COMPARISON OF RECOMMENDATIONS RELATING TO CORPORATE TAX SHELTERS MADE BY THE DEPARTMENT OF TREASURY AND THE STAFF OF THE JOINT COMMITTEE ON TAXATION

Scheduled for a Public Hearing

Before the

SENATE COMMITTEE ON FINANCE

on March 8, 2000

Prepared by the Staff

of the

JOINT COMMITTEE ON TAXATION

March 7, 2000

JCX-25-00 CONTENTS

Page

INTRODUCTION ...... 1

I. PROPOSALS RELATING TO CORPORATE TAXPAYERS ...... 3

A. Definition of a tax shelter...... 3

B. Definition of a corporate tax shelter...... 3

C. Codification of the common-law economic substance doctrine in a substantive rule ...... 6

D. Amount of penalty under section 6662 ...... 6

E. Definition of substantial understatement under section 6662 ...... 7

F. Disclosure by corporate taxpayers...... 8 1. Transactions required to be disclosed ...... 8 2. Exceptions from disclosure...... 10 3. Content of disclosure...... 12 4. Timing of disclosure ...... 12 5. Certification of disclosure...... 12 6. Penalty for nondisclosure ...... 12 7. Special disclosure to shareholders...... 13

(i) Page

II. PROPOSALS THAT AFFECT OTHER PARTIES INVOLVED IN CORPORATE TAX SHELTERS ...... 14

A. Impose tax on tax-indifferent parties that participate in corporate tax shelters ...... 14

B. Aiding and abetting penalty ...... 14

C. Injunctive action against promoters ...... 16

D. Promoter registration...... 17 1. Transactions required to be registered...... 17 2. Exceptions from registration ...... 19 3. Timing of registration ...... 20 4. Penalty for nonregistration ...... 20

E. Regulation of professional conduct of practice ...... 21

(ii) INTRODUCTION

The Senate Committee on Finance has scheduled a public hearing on March 8, 2000, regarding penalties and interest and corporate tax shelters. The Internal Revenue Service Restructuring and Reform Act of 1998 directed the Joint Committee on Taxation and the Department of the Treasury to undertake separate studies of the interest and penalty provisions of the Internal Revenue Code of 1986 (the “Code”), and make any legislative and administrative recommendations they deem appropriate to simplify penalty administration and reduce taxpayer burden. The staff of the Joint Committee on Taxation released its study1 on July 22, 1999. The Department of the Treasury released its White Paper discussion of corporate tax shelters2 and its report on penalty and interest provisions3 in July 1999 and October 1999, respectively. On February 7, 2000, the Department of the Treasury released their explanation of the President’s Fiscal Year 2001 Budget Proposals;4 included among the President’s budget proposals are five proposals having general application to corporate tax shelter arrangements.5 On February 28, 2000, the Department of the Treasury released temporary and proposed regulations relating to (1) disclosure of tax shelters by corporate taxpayers, (2) registration of confidential corporate tax shelters by tax shelter promoters, and (3) the maintenance of lists of investors in potentially abusive tax

1 Joint Committee on Taxation, Study of Present-Law Penalty and Interest Provisions as Required by Section 3801 of the Internal Revenue Service Restructuring and Reform Act of 1998 (including Provisions Relating to Corporate Tax Shelters) (JCS-3- 99), July 22, 1999.

2 Department of the Treasury, White Paper: The Problem of Corporate Tax Shelters (Discussion, Analysis and Legislative Proposals), July 1999 (“White Paper”).

3 Department of the Treasury, Report to the Congress on Penalty and Interest Provisions of the Internal Revenue Code, October 1999.

4 See Office of Management and Budget, Budget of the United States Government, Fiscal Year 2001: Analytical Perspectives (H. Doc. 106-162. Vol. III), pp. 54-86.

5 See Department of the Treasury, General Explanations of the Administration’s Fiscal Year 2001 Revenue Proposals, February 2000.

- 1 - shelters.6

This document,7 prepared by the staff of the Joint Committee on Taxation, provides a comparison of the legislative changes with respect to corporate tax shelters recommended8 by the Joint Committee staff and the Department of the Treasury.

