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Failure to comply with tax shelter disclosure regulations: what's at stake?

As part of its ongoing efforts to curb the use of corporate tax shelters, on February 28, 2003, the Department of the Treasury promulgated final tax shelter disclosure regulations. These regulations adopt the comprehensive definitions proposed in October 2002, requiring disclosure of six broad categories of transactions. Although the final regulations have considerably narrowed the scope of these categories, many non-abusive commercial transactions will be required to be disclosed, presenting serious compliance challenges for taxpayers.

This article summarizes the disclosure requirements under the recently issued final regulations, highlighting the breadth and ambiguous scope of several of the categories of reportable transactions. Next, it outlines the administrative, regulatory, and statutory penalties that the Internal Revenue Service, Treasury, and Congress have proposed or announced for taxpayers that fail to comply with such regulations. Finally, the article considers the compliance challenges facing corporate tax executives and tax departments under this expanded disclosure regime. Any compliance strategy will need to be broad in its approach, because compliance with the tax shelter disclosure regulations will require the cooperation, support, and input of personnel from the treasury, legal, information technology, and other departments within a corporation.

The final tax shelter disclosure regulations are applicable to transactions entered into on or after February 28, 2003, and may, at the taxpayer's option, be applied to transactions entered into on or after January 1, 2003, and prior to February 28, 2003. Because the final regulations generally contain narrower disclosure requirements than the temporary regulations, most taxpayers will find it beneficial to elect to apply the final regulations to all transactions entered into on or after January 1, 2003.

I. Disclosure Regulations

A. History and Requirements of the Corporate Tax Shelter Disclosure Provisions

To address concerns about the perceived proliferation of corporate tax shelters, in February 2000 the Treasury issued temporary regulations under section 6011 requiring disclosure of participation in certain tax shelter transactions by corporate taxpayers. (1) From the IRS's perspective, these temporary regulations proved ineffective. The IRS believed that taxpayers narrowly construed the five factors requiring disclosure and broadly construed the regulatory exceptions. Dissatisfied with the paucity of disclosures, the Treasury comprehensively amended the regulations in October 2002. Prior to release of the Treas. Reg. [section] 1.6011-4 on February 28, 2003, (2) the temporary regulations had been amended four times (3) as the Treasury and IRS strove to balance a number of competing goals, including (1) creating definitions that are broad enough to require disclosure of known abusive tax shelters; (2) having clear and objective definitions that minimize the uncertainty and controversy about what transactions are subject to disclosure; and (3) crafting definitions that minimize the number of non-abusive transactions entered into in the ordinary course of business that must be disclosed by taxpayers.

The final regulations, like the October 2002 temporary regulations, represent a fundamental rethinking of the balance between over-inclusiveness and clarity struck in the original temporary regulations issued in February 2000 and subsequent amendments. Earlier versions generally attempted to avoid over-inclusiveness by providing exceptions for, among other things, transactions entered into in the ordinary course of business in a form consistent with customary commercial practice where there was a generally held understanding that the tax benefits were available. (4) Applying these exceptions, however, required a high degree of subjective judgment. Taxpayers often were frustrated that they could not achieve a high degree of confidence that an exception applied, and the government became frustrated when taxpayers often resolved the resulting uncertainties in their favor. Furthermore, despite IRS statements that disclosure of a transaction would not affect the merits of a transaction, many taxpayers and practitioners feared that failure to avail oneself of this exception could be viewed as an admission against interest on the merits.

Both the October 2002 and the final regulations attempt to avoid these interpretational issues by using broad, objectively defined categories of transactions to be disclosed. Because these categories are not defined in terms of specific tax abuses, this approach will require the disclosure of many non-abusive transactions entered into by taxpayers in the ordinary course of business. This over-inclusiveness may be a cost of a more objective regime, even though the final regulations contain numerous objectively defined exceptions to key categories of reportable transactions. The Treasury and IRS appear to have determined that avoiding uncertainty and controversy over which transactions must be disclosed is more important than minimizing the number of disclosures.
What's at Stake?

If Proposed Legislation Is Enacted:

* $200,000 penalty for each undisclosed listed

* $100,000 penalty for each undisclosed reportable

* Doubling of the statute of limitations from 3 to 6 years

* Required SEC disclosure when certain penalties
 are imposed

* 40-percent penalty (for undisclosed) and 20-percent
 penalty (for disclosed) transactions lacking
 economic substance

* Denial of deduction for interest paid to the IRS

* New 30-percent accuracy-related penalty (20percent
 if transaction was disclosed)

* Extremely limited ability to have penalties
 waived or rescinded

According to Recently Announced IRS Policy:

* Requirement to provide tax accrual workpapers
 to the IRS

* Inability to participate LIFE program

* Inability to rely on an adviser's opinion for penalty

B. Disclosure and Document Retention Requirements

A taxpayer that has participated in a reportable transaction must attach Form 8886 to its return for each taxable year (5) in which the taxpayer participates in the transaction. In addition, a copy of Form 8886 must be sent to the IRS Office of Tax Shelter Analysis for the first year a taxpayer participates in the transaction (6) The taxpayer is also required to retain copies of all documents and other records that are relevant to an understanding of the tax treatment of a reportable transaction until the statute of limitations has run (7)

C. Categories of Reportable Transactions

The final regulations contain the same six categories of reportable transactions provided in the October 2002 temporary regulations: (1) listed transactions; (2) confidential transactions; (3) transactions providing contractual protection to the participant; (4) section 165 losses that exceed certain dollar thresholds; (5) transactions generating a significant book-tax difference; and (6) transactions generating at least a $250,000 tax credit and involving an asset held briefly. If a transaction is described in any one of these categories, it is a reportable transaction. There follows a description of the six categories, including highlights of changes in the final regulations; most of the changes are favorable to taxpayers.

