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Acceptable tax shelters make use of permitted loopholes
or tax breaks which are there to encourage certain types
of economic behaviour. The vast majority of tax shelters
are in full compliance with the tax laws, but an increasing
number of them have crossed the bounds into being what
the Government terms "abusive tax shelters". These are
cases where the revenue loss to the government produces
little or no tax benefit to society.
The Tax Reform
Act of 1986 represented the last major attack by Government
on tax shelters; in 2000 it tried again, but was stymied
by Congress. In 2003 the Treasury Department released
a new set of rules defining what it considers to be
'abusive' tax shelters. Throughout 2003 and 2004, the
IRS and the Treasury concentrated their attack, with
some success, more on the advisory firms that produce
and 'market' tax shelters, rather than on the corporate
users of the schemes.
Proposals to
close further tax 'loopholes' approved by the Senate
Finance Committee in early 2007 were removed by Congress
from the legislation to which they had been attached.
Many US tax shelters
are business ventures in which accounting losses far
exceed the accounting income. These losses are used
to offset the taxpayer's income from other sources.
Usually, a tax shelter also provides large deductions
in its early years although the taxpayer may not have
invested significant amounts of capital up front. For
example, a taxpayer might purchase a rental property
with a low down payment and offset his rental income
with deductions for interest, taxes, and the maximum
allowable depreciation.
Generally, losses are generated in the first
years of existence and passed through to investors,
who sometimes achieve a complete return of their original
investment through tax savings in the first two or three
years. But the existence of a loss does not always indicate
a tax shelter. A loss may also occur as a result of
business operations or from an unusual event such as
a casualty loss. The key element which distinguishes
a tax shelter loss from a true business loss is the
substance of the event which gave rise to the loss.
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Tax
Shelter Techniques |
There are many
methods by which taxpayers shelter their losses, but
these three characteristics are usually found in tax
shelters, either separately or in combination:
- Taxes are
deferred to later years;
- Ordinary gains (100 percent taxable) are
converted to capital gains (only 40 percent taxable),
or capital losses (only 50 percent deductible), are
converted to ordinary losses (100 percent deductible);
in both cases producing a lower tax liability;
- Leverage is obtained through various financing
arrangements.
Deferral also
occurs when excessive deductions are taken in the early
years of a tax shelter, a practice the IRS calls "front
end loading." Examples of illegal front end loading
practices are:
- Deducting capital items by classifying
them as advisory fees, management fees, or interest;
- Deducting prepaid interest;
- Not including
prepaid income;
- Deducting excessive depreciation, amortization,
or depletion by using the wrong method, too short
a useful life; and/or too large a basis.
The administration's
attempted legislation in 2000 included an extensive
package of revenue raisers targeting perceived corporate
tax shelters, corporate transactions, financial products,
international transactions, and insurance. New proposals
included the following:
- Tax shelter
penalties. The substantial understatement penalty
imposed on corporate tax shelter items (as redefined)
generally was to be increased to 40% (from 20%), with
no reasonable cause exception, effective for transactions
entered into on or after the date of "first committee
action;'
- Treasury authority to deny tax benefits.
The Treasury Department would disallow deductions,
credits, exclusions, or other allowances obtained
in a corporate tax shelter, effective for transactions
entered into on or after the date of first committee
action;
- No deduction
for corporate tax shelters. The proposal would deny
deductions for fees and tax advice expenses related
to corporate tax shelters and would impose a 25% excise
tax on fees received in connection with promoting
or rendering tax advice related to corporate tax shelters.
The proposal would be effective for payments made
and fees received on or after the date of first committee
action;
- Excise tax
on tax shelter "recission" provisions. The proposal
would impose on the corporate purchaser of a corporate
tax shelter an excise tax of 25% of the maximum payment
to be made under a tax benefit "protection arrangement."
These arrangements include certain recission clauses,
guarantees of tax benefits, or other arrangements
(e.g., insurance) protecting the purchaser. The proposal
would be effective for arrangements entered into on
or after the date of first committee action;
- Positions inconsistent with transaction
form. The proposal generally would preclude corporate
taxpayers from taking any position (on a tax return
or refund claim) that the Federal income tax treatment
of a transaction is different from that dictated by
its form if a "tax indifferent" person has a direct
or indirect interest in the transaction. Tax indifferent
persons would be defined as foreign persons, tax-exempt
organizations, Native American tribal organizations,
and domestic corporations with expiring loss or credit
carryforwards. The proposal would not apply where
the taxpayer discloses the inconsistent position on
its tax return. The proposal would be effective for
transactions entered into on or after the date of
first committee action;
- Tax-indifferent parties. Income allocable
to a tax-indifferent party with respect to a corporate
tax shelter would be taxable; other participants in
the tax shelter would be jointly liable for the tax.
