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FROM THE OFFICE OF PUBLIC AFFAIRS
March 8, 2000
TREASURY ACTING ASSISTANT SECRETARY FOR TAX POLICY JONATHAN TALISMAN TESTIMONY
BEFORE THE SENATE COMMITTEE ON FINANCE
Thank you for giving me the opportunity to appear before you today to discuss
two important issues - the interest and
On October 25, 1999, th
penalty provisions of the Internal Revenue Code and the problem
of corporate tax shelters. e Treasury Department issued a report on the interest
and penalty regime in the Internal Revenue Code. The report was mandated by
Section 3801 of the Internal Revenue Service Restructuring and Reform Act of
1998 (RRA98). The report reviewed the administration and implementation of
those provisions and made appropriate legislative and administrative recommendations.
I will focus on the main aspects of this report later in my testimony. However,
I would first like to address the problem of corporate tax shelters.
In the past, the Committee on Finance has reacted quickly and
appropriately with legislation when confronted with issues that posed grave
consequences to the tax system, such as the use of tax shelters by individuals
in the 1970's and 1980's and, more recently, the development of particular
abusive transactions. As indicated by Secretary Summers this morning, we believe
that the use of corporate tax shelters currently represents the most serious
compliance problem facing our tax system.
My testimony today will focus on the reasons for our concerns,
the steps Treasury, the Congress, and the IRS have undertaken to date to address
this problem, why this current approach is inadequate and legislation is necessary,
and what our legislative proposals entail.
I. Corporate Tax Shelters
A. General Discussion and Background
Over the last several years, the Treasury Department has become
increasingly aware and increasingly concerned about the proliferation of corporate
tax shelters. These concerns range from the short-term revenue loss to the
tax system, to the potentially more troubling long-term effects on our voluntary
income tax system. In its FY 2000 Budget, released in February 1999, the Administration
made several proposals to inhibit the growth of corporate tax shelters. These
proposals generated significant commentary from the corporate and tax practitioner
In July 1999, the Treasury Department issued its White Paper, The
Problem of Corporate Tax Shelters: Discussion, Analysis and Legislative Proposals.
This report discussed more fully the reasoning underlying the Budget proposals
relating to corporate tax shelters, provided a description and analysis of
the comments on the Budget proposals, and provided, in light of these comments,
refinements to those proposals. These refined proposals are contained in
the Administration's FY 2001 Budget proposals.
There have been several other important developments regarding
corporate tax shelters since the issuance of our FY 2000 Budget proposals approximately
a year ago. The staff of the Joint Committee on Taxation has issued its report
on the penalty and interest provisions of the Internal Revenue Code. In its
report, the staff found that "the corporate tax shelter phenomenon poses
a serious challenge to the efficacy of the tax system." Similar sentiments
have been expressed by the American Bar Association, the American Institute
of Certified Public Accountants, the New York State Bar Association, the Tax
Executives Institute, and many respected tax executives and practitioners in
testimony before the tax-writing committees and other presentations.
The Treasury and the IRS have issued administrative guidance
curtailing the use of specific abusive transactions in the past year, including "fast
pay" stock, "LILO" transactions, "BOSS" transactions, "chutzpah
trusts," and debt straddles. In 1999, Congress enacted legislation addressing
corporate tax shelters involving the use of certain liabilities to inflate
the adjusted basis of assets. The IRS has won significant victories in court,
successfully arguing that the transactions purportedly giving rise to certain
tax benefits should not be respected because the transactions did not possess
economic substance. Most recently, Treasury and the IRS issued temporary and
proposed regulations requiring registration of confidential corporate tax shelters,
maintenance of lists of shelter participants, and reporting of certain transactions
having characteristics common to corporate tax shelters.
With these developments in mind, I would like to emphasize the
following points in my testimony today.
First, despite these efforts, corporate tax shelters continue
to be a substantial and ongoing problem. While Congress, the Treasury Department
and the IRS take action to stop particular transactions as they are uncovered,
many abusive transactions remain undiscovered and numerous new transactions
are created all the time. Our new disclosure regulations primarily address
the visibility of corporate tax shelter transactions. Disclosure will help
the IRS identify and deal with abusive transactions more quickly and effectively.
It also is our hope that the disclosure requirements will deter corporate taxpayers
from entering into tax shelters. However, in the absence of Congressional action,
we do not believe the regulatory disclosure requirements are sufficient to
address fully the problem of corporate tax shelters, because they do not adequately
affect the cost/benefit analysis a corporation undertakes when deciding whether
to participate in a particular transaction.
Second, the ad hoc and piecemeal approach that Congress,
the Treasury Department, and the IRS have employed in the past to address corporate
tax shelters is inadequate. Admittedly, recent court decisions denying the
purported tax benefits of certain shelter transactions are important. However,
litigation is costly and inefficient. Moreover, these decisions are after-the-fact
actions against shelters - they do not prevent the design, marketing, and implementation
of new and different shelters. Furthermore, even though Congress has enacted
certain legislative changes curbing certain types of shelters, these statutory
prohibitions can sometimes be avoided by making certain adjustments to a transaction
to avoid the impact of the revised statutory provisions. A global legislative
solution is needed to prevent abusive, tax-engineered transactions before they
occur. The Treasury Department believes this global solution should include
four parts: increased disclosure, changes to the substantial understatement
penalty, codification of the economic substance doctrine, and sanctions on
other parties to the transaction.
Third, there are substantial similarities between the Treasury
Department's proposals and other proposals to curb corporate tax shelters.
