A CRITIQUE OF CURRENT STATE TAX SHELTER LAWS1
by
Marilyn A. Wethekam
I.
Introduction
Over and over again Courts have said there is nothing sinister in
so arranging one's affairs as to keep taxes as low as possible.
Everybody does so, rich or poor; and all do right, for nobody
owes any public duty to pay more than the law demands: taxes are
enforced exactions, not voluntary contributions. To demand more
in the name of morals is mere cant.2
Honorable Learned Hand
Corporate business transactions may result in a reduction of federal, international
and/or state income taxes. In some instances it may be the primary purpose of the
transaction or merely a favorable by-product of the transaction. All business planning
projects, restructuring projects and/or basic business transactions require attention to both
substance and detail and should be analyzed from both a business operation and financial
perspective. The tax consequences also must be considered in the analysis. In analyzing
the project one must consider not only the federal tax doctrines that have been used to
evaluate tax-orientated transactions but also the application of those doctrines by the state
taxing authorities. In addition to analyzing a project in light of the federal tax doctrines
and the various state interpretations of those doctrines, one must also take into
consideration the recently enacted tax shelter regimes and amnesty programs.
1
This
Marilyn Wethekam is a partner in the Chicago law firm of Horwood Marcus & Berk Chartered. She
practices exclusively in the area of state tax. The author would like to thank Heather A. Wallack for her
invaluable assistance in writing this article.
2
Comm’r v. Newman, 159 F.2d 848, 850-51 (2d Cir. 1947) (Hand, J., dissenting).
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analysis is not only required for future projects, but due to the recent statutory and
financial accounting rule changes, must also be applied to existing business transactions.
The challenge is, as evidenced by several recent court decisions, that at the state tax level
there is no uniform application of the federal doctrines or general tax policy with respect
to what will be considered an unacceptable transaction.
While the structuring of tax transactions to reduce or minimize tax liabilities is
not a new concept, in the late 1990s, there was a perception that there was a substantial
increase in the number of abusive tax shelters.3 The federal government and IRS began
cracking down on such transactions. In 2003, the IRS joined forces with several states to
combat the perceived increase in abusive tax shelters, and memoranda of understanding
between the IRS and individual states were executed.4
Generally, the goal of this
federal/state partnership was to increase the efficiency with which the federal and state
governments tackled abusive tax shelter schemes, primarily through increased exchanges
of information and coordination, as well as participation in joint public outreach
programs.5
3
There are a number of reasons for the recent proliferation of abusive tax shelters. Tax analysts generally
believe that the increase was due in large part to the substantial stock market-related capital gains that were
occurring during the late 1990s, as well as other large income gains on the corporate side. In response,
there developed an increasingly sophisticated [abusive tax shelter] industry that relies on complex tax and
income optimization modeling and legal and financial structures to offer tax-avoidance schemes.
In addition, some factors leading to the increase in ATS activity resulted from institutional changes and
other considerations associated with the tax collection agencies. These institutional factors included: (1) a
decline in the rate of federal tax agency compliance and auditing activities due to budgetary limitations and
a shift of resources to taxpayer services, (2) the lack of meaningful disclosure requirements, and (3) an
absence of sizeable penalties on ATS promoters and investors who are caught, relative to the magnitude of
tax savings achievable. California Legislative Analyst’s Office, Abusive Tax Shelters: Impact of Recent
California Legislation, (January 27, 2006).
4
News Release, Internal Revenue Service, IRS and States Announce Partnership to Target Abusive Tax
Avoidance Transactions, IR-2003-111, (Sept. 16, 2003).
5
Id.
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2
This article will review the federal tax doctrines that have been utilized when
evaluating business transactions. As these doctrines are the foundation for various states’
judicial challenges. The article will also address recently enacted federal tax shelter laws
and regulations, and examine select state statutes that have incorporated the federal laws
and regulations in whole or in part.
II.
Federal Tax Doctrines
The federal courts have developed four basic doctrines to apply when evaluating a
business transaction.
For federal tax purposes, a transaction will be evaluated by
applying the business purpose, step transaction, sham transaction, and/or economic
substance doctrines. There remains a question as to whether there are four separate
doctrines or merely the doctrines are subsets of each other.
A.
The Business Purpose Doctrine
The business purpose doctrine originated in the United States Supreme Court
decision in Gregory v. Helvering.6 In analyzing a tax-free reorganization, the Court
emphasized that, “the whole undertaking, though conducted according to the terms of
subdivision (B) [Revenue Act of 1928, section 112], was in fact an elaborate and devious
form of conveyance masquerading as a corporate reorganization, and nothing else.”7
Therefore, although the transaction met the strict letter of the law the Court held that the
transaction was not a tax-free corporate reorganization. In fact, the transaction had no
business or corporate purpose. The Court’s holding in Gregory v. Helvering has been
subsequently interpreted to mean that the literal compliance with a statute is insufficient.
6
7
293 U.S. 465 (1935).
Id. at 470.
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3
In order to fit within a specific provision of the statute a transaction must comply with
both the letter of the statutory section and also have a business purpose.
When drafting the Internal Revenue Code of 1954, Congress responded to the
Gregory v. Helvering8 holding and included in a business purpose requirement a number
of Internal Revenue Code (IRC) provisions. While the initial IRC provisions related to
stock redemptions, dispositions of preferred stock that was received as dividends,
corporate spin-offs, foreign personal holding companies and partnership income, the IRC
provisions requiring business purpose have increased from those provisions found in the
original 1954 IRC. Business purpose is now required for acquisitions made to evade or
avoid income tax;9 dispositions of preferred stock as dividends; 10 tax-free
incorporations;11 corporate spin-offs;12 assumptions of liabilities in connection with taxfree
incorporations
or
reorganizations;13
conveyance
of
property
to
foreign
corporations;14 tax-free reorganizations;15 and formation of partnerships.16
Initially, the courts applied the business purpose doctrine to transactions between
corporations and their sole shareholders.
transactions
involving
corporate
The application has been extended to
distributions,
interest
deductions,
sales/leasebacks transactions and forgiveness of debt. In these instances the analysis
has shifted from examining the corporate form to examining the taxpayer’s motives.
8
Id.
I.R.C. § 269 (2006).
10 I.R.C. § 306 (2006). It is important to note, however, that in January 2006, the IRS indicated that this
category of significant book/tax differences is going to be removed from IRS Reg. Section 1.6011-4.
11
I.R.C. § 351 (2006).
12
I.R.C. § 355 (2006).
13
I.R.C. § 357 (2006).
14
I.R.C. § 367 (2006).
15
I.R.C. § 368 (2006).
16
I.R.C. § 701 (2006).
9
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The United States Supreme Court decision in Moline Properties Inc. v.
Commissioner17 remains the standard for evaluating a corporation’s status as a taxable
entity. The Court was asked to determine whether a corporation organized to hold real
property should be taxed on the gain from the sale of the property.18 The corporation
leased the property, collected rents in its own name, defended condemnation proceedings
and instituted various lawsuits.19 Although the corporation had no books and records,
maintained no bank accounts and held no other assets,20 the Court held the corporation
could not be disregarded for tax purposes.21 In so holding the Court concluded that “the
doctrine of corporate entity fills a useful purpose in business life,”22 and “so long as that
purpose is the equivalent of business activity or is followed by the carrying on of
business by the corporation, the corporation remains a separate taxable entity.”23
B.
Step Transaction Doctrine
The step transaction doctrine basically combines or collapses formally distinct
and separate transactions to determine the tax treatment of a single integrated series of
events. The courts have developed three tests for determining the existence of a step
transaction. Those tests are the end result test, the interdependence test, and the binding
commitment test. In analyzing a transaction, the courts may employ one or all of three
17
319 U.S. 436 (1943).
Id.
19
Id. at 437-38.
20
Id. at 438.
21
Id. at 440.
22
Id. at 438.
23
Id. at 439.
18
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tests to determine whether each step should be treated separately or whether the
completed transactions should be viewed in its entirety24.
In sum, the key to the step transaction doctrine is the notion that literal
compliance with the tax statute does not secure a tax benefit. In addition, it is important
to note that presence of a business purpose does not mean that a court will not apply this
doctrine.
For example, the United States Court of Appeals for the Tenth Circuit
concluded that the existence of business purpose does not preclude the application of the
step transaction doctrine.25
C.
Sham Transaction Doctrine
The Honorable Learned Hand indicated that,
[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 chooses,
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 one's
taxes.26
However, a transaction that is considered a sham will be disregarded. Generally, taxing
authorities and the courts will consider two factors in determining if a transaction should
be considered a sham.27 The first factor is whether there is a demonstrated business
purpose for engaging in the transaction other than tax avoidance.28 The second factor is
24
The end result test analyzes all of the steps part of a single transaction aimed at obtaining an ultimate
result. The interdependence test analyzes whether the steps are so interrelated or interdependent that each
individual step would be useless unless all of the steps are completed. The binding commitment test
inquires as to whether a binding commitment exists among the parties to execute all transaction steps upon
the execution of the first step.
25
Associated Wholesale Grocers v. United States, 927 F.2d 1517, 1527 (10th Cir. 1991).
26
Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934).
27
Rice’s Toyota World, Inc. v. Comm’r of Internal Revenue, 752 F.2d 89, 91 (4th Cir. 1985).
28
Id.
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whether the transaction had economic substance beyond the creation of tax benefits.29
Courts apply these factors in different ways. Some apply this two-prong inquiry rigidly,
while others “treat economic substance and business purpose as ‘more precise factors to
consider in the application of [the] traditional sham analysis; that is, whether the
transaction had any practical economic effects other than the creation of income tax
losses.’”30
The sham transaction doctrine originated in the area of sale-leaseback
transactions. The United States Supreme Court in Frank Lyon Co. v. United States,31 in
reversing the Eighth Circuit, held the District Court was correct in holding that the saleleaseback transaction should be respected and should not be recast as a financing device.
The Court concluded,
where…there is a genuine multiple-party transaction with
economic substance which is compelled or encouraged by business
or regulatory realities, is imbued with tax-independent
considerations, and is not shaped solely by tax-avoidance features
that have meaningless labels attached, the Government should
honor the allocation of rights and duties effectuated by the parties.
Expressed another way, so long as the lessor retains significant and
genuine attributes of the traditional lessor status, the form of the
transaction adopted by the parties governs for tax purposes.32
The Court in Frank Lyon Co.33 cited seven factors used in determining the status
of the subject transaction. These factors were 1) more than two parties were involved;34
2) the buyer-lessor was primarily liable on the mortgage;35 3) the buyer-lessor was
29
Id.
Sherwin-Williams Co. v. Comm’r of Revenue, 778 N.E.2d 504, 516 (Mass. 2002) (quoting Sochin v.
Comm’r of Internal Revenue, 843 F.2d 351, 354 (9th Cir.)).
31
435 U.S. 561 (1978).
32
Id. at 583-84
33
435 U.S. 561 (1978).
34
Id. at 575.
35
Id. at 576-77.
30
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exposed to real and substantial risk;36
4) the buyer-lessor’s financial position was
substantially affected due to the presence of long-term debt and the use of working
capital;37 5) the seller-lessee was compelled to use the sale-leaseback transaction due to
regulatory constraints, namely, a non-tax business purpose existed;38
6) the sale-
leaseback was a non-family, arm’s length transaction;39 and 7) the government would
lose little, if any, revenue as a result of the transaction.40
Although the sham transaction doctrine may have originated in the area of saleleasebacks, it has been given a broader application. The doctrine has been also been used
when evaluating partnership transactions.41 Recently a number of state tax administrators
have cited the doctrine when challenging the viability of holding company structures.
In United Parcel Service of America v. Commissioner,42 the United States Tax
Court distinguished between two types of sham transactions, namely, sham in fact and
sham in substance.43 A sham in fact is when the transaction never occurred but was
merely created on paper.44 A sham in substance is when the transaction actually
occurred but lacks the substance its form represents.45
However, the sham transaction doctrine is not solely a judicial doctrine. States
are increasingly codifying and/or applying this doctrine in their efforts to combat abusive
tax avoidance transactions.
One example of the recent codification of the sham
transaction by the states is found in understatement penalties for non-economic substance
36
Id. at 577.
Id.
38
Id. at 577-79.
39
Id. at 575.
40
Id. at 580.
41
ASA Investerings P’ship v. Comm’r, 201 F.3d 505, 512 (D.C. Cir. 2000).
