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Tax Bulletin (August 2002)

Crackdown on Tax Shelters: Current
Enforcement Efforts and Calls for Reform

By Keith R. Gercken a tax partner in the San Francisco office of Pillsbury Winthrop Shaw Pittman LLP and Michael Richman, formerly a tax associate in our New York office. If you have or can obtain the Acrobat Reader, or have an Acrobat-enabled web browser, you may wish to download or view our August 2002 Tax Bulletin (a 529K pdf file), containing a printed version of this article and also available via ftp at ftp.pmstax.com/gen/bull0208.pdf.

See Material Available On-Line for links to the and administrative and legislative material discussed herein.

This bulletin is part of the Pillsbury Winthrop Shaw Pittman LLP Tax Page, a World Wide Web demonstration project, no portion of which is intended and cannot be construed as legal or tax advice. Comments are welcome on the design or content of this material.


Although the topic of corporate tax shelters has become much more prominent since the beginning of 2002, the Treasury Department and Internal Revenue Service have become increasingly focused over the past several years on what they believe to be an unacceptable and growing level of tax avoidance behavior. [fn. 1] The most recent legislative attempt to deter the proliferation of tax shelter transactions came in 1997 when Congress passed legislation putting into place enhanced registration and penalty requirements relating to certain specified tax-motivated transactions. [fn. 2] Following the Treasury's promulgation of implementing regulations in February 2000, the tax shelter rules generally require that (i) tax shelter promoters and organizers register "confidential corporate tax shelters" with the IRS and maintain lists of investors who have participated in "potentially abusive tax shelters," and (ii) corporate taxpayers disclose their participation in "reportable transactions." [fn. 3] Failure to comply with these registration, list maintenance and disclosure rules could trigger the imposition of significant penalties. [fn. 4]

On March 20, 2002, motivated in part by what it perceived to be a disappointingly small number of tax shelter arrangements disclosed by taxpayers during the 2001 filing season, the Treasury announced a number of new initiatives designed both to improve compliance with the existing rules as well as to expand and rationalize those rules so as to make them easier for the IRS to administer and enforce. As described in further detail below, these initiatives include increased enforcement activity, regulatory changes and calls for new legislation.

Taxpayer and Promoter Enforcement Initiatives

The Treasury's March 20 proposals outlined a number of new administrative enforcement measures designed to uncover previously unreported tax shelter arrangements:

  • A "voluntary disclosure" program under which the IRS would waive any accuracy-related penalty assessed with respect to tax underpayments relating to questionable transactions so long as the taxpayer voluntarily disclosed all relevant information relating to the transaction (including the identity of the promoter) prior to April 23, 2002.

  • The issuance of guidelines to ensure that penalties are consistently applied to all tax avoidance transaction cases.

  • A shift of audit resources to allow the IRS to devote more attention to potential tax avoidance transactions.

  • The development of a standard "information document request" designed to elicit information regarding potential tax shelter transactions from all corporate taxpayers under audit by the IRS' Large and Midsize Business Division.

  • Entering into "Tax Information Exchange Agreements" with offshore financial centers such as the Cayman Islands, Antigua and Barbuda, and the Bahamas.

  • Increased coordination with the Department of Justice relating to summons enforcement.

In response to Treasury's call for increased enforcement in the tax shelter area, the IRS has issued over 130 summonses demanding customer lists and other documents since March 20. While each of the Big Five accounting firms had initially refused to turn over customer lists and other documents, asserting both attorney-client and tax practitioner-client privilege, in its first widely publicized victory the IRS announced on June 27, 2002 that it had reached a settlement resolving tax shelter registration and investor list maintenance issues with PricewaterhouseCoopers ("PwC"). As part of the settlement, PwC agreed to make a "substantial payment" to the IRS and provide the IRS with certain client information. PwC also agreed to work with the IRS in developing processes to ensure its ongoing compliance with the tax shelter registration and list maintenance rules.