1. Listed Transactions

A listed transaction is a transaction that is the same as or "substantially similar" to one of the transactions that the IRS has determined to be a tax avoidance transaction and identified by notice, regulation, or other form of published guidance as a listed transaction. (8)

The final regulations do not make any significant modifications to the listed transaction category. The listed transactions regime is intended to give taxpayers notice that the IRS has identified specific transactions as abusive. The success of this regime depends upon the IRS providing "bright line" standards so that taxpayers can decide, on a principled basis, whether a given transaction is the same or substantially similar to a listed transaction. Of the 23 transactions currently on the list, most are defined with a reasonable degree of precision. The definitions of several of the transactions on the list, however, are sufficiently vague to be troubling. It is to be hoped that as the IRS maintains the list and adds transactions to the list, it will identify with precision the specific abuse involved in the listed transaction and clearly articulate why it considers the transaction to be abusive. A clear articulation of the rationale for listing a transaction will help tax executives determine whether a given transaction is "substantially similar" to the listed transaction.

2. Confidential Transactions

A confidential transaction is a transaction offered to a taxpayer under conditions of confidentiality. This category of reportable transaction is aimed at advisers seeking confidentiality with respect to the tax aspects of a transaction and not at taxpayers seeking protection for their own commercial information. Thus, disclosure will not be required unless the taxpayer's disclosure of the tax treatment or the tax structure of the transaction is limited in any manner by an express or implied understanding or agreement with any individual that provides tax advice with respect to the transaction. (9)

The final regulations retain (and expand) the exception in the October 2002 regulations for confidentiality provisions required to comply with securities laws, making it applicable to all securities laws and not merely U.S. federal and state securities laws. (10)

In response to comments received, the IRS added an important exception for confidentiality agreements with respect to mergers and acquisitions. This exception allows certain mergers and acquisitions to remain confidential and not create a disclosure obligation if the taxpayer is permitted to disclose the tax treatment and tax structure of the transaction no later than the earliest of (1) the date of the public announcement of discussions relating to the transaction, (2) the date of the public announcement of the transaction, and (3) the date of the execution of an agreement (with or without conditions) to enter into the transaction. A taxpayer may not employ this exception, however, if its ability to consult any tax adviser regarding the tax treatment or tax structure of the transaction is limited in any way. (11)

Obtaining a written statement permitting disclosure is a best practice that tax executives may wish to adopt.

The final regulations provide that the IRS may infer the existence of a confidentiality agreement from the behavior of the parties to a transaction. To avoid being forced to prove the non-existence of an agreement to maintain confidentiality, it will be important for taxpayers to avail themselves of a presumption in the regulations that a transaction is not confidential if the taxpayer receives written authorization to disclose the tax structure from all tax advisers to the transaction. The final regulations provide that a transaction will be presumed not to be confidential if the taxpayer receives from every adviser who makes a statement to the taxpayer about the federal income tax consequences of the transaction, within 30 days from the day such adviser first makes such statement, a written authorization in substantially the following form:
 "The taxpayer (and each employee, representative,
 or other agent of the taxpayer) may disclose
 to any and all persons, without limitation of any
 kind, the tax treatment and tax structure of the
 transaction and all materials of any kind (including
 opinions or other tax analyses) that are provided
 to the taxpayer relating to such tax treatment
 and tax structure." (12)

3. Transactions with Contractual Protection

Under the final regulations, a transaction with contractual protection is a transaction in which fees paid to a tax adviser are contingent upon the intended tax consequences being sustained. (13)

The IRS substantially narrowed the contractual protection definition in the final regulations. The earlier regulations had broadly defined contractual protection to include "contractual protection against the possibility that ... the intended tax consequences of the transaction will not be sustained, including ... rescission rights, ... a tax indemnity or similar arrangement." (14) This broader definition would have required taxpayers to disclose many routine transactions merely because of customary commercial terms governing the transactions. The revised definition in the final regulations targets more precisely the type of transaction that the IRS wants to see disclosed.

The final regulations generally do not consider a transaction to have contractual protection in situations where a person provides advice about the tax consequences of a transaction on a contingent fee basis only after the taxpayer has reported the transaction on a filed tax return (15)

4. Loss Transactions

The final regulations generally require corporate taxpayers to disclose any transaction producing a section 165 loss of at least $10 million in a single year or $20 million in any combination of taxable years. (16) In determining whether a transaction results in a taxpayer claiming a loss that meets the $20 million threshold over a combination of taxable years, only losses claimed in the taxable year that the transaction is entered into and the five succeeding taxable years are taken into account. (17)

Given the number of transactions affected by this general rule, the final regulations give the IRS authority to exclude common types of loss transactions, as was announced in Rev. Proc. 2003-24. The use of revenue procedures to provide exceptions within categories of reportable transactions gives the IRS the flexibility to update these exceptions periodically without going through formal rulemaking procedures.