For example, the staff of the Joint Committee on Taxation agrees that there
should be increased disclosure by participants, increased penalties on understatements
attributable to undisclosed transactions and tightening of the reasonable cause
exception, and sanctions on other parties to the transaction. As discussed
more fully in the White Paper, the American Bar Association and the New York
State Bar Association proposals contain several elements similar to those in
the Administration's proposal. Finally, H.R. 2255, introduced by Mr. Doggett,
also contains an approach similar to the Administration's proposal, including
the codification of the economic substance doctrine. We commend Mr. Doggett
for his leadership.
Finally, the proposed legislation would be inadequate without
effective enforcement. The Internal Revenue Service is undergoing a substantial
restructuring. This restructuring will concentrate IRS resources relating to
corporate tax shelters, enabling it to identify, focus on, and coordinate its
efforts against corporate tax shelters in a more efficient manner, while instituting
and maintaining appropriate taxpayer safeguards. The enactment of corporate
tax shelter legislation, combined with the efforts of the restructured IRS,
will deter abusive transactions before they occur and uncover and stop these
transactions to the extent they continue to occur.
The balance of my testimony with respect to corporate tax shelters
will elaborate on these points.
B. Reasons for Concern
Corporate tax shelters are designed to, and do, substantially
reduce the corporate tax base. Moreover, corporate tax shelters breed disrespect
for the tax system - both by the parties who participate in the tax shelter
market and by others who perceive unfairness. A view that well-advised corporations
avoid their legal tax liabilities by engaging in tax-engineered transactions
may cause a "race to the bottom." The New York State Bar Association
recently noted this "corrosive effect" of tax shelters: "The
constant promotion of these frequently artificial transactions breeds significant
disrespect for the tax system, encouraging responsible corporate taxpayers
to expect this type of activity to be the norm, and to follow the lead of other
taxpayers who have engaged in tax advantaged transactions." If unabated,
this will have long-term consequences to our voluntary tax system far more
important than the revenue losses we currently are experiencing in the corporate
Finally, significant resources - both in the private sector and
the government - are currently being wasted on this uneconomic activity. Private
sector resources used to create, implement and defend complex shelter transactions
are better used in productive activities. Corporations distort their business
decisions to take advantage of tax shelter opportunities. Similarly, the Congress
(particularly the tax-writing committees and their staffs), the Treasury Department,
and the IRS must expend significant resources to address and combat these transactions.
C. Corporate Tax Shelters and the Corporate Tax Base
Some have argued that the growth of corporate income tax receipts
demonstrates that corporate tax shelters cannot be a problem. Of course, the
size of the problem is not indicated by the amount of corporate tax
receipts, which vary over time for a number of reasons, but by the difference between
actual tax payments and those that would be remitted absent corporate tax shelters.
That difference is impossible to measure directly, but the increasing difference
between the income taxpayers report on their corporate tax forms (taxable income)
and the income they report to shareholders (book income) appears to be consistent
with the increasing use of corporate tax shelters.
One feature of many tax shelters is that they reduce taxable
income and taxes without reducing book income. Corporate taxpayers report their
book income on Schedule M-1 of Form 1120. Such data show that the difference
between book income and taxable income for large corporations (average assets
greater than $1 billion) increased between 1991 and 1997. Current income reported
on corporate tax returns (total receipts less total deductions) represented
a much smaller share of book income (calculated as book income after tax, plus
Federal taxes, less tax-exempt income) in 1997 than in the early 1990's. (See
Figure 1.) Thus, even though corporate income reported on tax returns has increased
markedly in the 1990's, book income has increased even faster. It is unclear
how much of the divergence between tax and book income reflects tax shelter
activity, but the data are clearly consistent with other evidence that the
problem is significant.
Book and tax measures of income can diverge for many reasons
that are unrelated to tax shelters. For example, increases in the rate of new
investment can cause book and taxable income to diverge because tax depreciation
is accelerated compared with book depreciation. But depreciation does not seem
to be a significant factor. Figure 2 shows that the difference due to depreciation
has changed little over the last several years while the difference between
book and tax income continues to climb. Hence, the depreciation discrepancy
is not a significant factor behind the divergence between the two income measures
in recent years.
D. Ad Hoc Approach to
Corporate Tax Shelters
To date, most attacks on corporate tax shelters have targeted
specific transactions and have occurred on an ad hoc, after-the-fact basis
- through legislation, administrative guidance, and litigation. In the past
few years alone, Congress, the Treasury Department and the IRS have taken a
number of actions to address specific corporate tax shelters. These include:
1. Two provisions enacted in 1996 and 1997 to prevent the abuse
for tax purposes of corporate-owned life insurance (COLI). Collectively, these
two provisions were estimated by the Joint Committee on Taxation to raise over
$18 billion over 10 years. As the then Chief of Staff of the Joint Committee
on Taxation stated: "When you have a corporation wiring out a billion
dollars of premium in the morning and then borrowing it back by wire in the
afternoon and instantly creating with each year another $35 million of perpetual
tax savings, that's a problem.... I think we were looking at a potential for
a substantial erosion of the corporate tax base if something hadn't been done."
2. Legislation enacted in 1998 to eliminate the ability of banks
and other financial intermediaries to avoid corporate-level tax through the
use of "liquidating REITs." The Treasury Department's Office of Tax
Analysis (OTA) estimated that eliminating this one tax shelter product alone
would save the tax system approximately $34 billion over the next ten years.
3. The IRS ruling addressing so-called lease-in, lease-out transactions,
or "LILO" schemes. Like COLI, these transactions, through circular
property flows and cash flows, offered participants millions of dollars in
tax benefits with no real economic substance or risk. Based on the transactions
we have been able to identify to date, OTA estimates that eliminating this
tax shelter saved $10.5 billion over ten years.
