The definition of a corporate tax shelter under sections 6662 and 6111 of the Internal Revenue Code
November 24, 1998
On November 24, 1998, Tax Executives Institute submitted the following comments on the new definition of “tax shelter” for purposes of the substantial understatement penalty to the Internal Revenue Service. The Institute’s comments were prepared under the joint aegis of TEI’s Federal Tax Committee, whose chair is Philip G. Cohen of Unilever United States Inc., and IRS Administrative Affairs Committee, whose chair is Stephen W. Boocock of Allegheny Teledyne, Inc. A number of TEI members contributed to the development of the submission through their postings on TEI On-Line.
The Taxpayer Relief Act of 1997 amended section 6662(d)(2)(C)(iii) of the Internal Revenue Code to provide a new definition of “tax shelter” for purposes of the substantial understatement penalty. Under this definition, a tax shelter includes any entity, investment, plan, or arrangement with a significant purpose of avoiding or evading federal income tax. Under prior law, a plan was a tax shelter only if tax avoidance or evasion was a principal purpose. The change is effective in respect of transactions entered into after August 5, 1997. The definition also affects the scope of section 6111(d)(1)’s registration requirements for confidential corporate tax shelters, which was also addressed by the 1997 legislation. (The registration provision becomes effective after promulgation of final Treasury regulations.) These comments set forth the Institute’s concerns and recommendations in respect of impending regulations relating to the amended definition of tax shelter under sections 6662 and 6111 of the Code.
Background
Tax Executives Institute is the principal association of corporate tax executives in North America. Our approximately 5,000 members represent 2,800 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and 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 cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works — one that is administrable and, because it provides certainty, that taxpayers can comply with in a cost-efficient manner.
Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the definition of corporate tax shelter under section 6662 of the Internal Revenue Code, relating to the substantial understatement penalty, and section 6111, relating to the registration requirements for confidential tax shelters.
The Definition of Corporate Tax Shelter
A. In General. Section 6662 of the Internal Revenue Code imposes a 20-percent penalty for “substantial” understatements of tax required to be shown on a return. For corporations, “substantial” is defined as an understatement that exceeds the greater of (i) 10 percent of the tax required to be shown on the return for the taxable year, or (ii) $10,000. Exceptions to the penalty apply if there is substantial authority for the position or if the position is disclosed on the taxpayer’s return and there is a reasonable basis for the position. These exceptions do not apply, however — and, hence, the existence of substantial authority or a taxpayer’s disclosure has no effect — in respect of any item attributable to a corporate “tax shelter.” Thus, if a corporation has a substantial understatement attributable to a tax shelter item, the penalty applies with respect to that understatement, unless the reasonable cause exception of section 6664(c)(1) is satisfied.
The Taxpayer Relief Act of 1997, Pub. L. No. 105-34, [sections] 1028, amended section 6662(d)(2)(C)(iii) of the Code to provide a new definition of “tax shelter” for purposes of the substantial understatement penalty. Under this definition, a tax shelter includes (i) a partnership or other entity, (ii) any investment plan or arrangement, or (iii) any other plan or arrangement “if a significant purpose of such partnership, entity, plan, or arrangement is the avoidance or evasion of Federal income tax.” (Emphasis added.) Prior to this amendment, the definition of “tax shelter” was defined as a plan or arrangement having as its principal purpose the avoidance or evasion of tax. The new definition thus potentially subjects more transactions to the tax shelter penalty. The change is effective for items with respect to transactions entered into after August 5, 1997.
TEI appreciates Congress’s desire to discourage abusive tax-motivated transactions. Whether amending the section 6662 penalty and extending the section 6111 registration provisions were the most efficacious way of accomplishing this goal is open to debate. (Too many penalties combined with vague substantive standards seem in our view a recipe not for enhanced compliance but for uncertainty and frustration by both taxpayers and IRS personnel.) What should not be open to debate, however, is whether Congress intended to capture within the definition of “tax shelter” routine business transactions that incorporate tax reduction planning ideas. It did not. Hence, TEI strongly urges the IRS and Treasury Department to confirm that transactions entered into for legitimate, nontax reasons will not be subject to section 6662(d)(2)(C) simply because the federal tax ramifications were evaluated when analyzing a transaction. Mere consideration of tax consequences should not subject a transaction to the substantial understatement penalty. Moreover, care must taken that the definition does not automatically taint any transactions where an outside adviser is used under a cloak of confidentiality.