42
78 T.C.M. (CCH) 262, n29 (1999), rev’d, 254 F.3d 1014 (11th Cir. 2001).
43
Id. at n29.
44
Id.
45
Id.
37
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transactions and abusive tax avoidance transactions.46 Another example is found in addback deductions in connection with intangible property.47 Although the codification of
the sham transaction doctrine by the states may be a new concept, the application is not
new.
A number of statutes have allowed administrators to adjust income and
apportionment factors to accurately reflect the business activities of the taxpayer in the
states.48
D.
Economic Substance
The economic substance doctrine is closely related to both the sham transaction
doctrine and a Section 48249 analysis. Several courts have used the economic substance
analysis as part of the sham transaction determination when examining substance versus
form. Recently the courts have applied the doctrine in evaluating the validity of capital
losses50.
In remanding United Parcel Service of America v. Commissioner,51 the United
States Court of Appeals for the Eleventh Circuit sets forth an economic substance
analysis involving an evaluation of both subjective and objective economic substance.
With regard to subjective economic substance, the Eleventh Circuit indicated, “[a]
“business purpose” does not mean a reason for a transaction that is free of tax
considerations. Rather, a transaction has a “business purpose” when we are talking about
a going concern like UPS, as long as it figures in a bona fide, profit-seeking business.”52
46
See CAL. REV. & TAX. CODE § 19774 ; 35 ILCS 5/1005(b)-(c); and N.Y TAX LAW § 685(p), (p-1).
See, for example, H.B. 1001, 114th Gen. Assem., Reg. Sess. (Ind. 2006).
48
See for example 35 ILCS 5/404, granting discretion to the Illinois Director of Revenue to adjust income,
apportionment factors or credits
49
I.R.C. § 482 (2006).
50
Colte Industries, In. v. U.S. Court of Appeals for the Federal Circuit, Dkt. No. 05-5111, July 12, 2006,
and Black & Decker v. U.S. 436 F.3d 431 (2006).
51
254 F.3d 1014 (11th Cir. 2001).
52
Id. at 1019.
47
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Also, a transaction is not required to be free from tax considerations; it must facilitate a
genuine profit-seeking business.53
In addition, it is permissible to choose a tax-
preferential form, provided the form does not undermine the business objectives.54
Finally, there is no obligation to choose the most direct means of achieving the business
objectives.55
With regard to objective economic substance, the Eleventh Circuit in United
Parcel Service of America56 stated, “[t]he kind of “economic effects” required to entitle a
transaction to respect in taxation include the creation of genuine obligations enforceable
by an unrelated party.”57 The court also indicated that there is need for a genuine
transaction to be enforceable by a third party.
Application of the economic substance doctrine requires consideration of factors
other than motive.
Specifically, in determining whether the taxpayer’s transaction
constituted a sham, the courts consider both the objective substance of the transaction and
the subjective business motivation behind it.58 Furthermore, the economic substance and
business purpose aspects of the inquiry are not discrete prongs in a two-step analysis, but
instead are “related factors” that are both used to determine if “the transaction had
sufficient substance, apart from its tax consequences, to be respected for tax purposes.”59
53
Id. at 1020.
Id.
55
Id.
56
254 F.3d 1014 (11th Cir. 2001).
57
Id. at 1018.
58
See, e.g., ACM P’ship v. Comm’r, 157 F. 3d 231, 247 (3rd Cir. 1998).
59
Id.
54
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III.
Federal Tax Shelter Regulations
A.
Overview of Federal Scheme
The 1970s and the early 1980s were the “heyday of the individual tax shelter
industry.”60 The IRS responded in 1986 by passing laws to deal with the industry. The
result was a shift in the industry from a focus on the individual taxpayer to the corporate
taxpayer.
Although the IRS was initially successful in some of its litigation to combat
corporate tax shelters, “it soon became apparent that those cases were only the tip of the
iceberg,” and many additional abusive tax shelters that were concealed likely existed.61
The Federal laws of the 1980s tended to focus heavily on penalties concerning the
taxpayers participating in abusive tax shelters, rather than the promoters of the shelters.
It was not until 1984 that Congress began to seriously monitor tax shelters by
enacting Section 6111,62 which requires tax shelter organizers to register the shelters with
the Secretary of Treasury.
Also in 1984, Congress enacted Section 6112,63 which
required that organizers and sellers of potentially abusive tax shelters keep lists of those
investors to whom they sold tax shelters, as well as related information. Such lists are
also referred to as “investor lists”.
There was a substantial increase in the use of corporate tax shelters during the late
1980s and into the 1990s. This prompted the IRS to issue a series of temporary and
proposed regulations addressing tax shelters.64 Three sets of temporary and proposed
regulations were issued that sought compliance from taxpayers that participated in
60
Sheldon D. Pollack and Jay A. Soled, Tax Professionals Behaving Badly, 105 TAX NOTES 201 (October
11, 2004).
61
Id.
62
I.R.C. § 6111 (200__).
63
I.R.C. § 6112 (200__).
64
2000-11 I.R.B. 747-65, 767; 2000-12 I.R.B. 835.
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abusive tax transactions and promoters of such transactions.65
The first set of
regulations66 involved IRC Section 6111(d) and required promoters to register
confidential corporate tax shelters with the IRS.67
The second set of regulations68
involved IRC Section 6112 and required promoters “to maintain lists of investors and
copies of all offering materials and to make this information available for inspection by
the [IRS] upon request.”69 The third set of regulations70 involved IRC Section 6011 and
required corporate taxpayers to report or disclose their participation in “reportable
transactions”.71 Although amended a number of times, the regulations were finalized on
February 28, 2003.72
The final regulations list six categories of reportable transactions and generally
apply to transactions entered into on or after the effective date of the final regulations,
February 28, 2003.73
It is important to note that a reportable transaction does not
automatically mean that it is an illegal tax shelter. The six categories of reportable
transactions include the following: (1) listed transactions; (2) confidential transactions;
(3) transactions with contractual protection; (4) Section 16574 loss transactions; (5)
transactions with a significant book-tax difference, for example, exceeding $10 million
65
Id.
Temp. Treas. Reg. § 301.6111-2T (2000); Prop. Treas. Reg. § 301.6111-2, 65 Fed. Reg. 11272 (Mar. 2,
2000).
67
T.D. 8876, 2000-11 IR.B. 753; REG-110311-98, 2000-11 IR.B. 767.
68
Temp. Treas. Reg. § 301.6112-1T (2000); Prop. Treas. Reg. § 301.6112-1, 65 Fed. Reg. 11271 (Mar. 2,
2000).
69
T.D. 8875, 2000-11 I.R.B. 761; REG-103736-00, 2000-11 I.R.B. 768.
70
Temp. Treas. Reg. § 1.6011-4T (2000); Prop. Treas. Reg. § 1.6011-4, 65 Fed. Reg. 11269 (Mar. 2, 2000).
71
T.D. 8877, 2000-11 I.R.B. 747; REG-103735-00, 2000-11 I.R.B. 770.
72
68 Fed. Reg. 10161 (Mar. 4, 2003); T.D. 9046, 2003-12 I.R.B. 614.
73
Treas. Reg. § 1.6011-4(b) (2006).
74
I.R.C. § 165 (200_).
66
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on a gross basis; and (6) transactions involving a brief asset holding period that generate
a tax credit in excess of $250,000.75
With regard to listed transactions, a listed transaction is one that is the same or
substantially the same as any transaction that has been identified by the IRS as a tax
avoidance transaction in published guidance.76 With regard to confidential transactions, a
confidential transaction is any transaction in which the taxpayer’s disclosure of the tax
treatment or the structure is limited in any manner by an express or implied
understanding or agreement.77
confidentiality.78
This relates to the advisor’s requirement of
This category is not affected by the existence of attorney-client
privilege.79
With regard to transactions with contractual protection, the issue is whether the
taxpayer has the right to a refund of all or a part of the fees if the intended tax treatment
of the transaction is not upheld and/or whether the fees are contingent on the realization
of tax savings or benefits from the transaction.80 With regard to loss transactions, the
transaction is expected to result in a gross loss under Section 16581 that equals or exceeds
the threshold amounts.82 For corporations the threshold is $10 million in a single year or
$20 million in multiple years.83
With regard to significant book/tax differences, generally, a transaction will have
a significant book to tax difference if the tax treatment differs from Generally Accepted
75
Treas. Reg. § 1.6011-4(b) (2006).
Treas. Reg. § 1.6011-4(b)(2) (2006).
77
Treas. Reg. § 1.6011-4(b)(3) (2006).
78
Treas. Reg. § 1.6011-4(b)(3) (2006).
79
Treas. Reg. § 1.6011-4(b)(3) (2006).
80
Treas. Reg. § 1.6011-4(b)(4) (2006).
81
I.R.C. § 165 (200_).
82
Treas. Reg. § 1.6011-4(b)(5) (2006).
83
Some transactions that are excluded from this category. See Rev. Proc. 2003-24, 2003-11 I.R.B. 599.
76
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Accounting Principles (GAAP) by more than $10 million.84 There are thirty categories of
transactions in which the book/tax differences will not be taken into consideration when
determining if a transaction is a reportable transaction.85 With regard to a brief assetholding period, this includes a transaction involving an asset that is held for 45 days or
less and generates a tax credit in excess of $250,000.86 This category includes foreign tax
credits as well.87
The final regulations impose certain record retention requirements.88
All
documents and other records related to a disclosed transaction must be maintained until
the expiration of the statute of limitations for the final taxable year for which disclosure is
required.89
Included are any documents that describe the business purpose of the
transaction.90
In 2004, the American Jobs and Creation Act of 200491 made further changes to
federal law in connection with abusive tax avoidance transactions.
The 2004 Act
primarily added penalties to the law for failures to file as required under Treas. Reg.
§1.6011-4.
The law became effective for returns fled after October 22, 2004, the
effective date of the Act.92 These 2004 changes will be discussed as applicable.
B.
Issues Concerning Taxpayers:
Related Penalties
84
Treas. Reg. § 1.6011-4(b)(6) (2006).
Rev. Proc. 2003-25, 2003 –11 I.R.B. 601.
86
Treas. Reg. § 1.6011-4(b)(7) (2006).
87
Treas. Reg. § 1.6011-4(b)(7) (2006).
88
Treas. Reg. § 1.6011-4(g) (2006).
89
Id.
90
Id.
91
Pub. L. No. 108-357, 118 Stat. 1418 (2004).
92
Pub. L. No. 108-357, 118 Stat. 1418 (2004).
85
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The Disclosure Requirement and
A taxpayer must disclose on its tax return for each year it participated in a
reportable transaction.93 In addition, the disclosure for the first year must also be filed
with the Office of Tax Shelter Analysis.94 Furthermore, if an undisclosed transaction
becomes a listed transaction after the filing of the return and the statute is not closed, the
disclosure must be filed on the first return filed after the listing of the transaction.95 This
filing must be made even if the transaction does not affect that return.96
The American Jobs and Creation Act of 200497 added a penalty provision to
federal tax law under IRC Section 6707A for the failure to include reportable transaction
information on a return.98 The penalty is $10,000 for individuals, and $50,000 for all
other taxpayers, such as corporations.99 In the event a failure to disclose involves a listed
transaction, the penalty increases to $100,000 for individuals, and $200,000 for all other
taxpayers.100
The Commissioner has the authority to rescind the penalty if the transaction does
not involve a listed transaction.101 There is no appeal, however, from the refusal to
rescind the penalty.102 In addition, in certain circumstances, taxpayers may have to make
related disclosures to the Securities and Exchange Commission, and failure to do so
results in the penalty for the failure to disclose listed transactions.103 IRC Section 6707A
93
Treas. Reg. § 1.6011-4 (2006). Form 8886 is the disclosure form
Treas. Reg.§ 1.6011-4(d) (2006).
95
Treas. Reg. § 1.6011-4(e)(2)(i) (2006).
96
Treas. Reg. § 1.6011-4 (2006).
97
Pub. L. No. 108-357, 118 Stat. 1418 (2004).
98
I.R.C. § 6707A (2006).
99
I.R.C. § 6707A(b)(1) (2006).
100
I.R.C. § 6707A(b)(2) (2006).
101
I.R.C. § 6707A(d) (2006).
102
I.R.C. § 6707A(d)(2) (2006).
103
I.R.C. § 6707A(e) (2006).