Among the most important exceptions to the section 165 loss category provided by Rev. Proc. 2003-24 is one for a loss from the sale or exchange of an asset with a "qualifying basis." (18) Generally, "qualifying basis" is basis determined by and equal to cash paid, as adjusted for improvements and depreciation. (19) A qualifying basis also includes a basis determined under (1) section 358 by reason of a transaction under section 355 or section 368 where carry-over basis is determined by reference to qualifying basis of prior holder, (2) section 1014 (basis of property acquired from a decedent), (3) section 1015 (basis of property acquired by gifts and transfers in trust), or (4) section 1031(d) (certain exchanges of like-kind property). (20)

Rev. Proc. 2003-24 also excludes a number of other types of section 165 losses. These include (1) certain losses arising from any mark-to-market treatment of an item under certain provisions, (2) a loss arising from a properly identified hedging transaction described in section 1221(b) or from a mixed straddle account under Treas. Reg. [section] 1.092(b)-4T, (3) a loss attributable to increases to basis of a REMIC holder arising from taxable income during such holder's ownership, (4) a loss from the abandonment of depreciable assets by a qualifying taxpayer, (5) a loss from the bulk sale of inventory if the basis of the inventory is determined under section 263A, (6) a loss that is equal to, and is determined solely by reference to, a payment of cash by the taxpayer, (7) casualty and theft losses, and (8) certain involuntary conversions.

5. Transactions with a Significant Book-Tax Difference

Under the final regulations, taxpayers generally must disclose a transaction when the amount for tax purposes of any item or items of income, gain, expense, or loss from the transaction differs by more than $10 million on a gross basis from the amount of the item or items for book purposes in any taxable year. Offsetting items shall not be netted for either tax or book purposes. (21) The significant book-tax difference category only applies to taxpayers that are (1) reporting companies under the Securities Exchange Act of 1934 and certain related entities or (2) business entities that have $250 (22) million or more in gross assets. (23)

This category of reportable transaction will likely be the most problematic for taxpayers to apply in practice. Large book-tax differences can arise from myriad transactions, most of which have nothing to do with tax abuse. The IRS has attempted to ease the disclosure burden by providing exceptions for specific types of book-tax differences. In connection with the final regulations, the IRS increased the number of exceptions from 13 (24) in the October 2002 regulations to 30. (25) The exceptions are currently contained in Rev. Proc. 2003-25, which allows the IRS to revise the list of exceptions periodically without going through formal rulemaking procedures. (26) Despite this effort to expand the list of exceptions, many common transactions that few would consider a tax shelter will be required to be disclosed under this category. For example, taxpayers exporting under the extra-territorial income regime (section 114) must disclose the resulting book-tax differences if they exceed $10 million dollars.

6. Transactions Involving a Brief Asset Holding Period

The last category of reportable transactions requires taxpayers to disclose transactions similar to those litigated in the Compaq or IES cases. (27) This category consists of transactions where the taxpayer claims a tax credit exceeding $250,000 (including a foreign tax credit) and the credit arises from holding an asset for 45 days or less. (28)

In finalizing this rule, the Treasury provided a helpful clarification by stating that "transactions resulting in a foreign tax credit for withholding taxes or other taxes imposed in respect of a dividend that are not disallowed under section 901(k) (including transactions eligible for the exception for securities dealers under section 901(k)(4)) are not considered transactions involving a brief asset holding period."

7. Application to Transactions of Controlled Foreign Corporations

The final regulations provide that United States shareholders of controlled foreign corporations must generally disclose reportable transactions entered into by their controlled foreign corporations. (29) Some relief is given with respect to the category of transactions giving rise to book-tax differences, in that a transaction of a controlled foreign corporation must be tested for book-tax differences only if the transaction reduces the amount of a subpart F inclusion to the reporting United States shareholder. (30) The need to monitor the activities of foreign subsidiaries on a transaction-by-transaction basis to comply with the tax shelter disclosure regime will be a major compliance burden on tax departments of U.S.-based multinational groups.

D. Document Retention Requirements

Taxpayers will need to review their document retention policies in light of the requirements under the final tax shelter disclosure regulations.

Under the regulations, a taxpayer must retain a copy of all documents and other records related to a transaction subject to disclosure that are material to an understanding of the tax treatment or tax structure of the transaction. (31)

The documents required to be retained may include marketing materials related to the transaction; written analyses used in decision-making related to the transaction; correspondence and agreements between the taxpayer and any adviser, lender, or other party to the reportable transaction that relate to the transaction; documents discussing, referring to, or demonstrating the purported or claimed tax benefits arising from the reportable transaction; and documents, if any, referring to the business purposes for the reportable transaction. (32) Such documents include electronic mail and other forms of electronic communications.

The taxpayer is not required to retain earlier drafts of a document if the taxpayer retains a copy of the final document (or more recent draft) and such document contains all the information in the earlier drafts material to an understanding of the purported tax treatment or tax structure of the transaction. (33) Taxpayers will need to review their document retention policies to make sure that the record retention requirements of the final regulations are met.

II. Penalties for Failure To Disclose Reportable Transactions

Given the breadth of the disclosures required under the final regulations, it is important to understand the consequences of the failure to disclose reportable transactions, including both the current law consequences stemming from a series of recent IRS enforcement initiatives and the penalties under proposed legislation.

