Introduction A brief review of the place of tax shelters in the American corporate landscape.

The Treasury's 2003 Offensive There was a kind of amnesty in 2002; and in 2003 the Treasury issued new guidance on tax sheltering.

Tax Shelter Techniques

There are many methods by which taxpayers shelter their losses, but these three characteristics are usually found in tax shelters, either separately or in combination:

• Taxes are deferred to later years;

• Ordinary gains (100 percent taxable) are converted to capital gains (only 40 percent taxable), or capital losses (only 50 percent deductible), are converted to ordinary losses (100 percent deductible); in both cases producing a lower tax liability;

• Leverage is obtained through various financing arrangements.

Deferral also occurs when excessive deductions are taken in the early years of a tax shelter, a practice the IRS calls "front end loading." Examples of illegal front end loading practices are:

• Deducting capital items by classifying them as advisory fees, management fees, or interest;

• Deducting prepaid interest;

• Not including prepaid income;

• Deducting excessive depreciation, amortization, or depletion by using the wrong method, too short a useful life; and/or too large a basis.

The administration's attempted legislation in 2000 included an extensive package of revenue raisers targeting perceived corporate tax shelters, corporate transactions, financial products, international transactions, and insurance. New proposals included the following:

• Tax shelter penalties. The substantial understatement penalty imposed on corporate tax shelter items (as redefined) generally was to be increased to 40% (from 20%), with no reasonable cause exception, effective for transactions entered into on or after the date of "first committee action;'

• Treasury authority to deny tax benefits. The Treasury Department would disallow deductions, credits, exclusions, or other allowances obtained in a corporate tax shelter, effective for transactions entered into on or after the date of first committee action;

• No deduction for corporate tax shelters. The proposal would deny deductions for fees and tax advice expenses related to corporate tax shelters and would impose a 25% excise tax on fees received in connection with promoting or rendering tax advice related to corporate tax shelters. The proposal would be effective for payments made and fees received on or after the date of first committee action;

• Excise tax on tax shelter "recission" provisions. The proposal would impose on the corporate purchaser of a corporate tax shelter an excise tax of 25% of the maximum payment to be made under a tax benefit "protection arrangement." These arrangements include certain recission clauses, guarantees of tax benefits, or other arrangements (e.g., insurance) protecting the purchaser. The proposal would be effective for arrangements entered into on or after the date of first committee action;

• Positions inconsistent with transaction form. The proposal generally would preclude corporate taxpayers from taking any position (on a tax return or refund claim) that the Federal income tax treatment of a transaction is different from that dictated by its form if a "tax indifferent" person has a direct or indirect interest in the transaction. Tax indifferent persons would be defined as foreign persons, tax-exempt organizations, Native American tribal organizations, and domestic corporations with expiring loss or credit carryforwards. The proposal would not apply where the taxpayer discloses the inconsistent position on its tax return. The proposal would be effective for transactions entered into on or after the date of first committee action;

• Tax-indifferent parties. Income allocable to a tax-indifferent party with respect to a corporate tax shelter would be taxable; other participants in the tax shelter would be jointly liable for the tax. The proposal would be effective for transactions entered into on or after the date of first committee action;

• Forward stock sales. A corporate issuer of stock sold through a forward sale contract would be required to recognize as interest the time-value element of the forward contract. The proposal would be effective for forward contracts entered into on or after the date of first committee action;

• Built-in losses. The proposal targets the "importation" of foreign losses and other tax attributes incurred outside the U.S. taxing jurisdiction that are used to offset income or gain otherwise subject to U.S. tax. The proposal would eliminate such attributes and require that tax basis be marked to market in certain circumstances, effective for transactions in which assets or entities become "relevant" for U.S. tax purposes on or after the date of enactment;

• S corporation ESOPs. The proposal would 1) require an ESOP to pay tax on S corporation income (including capital gains) as the income is earned and 2) allow the ESOP a deduction for distributions of such income to plan beneficiaries. The proposal would be effective for taxable years beginning, acquisitions of S corporation stock, and S corporation elections made on or after the date of first committee action;

• Serial liquidations. The proposal would impose withholding tax on any distribution made to a foreign corporation in complete liquidation of a U.S. holding company if the holding company was in existence for less than five years; the proposal also would apply with respect to serial terminations of U.S. branches. The proposal would be effective for liquidations and terminations occurring on or after the date of enactment;

• Basis shifting transactions. To prevent taxpayers from attempting to offset capital gains by generating artificial capital losses through basis-shift transactions involving foreign shareholders, the proposal would treat the portion of a dividend that is not subject to current U.S. tax as a nontaxed portion. The proposal would be effective for distributions made on or after the date of first committee action;

