Tax Havens: legislation in sight?

[edited to correct typos 031209 8pm]

As Congress settles in under the new administration, it appears much more likely that it will finally take some kind of decisive action to prevent the various international tax scams that have permitted many U.S. taxpayers to avoid paying the amount of tax that they should pay under the system as it is intended to work.  The question becomes not--will Congress act to prevent some of the offshore abuses? but rather --how will Congress act to prevent some of the offshore abuses?

Representative Lloyd Doggett of Texas has been a long-time proponent of action to prevent tax sheltering activity that goes against the intent of the overall schema set out by the tax code, but it has been difficult to get support in the Senate for that action.  Now it looks like there is a much better chance for passage.  A new version of the "Stop Tax Haven Abuse Act" has been introduced by Senator Carl Levin in the Senate (with a similar bill introduced by Lloyd Doggett in the House).  Senate, House Members Introduce Stop Tax Haven Abuse Act, Sen. Levin's Office.  This is similar to the bill co-sponsored in 2007 by then-Senator Barack Obama, with three additions, in particular, that greatly improve the bill: 

(i) Section 103 of the proposal:  treating large traded foreign corporations as domestic if they are managed and controlled in the US;

(ii) Section 108 of the proposal:  closing the hedge fund dividend loophole that purports to convert taxable US dividends into nontaxable dividends, by treating  (for both US statutory law and US tax treaty purposes) dividend equivalents under notional principal contracts in respect of stock of domestic corporations as dividends sourced in the US, and substitute dividend payments (ie, payments made to a securities lender "in lieu of" the dividend the securities lender would have otherwise received) as dividends sourced as the dividend itself would be sourced, and also requiring appropriate withholding on the dividend payment; and

(iii) Section 109 of the proposal:  expanding passive foreign investment corporation (PFIC) reporting requirements for PFIC shareholders. 

See also New Legislation Would Combat Tax Haven Abuse, Increase Transparency and Accountability, Global Financial Integrity.org, Mar.2, 2009.

In general, the proposal aims to provide the IRS with the tools it needs to find noncompliance, to enforce the tax Code, and to make offshore tax shelters harder to do and less likely to pay off for taxpayers (and tax advisers). It sets up a number of rules that relate to "offshore secrecy jurisdictions", which are defined as any "jurisdiction that the Secretary of the Treasury determines to have corporate, business, bank or tax secrecy rules and practices [both formal and informal] which... unreasonably restrict the ability of the United States to obtain information relevant to the enforcement of this title..."  This definition would include Singapore, Cayman Islands, Liechtenstein, Switzerland, among others.  In looking at the activities of financial institutions operating outside the United States, it very appropriately treats impeding U.S. tax enforcement on a par with money laundering.  It requires unregistered investment companies (and that includes hedge funds and private equity funds) to "establish anti-money laundering programs and submit suspicious activity reports."  The proposal, in other words, demonstrates some maturity in Congress in the way it looks at the problems of international tax enforcement as on a par with similar problems in the banking/corporate/financial regulatory world.

 Finding noncompliance will be easier with improved disclosure and reporting provisions, including:

• reporting requirments for withholding agents in respect of beneficial owners of foreign-owned financial accounts and for financial institutions that open an account or establish an entity on behalf of a US beneficial owner in an offshore secrecy jurisdiction. 

Enforcement will improve because of procedural changes, such as the following:

• extension of the statute of limitations for returns connected with offshore secrecy jurisdictions;
• rebuttable presumptions of control and income in respect of certain transactions in offshore secrecy jurisdictions;
• increased information sharing between federal agencies, so that when banking or SEC examinations reveal a potential violation, it is reported to the IRS for investigation (see  Section 305);

I am particularly pleased to see this cooperation provision, since I recommended something along these lines in my first article on corporate tax shelters, see Putting SEC Heat on Audit Firms and Corporate Tax Shelters: Responding to Tax Risk with Sunshine, Shame and Strict Liability, 29 Journal of Corporation Law 219 (2004).

• strengthening of John Doe summons use in cases involving offshore secrecy jurisdictions;
• requirement that documents related to tax exempt determinations be provided on request to Congressional committees for review (for future disclosures, not retroactive); and
• instruction to the Secretary of the Treasury to impose standards for written advice with respect to any listed transaction or transaction that has a potential for tax avoidance or evasion (confirming the authority of the Treasury to issue written opinion standards).  

There'll be more muscle behind the enforcement actions, including the following:

• increased penalties for failures to report and for promoting tax shelters (replacing a penalty under section 6700 that was the lesser of $1000 or 100% of gross income with one that "shall not exceed 150% of the gross income" derived from the activity, for each instance) and similarly for aiding and abetting tax understatements;
• limits on the ability of a taxpayer to rely on a legal opinion for a "reasonable cause/good faith" affirmative defense from penalties for transactions involving offshore secrecy jurisdictions (unless regulations permit reliance where the confidence level "substantially exceeds more likely than not" or where the subsection should not apply to a particular class of transaction, such as corporate reorganizations); and
• denial of any deduction for certain penalties (and other amounts).

