information and are commonly used to protect trade secrets, intellectual property rights, and other information that protects the company, its employees, creditors, vendors, or customers. Moreover, certain information must be kept confidential by law.

During the course of any business relationship, tax matters--such as withholding, tax indemnifications, or allocations of the tax risks that arise from the commercial relationship between the parties--may be discussed or documented. In some cases, there may be an additional agreement setting forth the tax terms; more often there may be no further discussions or documents exchanged between the parties except for invoices and payments. As currently drafted, the regulations will apply to many such agreements, including standard employment agreements, (6) Employers invariably provide tax information to the employee regarding the tax consequences of benefits and payroll taxes. For example, employers providing 401(k), employee stock purchase plans, qualified and non-qualified employee stock options, phantom stock plans, or other equity-based compensation plans routinely provide an explanation of the tax consequences of various transactions to affected employees. Since both the employer and employee may claim a tax benefit on their respective returns in respect of compensation (e.g., exclusion of income by the employee and a deduction by the employer), the regulations may require disclosure of transactions by both the employer and employee. Hence, employment agreements and routine transactions between the employee and the employer may be subject to disclosure under the regulations, standard vendor and supply agreements, (7) straightforward stock or asset acquisitions, and standard licensing agreements. The transactions undertaken pursuant to such agreements are clearly not the targets of the new disclosure regulations.

Exemptions for Ordinary Commercial Transactions

TEI recommends that the IRS promptly issue a revenue procedure, similar to Rev. Procs. 2003-24 and 2003-25, exempting routine commercial transactions from the definition of confidential transactions. An "angel list" for identified transactions would be beneficial either to supplement broader, more comprehensive revisions narrowing the scope of the confidential transaction rules or, if such revisions are not forthcoming, as a stand-alone approach to limit unnecessary reporting. Specifically, we recommend the revenue procedure exempt, among others, the following transactions:

* Purchase and sale agreements in respect of inventory of tangible property;

* Purchase and sale agreements for commercial real estate;

* Purchase and sale of nonfinancial services (other than services associated with tax planning or tax return preparation) such as security, maintenance, payroll, information technology support, etc.;

* Licenses of intellectual property and technology;(8)

* Procurement of raw materials, general supplies, feedstocks, etc.;

* Employee secondment or sharing agreements;

* Severance or employment contracts;

* Contracts for provision of routine services;

* Agreements settling employment or commercial disputes; and

* Agreements settling disputes with state or federal governmental agencies in respect of environmental, tax, or other matters.

Exempting these transactions from the separate return disclosure on Form 8886 would simplify taxpayers' compliance obligations without unduly limiting the IRS's ability to administer the tax laws and identify potentially abusive transactions. (9)

Revise the Required Time for Obtaining Waivers of Confidentiality Permitting Disclosure of Merger and Acquisition Agreements

When potential merger and acquisition agreements are negotiated, the taxpayers in the proposed transaction as well as their advisers generally enter into NDAs. Under Treas. Reg. [section] 1.6011-4(b)(3)(ii)(B) an M&A agreement subject to an NDA will not be considered a "confidential transaction" as long as a taxpayer is permitted to disclose the tax treatment and structure of the transaction no later than the earlier of three events: public announcement of discussions, public announcement of the transaction, or the date of execution of an agreement to enter into the transaction.

Taxpayers are concerned that the regulation may permit sensitive non-tax information to be disclosed when a deal falls through after a public announcement. Specifically, the broad waiver of confidentiality that the regulation requires to be incorporated in the NDA may permit disclosure of non-tax information following a "busted" deal. We recommend that the regulations be revised to eliminate the requirement that disclosure of the agreement's tax consequences be permitted no later than the earlier of the three specified events; instead, TEI recommends that the regulations adopt a rule permitting taxpayers to disclose no later than 30 days following consummation of a merger or acquisition transaction. As an alternative, the M&A exception of Treas. Reg. [section] 1.6011-4(b)(3)(ii)(B) should be available to taxpayers where the NDA states that the authorization to disclose the tax structure or consequences of the transaction (and other information subject to the NDA) lapses if the proposed transaction is not consummated.

