CURRENT DEVELOPMENTS IN TAX SHELTERS

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CURRENT DEVELOPMENTS IN TAX SHELTERS

• By Matthew D. Lerner and Jean Baxley

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Current Developments in Tax SheltersOverview

• Recent Tax Shelter Cases
• What Taxpayers and Their Advisors Need to Know
  About the American Jobs Creation Act
• Revisions to Circular 230
• IRS Requests for Tax Accrual Workpapers
• Recent Developments in Privilege

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• RECENT
• TAX SHELTER CASES

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Recent Tax Shelter CasesLong-Term Capital
Holdings v. United StatesFacts

• Onslow Trading and Commercial (OTC), a U.K.
  company, engaged in lease stripping transactions
  involving the sale and leasing of computers
  (CHIPS) and long-haul truck tractors (TRIPS).
  OTC received tax-free prepayments of rent, which
  it had a future obligation to pay to third
  parties.
• OTC contributed its leasehold interests, the
  lease payment obligations, and the prepaid rent
  collections to U.S. corporations in exchange for
  preferred stock, thereby purportedly giving the
  preferred stock a high basis (due to the
  contributed rent collections) and low value (due
  to the contributed lease payment obligations).

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Recent Tax Shelter CasesLong-Term Capital
Holdings v. United StatesFacts (continued)

• At the same time, a U.K. entity controlled by the
  owners of Long-Term Capital Management (LTCM),
  i.e. LTCM-U.K., made a 5 million recourse loan
  to OTC.
• A foreign bank made a loan to LTCM.
• LTCM contributed the loan proceeds to Long Term
  Capital Partners LP (LTCP), a U.S. limited
  partnership, in exchange for a partnership
  interest in LTCP.
• OTC contributed the high basis preferred stock
  received in the CHIPS and TRIPS transactions (and
  a portion of the proceeds from the LTCM-U.K.
  loan) to LTCP in exchange for a partnership
  interest in LTCP.

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Recent Tax Shelter CasesLong-Term Capital
Holdings v. United StatesFacts (continued)

• LTCP contributed the preferred stock (and the
  proceeds from both loans) to P, a hedge fund.
• OTC sold its interest in LTCP to LTCM via the
  exercise of a put option.
• P sold the preferred stock, for which it claimed
  basis of just over 100 million, for
  approximately 1 million in cash to affiliates of
  Merrill Lynch, thereby triggering the built-in
  losses.

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Recent Tax Shelter CasesLong-Term Capital
Holdings v. United StatesFacts (continued)
3
GE
Loan
CHIPS
OTC(U.K.)
LTCM(U.S.)
UBS
Loan
1
LTCP P/S Int.
3
NB
4
TRIPS
3
LoanProceeds
3
Leasehold Interests, Lease Obligations Prepaid
Rent Collections
2
LTCP(U.S.)
PreferredStock
PreferredStock LoanProceeds
U.S.Corp.
3
LoanProceeds
3
PreferredStock LoanProceeds
P(CaymanIslands)
ML
5
PreferredStock
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Recent Tax Shelter CasesLong-Term Capital
Holdings v. United StatesArguments

• The government argued that the transaction lacked
  economic substance, and was merely a tax ploy to
  create artificial capital losses.
• The taxpayer argued that the transaction had
  economic substance, and offered proof that
  Long-Term expected to realize a pre-tax profit
  from the transaction.

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Recent Tax Shelter CasesLong-Term Capital
Holdings v. United StatesOutcome

• The United States District Court for the District
  of Connecticut disallowed the claimed capital
  losses, holding that the transaction engaged in
  by OTC and the Long-Term entities lacked economic
  substance.
• The court held in the alternative that the
  transaction should be recast under the step
  transaction doctrine and treated as a sale of
  preferred stock by OTC to the Long-Term entities,
  resulting in a downward adjustment to the stock
  basis.

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Recent Tax Shelter CasesLong-Term Capital
Holdings v. United StatesEvidence of Lack of
Economic Substance

• The court treated the following facts as evidence
  of lack of economic substance
• The transactions were brought to Long-Term as a
  tax product rather than as an investment.
• Long-Terms purported primary business purpose of
  generating additional investment fees from the
  contribution of the preferred stock (and cash) to
  P was disingenuous.
• There was no reasonable expectation of profit
  from the transaction.
• Several side agreements provided hidden fees to
  the parties structuring the transactions.
• Long-Term permitted OTC to make the contribution
  of preferred stock (and cash) in contravention of
  the taxpayers investing requirements.

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Recent Tax Shelter CasesLong-Term Capital
Holdings v. United StatesPenalties

• The court upheld imposition of penalties, despite
  the legal opinion obtained by Long-Term from King
  Spalding. Indeed, the court stated that
  Long-Term failed to satisfy its burden to
  establish the applicability of the reasonable
  cause defense since it could not prove it
  received King Spaldings written opinion prior
  to the filing of its return.
• The court determined that the opinion included
  unreasonable factual assumptions (e.g., it was
  assumed that the taxpayer had a valid business
  purpose and reasonably expected to earn a
  material pre-tax profit), and that the opinion
  contained a selective discussion of authority .
  . . which bolsters its appearance as an advocacy
  piece not a balanced reasoned opinion with the
  objective of guiding a clients decisions.
• The court also concluded that the taxpayer tried
  to hide the loss on its tax return by combining
  lines of Schedule M-1, and that this demonstrated
  a lack of good faith for purposes of the
  reasonable cause exception.
• The penalty issue is on appeal to the Second
  Circuit (Case No. 04-5687, filed October 22,
  2004).

