TEI comments on pending U.S. legislation on international taxation proposals.

March 10, 2004

On March 10, 2004, Tax Executives Institute filed the following comments with the tax-writing committees of the Senate and House of Representatives on certain proposals in pending legislation.

On behalf of Tax Executives Institute, I submit the following comments on certain provisions being considered as part of H.R. 2896, the "American Jobs Creation Act of 2003" and S. 1637, the "JOBS Act of 2003," now before the House and Senate. Some of the provisions under consideration in conjunction with the international bills have special merit and should, TEI believes, be contained in the final legislation. Others contain special policy concerns, and TEI would ask that the provisions not be adopted when the legislation is finalized.

Tax Executives Institute

Tax Executives Institute was established in 1944 to serve the professional needs of business tax professionals. Today, the broad membership of the Institute is organized into 53 chapters in the United States, Canada, and Europe. Our diverse membership of more than 5,400 accountants, attorneys, and other business professionals work for 2,800 of the leading companies in North America and Europe. As a professional organization, the 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 costs and burdens of administration and compliance to the benefit of taxpayers and government alike. The Institute is committed to maintaining a system that works one that builds upon the principle of voluntary compliance and is consistent with sound tax policy, one that taxpayers can comply with, and one in which the IRS can effectively perform its audit function without unduly burdening taxpayers. Our background and experience enable us to bring a unique and, we believe, balanced perspective to the legislation at hand.

Provisions That Should Be Included in Final Legislation

TEI recommends favorable consideration of the following provisions.

Five Year Carryback of Net Operating Losses 

In general, a net operating loss (NOL) may be carried back two years and carried forward 20 years to offset taxable income in such years. In 2002, Congress temporarily extended the general NOL carryback to five years (from two years), and also provided that an NOL deduction attributable to NOL carrybacks arising in taxable years ending in 2001 and 2002, as well as NOL carryforwards to these taxable years, may offset 100 percent of a taxpayer's Alternative Minimum Taxable Income (AMTI). These provisions allow taxpayers to smooth out swings in business income that result from business cycles, and the carryback is a much more time effective remedy, that is, the relief arrives at or near the time of the economic setback from a recession like the one that many companies have had to endure in the past few years. The Senate bill would provide a three year carryback of NOLs arising in taxable years ending in 2003, and AMTI relief similar to that in the 2002 law. The House bill does not contain the provision, but the House separately passed a five-year relief provision similar to the Senate bill provision in H.R. 3521, the Tax Relief Extension Act of 2003. TEI urges the Congress to pass the five-year relief provision as part of the international bills. An extension of the five-year, or at least three-year, carryback would be a sound investment that pays for itself with healthier companies contributing toward the economy and higher tax receipts in the future.

Pension Related Provisions--Exclusion of ISO and Employee Stock Purchase Plan SOs from Wages

TEI commends Congress for its continuing efforts with respect to eliminating income tax withholding on the exercise of Employee Stock Purchase Plan options and Incentive Stock Options (collectively referred to as "options"). During 2003 alone, Congress has inserted language to clarify the appropriate treatment of in at least five separate pieces of legislation. For myriad reasons, none of the related bills reached the President's desk in final form, but nowhere has it been suggested that there is any disagreement with the intent of the proposals to exclude these options from wages.

Further, despite the fact that for more than 30 years Treasury policy was that options were not subject to employment tax withholding, in 2001, proposed rules were issued which would have imposed employment tax withholding beginning in 2003. However, Notice 2002-47, 2002-28 I.R.B. 97, was issued last year in which the IRS announced that until further guidance is issued, it will not assess FICA or FUTA taxes, or impose Federal income tax withholding obligations, upon either the exercise of an option or the disposition of the related stock. Nonetheless, representatives of both IRS and Treasury have stated that in order to maintain that position, legislation clarifying the law is important.

TEI urges Congress to clarify that neither FICA or FUTA taxes, nor Federal income tax withholding, need be imposed upon either the exercise of an option or the disposition of the related stock.

Extenders--The Research Credit

The current credit for increasing research activities will expire June 30, 2004. This credit is critical to the efforts of many U.S. companies to maintain their competitive business edge in the marketplace. Recognizing this, H.R. 463, the Investment in America Act of 2003, would permanently extend the research credit, increase the rates of the alternative incremental credit, and provide an alternative simplified credit for qualified research expenses. Similar legislation, S. 664, has been introduced in the Senate.

Last week, the Senate moved by amendment to adopt similar provisions into S. 1637 as it is considered on the floor, extending the credit for a period of eighteen months to December 31, 2005. Another timely extension of the credit, like that in the Senate bill, is critical, but making he credit permanent is badly needed. The potential for lapses or even expiration makes necessary planning and investment for facilities and programs very difficult.

