New Treasury regulations provide for greater scrutiny of illicit tax shelters.

In recent years, there has been a proliferation in the use of illicit tax shelters by major U.S. corporations. This development has created some concern that deliberate corporate noncompliance with the intent of the tax laws may actually threaten the viability of the U.S. tax system. As a result, the U.S. Department of Treasury has issued new regulations designed to deter further expansion of these tax practices. This paper addresses these concerns as well as possible remedies to the problem.

Introduction to the Problem

According to the United States Department of Treasury, the proliferation of illicit corporate tax shelters may be the most serious compliance issue threatening the U.S. tax system today. The Treasury Department estimates losses associated with illegal corporate tax shelters at $10 billion a year and growing. While the percentage of income paid in taxes by individuals has been on the rise in the past decade, it has been just the opposite for corporate America. For example, corporate taxes as a percent of profits fell from 26.6% in 1994 to only 21.8% in 1999 (Gleckman & Woellert, 1999). As another indication of the problem, corporate tax receipts were down 2.5 percent in 1999 when compared to 1998. This occurred even though the U.S. economy was expanding and there was not a comparable decrease in corporate profits. In contrast, tax revenues from individuals leaped by 6.2 percent in 1999.

There is little doubt that this reduction in corporate taxes is due in part to the use of legitimate means, such as the proper use of tax credits or the appropriate deduction of stock options exercised by employees. However, the factor of most concern to the Treasury Department is the rapid increase in the use of illegitimate tax shelters by large companies. Illegitimate tax shelters differ from legitimate ones in that they employ the use of accounting transactions that have no separate, justifiable business purpose. These transactions are designed solely for the purpose of manipulating income in order to reduce taxes. For example, a U.S. corporation that owes taxes might arrange a business relationship with an overseas company that does not owe taxes. To reduce its tax liability, the U.S. company shifts its profits to the overseas company. The U.S. company then receives the money back in ways that do not count as taxable income, thus avoiding taxes on the original profits. Another type of transaction that appears to be spreading rapidly involves a U.S. company making two separate but equal loans at equal interest rates to an affiliate abroad. Subsequently, the interest on one loan is eliminated while the interest rate on the second loan is doubled. The zero interest bearing loan is now counted as a loss on the U.S. company's tax return, while the double interest rate loan on the books of the overseas affiliate is not taxed in the U.S. Many big accounting firms as well as Wall Street investment firms currently help create and market such illegitimate tax plans for a fee. What concerns the Department of Treasury and IRS officials is the apparent willingness of prominent, reputable corporations to engage in such blatant tax evasion practices. Until recently, these tactics were found only among the most disreputable of companies.

Good Tax Planning Versus Illegal Tax Schemes

Maximizing after-tax profits for its shareholders is a legitimate goal of a corporation. Since taxes represent one of the major expenses of a corporation, it is appropriate for tax planners to take whatever legal steps are possible to minimize these taxes. However, there is increasing evidence that some tax planners are devising and promoting tax schemes that are outside the realm of legal transactions.

Tax shelters are fundamentally different from tax breaks that are commonly referred to as loopholes and corporate welfare. From time to time, Congress will deliberately insert into the tax law loopholes or provisions designed to benefit certain industries or even specific companies. The motivation for these "tax loopholes" may be to achieve political, economic, or even social objectives. Whatever the motivation, the fact is that Congress intended these tax breaks to be part of the tax law. In contrast to loopholes, tax shelters are intricate plans designed to circumvent the tax laws. These tax schemes are concocted by tax lawyers and accountants and then marketed to corporate clients. Some are legal and some clearly are not. Some companies and tax advisers are playing the "audit lottery", hoping they can fashion a scheme so complicated that the IRS cannot determine if it is illegal. In fact, some tax planners take advantage of the inconsistencies in the U.S. tax code and create tax shelters that are so complex that they almost defy description. Many of these derivative type products have names like collars, swaps, straddles and step-down preferred stock. These tax strategies are clearly designed to create tax deductions that were never intended by Congress.

In recent months, the IRS has won a number of big cases in federal Tax Court. For years the Tax Court was reluctant to rule against companies using tax shelters. But recently, federal judges seem to be losing patience with the proliferation and blatant nature of these shelter schemes (Gleckman & Woellert, 1999). In 1999 the tax court found that UPS engaged in a long-term tax "sham" that helped them to evade more than $1 billion in taxes. Also in 1999, the Tax Court found sufficient facts to indicate that Compaq Computer engaged in an abusive tax shelter transaction (Luscombe, 1999). The essence of the transaction was that Compaq purchased and sold the same securities within an hour to obtain a $3.4 million foreign tax credit. The Court found that there was no business purpose and no economic substance to the tax shelter, and that it was undertaken only to reduce the tax bill of the corporation. The Tax Court not only denied the credit, but also ruled in favor of the IRS that a 20% negligence penalty should be imposed.

"Pushing the Envelop"

"Sham" tax shelters that have been identified by IRS audits have been repeatedly ruled illegitimate by the tax courts. However, because of limited resources the IRS may find only 1 in 10 of such tax shelters. This low probability of being discovered has apparently emboldened many companies to risk being caught. The complexity of the tax law entices corporations to manipulate transactions with the intent of reducing taxes. Because of competitive pressures, CFOs do not want their corporation to be the one reporting the highest effective tax liability. An added factor today is the existence of tax planners who actively promote their products to corporations. Thus, CFOs are afraid of being left behind by their competition in the effort to minimize taxes.

In letters sent out to potential tax clients, one Big Five accounting firm offered a proposed tax strategy to eliminate the company's state and federal income taxes for a contingency fee of 30% of the tax savings, plus out-of-pocket expenses. Another Big Five accounting firm hired 40 new professional salesmen to market tax shelters to companies that were not current clients. And yet another Big Five firm requires its staff to come up with one new tax shelter idea per week to keep abreast of the competition (Novack & Saunders, 1998). Large Wall Street investment firms as well as large accounting firms identify weaknesses in the tax code and devise tax schemes that are now being aggressively sold to thousands of potential corporate clients. Are they legal? Will they hold up in tax court? Some will and some will not, but the tax strategies rely on the sophistication of modern corporate finance to deter detection by the IRS.

What's driving this frenzy of tax shelters? It is of course money. Reluctant at first to use questionable tax shelters, many respectable accounting firms, law firms, and corporations have yielded to competitive pressures. Accounting firms can earn hundreds of thousands of dollars as commissions on the amount of taxes avoided by tax shelters. Law firms can charge hundreds of thousands of dollars for writing opinion letters stating that these shelters are likely to succeed. And once corporate officials see how much tax savings is at stake, their inhibitions are reduced. They try the tax scheme, become more comfortable with it, and continue to use it.

Efforts to Remedy the Problem

The primary efforts to confront the tax shelter issue have been in the tax courts. The IRS has generally met with success, but only at a great expense of time and money. The Treasury Department has called for new laws that attack not only specific tax shelter transactions, but also the corporate tax shelter industry in general (Luscombe, 1999). These proposals include expanding the definition of a corporate tax shelter, increasing disclosure requirements, and increasing understatement penalties. In addition, the Treasury would like to see laws that have potential consequences for creators, promoters, and others involved in illegal tax shelter transactions. For example, the Treasury has called for Congress to pass a 25 percent excise tax on fees collected by firms arranging illicit tax shelters. Further, the Treasury would like Congress to double the penalty on taxes improperly avoided from the current 20 percent to 40 percent.