To hear the Treasury Department tell it, some $10 billion in federal revenue is lost each year to abusive corporate tax shelters, with only a portion subsequently recouped through Internal Revenue Service countermeasures. So the Clinton Administration has proposed sweeping changes to the tax laws governing corporate shelters, including stiffer penalties and broadened IRS authority.
No one doubts that the marketing of tax-saving strategies, or "products," by major accounting and financial services firms has become a bigger business over the past several years, or that corporate executives have exploited such schemes to the extent that the Treasury claims. All the major accounting firms, most leading investment banks, and many well-known law firms have recently marketed shelters that have been shut down by Treasury rulings or IRS court victories.
"There has certainly been a large amount of marketing of 'aggressive' shelters," says Robert Perlman, vice president of tax at Intel Corp. in Santa Clara, California. "That, combined with the complexity of the tax code and the pressures put on tax officers by their CEOs, CFOs, and boards to increase aftertax profits, has caused some tax officers to take more-aggressive positions than they might have otherwise."
But evidence of such a trend remains anecdotal, and the assumptions backing up the Treasury's claim of lost revenue are difficult to come by. Alan Bankman, a professor of law at Stanford University who came up with the $10 billion estimate, failed to respond to repeated requests for an interview. Certainly the government's own figures contain no evidence that corporations are making more use of tax shelters to reduce their liability, as corporate taxes as a percentage of profits are projected to remain relatively constant over the next several years. Except for an uptick next year, that percentage is expected to stay between 32.1 percent and 32.5 percent until at least fiscal 2009.
Also, the Treasury has managed to dismantle such shelters as the step-down preferred transaction, which involved liquidating real estate investment trusts, and leveraged debt-buyback programs. Among loopholes that have been closed or narrowed recently are those involving corporate-owned life insurance and the tax-exempt spin-off structure known as the Morris Trust transaction. And experts predict the Treasury will also be able to make a good case against another target--"circular" leasing arrangements with foreign, tax-exempt entities.
So what's the problem? Senior officials insist that it would cost taxpayers less if the IRS could nip such abuses in the bud. "We want to put enough of a disincentive in front of taxpayers that they make better decisions up front," says one policymaker. "Corporations have become too willing to play the audit game because the stakes don't seem to be high enough at present."
Raising the Stakes
Although the Administration's proposals are part of its budget plan for the fiscal year beginning next October, the effective date for any changes in tax-shelter treatment is up in the air. So, too, are their chances for passage, though the characterization of tax breaks for business on the part of their most vociferous opponents as "corporate welfare" clearly has some political appeal. In any case, the plan would attack shelters in two basic ways: by casting a wider net to encompass more such transactions, and by giving the IRS a bigger stick with which to discourage their use.
Widening the net. Under the proposals, a shelter would be defined as any arrangement in which a corporate participant tries to benefit by avoiding tax unless Congress clearly intended to provide that benefit. Currently, a shelter isn't formally defined, so the IRS has to go through a lengthy process to show that a transaction is abusive. If the proposals are enacted, any transaction might fit the new definition if it generates much greater tax benefits than pretax income.
The proposals would also prohibit companies from distorting the nature of a transaction to create a tax benefit--for example, some might argue, treating hybrid securities as equity on the balance sheet and as debt for purposes of interest deductions. The Treasury would also tax other parties involved in such a transaction even if they weren't U.S. taxpayers.
In addition, the proposals would take direct aim at a number of specific types of transactions.
Harsher penalties. The proposals would double the penalty imposed on corporations that use tax shelters, from 20 percent of the tax liability to 40 percent, unless they had registered the transaction as a possible shelter. Furthermore, companies would no longer be able to escape the penalty by getting an independent opinion beforehand that a transaction was more likely than not to withstand IRS scrutiny.
Nor would taxpayers be able to deduct fees paid for advice on such transactions. On the contrary--they would also have to cough up 25 percent of the advisory fees as an additional penalty.
To many tax attorneys, the plan would make an already troublesome system dangerously vague. "The broad definition of a tax shelter would sweep in many transactions one would not consider tax shelters today," warns Edward Kleinbard, an attorney with Cleary, Gottleib, Steen & Hamilton, in New York, who works primarily with multinational corporations. "Combined with the penalties and denial of tax benefits, this could be used by the IRS to leverage concessions from taxpayers in negotiations" over other tax benefits that might be in dispute.