The proposal would be effective for transactions entered
into on or after the date of first committee action;
- Forward stock sales. A corporate issuer
of stock sold through a forward sale contract would
be required to recognize as interest the time-value
element of the forward contract. The proposal would
be effective for forward contracts entered into on
or after the date of first committee action;
- Built-in losses. The proposal targets the
"importation" of foreign losses and other tax attributes
incurred outside the U.S. taxing jurisdiction that
are used to offset income or gain otherwise subject
to U.S. tax. The proposal would eliminate such attributes
and require that tax basis be marked to market in
certain circumstances, effective for transactions
in which assets or entities become "relevant" for
U.S. tax purposes on or after the date of enactment;
- S corporation
ESOPs. The proposal would 1) require an ESOP to pay
tax on S corporation income (including capital gains)
as the income is earned and 2) allow the ESOP a deduction
for distributions of such income to plan beneficiaries.
The proposal would be effective for taxable years
beginning, acquisitions of S corporation stock, and
S corporation elections made on or after the date
of first committee action;
- Serial liquidations.
The proposal would impose withholding tax on any distribution
made to a foreign corporation in complete liquidation
of a U.S. holding company if the holding company was
in existence for less than five years; the proposal
also would apply with respect to serial terminations
of U.S. branches. The proposal would be effective
for liquidations and terminations occurring on or
after the date of enactment;
- Basis shifting
transactions. To prevent taxpayers from attempting
to offset capital gains by generating artificial capital
losses through basis-shift transactions involving
foreign shareholders, the proposal would treat the
portion of a dividend that is not subject to current
U.S. tax as a nontaxed portion. The proposal would
be effective for distributions made on or after the
date of first committee action;
- Lessors of tax-exempt property. The proposal
would deny a lessor the ability to recognize a net
loss from a leasing transaction involving tax-exempt
use property during the lease term, effective for
leasing transactions entered into on or after the
date of enactment. For this purpose, tax-exempt use
property would include property leased to governments,
tax-exempt organizations, and foreign persons;
- Mismatching of deductions and income. Deductions
for amounts accrued but unpaid to related controlled
foreign corporations, passive foreign investment companies,
or foreign personal holding companies generally would
be allowable only to the extent the amounts accrued
by the payor are, for U.S. purposes, reflected in
the income of the direct or indirect U.S. owners of
the related foreign person. An exception would be
provided for certain short-term transactions entered
into in the ordinary course of business. The proposal
would be effective for amounts accrued on or after
the date of first committee action;
This is a useful
list of tax shelters, from the taxpayers' perspective,
especially since the Congress refused to pass the administration's
Bill. There were further proposals:
- Control test. The proposal would conform
the control requirement for tax-free incorporations,
distributions, and reorganizations with the ownership
test used for determining affiliation, effective for
transactions on or after the date of enactment;
- Tracking stock. The proposal would give
Treasury authority to treat "tracking stock" as nonstock
(e.g., debt or a notional principal contract) or as
stock of another entity as appropriate to prevent
tax avoidance, effective for stock issued on or after
the date of enactment;
- Transfers of intangibles. The transfer
of an interest in intangible property constituting
less than all of the substantial rights of the transferor
in the property would be treated as a tax-free transfer,
but the transferor would be required to allocate the
basis of the intangible between the retained rights
and the transferred rights based on their respective
fair market values. Consistent reporting would be
required. The proposal would be effective for transfers
on or after the date of enactment;
- Downstream mergers. Where a target corporation
holds less than 80% of the stock of an acquiring corporation,
and the target combines with the acquiring corporation
in a reorganization in which the acquiring corporation
is the survivor, the target would have to recognize
gain, but not loss, as if it distributed the acquiring
corporation stock that it held immediately prior to
the reorganization. The proposal would apply to transactions
occurring on or after the date of enactment;
- Bank short-term
obligations. The proposal would require banks to accrue
interest and original issue discount on all short-term
obligations, including loans made in the ordinary
course of the bank's business, effective for obligations
acquired or originated on or after the date of enactment;
- Current accrual of market discount. A taxpayer
that uses an accrual method of accounting would be
required to include market discount income as it accrues,
effective for debt instruments acquired on or after
the date of enactment;
- Partnership constructive ownership transactions.
