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Tax Shelter Final Regs. Treasury and the IRS issued tax shelter final regulations on taxpayer disclosure and material advisor list maintenance for reportable transactions.
This article focuses on certain differences between the final and temporary regulations and significant issues the former present. Dan L. Mendelson
Editors note: Mr. Mendelson chairs the AICPA Tax Divisions Tax Practice Responsibilities Committee.
Executive Summary
On Feb. 28, 2003, Treasury and the IRS issued tax shelter final regulations1 on the disclosure and list maintenance of reportable transactions. Although the final regulations addressed many of the shortcomings of the October 2002 temporary regulations2 and received generally positive reviews, difficult interpretive and administrative issues remain for taxpayers and their advisors. A two-part article in the February and March 2003 issues3 summarized the history of Treasurys efforts to curb the proliferation of corporate tax shelters and analyzed the regime established by the temporary regulations. This follow-up article focuses on certain remaining issues taxpayers and their advisors may face when attempting to comply with the final regulations.
Revised Effective Date The temporary regulations are effective for transactions entered into after 2002 and before Feb. 28, 2003; the final regulations are generally effective for transactions entered into after Feb. 27, 2003. However, under Regs. Sec. 1.6011-4(h), taxpayers may elect to apply the final regulations to all transactions entered into after 2002. Because the final regulations are generally narrower in scope of reporting than the temporary regulations, there is no benefit in applying the temporary regulations (rather than the final regulations) for transactions entered into after 2002 and before Feb. 28, 2003. How does a taxpayer determine when a transaction is entered into for purposes of applying the correct set of regulations? Many situations could arise in which the initial steps of a transaction commence before 2003, but the final steps occur after 2002. Which regulations should the taxpayer apply in such situations? The answer is significant, because many transactions would not be reportable under the prior rules, but would be under the final regulations. To rely solely on the step-transaction doctrine to determine which set of regulations to apply would be risky. Rather, taxpayers should evaluate the timing and significance of each transactional step and then ascertain the transactions reportability under the regulations in effect when the first substantive steps occur. In any event, both the prior and final regulations trigger disclosure in the first affected tax year.
Participation The final regulations are helpful, because they provide that a taxpayer must disclose a transaction when the taxpayer has participated in a reportable transaction. Regs. Sec. 1.6011-4(c)(3) further establishes when a taxpayer has participated in each of the six categories of reportable transactions.4 Like earlier regulations, there must be Federal tax benefits from the transaction.5 Thus, if the initial steps do not affect the taxpayers Federal tax liability, it is likely that the initial tax year is not the year of disclosure. The practical effect of this uncertainty, however, may be that conservative taxpayers will evaluate a transaction under the old regime when the first substantive steps occur prior to 2003 (and disclose if warranted), then evaluate the same transaction again under the new regime when substantive steps occur after 2002 (and possibly disclose a second time), to avoid the harsh proposed penalty regime. Exhibit 1 presents a quick reference guide highlighting the similarities and differences between the disclosure, list maintenance and registration requirements under the current regulations. Exhibit 2 is a decision tree for determining whether a transaction should be disclosed.
Penalties For tax returns filed after July 1, 2002, failure to disclose a listed transaction will now lead to the Service requesting tax-accrual workpapers.6 Failure to disclose a reportable transaction or to provide requested workpapers may bar a taxpayer from participating in a limited-scope IRS audit program.7 The CARE Act of 20038 (passed by the Senate):
In light of the recent Enron Report9 and the general legislative atmosphere surrounding perceived abuses as to corporate tax shelters, certain of the legislative proposals will likely be enacted by Congress this session. Proposed effective dates apply to returns due after the enactment date, so that transactions entered into before that date could be subject to penalty.
What Is a Transaction? Temp. Regs. Sec. 1.6011-4T(b)(1) defined a transaction as all of the factual elements relevant to the expected tax treatment of any investment, entity, plan, or arrangement, and includes any series of steps carried out as part of a plan and any series of substantially similar transactions entered into in the same taxable year. Regs. Sec. 1.6011-4(b)(1) changes this definition to limit the concept of substantially similar to listed transactions, so there is no aggregation when quantifying other reportable transactions for applicable thresholds. For example, under the temporary regulations, losses may be aggregated to meet the Sec. 165 loss threshold, whereas the final regulations quantify each individual transaction. However, the ability to aggregate similar transactions occurring in a single tax year on one Form 8886, Reportable Transaction Disclosure Statement, is retained for convenience.
