Developments
in 2004
Ominously,
a member of the US Public Company Accounting
Oversight Board (set up under the SEC as a result
of the Sarbanes-Oxley Act) hinted in 2004 that
the organisation was considering reforms that
would prevent corporate auditors from offering
certain tax planning and sheltering services
to their audit clients. Mark Goelzer, a member
of the board, advised auditors in comments prepared
for the mutual fund industry to exhibit caution
when offering these services to clients. "I
have no problem with auditors assisting their
clients with traditional tax compliance and
routine planning," Goelzer explained, but added
that: "Tax services that go beyond that - especially
the marketing to audit clients of novel, tax-driven,
financial products - raise serious issues."
However, Goelzer went on to acknowledge that
reforming this controversial area of tax planning
was not going to be straightforward, as the
boundaries between traditional tax advice and
the advocation of tax shelters are often blurred.
Nevertheless, given the public and political
fury vented following the collapse of firms
such as Enron and Worldcom, often at the accounting
firms which sold tax shelters to these companies,
Goelzer explained that "the board may have to
try its hand at solving the problem."
New
IRS rules on the registering and reporting of
tax shelters also had to be taken seriously.
Under the terms of the new registration rules,
advisers are obliged to report to the IRS any
tax minimization products and services offered
which the tax agency has dubbed 'abusive tax
shelters'. The reporting rules require tax professionals
to file a Reportable Transaction Disclosure
Statement 8886 with clients' tax returns for
each year that they have participated in the
tax sheltering arrangement, and with the Office
of Tax Shelter Analysis for their first year
of involvement in the scheme. The new list maintenance
rules require that tax advisers maintain lists
of participants in so-called abusive tax shelters
for possible future inspection by the tax authority.
In
January, 2004, the Treasury Department announced
a raft of legislative proposals to be included
in President Bush’s 2005 budget aimed at closing
tax loopholes, nullifying tax shelters, and
simplifying the taxation system.
Commenting on the series of new proposals, which
aim to clamp down on tax abuse on a broad front,
then-Treasury Secretary John Snow remarked:
“The laws must ensure that those who would shirk
their civic responsibilities cannot do so by
exploiting unintended loopholes, and the IRS
must ensure that taxpayers do not engage in
abusive tax avoidance transactions.”
“We
are committed to restoring confidence in the
tax system by ending the proliferation of abusive
tax avoidance transactions and simplifying the
tax code,” added Treasury Assistant Secretary
for Tax Policy Pam Olson. “Ultimately, there
is no “silver bullet” or “one-size-fits-all”
solution addressing abusive tax avoidance transactions
— other than continuing to simplify the tax
code and ensure that the tax results match the
economic realities of the transactions,” she
observed.
Meanwhile, IRS Commissioner Mark W. Everson
hoped that a new policy of tougher penalties
would help to drive home the administration’s
zero-tolerance message, which it intends to
send out with the glut of new proposals. According
to the Treasury, they would seek to:
-
Impose Penalties on the Failure to Disclose
Potentially Abusive Transactions;
-
Permit Uniform Disclosure Rules for Potentially
Abusive Transactions;
-
Permit Injunction Actions against Promoters
who Repeatedly Disregard the Registration
and List-Maintenance Requirements;
-
Impose a Penalty for the Failure to Report
an Interest in a Foreign Financial Account;
-
Curb Abusive Income-Separation Transactions;
-
Eliminate Obstacles to Disclosure;
-
Increase Penalties for False or Fraudulent
Statements Made to Promote Abusive Tax Avoidance
Transactions;
-
Eliminate Abusive Transactions Involving Foreign
Tax Credits;
-
Stop Abusive Leasing Transactions with Tax-Indifferent
Parties;
-
Require Charitable Deductions to Reflect Accurately
the Value of the Donation;
-
Prevent Misuse of Tax-Exempt Casualty Insurance
Companies;
-
Address the Tax Consequences of Changing Beneficiaries
of a Section 529 College Savings Plan;
-
Tighten the Deduction Limitation for Interest
Paid to Related Parties;
-
Prevent Avoidance of U.S. Tax on Foreign Earnings
Invested in U.S. Property;
-
Modify Tax Rules for Individuals Who Give
Up U.S. Citizenship or Green Card Status;
-
Curb Frivolous Returns and Submissions;
-
Terminate Instalment Agreements when Taxpayers
Fail to File Returns or Make Tax Deposits;
-
Streamline the Handling of Collection Due
Process Cases;
-
Improve Procedures for Taxpayers Seeking to
Resolve Their Tax Liabilities;
-
Make the Payment of FMS (Financial Management
Services) Fees for Levies More Efficient;
-
Expand the Use of Electronic Filing;
-
Permit Private Collection Agencies to Support
the IRS’ Collection Efforts
“I’m
very pleased the administration is continuing
its attacks on illicit tax shelters,” noted
Senator Charles Grassley. "The administration
should receive high marks for its anti-tax shelter
efforts. It’s issued numerous shelter regulations
over the past year and laid down a solid response
to attacking this problem. Congress needs to
back up these efforts by passing tax shelter
legislation,” he observed.