The proposal would treat long-term capital gain recognized
from a "constructive ownership" derivative transaction
as ordinary income to the extent the long-term capital
gain recognized from the transaction exceeds the long-term
capital gain that could have been recognized had the
taxpayer invested in the partnership interest directly.
The proposal would apply to gains recognized on or
after the date of first committee action;
- Debt-financed portfolio stock. The proposal
would tighten current-law rules requiring a corporation
to reduce its dividends-received deduction with respect
to dividends paid on debt-financed portfolio stock.
The proposal would be effective for portfolio stock
acquired on or after the date of enactment;
- Debt-for-debt exchanges. The proposal would
spread the issuer's net reduction for bond repurchase
premium in a debt-for-debt exchange over the term
of the new debt instrument using constant yield principles,
among other changes. The proposal would apply to debt-for-debt
exchanges occurring on or after the date of enactment
- Straddle rules. The proposal would 1) clarify
that net interest expense and carrying charges arising
from structured financial products containing a leg
of a straddle must be capitalized and 2) repeal the
current-law exception for certain straddles of actively
traded stock, effective for straddles entered into
on or after the date of enactment;
- Effectively connected income. The proposal
would expand the categories of foreign-source income
that could constitute effectively connected income
under IRC section 864(c)(4)(B)(ii) to include income
that may be sourced by analogy to interest (interest
equivalents) or dividends (dividend equivalents).
Interest equivalents would include letter-of-credit
fees, guarantee fees, and loan commitment fees. The
proposal would be effective for taxable years beginning
after the date of enactment;
- Overall foreign losses. For the purposes
of IRC section 904(f), property subject to the recapture
rules upon disposition under IRC section 904(f)(3)
would include stock in a controlled foreign corporation,
effective beginning on the date of enactment.
The tax-shelter
industry on Wall Street moved into top gear after the
proposals were anounced, pushing through large numbers
of schemes before the doors shut; but in the event the
Bill languished.
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The
Treasury's 2002/2003 Offensive |
During 2002 the Internal Revenue
Service mounted a Tax Shelter Disclosure Initiative,
which it said was a success, leading to 621 disclosures
covering 947 tax returns, and involving more than $16
billion in claimed losses and deductions.
The initiative was aimed at
corporate taxpayers and wealthy individuals worried
that tax shelters which they were using might be illegal,
but afraid to come forward. In return for full disclosure
regarding the transactions and details of the schemes,
the IRS promised to waive accuracy-related penalties
which might apply to tax shelter and other questionable
items on a return at a rate as high as 20%.
'Hundreds of taxpayers came
forward and took advantage of this opportunity to voluntarily
disclose questionable tax transactions and submit the
names of abusive tax shelter promoters,' said Larry
Langdon, the IRS Commissioner of Large and Mid-Size
Business.
In May, 2003, the US Treasury
Department and Internal Revenue Service released a final
version of their new rules designed to curb the promotion
and use of abusive tax shelters.
The rules are intended to update
earlier tax shelter disclosure laws which were too narrow,
and allowed many tax shelter promoters to slip through
the net. However, concerns were expressed that they
will almost certainly lead to an additional compliance
burden for individual and corporate taxpayers, who will
likely be asked to disclose details of perfectly legal
arrangements.
According to a Treasury statement,
six categories of potential tax avoidance transactions
are covered. Taxpayers will be required to disclose
and promoters will be require to maintain investor lists
for six categories of transactions:
- Listed transactions (i.e.,
transaction that have been specifically identified
by the IRS as tax avoidance transactions);
- Transactions marketed under
conditions of confidentiality;
- Transactions with contractual
protection;
- Transactions generating a
tax loss exceeding specified amounts;
- Transactions resulting in
a book-tax difference exceeding $10 million; and
- Transactions generating a
tax credit when the underlying asset is held for a
brief period of time.
The US Treasury Department
also issued new rules covering professional conduct
known as 'Circular 230'. This was circulated in draft
in early 2003, and late in the year the Treasury confirmed
that the stiff draft rules would be put into force.
