| Home Online Publications Online Issues TTA Home Table of Contents Tax Shelter Temp. Regs.(Part I) | |
Tax Shelter Temp. Regs. In October 2002, Treasury modified the temporary regulations on tax return disclosure statements and investor lists for potentially abusive tax shelters. Part I of this two-part article examines the reportable transactions subject to both the disclosure and investor-list rules.
Dan L. Mendelson
Editors note: Mr. Mendelson chairs the AICPA Tax Divisions Tax Practice Responsibilities Committee.
Executive Summary
On Oct. 22, 2002, Treasury released temporary regulations1 on tax return disclosure statements and maintenance of investor lists for reportable transactions and potentially abusive tax shelters. The temporary regulations are the fourth modification to the temporary tax shelter reporting regulations promulgated in February 2000.2 The February 2000 temporary regulations established three sets of rules, including (1) disclosure of tax avoidance transactions by corporate taxpayers,3 (2) list maintenance of investors in potentially abusive tax shelters by promoters (organizers and sellers)4 and (3) registration of confidential corporate tax shelters by promoters.5 However, the asymmetrical nature of the rules caused confusion, because promoters of potentially abusive tax shelters might be required to maintain a list of participants in a transaction, even though return disclosure was not required of the corporate taxpayer.6 The IRS previously modified the temporary regulations on Aug. 16, 2000,7 Aug. 2, 20018 and June 14, 2002.9 The June 2002 temporary regulations extended the Sec. 6011 disclosure requirements to individuals, partnerships, trusts and S corporations that participate, directly or indirectly, in listed transactions and repealed for all taxpayers the projected-tax-effect test for listed transactions. In addition, the definition of indirect participants was extended to those who know or have reason to know that the tax benefits claimed from the taxpayers transaction are derived from a reportable transaction. Most importantly, the June 2002 temporary regulations broadened the definition of substantially similar transactions to include transactions expected to obtain the same, or similar, types of tax benefits and are either factually similar or based on the same, or a similar, tax strategy. Finally, the time frame for providing return disclosure was clarified. Based on the meager number of return disclosures, Treasury conceded that the existing regulatory scheme was not working as intended and proposed a major overhaul. A Sept. 16, 2002 IRS news release10 indicated that 1,664 disclosure statements had been filed under an amnesty program offered to taxpayers for the voluntary disclosure of any tax shelter if filed by April 23, 2002.
New Regime The new temporary regulations substantially replace the prior return disclosure and advisor list-maintenance rules for transactions entered into after 2002. They contain two key changes from the prior regime. First, the new temporary regulations trigger both tax return disclosure and list maintenance from the same event (i.e., engaging in a reportable transaction). Also, Temp. Regs. Sec. 301.6112-1T(c)(2) places the obligation to maintain lists of reportable transactions on so-called material advisors. The desired result of these changes is to promote a high degree of consistency between transactions disclosed in tax returns and those required to be maintained on potentially abusive tax shelter lists. Material advisors are obligated to maintain names of taxpayers entering into transactions. However, at times, the advisor will not be required to maintain a taxpayers name on a list even though the taxpayer has disclosed the transaction due to the minimum-fee rules. Proposed legislation would require material advisors to register reportable transactions (not just confidential corporate tax shelters) with the IRS; Treasury indicated that it will amend the temporary registration regulations when such legislation is enacted.11 In the interim, there is no consistency between registerable tax shelter transactions and reportable transactions for return disclosure and list-maintenance purposes. See Exhibit 1 for a quick reference guide identifying the similarities and differences among the registration, list-maintenance and disclosure regulations. The disclosure and list-maintenance columns are based on the October 2002 modifications; the registration column is based on the June 2002 modifications.
Reportable Transactions Prior to the October 2002 temporary regulations, different definitions, but similar exceptions, applied to the three reporting requirements for taxpayers and promoters, resulting in significant uncertainty and complexity.12 Temp. Regs. Sec. 1.6011-4T(b) now defines a transaction that must be disclosed and listed to include the following six categories of reportable transactions:
While three of the six categories described above contain dollar thresholds, there is no longer an across-the-board minimum tax benefit threshold that must be met before disclosure is required. In addition, the six categories are more objective than the prior regime, but broader in scope. The October 2002 temporary regulations treat all taxpayers (including individuals and S corporations) equally; the prior regime focused primarily on corporations, as to disclosure. Other important distinctions from the prior rules include disclosure of listed transactions affecting estate, gift, employment, pension and exempt organization excise taxes, as well as Federal income tax.13 In addition, certain U.S. shareholders of foreign corporations subject to certain income inclusion rules (e.g., subpart F) are required to disclose reportable transactions of such corporations.14
Listed Transactions The IRS and Treasury were concerned that some taxpayers and their advisors have applied the substantially similar standard in a narrow manner to avoid disclosure.15 Consistent with earlier modifications to the tax shelter regulations, Temp. Regs. Sec. 1.6011-4T(c)(4) defines substantially similar (to a listed transaction) to include any transaction (1) expected to obtain the same or similar types of tax consequences and (2) either factually similar or based on the same or a similar tax strategy. Treasury suggests that the term should be broadly construed in favor of disclosure. AICPA comments on the June 14, 2002 tax shelter regulations recommended that the listed transactions be subject to a formal review process.16 The temporary regulations, however, do not incorporate such a process. In view of the absence of criteria and standards for determining whether a transaction should be listed, a formal advance notice procedure that enables taxpayers and their advisors to submit comments on the fact pattern and tax benefits analyses should be pursued. The IRS should identify which facts are salient in determining whether a transaction is substantially similar to the transaction described in the notice. Public comments on the characterization of a transaction as a listed transaction should significantly reduce uncertainties as to the intended scope.