6 See Temp. Treas. Reg. secs. 1.6011-4T; 301.6111-2T; and 301.6112-1T. These regulations are reflected, as appropriate, in the “Present Law” column in the table below.

7 This document may be cited as follows: Joint Committee on Taxation, Comparison of Recommendations Relating to Corporate Tax Shelters Made by the Department of Treasury and the Staff of the Joint Committee on Taxation (JCX-25-00), March 7, 2000.

8 As used in the “Recommendation” columns of this document, “No recommendation” means that no specific recommendation was made with respect to that item.

- 2 - PROVISION PRESENT LAW JCT STAFF TREASURY RECOMMENDATIONS RECOMMENDATIONS I. PROPOSALS RELATING TO CORPORATE TAXPAYERS A. Definition of a tax shelter An accuracy-related penalty Specific recommendations with Specific recommendations with under section 6662 applies to an respect to the definition of a respect to the definition of a understatement of tax that is corporate tax shelter are corporate tax shelter are attributable to a tax shelter. described below. described below.

A tax shelter is defined as a partnership, entity, plan, or arrangement a significant purpose of which is the avoidance or evasion of Federal income tax. B. Definition of a corporate Present law does not contain a Corporate tax shelter - A Corporate tax shelter - Any tax shelter special definition of a corporate partnership, entity, plan, or entity, plan, or arrangement in tax shelter. The definition of a arrangement (collectively which a direct or indirect tax shelter described above referred to as an “arrangement”) corporate participant attempts to applies to all taxpayers. involving a corporate participant obtain a “tax benefit” in a “tax will be considered to have a avoidance transaction.” It is significant purpose of Federal unclear whether this income tax avoidance or evasion recommendation would replace under section 6662 if it satisfies or be in addition to the present- one of five corporate tax shelter law significant purpose indicators. The mere purchase definition. or sale of an asset will not

-3- PROVISION PRESENT LAW JCT STAFF TREASURY RECOMMENDATIONS RECOMMENDATIONS constitute an arrangement for Tax benefit - Includes any these purposes. reduction, exclusion, avoidance, or deferral of tax, or an increase Corporate tax shelter indicators - in a refund, but would not (1) The present value of the include a tax benefit clearly reasonably expected pre-tax contemplated by the applicable profit from the arrangement is provision. insignificant relative to the present value of the reasonably Tax avoidance transaction - expected net tax benefits. (1) Any transaction in which the present value of the reasonably (2) The arrangement involves a expected pre-tax profit of the tax-indifferent participant, and transaction is insignificant (a) results in taxable income relative to the present value of materially in excess of economic the reasonably expected net tax income to the tax-indifferent benefits; and participant, (b) permits a corporate participant to (2) In the case of financing characterize items of income, transactions, any transaction in gain, loss, deductions, or credits which the present value of the in a more favorable manner than tax benefits of the taxpayer to it otherwise could without the whom the financing is provided involvement of the tax- is significantly in excess of the indifferent participant, or (c) present value of the pre-tax results in a noneconomic profit or return of the person increase, creation, providing the financing. multiplication, or shifting of basis for the benefit of the

-4- PROVISION PRESENT LAW JCT STAFF TREASURY RECOMMENDATIONS RECOMMENDATIONS corporate participant, and results in the recognition of income or gain that is not subject to Federal income tax because the tax consequences are borne by the tax-indifferent participant.

(3) The arrangement involves significant reasonably expected net tax benefits and a tax indemnity or similar agreement.

(4) The arrangement involves significant reasonably expected net tax benefits and a reasonably expected “permanent difference” for U.S. financial reporting purposes under generally accepted accounting principles.

(5) The arrangement involves significant reasonably expected net tax benefits and the corporate participant incurs little (if any) additional economic risk.

-5- PROVISION PRESENT LAW JCT STAFF TREASURY RECOMMENDATIONS RECOMMENDATIONS C. Codification of the The economic substance No recommendation. Codifies and clarifies the common-law economic doctrine has been developed in economic substance doctrine by substance doctrine in a common law through numerous disallowing any tax benefit substantive rule court cases. This doctrine has derived in a tax avoidance been invoked to deny claimed transaction (defined above). tax benefits if the transaction giving rise to those benefits Applies to any trade or business lacked economic substance or activity engaged in for profit independent of tax or for the production of income, considerations. including those that engage in business in non-corporate forms.