Assistant Treasury Secretary for tax policy Pamela Olson
explained: "We initially thought we were going to be
making a lot of changes” to the draft proposals. "But after reflecting on what
we've seen in the last couple of years, we don't think
we should be watering these down," added Olson. "We
think we should come out with a strong set of rules."
The focus during 2003 was indeed
very much on professionals involved in setting up tax
shelters, both in terms of attacking them directly,
and in terms of trying to force them to disgorge details
of shelters they have set up for taxpayers, although
the IRS has had only mixed success in this latter endeavour.
In June the IRS issued a summons
against a top law firm, ordering it to disclose the
names of 600 wealthy clients that the agency alleged
were sold tax shelter schemes. Chicago federal judge
John W. Darrah approved a request by the Revenue to
issue the summons against Dallas-based law firm Jenkens
and Gilchrist on the grounds that the firm had supposedly
taken around $72 million in fees for tax shelter advice,
according to Justice Department papers. Jenkens and
Gilchrist declared that it had no intention of compromising
client confidentiality and would not divulge details
of any of the names contained in the summons.
Then in July a three-judge
panel at the United States Court of Appeals for the
Seventh Circuit ruled that accounting firm BDO Seidman
must turn over the names of investors in tax shelters
to the IRS. The court found that under the US tax code,
BDO is obliged to keep records on tax sheltering arrangements,
and to report to the IRS the indentities of investors
in such schemes. This, the panel explained, means that
investors in the tax shelters did not have 'an expectation
of confidentiality in their communications with BDO,'
as the accounting firm had argued. And in October a
federal court ruled that the Chicago office of law firm,
Sidley Austin Brown & Wood must hand over information
about clients who have invested in 13 tax minimization
schemes since 1996. IRS Commissioner, Mark Everson explained
that: "Our actions show that we will require attorneys
who act as promoters to comply with the law's requirement
that they maintain lists of investors for certain abusive
transactions and furnish those lists, upon request,
to the IRS."
On the other hand, one of the
IRS's most prominent targets, KPMG, scored a success
in October when a specially appointed Master recommended
to a federal court that the company did not have to
hand over all the documents requested by the IRS, according
to a Wall Street Journal report. The IRS was seeking
to enforce 25 summonses that it had sent to KPMG demanding
tax sheltering documentation. The firm had handed over
hundreds of boxes of paperwork, but had also withheld
many documents, arguing that to lay them open to scrutiny
would be to breach client privilege. Consequently, in
December 2002, the Washington DC federal court appointed
retired US Magistrate Judge Patrick Attridge to appraise
KPMG's claim and examine the documents in question.
In his judgement delivered on October 8, Judge Attridge
ruled that whilst KPMG must hand over some of the documents,
those that contained material covered by client-attorney
privilege may be retained by the firm.
Congress was also been playing
its part in the tax-shelter crack-down in 2003. In December,
Charles Grassley, Chairman of the influential Senate
Finance Committee, announced that he wanted to accelerate
legislation that would crack down on so-called LILO
(lease in, lease out) tax shelters which had become
a popular tax saving vehicle with many corporations.
Under the leasing schemes, municipalities are paid an
up-front accommodation fee to lease their infrastructure
to a corporation. Grassley says that the cash received
by the municipality, however, pales in comparison to
the federal tax benefits received by the corporations,
which are able to depreciate taxpayer-funded bridges,
subways, and rail systems as a result of the lease.
"The shelter promoters are hiding behind the cities
and are sending them to Capitol Hill to talk about what
an important source of funding this is. This has nothing
to do with a ‘public-private' partnership. This is just
good, old-fashioned tax fraud," Grassley announced in
a statement.
Hearings into tax sheltering
held by the Senate Permanent Subcommittee on Investigations
in November, 2003, also gained a lot of publicity, although
they did not lead to much legislation since they were
organised largely by Democrat senators. The Senate subcommittee
came to the following conclusions: "First, the investigation
has found that the tax shelter industry is no longer
focused primarily on providing individualized tax advice
to persons who initiate contact with a tax advisor.
Instead, the industry focus has expanded to developing
a steady supply of generic “tax products” that can be
aggressively marketed to multiple clients. In short,
the tax shelter industry has moved from providing one-on-one
tax advice in response to tax inquiries to also initiating,
designing, and mass marketing tax shelter products."