Confidential Transactions Confidential transactions were carried over from prior rules because both the Tax Writing Committees and Treasury concluded that a lack of transparency contributed to abusive transactions. However, it is more likely that promoters were offering transactions under conditions of confidentiality to protect their proprietary interests in their transactions, rather than hiding the transaction from the IRS. After all, the transactions had to be reflected in filed returns. Nevertheless, advisors need to exercise caution from the outset when discussing with clients potentially reportable transactions, to avoid an inadvertent condition of confidentiality. Prior to the October 2002 temporary regulations, a transaction was presumed not to be offered under conditions of confidentiality if the promoter authorized the taxpayer in writing to disclose every aspect of the transaction to any and all persons, without limit. Under Temp. Regs. Sec. 1.6011-4T(b)(3)(i), the presumption applies to transactions (1) when written authorization is made by every person who discusses the potential tax consequences of the transaction and (2) such authorizations are effective without limit from the commencement of discussions. It is unclear why Treasury felt the need to once again clarify conditions of confidentiality. If a transaction is inadvertently offered under conditions of confidentiality at the time of commencement of the discussions, Temp. Regs. Sec. 1.6011-4T(b)(3)(iv) suggests that any subsequent written authorization to disclose the structure and tax aspects of the transaction may not be effective for exclusion purposes. To the extent any materials are provided to a client, or presentations made, they should be carefully reviewed to ensure that there are no limits of any kind related to disclosure or use of the tax structure or tax aspects of the proposed transaction. Treasury should reconsider its position and permit advisors to withdraw inadvertent or unintended conditions of confidentiality as long as the defect is cured in a reasonable amount of time.
Transactions with Contractual Protection This category of transaction remains substantially the same as in the prior regulations. Temp. Regs. Sec. 1.6011-4T(b)(4) is intended to reach transactions in which the tax benefits are guaranteed, the loss of the potential tax benefits is mitigated or professional fees are contingent on achieving tax benefits. The existence of an indemnity or fee characteristic is deemed to be indicative of a tax shelter without regard to the nature of the transaction, and may adversely affect certain industries.17 This is more suggestive of a public policy consideration rather than a meaningful attribute of an abusive transaction.
Loss Transactions This category affects a transaction resulting in, or that is reasonably expected to result in, a taxpayer claiming a loss under Sec. 165 in excess of thresholds specified in the new rules. Evaluation of transactions subject to this category may be difficult, as the scope of the reasonably expected loss rule is ambiguous. Presumably, this caveat is designed to require disclosure of transactions likely to result in a qualifying loss prior to execution, while exempting transactions that may or may not result in a qualifying loss due to unpredictable market conditions (e.g., short-term hedges on the value of stock).18 There is potential for this category of transactions to result in many taxpayer disclosures. Unfortunately, some taxpayers often enter into high-value transactions that result in unintended losses (e.g., securities traders and dealers). A taxpayers obligation to file an aggregated disclosure statement for all transactions exceeding the applicable dollar threshold of loss could be unduly burdensome.19 Likewise, a single disposal of a security at a loss exceeding the threshold will require disclosure, even if the disposition was not remotely tax motivated. Another example would be hedged positions to reduce exposures to changes in market values. Some taxpayers enter into hundreds of hedges and subsequently modify them. To deal with this undue reporting burden, Treasury should consider providing an exclusion for common securities transactions or permitting the aggregation of gains and losses on similar transactions entered into on a regular basis. Under Temp. Regs. Secs. 1.6011-4T(f) and 301.6112-1T(i), taxpayers may consider obtaining an IRS ruling as to whether a transaction or group of transactions are reportable. Taxpayers should not confuse losses attributable to ordinary and necessary business expenses (deductible under Sec. 162) with Sec. 165 losses.20
Transactions with a Significant Book-Tax Difference This category applies to SEC registrants, their affiliates and other businesses having assets in excess of $100 million. Under Temp. Regs. Sec. 1.6011-4T(b)(6), a transaction with a significant book-tax difference is one in which the Federal income tax treatment of any item or items differs (or is reasonably expected to differ) from the book treatment by more than $10 million on a gross basis, in any tax year. When making this determination, offsetting items are not netted for either tax or book purposes. Book income is determined by applying U.S. generally accepted accounting principles (GAAP) to worldwide in-come. By requiring taxpayers that use a basis other than GAAP for book purposes (e.g., tax basis, statutory accounting or International Accounting Standards) to convert to GAAP, an unnecessary burden is placed on taxpayers. An easier measurement rule would permit taxpayers to use the basis on which they regularly keep their books when evaluating book-tax differences. Stated another way, if a transaction does not have a financial statement impact before converting to GAAP, the taxpayer is not booking an economic benefit that is being avoided or deferred for tax purposes.21
It is questionable whether this category
