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.

The Treasury Department has also called on Congress to pass into law the "doctrine of economic substance." This doctrine was created by a 1935 Supreme Court Case and is sometimes used by judges to rule against blatantly abusive tax shelters. This doctrine holds that if a transaction superficially follows all the rules but is lacking economic substance and is designed to produce tax savings not intended by Congress, it can be regarded as a sham and disallowed (Novack & Saunders, 1998). The problem with this doctrine is that it is extremely nebulous, and must be applied by the IRS on a case by case basis. If Congress were to enact into law the "doctrine of economic substance" it would allow the IRS to fight abusive tax shelters on a universal basis rather than one court case at a time. However, due to heavy lobbying by accounting firms and investment bankers, calls for new legislation appear to be going nowhere for the time being. Nevertheless, the Treasury Department maintains that more aggressive enforcement by the IRS alone is not sufficient to halt tax shelter abuses, and additional enforcement laws must be passed by Congress. Under the current conditions, attacking this problem on a case by case basis often takes years and in some cases millions of dollars.

Due to the unlikely prospects of Congress passing new laws any time soon, the Treasury Department recently issued new regulations aimed at discouraging the use of abusive corporate tax shelters (Johnston, 2000). The new rules are targeted at requiring companies to immediately disclose new kinds of tax shelters as soon as they are developed. Companies will be required to disclose shelters when at least two of six conditions are met. These conditions include: 1) fees of more than $100,000 paid to outside firms for assistance in creating the shelter, 2) confidentiality agreements between the participating parties involved in the tax shelter, 3) sheltering of at least $5 million, and 4) the use of a "straw man" that doesn't gain any tax benefit. Early disclosure would allow the IRS to review the tax plan, and if found improper to bar it before its use becomes widespread. This proactive approach is in contrast to the normal procedure whereby disallowed shelters are discovered after their implementation through audits. Once implemented, illegal tax shelters often must be contested by the IRS one case at a time. This process is expensive, time consuming, and not always successful.

The new regulations also apply to providers of tax shelter plans. They require accounting firms, law firms, investment houses, and others who devise such shelters to disclose these tax plans to the IRS as soon as they start promoting them to potential clients. The promoters of such plans would also be required to maintain and make available to the IRS records of who bought these shelters and how they work. The Treasury Department plans additional steps to discourage accountants and lawyers from recommending illicit tax shelters. The guidelines governing the conduct of professionals representing clients before the IRS will be strengthened. Professionals as well as their firms will be subject to suspension and in extreme cases even disbarment from future IRS proceedings. As a further step to fight dubious tax shelters, the IRS will establish a special team of auditors that will analyze tax shelters and assist other auditors in identifying abusive shelter transactions (Johnston, 2000).

These new regulations are designed to restrict the use of tax strategies and accounting procedures that have no legitimate economic purpose and are used only as a means to evade taxes. Early notification of new tax shelter strategies will give the IRS the opportunity to better focus their limited resources. The requirement that promoters of tax shelters must maintain a list of all clients using the shelter enables the IRS to quickly track down other users of an abusive tax strategy. Clients who had counted on not being detected by the IRS will now most certainly be deterred from adopting an illicit tax scheme. Thus, the goal of the new regulations is to not only give the IRS early notification of a company's tax shelter plans, but also to discourage companies from engaging in abusive tax plans in the first place.

Conclusion

The Treasury Department has made clear that they feel that the issue of abusive tax shelters is a matter of national importance. The most troubling factor is the rapid spread of these types of corporate tax shelters. There is even some concern that the spread of illicit corporate tax schemes could serve as a catalysts for individuals to devise their own tax shelters, thus leading to widespread tax cheating. Secretary of the Treasury Lawrence Summers has stated that tax shelters are their number one problem, not only because of the lost revenue but because they foster disrespect for the tax system itself. While not agreeing with all of the Treasury Department's proposals, the American Institute of CPAs has testified that not only do they concur that more effective disclosure of tax shelters is needed, but that there also should be penalties that provide incentives for such disclosure (Journal of Accountancy, 2000). In addition, many top corporate tax executives are glad to see the government crack down on tax shelter abuses. The reason is that many tax executives feel pressure from their bosses to match the tax avoidance tactics of their competitors, even if it involves the use of tax shams (Johnston, 2000). It is incumbent on all parties involved to evaluate their role in the promotion of abusive tax shelters. As always, it is important for both corporate CEOs as well as members of the accounting profession to choose integrity over profits. Ultimately, nothing less than public confidence in their reputation for honesty and integrity is at stake.

References

(1.) Gleckman, H. and L Woellert, 1999. Kiss That Tax Shelter Goodbye? Business Week, no. 3655, Nov 15, p.50.

(2.) Johnston, D.C., 2000. U.S. Takes Aim at Tax Shelters. The New York Times, vol. CXLIX, no. 51,313, Feb. 29, pp. A1,C10.

(3.) Lifson Testifies on Tax Shelters, 2000. Journal of Accountancy, vol. 189, no 1, January, pp. 81-82.

(4.) Luscombe, M.A., 1999. The Corporate Tax Shelter Debate: Mostly Talk But A Little Action. Taxes, vol. 77, no. 11, Nov., pp. 3-4.

(5.) Novack, J. and L. Saunders, 1998. The Hustling of X Rated Shelters Forbes. vol. 162, no. 13, Dec. 14, pp. 198-208.

Paul J. Carruth, Ph.D., CPA, is a Professor of Accounting at Southeastern Louisiana University. He is a member of the American Accounting Association, the American Institute of CPAs, and the Institute of Management Accountants.