House Ways and Means Committee testimony: corporate tax shelters.

November 10, 1999

On November 10, 1999, the House Committee on Ways and Means held a public hearing on proposals relating to corporate tax shelters. Tax Executives Institute was represented at the hearing by its President, Charles W. Shewbridge, III of BellSouth Corporation. Mr. Shewbridge's written statement is reprinted below. TEI's position on proposals relating to corporate tax shelters was developed by the Institute's Corporate Tax Shelters Task Force, whose chair is Philip G. Cohen of Unilever United States Inc. Earlier this year, TEI testified on the same subject before the Senate Committee on Finance. That testimony is reprinted in the May-June 1999 issue of The Tax Executive.

I am Charles W. Shewbridge, III, Chief Tax Executive for BellSouth Corporation in Atlanta, Georgia. I appear before you today as the President of Tax Executives Institute, the preeminent group of corporate tax professionals in North America. The Institute is pleased to participate in the Committee's hearing on corporate tax shelters and to provide, among other things, comments on the proposals and recommendations offered by the staff of the Joint Committee on Taxation and the Treasury Department.(1)(*)

Mr. Chairman, this subject is a very important one to TEI members, to the tax community generally, and to the tax system as a whole. In the press release announcing this hearing, Chairman Archer identified the following five issues for consideration:

* The nature and scope of the perceived corporate tax shelter problem;

* The manner in which the IRS and the courts are currently addressing corporate tax shelters;

* Additional steps that the Administration could take under current law to address such tax shelters;

* Additional legislation that might be necessary to address corporate tax shelters; and

* Procedures the Administration has in place or could adopt, or that Congress could enact, to ensure that new or existing enforcement tools brought to bear on corporate tax shelters do not interfere with legitimate business transactions or make more difficult the application of an already complex income tax.

After providing background on Tax Executives Institute and my own experience as a tax executive, I will address each of these issues.

1. Background: The Perspective of In-House Tax Professionals

Tax Executives Institute was established in 1944 to serve the professional needs of in-house tax practitioners. Today, the Institute has 52 chapters in the United States, Canada, and Europe. Our 5,000 members are accountants, attorneys, and other business professionals who work for the largest 2,800 companies in the United States and Canada; they are responsible for conducting the tax affairs of their companies and ensuring their compliance with the tax laws. Hence, members of the Institute deal with the tax code in all its complexity, as well as with the Internal Revenue Service, on almost a daily a basis.(2) Tax Executives 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 cost and burden of administration and compliance to the benefit of taxpayers and government alike. Our background and experience enable us to bring a unique and, we believe, balanced perspective to the subject of corporate tax shelters.

Put another way, TEI's perspective differs from that of other organizations that have commented on this issue. The Institute does not represent the so-called tax shelter promoters and developers (including investment bankers) who either sell or facilitate the transactions. We do not represent the professional advisers (be they attorneys or accountants) who opine on the legitimacy of the arrangements. Rather, TEI's members work directly for the corporations that regularly enter into business transactions that require an analysis of their tax benefits and burdens. These companies have professional staffs dedicated to minimizing their tax liability while ensuring compliance with the law. To this end, these companies evaluate particular transactions (whether developed by their own staffs or brought to the companies by outside advisers or promoters), decide whether or not these offerings pass muster -- not only in terms of the substantive requirements of the tax law but, importantly, in terms of their own business needs and corporate culture -- and, if they proceed, report the transactions on their tax returns and defend them on audit. Ultimately, of course, these companies face potential exposure to sanctions (and public opprobrium) should their analysis of a transaction not be sustained. In other words, TEI's members are in the thick of it. We along with the government have the most at stake in trying to craft an equitable tax system that is administrable.

Although I am here today on TEI's behalf, I wish to provide some context for my testimony about my role as Chief Tax Executive for BellSouth Corporation. I have been a tax professional for nearly 30 years, and have been employed by BellSouth for half of that period. As the company's senior tax official, I am ultimately responsible for 40,000 federal, state, local, and foreign returns that BellSouth files each year. The company's 1998 federal income tax return, which I signed earlier this year, reflected an aggregate federal income tax liability of more than $1.6 billion.

Given the size of that number, it should go without saying that I take my job seriously. In discharging my duties, I oversee a staff of more than 100 people. We see our job as twofold -- first, to ensure BellSouth's compliance with the state, local, federal, and international tax laws and, second, to serve the company's shareholders by ensuring that we pay only the taxes required by law. This second facet of the job is not new and it is not something that we shrink from defending. Concededly, those who seek to influence the debate by the language they use pejoratively describe today's tax department as a "profit center,"(3) but the desire to reduce -- and the legitimacy of reducing -- one's tax liability is as old as the Rosetta Stone(4) and as legitimate as seeking shelter from the cold or rain.(5) With due respect, TEI suggests that those who wish to consign corporate tax departments to the role of scriveners, filling out tax returns, fundamentally misunderstand the historical, and we submit wholly proper, role of in-house tax professionals. Similarly, those who proceed on the assumption that tax executives neither understand nor willingly embrace our professional and legal responsibility to ensure our companies' compliance with the tax laws do us, our companies, our shareholders, and -- equally important -- the tax system a disservice. To be sure, there may be taxpayers who willfully or inadvertently cross over the line, just as there may be practitioners, promoters, revenue agents, government lawyers, and others who do the same. It would be a mistake, however, without sufficient empirical evidence to suggest that the problem is pandemic.(6) Let there be no mistake: TEI supports reasonable administrative, judicial, and legislative steps to address the tax shelter issue, but the steps must be measured, targeted, and based on fact, not feeling. Thus, we take to heart Congressman Doggett's statement last week that "immodest rhetoric" has no place in this debate. We regret, however, that such rhetoric seemingly emanates more often from those seeking to enact legislation than from those who seek to clarify its scope and effect. While we agree that if the tax system does not respond to noncompliance or to sham transactions, public confidence in the fairness of the system will be diminished, we also believe that public confidence can be equally impaired by the enactment of overreaching and overbroad legislation.