Don Carpenter, vice president of tax at Greenwich, Connecticut-based Tenneco Inc., agrees. "The definitions are broad enough that anything that saves taxes could be swept in," he says. "We consider ourselves to be very conservative in our filings, yet these proposals would bring in far more uncertainty to orthodox taxation than we would want. In dealing with the [Internal Revenue Service], you would be guilty until proven innocent."
Not surprisingly, opponents have been lobbying hard against the plan. Kenneth Kies, managing partner for national tax at PricewaterhouseCoopers and former chief of staff of Congress's joint committee on taxation for three years, blasted the proposals in hearings before the House Ways and Means Committee in March. "These proposals are overreaching, unnecessary, and at odds with sound tax-policy principles," says Kies.
First, he insists, Treasury has not come close to proving a need for the expanded powers to address abusive transactions. "Corporate tax payments have been increasing steadily with corporate earnings. Plus, the numbers they are using, such as the $10 billion a year estimate, [have] not been shown to have any basis in reality."
Second, Kies argues that the broad and flexible definitions--even if somewhat reworked by the Treasury Department to be more specific--would be "unadministerable." He contends they would allow IRS auditors to rule out "just about anything that reduced taxes, including dozens of normal business activities and transactions that are allowed at present."
Others point out that the IRS already has the tools necessary to combat abuse, including new ones involving shelter registration and penalty review passed by Congress only two years ago. These have yet to be enforced, because the agency hasn't gotten around to issuing regulatory guidance.
"Before enacting any new proposal, the existing proposals and tools should be carefully reviewed," says Mark Weinberger, a principal with Washington Counsel PC, a Washington, D.C.-based law and lobbying firm representing large, multinational corporations. "Without that review," Weinberger says, "adding another layer of penalties and rules creates more complexity and potential pitfalls for taxpayers."
A Different Approach
Treasury officials counter that critics misunderstand their intent. The idea, they say, is not simply to impose additional rules and penalties, but to sort out and codify the current jumble. That would enable the IRS to enforce the rules up front, instead of through a process that takes up to a decade to conclude. And the reason the IRS delayed guidance on the new authority Congress provided in 1997 was that the agency wanted to make sure its application would be consistent with the broader approach, which has been in the works since last fall.
"We strike no new ground in defining the nature of tax shelters," says Don Lubick, deputy assistant secretary of Treasury for tax affairs. "This is really not more than a debate on rules versus standards. Bright-line/safe-harbor tests, although appropriate in some circumstances, encourage [companies to take] aggressive positions and play the examination lottery. Standards, in contrast, require the application of common sense. Moreover, some uncertainty may be useful in discouraging taxpayers from venturing too close to the edge, and thereby going over the edge, of established principles."
Fine, say critics, but decisions involving standards and congressional intent should be left to the courts and Congress. "The Administration's proposals represent an unprecedented delegation of legislative authority to the executive branch and IRS revenue agents," Weinberger insists.
Attorney Kleinbard of Cleary, Gottleib suggests that Treasury has simply come to the wrong conclusion. "There's a residual belief within Treasury that clear guidance is a bad thing because it allows taxpayers to walk right up to the edge of what's allowable," Kleinbard says. But he contends that ambiguity has already been shown not to work by the current tax code. "Too much maintenance of the tax code has been deferred, and too little budget and manpower is available to catch up," says Kleinbard. "Taxpayers would be better off if Treasury had more resources, in order to create a clearer line through more guidance. After all, what's wrong with a clear line, as long as you're on the right side of it?"
Despite such vehement opposition, Congress has not dismissed the Administration's tax shelter proposals outright, as it has other revenue measures in the proposed 2000 budget. House Ways and Means Committee chairman Bill Archer (RTex.), no enemy of business, has said that the tax shelter proposals are, in his view, the only revenue raisers to "merit review."
To aid that process, the Treasury Department has promised a white paper before June that will spell out what the Administration intends to do. After considering it, the committee may well adopt some proposals simply to provide leeway for spending programs and tax cuts envisioned by the Republican leadership.
As a spokesman for the Ways and Means Committee stated, "It's still the first inning in the budget process. Anything could happen."