International Fiscal Association New England Region INTERNATIONAL TAX

International Fiscal Association New England Region INTERNATIONAL TAX SEMINAR Change is in the Air: What Can We Anticipate? November 21, 2002 Tax Shelter Developments Philip R. West Steptoe & Johnson LLP Washington, D. C. Copyright 2002 Philip R. West

Overview • Substantive Standards: Assessing Tax Shelters – Where we are today • Getting oriented • Review of case law and administrative action – Legislative proposals (Where will we be tomorrow? ) • Procedural Developments – Historical overview of governmental responses to the shelter issue – Current and proposed rules relating to • Disclosure requirements for taxpayers • Registration and investor list requirements for promoters, advisors • Penalties – Audit/controversy developments: • Confidentiality issues • Settlement offers 1

Substantive standards: Do we need them? • A rule-based system – Other systems are possible • Rulings systems • A “standards” system – Ours is more • Transparent • Equitable – Does this mean that technical results must always be respected? • Or is some combination of rules and standards appropriate? 2

Substantive Standards: “Economic substance” vs. other doctrines • Statutory, regulatory and treaty anti-abuse rules – Statutory • 446 • 269 • 482? – Regulatory • Partnership anti-abuse rule • Loss sourcing • OID • NOL – Treaty • LOB • Beneficial ownership • Residence, including dual residence • Hybrid entities • Other • Transaction recharacterization doctrines – Step Transaction • End result test • Mutual interdependence test • Binding commitment test – Court Holding/Est. of Kluener – Waterman Steamship/Esmark • Factual Sham 3

Substantive Standards: “Economic substance” basic principles? – Not just a “smell test” – Even if test failed, court has discretion to respect form – Different from profit potential test, although magnitude of tax benefits relevant – More complex, tax-advantaged way of executing a transaction should not lack economic substance if the transaction itself has economic substance • See Hariton, Sorting Out the Tangle of Economic Substance, 52 Tax Law. 235 (1999) 4

Substantive standards: Case law • Gregory: “That which the statute intended” – Famous quotes in tension: • • “Anyone may arrange his affairs. . . ” • “Like a melody is more than the sum of the notes. . . ” Knetsch, Goldstein: Prepaid interest: Circular vs. 3 d party Frank Lyon: The source of all the government’s problems? Glass, Rice’s Toyota World, Est. of Franklin: Factual shams? Sheldon: “A peppercorn of profit is not enough” ACM, et al. : Same cases, different results? Look at the facts. UPS: Right answer, wrong reason; or vice versa? Compaq/IES: Wrong answer, wrong reason? 5

Substantive standards: Administrative action • • • • Notice 2002 -70 – Certain Reinsurance Arrangements Notice 2002 -65 – Passthrough Entity Straddle Tax Shelter Notice 2002 -50 – Partnership Straddle Tax Shelter Revenue Ruling 2002 -46 – § 401 k Accelerators Notice 2002 -35 – Notional Principal Contracts Notice 2002 -21 – Inflated Basis "CARDS" Transactions Notice 2001 -45 – § 302 Basis-Shifting Transactions Notice 2001 -17 – Contingent Liability Transactions Notice 2001 -16 – Intermediary Transactions Notice 2000 -61 – Guam Trust Notice 2000 -60 – Stock Compensation Transactions Notice 2000 -44 – Inflated Partnership Basis Transactions Revenue Ruling 2000 -12 – Debt Straddles Treasury Regulation § 1. 7701(I)-3 – Fast Pay or Step-Down Preferred Transactions • • Notice 99 -59 – BOSS Transactions Revenue Ruling 99 -14 – Lease-In / Lease. Out or LILO Transactions Treasury Regulation § 1. 643(a)-8 – Certain Distributions from Charitable Remainder Trusts ASA Investering Partnership v. Commissioner -Transactions similar to that described in the ASA Investering litigation and in ACM Partnership v. Commissioner, 157 F. 3 d 231 (3 rd Cir. 1998) Notice 98 -5, part II – Foreign Tax Credit Transactions Notice 95 -53 – Lease Strips Notice 95 -34 – Certain Trusts Purported to be Multiple Employer Welfare Funds Exempted from the Lists of §§ 419 and 419 A Revenue Ruling 90 -105 – Certain Accelerated Deductions for Contributions to a Qualified Cash or Deferred Arrangement or Matching Contributions to a Defined Contribution Plan 6