Confidential Transactions of Controlled Foreign Corporations

Treas. Reg. [section] 1.6011-4 requires disclosure of transactions that result in federal tax benefits. If there is any prospect of a federal income tax benefit, no matter how remote, the regulations require disclosure, even where transactions are consummated solely to effect state or foreign tax savings. Under Treas. Reg. [section] 1.6011-4(c), the U.S. shareholder of a controlled foreign corporation (CFC) is deemed a participant in a reportable transaction where the CFC engages in a transaction that, were the CFC a domestic U.S. company, would be reportable. Thus, where a tax adviser brings a "confidential" foreign (or state and local) tax reduction transaction to a CFC, the U.S. shareholder or the CFC must obtain a waiver of confidentiality (as prescribed in Treas. Reg. [section] 1. 6011-4(b)(3)(iii)) from the tax adviser in order to avoid disclosing the transaction on the U.S. shareholder's return. (10) In our view, "confidential" foreign (and state and local) tax planning transactions that do not otherwise constitute a reportable transaction under the regulations should not have to be reported by the U.S. taxpayer because a reduction in foreign or state and local taxes will generally increase, rather than decrease, the taxpayer's net federal taxes. Thus, we recommend that the definition of confidential transaction be revised to exclude "confidential" tax transactions that are aimed at reducing foreign or state and local taxes. (11)

Conclusion

Tax Executives Institute appreciates this opportunity to present its views on the confidential transaction prong of Treas. Reg. [section] 1.6011-4(b) (3), relating to the disclosure of reportable transactions. The Institute's comments were prepared under the aegis of its Federal Tax Committee, whose chair is Mitchell S. Trager. If you have any questions, please do not hesitate to call Mr. Trager at 404.652.2690, or Jeffery P. Rasmussen of the Institute's professional staff at 202.638.5601.

(1) T.D. 9046, 2003-12 I.R.B. 614.

(2) The regulation requires taxpayers to adopt a waiver of confidentiality, as follows: "the taxpayer (and each employee, representative, or other agent of the taxpayer) may disclose to any and all persons, without limitation of any kind, the tax treatment and tax structure of the transaction and all materials of any kind (including opinions or other tax analyses) that are provided to the taxpayer relating to such tax treatment and tax structure." (Emphasis added.)

(3) Under Treas. Reg. [section] 1.6011-4(b) (3), it is unclear whether the IRS or taxpayer has the burden of proving that a transaction is or is not offered under conditions of confidentiality.

(4) For example, a vendor may wish to safeguard the pricing terms of an agreement in order to prevent other customers from negotiating a better price or a competitor from offering a superior bid. In the absence of the waiver, if the NDA addresses tax withholding obligations or tax indemnities or other tax information, or if the parties make any "statement" about the tax structure or consequences of the transaction, the transaction would be subject to disclosure. Since the waiver must be "without limitation of any kind," the taxpayer risks disclosure of the pricing information by the customer.

(5) 2003-12 I.R.B. 599 and 601, respectively.

(6) A typical employment agreement will prohibit employees from disclosing nonpublic information about the employer. It will also shield the employer from intellectual property claims made by the employee. Also, in many cases employers are subject to restrictions against disclosing certain aspects of the employer-employee relationship, whether pursuant to state or federal law or by the terms and conditions in the company's employee manuals.

(7) Companies use NDAs to prevent disclosure of material terms of their agreements such as price, conditions, representations, and indemnities. The waiver of confidentiality provision should not force companies to disclose such terms where the agreement also addresses the tax treatment or structure of the arrangement.

(8) To distinguish between ordinary day-to-day transactions and transactions for which disclosure may be appropriate, the IRS should consider defining the phrase "tax treatment or structure" to exclude certain standard contractual provisions relating to tax withholding, indemnification, gross-ups, and similar provisions that are used to define and allocate the tax risks between principals to a transaction. Such a revised definition, whether adopted alone or with the recommended exemptions for ordinary commercial transactions, would substantially diminish unnecessary taxpayer reporting.

(9) For many taxpayers, M&A transactions are so frequent that they may be considered "routine." In addition, multiple sections of the Code (e.g., sections 1060, 338, and 368) require separate disclosure statements to be included in the return. The IRS should consider excluding transactions subject to such separate tax return disclosure statements from the disclosure rules of section 6011.

(10) There is a possibility that the plan could cause a federal tax benefit through the reduction of the section 78 gross up upon payment of a dividend from the CFC. Hence, there is a remote, future U.S. tax benefit from all foreign tax planning ideas.

(11) More broadly, we question whether any part of the disclosure regulations should apply to reporting shareholders of CFCs for transactions aimed at reducing foreign or state and local taxes.

The regulations require disclosure of far too many routine transactions, engendering substantial administrative costs for taxpayers to report mudane transactions that are of little or no interest to the government.