II. What Is the Nature and Scope of the Perceived Corporate Tax Shelter Problem?

Before enacting expansive legislation dealing with corporate tax shelters, Congress is well advised both to ask and to answer the question "What is meant by the term `corporate tax shelter'?" It is not a question whose answer can be assumed. It is likewise not a question whose answer can be put off indefinitely. Whether you view the solution as lying in increased disclosure, the enactment of an economic substance doctrine or business purpose test, the imposition of new penalties, or "just" the racheting up of the IRS's enforcement activities, the definition must be both knowable and known. At this junction, TEI questions whether it is.

Thus, the Treasury Department and the staff of the Joint Committee on Taxation have both issued substantial and serious studies that provide much food for thought on the subject of corporate tax shelters. Both have devoted considerable resources to identifying the scope of the problem from their perspectives and to crafting proposed substantive definitions of "corporate tax shelter" that attempt to measure the tax benefits of a transaction against its economic substance. Although we greatly respect the expertise and good faith of those involved -- although we very much appreciate their efforts to date to respond to taxpayer and tax practitioner concerns and to refine their approaches -- we remain concerned that the proposals rely too much on amorphous and unworkable concepts that pose challenges to tax administration and may well sweep into the "tax shelter" net many legitimate transactions for the simple reason that they produce a tax benefit to the taxpayer.

Indeed, we are disappointed that some believe that lack of clarity is a virtue. Thus, the Treasury Department has previously framed the issue as between "rules" and "standards" (the latter being more general) and has recently suggested that what is necessary is a simple ex ante standard basically providing "Thou Shall Not Abuse the Tax Code."(7) TEI is concerned, however, that such a hortative approach to the Nation's heretofore rules-based tax system could be counterproductive, ultimately disrupting routine business transactions by emboldening revenue agents or others to challenge any tax planning idea or transaction as a corporate tax shelter.

In other words, unless the definition is clear -- or, at least, considerably clearer than it currently is -- there will remain too great a possibility that the vague label "tax shelter" will be invoked as a shibboleth to cut off debate. To be sure, the effect of such a broad-brush approach may be to prevent certain abusive transactions, but it may also be to vitiate a taxpayer's right to minimize its tax obligations without first examining the facts and circumstances of a particular transaction and then assessing how its business purpose and economic substance comport with the explicit provisions of the Internal Revenue Code.(8) Thus, TEI submits that any legislative action addressing abusive or over-aggressive transactions must acknowledge the role of legitimate tax planning to minimize corporate tax expense. Legitimate tax planning can include transactions undertaken solely for tax reduction purposes, such as financing a company with the issuance of debt rather than equity,(9) and a taxpayer should not have to proceed through litigation to validate legitimate tax planning.

We have gone on at some length about the definitional problems not because we seek to staunch any meaningful action by the Treasury Department, IRS, and Congress, but rather because we take seriously our obligation to help improve the system. TEI agrees that the current situation cannot be ignored. As tax executives, we see the challenge to the tax system every day. The unrelenting complexity of the law breeds opportunity.(10) The interaction of various intricate provisions of the Internal Revenue Code leads to uncertainty for taxpayers about the proper limits of tax planning and the line between legitimate and illegitimate transactions. Moreover, the uncertainty encourages some -- especially those who stand to reap substantial fees and rewards with little or no risk of loss -- to abuse or game the system. While the evidence is only anecdotal, TEI is very much concerned that abusive products or transactions are being developed, marketed, and purchased. In our view, this phenomenon poses a challenge to the efficacy of the tax system. If the problem of abusive products is not addressed, the integrity of the tax system may be weakened or, at a minimum, the perception of the tax system's fairness impaired. Hence, action is required.

At the same time, the problems with the current proposals can likewise not be ignored. There is no simple, easy solution to the corporate tax shelter "problem." The key is realistically assessing the causes of the problems and then designing measured, balanced approaches to dealing with them without adding even more complexity to the already overburdened tax law. In the final analysis, rules must be developed that encourage all participants to exercise self-restraint. Ultimately, it is the corporation that is responsible, for what is reported on its tax return, but in our view it is wrong to suggest that the problem lies only with taxpayers themselves and that the solutions should be directed only at them. Accordingly, TEI is pleased that the Treasury Department, the staff of the Joint Committee on Taxation, and others have concluded that attention must be paid to both the promoters of tax-advantaged products and to the outside advisers whose opinions facilitate the marketing of such products. We are certainly not claiming that sophisticated taxpayers are "victims," but in our view the solutions must reach the enterprises and advisers who put unduly aggressive "products" into play.(11)

III. The Manner in which the IRS and Courts Have Addressed Tax Shelters

When the Ways and Means Committee held its first hearing on the Administration's tax shelter proposals last spring, several witnesses testified that while the Department of the Treasury and the Internal Revenue Service had several tools at their disposal to combat "abusive" corporate transactions, the agencies had failed to make appropriate use of those tools. Perhaps more fundamentally, it was questioned whether the Treasury had sufficiently demonstrated that the provisions of the current tax code are inadequate to staunch the perceived growth of tax shelters. TEI agrees that there is a powerful array of tools available to address abuses -- from substantive provisions already in the tax code, to the authority to issue notices and regulations to halt specific abuses, to the ability to target transactions for litigation using one or more common-law anti-abuse doctrines.