4. Legislation signed into law on June 25, 1999, aimed at section
357(c) basis creation abuses. In these transactions, taxpayers exploited the
concept of "subject to" a liability and claimed increases in the
bases of assets that resulted in bases far in excess of the assets' values.
5. Regulations addressing fast-pay preferred stock transactions.
These financing transactions purportedly allowed taxpayers to deduct both principal
and interest. It was reported that one investment bank created nearly $8 billion
of investments in a few months.
6. Notice 98-5 dealing with foreign tax credit abuses.
7. Recent administrative actions taken with respect to the "BOSS" transaction
and debt straddles, the latter of which has been described as a "heads,
I win; tails, I win" proposition for the taxpayer.
8. The Government's victories in several important corporate
tax shelter cases-ACM Partnership v. Commissioner and ASA Investerings Partnership
v. Commissioner, and those cases mentioned in footnote one of this testimony.
In these cases, the courts disallowed tax benefits from transactions that lacked
Addressing corporate tax shelters on a transaction-by-transaction,
ad hoc basis, however, has substantial defects. First, because it is not possible
to identify and address all (or even most) current and future sheltering transactions,
this type of transaction-by-transaction approach is inadequate. There will
always be transactions that are unidentified or not addressed by the legislation.
As Treasury Secretary Lawrence H. Summers said: "Treasury and the IRS
have come to understand new tax shelters only by capturing them on audit, picking
up reports in the trade press, receiving anonymous tips and finding irregularities
on tax returns. What we see, we can act upon. What we cannot see, by definition,
we cannot act upon. But what we fear is that visible corporate tax shelters
are only the tip of a very large iceberg."
Second, although the IRS has recently won some important cases
involving corporate tax shelters, reliance on judicial decisions, which taxpayers
may attempt to distinguish, is not the most efficient means of addressing corporate
tax shelters. Litigation is expensive and time-consuming, both for the government
and taxpayers, and frequently does not provide a coherent set of rules to be
applied to subsequent transactions. Tax Court Judge Laro, speaking on his own
behalf before the Tax Executives Institute last year, acknowledged that the
courts have provided little guidance on the amount of economic substance or
business purpose sufficient for a transaction to be respected. He stated that
such concepts "may require further development in the case law," but
highlighted the difficulty with such an approach when he said that judges "decide
cases one at a time...and don't make tax policy."
Third, addressing tax shelters on a piecemeal basis complicates
the tax law. In the past few years alone, Congress has passed numerous provisions
to prevent specific tax shelter abuses. The layering of provision upon provision
may lead one to believe that there is a rule for every situation and thus what
is not specifically proscribed is, by negative inference, allowed. In time
these specific rules themselves are used in unintended ways to create corporate
Fourth, a legislative strategy that deals with tax shelter transactions
on a piecemeal basis calls into question the viability of current rules and
standards, particularly the common law tax doctrines such as sham transaction,
business purpose, economic substance and substance-over-form. Finally, reliance
on a transaction-by-transaction legislative approach to corporate tax shelters
may embolden some promoters and participants to rush shelter products to market
on the assumption that any Governmental reaction would be applied only on a
E. Temporary and Proposed Regulations
On February 28, 2000, the Treasury Department and the IRS issued
three sets of temporary and proposed regulations requiring promoters to register
confidential corporate tax shelters and to maintain lists of investors and
requiring corporate taxpayers to disclose large transactions that have characteristics
common to corporate tax shelters. In addition, the IRS announced it has created
an Office of Tax Shelter Analysis (described below) to serve as the focal point
for efforts to gather and analyze information relating to tax shelter activity
and to coordinate appropriate responses. Together, these actions will enable
the IRS to more quickly and effectively address transactions used to claim
tax benefits that are not properly allowable under the Internal Revenue Code.
General scope and effect of new disclosure requirements
In general, the three regulations are designed to provide the
IRS with better information about tax shelters and other tax-motivated transactions
through a combination of registration and information disclosure by promoters
and tax return disclosure by corporate taxpayers. The regulations are intended
to require disclosure of transactions that should be subject to careful scrutiny
by the IRS. The regulations are designed not to require disclosure of customary
business transactions or transactions with tax benefits that the IRS has no
reasonable basis to challenge. The regulations do not alter substantive tax
rules, and thus disclosure under the regulations does not affect the legal
determination whether tax benefits claimed by taxpayers are allowable.
Registration of tax shelters by promoters
The first set of regulations is issued under section 6111(d)
of the Code as enacted by the Taxpayer Relief Act of 1997. These regulations
require tax shelter promoters to register with the IRS transactions (1) that
have been structured for a significant purpose of tax avoidance or evasion,
(2) that are offered to corporate participants under conditions of confidentiality,
and (3) for which the tax shelter promoters may receive fees in excess of $100,000.
The promoter registration requirements apply to confidential
corporate tax shelters offered for sale after February 28, 2000. In general,
registration of a confidential corporate tax shelter is required not later
than the day that the first offering for sale of interests in such shelter
occurs. However, as a transition matter, no registration is required to be
filed until 180 days after February 28, 2000.
List maintenance requirements for promoters
The second set of regulations, issued pursuant to section 6112
of the Code, requires promoters of corporate tax shelters to maintain lists
of investors and copies of all offering materials and to make this information
available for inspection by the IRS upon request. These requirements apply
to transactions that have been structured for a significant purpose of tax
avoidance or evasion (as defined under section 6111(d)), whether or not offered
under conditions of confidentiality and whether or not the promoter fees may
These new list maintenance requirements apply to interests in
corporate tax shelters acquired by investors after February 28, 2000. However,
as a transition matter, the IRS will not ask to inspect the lists or offering
materials until 180 days after February 28, 2000.