Does not apply to any claimed loss or deduction economically been incurred by a taxpayer before entering into the transaction. D. Amount of penalty under Imposes a 20-percent penalty on Increases the penalty rate to 40 Increases the penalty rate to 40 section 6662 the portion of any underpayment percent for any understatement percent for any understatement attributable to (1) negligence or that is attributable to a corporate that is attributable to a corporate (2) any substantial tax shelter. The IRS would not tax shelter. understatement of income tax. have the discretion to waive the understatement penalty in settlement negotiations or otherwise for corporate tax shelters.

-6- PROVISION PRESENT LAW JCT STAFF TREASURY RECOMMENDATIONS RECOMMENDATIONS Reduces the 40-percent rate to Reduces the 40-percent rate to 20 percent if certain disclosures 20 percent if certain disclosures are made and the tax treatment is are made. supported by substantial authority.

Penalty does not apply if the Penalty does apply if the Penalty does not apply if the taxpayer establishes reasonable corporate taxpayer (1) satisfies taxpayer discloses the cause for the underpayment and disclosure requirements transaction and satisfies a the taxpayer acted in good faith. (including corporate officer strengthened reasonable cause Reasonable cause may be certification), (2) reasonably standard (i.e., the taxpayer established with a more-likely- believes that there is at least a shows that it had a strong chance than-not opinion of a third-party. 75-percent likelihood of of sustaining its tax position and sustaining the position on its acted in good faith). merits, and (3) has a material nontax business purpose. Repeals the present-law reasonable cause exception. E. Definition of substantial A substantial understatement Modifies the penalty with No recommendation specific to understatement under section exists if the correct income tax respect to a corporate tax shelter corporate tax shelters, but 6662 liability for a taxable year to eliminate the requirement that another proposal treats any exceeds the liability reported by the understatement be corporate understatement in the taxpayer by the greater of 10 substantial. Imposes the penalty excess of $10 million as percent of the correct tax or on the understatement substantial, regardless of $5,000 ($10,000 in the case of attributable to each corporate tax whether it exceeds 10 percent of most corporations). shelter (without regard to the tax liability. whether there was an overall underpayment of tax for the

-7- PROVISION PRESENT LAW JCT STAFF TREASURY RECOMMENDATIONS RECOMMENDATIONS taxable year). F. Disclosure by corporate taxpayers 1. Transactions required to A corporate taxpayer must 30-day disclosure - Same as present law (proposed be disclosed disclose: Arrangements that are described and temporary regulations issued (1) Any transaction that is the by a tax shelter indicator and in in February 2000 include same as, or substantially similar which the expected net tax disclosure requirements that are to, a transaction identified by the benefits are at least $1 million similar to those contained in the IRS in published guidance as must be disclosed within 30 days President’s budget proposals). being a tax avoidance of entering into the arrangement. transaction (a“listed” transaction) and which is Tax-return disclosure - expected to reduce Federal Arrangements that are described income tax liability by more by a tax shelter indicator are than $1 million in any single required to be disclosed on year or by more than $2 million corporate taxpayer’s tax returns. for any combination of years, or (2) Any transaction having at Corporate tax shelter indicators least two of six characteristics (same as described in connection (“filters”) and which is expected with the definition of a corporate to reduce Federal income tax tax shelter) - liability by more than $5 million in any single year or $10 million (1) The present value of the for any combination of years. reasonably expected pre-tax profit from the arrangement is insignificant relative to the present value of the reasonably

-8- PROVISION PRESENT LAW JCT STAFF TREASURY RECOMMENDATIONS RECOMMENDATIONS Filters: expected net tax benefits.