"Secondly, the investigation
has found that numerous respected members of the American
business community are now heavily involved in the development,
marketing, and implementation of generic tax products
whose objective is not to achieve a business or economic
purpose, but to reduce or eliminate a client’s US tax
liability. Dubious tax shelter sales are no longer the
province of shady, fly-by-night companies with limited
resources. They are now big business, assigned to talented
professionals at the top of their fields and able to
draw upon the vast resources and reputations of the
country’s largest accounting firms, law firms, investment
advisory firms, and banks." Well, what a surprise!
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The
Treasury's 2004 Campaign |
Ominously, a member of the US Public Company
Accounting Oversight Board (set up under the SEC as
a result of the Sarbanes-Oxley Act) hinted in 2004 that
the organisation was considering reforms that would
prevent corporate auditors from offering certain tax
planning and sheltering services to their audit clients.
Mark Goelzer, a member of the board, advised auditors
in comments prepared for the mutual fund industry to
exhibit caution when offering these services to clients.
"I have no problem with auditors assisting their clients
with traditional tax compliance and routine planning,"
Goelzer explained, but added that: "Tax services that
go beyond that - especially the marketing to audit clients
of novel, tax-driven, financial products - raise serious
issues." However, Goelzer went on to acknowledge that
reforming this controversial area of tax planning was
not going to be straightforward, as the boundaries between
traditional tax advice and the advocation of tax shelters
are often blurred. Nevertheless, given the public and
political fury vented following the collapse of firms
such as Enron and Worldcom, often at the accounting
firms which sold tax shelters to these companies, Goelzer
explained that "the board may have to try its hand at
solving the problem."
New IRS rules on the registering
and reporting of tax shelters also had to be taken seriously.
Under the terms of the new registration rules, advisers
are obliged to report to the IRS any tax minimization
products and services offered which the tax agency has
dubbed 'abusive tax shelters'. The reporting rules require
tax professionals to file a Reportable Transaction Disclosure
Statement 8886 with clients' tax returns for each year
that they have participated in the tax sheltering arrangement,
and with the Office of Tax Shelter Analysis for their
first year of involvement in the scheme. The new list
maintenance rules require that tax advisers maintain
lists of participants in so-called abusive tax shelters
for possible future inspection by the tax authority.
In January, 2004, the Treasury
Department announced a raft of legislative proposals
to be included in President Bush’s 2005 budget aimed
at closing tax loopholes, nullifying tax shelters, and
simplifying the taxation system.
Commenting on the series of
new proposals, which aim to clamp down on tax abuse
on a broad front, then-Treasury Secretary John Snow
remarked: “The laws must ensure that those who would
shirk their civic responsibilities cannot do so by exploiting
unintended loopholes, and the IRS must ensure that taxpayers
do not engage in abusive tax avoidance transactions.”
“We are committed to restoring
confidence in the tax system by ending the proliferation
of abusive tax avoidance transactions and simplifying
the tax code,” added Treasury Assistant Secretary for
Tax Policy Pam Olson. “Ultimately, there is no “silver
bullet” or “one-size-fits-all” solution addressing abusive
tax avoidance transactions — other than continuing to
simplify the tax code and ensure that the tax results
match the economic realities of the transactions,” she
observed.
Meanwhile, IRS Commissioner
Mark W. Everson hoped that a new policy of tougher penalties
would help to drive home the administration’s zero-tolerance
message, which it intends to send out with the glut
of new proposals. According to the Treasury, they would
seek to:
- Impose Penalties on the Failure
to Disclose Potentially Abusive Transactions;
- Permit Uniform Disclosure
Rules for Potentially Abusive Transactions;
- Permit Injunction Actions
against Promoters who Repeatedly Disregard the Registration
and List-Maintenance Requirements;
- Impose a Penalty for the
Failure to Report an Interest in a Foreign Financial
Account;
- Curb Abusive Income-Separation
Transactions;
- Eliminate Obstacles to Disclosure;
- Increase Penalties for False
or Fraudulent Statements Made to Promote Abusive Tax
Avoidance Transactions;
- Eliminate Abusive Transactions
Involving Foreign Tax Credits;
- Stop Abusive Leasing Transactions
with Tax-Indifferent Parties;
- Require Charitable Deductions
to Reflect Accurately the Value of the Donation;
- Prevent Misuse of Tax-Exempt
Casualty Insurance Companies;
- Address the Tax Consequences
of Changing Beneficiaries of a Section 529 College
Savings Plan;
- Tighten the Deduction Limitation
for Interest Paid to Related Parties;
- Prevent Avoidance of U.S.