A. Overview of Existing Law and Proposed Penalties

There are no specific statutory penalties for failure to disclose a reportable transaction under current law. In order to encourage compliance with the disclosure requirements, the Treasury has proposed regulations that would limit the defenses to imposition of the accuracy-related penalty when taxpayers fail to disclose reportable transactions. The IRS has also adopted administrative policies that sanction taxpayers that fail to disclose a listed transaction by (i) preventing their participation in new Limited Issue Focus Examination (LIFE) audit procedures and (ii) routinely requesting their tax accrual workpapers on audit. To address the current lack of statutory penalties for failure to disclose, Congress is considering legislation to impose severe statutory sanctions on taxpayers that fail to disclose reportable transactions.

B. Current Administrative Sanctions

1. Prop. Reg. [subsection] 1.6662-3 and 1.6664-4

Generally, under current law, the accuracy-related penalty equals 20 percent of the "underpayment amount" (34) This penalty can be imposed when underpayments of tax are caused by negligence or disregard of the tax laws, (35) or when the understatements are substantial (36) An understatement is substantial if it exceeds the greater of 10 percent of the tax required to be shown on the return, or $10,000 for corporations (37) Under section 6664(c), taxpayers have been able to avoid the accuracy-related penalty if they establish, among other things, that they had reasonable cause for the underpayment and acted in good faith (38) Taxpayers have often relied upon favorable opinions of professional tax advisers to establish that they acted with reasonable cause and in good faith.

Convinced that many taxpayers have relied improperly on tax opinions (often opinions prepared by promoters), the Treasury issued proposed regulations to preclude such reliance in certain cases. Under the proposed regulations (to be effective for returns filed after December 31, 2002, with respect to transactions entered into on or after January 1, 2003), taxpayers that fail to disclose a reportable transaction could not rely on an adviser's opinion to satisfy the reasonable cause and good faith exceptions to present-law accuracy-related penalties (39) The proposed regulations would also provide that a taxpayer may not rely on the "realistic possibility" standard under section 6662 to avoid the accuracy-related penalty for negligence or disregard of rules or regulations with respect to a reportable transaction if the taxpayer's position is contrary to a revenue ruling or notice.

2. Tax Accrual Workpapers

As part of its effort to encourage disclosure of and to combat tax shelters, the IRS has changed its longstanding policy regarding when it will request copies of a taxpayer's tax accrual workpapers. For returns filed after July 1, 2002, the IRS routinely will request tax accrual workpapers under the following circumstances:

* If a listed transaction was not disclosed;

* If the taxpayer has entered into more than one listed transaction, regardless of whether the listed transactions were disclosed; or

* If there are reported financial accounting irregularities (such as those requiring earnings restatement) in connection with a return under examination that includes tax benefits from a disclosed, listed transaction.

With respect to an original return filed before July 1, 2002, the IRS can request tax accrual workpapers whenever it determines that there was a tax benefit claimed on the return from a transaction that was a listed transaction. This request, however, will be limited to the tax accrual workpapers pertaining to the listed transaction.

3. Inability to Participate in a LIFE Audit

While the Large and Mid-Size Business Division is moving to streamline audit procedures, most notably through the recently announced LIFE program, a taxpayer may be barred from participating in that program if the IRS learns that the taxpayer has failed to disclose a reportable transaction or has failed to provide some or all of its tax accrual workpapers, when requested.

A taxpayer denied participation in LIFE will lose this program's benefits, including increased communication with the IRS, the limited scope of the LIFE examination, and the reduced time span of the examination. The benefits of increased communication with the IRS consist of greater involvement in the planning of the examination, enhanced discussion of Information Document Requests before issuance, and development of an outline of key aspects of the examination. The scope of a LIFE audit is limited because certain administrative requirements of an examination may be waived, and there generally are fewer examined issues. Furthermore, IRS's ability to expand the audit is limited.

C. Proposed Legislative Penalties

1. Penalty for Failure to Disclose Reportable Transactions

The CARE Act of 2003, (40) as approved in February by the Senate Finance Committee, would create a new penalty for any person that fails to include, with any return or statement, any required information about a reportable transaction. If enacted, the new penalty would apply without regard to whether the transaction ultimately results in an understatement of tax and in addition to any accuracy-related penalty that may be imposed. (41) In the case of large corporations, the proposed penalty for failing to disclose a reportable transaction is $100,000; the proposed penalty is increased to $200,000 if the undisclosed transaction is a listed transaction. (42)

The penalty, as proposed, could not be waived with respect to a listed transaction, and for other reportable transactions could be rescinded or abated only in extremely limited circumstances by the IRS Commissioner personally or by the head of the Office of Tax Shelter Analysis. In addition to the proposed penalty for failing to disclose a listed transaction, the CARE Act also provides that the taxpayer must disclose the imposition of such penalty in reports filed with the SEC.

The penalties for failure to disclose reportable transactions in the CARE Act:

* Are identical to the failure-to-disclose penalties in S. 9, Pension Protection and Expansion Act as introduced January 7, 2003 by Senate Minority Leader Thomas Daschle (D-SD);

* Closely resemble penalties in H.R. 5095 introduced in the 107th Congress by House Ways and Means Committee Chairman Bill Thomas (R-CA) (the Thomas Bill); and

* Are similar to penalties proposed in President Bush's Budget for Fiscal Year 2004, which goes further by proposing, with respect to failure to disclose listed transactions, a five-percent penalty above the $200,000 penalty.

