Statement of Kenneth J. Kies, Managing Partner
Washington National Tax Services, PricewaterhouseCoopers, Washington, D.C.

Testimony Before the House Committee on Ways and Means

Hearing on Revenue Provision in President's Fiscal Year 2000 Budget

March 10, 1999

I. Introduction

PricewaterhouseCoopers appreciates the opportunity to submit this written testimony to the Committee on Ways and Means on the revenue-raising proposals included in the Administration's FY 2000 budget submission.

PricewaterhouseCoopers, the world's largest professional services organization, provides a full range of business advisory services to corporations and other clients, including audit, accounting, and tax consulting. The firm, which has more than 6,500 tax professionals in the United States and Canada, works closely with thousands of corporate clients worldwide, including most of the companies comprising the Fortune 500. These comments reflect the collective experiences of many of our corporate clients.

Our testimony focuses on broad new measures proposed by the Administration relating to "corporate tax shelters." Specifically, these include proposals that would (1) modify the substantial understatement penalty for corporate tax shelters; (2) deny certain tax benefits to persons avoiding income tax as a result of "tax-avoidance transactions"; (3) deny deductions for certain tax advice and impose an excise tax on certain fees received with respect to "tax-avoidance transactions"; (4) impose an excise tax on certain rescission provisions and provisions guaranteeing tax benefits; (5) preclude taxpayers from taking tax positions inconsistent with the form of their transactions; and (6) tax income from corporate tax shelters involving "tax-indifferent parties."(1)

In our view, these proposals are overreaching, unnecessary, and at odds with sound tax policy principles. They introduce a broad and amorphous definition of a "corporate tax shelter" that could be used by Internal Revenue Service (Service) revenue agents to challenge many legitimate transactions undertaken by companies operating in the ordinary course of business in good-faith compliance with the tax laws. If enacted by Congress, these proposals would represent one of the broadest grants of authority ever given to the Treasury Department in the promulgation of regulations and, even more troubling, to Service agents in their audits of corporate taxpayers.

A. Initial observations.

1. Revenue data shows no erosion of the corporate tax base.

Before turning to our specific concerns with the Administration's proposals, it is worthwhile to consider several important points. First, these proposals have arisen in response to a perception at the Treasury Department that tax-planning activities are eroding the corporate tax base.(2) The facts suggest otherwise. Corporate income tax payments reached $189 billion in 1998 and are projected by the Congressional Budget Office (CBO) to grow to $267 billion in the next 10 years.(3) Projections by the CBO and the Office of Management and Budget (OMB) show that these corporate revenues will remain relatively stable as a share of the overall economy in the coming years. There is no data in the projections of CBO or OMB to suggest that corporate tax activity will cause corporate tax revenues to decline in the future.

Moreover, corporate income tax receipts as a percentage of taxable corporate profits stood at 32.4 percent in 1998 and are projected to remain relatively constant over the next 10 years (32.5 percent in 2008). (4) This is approximately the effective tax rate that would result by subjecting all corporate taxable income to the graduated corporate tax rate schedule, which taxes income at rates starting at 15 percent and increasing to the top statutory rate of 35 percent.(5) The CBO measure of the corporate tax base is based, with minor modifications, on the economic profits measured by the national income and product accounts rather than income reported for tax purposes. As a result, there is nothing in this forecast to suggest that the corporate tax base is under assault from an imagined new "market" in corporate tax shelters.

In fact, during the past four years corporate income tax payments as a percentage of gross domestic product have reached their highest levels since 1980. (6)

2. The proposals are inconsistent with the Congressional view that the scope of Treasury Department authority should be limited.

The Administration's proposals run counter to the spirit of recent Congressional actions. In last year's landmark Internal Revenue Service Restructuring and Reform Act,(7) Congress enacted significant new limitations on the authority of Service agents in audit situations. Now, a mere eight months later, the Administration is asking Congress to empower agents with broad authority to "deny tax benefits" where they see fit.

In last year's Administration budget (for FY 1999), Treasury asked for expansive authority to "set forth the appropriate tax results" and "deny tax benefits" in hybrid transactions(8) and in situations involving foreign losses.(9) Congress dismissed these proposals. The FY 2000 budget proposals now ask for authority of the same type but significantly broader than the authorization that Congress rejected just last year. The Treasury's new proposals thus can be seen as an attempted end run around earlier failed initiatives - this time accompanied by the shibboleth of "stopping tax shelters."

3. Congress in the past has taken actions to stop perceived tax shelter abuses when necessary.

Congress has been alert to perceived tax shelter issues and has taken a series of actions in the past. In fact, Congress in 1997 enacted legislation(10) broadening the definition of a "tax shelter" subject to stiff penalties under the Internal Revenue Code and requiring that such arrangements be reported in writing to the Service.(11) The Joint Committee on Taxation's "Blue Book" explanation discusses the intent underlying these changes:(12)

The Congress concluded that the provision will improve compliance with the tax laws by giving the Treasury Department earlier notification than it generally receives under present law of transactions that may not comport with the tax laws. In addition, the provision will improve compliance by discouraging taxpayers from entering into questionable transactions.

Nineteen months later, the Treasury Department has yet to implement the new tax shelter reporting rules. To provide fair notice to taxpayers, Congress made the effective date of these provisions contingent upon Treasury's issuing guidance on the new requirements. But as of this date, no such guidance has been issued. It is totally inappropriate from the standpoint of sound tax policy that Treasury at this time would request expanded authority to address the issue of tax shelters when it has eschewed recent authority explicitly granted by the Congress on the identical issue.(13)

Moreover, the Administration's penalty proposals come at the same time that Treasury and the Joint Committee on Taxation, as required by the 1998 Internal Revenue Service Restructuring and Reform Act, are conducting studies reviewing whether the existing penalty provisions are "effective deterrents to undesired behavior."(14) These studies, which are required to be completed by this summer, are to make any legislative and administrative recommendations deemed appropriate. The Treasury proposals, if enacted, would preempt the careful penalty review process that was designed by the Congress last year.

Meanwhile, Congress and Treasury successfully have worked together to identify specific situations where the tax laws are being applied inappropriately and to enact quickly substantive tax-law changes in response. Recent examples include legislation enacted or introduced relating to liquidations of REITs or RICs(15) and transfers of assets subject to liabilities under section 357(c).(16) The Administration's FY 2000 budget proposes a series of specific changes in a number of other areas. Whether or not the tax policy rationales given by Treasury for these targeted proposals are persuasive, the appropriate manner in which to curb avoidance potential is for Congress to deliberate upon specific legislative proposals, and not to grant broad and unfettered authority to Treasury and Service revenue agents.

Finally, it should be mentioned that the broad grant of authority in the Treasury Department tax shelter proposals is totally unnecessary. On several occasions in recent years, Treasury has determined that administrative actions were necessary to stop certain perceived avoidance transactions.(17) While we may not agree that Treasury's action was appropriate in each instance that such action was taken, it is clear that no further grant of authority is necessary or warranted from the Congress on these matters.

B. Outline of comments.

These comments set forth a number of key considerations that should be weighed by Congress in evaluating the Administration's corporate tax shelter proposals:

First, we discuss each of the Administration's corporate tax shelter proposals, offering a brief critique and analysis on tax policy grounds.

Second, we explore the potential detrimental impact of the Administration's proposals on an illustrative series of legitimate business transactions.

Third, we analyze the existing tools that are available to the Treasury Department and the Internal Revenue Service - and Congress - to address tax shelters and other perceived abuses under the tax system. This discussion includes an explanation of current-law penalty and disclosure rules; specific anti-abuse rules; common-law doctrines (e.g., "economic substance" and "substance over form") that may be invoked; and opportunities to address abuses through legislative action.

Fourth, we discuss the vital role played by corporations in administering U.S. tax laws - while dealing with their complexity - and the important responsibilities of corporate tax directors to their shareholders. These roles and responsibilities are often overlooked during consideration of U.S. corporate income tax policy.

Finally, we discuss the role played by accounting firms in advising corporations on tax issues.


Modify substantial understatement penalty for corporate tax shelters.

Treasury proposal.

The proposal generally would increase the penalty applicable to a substantial understatement by a corporate taxpayer from 20 percent to 40 percent for any item attributable to a "corporate tax shelter," effective for transactions occurring on or after the date of first committee action. In addition, the present-law reasonable cause exception from the penalty would be repealed for any item attributable to a corporate tax shelter.

A "corporate tax shelter" would be defined as any entity, plan, or arrangement (to be determined based on all facts and circumstances) in which a direct or indirect corporate participant attempts to obtain a tax benefit in a tax avoidance transaction. A "tax benefit" would be defined to include a reduction, exclusion, avoidance, or deferral of tax, or an increase in a refund, but would not include a tax benefit "clearly contemplated by the applicable provision (taking into account the Congressional purpose for such provision and the interaction of such provision with other provisions of the Code)."

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, a tax avoidance transaction would be defined to cover certain transactions involving the improper elimination or significant reduction of tax on economic income.

2. Analysis.

This proposal is overbroad, unnecessary, and totally inconsistent with the goals of rationalizing penalty administration and reducing taxpayer burdens.

First, the proposal creates the entirely new and vague concept of a "tax avoidance transaction." The first prong of the definition of a tax avoidance transaction is styled as an objective test requiring a determination of whether the present value of the reasonably expected pre-tax profit from the transaction is insignificant relative to the present value of the reasonably expected tax benefits from the transaction. However, the inclusion of so many subjective concepts in this equation precludes its being an objective test. As an initial matter, what constitutes the "transaction" for purposes of this test? Next, what are the parameters for "reasonable expectation" in terms of both pre-tax economic profit and tax benefits? Further, where is the line drawn regarding the significance of the reasonably expected pre-tax economic profit relative to the reasonably expected net tax benefits?

Not only is this prong of the test extremely vague, the uncertainty is compounded by the second prong of the definition of tax avoidance transaction. Under this alternative formulation, certain transactions involving the improper elimination or significant reduction of tax on economic income would be considered to be tax avoidance transactions even if they did not satisfy the profit/tax benefit test described above. The inclusion of this second prong renders the definition entirely subjective, with virtually no limit on the Service's discretion to deem a transaction to be a tax avoidance transaction.

Second, elimination of the reasonable cause exception would result in situations where a revenue agent is compelled to impose a 40-percent penalty even though the agent determines that (1) there is substantial authority supporting the return position taken by the taxpayer, and (2) the taxpayer reasonably believed (based, for example, on the opinion or advice of a qualified tax professional) that its tax treatment of the item was more likely than not the proper treatment. If, in that situation, a revenue agent concluded it would be appropriate to "waive" the penalty, the agent could do so only by determining that the transaction in question was not a corporate tax shelter, i.e., that the increased penalty was not applicable. Over time, one clearly unintended consequence of forcing revenue agents to make such choices might be a skewed definition of the term "tax shelter."

The automatic nature of the proposed increased penalty would alter substantially the dynamics of the current process by which the vast majority of disputes between the Service and corporate taxpayers are resolved administratively. Today, even where a corporation and the Service agree that there is a substantial understatement of tax attributable to a tax shelter item, the determination as to whether the substantial understatement penalty should be waived for reasonable cause continues to focus on the merits of the transaction and the reasonableness of the taxpayer's beliefs regarding those merits. If, however, the reasonable cause exception no longer were available, the parties necessarily would have to focus on whether the transaction in question was a "tax avoidance transaction" and other definitional issues unrelated to the underlying merits of the transaction.

Stripping revenue agents of their discretion to waive penalties for reasonable cause would make it more difficult for the Service to achieve its objective of resolving cases at the lowest possible level. Unnecessary litigation also would result. In many cases, the size of the penalty and the absence of flexibility regarding its application could compel the taxpayer to refuse to concede or compromise its position on the merits of the issue, since only by prevailing on the merits could the taxpayer avoid the penalty. Moreover, the mere availability of such an onerous penalty may cause some revenue agents to threaten its assertion as a means of exacting unrelated (and perhaps unwarranted) concessions from the taxpayer. Clearly, the use of the increased substantial understatement penalty as a "bargaining chip" is not appropriate or warranted for the proper determination of tax liability of a corporation and the efficient administration of the examination process.

Increasing the penalty on substantial understatements that result from corporate tax shelters to 40 percent also would be inconsistent with the Service's published policy regarding penalties. Policy Statement P-1-18 states that "[p]enalties support the Service's mission only if penalties enhance voluntary compliance." Similarly, Internal Revenue Manual (20)122 provides that "[t]he fundamental reason for having penalties is to support and encourage voluntary compliance." Thus, the Service's principal purpose in asserting penalties is not to punish, but rather to ensure and enhance voluntary compliance. The imposition of a 40-percent substantial understatement penalty in situations where under current law reasonable cause would be found to exist would punish taxpayers that in fact are in compliance with the tax laws.

Creating new penalties -- especially ones whose applicability depends on whether a particular transaction meets an inexact definition -- would put too many revenue agents in a position of having to interpret statutes, rules, and regulations unrelated to the substance of the issue or transaction in question. Based on our experience, it is likely that many agents would find it easier and less risky to assert the new penalty rather than expose themselves to being second-guessed by others at the Service as to whether the penalty was applicable. Accordingly, pressures on revenue agents may cause the new penalty to be asserted initially in far too many circumstances than are warranted.

Further, the Service historically has had significant difficulty administering civil tax penalties fairly and consistently among regions, service centers, district offices, and functions. Those difficulties resulted in the Commissioner's establishing a task force in 1987 to study civil tax penalties, the issuance of a report by that task force in February 1989, a legislative overhaul of the Code's penalty provisions in 1989,(18) and the creation and issuance of the Consolidated Penalty Handbook as part of the Internal Revenue Manual.

