Corporate Tax Shelters: What Will Be the Impact of the New Regulations on U.S. Multinational Corporations?

Introduction
In late February of this year, the Internal Revenue Service issued three sets of temporary and proposed regulations requiring promoters to register confidential corporate tax shelters and maintain lists of investors in certain suspect transactions and requiring corporate taxpayers to disclose large transactions that exhibit characteristics common to tax shelters.¹ The new disclosure requirements are intended to discourage corporations from entering into questionable transactions and are expected to lead to better enforcement of existing anti-abuse rules. Increased disclosure is also an important component of a broader IRS attack on corporate tax shelters that includes the proposed codification of the economic substance doctrine and the modified substantial understatement penalty proposal.² Additionally, the disclosure requirements provide the IRS and Treasury with information that will permit them to learn about various transactions in which taxpayers engage and provide public guidance as to those transactions.

In addition to the three sets of regulations, the IRS announced the creation of an Office of Tax Shelter Analysis that will, among other things, review all disclosures relating to corporate tax shelters and coordinate any responses that the IRS may initiate with respect to such disclosures.³ The Office of Tax Shelter Analysis will be under the direction of the newly formed Large and Mid-Size Business ("LMSB") division.⁴ The commissioner for that division is the former tax department head of a large corporation, familiar with the various tax compliance issues that confront large corporations. The creation of a centralized point of review in dealing with corporate tax shelters apparently is intended, in part, to counter criticism that definitional ambiguities in the proposed codification of the economic substance doctrine will give IRS agents too much discretion to formulate their own interpretations of what is a corporate tax shelter.⁵

The creation of a centralized review body has precedent. For example, in order to impose the noncompliance penalty adjustment under §6038A(e)(3) (permitting the District Director to determine the cost of goods sold or any deductions in his/her sole discretion), the proposed imposition must be reviewed and approved by the Associate Chief Counsel (International).⁶ Additionally, the penalty for substantial valuation misstatement under §6662(e) requires review by the Penalty Oversight Committee, a committee established to monitor and gather information on the application of the transfer pricing penalty.⁷ In each of these cases, the penalty involved has such a strong punitive effect that the IRS wisely has determined that such penalties should not be imposed without one body reviewing all the cases so that uniform principles of application will apply to all affected taxpayers.⁸

According to the IRS, the new regulations do not alter substantive tax rules and, therefore, disclosure under the regulations does not affect the legal determination whether tax benefits claimed by taxpayers are allowable.⁹ On the other hand, various penalties may be imposed for failure to comply with the new disclosure regulations and a taxpayer may affect its exposure to the accuracy-related and fraud penalties under §§6662 and 6663 for the failure to disclose. Although the new regulations do not alter existing substantive tax rules in general, the courts and the IRS have applied existing substantive tax rules in unanticipated ways in recent years, exposing taxpayers in situations of first impression to the imposition of penalties. For example, in Compaq v. Com'r,¹⁰ not only were foreign tax credits disallowed, but a 20% negligence understatement penalty was sustained by the Tax Court. The foreign tax credits were disallowed under a theory similar to that of Notice 98-5,¹¹ which was published in late December 1998, well after the 1992 taxable year in which Compaq entered into the transactions. Although one can argue that the nature of the transactions, i.e., tightly controlled purchase and sale transactions, should have put the taxpayer on notice that it was incurring risk as to its claim for the foreign tax credits, the imposition of the negligence penalty under §6662(a) was not as foreseeable in 1992.

The IRS also is applying novel and questionable analyses in order to defeat what it views as abusive transactions. In FSA 199909005 (November 17, 1998), the Service advised that a lease-stripping transaction may be subject to the application of §482, even though none of the parties to the transaction had either an ownership interest in, or controlled the decision-making of, any other party. The tentative application of §482 was advanced because the lease transaction was structured in accordance with the "common design" of all parties, resulting in the arbitrary shifting of income and deductions among them. The FSA invoked and elaborated upon Notice 95-53,¹² in which the IRS indicated that it would apply §482 to lease stripping transactions even where the parties were "owned predominantly" by unrelated persons on the premise that in such transactions -- where income may be accelerated so as to be reportable by tax favored entities -- the parties "act in concert with the common goal of arbitrarily shifting income or deductions."¹³

For the rest of this article, please contact author Carol P. Tello at 202-452-7925 (or via email at tellocp@silmul.bipc.com) or Richard S. Marshall at 202-452-7961 (or via email at marshallrs@silmul.bipc.com).

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¹Announcement 2000-12; 2000-12 IRB 1 (February 28, 2000).
²White Paper at 34. In the wake of the Treasury and IRS legislative proposals and regulatory action, the Securities and Exchange Commission may be considering whether accounting firms are violating conflict of interest rules by organizing and promoting corporate tax shelters to their audit clients. Wall S.J., "SEC Checking Accountants Over Shelters," (3/24/00).
³Announcement 2000-12; 2000-12 IRB 1 (February 28, 2000).
⁴The IRS anticipates that the LMSB will "stand up" on June 4, 2000 and become fully operational with budget authority on October 1, 2000, the beginning of the government's fiscal year.
⁵See Joint Committee On Taxation, Description of Revenue Provisions Contained in the President's Fiscal Year 2001 Budget Proposal (JCS-2-00), March 6, 2000, 294. In fact, in his statement on behalf of the Tax Executives Institute, Charles Shewbridge provides as an example of an erroneously identified tax shelter by an IRS auditor a claim for research tax credits. See fn. 29
⁶IRM 4.3.1.1.5.3.10 - IRC Sec. 6038A(e) Procedures and Guidelines.
⁷Ann. 96-15, 1996-13 I.R.B. The Committee reviews all cases in which a district director considers the assertion of a penalty under §6662(e). The goal of the Committee is to ensure uniform application of the reasonableness standard and the documentation requirements on a nationwide basis. The Committee is composed of personnel from International, Examination, Appeals, and Chief Counsel. However, Joy DeGrosky, a member of the Committee, recently stated that the Committee concluded that the penalty was properly applied in 72 out of 86 taxable years. 85 DTR G-1 (5/2/00). This 84% approval rate by the Committee may not provide taxpayers with much comfort.
⁸Canada also uses a central committee to monitor its statutory general anti-abuse rule under §245 of the Income Tax Act ("GAAR") through the so-called "GAAR Committee," a committee composed of officials from Revenue Canada and from the Justice and Finance Departments. Information Circular 88-2. For a discussion of this committee, see Couzin, 955-22d T.M., Business Operations in Canada."
⁹Announcement 2000-12; 2000-12 IRB 1 (February 28, 2000).
¹⁰113 T.C. No. 17 (9/21/99).
¹¹1998-3 I.R.B. 49.
¹²1995-2 C.B. 334.
¹³For a critical discussion of FSA 199909005, see Warner, "Control, Causality and Section 482," 28 Tax Mgt. Int'l J. 403 (7/9/99).

Reproduced with the permission of Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc., Washington, D.C. All rights reserved.

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