Proposed amendment of the substantial understatement penalty.

Tax Executives Institute opposes the proposal in pending GATT funding legislation that would amend the substantial understatement penalty to provide that the amount of any corporate understatement may not be reduced to the extent attributable to a "tax shelter." The proposal is misguided and discriminatory, and should be rejected.

Background

In 1989, Congress enacted the Improved Penalty Administration and Compliance Act, which was intended to strip the Internal Revenue Code of irrational, unfair, and duplicative penalties. IMPACT was the result of a comprehensive, bipartisan, government-private sector initiative to improve the tax system and to restore balance to a penalty regime that was badly out of whack.

Although Congress has enacted amendments to the penalty provisions of the Code since 1989 (in particular, in respect of transfer pricing adjustments under section 482), the basic structure and philosophy of IMPACT remain intact. As the principal association of corporate tax executives in North America,(1) Tax Executives Institute was pleased to participate in the process that led to the enactment of IMPACT. The legislation not only brought a measure of rationality to the Code's penalty provisions, but it also restored fairness and promised stability. Regrettably, that rationality, fairness, and stability would be significantly eroded by the GATT penalty proposal.

Under current law, a 20-percent accuracy-related penalty will be imposed, in the absence of reasonable cause, in respect of substantial understatements of income tax. (I.R.C. [sections][sections] 6662(a), (d).) The amount of any understatement, however, is to be reduced to the extent it is attributable to (i) an item that is adequately disclosed on the taxpayer's return or (ii) an item in respect of which the taxpayer's treatment is supported by substantial authority. (I.R.C. [sections] 6662(d)(2).)(2) More stringent rules already apply in respect of tax shelters. Specifically, section 6662(d)(2)(C) provides that disclosure of an item on the taxpayer's return will not insulate the taxpayer from a penalty and, further, that the substantial authority exception will be available in respect of tax shelter items only if the taxpayer reasonably believed that the tax treatment of the item was "more likely than not" the proper tax treatment. For purposes of the penalty, section 6662(d)(2)(C)(ii) defines a tax shelter as--

    (I)    a partnership or other enti-
           ty,
    (II)   any investment plan or ar-
           rangement, or

(III) any other plan or arrange-

ment,

if the principal purpose of such

partnership, entity, plan, or ar-

rangement is the avoidance or

evasion of Federal income tax.

Although the language of the proposal has not been released and, indeed, the description of its terms remains vague,(3) it appears that the proposal would amend section 6662(d)(2) to provide, as follows: Where an understatement of federal income tax by a corporation is attributable to a tax shelter, the 20-percent penalty will automatically and unconditionally be imposed; the existence of substantial authority for the taxpayer's position and the taxpayer's reasonable belief that the treatment of an item is more likely than not the proper treatment will provide no protection to the corporate taxpayer. In other words, the proposal would transform section 6662(d) into a no-fault penalty whenever the IRS asserts that the item giving rise to the understatement is a tax shelter. TEI strongly objects to the proposal.

Summary of TEI's Position

The GATT funding proposal in respect of the accuracy-related penalty for substantial understatements of tax by corporations should be rejected. The proposal misapprehends the basic purpose of penalties--to punish culpable behavior. Consequently, it is unfair and threatens to undermine taxpayer confidence in the tax system. Indeed, the proposal threatens to upset the balance that IMPACT struck between the rights of taxpayers (struggling in good faith to comply with an undeniably complex tax law, especially as it applies to corporations) and the Internal Revenue Service (charged with enforcing that law), by handing the IRS a blunt instrument with which it can extract taxpayer concessions. Finally, the proposal discriminates against one class of taxpayers--corporations--where there is no empirical, or even anecdotal, evidence--suggesting that they should be targeted for harsher treatment.