• Lessors of tax-exempt property. The proposal would deny a lessor the ability to recognize a net loss from a leasing transaction involving tax-exempt use property during the lease term, effective for leasing transactions entered into on or after the date of enactment. For this purpose, tax-exempt use property would include property leased to governments, tax-exempt organizations, and foreign persons;

• Mismatching of deductions and income. Deductions for amounts accrued but unpaid to related controlled foreign corporations, passive foreign investment companies, or foreign personal holding companies generally would be allowable only to the extent the amounts accrued by the payor are, for U.S. purposes, reflected in the income of the direct or indirect U.S. owners of the related foreign person. An exception would be provided for certain short-term transactions entered into in the ordinary course of business. The proposal would be effective for amounts accrued on or after the date of first committee action;

This is a useful list of tax shelters, from the taxpayers' perspective, especially since the Congress refused to pass the administration's Bill. There were further proposals:

• Control test. The proposal would conform the control requirement for tax-free incorporations, distributions, and reorganizations with the ownership test used for determining affiliation, effective for transactions on or after the date of enactment;

• Tracking stock. The proposal would give Treasury authority to treat "tracking stock" as nonstock (e.g., debt or a notional principal contract) or as stock of another entity as appropriate to prevent tax avoidance, effective for stock issued on or after the date of enactment;

• Transfers of intangibles. The transfer of an interest in intangible property constituting less than all of the substantial rights of the transferor in the property would be treated as a tax-free transfer, but the transferor would be required to allocate the basis of the intangible between the retained rights and the transferred rights based on their respective fair market values. Consistent reporting would be required. The proposal would be effective for transfers on or after the date of enactment;

• Downstream mergers. Where a target corporation holds less than 80% of the stock of an acquiring corporation, and the target combines with the acquiring corporation in a reorganization in which the acquiring corporation is the survivor, the target would have to recognize gain, but not loss, as if it distributed the acquiring corporation stock that it held immediately prior to the reorganization. The proposal would apply to transactions occurring on or after the date of enactment;

• Bank short-term obligations. The proposal would require banks to accrue interest and original issue discount on all short-term obligations, including loans made in the ordinary course of the bank's business, effective for obligations acquired or originated on or after the date of enactment;

• Current accrual of market discount. A taxpayer that uses an accrual method of accounting would be required to include market discount income as it accrues, effective for debt instruments acquired on or after the date of enactment;

• Partnership constructive ownership transactions. The proposal would treat long-term capital gain recognized from a "constructive ownership" derivative transaction as ordinary income to the extent the long-term capital gain recognized from the transaction exceeds the long-term capital gain that could have been recognized had the taxpayer invested in the partnership interest directly. The proposal would apply to gains recognized on or after the date of first committee action;

• Debt-financed portfolio stock. The proposal would tighten current-law rules requiring a corporation to reduce its dividends-received deduction with respect to dividends paid on debt-financed portfolio stock. The proposal would be effective for portfolio stock acquired on or after the date of enactment;

• Debt-for-debt exchanges. The proposal would spread the issuer's net reduction for bond repurchase premium in a debt-for-debt exchange over the term of the new debt instrument using constant yield principles, among other changes. The proposal would apply to debt-for-debt exchanges occurring on or after the date of enactment

• Straddle rules. The proposal would 1) clarify that net interest expense and carrying charges arising from structured financial products containing a leg of a straddle must be capitalized and 2) repeal the current-law exception for certain straddles of actively traded stock, effective for straddles entered into on or after the date of enactment;

• Effectively connected income. The proposal would expand the categories of foreign-source income that could constitute effectively connected income under IRC section 864(c)(4)(B)(ii) to include income that may be sourced by analogy to interest (interest equivalents) or dividends (dividend equivalents). Interest equivalents would include letter-of-credit fees, guarantee fees, and loan commitment fees. The proposal would be effective for taxable years beginning after the date of enactment;

• Overall foreign losses. For the purposes of IRC section 904(f), property subject to the recapture rules upon disposition under IRC section 904(f)(3) would include stock in a controlled foreign corporation, effective beginning on the date of enactment.

The tax-shelter industry on Wall Street moved into top gear after the proposals were anounced, pushing through large numbers of schemes before the doors shut; but in the event the Bill languished.

Introduction A brief review of the place of tax shelters in the American corporate landscape.

The Treasury's 2003 Offensive There was a kind of amnesty in 2002; and in 2003 the Treasury issued new guidance on tax sheltering.