The severe limitations on the ability of the IRS to waive or rescind penalties in the proposed legislation make it important for tax executives to adopt internal controls and procedures that ensure their organizations can identify reportable transactions.

While each of the current bills and the President's Budget would require SEC disclosure by publicly held corporations of failures to disclose listed transactions, SEC disclosure requirements vary in the pending legislation and administrative proposals for penalties assessed for failure to properly disclose other reportable transactions.

2. Modifications to the Accuracy-Related Penalties for Listed Transactions and Reportable Transactions Having a Significant Tax Avoidance Purpose

a. Current Provisions

Currently, the accuracy-related penalty for income taxes applies to the portion of any underpayment that is attributable to negligence or a substantial understatement. For most corporations, a substantial understatement is the greater of (1) the excess above 10 percent of the correct tax or (2) $10,000. The amount of the accuracy-related penalty is 20 percent of the underpayment. With respect to understatements attributable to corporate tax shelters, (43) the only defense against the penalty is the reasonable cause and good faith exception of section 6664(c). Current regulations provide that reasonable reliance on a qualified opinion from a tax adviser is a helpful, but not decisive, factor in establishing that a taxpayer acted with reasonable cause and in good faith. (44)

b. Legislative Proposals

The CARE Act would replace the current understatement penalty rules applicable to tax shelters with new provisions that would apply to listed transactions and reportable transactions with a significant tax avoidance purpose ("reportable avoidance transactions"). The penalty rate and potential defenses would vary depending on whether the transaction was disclosed. A 20-percent accuracy-related penalty would apply to understatements arising from disclosed transactions unless a "strengthened reasonable cause and good faith exception" applied. A taxpayer could not rely on an opinion of a material tax adviser to a transaction for purposes of establishing this strengthened reasonable cause and good faith exception. If a listed transaction or reportable avoidance transaction is not disclosed, the penalty rate would be raised to 30 percent and no defenses would be available. The understatement amount would be calculated by multiplying the transaction-related deduction or loss by the maximum marginal tax rate (regardless of whether the taxpayer received a cash tax benefit from the transaction).

Once a 30-percent penalty has been asserted in a Revenue Agent's Report, the penalty could not be compromised for purposes of a settlement without the personal approval of the Commissioner of Internal Revenue or the head of the Office of Tax Shelter Analysis. In addition, a public corporation would have to disclose any 30-percent penalty in reports to the SEC.

3. Penalty for Understatements from Transactions Lacking Economic Substance

In addition to the existing categories of accuracy-related penalties, the CARE Act would add the category of "non-economic substance transaction," (i.e., transactions that do not meet the economic substance test proposed in the CARE Act). (45) The proposed penalty rate for these transactions would be 40 percent if not disclosed and 20 percent if adequately disclosed. The understatement amount is calculated by multiplying the transaction-related deduction or loss by the maximum marginal rate (regardless of whether the taxpayer received a cash tax benefit with respect to the transaction). Again, the proposal creates a strict-liability penalty because there would be no exceptions. Once a penalty has been included in the Revenue Agent's Report, the penalty could not be compromised for purposes of a settlement without the personal approval of the Commissioner or the head of the Office of Tax Shelter Analysis. A public entity required to pay this penalty also would have to report this to the SEC.

With respect to penalties on non-economic substance transactions, the CARE Act tracks the provisions of the Thomas Bill, except that the CARE Act also would require SEC reporting of penalties imposed. Neither S. 9 nor the President's Budget Proposal propose to codify the economic substance doctrine.

4. Extend Statute of Limitations for Certain Undisclosed Transactions

In general, the Code requires that taxes be assessed within three years after the date a return is filed. (46) If there has been a substantial omission of items of gross income that total more than 25 percent of the amount of gross income shown on the return, the period during which an assessment must be made is extended to six years. (47) The CARE Act would extend the statute of limitations to six years for the entire tax return if a taxpayer failed to adequately disclose a listed transaction on the return.

5. Deny Deduction for Interest Paid to IRS on Underpayments Involving Certain Tax-Motivated Transactions

The CARE Act would disallow any deduction for interest paid or accrued within a taxable year on any portion of an underpayment of tax that is attributable to an understatement arising from an undisclosed listed or reportable avoidance transaction or a transaction that lacks economic substance.

III. Meeting the Challenge of Complying with the Disclosure Regime

The operational challenges of complying with the final disclosure regulations will be formidable and the consequences of failure to comply fully will be serious. The following observations may help tax executives as they consider implementing systems and procedures to meet this challenge.

A. Effective Compliance Will Require Awareness and Support from Throughout the Organization

Coping with the final disclosure regulations should not be the sole responsibility of the tax department. One clear priority in dealing with the disclosure regime is to avoid inadvertently or unnecessarily triggering disclosure obligations. To this end, the legal department and transactional groups within a taxpayer should be educated about how their activities can trigger disclosure obligations. Such groups should be made aware of the effects of entering into confidentiality agreements with respect to tax structures and the need to obtain consent authorizations to come within the presumption that a transaction is not confidential. Such groups should also be educated about the disclosure consequences of contingent fee arrangements. As transactional groups within taxpayers evaluate potential transactions, a standard part of the analysis should be whether the transaction would be a reportable transaction, and advisers to the transaction should be asked whether they consider the transaction reportable for list maintenance purposes. If it is concluded that a transaction is reportable, procedures should be put in place to ensure that the tax department captures the relevant information regarding the transaction and prepares the required Form 8886. By educating and working with the transactional side of the organization, a tax department should be able to minimize the number of reportable transactions and increase the chances of capturing the necessary information with respect to reportable transactions that are done.

