ataxingmatter

Transactions of Interest

The IRS issued two notices today identifying transactions of interest for purposes of section 1.6011-4(b)(6) of the Regulations, and sections 6111 and 6112.  In its news release, the Service indicated its hopes that these notices will help practitioners understand the types of transactions that will be considered "transactions of interest".  These are categories of transactions of which the Service has become aware that it considers potentially abusive but for which it lacks sufficient information to be certain of the appropriate analysis.  A transaction of interest may later progress to listed transaction status or to a new category of reportable transaction.

The two transactions identified by notice are a "toggling" grantor trust transaction, Notice 2007-73, and a charitable contribution of a successor member interest, Notice 2007-72. 

The success interest in Notice 2007-72 involves the potential inflation of values for charitable contribution deduction purposes.  These are transactions in which an owner of membership interests in an LLC that holds, for example, leased real estate sells to a taxpayer a future ownership right to the membership interests. After a year, the taxpayer transfers the right to future ownership to a charity and claims a charitable contribution deduction that is significantly more than the amount paid for the interest or what would be expected as normal appreciation.  Why is this a transaction of interest rather than a straight-forward valuation abuse? 

The toggling grantor trust involves a purported termination and re-creation of a trust in a way that purports to provide tax benefits to the grantor--either through creation of an artificial loss in excess of any economic loss sustained by the grantor or avoidance of taxation on gain in what would otherwise be a taxable exchange of appreciated assets for liquid assets.  Each toggling grantor trust transaction described involves a series of transactions completed generally within 30 days.  In one, as I understand the Service's notice, a taxpayer purports to: purchase offsetting options, contribute those options to a trust, create a unitrust beneficiary interest and a remainder interest and sell the remainder interest (claiming the sale terminates the trust but generates no taxable gain because the taxpayer's basis in the interest is essentially equal to its fair market value.  Then, because the trust instruments provide the taxpayer a power of substitution that "triggers on" after the sale, the taxpayer claims the substitution power reestablishes the grantor trust status.  Thus, when the trust closes out the loss options, the taxpayer claims recognition of a (noneconomic) loss, as the "grantor" of the trust. (The noneconomic loss is generated by using the asset basis twice--on the sale of the remainder interest and on closing out the loss options.)   The buyer buys the unitrust interest, terminates the trust and claims a basis in the remaining gain options of the amount paid for the two interests.  The taxpayer claims no tax on any exchange.

The toggling grantor trust seems to be whipsawing the IRS with the look-through nature of the trust combined with the on again-off again status which purports to allow the grantor the double use of basis.  Once the grantor sells the remainder interest, however, I do not see how he can be considered an indirect owner of the underlying trust assets, which is what the term "grantor" means.  Similarly, when a sponsor creates a grantor trust for a securitization transaction by contributing assets and then sells beneficiary certificates representing ownership interests in the trust, the sponsor is no longer the grantor because the certificate holders step into the shoes of the sponsor and become the grantors for purposes of the tax rules that treat the grantors as the owners of the underlying trust assets.  Thus, the existence of the substitution power at that point would appear not to "restart" the trust as a grantor trust as to taxpayer. And any exercise of the substitution power, such as the substitution of appreciated assets for liquid assets in the second version of the toggling grantor trust discussed in the notice, would be a taxable exchange as to the taxpayer.

Jenkens & Gilchrist: settlement information useful to taxpayers contesting shelter?

The U.S. Court of Federal Claims ruled on August 9 in JZ Buckingham Investments LLC v. United States regarding a motion by a third party, the now-disbanded lawfirm Jenkens & Gilchrist, to quash a subpoena for information about Jenkens' settlement agreement with the Department of Justice and Internal Revenue Service (Service) related to the "currency options bring reward alternatives" (COBRA) tax shelter promoted by Deutsche Bank with Jenkens & Gilchrist and others.

The COBRA deal involved a partnership entering into long and short positions in foreign currencies.  The long positions were treated as increasing basis, and the short positions were disregarded as contingent liabilities in the calculation of partnership basis.  When the deal was all done, the taxpayer claimed a loss from the artificial basis generated by disregarding the short position that offset a gain elsewhere.