It is evident that Congress believes there is room for significant further improvement and clarity in the administration of penalties. As discussed above, the Internal Revenue Service Restructuring and Reform Act of 1998 requires the Joint Committee on Taxation and the Treasury Department to conduct separate studies regarding whether the current civil tax penalties operate fairly, are effective deterrents to undesired behavior, and are designed in a manner that promotes efficient and effective administration.(19) The Joint Committee and Treasury will make whatever legislative and administrative recommendations they deem appropriate to simplify penalty administration and reduce taxpayer burden. With these important studies in process at this time, this legislative proposal to increase the substantial understatement is ill-conceived and unwarranted.

Deny certain tax benefits to persons avoiding income tax as a result of tax-avoidance transactions.

1. Treasury proposal.

The proposal would expand the current-law rules in section 269 to authorize Treasury to disallow a deduction, credit, exclusion, or other allowance obtained in a "tax avoidance transaction" (as defined above). The proposal would be effective for transactions entered into on or after the date of first committee action.

2. Analysis.

In crafting this proposal, Treasury has disregarded the off-quoted observation of Judge Learned Hand that taxpayers are entitled to arrange their business affairs so as to minimize taxation and are not required to choose the transaction that results in the greatest amount of tax.(20) Under the Treasury proposal, even though a taxpayer's transaction has economic substance and legitimate business purpose, the Service would be empowered to deny the tax savings to the taxpayer if another route of achieving the same end result would have resulted in the remittance of more tax.

Essentially, this proposal would grant unfettered authority to the Service to determine independently whether a taxpayer is engaging in a transaction defined as a "tax avoidance transaction," and, based on that determination, to disallow any deduction, credit, exclusion, or other allowance obtained by the taxpayer. A tax avoidance transaction would be defined to include a transaction involving the "improper elimination" or "significant reduction" of tax on economic income. In other words, if the Service believed for any reason that the taxpayer had structured a transaction that yields too much in tax savings, it would have the power to strike it down. This power could be invoked without regard to the legitimacy of the taxpayer's business purposes for entering into the transaction or the economic substance underlying the transaction. In other words, if the transaction is too tax efficient, then it simply would not be permitted by the Service.

The Administration states that this proposed enormous expansion of the current section 269 rules must be adopted because the current-law restrictions only apply to the acquisition of control or the acquisition of carryover basis property in a corporate transaction. It is important to place the current rules in context. The statutory rule has been in the tax law since 1943. Congress at that time was concerned that corporations were trafficking in net operating losses and excess profits credits.(21) The statute is focused on acquisitions of corporate control and nontaxable corporate reorganizations that produce tax advantages following the combination that were not independently available to the parties prior to the combination.

The original objective for enactment of section 269 -- to police the transfer of tax benefits in corporate combinations -- has been virtually superseded by other statutes and regulations. For example, sections 382, 383, and 384 provide detailed limitations on the use of NOLs, built-in deductions, and tax credits following certain corporate combinations. The consolidated return regulations under section 1502 contain numerous limitations on the use of net operating losses, built-in deductions, and tax credits following the addition of a new member to a consolidated group. Further, section 1561 places limits on surtax exemptions in the case of certain controlled corporate groups.

Nevertheless, even though section 269 has been superseded in certain respects by subsequent specific legislation and thereby rarely is applied, taxpayers considering prudent planning transactions must take into account section 269 in many different corporate contexts because of the broad reach of its provisions. This statute results in burdensome and time-consuming administrative issues for taxpayers and revenue agents alike, with few changes in positions ultimately required and little revenue generated in return. The issue of whether the taxpayer has obtained a particular benefit it would not otherwise enjoy often is a difficult determination, and determining the taxpayer's principal purpose is a subjective exercise. This results in a lack of uniformity in the statute's application.

The Administration now proposes to expand significantly an outdated and significantly superseded statute. The proposal would cover transactions that significantly reduce tax on what the Service views as "economic income." Such potentially broad application would create uncertainty for corporate taxpayers following prudent tax planning to implement business objectives in a variety of transactions.

Another significant expansion of section 269 contemplated in the Treasury proposal is to cover any "exclusion" obtained in conjunction with any broadly defined "tax avoidance transaction." Currently, section 269 refers only to a "deduction, credit or other allowance" secured by the taxpayer in an inappropriate manner. Under current law, courts have refused to apply section 269 in instances where the secured benefit is an exclusion from income.(22) To address the allocation of income from one taxpayer to another, Congress has legislated other provisions, such as the allocation rules of section 482 under which Treasury has promulgated comprehensive regulations. No tax policy rationale exists for the expansion of current section 269 to cover these situations.

C. Denial of deductions for certain tax advice; excise tax on certain fees received with respect to corporate tax shelters.

1. Treasury proposal.

The Treasury proposal would deny a deduction to a corporation for fees paid or incurred in connection with the purchase and implementation of corporate tax shelters and the rendering of tax advice related to corporate tax shelters. The proposal also would impose a 25-percent excise tax on fees received in connection with the purchase and implementation of corporate tax shelters (including fees related to the underwriting or other fees) and the rendering of tax advice related to corporate tax shelters. These proposals would be effective for fees paid or incurred, and fees received, on or after the date of first committee action.

2. Analysis.

The imprecise definition of a corporate tax shelter transaction contained in this and related Treasury proposals would make it difficult for taxpayers and professional tax advisers to determine the circumstances under which this provision would be applicable. The substantive burdens of interpreting and complying with the statute and the administrative problems that taxpayers and the Service would face in attempting to apply this provision cannot be overstated.

Further aggravating the complexity and burdens that are imbedded in this proposal is the fact that the ultimate determination that a particular transaction was a corporate tax shelter may not be made until several years after the fees are paid. In that situation, issues arise as to when the excise tax is due, whether the applicable statute of limitations has expired, and whether and upon what date interest would be owed on the liability.

More fundamentally, the creation of the proposed excise tax subjects tax advisers to an entirely new and burdensome tax regime, a regime that again shifts the focus away from the substantive tax aspects of the transaction to unrelated definitional and computational issues. It is also unclear who would administer or enforce this new tax regime. For instance, if the existence of a tax shelter is determined as a result of an income tax examination of a corporation, would the revenue agents conducting that examination have jurisdiction over a resulting excise tax examination of the taxpayer's tax adviser? Would the income tax and excise tax examinations be conducted concurrently? How would conflicts of interest between the taxpayer and the adviser be identified and handled? These are only a few of the serious real-world issues that would have to be resolved to administer an inherently vague and cumbersome proposal.

Finally, the real possibility exists that the effect of the proposal may be to deter certain taxpayers from seeking and obtaining necessary advice and guidance from a qualified tax professional in many transactions where the broad and vague scope of the prohibition calls into question the ultimate deductibility of fees. In many such cases, it is likely that qualified tax advice would have either convinced the taxpayer that it would be unwise or improper to enter into the transaction, or resulted in the restructuring of the transaction so as to bring it within full compliance with the letter and spirit of the internal revenue laws.

D. Impose excise tax on certain rescission provisions and provisions guaranteeing tax benefits.

1. Treasury proposal.

The proposal would impose on the corporate purchaser of a corporate tax shelter an excise tax of 25 percent on the maximum payment under a "tax benefit protection arrangement" (including a rescission clause and insurance purchased with respect to a transaction) at the time the arrangement is entered into. The proposal would apply to arrangements entered into on or after the date of first committee action.

2. Analysis.

This proposal breaches basic normative rules of tax law by purporting to tax an expectancy, and by not limiting tax to income received or realized by a taxpayer.

As a practical matter, the provision fails to consider the way rescission provisions or guarantees work. Generally, such an agreement puts the tax adviser at risk for an agreed-upon percentage of the amount of additional tax for which the taxpayer ultimately is liable as a result of the transactions to which the adviser's advice relates. That amount, of course, cannot be determined unless and until the Service proposes adjustments to the taxpayer's liability related to the item or transaction in question, and the taxpayer's correct liability is either agreed upon or determined by a court. Until such time, it is unclear how an excise tax determination appropriately could be made, and assessing tax based upon the highest potential rescission benefits obtainable by a taxpayer in the future, whether actually realized or not, contravenes basic issues of fairness in our normative income tax system.

Further, the creation of the proposed excise tax subjects corporate taxpayers to an entirely new and burdensome tax regime, a regime that again shifts the focus away from the substantive tax aspects of the transaction in question to unrelated matters regarding the taxpayer's use of a tax adviser and the details of its relationship with the adviser. As such, the provision constitutes an unwarranted intrusion into the manner in which corporate taxpayers conduct their business affairs. In addition, the provision not only discourages, but actually stigmatizes, the willingness of qualified tax advisers to stand behind the quality and accuracy of their professional services.

E. Preclude taxpayers from taking tax positions inconsistent with the form of their transactions.

1. Treasury proposal.

The proposal generally would provide that a corporate taxpayer could not take any position on its return or refund claim that the income tax treatment of a transaction differs from that dictated by its form if a "tax-indifferent party" has an interest in the transaction. The form of a transaction would be determined based on all facts and circumstances, including the treatment given the transaction for regulatory or foreign law purposes. A "tax indifferent party" would be defined to include foreign persons, Native American tribal organizations, tax-exempt organizations, and domestic corporations with expiring loss or credit carryforwards. The proposal would be effective for transactions entered into on or after the date of first committee action.

2. Analysis.

The prevalent theme of this proposal is an approach of "heads I win, tails you lose."

The Administration's proposal would turn upside down the most sacred of all tax doctrines: the tax treatment of a transaction should be based on its substance, and not its form, when its form does not properly reflect its substance. While some courts have said that there are restrictions on when a taxpayer may take a position contrary to the form of its own transaction, even those courts have not imposed an absolute prohibition. If the form chosen by the taxpayer has economic substance, then the taxpayer generally may not assert that the transaction should be taxed in accordance with a different form. However, if the taxpayer can show that the form chosen does not reflect the economic substance of the transaction, then a court generally will evaluate the merits of the taxpayer's claim.

In cases where the tax treatment of a transaction is derived from a written agreement between a taxpayer and a third party, courts have been more hesitant to entertain a substance-over-form argument made by the taxpayer. In these cases, the economic relationship between the taxpayer and other party is established primarily by the agreement itself, rather than independent evidence. The most typical case involves an allocation of the purchase price among various assets after the taxable acquisition of a business. Courts essentially have incorporated the "parol evidence" rule from applicable State law into the tax law. In some circuits, this means that the taxpayer may assert substance over form only with "strong proof." Other circuits, following the so-called "Danielson rule," hold that the taxpayer may assert substance over form only with proof that would render the agreement unenforceable (e.g., proof of mistake or fraud). Courts have limited the application of the strong proof rule or the Danielson rule to cases involving a written agreement between two parties, where the Service is confronted with potentially conflicting tax claims and thus a potential whipsaw.

The Treasury proposal essentially is a drastic expansion of the Danielson rule with an unusual twist. First, the proposed rule prohibiting taxpayers from asserting substance over form would not be limited to cases involving an economic relationship set forth in a written agreement with a third party; rather, it would apply to any transaction where a taxpayer has chosen a particular form. Second, the proposal would apply where there are no potentially conflicting tax claims, and thus no potential for whipsaw, contrary to the approach adopted by the courts.

The fact that a taxpayer, under the proposal, could disclose on its return that it was treating a transaction differently than the transaction's form does not answer these criticisms. The meaning of "form" would be unclear in many circumstances. Does "form" refer to the label given to the transaction or instrument, or does it refer to the rights and liabilities set forth in the documentation? For example, if an instrument is labeled debt, but has features in the documentation typically associated with an equity interest, is the form debt or equity?

Recent attention has been given to Canadian exchangeable share transactions, in which a U.S. corporation acquires a Canadian corporation and the Canadian shareholders retain shares in the Canadian target that are exchangeable for shares in the U.S. acquiror. These shares appear in form to be shares in the Canadian target but in substance may have legal and economic rights equivalent to shares in the U.S. acquiror. One commentator recently suggested that taxpayers structuring these transactions and treating these instruments as shares in the Canadian target are taking positions contrary to the "form." However, this seems to be a classic case where the Service would be asserting that the form of the transaction (i.e., shares in the Canadian target) does not reflect its substance (i.e., shares in the U.S. acquiror). The issue should not be what the form of the transaction is but rather what the substance is.

This proposal would have the unfortunate effect of forcing the taxpayer and the Service to fight over the characterization of a transaction's form, when they ought to be debating the substance of the transaction. The proposal does not subject the Service to the same rule, i.e., the Service would not be precluded from asserting substance over form.

F. Tax income from corporate tax shelters involving tax-indifferent parties.

1. Treasury proposal.

The proposal would impose tax on "tax-indifferent parties" on income allocable to such a party in a corporate tax shelter, effective for transactions entered into on or after the date of first committee action.

2. Analysis.

This proposal ignores the fact that many businesses operating in the global economy are not U.S. taxpayers, and that in the global economy it is increasingly necessary and common for U.S. companies to enter into transactions with such entities. Moreover, the fact that a tax-exempt person earns income that would be taxable if instead it had been earned by a taxable entity cannot in and of itself be viewed as objectionable by the government - if that were the case, the solution simply would be to repeal all tax exemptions. This overreaching Treasury proposal cannot be justified on any tax policy grounds.

Invocation of a rule that would impose tax on otherwise nontaxable persons should require some greater evidence of tax abuse than the mere fact that one of the parties is a foreign person or a tax-exempt entity. The only limit on the application of this proposed rule would be the basic definition of a corporate tax shelter, but as discussed elsewhere in this testimony, that overbroad definition and the nearly unfettered authority contained in the proposal likely would cover many routine business arrangements.

