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Document 23 of 113.

March 8, 2000, Wednesday

SECTION: PREPARED TESTIMONY

LENGTH: 3614 words

HEADLINE: PREPARED TESTIMONY OF PETER L. FABER

BEFORE THE SENATE COMMITTEE ON FINANCE

BODY:
Summary

1. There is a corporate tax shelter problem. The healthy level of corporate tax revenue should not obscure the fact that many corporations have adopted inappropriately aggressive tax strategies.

2. The tax shelter phenomenon has been aggravated by the mass marketing of aggressive tax "products" by Big-5 accounting firms and investment banking firms.

3. Congress should tread cautiously in attempting to deal with the tax shelter phenomenon by legislation. Some aspects of the problem are better dealt with by regulations and judicial doctrines than by legislation. For example, it may not be possible to draft a generic definition of "tax shelter" that applies only to inappropriately aggressive transactions and that does not apply to nonabusive transactions. 4. Greater disclosure of aggressive tax strategies should be required. Last week's Treasury proposals along these lines deserve careful study.

5. The Internal Revenue Service should be given the personnel and resources that it needs to conduct an effective information and audit program in this area.

***** STATEMENT OF PETER L. FABER

Good morning, Mr. Chairman and members of the Committee. My name is Peter L. Faber. I am a partner in the law firm of McDermott, Will & Emery and I have been engaged in the practice of corporate tax law for 37 years. I have served as Chair of the American Bar Association Section of Taxation and the New York State Bar Association Tax Section and currently chair the Tax Committee of the New York City Partnership and Chamber of Commerce, but I appear before you today in my individual capacity and not on behalf of any organization.

I want to offer you the perspective of a practicing tax lawyer who deals with the tax managers of large corporations every day. Our firm advises over 50 of the Fortune 100 companies in tax matters on a regular basis, and we are often called upon to counsel them with respect to proposed aggressive tax strategies that have been suggested to them by accounting and investment banking firms. Here is a view from the trenches.

I, and I suspect most of my colleagues in the corporate tax bar, believe that there is a corporate tax shelter problem and that it is qualitatively and quantitatively different from any kind of compliance problem that we have seen in recent years. I do not have any easy answers to suggest to you, and I would submit that the problem, and the possible solutions, are more complex than would first appear. In fact, the corporate tax shelter phenomenon raises fundamental issues about the extent to which taxpayers in general, not just corporations, can rely on the literal language of statutes and regulations. I would urge the Committee to proceed cautiously in this area. Solutions should be tailored to meet the problems that they address and should not inhibit the ability of taxpayers to conduct legitimate business operations. What may be a "tax shelter" in the eyes of one person may be a legitimate tax planning strategy in the eyes of another. If we start spraying machine gun fire at a crowd of people because we know that there is a murderer among them, we may kill the murderer but we will inevitably hurt a lot of innocent people in the process. Congress should not do that here.

The problem is real, make no mistake about that. For reasons that I will describe, people at Big-5 accounting firms are under pressure to develop and sell tax planning ideas to corporations and tax managers at corporations are under pressure to buy them. It is no answer to say that corporate tax revenues are up or that they are a high percentage of corporate profits. Were it not for corporate tax shelters, they might be higher.

What we are seeing today is not new. It is an old game, but the players have changed. In the 1970s and early 1980s, tax shelters were marketed all the time. The sellers were so-called "financial planners" (typically insurance salesmen) and the buyers were doctors. Today, the sellers are Big-5 accounting firms and the buyers are large corporations. But there is qualitative difference between the old tax shelters and the new ones. The difference results from the greater tax sophistication of both the sellers and the buyers. The shelters that were sold to individuals in the 1970s were clearly phony. They typically were based on the purchase of depreciable property at inflated prices for nonrecourse notes that did not expose the buyer to economic risk. (I described one of these schemes to my family once at the dinner table and my 12-year-old daughter immediately spotted the flaw, thus showing more perceptive analytical ability than most of my clients.) The corporate shelters of today are much subtler. They literally comply with the statute and the regulations, exploiting glitches or drafting errors to create artificial tax benefits that do not reflect economic reality. One technique, invented by an accounting firm and previously brought to the attention of this Committee, involved using an artificial structure of domestic and foreign limited liability companies so as to create a fictional tax loss through the operation of basis adjustments under IRS regulations despite the fact that the taxpayer suffered no economic loss. The IRS announced that it would shut this technique down, but its ability to do so remains to be seen. A company using it would have literally complied with the Internal Revenue Code and the Treasury's own regulations.

