Copyright © 1999 Robert L. Sommers, all rights reserved.
As with the crude and unsophisticated trust scams, these fancy corporate tax shelters, once discovered and analyzed, are ripped apart by the sham transaction doctrine. The recent ACM Partnership vs Commissioner case (discussed below) illustrates how the best and brightest Wall Street tax brokers and corporations scheme to rip-off Uncle Sam. Unfortunately, these tycoons were nailed by the same sham transaction doctrine that snares the lowly trust scam operators as well. The lesson: Transactions that lack economic significance, no matter how well-dressed up they are, are shams under the tax law and will be disregarded.
Thus far, once the IRS catches up to the transaction, the courts have accepted sham transaction doctrine over the protests of the scheming taxpayer. The leading case in this area, ACM Partnership vs Commissioner (Nos 97-7484 and 97-7527, 3rd Circuit, October 13, 1998), cert denied, April 15, 1999, involved an elaborate contrivance devised by Merrill Lynch.
The ACM case, as with any well planned corporate tax scheme, was extremely complex. A simplified version of the facts follows: Merrill Lynch got the bright idea that its client, Colgate-Palmolive, could avoid paying $105 million in capital gains taxes by entering into a foreign partnership which would artificially create $100 million in losses (through the purchase and sale of Citicorp note) and then allocate those losses to Colgate.
The losses were accomplished through a manipulation of the installment sales rules (the ratable basis rules that apply to contingent debt under IRC 15a.453-1(c)(3)(i)) to distort the adjusted basis of the installment payments. This created a large gain in year one which was allocated to the foreign partner (which paid no U.S. tax) and losses in years 2-4 which were allocated to Colgate and used to off-set its capital gain. Of course, there was no economic substance to the transaction, other than to provide Colgate with an undeserved tax loss, as both the Tax Court and the Third Circuit Court of Appeals ruled (the Supreme Court refused to hear ACMs appeal).
The court noted that ACM:
engaged in mutually offsetting transactions by acquiring the Citicorp notes only to relinquish them a short time later under circumstances which assured that their principal value would remain unchanged and their interest yield would be virtually identical to the interest yield on the cash deposits which ACM used to acquire the Citicorp notes.
so we find that ACM's intervening acquisition and disposition of the Citicorp notes was a mere device to create the appearance of a contingent installment sale despite the transaction's actual character as an investment of $35 million in cash into a roughly equivalent amount of LIBOR notes.
The court concluded that the acquisition and disposition of Citicorp notes:
had no effect on ACM's net economic position or non-tax business interests and thus, as the Tax Court properly found, did not constitute an economically substantive transaction that may be respected for tax purposes.
The court stated that deductions were allowable only if losses the taxpayer sustains are bona fide losses determined by the substance of the transaction. Tax losses which are purely an artifact of tax accounting methods and which do not correspond to any actual economic losses, do not constitute deductible losses under the tax code.
Naturally, the taxpayers brought in their experts to argue the transaction had economic substance, but the court saw through the smoke screen. The ACM decision has generated several major articles in tax publications regarding the application of the sham transaction doctrine, but the transparency of the ACM transaction has not been seriously questioned.
Perhaps the most disturbing part of ACM is not the courts opinion, but rather a dissent issued by one of the judges. Evidently, the dissenting judge bought into ACMs argument that this transaction had economic substance and misunderstood the essence of the sham transaction doctrine. This dissent could give the corporate shelter hucksters new hope that if they create a transaction with enough complications , they could fool the court into believing economic substance existed.
Here's the epic battle between taxpayers who structure transactions that literally fall within the tax code and the IRS -- it is the interpretation of the "sham transaction" doctrine. Pitted on one side is the famous quote by Judge Learned Hand, in Helvering v. Gregory, 69 F. 2d 809, 810 (2nd Cir, 1934), affd 293 U.S. 465 (1935) that forms the basis of all tax planning:
[A] transaction, otherwise within an exception of the tax law, does not lose its immunity, because it is actuated by a desire to avoid, or, if one choose, to evade, taxation. Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase ones taxes.
Contrast Learned Hand's statement with the sham transaction doctrine as approved by the court in Jacobson v. CM, 915 F. 2d 832 (2nd Cir, 1990)
Transactions that are entered into solely for the purpose of obtaining tax benefits and that are without economic substance are considered shams for Federal income tax purposes and purported indebtedness associated therewith will not be recognized . [A] sham transaction [is] a transaction that is lacking in objective economic reality and that has no economic significance beyond expected tax benefits.
In deciding whether transactions lack economic substance, we consider such factors as the lack of arms-length negotiations, inflated purchase prices, the structure of the financing of the transactions, and the degree of adherence to contractual terms.
At the heart of every tax shelter is whether the transaction, apart from the tax savings, had economic substance and reality beyond the tax benefits. Of course, the answer is these transaction never had actual economic significance, but the "game" is whether the promoter can provide just enough economic significance to avoid the sham transaction doctrine. Is 2% or 5% substance enough to clear the sham transaction hurdle or at least prevent the imposition of negligence or fraud penalties? The problem faced by the promoter is if there is too much substance (i.e. real economic risk) the party nominally benefiting from the transaction will back out. As noted above, two-party transactions invariably have one party who needs the tax break and the nominal entity.
IRS, alarmed by this threat to the treasury is busy lobbying for more laws to penalize those participating in these transaction. I contend that minimal changes in the law are necessary, but IRS needs to change tactics in dealing with these promoters. First and foremost, IRS has to stop playing "chase the shelter" since that is a game it can never win. Of course, that is precisely what the tax brokers want: an undermanned IRS attempting to ferret-out their complex and well-disguised tax schemes in which taxpayers have virtually no risk, other than repaying the taxes they would otherwise owe, plus interest.
