Comments on revenue offset provisions in Senate tax reconciliation bill: January 10, 2006.
On behalf of Tax Executives Institute, I am writing to express TEI's opposition to certain revenue offset provisions contained in S. 2020, The Tax Relief Act of 2005, approved by the Senate. Identical or substantially similar provisions included in bills previously passed by the Senate have been previously rejected, most recently in H.R. 3, the Safe Accountable, Flexible, and Efficient Transportation Equity Act of 2005. The provisions should not be enacted in connection with the tax reconciliation measures currently pending in Congress relating to the federal government's 2006 fiscal year budget.
As the preeminent global association of in-house business tax professionals, TEI 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.
S. 2020, the Tax Relief Act of 2005 (hereinafter "the bill"), was approved by the Senate on November 18, 2005. The revenue offset provisions in the bill that are of concern to TEI have no counterparts in the Tax Relief Extension Reconciliation Act of 2005 (H.R. 4297), which was approved by the House of Representatives on December 8, 2005. A conference to reconcile the measures is expected soon.
TEI urges that the following provisions not be included in the final tax reconciliation bill.
Codification of the Economic Substance Doctrine and Related Provisions. Section 511 of the bill resurrects prior proposals to superimpose an "economic substance" test on top of the Internal Revenue Code's substantive provisions. Section 512 of the bill would add a penalty for understatements of tax for transactions lacking economic substance. Section 513 of the bill would deny the deduction for interest on underpayments attributable to transactions lacking economic substance.
TEI firmly believes that the key to stopping tax shelter abuses is the effective administration of the tax law's substantive provisions. 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 has long supported the full and adequate funding of the Internal Revenue Service. We also 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. In response, the Treasury and IRS developed regulations under section 6011 requiring extensive disclosures of reportable transactions that might be indicative of tax shelter transactions; Congress, for its part, enacted sections 6662A and 6707A, which penalize taxpayers for tax understatements attributable to reportable transactions and for failing to disclose reportable transactions, respectively. In addition, the IRS has developed a new Schedule M-3 as part of the Form 1120 U.S. Corporation Income Tax Return (among other returns) that dramatically expands the disclosure and reconciliation of financial and tax accounting differences. Finally, the Treasury Department and IRS have issued rules to restrict tax-shelter promoter activities and have substantially revised the standards of professional conduct for practice before the IRS (the Circular 230 rules), including the rules governing the issuance of opinions on transactions. TEI believes that these actions have already substantially curbed tax shelter activities, especially by large companies. (1) (See also the recent comments by the outgoing Director of the Congressional Budget Office that the recent upsurge in corporate tax receipts may be a result of stepped-up enforcement activities as well as greater restraint by companies because of greater attention to accounting rules. (2))
The economic substance doctrine was developed by the courts as a backstop to the Internal Revenue Code's substantive provisions. When abuses of substantive provisions of the Code occur, the courts have demonstrated their willingness and ability to use existing doctrine (or create new ones) to prevent such abuses. There is little if any empirical evidence suggesting anything more is needed. Indeed, codifying the economic substance doctrine would further complicate the system, confuse taxpayers and revenue agents, raise significant issues of statutory construction, impede the courts' ability to rely on existing precedent, and interfere with legitimate commercial transactions. Thus, adding a complex, subjective anti-abuse rule like section 511 of the bill to the Internal Revenue Code might well be counterproductive and even frustrate IRS efforts to combat abusive transactions. As a result, TEI urges rejection of the codification of the economic substance doctrine.
In addition, we oppose the penalty provision for "noneconomic transactions" set forth in section 512 of the bill as creating unnecessary complexity and confusion. The penalty would overlap with many existing penalty provisions including the general underpayment of tax penalty in section 6662 and the recently enacted section 6662A penalty for underpayments of tax for reportable transactions. Finally, we believe that a 40-percent penalty is too high and may affect the decisions of the IRS to assert the penalty or the courts to uphold them. There is no evidence, anecdotal or otherwise, that the efficacy of the current penalty regime would be increased by layering on another penalty regime or raising the rate above an already high 20 percent. TEI believes that consistency, certainty, and fairness in the application of penalties play a bigger role in deterring noncompliance than viscerally increasing the penalty rate. Thus, we urge that section 512 of the bill (as well as the related provision in section 513 denying an interest deduction for underpayments attributable to noneconomic transactions) be rejected.
Denial of Deduction for Certain Fines, Penalties, and Other Amounts. Section 533 of the bill would disallow a deduction for certain fines, penalties, or other amounts paid at the direction of a government entity in relation to a violation of law, investigation, or inquiry into a potential violation of law. Although intended to clarify what fines and penalties are non-deductible under Code section 162(f), the proposal goes much further, potentially denying a deduction for "other amounts" such as costs associated with safety recalls, food safety or health department directives, or recommendations of the Occupational Safety and Health Administration or the Environmental Protection Agency. As important, there are a host of court decisions that provide guidance to distinguish between nondeductible fines and penalties and deductible amounts, such as restitution or other compensatory payments. Thus, when government agencies settle claims and inquiries into potential violations of the law, there is currently ample guidance available that will permit the governmental agencies to structure the payments as deductible--or not--as appropriate to the circumstances. Given the public policy ramifications of hampering the many remedial and compensatory activities undertaken by taxpayers, as well as the added disincentive the proposal would create for quickly settling governmental inquiries and investigations, the proposal should be set aside.
Disallowance of the Deduction for Punitive Damage Awards. Section 534 of the bill would amend section 162(g) of the Code to disallow deductions for punitive damages that are paid or incurred as a result of a judgment or in settlement of a claim. In addition, if the liability for punitive damages is covered by insurance, the punitive damage amount paid by the insurer would be includible in the income of the insured. Punitive damage awards are all too common under the tort compensation system in United States. Indeed, one measure of their commonness is their longstanding treatment as an ordinary and necessary business expense deduction under section 162. Because the federal income tax is a tax on net income, accurate measurement of net income requires taking into account all expenses associated with the production of that business income, including punitive damage awards. In addition, although the proposal would disallow punitive damages in "settlement" of legal claims, settlement agreements rarely allocate payments to punitive damages. Thus, the proposal may embolden the filing of frivolous lawsuits or may compel defendants to pay inflated compensatory damages in order to avoid paying a nondeductible punitive damage award. Because of the mismatching of ordinary and necessary expenses with the business income that engenders the expense as well as the potential for interfering with the judicious and efficient disposition of tort claims, this provision should be rejected.
If you have any questions about TEI's positions on S. 2020 or any other tax provisions, please feel free to contact TEI's Executive Director, Timothy J. McCormally, or Chief Tax Counsel, Eli J. Dicker, at 202.638.5601.
(1) Other congressional actions, such as passage of the Sarbanes-Oxley Act, and the rulemaking and enforcement activities of the Securities and Exchange Commission and the Public Company Accounting Oversight Board pursuant to the authority granted by that Act have complemented the Treasury Department and IRS's efforts to curb tax shelters. For example, the PCAOB has adopted independence rules that severely restrict the tax advice that accountants may render to their audit clients. In addition, section 404 of the Sarbanes Oxley Act requires companies to diligently document and support the tax benefits that are reflected in their financial statements. As a result, company standards for implementing tax planning strategies have increased and questionable transactions simply do not survive the enhanced internal scrutiny; these changes have also increased the transparency of any implemented transactions, thereby ensuring their appropriate review by the IRS.
(2) Outgoing CBO Director Sees Enforcement As Possible Cause of Business Receipt Gain, DAILY TAX REPORT (January 3, 2006), at G-10.
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|Date:||Jan 1, 2006|
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