Moreover, as it applies to foreign persons in particular, the provision is overbroad in two significant respects. First, treating foreign persons as tax-indifferent ignores the fact that in many circumstances they may be subject to significant U.S. tax, either because they are subject to the withholding tax rules, because they are engaged in a U.S. trade or business, or because their income is taxable to their U.S. shareholders. To treat all such persons as by definition tax-indifferent would lead to the application of the tax-indifferent party tax to persons that are already subject to U.S. tax. The coordination of normal U.S. taxes with the special tax- indifferent party tax is not addressed by the proposals, so it is not clear whether it is intended that a second U.S. tax would be collected in such cases. If that is not the intent, then coordination rules would be required, which could create substantial complexity, particularly when the liability for the tax-indifferent party tax is imposed on other parties to the transaction.

Second, limiting the collection of the tax to parties other than treaty-protected foreign persons does not hide the fact that the tax-indifferent party tax would constitute a significant treaty override. Collecting the tax-indifferent party liability from other parties would function purely as a collection mechanism, much like a withholding tax, but it is the income of the foreign person that would be subject to the tax.(23) Imposing such a tax on treaty-protected income remains inconsistent with treaty obligations regardless of the collection mechanism adopted. Such a treaty override seems doubly objectionable in a context in which the tax avoidance about which Treasury is concerned is not that of the treaty-protected foreigner, but rather that of another taxpayer. Thus, while Treasury and Congress may conclude that in certain circumstances a treaty override is required to advance significant U.S. tax policy goals, this misguided and unnecessary provision does not justify the serious damage to treaty relationships that it would engender.


The overreaching and vague Treasury Department proposals would have a severely detrimental impact on tax analysis and planning relating to a large number of legitimate business transactions. The proposals contemplate that many of the provisions would apply whenever a corporate tax shelter (as newly defined) is found to exist, even if the taxpayer's position is substantively correct under the Code, regulations, and case law.(24) By contrast, the current-law tax shelter penalty provisions come into play only if the taxpayer initially is found to have understated its tax liability.

Faced with the regime of draconian sanctions proposed by Treasury, taxpayers would find it difficult to make business decisions with any certainty as to the tax consequences, since even a correct application of existing rules could be overturned based on a finding that a transaction worked an "improper deferral" or a "significant reduction of tax." Our testimony below presents only a few of the examples that could be cited of normal business transactions that could be caught in the web woven by the new proposals.

A. International transactions.

1. Debt capitalization of U.S. subsidiary of foreign parent.

Something as basic as the capital structure of a company can be said to reduce the tax on the company's economic income. For example, if the foreign parent of a U.S. subsidiary chooses to capitalize the subsidiary with significant debt, the U.S. tax liability of the U.S. subsidiary may be reduced substantially, with no effect on the group's economic income. Existing law includes provisions under which the Service can test the legitimacy of the interest deductions claimed by the subsidiary in that situation, including the "earnings stripping" rules under section 163(j), the anti-conduit rules under section 7701(l), various treaty-shopping rules, and common law debt-equity principles. Even if the taxpayer's interest deduction passed all of those hurdles, the Treasury proposals could be interpreted to label the corporation's capital structure as a tax shelter, given the reduction of tax on economic income.

The taxpayer could avoid the tax shelter designation only if it could show that the tax benefit of its interest deduction was "clearly contemplated" under the Code. Thus, notwithstanding all the rules that the tax law has developed to test interest deductions, the final determination of the taxpayer's liability would come down to application of a rule that provides virtually no substantive guidance. When is the tax benefit of a deduction for interest "clearly contemplated" by the Code? Obviously not always, because the Code has many specific rules that limit the extent to which a taxpayer may receive a tax benefit for interest it has paid. If a transaction satisfies those specific provisions of the Code, can its tax benefits safely be described as "clearly contemplated" within the meaning of the proposed tax shelter provisions? Presumably not, because Treasury considers its proposal to be a significant change to current law, so as to permit the Service to prevail in circumstances in which it could not prevail under existing law.

Thus, under the Treasury proposals, taxpayers are left with the uneasy sense that some interest deductions that satisfy all current substantive tax provisions must be "clearly contemplated," and hence are safe from further scrutiny under this proposal as corporate tax shelters, while other interest deductions would not so qualify. The taxpayer, however, would have no idea how to distinguish between them. Moreover, taxpayers and the Service often would disagree over when a benefit was "clearly contemplated." In the case of a debt-capitalized U.S. subsidiary, the Service might well argue that in its opinion the benefit received (namely, the interest deduction) exceeds that which was "clearly contemplated" by Congress.

To complicate matters further, the likelihood of a "not clearly contemplated" attack may be greater in the context of a cross-border transaction. While the current Treasury explanation of its proposals does not discuss extensively the use of hybrid entities or instruments,(25) previous Treasury proposals suggest that the presence of a cross-border hybrid likely would affect Treasury's analysis. For example, suppose that the debt instrument giving rise to the U.S. subsidiary's interest deduction was viewed as stock by the parent's home country, so that the payments were viewed as dividends that received favorable tax treatment in that jurisdiction.(26) Would the Service argue that the benefit of the subsidiary's interest deduction is "clearly contemplated" only when the payment is viewed as interest in the hands of both the payor and the payee? Treasury pronouncements to date provide no clear answer, having suggested, for example, that inconsistent cross-border characterizations leading to the recognition of a foreign tax credit in two jurisdictions simultaneously may be abusive in Treasury's view, while the simultaneous recognition of depreciation deductions in two jurisdictions has been viewed by Treasury as appropriate.(27)

Accordingly, a foreign parent faced with the need to determine the capital structure for its U.S. operations would find it extraordinarily difficult to predict its U.S. tax treatment with any certainty. Even if a cross-border transaction complies with all existing rules, and regardless of whether the transaction tries to achieve any cross-border arbitrage, a company always would face the possibility of a Service challenge that would deny the benefit of its deductions and impose several other sanctions based on interpretations of the "corporate tax shelter" definition. Adding this type of fundamental uncertainty to the already extreme complexity of the Code cannot be defended as appropriate tax policy.

2. Foreign tax reduction

As a threshold matter, it is not clear whether the Treasury proposal is limited to avoidance of U.S. as opposed to foreign taxes. The proposals are drafted broadly in terms of "a tax benefit in a tax avoidance transaction," "a significant reduction of tax," etc. Recent Treasury Department activities should make it clear that the inquiry is a serious one, since IRS Notice 98-11 establishes that Treasury may be as concerned about avoidance of foreign taxes as about U.S. taxes. This follows from the fact that the Notice would treat otherwise identical transactions differently, depending on whether the effect of the transaction was to achieve a reduction of foreign tax.(28)

The new tax shelter proposals would seem to give Treasury authority to deny tax benefits in connection with any arrangements entered into by a U.S.-based multinational in connection with the debt-capitalization of its foreign operations, or indeed any transaction or structure that had the effect of significantly reducing foreign taxes. The uncertainty would be further compounded by the issue of hybrid status discussed above - would the Service be more likely to challenge a foreign tax-reduction structure with hybrid elements? For example, would a "hybrid branch" within the meaning of Notice 98-11 be more susceptible to challenge than a conventional branch that had the same tax effect (i.e., foreign tax reduction with no subpart F inclusion)? The question cannot be answered based on the proposals themselves or any other Treasury guidance.

Accordingly, enactment of the Treasury proposals would throw the structuring of international operations of U.S. companies into complete tax uncertainty - the tax consequences of many transactions and investments would not be determinable until long after the fact, since their tax results could not be determined based on the existing Code, regulations, or case law. Instead, the taxpayer would have to wait until Service revenue agents reviewed the transactions and determined whether they were offended by any particular aspect, regardless of the extent to which the transaction complied with existing law. This discretion and the unprecedented complexity and uncertainty it would cause cannot be justified on any tax policy principle.

3. Foreign tax credits in high-tax settings.

If the Treasury proposals were enacted, a U.S.-based multinational could find itself in a remarkable whipsaw. Efforts to reduce foreign taxes could trigger a response of the Service based on Notice 98-11 type concerns; on the other hand, failure to reduce foreign taxes potentially could subject the taxpayer to scrutiny based on the fact that the resulting foreign tax credits were deemed disproportionate to its economic income. This follows from the Treasury proposal defining a tax shelter to include any arrangement in which pre-tax profits are insignificant in relation to net tax benefits. By selectively defining the relevant "transaction," the Service could determine that any particular activity in a foreign jurisdiction produced limited net income, and thus that such income was "insignificant" in relation to the foreign tax credits associated with it. This problem is particularly acute in the case of financial institutions that may engage in a portfolio of transactions, some of which could be isolated and shown to be economic losses. But the problem also could be faced by any business with multiple product or service lines of varying profitability.

Further, even in the case of an activity with "normal" profits, foreign tax base or timing differences could increase artificially the apparent foreign tax rate to the point where the economic profit would appear to be insignificant by comparison. With tax base and timing differences, a normal business scenario could produce a foreign tax rate that looks high enough that the economic profit could be viewed as not substantial relative to the foreign tax credit benefits.

Moreover, by treating foreign taxes paid as an expense like any other, the proposals misconceive and distort the role of the foreign tax credit in the U.S. tax system. By treating foreign taxes as an expense, Treasury is in effect positing that the correct standard for identifying an abuse is to ask whether the taxpayer would carry out a transaction if it did not receive a foreign tax credit at all - in other words, a transaction should be viewed as proper only if it makes economic sense without regard to any foreign tax credits.

This cannot be right in view of the fundamental purpose of the foreign tax credit. Most foreign business operations conducted by U.S.-based taxpayers in jurisdictions that impose significant taxes probably would be untenable in the absence of a U.S. credit for those foreign taxes. Does the Treasury proposal mean that all U.S.-owned controlled foreign corporations in Germany, Japan, Italy, France, and the United Kingdom, among other countries, represent corporate tax shelters? The basic goal of the foreign tax credit is to enable U.S.-based companies to conduct overseas activities without suffering double taxation, and that function is served by treating a foreign tax as if it were a U.S. tax (up to the U.S. rate). Thus, adopting a definition of tax shelter that takes as its analytical starting point a world in which no foreign taxes are creditable is inconsistent with the fundamental operation of U.S. international tax rules as they have operated for decades.

In sum, the Treasury proposals would make the U.S. tax results of cross-border transactions largely unknowable. Transactions that satisfied the requirements of all existing statutory, regulatory, and judicial standards nevertheless could be challenged by the Service under standards of utter vagueness. They could be attacked for paying too little foreign tax, or for paying too much. They could be targeted for violating nebulous policy concerns, such as those with respect to hybrids, that Treasury has not yet managed to articulate fully.

This fundamental tax uncertainty would deprive U.S. businesses of the ability to make rational cross-border business decisions, disrupting international trade and investment at a time when the growth of a global economy has made them an increasingly important component of U.S. economic prosperity. Finally, the Treasury proposals would damage U.S. international tax policy by abandoning some of its fundamental precepts, and do broader damage to U.S. tax policy in general by seeking to replace known legal standards with a regime governed solely by administrative edict.

B. Corporate transactions.

1. In general

There is a lengthy list of legitimate merger and acquisition transactions that could be caught by Treasury's proposed broad definition of "tax avoidance transaction." For example, tax-free reorganizations involving small corporations acquired by large corporations or spin-off transactions involving unequal amounts of debt allocated between the separated entities might be treated by the Service as "tax avoidance transactions." The nearly unfettered ability of the Service to recharacterize the tax effects of legitimate corporate transactions would cause considerable uncertainty in many cases of prudent and appropriate tax structuring of transactions.

By contrast to the haphazard manner in which the rules for taxing corporate transactions would develop under the Treasury proposals, current law consists of statutory, regulatory, and judicial doctrines that have been refined and developed over time and that provide guidance and appropriate tax results in corporate transactional planning.

2. Reasons for concern.

Broad anti-abuse rules like the Treasury proposals can adversely affect the ability of corporations to engage in legitimate business transactions by bringing the tax consequences of ordinary transactions into question. Given the Service's limited resources, such disputes may not be resolved satisfactorily through ordinary avenues such as the private letter ruling process.

The development of the tax law regarding transfers of property outside the United States provides a relevant example. Prior to 1984, section 367(a) required transferors of property to foreign persons to receive permission from the Service, in the form of a private letter ruling, in order for the transfer to qualify as a nontaxable transaction. This was to ensure that the principal purpose of the outbound transfer was not tax avoidance. By requiring that taxpayers get advance approval before making an outbound transfer of assets, taxpayers were precluded from completing a transaction and determining in later litigation, if necessary, the question of whether tax avoidance was one of the principal purposes of the transaction. Under these rules, Treasury was able to prevent taxpayers from undertaking legitimate business transactions simply by declining to issue a favorable private letter ruling.

To remedy this inequity, the Tax Reform Act of 1976 established a special declaratory judgment procedure (section 7477) allowing taxpayers to immediately litigate the Service's section 367 determinations in the Tax Court. Under the procedure, the taxpayer was able to have the dispute reviewed by the Tax Court if it was demonstrated that a request had been made to the Service for a determination and that the Service either failed to act or acted adversely. After a number of taxpayer-favorable decisions, Congress replaced this system in 1984, and today taxpayers are not required to obtain a private letter ruling in advance of a section 367 transaction.

Obviously, requiring taxpayers to obtain prior approval from Treasury for legitimate business transactions proved to be an unworkable process. In order for a voluntary tax system to work in a global economy, taxpayers must be able to implement their business strategy while providing a review process that ensures appropriate and consistent tax treatment for all. The Treasury proposals, by creating general corporate anti-abuse rules without guidelines or restrictions, would result in uncertainty for taxpayers engaging in ordinary corporate transactions and generally would burden taxpayers with the responsibility of litigating disputes with the Service over the limits of the anti-abuse rules themselves.

C. Partnership transactions.

As the globalization of the world economy continues, many companies are turning to partnership joint ventures as a preferred business form to conduct new business operations. Such joint ventures provide immediate access to technology, financing, new markets, and human capital that otherwise might take years for a company to develop internally. The reach of Treasury's tax shelter proposals seriously jeopardizes this legitimate joint-venture activity.