will provide enough useful information to justify the deluge of
disclosures by large corporations of book-tax differences. Last June,
the American Bar Association (ABA) Tax Section commented on the
significant number of potentially affected transactions on the returns
of large corporations and the current availability of such information
to revenue agents through Schedule The AICPA comments advanced similar concerns as to the $10 million threshold, stating that the proposed category subjects clearly routine business transactions to disclosure. In addition, large corporations have many book-tax differences exceeding $10 million that are already properly disclosed on their returns; for many such corporations, almost every transaction disclosed on Schedule M-1 exceeds $10 million. As a result, the AICPA believes that to avert an onerous reporting obligation for such businesses, Treasury will need to provide an expansive list of specific exemptions.24 An alternative view expressed by the New York State Bar Association Tax Section advocates a lower dollar threshold in order to identify transactions by high-net worth individuals and small businesses that may not rise to the $10 million level.25 However, because it is reasonable to expect that many taxpayers will err on the side of disclosure due to the draconian penalties for non-compliance anticipated from future legislation, lowering the dollar threshold would likely increase disclosures to an unmanageable level. This category will likely catch many nonabusive tax-free corporate reorganizations, as the traditional theory of the reorganization provisions is that gain or loss should not be recognized when a shareholders investment remains in the reorganized corporate entity or when the reorganization does not change the substance of the shareholders rights to the corporate assets.
Temp. Regs. Sec. 1.6011-4T(b)(6)(ii) also provides specific rules on the book-tax category for taxpayers filing consolidated returns, foreign persons, disregarded entities, partnerships and shareholders of certain foreign corporations. In addition, Temp. Regs. Sec. 1.6011-4T(b)(6)(iii) provides various exceptions from disclosure under this category, including certain transactions with respect to depreciation (as to method and lives, not basis), depletion and amortization; bad debts; Federal, state, local and foreign taxes; and employee compensation, among others. Several commentators have suggested other types of transactions that should be granted exceptions. For example, the ABA Tax Section recommends an exception for Sec. 1031 transactions (like-kind exchanges).26 PricewaterhouseCoopers comments include a host of potential exception items, such as: certain transactions that generate a book-tax difference because of a specific gross income exclusion provided by Congress; the recurring application of methods of accounting; transactions generating a book-tax basis difference; state and local property taxes; mark-to-market adjustments; dividends-paid and dividends-received deductions and environmental cleanup costs.27 IRS and Treasury are evaluating these and other comments to determine whether additional exceptions should be added to the temporary regulations (the Angels List).28 The authors believe many disclosures could be eliminated by refining the definition of transaction to exclude accounting method and period changes and transactions already requiring disclosure on the return, such as statutory reorganizations, Sec. 338 transactions, like-kind exchanges and many others.
Transactions Involving a Brief Asset-Holding Period This category was surely triggered by cases involving very short transitory holding periods of certain assets yielding tax credits. Nevertheless, there is concern that this category may also include transactions with economic substance and entered into in the normal course of business. The AICPA comments illustrate the unintended results of this category: For example, a corporations normal royalty and interest streams might generate a reportable transaction under this category. It is not uncommon that a related offshore party requires short-term financing. Code 7872 and the transfer pricing rules require a U.S. creditor to recognize interest income on such a transaction. Most countries have withholding tax requirements on interest paid to foreign persons, thus giving rise to a foreign tax credit in the recipients home country. Therefore, it is quite possible that such a transaction will be reportable, even though there is no tax-avoidance motive on the lenders part.29 Specifically, this category applies to Compaq-type transactions (i.e., certain foreign tax credit (FTC) trades),30 as well as other transactions involving FTCs for foreign withholding taxes imposed on dividends under Sec. 901(k).31 Because this category is far narrower than the others, perhaps it should be covered in a listed transaction that more clearly identifies the abusive situations.
Conclusion The same reportable transactions trigger both the return disclosure statements and the investor-list maintenance requirements. The introduction of more objective standards by the October 2002 temporary regulations is a significant improvement over the prior regulations. There is, however, a risk that the more objective standards will lead to over-inclusiveness, requiring disclosure and list maintenance of transactions entered into in the ordinary course of business that are not potentially abusive tax shelters. To strike a balance between such over-inclusiveness and implementing a reporting regime that will assist Treasury and the IRS in identifying abusive tax shelters, it is important that refinements be made to the proposed regulations to avoid the uncertainties and controversies as to which transactions are reportable transactions. Part II, in the next issue, will examine the material advisor concept, minimum-fee thresholds, expected changes to the registration rules and Circular 230 tax shelter opinions. |