A second major potential source of reportable transactions is the treasury function. The tax department should work with members of the treasury function to identify the disclosure consequences of various choices of financing and the importance of proper hedging identifications in minimizing reportable losses and book-tax differences. Working closely with the legal department and information technology groups in reviewing and revising a taxpayers' document retention policies will also be important to comply with the broad retention requirements under the final disclosure regulations. To gain the cooperation and support from these groups throughout the organization, it will be necessary to educate the relevant personnel on the scope of a taxpayer's disclosure and document retention obligations and the severe consequences of a failure to meet these obligations.

B. The Adequacy of a Taxpayer's Information Systems Should Be Reviewed

Reliably capturing the information required to identify reportable transactions may well be beyond the capabilities of the current information systems available to the tax departments of many taxpayers. Many tax departments do not routinely receive information about gross items of loss or tax-book differences on an item-by-item, transaction-by-transaction basis. Receiving such detailed information would be particularly unusual with respect to the transactions of foreign subsidiaries, joint ventures and partnerships.

C. Taxpayers Should Consider Establishing Documented Compliance Procedures and Controls

A large organization will likely find it impossible to achieve a high level of compliance with the final tax shelter disclosure and document retention regulations without establishing procedures and processes (i) to collect and centralize information regarding potentially reportable transactions, (ii) to analyze such information to determine which transactions are in fact reportable, (iii) to prepare the appropriate disclosure documentation with respect to such transactions, and (iv) to preserve all relevant documentation with respect to the identified reportable transactions. These processes will require a tax staff with a strong working knowledge of the disclosure regulations, the current revenue procedures containing exceptions to the categories of reportable transactions, and the distinguishing factors of the transactions on the current list of listed transactions. A solid understanding of the interaction of financial accounting and tax accounting rules as applied to the taxpayer's business will also be necessary. Both formal training programs and access to appropriate reference materials, technical resources, and templates would be helpful in implementing such systems and procedures.

Although implementing such procedures and processes will be indispensable in achieving a good level of compliance with the disclosure and documentation requirements of the final regulations, perfect compliance may be impossible given the operational challenges and unresolved interpretational issues under the regulations. For this reason, taxpayers should fully document their compliance procedures. By documenting its systems and procedures for capturing information regarding potential reportable transactions and recording why a given transaction was or was not reportable, a taxpayer will be in a better position to establish its good faith efforts to comply with the disclosure and document retention regimes notwithstanding occasional failures to capture and disclose every reportable transaction.

The penalties proposed in the CARE Act of 2003 for failure to disclose a reportable transaction could be waived only if (1) the taxpayer on which the penalty is imposed has a history of complying with the federal tax laws, (2) it is shown that the violation is due to an unintentional mistake of fact, (3) imposing the penalty would be against equity and good conscience, and (4) rescinding the penalty would promote compliance with the tax laws and effective tax administration (48) The establishment and documentation of well-developed policies and procedures could help a taxpayer satisfy the first two requirements for penalty waiver. It would be up to the IRS to decide whether the last two requirements are satisfied. A well-documented effort to comply with the regulations could well be persuasive to the IRS as it considers whether the last two requirements were satisfied if a taxpayer that fails to identify and disclose a reportable transaction.

D. Coordination with Sarbanes-Oxley Compliance

Finally, tax shelter compliance issues should be considered in the broader context of Sarbanes-Oxley Act compliance. Creating effective tools to ensure tax shelter compliance can be viewed as an integral part of the broader Sarbanes-Oxley Act compliance initiatives underway at most SEC registrants. Of particular interest are sections 404 and 302 of the Act, which generally require that management establish and maintain an adequate internal control structure and assess the adequacy of the internal control structure. Additionally, an independent auditor must attest to, and report on, management's assessment of its internal control structure. The heightened interest in internal controls caused by the Sarbanes-Oxley Act--coupled with the events that brought about its passage, the proposed penalties related to these regulations, and the proposed CEO signature of corporate tax returns--has created an environment where the implementation of a tax shelter compliance process will be an important objective for tax executives during the next year.

Given the current efforts companies are making to comply with the internal control requirements of Sarbanes-Oxley, properly informed senior management will support the tax department's effort to implement internal policies and procedures aimed at identifying and disclosing reportable transactions.

(1) Temp. Reg. [section] 1.6011-4T (T.D. 8877, 65 Fed. Reg. 11,205 (Mar. 2, 2000)).

(2) Treas. Reg. [section] 1.6011-4 (T.D. 9046, 68 Fed. Reg. 10,161 (Mar. 4, 2003)).

(3) T.D. 8877, 65 Fed. Reg. 11,205 (Mar. 2, 2000) was amended by T.D. 8896, 65 Fed. Reg. 49,909 (Aug 16, 2000); T.D. 8961, 66 Fed. Reg. 41,133 (Aug. 7, 2001); T.D. 9000, 67 Fed. Reg. 41,324 (June 18, 2002); and T.D. 9017, 67 Fed. Reg. 64,799 (Oct. 22, 2002).

