Administration Proposals: Tax Avoidance and Corporate Tax Shelters

by Elliot Pisem
Published: February 28, 1999
Source: R & H Newsletter -- Tax Insights

The Clinton Administration's recently released budget for the coming year contains proposals dealing with an overwhelmingly broad range of tax issues, including, just to name a few examples, retirement savings, financial products, international taxation, and the ubiquitous "simplification."

Although it is far too early in the highly political budget process to make any predictions about which of the 135 proposals made by the Administration will survive in some form, it is not too early to start focusing on one particular set of proposals. They deal with "tax avoidance transactions" and "corporate tax shelters" and seem designed to target the types of tax shelters discussed in the December 14, 1998 issue of Forbes.

The Administration would expand the armamentarium of blunderbuss weapons available to the Internal Revenue Service to attack both existing transactions and transactions which may be developed in the future. As is the nature of such weapons, however, the new provisions raise the risk of serious wounds being inflicted on innocent bystanders.

The central concepts that run through these proposals are "tax avoidance transactions" and "corporate tax shelters."

Tax avoidance transactions would be defined to include two classes of transactions:

(1) any transaction in which the reasonably expected pre-tax profit (on a present value basis) is insignificant relative to the reasonably expected net tax benefits (on a present value basis); and

(2) certain transactions involving the improper elimination or significant reduction of tax on economic income.

A corporate tax shelter would exist if a corporate participant attempted to reduce, exclude, avoid, or defer tax in a tax avoidance transaction.

Thus, a corporate tax shelter would require both the existence of a tax avoidance transaction and an attempt by a corporate taxpayer to obtain a tax benefit of a particular sort through the transaction. However, the second prong of the definition is so broad -- almost any tax planning in a case challenged by the IRS could be said to come within it (even, perhaps, if the taxpayer ultimately prevailed on the underlying substantive issue!) -- that the really crucial determination in the application of all these provisions is likely to be whether the transaction is a tax avoidance transaction.

The following provision would apply simply because of the existence of a "tax avoidance transaction:"

1. Deny Certain Tax Benefits to Persons Avoiding Income Tax as a Result of Tax Avoidance Transactions. Under this proposal, the IRS would be authorized to disallow a deduction, credit, exclusion, or other allowance obtained in a tax avoidance transaction. The taxpayer's purpose in entering into the transaction would be irrelevant. This is an extremely broad proposal, which could enable the IRS to turn on and off at will the generally applicable rules set out in the Internal Revenue Code in any case in which it determined that there was insufficient economic profit in a transaction.

The following provisions would apply to "corporate tax shelters:"

2. Modify Substantial Understatement Penalty for Corporate Tax Shelters. Under existing law, a penalty of 20% exists for substantial understatements of tax. There are various exceptions to the application of this penalty, even in the case of tax shelter items (although those exceptions are less liberal than in the case of non-shelter items). This proposal would increase the penalty for an understatement attributable to corporate tax shelter items to 40% of the understatement. Moreover, in the case of such items, there would no longer be an exception to the application of the penalty, even if the taxpayer demonstrated that it had acted reasonably and in good faith. However, the penalty could be reduced back down to 20%, but not eliminated entirely, if the taxpayer made a "super-disclosure" to the IRS both at the time the transaction was consummated and on its tax return.

3. Deny Deductions for Certain Tax Advice and Impose an Excise Tax on Certain Fees Received. This proposal attempts to increase the cost of entering into corporate tax shelter transactions by denying to the corporate taxpayer any deduction for fees paid or incurred in connection with the purchase or implementation of a corporate tax shelter or the rendering of tax advice with respect to a corporate tax shelter. (Fees incurred in connection with a tax audit or controversy would continue to be deductible, even if related to corporate tax shelter items.)

The proposal also attempts to punish tax shelter promoters and tax advisers who allow their clients to participate in corporate tax shelters and would impose a 25% excise tax on fees received in connection with the purchase and implementation of shelters (including underwriting fees) and on fees received for rendering tax advice relating to corporate tax shelters. It would apparently not matter under the proposal whether a tax adviser was engaged in promoting the shelter or was consulted by the taxpayer in an effort to determine whether or not to invest in the shelter. It would not even matter if the adviser had recommended to the client not to go forward! It can be expected that the organized legal and accounting professions will be vociferous in their opposition to this proposal.

4. Impose Excise Tax on Certain Rescission Provisions and Provisions Guaranteeing Tax Benefits. It is common in many sorts of transactions for investors to obtain some sort of protection that the tax benefits anticipated from the transaction will be realized. This protection may take several forms, including tax indemnity agreements or insurance. Under this proposal, a taxpayer entering into a corporate tax shelter that included such protection would be subject to an immediate 25% excise tax on the maximum amount that might be payable to the taxpayer under the tax indemnity arrangement, if the tax benefits were ultimately allowed in full or in part.

5. Tax Income from Corporate Tax Shelters Involving Tax-Indifferent Parties. It is often not possible to eliminate entirely the taxable income arising from a transaction. However, many shelter transactions are structured by directing taxable income to a nontaxpaying entity -- which may be a taxpayer with large net operating loss carryovers, a foreign person in a treaty jurisdiction, a Native American tribal organization, or a tax-exempt organization (such as a charity) -- while offsetting deductions are directed to a taxpayer. Under this proposal, the income of a "tax indifferent party" (such as those enumerated) arising in a corporate tax shelter transaction would be fully taxable. Depending on the circumstances, however, the tax indifferent party's tax might be collectible not from the tax indifferent party itself, but from the other participants in the transaction, all of whom would be jointly and severally liable for that tax.

Effective Date This legislation is proposed to be effective for transactions occurring or entered into, fees paid, incurred, or received, or arrangements entered into "on or after the date of first committee action" in the Congress. In view of this accelerated effective date, great caution must be exercised now, even by noncorporate taxpayers, to ensure that they are not swept up by any new rules that are adopted.