94
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applies to returns and statements that are due after October 22, 2004.104 The IRS issued
interim guidance concerning Section 6707A on February 14, 2005.105
Related
regulations are pending.
C.
Accuracy-Related Penalties
Another related and notable section of the IRC is Section 6662, which involves an
accuracy-related penalty concerning the underpayment of tax.106 For purposes of this
Section, a tax shelter is defined as the following: “(I) a partnership or other entity, (II)
any investment plan or arrangement, or (III) any other plan or arrangement, if a
significant purpose of such partnership, entity, plan, or arrangement is the avoidance or
evasion of Federal income tax.”107
Section 6662 imposes a penalty when an
underpayment is attributed to any of the following: “(1) [n]egligence or disregard of
rules or regulations; (2) [a]ny substantial understatement of income tax; (3) [a]ny
substantial valuation misstatement under chapter 1; (4) [a]ny substantial overstatement of
pension liabilities;
[and] (5) [a]ny substantial estate or gift tax valuation
understatement.”108 The IRC defines “substantial understatement” for the purposes of
this Section.109
The penalty amount under Section 6662 is twenty percent of the underpayment,110
and the penalty increases to forty percent if a gross valuation misstatement is involved.111
The Section 6662 penalty will not apply, however, if the taxpayer had reasonable cause
104
[IRB 2005-7].
I.R.S. Notice 2005-11, 2005-7 I.R.B. 493.
106
I.R.C. § 6662 (200_). Section 6664(a) of the Code provides a definition of underpayment. I.R.C.
6664(a) (200__).
107
I.R.C. § 6662(d)(2)(C)(iii) (200_).
108
I.R.C. § 6662(b) (200_).
109
I.R.C. § 6662(d)(1) (200_).
110
I.R.C. § 6662(a) (200_).
111
I.R.C. § 6662(h) (200_).
105
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and acted in good faith with regard to the underpayment.112 Nor will the Section 6662
penalty apply to any portion of an underpayment where a penalty is imposed for fraud
under Section 6663.113
The American Jobs Creation Act of 2004114 added additional accuracy-related
penalty provisions to federal tax law for understatements in connection with reportable
transactions.115 In general, there is now a twenty percent penalty for any accuracy-related
reportable transaction understatement.116 The penalty increases to thirty percent if the tax
treatment was not adequately disclosed.117 Similar to Section 6662, a reasonable cause
exception was added and is available for reportable transaction underpayments, although
the exception is stricter with regard to reportable transaction understatements than
underpayments.118
The IRS issued interim guidance concerning Section 6662A on
February 14, 2005.119
D. Issues Concerning Material Advisors, Organizers and Promoters:
Registration Requirements, List Requirements, and Related Penalties
The IRC provides various penalties related to promoters of tax shelters. Section
6700 penalizes those who promote or organize abusive tax shelters.120 Section 6701
penalizes those who knowingly aid and abet in the understatement of tax liability.121
Those individuals that provide advice with respect to tax shelters are also subject to
reporting requirements and penalties.
112
I.R.C. § 6664(c) (200_).
I.R.C. § 6664(b) (200_).
114
Pub. L. No. 108-357, 118 Stat. 1418 (2004).
115
I.R.C. § 6662A (2006).
116
I.R.C. § 6662A(b) (2006).
117
I.R.C. § 6662A(c) (2006).
118
I.R.C. § 6664(d) (2006).
119
I.R.S. Notice 2005-12, 2005-7 I.R.B. 494.
120
I.R.C. § 6700 (200_).
121
I.R.C. § 6701 (200_).
113
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The federal law defines a material advisor as any person who “provides any
material aid, assistance, or advice with respect to organizing, managing, promoting,
selling, implementing, insuring, or carrying out any reportable transaction, and who
directly or indirectly derives gross income in excess of the threshold amount…for such
aid, assistance, or advice.”122
The threshold amount is $50,000 for a reportable
transaction when the taxpayer is a person, and is $250,000 for all other cases.123
Material advisors are required to disclose reportable transactions.124 Form 8264 is
the Application for Registration of a Tax Shelter. There are penalties found at IRC
Section 6707 for the material advisors who fail to meet these requirements.125 Also,
generally, material advisors must maintain, and provide to the IRS if required, lists of
those parties to whom they acted as advisor.126 Penalties will be imposed for the failure
to meet these requirements.127
IV.
State Legislative Approaches to Tax Shelters
The states in the last three to four years have begun to address the issue of tax
shelters and perceived abusive transactions. It is notable, however, that while some states
have acted, a number of states have chosen to take no action thereby electing a wait and
see approach. The approach taken by the states to address the issue has taken several
forms. A number of states have enacted legislation that focuses on specific types of
transactions, such as holding companies, inter-company financing arrangements, or intercompany royalty arrangements. This approach has resulted in legislation or regulations
122
I.R.C. § 6111(b)(1)(A) (2006).
I.R.C. § 6111(b)(1)(B) (2006).
124
I.R.C. § 6111(a) (2006).
125
I.R.C. § 6707 (2006).
126
I.R.C. § 6112(a) (2006).
127
I.R.C. § 6708 (2006).
123
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that requires the add-back of deductions in connection with royalties and other intangible
expenses ex. interest expenses, that are paid to related parties. This approach deviates
from the concept of listed and reportable transactions. A second legislative approach
adopts the broader federal concept of a tax shelter.128 A third approach is to target
specific transactions that lack either economic substance or a substantive business
purpose.129 A fourth approach has been the enactment of general amnesty programs
designed to bring the non-compliant taxpayer into compliance using the “carrot and
stick” method.130
In addition to the various statutory approaches, there is further disparity among
the states with regard to the details of these approaches. For example, some states, such
as California, Illinois, New York, Minnesota, West Virginia, and Utah131, have
disclosure, registration, and investor list maintenance requirements. Other states, such as
Connecticut and Massachusetts, only provide penalties for failures to disclose at the
federal level. In addition, some states require, such as California and Utah, or enable the
state to require, such as New York, the disclosure of state listed and reportable
transactions, in addition to the federal transactions. Other states, such as Illinois and
Minnesota, are restricted to only federal listed and reportable transactions.
This disparity in approach is also reflected in the application of amnesties
generally known in the tax shelter context as voluntary compliance initiatives. Some
states included voluntary compliance initiatives as part of new legislation concerning tax
128
For example, California and Illinois have used this approach.
For example, Massachusetts and Ohio have used this approach that, “[Massachusetts and Ohio] have
attempted to change the legal standards used to differentiate legitimate tax planning and impermissible tax
avoidance.” Id. at v.
130
For example, North Carolina used this approach. In addition, California and Illinois recently
administered such amnesty programs.
131
The Utah tax shelter law is not effective until January 1, 2007. Utah S.B. 139, enacting Utah Code Ann.
§§ 59-1-1301, et. seq.
129
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shelters, such as California and Illinois.
Other states utilized voluntary compliance
initiatives as the sole means to address abusive tax transactions, such as North Carolina.
A number of states developed their own versions of voluntary disclosure (rather than
compliance) initiatives to combat abusive tax transactions, ex. Arizona, Connecticut, and
New Jersey, and South Carolina. Finally, some states have adopted programs with
altogether different characteristics, such as Massachusetts and Ohio.
Constitutional concerns exist with respect to some of these approaches. The third
approach, targeting transactions that lack either economic substance or a substantive
business purpose, raises issues since as noted at the federal level there is a lack of a
specific definition for either concept. This lack of a definition will inject uncertainty into
the analysis.
There is a question as to whether with this uncertainty the goal of
eliminating abusive transactions can be achieved. The fourth approach, which utilizes
amnesties, often raises due process concerns.132
More importantly there is a valid
argument that amnesties benefit non-compliant parties, as opposed to the law-abiding
taxpayers.
An indirect result of these amnesty programs is the re-evaluation of
transactions by all taxpayers due to threat of enhanced penalties.
There has been speculation with respect to the reason for the rise in the use of tax
shelters at the corporate level.
While there may be a number of causes, the state
legislation in most instances is structured to tackle the following: 1. minimal audit
coverage; 2. the lack of penalties to deter taxpayers from engaging in inappropriate tax
shelters; 3) overly aggressive tax and financial advisors; and 4) inconsistent court
decisions. The states with the earliest abusive tax shelter laws, California and Illinois
132 Paul H. Frankel & Amy F. Nogid, Hammers Disguised as Amnesties: States Take a Wrong Turn,
(August 2005).
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laws appear to address the aforementioned causes one, two and three, and the
Massachusetts and Ohio laws appear to address the aforementioned cause four.
There is also an inherent challenge in defining the term “tax shelter,” some states,
have not attempted to define the term e.g. California and Illinois. Rather these states
have adopted the federal tax scheme that has identified characteristics that indicate a
transaction has the potential to be a tax shelter.
Another consideration for state legislatures in drafting and implementing this type
of legislation should be the administrative costs to the taxpayers for compliance with the
new statutory requirement.
The reality is that multistate corporate taxpayers must
comply with the laws of several jurisdictions. The states should keep in mind that if the
laws are clear ,and uniform the compliance is then not unduly burdensome.
While the states undertake various approaches with regard to perceived abusive
tax shelters, taxpayers should remember certain realities. Taxpayers should keep in mind
that proper tax planning is still valid.
However, as new legislative and policy regimes
are being administered by the various states, taxpayers must consider the hazards of
litigation and penalty assessments when evaluating their options.
The Multistate Tax Commission (MTC)133 has also undertaken a project to
address the tax shelter issues. In connection with corporate tax sheltering, the MTC
recently decided to propose three uniform statutes.134 The proposals include (1) a model
addback statute intended to restrict corporate tax sheltering based on royalty and interest
133
The MTC is an agency consisting of tax administrators of member states. It “was established to
improve the fairness, efficiency and effectiveness of state tax systems as they apply to interstate and
international commerce, and preserve state tax sovereignty.” The MTC analyzes state tax issues and
recommends uniform tax laws and regulations to the states, “which apply to multistate and multinational
enterprises.” Id. According to the MTC, “[g]reater uniformity in multistate taxation helps ensure that
interstate commerce is neither undertaxed nor overtaxed and helps reduce the potential for Congress to
preempt or unduly limit state taxing authority. Id.
134
Karen Setze, MTC to Survey States on Proposed Corporate Tax Statutes, 2006 STT 93-2.
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payments to intangible holding companies; 2) a model statute on reportable transactions
and inconsistent filing positions that includes a mandate for taxpayers to create a 51-state
spreadsheet providing tax data for some issues regarding tax positions taken in each state
and the District of Columbia; and 3) a companion statute on voluntary compliance
programs for tax avoidance transactions.”135
This first proposed MTC uniform statute was generally modeled after
Massachusetts law. There is some concern that it is simply too late for such a statute.
Administrative concerns exist with regard to second proposed statute. The third MTC
statute concerning voluntary compliance is modeled after the 2004 California law.
A.
California
California was the first state to adopt tax shelter legislation. The California
legislature enacted Assembly Bill 1601 and Senate Bill 614 on October 3, 2003.136 These
bills amended California tax law to adopt a modified version of the federal tax shelter
rules and impose stiff penalties for any abusive tax avoidance transactions.
This
legislation also provided for a limited amnesty. Furthermore, in 2005, the legislature
enacted Assembly Bill 115137 in order to comply with the changes to federal law
concerning tax shelters resulting from the American Jobs Creation Act of 2004.138 The
2005 laws generally target the tax shelter promoters, or “material advisors”, rather than
the investors.
135
Id. The drafted versions of the statues are available at www.mtc.gov.
AB 1601, 2003-2004 Session (Cal. 2003); SB 614, 2003-2004 Session (Cal. 2003).
137
AB 115, 2005-2006 Session (Cal. 2005).
138
Pub. L. No. 108-357, 118 Stat. 1418 (2004).
136
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Section 18407139 was added to the California Revenue and Taxation Code as a
result of Senate Bill 614, and it conforms California tax law to IRC Section 6011 and the
underlying regulations requiring the disclosure of reportable transactions. Reportable
transactions include those identified by the IRS and those determined by the California
Franchise Tax Board (FTB)140 “as having potential for tax avoidance or evasion including
deductions, basis, credits, entity classification, dividend elimination, or omission of
income….”141 In addition, the FTB is required to publish listed transactions.142 The FTB
has issued one pronouncement to date.143 This pronouncement adds certain Real Estate
Investment Trust transactions and Regulated Investment Company transactions as types
of listed transactions.144 Investors disclose the investment to the FTB by submitting
federal Form 8886 with the California return.145 Another section of California tax law,
namely Section 19164(b), allows the FTB to issue a list of positions for which it believes
there is no substantial authority for the position or the tax treatment is “more likely than
not the proper tax treatment.”146 A benefit to this approach is that California can target
specific perceived abusive state tax shelter transactions.