Concerns about the Process

Before turning to our substantive objections to the GATT penalty proposal, TEI wishes to register its concern about the process by which the proposal was developed.(4) To the Institute's knowledge, no showing of need has been made for the proposed amendment to section 6662. No analysis has been prepared by the Treasury Department, IRS, or tax-writing committees on the need for any change; no hearing has been held; no legislative language has been released for public comment (if such language has even been prepared); no opportunity has been provided to affected taxpayers to understand the proposal and to present arguments (pro or con) on its merits. TEI submits that it is only by airing such proposals--by letting them, quite candidly, pass or flunk the smell test--that Congress can vindicate the constitutional right to petition the government for rederss of grievances and fulfill its obligations to the American people to pass rational, necessary, and effective legislation. Concededly, opening up the process may require more time, but we believe it would produce better results than those that emerge from behind closed doors. For example, if hearings were held on the GATT penalty proposals, IRS and Treasury officials (as well as the congressional leaders who led the reform effort that culminated in IMPACT) could address whether their agencies have changed their view on the purposes of the Code's penalty provisions and, if not, how the GATT penalty proposal can be squared with the philosophy underlying IMPACT.

Discussion

TEI submits that the GATT penalty proposal misapprehends the basic purpose of penalties to punish culpable behavior. To encourage compliance, to be fair, penalties should not be automatic; rather, they should be fault-based. In 1989, Congress overhauled the Code's penalty provisions because of concern that the accuracyrelated penalties "have been determined too routinely and automatically by the IRS." (H.R. Rep. No. 101-247, 101st Cong., 1st Sess. 1391 (1989).) The purpose of penalty reform was to avoid a "gotcha" mentality--the notion that if your tax treatment of an item is incorrect, you intentionally must have done something wrong and you shall be penalized.

Regrettably, that is precisely what the GATT penalty proposal would do: it would impose penalties automatically without any regard to the taxpayer's culpability. The proposal thus ignores the fact that the tax law is by no means clear: it is so complicated and prolix; so open to multiple interpretations (especially in the absence of regulatory guidance); and so subject to numerous, varied, and rapid changes, that taxpayers cannot help but sometimes take positions that in retrospect are determined to be erroneous.(5) TEI believes--and common sense and fairness demand--that taxpayers who strive in good faith to comply should not be penalized.(6)

Let there be no mistake: The Internal Revenue Code is currently replete with provisions to penalize taxpayers for taking erroneous and unduly aggressive positions. There has been no showing of an increase in corporate misbehavior and, just as important, no showing why any misbehavior that may be occurring cannot be adequately dealt with under the current penalty scheme.

Specifically, no explanation has been forthcoming on why the substantial understatement penalty should be "tightened" in respect of so-called tax shelters. The supporters of the proposal apparently believe that tax shelters are so heinous, so inimical to the fair operation of the tax system, that any taxpayer who engages in them should be automatically penalized. In other words, the term "tax shelter" is being used as a shibboleth--a catchphrase that, combined with what appears to be a conscious decision not to release the details of the proposal and not to consult with the practitioner community, is intended to cut off debate. "It deals with tax shelters," someone might be heard saying. "Trust us. Only bad guys deal in tax shelters."

In point of fact, the term "tax shelter" is extraordinarily broad and ambiguous. Under section 6662(d)(2)(C), it encompasses any partnership, entity, investment plan or arrangement, or any other plan or arrangement if the principal purpose of the partnership, entity, plan, or arrangement is the avoidance or evasion of tax. The problem is that no one knows for sure what is included within the scope of the term, especially since it makes no distinction between tax evasion and tax avoidance.(7) What is known is that, if the GATT proposal becomes law, an IRS examining agent need only assert that a partnership, entity, plan, or arrangement is a "tax shelter" and the taxpayer will be face-to-face with a 20-percent, no-fault penalty.