Unable to reach similar settlements with other accounting firms, on July 9 the Justice Department, on behalf of the IRS, filed summons enforcement actions in federal district court against both KPMG and BDO Seidman seeking information relating to whether these firms had complied with the tax shelter registration and list maintenance rules. As part of its filed petition in the KPMG action, the Justice Department submitted KPMG's own lengthy (and unredacted) privilege logs describing the types of documents withheld, the names of the senders and recipients, and the reasons for not disclosing the contents. Unsurprisingly, this disclosure created a media firestorm as reporters examined the privilege log for the names of KPMG clients and the types of tax shelter transactions that they may have participated in. While the government continues to assert that this public disclosure broke no laws, and that the submission of the privilege logs to the court was necessary in order to rebut KPMG's contention that it was not required to respond to the summons based on its privilege claims, all three of the government agencies involved (Treasury, Justice and the IRS) have acknowledged that the public disclosure was inappropriate and have stated that procedures will be put into place in the future to protect confidential taxpayer information in promoter enforcement actions. Nevertheless, this episode makes it clear that corporate taxpayers remain at risk of public exposure to the extent that they engage in transactions subject to the tax shelter registration and list maintenance rules, particularly if their claim to confidentiality is grounded only on the relatively new statutory tax practitioner-client privilege.[fn. 5]

    Amended Tax Shelter Disclosure Regulations and Other Treasury Administrative Action

On June 14, 2002, the Treasury Department announced a number of amendments to the temporary regulations governing tax shelter registration requirements, promoter list maintenance requirements and taxpayer disclosure requirements. In general, these amendments are intended to subject a broader class of taxpayers to the tax shelter disclosure requirements as well as to expand the universe of transactions that are subject to the rules.

  • Extension of Disclosure Requirement to Trusts, Partnerships, S Corporations and High-Income Individuals. The existing regulations had generally provided that corporate taxpayers (other than S corporations) were required to disclose their participation in certain tax shelter transactions. [fn. 6] Based on its belief that a significant number of tax shelter transactions have been entered into by noncorporate taxpayers, in the case of listed transactions the Treasury has amended the regulations to expand the disclosure requirements to cover individuals, partnerships, S corporations and trusts as well as regular C corporations. [fn. 7] In addition, partners and S corporation shareholders are now required to make a separate disclosure on their own tax returns if their partnerships or S corporations engage in listed tax shelter transactions. As a result of this change, all taxpayers will now have to comply with the tax shelter disclosure rules if they participate in a listed transaction.

  • Clarification of "Indirect" Participation. The existing regulations provide that the tax shelter disclosure rules are applicable even if a taxpayer only participates "indirectly" in a listed or reportable transaction. In an effort to clarify what constitutes "indirect" participation, the amended regulations provide that a taxpayer will be considered to have indirectly participated in a transaction where the taxpayer knows or has reason to know that the tax benefits claimed are attributable to a reportable transaction that was entered into by another taxpayer. [fn. 8] The extension of the tax shelter disclosure rules to taxpayers who "know or have reason to know" that their tax benefits are attributable to a listed or reportable transaction entered into by another taxpayer puts a premium on being able to thoroughly understand all ancillary transactions, including those to which the taxpayer was not a party.

  • Clarification of "Substantially Similar" Transactions. The existing regulations generally impose disclosure and registration requirements for both listed transactions as well as transactions that are "substantially similar" to listed transactions. The Treasury believes that some taxpayers and shelter promoters have been interpreting the "substantially similar" standard in an unjustifiably narrow fashion in order to improperly avoid these disclosure and registration requirements. Accordingly, the regulations have been amended to clarify that the term "substantially similar" is intended to include any transaction that is expected to obtain the same or similar types of tax benefits and that is either factually similar or based on the same or similar tax strategy. The amended regulations further provide that the receipt of an opinion letter concluding that the tax benefits from the taxpayer's transaction are allowable is not relevant to the determination of whether the taxpayer's transaction is the same as or substantially similar to a listed transaction. It is questionable whether the clarification offered in the amended regulations will ultimately prove to be particularly helpful to taxpayers in determining whether a given transaction is "substantially similar" to a listed tax shelter transaction. Accordingly, taxpayers should exercise extreme caution in evaluating any transaction that is even arguably similar to a listed transaction.

