Taxpayers have a unique opportunity to limit their exposure to the consequences of controversial tax-sheltered transactions
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By Steven Toscher and Charles P. Rettig
Steven Toscher and Charles P. Rettig are principals in Hochman, Salkin, Rettig, Toscher & Perez, P.C., a Beverly Hills firm that specializes in tax litigation and controversy and tax planning.
Deadline for Penalty Waiver Looms
The deadline for the IRS’s recently announced “disclosure initiative” is just around the corner. The initiative provides for the waiver of the accuracy-related penalty under Section 6662 of the Internal Revenue Code that can arise out of tax-sheltered investments and other controversial tax reporting positions. The disclosure initiative provides that taxpayers must make a written disclosure before the earlier of 1) the date the item is raised during an examination, or 2) April 23, 2002. The disclosure initiative and penalty waiver is not likely to be extended nor offered to taxpayers again. Time is of the essence.—S.T. & C.P.R.
Over the past few years, the IRS has instituted an array of enforcement initiatives that are designed to ferret out taxpayers who have entered into what the IRS considers to be questionable tax-sheltered investments and to deter others from proceeding in that direction. In recent months, developments along two fronts have altered the landscape of these transactions and should affect the advice practitioners offer their clients.
The first front is located in the federal courts, where, in some cases, important victories that the IRS won in the Tax Court have been reversed by courts of appeals. These setbacks throw into question the ability of the IRS to rely upon the “business purpose” and “economic substance” doctrines to disallow the benefits of tax-sheltered investments.
On the second front, the IRS, on December 24, 2001, announced a new disclosure initiative that generally allows a taxpayer to avoid accuracy-related penalties if the taxpayer comes forward before the earlier of April 23, 2002, or being identified by the IRS.1 The accuracy-related penalties imposed in connection with these investments can range from 20 percent to 40 percent plus statutory interest on the penalty. Taxpayers involved in tax-sheltered investments or other controversial transactions have a brief window of opportunity to avoid the risk of these penalties. The cost, however, is disclosure of the controversial transaction to the IRS.
The Appellate Courts
Only a year and a half ago, the IRS had established an impressive series of victories in tax shelter litigation, primarily before the U.S. Tax Court. In ACM Partnership v. Commissioner,2 the Tax Court found that the taxpayer’s attempt to utilize the contingent installment payment regulations failed because the transaction lacked any real economic substance. The court found that the transaction was predesigned and entered into solely for tax purposes.
Following ACM, the Tax Court held in UPS Inc. v. Commissioner3 that an offshore captive insurance affiliate was a transactional sham. Next, in Compaq Computer Corporation v. Commissioner,4 the Tax Court held that a “foreign tax credit strip” transaction that was motivated entirely by tax considerations lacked economic substance. Finally, in Winn-Dixie Storage Inc. v. Commissioner,5 the Tax Court held that a leveraged corporate-owned life insurance transaction lacked economic substance and business purpose. Two of these decisions were affirmed by courts of appeals. The Third Circuit affirmed, for the most part, the ACM decision.6 Similarly, the Eleventh Circuit affirmed the Tax Court’s Winn-Dixie decision.7
More recently, however, courts of appeals and one federal district court have reversed the trend and have given taxpayers meaningful victories in tax shelter litigation. In UPS v. Commissioner,8 the Court of Appeals for the Eleventh Circuit reversed the Tax Court’s findings that a captive insurance affiliate was a transactional sham and allowed UPS to exclude from income shipping charges paid to the offshore insurance company. The court found that the structure served a valid business purpose.
The Tax Court’s decision in Compaq Computer v. Commissioner was also reversed.9 The Court of Appeals for the Fifth Circuit disagreed with the Tax Court’s findings that the transactions lacked business purpose and economic substance. Similarly, in I.E.S. Industries, Inc. v. United States,10 the Eighth Circuit reversed the district court’s finding that a foreign tax credit strip transaction (one similar to the Compaq transaction) did not have economic substance or a valid business purpose. Finally, in Bocca Investerings Partnership v. United States,11 the Federal District Court for the District of Columbia found that a transaction substantially identical to the contingent installment sale transaction in ACM had economic substance and should be recognized for tax purposes.