Substantive standards: Legislative proposals • H. R. 5095 – “Clarify and, in certain circumstances, enhance” the economic substance doctrine • Continues to leave to the courts when the doctrine applies • Also leaves to courts whether to respect form despite lack of E. S. ? – Conjunctive test • “Meaningful” change in taxpayer’s economic position – Internal restructurings? – Hedged transactions » 98 -5 Transactions » Defeased transactions » Circular cash flow to get foreign benefits • Substantial non-tax business purpose – Financial statement benefit generally should not qualify – Financial statement income from tax deduction does not qualify • “A reasonable means of accomplishing such purpose” 7

Substantive standards: Legislative proposals • Small Business and Farm Economic Recovery Act (SBFERA) – No legislative language yet, but SEE JCT description • Codifies economic substance test – S. 2498 (Baucus/Grassley Shelter Transparency Act) did not do so – Appears to be based on S. 2339 (Kerry), and H. R. 2520 (2001 Doggett) – Conjunctive test similar to H. R. 5095, but twice the revenue pick-up: • Adds profit test of Notice 98 -5, if profit is used to show meaningful change in economic position • Specifies that foreign taxes reduce profit in this calculation • Tougher on financial statement impact as business purpose – Financial statement benefit “will” not qualify » (Compare “generally should not” of H. R. 5095) – Financial statement income generation also does not qualify • Specific rules on transactions with tax-indifferent parties – financings and income- and basis-shifting – Compare H. R. 5095 reg authority – Leasing gets a pass 8

Substantive standards: Legislative proposals • Other proposals: – Treasury • No attempt to codify economic substance • Targeted transactional (and procedural) provisions – H. R. 2520 (Doggett ’ 01) • Significant refinement of Doggett ‘ 99 – S. 2339 (Kerry) • Additional tax haven provisions – Some based on 2000 budget proposals 9

Procedural developments: Governmental response over the years • • 1982: Sections 6700 and 7408 1984: Sections 6111 and 6112 1986: Section 469 (systemic effect) 1997: Section 6111(d) 1999: Treasury legislative proposals 2000: Senate Finance Committee Proposals 2000: Regulations under sections 6011, 6112 2000 -02: Numerous proposed and adopted revisions to §§ 6011, 6112 statute/regulations 10

Procedural Developments: The big 3 • Section 6011 – Any person who participates, directly or indirectly – In any “reportable transaction” – Must file a disclosure statement with return relating to the RT • Section 6111 – Any “tax shelter organizer” – Of any “tax shelter” – Must register the tax shelter with IRS • Section 6112 – Any person who “organizes” or “sells” – Any “potentially abusive tax shelter” – Must maintain a list of investors in the PATS 11

Procedural Developments: Section 6011 • New regs apply to TOA 1/1/03 • File disclosure statement for each year tax that is affected by reportable transaction • If taxpayer uncertain whether disclosure required – Can make a protective disclosure, or – Seek a ruling! 12

Procedural Developments: Section 6011 • 6 classes of “reportable transactions” – – – Listed transactions Confidential transactions Transactions with tax benefit loss protection Significant loss generators Transactions with significant book-tax difference Transactions involving a brief asset holding period 13

Procedural Developments: Section 6011 -- listed transactions • Identified transactions – See slide 4 for transactions listed to date – Consult IRS website for future additions • Also covered are “substantially similar” transactions – Son of BOSS – Royalty strips similar to lease strips? – 98 -5 royalty plays? • (See brief holding period transactions) 14

Procedural Developments: Section 6011 -- confidential transactions • All facts and circumstances considered to determine whether conditions of confidentiality exist – Compare § 6111(d), setting forth more precise rules • Applicability of the attorney-client privilege is not a condition of confidentiality • Presumed not confidential if – Every person making a statement about potential tax consequences provides taxpayer with express written consent to disclose, without limitation, structure and tax consequences 15