Later
in January, tax collectors in twelve states,
including California and New York, met with
representatives from the Federation of Tax Administrators
and the Multistate Tax Commission to discuss
how to combat tax sheltering on a broad front.
"California
is joining forces with other states to crack
down on abusive tax shelters, and we're putting
our collective resources to work," commented
Californian State Controller Steve Westly. "We're
going to use the best ideas from every state
to find and prosecute tax cheats," he added.
The other participating states and cities included
Colorado, Connecticut, Illinois, Massachusetts,
Michigan, Minnesota, New Jersey, Ohio, Tennessee,
and Wisconsin, as well as New York City.
California also offered a Voluntary Compliance
Initiative for taxpayers who invested in abusive
tax shelters. Taxpayers had until April 15 to
correct their tax returns and make full payment
of the taxes owed or face new harsh penalties.
The Californian Franchise Tax Board claims the
state loses $600 million to $1 billion in tax
money annually through abusive tax sheltering.
In 2003, 41 states, among them New York and
California, signed a Memorandum of Understanding
with the IRS allowing federal and state tax
collection agencies to pool their collective
information on delinquent taxpayers and concentrate
the battle against abusive tax shelters.
At
the end of the month, the Treasury Department
issued a ruling to shut down abusive transactions
involving ‘S corporation ESOPs’ (employee stock
ownership plans) in a ruling that will classify
such investments as listed transactions for
the purposes of tax shelter disclosure.
According to a Treasury statement: “An employee
stock ownership plan is a type of retirement
plan that invests primarily in employer stock.
Congress has allowed an ‘S corporation’ to be
owned by an ESOP, but only if the ESOP gives
rank-and-file employees a meaningful stake in
the S corporation. When
an ESOP owns an S Corporation, the profits of
that corporation generally are not taxed until
the ESOP makes distributions to the company’s
employees when they retire or leave the job.
This is an important tax break which allows
the company to reinvest profits on a tax-deferred
basis, for the ultimate benefit of employees
who are ESOP participants.
“The
ruling shuts down transactions that move business
profits of the S corporation away from the ESOP,
so that rank-and-file employees do not benefit
from the arrangement. For example, the ruling
prohibits using stock options on a subsidiary
to drain value out of the ESOP for the benefit
of the S corporation’s former owners or key
employees.”
Treasury Assistant Secretary for Tax Policy
Pam Olson observed: "Congress recognized the
potential for attempts to circumvent the rules
and specifically authorized Treasury and IRS
to prevent it. This notice does just that, imposing
a 50% excise tax on the option holders in cases
where rank-and-file ESOP participants are deprived
of the business profits."
In
May, 2004, the IRS announced a new amnesty scheme
for taxpayers who may have employed a tax minimisation
technique commonly referred to as ‘Son of Boss,’
which the agency claims has deprived the government
of some $6 billion in tax revenues. The
so-called Son of Boss scheme is derived from
an earlier scheme known as ‘Boss’ (bond and
option sales strategy), and was commonly used
in the late 1990s to offset large one-off gains
such as the sale of a business.
However, according to IRS Chief Mark W. Everson:
“Son of Boss deals had only one purpose – the
elimination of tax. These transactions were
developed and marketed by an interlocking network
of commercial interests, including leading law
firms, accounting firms and investment banks.”
The IRS claims that many transactions undertaken
through Son of Boss schemes generated tax losses
of between $10 million and $50 million leading
to a total understatement of tax in excess of
$6 billion.
