TEI Urges Congress to Clarify Definition of Tax Shelter
Institute Also Comments on Code’s Interest and Penalty Provisions, Encourages Supreme Court to Overturn California Interest Offset Statute
Concerns about the definition of a corporate tax shelter cannot be cavalierly dismissed, Tax Executives Institute President Charles W. Shewbridge, III recently cautioned the House Ways and Means Committee. Mr. Shewbridge represented TEI at the committee’s November 10 hearing to determine the nature and scope of the perceived corporate tax shelter problem. The hearing focused on recent proposals by the staff of the Joint Committee on Taxation and the U.S. Department of Treasury to combat so-called tax shelter abuses.
In his testimony before the Committee (which is reprinted in this issue beginning on page 494), TEI’s president said, “It is critical to know what we are talking about.” The definition must be as objective and as clear as possible — a requirement that is now lacking — in order for solutions to be found, he added.
Questioning the inflammatory rhetoric that has been used to discuss the tax shelter issue, Mr. Shewbridge explained that he had been a tax professional for nearly 30 years. “As BellSouth Corporation’s senior tax official,” he stated, “I am ultimately responsible for the 40,000 federal, state, local, and foreign returns we file annually. BellSouth’s 1998 federal income tax return reflects aggregate tax payments of more than $1.6 billion. Given the size of those numbers and given the fact that I sign BellSouth’s tax returns under penalties of perjury, it should go without saying that I take my job, including my responsibility to the tax system, seriously. So do my colleagues at TEI.”
Mr. Shewbridge also noted that the proposal to require a company’s chief financial officer or other senior officer to certify that the facts disclosed about a tax-shelter transaction are true and correct “misses the mark.” The proposal “misapprehends the role of the tax department as well as that of the CFO, it impugns the integrity and professionalism of both, and it ignores how the provision would adversely affect the examination process,” he said. If enacted, the proposal could lead to focusing not on the underlying transaction but on the CFO’s statement. “Hence, the key would not be whether a transaction passes muster under the law, but rather `What did the senior officer know and when did he know it?’,” Mr. Shewbridge stated. “We regret that the proposal could easily spawn suspicion and distrust comparable to that which existed in the 1970s concerning questionable payments to foreign persons.”
Turning his testimony to areas of agreement among the Institute, the government, and other professional groups, Mr. Shewbridge stated, “We agree that over-aggressive tax-advantaged products are being marketed. We agree that the IRS must do more to challenge and curtail these transactions, including raising practitioner standards and, where appropriate, asserting penalties more frequently. And we agree that better, fuller disclosure — including early warning disclosure by promoters — lies at the heart of successfully dealing with the situation.”
In its written statement to the committee, TEI urged the Internal Revenue Service and the Treasury Department to make greater use of the tools already at their disposal, including the tax shelter registration requirements of Code of section 6111(d), both the injunction rules of section 7408 and the summons authority of section 7609(f) in respect of shelter promoters, and the authority under section 269 to disallow tax benefits in respect of certain acquisitions. “[T]here can be no substitute for an effective enforcement program by the IRS,” the Institute stated.
TEI acknowledged that one deficiency in the current system is the lack of downside risk to those who promote corporate tax shelters. This shortcoming, TEI explained, could be addressed by imposing a disclosure requirement on promoters of particular types of transactions. “Indeed, promoter disclosure could effectively operate as an `early warning system’ that enables the IRS and Treasury Department to evaluate products and issue guidance — whether in the form of notices, rulings, or regulations — shutting down transactions that are perceived as `abusive’ before they proliferate.”
An effective system will impose the obligation for early disclosure on the promoter, TEI stated. “Because taxpayers will be required to make a detailed disclosure on their tax returns in order to avoid penalties, we do not support the imposition of a duplicate early disclosure requirement on taxpayers.” For early disclosure to have the intended salutary effect, TEI said, the IRS and the Treasury must undertake to analyze and take appropriate action on the disclosed transactions.
TEI Comments on Interest and Penalty Studies
TEI also filed comments with the Oversight Subcommittee of the House Ways and Means Committee on two recent studies on the Internal Revenue Code’s interest and penalty provisions conducted by the staff of the Joint Committee on Taxation and the U.S. Department of Treasury. The Institute’s November 9 comments were submitted in conjunction with a subcommittee hearing that was subsequently postponed; they are reprinted in this issue beginning on page 504.
In its written statement, the Institute agreed that it is time for an in-depth review of the Code’s interest and penalty provisions: “The interest rules operate in an unfair manner, are difficult to administer, and, in many cases, have served as an inappropriate penalty — such as with the estimated tax penalty — rather than as recompense for the time value of money. Moreover, the interest calculation itself is extremely difficult and leads to errors by both the government and the taxpayer.”
TEI noted that the unfairness and complexity of the rules have been exacerbated by the delay in issuing guidance. For example, the IRS Restructuring Act mandates the use of interest netting when there are overlapping periods of under- and overpayments. A transition rule permits taxpayers to apply the relief provision retroactively, but to take advantage of it, taxpayers must file elections by the end of the year. Even though less than two months remain to qualify for transitional relief, the IRS and Treasury Department have not yet issued guidance on the mechanics of the election. The delay in issuing the procedure “feeds the perception that the IRS continues to resist interest netting notwithstanding Congress’s mandate,” TEI stated. (After TEI’s comments were filed, the IRS issued Rev. Proc. 99-43, which extends the time for filing for relief taxpayers that have at least one year open under the applicable statute of limitations.)