Section 18628147 was amended in the California Revenue and Taxation Code in
2003 and 2005, and it conforms California tax law to the federal tax shelter registration
requirements found in IRC Section 6111 with a few California modifications. These
139
CAL. REV. & TAX CODE § 18407 (2006).
The FTB is one of the two primary California administrative agencies that oversee state taxes. The
other agency is the California State Board of Equalization. The FTB administers the personal income tax
and the corporation tax.
141
CAL. REV. & TAX CODE § 18407(a)(3) (2006).
142
CAL. REV. & TAX CODE § 18407(a)(4)(A) (2006).
143
Chief Counsel Announcement 2003-1 (December 31, 2003).
144
Id.
145
CAL. REV. & TAX CODE § 18407 (2006).
146
CAL. REV. & TAX CODE § 19164(b) (2006).
147
CAL. REV. & TAX CODE § 18628 (2006).
140
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modifications include the fact that additional information may be required by a FTB
Notice.148 In addition, Section 18628 sets forth specific registration requirements in
connection with material advisors who have connection to a reportable transaction that
was organized in California or derived business from California:
Section 18628 contains additional provisions that address the timing of registering
a tax shelter. There are specific registration requirements for transactions that become
California-only listed transactions if the transaction was entered into on or after
September 2, 2003, registration is required by the later of 60 days after entering into the
transaction, 60 days after the transaction becomes a listed transaction, or 60 days after
October 7, 2005.149
Section 18648150 was added to the California Revenue and Taxation Code in 2003
and amended in 2005, and it conforms California tax law to IRC Section 6112 requiring
organizers and material advisors of potentially abusive tax shelters to maintain and
provide lists. A material advisor must provide the list to the FTB within 20 days of a
request.151 For a transaction that is entered into after February 28, 2000, that becomes a
listed transaction at the federal level the material advisor must provide the list to the FTB
no later than 60 days after entering into the transaction, 60 days after the transaction
becomes a listed transaction, or April 30, 2004.152 For a transaction that is entered into
after on or after September 2, 2003, that becomes a listed transaction at the California
level the material advisor must provide the list to the FTB no later than 60 days after
148
See FTB Notice 2004-1 (January 30, 2004) for the additional requirements.
CAL. REV. & TAX CODE § 18628(f) (2006).
150
CAL. REV. & TAX CODE § 18648 (2006).
151
CAL. REV. & TAX CODE § 19173 (2006).
152
CAL. REV. & TAX CODE § 18648(d)(3) (2006).
149
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entering into the transaction, 60 days after the transaction becomes a listed transaction, or
April 30, 2004.153
The California penalty provisions concerning material advisors are generally
found in Sections 19173 and 19182.154 In general, the provisions mirror the related
federal provisions, specifically, IRC Section 6708 regarding failure to maintain lists in
connection with reportable transactions and make such lists available, and IRC Section
6707 regarding failure to register a tax shelter and failure to file an information return in
connection with reportable transactions, respectively.155
Also, under Section 19173,
California law provides a separate penalty for a failure to file an investor list with the
FTB in connection with listed transactions.156
Several new penalty provisions concerning taxpayers were added to California tax
law in 2003 as a result of Senate Bill 614. Specifically, Section 19164 was amended and
Section 19773 was added to California tax law to impose a number of new penalties.157
In general, the accuracy-related penalty was modified158 and a new reportable transaction
understatement penalty was added in lieu of the accuracy penalty.159 However, this new
reportable transaction understatement penalty was subsequently repealed.160 The rates
and defenses vary under these provisions depending on the category of the transaction.161
153
CAL. REV. & TAX CODE § 18648(d)(4) (2006).
CAL. REV. & TAX CODE §§ 19173, 19182 (2006).
155
I.R.C. §§ 6707, 6708 (2006).
156
CAL. REV. & TAX CODE § 19173(d) (2006).
157
CAL. REV. & TAX CODE §§ 19164, 19773 (2006).
158
CAL. REV. & TAX CODE § 19164 (2006).
159
CAL. REV. & TAX CODE § 19773 (2006).
160
According to FTB Notice 2006-1 (January 11, 2006), “pursuant to section 15, subdivision (b), of SB 614
(Stats. 2003, ch. 656) and AB 1601 (Stats. 2003, ch. 654), RTC section 19773 was operative for taxable
years beginning on or after January 1, 2003. AB 115 (Stats. 2005, ch. 691, §§ 50.3 and 50.4) repealed RTC
section 19773 for taxable years beginning on or after January 1, 2005.”
161
CAL. REV. & TAX CODE §§ 19164, 19773 (2006).
154
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A reportable transaction accuracy-related penalty, specifically, Section 19164.5,
was added to California tax law in 2005.162 The law mirrors the new federal penalties
under IRC Section 6662A. The penalty will not include amounts subject to the penalty of
Section 19774, namely, the non-economic substance penalty.163 Also, only the Chief
Counsel can waive the penalty, and any such decision is not reviewable or appealable.164
For taxpayers that have been contacted by the FTB regarding the use of a
potentially abusive tax shelter, the definition of substantial understatement has been
modified.
A substantial understatement will occur if the understatement of the tax
exceeds the lesser of ten percent of the tax required to be shown on the return or
$5,000,000 if the tax on the return is more than $2,500.165 Section 19755 extends the
statute of limitations to eight years for taxpayers who invest in an abusive tax avoidance
transaction.166 This section applies to any tax return filed on or after January 1, 2000.167
Section 19772 imposes a taxpayer penalty for the failure to disclose a reportable
transaction, and is analogous to IRC Section 6707A. The penalty under California law is
$15,000 and increases to $30,000 if the transaction is a listed transaction.168 Under prior
law, this penalty applied to large entities, such as those with gross receipts in excess of
$10 million and high net worth individuals, specifically, net worth in excess of $2
million.169 This Section was amended in 2005 to apply to taxpayers with taxable income
exceeding $200,000.170
These penalties cannot be waived if related to a listed
162
AB 115, 2005-2006 Session (Cal. 2005).
CAL. REV. & TAX CODE § 19164.5(b)(1) (2006).
164
CAL. REV. & TAX CODE § 19164.5(d) (2006).
165
CAL. REV. & TAX CODE § 19164(a)(C)(3) (2006).
166
CAL. REV. & TAX CODE § 19755(a) (2006).
167
CAL. REV. & TAX CODE § 19755(b) (2006).
168
CAL. REV. & TAX CODE § 19772(b) (2003), (amended 2005).
169
CAL. REV. & TAX CODE § 19772(d) (2003), (amended 2005).
170
CAL. REV. & TAX CODE § 19772(d) (2003), (amended 2005).
163
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transaction.171
There are specific provisions for rescinding a penalty related to a
reportable transaction, and only the Chief Counsel may rescind the penalty.172
Section 19777 creates a new interest penalty for taxpayers contacted by the
FTB.173 Any underpayment of tax due to a potentially abusive tax shelter will incur a
penalty equal to one hundred percent of the accrued interest on the underpayment.174 A
potentially abusive shelter is defined as any transaction required to be registered under
federal law and is reportable under either the federal or state law.175 This penalty is in
addition to any other penalties that may be assessed.176
Section 19778 increases the interest rate by fifty percent for taxpayers that have
not been contacted by either the FTB or the IRS for the use of a reportable transaction.177
The higher rate applies to any amended return filed after April 15, 2004, and for taxable
years beginning after December 31, 1998.178 Another provision, Section 21028 removes
all tax shelters from the confidentiality provisions of the California tax code.179
A non-economic substance penalty was also added to California tax law.180
Section 19774 imposes a penalty for an understatement attributable to any transaction
that lacks economic substance.181 This penalty, unlike several of the other penalties that
are limited to listed or reportable transactions, applies to any transaction that lacks
171
CAL. REV. & TAX CODE § 19772(f) (2003), (amended 2005).
CAL. REV. & TAX CODE § 19772(f) (2003), (amended 2005).
173
CAL. REV. & TAX CODE § 19777 (2006).
174
CAL. REV. & TAX CODE § 19777(a) (2006).
175
CAL. REV. & TAX CODE § 19777(a) (2006).
176
CAL. REV. & TAX CODE § 19777(b) (2006).
177
CAL. REV. & TAX CODE § 19778 (2006).
178
Id.
179
CAL. REV. & TAX CODE § 21028(b) (2006).
180
Kathleen K. Wright, California Tax Shelters – This Time It’s Federal Conformity, 2006 STT 14-12.
Wright noted that, “[f]ederal law did not enact a separate penalty for transactions that might lack economic
substance. That provision was “left on the cutting room floor” and was not included in the final version of
the [American Jobs Creation Act of 2004].” Id.
181
CAL. REV. & TAX CODE § 19774 (2006).
172
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economic substance.182 The penalty rate is forty percent and will be reduced to twenty
percent if the facts were adequately disclosed on the tax return.183 The facts will be
adequately disclosed if the taxpayer reporting the tax shelter reported the tax shelter
registration number.184
A non-economic substance transaction “includes the
disallowance of any loss, deduction or credit, or addition to income attributable to a
determination [that the transaction] lacks economic substance.”185 A transaction will lack
economic substance if it does not have a valid non-tax California business purpose.186
The penalty may also be assessed if an entity is disregarded because it lacks economic
substance.187 In addition, only the Chief Counsel has the authority to compromise any or
all of the penalty, and any such decision is not reviewable or appealable.188
The Internal Revenue Code does not have penalty analogous to Section 19774.189
As a result, this California provision presents some challenges because a taxpayer will be
required to report the transaction that is not reportable under the federal code. Although
there is no guidance on the form the report should take.
In January 2006, the California Legislative Analyst’s Office issued a report
entitled, Abusive Tax Shelters: Impact of Recent California Legislation.190 This report is
mandated by the previously mentioned 2003 California tax legislation.191 The report
indicated that California was the state frontrunner in abusive tax shelter legislation and
182
CAL. REV. & TAX CODE § 19774(a) (2006).
CAL. REV. & TAX CODE § 19774(b)(1) (2006).
184
CAL. REV. & TAX CODE § 19774(b)(2) (2006).
185
CAL. REV. & TAX CODE § 19774(c)(2) (2006).
186
CAL. REV. & TAX CODE § 19774(c)(2) (2006).
187
CAL. REV. & TAX CODE § 19774(c)(2) (2006).
188
CAL. REV. & TAX CODE § 19774(d) (2006).
189
CAL. REV. & TAX CODE § 19774 (2006).
190
California Legislative Analyst’s Office, Abusive Tax Shelters: Impact of Recent California Legislation,
January 27, 2006.
191
Id.
183
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initiatives, and many other states adopted similar programs, including Connecticut,
Illinois, Arizona, Minnesota, and New York.192
As previously mentioned, the 2003 California legislation contained a voluntary
compliance initiative (VCI).
This VCI has been described as “the heart”193 or
“cornerstone”194 of the legislation.195 The VCI was “a targeted amnesty which allowed
business and individuals who had participated in specific identified (abusive tax shelters)
to pay the tax liability associated with this (abusive tax shelter) and thus avoid any future
tax enforcement actions and noncompliance penalties.”196 The program was in effect
from January 1, 2004, through April 15, 2004.197 There was more taxpayer participation
in the VCI than was anticipated, and the program was deemed successful.198
The report of the California Legislative Analyst’s Office indicated that other than
the VCI, the effect of the new laws, such as the penalty provisions, were less easily
assessable.199 On an optimistic note, the report noted that the extension of the statute of
limitations to eight years “would allow the FTB to fully develop and litigate abusive tax
shelter cases.”200 The report did recognize concerns about the impact of the legislation
on the business community in California, and it provided some guidance in that regard,
and also noted that relative certainty should already exist for the taxpayer.201 However,
the report cautioned that, “[n]evertheless, as California moves forward in its attempt to
192
Id. The report states that “[i]n virtually all of these cases, the tax shelter enforcement efforts coupled a
voluntary compliance program-or targeted amnesty-together with increases in various penalties and
increased legal tools.” Id.