B. The 1997 Amendment Was Not Intended to Reach Bona Fide Business Transactions. The 1997 amendment to the penalty definition was enacted in conjunction with the addition of section 6111(d)(1) of the Code, which amended the definition of “tax shelters” that must be registered with the Internal Revenue Service by promoters and, in some cases, participants. This registration provision defines “tax shelter” with the same “significant purpose” test for corporate participants as appears in section 6662(d)(2), but limits its reach to arrangements offered under conditions of confidentiality in respect of which the promoters receive aggregate fees in excess of $100,000.
When the provision was adopted in 1997, the House Ways and Means Committee emphasized that the change in the substantial understatement penalty was intended to coordinate the definitions of tax shelter in sections 6662 and 6111:
The second modification affects the special tax shelter rules, which define
a tax shelter as an entity the principal purpose of which is the avoidance
or evasion of Federal income tax. The provision instead provides that a
significant purpose (rather than the principal purpose) of the entity must
be the avoidance or evasion of Federal income tax for the entity to be
considered a tax shelter. This modification conforms the definition of tax
shelter for purposes of the substantial understatement penalty to the
definition of tax shelter for purposes of these new confidential corporate
tax shelter registration requirements.
H.R. Rep. No. 105-148, 105th Cong., 1st Sess. 431 (1997) (Report of the House Committee on the Budget). Thus, congressional intent in adding new section 6111(d)(1) sheds light on the definition of “tax shelter” for purposes of section 6662(d)(2)(C)(iii).
The purpose of section 6111(d)(1) was to provide an “early warning” system to the IRS and Treasury Department:
The provision will improve compliance with the tax laws by giving the
Treasury Department earlier notification than it generally receives under
present law of transactions that may not comport with the tax laws. In
addition, the provision will improve compliance by discouraging taxpayers
from entering into questionable transactions. Also, the provision will
improve economic efficiency, because investments that are not economically
motivated, but that are instead tax-motivated, may reduce the supply of
capital available for economically motivated activities, which could cause
a loss of economic efficiency.
H.R. Rep. No. 105-148 at 429 (emphasis added). Thus, the registration provision is aimed at transactions that, absent tax considerations, have little or no economic substance, are often organized and marketed under a cloak of confidentiality, and do not constitute legitimate tax planning that arises in the context of bona fide business transactions.(1) The Institute recommends that the implementing regulations under section 6662 be targeted to reach only these transactions. Bona fide transactions structured to provide substantial economic benefit to a corporation should not be considered tax shelters merely because tax savings flow from the transactions.
Concededly, the language of both sections 6662 and 6111 is facially broad. It would be wrong, however, to interpret the words without due regard to the statutes’ purpose. Absent the prudent drafting of implementing regulations, legitimate transactions may be swept into the definition of “tax shelter” merely because tax issues were considered, even peripherally. An overbroad definition of tax shelter would fly in the face of one immutable fact: The Internal Revenue Code is replete with provisions intended to drive behavior. For example, the provisions of the Code prompt companies to perform research and development activities in the United States or to invest in low income housing in order to secure tax benefits.(2) The tax law has long recognized the difference between tax avoidance (minimization of tax liability) and tax evasion. Consider, for example, the donation of appreciated property to charity, which entitles the donor to enhanced tax benefits (compared with the donation of cash). Tax planning is a significant purpose in such donations — the enhanced tax benefit materially changes the economics of the transaction — yet the activity is actively encouraged by the tax law. Do these activities constitute a tax shelter in the corporate setting?
Taxes are always a significant consideration for any corporation evaluating a transaction. Companies ignore the tax law at their peril. TEI believes that distending the definition of tax shelter to encompass routine corporate transactions was not the intent of the 1997 amendment and, indeed, would undermine congressional intent in enacting the underlying provisions. The drafters of the regulations should not lose sight of the fact that hundreds of Code sections prescribe conditions for qualifying for a particular tax treatment — provisions Congress wanted companies to pay attention to in planning their affairs. If taxpayers satisfy these conditions, the transaction should not mechanically be cast as a tax shelter and taxpayers should not be subjected to penalties for utilizing them.(3)
Moreover, because disclosure of the tax shelter item does not insulate a taxpayer from assertion of the section 6662 penalty, overreaching regulations could have the perverse effect of discouraging taxpayers from disclosing aggressive tax-planning positions on their returns. Such a result would run counter to the “early warning” concern identified by Congress in enacting the 1997 amendments and should be avoided.
