Rules Change For Registering Corporate Tax Shelters

Rules Change For Registering Corporate Tax Shelters

August 01, 2001

The Bush administration made changes in early August to rules that require corporations to attach forms to their tax returns disclosing details about transactions that the US authorities will probably want to examine on audit.

The revisions make it less likely that corporate tax shelters will have to be disclosed in the future.

US Treasury officials were very concerned during the Clinton administration about the growing market in “tax products” being peddled by the big accounting firms and investment banks.  Last year in March, the Internal Revenue Service issued regulations requiring greater disclosure of the details of corporate tax shelter transactions in the hope that this would act as a deterrent to the marketing of such products.  The regulations also require promoters of corporate tax shelters to register them with the IRS 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 disclosure regulations came under fire from the business community.

In early August, the Bush Treasury made a number of revisions.  Most are clarifying in nature.  However, the government has dropped the fact that a transaction is a “hybrid” — meaning that it is expected to be characterized differently by the tax authorities in the US and a foreign country — as a factor suggesting it might be a tax shelter.  In addition, the government will no longer require promoters to register transactions merely because they produce an insignificant profit in relation to the tax benefits.  The rules, as revised in August, are now as follows.

Disclosure

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 typically 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.  For this purpose, 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.

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” in February 2000, but has updated it several times since then.  The list now has on it 16 items.  They include LILOs, or lease-in-lease-out transactions where a foreign entity or US municipality leases a power plant, gas pipeline, railcars or other equipment to a US investor 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.  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 generally accepted understanding” that the transaction works from a US tax standpoint.  The exception does not cover “listed transactions.” The exception exempts plain-vanilla lease transactions from disclosure, whether they are domestic or cross-border.  Other more exotic lease transactions — such as defeased deals — would seem more problematic.

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

Companies are barred from disposing of any documents “that are material to an understanding of the facts of the transaction, the expected tax treatment of the transaction, or the corporation’s decision to participate in the transaction.” The new disclosure regulations are “temporary and proposed” and may undergo some further revision before they are reissued in final form.  They are effective as written in the meantime.

Tax Shelter Registration

IRS regulations 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.

Second, the transaction must be offered “under conditions of confidentiality.” The IRS said there can be implied confidentiality for a transaction — for example, where an accounting firm, investment banker or other promoter 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.”

Many tax shelters were already subject to IRS registration, but tax schemes offered to corporations often escaped these rules The new regulations 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.  As noted above, three things must be true about a corporate tax shelter before the promoter has to register it.  However, 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