The proposal is also designed to increase collections with respect to offers that the IRS either rejects or returns. The Taxpayer Advocate's most recent report states: "The IRS collected nothing from individual taxpayers in 21 percent of the [offers-in-compromise] that it rejected and in 37 percent of the [offers-in-compromise] that it returned after acceptance for processing. The IRS collected nothing from business taxpayers in 46 percent of the [offers-in-compromise] that it rejected and in 60 percent of the [offers-in-compromise] that it returned after acceptance for processing." 9937 37 National Taxpayer Advocate, 2004 Annual Report to Congress (December 31, 2004), at 311, citing a recent IRS study. C. Clarify Standards of Scrutiny for Certain Transactions with Characteristics of Tax Shelters Present Law In general The Code provides specific rules regarding the determination of tax liability, including the amount, timing, source, and character of items of income, gain, loss and deduction. These rules are designed to provide taxpayers with a degree of certainty as to what their tax liability will be if they undertake a particular course of action. They also tend to ensure that different taxpayers will be treated equally, and encounter the same tax liability, if they carry out the same transaction. From the government's perspective, specific rules generally avoid the need for timeconsuming, case-by-case determinations of tax liability after particular transactions have been undertaken. In addition to the statutory provisions, courts have developed several doctrines that can be applied to deny the tax benefits of tax motivated transactions, notwithstanding that the transaction may satisfy the literal requirements of a specific tax provision. The common-law doctrines are not entirely distinguishable, and their application to a given set of facts is often blurred by the courts and the IRS. Although these doctrines serve an important role in the administration of the tax system, invocation of these doctrines can be seen as at odds with an objective, “rule-based" system of taxation. Nonetheless, courts have applied the doctrines to deny tax benefits arising from certain transactions. Economic substance doctrine In general 38 A common-law doctrine applied with increasing frequency is the "economic substance" doctrine. In general, this doctrine denies tax benefits arising from transactions that do not result in a meaningful change to the taxpayer's economic position other than a purported reduction in Federal income tax. 39 Courts generally deny claimed tax benefits if the transaction that gives rise to those benefits lacks economic substance independent of tax considerations -- notwithstanding that the purported activity actually occurred. The Tax Court has described the doctrine as follows: The tax law... requires that the intended transactions have economic substance 38 See, e.g., ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998), aff'g 73 T.C.M. (CCH) 2189 (1997), cert. denied 526 U.S. 1017 (1999). 39 Closely related doctrines also applied by the courts (sometimes interchangeable with the economic substance doctrine) include the "sham transaction doctrine" and the "business purpose doctrine." See, e.g., Knetsch v. United States, 364 U.S. 361 (1960) (denying interest deductions on a "sham transaction" the only purpose of which was to create the deductions). warranted, where a taxpayer seeks to claim tax benefits, unintended by Congress, 40 Business purpose doctrine Another common law doctrine that overlays and is often considered together with (if not part and parcel of) the economic substance doctrine is the business purpose doctrine. The business purpose test is a subjective inquiry into the motives of the taxpayer -- that is, whether the taxpayer intended the transaction to serve some useful nontax purpose. In making this determination, some courts have bifurcated a transaction in which independent activities with nontax objectives have been combined with an unrelated item having only tax-avoidance objectives in order to disallow the tax benefits of the overall transaction. doctrine.42 Application of the doctrine There is a lack of uniformity regarding the proper application of the economic substance Some courts apply a conjunctive test that requires a taxpayer to establish the presence of both economic substance (i.e., the objective component that there be a meaningful change in the taxpayer's position) and business purpose (i.e., the subjective component that there be a useful non-tax purpose for the taxpayer's course of action) in order for the transaction to survive judicial scrutiny. A narrower approach is to conclude that either a business purpose or economic substance is sufficient. A third approach regards economic substance and business 43 40 ACM Partnership v. Commissioner, 73 T.C.M. at 2215. 41 42 ACM Partnership v. Commissioner, 157 F.3d at 256 n.48. "The casebooks are glutted with [economic substance] tests. Many such tests proliferate because they give the comforting illusion of consistency and precision. They often obscure rather than clarify." Collins v. Commissioner, 857 F.2d 1383, 1386 (9th Cir. 1988). 43 See, e.g., Pasternak v. Commissioner, 990 F.2d 893, 898 (6th Cir. 1993) (“The threshold question is whether the transaction has economic substance. If the answer is yes, the question becomes whether the taxpayer was motivated by profit to participate in the transaction"). 