homesheltersuncovering schemesprospects for reform

is sweeping reform necessary?
Most agree that at the core of the abusive tax shelter problem with is the "economic substance" doctrine. That is, if a company enters a transaction strictly for the purpose of lowering its tax rate, the deal lacks any sort of business or economic purpose and should be considered bogus. There is a great debate over how to address the economic substance question. Former Treasury Secretary Lawrence Summers has proposed a broad rule to outlaw any transaction that lacks economic substance. Others maintain, however, that a broad rule is difficult to interpret and would interfere with legitimate business transactions. They say that the problem can be brought under control through a piecemeal approach that addresses specific abusive transactions. Here are the views of Summers, former IRS officials Charles Rossotti and Larry Langdon, Senator Charles Grassley, former Assistant Treasury Secretary Pamela Olson, U.S. Rep. Lloyd Doggett, and leasing industry lobbyist Ken Kies on the economic substance issue.

Charles Rossotti
IRS commissioner (1997-2002)

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One of the great debates is, "What is the law in the area of tax shelters?" My view is, and I said to people, "We ought to outlaw tax shelters." People would say, "What do you mean outlaw tax shelters? Aren't they already illegal?"

The answer is, "Not in terms of anything the Congress has ever passed." The law about tax shelters, for the most part, stems from a long series of complicated court decisions that go back to 70 years about the doctrine of supposedly what's called "economic substance," meaning that, if you go through a bunch of transactions, but there's really nothing that happens other than you structure the same taxes, that can be challenged and overturned as a tax shelter. But it's a very murky and frankly weak barrier, legally, I believe. …

So, bottom line, I think the Congress needs to change the law. They need to make it much clearer by act of Congress, not just by a set of tax decisions in various courts.

Change the law to do what?

… I think Congress has to say it plain and simple -- that if you're just doing a transaction that's structured for tax benefits that you wouldn't do in the absence of the tax benefits, then it's a tax shelter and it's not legitimate.

Charles Grassley
Senator, (R-Iowa)

How do you deal with the economic substance?

Well, that's a definition within law and it's not easy to do an economic substance definition to shut down the tax shelters without sometimes doing harm to arms-length legitimate business transactions. We obviously don't want to destroy this over here because it's the substance of the free market economic system. But we obviously have a right to shut down tax shelters that are using economic substance in a way that isn't innocent. …

You also -- in your bill, as I recall -- say that for a business transaction to work under the tax code it has to have economic substance, has to have business purpose. Is that right?

Our bill builds upon the free market system that's been the backbone of our great nation and that is that there ought to be economic substance to every business transaction. It ought to be arms-length business dealings, not this business that goes on within the tax shelters of people thinking up things where there's no risk, no economic substance and still save taxes.

Pamela Olson
Treasury assistant secretary for tax policy (2002-2004)

People like Charles Rossotti or Senator Grassley say there's this hop skip and jump effect that the tax shelter promoters and devisers and creators are always a step or two or three or four ahead of the IRS. Why not issue a blanket rule? Why not pass a law that makes it clear that transactions that lack economic substance and business purpose simply are out of bounds?

Well, it wouldn't do anything to stop those things that you saw discussed at the permanent subcommittee on investigations hearing, because those opinions were all written saying that they had economic substance.

The problem is that the economic substance test is something like a Rorschach inkblot. It looks different to a lot of different people. If they conclude that the test doesn't apply or that they've satisfied it, it doesn't do anything to stop anybody from going forward. Those guys will sign a ham sandwich, they'll conclude that they've got economic substance. It's not going to serve as the speed limit that I think we might need on the tax highways.

Isn't it going to put corporations and informed individuals on notice? … If it's quite clear that there's a law passed by Congress that says there is no acceptance of any deals that don't have economic substance [or] a business purpose, you can't do them and come in and expect to get a tax benefit from that. You put the public on general notice. Isn't there a benefit there? That's at least what the advocates are saying.