Experience teaches that these tools can be and have been successfully invoked to curb several questionable transactions. For example, there have been a number of cases in which the courts have upheld the IRS's challenge to the business purpose or economic substance of a transaction that generated significant tax benefits. See, e.g., ACM Partnership v. Commissioner, 73 T.C.M. 2189 (1997), aff'd in part, rev'd in part, 157 F. 3d 231 (3rd Cir. 1998), cert. denied, 119 S. Ct. 1251 (1999); ASA Investerings Partnership v. Commissioner, 76 T.C.M. 325 (1998), on appeal to the Federal Circuit; United Parcel Service of America, Inc. v. Commissioner, T.C. Memo No. 268 (1999); Compaq Computer Corporation v. Commissioner, 113 T.C. No. 17 (Sept. 21, 1999); IES Industries v. United States, No. C97-206 (N.D. Iowa, Sept. 22, 1999); Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C. No. 21 (Oct. 19, 1999); and Saba Partnership v. Commissioner, T.C. Memo. 1999-359 (Oct. 27, 1999). Indeed, the last five of these government-favorable decisions were issued in the past three months. Let me be clear, Mr. Chairman: TEI does not necessarily subscribe to the view that all of these decisions involved "corporate tax shelters," even assuming the government's challenge to the transactions at issue were properly sustained. We do believe, however, that the cases illustrate the arguments and resources -- and the power -- the IRS can successfully bring to bear when it concludes that taxpayers have engaged in improper transactions.

In addition, the Treasury Department and the IRS have not been reticent to issue regulations, rulings, and announcements challenging the purported tax benefits of certain transactions. Most recently, the IRS issued Rev. Rul. 99-14, 1999-13 I.R.B. 3, which addresses so-called lease-in/ lease-out (LILO) real estate transactions, which often involve the leasing of property by a foreign party, often a municipality, to a U.S. taxpayer, followed by the sublease of the same property by the U.S. taxpayer to the foreign party. Explaining that the transactions are structured to produce significant tax benefits based on the deduction of prepaid rent with little or no business risk, the ruling states that the IRS will scrutinize LILO transactions for lack of economic substance and, where appropriate, recharacterize these transactions for tax purposes based on their substance.(12)

Finally, the Treasury has proven effective in persuading Congress to act to amend the Internal Revenue Code where legislation is necessary to prevent taxpayers from receiving unintended benefits. Thus, as the Chairman noted when calling this hearing, "since 1995, [Congress has] stopped $50 billion in tax abuses." An example of such legislation is the amendment earlier this year of section 357(c) to prevent the artificial creation of basis. See [sections] 3001 of H.R. 435 (enacted June 25, 1999).

Nonetheless, TEI believes that more can and should be done to encourage the IRS to employ -- within the bounds of sound administrative practices and the exercise of managerial discretion and congressional oversight -- its current statutory and common law substantive and administrative tools to curb transactions that are perceived as tax shelters. This includes the assertion of existing penalties in appropriate cases. The IRS must identify its workload requirements in order to determine staffing needs. To our knowledge, this has not yet occurred. Accordingly, we believe that the IRS's current initiative to identify and quantify potentially troubling corporate transactions is commendable.

Moreover, Congress must bear up to its responsibilities and ensure that the IRS is consistently well-funded with appropriations. To be effective, the IRS must have a well-trained workforce, and nowhere is this more true than with respect to the complex transactions that have been challenged as corporate tax shelters. Congress should ensure that the IRS has stable funding to meet its ongoing training needs.

IV. Additional Steps that the Administration Can Take Under Current Law

Before enacting new legislation, the Ways and Means Committee is right to ask whether there are additional steps that can be taken under current law. TEI believes there are. More fundamentally, we believe that there are administrative and regulatory steps the Treasury Department and the IRS must take even if legislation is enacted to enhance the disclosure of questionable transactions or otherwise address the tax shelter issue. Stated differently, the tax shelter problem is not one that Congress alone can cure. There is no legislative panacea, no single step or series of steps that Congress can take and thereby relieve the Treasury and the IRS of their ongoing responsibility. The Treasury and the IRS must continue to play their roles and if they fail to do so, they should be held accountable.

For example, in 1997 Congress enacted a provision relating to the registration of corporate tax shelters. Section 6111(d) of the Code was intended to help the IRS obtain useful information about corporate transactions at an early stage in order to identify transactions that should be audited and then take additional action -- through enforcement proceedings, regulatory changes, or targeted legislative action. The provision, however, does not become effective until the issuance of Treasury regulations, and to date no such regulations have been issued. It may be that section 6111(d) is flawed (for example, because it is keyed to the use of confidentiality agreements and an excessively broad "significant purpose" test), but if the Treasury proves no more willing or able to act under any new legislation than it has been under current law, we believe it is reasonable to question why new legislation should be enacted.

Section 6111(d) does not stand as the only provision that has not been effectively used by the Treasury Department and the IRS. Questions could also be asked about the government's use of section 7408, which gives the government the authority to enjoin tax shelter promoters, and section 7609(f), concerning the issuance of so-called John Doe summonses to promoters. There is also a question about the Treasury's and IRS's not toughening the rules of conduct that govern return preparers and other practitioners. Perhaps more important, some have questioned whether the IRS has made adequate use of section 269, which authorizes the IRS to disallow tax benefits in respect of acquisitions made to evade or avoid income tax. Surely before enacting a greatly expanded section 269 to disallow deductions, credits, exclusions, or other allowances obtained in tax shelter transactions, the Treasury Department and the IRS should be called into account for its current use -- or disuse -- of section 269. Similarly, we suggest that before Congress acts on proposals to double the accuracy-related penalty, it should receive testimony from the IRS on both how frequently the current 20-percent penalty has been asserted (and sustained by the courts) and whether there is any evidence that the level of the penalty is insufficient to encourage compliance.(13)

Stated simply, TEI believes that there can be no substitute for an effective enforcement program by the IRS. No statute or series of statutes, no single or group of ex ante pronouncements, can eliminate the need for a well-trained workforce that has the financial resources and the managerial will to get the job done. In other words, the Institute believes the Administration should utilize all appropriate enforcement tools currently at its disposal, including the wider use of focused information document requests and the assertion of penalties in appropriate cases.(14) The Treasury Department should also consider whether an amendment to the applicable penalty regulations -- most notably, Treas. Reg. 1.6664-4(c), relating to a taxpayer's ability to rely on an adviser's opinion in establishing its eligibility for the reasonable cause exception -- are appropriate.(15)

Lastly, Mr. Chairman, we believe that the Treasury Department and the IRS (as well as Congress) can alter the environment in which so-called corporate tax shelters can flourish by working to simplify the law and to apply it in an evenhanded manner. As previously stated, we believe many of today's so-called tax shelters are attributable to one-sided rules that were crafted for a "pro-government" purpose but subsequently turned on their head.