Reporting requirements for corporate taxpayers
The third set of regulations is issued pursuant to section 6011
of the Code and requires corporate taxpayers to disclose their participation
in "reportable transactions" by attaching a short information statement
to their income tax returns. In general, a separate statement will be required
for each reportable transaction for each taxable year in which a corporation's
federal income tax liability is affected by its participation in such a transaction.
For the first taxable year in which a statement is attached to a taxpayer's
return, a copy of the statement must be filed with the IRS in Washington, D.C.
All of the information required to complete the statement should be readily
available to taxpayers at the time their returns are filed.
Disclosure is generally required only for transactions that are
expected to reduce a taxpayer's income tax liability by more than $5 million
in a single taxable year or more than $10 million in multiple years and that
have characteristics common to corporate tax shelters. However, these thresholds
are lowered to $1 million and $2 million for certain transactions identified
through published guidance as "listed transactions" (discussed below).
Reporting generally is not required for customary business transactions or
transactions with tax benefits that the IRS has no reasonable basis to challenge.
In general, disclosure is required only for reportable transactions
entered into after February 28, 2000. However, disclosure is required for a
listed transaction entered into on or before February 28, 2000 if the tax benefits
of the transaction are first claimed on a return filed after February 28, 2000.
Notice 2000-15: Listed transactions
Under the regulations, promoter registration and taxpayer disclosure
generally are required for certain listed transactions. The specific transactions
currently designated as listed transactions are identified in Notice 2000-15,
which was issued concurrently with the temporary and proposed regulations.
The Treasury and the IRS have determined that each of those listed transactions
involves a significant tax avoidance purpose and that the intended tax benefits
are subject to disallowance under existing law. The list set forth in Notice
2000-15 may be supplemented from time to time, when other such tax avoidance
transactions are identified.
F. Administration's Legislative Proposals
In its FY 2000 and 2001 Budgets, the Administration made several
proposals designed to inhibit the growth of corporate tax shelters. These proposals
build upon the common characteristics of corporate tax shelters and focus on
the following areas:
(1) increasing disclosure of corporate tax shelter activities,
(2) increasing and modifying the penalty relating to the substantial
understatement of income tax,
(3) codifying the economic substance doctrine, and
(4) providing consequences to all the parties to the transaction
(e.g., promoters, advisors, and tax-indifferent, accommodating parties).
Greater disclosure of corporate tax shelters would aid the IRS
in identifying corporate tax shelters and would therefore lead to better enforcement
by the IRS. Also, greater disclosure likely would discourage corporations from
entering into questionable transactions. The probability of discovery by the
IRS should enter into a corporation's cost/benefit analysis of whether to enter
into a corporate tax shelter.
In order to be effective, disclosure must be both timely and
sufficient. In order to facilitate examination of a particular taxpayer's return
with respect to a questionable transaction, the transaction should be prominently
disclosed on the return. Moreover, because corporate tax returns may not be
examined for a number of years after they are filed, an "early warning" system
should be required to alert the IRS to tax shelter "products" that
may be promoted to, or entered into by, a number of taxpayers. Disclosure should
be limited to the factual and legal essence of the transaction to avoid being
overly burdensome to taxpayers.
Disclosure would be required if a transaction has certain of
the objective characteristics identified above that are common in many corporate
tax shelters. The Treasury Department believes that two forms of disclosure
are necessary. Disclosure would be made on a short form separately filed with
the National Office of the IRS. Corporations entering into transactions requiring
disclosure would file the form by the due date of the tax return for the taxable
year for which the transaction is entered into and would include the form in
all tax returns to which the transaction applies. The form would require the
taxpayer to provide a description of the characteristics that apply to the
transaction. The form should be signed by a corporate officer who has, or should
have, knowledge of the factual underpinnings of the transaction for which disclosure
is required. Such officer should be made personally liable for misstatements
on the form, with appropriate penalties for fraud or gross negligence and the
officer would be accorded appropriate due process rights.
Substantial understatement penalty
In order to serve as an adequate deterrent, the risk of penalty
for corporations that participate in corporate tax shelters must be real. The
penalty also must be sufficient to affect the cost/benefit analysis that a
corporation considers when entering into a tax shelter transaction.
The Treasury Department believes that the substantial understatement
penalty imposed on understatements of tax attributable to corporate tax shelters
should be greater than the penalty generally imposed on other understatements.
This view is shared by the staff of the Joint Committee on Taxation, the ABA,
the NYSBA and others. Thus, to discourage the use of shelters, the Treasury
Department would double the current-law substantial understatement penalty
rate to 40 percent for corporate tax shelters. To encourage disclosure, the
penalty rate would be reduced to 20 percent if the taxpayer files the appropriate
In its FY 2000 Budget proposal, the Administration provided that
the rate could not be further reduced below 20 percent or eliminated by a showing
of reasonable cause (i.e., the penalty would be subject to a strict liability
standard). Although one may rhetorically question whether there ever is any
reasonable cause for entering into a corporate tax shelter transaction, many
commentators have criticized the proposed elimination of the reasonable cause
exception for corporate tax shelters. These commentators cited the potentially
vague definitions of corporate tax shelter and tax avoidance transaction, the
allowance of a reasonable cause exception for other penalties, and basic fairness
for opposing a "strict liability" penalty.
In light of the comments received, the Treasury Department modified
its FY 2001 Budget proposal to provide that the substantial understatement
penalty should be reduced or eliminated where the taxpayer properly discloses
the transaction and the taxpayer has a reasonable belief that it has a strong
chance of sustaining its tax position.
