Financial Statement Disclosure of Corporate Tax Shelters

By J. Gregory Jenkins and Roby B. Sawyers

In Brief

Abusive Tax Shelter Disclosure and Control

While most of the controversy surrounding corporate tax shelters deals with issues of registration, listing, and disclosure of shelters for tax purposes, the disclosure of corporate tax shelters in a company’s financial statements can be overlooked. The authors provide some basic background about tax shelters and discuss recent Treasury Regulations requiring the disclosure of certain transactions to the IRS. They analyze whether the accounting profession’s current guidance and standards related to materiality and contingent liabilities could be useful in determining the appropriate financial statement disclosure of tax shelters.

According to Lawrence H. Summers, former Secretary of the Treasury, abusive corporate tax shelters represent “the most serious compliance issue threatening the American tax system today” (“Treasury Turns Up the Spotlight on Abusive Corporate Tax Shelters,” Tax Notes, March 6, 2000, p. 1333). While the anti-tax shelter position of the Clinton administration has been restrained somewhat by the Bush administration, a number of recent high-profile tax shelter court cases, settlements, proposed legislation, and modifications of the corporate tax shelter regulations have kept tax shelters in the limelight. As noted by Lee Sheppard (“Constructive Thinking About Tax Shelter Penalties,” Tax Notes, August 20, 2001, p. 1013), “the shelter problem has clearly advanced beyond anecdotal evidence when legislators who are not normally associated with the aggressive pursuit of corporate tax dollars are drafting tax shelter legislation.”

Primer on Tax Shelters

Although the precise impact of corporate tax shelters is difficult to quantify, the Joint Committee on Taxation (JCT) estimated that abusive corporate tax shelters result in annual tax revenue losses exceeding $10 billion (JCS-3-99, July 22, 1999). More recently, the IRS reported that about 25 companies have disclosed under the new tax shelter disclosure regulations that they expected to receive $4 billion in tax savings from disclosed shelter transactions. Of this amount, about $1.5 billion was attributed to 1999 and 2000.

Under present law, a transaction is treated as a corporate tax shelter if it has as a significant purpose the avoidance or evasion of federal income tax. Although difficult to define precisely, the Treasury Department has identified a number of common characteristics of tax shelters, including the following:

The recent IRS court victories in the abusive tax shelter area suggest that current tax laws are sufficient to curtail abusive shelters. Nonetheless, abusive tax shelters must ultimately be shut down before they are consummated. Disclosure and increased penalties are frequently cited as ways to accomplish this. On February 28, 2000, three temporary and proposed Treasury Regulations that require disclosure of “tax motivated transactions” by promoters and corporate taxpayers to the IRS were released. These regulations have subsequently been modified twice, most recently by T.D. 8961, effective August 2, 2001.

As described by Treasury, “the three regulations are designed to provide the Service with better information about tax shelters and other tax-motivated transactions through a combination of registration and information disclosure by promoters and tax return disclosure by corporate taxpayers” (IRS Announcement 2000-12, I.R.B. 2000-12).

The first set of regulations [issued under IRC section 6111(d)] requires tax shelter promoters to register with the IRS transactions that are structured for a significant purpose of tax avoidance or evasion, are offered to corporate participants under conditions of confidentiality, and for which the tax shelter promoter receives fees in excess of $100,000 (Temporary Regulations section 301.6111-2T).

The second set of regulations (issued under IRC section 6112) requires 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. These requirements apply to transactions structured for a significant purpose of tax avoidance or evasion, regardless of whether they are offered under conditions of confidentiality and whether the promoter’s fees exceed $100,000 (Temporary Regulations section 301.6112-1T).

The third set of regulations (issued pursuant to IRC section 6011) requires corporate taxpayers to disclose their participation in “reportable transactions” by attaching a statement to their income tax returns (Temporary Regulations section 6011-4T). Disclosure is generally required for transactions that are expected to reduce a taxpayer’s income tax liability by more than $5 million in a single taxable year or more than $10 million in multiple years. These thresholds are reduced to $1 million and $2 million for transactions identified as “listed transactions” by the IRS. According to Treasury, “reporting generally is not required for customary business transactions or transactions with tax benefits that the Service has no reasonable basis to challenge” (IRS Announcement 2000-12, as clarified by T.D. 8961).