193
Id.
194
Id.
195
Id.
196
Id. This amnesty is different from the general state amnesty that occurred in early 2005. Id.
197
Id.
198
Id. For further detailed information concerning the results of the VCI, please refer to the California
report.
199
Id.
200
Id.
201
Id.
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rein in [abusive tax shelter] activity, it should be mindful of legitimate tax planning by
business entities.”202 In addition, the report pointed out some areas for the FTB to
consider, such as an evaluation of the penalties to ensure parity among different types of
tax non-compliance, and it made some additional observations related to interstate
sharing of information, tax years from which revenues derived, and revenue generated
out-of-state.203 The report encouraged the legislature to continue its efforts, stay current
on abusive tax shelter issues, and periodically monitor the efforts of and communicate
with the FTB in this regard.204
B.
Illinois
The Illinois General Assembly enacted Public Act 93-840205 in 2004, which
provided for a Voluntary Compliance Program (VCP)206 and a new tax shelter regime.
The Illinois Department of Revenue first publicized its new approach to abusive tax
shelters in October 2004.207 In its initial press release, the Department indicated that its
“team of tax auditors…has already begun working with IRS auditors and had traveled to
California, the first state to lead a concerted effort against tax shelters, to learn more
about how to recognize and unravel these convoluted schemes.”208
Illinois Public Act 93-840 principally adopted the federal tax shelter provisions.
Unlike the California legislation, the Illinois legislation did not allow the Department of
202
Id.
Id.
204
Id.
205
FY2005 Budget Implementation (Revenue) Act, P.A. 93-840, eff. July 30, 2004.
206
The Illinois Department of Revenue issued an Informational Bulletin about the program. Illinois
Department of Revenue, Information Bulletin, FY 2005-06, Tax Shelter Voluntary Compliance Program
(Aug. 2004).
207
Illinois Department of Revenue, Press Release, Illinois Announces Crackdown on Abusive Tax Shelters
- Taxpayers Encouraged to Come Forward (Oct. 18, 2004). See also Illinois Department of Revenue,
Publication, Federal and State Alignment to Bring Abusive Tax Shelters to Heel (Jan. 13, 2004).
208
Illinois Department of Revenue, Press Release, Illinois Announces Crackdown on Abusive Tax Shelters
- Taxpayers Encouraged to Come Forward (Oct. 18, 2004).
203
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Revenue to include transactions not covered by the federal regulations. One possible
shortcoming to Illinois as a result of the limitation is that the perceived abusive state tax
shelters will escape disclosure.
The Illinois law was designed to curtail perceived abusive avoidance transactions
by implementing detailed disclosure requirements, enhancing the penalties for investors,
promoters, organizers and material advisors. The general disclosure requirement only
applies to transactions that are required to be disclosed at the federal level in accordance
with Treasury Regulation Section 1.6011-4.209
In addition, Illinois has adopted a
registration requirement for promoters, organizers, sellers and material advisors that are
similar to the federal requirements.210
There are constitutional limitations on the states’ ability to impose a reporting
requirement on both individuals and entities that are outside the states’ jurisdiction.
Illinois has recognized those limitations and has developed a nexus standard as part of its
tax shelter regime. The Department of Revenue has taken the position that the nexus of
the tax shelter is what controls. Thus, whether the ultimate taxpayer who is deriving a
benefit from the transaction has nexus is irrelevant for purposes of the registration
requirements. Also, the Illinois registration and reporting requirements for organizers,
sellers, material advisors, and promoters apply to any shelter that consists any of the
following characteristics: it is organized in Illinois; it does business in Illinois; or it
derives income from Illinois sources.211 In addition, the Illinois rules with respect to list
209
35 ILCS 5/501(b) (2006); 86 Ill. Admn. Code § 100.5060(a)(2)(A) (2006).
35 ILCS 5/1405.5 (2006).
211
35 ILCS 5/1405.5(c) (2006).
210
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maintenance are modeled after the federal rules. If the nexus requirements are met, the
lists must be provided to the Department of Revenue.212
As with California, the Illinois legislation enacted new penalties. Taxpayers are
subject to a $15,000 penalty for the failure to disclose a reportable transaction.213 The
penalty is increased to $30,000 for the failure to disclose a listed transaction.214 The
penalty for the failure to timely register or maintain a list is $15,000 per occurrence.215 If
a listed transaction is involved, the penalty increases to $100,000 per occurrence.216
Further penalties include the penalty for the failure to provide the required
investors lists is $15,000 per occurrence and increases to $100,000 per occurrence for
listed transactions.217 Also, taxpayers who participate in certain reportable transactions
are subject to an understatement penalty of twenty percent.218 The penalty increases to
thirty percent if the transaction was not properly disclosed.219 The ability to abate the
penalties based on a reasonable cause argument is limited.220 In addition, a taxpayer who
has been contacted by either the IRS or the Department of Revenue regarding the use of a
potential tax avoidance transaction is subject to an additional one hundred percent of the
interest accruing on the deficiency.221 The federal tax shelter promoter penalties have
212
35 ILCS 5/1405.6 (2006).
35 ILCS 5/1001(b)(1) (2006).
214
35 ILCS 5/1001(b)(2) (2006).
215
35 ILCS 5/1007(b)(1) (2006).
216
35 ILCS 5/1007(b)(2) (2006).
217
35 ILCS 5/1007(b)(3), (b)(4) (2006).
218
35 ILCS 5/1005(b) (2006).
219
35 ILCS 5/1005(b)(3) (2006).
220
35 ILCS 5/1005(b)(4) (2006).
221
35 ILCS 5/1005(c) (2006).
213
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also been incorporated into the Illinois Act.222 The penalty is the greater of $10,000 or
fifty percent of the gross income derived by the promoter.223
A failure to disclose a reportable transaction also has additional ramifications.
Such a failure to disclose will extend the statute of limitations for assessment purposes
from three to six years.224
C.
New York
Governor Pataki signed AB 6845225 into law on April 12, 2005. The bill enacted
tax shelter legislation that was both similar to that enacted by California and incorporated
the federal tax principles. As part of this legislation, as with California and Illinois, New
York established a Voluntary Compliance Initiative (VCI).226
The New York legislation, like California, modified the federal regulations to
require disclosure not only of the federal reportable and listed transactions but also to
include New York reportable transactions.227 A New York reportable transaction is
defined as those transactions that have the potential to be tax avoidance transactions as
determined by the Commissioner.228 In addition to requiring the disclosure of federal
reportable and listed transactions, a promoter, organizer, seller and/or material advisor
must also disclose a New York reportable transaction.229
Similar to California and Illinois, New York has developed a nexus standard
related to filing reportable transaction returns. However, rather than having the tax
222
35 ILCS 5/1008 (2006).
Id.
224
35 ILCS 5/905(b)(2) (2006).
225
A.B. 6845, 2005-2006 Regular Sessions (N.Y. 2005).
226
Chapter 61 of the Laws of New York of 2005, Part N, section 11, as amended by Chapter 63, Part A,
section 18 of the Laws of New York of 2005.
227
N.Y. TAX LAW § 25(a)(1), (a)(2) (2006).
228
N.Y. TAX LAW § 25(a)(2) (2006).
229
N.Y. TAX LAW § 25(a), (b) (2006).
223
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shelter connected to the state, New York law mandates having the taxpayer or return filer
connected to the state. The reporting requirements will apply if any of the following
conditions are met: the person is organized in New York; the person is doing business in
New York; the person is deriving income from New York; or the shelter has a New York
investor and the material advisor provides material and assistance or advice with respect
to the organizing, managing, promoting, selling implementing or carrying out any
reportable transaction.230
With respect to maintaining lists, New York follows the federal requirements. It
conforms New York tax law to IRC Section 6112 requiring organizers and material
advisors of potentially abusive tax shelters to maintain and provide lists.231 The law also
provides penalties for failure to do so.232 With regard to additional penalties, New York
law provides for substantial understatement penalties233 and reportable transaction
understatement penalties.234 In addition, New York law provides penalties for failure to
disclose a reportable transaction235 and failure to file a reportable transaction return.236
Also, New York added a promoter penalty.237 New York law generally follows the
federal statute of limitations and it extends the statute of limitations under a variety of
circumstances, including an extension to six years if the taxpayer fails to properly
disclose a reportable transaction.238
D.
Connecticut
230
N.Y. TAX LAW § 25(b)(1) (2006).
N.Y. TAX LAW § 25(c) (2006).
232
N.Y. TAX LAW §§ 685(z), 1085(r) (2006).
233
N.Y. TAX LAW §§ 685(p), 1085(k) (2006).
234
N.Y. TAX LAW §§ 685(p-1), 1085(k-1) (2006).
235
N.Y. TAX LAW §§ 685(x)(2), 1085(p)(2) (2006).
236
N.Y. TAX LAW §§ 685(y), 1085(q) (2006).
237
N.Y. TAX LAW §§ 685(bb), 1085(t) (2006).
238
N.Y. TAX LAW § 683(c)(11) (2006).
231
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On June 24, 2005, Connecticut enacted Public Act No. 05-116, which put in place
a statutory tax shelter regime.239 Previously, in 2004, Connecticut had conducted an
Abusive Tax Shelter Initiative.240 The initiative was a compliance program for taxpayers
that had participated in potentially abusive transactions that were considered listed
transactions by the IRS.241 Under the program the taxpayer was to concede one hundred
percent of the state tax liability and the interest associated with the potentially abusive
shelter.242 If a taxpayer complied with the initiative he could deduct all the costs and fees
associated with the transaction and was exempt from any civil penalties or criminal
prosecution.243 If a taxpayer failed to comply he was subject to enhanced penalties.244
The 2005 statutory regime is modeled after the federal regulations and requires
the disclosure of any abusive shelter that is designated by the IRS as a listed transaction.
In the event a taxpayer fails to disclose, the statute of limitations for assessment purposes
is extended from three to six years.245 If any deficiency results from the failure to
disclose a listed transaction, a seventy-five percent underpayment penalty will be
imposed.246 Thus, Connecticut is penalizing a taxpayer who has failed to comply with
federal laws. Furthermore, it should be noted there is a lack of parity of the penalty
between the federal law and Connecticut level. Specifically, the federal law imposes a
239
An Act Concerning Penalties for Failure to Report Listed Transactions, P.A. 05-116, § 2, eff. June 24,
2005, as amended by An Act Concerning Certain Taxes Administered by the Department of Revenue
Services, P.A. 05-260, § 7, eff. July 13, 2005.
240
State of Connecticut – Department of Revenue Services, Announcement, AN 2004(5) – Abusive Tax
Shelter Compliance Initiative (June 16, 2004).
241
Id.
242
Id.
243
Id.
244
Id.
245
CONN. GEN. STAT. § 12-233(a)(4) (2006).
246
CONN. GEN. STAT. §§ 12-233(b)(1); 12-728(a)(2) (2006).
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penalty for the failure to disclose,247 whereas the state law imposes a penalty “when it
appears that any part of the deficiency for which a deficiency is made…is due to failure
to disclose a listed transaction.”248 The deficiency is actually a result of an incorrect
position rather than the failure to file the disclosure. This difference raises questions
about the practical application of this provision.
Under Connecticut law, any person promoting an abusive tax shelter, as that term
is defined in IRC Section 6700(a), where the activities affect tax returns required to be
filed with the state will be subject to a fifty percent penalty on the gross income derived
from or to be derived from the promotion activity.249 It is notable that IRC Section
6700(a) involves false tax statements, not just reportable and listed transactions of IRC
Section 6707A. The statute is not clear as to whether the penalty will apply to all activity
of the promoter, or just that which involves Connecticut returns. Interestingly,
Connecticut law does not have registration or record (same as list retention requirements)
for promoters. Thus in some ambiguity regarding the effective date of the penalty.
Promoters apparently were able to avoid these penalties if they participated in the 2005
Abusive Tax Shelter Compliance Initiative, which ran from October 1, 2005, until
December 31, 2005.250 Under the Initiative, promoters only had to provide a complete
investor list and fee schedule,251 and no disclosure concerning the structure or related tax
benefits was required.
247
I.R.C. § 6707A(a), (b)(2) (2006).
CONN. GEN. STAT. § 12-233(b)(1) (2006).
249
CONN. GEN. STAT. § 12-30c (2006).