Codify the economic substance doctrine
As evidenced by the comments from the ABA, AICPA, NYSBA, and
others, corporate tax shelters are proliferating under the existing legal regime.
This proliferation results, in part, because discontinuities in objective statutory
or regulatory rules can lead to inappropriate results that have been exploited
through corporate tax shelters. Current statutory anti-abuse provisions are
limited to particular situations and are thus inapplicable to most current
corporate tax shelters. Further, application of existing judicial doctrines
has been inconsistent over time, which encourages the most aggressive taxpayers
to pick and choose among the most favorable court opinions.
The current piecemeal approach to addressing corporate tax shelters
has proven untenable, as (1) policymakers do not have the knowledge, expertise
and time to continually address these transactions; (2) adding more mechanical
rules to the Code adds to complexity, unintended results, and potential fodder
for new shelters; (3) the approach may reward taxpayers and promoters who rush
to complete transactions before the anticipated prospective effective date
of any reactive legislation; and (4) the approach results in further misuse
and neglect of common law tax doctrines. Thus, the Treasury Department believes
that a codification of the economic substance doctrine is necessary in order
to curb the growth of corporate tax shelters. While increased disclosure and
changes to the penalty regime are necessary to escalate issues and change the
cost/benefit analysis of entering into corporate tax shelters, these remedies
are not enough if taxpayers continue to believe that they will prevail on the
underlying substantive issue.
The centerpiece of the substantive law proposal is the codification
of the economic substance doctrine first found in seminal case law such as
Gregory v. Helvering and most recently utilized in ACM Partnership and the
cases in footnote one. The economic substance doctrine requires a comparison
of the expected pre-tax profits and expected tax benefits. This test is incorporated
in the first part of the Administration's proposed definition of "tax
avoidance transaction." Under that test, a tax avoidance transaction would
be defined as any transaction in which the reasonably expected pre-tax profit
(determined on a present value basis, after taking into account foreign taxes
as expenses and transaction costs) of the transaction is insignificant relative
to the reasonably expected net tax benefits (i.e., tax benefits in excess of
the tax liability arising from the transaction, determined on a present value
basis) of such transaction. In addition, the economic substance doctrine would
apply to financing transactions (that do not lend themselves to a pre-tax profit
comparison) by comparing the tax benefits claimed by the issuing corporation
to the economic profits derived by the person providing the financing.
A tax benefit would be defined to include a reduction, exclusion,
avoidance or deferral of tax, or an increase in a refund. However, the definition
of tax benefit subject to disallowance would not include those benefits that
are clearly contemplated by the applicable Code provision (taking into account
the Congressional purpose for such provision and the interaction of the provision
with other provisions of the Code). Thus, tax benefits that would normally
meet the definition, such as the low-income housing credit and deductions generated
by standard leveraged leases, would not be subject to disallowance.
A similar approach to that discussed above can be found in H.R.
2255, the "Abusive Tax Shelter Shutdown Act of 1999," introduced
by Messrs. Doggett, Stark, Hinchey and Tierney on June 17, 1999.
The Treasury Department continues to believe that it is necessary
to codify the economic substance doctrine, thus requiring taxpayers to perform
a careful analysis of the pre-tax effects of a potential transaction before
they enter into it. The Treasury Department's proposed substantive provision
is intended to be a coherent standard derived from the economic substance doctrine
as enunciated in a body of case law to the exclusion of less developed, inconsistent
decisions. Codification of the doctrine, while not creating a new doctrine,
would create a consistent standard so that taxpayers may not choose between
the conflicting decisions to support their position. Codification would isolate
the doctrine from the facts of the cases so that taxpayers could not simply
distinguish the cases based on the facts.
Consequences to other parties
Proposals to deter the use of corporate tax shelters should provide
sanctions on other parties that participate in, and benefit from, a corporate
tax shelter. These sanctions would reduce or eliminate the economic incentives
for parties that facilitate sheltering transactions, thus discouraging those
transactions. As the ABA stated in its recent testimony: "All essential
parties to a tax-driven transaction should have an incentive to make certain
that the transaction is within the law." With respect to corporate tax
shelters, the "other parties" generally are promoters, advisors,
and tax-indifferent parties that lend their tax-exempt status to the shelter
transaction to absorb or deflect otherwise taxable income.
When Congress was concerned with the proliferation of individual
tax shelters in the early 1980's, it enacted several penalty and disclosure
provisions that applied to advisors and promoters. These provisions were tailored
to the types of "cookie-cutter" tax shelter products then being developed.
Similar provisions could be enacted that are tailored to corporate tax shelters.
Alternatively, with respect to promoters and advisors of corporate
tax shelters, the Treasury Department proposes to affect directly their economic
incentives by levying a penalty excise tax of 25 percent upon the fees derived
by such persons from the corporate tax shelter transaction. Only persons who
perform services in furtherance of the corporate tax shelter would be subject
to the proposal, and appropriate due process procedures for such parties with
respect to an assessment would be provided.
A tax-indifferent party often has a special tax status conferred
upon it by operation of statute or treaty. To the extent such person is using
this status in an inappropriate or unforeseen manner, the system should not
condone such use. Imposing a tax on the income allocated to tax-indifferent
parties could deter the inappropriate rental of their special tax status, limiting
their participation in corporate tax shelters, and thus reducing other taxpayers'
use of shelters that utilize this technique.
The Treasury Department proposes to require tax-indifferent parties
to include in income (either as unrelated business taxable income or effectively
connected income) income earned in a corporate tax shelter transaction. To
the extent such parties are outside the U.S. tax jurisdiction, such liability
would be joint and several with the U.S. corporate participant. The proposal
would apply only to tax-indifferent parties that are trading on their special
tax status and such parties would have appropriate due process rights.
