The US Congress is edging closer to action against corporations that engage in aggressive tax planning. The Senate Finance Committee released a draft bill for comment in late May. The bill is expected to pass the Senate this summer. Its future is less certain in the House.

40% Penalty

Under the bill, corporations that have tax benefits from a “corporate tax shelter” disallowed will be hit with a 40% penalty.

The bill defines “corporate tax shelter” broadly as any transaction where a tax-shelter indicator is present. The indicators are as follows:

• The expected pre-tax profit from the transaction is insignificant in relation to the expected tax benefits. This is true of most affordable housing deals and alternative fuels projects that qualify for section 29 tax credits.
• The transaction is with a “tax-indifferent party” and this produces a benefit for the US participant. An example may be a leasing transaction between a US equity and a foreign lessee. The benefits that would trigger this indicator are a shifting of more taxable income than economic income to the tax-indifferent party, or the ability of the US participant — because the transaction involves a tax-indifferent party — either to characterize its tax position more favorably than it would otherwise or to claim a “non-economic” step-up in asset basis.
• The taxpayer has a “tax indemnity or similar arrangement” to ensure it gets the tax benefits from the transaction. However, a “customary indemnity in an acquisition” does not count if the indemnity is given by a party with a “meaningful economic interest” in the transaction.
• The taxpayer has little economic risk.
• The transaction will produce a “permanent” book-tax difference in how any income is reported.

The last three indicators only apply in transactions where the expected net tax benefits are significant. The bill implies that net tax benefits with a present value of at least $5 million are significant. It specifies the discount rate to be used for present value calculations: the federal short-term rate plus 1%.

Penalty Shifts to Advisers

A corporation could reduce or eliminate the penalty by getting a tax opinion and disclosing the details of the transaction to the Internal Revenue Service, but only where it has a material nontax business purpose for the transaction. The chief financial officer “or other senior corporate officer with knowledge of the facts” would have to sign a perjury statement attesting to the accuracy of the disclosure. The penalty would then shift to the tax adviser writing the opinion. However, in his case, he would be exposed to a penalty for half his fees.

The tax opinion would have to be at least a “should” opinion to avoid penalties. (A “more-likely-than-not” opinion from the tax adviser would reduce the potential penalty to 20%, but not eliminate it. There would be no shift in that case of penalties to the tax adviser.)

The bill goes into some detail about when a corporation would be able to rely on the tax opinion. The opinion would have to be “long form.” In other words, it would have to recite all the material facts of the transaction. The adviser would have to inquire into whether there is a material nontax business purpose; he could not unreasonably assume it. The opinion must do a thorough job of identifying and considering all the relevant judicial doctrines. This will tend to drive the job of opinion writing to the better firms; the taxpayer runs the risk of not being able to rely on it if the opinion is not thorough. The opinion cannot come from the tax shelter promoter. The tax adviser writing it cannot be paid by the promoter. His fee cannot be contingent on the tax benefits.

Tax advisers who give “should” opinions run the risk of being penalized for half their fees from the transaction if the tax benefits are disallowed. All persons who assist with “creation, organization, sale, implementation, management or reporting” of a corporate tax shelter also run the risk of the same penalty.

The IRS will publish the names of persons who are penalized in connection with corporate tax shelters.

In addition, the corporation would have to send a notice to let its shareholders know that it has been penalized for participating in a corporate tax shelter. This would be required for penalties of at least $1 million.

Outlook

There is a growing consensus in Washington that Congress must take action to prevent corporations from adopting aggressive tax schemes. The staff of the Congressional Joint Committee on Taxation released a set of recommendations last summer. The chairman and ranking democrat on the Senate tax-writing committee — Senators William Roth (R.-Del.) and Daniel Patrick Moynihan (D.-N.Y.) — released the draft bill described in this article in late May for public comment. The bill is now being reworked to reflect comments. (Comments were due on June 9.) Roth has said he plans to put it through the Senate this summer. The main opponent to action by the House is the chairman of the House tax-writing committee, Rep. Bill Archer (R.-Texas). Archer retires at the end of this year.