(1) The transaction is offered (2) The arrangement involves a under conditions of tax-indifferent participant, and confidentiality. the arrangement (a) results in taxable income materially in (2) The transaction involves excess of economic income to contractual protection against the tax-indifferent participant, the possibility that part or all of (b) permits a corporate the intended tax benefits from participant to characterize items the transaction will not be of income, gain, loss, sustained. deductions, or credits in a more favorable manner than it (3) Aggregate contingent otherwise could without the promoter fees for such involvement of the tax- transactions exceed $100,000. indifferent participant, or (c) results in a noneconomic (4) The transaction involves a increase, creation, book/tax difference in excess of multiplication, or shifting of $5 million in any year. basis for the benefit of the corporate participant, and results (5) The transaction involves a in the recognition of income or person that the taxpayer knows gain that is not subject to or has reason to know is in a Federal income tax because the Federal income tax position that tax consequences are borne by differs from that of the taxpayer the tax-indifferent participant. (e.g., a tax-exempt entity or foreign person), and the taxpayer (3) The arrangement involves

-9- PROVISION PRESENT LAW JCT STAFF TREASURY RECOMMENDATIONS RECOMMENDATIONS knows or has reason to know significant reasonably expected that such difference has net tax benefits and a tax permitted the transaction to be indemnity or similar agreement. structured to provide the taxpayer with more favorable (4) The arrangement involves Federal income tax treatment significant reasonably expected than it could have obtained net tax benefits and reasonably without the participation of such expected “permanent difference” person. for U.S. financial reporting purposes under generally (6) The expected U.S. tax and accepted accounting principles. foreign tax characterizations of any significant aspect of the (5) The arrangement involves transaction differ. significant reasonably expected net tax benefits and the corporate participant incurs little (if any) additional economic risk. 2. Exceptions from Disclosure is not required for (1) Disclosure is not required for Authorizes the Treasury disclosure transactions otherwise subject to arrangements that are properly Secretary to provide exceptions disclosure (i.e., exhibiting at reported on certain forms (e.g., from disclosure. least 2 of the 6 filters described Form 1120-FSC for foreign above) if: sales corporations; Form 1120- DISC for domestic international (1) The taxpayer participated in sales corporations; Form 8586 the transaction in the ordinary for the low income housing course of the taxpayer’s trade or credit; Form 1120, schedule K, business in a form consistent line 12 for tax-exempt interest;

-10- PROVISION PRESENT LAW JCT STAFF TREASURY RECOMMENDATIONS RECOMMENDATIONS with customary commercial and Form 8860 for the qualified practice and would have entered zone academy bond credit), but into the transaction on only to the extent provided by substantially the same terms the Treasury Secretary in irrespective of the expected regulations. Federal income tax benefits. (2) Solely for purposes of the (2) The taxpayer participated in 30-day disclosure, disclosure is the transaction in the ordinary not required for leasing course of its business in a form transactions that satisfy the consistent with customary guidelines in Rev. Proc. 75-21 commercial practice and the and the case law thereunder. taxpayer reasonably determines that there is a long-standing and generally accepted understanding that the expected Federal income tax benefits from the transaction are allowable.

(3) The taxpayer reasonably determines that there is no reasonable basis under Federal tax law for denial of any significant portion of the expected tax benefits.

(4) The transaction is identified in published guidance as

-11- PROVISION PRESENT LAW JCT STAFF TREASURY RECOMMENDATIONS RECOMMENDATIONS excepted from disclosure. 3. Content of disclosure The disclosure is required to The disclosure is required to Same as present law. include: the name of transaction, include: a summary of relevant whether it has been registered by facts and assumptions, the a promoter, a description of the expected net tax benefits, principal elements giving rise to identification of each tax shelter tax benefits, a description of the indicator that describes the tax benefits, identification of arrangement, legal analysis and each tax year affected (and the rationale for the tax treatment, amount of tax benefits). the business purpose, and the existence of any contingent fees. 4. Timing of disclosure The disclosure is required no One disclosure required within The disclosure is required no later than the due date of tax 30 days of entering into the later than the original due date of return (with extensions). arrangement and a second tax return (without extensions). disclosure required by the due date of the tax return (with extensions). 5. Certification of disclosure No special certification required. A corporate officer must certify A corporate officer must certify (under penalties of perjury) the (under penalties of perjury) the adequacy of the disclosure. adequacy of the disclosure. Such officer would be personally liable for misstatements on the disclosure form. 6. Penalty for nondisclosure No provision. However, a No recommendation. However, Penalty of $100,000 imposed per failure to disclose adequately a a failure to disclose adequately a failure to disclose regardless of reportable transaction is a factor reportable transaction will whether the arrangement is a tax