To combat these techniques, the IRS has been using principles that the courts have developed over the years to deal with situations in which the statutory law has led to results that the judges regarded as inappropriate. These include the economic substance, business purpose, and step transaction doctrines. Although the Service has been successful in convincing courts to apply these doctrines to transactions that the Service regarded as abusive, one suspects that many transactions have gone undetected. Although large corporations are audited on a regular basis, aggressive tax strategies engaged in by smaller and mid-sized corporations may not be picked up.

The reason that corporate tax shelters have become more of an issue in recent years has been their mass marketing by the Big-5 accounting firms. The aggressive tax strategies are more sophisticated than those that were marketed 20 years ago, they are packaged more effectively, and they are marketed more extensively and more aggressively.And corporations have been willing to engage in strategies that years ago they might have been reluctant to consider. Why is this? In my experience, there are pressures on both the sellers' side and the buyers' side that have encouraged the proliferation of aggressive tax strategies.

Let's look first at the sellers' side. The large accounting firms are putting pressure on their partners to maximize revenues. The partners are being urged to sell big ticket items and not to rely on counseling clients on the tax consequences of normal business transactions, for which they may only be able to bill at hourly rates. If they can sell a client on a new tax saving idea, they can often bill for it based on a percentage of tax savings, and I have seen some tax strategies for which accounting firms have billed as much as 40% of the anticipated savings.

The internal pressure to generate profits is applied at the office and individual partner level, and it can be seen in the reluctance of offices of accounting firms to use people in other offices even when those people have needed expertise. 1

The accounting firms have partners and employees whose sole job is to dream up new tax saving ideas and others whose sole job is to sell them. An article in Forbes magazine quotes a Big-5 partner as saying that his firm had an inventory of 1,000 "mass market tax savings ideas" and had recently fired 40 "professional salesmen" to sell them. 2 Last year I was in the office of a Big-5 firm and overheard the person in the next office on the telephone trying to convince a company to use her firm for tax planning services. Her big pitch was that "we have a group of people in Washington who do nothing but dream up tax savings ideas."

What we are seeing now is that tax savings ideas are being marketed like toothpaste. They have become, and are commonly referred to as, "tax products," and the accounting firms are quite blatant about treating them as such. In fact, I remember seeing a recruiting advertisement in a tax magazine a year or so ago in which a job at a Big-5 firm was described as including the development and marketing of "tax products."

When people are under this kind of pressure to produce and sell tax products, they are inevitably going to come up with ideas that literally seem to work if one reads them "once over lightly" but that arguably do not stand up under a rigorous application of the "common law" tests of economic substance, business purpose, and step transaction. People who are under pressure to produce a certain number of tax saving ideas a month may not think them through carefully. Although all of the Big-5 firms will tell you that they have rigorous internal review procedures, the fact of the matter is that a number of schemes have emerged from the accounting firms in recent years that never should have seen the light of day. The internal dynamics are such that there is pressure to bring an idea to market that has a potential for generating big fees, and one suspects that it may be hard for people in the internal review process to say "no."

This raises issues of professionalism that perhaps go beyond the scope of these hearings but that are of concern to me. The accounting firms for years have acted as professional advisors to their clients, and the clients have come to expect that of them. If a firm presents a tax product to a company for which it expects to be paid a fee based on a percentage of expected tax savings, it is functioning as a commission salesman and not as a professional advisor. A firm that presents a client with a 20-page "opinion" that a tax product that it is selling for a percentage of tax savings works is deceiving the client and misrepresenting its role. The "opinion" is not a professional opinion, it is a sales document. I have seen "opinions" of this sort from Big-5 firms that failed to point out significant weaknesses in the proposals. The lack of professionalism continues after the product is sold. I have seen one instance in which a Big-5 firm that sold a tax product to a client that clearly did not work urged the client to vigorously defend the technique when the Internal Revenue Service challenged it on audit despite the fact that defending it would clearly have been fruitless and by doing so the client might have lost the opportunity to trade the issue in exchange for IRS concessions on other issues. It is clear that the accounting firm did so because it wanted to defend its own product and not because it was acting in the client's best interests.