  • Repeal of the Projected Tax Effect Test for Listed Transactions. The existing regulations provided that no disclosure was required unless certain "projected tax effect" thresholds were exceeded. In the case of listed transactions, the existing regulations provided for a disclosure requirement only if a taxpayer reasonably believed that the transaction would reduce its federal income tax liability by more than $1 million in any one year or by more than $2 million in any combination of years; in the case of reportable transactions, the projected tax effect threshold required in excess of $5 million in tax savings in any one year and more than $10 million in tax savings in any combination of years. The Treasury concluded that this "projected tax effect" limitation was inappropriate in the case of listed transactions, and accordingly has amended the regulations to provide that all taxpayers must disclose participation in listed transactions without regard to actual tax savings. As a result of this change, all taxpayers are now required to disclose their participation in listed transactions regardless of the amount of tax savings.

In addition to these regulatory amendments, the Treasury's March 20 announcement signaled its intention to take a number of other administrative actions:

  • Centralize the receipt and review of tax shelter disclosures by partnerships, S corporations, trusts and high-income individuals in order to facilitate the process of identifying potentially abusive transactions by the IRS Office of Tax Shelter Analysis.

  • Further expand the definition of a "reportable transaction" and ensure that this expanded definition applies uniformly to the disclosure, registration and list maintenance rules.

  • Establish a new strict liability penalty for any taxpayer that is subject to an understatement penalty relating either to an undisclosed reportable transaction or an undisclosed position relating to the purported invalidity of a Treasury regulation.

  • Broaden the scope of persons required to register tax shelter transactions and maintain lists of investors so as to help the IRS more easily identify the taxpayers participating in abusive tax avoidance transactions.

  • Establish higher standards for legal opinions in order to curb the promotion of abusive tax avoidance transactions through the rendering of unsound legal advice.

  • Create a standard format for all required tax shelter disclosures.

  • Establish accelerated audit procedures for early examination of potential tax avoidance transactions.

  • Shift IRS resources to concentrate on identifying and shutting down tax shelter transactions.

New Legislation

A major portion of Treasury's March 20 announcement was devoted to outlining legislative proposals that, if enacted, would significantly increase the penalties on taxpayers, promoters and advisers who fail to comply with the registration, list maintenance and disclosure rules. Tax writers in both the Senate and House have responded to Treasury's call with proposed legislation.

    The Tax Shelter Transparency Act (S. 2498)

On May 9, 2002, Senate Finance Committee Chairman Max Baucus and Ranking Member Chuck Grassley introduced the Tax Shelter Transparency Act in the Senate. In their press release announcing the introduction of the legislation, Senators Baucus and Grassley said that the bill is aimed at combating "carefully engineered transactions...that have little or no economic substance, are designed to achieve unwarranted tax benefits rather than business profit, and place honest corporate competitors at a disadvantage." As outlined below, the proposed legislative changes are intended to discourage participation in abusive tax transactions by imposing tougher penalties on the promoters and participants.

  • Penalty for Failure to Disclose Reportable Transactions (Section 101 of the Bill). Under current law, while failure to disclose a listed or reportable transaction may jeopardize the taxpayer's ability to defend against the imposition of certain accuracy-related penalties, there is no separate penalty that is imposed for simply failing to disclose such transactions. In addition to whatever other penalties that may also apply, this bill would impose a separate non-waivable penalty of $200,000 for failure to disclose a listed transaction, and a penalty of $100,000 for failure to disclose a reportable transaction. [fn. 9] The bill would also require any publicly traded company that is penalized for failing to disclose a listed or reportable transaction to disclose the imposition of such penalty to the Securities and Exchange Commission. The imposition of these very substantial strict liability penalties could catch a taxpayer by surprise since they would be imposed without regard to whether the taxpayer actually claims any tax benefit attributable to the listed or reportable transaction.