Tax on Foreign Earnings Invested in U.S. Property;
- Modify Tax Rules for Individuals
Who Give Up U.S. Citizenship or Green Card Status;
- Curb Frivolous Returns and
Submissions;
- Terminate Instalment Agreements
when Taxpayers Fail to File Returns or Make Tax Deposits;
- Streamline the Handling of
Collection Due Process Cases;
- Improve Procedures for Taxpayers
Seeking to Resolve Their Tax Liabilities;
- Make the Payment of FMS (Financial
Management Services) Fees for Levies More Efficient;
- Expand the Use of Electronic
Filing;
- Permit Private Collection
Agencies to Support the IRS’ Collection Efforts
“I’m very pleased the administration
is continuing its attacks on illicit tax shelters,”
noted Senator Charles Grassley. "The administration
should receive high marks for its anti-tax shelter efforts.
It’s issued numerous shelter regulations over the past
year and laid down a solid response to attacking this
problem. Congress needs to back up these efforts by
passing tax shelter legislation,” he observed.
Later in January, tax collectors
in twelve states, including California and New York,
met with representatives from the Federation of Tax
Administrators and the Multistate Tax Commission to
discuss how to combat tax sheltering on a broad front.
"California is joining forces
with other states to crack down on abusive tax shelters,
and we're putting our collective resources to work,"
commented Californian State Controller Steve Westly.
"We're going to use the best ideas from every state
to find and prosecute tax cheats," he added.
The other participating states
and cities included Colorado, Connecticut, Illinois,
Massachusetts, Michigan, Minnesota, New Jersey, Ohio,
Tennessee, and Wisconsin, as well as New York City.
California also offered a Voluntary
Compliance Initiative for taxpayers who invested in
abusive tax shelters. Taxpayers had until April 15 to
correct their tax returns and make full payment of the
taxes owed or face new harsh penalties. The Californian
Franchise Tax Board claims the state loses $600 million
to $1 billion in tax money annually through abusive
tax sheltering.
In 2003, 41 states, among them
New York and California, signed a Memorandum of Understanding
with the IRS allowing federal and state tax collection
agencies to pool their collective information on delinquent
taxpayers and concentrate the battle against abusive
tax shelters.
At the end of the month, the
Treasury Department issued a ruling to shut down abusive
transactions involving ‘S corporation ESOPs’ (employee
stock ownership plans) in a ruling that will classify
such investments as listed transactions for the purposes
of tax shelter disclosure.
According to a Treasury statement:
“An employee stock ownership plan is a type of retirement
plan that invests primarily in employer stock. Congress
has allowed an ‘S corporation’ to be owned by an ESOP,
but only if the ESOP gives rank-and-file employees a
meaningful stake in the S corporation. When an ESOP owns an S Corporation,
the profits of that corporation generally are not taxed
until the ESOP makes distributions to the company’s
employees when they retire or leave the job. This is
an important tax break which allows the company to reinvest
profits on a tax-deferred basis, for the ultimate benefit
of employees who are ESOP participants.
“The ruling shuts down transactions
that move business profits of the S corporation away
from the ESOP, so that rank-and-file employees do not
benefit from the arrangement. For example, the ruling
prohibits using stock options on a subsidiary to drain
value out of the ESOP for the benefit of the S corporation’s
former owners or key employees.”
Treasury Assistant Secretary
for Tax Policy Pam Olson observed: "Congress recognized
the potential for attempts to circumvent the rules and
specifically authorized Treasury and IRS to prevent
it. This notice does just that, imposing a 50% excise
tax on the option holders in cases where rank-and-file
ESOP participants are deprived of the business profits."
In May,
2004, the IRS announced a new amnesty scheme for taxpayers
who may have employed a tax minimisation technique commonly
referred to as ‘Son of Boss,’ which the agency claims
has deprived the government of some $6 billion in tax
revenues. The so-called Son of Boss scheme is derived
from an earlier scheme known as ‘Boss’ (bond and option
sales strategy), and was commonly used in the late 1990s
to offset large one-off gains such as the sale of a
business.
However, according to IRS Chief
Mark W. Everson: “Son of Boss deals had only one purpose
– the elimination of tax. These transactions were developed
and marketed by an interlocking network of commercial
interests, including leading law firms, accounting firms
and investment banks.”