V. Additional Legislation That Might be Necessary

To the extent Congress determines legislation is necessary, TEI believes that it must be measured and restrained. Any response must carefully balance the benefit of any legislative proposal against the possible adverse consequences, including the likelihood that the provision would unduly interfere with routine business transactions and legitimate tax planning, impose needless complexity, and inevitably operate as a tax increase. It is imperative that Congress not overreact and enact a general anti-abuse rule (sometimes referred to as a "super section 269" provision) that would permit IRS agents to disallow transactions based solely on a subjective finding that the taxpayer had a significant purpose of tax avoidance in entering into a transaction. Such a provision would be exceedingly disruptive to ordinary business transactions and tax planning.(16)

A. The Focus Should Be on Meaningful Disclosure

Disclosure of information to the IRS is a most effective element of tax enforcement. Corporations are already required to reconcile their book and taxable incomes on Schedule MI of the tax return.(17) Indeed, the examination of corporate taxpayers generally centers around the book and tax differences disclosed on that schedule. During the course of an examination, taxpayers must expend considerable resources explaining, justifying, and supporting the differences. As a result, it is odd that the Treasury and Joint Committee staff both focus on book-tax differences as an indicator of a corporate tax shelter. These differences are not so much "indicators" as they are an unavoidable byproduct of the Internal Revenue Code that Congress -- often with Treasury's direct support -- has crafted. Mr. Chairman, I do not believe my company had any corporate tax shelters on the 1998 tax return that was just filed in September. But I do know that we had more than 125 separate items disclosed on our company's Schedule M-1 reconciling book and tax income.

The country's largest 1,700 companies are subject to continual audit by the IRS as part of the CEP program, but proponents of legislation downplay the significance of this. Hence, the Joint Committee staff's study states that "audits of large corporations typically follow an agreed agenda of issues that is negotiated by the IRS and the corporate taxpayer" and both the Treasury Department and the Joint Committee staff refer repeatedly to the "audit lottery." Taxpayers do strive to work cooperatively with the IRS, but they certainly are not capable of "walling off' some issues from examination. In practice, it is the IRS audit team that determines what transactions will be scrutinized. It is the IRS audit team that determines what information it needs. And it is the IRS audit team that ultimately determines what adjustments to propose. Any implication that large corporate taxpayers can win the "audit lottery" by narrowing the scope of the audit does not reflect the realities of the examination process. Mr. Chairman, you and the Committee may be assured that when large taxpayers have a new, non-routine Schedule M-1 item on their return, it will be examined.

B. Possible Expansion of Disclosure Requirements

One deficiency in the current system is the lack of downside risk to those who promote corporate tax shelters.(18) This shortcoming could be addressed by imposing a disclosure requirement on promoters of particular types of transactions.(19) Indeed, promoter disclosure could effectively operate as an "early warning" system that enables IRS and the Treasury Department to evaluate products and issue guidance -- whether in the form of notices, rulings, or regulations -- shutting down transactions that are perceived as "abusive" before they proliferate. This will also enable the IRS to marshal its resources and focus on examining transactions, including those undertaken by non-CEP taxpayers (individuals and middle-market end small companies) for whom the perception of the risk of detection is skewed by the "audit lottery." TEI believes that an effective system will impose the obligation for early disclosure on the promoter.(20) Because taxpayers will be required to make a detailed disclosure on their tax returns in order to avoid penalties, we do not support the imposition of a duplicate early disclosure requirement on taxpayers. As previously suggested, for early disclosure to have the intended salutary effect, the IRS and the Treasury must undertake to analyze and take appropriate action on the disclosed transactions.

In addition, TEI believes steps can be taken to enhance the value of return disclosures by taxpayers themselves. One means of ensuring that IRS examiners will not miss issues, even in respect of CEP taxpayers, is to require a taxpayer to attach a copy of the promoter's disclosure notice to the taxpayer's return. Furthermore, the specific types of information that must be disclosed on the return in respect of certain transactions could be specified, either by Congress in the statute or in regulations.

C. The Senior Corporate Officer Attestation Proposal Should Be Rejected

It has been proposed that Congress require the Chief Financial Officer or another senior officer to certify that the facts disclosed (or reported on a return) about a tax-shelter transaction are true and correct. Indeed, some proponents of legislation have characterized such an attestation requirement as a "linchpin" in any successful effort to curb abusive tax shelters. Even if enhanced disclosure is appropriate, we regret that this attestation proposal misses the mark. It misapprehends the role of the tax department as well as the CFO, it impugns the integrity and professionalism of both, and it ignores how an attestation provision would adversely affect the examination process. TEI strongly opposes its enactment.

Stated bluntly, the senior officer attestation proposal obfuscates the issue because it proceeds from a faulty premise that companies do not enter into major transactions knowingly and that the people who prepare and sign billion-dollar corporate returns do so cavalierly. Corporate tax returns are already filed under penalties of perjury, and while I will not presume to speak for all my peers, I defy the proponents of this proposal to identify a sufficient number of corporate tax directors who take their return-signing duty so lightly that it justifies the attestation requirement. As one commentator wrote recently in Tax Notes: "[I]f the corporate tax manager does not have full knowledge of the facts of the corporation's tax-motivated transactions, why is he signing the return? And if he does not know what is going on, why is anyone's signature on the extra form necessary, except for show?"(21) Equally important, it is totally without basis for proponents to say that a company's CFO and the other senior officers who might be subject to the attestation provision would permit abusive transactions but for the sanctions that might flow from the proposal.

