US companies with deals that might not close until very late this year should take into account the possibility that Congress might pass legislation this fall to penalize corporations and outside advisers involved in aggressive tax schemes that are later disallowed by the tax authorities.

A senior US Treasury official predicted at an American Bar Association meeting in August that such legislation would be enacted this fall. This may be optimistic. The chairmen of the tax-writing committees in Congress have only promised to hold hearings on the subject.

However, Congress released a set of staff recommendations in late July about what action should be taken. The staff proposals are in a 486-page paper released by the Joint Committee on Taxation. They would have the effect of increasing the level of tax opinion required in deals.

The main proposal is to collect a 40% penalty from any corporation that has tax benefits disallowed from a transaction the government considers a “corporate tax shelter.”

The corporation could avoid the penalty only by doing three things. First, it would have to be “highly confident” of the tax results. This will usually mean getting an opinion from an outside tax adviser that there is at least a 75% likelihood of prevailing on the merits. The opinion must be credible. The tax adviser could not assume away inconvenient facts. Second, the corporation would have to have a “material,” or credible, business purpose for the transaction other than reducing taxes. Third, it would have to disclose the details of the transaction to the Internal Revenue Service in a filing within 30 days after the transaction closes and again when its tax return is filed. The chief financial officer (or another senior corporate officer with knowledge of the facts) would have to certify, under penalties of perjury, that the disclosure statements are true and complete.

Disclosure would be mandatory for all corporate tax shelters involving more than $1 million in tax benefits. There is an exception for leasing transactions that are “within the scope” of the IRS “true lease” guidelines in Revenue Procedure 75-21. The staff said, “The volume of such transactions would make 30-day disclosure [too] burdensome for the IRS.”

The staff is also recommending an “aiding and abetting penalty” equal to the greater of $100,000 or half the person’s fees from the transaction. This would be levied against outside advisers who assist in implementing a corporate tax shelter transaction that is later disallowed by the IRS. However, the penalty would apply only where

“(1) the person to be penalized knew, or had reason to believe, that the corporate tax shelter (or any portion thereof) could result in an understatement of tax liability to the corporate participant; (2) the person opined, advised, represented, or otherwise indicated (whether express or implied) that, with respect to the tax treatment of the corporate tax shelter (or any potion thereof), there existed at least a 75-percent likelihood that its tax treatment would be sustained on its merits if challenged; and (3) a reasonable tax practitioner would not have believed that, with respect to the tax treatment of the corporate tax shelter (or any portion thereof), there existed at least a 75-percent likelihood that its tax treatment would be sustained on its merits if challenged.”

An example in the staff paper makes clear that the penalty can be imposed on investment bankers. In the example, a “promoter” pitching the transaction to a potential equity participant is penalized for showing the potential equity a 75% opinion from an outside counsel that the transaction works.

This may lead to a change in the way investment banks promote deals. Investment banks will not want to make any representation about whether a transaction works, but rather encourage equity to rely on is own tax counsel. They will also want to be careful about what is said in internal memos, since these are usually not protected from disclosure to the IRS, and get a formal statement from the equity that no express or implied assurances have been made by the investment bank about tax results.

“Corporate tax shelter” would be defined broadly as any arrangement, partnership or transaction where at least one of five factors is present. The five factors are as follows.

1. The expected pre-tax profit is insignificant in relation to the expected net tax benefits. The present value of benefit streams would be determined by using the short-term AFR (applicable federal rate) plus 1% as the discount rate. The short-term AFR was 5.43% in August (the figure with annual compounding). The staff recommends an “anti-stuffing rule” that would let the government look only at the legs of the transaction that contribute to the tax results. This would prevent corporations from “increasing the reasonably expected pre-tax profit by contributing income-producing assets that are not a necessary element of the arrangement.”
2. The arrangement shifts tax burdens to a “tax-indifferent party” or shifts tax basis to the US participant. The staff paper gives as an example “certain” LILOs, or lease-in-lease-out transactions.
3. The transaction involves significant tax benefits, and the corporation receives a “tax indemnity or similar agreement.” Certain “customary” indemnities would not count. The staff says these are indemnities tied to representations that all tax returns have been filed and taxes paid and about the tax audit history of a party to the transaction, about the tax-exempt status of bonds, about the seller’s status as a “US real property holding corporation,” and about tax-free reorganizations or spinoffs.
4. The transaction involves significant tax benefits, and it is expected to create a permanent difference between taxable income and US GAAP income.
5. The transaction involves significant tax benefits, and the corporation has “little (if any) additional economic risk” because of the way the transaction is structured. The staff suggested the following raise red flags: “use of nonrecourse financing, guarantees, stop loss agreements, rescission clauses, unwind clauses, hedged positions, and other similar arrangements.”

The government could still treat a transaction where none of the five factors is present as a corporate tax shelter if US tax avoidance or evasion is a “significant purpose” for the transaction.