Confidential Transactions The reportable transaction category of confidential transactions seems to raise the most questions among advisors. The final regulations addressing confidential transactions further complicate the matter by adding an exception for certain transactions and modifying an existing provision. Many comments submitted on the temporary regulations asserted that this category would unduly mandate disclosure of many nonabusive transactions involving mergers and acquisitions (M&A), as the parties involved often impose confidentiality for nontax reasons. Responding to these concerns, Regs. Sec. 1.6011-4(b)(3)(ii)(B) provides an exception for certain acquisitions of the historic assets of more than 50% of the stock of a corporation that constitutes an active trade or business the acquirer intends to continue, if there is no limit on the disclosure of the transactions tax treatment and structure beyond the date (1) of public announcement of discussions, (2) of public announcement of the transaction or (3) the parties execute an agreement (with or without conditions) to enter into the transaction. This exception is not available, however, if the taxpayers ability to consult any tax adviser as to the transactions tax treatment or structure is limited in any way. Although this exception is certainly welcome, substantive questions remain, including (1) what constitutes an active trade or business, (2) what are the procedures, if any, for amending agreements signed before the issuance of the final regulations to invoke the exception and (3) does the exception apply to the acquisition of entities other than corporations. Presumption of nonconfidentiality: The temporary regulations provided a presumption of nonconfidentiality only if written authorization for the taxpayer to disclose was effective without limit from the commencement of discussions; as a result, many commentators wondered about the practical implications of communicating the presumption. Regs. Sec. 1.6011-4(b)(3)(iii) seeks to provide clarification by expressly restricting the presumption to transactions with written authorizations provided no later than 30 days from the first statement made to the taxpayer as to the transactions tax consequences. Because of this so-called 30-day rule, advisors should consider establishing a firm policy not to enter into conditions of confidentiality and to communicate the policy to all recurring clients at the earliest opportunity, using language provided in the final regulations. Advisors relying on their engagement letters to satisfy the presumption may find that these are often not issued within 30 days after discussions begin. Other possible solutions include advisors distributing the authorization at the first meeting with potential new clients or including such language in all presentations. Hopefully, Treasury and the IRS will recognize the difficulty of satisfying the presumption and provide more help. So far, Treasury representatives have expressed surprise about the amount of interest in the written authorization to establish the presumption. They say that the fact remains that there must be no conditions of confidentiality; the presumption only serves as evidence of a lack of such conditions. The substance of the provision is whether the transaction is considered offered to the taxpayer under conditions of confidentiality, not whether the presumption is satisfied. Thus, Regs. Sec. 1.6011-4(b)(3)(iii) adds a provision that transactions held out as exclusive or proprietary will not be deemed confidential if the presumption requirements are satisfied and the transaction is not otherwise confidential. As was the case under the August 2000 modifications to the temporary rules, advisors can enter into exclusivity agreements10 as long as the presumption is in place and the transaction is not otherwise confidential. In the absence of a need for confidentiality (such as under the securities laws), some taxpayers have insisted on obtaining written confirmations at the beginning of discussions from all of their advisors that they do not contemplate conditions of confidentiality.
Transactions with Contractual Protection Although Regs. Sec. 1.6011-4(b)(4)(i) narrows the scope of this category to focus on transactions in which fees are refundable or contingent on the intended tax consequences being sustained, this category must be considered in light of the July 26, 200211 Circular 23012 restrictions on contingent and value-added fees. Circular 230 Section 10.27(b) permits Federally authorized tax practitioners to charge contingent fees only in connection with amended returns or refund claims that receive IRS substantive review. Regs. Sec. 1.6011-4(b)(4)(iii)(B) excepts transactions when an advisor makes or provides a statement as to the potential tax consequences only after the taxpayer has entered into, and reported, the transaction on a filed return, and the advisor has not previously received fees from the taxpayer. Consequently, there is only a limited possibility for this category to apply, because contingent fees may only be charged for controversy services involving a refund claim, not an original return.13
Loss Transactions Regs. Sec. 1.6011-4(b)(5)(ii) clarifies what constitutes participation in a loss transaction over a combination of tax years. While the temporary disclosure regulations provided thresholds for any combination of taxable years, the final regulations provide that in determining whether a threshold is met, only losses claimed in the tax year that the transaction is entered into, and the five succeeding tax years, are considered. However, under Regs. Sec. 301.6112-1(b)(2)(i)(B), advisors must still use the reasonably expected standard when determining whether a list-maintenance obligation exists, likely creating situations in which he or she is required to add a taxpayer to a list even though the taxpayer does not disclose the transaction. The temporary regulations limited exceptions have been significantly expanded and moved into Rev. Proc. 2003-24,14 providing the IRS with the flexibility to update them without having to go through the regulation process. Sections 4.01, 4.02(3) and 4.03 provide a general exception for losses from the sale or exchange of an asset with a qualifying basis (including those financed with certain debt instruments), as well as specific exceptions for an expanded list of other losses. However, taxpayers and their tax advisers may find it difficult to interpret the qualifying basis and debt instrument provisions, as they are quite complex. Nevertheless, in addition to the exception provided for assets with a qualifying basis, the list of other exceptions has been expanded from the two provided in the temporary regulations to the eight specified in the procedure.