Mr. Chairman, TEI's objections to the attestation proposal go beyond its denigration of the professionalism of corporate tax directors. The proposal poses a serious threat to the efficient operation of corporate tax return preparation and, especially, the examination processes. If enacted, the proposal could lead to focusing not on the underlying transaction but on the attestation. Hence, the key would not be whether a transaction passes muster under the law, but rather "what did the senior officer know and when did he know it?" Such inquiries could well result in intrusive or threatening examination practices that the IRS Restructuring and Reform Act was enacted to prevent.(22) Indeed, the proposal could easily spawn suspicion and distrust about the entire return preparation and examination process comparable to that which existed during the era of the infamous "Eleven Questions" (relating to the treatment of facilitation payments to foreign persons) in the 1970s. For the foregoing reasons, we urge Congress to reject the senior officer attestation proposal.

D. Changes to the Code's Penalty Structure Must Be Measured

Although TEI believes that the primary focus of Congress should be ensuring meaningful and timely disclosure of transactions, we recognize that a comprehensive approach to this subject requires an examination of the Code's penalty provisions, including most particularly the accuracy-related penalty and the multitude of standards governing taxpayers, tax practitioners, and tax-return preparers. In proceeding, we urge Congress to keep in mind the following:

1. We cannot help but comment on the complexity of the proposed penalty regime set forth in the Joint Committee Study. Although seeking to consolidate and simplify the various standards to which taxpayers, preparers, and promoters are subject, the Joint Committee staff was forced to create an 11 x 5 matrix to explain the proposal. Concededly, one of the columns was devoted to listing current law, but it remains that the proposal is highly complicated and supposes a level of mathematical precision that does not exist in respect of what in many cases are essentially judgment calls -- does a transaction legitimately reduce taxes?

2. TEI is very much concerned about proposals to increase the accuracy-related penalty in respect of certain tax shelter transactions to 40 percent. Indeed, we suggest that a fundamental problem with the administration of the current 20-percent penalty is that it is so high that it is rarely asserted against corporate taxpayers. Where penalties are disproportionate compared with the conduct involved, 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 ever asserted it.(23) Thus, while steps should be taken to address the certainty of application, we do not at this time believe the level of the accuracy-related penalty should be increased.

3. TEI believes that taxpayers should generally not be subject to penalties if they make a complete and meaningful disclosure about a product or transaction in the tax return and satisfy the applicable standard (see comment below 5). If the taxpayer fails to disclose a transaction that is subsequently deemed to be a tax shelter and the taxpayer does not prevail on the merits, the taxpayer should be subject at most to a 20-percent understatement penalty where it has substantial authority for its treatment of an item. On the other hand, if a taxpayer fails to disclose a transaction that should be disclosed because it meets objective disclosure criteria and the taxpayer prevails on the merits of the issue, it may be appropriate to impose an information-reporting type penalty on the taxpayer, the rate of which should not generally be linked to tax benefits at issue.

4. Given the complex nature of the tax law, TEI believes the enactment of a strict liability penalty is wholly inappropriate. Penalties should be designed either to punish purposeful misbehavior or to provide an incentive to behave properly. Accordingly, we support the retention of the reasonable cause exception. We do, however, believe the scope of the exception should be clarified. Hence, TEI believes that opinion standards should be revised for purposes of the reasonable cause exception. Before relying on an adviser's opinion to avoid a penalty, the taxpayer must be able to demonstrate that the opinion is based on the actual facts of the taxpayer's transaction and not an assumed set of facts.

5. Although TEI believes that some adjustment to and harmonization of taxpayer, practitioner, and preparer standards may be appropriate to encourage the filing of more accurate returns, we have concerns about proposals to raise the standards, in respect of both shelter and non-shelter items. Let there be no mistake: The multitude of standards now contained in the Code -- more likely than not, realistic possibility of being sustained, substantial authority, reasonable basis, not frivolous -- is undeniably confusing. The multiple standards have reduced taxpayers, practitioners, and preparers to assigning mathematical probabilities to each standard and then divining (to the extent possible) whether a proposed return position meets or exceeds the applicable standard. The clarity suggested by the use of such mathematical probabilities, however, is a false one, for the tax law is marked by many things, but mathematical precision is rarely one of them.

Regrettably, the false clarity of current law would be exacerbated under the Joint Committee staff's proposal to engraft a "highly confident" standard on the Code, which the staff defines as a 75- percent or greater likelihood of success on the merits if challenged. At one level, we are concerned that the combination of the "highly confident" and "more likely than not" standards may unleash a torrent of disclosures that consumes valuable IRS resources and distracts revenue agents from issues more worthy of their scrutiny. Equally important, we are concerned the imposition of higher standards will leave taxpayers facing penalties where, several years after they grappled with the vagaries and interstices of the tax law, a revenue agent or court concludes -- with the benefit of hindsight -- that the taxpayer erred in concluding its position was "at least probably right" (under the "more likely than not standard") or "highly confident."(24) This concern is especially pronounced in light of the Joint Committee staff's recommendation that the reasonable cause exception of current law be repealed. (See comment 4 above.)

6. Congress should not make changes in this area in a vacuum and should resist the temptation to make ad hoc changes in the Code's penalty provisions. A comprehensive overhaul of the provisions, as was presaged at yesterday's hearing of the Subcommittee on Oversight, is preferable.

VI. Steps to Ensure That Legitimate Business Transactions Are Not Impeded 

Mr. Chairman, in announcing this hearing you expressed a desire to explore the procedures the Administration has in place or could adopt, or that Congress could enact, to ensure that new or existing enforcement tools brought to bear on corporate tax shelters do not interfere with legitimate business transactions or make more difficult the application of an already complex income tax. We agree that this should be a primary consideration of the Committee. If legislation is enacted that is overbroad or unclear -- if it does an insufficient job of defining what is acceptable and what is unacceptable -- it is the corporate community as a whole that will suffer.

TEI believes that the recommendations contained throughout this testimony address this issue, but in summary we offer the following:

* The definition of corporate tax shelter cannot be assumed. It must be known. Thus, while we agree that there will not be as much "pressure" on the definition if a disclosure-based proposal is adopted (as opposed to changes to the Code's substantive provisions), the problems do not disappear. Unless the "indicators" or "triggers" are objective or relatively easy to apply, there will be a likelihood not only of massive disclosures ("just to be safe") but of potential abuse by revenue agents or courts using hindsight to impose penalties. Neither of these developments would be good for tax administration.