  • Modification to the Accuracy-Related Penalties for Reportable Transactions (Section 102 of the Bill). The bill would significantly revise the application of the underpayment penalty regime as it relates to tax shelter transactions. In general, subject to a limited "reasonable cause and good faith" exception, a 20% penalty would be imposed on any understatement of tax attributable to either a listed transaction or to a reportable transaction having a significant tax avoidance purpose. If the transaction is not disclosed, however, that penalty would increase to 30% in the case of listed transactions and 25% in the case of reportable transactions having a significant tax avoidance purpose. Finally, these penalty rates would be applied with reference to the highest amount of tax that the taxpayer could theoretically have saved as a result of the tax shelter transaction, without regard to whether the actual tax savings would have been less due to the availability of other losses or credits on the taxpayer's return. The higher rates and the more stringent "reasonable cause and good faith exception" should subject a much larger number of tax shelter transactions to significant penalty exposure.

  • Modification to the Substantial Understatement Penalty (Section 103 of the Bill). The bill would also modify the rules relating to the calculation of a tax understatement by a corporate taxpayer. Current law provides for a 20% penalty on any "substantial understatement" of tax, which is defined as the amount by which the taxpayer's correct tax liability for a taxable year exceeds the greater of (i) 10% of the taxpayer's tax liability as reported, or (ii) $10,000. For purposes of applying this rule, the amount of any tax understatement is reduced to the extent that the understatement is attributable to a position for which there is "substantial authority," or if the facts relevant to the tax treatment of the position were adequately disclosed and there was a reasonable basis for the position. The bill would redefine a "substantial understatement" of tax liability for corporate taxpayers to mean the amount by which the taxpayer's correct tax liability exceeds the lesser of (i) 10% of the taxpayer's tax liability as reported (or, if greater, $10,000), or (ii) $10 million. In addition, in the case of an undisclosed position, the bill would permit the reduction of the understatement amount only if the taxpayer had a reasonable belief that the taxpayer's treatment of the position was "more likely than not" the correct treatment. If enacted, the substitution of a "more likely than not" standard for the "substantial authority" standard would result in a significant expansion of the potential scope of the substantial understatement penalty for all corporate taxpayers, even outside the context of tax shelter transactions.

  • Confidentiality Privileges Relating to Taxpayer Communications (Section 104 of the Bill). Under current law, communications between a (non-attorney) tax practitioner and a taxpayer are generally considered to be privileged unless, in the case of a corporate taxpayer only, the communication relates to a tax shelter. The bill would extend the tax shelter exception to the tax practitioner-client privilege to all taxpayers generally. This provision is consistent with the Treasury's policy objective of subjecting non-corporate taxpayers to the tax shelter rules generally. It would not, however, undermine the protection afforded by the traditional attorney-client privilege for either corporate or non-corporate taxpayers.

  • Disclosure of Reportable Transactions by Material Advisors (Sections 201 and 202 of the Bill). Under the current rules, a tax shelter promoter is required to register a tax shelter with the IRS no later than the day the shelter is first offered for sale. Promoters are subject to penalties of up to $10,000 for failing to timely register a tax shelter, and a $100 penalty for each failure to furnish an investor with the required tax shelter identification number. Moreover, current law provides that investors are subject to a $250 penalty for each failure to include a tax shelter identification number on their return. The bill would repeal the current rules and replace them with a regime under which each "material advisor" with respect to a listed or reportable transaction would be required to file an information return with the IRS identifying and describing the transaction. A "material advisor" would generally be defined as any person (i) who provides material aid, assistance or advice with respect to promoting, selling or carrying out a reportable transaction and (ii) who derives gross income in excess of $250,000 (or $50,000 in the case where natural persons receive substantially all of the tax benefits) for such advice or assistance. The bill further provides that material advisors who fail to file a required information return would be subject to substantial penalties: $200,000 (or, if greater, 50% of the gross income derived from the transaction) in the case of a listed transaction, and $50,000 in the case of a reportable transaction. If enacted, accountants, consultants and other professionals involved in tax shelter transactions could become subject to potentially burdensome reporting requirements. Due to the substantial penalties for failure to comply, this may prove troublesome for all parties involved given both the uncertain scope of the transaction information required to be provided as well as the very sweeping definition of "material advisor."

