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In the last year or two, no issue has rumbled through the tax community more noisily than that of corporate tax shelters. After a long bout of inertia, the Treasury Department took action against tax shelters earlier this year. Describing abusive corporate tax shelters as perhaps “the most serious compliance issue threatening the American tax system today,” Treasury Secretary Lawrence H. Summers in late February announced three sets of temporary IRS regulations aimed at squelching them. The first test of the regulations will occur Aug. 26, the deadline for corporate taxpayers to disclose transactions that exhibit characteristics common to tax shelters. In addition to the disclosure requirement, the IRS is also demanding that promoters register confidential corporate tax shelters and maintain lists of investors in certain transactions. The IRS has finally “dipped its toe in the water,” said Dana L. Trier, a partner at Davis Polk & Wardwell and former Treasury official who was the principal drafter of a New York State Bar Association Tax Section report last year that urged the government to take stronger action against tax shelters. DEVIL IN THE DETAILS The regulations have generated a torrent of commentary from tax advisers, promoters and business clients. Many agree with William J. Wilkins, a partner at Washington, D.C.’s Wilmer, Cutler & Pickering, and one of the vice chairs of the American Bar Association Section of Taxation. In theory, he said, a disclosure requirement is a valid approach to the problem of corporate tax shelters, which can be extremely difficult to detect. At the same time, tax professionals have expressed doubts as to soundness of the IRS’s proposed implementation. “The cons all have to do with how you get there from here,” Wilkins said, adding, “It is ‘the devil is in the details’ problem.” A number of critics contend that the IRS’s definition of “reportable transactions” is simply too broad. The IRS “may find that it has cast a very wide net, wider even than it has anticipated,” said Carol P. Tello, special counsel at Silverstein & Mullens, a Washington, D.C., division of Buchanan Ingersoll, and a former IRS attorney. “If the IRS doesn’t narrow the regulations, it is going to be so busy with opening mail that it won’t have the time to focus on the analysis of the transaction,” said Jeffrey P. Rasmussen, tax counsel to the Tax Executives Institute Inc., a nonprofit organization in Washington, D.C., for corporate tax professionals. Rasmussen expressed another widespread concern that the IRS will “treat the disclosure statement as a red flag” and make an automatic adjustment, rather than analyze the transaction to determine whether it is indeed disallowed. The agency has shown that it is open to suggestions. Over the weekend, in response to comments, it issued revisions to the temporary regulations, which may remain in effect for up to three years. Most significantly, Tello said, it added a de minimus requirement to exempt the smaller “Mom and Pop” types of businesses from the investor lists that tax shelter promoters are required to maintain. COURTS CRACK DOWN Meanwhile, the U.S. Tax Court has displayed a growing impatience with tax shelters, disallowing tax deductions in a string of recent cases for transactions that lacked economic substance or had no real business purpose other than tax savings. “The courts are leaning very hard on tax shelters,” said Robert A. Jacobs, a partner at Milbank, Tweed, Hadley & McCloy LLP and incoming chairman of the New York State Bar Association Tax Section. One Tax Court case, ACM Partnership v. Commissioner, decided in 1997, is commonly regarded as providing the breakthrough ruling. Colgate-Palmolive Co., Merrill Lynch and a Dutch bank formed an offshore partnership that through a complex series of transactions created an artificial capital loss to offset a gain that Colgate had realized from selling a business. The court found the transaction to lack both economic substance and any viable business purpose. The decision “helped blow away some of the narrower readings of the economic substance doctrine,” Wilkins said. Since ACM, the court has continued “raising the bar,” Rasmussen said, siding with the IRS in a series of decisions involving Winn-Dixie, United Parcel Service, Compaq Computer Corp., The Limited and Brunswick Corp. In two of the cases, the Tax Court went even further, imposing penalties on the offending corporation. Last August, Judge Robert P. Ruwe held that UPS had impermissibly inflated its tax deductions for insurance expenses when the money ultimately went to an offshore captive insurance company. The next month, former Chief Judge Mary Ann Cohen disallowed a $3.4 million foreign tax credit taken by Compaq as a “financial fantasy.” In both instances, the Washington, D.C.-based court slapped the companies with a negligence penalty of 20 percent of the taxes in question. Most recently, Congress has also jumped on the anti-tax-shelter bandwagon, with a draft Senate Finance Committee bill that would boost the negligence penalty for understated taxes and subject promoters of tax shelters to penalties as well. Observers do not expect that Congress will act on the bill any time this year. NO QUICK FIXES Corporate tax shelters first blipped onto the radar screen in the late 1980s, but it was not until the mid-90s that the phenomenon “really started to show itself” Trier said, likening it to a “snowball rolling downhill.” Since that time, an entire industry has been built around the selling and legal justification of corporate tax shelters, involving many of the large investment banks, accounting firms and the law firms that service them. Observers blame an uncommonly passive Congress and Treasury Department, the use of value-added fees based on tax savings realized, an overly complex tax system and aggressive marketing and competition among tax shelter promoters. And both promoters and companies have faced very little risk in using tax shelters. “The worst that could happen is that a company had to pay the owed taxes plus interest,” Jacobs said. On the upside, he said, the company might get away with the scheme completely, and even if the IRS caught the scheme, prosecuted and won, such a victory could be years down the road. In the UPS case, for example, it took the IRS 15 years to shoot down the tax deductions. One of the hallmarks of a corporate tax shelter is that, unlike traditional tax planning tailored to a particular client, “the product is designed first and then marketed” to as many clients as possible, Tello explained. The transaction is also characterized by high premium fees and a “very aggressive and relatively weak professional opinion,” Trier said. Under current law, penalties can be avoided if the taxpayer can establish that the tax shelter was used with reasonable cause and in good faith. This can include reliance on a tax practitioner’s opinion. If a company or a promoter does not get a tax opinion to its liking, it may shop around until it does. While most observers would agree that the problem of corporate tax shelters is real and needs to be addressed, consensus collapses on what to do about it. “No one has found the talisman that is going to make tax shelters go away,” Jacobs said. One of the main sticking points is that at the margin, “there is a very fine line between legitimate tax planning and tax shelters,” Tello said. “No one has come up with a definition of corporate tax shelters that works,” Jacobs said. For this reason, he opposes codification of the economic substance doctrine that lies at the heart of the tax shelter analysis, which has been proposed by the Treasury Department and Congress. Wilkins argues that a statute would be redundant: “the tax court has demonstrated that the judicial doctrines have power,” he said. While “perfectly happy to applaud the initiative” shown by the IRS, Trier also remained skeptical that it could come up with a “quick fix.” “We will have this phenomenon forever. Every year you can expect 10 to 15 new concepts,” he said, adding, “The game will be about control.”

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