G. IRS Administrative Actions
The IRS currently is undergoing a substantial restructuring in
which it will be reorganized into divisions based on types of taxpayers. The
newly established Office of Tax Shelter Analysis is part of the Large and Mid-Size
Business Division located in Washington, D.C. The office is expected to serve
as a clearinghouse for all information relating to tax shelter activity that
comes to the attention of the IRS, including information relating to tax shelters
affecting taxpayers other than those served by the Large and Mid-Size Business
The Office of Tax Shelter Analysis will, among other things,
review all disclosures by promoters and taxpayers under the new disclosure
regulations for the purposes of identifying potentially improper tax shelter
transactions, identifying taxpayers that have participated in such transactions,
and better assessing the overall extent of tax shelter activity by corporate
taxpayers. Where it is determined to be warranted, the Office of Tax Shelter
Analysis will also coordinate the IRS's follow-up efforts relating to such
The Office of Tax Shelter Analysis, acting with the Office of
Chief Counsel and Treasury's Office of Tax Policy, will evaluate the tax treatment
of new forms of tax-structured transactions at the earliest possible time.
This review process is necessary not only to identify improper tax shelters,
but also to protect taxpayers that engage in legitimate business transactions.
The IRS wants to ensure that transactions are not labeled as improper tax shelters
merely because they are novel or complex.
In addition to analyzing transactions that are reported to the
IRS under the new disclosure rules, the Office of Tax Shelter Analysis will
provide a centralized point for the review of tax shelter transactions that
come to the attention of the IRS in other ways, including transactions examined
by field personnel and those that are disclosed to the IRS by taxpayers, practitioners,
and other members of the public. The Treasury Department will work closely
with the IRS to create appropriate systems and procedures to centralize review
and analysis, to ensure fair, consistent, and expeditious consideration of
corporate tax shelter issues.
II. Penalties and Interest
A. General Discussion
As stated in its report, Treasury focused its penalty and interest
report on the principal civil penalty provisions that affect large numbers
of taxpayers and account for the majority of penalty assessments and abatements.
In evaluating these penalties, Treasury was mindful that achieving a fair and
effective system of compliance involves striking a balance that (1) fosters
and maintains the high degree of voluntary compliance among the vast majority
of taxpayers, (2) encourages taxpayers who are not compliant to expeditiously
resolve noncompliance problems with the IRS, and (3) imposes an adequate system
of sanctions that are fair to taxpayers whose noncompliance may be due to diverse
causes that involve different degrees of culpability, but do not impose substantial
additional complexity or burden. Achieving such a balance is inherently difficult
because a system of sanctions that is calibrated to account for these differences
may be complex, but a system that does not make adequate distinctions may be
unfair. There is no perfect system of sanctions and striking the appropriate
balance inherently involves tradeoffs among competing concerns.
The issue of penalties is one that often strikes an emotional
chord, particularly with respect to penalties with their attendant normative
overtones. At the same time, compliant taxpayers-the vast majority of taxpayers
- deserve a tax system that recognizes their compliance. Although a penalty
regime should not be overly harsh to noncompliant taxpayers whose noncompliance
may not reflect deliberate flouting of the tax laws, it is equally true that
the currently high compliance level should not be discouraged. Treasury's report
and recommendations reflect an effort to strike a reasonable balance, understanding
that there is no single solution and different approaches can be formulated
to achieve the same goals.
Treasury also examined the respective roles of penalties and
interest in our tax system, with a view toward maintaining an appropriate distinction
between penalties as sanctions for noncompliant conduct and interest as a charge
for the use or forbearance of money. Treasury recognizes that current law does
not always make a clear or consistent distinction between interest and penalties,
but believes that this distinction is important both with respect to taxpayer
perception of the amounts they are required to pay and the underlying reasons
for the imposition, the desired deterrent effects, and the corollary consequences
of the characterization of the payment.
The distinction between penalties and interest has particular
consequence for the statutory provisions that permit abatement of those impositions.
Penalties generally can be abated for reasonable cause and other statutorily-prescribed
reasons that reflect their function as a sanction, that is, as a deterrent
to noncompliant conduct. By contrast, the grounds for abatement of interest
traditionally have been more narrowly drawn because interest is a charge for
the use or forbearance of money. To the extent that current-law penalties are
converted to interest charges or interest becomes a more dominant mechanism
for dealing with arrears in payment, important corollary consequences, such
as interest deductibility or interest abatement provisions, must be considered.
In general, Treasury's position is that interest should remain
principally a charge for the use or forbearance of money and should be set
at a rate that approximates market rates. Although there are penalties in the
Code that have attributes of an interest charge and whose legislative origins
support that characterization, these penalties also function as sanctions.
Treasury is particularly concerned that conversion of certain penalties to
interest, even if supportable on analytical grounds, may involve a correlative
blurring of the distinctions that have been drawn in the Code between penalty
and interest abatement provisions. If that distinction is blurred, it may cause
further confusion among taxpayers regarding the distinction between penalties
Treasury also is mindful of the ongoing IRS reorganization and
implementation aspects of the new taxpayer right provisions of RRA98. Considerable
guidance has been issued by Treasury in the past year relating to a number
of these new provisions and the IRS is engaged in a major overhaul of its structure
and systems as directed by Congress. Time is required for the impact of these
new provisions to be evaluated and certain of the new provisions affect IRS
programs, such as the offer-in-compromise program, that provide avenues other
than abatement for relief from monetary impositions.
B. Specific Recommendations
In its report, Treasury made a number of specific legislative
recommendations, which are described below.