Many joint ventures are speculative in nature. Pre-tax profits are anticipated but may be longer term, and the investment's ultimate rate of return is uncertain. It is quite common for joint ventures to generate economic losses in formative years; these "tax benefits" could be significant when compared to reasonably expected pre-tax profits at the outset of the joint venture.

The breadth of the Treasury's proposed definition of a tax shelter quite likely would impose an in terrorem effect in the formation of joint ventures with marginal rates of return because of increased uncertainty created by the potentially broad reach of the new proposals. The consequence would be a lack of competitiveness by U.S. companies in the global market.

In certain industries, partnerships are used to spread the risk of research. These research partnerships, which generate little in short-term profits, are economically viable because of the potential intellectual capital created in the long term. Conceivably, under the Administration's definition of tax shelters, the Service would be put in the position of second-guessing the economics of a particular research partnership, causing the parties to justify anticipated pre-tax profits in light of failures to generate viable new technology. Fear of Service challenges to what are otherwise legitimate business decisions could well dampen the kind of research U.S. companies undertake.

Oil and gas exploration depends on huge amounts of capital generated through the formation of partnerships. This industry can be wildly speculative. If the Treasury tax shelter proposals were adopted, the Service effectively would sit side-by-side with the wildcatters in assessing what wells can be drilled in order to avoid these activities later being defined as a tax shelter.

Consider, for example, the case of an independent oil and gas operator that frequently engages in searches for oil on undeveloped and unexplored land that is not near proven fields. The taxpayer engages in a particular speculative wildcat oil-drilling venture at an anticipated cost of $5 million. Based on the experience of taxpayers engaging in this type of business, there is a 90-percent chance that the taxpayers will not find a commercially profitable oil deposit and that the entire $5 million investment will be lost. There is a 10-percent probability that the venture will produce pre-tax economic profits in the average probability-weighted amount of $40 million. Under the Treasury proposals, the Service might treat the venture as a corporate tax shelter on the ground that the reasonably expected pre-tax profit is insignificant relative to the reasonably expected net tax benefits.

The real estate industry also relies heavily on partnership vehicles. In the case of real estate investment trusts (REITs), lower-tier partnerships routinely are used to acquire new properties from sellers interested in diversifying their own investment portfolios. The proposed definition of a tax shelter would cause reassessments of what properties a REIT can invest in because, more often than not, a particular real estate deal will be speculative in nature.

Other industries that use the partnership vehicle to aggregate capital for investment purposes include venture capital funds and investment partnerships. Both generate capital to be invested in other businesses for higher and sometimes speculative rates of return. An overbroad and vague tax shelter definition may well alter the types of investments made at the margin by these industries.

Investment decisions are made all the time by competent business executives and investors. Unfortunately, Treasury's misguided tax shelter proposals would call into question many of their investment decisions. Injecting the Service into what are otherwise legitimate business decisions would create an unintended and detrimental drag on our robust economy.

D. Other illustrations

As discussed above, the Treasury proposals would discourage taxpayers from undertaking beneficial but unprofitable activities that, absent legitimate tax incentives, they would not perform. Such activities particularly are vulnerable to being tagged as tax shelters because they literally could be viewed as arrangements in which a "corporate participant attempts to obtain a tax benefit in a tax avoidance transaction."

As one example of the potential chilling effects of the Treasury proposals, legislation enacted in 1997 allows taxpayers to deduct certain costs of cleaning up economically depressed sites, known as "brownfields." The legislation sought to encourage taxpayers to clean up sites that otherwise might prove too costly or uneconomical to clean up. Under the tax shelter proposal, a taxpayer's attempt to deduct cleanup costs whose treatment is not clear under the brownfields statute could be treated as a tax shelter.

The claimed deductions might constitute a "tax benefit" under the proposal because certain deductions while potentially permissible may not be deemed "clearly contemplated by the applicable provision" (emphasis added). Moreover, the taxpayer's cleanup activities could be considered a "tax avoidance transaction" because the taxpayer's pre-tax profit from cleaning up a site probably would be insignificant relative to its reasonably expected tax benefits. Thus, a taxpayer that cleans up a brownfields site and claims a deduction for its costs could face a serious risk of being treated as a tax shelter participant merely because the treatment of some of those costs is less than clear under the statute. Treasury may well respond that it does not intend to impact detrimentally the recently enacted "brownfields" statute. The fact remains that the overbroad reach of the Treasury proposals could call into question the tax effect of this provision and many other normal business transactions and activities.

Besides the examples set forth above, numerous ordinary business transactions could be affected by the Treasury proposals. These could include certain hedging transactions, certain sale-leaseback transactions, various corporate distributions, and certain transactions between joint venture entities.


A. Current penalties and registration requirements relating to tax shelters.

The chief tax executive of a corporation has several duties and responsibilities in the tax analysis, collection, and enforcement process.(29) Some are derived from the tax executive's fiduciary duties to shareholders to preserve and protect corporate assets, including a duty to protect corporate assets from unnecessary additions to tax through the imposition of penalties.

The existing penalty structure in the Code is a burdensome and complex patchwork of rules that present the chief tax executive with considerable uncertainty in determining their application and scope. The corporate tax executive must consider carefully the possible application of those penalties prior to implementing any particular course of action.

Three broad types of penalties potentially apply with respect to tax shelters: (1) the accuracy-related penalty under section 6662, which is applicable to underpayments of tax resulting from certain types of conduct, (2) tax shelter-specific penalties such as those applicable to promoters of abusive tax shelters and to the failure to register or furnish information regarding tax shelters, and (3) penalties related to the preparation or presentation of tax returns, claims, or other documents reporting the benefits or attributes of tax shelter items. A list of these penalty provisions is contained in Appendix A.

1. Accuracy-related penalty.

One of the most significant penalties that a chief tax executive must consider in analyzing any transaction is the accuracy-related penalty under section 6662. That penalty is imposed on any portion of an underpayment attributable to one or more of the following:

The penalty equals 20 percent of the portion of the underpayment attributable to the specified conduct. The first three components of the accuracy-related penalty (i.e., the negligence/intentional disregard, substantial understatement, and valuation misstatement components) are the most relevant to potential tax shelter transactions.

Pursuant to section 6664(c), the accuracy-related penalty will not be imposed on any portion of an underpayment if the taxpayer shows there was a reasonable cause for the underpayment and that the taxpayer acted in good faith with respect to such portion. The determination of whether a taxpayer acted with "reasonable cause and in good faith" is made on a case-by-case basis, taking into account all pertinent facts and circumstances, the most important of which is the extent of the taxpayer's efforts to assess its proper tax liability. As a general rule, it is more difficult to establish the existence of reasonable cause when the underpayment of tax is attributable to true tax shelter activities.

a. Definition of "tax shelter" for purposes of the accuracy penalty rules.

For purposes of the accuracy-related penalty imposed by section 6662, the term "tax shelter" means a partnership or other entity (e.g., a trust), an investment plan or arrangement, or any other plan or arrangement the purpose of which is to avoid or evade federal income tax. Congress significantly broadened the scope of these rules in the Taxpayer Relief Act of 1997, to treat an entity, plan, or arrangement as a tax shelter if one of its significant purposes is tax avoidance or evasion.(30) The Service and Treasury have not yet issued guidance regarding the definition of the term "significant purpose."

The broadened definition of the term "tax shelter" for accuracy-related penalty purposes under the 1997 Act is a powerful tool that the Treasury and the Service can utilize to respond to perceived avoidance situations. The failure, however, to provide necessary guidance under that statute, in the form of regulations or otherwise, has made it extremely difficult for chief tax executive to analyze and evaluate potential transactions so as to protect against the imposition of such penalties.

b. Negligence or disregard of rules or regulations.

A 20-percent accuracy-related penalty is imposed on the amount of any underpayment that is attributable to negligence or the disregard of rules or regulations. Negligence includes any careless, reckless, or intentional disregard of rules or regulations, any failure to make a reasonable attempt to comply with the provisions of the law, and any failure to exercise ordinary and reasonable care in the preparation of a tax return. In other words, negligence is the lack of due care or failure to do what a reasonable and ordinarily prudent person would do under the circumstances. Disregard of rules or regulations means any careless, reckless, or intentional disregard of the Code, regulations (final or temporary), or revenue rulings or notices published in the Internal Revenue Bulletin.(31)

Negligence includes the failure to keep adequate books and records or to substantiate items properly.(32) A position with respect to an item is attributable to negligence if it lacks a "reasonable basis."(33) Negligence is strongly indicated where, for example, a taxpayer fails to include on an income tax return an income item shown on an information return, or a taxpayer fails to make a reasonable attempt to ascertain the correctness of a deduction, credit, or exclusion on a return that would seem to a reasonable and prudent person to be "too good to be true" under the circumstances.(34) This prudence standard is imposed on a chief tax executive as he or she analyzes the appropriateness of a particular transaction.

c. Substantial understatement of income tax.

In determining whether it would be prudent to enter into a particular transaction, the corporate tax executive also must consider the component of the accuracy-related penalty that is imposed on the portion of any underpayment that is attributable to a substantial understatement of income tax. An "understatement of tax" is the excess of the amount required to be shown on the return for the tax year less the amount of tax actually shown on the return, reduced by any rebates.

An understatement is "substantial" if the understatement exceeds the greater of (1) 10 percent of the tax required to be shown on the return for the tax year, or (2) $10,000 (in the case of a corporation other than an S corporation or a personal holding company).

d. Substantial valuation misstatement.

A 20-percent accuracy-related penalty also is imposed on the portion of any underpayment of tax attributable to a substantial valuation misstatement with respect to the value or adjusted basis of property reported on any return. In the case of a gross valuation misstatement, the penalty is increased to 40 percent. These penalties apply if the aggregate of all portions of the underpayment attributable to the misstatement exceeds $10,000 for corporations other than S corporations or a personal holding company.(35) This aspect of the accuracy-related penalty regime has received renewed emphasis and review by corporate tax executives in light of the Tax Court's recent decision upholding the Service's imposition of the 40-percent penalty.(36)

e. Concluding analysis.

In sum, the accuracy-related penalty provides a powerful incentive for corporate tax executives to review closely and analyze both the structure and the implementation of any proposed business transaction that results in tax benefits, and to impose prudence on the decision-making process. This penalty, and the overall penalty regime, can be made much clearer and more precise so as to provide corporate tax executives with certainty in analyzing particular transactions. To this end, the ongoing studies aimed at reviewing and potentially streamlining the current complex and burdensome penalty system hold the potential for meaningful improvements.(37) At this time, there is no demonstrated justification for increasing the penalties and adding further uncertainty to the process as contemplated by the Treasury proposals.

2. Penalties imposed on tax shelter promoters.

The Code contains a number of penalties applicable to tax shelter promoters. These promoter penalties collectively form a "safety net" to ensure that tax shelter activities are not promoted and that misinformation about proper tax rules is not disseminated by unscrupulous advisors. It is highly unlikely that a prudent tax executive of a large corporation seriously would consider entering into the sort of abusive transaction for which promoter penalties would be applicable. Accordingly, the penalties are briefly described below to illustrate that the Code already contains a number of safeguards against abusive tax planning activities.

a. Penalty for promoting abusive tax shelters.

Under section 6700(a), a civil penalty -- equal to the lesser of $1,000 or 100 percent of the gross income derived (or to be derived) by the particular promoter from the activity -- may be imposed against persons who promote abusive tax shelters. The term "promoting" encompasses organizing such tax shelters, participating directly or indirectly in their sale, and making or furnishing (or causing another person to make or furnish) certain false or frauduent statements(38) or gross valuation overstatements(39)

in connection with their organization or sale. Pursuant to section 7408, the Service also can obtain an injunction against such promoters to enjoin them from further promotion activity.

b. Aiding and abetting penalty.

The Service may impose a penalty under section 6701 of $1,000 ($10,000 with respect to corporate tax returns and documents) against any person who (1) aids, assists, or gives advice in the preparation or presentation (e.g., during a Service examination) of any portion of a tax return, affidavit, claim, or other document; (2) knows (or has reason to believe) that the portion of the return or document will be used in connection with any material matter arising under the internal revenue laws; and (3) knows that, if the portion of the tax return or other document is used, an understatement of another person's tax liability would result.

In addition, disciplinary action may be taken against any professional appraiser against whom an aiding and abetting penalty under section 6701(a) has been imposed with respect to the preparation or presentation of an appraisal resulting in an understatement of tax liability.

3. Penalties for failure to furnish information regarding tax shelters.

a. Penalty for failure to register a tax shelter.

An organizer of an entity, plan, or arrangement that meets the definition of a tax shelter under section 6111 who fails to timely register such shelter, or who files false or incomplete information with such registration, is subject to a penalty under section 6707(a). The penalty equals the greater of (1) $500 or (2) one percent of the amount invested in the shelter.

The penalty for failing to register a "confidential corporate tax shelter," as defined in section 6111(d) (as amended by the Taxpayer Relief Act of 1997), is the greater of (1) $10,000, or (2) 50 percent of the fees paid to all promoters with respect to offerings prior to the date of the late registration. The penalty applies to promoters and to actual participants in any corporate tax shelter who were required to register the tax shelter but failed to do so. For participants, the 50-percent penalty is based solely on fees paid by the participant. The penalty is increased to 75 percent of applicable fees where the failure to register the tax shelter is due to intentional disregard on the part of either a promoter or a participant.(40)

b. Penalty for failure to furnish tax shelter identification numbers.

Pursuant to section 6707(b)(1), a person who sells an interest in a tax shelter and fails to furnish the shelter's identification number to each investor in the shelter is subject to a monetary penalty unless the failure is due to reasonable cause. Section 6707(b)(2) provides that an investor who fails to furnish the shelter's identification number on a return reporting a tax item related to the tax shelter also is subject to penalty.

c. Penalty for failure to maintain lists of investors in potentially abusive tax shelters.