Under the terms of the amnesty, which are a
lot less generous than previous amnesty programs,
eligible taxpayers must concede 100% of the
claimed tax losses, must pay all applicable
interest and must accept the imposition of a
penalty unless they had previously disclosed
their participation in the transaction.
However, participating taxpayers will be allowed
to deduct as a loss their out of pocket transaction
costs, typically promoter and professional fees.
Everson points out that taxpayers will remain
able to contest the IRS in court over such issues,
although he warned that the government will
“vigorously pursue the full tax due”, plus full
interest and penalty payments owing. However,
IRS officials revealed to the Washington Post
that taxpayers will be barred from using the
agency's normal appeals process to contest such
cases. Confirming the agency's tough stance
on the subject, IRS Chief Counsel Donald Korb
added that taxpayers "should not expect to settle
court cases on terms more favorable than those
offered in the IRS settlement initiative.”
Also
in May, law firm Jenkens and Gilchrist was ordered
by a federal judge to hand over the names of
clients who invested in tax schemes formulated
by its Tax and Estate Planning Practice Group
and its Structured Investment Practice, between
June 1998 and June 2003. The ruling marked the
conclusion of a five year battle between the
firm and the Internal Revenue Service.
Ruling
at the Northern District of Illinois court on
Friday, US District Judge James Moran granted
permission for the law firm's clients to raise
claims of attorney-client privilege. However,
he observed that there "does not appear to be...sustainable
grounds for the assertion of privilege for the
great majority of client materials", and warned
that clients would be penalised for bringing
frivolous privilege claims.
Despite
some tactical victories, an informant for the
IRS told Congress in July, 2004, that the agency
is ill-equipped to win the battle against the
increasingly sophisticated use of tax shelters.
"From my vantage point, the IRS simply does
not understand how the tax shelters work, or
how the transactions and structures fit together,"
the Senate Finance Committee was told by the
anonymous witness, who works for a Wall Street
bank. The problem is being compounded by the
IRS’s lack of trusted informants and confidential
witnesses, the banker known as ‘Mr ABC’ testified.
The informant went on to give as an example
a situation in which the IRS failed to act on
his disclosure in 1999 that Enron was engaged
in illegitimate tax activities in a bid to artificially
drive up the company’s earnings. The witness
stated that in all, he had made disclosures
to the IRS on three types of tax shelters and
other schemes involving around $10 billion in
taxable income. He expressed dismay that the
IRS had seen fit not to offer any type of reward
for such substantial revelations of illegal
tax dealings.
Ruling
in September in Manhattan's district court in
the case of Seippel v. Jenkens and Gilchrist,
Southern District Judge Shira A. Scheindlin
allowed fraud and recission claims against the
Sidley Austin Brown & Wood law firm to proceed.
Telecommunications
executive, William Seippel participated in a
tax sheltering arrangement known as COBRA (Currency
Options Bring Reward Alternatives), which was
developed by Jenkens & Gilchrist in conjunction
with Brown & Wood, prior to the latter's merger
with Sidley & Austin in 2001.
Following
an Internal Revenue Service investigation into
the shelter which led to Mr Seippel and his
wife paying more than $5 million in taxes, penalties
and fees, the couple sued the law firms in question
alleging fraud, infringement of the Racketeer
Influenced and Corrupt Organizations (RICO)
Act, legal malpractice, breach of contract,
negligent misrepresentation, and breach of fiduciary
duty.
Although
Judge Scheindlin dismissed the RICO, malpractice,
breach of contract, negligent misrepresentation
and breach of fiduciary duty claims, she allowed
the fraud and recission of fees actions to continue,
observing that:
"The
fact that the Seippels may not ultimately owe
the tax authorities additional taxes does not
mean that their action is not ripe. The Seippels
allege that they have been damaged, and continue
to be damaged, as a result of the defendants'
conduct."
She
continued: "Their damages include the fees paid
to defendants, losses incurred in the transactions,
expenses paid to accountants and attorneys that
are assisting the Seippels in defending the
audits, losses caused as a result of being forced
to sell assets at distressed prices to meet
tax obligations, and tax penalties already assessed
and paid."
Towards
the end of 2004, however, the IRS lost a series
of tax shelter cases, although it did score
one signal triumph.