The mixed results of these appellate court decisions are a result of the extreme complexity of tax-sheltered investments, which are often premised upon technical applications of the tax law. Recent litigation has focused on the meaning of the judicial doctrines of “economic substance” and “business purpose.” These terms, judicial glosses on the Internal Revenue Code, are designed to deal with taxpayers who apply various sections of the code in a strictly literal matter that may or may not match the intention of Congress. One, therefore, should not be surprised that members of the judiciary would disagree on the application of the economic substance and business purpose doctrines to any particular set of facts and circumstances. The application of these judicial doctrines and the tension inherent in their application suggest that there will be continued disagreements.
This uncertainty is perhaps best illustrated by the decision in the Compaq case. In Compaq, the taxpayer entered into the purchase of Royal Dutch American Depository Receipts (ADRs) prior to their dividend record date and was therefore entitled to the dividend paid by Royal Dutch, subject to a Netherlands withholding tax. The benefit to the taxpayer was twofold. First, because the Royal Dutch ADRs were sold after the dividend record date, they sold for a lesser amount (without the dividend), and the taxpayer generated a capital loss. This loss was used to offset a capital gain reported for an unrelated transaction. Second, the Netherlands foreign tax withholding generated a foreign tax credit that could be utilized by the taxpayer.
The Tax Court concluded that the transaction lacked economic substance and was motivated solely by tax considerations. In some rather strong language condemning the transaction, the Tax Court concluded that the transaction had no purpose other than to “minimize taxes[, which] does not include the right to engage in financial fantasies with the expectation that the IRS and courts will play along.”12 On appellate review, however, the Fifth Circuit disagreed and, in equally strong language, condemned the position of the IRS and the Tax Court as an effort to “stack the deck” against the taxpayer.13
At the heart of the dispute is the application of the economic substance and business purpose doctrines and how these doctrines should be applied in a given circumstance. The Fifth Circuit started its analysis in Compaq with the most recent U.S. Supreme Court interpretation of the economic substance doctrine. In Frank Lyon Company v. United States,14 the Supreme Court stated that when “there is a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached, the Government should honor the allocation of rights and duties effectuated by the parties.”15 The Fifth Circuit also noted, citing its decision in Merryman v. Commissioner,16 that “[t]he existence of a tax benefit resulting from a transaction does not automatically make it a sham as long as the transaction is imbued with tax independent considerations.”
The Fifth Circuit looked to the Fourth Circuit’s 1985 decision in Rice’s Toyota World Inc. v. Commissioner,17 which contains a well-recognized analysis of the economic substance and business purpose doctrines. Rice’s Toyota World held that in order “to treat a transaction as a sham, the Court must find the taxpayer was motivated by no business purpose other than obtaining tax benefits in entering the transaction, and the transaction had no economic substance because no reasonable possibility of profit exists.”18 In Compaq, the Fifth Circuit noted that the Third Circuit’s formulation in ACM was somewhat different, indicating that business purpose and reasonable possibility of profit were merely factors to be considered in determining whether the transaction is a sham.19 The Fifth Circuit did not resolve which view to adopt because it concluded that the Compaq ADR transaction had both economic substance and a business purpose.
In reaching this conclusion, the Fifth Circuit found highly persuasive the Eighth Circuit’s decision in I.E.S. Industries, Inc. v. United States.20 In that decision the Eighth Circuit held that an ADR transaction similar to the one in Compaq was not a sham for income tax purposes. The I.E.S. Court undertook the two-step inquiry set out in Rice’s Toyota World and concluded that both economic substance and business purpose were present and that it did not have to decide the question of whether the transaction would be considered a sham if only economic substance or a business purpose, but not both, was present.
A significant element in the Fifth Circuit’s decision was its lack of any constraint when reviewing a trial court’s determination that a transaction lacked economic substance. Citing its own previous decision in Killingsworth v. Commissioner,21 the Fifth Circuit concluded that “legal conclusion[s] that transactions are shams in substance are reviewed de novo.”