-12- PROVISION PRESENT LAW JCT STAFF TREASURY RECOMMENDATIONS RECOMMENDATIONS in determining whether any preclude reduction of the section avoidance transaction. In understatement attributable to 6662 penalty rate below 40 addition, failure to disclose the transaction is due to percent. adequately a tax avoidance reasonable cause, and that the transaction will preclude taxpayer acted in good faith. reduction of the section 6662 penalty rate below 40 percent. 7. Special disclosure to No provision. Requires a corporate participant No recommendation. shareholders to disclose to its shareholders the payment (including the amount and transaction details) of an understatement penalty of at least $1 million that was attributable to a corporate tax shelter.

-13- PROVISION PRESENT LAW JCT STAFF TREASURY RECOMMENDATIONS RECOMMENDATIONS II. PROPOSALS THAT AFFECT OTHER PARTIES INVOLVED IN CORPORATE TAX SHELTERS A. Impose tax on tax- No provision. However, one of No recommendation. However, Any income allocable to a tax- indifferent parties that the filters (described above) one of the corporate tax shelter indifferent party (trading on its participate in corporate tax relates to the involvement of indicators (described above) tax exemption) with respect to a shelters certain tax-indifferent parties. relates to the involvement of corporate tax shelter would be certain tax-indifferent parties. taxable to such party without regard to any statutory, regulatory, or treaty exclusion or exception. The other corporate participants in the corporate tax shelter would be jointly and severally liable for such tax (in addition to any tax resulting from the denial of tax benefits to the corporate participants under the codification of the economic substance doctrine). B. Aiding and abetting Section 6701 imposes a penalty Expands the scope of the aiding No recommendation with penalty on any person who (1) aids, and abetting penalty to apply to respect to aiding and abetting. assists, procures, or advises with any person who assists or The proposal includes, however, respect to the preparation or advises with respect to the a new penalty excise tax of 25 presentation of any portion of a creation, implementation, or percent on fees received in return, affidavit, claim, or other reporting of a corporate tax connection with the purchase

-14- PROVISION PRESENT LAW JCT STAFF TREASURY RECOMMENDATIONS RECOMMENDATIONS document, (2) knows (or has shelter that results in an and implementation of a reason to believe) that the understatement penalty if (1) the corporate tax shelter (as defined document will be used in person knew or had reason to above) and the rendering of connection with any material believe that the corporate tax certain tax advice related to a matter arising under the internal shelter could result in an corporate tax shelter. The 25- revenue laws, and (3) knows that understatement of tax, (2) the percent penalty excise tax the document would result in an person opined or advised the applies only to persons who understatement of another corporate participant that there perform services in furtherance person’s tax liability. Aiding or existed at least a 75-percent of a corporate tax shelter. abetting requires “direct likelihood that the tax treatment Appropriate due process rights involvement” in the preparation would be sustained on the merits to contest the excise tax would or presentation of a tax return or if challenged, and (3) a be provided. other tax-related document. reasonable tax practitioner would not have believed that there existed at least a 75- percent likelihood that the tax treatment would be sustained on the merits if challenged.

The penalty for aiding and Increases penalty from $10,000 No recommendation. abetting with respect to an to the greater of $100,000 or individual’s tax liability is one-half of the fees related to the $1,000; the penalty is $10,000 transaction. with respect to a corporation’s tax liability.

Requires the publication of the No recommendation. names of any person penalized

-15- PROVISION PRESENT LAW JCT STAFF TREASURY RECOMMENDATIONS RECOMMENDATIONS and an automatic referral of the person to the IRS Director of Practice. C. Injunctive action against Under section 7408, the Clarifies that traditional equity No recommendation. promoters Secretary may bring a civil factors such as irreparable injury action in district court to enjoin and likelihood of success on the a person from further engaging merits need not be considered in conduct subject to penalty once the government has under section 6700 (the penalty satisfied the statutory for promoting abusive tax requirements. shelters) or section 6701 (the penalty for aiding and abetting the understatement of tax liability. The court may grant injunctive relief if it finds (1) that the person has engaged in conduct subject to the penalty, and (2) that injunctive relief is appropriate to prevent recurrence of such conduct. Case law has indicated that traditional equity factors such as irreparable injury and likelihood of success on the merits need not be considered, provided that the government has satisfied the statutory requirements.