While disclosure of corporate tax shelters to the IRS is mandated by the newly issued Treasury Regulations, neither current IRS rules and regulations, current SEC rules, or GAAP specifically require companies to disclose tax shelters and penalties related to tax shelters to shareholders in their financial statements.

Contingent Liabilities

Given current accounting standards, tax shelters are unlikely to be disclosed unless they result in a material contingent liability. The appropriate treatment of any such contingent liability is addressed by SFAS 5, Accounting for Contingencies, which requires an assessment of two aspects of a contingent liability: the degree of uncertainty surrounding the contingency, and the estimability of the related liability.

Under SFAS 5, financial statement preparers must assess the degree of uncertainty of occurrence as remote, reasonably possible, or probable. Making this determination is a matter of judgment; no explicit guidance is provided in the standard. If the occurrence of the loss is judged remote, then no financial statement disclosure is necessary. If the occurrence is judged reasonably possible, then footnote disclosure is appropriate. If the occurrence of the contingency is judged probable and the loss is estimable, a loss should be accrued and footnote disclosure should be included in the financial statements. However, if the loss cannot be estimated, but the occurrence of the contingency is still judged probable, footnote disclosure is appropriate.

An evaluation of a contingent liability requires the use of considerable judgment of evidence acquired through the following activities:

Obtaining written representation (i.e., opinion letters) from attorneys concerning the appropriate tax treatment of a transaction may be particularly problematic in the case of tax shelters. Opinion letters are often written by attorneys and accountants for the promoters of tax shelters and then provided to tax shelter participants. They are typically worded to provide participants assurance that the tax treatment of the transaction is “more likely than not” the proper tax treatment. These letters are often used by corporate taxpayers to avoid penalties should a tax shelter be disallowed.

The typical opinion letter, however, has come under fire because it is often generic, assuming without justification the presence of a valid business reason for the transaction and other necessary facts. Consequently, opinion letters are increasingly viewed as sales documents rather than legal opinions, and they should be considered as such for financial statement purposes. At a minimum, the opinion letters should be reviewed by someone with no stake in the outcome, or be prepared by an outside firm.

A Matter of Materiality

The IRS recently announced (News Release IR-2001-74) that Merrill Lynch agreed to settle a case related to a tax shelter it had promoted. While the amount of the penalty settlement was not disclosed, the IRS has called it substantial. Merrill Lynch neither admitted nor denied liability for the penalties, and said the penalty was not material to the company’s financial results. The Wall Street Journal reported that the amount was understood to be under $10 million (“IRS, Merrill Reach Pact on Shelters,” August 29, 2001, p. C1).

Under current practice, tax shelters are generally not disclosed on financial statements because their financial and tax consequences are typically not quantitatively material to a company’s financial statements. Whether such a simplistic dismissal of disclosure is appropriate is an open question.

Materiality is defined only in the broadest terms by the profession’s standards, an explicit recognition that a “one size fits all” approach is inappropriate. Statement of Financial Accounting Concept 2 states that an item is material if “in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person … would have been changed or influenced by the inclusion or correction of the item.”

Many companies and their auditors have developed quantitative benchmarks to assist them in the preparation and audit of a set of financial statements. However, in its Staff Accounting Bulletin 99, Materiality, the SEC states that “exclusive reliance on certain quantitative benchmarks to assess materiality … is inappropriate.” SAB 99 goes on to say that “exclusive reliance on any percentage or numerical threshold has no basis in accounting literature or the law,” and that an assessment of materiality requires one to view the facts in the context of surrounding circumstances. A similar position is espoused in the report of the Big Five Audit Materiality Task Force. The materiality of a quantitatively small misstatement may be affected by whether the misstatement alters compliance with regulatory requirements or whether the misstatement involves the concealment of an unlawful transaction. Thus, while a tax shelter may not be quantitatively material, the motivation to promote such a shelter, or to use an abusive transaction to shelter income, may reflect behavior that is inappropriate and therefore qualitatively material.

Conflicts of Interest

The SEC has also suggested that some accounting firms may be violating conflict-of-interest rules by promoting corporate tax shelters to their audit clients. While accounting firms are supposed to be independent with respect to their audit clients, the SEC worries that they may be “reaping huge fees by showing the same companies how to save money on taxes through sophisticated—and sometimes legally questionable—accounting gymnastics.” Of particular concern are shelters marketed on a contingency fee basis, “putting pressure on auditors to uphold the tax strategies, even if they believe the plans aren’t proper” (The Wall Street Journal, March 24, 2000, p. A3). Many CPA firms consider the fees they charge for tax products to be “value-based” and outside the technical definition of “contingency fee” (“SEC Looks at the Sale of Aggressive Products to Audit Clients,” Tax Notes, April 3, 2000, p. 13). Others argue that the conflict-of-interest question is not relevant because tax shelter transactions are not quantitatively material to the financial statements.