Pursuant to section 6708, any person who is required to maintain a tax shelter customer list, as required by section 6112, and who fails to include any particular investor on the list will be assessed a penalty for each omission unless it is shown that the failure results from reasonable cause and not from willful neglect. The maximum penalty for failure to maintain the list is $100,000 per calendar year. This penalty is in addition to any other penalty provided by law.

4. Tax return preparer penalties.

Section 6694(a) provides that if any part of an understatement of liability with respect to a return or claim for refund is due to a position that did not have a realistic possibility of being sustained on its merits(41) and an income tax return preparer with respect to that return or claim knew (or reasonably should have known) of that position, the preparer is subject to a penalty of $250 with respect to the return or claim, unless it is shown that there is reasonable cause for the understatement and that the preparer acted in good faith. The penalty will not apply if the position (1) was adequately disclosed and (2) is not frivolous.(42)

If the preparer establishes that an understatement attributable to an unrealistic position was due to reasonable cause and that the preparer acted in good faith, the preparer penalty will not be imposed. This determination depends upon the facts and circumstances of the particular case, including the nature of the error, the frequency and materiality of the error, the preparer's normal office practices, and reliance on any other preparer's advice.(43)

5. Registration requirements.

Section 6111 requires tax shelter organizers(44) to register tax shelters with the Service by the day on which the first offering for sale of interests in the tax shelter occurs.(45) Pursuant to section 6111(d), which was added by the Taxpayer Relief Act of 1997, certain "confidential arrangements" are also treated as tax shelters for purposes of the registration requirements. Those provisions, however, are not effective until the Service or Treasury issues guidance with respect to the 1997 Act amendments to the registration requirements. To date, no such guidance has been issued. The Service and Treasury, therefore, have failed to take advantage of what would appear to be a potent weapon in the Government's arsenal to curb abusive tax shelter activity.

In the context of the tax shelter registration requirements, section 6111(d)(1) provides that a "corporate tax shelter" includes any entity, plan, arrangement, or transaction: (1) that has as a significant purpose the avoidance(46) of tax or evasion by a corporate participant; (2) that is offered to any potential participant under conditions of confidentiality;(47) and (3) for which the tax shelter promoters may receive total fees in excess of $100,000.

Under the rules applicable to confidential corporate tax shelters, individuals who merely discussed participation in the shelter may in some circumstances be required to comply with the registration requirements. A promoter of a corporate tax shelter is required to register the shelter with the Service not later than the day on which the tax shelter is first offered for sale to potential users. As previously discussed, civil penalties under section 6707 may be imposed for the failure to timely register a tax shelter. Criminal penalties are applicable to willful noncompliance with the registration requirements.(48)

These registration rules, which Treasury and the Service have not yet implemented, as well as the collective impact of the existing complex and disparate penalty regime, render the Treasury proposals unnecessary and inappropriate.

B. Existing "common-law" doctrines.

Pursuant to several "common-law" tax doctrines, Treasury and the Service have the ability to challenge taxpayer treatment of a transaction that they believe is inconsistent with statutory rules and the underlying Congressional intent. For example, these doctrines may be invoked where the Service believes that (1) the taxpayer has sought to circumvent statutory requirements by casting the transaction in a form designed to disguise its substance, (2) the taxpayer artificially has divided the transaction into separate steps, (3) the taxpayer has engaged in "trafficking" in tax attributes, or (4) the taxpayer improperly has accelerated deductions or deferred income recognition.

These broadly applicable doctrines -- known as the business purpose doctrine, the substance over form doctrine, the step transaction doctrine, and the sham transaction and economic substance doctrine -- provide the Service considerable leeway to recast transactions based on economic substance, to treat apparently separate steps as one transaction, and to disregard transactions that lack business purpose or economic substance. Recent applications of those doctrines have demonstrated their effectiveness and cast doubt on Treasury's asserted need for additional tools.

Since the enactment of the internal revenue laws, the Service, often with the blessing of the courts, has probed taxpayers' business motives. Such inquiries have led to the development of the "business purpose doctrine," which permits the Service to disregard for federal income tax purposes a variety of transactions entered into without any economic, commercial, or legal purpose other than the hoped-for favorable tax consequences. Although the business purpose doctrine originated in the context of corporate reorganizations,(49) it quickly was extended to other areas.(50)

The "substance over form doctrine" often is associated with the business purpose doctrine. Under the substance over form doctrine, a court may ignore the form of a transaction and apply the tax law to the transaction's substance if the court perceives that the substance of a transaction lies within the intended reach of a statute, but that the form of the transaction takes the event outside that reach.(51) Therefore, while a taxpayer may structure a transaction so that it satisfies the formal requirements of the tax law, the Service may deny legal effect to the transaction if its sole purpose is to evade taxation.(52)

The courts have long been willing to elevate substance over form in interpreting a sophisticated code of tax laws where slight differences in a transaction's design can lead to divergent tax results. In the tax law arena, the substance over form doctrine has been used expansively to justify the Service's recasting of transactions.(53) For example, the doctrine has been used to: (1) void reorganizations,(54) (2) reject the assignment of income,(55) (3) recharacterize the sale or transfer of property between related parties,(56) (4) recharacterize sale and leaseback arrangements,(57) (5) disallow interest deductions,(58) and (6) disregard the separate corporate entity.(59)

The "step transaction" doctrine permits the Service to aggregate formally separate transactions into a single transaction. Under the doctrine, tax results are determined by looking at the final result of the various steps of the transaction. The doctrine particularly ignores the intermediate steps in a transaction where those steps primarily were taken for tax purposes.

The "sham transaction" doctrine allows the Service to deny deductions and losses or otherwise recast transactions that lack any economic results beyond a tax deduction. The sham transaction doctrine has been expanded to apply even to certain bona fide transactions, where sufficient economic motivation is lacking.

The recent decisions in ACM v. Commissioner(60) and ASA Investerings v. Commissioner(61) illustrate the continuing force of these long-standing judicial doctrines. In ACM, the Third Circuit, affirming the Tax Court, relied on the sham transaction and economic substance doctrines to disallow losses generated by a partnership's purchase and resale of notes. The Tax Court similarly invoked those doctrines in ASA Investerings to disallow losses on the purchase and resale of private placement notes. Both cases involved complex, highly sophisticated transactions, yet the Service successfully used common law principles to prevent the taxpayers from realizing tax benefits from the transactions.

1. The business purpose and substance over form doctrines.

The business purpose and substance over form doctrines continue to serve as powerful tools for the Service to recharacterize a taxpayer's transactions to combat tax avoidance.(62) The business purpose doctrine generally provides that a transaction will not be respected for tax purposes unless it serves some purpose other than tax avoidance. The Supreme Court's decision in Gregory v. Helvering,(63) generally is cited as the origin of the business purpose doctrine. In Gregory, a reorganization complied with all of the formal statutory requirements, but was disregarded for federal income tax purposes because no valid economic purpose existed for the creation and immediate liquidation of a transferee corporation. The transaction simply was an attempt to convert ordinary dividend income into capital gains. The Supreme Court's decision was not based on any tax-avoidance motive of the taxpayer, but rather on the lack of a business purpose for the transaction which the statutory scheme contemplated. The court stated:

The legal right of the taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted. But the question for determination is whether what was done, apart from tax motive, was the thing which the statute intended. [293 U.S. at 469]

The Tax Court has noted that the doctrine in Gregory is not limited to the field of corporate reorganizations, but has a much wider scope.(64)

The substance over form doctrine, which is closely associated with the business purpose doctrine, generally allows courts to follow the economic substance of a transaction where a court believes the taxpayer's empty form shelters a transaction from the rules that otherwise should govern. As indicated above, the Service has succeeded in using the substance over form doctrine to recharacterize a variety of transactions. Furthermore, the substance over form doctrine offers the Service the added advantage of generally working in the government's favor and not in the taxpayer's.(65)

2. The step transaction doctrine.

Another version of the substance over form concept appears in the "step transaction doctrine," which also applies throughout the tax law. The step transaction doctrine allows the Service to collapse and treat as a single transaction a series of formally separate steps, if the steps are "integrated, interdependent, and focused toward a particular result."(66) Thus, the step transaction doctrine ignores the intermediate steps in a transaction where those steps constitute an indirect path toward the transaction's endpoint and where those steps primarily were taken to get better tax results. Under the doctrine, tax results are determined by looking at the ultimate result of a series of transactions.

While the boundaries of the step transaction doctrine are subject to debate, courts have articulated three versions of the doctrine: (1) an end result test, (2) an interdependence test, and (3) a binding commitment test.(67) The broadest version is the end result test, which aggregates a series of transactions if the transactions are prearranged parts of a single transaction intended from the start to reach an ultimate result. Slightly less broad is the interdependence test, which groups together a series of transactions if the transactions are so interdependent that the legal relations created by one transaction would be pointless absent the other steps. The narrowest version is the binding commitment test, which joins together a series of transactions if, at the time the first step is taken, a binding legal commitment requires the later steps.(68) While the courts have disagreed over which particular test to apply in particular circumstances, such uncertainty has not prevented the courts from applying the doctrine liberally.(69)

3. Sham transaction doctrine and economic motivation test.

The sham transaction doctrine offers another route by which courts and the Service have attacked transactions lacking in economic substance or reality. Among the leading cases articulating the sham transaction doctrine are Knetsch v. U.S. (70) and Goldstein v. Commissioner.(71) In Knetsch, the Supreme Court held that a transaction - the purchase of ten 30-year deferred annuity bonds, financed by a down payment and funds borrowed from the issuer against the cash surrender value of the bonds - was "a sham," lacking any appreciable economic results, because "there was nothing of substance to be realized [by the taxpayer] beyond a tax deduction" (364 U.S. at 366). The court diverted its attention from the taxpayer's tax avoidance motive and focused instead on the taxpayer's failure to establish the presence of business purpose (the taxpayer's subjective state of mind) or a justifying economic substance (an objective test) in the transaction.

The court based its conclusions on the fact that the taxpayer paid 3½ percent interest to the issuer of the bonds on its financing loan, while the investment grew at only 2½ percent per year. The net annual cash loss of one percent of the borrowed funds was incurred only to achieve a tax deduction for the interest paid, not for an "economic" profit. Although the taxpayer could have refinanced the loan if funds became available from another lender at a lower rate, he either failed to present evidence regarding the prospect of a decline in interest rates or failed to convince the trial judge that refinancing was a realistic option, and the Supreme Court implicitly assumed that it was not.(72)

In Goldstein, the taxpayer borrowed funds at 4 percent interest to purchase bonds paying 1½ percent interest and pledged the bonds as security for the loan. While the court held that the loans were not sham transactions because the indebtedness was valid, it nevertheless denied the interest deduction because the taxpayer did not enter into the transactions in order to derive any economic gain through appreciation in value of the bonds. Rather, the taxpayer borrowed the money solely in order to secure a large interest deduction which could be deducted from other income.

The Second Circuit's approach extended the sham transaction doctrine by adding an economic motivation requirement. As a result, the interest expense arising from even a bona fide indebtedness must meet an additional requirement of economic motivation to be deductible. Courts have denied interest deductions in transactions similar to those in Goldstein but without calling the transaction a sham - a term now reserved for a mere paper or "fake" transaction.(73) Under the economic motivation requirement, an interest deduction may be disallowed if no economic gain could be realized beyond a tax deduction.(74)

More recently, in ACM, supra, the Third Circuit applied the economic substance requirement and sham transaction doctrine to disallow losses generated by a partnership's purchase and resale of notes. The Tax Court, in disallowing the losses, stressed the taxpayer's lack of any nontax business motive. However, the Third Circuit, affirming the Tax Court, focused on the transaction's lack of economic substance. The court held the transaction lacked economic substance because it involved "only a fleeting and economically inconsequential investment by the taxpayer." The Tax Court pursued a similar approach in ASA Investerings, supra, to deny a loss on the purchase and resale of private placement notes.

The above judicial doctrines and the numerous of cases they have generated have proven difficult to translate into clear, bright-line rules. That difficulty stems in part from the highly complicated facts in those cases, and in part from the uncertainty as to which facts the courts believed credible and which facts proved relevant to the outcome.(75) As a result of this uncertainty, the exact scope of those judicial doctrines is ill-defined and potentially extremely broad. This breadth, in effect, has acted as yet another arrow in the Service's quiver by exerting a strong in terrorem effect. While those judicial doctrines may not be impermeable, they represent a broad range of weapons available to the Service to attack tax avoidance. Moreover, those doctrines already impose high costs on legitimate business planning and inhibit efficiency.

C. Current anti-abuse rules in the Code.

The Code contains numerous provisions that give the Treasury Department and the Service broad authority to prevent tax avoidance, to reallocate income and deductions, to deny tax benefits, and to ensure taxpayers clearly report income. An illustrative list of more than 70 provisions that explicitly grant Treasury and the Service such authority appears in Appendix B.

As demonstrated by this list, Treasury and the Service long have had powerful ammunition to challenge tax avoidance transactions. The Service has broad power to reallocate income, deductions, credits, or allowances between controlled taxpayers to prevent evasion of taxes or to clearly reflect income under section 482. While much attention has been focused in recent years on the application of section 482 in the international context, section 482 also applies broadly in purely domestic situations. The Service also has the authority to disregard a taxpayer's method of accounting if it does not clearly reflect income under section 446(b).

In the partnership context, the Service has issued broad anti-abuse regulations under subchapter K.(76) Those rules allow the Service to disregard the existence of a partnership, to adjust a partnership's methods of accounting, to reallocate items of income, gain, loss, deduction, or credit, or to otherwise adjust a partnership's or partner's tax treatment in situations where a transaction meets the literal requirements of a statutory or regulatory provision, but where the Service believes the results are inconsistent with the intent of the partnership tax rules.