250
State of Connecticut – Department of Revenue Services, Announcement, AN 2005(15) – 2005 Abusive
Tax Shelter Compliance Initiative (Sept. 13, 2005).
251
State of Connecticut – Department of Revenue Services, Announcement, AN 2005(15) – 2005 Abusive
Tax Shelter Compliance Initiative (Sept. 13, 2005).
248
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The Connecticut approach to abusive tax shelters is a minimalist approach
because disclosure is not affirmatively required under the law, but rather the state
penalizes for nondisclosure at the federal level. Second, the Connecticut statute only
addresses listed transactions, whereas other states who have enacted tax shelter
legislation also included reportable transactions, with some states further extending the
reach of their laws to specific state only transactions.
E.
Minnesota
Minnesota also enacted tax shelter legislation in the summer of 2005.252 The
Minnesota Department of Revenue also administered a Voluntary Compliance Program.
The program ran from August 1, 2005, through January 31, 2006.253
As with many of the other states previously discussed, all material advisors are
required to register in Minnesota if the advisor is required to register under the federal
regulations.254 In determining if an advisor has nexus with the state, Minnesota has
adopted a standard that is similar to the California standard.255 In other words, reporting
is required if the shelter has either Minnesota nexus or Minnesota investors.256
Minnesota requires an organizer, seller, or material advisor to maintain an
investor list and produce that list to the state.257 The penalty for failure to maintain or
produce the list will accrue twenty days after receiving a written request from the
Department of Revenue requesting production of the list, and the penalty is $10,000 per
day.258 Also, the penalty for the promotion of tax shelters was enhanced.259 In addition
252
Minn. Laws, 1st Special Session, ch. 3, art. 8, eff. July 13, 2005.
Minnesota Department of Revenue, Publication, The Revenue Connection # 6 (Aug. 18, 2005).
254
MINN. STAT. § 289A.121, Subd. 3(a) (2005).
255
MINN. STAT. § 289A.121, Subd. 1 (2005).
256
Id.
257
MINN. STAT. § 289A.121, Subd. 6(a) (2005).
258
MINN. STAT. § 289A.60, Subd. 26(e) (2005).
253
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there is an “aiding and abetting understating of tax” penalty of $1,000 related to
individuals and $10,000 related to corporations for anyone, generally a tax return
preparer, who:
(1) aids or assists in, procures, or advises with respect to, the
preparation or presentation of any portion of a return, affidavit,
claim, or other document;
(2) knows or has reason to believe that the portion of a return,
affidavit, claim, or other document will be used in connection with
any material matter arising under the Minnesota individual income
or corporate franchise tax; and
(3) knows that the portion, if so used, would result in an
understatement of the liability for tax of another person.260
There are additional penalties for tax preparers.261
A $50,000 penalty is imposed on a material advisor for the failure to timely
register a tax shelter and provide the required information.262 Also, if the shelter is a
listed transaction, the penalty is increased to the greater of $200,000, fifty percent of the
gross income derived from the activity, or seventy-five percent of the gross activity of the
failure to register was intentional.263 Through October 15, 2005, however, promoters and
material advisors were able to avoid the penalties by registering reportable transactions
and abusive tax shelters by submitting of copy of federal Form 8264 with the Minnesota
Department of Revenue.264
There are enhanced penalties for taxpayers under the Minnesota law as well. The
penalties for failure to disclose reportable transactions are significant and are as high as
the federal level at IRC Section 6707A. The penalty for an individual who fails to
259
MINN. STAT. § 289A.60, Subd. 20(b) (2005).
MINN. STAT. § 289A.60, Subd. 20a(a) (2005).
261
MINN. STAT. § 289A.60, Subd. 13 (2005).
262
MINN. STAT. § 289A.60, Subd. 26(c) (2005).
263
Id.
264
Minnesota Department of Revenue, News Release, Minnesota Offers Way Out for Taxpayers Using
"Abusive" Tax Shelters (Aug. 1, 2005).
260
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disclose a reportable transaction is $10,000 and is $100,000 for a listed transaction.265
The penalty for other taxpayers, such as corporations, who fail to disclose a reportable
transaction is $50,000 and is $200,000 for a listed transaction.266
There is also a reportable transaction understatement penalty.267 The penalty is
twenty percent of the increased tax liability relating to the reportable transaction.268 The
penalty will increase to thirty percent if the taxpayer has not complied with the disclosure
requirements.269 As with several of the other states, the reasonable cause provisions for
abatement are limited.270
With regard to the statute of limitations, if a taxpayer fails to disclose a reportable
transaction, the statute of limitations is extended for the later of six years after the return
for the year was filed, or if a listed transaction, one year after the earlier of the date the
information furnished to the Commissioner, or the date the material advisor furnishes the
list of Minnesota investors.271
While this is likely how courts would interpret this
provision, commentary points out that this provision is subject to multiple
interpretations.272 The assessment is limited to the additional tax resulting from an item
that has not been disclosed.273
F.
North Carolina
The North Carolina Department of Revenue recently offered two amnesty-type
programs in an effort to combat abusive tax shelters. The first of the two programs was a
265
MINN. STAT. § 289A.60, Subd. 26(d)(1) (2005).
MINN. STAT. § 289A.60, Subd. 26(d)(1) (2005).
267
MINN. STAT. § 289A.60, Subd. 27 (2005).
268
MINN. STAT. § 289A.60, Subd. 27(a) (2005).
269
MINN. STAT. § 289A.60, Subd. 27(d) (2005).
270
MINN. STAT. § 289A.60, Subd. 27(e) (2005).
271
MINN. STAT. § 289A.38, Subd. 16(a) (2005).
272
Kathleen Pakenham, State Tax Shelter Legislative Update, 2006 STT 19-3.
273
MINN. STAT. § 289A.38, Subd. 16(b) (2005).
266
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Voluntary Compliance Program.274
The North Carolina Department of Revenue
Secretary announced this program in December 2004.275 The program may have been in
response to the North Carolina’s Court of Appeals’ unanimous decision in A&F
Trademark, Inc. v. Tolson.
While the program may have been in response to the
Appellate Court decision, it was offered prior to a final decision in A&F Trademark. The
program had a short participation period leaving the taxpayer little time to evaluate their
positions and take all necessary related action steps. This “one-time opportunity”276 was
not authorized by the state legislature through the enactment of a statute. The lack of
statutory authority raises questions as to whether a state agency merely by listing
transactions has sufficient authority to determine that those listed transactions are not
valid.
The North Carolina Department of Revenue offered a second program in 2006,
which it called the Settlement Initiative.277 One source indicates that, “[a]ccording to
public statements by [the North Carolina Department of Revenue Secretary],
the…amnesty was instituted because of taxpayer questions and confusion about the
timing and coverage of [the Voluntary Compliance Initiative].”278 The taxpayers that
participated in specified transactions, designated Eligible Transactions, were able to
participate in the program.279 Among the Eligible Transactions were three kinds of listed
274
North Carolina Department of Revenue, Press Release, N.C. Department of Revenue Offers Taxpayers
Chance for Reprieve (Dec. 28, 2004).
275
Id.
276
North Carolina Department of Revenue, Press Release, N.C. Department of Revenue Offers Taxpayers
Chance for Reprieve (Dec. 28, 2004).
277
Frequently Asked Questions about the Settlement Initiative. For additional information concerning the
Settlement Initiative, see Giles Sutton & Jaime C. Yesnowitz, Assessing North Carolina’s Settlement
Initiative: Not Every Taxpayer Stands to Benefit From Participating, BNA Article, vol. 13, no. 4 (Apr. 28,
2006).
278
Michael Hannah, Tax Plan Leaves Many Questions, CHARLOTTE BUS. J., May 5, 2006.
279
Frequently Asked Questions about the Settlement Initiative.
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transactions at the federal level and certain state-only transactions. The only Ineligible
Transactions identified in the program were Non-filing Trademark Holding
Companies.280 The reason for this exception was a product of the A&F Trademark, Inc.
v. Tolson decision281 because the Department had previously provided an opportunity to
disclose these transactions.
Taxpayers had to elect to participate in the program by June 15, 2006, an ability
to opt-out existed, and taxpayers had to fulfill all requirements under the program by
December 15, 2006.282 There were further reduced penalties for transactions that had not
been part of the Voluntary Compliance Program.283
As with the Voluntary Compliance Program, criticism existed regarding the
Settlement Initiative.284 For example, one commentator noted,
[t]he absence of department guidelines and case law that interpret
the applicable statutes make a decision regarding whether to
participate in the new amnesty very difficult. Taxpayers may be
unable to determine in advance whether their corporate structures
and intercompany transactions may run afoul of unpublished audit
policies. The department's "we'll know it when we see it" audit
philosophy may further confound taxpayers because intercompany
transactions previously audited and assumed to be acceptable may
now be deemed to distort state taxable income….[The North
Carolina Department of Revenue Secretary] agreed court guidance
on interpretation of the applicable statutes may be desirable, but
declined to issue written guidelines, which he said might provide
taxpayers with a "road map to tax avoidance."285
280
Frequently Asked Questions about the Settlement Initiative.
605 S.E.2d 187 (N.C. 2004), appeal denied, 259 N.C. 320 (2005), cert. denied, 126 S. Ct. 353 (2005).
282
Frequently Asked Questions about the Settlement Initiative.
283
Frequently Asked Questions about the Settlement Initiative. Specifically, the penalties were fifty
percent for certain transactions not a part of the Voluntary Compliance Program, as opposed to ninety
percent for those that had been.
284
Michael Hannah, Tax Plan Leaves Many Questions, CHARLOTTE BUS. J., May 5, 2006.
285
Id.
281
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I.
West Virginia
The West Virginia legislature enacted House Bill 4630 on March 9, 2006.286 The
laws went into effect on June 9, 2006.287 This legislation provided for a Voluntary
Compliance Program,288 new penalties targeted at investors and promoters in connection
with abusive tax avoidance transactions,289 and a statute of limitations of six years for an
assessment in the event a taxpayer does not disclose a listed transaction.290
The Voluntary Compliance Program ran from August 1, 2006, to November 1,
2006.291
It covers reportable transactions entered before January 1, 2006, and
amendments are permitted for the returns of the three most recent tax years.292 The new
laws also provide a definition of an eligible taxpayer.293 In order to participate in the
program, a taxpayer must elect to do so,294 and no opt-out is available.295 In addition, a
taxpayer can choose whether to participate in the program with or without appeal
options.296
West Virginia law defines a tax avoidance transaction as the following: “a plan or
arrangement devised for the principal purpose of avoiding federal or state income tax or
both. Tax avoidance transactions include, but are not limited to, "listed transactions" as
defined in Treasury Regulations Section 1.6011-4(b)(2).”297
286
In connection with tax
HB 4630, 2006 Regular Session (W. Va. 2006).
Id.
288
W. VA. CODE § 11-10E-2 (2006).
289
W. VA. CODE §§ 11-10-18(f), 11-10E-5-7 (2006).
290
W. VA. CODE § 11-10-15(a) (2006). Also, the statute of limitations is three years for an amended return.
Id.
291
W. VA. CODE § 11-10E-2(a) (2006).
292
W. VA. CODE § 11-10E-2(a) (2006); WV Voluntary Compliance Program - Frequently Asked
Questions.
293
W. VA. CODE § 11-10E-2(d) (2006).
294
W. VA. CODE § 11-10E-2(c) (2006).
295
W. VA. CODE § 11-10E-2(c) (2006).
296
W. VA. CODE § 11-10E-2(c)(1), (c)(2) (2006).
297
W. VA. CODE § 11-10E-3 (2006).
287
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shelters, the new laws include disclosure, registration, and investor list maintenance
requirements.298 New penalties were also instituted under the new law. There is an
understatement or underreporting of tax penalty,299 failure to register tax shelter, or
maintain and provide list penalties,300 and promotion of tax shelter penalty.301 Also,
similar to California, West Virginia indicates that any underpayment of tax due to a
potentially abusive tax shelter will incur a penalty equal to one hundred percent of the
accrued interest on the underpayment.302
J.
V.
Other State Laws: Massachusetts and Ohio
Legal Challenges to Perceived Tax Shelters
Existing statutory provisions, jurisdictional concepts and the application of the
federal doctrines have been utilized by a number of the states to challenge transactions
that are considered abusive or result in a shifting of income from the taxing jurisdiction.