Jenkens & Gilchrist entered into a settlement agreement with the DOJ based on a closing agreement with the IRS, in which it agreed to pay $76 million in penalties in connection with the COBRA deals.  JZ Buckingham Investments wants to know the IRS's thinking on the deals and has subpoened Jenkens & Gilchrist for documents relating to its negotiations with the IRS, including the Closing Agreement and Settlement Agreement.  It apparently believes that the IRS is playing a tails-I-win, heads-you-lose strategy as to whether the options should be treated as a single net option (the advantageous position as to taxpayers) or as separate options (the advantageous position as to promoters in respect of calculating the penalty under section 6707).   It is therefore seeking information from the Jenkens settlement that will shed light on this inconsistent approach.

There are three grounds for quashing a subpoena:  irrelevance, lack of need, and undue hardship.  Jenkens & Gilchrist argued that the documents sought in the subpoena are irrelevant and protected by privilege, and that the production would impose an undue burden on the disbanded firm.

  The court concludes that the information about the IRS calculation of penalties would be  relevant (even if it might be inadmissible at trial), but concludes that the Closing Agreement is protected and need not be disclosed because it does not provide that information. 

Jenkens & Gilchrist also argued that testimony about the Closing Agreement with the IRS and the Closing Agreement itself should be protected from discovery by a settlement privilege.  The court addresses that argument and concludes that there is no settlement privilege that would otherwise protect the document, in part because the IRS would rely on Code Section 6103 (protecting taxpayers against disclosure of information by the IRS) to resist production of information related to settlement with particular taxpayers. 

Finally, the court rejected Jenkens & Gilchrist's argument that responding to the subpoena would cause an undue burden on the firm.  Although Jenkens & Gilchrist has been reduced to a "caretaker" partner and contract employee, the court felt that responding to the legal subpoena would not be an unreasonable burden on that firm.

Schumer and carried interests

Chuck Schumer has apparently taken some heat for his attempt to wiggle free of holding his Wall Street donors to the same standard of tax fairness that applies to the rest of us.  As I reported in an earlier posting, Schumer had expressed reluctance to support the Senate Bill dealing with private equity partnerships and hedge funds.  Now, however, he says he is in favor of the House bill, because it is "broader" and "fairer" and may introduce similar legislation in the Senate.  See Taxes Owed: Democrats should support higher rates even if doing so pinches their contributors, Washington Post, Aug. 9, 2007, A16. 

The Senate Bill focuses on the publicly traded partnership rules and the "passive income" exception that entities like Blackstone (after its recent IPO) claim allow it to continue its active management business while benefiting from rules designed for passive entities by not having to pay corporate income tax like other active businesses.  I''ve argued that this exception shouldn't apply in these cases. 

The House bill closes the purported carried interest loophole.  (I say 'purported' because it all depends on the appropriate taxation for profits interests in partnerships, and there is no crystal clear answer.)  The House bill requires carried interest income to be treated as compensation and taxed at ordinary rates where it is received on a profits interest received for services.

Why would anybody think rich fund managers should be singled out for a special tax break of being allowed capital gains on their services compensation?  Maria Cantwell worries that increased taxes will be passed along to investors like pension funds.  Doubtful--managers are already charging investors to the hilt, and wouldn't get away with charging more just to preserve their super-lucrative profits.  Those investors would go somewhere else.  Others say that taxing these managers appropriately will "discourage capital formation."  That's bunk.  As the Post article notes, the investors who contribute capital won't pay any higher taxes, but the managers who make money for them will.   