Procedural Developments: Section 6011 -- tax benefit loss protection • Includes – – – Rescission right Fee refund provision Contingent fee Tax benefit insurance Tax indemnity • Excludes – Customary indemnity provided by a principal that did not participate in promotion or offering – Withholding tax gross-up – Withholding tax redemption trigger 16

Procedural Developments: Section 6011 -- significant loss generators • Thresholds – – Corporations: $20 M or $10 M/year Partnerships and S Corps: $10 M or $5 M/year Individuals and trusts: $4 M or $2 M/year Individuals and trusts re § 988 transactions: $50 k/year • Determination is exclusive of offsets and limitations – Offsetting income does not reduce loss – Capital loss limitation does not reduce loss • Applies to section 165 losses – Not casualty losses – Not involuntary conversions 17

Procedural Developments: Section 6011 -- significant book-tax difference • Applicability – Book-tax difference of more than $10 M – Only companies that • Are reporting companies under ‘ 34 Act, or • Have at least $100 M in gross assets – Foreign corps count only US assets • Special rules – Foreign corps count only ECI – Transactions solely among consolidated group members are disregarded – Book items of disregarded entities are treated as owners’ – Book items of partnerships are treated as partners’ – Unlike other reportable transactions, even a “reporting shareholder” of a foreign corp is not an “indirect” participant in a transaction that is “reportable” b/c of a book-tax difference 18

Procedural Developments: Section 6011 -- significant book-tax difference • “Angel” list (Treasury has said many more may be forthcoming) – – – – Book loss claimed before or without tax loss Tax income claimed before or without book income Depreciation differences relating solely to lives, methods or conventions Bad debt or COD income Federal, state, local or foreign taxes Compensation amounts, including options, pensions Items that can’t be deducted or capitalized for tax, such as fines or certain meals & entertainment Charitable contributions of cash or tangible property Tax exempt interest Dividends, including § 78 amounts, inclusions under §§ 551, 951, 1293 and distributions of PTI under §§ 959 and 1293 Involuntary conversions §§ 475 and 1296 gains and losses § 481 Adjustments 19

Procedural Developments: Section 6011 -- brief asset holding period • Transaction reasonably expected to result in credits exceeding $250, 000 • If the asset giving rise to the credit is held less than 45 days – Time computed using § 246(c) principles • Holding period reduced for time risk of loss is diminished (e. g. , options) • Notice 98 -5 royalty plays 20

Procedural developments: Comparison to current regulations under § 6011 • Under current regs, – Non-corporate taxpayers disclose only listed transactions – Reportable transactions are • Listed transactions, and • Other transactions that – Meet projected tax effect test ($10 M or $5 M/year) and – Meet two of the following five factors, unless an exception applies » Confidentiality » Contractual protection for expected tax results » Participation is promoted, solicited, or recommended by person who received or expects to receive >$100, 000 in fees as a result of the taxpayer’s participation » > $5 million difference in book and tax treatment » Presence of an accommodation party 21

Procedural developments: Comparison to current regulations under § 6011 • Exceptions under current regs. – Even transactions meeting two of the five factors are not reportable, if • The taxpayer participated in the transaction in the ordinary course of its business and – The taxpayer would have participated irrespective of tax benefits, or – the taxpayer’s tax treatment is generally accepted, or • The taxpayer deems that there is no reasonable basis for denial of any of the expected tax benefits, or • The transaction is identified in published guidance as excepted from disclosure 22

Procedural Standards: Section 6111 • Section 6111 – Any “tax shelter organizer” – Of any “tax shelter” – Must register the tax shelter with IRS 23