There are also pressures on the buyers' side that have made corporate tax managers more willing to consider aggressive tax strategies than they were in the past. Corporate tax managers are often urged to minimize their companies' tax burdens. Taxes may be viewed by financial people as being like other costs of doing business that can be reduced by sound management. The sellers of tax products are beginning to realize that they may be. able to sell their wares to corporations no.t by approaching the tax managers but by approaching the chief financial officer, who will then put pressure on the tax people to go along. If the chief financial officer advises the head of the tax department that the company's taxes are a higher percentage of income than those of its competitors and that a number of its competitors have adopted a particular tax strategy and wants to know why their company cannot be equally creative, it takes a hardy tax manager to stand up to this kind of pressure.

My bottom line, based on giving tax advice to large corporations every day, is that there is a problem. Having said that, I do not have any easy solutions to offer to you, and I would urge caution on both the Congress and the Treasury in how they approach the corporate tax shelter phenomenon.

I begin with two basic propositions: (1) there is nothing wrong with a corporation structuring its operations so as to minimize its tax burden, and (2) taxpayers, including corporations, should be entitled to rely on laws and regulations as written without having to psychoanalyze the drafters to think of what they would have written if they had been perceptive enough to anticipate modern-day transactions. Judge Learned Hand said over 65 years ago that "anyone 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." 3 If this were not so, I and my colleagues would be out of business. There is nothing wrong, for example, with putting a foreign manufacturing operation in a separate foreign subsidiary so as to defer U.S. tax on the income. The fact that the U.S. parent corporation would have been currently taxed by the United States if it had conducted the operation in a foreign branch is immaterial. If the corporation in fact creates a foreign corporation to conduct a foreign manufacturing operation and the foreign corporation is a real entity with assets, employees, and operations, it should be respected as such, even if the decision to create it was tax motivated. Similarly, if a corporation desiring to distribute assets to its shareholders transfers them to a newly-formed subsidiary and distributes the stock of that subsidiary to its shareholders in a manner that meets the requirements of section 355 of the Internal Revenue Code, the transaction should be treated as a tax- free spin-off, even though, had the assets been distributed directly, both the corporation and the shareholders would have been taxed.

There is much to be said for the proposition that a taxpayer should be allowed to rely on the literal language of statutes and regulations. The tax laws are extremely complicated, and they have been so for as long as I can remember.4 It is hard enough to read and understand the laws and regulations as written. The problem of the tax practitioner and corporate tax manager is compounded if one cannot assume that they mean what they say and that there are circumstances in which literal compliance with their terms will not be enough. We are, after all, a country of laws and not people, and taxpayers, like other citizens, should be entitled to rely on the laws as they appear in the law books.

I do not urge that the economic substance, business purpose, and step transaction doctrines be repealed, but only that they be applied cautiously. None of us are perfect, and the people who draft statutes and regulations will from time to time make mistakes or will fail to anticipate transactions to which those laws and regulations might be applied so as to produce results that, had they thought of them, they would not have permitted. If that happens, arguably the correct remedy is to change the law or regulation and not to penalize a taxpayer who thought that it meant what it said.

I am troubled by the idea that one can draft a generic definition of "tax shelter" that will bring within its scope only the "bad" transactions and that will omit the "good" ones. I have participated in bar association attempts to codify the economic substance doctrine and to develop a definition of "tax shelter" and I am not sure that it can be done. Every definition that I have seen has either failed to catch some abusive tax strategies or has caught nonabusive strategies that should not have been caught. Congress should not, for example, in an attempt to stop abusive transactions enact rules that will impose tax penalties on ordinary everyday equipment leasing transactions.

We should think long and hard about what aspects of the problem can be addressed by legislation, what aspects can be addressed by regulations and rulings, and what aspects should be addressed by the courts. In my view, the issue should be addressed by all three branches of government and it should not be assumed that all aspects of the situation should be addressed by legislation. I think, for example, that it would be a mistake to try to codify the common law principles that the courts have developed over many decades.