Bush has claimed that the effort to tax private equity fund managers might somehow "hurt small business".   Just which small businesses was he concerned about? Certainly not the megabuck managers who could still manage quite well, thank you, if they took home $650,000 instead of $850,000 (or multiples thereof).   One thinks that these economic rationales are becoming mere shibboleths invoked for their deep emotional meaning to free marketeers even if only vaguely applicable to the actual situation.  There's a whole list of those phrases pulled out of a hat to ward off the possibility of tax increases for certain protected classes:  "hurting small business" (even if most of the players are in fact megabusinesses),  "discouraging entrepreurship" (even if the "business" that the managers are engaging in is exploiting a temporary market disequilibrium to buy cheap, rip out the heart by firing people and closing plants, then flipping the asset by selling it into the markets at a much higher price--not exactly what I would call entrepreneurship since it is more like a con game), "discouraging capital formation,"  (even if the market for the activity has been distorted by the tax subsidy in question, so that there may be more buying/stripping/and flipping going on than is healthy for an economy), and "keeping business from being able to compete effectively internationally" (even if the "competitor" is also a domestic US corporation, like Pepsi and Coke, and the competition involved is primarily a race to get out of paying taxes to anybody).

Capital Gains: CTJ report on who benefits

Citizens for Tax Justice (CTJ) has released a new paper on the distribution of the benefits from the reductions in the preferential rate for capital gains and the 2003 enactment of a preferential rate for corporate dividends.  See   New IRS Data Peg Cost of Special Low Rates on Capital Gains and Dividends at $92 Billion in 2005 Alone, Tax Justice Journal (Aug. 10, 2007).

Here's the gist of the study (beyond what is quite succinctly summarized in its title). 

• Taxpayers with annual incomes in excess of half a million dollars received 73.4% of the benefit of the preferential capital gains rate in 2005.  Those taxpayers comprise only point 6 percent (0.6%) of U.S. taxpayers.  Put another way, a very tiny proportion of US taxpayers enjoys the lion's share of the capital gains benefit.  That amounted to an average tax cut for this wealthy benefitted group of $81,204--more than most Americans make in a year.
• But those at the very tip of the income scale did even better.  Those 13,776 taxpayers who took hom more than $10 million in 2005 received a whopping $1,876,280 tax cut due to the preferential rates.  That's 28.2 percent of the benefit to a mere point 1 percent (0.1%) of taxpayers.
• How did the majority of Americans who don't even make $35,000 a year fare?  The bottom half of the income distribution got virtually no benefit from the capital gains preferential rate.

Robert McIntyre said it all with the following statement: 

“When half a percent of all tax filers gets three-quarters of the benefits of a tax subsidy, you can bet that the politicians who voted them this largesse probably know most of them personally.”

Corporate Tax Shelter Developments: Brocade, KPMG, Hilfinger in the news

The trial of the remaining 5 KPMG defendants will apparently begin in October as scheduled.  The judge on Aug. 3 denied the defendants' motion for a continuation. 

As corporate attempts to avoid tax through super-aggressive schemes become more widely understood, the corporations face not just IRS penalties and interest, but the potential for class securities fraud claims.  Case in point--In re Tommy Hilfiger Securities Litigation, S.D.N.Y. No. 04 Civ. 7678 (July 20, 2007).   The US district court in the Southern District of New York decided in July that plaintiff's claims were adeuqate for the case to proceed.  The complaint alleges an illegal tax evasion scheme to lower its effective tax rate and falsely improve its financial condition.  The scheme involved payment of an inflated "buying office commission" to an oversaes subsidiary, resulting in moving income offshore and avoiding US tax on that income.  The government entered into a nonprosecution agreement with the company, but the securities fraud case will go forward.

Similarly, in San Francisco, former Brocade CEO Greg Reyes was convicted Aug. 7 for backdating stock option grants for his friends.  The company had agreed to pay $7 million to settle SEC civil fraud charges back in May, without admitting the SEC's allegations.  These charges are for securities violations, not tax law violations.  For public companies, the backdating of currently in-the-money options to a period when they appear to be at-the-money leads to inappropriate reporting of compensation expenses.

Note--it is very unlikely these days that big corporations will be indicted for criminal actions, even if the corporate behavior clearly qualifies.  See this discusison of the increased use of non-prosecution agreements to avoid charging large corporations.   The business outcry over the impact on Arthur Andersen of its prosecution for accounting fraud had a major impact on prosecutors' willingness to pursue criminal indictments even against obviously guilty corporations.