The challenges have generally focused on two basic state tax theories, nexus and forced
combination. The states’ approach to both theories has incorporated the federal doctrines
specifically the focus has been on the economic substance and business purpose
doctrines.
A.
Nexus Challenges
298
W. VA. CODE §§ 11-10E-5, 11-10E-8, 11-10E-9 (2006).
W. VA. CODE §§ 11-10-18(f)(2), 11-10E-5(b) (2006).
300
W. VA. CODE § 11-10E-6 (2006).
301
W. VA. CODE §§ 11-10-18(f)(1), 11-10E-7 (2006).
302
W. VA. CODE § 11-10E-5(c) (2006).
299
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Louisiana has employed a nexus analysis when challenging intercompany
transactions. In Bridges v. AutoZone Properties, Inc.,303 an out-of-state owner of a real
estate investment trust (REIT) that received dividends from the REIT was subject to
Louisiana corporate income tax on the dividends because the owner of the REIT had
sufficient nexus with the state to satisfy the requirements of the Due Process Clause.304
The Louisiana Appellate Court held the owners’ shares of the REIT did not
acquire business situs in Louisiana because they were not acquired by the owner in the
course of any business conducted in Louisiana nor was there any indication of share
ownership or dividend receipt in the state.305 The appellate court extracted from case law
the doctrines that related to the taxation of intangible property in Louisiana.306 The
doctrines indicated that intangible property is taxed at the legal domicile of its owner
unless it has obtained business situs in a foreign state.307 The owner of the REIT was not
qualified to do business in Louisiana, had no property, office or employees in the state.308
Therefore in the opinion of the appellate court the REIT owner did not have sufficient
nexus with Louisiana to meet the Due Process standards.
The Louisiana Supreme Court, citing International Harvester Co. v. Wisconsin
Department of Taxation,309 reversed the holding of the appellate court.310 In reaching its
conclusion, the Supreme Court first addressed the issue of whether the REIT would be
characterized as a trust for Louisiana purposes.311 The court dismissed the Department’s
303
900 So. 2d 784 (La. 2005).
Id. at 786-87.
305
Id. at 789.
306
Id. at 789.
307
Id.
308
Id. at 789-90.
309
322 U.S. 435 (1944).
310
900 So. 2d 784, 809 (La. 2005).
311
Id. at 796.
304
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argument indicating that the “status as a corporation remains intact and is not converted
to a trust simply by its business operations in Louisiana.”312
The court then turned to the jurisdictional issue, namely, whether Louisiana has
jurisdiction to tax the dividend income of AutoZone Properties (“Properties”) based
solely on its investment in the REIT that received benefits and protection from doing
business in Louisiana.313 The court acknowledged that the nexus requirements of the
federal Due Process Clause control in this matter.314 The court stated, “the Due Process
Clause requires some definitive link, some minimum connection between a state and the
person, property or transaction it seeks to tax.”315 In addition, the court remarked, the
income sought to be taxed “must be rationally related to the values” provided by the
taxing jurisdiction.316 The court found the REIT had received benefits and protection
from Louisiana.317 Therefore, because “Louisiana…helped create the income,” it is not
prevented from taxing its share of the income.318
Louisiana raised a similar nexus challenge with respect to an intangible holding
company. Secretary, Dep’t of Revenue, Louisiana v. Gap (Apparel) Inc.319 In this case,
the Louisiana appellate court affirmed the trial court’s holding that it had personal
jurisdiction over Gap Apparel Inc. (“Apparel”).320 The Gap, Inc. (Gap) is a Delaware
corporation that owns and operates retail stores in the United States with 41 of those
312
Id. at 800.
Id. at 800.
314
Id. at 801. Because the Commerce Clause was not raised as an issue, the court did not address it. Id.
315
Id. at 800-01.
316
Id. at 801.
317
Id. at 809.
318
Id.
319
Secretary, Dep’t of Revenue, Louisiana v. Gap (Apparel) Inc., 886 So. 2d 459 (La. Ct. App. 2004).
320
Id. at 462.
313
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stores in Louisiana.321 Gap developed a number of trade names, trademarks and service
marks as part of its business.322
The marks were transferred to a subsidiary, GPS
(Delaware), Inc., and subsequently to Apparel.323 After the transfer,, Apparel and Gap
entered into a licensing agreement whereby Apparel licensed to Gap and its affiliates the
use of the intellectual property and the licensees paid a royalty to Apparel for such use.324
Apparel is a California corporation with its principal place of business in that state.325
The Department filed suit for the non-payment of corporate income and franchise
tax.326 Apparel responded by arguing the court lacked personal jurisdiction over the
company, as it had no contact with the state.327 The appellate court acknowledged that
Apparel may not have physical presence in Louisiana, however, its intangible property
had a connection with the state.328 Citing United Gas Corp. v. Fontenot,329 the court
concluded the marks licensed by Apparel “have been used in Louisiana in such a way as
to become an integral part of the licensees’ businesses” in Louisiana.330 The court
continued to indicate that as such, “the intangibles have acquired business situs in
Louisiana and are subject to taxation.”331
North Carolina also has asserted taxing jurisdiction over an intangible holding
company.
A&F Trademark, Inc. v. Tolson.332
Although the intangible holding
companies had no physical presence in North Carolina it licensed trademarks valued
321
Id. at 461.
Id.
323
Id.
324
Id.
325
Id. at 462.
326
Id. at 461.
327
Id. at 462.
328
Id.
329
241 La. 488 (1961).
330
886 So. 2d 459, 462 (La. Ct. App. 2004).
331
Id.
332
605 S.E.2d 187 (N.C. 2004), appeal denied, 359 N.C. 320 (2005), and cert. denied, 126 S. Ct. 353
(2005).
322
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approximately $1.2 billion333 to separate retail operating subsidiaries in North Carolina.
The North Carolina Supreme Court held the holding company was doing business in the
state and subject to franchise tax. The court noted that the company was doing business
in the state because North Carolina provided privileges and benefits that fostered and
promoted the related retail companies and made it possible for the taxpayers to earn
income pursuant to the licensing agreements.334 In so doing, the court rejected the
taxpayers’ claim that physical presence in the state is required for the state to have
jurisdiction to tax under the Commerce Clause for purposes of income and franchise
taxes.335
The court concluded that, “where a wholly-owned subsidiary licenses
trademarks to a related retail company operating stores located within North Carolina,
there exists a substantial nexus with the State sufficient to satisfy the Commerce
Clause.”336
In Lanco Inc. v. Director, Division of Taxation,337 the New Jersey Superior Court,
Appellate Division reversed the Tax Court and also held that physical presence is not
required for the imposition of the Corporate Business Tax.338 Lanco, Inc. (“Lanco”) is a
Delaware corporation that owned intellectual property such as trade names and
trademarks.339 The intellectual property was licensed to Lane Bryant, Inc., a retailer with
333
Id. at 189.
Id. at 192.
335
Id. at 193.
336
Id. at 195.
337
879 A.2d 1234 (N.J. Super. Ct. App. Div. 2005), cert. granted, 892 A.2d 1291 (N.J. 2006).
338
Id. at 1242.
339
Id. at 1236.
334
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New Jersey locations.340 Lanco had no office, employees or property in New Jersey.341
Lane Bryant paid a royalty to Lanco for the use of the intellectual property.342
The court, in reaching its conclusion, rejected the Tax Court’s conclusion that the
holding of Quill Corp. v. North Dakota343 applied to corporate income taxes.344 Rather,
the court adopted the rationale of Geoffrey Inc. v. South Carolina Tax Commission345 that
physical presence was not required to satisfy the Commerce Clause’s substantial nexus
requirement.346
In Geoffrey, Inc. v. The Oklahoma Tax Commission,347 the Oklahoma Appellate
Court affirmed the holding of the Oklahoma Tax Commission that the imposition of
Oklahoma income tax attributable to royalty income earned by Geoffrey, Inc. (Geoffrey)
under a licensing agreement which was based on sales within Oklahoma did not offend
the Due Process Clause nor burden interstate commerce in violation of the Commerce
Clause of the United States Constitution.348
Geoffrey, a Delaware corporation, appealed an Order of the Oklahoma Tax
Commission imposing income tax on the royalties received from licensing its
intangibles.349 As part of a corporate restructuring in the mid-1980s, Toys ‘R’ Us, Inc.
formed Geoffrey, and assigned certain intellectual property, such as trademarks, to
340
Id.
Id.
342
Id.
343
504 U.S. 298 (1992).
344
Lanco Inc. v. Dir., Div. of Taxation, 879 A.2d 1234, 1238 (N.J. Super. Ct. App. Div. 2005), cert.
granted, 892 A.2d 1291 (N.J. 2006).
345
437 S.E.2d 13 (1993).
346
Lanco Inc. v. Dir., Div. of Taxation, 879 A.2d 1234, 1238 (N.J. Super. Ct. App. Div. 2005), cert.
granted, 892 A.2d 1291 (N.J. 2006).
347
132 P.3d 632 (Okla. Civ. App. 2005).
348
Id. at 641.
349
Id. at 633.
341
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Geoffrey in exchange for Geoffrey stock.350 Geoffrey entered into licensing agreements
with Toys ‘R’ Us, Inc. for the use of the intellectual property.351 The royalties for the use
of the marks were equal to either two percent or three percent of sales depending on the
mark.352 The licensing of the intangible property was the only business activity of the
company.353 Geoffrey did not maintain an office or have employees in Oklahoma.354
The Oklahoma Appellate Court rejected Geoffrey’s argument that the Commerce
Clause requires substantial nexus through physical presence and that the Due Process
requires minimum contacts.355 In so doing, the court rejected the argument that the
Quill356 decision extended the bright-line physical presence test to all taxes.357 Agreeing
with and applying the benefits test of a decision in South Carolina involving Geoffrey
and similar issues,358 the Oklahoma court concluded that the real source of income was
not the license agreement, but rather the Oklahoma customers and by Oklahoma
“providing an orderly society” in which to conduct business made it possible to earn the
income.359 The tax is rationally related to the benefits and protections provided by
Oklahoma and the Due Process minimum contacts requirement was met because
Geoffrey purposefully directed its activities towards Oklahoma.360
350
Id. at 634.
Id.
352
Id.
353
Id.
354
Id.
355
Id. at 635.
356
Quill Corp. v. North Carolina, 504 U.S. 298 (1992).
357
Id.
358
Geoffrey, Inc. v. South Carolina Tax Comm’n, 437 S.E.2d 13 (S.C 1993).
359
Geoffrey, Inc. v. Oklahoma Tax Comm’n, 132 P.3d 632, 638-39 (Okla. Civ. App. 2005).
360
Id. at 639.
351
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In Acme Royalty Co. v. Dir. of Revenue,361 the Missouri Supreme Court reached
the opposite conclusion holding that intangible holding companies were not subject to
Missouri corporate income tax because they had no contacts, and specifically no sales,
within Missouri.362 To be subject to Missouri tax, the companies had to have some
activity, such as payroll, property, or sales, in Missouri.363 The companies did not do
business, maintain employees or agents, conduct sales, or distribute property in
Missouri.364 The court noted that despite the fact that related companies did business and
paid tax in Missouri, the intellectual property holding companies were separate legal
entities and should be treated as such.365 Because the companies did not derive income
from sources in the state, the court concluded that the income sought to be taxed by the
Director was outside the scope of Missouri taxation.366 Therefore, the decisions of the
Missouri Administrative Hearing Commission were reversed.367
B.
Forced Combination
In In the Matter of Sherwin-Williams v. Tax Appeals Tribunal,368 the New York
Appellate Division affirmed the New York Tax Tribunal’s holding that SherwinWilliams should be combined with its two affiliated trademark protection companies.369
In reaching its conclusion, the court rejected Sherwin-Williams’ argument that the
statutory distortion requirement should be narrowly construed.370
The court
acknowledged that from the viewpoint of Sherwin-Williams, the transactions represented
361
96 S.W.3d 72 (Mo. 2002).
Id. at 75.
363
Id.
364
Id.
365
Id.
366
Id.
367
Id. at 73.
368
784 N.Y.S.2d 178 (N.Y. App. Div. 2004).
369
Id. at 184.
370
Id. at 182.