That's what the advocates are saying. Again I just don't think it works. I mean if you think about the gentleman who testified at the Senate Finance Committee hearing about what he did at KPMG, he talked about how they added economic substance to transactions, how they found economic substance in transactions. I just don't think it's going to serve as the deterrent that we'd like to have.

I think what we need if we want a deterrent is something that very clearly captures the kinds of transactions that we're interested in and says you don't get the losses. That clear rule -- you don't get the losses for particular kinds of transactions -- is what would deter the marketing.

Lloyd Doggett
U.S. Representative, (D-Texas)

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Because these tax shelters are so complex, it just does not work to deal with them on a case-by-case basis. You hear about IRS effectively dealing with one transaction, and so it's changed slightly, but it comes out in another form. The IRS is just getting a few of the proposals. The creative people who come up with the tax shelters always find a way to circumvent it. That's why we need an economic substance rule, a fraud rule, that will cover more than individual transactions.

Explain what that is. What kind of a rule do you advocate to deal [with the shelter phenomenon]?

We need a general rule that protects legitimate transactions, but that says if what you're doing is to generate losses for the tax collector, not to generate gains for your shareholders, that doesn't have economic substance. Economic substance is nothing more than the kind of analysis that businesses go through all the time to see if the deal is worthwhile.

I would have a broad rule that the courts could apply -- and should apply -- to prevent these sham transactions, not just to catch one and let 10 more go through and wait to get the other nine.

There are people on the other side who say that, if you pass a broad rule that requires economic substance of across the board, you will kill the legitimate leasing industry or you will kill other legitimate business.

… I believe that we can take account of all really legitimate transactions, see that they continue, but not permit these sham transactions. It seems to me to be a very pro-business stance to want the playing field leveled. It's unfair to the business that doesn't engage in these tax shams to be placed at a competitive disadvantage with another company that does.

larry langdon
IRS commissioner, Large and Midsize Business Division (1999-2003); former tax director of Hewlett-Packard

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It's hard to codify rules that get at tax shelters that are constantly evolving. It's, again, the proverbial chess game of creating new products. So I think that it's very incumbent upon the IRS and the Treasury, with help from [the Department of] Justice, to continue to pursue these things and develop administrative rules as fast as these things occur because, in fairness to Congress, they can't act quick enough. …

You're suggesting that the IRS and Treasury can catch up with tax shelters case-by-case, example-by-example?

I don't know of any other material solution, other than using the tools of effective tax administration. …

Do you think we need to amend the laws?

I would be a little bit reluctant to amend the laws with regard to -- and this is the current position of the Treasury Department -- the economic substance and what constitutes "adequate business purpose," because [what] we end up with is a gray standard that's difficult to administer. We really need to look at it on a transaction-by-transaction basis.

Now, maybe we need to change our ruling process, so that a promoter or company can come in and disclose a transaction, and within 60 days the IRS has to say "yea" or "nay" with regard to whether the thing works or not. I think that may be a better way of attacking this problem on a case-by-case basis.

Lawrence Summers
Treasury secretary (1999-2000), deputy treasury secretary (1995-1999)

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We proposed codifying a principle that continues to seem compelling to me -- that transactions have to have economic substance, rather than be purely tax-motivated, where you're not allowed to take deductions for them.

A lot of shelters didn't have any economic substance, didn't have business purpose.

That's basically the essence of a tax shelter. People [that] do activities that are best for their businesses and think about the tax consequences if they do it -- that's perfectly legitimate. What's not legitimate is transactions that have as their overwhelming motivation the reduction in reported tax income without changing the underlying substance of business activity. Sure, there are going to be some hard lines to draw there, and people can reasonably argue about the close cases. But there are so many cases that are on the side of essentially no economic substance and pure tax motivation that we thought there was a clear need for changes in the definitional standard.

What happened on Capitol Hill when you sent those proposals out?

There was a certain amount of discussion. The income -- probably even the taxable income -- of many lobbyists was increased. As they scurried and were well paid to fight those proposals, very [little] happened on Capitol Hill. …

What was the chief obstacle? What was the sticking point? What was the obstacle to getting your proposals passed in Congress?