Krugman on Carried Interests

Paul Krugman's August 3 op-ed in the New York Times, "A Test for Democrats", shouldn't have gone unnoticed here. He calls last week a "good Democrats, bad Democrats" week. Good, because the House passed the children's health insurance expansion that most Americans support by cutting subsidies to Medicare Advantage, the "privatization scheme that yhields big profits for insurers, but that the budget office estimates would cost taxpayers $54 billion in excess payments over the next five years."

Bad, because Schumer came out in opposition to fair taxation of hedge fund managers, even though it is clear that the hedge and equity funds are shorting the government by means of a tax loophold (the uncertainty over appropriate treatment of partnership "profits" interests as compensation and the long term acceptance by the Treasury that profits partners get capital gain treatment when the partner receives a distributive share from the partnership they've contributed their services to when it recognizes a capital gain.

Krugman notes two problems with the arguments for not ensuring that these investment managers pay ordinary rates on their compensation.  As to the argument that low taxes are necessary to encourage risk-taking, the managers aren't risking their own money so don't need special tax breaks.  As to the argument that management fees would just increase further, impacting investors' returns, Krugman resorts to sarcasm.  "[A]s if someone with a $100 million a year hedge fund job would walk away if his take-home pay fell from $85 million to $65 million." 

Krugman notes that "[i]f being a Democrat means anything, it means opposing this kind of exorbitant privilege." 

Energy Bill

The House finally passed the energy bill last week.  The substantive energy bil is H.R. 3221, which requires utilities to get 15% of their energy from renewable resources.  It passed the House 241 - 172.  See this article by J.R. Pegg on the Environmental News Service.  Energy tax measures are in H.R. 2776 but will be folded into H.R. 3221 on engrossment.  The tax measures passed by a surprisingly strong 221-189.  Eleven Democrats voted against the bill, and nine Republicans voted for it.

Perhaps the most controversial measure in the energy tax bill is the elimination of the manufacturing deduction under section 199 for oil and gas companies.  If you are not a tax person, you are probably doing a double-take along the lines of "Manufacturing deduction?  Why would oil and gas companies ever have been invited to that game in the first place? They've already got all those other tax subsidies as extractive industries."  And of course, you'd be exactly right.  It appears a majority in the House has finally realized that there can in fact be too many subsidies for Big Oil, especially when Big Oil is enjoying windfall profits.

Among the other measures in the bill is an extension of the section 45d renewable energy tax credits and the investment credit for solar and other alternative energies.  The bill also increases the depreciation allowance for energy-saving devices, as an incentive to encourage their use.  The two controlled foreign corporation provisions dealing with oil companies (sometimes fondly called FORI and FOGEI) will be essentially merged, resulting in additional tax revenues of about $3.2 billion.  All in all, the bill "diverts" about $15 billion in taxes from oil and gas to support alternative and efficient energy.  Id.

The House and Senate (H.R. 6, passed in mid-June) energy bills will be difficult to reconcile.  The House included the 15% renewable energy requirement, but the Senate did not.  The Senate requires a 40% increase in fuel economy and increased ethanol use, but the House did not pass any such standard.  The Senate didn't pass any energy tax provisions at all.  The final bill is not written yet and there will be much discussion before we know whether the United States will finally increase auto fuel efficiency standards after 30 years of neglect.

State Children's Health Insurance Program

When I was in the Peace Corps in Colombia, I met with the Colombian bishop to urge that he take a leadership role in pushing the church to do more for the very poor rural families, the campesinos, with which I worked.  The Bishop took me out to a luxurious retreat that he was building for priests--it was similar to a resort on a pleasant windswept acreage removed from the hustle and bustle of Bogota.  I asked him how he could justify spending the construction costs on the "retreat" rather than for programs to meet the needs of the poor.  His answer shocked me.  He said that the campesinos were not worth worrying about.  No matter what one did, the poor would be poor, so it's better just to let them be.