The Service also has issued a series of far-reaching anti-abuse rules under its legislative grant of regulatory authority in the consolidated return area. For example, under Treas. Reg. Sec. 1.1502-20, a parent corporation is severely limited in its ability to deduct any loss on the sale of a consolidated subsidiary's stock. The consolidated return investment basis adjustment rules also contain an anti-avoidance rule.(77) The rule provides that the Service may make adjustments "as necessary" if a person acts with "a principal purpose" of avoiding the requirements of the consolidated return rules. The consolidated return rules feature several other anti-abuse rules.(78)

D. IRS Notices.

The Service from time to time has issued IRS Notices stating its intention to issue subsequent regulations that would shut down certain transactions. Thus, a Notice allows the government (assuming that the particular action is within Treasury's rulemaking authority) to move quickly, without having to await development of the regulations themselves - often a time-consuming process - that will provide more detailed rules concerning a particular transaction.

The Service has not been adverse to issuing such Notices. Recent examples include Notice 97-21, in which the Service addressed multiple-party financing transactions that used a special type of preferred stock; Notice 95-53, in which the Service addressed the tax consequences of "lease strip" or "stripping transactions" separating income from deductions; and Notices 94-46 and 94-93, addressing so-called "corporate inversion" transactions viewed as avoiding the 1986 Act's repeal of the General Utilities doctrine.(79) Appendix C includes an illustrative list of these types of IRS Notices issued in the past 10 years.

Moreover, the Service currently has the ability to prevent abusive transactions that occur before a Notice is issued. Section 7805(b) expressly gives the Service authority to issue regulations that have retroactive effect "to prevent abuse." Therefore, although many Notices have set the date of Notice issuance as the effective date for forthcoming regulations,(80) the Service can and has used its authority to announce regulations that would be effective for periods prior to the date the Notice was issued.(81) Alternatively, the Service in Notices has announced that it will rely on existing law to stop abusive transactions that have already occurred.(82)

Legislative changes.

To the extent that Treasury and the Service may lack rulemaking or administrative authority to challenge a particular transaction, the avenue remains open to seek enactment of legislation. In this regard, over the past 30 years dozens upon dozens of changes to the tax statute have been enacted to address perceived avoidance and abuses. Appendix D includes an illustrative list.

These legislative changes can be broken down into two general categories. The first includes legislative changes that respond specifically to a transaction deemed to be abusive or otherwise outside the intended scope of the tax laws. For example, bills (H.R. 435, S. 262) now pending before the 106th Congress would address "basis-shifting" transactions involving transfers of assets subject to liabilities under section 357(c). The proposal first was advanced by the Administration, in its FY 1999 budget submission, and subsequently was introduced as legislation by House Ways and Means Committee Chairman Bill Archer. Other recent examples of specific legislative actions to address potential or identified abuses would include a provision addressing liquidating REIT and RIC transactions enacted in the 1998(83) and a provision imposing a holding period requirement for claiming foreign tax credits with respect to dividends under section 901(k), enacted as part of the Taxpayer Relief Act of 1997.(84) The Administration's FY 2000 budget submission includes a number of proposals addressing specific types of transactions. As stated above, whether or not the tax policy rationales given by Treasury for these proposals are persuasive, as a procedural matter it is proper that these proposals now will undergo Congressional scrutiny.

These targeted legislative changes often have immediate, or even retroactive, application. For example, the section 357(c) proposal currently before Congress would be effective for transfers on or after October 19, 1998 - the date that Chairman Archer introduced the proposal in the form of legislation. Chairman Archer took this action, in part, to stop these transactions earlier than would have been the case under effective date originally proposed by the Administration (the date of enactment). Moreover, in some cases, Congress includes language in the legislative history stating that "no inference" is intended regarding the tax treatment under prior law of the transaction addressed in the legislation. This language is intended, in part, to preclude any interpretation that otherwise might arise that enactment of the provision necessarily means that the transaction in question was sanctioned by prior law.

It should be noted that Congress and the Administration do not always agree on the appropriateness of specific legislative proposals advanced by Treasury that purport to address areas of perceived abuse. In fact, more than 40 revenue-raising proposals proposed by the Administration in its last three budget proposals (for FY 1997, FY 1998, and FY 1999) have been rejected by the Congress. Appendix E provides a list of these Administration proposals.

The second category of legislation includes more general changes to the ground rules under which corporate tax executives and the Service operate. These "operative rules" include, for example, modifications to the penalty structure applicable to tax shelters, tax understatements, and negligence, as well as new reporting requirements. Operative changes generally are considered by Congress far less frequently than the changes targeting specific abuses, and for good reason. These changes typically are intended to influence taxpayer behavior or increase Service audit tools where Congress sees an identifiable need for change. Changes then usually are given time to take full effect so that their impact can be measured to determine if they have achieved their desired result or if additional action might be necessary.

In 1997, as discussed above, Congress enacted changes broadening the definition of "tax shelter" transactions subject to penalties and requiring that transactions be reported to the Service when undertaken under a confidentiality arrangement. Congress concluded that this change would "improve compliance by discouraging taxpayers from entering into questionable transactions."(85) Because these changes have not yet taken effect (a result of Treasury's failure to issue regulations - to this date - that would activate the changes), Congress has not yet had an opportunity to gauge their impact.

Before the 1997 Act changes to the tax shelter rules, Congress had last enacted operative changes in this area of the tax law as part of the Uruguay Round Agreement Act of 1994, under which Congress modified the substantial understatement penalty for corporations participating in tax shelters.

The corporate tax shelter proposals advanced in the Administration's FY 2000 budget that are within the scope of this testimony would represent the most far-reaching operative changes ever enacted by Congress. Moreover, not only would they take effect before Congress has had a chance to evaluate the impact of its last round of operative changes, they would take effect even before the last round of changes has entered into force. Such a change is unprecedented in the annals of tax policymaking in this area.

In some instances, these newly proposed operative provisions would allow Treasury to challenge the very same types of transactions that have been targeted by specific legislative changes sought by the Administration but rejected by Congress. Given the apparent divergence of views between Congress and the Administration on the appropriateness of specific tax legislative changes, it would be odd for the Congress at this time to hand Treasury and the Service unprecedented authority to dictate tax policy.


A. Responsibilities of corporate tax executives.

The chief tax executive of a typical U.S. corporation has many responsibilities and burdens in the tax preparation, collection, and enforcement process. This individual must oversee and implement systems to collect a variety of federal income, wage withholding, and excise taxes. He or she must be able to analyze and implement an incredibly complex, ever-changing and, in many instances, arcane and outdated tax system made up of an intricate jumble of statutes, case law, regulations, rulings, and administrative procedural requirements.

Notwithstanding this veritable maze of complicated and many times inconsistent rules that collectively comprises our tax law, this individual has a further responsibility to the management and shareholders of the corporation. He or she must understand management's business decisions and planning objectives, assess the tax law consequences of business activities, and counsel management about the tax consequences of various possible decisions. In the course of assisting management in the formation of business decisions, the corporate tax executive must assess the state of a very complex and uncertain tax law and must be able to provide advice to management on appropriate ways to minimize tax liabilities.

Once those business decisions are made, he or she must implement them by supervising the formation of applicable entities, creating necessary systems for capturing tax-related information as it is generated from the business, and implementing necessary procedures for the calculation and remittance of taxes, information returns, and other documentation and materials necessary for compliance under the federal tax laws. Finally, the chief tax executive must be able to explain the appropriateness of tax positions taken by the company, as well as its tax collection, remittance, and reporting systems, to the Service upon examination. (86)

In short, a chief tax executive must be able to understand an incredibly complex set of federal tax rules, advise and assist management in the formation of decisions that result in proper minimization of taxes, implement tax collection and reporting system for those decisions, and explain the appropriateness of those decisions and systems in examination discussions with the Service.

B. Tax executive's vital role to the U.S. government as tax administrator.

Collectively, the chief tax executives of U.S. corporations play a very significant role in the collection and remittance of federal taxes. They shoulder the ultimate responsibility within their corporations for adequate systems to collect and remit corporate income taxes, federal wage withholding taxes, and an array of excise taxes. The corporate tax department is the private administrator of the U.S. income tax.

It is estimated that corporate income tax collections in FY 1998 were $189 billion. Individual income tax payments withheld by corporations and remitted to the Treasury were approximately $375 billion, or more than 40 percent of gross individual income tax collected. Payroll tax withheld for Social Security and unemployment insurance by corporations amounted to approximately $315 billion, or 61 percent of payroll taxes collected. Corporations accounted for the bulk of the $76 billion in excise and customs duties collected. In sum, of the $1.7 trillion in tax revenue collected by the Federal government in FY 1998, corporations either remitted directly or withheld and remitted more than 50 percent, vastly reducing the compliance burden on the Service and individuals.

In addition to direct tax payments and withholding, corporations also provide information returns to the Service on payments made to employees, contractors, suppliers, and investors. In 1998 more than one billion information returns were filed by U.S. businesses with the Service, accounting for income and transactions exceeding $18 trillion.(87) In addition to providing this information to the Service, U.S. businesses also provide this information (as required) to affected taxpayers to assist them in meeting their tax filing obligations.(88) Corporations provided the vast majority of these information returns.

Without the help of corporate tax departments, collection and other administrative costs to the government would be significantly higher and rates of compliance significantly lower.

C. Challenges and burdens presented by tax law complexity.

1. In general: burdens and costs.

The extreme complexity of the U.S. tax law is especially burdensome for corporate taxpayers. Confronted by a jumble of statutes, case law, and administrative rulings and notices, the tax executives of a corporation often must take into account a veritable library full of materials in determining the appropriate tax treatment of a specific transaction.

There are 3,052 pages of statutory language in the Internal Revenue Code (1994 ed.), and 11,368 pages of Treasury regulations contained in Title 26 of the Code of Federal Regulations. (Additionally, the Treasury Department has a substantial backlog of unfinished guidance projects designed to assist in the clarification of these complex rules (see list contained in Appendix F)). Further, there are thousands of pages of Revenue Rulings, Revenue Procedures, Notices, private letter rulings, technical advice memoranda, field service memoranda, and other administrative materials potentially relevant to the determination of the appropriate tax treatment of a particular transaction. More than 9,300 Tax Court cases have been decided since 1949, and thousands of additional court precedents exist in tax cases decided by the U.S. District Courts, the U.S. Courts of Appeals, the Court of Claims, and the U.S. Supreme Court. Further, there are about 50 international tax treaties and various other agreements that may be applicable to the U.S. tax treatment of specific international transactions.

Research has found that the compliance costs of the corporate income tax resulting from this complexity are significant. In 1992, Professor Joel Slemrod of the University of Michigan surveyed firms in the Fortune 500 and found an average compliance cost of $2.11 million, or more than $1 billion for the entire Fortune 500.(89) The cost for a sample of 1,329 large firms was more than $2 billion in the aggregate. About 70 percent of this cost is estimated to be attributable to the federal tax system, with the remaining 30 percent attributable to State and local income taxes. These estimates exclude the costs of complying with payroll, property, excise, withholding, and other taxes.

The firms surveyed by Professor Slemrod generally were among the largest 5,000 U.S. companies. He found that compliance costs are largest for the biggest firms, but relative to firm payroll, assets, or sales, they are proportionately larger for the smaller firms in this sample.

The specific sources of the complexity of the U.S. tax law are many. In Professor Slemrod's survey, respondents were asked to identify the aspects of the tax law that were most responsible for the cost of compliance. Three aspects cited most often were the depreciation rules, the alternative minimum tax, and the uniform capitalization rules.

The depreciation and uniform capitalization rules are examples of the complexity created through differences between financial statement income and taxable income. The U.S. tax accounting rules deviate significantly from financial accounting rules, requiring substantial modifications to financial statement income in order to compute taxable income. This is in contrast to the tax laws of other countries, such as Japan, where there is much greater conformity between book income and taxable income. The depreciation and uniform capitalization rules also are examples of areas that have become more burdensome in recent years, with changes enacted with the Tax Reform Act of 1986 serving to increase the complexity.

The other area most frequently cited by the survey respondents, the alternative minimum tax, adds yet another layer of complexity. After making all the adjustments from financial statement income required in computing regular taxable income, the taxpayer then must compute alternative minimum taxable income. The computation of alternative minimum taxable income requires an extensive series of adjustments to regular taxable income, including adjustments to reflect different depreciation rules (which already is an area of particular complexity under the regular income tax). It is not just alternative minimum taxpayers that must make these computations; all these computations must be made in order for the taxpayer to determine whether it is subject to the alternative minimum tax. Moreover, like the depreciation and uniform capitalization rules, the alternative minimum tax rules were made significantly more burdensome by the 1986 Act changes.(90)

2. Complexity in international transactions.

For a corporate taxpayer with foreign operations or foreign-source income, compliance with complicated rules noted above is just the beginning. These taxpayers are subject to a set of detailed rules with respect to the U.S. tax treatment of the taxpayer's foreign income. The United States taxes domestic corporations on their worldwide income. The international tax rules -- both specific provisions and the body of rules in general -- were another area of complexity cited by many of the respondents in Professor Slemrod's study.

U.S. taxpayers must calculate separately domestic-source and foreign-source income. To do so, they must allocate and apportion all expenses between domestic and foreign sources. In addition, the foreign tax credit rules apply separately to nine different categories or "baskets" of income.(91) Accordingly, U.S. taxpayers must calculate foreign- and domestic-source income - and allocate and apportion expenses to such income - separately for each basket. All these computations then must be done again under the alternative minimum tax rules.