* To the extent a broad disclosure regime is adopted, any requirement for "early warning" disclosure should be imposed on promoters rather than taxpayers. This would ensure that promoters of tax shelters will have an incentive not to market abusive transactions, without unduly burdening taxpayers. Taxpayers, however, should be subject to more meaningful return disclosure requirements.

* Congress should reject the Siren's song of senior corporate officer attestation. So, too, should it reject the allure of doubling penalty rates. The IRS and Treasury would be better advised to develop effective audit strategies and to build the case for the appropriate assertion of a penalty.

* The standards for taxpayers, preparers, and advisers should be harmonized.

* Last but not least, neither Congress nor the Treasury should shrink from their obligation to improve and simplify the substantive provisions of the tax law.

VII. Conclusion

Mr. Chairman, as evidenced by these comments, there are no magical solutions to the corporate tax shelter phenomenon. TEI believes the keys are (1) encouraging clear and meaningful disclosure by tax-shelter promoters and taxpayers; (2) substantially changing the risk-reward profile for tax-shelter promoters; and (3) clarifying that tax "opinions" based on assumed facts and circumstances unrelated to the taxpayers' will not be sufficient to excuse taxpayers from disclosure or understatement penalties. Solutions to the tax shelter dilemma must be carefully targeted and should not exacerbate the problem by adding further complexity to the Internal Revenue Code or by transforming a putatively neutral IRS examination process into an adversarial -- even prosecutorial -- search for "bad actors."

(*) Notes appear beginning on page 502.

Notes

(1) See Staff of the Joint Committee on Taxation, Study of Present-Law Penalty and Interest Provisions as Required by Section 3801 of the Internal Revenue Service Restructuring and Reform Act of 1998 (Including Provisions Relating to Corporate Tax Shelters) (JCS-3-99) (July 22, 1999); Office of Tax Policy, U.S. Department of the Treasury, The Problem of Corporate Tax Shelters: Discussion, Analysis and Legislative Proposals (July 1999).

(2) Most of the companies represented by our members are part of the IRS's Coordinated Examination Program (CEP), pursuant to which they are audited on an ongoing basis.

(3) The Bureau of National Affairs recently reported that a senior Treasury Department official had said that so-called abusive shelters "have arisen at a time when the culture of corporate tax departments has changed from one in which compliance was its primary function to one in which it is expected to generate money-saving opportunities." "Piecemeal Solutions to Tax Shelter Problems Contribute to Growth, Treasury Officials Says," BNA Daily Tax Report No. 210, at G-8 (November 1, 1999).

(4) Charles Adams, For Good and Evil: The Impact of Taxes on the Course of Civilization 15-25 (1993).

(5) That tax planning by itself violates no moral code or substantive provision of the tax law has long been confirmed by the courts. Perhaps the most famous formulation of this axiom is Judge Learned Hand's: "[A]nyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes." Helvering v. Gregory, 69 F. 2d 809, 810 (2d Cir. 1934), aff'd, 293 U.S. 465 (1935) ("The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted.").

(6) While recognizing that the precise level of noncompliance owing to so-called tax shelter activity may be difficult to quantify, TEI has been very much concerned about broad statements of the enormity of the problem without empirical support. We are pleased that the IRS recently announced its intention to attempt to identify the scope of the problem. Assuming the methodology of the IRS's initiative is sound (and does not rely on revenue agents and others self-defining tax shelters as any transaction that produces a tax benefit they disagree with), it should meaningfully contribute to the process.

(7) E.g., "Piecemeal Solutions to Tax Shelter Problems Contribute to Growth, Treasury Officials Says," BNA Daily Tax Report No. 210, at G-8 (November 1, 1999) (remarks of Joseph M. Mikrut, Treasury's Tax Legislative Counsel).

(8) Stated differently, we fear that without clear limits, "corporate tax shelter" might become little more than the word "glory" in Through the Looking Glass: meaning whatever a revenue agent, like Humpty Dumpty, says it means. Lewis Carroll, Through the Looking Glass 186 (Signet Classic 1960) ("`When I use a word [`glory'], Humpty Dumpty said, in a rather scornful tone, "it means just what I choose it to mean -- neither more nor less."').

(9) The need to recognize that actions can be wholly motivated by tax considerations and still be proper is illustrated by the following, concededly simplistic example: A woman is walking down the street and comes upon a homeless person, asking for money so he can buy something to eat. If the woman pulls a five-dollar bill out of her pocket and hands it to the man, she has effected a transaction that has an economic cost to her but no favorable tax consequences. Now assume she walks the man across the street to a homeless shelter that has secured tax-exempt status. As the homeless man enters the soup line, the woman writes a check for a tax-deductible contribution to the shelter. She has engaged in essentially the same economic transaction but has taken additional steps, arguably only to secure the tax benefits of writing the check to the charity running the homeless shelter. Should she be denied a tax deduction for her contribution to a charity -- in the nomenclature of the day, a tax-indifferent party -- because her motivation for the action generating the deduction was solely to reduce her tax liability?

(10) TEI believes it is necessary to recognize the part that Congress, the Treasury Department, and the IRS each play in creating an environment in which so-called corporate tax shelters can flourish. Each of the government players, too, bears responsibility -- for how the law reads (warts, "discontinuities," and all), how it is interpreted, and how it applies. Thus, TEI must acknowledge its frustration that the Administration has not sought to address either the complexity that characterizes the tax law or the unfair, one-sided provisions that, while crafted for a "pro-government" purpose, are often turned on their head by taxpayers in what is later deemed to be a tax shelter. For example, the contingent payment regulations that the taxpayer invoked in the ACM case were drafted by the government in a manner to be used against taxpayers; the taxpayers in that case simply tried to utilize the rules for their own benefit. An evenhanded rule would not have presented even the opportunity for abuse.

