Corporations will be required to attach forms to their US tax returns disclosing details about transactions that the US authorities will probably want to examine on audit under new rules issued by the Internal Revenue Service in early March.

The new rules are part of an all-out war the US Treasury is waging against aggressive US tax planning by corporations. The government is alarmed at the growing market in “tax products” being peddled by the big accounting firms and investment banks. It has asked Congress for more tools to combat the trend and is hoping, in the meantime, that greater disclosure of the details of these transactions will act as a deterrent.

The new rules also require promoters of corporate tax shelters to register them with the Internal Revenue Service before the shelters are offered to corporations and to keep a list of companies they persuade to invest in case the IRS wants to see it.

The IRS has scheduled a public hearing for June 20 to collect comments.

Disclosure

Under the new rules, any corporation that participates “directly or indirectly” in a “reportable transaction” must attach a form with the details of the transaction to its tax returns for each year the transaction affects its US tax position. A copy of the form must also be sent the first year to a special office the IRS has set up to monitor aggressive tax schemes.

Two things must be true before a tax maneuver rises to the level of a “reportable transaction.”

First, either it must appear on a list of transactions the government considers abusive — so-called “listed transactions” — or it must possess some of the following characteristics. Any two of these characteristics will require reporting.

• The corporation participated in the transaction “under conditions of confidentiality.” An example is where the transaction was pitched to the corporation as a proprietary idea by an outside tax adviser.
• The corporation has contractual protection against the possibility that some of the tax benefits will be disallowed. Examples of contractual protection are an unwind clause, a right to a partial refund of fees, fees that are contingent in the first instance on the tax benefits from the transaction, or a tax indemnity. However, a tax indemnity from another participant in the transaction who had no role in promoting it — such as the tax indemnities that lessees give lessors in big-ticket lease transactions — are not a problem.
• The advisers who “promoted, solicited or recommended” the transaction to the corporation are expected to receive more than $100,000 in aggregate fees. However, fees only count if they are contingent on closing the transaction.
• The expected treatment of the transaction for tax purposes is expected to differ from its book treatment by more than $5 million in any single year.
• One of the other parties to the transaction is in a different tax position — like a tax-exempt entity or foreign person — and this lets the corporation realize tax benefits that it could not have gotten otherwise.
• The transaction is a hybrid in the sense that “any significant aspect” is expected to be characterized differently by the tax authorities in the US and a foreign country.

Second, the expected tax benefits from the transaction must be large enough to warrant IRS attention. A “listed transaction” satisfies the dollar thresholds if the corporation expects to reduce its federal income taxes by more than $1 million in a single year or more than $2 million in any combination of years. The thresholds for other transactions are more than $5 million in a single year or more than $10 million in any combination of years.

The IRS published an initial list of “listed transactions” on February 28. It has on it 10 items. They include LILOs, or lease-in-lease-out transactions where a foreign entity or US municipality leases a power plant, gas pipeline or other equipment to a US equity and subleases it back, certain tax plays involving foreign tax credits that are described in IRS Notice 98-5, “lease strips,” and ACM Partnership-type transactions.

There is one important exception from disclosure. This exception should exempt plain-vanilla lease transactions in the US domestic market from disclosure; whether the exception covers cross-border lease deals is less clear. A transaction does not have to be reported if the corporation “participated in the transaction in the ordinary course of its business in a form consistent with customary commercial practice” and either would have participated on substantially the same terms irrespective of tax benefits or “there is a long-standing and generally accepted understanding” that the transaction works from a US tax standpoint. The exception does not cover “listed transactions.”

The new disclosure requirement applies to tax maneuvers entered into after February 28, 2000.

Some closed deals may also have to be reported. Any “listed transaction” closed during 1999 will probably have to be reported. The rule is that a listed transaction that already closed can escape disclosure only if the corporation already claimed tax benefits from it on an annual tax return it filed with the IRS before February 28, 2000.

Companies are barred from disposing of any documents relating to disclosed transactions, even drafts. These include all internal e-mails and memos and all communications between the company and outside promoters, advisers, lenders or other parties to the transaction that the company had in its possession at any time on or after February 28, 2000. IRS officials admit the ban is probably too broad. The new rules are “temporary and proposed” and may undergo some revision before they are reissued in final form. They are effective as written in the meantime.

Advance Registration

The new rules also require promoters of corporate tax shelters to register them with the Internal Revenue Service before the shelters are offered to corporations.

Three things must be true about a transaction before registration is required.

First, it must have “avoidance or evasion” of federal income taxes as a “significant purpose.” So-called listed transactions fall into this category automatically. Other transactions where federal income tax benefits are “an important part of the intended results” do also, but only where the promoter expects to offer the transaction to more than one potential participant. Thus, unless the transaction is a one-off deal that will never be repeated, it will trip this “avoidance or evasion” test. Transactions that lack economic substance also involve avoidance or evasion. A transaction lacks economic substance if the pre-tax profit the company expects from the transaction — “after taking into account foreign taxes as expenses and transaction costs” — in present-value terms is insignificant compared to the expected tax savings. The economic substance of transactions to raise debt or equity capital is tested differently. They lack economic substance if the present value of the tax deductions to the borrower significantly exceeds the pre-tax return expected by the lender or equity participant.

Second, the transaction must be offered “under conditions of confidentiality.” The accounting firms expected this condition would be easy to avoid. The IRS said there can be implied confidentiality for a transaction — for example, where the accounting firm leads the company to believe the idea is proprietary. The IRS effectively issued a challenge: a transaction is not offered under conditions of confidentiality if the promoter signs a written agreement with everyone with whom he discusses possible participation “expressly authoriz[ing] such persons to disclose every aspect of the transaction with any and all persons, without limitation of any kind.”

Finally, the promoters must be expected to receive more than $100,000 in total fees. Fees from all “substantially similar” deals the promoter does must be aggregated. Thus, if he expects to repeat the deal several times with other companies, the fees add up to a much larger number.

Registration applies to tax shelters offered after February 28, 2000. If a shelter was offered before, registration will be triggered the first time it is offered again after February 28. Registration must occur before interests in the transaction are “offered for sale.” However, the IRS is giving promoters a grace period until August 26 this year to file registrations required by the new rules. None is required before then.

Many tax shelters were already subject to IRS registration, but tax schemes offered to corporations often escaped these rules. The new rules broaden the net. Registrations are filed on IRS Form 8264.

Tax maneuvers engaged in by foreign companies may have to be registered. These will be viewed as involving indirect participation by a US company — and, therefore, as potentially involving the “avoidance or evasion” of US taxes — if a US company owns at least 10% of the shares by vote or value of the foreign company that is the direct participant in the scheme. If the foreign company is a partnership for US tax purposes, ownership by the US company of at least a 10% capital or profits interest, or expected receipt of at least 10% of loss allocations, will be enough to require US registration.

Investor List

Promoters must also keep a list for seven years of companies they persuade to invest in corporate tax shelters in case the IRS wants to see it.

Lists are required even for corporate tax shelters that do not have to be registered. While three things must be true about a corporate tax shelter before the promoter has to register it, he must keep a list of investors in any transaction that has US tax “avoidance or evasion” as a significant purpose, regardless of whether it was offered under conditions of confidentiality or the amount of fees paid.

by Keith Martin, in Washington