C. Current Regulations Providing A Carve-Out for Routine Business Transactions Should Be Retained. Even though the 1997 amendment substituted the word “significant” for “principal,” the current regulations, which provide a carve-out for routine business transactions, remain valid. Treas. Reg. [sections] 1.6662-4(g)(2)(i) defines the types of transactions intended to be covered by the substantial understatement penalty provisions:
Typical of tax shelters are transactions structured with little or no
motive for the realization of economic gain, and transactions that utilize
the mismatching of income and deductions, overvalued assets or assets with
values subject to substantial uncertainty, certain nonrecourse financing,
financing techniques that do not conform to standard commercial business
practices, or mischaracterization of the substance of the transaction.
Treas. Reg. [sections] 1.6662-4(g)(2)(ii) provides the support for carving out routine tax planning by excluding from the definition of a tax shelter item, items —
if the entity, plan or arrangement has as its purpose the claiming of
exclusion from income, accelerated deductions or other tax benefits in a
manner consistent with the statute and Congressional purpose. For example,
an entity, plan or arrangement does not have as its principal purpose the
avoidance or evasion of Federal income tax solely as a result of the
following uses of tax benefits provided by the Internal Revenue Code: the
purchasing or holding of an obligation bearing interest that is excluded
from gross income under section 103; taking an accelerated depreciation
allowance under section 168; taking the percentage depletion allowance
under section 613 or section 613A; deducting intangible drilling and
development costs as expenses under section 263(c); establishing a
qualified retirement plan under sections 401-409; claiming the possession
tax credit under section 936; or claiming tax benefits available by reason
of an election under section 992 to be taxed as a domestic international
sales corporation (“DISC”), under section 927(f)(1) to be taxed as a
foreign sales corporation (“FSC”), or under section 1362 to be taxed as an
S corporation.
In enacting the 1997 amendments, Congress expressed no dissatisfaction with these common-sense regulations, and TEI urges the IRS and Treasury to retain comparable provisions in any ensuing regulations. In addition, the regulations should provide additional examples of the types of transactions that will not be characterized as a tax shelter solely because minimizing federal income tax was a consideration in the decision to use a particular structure. Some examples include: using three parties in a like-kind exchange, deferring service income under Rev. Proc. 71-21, deferring advance payments for goods under Treas. Reg. [sections] 1.451-5, using a flow-though entity rather than a corporation under the check-the-box regime, structuring a transaction to qualify as a tax-free reorganization under Subchapter C, using stock or options to provide noncash compensation, using intercompany loans between foreign affiliates, and using studies to identify potentially overlooked tax benefits in areas such as research and experimentation, cost segregation studies, and FSC transaction-by-transaction pricing calculations.(4) As long as the underlying business transaction serves a business purpose, the use of a tax reduction technique should not reflexively transform a transaction into a tax shelter.
The regulations should also confirm that the reduction of non-federal taxes is a legitimate business purpose and will not fall within the tax shelter definition. For example, under the corporate reorganization provisions, the reduction of non-federal (i.e., state) taxes is explicitly found to be a valid corporate purpose. Treas. Reg. [sections] 1.355-2(b)(2). This valid purpose extends to the reduction of foreign taxes. See Rev. Rul. 89-101, 1989-2 C.B. 67 (holding that a distribution of stock is supported by a corporate business purpose “because it will benefit the affiliated group of corporations by reducing substantially the amount of foreign withholding tax imposed on distributions from a member of the group”).(5) The section 6662 and 6111 regulations should not effectively override these authorities.
The current regulations set up a tracing requirement to determine the origin of a tax shelter item. Treas. Reg. [sections] 1.6662-4(g)(3) discusses a partnership that is established to acquire and overstate the basis of property for purposes of claiming accelerated depreciation. These depreciation deductions are tax shelter items, but the regulations provide that if this same partnership claims a deduction for a separate transaction, that deduction is not a tax shelter item if the transaction is not part of a plan that has a principal (now significant) purpose of tax avoidance. Bona fide business transactions and uses of tax benefits thus do not give rise to tax shelter items.