In Compaq, the Fifth Circuit had little difficulty finding economic substance to the transaction, concluding that the manner in which the IRS and the Tax Court analyzed the profit potential was inconsistent and “stacked the deck” against the taxpayer. The Fifth Circuit noted that the Tax Court erred by failing to include Compaq’s $3.4 million U.S. tax credit when it calculated Compaq’s after-tax profit. The court noted that this omission taints the Tax Court’s conclusion that the net economic loss from the transaction after tax was about $1.5 million. The court noted that “if the effects of tax law, domestic or foreign, are to be accounted for when they subtract from the transaction’s net cash flow, tax law effects should be counted when they add to cash flow. To be consistent, the analysis should either count all tax law effects or not count any of that. To count them only when they subtract cash flow is to stack the deck against finding the transaction profitable.”22 If the effects of the transaction are determined consistently according to the Fifth Circuit, Compaq made both a pretax profit and an after-tax profit from the ADR transaction.
Although the Tax Court found that the parties attempted to minimize the risks incident to the transaction, the Fifth Circuit found that risks did exist and were not by any means insignificant. The appellate panel found it significant that the transaction occurred in a public market (an environment not controlled by the taxpayer), the market prices of the ADRs could have changed, individual trades could have been broken up or executed incorrectly, and the dividend might not have been paid or might have been paid in an amount different than anticipated. The court noted that “the absence of risk that can legitimately be eliminated does not make the transaction a sham.”23 This analysis distinguished Compaq from the Fifth Circuit’s prior decisions that found sham transactions in situations in which there had been no independent third parties or independent market risk.24
Compaq, EIS, Bocca, and UPS illustrate the inherent difficulty and subjectivity in applying the economic substance and business purpose doctrines. The trial courts concluded that the transactions at issue were structured solely for tax purposes and were not within the allowable parameters of tax planning. The circuit courts felt otherwise.
These cases will by no means end the discussion. The IRS, the appellate courts, and perhaps even a case in the Supreme Court, can be expected to bring more clarity to the application of these doctrines. In the meantime, while the law rests in this area of uncertainty, the IRS has indicated that “litigation remains an important part of the agency’s strategy.”25 The ultimate answer, however, may come from Congress, which has the authority to make legislative changes in the Internal Revenue Code. Indeed, the Enron controversy may breathe new life into legislative efforts. Senator Charles Grassley recently said that “the Enron debacle gives Congress an opportunity to pass legislation…that it otherwise might not have had.”26
The Disclosure Initiative
On December 24, 2001, the Internal Revenue Service announced a disclosure initiative aimed at encouraging taxpayers to disclose tax-sheltered investments and other controversial items reported on their tax returns.27 The disclosure initiative is one of many steps the IRS and the Treasury Department have taken in the last two years to identify, scrutinize, and deter tax-sheltered investment activities. One of the rationales, according to Larry Langdon, commissioner of the IRS Large and Midsize Business Division, is that “these taxpayers are aware that those transactions may be challenged upon an IRS audit, but they may be reluctant to disclose a transaction because of the potential for the application of penalties. They now have additional incentive to bring any questionable transaction to the IRS’[s] attention.”28
When the taxpayer makes a timely and accurate disclosure, the IRS will waive potential accuracy-related penalties for underpayment of tax attributable to 1) negligence, 2) substantial understatement of income tax, 3) certain substantial valuation misstatements, or 4) substantial overstatement of pension liabilities. These penalties range from 20 percent to 40 percent of the underpayment of tax plus statutory interest on the penalty.29
The required disclosure must occur before the earlier of the item being raised during an examination or April 23, 2002. For purposes of the disclosure initiative, an issue is raised during an examination if the examiner communicates to the taxpayer knowledge about the specific item, or on or before December 21, 2001, the examiner has made a request to the taxpayer for information, and the taxpayer could not make a complete response to that request without giving the examiner knowledge of the specific item. The IRS recently announced that on April 24, 2002, the day after the current disclosure deadline, its agents will be required to use new standardized Information Document Requests (IDRs) designed to force disclosure of tax-sheltered investments.30
The disclosure initiative not only covers what might be considered tax shelter transactions; it also includes any controversial item on a taxpayer’s tax return and applies to both individuals and corporations. There are, however, certain exclusions from the disclosure initiative. The disclosure initiative will not apply to transactions that:
1) Did not in fact occur in whole or in part, but for which the taxpayer claimed a tax benefit on its return.