  • Retention and Disclosure of Investor Lists (Sections 201 And 203 of the Bill). Under current law, promoters must generally maintain a list that identifies each person that was sold an interest in any reportable tax shelter transaction, and contains detailed information about the tax shelter (including details of the expected tax benefits). Promoters that fail to maintain the required list are subject to annual penalties in an amount equal to $50 for each name omitted from the list (with a maximum penalty of $100,000 per year). Under the bill, each "material advisor" would be required to maintain a list which identifies each person that the advisor aided with respect to a reportable transaction, and would be required to provide the list to the IRS within 20 days of request. Material advisors who fail to make such list available to the IRS would be subject to a $10,000 per day penalty. Combined with the further narrowing of the tax practitioner-client privilege, the imposition of such draconian penalties on the failure to provide tax shelter investor lists should enable the IRS to quickly force promoters and other material advisors to disclose client lists.

The Senate bill would also make a number of other changes relating to tax shelter enforcement, including (i) giving the IRS the power to seek injunctions with respect to tax shelter disclosure and investor list requirements, (ii) the imposition of penalties on tax return preparers, (iii) penalties for failure to report interests in foreign financial accounts, and (iv) increased penalties for filing frivolous tax returns.

    The American Competitiveness and Corporate Accountability Act of 2002 (H.R. 5095)

On July 11, 2002, House Ways and Means Committee Chairman Bill Thomas introduced the American Competitiveness and Corporate Accountability Act of 2002. In addition to addressing tax avoidance transactions, the proposed legislation aims to simplify certain tax rules relating to international business operations. Although many of the tax shelter provisions in this bill are similar to provisions contained in the Tax Shelter Transparency Act, there are several noteworthy differences.

  • Codification of the Economic Substance Doctrine (Section 101 of the Bill). One method by which the courts have traditionally responded to certain tax avoidance transactions has been to apply an "economic substance" doctrine, denying tax benefits to taxpayers who have entered into one or more transactions that have not meaningfully altered their overall economic position, even if such tax benefits are technically available under a literal reading of the Internal Revenue Code and applicable regulations. Given that the economic substance doctrine is a creature of common law that has been developed over many decades, there is an understandable lack of uniformity among the courts as to how and under what circumstances the doctrine should be applied. The bill seeks to eliminate the courts' inconsistent application of the doctrine by providing that a transaction would be considered to have economic substance only if (i) the transaction changes the taxpayer's economic position in a meaningful way (apart from federal income tax effects), and (ii) the taxpayer has a substantial non-tax purpose for entering into the transaction and the transaction is a meaningful means of accomplishing such purpose. Understatements of tax attributable to transactions which fail the economic substance test would generally be subject to a 20% penalty if disclosed, and a 40% penalty if undisclosed, without provision for a reasonable cause exception. If enacted, this provision would apply not only to tax shelter transactions, but for purposes of the tax law generally. Given the bill's failure to define such key concepts as "changing the taxpayer's economic position in a meaningful way" and "a substantial non-tax purpose," it seems likely that the Treasury and IRS would end up having to exercise broad administrative discretion in interpreting these terms.

  • Penalty for Failure to Disclose Reportable Transactions (Section 102 of the Bill). The bill would impose penalties for the failure to disclose listed and reportable transactions similar to the provisions in the Senate bill. the Senate bill, the House bill does not provide for mandatory disclosure to be given to the SEC in the event that these penalties are imposed.