The IRS claims that many transactions
undertaken through Son of Boss schemes generated tax
losses of between $10 million and $50 million leading
to a total understatement of tax in excess of $6 billion.
Under the terms of the amnesty,
which are a lot less generous than previous amnesty
programs, eligible taxpayers must concede 100% of the
claimed tax losses, must pay all applicable interest
and must accept the imposition of a penalty unless they
had previously disclosed their participation in the
transaction.
However, participating taxpayers
will be allowed to deduct as a loss their out of pocket
transaction costs, typically promoter and professional
fees.
Everson points out that taxpayers
will remain able to contest the IRS in court over such
issues, although he warned that the government will
“vigorously pursue the full tax due”, plus full interest
and penalty payments owing. However, IRS officials revealed
to the Washington Post that taxpayers will be barred
from using the agency's normal appeals process to contest
such cases. Confirming the agency's tough stance on
the subject, IRS Chief Counsel Donald Korb added that
taxpayers "should not expect to settle court cases on
terms more favorable than those offered in the IRS settlement
initiative.”
Also in May, law firm Jenkens
and Gilchrist was ordered by a federal judge to hand
over the names of clients who invested in tax schemes
formulated by its Tax and Estate Planning Practice Group
and its Structured Investment Practice, between June
1998 and June 2003. The ruling marked the conclusion
of a five year battle between the firm and the Internal
Revenue Service.
Ruling at the Northern District
of Illinois court on Friday, US District Judge James
Moran granted permission for the law firm's clients
to raise claims of attorney-client privilege. However,
he observed that there "does not appear to be...sustainable
grounds for the assertion of privilege for the great
majority of client materials", and warned that clients
would be penalised for bringing frivolous privilege
claims.
Despite some tactical victories,
an informant for the IRS told Congress in July, 2004,
that the agency is ill-equipped to win the battle against
the increasingly sophisticated use of tax shelters.
"From my vantage point, the IRS simply does not understand
how the tax shelters work, or how the transactions and
structures fit together," the Senate Finance Committee
was told by the anonymous witness, who works for a Wall
Street bank. The problem is being compounded by the
IRS’s lack of trusted informants and confidential witnesses,
the banker known as ‘Mr ABC’ testified.
The informant went on to give
as an example a situation in which the IRS failed to
act on his disclosure in 1999 that Enron was engaged
in illegitimate tax activities in a bid to artificially
drive up the company’s earnings. The witness stated
that in all, he had made disclosures to the IRS on three
types of tax shelters and other schemes involving around
$10 billion in taxable income. He expressed dismay that
the IRS had seen fit not to offer any type of reward
for such substantial revelations of illegal tax dealings.
Ruling
in September in Manhattan's district court in the case
of Seippel v. Jenkens and Gilchrist, Southern
District Judge Shira A. Scheindlin allowed fraud and
recission claims against the Sidley Austin Brown &
Wood law firm to proceed. Telecommunications executive, William Seippel
participated in a tax sheltering arrangement known as
COBRA (Currency Options Bring Reward Alternatives),
which was developed by Jenkens & Gilchrist in conjunction
with Brown & Wood, prior to the latter's merger
with Sidley & Austin in 2001.
Following an Internal Revenue
Service investigation into the shelter which led to
Mr Seippel and his wife paying more than $5 million
in taxes, penalties and fees, the couple sued the law
firms in question alleging fraud, infringement of the
Racketeer Influenced and Corrupt Organizations (RICO)
Act, legal malpractice, breach of contract, negligent
misrepresentation, and breach of fiduciary duty.
Although Judge Scheindlin dismissed
the RICO, malpractice, breach of contract, negligent
misrepresentation and breach of fiduciary duty claims,
she allowed the fraud and recission of fees actions
to continue, observing that:
"The fact that the Seippels
may not ultimately owe the tax authorities additional
taxes does not mean that their action is not ripe. The
Seippels allege that they have been damaged, and continue
to be damaged, as a result of the defendants' conduct."
She continued: "Their damages
include the fees paid to defendants, losses incurred
in the transactions, expenses paid to accountants and
attorneys that are assisting the Seippels in defending
the audits, losses caused as a result of being forced
to sell assets at distressed prices to meet tax obligations,
and tax penalties already assessed and paid."
Towards the end of 2004, however,
the IRS lost a series of tax shelter cases, although
it did score one signal triumph.