Sometimes it seems to me that the Bush Administration took a lesson from that arrogant bishop.  The President has recently stated that we don't need to increase the funding for the health insurance program for children because they can always go to the emergency room for the care they need, and he thinks the program goes too far towards "federalizing" health care. He's threated to veto the expansion of the program if it arrives on his desk. See this July 31 article in the International Herald Tribune. Pete Sessions claimed that the legislation "uses children as pawns in a cynical attempt to make millions of Americans completely reliant on government for their health care needs." For the administration and some Republicans in Congress, it appears that the very success of government-funded health care is the problem--they fear that the success of this program will eventually convince most Americans that single-payer, single-provider health care is the best way to ensure that all Americans have decent health care.    Illinois' Rahm Emanuel pointed out that members of Congress and their children already have government-provided health care, so it is not unreasonable to provide the same to the children of their constituents.   It's strange that the provision of medical care for those who have none is cast as a loss of choice, see this freedomworks statement.  Children who have no health care have no choice.

Thankfully, the House and Senate have not been intimidated by that threat.  The House passed a substantial expansion of the program on Wednesday, funding it with an increase in tobacco taxes and a reduction in the expensive subsidies for private Medicare insurance plans.  (Medicare currently pays private plans on average 12% more than it would cost for the same coverage under traditional Medicare; somehow this subsidized and more expensive "choice" is supposed to show that private health care is more cost-efficient than a government run system.) See this August 2, 2007 New York Times article by Robert Pear. The Senate has now also passed its own version of the legislation to reauthorize and expand the State Children's Health Insurance Program (SCHIP), S 1893, with a healthy, veto-proof margin:  all 48 Democrats, 2 Independents, and 18 Republicans.  See this August 3, 2007 New York Times article by Robert Pear. 

It's not clear how the two arms of Congress will reach a compromise.  The House bill is much bigger than the Senate bill, and includes the reasonable change to the Medicare private plan subsidy.  Some tax revenues will be necessary to fund this program, one way or another.  Senator Kerry's proposal to increase the tax rate on taxpayers making more than one million a year was not adopted--instead, the bill relies on regressive "sin" taxes (an increase of 61 cents a pack in the Senate version) to fund the program.

At some point, Congress needs to seriously consider the mess they've made of the tax code over the last few years.   There are many serious needs for government spending--from bridge repairs to children's health.  We should use our tax system to raise revenues appropriately for the many tasks that government must accomplish in an age of globalization.  Maybe it's time to consider a suggestion like Senator Kerry's proposal here to increase the rate on those making a million or more annually.

New Chief of Staff for the Joint Committee on Taxation

Senator Baucus and Congressman Rangel announced yesterday the appointment of Edward Kleinbard, currently a partner at Cleary Gottlieb in New York, as the new chief of staff for the Joint Committee on Taxation.  He'll take up his new position on September 1.  See the news release, here.

I have a special interest in this story, since I was an associate at Cleary for six years before moving to academe.  I worked with Les Samuels, Jim Peaslee and Ed Kleinbard--all brilliant tax laywers who fully merit their renown in the field.  Ed is also one of the wittiest people I've ever met, whose speeches to new associates about the possibility of working in tax could qualify as stand-up comedy routines on the Seinfeld show. (I know that is hard to believe.  Can talking about tax law possibly lead people to laugh and be happy?  Even more, can talking about the grinding work an associate has to do when learning the tax law result in good humor all around, among a bunch of associates considering the prospect of working in tax?  The answer, when Ed is the speaker, is--yes!)  Ed has very high standards for the work he does, and he is demanding of subordinates and colleagues alike to ensure that those standards are met.  That made life difficult for tax associates in the firm sometimes, working hundreds of hours to get a research memo right, but it should stand the JCT in good stead as they try to get tax policy right for the country.

I've disagreed with Ed strongly on certain tax policy issues, with the most obvious case being the drive by financial institutions for mark-to-market accounting that conforms to their financial accounting.  The financial institutions argued that the government should just defer to their reasonable business judgments about valuations.  As I wrote in a long article about book-tax conformity, Book-Tax Conformity and the Corporate Tax Shelter Debate: Assessing the Proposed Section 175 Markk-to-Market Safe Harbor, there are real concerns that this approach will permit financial institutions to manipulate their tax liability, just as some corporations manipulated their accounting numbers in the recent accounting fraud scandals.  My greatest reservation about Kleinbard in this position is thus based on his long role as an adviser to the Securities Industry Association, an already very powerful block of financial institutions with particular interests in the tax law and considerable influence in Congress.   As a partner at a law firm that works closely with financial institutions around the world, his perspective is closely aligned with Wall Street's.  Those of us who care will have to work very hard to keep the perspectives and needs of ordinary "Main Street" Americans on Congress's agenda.