362
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a relatively small part of the company’s overall transactions.371 However, the court
determined that a narrow interpretation redirects the purpose of the applicable statute.372
Further, the court observed that there were sufficient intercorporate transactions to
involve the statutory rebuttable presumption of distortion.373
The court determined that the primary question whether, under the totality of the
circumstances of the intercompany relationship in the matter at hand, did combined
reporting more accurately represent the true income.374 In analyzing the issue, the court
reviewed the rationale for establishing the trademark companies and concluded there was
“substantial evidence” to support the Tribunal’s conclusion that the structure lacked
economic substance and business purpose.375 As a result, there was no need for the court
to determine if the royalty rates were arm’s length rates.
In contrast to the Sherwin Williams decision, the Administrative Law Judge
(ALJ) in In the Matter of Petition of Hallmark Marketing Corporation,376 held the
Department of Taxation and Finance could not forcibly combine Hallmark’s distribution
company with the out-of-state manufacturing company.377 In so concluding, the ALJ
held Hallmark sustained its burden of establishing the inter-company pricing met the
requirements of IRC Section 482.378
Thus, the company successfully rebutted the
Department’s presumption of distortion.379
371
Id.
Id.
373
Id.
374
Id.
375
Id. at 183-84.
376
New York Division of Tax Appeals, No. 819956 (January 26, 2006); 2006 N.Y. Tax LEXIS 13 (2006).
377
Id. at *82.
378
Id.
379
Id.
372
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Hallmark Cards is engaged in the design, manufacture and sale of social
expression products. Hallmark Marketing, a subsidiary, was the exclusive domestic
distribution arm of the products. The products were sold primarily to third-party retailers
located throughout the United States. Hallmark Marketing purchased the products from
Hallmark Cards. The purchase price was set in accordance with a contemporaneous
transfer pricing study. The purchase price of the products was determined by analyzing
the profits earned by comparable third-party companies.
Hallmark Marketing’s
profitability was consistent with that of the unrelated third-party companies.
Hallmark Marketing filed its own New York return. On audit, the Department
attempted to combine the company with Hallmark Cards. In holding the companies
should not be combined, the ALJ relied on the fact that the inter-company pricing was
consistent with the reasonable and flexible approach suggested by IRC Section 482.380
In In the Matter of Toys “R” Us-NYTEX,381 the New York City Tax Appeals
Tribunal held that Toys “R” Us (“Toys”) was not required to file a combined New York
City general corporation tax return with its intellectual property company Geoffrey, Inc.
Toys is a New York corporation and Geoffrey is a Delaware corporation. Geoffrey
licensed trademarks and trade names to Toys and other third parties, and in turn, Geoffrey
received royalties pursuant to the licensing agreements. The royalty rate was based on
the royalties charged to third parties. Geoffrey maintained a Delaware office with one
part-time employee and received administrative services from another affiliate pursuant
to a service agreement.
380
381
Id. at *81.
TAT (E) 93-1039 (GC) (N.Y.C. Tax App. Trib., Jan. 14, 2004).
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The City argued that the inter-company transactions had no economic substance
and therefore the deduction of the royalties produced distortion resulting in an
understatement of Toys’ income. In response to the City’s arguments Toys produced
extensive evidence of the arm’s length nature of the transactions.
The Tribunal held that the Toys transfer pricing experts demonstrated that the
licensing of intangibles and receipt of the royalty income by Geoffrey constituted an
arm’s length transaction.
Therefore, because Toys overcame the presumption of
distortion, the Tribunal did not have address the issues of business purpose and economic
substance.
C.
Economic Substance and Business Purpose
The Connecticut Supreme Court held that a parent corporation could deduct
interest expenses incurred on a loan to a wholly-owned subsidiary because the subsidiary
had economic substance and business purpose, and the transactions between the
companies were legitimate. Carpenter Tech. Corp. v. Comm’r of Revenue Services.382
The subsidiary, which was established with a $300 million capital contribution from the
taxpayer, was created to own a number of foreign subsidiaries and thus shield the
taxpayer from potential foreign liabilities.383 Each of the five installments of the $300
million contributed by the taxpayer to the subsidiary as capital was immediately loaned
back to the taxpayer.384 The Commissioner had attempted to disallow the deductions on
the basis of the sham transaction doctrine.385 However, the lower court held that, since
there was a valid business purpose for setting up the subsidiary, the parent could deduct
382
772 A.2d 593 (Conn. 2001).
Carpenter Tech. Corp. v. Comm’r of Revenue Services, 779 A.2d 239, 241 (Conn. Super. Ct. 2000).
384
Id.
385
Id. at 242.
383
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the interest expense on the inter-company loans.386 In a per curium decision affirming
the lower court’s ruling, the Connecticut Supreme Court adopted the lower court’s
reasoning without further analysis.387
In Carpenter Tech. Corp. v. Comm’r of Taxation & Fin.,388 the Supreme Court of
New York, Appellate Division, affirming a decision of the New York Tax Appeals
Tribunal reached the exact opposite conclusion and disallowed a parent corporation’s
deduction for interest payments made on a loan from its subsidiary.389 In upholding the
disallowance, the court held that although the subsidiary may have been formed for a
legitimate business purpose, such as insulating the parent from liability, the interest
payments were non-deductible under the provision in the law disallowing deductions for
interest directly attributable to subsidiary capital.390
The Massachusetts Supreme Judicial Court has also applied the federal doctrines
of economic substance and business purpose, holding that Sherwin-Williams, was
entitled to a deduction for royalties and interest paid to its subsidiary intangible holding
companies for use of trademarks and trade names391. The court concluded that the
Appellate Tax Board erred when it found that the transfer and licensing back transactions
at issue were without economic substance and therefore a sham. Further, because the
royalties paid by Sherwin-Williams reflected fair value, there was no basis to support the
elimination of such payments. The court disagreed with the Commissioner’s position
386
Id. at 242-43.
Carpenter Tech. Corp. v. Comm’r of Revenue Services, 772 A.2d 593, 594 (Conn. 2001).
388
745 N.Y.S.2d 86 (N.Y. App. Div. 2002).
389
Id. at 91.
390
Id. at 90.
391
Subsequent to the decision in Sherwin Williams, the Massachusetts statute was amended to allow the
Commissioner to exercise his discretion to disallow the tax benefits resulting from transactions he regards,
as shams or otherwise invalid. If challenged, the taxpayer bears the burden of demonstrating by clear and
cogent evidence that the transaction possessed both (i) a valid good-faith business purpose other than tax
avoidance and (ii) economic substance apart from the asserted tax benefits. Mass. Gen. Law. Ch. 63 §311.
387
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that because the transfer of the trademarks to the holding companies was tax motivated,
the transfer and subsequent licensing should be disregarded. The court found motive to
be irrelevant and noted that the analysis of business purpose and economic substance
must look at the totality of the business operations, not just the initial reorganization
transaction.
The court found that the holding companies had a legitimate business in licensing
their marks to the taxpayer and to third parties, and in investing the proceeds from these
licensing agreements with third parties. The fact that the taxpayer incurred advertising
expenses to sell its product did not affect the result because the advertising expenses were
not incurred for the primary purpose of strengthening the holding companies’ marks but
were intended primarily to sell more of the taxpayer's products.392
A similar conclusion was reached by the Massachusetts Appellate Tax Board in
Cambridge Brands, Inc. v. Comm’r of Revenue.393 The Board concluded that royalties
paid by a candy manufacturer to an affiliate for use of trademarks and other intellectual
property were deductible as ordinary and necessary business expenses. Both companies
were subsidiaries of the same parent company. The taxpayer produced the candy while
the affiliate held and managed trademarks relating to the products manufactured by the
parent and various affiliates. The licensing arrangement had a valid business purpose and
economic substance because the taxpayer realized higher profit margins through the use
of the trademarks and benefited from the marketing, sales forecasts and production
schedules created by the affiliate. There was no evidence that the “arrangement was a tax
scheme designed to create deductions while at the same time creating a circular tax-free
392
393
Id.
Docket No. C259013 (Mass. App. Tax Bd. July 16, 2003).
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distribution [of payments] back to the paying entity.” The amount of the royalty fees did
not exceed fair market value.
Therefore, the Commissioner’s statutory authority to
eliminate deductions in excess of fair market value did not apply394.
In the consolidated case of Comptroller of the Treasury v. SYL Inc.,395 the
Maryland high court applied the business purpose and economic substance doctrine to
uphold the income tax assessments against corporations. Syms Inc. (Syms) is a New
Jersey corporation that sells clothing in several states, including Maryland. In 1986,
Syms created SYL Inc. (SYL) as its wholly owned subsidiary. SYL is a Delaware
corporation, which owns Syms’ intellectual property assets. SYL granted Syms the right
to use the intellectual property in exchange for a four percent royalty on Syms’ sales.
SYL had no presence in Maryland. In 1996, the Comptroller of the Treasury issued SYL
corporate income tax assessment for 1986 through 1993 tax years. SYL protested the
assessment, which the hearing officer affirmed. because SYL lacked economic
substance.396 The hearing officer cited the fact that the company’s employees were
merely employees of nexus service providers and all of SYL's income was generated by
Syms.
The Maryland Tax Court overturned the assessment concluding that SYL was not
merely a "phantom" and that it lacked sufficient nexus with Maryland. The Tax Court
also found that the foundation of the Comptroller's argument in Comptroller v. Atlantic
Supply Co.397 and Comptroller v. Armco398 applied only when the subsidiary had no
economic substance.399
394
438 Mass. 71; 778 N.E. 2d 504 (2002).
825 A.2d 399 (Md. 2003).
396
Id.
397
448 A.2d 955 (Md. 1982).
395
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In Comptroller of the Treasury v. Crown Cork and Seal Co., the case consolidated
with Comptroller of the Treasury v. SYL Inc., Crown Cork & Seal (Subsidiary) is the
wholly owned subsidiary of Crown Cork & Seal Company, Inc. (Crown).400 Both entities
are Delaware corporations.401
Crown and Subsidiary, which owned the intellectual
property, operated in a similar fashion to Syms and SYL. The Subsidiary had no contacts
with Maryland and operated primarily through an unrelated third party. All royalty
payments made by Crown to Subsidiary were immediately loaned back to Crown.
Between 1989 and 1993, the years in issue, Crown’s indebtness to the subsidiary
increased by the amount of the royalties.
The Maryland Court of Appeals held that there was sufficient nexus between
Maryland and SYL and the Crown Subsidiary to constitutionally tax the state portion of
their incomes. First, the court noted that under Maryland law, corporate income is
taxable to the full extent ‘constitutionally permissible.” Second, the court determined
that SYL and the Crown Subsidiary had “no real economic substance as separate business
entities.” In reaching that conclusion, the court noted the lack of employees, the “mail
drop”-type corporate offices, and absence of change in operations following the
subsidiaries’ incorporation. Thus, the court ruled that, under the rule established in
Armco, a portion of SYL's and the Crown subsidiary's income was subject to Maryland
income tax.
I.
Conclusion
398
572 A.2d 562 (Md. Ct. Spec. App. 1990).
Id. at 405.
400
Id. at 407.
401
Id.
399
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With the enactment of tax shelter legislation at the state level one could argue
there has been a trend by the states to place less of reliance on the federal government to
identify abusive transactions. However, when determining if such legislation should be
enacted the legislators should ask themselves a number of questions. First what is the
goal that the legislature is seeking to achieve? If, the goal is to stop or curtail the use of
abusive or impermissible transactions, i.e. those that lack economic substance or business
purposes, is legislation actually required or may that goal be achieved through a
partnership with the Internal Revenue Service. In the alternative if that is the stated goal
then it should be determined if the goal can be achieved by adopting and administering a
tax scheme that mirrors the federal approach. From a taxpayer perspective this type of
approach would provide both clarity and certainty.
If the goal is to not only curb the use of transactions that are determined to be
abusive at the federal level but also curb the use of transactions that do not fall with those
that are listed or reportable transactions for federal tax purposes taxing authorities must
ask themselves what is the best way to achieve that goal. In analyzing the best approach
to achieve that goal legislatures and tax administrators should take into consideration the
burden of administering a new law or policy both on the part of the state and the
taxpayer.
As evidenced by a number of recent court decisions, without consistent
definitions or uniform applications of the federal doctrines a transaction may pass muster
in one state but not another. The result is a taxpayer due to this uncertainty may be
heavily penalized in one state due to the form of a transaction that is perfectly acceptable
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in a number of other states. The real question is can tax administrators achieve this goal
without enacting specific tax shelter legislation by using existing statutes and policies.
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