There are a number of other commendable provisions here.  To list just a few:

• Section 303 of the bill would amend section 101 of the Patent Act to make tax planning strategies ineligible for patenting, but leave tax preparation software patentable. Again, this is something I have written extensively about:  see  Tax Patents: At the Crossroads of Tax and Patent Law, 2008 Journal of Law, Technology and Policy 107; At the Crossroads, 121 Tax Notes (2008) (an updated article incorporating the Federal Circuit's opinion in Bilski); Tax Shelters and the Tax Minimization Norm: How does the Patenting of Tax Advice Transform the (Global) Playing Field, Journal of Law and Society (2008).
• Section 304 prohibits fee arrangements based on projected tax savings or losses that can be used to offset other taxable income. 

The bill also includes, in Title IV, Section 401,  a "clarification of the economic substance doctrine."  It indicates that a transaction will have economic substance only if it "changes in a meaningful way (apart from Federal tax effects) the tqaxpayer's economic position" and "the taxpayer has a substantial purpose (other than a Federal tax purpose) for entering into such transaction."   If the purpose is to garner a profit, the transaction won't be treated as "having economic substance solely by reason of having a potential for profit unless the present value of the reasonably expected pre-Federal tax profit from the transaction is substantial in relation to the present value of the expected net Federal tax benefits that would be allowed if the transaction were respected" taking fees and other transaction costs--including foreign taxes, if the Secretary so decides--into account.  Financial accounting benefits don't count as a purpose, if the origin of the accounting benefit is a reduction in tax.

I am of mixed views about changing this rather powerful judicial doctrine into a statutory rule.  In spite of the inability of courts to consistently apply the doctrine and thus the ability of skillful practitioners to create customized transactions to generate phantom losses that squeak by the courts, I worry that codification of the flexible judicial doctrine will result in stultification of a provision that has permitted the courts to interpret the Code in ways that are responsive to the inventiveness of tax practitions.  Once codified, tax practitioners may successfully limit the reach of the doctrine through interpretation of the statute, and it will make it possible for nonsubstantive transactions to escape the kind of judicial review that is currently possible.  

The bill is far from perfect.   But it is a start.  And it includes a number of provisions that I have argued for, both on this blog and in my scholarship, that will make the tax laws both fairer and more transparent. 

Another bill sponsored by Senator Levin in the Senate is the Incorporation Transparancy and Law Enforcement Assistance Act.  See this release.  This bill would require states to obtain information from incorporators about the beneficial ownership of new entities, with civil and criminal penalties applicable to fraudulent information.  Law enforcement agencies could obtain the information with a subpoena or summons. As Levin notes in the release, the ability to create dummy corporations that disguise ownership of business activities facilitates a variety of tax scams, for US taxpayers and for taxpayers of other countries using the United States as a tax haven.

[I]n a list of the “Dirty Dozen” tax scams in 2007, the IRS highlighted shell companies with unknown owners as number four on the list, as follows. “4. Disguised Corporate Ownership: Domestic shell corporations and other entities are being formed and operated in certain states for the purpose of disguising the ownership of the business or financial activity. Once formed, these anonymous entities can be, and are being, used to facilitate underreporting of income, non-filing of tax returns, listed transactions, money laundering, financial crimes and possibly terrorist financing. The IRS is working with state authorities to identify these entities and to bring their owners into compliance.” That’s not all. Dozens of Internet websites advertising corporate formation services highlight the fact that some of our States allow corporations to be formed under their laws without asking for the identity of the beneficial owners. These websites explicitly point to anonymous ownership as a reason to incorporate within the United States, and often list certain States alongside notorious offshore jurisdictions as preferred locations for the formation of new corporations, essentially providing an open invitation for wrongdoers to form entities within the United States.

One website, for example, set up by an international incorporation firm, advocates setting up companies in Delaware by saying: “DELAWARE - An Offshore Tax Haven for Non US Residents.” It cites as one of Delaware’s advantages that: “Owners’ names are not disclosed to the state.” Another website, from a U.K. firm called “formacompany-offshore.com,” lists the advantages to incorporating in Nevada. Those advantages include: “No I.R.S. Information Sharing Agreement” and “Stockholders are not on Public Record allowing complete anonymity.”   Id.

The individual states have failed to address this problem satisfactorily, as serving as a tax haven has become just one more way for states to "race to the bottom" in competition with each other.  Levin indicates that the failure of the National Association of Secretaries of State to adequately address the problem demonstrates the need for federal legsilation to "level the playing field among the States, set minimum standards for obtaining beneficial ownership information, put an end to the practice of States forming millions of legal entities each year without knowing who is behind them, and bring the United States into compliance with its international commitments."  Id.  The bill has a huge loophole that could swallow the rule, however, allowing States to idenity "certain corporations, either individually or as a class" that would not have to comply with the rule.   See also Levin Grassley McCaskill Bill Introduced to Stop Misuse of U.S. Companies.