-16- PROVISION PRESENT LAW JCT STAFF TREASURY RECOMMENDATIONS RECOMMENDATIONS D. Promoter registration 1. Transactions required to Registration required for an Modifies the present-law rules to No recommendation. be registered entity, plan, or arrangement: (1) (1) eliminate the confidentiality a significant purpose of which is requirement, (2) increase the fee the avoidance or evasion of threshold from $100,000 to $1 Federal income tax, (2) is million, and (3) expand the offered under conditions of registration requirement to cover confidentiality, and (3) the any corporate tax shelter that is promoters of which receive reasonably expected to be aggregate fees in excess of presented to more than one $100,000. potential participant.

An entity, plan, or arrangement has a significant purpose of avoiding or evading Federal income tax if: (1) it is the same as, or substantially similar to, a transaction identified by the IRS as being a tax avoidance transaction (i.e., a “listed” transaction); (2) (a) the present value of the reasonably expected pre-tax profits is insignificant relative to the present value of the expected net tax benefits, or (b) in the case of transactions that in substance are the borrowing of money or

-17- PROVISION PRESENT LAW JCT STAFF TREASURY RECOMMENDATIONS RECOMMENDATIONS acquisition of financial capital, the present value of the income tax deductions of the taxpayer to whom the loan or financial capital is provided significantly exceeds the present value of the pre-tax return of the lender or provider of the financial capital; or (3) the arrangement is structured to produce tax benefits that constitute an important part of the intended results of the arrangement and the promoter reasonably expects to present the arrangement to more than one taxpayer.

-18- PROVISION PRESENT LAW JCT STAFF TREASURY RECOMMENDATIONS RECOMMENDATIONS 2. Exceptions from Registration not required if - No recommendation. No recommendation. registration (1) the transaction is identified by the IRS in published guidance as excepted from registration; (2) if not identified as a tax avoidance transaction in published guidance (i.e., is not a “listed” transaction) and the promoter reasonably determines that there is no reasonable basis under Federal tax law for denial of any significant portion of the expected Federal income tax benefits from the transaction; or (3) with respect to the third category of transactions (i.e., transaction in which tax benefits constitute an “important part” of the intended results), the promoter reasonably determines that the potential participant is expected to participate in the transaction in the ordinary course of its business in a form consistent with customary commercial practice, and that there is a long-standing and

-19- PROVISION PRESENT LAW JCT STAFF TREASURY RECOMMENDATIONS RECOMMENDATIONS generally accepted understanding that the expected Federal income tax benefits from the transaction are allowable under the Code. 3. Timing of registration Registration required no later Requires registration of No recommendation. than the day on which the tax corporate tax shelters no later shelter is first offered to than the earlier of: (1) the potential users. earliest day on which there is a reasonable belief that the promoter intends to present the promotional or marketing materials to more than one potential corporate participant, or (2) the day on which the presentation to the second potential participant occurs. 4. Penalty for nonregistration Penalty for nonregistration No recommendation. No recommendation. equals the greater of $10,000 or 50 percent (75 percent if intentional) of the fees payable to any promoter with respect to offerings prior to the date of late registration.

-20- PROVISION PRESENT LAW JCT STAFF TREASURY RECOMMENDATIONS RECOMMENDATIONS E. Regulation of professional Treasury Department regulations Includes the explicit statutory No recommendation. The conduct of practice govern the practice of attorneys, authorization for Circular 230 in Treasury Department recently certified public accountants, the Code and authorizes the announced, however, that an enrolled agents, and other imposition of monetary updated version of Circular 230 persons representing clients sanctions. will be issued later in 2000. before the IRS (“Circular 230"). The IRS Office of Director of With respect to corporate tax Practice is responsible for the shelters, directs the Treasury enforcement of Circular 230. Department to amend Circular 230 to conform to the above recommendations by revising definitions and standards of practice and providing more meaningful enforcement measures.

-21-