U.S. taxpayers with foreign subsidiaries must report currently for U.S. tax purposes certain types of the foreign subsidiaries' income, even though that income is not distributed currently to the U.S. parent. In addition to the complicated rules that must be applied to determine the portion of the subsidiaries' income that is subject to current inclusion, U.S. tax accounting rules must be applied to determine the foreign subsidiaries' earnings and profits (which may require a translation first from local GAAP to U.S. GAAP and then from U.S. GAAP to U.S. tax accounting principles). The U.S. parent also must include with its U.S. tax return detailed information with respect to each foreign subsidiary.(92)

Of course, a U.S. taxpayer with foreign operations is subject not just to the U.S. tax rules but also to the tax rules of the country where the operations are located. For many U.S. multinational corporations, this means that the corporation will be responsible for compliance with the tax laws of numerous jurisdictions around the world. The results of each operation must be reported both for local tax purposes and for U.S. tax purposes, under rules that may reflect significant differences in terms of both characterization and timing. Layered on top of the local and U.S. tax rules are the provisions of an applicable income tax treaty between the two countries. The treaty provisions have the effect of modifying the impact of the internal rules of the particular countries. Application of the treaty requires understanding of the provisions of the treaty itself as well as any understandings or protocols associated with the treaty and the Treasury Department's detailed technical explanation of the treaty.

One specific example of the tax law complexities and commensurate responsibilities confronting a chief tax executive of a large U.S.-based multinational corporation is the planning and analysis necessary to implement an internal restructuring of a line of business within the company. An internal restructuring of a particular business unit within a corporate structure may be desired by management to build efficiencies in the overall business, to prepare for an acquisition of a related line of business, or to prepare for a disposition of a line of business. In any event, the chief tax executive must research and analyze dozens of discrete tax issues in the implementation of this management decision, including the choice of appropriate entity (e.g., partnership, corporation, or single member LLC), place of organization (involving State tax or international tax issues), possible carryover of tax attributes (e.g., accounting methods and periods, earnings and profits, and capital and net operating losses), consideration of new tax elections, and consideration of the application of complex consolidated tax return regulations. Moreover, if the internal restructuring impacts any foreign operations of the company, the chief tax executive also must research and analyze all the foreign tax implications of the restructuring. The foreign tax treatment of the internal restructuring - and of any alternative approaches to accomplishing the business objectives - may be very different than the U.S. tax treatment of the same transaction or transactions.

D. Responsibility of the corporate tax executive to shareholders.

Corporate executives have a fiduciary duty to increase the value of a corporation for the benefit of its shareholders. Reducing a corporation's overall tax liability can increase the value of a corporation's stock. There are, however, several reasons that corporate tax executives will avoid undertaking aggressive, tax-motivated transactions.

Corporate tax executives must meet professional and company-imposed ethical standards that preclude taking unsupported, negligent, or fraudulent tax positions.(93) Also, incurring significant tax penalties has the effect of reducing shareholder value. If the reversal of a tax position and the cost of the penalties are not properly provided for in a company's financial statements, a restatement of those financial statements may be required, which could be devastating to a corporation's stock value. Financial accounting standards require that all material tax positions which are contingent as to their outcome must be specifically disclosed to shareholders. Also, with most corporations focused on preserving and enhancing their brands, corporate tax executives are careful not to recommend a transaction to management that later might be reported unfavorably in the national press as being improper.


This section of the testimony sets out views of the role played by accounting firms in providing assistance to corporations on tax issues.

A. Reasons why corporate tax executives need assistance.

As discussed previously, the chief tax executive of a corporation has many duties and burdens in analyzing federal, State, and foreign tax consequences of business decisions, implementing collection and remittance systems for a variety of federal and State income and excise taxes, and reviewing tax return positions with Service and State tax personnel upon examination of tax return positions. These duties require accurate analysis of very complex federal statutes, regulations, rulings, and administrative procedures, which in turn requires keeping current on statutory, regulatory, and administrative developments as well as a burgeoning body of case law. Also, today's chief tax executive must have an intimate knowledge of information technology systems designed to capture necessary tax data from business operations and provide essential compliance and remittance functions.

Only in the smallest of corporate business contexts can one person be charged with all these disparate responsibilities. In large corporations, even with the assistance of a significant number of knowledgeable staff, the chief tax executive must turn to outside advisers for professional assistance for a variety of consulting and compliance needs.

Assisting tax executives fulfill duties as tax administrators.

The accounting profession provides invaluable assistance to the chief tax executive in his or her role as a tax administrator charged with the collection and remittance of a variety of federal taxes. Accounting firms provide assistance in designing and implementing information technology systems to track data for preparation of the company's tax return, as well as systems for collecting, remitting, and providing appropriate information returns and schedules for employee withholding and other taxes.(94) In many instances, the chief tax executive of a corporation utilizes a mix of systems provided by accounting firms and other service providers which are then implemented by corporate personnel; in other instances, compliance and reporting functions are "outsourced" in whole or in part to accounting firms by the corporation.

To the extent accounting firms assist in the tax administrator role of the chief tax executive of a corporation, the accounting firm is subject to the commensurate duties to provide accurate data collection, retrieval, remittance, and reporting systems. Given the sophisticated information technology systems necessary in large corporations to comply with the complex tax laws, it is fair to say that the accounting profession's involvement substantially enhances corporate tax compliance and augments Service tax administration.

C. Assistance in addressing complex analytical issues.

The ever-changing tax law, with its lack of precision and clarity, requires a chief tax executive to confront analytical difficulties in assessing the tax consequences of business activities. Many of these business activities are common to many corporations and industries. For example, considerable uncertainty exists currently as to the appropriate tax classification of a variety of expenditures made by corporations in upgrading technological business systems.

The accounting profession can bring invaluable assistance to corporate tax executives faced with having to analyze the tax consequences of an array of business activities where the appropriate tax analysis is not clear from the rules and procedures, and where the time invested by the corporation in developing an independent analysis of the taxation of a business activity cannot be justified given the broad experience of professional advisors in analyzing similar situations for other corporations. (95) In such cases, the accounting firm providing analytical assistance is subject to standards of professional responsibility. (96)

Also, decisions made to promote the objectives of a corporation -- for example, to expand a U.S.- based business abroad or to divest a portion of the business deemed no longer part of the "focus" of the corporation -- can result in literally hundreds of substantive tax issues that must be researched and assessed in order to provide the chief tax executive a degree of certainty that certain tax positions are appropriate. Only the largest corporations have tax departments of sufficient size and personnel specialization to afford the company the ability to perform this necessary analysis internally. In many cases, the accounting profession provides essential assistance to corporations in fulfilling these analytical responsibilities.

D. Assistance in prudent tax planning.

Corporate executives have fiduciary duties to shareholders to consider the tax results of various potential business decisions and appropriately to minimize the tax impact of business operations. Accordingly, in working closely with management, the chief tax executive of a corporation must offer proactive assistance in structuring business decisions to meet planning objectives while prudently minimizing tax consequences.

As one simple example, a company may feel that the product manufactured by a particular subsidiary no longer promotes the business objectives of the corporation. The value of the subsidiary exceeds the tax basis in its assets, and if the subsidiary were sold a large capital gain would be realized and recognized by the corporation. A prudent tax professional would recommend to management that, as part of its overall business decision making process regarding the subsidiary, a tax-free reorganization be considered, possibly a spin-off of the subsidiary to the corporation's shareholders for a valid business purpose (the fit and focus of the remaining group) while preserving the most value of the subsidiary to those shareholders. The chief tax executive of a corporation would be remiss if he or she did not focus management on the tax implications of this potential decision and actively explore alternative business structures to fulfill management objectives.(97)

Accounting firms provide professional consulting services to the chief tax executive as various planning ideas are reviewed and analyzed to determine the most advantageous method for implementing business objectives from a tax standpoint. Such planning assistance is necessary for most corporations that do not have sufficient internal resources to review and understand the vast number of issues involved in assessing the best structure or optimal course of action necessary to fulfill corporate objectives in the most tax-efficient manner.

In some areas of business planning, many corporations may share similar objectives. For example, many corporations across various industries recently have been investigating mergers to obtain essential business economies of scale. Accordingly, accounting firms have developed specialty expertise in many complex and sophisticated issues relating to the taxation of merger and acquisition activity. These firms thus can advise corporate executives in an efficient manner on merger and acquisition issues without forcing the executives to "reinvent the wheel" by devoting a significant amount of time and resources to obtaining solutions that accounting firms have more readily available because of specialization and experience. Also, to the extent that the contemplated transaction would result in potential foreign tax law consequences, the fact that large accounting firms have personnel or affiliated firms in multiple world-wide locations means that they can provide efficient services to the chief corporate executive of a U.S.-based multinational corporation.


We respectfully urge Congress to reject the Administration's broad proposals relating to "corporate tax shelters." As discussed above, the proposals could affect many legitimate business transactions, further hamstringing corporate tax executives seeking to navigate the maze of federal, State, and international tax laws applicable to corporations. Congress already has provided Treasury with ample administrative tools - some of which Treasury has not yet self-activated - to address situations of perceived abuse. There is no demonstrated need at this time to expand these tools, particularly in such a way that would give the Service's revenue agents nearly carte blanche authority to "deny tax benefits." Instead, where specific areas of concern are identified, Congress and the Treasury should work together - as they have done in the past - to enact legislation targeting such cases.

1. General Explanation of the Administration's Revenue Proposals, Department of the Treasury, February 1999, pp. 95-105.

2. Budget of the United States Government: Fiscal Year 2000, Analytical Perspectives, p. 71.

3. The Economic and Budget Outlook: Fiscal Years 2000-2009, Congressional Budget Office, January 1999, p. 53.

4. Ibid.

5. Approximately 80 percent of corporate income is earned by corporations subject to the 35-percent top statutory rate. The largest 7,500 corporations account for approximately 80 percent of all the corporate income tax collected.

6. The Economic and Budget Outlook: Fiscal Years 2000-2009, supra n.4., at 131.

7. Internal Revenue Service Restructuring and Reform Act of 1998, P.L. 105-208.

8. General Explanation of the Administration's Revenue Proposals, Department of the Treasury, February 1998, p. 144.

9. Id. at 143.

10. Taxpayer Relief Act of 1997, P.L. 105-34.

11. Under the 1997 legislation, the statutory definition of a tax shelter was modified to eliminate the requirement that the tax shelter have as "the principal purpose" the avoidance or evasion of Federal income tax; the new law requires only that the tax shelter have as "a significant purpose" the avoidance or evasion of tax. See discussion in Part IV below of current penalties and registration requirements applicable to tax shelters.

12. Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in 1997 (JCS-23-97), December 17, 1997, p. 222.

13. It should be noted that this unfinished regulation project is but one of many interpretive projects that the Treasury Department has not completed; the collective effect of this unfinished work is considerable uncertainty for corporate taxpayers attempting to comply with the tax law in good faith. This issue will be discussed further in these comments, and an illustrative list of unfinished regulation projects relevant to corporate taxpayers is set forth in Appendix F.

14. P.L. 105-208, sec. 3801.

15. P.L 105-277, sec. 3001 (provision aimed at attempts to read statutory provisions as permitting income deducted by a liquidating REIT or RIC and paid to its parent corporation to be entirely tax free during the period of liquidation).

16. A provision addressing the tax treatment of certain transfers of assets subject to liabilities described in section 357(c) passed the House February 8, 1999, as part of H.R. 435; an identical provision was approved by the Senate Finance Committee January 22, 1999, as part of S. 262. The provisions would apply to transfers on or after October 19, 1998, the date on which House Ways and Means Committee Chairman Bill Archer introduced legislation on this topic. That legislation was developed by Chairman Archer in coordination with the Treasury Department in response to concerns that some taxpayers were structuring transactions "to take advantage of the uncertainty" under the tax law.

17. Treasury Department activities to stop perceived avoidance transactions will be discussed in further detail in these comments. An illustrative list of prior Treasury Department administrative actions to stop perceived avoidance is set forth in Appendix C.

18. The "Improved Penalty Administration and Compliance Tax Act" was enacted as part of the Omnibus Budget Reconciliation Act of 1989. (P.L. 101-239, secs. 7701-7743)

19. See n.14, supra.

20. Judge Hand wrote: "Over and over again courts have said that there is nothing sinister in so arranging one's affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced extractions, not voluntary contributions" (Comm'r v. Newman, 159 F.2d 848, 850-51 (2d Cir.1947) (dissenting opinion)).

21. See H.Rpt. No. 871, 78th Cong., 1st Sess. 49 (1943).

22. Modern Home Fire and Casualty Insur. Co. v. Comm'r, 54 TC 839 (1970).

23. Depending on the terms of the relevant contractual arrangements, the other participants who paid the tax on the income of the foreign person might well seek to recover that tax from the foreign person.

24. This follows from the facts that the trigger for applying several of the proposed sanctions (other than the understatement penalty) is the mere existence of a corporate tax shelter, and that the definition of a corporate tax shelter does not appear to exclude any arrangement based on the substantive correctness of the positions taken by the taxpayer. Sanctions that could be invoked on this basis include the denial of tax benefits under section 269, the denial of deductions for fees paid, the excise tax on fees received, and the excise tax on tax benefit guarantees. Indeed, it would appear that by permitting the denial of benefits under section 269 without reference to substantive correctness, the Treasury proposal then could come full circle and impose an understatement penalty on the taxpayer even though its position had been shown to be substantively correct in the first instance.

25. There is an oblique reference to hybrid arrangements in connection with the proposal that would prohibit taxpayers from taking a position that is inconsistent with the form of their transactions.

26. For example, the parent might receive a foreign tax credit for the underlying U.S. corporate tax paid by the U.S. subsidiary, or the dividends might be eliminated through a "participation exemption" or similar regime.

27. See Notice 98-5 and the Administration's 1998 budget proposals.

28. The Notice proposes rules that would trigger subpart F inclusions with respect to payments involving hybrid branches only if such payments had the effect of reducing foreign taxes. The policy debate concerning the substantive treatment set forth in the statute is beyond the scope of this testimony - it should suffice for our purposes here to note that Treasury does seem to object to foreign tax reduction by U.S. taxpayers.

29. A detailed description of the responsibilities and burdens of a chief tax executive is set forth in Part V of these comments.

