New disclosure rules require serious attention: a tax attorney reviews new regulations on 'reportable transactions' and their obligations on corporate taxpayers.

Spawned in reaction to the proliferation of heavily marketed "corporate tax shelters" and other "tax products," recently finalized Treasury regulations impose extensive disclosure and information retention obligations upon taxpayers and outside tax advisers in connection with so-called "reportable transactions." These rules are likely to have a significant impact upon the tax compliance function at most large corporations and other substantial business entities.

First proposed in early 2000, the disclosure regulations responded to the tax shelters' promise of very favorable tax results, based on often-strained readings of complex Internal Revenue Code provisions. The asserted tax treatment of some of these transactions is clearly improper under applicable law. But others can reasonably be viewed as falling in a gray area, and the courts have indeed sided with taxpayers in several tax shelter cases.

The Treasury Department and the Internal Revenue Service (IRS) believe that the most effective way to curb inappropriate tax shelter behavior is to shine an early spotlight on potentially abusive transactions by requiring detailed tax return disclosures. The cornerstone of the taxpayer disclosure regulations (promulgated under I.R.C. section 6011) is the reportable transaction" concept A companion set of "list maintenance" regulations keys off the same concept. It requires out-side promoters and tax advisers who receive fees prescribed thresh-olds (generally $250,000 for corporate taxpayers) to turn over to the IRS, upon request, substantial information regarding that tax structure and benefits of reportable transactions in which they are involved, including information on actual and prospective taxpayer-participants.

The final disclosure and listing regulations are significantly tighter than earlier versions, which applied only to corporate taxpayers, required the existence of at least two tax shelter characteristics and provided subjective-type exceptions that taxpayers and their advisers were prone to rely upon. Any one of six prescribed types of reportable transactions will now trigger disclosure, and the subjective exceptions are no longer available. What's more, the regulations now extend to all types of taxpayers, and also to taxes other than the income tax (including employment taxes, pension excise taxes and wealth transfer taxes).

The required disclosure of a reportable transaction is not an admission by the taxpayer that the claimed tax treatment is or may be incorrect. Nor will disclosure necessarily result in an audit, though the IRS does say that it expects to review all disclosures.

Listed Transactions

Only one of the "reportable transaction" categories targets transactions clearly perceived by the IRS as yielding "too good to be true" tax results--namely, "listed transactions" specifically identified as abusive tax shelters in published Treasury or IRS notices. Some 25 of these notices have been issued to date. (A current list can be viewed on the IRS Web site.)

Transactions deemed "substantially similar" to a listed transaction are also reportable. These include transactions based on a similar tax strategy, even if the fact pattern is dissimilar. The regulations warn that the "substantially similar" concept must be broadly construed. Many practitioners worry about the open-ended nature of the rules and potential misapplication by aggressive revenue agents.

Under current IRS audit procedures, examining revenue agents are instructed to obtain the "tax accrual workpapers" relating to the financial accounting treatment of listed transactions. If the listed transaction wasn't reported, or the taxpayer engaged in multiple listed transactions, the agent will likely ask for all of the taxpayer's tax accrual workpapers. In addition, proposed statutory penalties tied to the non-disclosure of reportable transactions would be more severe in the case of listed and "substantially similar" to listed transactions.

Other Reportable Transactions

Apart from listed transactions, the other reportable transaction categories include:

* Transactions that generate tax losses under I.R.C. section 165 exceeding specified one-year or multiple-year dollar thresholds ($10 million/$20 million for corporations).

* Transactions of public companies, or non-public companies with gross assets of at least $250 million, that give rise to book-tax differences exceeding $10 million.

* Transactions offered under conditions of confidentiality.

* Transactions in which the taxpayer's obligation to pay fees to a promoter or tax adviser depends on whether the asserted tax consequences are ultimately sustained or the taxpayer actually realizes tax benefits from the transaction.

* Transactions that generate a tax credit exceeding $250,000 (including a foreign tax credit) in connection with particular assets held by the taxpayer for less than 45 days (such as a dividend-paying stock).

For companies with a substantial volume of high-dollar and complex transactions, the loss transaction, book-tax and confidentiality triggers will require especially close attention. Contemporaneous with issuance of the disclosure regulations, the IRS issued a revenue procedure (Rev. Proc. 2003-24) that provides an exception for loss transactions associated with any asset that has a "qualifying tax basis." This generally protects loss assets that were purchased solely for cash (including with borrowed funds) or acquired in certain types of non-taxable transactions (including "like-kind exchanges," tax-free reorganizations and spin-offs of controlled subsidiaries).

Rev. Proc. 2003-24 further exempts from disclosure several specific types of loss transactions, whether or not the loss asset has a qualifying basis. This so-called "angel list" includes losses arising out of "mark-to-market" and hedging transactions, bulk sales of inventory and the abandonment of depreciable property.

Another revenue procedure (Rev. Proc. 2003-25) contains an "angel list" of some 30 specific exceptions to the book-tax trigger. These include certain "timing" differences (such as an expense item booked before it's deducted for tax purposes) and "permanent" differences (such as an item included as income for tax purposes, but never booked as income), as well as a host of other differences attributable to various items (such as financing transactions booked as "sales" or "leases," intercompany dividends or tax-free reorganization transactions).

Notably absent from this angel list are differences attributable to the use of "purchase" accounting in stock acquisitions for which an election is not made (trader I.R.C. section 338) to adjust the tax basis of the acquired corporation's assets to fair market value.