2) Involved the taxpayer’s fraudulent concealment of the amount or source of any item of gross income.
3) Involved the taxpayer’s concealment of its interest in or signature or other authority over a financial account in a foreign country.
4) Involved the taxpayer’s concealment of a distribution from, a transfer of assets to, or that the taxpayer was a grantor of, a foreign trust.
5) Involved the treatment of personal, household, or living expenses as deductible trade or business expenses.31
The penalty waiver also will be applied in the case of certain IRC Section 482 transfer price adjustments if the documentation standards of IRC Section 6662(e)(3)(B) are met. Finally, the announcement makes it clear that the initiative does not affect whether the IRS will impose, as appropriate, any other civil penalty that may be applicable under the Internal Revenue Code or investigate any associated criminal conduct or recommend prosecution for violations of any criminal statute.32
The contents of the required disclosure are significant. Under IRS Announcement 2002-2, the taxpayer must provide the following:
(1)A statement describing the material facts of the item;
(2)A statement describing the taxpayer’s tax treatment of the item;
(3)The taxable years affected by the item;
(4)If the taxpayer is a coordinated industry case (“CIC”) taxpayer, a statement that the taxpayer will agree to address the disclosed item under the Accelerated Resolution process described in Rev. Proc. 94-67, 1994-2 C.B. 800, if requested to do so by the IRS;
(5)The names and address of (a) any parties who promoted, solicited or recommended the taxpayer’s participation in the transaction underlying the item and who had a financial interest, including the receipt of fees, in the taxpayer’s decision to participate; and (b) if known to the taxpayer, any parties who advised the promoter, solicitor, or recommender with respect to the transaction;
(6)A statement agreeing to provide, if requested, copies of the following:
(a)All transactional documents, including agreements, contract instruments, schedules, and if the taxpayer’s participation in the transaction was promoted, solicited or recommended by any other party, all material received from that other party or that party’s advisors;
(b)All internal documents and memoranda used by the taxpayer in its decision making process, including, if applicable, information presented to the taxpayer’s board of directors; and
(c)All opinions and memoranda that provide a legal analysis of the item, whether prepared by the taxpayer or a tax professional on behalf of the taxpayer; and
(7)A penalty of perjury statement that the person signing the disclosure has examined the disclosure and to the best of the person’s knowledge and belief, the information provided as part of the disclosure contains all relevant facts and is true, correct and complete. In the case of an individual taxpayer, the declaration must be signed and dated by the taxpayer, and not the taxpayer’s representative. In the case of a corporate taxpayer, the declaration must be signed and dated by the officer of the corporate taxpayer who has personal knowledge of the facts. If the corporate taxpayer is a member of an affiliated group filing consolidated returns, a penalties of perjury statement must also be signed, dated and submitted by an officer of the common parent of the group. The person signing for a trust, state law partnership or a limited liability company must be, respectively, a trustee, general partner or member manager who has personal knowledge of the facts. A stamped signature is not permitted.
Taxpayers who were not under an IRS examination as of December 21, 2001, must send the disclosure information to the Office of Tax Shelter Analysis, 1111 Constitution Avenue, NW, Washington, DC 20224. If the taxpayer was under examination as of that date, the information must be submitted to the examiner with copies sent to the Office of Tax Shelter Analysis at the above address. A CIC taxpayer must submit the disclosure information to the assigned team manager and send a copy of the information to the Office of Tax Shelter Analysis.
One controversial aspect of the disclosure initiative is the requirement to disclose to the IRS, if requested, legal opinions concerning the transaction that might otherwise be privileged.33 While the IRS has indicated it may be clarifying this requirement,34 some form of disclosure of the legal analysis involved with the tax shelter transaction will be required. Commissioner Langdon stated the IRS is looking for “the most robust opinion the taxpayer relied on” and that the IRS is “entitled to the opinion relied on to take a position on a tax return[,]…but we think it’s inappropriate to ask for advice given after the return is filed.”35
The penalty waiver is about as close as the IRS has come over the years to an amnesty—at least an amnesty relating to certain civil penalties. Fundamental questions remain, such as which taxpayers should make the disclosure and what will be the impact of the disclosure initiative on the government’s enforcement efforts.