(11) TEI also believes that, since the problem extends beyond corporate taxpayers (with some of the suspect products' being sold to partnerships and individuals), any solution crafted by Congress should not be confined to corporations.

(12) Some examples of the Treasury Department's and the IRS's using their regulatory power to challenge certain classes of transactions include the partnership anti-abuse regulations (Treas. Reg. [sections] 1.701-2), the anti-conduit financing regulations (Treas. Reg. [sections] 1.881-3 and Prop. Reg. [sections] 1.7701(1)-2), and recently proposed regulations concerning fast-pay stock (Prop. Reg. [sections] 1.7701(1)-3). Moreover, the Treasury Department and the IRS have acted to pre-empt many transactions by formally announcing an intention to issue regulations attacking transactions with which they disagree. Examples of such administrative notices include those involving fast-pay stock (Notice 97-21, 1997-1 C.B. 407), foreign tax credit transactions (Notice 98-5, 1998-3 I.R.B. 49), and transactions involving foreign hybrid entities (Notice 98-11, 1998-6 I.R.B. 13). The Treasury has on occasion made its notices retroactive, which by itself dissuades taxpayers from undertaking transactions that the government might deem abusive. The foregoing list is not exhaustive, but it does illustrate the Treasury's and the IRS's willingness and ability to challenge abusive transactions without new legislation.

(13) It may well be that compliance is affected more by the certainty (or uncertainty) of application than by the level of the penalty.

(14) Coincidentally with the controversy about corporate tax shelters, the IRS has built an impressive track record in cases it perceives as abusive. See, e.g., Jacobs Engineering Group, Inc. v. United States, 97-1 U.S.T.C. [paragraph] 50,340, at 87,755 (C.D. Cal. 1997), aff'd, 99-1 U.S.T.C. [paragraph] 50,335, at 87,786 (9th Cir. 1999); The Limited, Inc. v. Commissioner, 113 T.C. No. 13 (Sept. 7, 1999), as well as the cases listed on page 11 of this testimony. What was missing was the IRS's willingness and ability to successfully assert penalties against sophisticated taxpayers. Significantly, the IRS has begun to assert and the courts sustain penalties against large corporate taxpayers. See Compaq Computer Corp. v. Commissioner, 113 T.C. No. 17 (1999), and United Parcel Service of America v. Commissioner, T.C.M. No. 268 (1999). This is a significant development, for it not only underscores the continuing vitality of the common law business purpose requirement but cannot help but prompt otherwise aggressive taxpayers to modify their behavior.

(15) For example, revised regulations could provide that a taxpayer may not rely on the opinion of a professional adviser that fails to contain a complete and accurate description of the facts underlying the transaction.

(16) It is clear from the recent IRS victories in court that when the IRS becomes aware of a potentially abusive transaction, judicial doctrines including those relating to sham, economic substance, business purpose, substance over form, and step transaction -- especially when coupled with existing statutes such as sections 446, 482, 7701(1), and 269 -- provide the IRS with significant tools to ensure that the system works. We are concerned that attempting to codify the common law doctrines could further complicate and confuse the system and undermine legitimate tax planning.

(17) Under section 6662, disclosure can have the effect of immunizing taxpayers from the accuracy-related penalty, but disclosure will not have this effect if a tax-shelter item is involved. Ironically, then, current law has the perverse effect of discouraging disclosure of such items.

(18) Thus, TEI agrees with the Joint Committee staff and Treasury Department that the tax system may require adjustments to better balance the cost-benefit analysis undertaken by promoters. Otherwise, a promoter may have little incentive to stop marketing abusive products. We note that some have argued that promoter fees are the "oxygen" vital to the fire of tax shelter products and they have therefore proposed that promoter penalties should be as much as 50 percent of the fees earned on the product and, further, that they be crafted so that the promoters cannot avoid the incidence of the penalty by passing on the risk to clients. While TEI believes that these proposals may merit consideration, the Institute has not yet taken a formal position on them. We do believe, however, that should new promoter penalties be enacted, they should afford promoters an independent review process that is separate from the examination of the taxpayer's return. Moreover, any legislation should make it clear that where a taxpayer implements a sound tax planning idea in an abusive manner, penalties should not be imposed on promoters.

(19) While section 6111(d), once operative through the issuance of regulations, will require registration of more transactions, that provision may not work as intended.

(20) TEI believes that a key to an effective early warning system involving promoters is the development of clear "triggers" for disclosure. Hence, we suggest that a promoter's disclosure could be tied to (1) the receipt of a minimum level of fees by the promoter and (2) the presence of other "indicators" or "filters" in a transaction. One possible approach would require the promoter to file a statement with the IRS no later than 30 days after the receipt of $100,000 or more in fees from two or more taxpayers in respect of that product (or a substantially similar product). At a minimum, two or more tax shelter "indicators" or "filters" would be required (promoter fees plus some other indicator) for a tax shelter transaction to be found. The disclosure statement filed by the promoter would fully describe the product, the amount of fees collected, the name and employer identification number of the clients, and which indicators were triggered. Consideration should be given to affording promoters the opportunity to obtain an advance ruling on whether a product should be registered. The purpose of the disclosure is to alert the IRS that it might wish to examine the transaction. Whether through this or other means, taxpayers with transactions meeting two or more "indicators" should be required to provide complete and meaningful disclosure with their retrains. While alerting the examiner to a potential problem area, TEI strongly believes that the indicators should be used exclusively to trigger promoter disclosures. Hence any legislation should confirm that no inference should be drawn concerning the proper treatment of a transaction that is subject to early disclosure by a promoter.

(21) Lee Sheppard, "Slow and Steady Progress on Corporate Tax Shelters," Tax Notes, July 12, 1999, at 194. Some proponents of the attestation requirement have previously expressed surprise at TEI's opposition to the proposal, suggesting that the requirement would take in-house tax professionals "off the hook" by transferring responsibility to the CFO or another senior corporate officer. Whether short sighted or not, we take our professional responsibility to our companies and to our systems too seriously to support such a "pass the buck" strategy.