In
November, the US Court of Federal Claims in
Washington rejected a claim by the IRS that
industrial firm, Coltec Industries, used sham
transactions in order to avoid taxes, representing
the second defeat for the agency in a tax shelter
case in the space of two weeks. The IRS argued
that Coltec, a maker of aircraft landing systems,
had used a transaction known as a contingent
liability deal to generate capital losses which
the firm used to offset capital gains from the
sale of a business unit in 1996. However, Judge
Susan Branden rejected the IRS’s argument that
the transactions had no economic purpose, and
stated that in her opinion Coltec had complied
with all the statutory requirements laid down
by Congress. Awarding Coltec an $82.8 million
refund, Judge Branden suggested that: “The use
of the 'economic substance' doctrine to trump
'mere compliance with the code' would violate
the separation of powers" as laid down in the
US Constitution.
Then the IRS suffered a similar defeat in a
case involving Black & Decker Corp., where an
US district court in Baltimore upheld the firm’s
right to a $57 million refund centred on a transaction
that the agency deemed abusive.
The
IRS's third court defeat in the space of two
weeks came when it was ordered by Judge Stefan
R. Underhill of the United States District Court
of Connecticut to refund TIFD III-E Inc, a subsidiary
of General Electric Corp., more than $62 million.
At the heart of the case was a complex set of
transactions involving three GE subsidiaries
which formed a partnership, Castle Harbour,
in 1993, to which GE contributed a number of
aircraft in addition to cash and stock worth
more than $500 million in total.
The partnership’s three shareholders, of which
TIFD III-E was one, then sold their stake to
two Dutch banks and for tax purposes, the subsidiary's
income was allocated to the banks, which did
not pay US income taxes. Judge Underhill disagreed
that the transactions had no economic substance,
as the Dutch banks had invested in Castle Harbour,
and observed that "the economic reality of such
a transaction is hard to dispute." However,
he also acknowledged that one of GE’s principle
motives was avoidance of tax.
"In
short, the transaction, though it sheltered
a great deal of income from taxes, was legally
permissible," he wrote in his judgement. However,
he added: "Under such circumstances, the IRS
should address its concerns to those who write
the tax laws."
The
IRS's success came in December when a federal
jury convicted six people in a $120 million
tax shelter scheme described by the authorities
as one of the most extensive cases of its type
ever tried. The case involved the Washington
state-based firm Anderson Ark and Associates,
which charged around 1,500 clients fees ranging
from $50,000 to $250,000 for tax shelter plans
that helped them take income tax deductions
in the period form 1997 to 2001.
The
schemes, which were sold over the internet,
involved transactions using shell companies
and loans connected to Costa Rican bank accounts
to create the appearance that clients had legitimate
tax-deductible business expenses. Six defendants
were convicted of a number of offences after
the seven-week trial, including filing false
tax returns, mail fraud, wire fraud, and money
laundering.
Welcoming
the verdict, IRS Commissioner Mark W. Everson
noted that the case represents “a real blow
to promoters of shady offshore tax schemes."
The authorities are considering re-filing charges
against four defendants about whom the jury
was unable to reach a verdict.
Rounding
off a busy year for the tax avoidance industry,
the US government issued final regulations amending
Treasury Department Circular 230, which apply
to attorneys, accountants and other tax professionals
who practice before the IRS, providing standards
of practice for written advice that reflect
current best practices, and are intended to
restore and maintain public confidence in tax
professionals.
The
revisions aim to ensure that tax professionals
do not provide inadequate advice, and to increase
transparency by requiring tax professionals
to make disclosures if the advice is incomplete.
Welcoming the new measures, IRS Commissioner
Mark W. Everson commented: “These new standards
send a strong message to tax professionals considering
selling a questionable product to clients. The
new provisions give us more tools to battle
abusive tax avoidance transactions and to rein
in practitioners who disregard their ethical
obligations.”
Ensuring
that attorneys, accountants and other tax practitioners
adhere to professional standards is one of the
IRS’s top four enforcement goals, and the agency
considers the Circular 230 revisions a key component
of this strategy. The final regulations provide
best practices for all tax advisors, mandatory
requirements for written advice that presents
a greater potential for concern, and minimum
standards for other advice.
“These
revisions to Circular 230 strike an appropriate
balance between tightening practitioner standards
and minimizing burden on everyday advice,” noted
Assistant Secretary for Tax Policy Greg Jenner.
“These rules target the types of written advice
that present a significant cause for concern
and avoid undue interference with the practitioner-client
relationship,” he added.
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