In answering the first question, taxpayers and their advisers need to make a realistic assessment of the taxpayers’ financial exposure to civil penalties, bearing in mind that while there are valid defenses to the application of penalties,36 the courts have not hesitated to impose penalties in appropriate circumstances. These penalties would normally be 20 percent of the resulting tax deficiency plus statutory interest on the penalty, but in the case of certain overvaluations (which may include claims of excessive basis) penalties can be 40 percent of the tax deficiency plus interest.37 Taxpayers also need to consider the likelihood that they will lose the “audit lottery,” and the IRS will discover their questionable transactions. Some taxpayers who have engaged in these investments may not wish to give up their anonymity if the risk of the IRS finding and examining the transaction is highly speculative. On the other hand, if it is likely that the investment will be examined by the IRS, a timely disclosure may result in giving up very little in exchange for relief from potential penalties.
The effect that the disclosure initiative will have on IRS enforcement activities is unclear. The IRS felt the need to provide an inducement to taxpayers to come forward in its effort to ferret out undiscovered tax-sheltered investments that have not otherwise been discovered through existing enforcement efforts. The disclosure by one client who invested in a particular financial product could ultimately trigger the examination of other investors in the product who did not disclose the transaction. Thus, additional enforcement activity and broader examination coverage seems likely.
Disclosing a controversial transaction does not mean that a taxpayer forgoes the right to defend the transaction’s legality. In fact, those taxpayers who have disclosed and thereby avoided the risk of penalties may have less of an inducement to settle the matter with the IRS, since the taxpayers will only be faced with the costs of litigation if they choose to pursue the matter in court and wind up losing. With the economic club of penalties removed, the IRS may be required to resolve these cases on a basis more favorable to the taxpayer or face litigation throughout the country.
Taxpayers who have not made disclosures should anticipate that the IRS will use the penalties as an economic inducement to resolve the case. Over the years, the IRS has often negotiated appropriate relief from penalties as part of a resolution of questionable tax issues, and in cases where there has been no disclosure, the IRS may take a tougher position on the applicability of penalties. It is simply not clear what policies the IRS will follow in these cases.
The IRS no doubt will reassess the vitality of the economic substance and business purpose doctrines as its primary weapon of war. The IRS has stated that “a taxpayer has a much better chance than a year ago” of working with the IRS to resolve tax disputes.38 The disclosure initiative also offers taxpayers a unique opportunity—what Langdon called “a once in a lifetime opportunity”—that will not be offered again.39 This opportunity may not be advantageous for every taxpayer who is involved in a tax-sheltered investment or certain other controversial transactions, but in the proper circumstance, it may significantly reduce a major economic risk and allow a more appropriate focus on the merits of the transactions, leading to a more prompt and fair resolution of these disputes.
1 I.R.S. Announcement 2002-2, I.R.B. 2002-2 (Jan. 14, 2002). See also I.R.S. News Release, IR 2001-121.
2 ACM P’ship v. Commissioner, T.C. Memo 1997-115, aff’d in part and rev’d in part, 157 F. 3d 231 (3d Cir. 1998), cert. denied, 119 S. Ct. 1251 (1999).
3 UPS Inc. v. Commissioner, T.C. Memo 1999-268.
4 Compaq Computer Corp. v. Commissioner, 113 T.C. 214 (1999).
5 Winn-Dixie Storage Inc. v. Commissioner, 113 T.C. 254 (1999).
6 ACM P’ship v. Commissioner, 157 F. 3d 231 (3d Cir. 1998), cert. denied, 119 S. Ct. 1251 (1999). More recently, the Court of Appeals for the District of Columbia affirmed a Tax Court ruling disallowing the tax benefits of a transaction similar to the one in ACM. See ASA Investerings P’ship v. Commissioner, 201 F. 3d 505 (D.C. Cir. 2000).