In respect of the Code’s penalty provisions, TEI stated that they should be “simple, fair, and easy to administer.” Unfortunately, we have moved away from this concept since the penalty reform effort of 1989, the organization added. Penalty has been piled upon penalty to target specific areas such as transfer pricing and corporate tax shelters. “We seem to have lost track of the concept that penalties should be applied only in cases of intentional noncompliance, and not for every error or omission.”
The Institute offered the following recommendations for reform of the tax law’s interest and penalty provisions:
* The interest-rate differential should be repealed and the interest charged on under- and overpayments should be equalized.
* The rate of interest on deficiencies and refunds should equal the applicable federal rate plus two or three percentage points.
* The estimated tax penalty should be converted to an interest charge and a safe harbor should be created for all taxpayers, corporate and individual.
* The Code’s penalty regime should encourage disclosure by taxpayers (i.e., the standards for imposing penalties should be harmonized and consistently applied).
* There should be a realization that certainty and fairness of application play a bigger role in encouraging compliance than an increase in penalty rates.
Amicus Brief Filed in California Interest-Offset Case
TEI has urged the Supreme Court of the United States to declare California’s interest-offset rule unconstitutional because it discriminates against out-of-state corporations. The Institute’s comments were made in a friend-of-the-court brief filed on November 10 in Hunt-Wesson, Inc. v. Franchise Tax Board. The brief is reprinted in this issue, beginning on page 511.
Like many states, California imposes a corporate franchise tax for the privilege of doing business in the state, using an apportionment formula in respect of corporations with income from sources within and without the state. In calculating a taxpayer’s net taxable income, business interest expense is generally deducted from business income. Under section 24344 of the California Revenue and Taxation Code, however, taxpayers must offset their business interest expense — on a dollar-for-dollar basis — with non-business income not allocable to the state. Thus, out-of-state corporations are compelled to reduce their interest deduction by the amount of their nontaxable income, without regard to whether the interest expense is related to the nontaxable income. It is this statute that is at issue in the case.
In Hunt-Wesson, the trial court concluded that section 24344 violates the Due Process, Commerce, and Equal Protection Clauses of the Constitution. This decision was reversed by the Court of Appeal, First Appellate District, largely on the force of the Supreme Court of California’s 1972 decision in Pacific Tel. & Tel. Co. v. Franchise Tax Board. Earlier this fall, the Supreme Court agreed to review the decision.
In Pacific Telephone, the taxpayer challenged the California interest-offset statute as it applied to nondomiciliary corporations. In reviewing the rule, the California Supreme Court conceded that “when viewed in the light of a domiciliary corporation,” the rule “does not deprive the taxpayer of any of its interest deduction, but is merely an attempt to provide how the interest expense shall be allocated as between income from operations and income from investments.” The court also commented that the allocation of interest expense is “very favorable” to the domiciliary corporation.
In its brief, TEI explained that as applied to out-of-state companies, the allocation is manifestly not favorable. “Hence, on its face, the rule violates the overarching principle of the Commerce and Due Process Clauses that an apportionment formula must, first and foremost, be fair.”
TEI explained that Commerce Clause jurisprudence has evolved significantly since California’s 1972 decision on which the court relied in Hunt-Wesson. “Nowhere has this evolution been more profound than in respect of statutory schemes that facially discriminate against out-of-state commerce.” Citing several cases that have been decided by the Court in the last five years, the Institute concluded that “[b]y its very terms, the interest-offset rule at issue here violates the Commerce Clause.”
TEI also contended that the law offends the Due Process Clause, which requires a minimal connection between the interstate activities and the taxing state, as well as a rational relationship between the income attributed to the taxing state and the intrastate value of the corporate business. “California does not contend that the non-business income at issue here bears any relation to [Hunt-Wesson’s] in-state activities,” TEI said. “Rather, the state seeks to tax [Hunt-Wesson’s] extraterritorial activities by requiring a dollar-for-dollar offset of constitutionally protected income against interest expense.” The dividend income sought to be taxed here bears no relationship to Hunt-Wesson’s in-state activities and thus California’s covert attempt to tax it should be rejected as violative of due process, the Institute concluded.
TEI also argued that the State’s semantics — that the interest-offset rule is not a “tax” — cannot change the substance of the statute. “It is clear that California could not tax [Hunt-Wesson’s] dividend income directly. It is also clear that a state may not, through constitutional alchemy, indirectly tax constitutionally protected income.”
TEI urged the Court to reverse the decision below. A decision is expected next year.
TEI, IRS Co-Sponsor IRS Modernization Seminar
In January 2000, Tax Executives Institute, the Internal Revenue Service, and several other organizations will co-sponsor a seminar on The New IRS Stands Up: What the Modernized Agency Means for You. Treasury Secretary Lawrence Summers, IRS Commissioner Charles Rossotti, and former TEI member Larry Langdon, who is slated to head the new IRS Large & Mid-Size Business Division, will be featured speakers. TEI President Charles Shewbridge will moderate a breakout session on the LMSB operating division.
Participants at the program will learn how the IRS reorganization will affect taxpayers, tax practitioners, and IRS employees. The objective of the conference is to answer fundamental questions about IRS modernization, such as: What is it? How and when will it be implemented? What will be its effect inside and outside the IRS?
The program will be held on January 13-14, 2000, at the Hyatt Regency Washington in Washington, D.C. The cost of the two-day program is $200 for reservations received before December 15, 1999, and $250 for reservations received thereafter. Other program sponsors are the ABA Section of Taxation, the American Tax Policy Institute, the AICPA Tax Division, and the National Association of Enrolled Agents.
Additional information may be obtained by contacting TEI Headquarters at (202) 638-5601, or you may register on line at www.naea.org. TEI itself, however, is not processing registrations.
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