  • Tax Treatment of Expatriated Entities (Section 202 of the Bill). In general, the United States employs a "worldwide" tax system, under which domestic corporations are taxed on all income earned, regardless of source. In contrast, foreign corporations are generally subject to U.S. tax on (i) certain U.S. source income, and (ii) income that is "effectively connected" with the conduct by the foreign corporation of a trade or business in the U.S. To take advantage of the more limited scope of income that is subject to U.S. tax that is afforded to foreign corporations, a number of U.S. corporations have reincorporated in low-tax jurisdictions (so-called "corporate inversion transactions"), while a number of other corporations are reported to be considering such a move. While current law would generally result in a shareholder-level tax on gain realized in a corporate inversion on the exchange of their shares in the U.S. company for shares in the new foreign parent, current stock market conditions have tended to diminish the impact of that tax liability. To curb the flight of U.S. corporations to low-tax jurisdictions, the bill would provide that, in certain situations, where a former U.S. corporation inverts (or otherwise transfers substantially all of its properties to a foreign-incorporated entity) the surviving foreign entity would continue to be taxed as a domestic U.S. corporation. Other favorable tax attributes, such as net operating losses or foreign tax credits, would also be lost by an inverting U.S. corporation. Finally, insiders, top executives and directors of inverting U.S. corporations would be subject to a 20% excise tax on the value of all stock options and other stock-based compensation received during the period beginning six months before and ending six months after the date of the inversion. If enacted, this provision would apply to all corporate inversions completed after March 20, 2002 and before March 21, 2005. It appears to be designed to put a halt to all inversion activity for a three-year period to allow Congress to consider appropriate permanent legislation.

In addition to the foregoing, the House bill contains a number of other miscellaneous "loophole closers" designed to shut down specific tax-motivated strategies.

Material Available On-Line

Listed below are the administrative and legislative materials discussed in this bulletin as well as some related items. You'll need the Acrobat Reader, or its equivalent to review these files.

Administrative Material

Legislative Material

    S. 2498 [279K], the Tax Shelter Transparency Act, as reported from the Senate Finance Committee

    Senate Report 107-189 [125K], Senate Finance Committee Report on S. 2498

    JCX-19-02 [170K], Joint Committee on Taxation, "Background and Present Law Relating to Tax Shelters," prepared for March 21, 2002 Senate Finance Committee hearing

    H.R. 5095 [330K], the American Competiveness and Corporate Accountability Act of 2002, as introduced in the House


  1. See U.S. Department of the Treasury, "The Problem of Corporate Tax Shelters: Discussion, Analysis and Legislative Proposals," July 1999 ("Treasury White Paper"). This Treasury White Paper provides a comprehensive overview of tax shelter and tax avoidance issues, as well as the statutory, regulatory and judicial responses to these issues. [return to text]

  2. P.L. 105-34, 111 Stat. 926 (codified as Internal Revenue Code ("IRC") § 6111(d)). [return to text]

  3. See IRC §§ 6111, 6112; Temp.Income Tax Regs. §§ 301.6111-2T, 301.6011-4T. [return to text]

  4. See IRC §§ 6707, 6708, 6662. [return to text]

  5. While IRC § 7525 generally provides that common law protections of confidentially extend to communications between a tax practitioner and his client, it further provides that such confidentiality shall not extend to any written communication between a tax practitioner and a corporation in connection with the promotion of a tax shelter. [return to text]

  6. In general, if specified projected tax effect thresholds are satisfied, the tax shelter disclosure rules apply to two broad classes of tax shelters: (i) specific transactions that have been previously designated by the IRS as having the potential for significant tax avoidance ("listed transactions"), and (ii) other transactions that have characteristics (i.e., transactions that are marketed under conditions of confidentiality, transactions that are intended to produce significant book/tax disparities, etc.) that suggest the potential for inappropriate tax avoidance ("reportable transactions"). [return to text]

  7. Although it has not done so yet, the Treasury has announced plans to further modify the regulations by extending the disclosure requirement for individuals, partnerships, S corporations and trusts to also apply to reportable transactions. [return to text]

  8. Such a situation would typically arise in the case of a substituted-basis transaction in which the taxpayer receives high-basis but low-value property from a related person. [return to text]

  9. Entities with annual gross receipts of $10 million or less and individuals having a net worth of $2 million or less would be subject to penalty at half of this rate (i.e., $100,000 for failure to report listed transactions and $50,000 for failure to disclose reportable transactions). [return to text]

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