Procedural Standards: Section 6111 • “Tax Shelter” (Treasury, H. R. 5095 and Farm Bill propose amending definition) – Any investment • With respect to which any person could reasonably infer from the representations made in connection with the offering of the investment that – The “tax shelter ratio” (i. e. , the ratio of deductions and credits to investment) for any investor as of the close of any of the first five years ending after the date on which the investment is offered for sale may be greater than 2 to 1, and • Which is one of the following – Required to be registered under federal or state securities laws – Sold pursuant to a securities registration exemption – A “substantial investment. ” » Aggregate amount that may be offered for sale exceeds $250, 000, and » There are expected to be 5 or more investors 24

Procedural Standards: Section 6111(d) • “Tax shelter” also includes – Any entity, plan, arrangement, or transaction • A significant purpose of the structure of which is the avoidance or evasion of Federal income tax, • Which is offered to any potential participant under conditions of confidentiality, and • For which the tax shelter promoters may receive fees in excess of $100, 000 in the aggregate 25

Procedural Standards: Section 6112 • Investor list maintenance requirements – Any person who “organizes” or “sells” – Any “potentially abusive tax shelter” – Must maintain a list of investors in the PATS 26

Procedural developments: Section 6112 • List must identify each person who was sold an interest in the potentially abusive tax shelter • Persons required to maintain the list must – Make the list available to the IRS upon request and – Retain the information which is required to be included on the list for 7 years 27

Procedural developments: Section 6112 New regs effective TOA 1/1/03 • Q: Who “organizes” or “sells”? • A: A “material advisor” – Any person who • Expects to receive fees of at least – $250, 000 for a transaction involving a corporation or – $50, 000 for a transaction involving an individual and • Makes statements to any person re the potential tax consequences of the transaction – Extremely broad definition 28

Procedural developments: Section 6112 New regs effective TOA 1/1/03 • “Potentially abusive tax shelter” – Any transaction • That is a “listed transaction” under § 6011, • That a “potential material advisor” knows or has reason to know is a “reportable transaction” under § 6011 (other than a listed transaction), or – Any § 6111 “tax shelter” for which registration is required 29

Procedural developments: Legislative and administrative proposals re definitions in §§ 6011, 6111, and 6112 • Currently, only § 6111 statutorily defines the transactions targeted without accompanying reg authority – Treasury seeking amendment of § 6111 “tax shelter” definition to conform with § 6112 reg authority – H. R. 5095 would amend § 6111 to target those transactions targeted by § 6011 • Same result as Treasury proposal (§ 6112 regs reference § 6011) – H. R. 5095 would also harmonize the definition of persons required to register under § 6111 with those required to maintain lists under § 6112 • Uses “material advisor” standard, similar to new § 6112 definition • Treasury has a similar proposal, which would combining regulatory amendments with confirming regulatory authority 30

Procedural developments: Penalties • Penalties for failure to disclose under § 6011 – Current law • Disclosure requirement is not statutory; no statutory penalty • See, however, penalty for substantial understatement attributable to a tax shelter under § 6662(d)(2)(C)(iii) – Items of corporations attributable to tax shelters » Reduction in penalty that otherwise would apply where there is substantial authority or disclosure does not apply – Items of other taxpayers attributable to tax shelters » Reduction in penalty that otherwise would apply where there is substantial authority does not apply » Reduction in penalty that otherwise would apply where there is disclosure does not apply unless taxpayer reasonably believed tax treatment was more likely than not correct – Note that “tax shelter” is defined for this purpose yet another way 31

Procedural developments: Penalties • Penalties for failure to disclose under § 6011 – Treasury Proposal (“strict liability”) • Would amend regs to eliminate possibility under current rules of avoiding accuracy-related penalty under § 6662 where: – TP has listed transaction – Does not disclose it, and – Claims a reasonable basis for position and reasonable cause based on opinion • Would amend regs to impose accuracy related penalty on any listed transaction that is not disclosed • Would also amend regs to eliminate possibility of a defense to accuracy-related penalty when – Position is based on invalidity of a reg, whether or not listed, – Unless position is adequately disclosed 32