Transactions with a Significant Book-Tax Difference Regs. Sec. 1.6011-4(b)(6)(i) was modified in response to many comments on the temporary regulations. It provides that taxpayers who keep their books on a basis other than U.S. generally accepted accounting principles (GAAP) for financial reporting purposes, and do not maintain GAAP books for any purpose, will not be required to convert book values to GAAP in determining the amount of an item for book purposes, provided the books are kept on the same basis from year to year. In addition, Regs. Sec. 1.6011-4(b)(6)(ii)(A)(2) increases the applicability threshold for companies other than SEC registrants from $100 million to $250 million of gross assets, as measured at the end of any financial accounting period that ends with, or within, the entitys tax year in which the transaction occurs. As with loss transactions, the list of excepted transactions was expanded and captured in Rev. Proc. 2003-25.15 Instead of the 13 exceptions included in the temporary regulations, the procedure expands the list to 30 transactions. Of particular interest is the addition of transactions generating significant book- tax differences resulting from the application of Sec. 354, 355, 361, 367, 368 or 1031. While they seem to provide cover for many types of reorganizations, significant book-tax differences resulting from the application of Sec. 351 are not included in the exception, thereby providing no relief for many popular planning techniques. This exception is available only if the taxpayer fully complies with the filing and reporting requirements for the affected sections, including any requirements contained in the corresponding regulations or forms.
Document Retention Under Regs. Sec. 1.6011-4(g), a taxpayer is not required to retain earlier drafts of documents if the taxpayer retains the final document and it contains information included in the prior draft material to an understanding of the transactions tax treatment or structure. However, taxpayers may still be burdened with excessive document-retention requirements, because a transaction may subsequently be designated as a listed transaction by the IRS. As a result, when evaluating whether a transaction must be disclosed, astute taxpayers will retain material documentation regardless of the current disclosure decision. Material advisors received a two-pronged document retention requirement that is both awkward and confusing. Regs. Sec. 301.6112-1(f) requires that they maintain the listfor seven years following the earlier of the date on which the material advisor last made a tax statement relating to the transaction, or the date the transaction was entered into, if known. This provision is unadministerable in firms with several tax advisers, because keeping track of statements made by all the practitioners is not feasible. Perhaps Treasury and the IRS will reconsider and substitute a six-year retention period from the date a transaction is entered into. As to newly designated listed transactions, it is clear under Regs. Sec. 301.6112-1(e)(2)(i) that practitioners need look back no further than six years to list such transactions. Although not expressed in Regs. Sec. 1.6011-4(g), it appears that taxpayers need not worry about newly designated listed transactions entered into more than six years before, due to document-retention requirements tied to an SOL.
Minimum Fee The final regulations provide some clarification as to the types of fees taken into account when determining whether the minimum-fee threshold is satisfied. Fees for services to analyze, implement and document a transaction are included under Regs. Sec. 301.6112-1(c)(3)(iii), as are fees for return preparation services (to the extent such fees are attributable to the transaction or reflect a misallocation). However, the final regulations remain unclear as to whether accounting advice and tax provision services are included.
Registration It appears from Section 707 of the proposed CARE Act that registration of confidential corporate tax shelters and certain Sec. 6111(c) transactions with tax-benefit ratios in excess of two-to-one would be repealed. A material advisor disclosure requirement would replace it, so that advisors would be subject to both list maintenance and disclosure under the same definitions as those applicable to taxpayer disclosure. The Congressional Tax Writing Committees would leave the time for filing of such advisor disclosures to Treasury and the Service. Hopefully, such disclosures would not be due until transactions are entered into, rather than the day a transaction is first offered to a potential participant, as provided under the registration statute.
Lack of Economic Substance Tax Writing Committees are apparently weighing the addition of a seventh category of reportable transaction (with its own penalties) for transactions lacking economic substance. However, Treasury continues to oppose the need to codify the judicial doctrine of economic substance.
Conclusion The final regulations relieve some of the unwarranted complexity and excessive disclosure contained in the temporary regulations. With the use of the two revenue procedures containing exceptions for book-tax differences and loss transactions, Treasury and the IRS should be able to more timely maintain lists of exceptions. No doubt the Service will tire from seeing disclosures of many types of nonconsequential transactions and will add them to the procedures. Many practitioners, however, continue to have difficulty with the practical implications of certain provisions, such as the communication and timing of the confidentiality presumption and the tension created by certain transactional documents that taxpayers would like to keep private for competitive reasons. Document retention by taxpayers and their advisors as an evidentiary matter is the overriding consideration and obligation under these regulations. Congress will surely enact strict penalties to dramatically shift the balance from nondisclosure to disclosure. Taxpayers and their advisors must have processes in place to be able to identify transactions that are potentially reportable, and all client-facing tax professionals must consider a thorough understanding of the final reportable transaction regulations to be a core competency, to avoid pending taxpayer and advisor penalties. The regulations may be final, but more changes are just around the corner to deal with the imminent repeal of the registration rules and the imposition of material advisor disclosures, as well as other changes and refinements based on the Enron Report. |