Instead of taking on these transactions, IRS should declare war on the accountants directly. This is surprisingly easy to do, provided IRS has the political backing. Unlike the trust scam promoter who derives almost 100% of his profits through selling tax frauds, the tax brokers comprise a small, but growing, section within the accounting firms. Accounting firms still rely on the SEC audit work for the bulk of their fees. This is where they are vulnerable.
One of the more interesting aspects to the new corporate tax shelter phenomenon is the cozy relationship among the large accounting firms. Assume Firm A is the auditor for a large public company, it is precluded from selling tax advice on a contingency basis. Therefore, another accounting firm, Firm B, may pitch the tax shelter.
This, in turn, causes Firm A a problem, as the Forbes article explains: " [W]hether a company should set up reserves in its reported earnings for the possibility that IRS will detect and disallow the tax gimmick." Since the possibility exists that Firm A will sell a Firm B client a tax shelter in the future, if it discloses the risk as the auditor in the first transaction, it can expect Firm B to return the favor. Therefore, a conspiracy of silence between the auditing firm and the tax promoting firm serves the interests of both, while shafting the government and misleading the shareholders.
IRS and SEC need to jointly attack this problem by proclaiming that any accounting firm that fails to disclose a tax shelter as part of its auditing work will risk losing its license to audit corporations under the appropriate SEC rules. Also, if Accounting Firm A fails to disclose a suspicious transaction proposed by Accounting Firm B and Accounting Firm B returns the favor by failing to disclose a suspicious transaction involving Accounting Firm A, then both will be barred from practicing before the SEC and IRS and the officers of both could face appropriate criminal charges for engaging in this enterprise (whether those charges amount to a criminal conspiracy, stock manipulation or RICO is outside the scope of this article).
A suspicious transaction would include any transaction in which the sham transaction doctrine could apply, namely; the promoter received abnormal compensation such as a contingency fee, a commission or an equity stake; the transaction involved a non-U.S. taxpaying entity which received the income; or the transaction was conceived or sold to the client by a company pitching tax shelters.
Such a strong and united position between SEC and IRS would create factional infighting within the accounting firm between the tax brokers and the traditional SEC auditors since the auditors' livelihoods would be directly jeopardized by the actions of the tax brokers. Of course, no sanctions would apply if the accounting firms disclosed the transactions on the audited financials, as they are supposed to do in the first place.
IRS should create a reward program similar to the "whistle'-blowing" provisions for government fraud and waste. Those providing information on corporate tax shelters should receive 5% of the first $5,000,000 and 2% thereafter on all sums recovered in taxes and interest. To pay for the reward, the promoter and taxpayer should be assessed an additional 5% penalty. The person providing the information would receive complete anonymity and could form a foreign or domestic corporation or trust to deal with IRS. If IRS failed to pay the reward, or if there were more than one person entitled to it, the participant would be entitled to a hearing by an independent administrative board to determine rights to the reward.
To make the reward effective, the "information" provided should be considered a long-term capital asset, thus eligible for favorable capital gains treatment and it should be deemed to have a fair market value of $1.00 until the payment is made, to facilitate estate planning. The recipient should have the choice of receiving payment in a lump-sum or over any period he/she chooses, up to 20 years, with interest at the appropriate T-bill rate applying to the unpaid principal. In addition, the reward and stream of payments should not be taxed until received and should be freely assignable and transferable.
To avoid retaliation by the taxpayer or those participating in the tax shelter, any agreements attempting to limit the right of those to provide information under the reward program will be considered void as against public policy and any person who is sued by a participant in the scheme should be entitled to attorney's fees and general damages of at least $100,000 or triple the actual damages, whichever is higher.
By creating an effective reward program, disgruntled employees of the promoter, professionals who know about the transaction or participate in it, and employees of the taxpayer, will have an economic incentive to alert IRS to the tax shelter. It will also breed extensive paranoia within the promoters, advisers and taxpayers since their employees would be armed with potentially damaging information on which he/she can make a large profit.
This approach plays off the greed and avarice that fosters the corporate tax shelter in the first place. Also, there is poetic justice when these tax brokers turn on each other -- while the government sits back, collects its information, goes after the taxpayer and its advisors for the taxes, penalties and interest, and makes them pay for the reward with an increased penalty!
Note: This program could serve as a model for tax-related information, including trust scams and other tax frauds.
Why should the taxpaying public stand by and allow the largest U.S. corporations to escape tax through bogus corporate tax shelters? How many billions in uncollected taxes are at stake?
The esoteric corporate tax shelters devised by the large accounting firms and their industry cohorts are a product of an overly complex tax code, an understaffed IRS and greedy corporate taxpayers, playing audit roulette. No one seriously believes these shelters work, the key question is whether they will get caught. As the ACM cases shows, the sham transaction doctrine will defeat these schemes because they lack economic substance.
The accounting firms who engage in these practices for some clients, while providing audit services for others are in conflict: If, as auditors they disclose the risks, they can expect the same treatment from other auditing firms when they turn around and sell an unscrupulous tax shelter themselves.
Although these accounting firms may consider themselves invincible, because of their sheer size they will have disgruntled employees who could blow the whistle by providing IRS with a copy of a scheme. The SEC could take a major role in stopping this practice by threatening to bar any accounting firm from auditing publicly-held firms, if it fails to disclose a suspicious tax shelter on a balance sheet .
In conclusion, the solution to this problem is simple: Put real pressure on the accounting firms engaged in this activity and make them report any suspicious transactions in the audits. Pay those who provide information on these transactions real rewards, protect them against retaliation and watch the tax broker business crumble.
**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**