7 Winn-Dixie Storage Inc. v. Commissioner, 254 F. 3d 1313 (11th Cir. 2001).
8 UPS v. Commissioner, 254 F. 3d 1014 (11th Cir. 2001), 2001-2 U.S.T.C. 5475.
9 Compaq Computer Corp. v. Commissioner, 277 F. 3d 778 (5th Cir. 2001), 2002-1 U.S.T.C. 50,144, reversing 113 T.C. 214 (1999).
10 I.E.S. Indus., Inc. v. United States, 253 F. 3d 350 (8th Cir. 2001).
11 Bocca Investerings P’ship v. United States, 167 F. Supp. 2d 298 (D. D.C. 2001).
12 Compaq Computer Corp. v. Commissioner, 113 T.C. at 221 (quoting Saviano v. Commissioner, 765 F. 2d 643, 654 (7th Cir. 1985)).
13 Compaq Computer, 277 F. 3d 778, 785.
14 Frank Lyon Co. v. United States, 435 U.S. 561, 581, 98 S. Ct. 1291 (1978).
15 Id., 435 U.S. at 583-84.
16 Merryman v. Commissioner, 873 F. 2d 879, 881 (5th Cir. 1989).
17 Rice’s Toyota World Inc. v. Commissioner, 752 F. 2d 89 (4th Cir. 1985).
18 Id. at 91.
19 ACM P’ship v. Commissioner, 157 F. 3d 231, 237 (3d Cir. 1998) (“These distinct aspects of the economic sham inquiry did not constitute discrete prongs of a ‘rigid two-step analysis,’ but rather represent related factors both of which inform the analysis of whether the transaction had sufficient substance, apart from the tax consequences to be respected for tax purposes.”).
20 I.E.S. Indus., Inc. v. United States, 253 F. 3d 350 (8th Cir. 2001).
21 Killingsworth v. Commissioner, 864 F. 2d 1214, 1217 (5th Cir. 1989). See also Frank Lyon Co. v. United States, 435 U.S. 561, 581, n. 16, 98 S. Ct. 1291, 1302, n. 16.
22 Compaq Computer Corp. v. Commissioner, 277 F. 3d 778, 785 (5th Cir. 2001).
24 Freytag v. Commissioner, 904 F. 2d 1011 (5th Cir. 1990), aff’d on other grounds, 501 U.S. 868, 111 S. Ct. 2631 (1991) (The taxpayer’s investment agents “have absolute authority over pricing and timing of transactions which occurred in a self-contained market of its own making.”).
25 New Standardized IDR Designed to Force Tax Shelter Disclosures, Daily Tax Rep. (BNA) (Feb. 13, 2002).
26 Grassley Pension Plan Would Tax Corporate Stock Sales during Blackouts, Tax Day (CCH) (Feb. 27, 2002). For a brief summary of previous legislative activity, see Steven Toscher & Bruce I. Hochman, The Multifront War against Corporate Tax Shelters, Los Angeles Lawyer, Nov. 2000, at 19.
27 I.R.S. News Release, IR 2001-121 (Dec. 24, 2001).
29 I.R.C. §6662.
30 New Standardized IDR Designed to Force Tax Shelter Disclosures, Daily Tax Rep. (BNA) (Feb. 13, 2002).
31 I.R.S. Announcement 2002-2, supra note 1.
34 IRS Considering Additional Guidance on Shelter Penalty Waivers, Daily Tax Rep. (BNA) (Jan. 22, 2002).
36 See I.R.C. §6664(c). I.R.S. Announcement 2002-2, supra note 1, expressly provides that “taxpayers who do not disclose under this initiative are not prevented from demonstrating that they satisfy the reasonable cause exception under §6664(c).…”
37 I.R.C. §6662.
38 New Standardized IDR Designed to Force Tax Shelter Disclosures, Daily Tax Rep. (BNA) (Feb. 13, 2002).
39 IRS Considering Additional Written Guidance on Shelter Penalty Waivers, Daily Tax Rep. (BNA) (Jan. 22, 2002).