There's a concentrated focused constituency for the tax shelter -- the person who doesn't have to write a check to the government, and the people whose livelihood depend on marketing those tax shelters in the accounting profession in particular. They were a strong constituency for tax shelters.

On the other side, you have a general national interest -- and that's always the challenge in Washington. [A] specific interest that's prepared to invest a lot of money in a particular political issue will often beat the broader national interest, and that was our challenge. …

Are there any particular lobbyists who have influence on the Hill, either because of personal connections, or past work?

In our period, Ken Kies had enormous influence. Ken had been the staff director of the Joint Tax Committee and a most trusted aide of key legislators. He then went to work for one of the accounting firms that was particularly aggressive in marketing tax shelters. He defended all of those tax shelters, and used all his influence to protect those shelters. He was a smart, effective, well-prepared, knowledgeable person on those issues, who had built up an enormous reservoir of loyalty. He was, I'm sure, sincere in his convictions and therefore difficult to contend with. But many of the transactions that were being defended I believe were very expensive; not just to the nation's treasury, but to our reservoir of integrity.

ken kies
Leasing industry lobbyist

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Where I am on that legislation is where the U.S. Treasury Department is and where a number of tax experts are. That is the consensus view of many -- that this is not good legislation, that the economic substance doctrine, which that legislation purports to codify or put into a statute, is much better off left in the hands of the courts, who have used it appropriately to disqualify transactions where the transaction was heavily motivated, if not exclusively, by tax considerations.

Any attempt to codify that statute would have unintended consequences that far outweigh the benefits of attempting to codify it. The courts have demonstrated that they're very capable of applying the doctrine in ways that are sensible. It's better off left there than any attempt by Congress to try and reduce it to statutory language.

You've said several times in our conversation, if Congress doesn't like the way some of these transactions work out, then what they should do is change the law. Yet now here is an effort by some people in Congress to change the law, and not just case by case, but to try to set a general set of rules so that taxpayers can know. ...

There is far more harm that can be done by passing a generic statute like that than the good that can come from it. The Internal Revenue Code is a set of specific rules that people are supposed to operate within. If you put on top of that some generic statement of the economic substance doctrine, it's going to create a lot of confusion. ...

We really have to have a tax code that's a set of statutes. My view is that there are plenty of ways for the Internal Revenue Service to deal with overly aggressive transactions, and that sometimes Congress does need to come in and legislate specific rule changes. That's the way this situation should be handled, rather than some sort of omnibus broad statute that really would create more confusion than it would do good in terms of the administration of the tax law.

If Congress tries to deal with individual tax shelter problems one by one, how do you avoid adding to the complexity of a tax code, when the complexity itself invites still further efforts to get around the tax code?

You're never going to eliminate the tax code, and there have been a number of instances where the solution to a tax shelter was a very simple legislative change. In the case of the leveraged corporate and life insurance [COLI] problem which we dealt with in 1995 and 1996, the Congress enacted a very simple tax change that shut down those transactions. So it's wrong to assume that solutions to aggressive transactions or loopholes have to be complicated. They don't necessarily have to be. It really depends on the nature. …

I asked Larry Summers and some of the people who work with [him] why some of the proposals that they've put forward three or four years [ago haven't moved forward]. The response was the effective lobbying of the financial services industry -- very powerful influence with Capitol Hill key committees -- House Ways and Means, Senate Finance.

Everybody always looks for an excuse as to why you didn't accomplish something that you set out to do. I think it really overstates it to suggest that it was just because of effective lobbying. I think a number of thoughtful members of Congress said, "Lets go slow on this." Does the IRS really need more than they already have? The evidence to date is that the answer is probably, for the most part, that the IRS has very effectively under B. John Williams, when he was chief counsel, shut down a lot of corporate tax shelters that probably were inappropriate.

They did it with the powers they had, without the proposals that Secretary Summers had proposed. For the most part, I think, they really brought most of the corporate tax shelter problem under control.


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posted february 19, 2004

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