The potential conflict of interest also raises questions regarding the accounting firm’s independence. Regardless of the issues surrounding contingent fee arrangements and quantitative materiality, when an accounting firm sells a $3 million audit client a $10 to $50 million tax strategy, independence becomes an issue. “When an accounting firm has a proprietary interest in the strategy, it creates a built-in conflict … whether to reserve funds to cover liabilities if the idea doesn’t work” (“SEC Looks at the Sale of Aggressive Products to Audit Clients,” Tax Notes, April 3, 2000, p. 14). Auditors may be reluctant to admit that a tax strategy sold by the firm’s tax specialists might not work and therefore set up reserves for a related contingency.

The Disclosure of Tax Shelter Penalties

Even if corporate tax shelters are not disclosed as contingent liabilities, shareholders should still be made aware of a corporation’s unsuccessful attempt to avoid or evade Federal income tax:

Tax penalties are a measure for deterring and punishing failure to comply with the tax law … any sanction for an aggressive transaction in which a significant purpose is the avoidance or evasion of Federal income tax may be indicative of conduct that is contrary to public policy and should be considered a qualitatively material item that warrants disclosure to a corporation’s shareholders (JCS-3-99, July 22, 1999, p. 222).

In the past, both the staff of JCT and the Senate Finance Committee have recommended that corporate participants be required to disclose to shareholders the payment of understatement penalties exceeding $1 million and assessed in connection with a corporate tax shelter. The JCT staff further recommended that the disclosure be in the form of a separate annual statement or other report provided to shareholders and that the disclosure include the amount of the penalty and the factual setting under which the penalty was imposed.

For similar reasons, the SEC requires disclosure of actual and potential violations of environmental regulations where a governmental authority is party to the proceeding and there are potential monetary sanctions that are not reasonably believed to be less than $100,000. The SEC asserts that disclosure of fines imposed by governmental authorities may be of particular importance in assessing a corporation’s environmental compliance problems (JCS-3-99, July 22, 1999, page 222).
The IRC provides at least two precedents for financial statement disclosure of tax shelters. For example, disclosure is a prerequisite to obtain certain exceptions related to specific employee remuneration agreements under IRC section 162(m) and golden parachute payments under IRC section 280G. The Joint Committee staff has argued that “the qualitative issues that give rise to the shareholder disclosure requirements in section 162(m) and 280G, and which resulted in the SEC requiring disclosure of sanctions for violations of environmental laws, are similar to the qualitative issues that arise when a corporate taxpayer is penalized for an understatement of tax attributable to a tax shelter.”

To Disclose or Not Disclose

Corporate tax managers should evaluate tax shelters (and other tax strategies) from three perspectives: Will they stand up in court? Will they result in penalties? and, Will they result in bad publicity for the company? (State Tax Notes, March 27, 2000, p. 1007). Each of these questions addresses matters that may bear on whether tax shelters should be disclosed in a company’s financial statements. With respect to the first two questions, companies and their auditors must understand that tax shelter transactions are much more likely to be uncovered and litigated under current Treasury Regulations. If litigated, penalties may be assessed under current law unless the taxpayer has substantial authority and a reasonable belief that the treatment of the shelter item is more likely than not to prevail. If companies intend to rely on an opinion letter to avoid penalties, they must take care that the opinion is from an objective source with no stake in the outcome of the transaction.

Absent a requirement by Congress or the SEC for disclosure of penalties associated with tax shelters, the question of disclosure is likely to hinge on an assessment of qualitative materiality—that is, are these transactions important to shareholders? Moreover, a disclosure decision will likely include consideration of the potential for negative publicity resulting from either an IRS investigation or press coverage. Given the contentious nature of these transactions, companies may wish to disclose them sooner rather than later.

J. Gregory Jenkins, CPA, PhD, is assistant professor of accounting at North Carolina State University.
Roby B. Sawyers, CPA, PhD, is associate professor of accounting at North Carolina State University.

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