(22) Specifically, we are concerned that revenue agents might use the possible assertion of penalties against the CFO as a lever in their negotiation of the underlying tax treatment with the corporate tax director. Thus, the discussion could go, as follows: "If you don't concede the merits of this transaction, I am going to refer your boss's attestation to the criminal investigation division." Although according the attesting officer due process rights in respect of any penalty assertion is important, we question whether that alone will ensure the provision is not used improperly. Similar concerns make us less than sanguine about requiring companies to publicly disclose tax penalties above a certain dollar threshold in their financial statements.

(23) 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.

(24) It should also be recognized that the person making the decision whether the taxpayer was "at least probably right" or assessing the correctness of the taxpayer's "highly confident" claim (i.e., revenue agent, Appeals officer, or court) would not even reach that question until concluding that the taxpayer was wrong on the merits.

Chuck Shewbridge's Oral Statement

At the Committee on Ways and Means hearing, TEI's President Charles W. Shewbridge, III had five minutes to summarize the Institute's written testimony. Mr. Shewbridge's oral statement follows.

Mr. Chairman, TEI's perspective differs from that of other organizations represented on this panel. The Institute does not represent the so-called tax shelter promoters and developers who either sell or facilitate the transactions. And we do not represent the professional advisers who opine on the legitimacy of the arrangements. Rather, TEI members work directly for the corporations that enter into business transactions that require an analysis of their tax benefits and burdens. In other words, TEI members are in the thick of it. We along with the government have the most at stake in trying to craft a workable solution to this challenge.

Before proceeding, Mr. Chairman, I want to endorse a comment that Congressman Doggett made last week. He recommended that both sides avoid "immoderate rhetoric," which I interpret as meaning we should act on facts, not feelings. Thus, I think it is both unfair and inaccurate to make blanket statements about the cause and scope of the tax shelter problem. And if I might, I wish to register my particular disagreement with the comment in the ABA's written statement that "corporate tax managers often believe they have nothing to lose by entering into an aggressive tax shelter." Yes, there may be so-called bad actors in the tax community who promote, opine on and otherwise facilitate, or participate in aggressive transactions. I believe, however, that we must guard against overstatement.

I have been a tax professional for nearly 30 years, and have been employed by BellSouth for half of that period. As the company's senior tax official, I am ultimately responsible for the 40,000 federal, state, local, and foreign returns we file annually. BellSouth's 1998 federal income tax return, which I signed earlier this year, reflects aggregate tax payments of more than $1.6 billion. Given the size of those numbers and given the fact that I sign BellSouth's tax returns under penalties of perjury, it should go without saying that I take my job, including my responsibility to the tax system, seriously. So do my colleagues at TEI.

Although I question some of the rhetoric that has been used in discussing tax shelters, I think it is very important to note significant areas of agreement. We agree that over-aggressive tax-advantaged products are being marketed. We agree that the IRS must do more to challenge and curtail these transactions, including raising practitioner standards and, where appropriate, asserting penalties more frequently. And we agree that better, fuller disclosure -- including early warning disclosure by promoters -- lies at the heart of successfully dealing with the situation.

Where we disagree, Mr. Chairman, is in very important details. First, as an organization of women and men who will have to comply with whatever disclosure regime is enacted, TEI does not believe concerns about the definition of a corporate tax shelter can be cavalierly dismissed. It has been suggested that a tax shelter is any transaction where the potential business or economic benefit is immaterial or insignificant in relation to the tax benefit. With three decades experience, I think I know what is meant by the words "immaterial" and "insignificant," and I strongly believe that BellSouth has engaged in no abusive tax shelters. But I am very much concerned that some time in the future a revenue agent may disagree with me. At that point the issue will be joined as both sides may be forced to engage experts to argue over the meaning of "significant" and "material" and, in the case of the ABA's proposal, whether the $10 million disclosure threshold was crossed.

Mr. Chairman, TEI believes it is critical to know what we are talking about. The definition of tax shelter must be as objective as possible. Thus, we look forward to working with the Treasury and congressional staffs and our colleagues in the practitioner community in refining the definition of corporate tax shelters.

The second issue I wish to discuss is the proposal that the Chief Financial Officer or another senior officer be required to certify that the facts disclosed about a tax-shelter transaction are true and correct. TEI believes the proposal misses the mark. It misapprehends the role of the tax department as well as the CFO, it impugns the integrity and professionalism of both, and it ignores how the provision would adversely affect the examination process.

The proposal is flawed because it proceeds from the faulty premise that companies unknowingly enter into major transactions and that the people who prepare and sign billion-dollar corporate returns do so lightly. I certainly do not. It is totally without basis to say that a company's senior officers would permit abusive transactions to go forward but for the sanctions that would flow from the proposal.

TEI's concerns, however, go beyond the proposal's attack on the professionalism of corporate tax directors. It poses a serious threat to tax administration. If enacted, the proposal could lead to focusing not on the underlying transaction but on the CFO's statement. Hence, the key would not be whether a transaction passes muster under the law, but rather "what did the senior officer know and when did he know it?" We regret that the proposal could easily spawn suspicion and distrust comparable to that which existed in the 1970s concerning questionable payments to foreign persons.

In conclusion, TEI supports meaningful action in this area, but before legislation is enacted, the proposals must be refined. We look forward to working with the committee to this end. Thank you.

TEI Hosts IRSAC, Senior IRS Officials

On November 9, TEI hosted a reception for the members of the IRS Advisory Council and senior IRS officials. Among the issues discussed at the meeting was the IRS's ongoing modernization effort, including the establishment of a Large and Mid-Size Business Business Operating Division and the organization of the division along industry, as opposed to geographic lines. During the reception, Larry R. Langdon (at left in the photo), formerly of Hewlett-Packard Company and a recipient of TEI's Honorary Membership award, talked with TEI President Chuck Shewbridge about the challenges awaiting him as the Commissioner of the LMSB division.