(4) Temp. Reg. [section] 1.6011-4T(b)(3)(ii) (as amended by T.D. 9000, 67 Fed. Reg. 41,324 (June 18, 2002)). This provision was eliminated with the amendment of Temp. Reg. [section] 1.6011-4T on October 17, 2002 (T.D. 9017, 67 Fed. Reg. 64,799 (Oct. 22, 2002)).

(5) Treas. Reg. [section] 1.6011-4(e)(1) (2003). If a reportable transaction results in a loss that is carried back to a prior year, the Form 8886 for the reportable transaction must be attached to the taxpayer's application for tentative refund.

(6) Treas. Reg. [section] 1.6011-4(e)(1) (2003)

(7) Treas. Reg. [section] 1.6011-4(g)(2003).

(8) Treas. Reg. [section] 1.6011-4(b)(2) (2003). The IRS has identified 23 listed transactions. A comprehensive discussion of these listed transactions is beyond the scope of this article. The listed transactions can be found by visiting the IRS website (available at, selecting "Businesses" from the contents menu, then "Corporations" from the contents menu, and then "Abusive Tax Shelters and Transactions" under the heading "Tax Information for Corporations." In addition to the listed transactions, tax executives will find a wide range of information on the IRS's strategy to deal with corporate tax shelters in this portion of the IRS website.

(9) Treas. Reg. [section] 1.6011-4(b)(3) (2003).

(10) The securities law exception is contained in Treas. Reg. [section] 1.6011-4(b)(3)(ii)(A) (2003). Such exception, introduced in the October 2002 regulations, provides that a transaction is not considered to be offered to a taxpayer under conditions of confidentiality if disclosure of the tax treatment or tax structure of the transaction is subject to restrictions reasonably necessary to comply with securities laws and such disclosure is not otherwise limited.

(11) Treas. Reg. [section] 1.6011-4(b)(3)(ii)(B) (2003).

(12) Treas. Reg. [section] 1.6011-4(b)(3)(iii) (2003).

(13) Treas. Reg. [section] 1.6011-4(b)(4) (2003).

(14) Temp. Reg. [section] 1.6011-4T(b)(4) (as amended in 2002). This temporary regulation was repealed with the promulgation of the final regulations on February 28, 2003.

(15) Treas. Reg. [section] 1.6011-4(b)(4)(iii)(B) (2003).

(16) Treas. Reg. [section] 1.6011-4(b)(5)(i)(A) (2003).

(17) Treas. Reg. [section] 1.6011-4(b)(5)(ii) (2003).

(18) Rev. Proc. 2003-24, [section] 4.01. In addition to the requirement that the basis of the asset (for purposes of determining the loss) is a "qualifying basis," in order to qualify from the loss disclosure rules, the asset generating the loss cannot be an interest in a passthrough entity (within the meaning of section 1260(c)(2)), such loss cannot be treated as ordinary pursuant to section 988, the asset generating the loss cannot have been separated from any portion of the income it generates, and the asset generating the loss is not, and has never been, part of a straddle within the meaning of section 1092(c), excluding a mixed straddle under Treas. Reg. [section] 1.1092(b)-4T.

(19) See Rev. Proc. 2003-24 for the types of losses that cannot qualify for this exception.

(20) Rev. Proc. 2003-24. It is worth noting that the IRS did not treat property acquired in a section 1032 transaction (where the corporation uses its own stock to acquire property) as generating qualifying basis.

(21) Treas. Reg. [section] 1.6011-4(b)(6) (2003).

(22) The October 2002 temporary regulations used $100 million as the threshold. Treas. Reg. [section] 1.6011-4T(b)(6)(ii)(A)(2) (as amended in 2002). Such regulation was repealed upon the issuance of the final regulations on February 28, 2003.

(23) Treas. Reg. [subsection] 1.6011-4(b)(6)(ii)(A)(1) and (2) (2003).

(24) The temporary regulations originally had 13 categories of transactions. Reference should be made to T.D. 9017 (October 17, 2002) for the list of these 13 categories of transactions. In addition to adding 18 categories of transactions, the IRS removed a category of transaction where the item could not be deducted for federal income tax purposes. This category was duplicative of the first category which now reads: "Items to the extent a book loss or expense is reported before or without a loss or deduction for federal income tax purposes."