In November, the US Court of
Federal Claims in Washington rejected a claim by the
IRS that industrial firm, Coltec Industries, used sham
transactions in order to avoid taxes, representing the
second defeat for the agency in a tax shelter case in
the space of two weeks. The IRS argued that Coltec,
a maker of aircraft landing systems, had used a transaction
known as a contingent liability deal to generate capital
losses which the firm used to offset capital gains from
the sale of a business unit in 1996. However, Judge
Susan Branden rejected the IRS’s argument that the transactions
had no economic purpose, and stated that in her opinion
Coltec had complied with all the statutory requirements
laid down by Congress. Awarding Coltec an $82.8 million
refund, Judge Branden suggested that: “The use of the
'economic substance' doctrine to trump 'mere compliance
with the code' would violate the separation of powers"
as laid down in the US Constitution.
Then the IRS suffered a similar
defeat in a case involving Black & Decker Corp.,
where an US district court in Baltimore upheld the firm’s
right to a $57 million refund centred on a transaction
that the agency deemed abusive.
The IRS's third court defeat
in the space of two weeks came when it was ordered by
Judge Stefan R. Underhill of the United States District
Court of Connecticut to refund TIFD III-E Inc, a subsidiary
of General Electric Corp., more than $62 million. At
the heart of the case was a complex set of transactions
involving three GE subsidiaries which formed a partnership,
Castle Harbour, in 1993, to which GE contributed a number
of aircraft in addition to cash and stock worth more
than $500 million in total.
The partnership’s three shareholders,
of which TIFD III-E was one, then sold their stake to
two Dutch banks and for tax purposes, the subsidiary's
income was allocated to the banks, which did not pay
US income taxes. Judge Underhill disagreed that the
transactions had no economic substance, as the Dutch
banks had invested in Castle Harbour, and observed that
"the economic reality of such a transaction is hard
to dispute." However, he also acknowledged that one
of GE’s principle motives was avoidance of tax.
"In short, the transaction,
though it sheltered a great deal of income from taxes,
was legally permissible," he wrote in his judgement.
However, he added: "Under such circumstances, the IRS
should address its concerns to those who write the tax
laws."
The IRS's success came in December
when a federal jury convicted six people in a $120 million
tax shelter scheme described by the authorities as one
of the most extensive cases of its type ever tried.
The case involved the Washington state-based firm Anderson
Ark and Associates, which charged around 1,500 clients
fees ranging from $50,000 to $250,000 for tax shelter
plans that helped them take income tax deductions in
the period form 1997 to 2001.
The schemes, which were sold
over the internet, involved transactions using shell
companies and loans connected to Costa Rican bank accounts
to create the appearance that clients had legitimate
tax-deductible business expenses. Six defendants were
convicted of a number of offences after the seven-week
trial, including filing false tax returns, mail fraud,
wire fraud, and money laundering.
Welcoming the verdict, IRS
Commissioner Mark W. Everson noted that the case represents
“a real blow to promoters of shady offshore tax schemes."
The authorities are considering re-filing charges against
four defendants about whom the jury was unable to reach
a verdict.
Rounding off a busy year for
the tax avoidance industry, the US government issued
final regulations amending Treasury Department Circular
230, which apply to attorneys, accountants and other
tax professionals who practice before the IRS, providing
standards of practice for written advice that reflect
current best practices, and are intended to restore
and maintain public confidence in tax professionals.
The revisions aim to ensure
that tax professionals do not provide inadequate advice,
and to increase transparency by requiring tax professionals
to make disclosures if the advice is incomplete. Welcoming
the new measures, IRS Commissioner Mark W. Everson commented:
“These new standards send a strong message to tax professionals
considering selling a questionable product to clients.
The new provisions give us more tools to battle abusive
tax avoidance transactions and to rein in practitioners
who disregard their ethical obligations.”
Ensuring that attorneys, accountants
and other tax practitioners adhere to professional standards
is one of the IRS’s top four enforcement goals, and
the agency considers the Circular 230 revisions a key
component of this strategy. The final regulations provide
best practices for all tax advisors, mandatory requirements
for written advice that presents a greater potential
for concern, and minimum standards for other advice.
“These revisions to Circular
230 strike an appropriate balance between tightening
practitioner standards and minimizing burden on everyday
advice,” noted Assistant Secretary for Tax Policy Greg
Jenner. “These rules target the types of written advice
that present a significant cause for concern and avoid
undue interference with the practitioner-client relationship,”
he added.
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