Penalties for failure to file and failure to pay
Treasury recommends that the failure to file and failure to pay
penalties be restructured to eliminate the frontloading of the failure to file
penalty and to impose a higher failure to pay penalty than under current law.
The frontloading of the failure to file penalty under current law in the first
five months of a filing delinquency does not provide a continuing incentive
to correct filing failures and imposes additional financial burden on taxpayers
whose filing lapse may be coupled with payment difficulties so as to impede
compliance. The filing obligation is of paramount importance to the tax system,
but imposition of a severe penalty in the first five months of a filing delinquency
appears incongruent with the availability of automatic extensions of time to
file. Treasury proposes, accordingly, that the failure to file penalty be restructured
to impose a lower penalty rate over a longer period of time, up to the current-law
maximum amount. The current-law higher penalty for fraudulent failures to file,
however, would be maintained. This proposal would maintain a failure to file
penalty to encourage timely filing, but not impose as significant a financial
burden as under current law for a filing lapse of short duration, while providing
a continuing incentive for delinquent filers to correct a filing lapse of longer
The failure to pay penalty should provide appropriate incentives
to taxpayers to correct a payment delinquency and, if necessary, arrange for
payment under various payment programs that the IRS makes available. A taxpayer
who fails to make such arrangements in a timely manner should be subject to
a higher penalty rate than that provided under current law. Treasury proposes,
accordingly, that the failure to pay penalty be restructured to accomplish
these purposes by imposing a penalty at the current rate of 0.5 percent per
month for the first six months of a payment delinquency. The penalty rate would
be raised to one percent per month for continuing payment delinquencies after
the sixth month to provide an additional incentive to pay an outstanding tax
liability. As under current law, the maximum penalty would be 25 percent. These
penalty rates would be reduced if taxpayers make, and adhere to, arrangements
with the IRS for payment. The failure to pay penalty would not be coordinated,
as under current law, with the failure to file penalty to recognize that each
form of delinquency is a separate act of noncompliance. More specifically,
these recommendations would:
(1) Restructure the failure to file penalty to impose a penalty
of 0.5 percent per month of the net amount due for the first six months of
a delinquency in filing tax returns, which penalty rate will be increased to
one percent per month thereafter, up to a maximum 25 percent. This restructured
penalty would eliminate the current-law frontloading of the penalty into the
first five months of a filing delinquency, providing a continuing incentive
for delinquent filers to correct their filing delinquency over longer periods
of time. The maximum penalty of 25 percent is the same as under current law.
As under current law, fraudulent failures to file would be penalized at a higher
penalty rate of 15 percent per month, up to a maximum of 75 percent.
(2) Restructure the failure to pay penalty to impose a penalty
of 0.5 percent per month of the net amount due for the first six months of
a payment delinquency, which rate would be increased to one percent per month
thereafter, up to a maximum 25 percent. The penalty rate would be decreased
from 0.5 percent to 0.25 percent per month if the taxpayer, within six months,
enters into a payment arrangement with the IRS to which the taxpayer adheres.
Likewise, the one- percent penalty rate would be reduced to 0.5 percent if
the taxpayer, after the lapse of six months, enters into a payment arrangement
with the IRS to which the taxpayer adheres.
Treasury also recommends that consideration be given to charging
a fee, in the nature of a service charge, for late filing of "refund due" or "zero
balance" returns. Presently, the failure to file penalty is imposed if
a balance is due with the return but is not imposed if tax is not owed as a
result, for example, of overwithholding. The importance of the filing obligation
and the IRS administrative costs associated with nonfiling may warrant imposition
of a fee for late-filed returns to encourage timely filing even if no balance
is due with the return, at least after the IRS has contacted the nonfiling
Consideration also can be given to permitting the IRS to utilize
a fixed interest rate for installment agreements to avoid the incurrence by
a taxpayer who has made the required installment payments of a balloon payment
at the end of the agreement.
Penalties for failure to pay estimated tax
Treasury recommends that the current-law addition to tax for
failure to pay estimated tax remain treated as a penalty. Treasury recognizes
that the current sanction has attributes of interest and of a penalty. The
ancillary effects, however, of converting the sanction to an interest charge
do not warrant such a change. Conversion to an interest charge may mean that
existing statutory waiver provisions are inappropriate. Conversion to interest
also would permit corporations to deduct the payment of such sanction.
In recognition, however, of the potentially cumbersome nature
of complying with the estimated tax payment requirements, the following simplifying
changes are recommended for consideration:
(1) Individuals should not be subject to estimated tax penalties
if the balance due with their returns is less than $1,000. Thus, estimated
tax payments should be included in the calculation of the $1,000 threshold,
but Treasury recommends this change under a simplified averaging method that
would preclude taxpayers from satisfying the threshold by concentrating estimated
tax payments in later installments.
(2) A reasonable cause waiver from penalty should be permitted
for individuals who are first-time estimated taxpayers, provided the balance
due on the tax return is below a threshold amount and is paid with a timely
(3) Penalty waiver should be provided for individual estimated
tax penalties below a de minimis amount, in the range of $10 to $20.
Penalty for failure to deposit
Treasury recommends that few immediate changes be made to the
deposit rules or penalties at this time to provide a sufficient period of time
for changes to the deposit rules enacted by RRA98 to take effect. However,
the penalty for failure to use the correct deposit method should be reduced.
The current-law 10-percent penalty is too severe for this type of error.
Treasury also recommends that, in cases where depositors miss
a deposit deadline by only one banking day, consideration be given to a reduction
in the current penalty rate of two percent to a lower amount, but above an
interest charge for a one-day delay.