(25) Book-tax differences arising by reason of the following items are not taken into account in determining whether a transaction has a significant book-tax difference under Treas. Reg. [section] 1.6011-4(b)(6) and Rev. Proc. 2003-25: (1) Items to the extent a book loss or expense is reported before or without a loss or deduction for federal income tax purposes, (2) Items to the extent income or gain for federal income tax purposes is reported before or without book income or gain, (3) Depreciation, depletion under code section 612, and amortization relating solely to differences in methods, lives (for example, useful lives, recovery periods), or conventions as well as differences resulting from the application of sections 168(k), 1400I, or 1400L(b), (4) Percentage depletion under section 613 or section 613A, and intangible drilling costs deductible under section 263(c), (5) Capitalization and amortization under sections 195, 248, and 709, (6) Bad debts or cancellation of indebtedness income, (7) Federal, state, local, and foreign taxes, (8) Compensation of employees and independent contractors, including stock options and pensions, (9) Charitable contributions of cash or tangible property, (10) Tax-exempt interest, including municipal bond interest, (11) Dividends as defined in section 316 (including any dividends received deduction), amounts treated as dividends under section 78, distributions of previously taxed income under sections 959 and 1293, and income inclusions under section 551, 951, and 1293, (12) A dividends paid deduction by a publicly traded REIT, (13) Patronage refunds or dividends of cooperatives without a section 267 relationship to the taxpayer, (14) Items resulting from the application of section 1033, (15) Items resulting from the application of sections 354, 355, 361, 367, 368, or 1031, if the taxpayer fully complies with the filing and reporting requirements for these sections, including any requirement in the regulations or in forms, (16) Items resulting from debt-for-debt exchanges, (17) Items resulting solely from the treatment as a sale, purchase, or lease for book purposes and as a financing arrangement for tax purposes, (18) Treatment of a transaction as a sale for book purposes and as a nontaxable transaction under section 860F(b)(1)(A) for tax purposes, not including differences resulting from the application of different valuation methodologies to determine the relative value of REMIC interests for purposes of allocating tax basis among those interests, (19) Items resulting from differences solely due to the use of hedge accounting for book purposes but not for tax purposes, the use of hedge accounting under Treas. Reg. 1.446-4 for tax purposes but not for book purposes, or the use of different hedge accounting methodologies for book and tax purposes, (20) Items resulting solely from (i) the use of a mark-to-market method of accounting for book purposes and not for tax purposes, (ii) the use of a mark-to-market method of accounting for tax purposes but not for book purposes, or (iii) in the case of a taxpayer who uses mark-to-market accounting for both book purposes and tax purposes, the use of different methodologies for book purposes and tax purposes, (21) Items resulting from the application of section 1286, (22) Inside buildup, death benefits, or cash surrender value of life insurance or annuity contracts, (23) Life insurance reserves determined under section 807 and non-life insurance reserves determined under section 832(b), (24) Capitalization of policy acquisition expenses of insurance companies, (25) Imputed interest income or deductions under sections 483, 1274, 7872, or Treas. Reg. [section] 1.1275-4, (26) Gains and losses arising under sections 986(c), 987, and 988, (27) Items excluded under sections 883, 921, or an applicable treaty from a foreign corporation's income that would otherwise be subject to tax under section 882, (28) Section 481 adjustments, (29) Inventory valuation differences whether attributable to differences in last-in, first-out (LIFO) computations or obsolescence reserves, and (30) Section 198 deductions for environmental remediation costs.

(26) A detailed discussion of these 30 exceptions to transactions with a significant book-tax difference is beyond the scope of this article.

(27) Compaq Computer Corp. v. Commissioner, 277 F.3d 778 (5th Cir. 2001); IES Industries, Inc. v. U.S., 253 F.3d 350 (8th Cir. 2001).

(28) Treas. Reg. [section] 1.6011-4(b)(7) (2003).

(29) Treas. Reg. [section] 1.6011-4(c)(3)(i)(G) (2003).

(30) A transaction that reduces an income inclusion under section 551 or section 1293 also is subject to such testing.

(31) Treas. Reg. [section] 1.6011-4(g) (2003).

(32) Treas. Reg. [section] 1.6011-4(g) (2003).

(33) Treas. Reg. [section] 1.6011-4(g) (2003).

(34) I.R.C. [section] 6662(a).

(35) I.R.C. [section] 6662(b)(1).

(36) I.R.C. [section] 6662(b)(2).

(37) I.R.C. [section] 6662(d)(1).

(38) Treas. Reg. [section] 1.6662-1 (1995).

(39) Prop. Reg. [section] 1.6664-4(c)(2).

(40) S. 476, 108th Cong., 1st Sess. (2003).

(41) For an explanation of the CARE Act provisions, see S. Rep. No. 108-11, 108th Cong., 1st Sess. 83 (2003).

(42) A large entity is defined as any entity with gross receipts in excess of $10 million in the year of the transaction or in the preceding year.

(43) Broadly defined for this purpose in section 6662(d)(2)(C)(iii) to include any entity, investment plan or arrangement a significant purpose of which is the avoidance of Federal income tax.

(44) Treas. Reg. [subsection] 1.6662-4(g)(4)(i)(B) (1998) and 1.6664-4(c) (1998).

(45) The bill provides that a transaction has economic substance (and thus satisfies the economic substance doctrine) only if the taxpayer establishes that (1) the transaction changes in a meaningful way (apart from Federal income tax consequences) the taxpayer's economic position, and (2) the taxpayer has a substantial non-tax purpose for entering into such transaction and the transaction is a reasonable means of accomplishing such purpose.

(46) I.R.C. [section] 6501(a).

(47) I.R.C. [section] 6501(e).

(48) S. 476, supra, note 41.

DAVID SHURBERG is a senior manager, DAVID GILBERTSON is a manager, and BRUCE LARSEN is a senior associate with PricewaterhouseCoopers LLP's (PwC) Washington National Tax Service. The views expressed in this article represent the authors views and do not necessarily represent the views of PwC. The authors acknowledge the thoughtful comments and suggestions provided by Elaine Church, Chip Harter, Dwight Littlefield, Mark McConaghy, Dan Mendelson, Dick Ruge, and Tim Throndson on prior drafts of this article. Copyright [c] 2003 PricewaterhouseCoopers LLP.
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Author:Larsen, Bruce
Publication:Tax Executive
Date:Mar 1, 2003
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