44 See, e.g., Rice's Toyota World v. Commissioner, 752 F.2d 89, 91-92 (4th Cir. 1985) ("To treat a transaction as a sham, the court must find that the taxpayer was motivated by no business purposes other than obtaining tax benefits in entering the transaction, and, second, that the transaction has no economic substance because no reasonable possibility of a profit exists."). As noted earlier, the economic substance doctrine and the sham transaction doctrine are similar and sometimes are applied interchangeably. For a more detailed discussion of the sham transaction doctrine, see, Joint Committee on Taxation, Study of Present-Law Penalty and Interest Provisions as Required by Section 3801 of the Internal Revenue Service Restructuring and Reform Act of 1998 (including Provisions Relating to Corporate Tax Shelters), (JCS-3-99) at 182. purpose as "simply more precise factors to consider" in determining whether a transaction has any practical economic effects other than the creation of tax benefits." Recently, the Court of Federal Claims questioned the continuing viability of the doctrine.46 The court also stated that "the use of the 'economic substance' doctrine to trump 'mere compliance with the Code' would violate the separation of powers. ,,47 Nontax economic benefits There also is a lack of uniformity regarding the type of non-tax economic benefit a taxpayer must establish in order to satisfy economic substance. Several courts have denied tax benefits on the grounds that the subject transactions lacked profit potential.48 In addition, some courts have applied the economic substance doctrine to disallow tax benefits in transactions in which a taxpayer was exposed to risk and the transaction had a profit potential, but the court concluded that the economic risks and profit potential were insignificant when compared to the tax benefits." Under this analysis, the taxpayer's profit potential must be more than nominal. Conversely, other courts view the application of the economic substance doctrine as requiring an objective determination of whether a "reasonable possibility of profit" from the transaction existed apart from the tax benefits. In these cases, in assessing whether a reasonable possibility of profit exists, it is sufficient if there is a nominal amount of pre-tax profit as measured against expected net tax benefits. 49 50 45 See, e.g., ACM Partnership v. Commissioner, 157 F.3d at 247; Sacks v. Commissioner, 69 F.3d 982, 985 (9th Cir. 1995) (“Instead, the consideration of business purpose and economic substance are simply more precise factors to consider.... We have repeatedly and carefully noted that this formulation cannot be used as a 'rigid two-step analysis”). 46 Coltec Industries, Inc. v. United States, 62 Fed. Cl. 716 (2004) (slip opinion at 123124). The court also found, however, that the doctrine was satisfied in that case. Id. at 128. 47 48 Id. at 128. See, e.g., Knetsch, 364 U.S. at 361; Goldstein v. Commissioner, 364 F.2d 734 (2d Cir. 1966) (holding that an unprofitable, leveraged acquisition of Treasury bills, and accompanying prepaid interest deduction, lacked economic substance). 49 See, e.g., Goldstein v. Commissioner, 364 F.2d at 739-40 (disallowing deduction even though taxpayer had a possibility of small gain or loss by owning Treasury bills); Sheldon v. Commissioner, 94 T.C. 738, 768 (1990) (stating that "potential for gain... is infinitesimally nominal and vastly insignificant when considered in comparison with the claimed deductions"). 50 See, e.g., Rice's Toyota World v. Commissioner, 752 F.2d at 94 (the economic substance inquiry requires an objective determination of whether a reasonable possibility of profit from the transaction existed apart from tax benefits); Compaq Computer Corp. v. Commissioner, 277 F.3d at 781 (applied the same test, citing Rice's Toyota World); IES Industries v. United States, 253 F.3d 350, 354 (8th Cir. 2001). Financial accounting benefits In determining whether a taxpayer had a valid business purpose for entering into a transaction, at least one court has concluded that financial accounting benefits arising from tax savings do not qualify as a non-tax business purpose." However, based on court decisions that recognize the importance of financial accounting treatment, taxpayers have asserted that financial accounting benefits arising from tax savings can satisfy the business purpose test. Reporting and penalty regimes 52 As enacted in the American Jobs Creation Act of 2004 ("AJCA"), present law provides new and strengthened accuracy related penalties with respect to "reportable transactions" and "listed transactions," a subset of reportable transactions that includes transactions the IRS views as tax avoidance transactions. If listed transactions or other reportable transactions with a significant tax avoidance purpose are adequately disclosed on the tax return, the accuracy related penalties do not apply if there was reasonable cause for the understatement and the taxpayer acted in good faith.53 In the case of a nondisclosed "listed transaction," the accuracy related penalty is a "strict liability" penalty that is imposed notwithstanding the fact that a taxpayer may have had an otherwise permissible opinion of counsel stating that the taxpayer is believed to be "more likely than not" to prevail if the matter is litigated.54 2001). 51 See, American Electric Power, Inc. v. U.S., 136 F. Supp. 2d 762, 791-92 (S.D. Ohio 52 See, e.g., Joint Committee on Taxation, Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations (JSC-3-03) February, 2003 ("Enron Report"), Volume III at C-93, 289. Enron Corporation relied on Frank Lyon Co. v. United States, 435 U.S. 561, 577-78 (1978), and Newman v. Commissioner, 902 F.2d 159, 163 (2d Cir. 1990) to argue that financial accounting benefits arising from tax savings constitutes a good business purpose. 53 In order to satisfy these requirements there must have been substantial authority for the taxpayer's position and the taxpayer must have reasonably believed that the claimed treatment was more likely than not the proper treatment. A taxpayer may not rely on a tax opinion that is issued by a "disqualified advisor" (in general, an advisor with certain relationships to the transaction) and may not rely on any tax opinion that is a "disqualified opinion" that does not meet certain standards. Sec. 6662A. 54 Sec. 6662A. In the case of a nondisclosed reportable transaction that is not listed but that has a significant purpose of evading or avoiding Federal income tax, the IRS may waive the accuracy related penalty only if the Commissioner determines that such waiver will enhance compliance and tax administration. |