It is clear that corporate tax shelters will not be discouraged unless a meaningful "downside" risk is created.

If a corporate tax manager believes that the only risk of engaging in an aggressive tax strategy is the later repayment of taxes that the company would have had to pay if it had not engaged in the strategy and interest, which represents the cost of the money of which it had the use, there will be no disincentive to adopting the next "tax savings idea of the month" that is presented by an accounting or investment banking firm. One possibility would be to increase the levels of existing penalties without trying to draft a generic definition of "tax shelter."

Another approach would be to require increased disclosure and to heighten the risk of an Internal Revenue Service audit. Last week, the Treasury Department released comprehensive proposed regulations requiring greater disclosure of aggressive tax strategies. These proposals will be carefully reviewed by responsible organizations in the business community, including the American Bar Association Section of Taxation, the New York State Bar Association Tax Section, the American Institute of Certified Public Accountants, and the Tax Executives Institute, Inc. I can tell you from personal experience that many aggressive strategies that were adopted by corporations would not have been adopted if the disclosure regime contemplated by these proposals had been in place.

Requiring tax shelter promoters to provide the Internal Revenue Service with a list of taxpayers that have adopted particular types of tax strategies is an idea that should be explored seriously. Imposing penalties on the sellers of tax products as well as on the buyers should also be examined. Here again, some caution is recommended. It would not be appropriate to require an accounting or law firm to disclose the name of every client, that it advised that owning property might be more tax-efficient than leasing it. Legitimate business transactions should not be brought within the sweep of disclosure rules aimed at tax shelters, and the IRS should not be inundated with useless information. I suspect that the Internal Revenue Service and the Treasury Department already have the authority to require a sufficient degree of disclosure to enable them to enforce the laws effectively, but you should seriously consider any proposals that they may advance or legislation that would increase their ability to detect aggressive tax strategies.

Along the same lines, you should give them the tools, including personnel and other resources, that they need to do their jobs in this area. Ultimately, no legislative or regulatory approach to corporate tax shelters will work unless the Internal Revenue Service is given the resources that it needs to enforce them. It has been politically popular in recent years to criticize the IRS, but the few instances of abuse that have been publicized by this Committee and others should not obscure the fact that the overwhelming majority of IRS employees are competent, dedicated, and honest men and women who do their jobs conscientiously and who do not abuse their public trust. Any failure to provide the Service with the resources that it needs to administer the tax laws can only result in a lower audit rate and that encourages taxpayers, individual as well as corporate, to take aggressive positions.

In conclusion, Mr. Chairman, let me say that in my view, and in the view of most other responsible tax practitioners with whom I have discussed the matter, there is a corporate tax shelter problem, and I am pleased that this Committee is holding hearings on the subject. The problem should be addressed by all three branches of government, and one should not assume that legislation is necessarily the way to address all aspects of it. Congress should move cautiously in defining "bad" transactions and it should encourage the Treasury to require increased disclosure of aggressive tax strategies. The Treasury should also be encouraged to regulate the conduct of the promoters of tax shelters by tightening the standards reflected in Circular 230 and elsewhere. I will be happy to answer any questions that you and the members of the Committee may have.

1 An extreme example of this is one case in which an out-of-state office of a Big-5 firm litigated a New York State tax case in New York without consulting the New York office, one suspects because they did not want to share credit for the fees with the New York office. (A reading of the opinion indicates that they did a bad job of it.)

2 Janet Novack and Laura Saunders, "The Hustling of X-Rated Shelters," Forbes, December 14, 1998.

3 Gregory v. Helvering, 69 F.2d 809, 810 (2d Cir. 1934), aft'd, 293 U.S. 465 (1935).

4 I recently sent to Senators Roth and Moynihan copies of testimony that I presented to this Committee on behalf of the New York State Bar Association Tax Section 24 years ago urging that the tax laws be simplified. It was reprinted in Tax Notes, February 21, 2000, at page 1163.

END

LOAD-DATE: March 9, 2000

Document 23 of 113.


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