The confidentiality trigger comes into play when disclosure of the "tax treatment" or "tax structure" of the transaction is explicitly or implicitly limited to any extent. Confidentiality provisions frequently exist in everyday business transactions and agreements (such as leases, credit agreements, supply contracts, licenses, joint ventures, private placements, etc.). Yet it often will be difficult to conclude that sensitive information the parties wish to protect isn't in some way related to the transaction's tax treatment or tax structure.

Nor is it entirely clear that the confidentiality trigger can be avoided simply by using a "blanket" confidentiality clause with a carve-out for "anything relating to the tax treatment or tax structure of the transaction (subject to the securities law and M&A exceptions)."

Under a "safe harbor" rule, the confidentiality taint is removed if every person making a statement regarding the transaction's tax treatment furnishes to the taxpayer (within 30 days) a written authorization to disclose all tax-related information--including any tax opinions or analyses, or any documents or materials applicable to the tax treatment or tax structure.

The safe harbor may be of limited utility in large multi-party/multi-adviser transactions--because it may be impractical to identify every person who made a tax statement to the taxpayer or its representatives; or because the negotiations drag on for several months and not everyone making tax statements is diligent about satisfying the 30-day requirement.

The regulations also permit limited confidentiality under the so-called "securities law" and "M&A" exceptions. The former allows restrictions upon disclosure that are reasonably necessary to comply with applicable securities laws. The latter permits temporary confidentiality in the case of certain corporate acquisitions, until the earliest of the date on which: 1) discussions between the parties are publicly announced; 2) the transaction is publicly announced; or 3) the acquisition agreement is executed.

The Disclosure Process

Reportable transactions must be disclosed on IRS Form 8886, as an attachment to the taxpayer's return for the year in which the transaction occurs (or any subsequent taxable years to which it extends), Disclosures also are required for previously undisclosed transactions that subsequently become "listed," and in connection with refund applications claiming a loss carryback generated by a reportable transaction.

The required information includes a designation of the types(s) of reportable transaction involved; a fairly detailed description of the transaction and the expected tax benefits; and the names and address of any promoters or outside tax advisers involved in the transaction. A copy of initial Form 8886 for a reportable transaction has to be sent to the IRS Office of Tax Shelter Analysis in Washington.

Taxpayers can seek a private letter ruling front the IRS solely as to whether a contemplated transaction would be reportable; but disclosure generally won't be necessary if a rifling is obtained on the transaction's tax consequences. Alternatively, a "protective" disclosure can be filed in order to avoid any penalties tied to non-disclosure of reportable transactions.

Risks of Noncompliance 

Present penalties with respect to tax shelter transactions successfully challenged by the IRS are generally limited to the 20 percent "accuracy-related" penalty with respect to "substantial understatements" of tax liability (under I.R.C. section 6662). This penalty has often been avoided by obtaining an opinion from outside tax counsel that the transaction's asserted tax consequences are "more likely than not" correct.

There currently is no separate penalty for failure to disclose a reportable transaction. However, under proposed regulations that would apply to transactions occurring after Jan. 1, 2003, taxpayers cannot rely upon an outside "penalty protection" tax opinion with respect to an undisclosed reportable transaction.

The penalty stakes could soon become much more severe--see box on page 60. Other proposed anti-shelter measures include: 1) extending the statute of limitations from three to six years for undisclosed reportable transactions; 2) denying interest deductions with respect to tax deficiencies arising out of most reportable transactions; and 3) requiring CEOs to sign corporate tax returns. It's not clear that all of these measures will ultimately be enacted; but the odds are high that most will be.

Internal Compliance Measures

Most large companies have begun to develop and implement internal systems and procedures for identifying reportable transactions, gathering disclosable information and retaining related documents or other materials that may have to be disclosed in the course of an audit examination. Close coordination between the company's tax and accounting/financial departments, and consultation with the outside auditors, will be especially important in monitoring compliance with the book-tax and loss transaction triggers,

Likewise, in-house legal personnel should consult with the tax department (and, if necessary, outside counsel) regarding the language of all confidentiality provisions in company documents, as well as possible eligibility for the confidentiality safe harbor or the securities law or M&A exceptions.

Affected companies also should carefully document whatever compliance procedures may be adopted in connection with the identification and disclosure of reportable transactions. If and when a disclosable item inadvertently slips through the cracks, evidence of good-faith compliance efforts could help in obtaining an IRS waiver of penalties tied to non-disclosure,

Nondisclosure Penalties: Set to Rise?

Under proposed anti-tax shelter legislation now pending before both houses of Congress, nondisclosure of a reportable transaction (whether or not successfully challenged by the IRS) could result in penalties as high as $200,0000 for "listed" transactions and $100,00 for other reportable transactions. In addition:

* The existing 20 percent accuracy penalty would increase to 30 percent for listed and certain other reportable transactions that are not disclosed.

* Undisclosed transactions that lack "economic substance" (under proposed statutory criteria) could draw a 40 percent penalty.

* Listed and most other reportable transactions that are disclosed would escape penalty only if the taxpayer reasonably believed that the asserted tax treatment was more likely than not correct. Opinions from "disqualified tax advisers" could not be relied upon for this purpose.

* The penalty avoidance threshold would rise from "substantial authority" to "more likely than not" even for non-reportable transactions that are not disclosed.

Herbert N. Belier ([e-mail]) is a tax partner with Sutherland Asbill & Brennan LLP in Washington, D.C. He is the immediate past Chair of the American Bar Association Section of Taxation, is Co-Chair of the National Conference of Lawyers and CPAs and is a member of the Board of Regents of the American College of Tax Counsel.