Provisions That Should Not Be Included in Final Legislation

TEI recommends that the following provisions be abandoned or, in the case of the tax shelter penalty provisions, be substantially modified.

CEO Reviews of and Signatures on Corporate Tax Returns

We fully support the goals of enhancing corporate accountability and improving the tax system, but regret that proposals that would require the corporate CEO to review and sign the corporate tax returns would not have the salutary effects hoped for and, indeed, could prove counterproductive. We urge the Committee to abandon it insofar as it would require the CEO to focus on the tax returns of a company, rather than the process of ensuring the complete and proper reporting of its tax obligations.

Currently, most companies designate their Chief Tax Officer or Chief Financial Officer as the responsible officer who must perform that certification. Although intended to enhance corporate accountability in the aftermath of recent financial reporting failures, the CEO signature proposal will not advance the goal of minimizing such failures and, indeed, would put undue burdens on fully compliant companies and even prove counterproductive. The Sarbanes-Oxley Act of 2003 strengthened the accountability of CEOs and CFOs for corporate financial matters. For example, CEOs are now required to certify the financial statements of corporations, which contain a provision for taxes. This certification requirement, which requires significant corporate resources, ensures that the CEO is committed to, and responsible for, the fair presentation of the company's financial results, including its taxes.

The tax affairs of major corporations, especially those with operations in numerous countries, are extraordinarily complicated. For this reason, their day-to-day management is routinely delegated to the Chief Tax Officer (or similarly titled individual) who has been specially trained. While the senior officers (including the CEO and CFO) remain ultimately responsible for the company's compliance with the tax laws--and all other laws--rarely would a CEO be personally involved in the myriad tax rules that apply to literally thousands of transactions reflected in the company's tax returns.

The CEO signature proposal would force companies to devote substantial time and resources to educating CEOs about the intricacies of the company's tax affairs, distracting them (and the company's tax personnel) from activities that put their respective professional expertise to their best uses--including, in the case of the CEO, overarching issues of corporate governance and accountability, as well as the company's strategic vision and operations. The burdens would be especially pronounced in respect of companies that are subsidiaries of foreign companies, whose CEOs may require even more detailed briefings.

In a typical year, corporate tax officials will sign under penalties of perjury hundreds, sometimes thousands, of U.S. federal, state, and local income, excise, and property tax returns, as well as foreign tax returns. These returns contain a number of schedules that are separately signed by the officer executing the affected return.

If this provision is emulated by state and local and foreign jurisdictions in an effort to address the same concerns, the CEO of a corporation may be required to devote an ever greater amount of his or her time and corporate resources to these matters.

Codification of the Economic Substance Doctrine

TEI is pleased that the House, in considering H.R. 2896, has not included the proposal to codify the economic substance doctrine, and has included a modified version of the tax shelter penalty provisions.

TEI firmly believes that the key to stopping tax shelter abuses is the effective administration of the tax law. Effective administration of the law, in turn, depends upon the ability of IRS agents to identify and analyze transactions, and, where necessary, to challenge them. For this reason, the Institute supported the creation of the IRS's Office of Tax Shelter Analysis to identify, quantify, and develop comprehensive approaches to dealing with tax shelters (including the issuance of needed substantive guidance). Moreover, TEI has consistently urged the Congress and the Treasury Department to focus on and enhance disclosure-based approaches to address tax shelters.

The proposal to codify the economic substance doctrine adopts a much different approach to the tax shelter issue, which TEI opposes for the following reasons:

* The provision is too broad in scope, ensnaring many wholly legitimate transactions.

* Taxpayers cannot adequately define "meaningful" changes to economic position, "substantial" nontax purpose or "reasonable" means of accomplishing such purpose.

* Current law permits taxpayers to enter transactions lacking economic substance if the resulting tax benefits were intended by Congress. The proposal would seemingly make all tax benefits resulting from transactions that lack economic substance, including tax benefits specifically intended by Congress, open to challenge.

* Granting the Treasury Department regulatory authority to clarify the above issues will only postpone the difficult decisions, will likely make tax administration more complicated, and also raises troublesome tax policy issues.

Overlaying the Internal Revenue Code with a complex, subjective anti-abuse rule would add significantly to the overall complexity of the tax system, significantly reduce the certainty of application of its rules, make voluntary compliance difficult for many taxpayers, and perhaps even frustrate future efforts to combat abusive transactions.