Accuracy-related and preparer penalties
The minimum accuracy standards, for disclosed and nondisclosed
tax return positions, should be modified to impose the same standards on taxpayers
and tax return preparers. A significant proportion of taxpayers rely on paid
preparers. Such professionals have dual responsibilities to their client/taxpayers
and to the integrity of the tax system and should be expected to be knowledgeable
and diligent in applying the Federal tax laws.
The minimum accuracy standards should be raised to require a "realistic
possibility of success on the merits" for a disclosed tax return position
and "substantial authority" for an undisclosed return position. The
standards for tax shelter items of noncorporate taxpayers should be higher.
In the case of disclosed positions, substantial authority and a reasonable
and good faith belief that the position had a "more likely than not" chance
of success should be required. For undisclosed positions, substantial authority
should be accompanied by a reasonable and good faith belief based upon a higher
standard of accuracy than the "more likely than not" chance of success
standard. The proposed changes in the accuracy standards would reduce the number
of accuracy standards, impose minimum standards that are higher than current
law litigating standards to discourage aggressive tax reporting, and eliminate
divergence between the standards applicable to taxpayers and tax preparers.
Treasury further recommends consideration of better harmonization
of the substantial understatement and negligence penalties. In many cases,
the standards applicable to the substantial understatement penalty may subsume
the negligence standards. It may be appropriate to consider whether the negligence
penalty should relate only to understatements that do not satisfy the "substantiality" requirement.
In determining the amount of the preparer penalty, consideration
should be given to a fee-based or other approach to more closely correlate
the preparer penalty to the amount of the underlying understatement of tax,
rather than the current-law flat dollar penalty amount.
Finally, Treasury also recommends enactment of the Administration's
Budget proposals that would address penalties applicable to corporate tax shelters
and the determination of "substantiality" for large corporate underpayments.
Penalty for filing a frivolous return
The current-law penalty for filing a frivolous tax return should
be raised from $500 to $1,500, but the IRS should abate the penalty for a first-time
occurrence if a nonfrivolous return is filed within a reasonable period of
time. This penalty amount was last raised in 1982 and significant numbers of
such penalties are assessed. This approach will help bring taxpayers who file
frivolous returns into better compliance.
Failures to file certain information returns with respect
to employee benefit plans
Several penalties currently apply to a qualified retirement plan's
failure to file IRS Form 5500. These penalties should be consolidated into
a single penalty not in excess of a monetary amount per day and not to exceed
a monetary cap per return. This penalty would be waived upon a showing of reasonable
cause. Welfare and fringe benefit plans should be subject to a similar single
Penalty and Interest Abatement
Abatement of interest in situations where taxpayers have reasonably
relied on erroneous written advice of IRS personnel should be available. Treasury
does not recommend further legislative expansion of the provisions permitting
abatement of interest. A distinction exists between the imposition of interest
as a charge for the use of money and penalties as sanctions for noncompliance.
Because of this distinction, abatement of interest should be allowed in more
limited circumstances than for penalties and generally restricted to circumstances
where the IRS may be at fault or where serious circumstances outside the taxpayer's
control result in payment delays. Current law provisions permitting abatement
in circumstances of unreasonable IRS error or delay and in certain other prescribed
circumstances provide sufficient scope for interest abatement at this time.
In addition, taxpayers have recourse to other mechanisms for mitigation of
interest and penalties, such as the offer-in-compromise program, which are
in the early stages of implementing changes after enactment by RRA98.
Consideration of any modification of the current law monetary
limitation on mandatory interest abatement in cases of erroneous refunds should
be coupled with consideration of whether the IRS has adequate means under current
law to recover erroneous refunds. Procedural impediments exist with regard
to the recovery of erroneous refunds by assessment in all cases and litigation
is required in some circumstances.
Other than as described above, Treasury recommends that the IRS
implement administrative improvements to ensure greater consistency in the
application of penalty abatement criteria and enhanced quality review of penalty
The underpayment interest rate (other than the "hot interest" rate)
should be a uniform rate determined by appropriate market rates of interest.
Treasury recognizes that no single rate is the appropriate market rate for
all taxpayers but concludes that, for reasons of fairness and administrability,
a single rate generally should apply to underpayments of tax. The appropriate
rate should be in the range of the Applicable Federal Rate (AFR) plus two to
five percentage points to reflect an average market rate for unsecured loans.
The existing rate differentials between the underpayment and
overpayment rates for corporate underpayments and overpayments, including the "hot
interest" rate on large corporate underpayments, should be retained. Because
of the recent enactment of global interest netting rules, it is premature to
eliminate existing rate differentials.
Treasury does not support an exclusion from income for overpayment
interest paid to individuals. The legislative policy precluding deductions
of consumer interest does not warrant such a change.
Mr. Chairman, the proliferation of corporate tax shelters presents
an unacceptable and growing level of tax avoidance behavior by wasting economic
resources, reducing tax receipts, and threatening the integrity of the tax
system. This morning we have laid out the rationale for our suggested approach
for combating this problem, and discussed why we believe that existing law
does not provide sufficient tools to combat this behavior. We look forward
to working with you and the members of the Committee to address this important
problem, as we have in the past to curb specific abuses.
Treasury strongly supports a penalty and interest regime that
fosters and maintains the current high level of compliance, provides appropriate
costs and sanctions for noncompliance, and provides a reasonable and administrable
degree of latitude for individual taxpayer circumstances and errors.
The proposals made in Treasury's report strike an appropriate
balance among these objectives. Consideration of any legislative change in
the current penalty and interest regime must take into account: (1) behavioral
impact of significant change cannot be predicted with precision, and (2) the
ability of the IRS to administer the new rules in a timely and equitable manner.