The final reportable transaction regulations

The IRS released today (July 31, 2007) a set of three final "reportable transaction" regulations on tax shelter disclosure and registration:  TD 9350; TD 9351 (section 6111 material advisor rules); TD 9352 ( list maintenance rules) (all available on BNA's service).  The regulations are generally effective August 3, 2007, except that the "transactions of interest" reporting requirements apply to transactions entered into on or after November 2, 2006.

The transactions of interest regulations retain the fairly broad defining language of the proposed regulations:

"A transaction of interest is a transaction that is the same as or substantially similar to one of the types of transactions that the IRS has identified by notice, regulation, or other form of published guidance as a transaction of interest."

The preamble notes that commentators asked for "clear" language and complained that the category appeared overbroad.

"The IRS and Treasury Department believe that providing a specific definition for the transactions of interest category in the regulations would unduly limit the IRS and Treasury Department’s ability to identify transactions that have the potential for tax avoidance or evasion. In order to maintain flexibility in identifying a transaction of interest, the description of a transaction of interest will be provided in the published guidance  that identifies the transaction of interest. The published guidance identifying a transaction of interest will provide taxpayers with the information necessary to determine whether a particular transaction is the same as or substantially similar to the transaction described in the published guidance and to determine who participated in the transaction."  TD 9350

Similarly, the government rejected a comment suggesting that the transactions of interest designation should be viable for only 24 months.  Commentators had also argued that owners of pass-through entities should not be required to disclose, at least in the case that they were unaware of the reportable transaction.  The government amended the regulations to provide some flexibility in dealing with pass-through entity reporting.  The time for filing a disclosure statement after a transaction has been identified as a reportable transaction or a transaction of interest was also lengthened from 60 days to 90 days in response to commentary.

The regulations eliminate the brief asset holding period category of reportable transactions.

The material advisor regulations in TD 9351 lower the gross income threshold for reporting when a reportable transaction provides "substantially all of the tax  benefits" to natural persons.  The regulations indicate in 301.6111-3(b)(3)(i)(D) that this is a "facts and circumstances" test that will generally be satisfied if 70 percent or more of the benefits go to natural persons. The gross income  includes all fees for a tax strategy or for services for advice or implementation of the transation--including services not related to tax advice (documentation, analysis, preparation of tax returns).  But the regulations provide that the fees taken into account do not include amounts paid to the advisor in his capacity as a party to the transaction (e.g., reasonable charges for use of capital).  The regulation provides a broad definition of tax benefit, including deductions, exclusions, adjustments to basis, nonrecognition, and "any other tax consequences that may reduce a taxpayer's Federal tax liability by affecting the amount, timing, character, or source of any item of income, gain, expense, loss or credit."

When a material advisor reports a transaction to the IRS, the IRS will issue a "reportable transaction number" and the material advisor must provide that number to anyone to whom the material advisor acted as a material advisor in respect of the transaction.

The final regulations permit various material advisors to contractually agree that a particular advisor will be the one to disclose the transaction to the IRS.  The preamble notes that a commentator's suggestion that a "good faith" participation in a designation agreement should be enough to relieve a material advisor of any reporting obligation.  The IRS did not accept that comment.   

"Inherent  in the language is the assumption that the designated material advisor will comply with the requirements.  Absolving the non-designated material advisors from the obligations... for good faith designation agreements would require the IRS to determine whether the designation agreement was entered into in good faith and would increase the burdens on tax administration."  TD 9351

The list maintenance proposed regulations required that a material advisor furnish information on the list to the IRS within 20 business days of a request for such information.  Commentators suggested that this was too rigid, and that the RIS should permit a phased disclosure or give advisors an opportunityh to gather the required information.  The preamble of TD 9352 indicates that the idea of an alternative schedule would be developed in separate guidance under Section 6708 and thus the final regulations remove the 20-day period for providing the list information.