Procedural developments: Penalties • Penalties for failure to disclose under § 6011 – Treasury Proposal • Would amend Code to impose “non-waivable” penalty on taxpayers for each failure to disclose – Corporate taxpayers: » Listed transaction: $200, 000 for each failure, plus 5% of any underpayment from the listed transaction » Reportable transaction: $50, 000 for each failure. – Partnerships, S corporations, and trusts » Listed transactions: $200, 000 » Reportable transactions: $50, 000 – Individuals » Listed transactions: $100, 000, plus 5% of any underpayment » Reportable transactions: $10, 000 • Would also require Corporate taxpayers to disclose penalties in SEC filings 33

Procedural developments: Penalties • Penalties for failure to disclose under § 6011 – H. R. 5095 and Senate Farm Bill • Broadly similar provisions on modifications to accuracyrelated penalty for tax shelter positions • Broadly similar provisions on imposition of penalty for failure to disclose participation in tax shelters – Thresholds differ • SEC disclosure – House excludes – Senate includes 34

Procedural Developments: Current Promoter Penalties • Tax shelter registration (§ 6707) – Failure to register a non-confidential tax shelter results in a penalty equal to the greater of • 1% of the “aggregate amount invested in the tax shelter, ” or • $500 – Failure to register a confidential tax shelter results in a penalty equal to the greater of • 50% of the fees paid to all promoters or • $10, 000 – No penalty is imposed if the failure to register the tax shelter was due to “reasonable cause” • Maintenance of investor list (§ 6708) – Failure to maintain an investor list results in a penalty of • $50 for each person that should be on the investor list • Maximum fine is $100, 000 for any calendar year 35

Procedural Developments: Proposed Promoter Penalties • Treasury proposals on promoter penalties (House and Senate bills are consistent) – Failure to register • Listed Transactions – Failure to register a listed transaction would result in penalty equal to the greater of » 50% of the fees paid to the promoter (75% for intentional failure) or » $200, 000 – Current law comparison: » Tightens current law by removing reasonable cause exception » Appears to loosen current law in some situations – a broadly marketed shelter might result in a higher “ 1% of investment” penalty than “ 50% of fees paid” penalty (assuming Treasury proposal would repeal current law, as does H. R. 5095) • Other reportable transactions – Penalty would be $50, 000 – Investor list • If investor list not submitted 20 business days after request, $10, 000 per business day fine 36

Procedural Developments: Circular 230 • Proposed Regulations Issued in January 2001 re Tax Shelter Opinions (§§ 10. 33 and 10. 35) – Directives for • Opinions used by 3 rd parties to market shelters (§ 10. 33) • “More likely than not” opinions (§ 10. 35) • Regulations reflected Treasury’s concern that “some tax professionals are rendering opinions that fall short of the minimum standards that. . . Treasury. . . believes are appropriate ” – Treasury Proposal • Treasury is reviewing comments received to the proposed regulations and promises revised proposed regulations “shortly” that will set “minimum standards for these types of opinions” 37

Audit/Controversy Developments: Confidentiality issues • Opinions – IRS arguments • Penalties put state of mind of taxpayers at issue • Opinions are provided in connection with tax return prep • No privilege unless confidential client fact at risk of disclosure • Privilege waived if opinion circulated to third party • Investor lists – KPMG, BDO-Seidman cases • Accrual workpapers – Announcement 2002 -63 38

Audit/Controversy Developments: Settlement Initiatives • Contingent Liability (Rev. Proc. 2002 -67) – Two types of resolution available • Fixed Concession/Fast Track • Baseball Arbitration • COLI (Announcement 2002 -96) – Termination of COLI settlement initiative; 45 day window from receipt of letter (!0/4 -18) – Offer must include • Concession of 80 percent of the claimed COLI interest deductions; and • Agreement not to use interest deduction as a deduction or basis adjustment in any year • § 302 Basis Shifting Transactions (Announcement 2002 -97) – Case resolution guidelines; • Report gain or loss ignoring the basis shift and deduction of transaction costs • Concede 80% of claimed basis shift and all transaction cost deductions • Treat 20% of the transaction costs as a capital loss • Penalties may be assessed • Taxpayers have until Dec. 3 to notify the IRS of desire to settle – See also new § 302 regs 39