The standard adopted by the Tax Court in ACM Partnership v. Commissioner(6) supports the proper delineation between a tax shelter and a bona-fide business transaction, as articulated in Treas. Reg. [sections] 1.6662-4(g). In the ACM case, the court acknowledged —
[the] perennial challenge in the courts to set boundaries between
acceptable tax planning and abuse, while taking into account the importance
of maintaining public confidence in the integrity of the tax system.(7)
The court then evaluated the economic substance of the transaction, and although it concluded that there was no reasonable expectation of profit on a pre-tax basis, it was careful to explain that “we do not suggest that a taxpayer refrain from using the tax laws to the taxpayer’s advantage.”(8)
The Tax Court’s reasoning was affirmed on appeal. A footnote in the Third Circuit’s opinion articulating this standard provides —
[W]here a transaction objectively affects the taxpayer’s net economic
position, legal relations, or non-tax business interests, it will not be
disregarded merely because it was motivated by tax considerations. See,
e.g., Gregory [v. Helvering], 293 U.S. [465,] 468-69 (1935)] … (“if a
reorganization in reality was effected … the ulterior purpose will be
disregarded”); Northern Indiana Pub. Serv. Co. [v. Commissioner,] 115 F.3d
[506,] 510 [(7th Cir. 1997)] (emphasizing that Gregory and its progeny “do
not allow the Commissioner to disregard economic transactions … which
result in actual, non-tax-related changes in economic position” regardless
of “tax-avoidance motive” and refusing to disregard role of taxpayer’s
foreign subsidiary which performed a “recognizable business activity” of
securing loans and processing payments for parent in foreign markets in
exchange for legitimate profit); Kraft Foods Co. v. Commissioner, 232 F. 2d
118, 127-28 & n.19 (2d Cir. 1956) (refusing to disregard tax effects of
debenture issue which “affected … legal relations” between taxpayer and
its corporate parent by financing subsidiary’s acquisition of venture used
to further its non-tax business interests).(9)
It is vital that the forthcoming regulations under section 6662(d)(2)(C)(iii) recognize that tax consequences suffuse almost all corporate decisions. The proposed regulations must confirm that companies may structure their business transactions in the most tax-efficient way permitted by law.
D. At a Minimum, No Radical Changes Should Be Made Until the Required Study Is Completed. The IRS Restructuring and Reform Act of 1998 includes a provision (section 3801) directing the Joint Committee on Taxation and the Treasury Department to —
examine whether the current penalty and interest provisions encourage
voluntary compliance. The studies should also consider whether the
provisions operate fairly, whether they are effective deterrents to
undesired behavior, and whether they are designed in a manner that promotes
efficient and effective administration of the provisions by the IRS.
The report is due by July 22, 1999. Thus, there should be ample opportunity to review the adequacy of the penalty provisions under the current regime and determine what substantive changes in the definition of a tax shelter are warranted and what guidance should be provided by legislation.
(1) This approach is consistent with the Conference Report on the IRS Restructuring and Reform Act of 1998, which included the establishment of a new tax-practitioner privilege (in new section 7525). The provision excludes from the scope of the new privilege advice relating to the promotion of corporate tax shelters. The Conference Report goes on to state, however, that “[t]he Conferees do not understand the promotion of tax shelters to be part of the routine relationship between a tax practitioner and client. Accordingly, the Conferees do not anticipate that the tax shelter limitation will adversely affect such routine relationships.” H.R. Rep. No. 105-599, 105th Cong., 2d Sess. 89 (1998).
(2) Congress was well aware that tax consequences may drive certain economic behavior. How could an investment in low income housing ever fail to meet the “significant” purpose test, since these investments, by intent, are economically driven by their tax benefits?
(3) Hence, the question is not whether a taxpayer utilizing certain provisions of the Code might engage in a transaction properly characterized as a tax shelter; it is whether, by utilizing these provisions, the transaction should be automatically characterized as such.
(4) For example, the Subchapter K anti-abuse rules provide that “Subchapter K is intended to permit taxpayers to conduct joint business activity through a flexible economic arrangement without incurring an entity-level tax…. The decision to organize and conduct business through [a partnership] in order to take advantage of the look-through rules for foreign tax credit purposes, thereby maximizing [taxpayer’s] use of its proper share of foreign taxes paid by [the partnership] is consistent with this intent.” Treas. Reg. [sections] 1.701-2(d), Ex. 3.
(5) Indeed, the failure to reduce foreign tax could result in a noncreditable tax under section 901. See Treas. Reg. [sections] 1.901-2(e)(5) (taxpayer must make reasonable efforts to minimize contested foreign taxes); Rev. Rul. 92-75, 1992-2 C.B. 197 (denying a deemed paid foreign tax credit because of the lack of effort to reduce the subsidiary’s foreign income tax liability).
(6) 73 T.C. Memo 1997-115 (Mar. 5, 1997), rev’d in. part and aff’d in part, 82 A.F.T.R.2d 98-6682 (3d Cir., Oct. 13, 1998).
(7) Id. at 2215.
(8) Id. at 2215.
(9) ACM Partnership v. Commissioner, 82 A.F.T.R.2d 98-6682, 98-6697 n.31 (3d Cir., Oct. 13, 1998).
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