The economic substance doctrine was developed by the courts to complement, or provide a backstop to, the Internal Revenue Code's substantive provisions. When abuses occur, the courts have demonstrated their willingness to utilize existing doctrine or to create new ones to prevent abuse. Regrettably, codifying the economic substance doctrine would further complicate and confuse the system and undermine not only legitimate tax planning but the courts' willingness and ability to apply this and other judicial doctrines. Accordingly, TEI urges Congress to reject these provisions.

Tax Shelter Penalties

Penalty provisions contained in pending Senate bills raise serious concerns:

* The use of strict liability penalties will not accomplish their intended purpose.

* There is no evidence that raising the penalty rate above an already high 20 percent would increase the efficacy of the current penalty regime.

Sections 402, 403, 404, 405, 416, and 417 of S. 1637, like similar provisions contained in other pending legislation, would make significant use of increased accuracy-related penalty rates (as noted above, as high as 40 percent), impose stringent standards for avoidance of penalties and waiver of them (which in many cases essentially impose a form of strict liability that affords no discretion in their application), and impose other punitive provisions on taxpayers that would deny interest deductions on underpayments, extend statutes of limitations, levy fines, and require disclosures in filings with the Securities and Exchange Commission.

There is no evidence, anecdotal or otherwise, that the efficacy of the current penalty regime would be increased by raising the rate above an already high 20 percent. (1) TEI believes that consistency, certainty, and fairness in the application of penalties play a bigger role in deterring noncompliance than viscerally increasing the amount of them.

A fundamental problem with the administration of the current penalty is that the rate is already so high that it is rarely asserted against corporate taxpayers. Where penalties and their consequences are disproportionate to the conduct involved, revenue 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 asserted it. (2) In this regard, we reiterate our concern about taking the decision to assert the penalty out of the hands of the examiners, (3) which may have the perverse effect of putting not only the penalty imposition at risk, but the underlying tax as well, because field agents may decide not to challenge the underlying return position itself given the harsh and unavoidable consequences. Thus, while administrative review is often helpful in strengthening the fairness and certainty of application of penalties, TEI believes diminishing the agent's discretion is unwarranted.

Further, proposed strict liability regimes stand in marked contrast to current law where, no accuracy-related penalty will be imposed in respect of any portion of the underpayment for which there is reasonable cause if the taxpayer acted in good faith. Strict liability penalties for underpayments or nondisclosure will invariably produce harsh and disproportionate results. There is no evidence to suggest that the in terrorem effect of a no-fault penalty regime would have a positive effect on compliance.

Finally, TEI submits that the standard of authority required for avoiding understatement penalties for an undisclosed transaction, combined with the new penalty provisions, would effectively compel cautious taxpayers to disclose myriad legitimate business transactions that otherwise do not meet the definition of a reportable transaction, undermining the goal of highlighting troublesome transactions to the IRS. We urge Congress to rethink these proposals.

In summary, as we have in the past, we continue to urge Congress to move cautiously in enacting new penalties.

In Conclusion

As Congress works to complete this important legislation, we ask consideration of these comments, specifically that provisions be added to the bill that would: (1) add a five-year, or at least a three-year carryback, of NOLs similar to previously passed legislation; and, (2) clarify that neither FICA or FUTA taxes, nor Federal income tax withholding, need be imposed upon either the exercise of an option or the disposition of the related stock. TEI urges Congress to timely act on the research and experimentation credit to keep these vital activities underway in the United States.

Lastly, several provisions now being considered as part of the process of finalizing the legislation should be abandoned or substantially modified as the bills are completed. Specifically, we ask that the provisions requiring CEOs to review and sign the tax returns of a corporation and codification of the economic substance doctrine together with the related 40-percent penalty be dropped, and that the tax shelter penalty proposals be substantially modified as discussed above.

Any questions about the Institute's views should be directed to either Timothy J. McCormally, TEI Executive Director, or Fred F. Murray, the Institute's General Counsel and Director of Tax Affairs at 202.638.5601.

(1) Those who minimize the deterrent effect of a 20-percent penalty, averring it as merely constituting another "cost of doing business," fail to understand both the mathematics of the situation and the aversion of companies (especially publicly held companies) to having any penalty imposed.

(2) 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.

(3) Once a penalty (regardless of whether the transaction was disclosed) has been included in the Revenue Agent Report, the penalty cannot be compromised for purposes of a settlement without the approval of the Commissioner personally or the head of the Office of Tax Shelter Analysis. Furthermore, the IRS is required to submit an annual report to Congress summarizing the application of this penalty and providing a description of each penalty compromised under this provision and the reasons for the compromise." S. REP. No. 108- --, at 32-33 (2003). These requirements were obviously designed to make it difficult to waive the penalty; however, the design essentially makes it almost certain that the penalty would not be waived in a given case.