True, the taxpayer may be able to establish that the principal purpose of the transaction is not tax avoidance, but the provision will clearly be available for use as a club against taxpayers who endeavor in good faith to comply with the tax law. (See Staff of the Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Tax Equity and Fiscal Responsibility Act of 1982 (H.R. 4961, 97th Cong., Public Law 97-248), 97th Cong., 2d Sess. 218 (1982).) Indeed, since the TAx Reform Act of 1986 effectively shut down the abusive arrangements that originally gave rise to congressional action on tax shelters, there is a very real concern that the term will be stretched to encompass legitimate transactions. Thus, an agent could approach a taxpayer and say, "if you agree to this adjustment that will be it, but if you fight it, I will characterize it as a tax shelter and you will be looking at a 20-percent higher figure--automatically." Such a "hard-line" approach may generate the promised revenue, but it will likely also breed disrespect for the fairness of the tax system. What is more, it may increase the likelihood that some taxpayers will expend greater resources disputing the asserted liabilities, rather than settling their cases. At a minimum, it threatens to make a mockery of the promises underlying the taxpayer bill of rights in general and IMPACT in particular.

In addition, the GATT penalty proposal would discriminate against businesses that operate in corporate form, even though there is no empirical evidence suggesting that they should be singled out for harsher treatment. Thus, just as the lowerinterest-on-refund GATT proposal is aimed at the corporate community for no principled reason, the target of the GATT penalty proposal is similarly only corporate taxpayers. What is ironic about this is that, if previous experience with tax shelters is any guide, corporations are not the taxpayers that engage in tax shelters; it is individuals who do so. Indeed, inasmuch as corporations (especially publicly traded corporations) are subject to scrutiny by federal and state regulators (as well as to the scrutiny of independent public accountants), it is unfathomable that corporations are being singled out for harsh treatment.

Finally, we suggest that there is something perverse in enacting a penalty provision as part of a trade agreement that will stifle the very form of business entities that companies are likely to employ in structuring international joint ventures--viz., partnerships. Specifically, we believe the GATT penalty proposal would undercut efforts by U.S. corporations to compete more effectively abroad, by raising the specter that partnerships and other innovative forms of doing business will be characterized as tax shelters for purposes of section 6662(d).

For the foregoing reasons, TEI opposes the proposal to amend the substantial understatement penalty.

(1)The Institute's nearly 5,000 members represent the largest 3,000 companies in the United States and Canada, and are dedicated to promoting the uniform and equitable enforcement of tax laws throughout the nation and to reducing the costs and burdens of compliance to the benefit of both the government and taxpayers.

(2)In addition, section 6664(c) provides that the penalty is to be waived where it can be shown that there was reasonable cause for the taxpayer's treatment and that the taxpayer acted in good faith.

(3)For example, the "House Offer to Resolve Outstanding Differences Between the House Ways and Means and Senate Finance Committees on Implementing Legislation for the Uruguay Round Trade Agreements" (released August 22, 1994), states simply that proposal would "prohibit corporations from reducing the amount of an understatement for purposes of the substantial understatement penalty to the extent attributable to a tax shelter."

(4)These comments apply, with equal force, to other GATT funding proposals--including those relating to the interest rate on corporate tax refunds and to the exportsource rule.

(5)Sometimes the erroneous positions on the original return benefit the government and the taxpayer ultimately must file an amended return to secure a refund of the taxes it erroneously overpaid; other times the discovery of an error positions ultimately necessitate the payment of additional taxes.

(6)This is why TEI not only opposes the proposal to amend the substantial understatement penalty, but also opposes the proposal to reduce the interest rate on certain corporate tax refunds. The two proposals in tandem constitute a one-two punch against fairness in the tax law.

(7)Generally speaking, tax "evasion" encompasses illegitimate tax planning as well as conduct that is improper or illegal), whereas tax "avoidance" refers to tax minimization that is viewed as legitimate. See Richard A. Westin, The Tax Lexicon 1989, at 597, 599 (1988). See generally Helvering v. Gregory, 69 F.2d. 809, 810 (2d Cir. 1934) (Hand, J.) ("[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."), aff'd, 293 U.S. 465 (1935).