30. Section 6662(d)(2)(C)(iii). Prior law defined tax shelter activity as an entity, plan or arrangement only if it had as its primary purpose the avoidance or evasion of tax.

31. Treas. Reg. section 1.6662-3(b)(2).

32. Treas. Reg. section 1.6662-3(b)(1).

33. Pursuant to Treas. Reg. section 1.6662-3(b)(3), the "reasonable basis" standard is a relatively high standard of tax reporting and is not satisfied by a return position that is merely arguable or merely a colorable claim. A return position generally satisfies the standard if it is reasonably based on one or more of the authorities set forth in Treas. Reg. section 1.6662-4(d)(3)(iii), taking into account the relevance and persuasiveness of the authorities and subsequent developments, even though it may not satisfy the substantial authority standard as defined in Treas. Reg. section 1.6662-4(d)(2).

34. Treas. Reg. section 1.6662-3(b).

35. Section 6662(e)(1) provides that a valuation misstatement is substantial if: the value or adjusted basis of any property claimed on any income tax return is 200 percent or more of the correct value or adjusted basis; or (a) the price for any property or services (or for the use of property) in connection with any transaction between trades or businesses owned or controlled, directly or indirectly, by the same interests (as described in section 482) is 200 percent or more (or 50 percent or less) of the amount determined to be the correct amount of such price, or (b) in tax years beginning after December 31, 1993, the net section 482 transfer price adjustment for the tax year exceeds the lesser of $5,000,000 or 10 percent of the taxpayer's gross receipts. Pursuant to section 6662(h)(2), a gross valuation misstatement occurs where: the value or adjusted basis of any property claimed on any return is 400 percent or more of the amount determined to be the correct value or adjusted basis; or (a) the price for any property, or for its use, or for services, claimed on any return in connection with a transaction between persons described in section 482 is 400 percent or more (or 25 percent or less) of the amount described in section 482 to be the correct amount of such price, or (b) in tax years beginning after December 31, 1993, the net section 482 transfer price adjustment for the tax year exceeds the lesser of $20,000,000 or 20 percent of the taxpayer's gross receipts.

36. DHL Corp. v. Comm'r, T.C. Memo. 198-461, December 30, 1998.

37. The penalty studies were required by section 3801 of the Internal Revenue Service Restructuring and Reform Act of 1998.

38. A statement with respect to the allowability of any deduction or credit, the excludability of any income, or the securing of any other tax benefit by reason of holding an interest in the entity or participating in the plan or arrangement which the person knows or has reason to know is false or fraudulent as to any material matter. Section 6700(a)(2)(A).

39. A gross valuation overstatement is a statement as to the value of property or services that is directly related to the amount of any income tax deduction or credit, provided that the value exceeds 200 percent of the correct value. Section 6700(a)(2)(B).

40. Section 6707(a)(3).

41. A position is considered to satisfy the realistic possibility standard if a reasonable and well-informed analysis by a person knowledgeable in tax law would lead that person to conclude that the position has approximately a one-in-three, or greater, likelihood of being sustained on its merits. Treas. Reg. section 1.6694-2(b)(1). In determining whether a position has a realistic possibility of being sustained, the relevant authorities are the same as those considered in determining whether, for purposes of the accuracy-related penalty, there is substantial authority for a tax return position. Treas. Reg. section 1.6694-2(b)(2).

42. A frivolous position is one that is patently improper. Treas. Reg. section 1.6694-2(c)(2).

43. Treas. Reg. section 1.6694-2(d).

44. The term "tax shelter organizer" is defined as the person who is principally responsible for organizing a tax shelter ("the principal organizer"), i.e., any person who discovers, creates, investigates, or initiates the investment, devises the business or financial plans for the investment, or carries out those plans through negotiations or transactions with others. Temp. Treas. Reg. section 301.6111-1T, A-27.

45. The temporary regulations provide that certain investments will not be subject to tax shelter registration even if they technically meet the definition of a tax shelter. The following investments are not subject to registration: (1) sales of residences primarily to persons who are expected to use the residences as their principal place of residence, and (2) with certain exceptions, sales or leases of tangible personal property by the manufacturer (or a member of an affiliated group) of the property primarily to persons who are expected to use the property in their principal active trade or business. By Notice, the Service may specify other investments that are exempt from the registration requirement. Temp. Treas. Reg. section 301.6111-1T, A-24. In addition, the tax shelter registration requirements are suspended with respect to any tax shelter that is a "projected income investment." Generally, a tax shelter is a projected income investment if it is not expected to reduce the cumulative tax liability of any investor for any year during any of the first five years ending after the date on which the investment is offered for sale.

46. As in the case of the definition of "tax shelter" for accuracy-related penalty purposes, the terms "significant purpose" and "tax avoidance" are not defined or explained for tax shelter registration purposes.

47. A transaction is offered under conditions of confidentiality if: (1) a potential participant (or any person acting on its behalf) has an understanding or agreement with or for the benefit of any promoter to restrict or limit the potential participant's disclosure of the tax shelter or any significant tax features of the tax shelter; or (2) the promoter (a) claims, knows, or has reason to know, (b) knows or has reason to know that any other person (other than the potential participant) claims, or (c) causes another person to claim that the transaction (or any aspect thereof) is proprietary to the promoter or any party other than the potential participant, or is otherwise protected from disclosure or use. Section 6111(d)(2).

48. See, e.g., section 7203.

49. Gregory v. Helvering [35-1 USTC para. 9043], 293 U.S. 465 (1935), which generally is regarded as the origin of the business purpose doctrine, involved a reorganization motivated by tax avoidance.

50. In Commissioner v. Transport Trading & Terminal Corp. [49-2 USTC para. 9337], 176 F.2d 570 (2d Cir. 1949), cert. denied, 338 U.S. 955 (1950), the doctrine was extended to all statutes that describe commercial transactions.

51. The Business Purpose Doctrine: The Effect of Motive on Federal Income Tax Liability, 49 Fordham L. Rev. 1078, 1080 (1981).

52. Stewart v. Commissioner [83-2 USTC para. 9573], 714 F.2d 977, 987 (9th Cir. 1983).

53. 49 Fordham L. Rev. at 1080-81 (listing examples and collecting citations).

54. Gregory v. Helvering, supra n. 49.

55. Helvering v. Horst [40-2 USTC para. 9787], 311 U.S. 112, 114-120 (1940) (holding that income, rather than income-producing property, had been assigned).

56. Commissioner v. Court Holding Co. [45-1 USTC para. 9215], 324 U.S. 331, 333-334 (1945).

57. Frank Lyon Co. v. U.S. [78-1 USTC para. 9370], 435 U.S. 561 (1978).

58. Knetsch v. U.S. [60-2 USTC para. 9785], 364 U.S. 361 (1960).

59. Moline Properties, Inc. v. Commissioner [43-1 USTC para. 9464], 319 U.S. 436, 438-439 (1943).

60. 157 F3d 231 (3d Cir. 1998).

61. [98-2 USTC para. 52,845], T.C.M. 1998-305 (1998).

62. See, e.g., ASA Investerings, supra; ACM Partnership, supra.

63. Supra n. 49.

64. Braddock Land Co.v. Commissioner, 75 T.C. 324, 329 (1980).

65. Higgins v. Smith, 308 U.S. 473 (1940); U.S. v. Morris & E.R. Co., 135 F.2d 711, 713 (2d Cir. 1943) ("[T]he Treasury may take a taxpayer at his word, so to say; when that serves its purpose, it may treat his corporation as a different person from himself; but that is a rule which works only in the Treasury's own favor[.]"), cert. denied, 320 U.S. 754 (1943).

66. Penrod v. Commissioner, 88 T.C. 1415, 1428 (1987). See M. Ginsburg & J. Levin, Mergers, Acquisitions and Buyouts, ¶608 (Oct. 1998 ed.).

67. Ginsburg & Levin, supra, at ¶608.1.

68. Id.

69. See, e.g., Jacobs Engineering Group v. U.S. [97-1 USTC para. 50,340], No. CV 96-2662, 1997 U.S. Dist. LEXIS 3467 (C.D. Calif. March 6, 1997); Associated Wholesale Grocers v. U.S. [91-1 USTC para. 50,165], 927 F.2d 1517 (10th Cir. 1991); Security Industrial Insurance Co. v. U.S. [83-1 USTC para. 9320], 702 F.2d 1234 (5th Cir. 1983).

70. 60-2 USTC para. 9785], 364 U.S. 361 (1960).

71. [66-2 USTC para. 9561], 364 F.2D 734 (2d Circ. 1966), cert. denied 385 U.S. 1005 (1967)

72. B. Bittker, Pervasive Judicial Doctrines in the Construction of the Internal Revenue Code, 21 How. L. J. 693 (1978).

73. Rice's Toyota World, Inc. v. Commissioner, 81 T.C. 184, 200 (1983).

74. See, e.g., Rothschild v. U.S. [69-1 USTC para. 9224], 186 Ct.Cl. 709, 407 F.2d 404, 406 (1969).

75. Bittker, supra n. 72.

76. Treas. Reg. § 1.701-2.

77. Treas. Reg. § 1.1502-32(e).

78. E.g., Treas. Reg. § 1.1502-13(h) (anti-avoidance rules with respect to the intercompany transaction provisions) and Treas. Reg. § 1.1502-17(c) (anti-avoidance rules with respect to the consolidated return accounting methods).

79. The General Utilities doctrine generally provided for nonrecognition of gain or loss on a corporation's distribution of property to its shareholders with respect to their stock. See, General Utils. & Operating Co. v. Helvering, 296 US 200 (1935). The General Utilities doctrine was repealed in 1986 out of concern that the doctrine tended to undermine the application of the corporate-level income tax. H.R. Rep. No. 426, 99th Cong., 1st Sess. 282 (1985).

80. See, e.g., Notice 95-53, 1995-2 CB 334, and Notice 89-37, 1989-1 CB 679.

81. See, e.g., Notice 97-21, 1997-1 CB 407.

82. Notice 96-39, I.R.B. 1996-32.

83. P.L. 105-277, section 3001.

84. P.L. 105-34, section 1053.

85. Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in 1997 222 (1997).

86. Large corporations are enrolled in the Service's coordinated examination program (CEP) and generally are under continuous audit by the Service to assure the appropriateness of tax return positions taken by those corporations.

87. Not all dollar amounts reported on information returns are included in income. For example, the 1099-B reports the gross proceeds from the sale of certain investments. Only the gain from the sale of these investments is included in gross income.

88. These information returns include Form W-2 (Wage and Tax Statement), Form W-2G (Certain Gambling Winnings), Form 1099-DIV (Dividends and Distributions), Form 1099-INT (Interest Income), Form 1099-MISC (Miscellaneous Income), Form 1099-OID (Original Issue Discount), Form 1099-R (Distributions from Pensions, Annuities, etc.), Form 1099-B (Proceeds from Broker and Barter exchange Transactions), Form 5498 (Individual Retirement Arrangement Contribution Information), Form 1099-A, Acquisition or Abandonment of Secured Property, Form 1098 (Mortgage Interest Statement), Form 1099-S (Proceeds from Real Estate Transactions), Form 1099C (relating to forgiven debt), Form 5498-MSA (Medical Savings Account Information), Form 1099-MSA (Distributions from Medical Savings Accounts), Form 1099-LTC (Long-Term Care and Accelerated Death Benefits), and Form 1098-E (Student Loan Interest Statement).

89. Joel B. Slemrod and Marsha Blumenthal, "The Income Tax Compliance Cost of Big Business," Public Finance Quarterly, October 1996, v. 24, no. 4, pp. 411-438.

90. Respondents in Professor Slemrod's survey, supra n. 89, cited alternative minimum tax, uniform capitalization, and depreciation as among the 1986 Act provisions that most contributed to increasing the complexity of the U.S. tax system.

91. The rules currently create additional income baskets for dividends from each foreign corporation in which the taxpayer owns a 10-percent voting interest but which is not a controlled foreign corporation. Although the Taxpayer Relief Act of 1997 included a provision eliminating these additional baskets, that provision will not be effective until 2003. (A Treasury budget proposal would accelerate this elimination.)

92. Provisions enacted with the 1997 Act require similar reporting with respect to foreign partnerships in which the U.S. taxpayer has an interest.

93. Corporate tax executives are governed by professional conduct standards promulgated by the American Bar Association (ABA) and the American Institute of Certified Public Accountants (AICPA) if the corporate tax executive is a member of either of these two professions. In addition, a corporate tax executive is governed by "Circular 230" (31 C.F.R. Part 10), which provides rules of conduct for practicing before the Service. Additionally, the existing penalty provisions (discussed above) that apply to the corporation act as a significant deterrent to a tax exeuctive's recommending a transaction that might trigger penalties.

94. Payroll service firms and other service providers also can provide corporations with assistance in tax administrative functions.

95. Law firms provide legal advice with respect to tax analytical and planning issues. These comments are focused on the role of accounting firms.

96. The AICPA's "Statements on Responsibilities in Tax Practice" (1988 Rev.) consist of advisory opinions that provide conduct guidelines to practicing CPAs. The statements (cited as "SRTPs") cover a number of common situations that the practicing CPA deals with on a regular basis. Most importantly, SRTP No. 1 provides guidelines for taking tax return positions.

97. It is pertinent to note that the tax law allows taxpayers to select among a variety of structures and forms to accomplish business objectives, some of those decisions resulting in lower ultimate tax liability than other decisions. This deliberation and choice for taxpayers should be considered a normal part of the income tax system, and should not be inhibited or penalized. For example, the staff of the Joint Committee on Taxation does not consider choosing doing business in partnership form (subject to a single level of tax on operations) instead of doing business in corporate form (subject to taxation at the corporate and shareholder levels) a tax expenditure, or exception to normal tax rules. See, Joint Committee on Taxation, Estimates of Federal Tax Expenditures For Fiscal Years 1999-2003 (JCS-7-98), December 14, 1998, p. 6.