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Recent Tax Shelter CasesBlack Decker
Corporation v. United StatesFacts

• The transaction was structured in similar fashion
  to the listed transaction described by the
  Internal Revenue Service (IRS) in Notice
  2001-17, 2001-1 C.B. 730. The transaction
  involved the centralization of the management and
  administration of the taxpayers employee and
  retiree healthcare benefit plans in a separate
  subsidiary.
• BD and certain of its subsidiaries exchanged
  cash of approximately 561 million for stock in a
  separate subsidiary, Black Decker Healthcare
  Management, Inc. (BDHMI), and the assumption by
  BDHMI of certain employee and retiree healthcare
  liabilities with a value of 560 million.
• BD and its subsidiaries later sold stock in
  BDHMI in an arms length sale to an independent
  third-party for 1 million.
• BD claimed a 560 million capital loss, based on
  the position that the cost basis of the BDHMI
  shares (i.e., 561 million) was unreduced by the
  contingent liabilities assumed by BDHMI.

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Recent Tax Shelter CasesBlack Decker
Corporation v. United StatesArguments

• The government argued that the transaction was
  merely a tax avoidance vehicle that must be
  disregarded for tax purposes.
• BD argued that the transaction had economic
  substance, that its basis in the BDHMI stock was
  561 million, and that it realized a bona fide
  capital loss of 560 million on the sale of the
  BDHMI stock. BD conceded, for purposes of the
  motion for summary judgment, that tax avoidance
  was its sole motivation for the transaction.

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Recent Tax Shelter CasesBlack Decker
Corporation v. United StatesOutcome

• The United States District Court for the District
  of Maryland granted summary judgment in favor of
  BD and upheld BDs 560 million capital loss.
  The court held that the transaction could not
  be disregarded as a sham and concluded that the
  transaction had very real economic implications
  for the beneficiaries of BDs employee benefits
  programs, BD, and BDHMI.
• The court applied the Fourth Circuits sham
  transaction doctrine. In support of its
  analysis, the court reasoned that "a corporation
  and its transactions are objectively reasonable,
  despite any tax-avoidance motive, so long as the
  corporation engages in bona fide
  economically-based business transactions."

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Recent Tax Shelter CasesBlack Decker
Corporation v. United StatesEvidence of
Objective Economic Substance

• The court found the following facts as evidence
  of the objective economic substance of BDs
  transaction
• BDHMI assumed the responsibility for the
  management, servicing, and administration of
  plaintiff's employee and retiree health plans
• BDHMI considered and proposed numerous healthcare
  cost containment strategies since its inception,
  many of which have been implemented by BD
• BDHMI has always maintained salaried employees
  and
• BDHMI became responsible for paying the
  healthcare claims of BDs employees and such
  claims are paid with BDHMIs assets.

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Recent Tax Shelter CasesColtec Industries, Inc.
v. United StatesFacts

• The transaction was structured in similar fashion
  to the transaction at issue in Black Decker.
• Coltec and its subsidiary, Garlock, transferred
  cash, stock of a related company, and an
  intercompany note to a newly-created subsidiary,
  Garrison, in exchange for Garrisons assumption
  of contingent asbestos litigation liabilities
  valued at 371 million and Garrison stock.
  Garrison was formed for the purpose of managing
  the contingent asbestos liabilities.

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Recent Tax Shelter CasesColtec Industries, Inc.
v. United StatesFacts (continued)

• Coltec then sold the Garrison stock received by
  Garlock in the exchange to Nationsbank and First
  Union to establish the market price of the stock
  for subsequent sales to service providers. These
  sales included put and call rights
  exercisable after five years the options were
  never exercised, and have expired.
• Coltec claimed 370 million in capital losses
  from these stock sales.
• Two years later, Coltec sold additional stock in
  Garrison to a select group of lawyers involved in
  defending its asbestos claims to provide these
  lawyers an additional performance incentive.

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Recent Tax Shelter CasesColtec Industries, Inc.
v. United StatesArguments

• The government argued that (1) Garrisons
  assumption of the liabilities reduced Garlocks
  basis in the Garrison stock because the principal
  purpose for Garrisons assumption of the
  liabilities was not a bona fide non-tax business
  purpose (2) no sale of the Garrison stock
  occurred because the put and call options negated
  any transfer of beneficial ownership to the
  banks and (3) the transactions lacked economic
  substance.
• Coltec argued that (1) the Code did not require
  a reduction in Garlocks basis in the Garrison
  stock for the contingent liabilities transferred
  to Garrison (2) Garlocks transfer of Garrison
  stock to the banks was a sale (3) no separate
  business purpose was required for the sale of
  Garrison stock to the banks and (4) the
  transactions had economic substance and were not
  shams because the Garrison transaction had a
  legitimate business purpose.

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Recent Tax Shelter CasesColtec Industries, Inc.
v. United StatesOutcome

• The Court of Federal Claims upheld Coltecs 370
  million capital loss, holding that Coltec had
  satisfied all of the statutory requirements for
  claiming a capital loss from the stock sale
  (including the tests of section 357(b)).
• The court declined to apply the economic
  substance doctrine so as to trump Coltecs
  compliance with the Code. Citing Gitlitz v.
  Commissioner, 531 U.S. 206 (2000), and United
  States v. Bynum, 408 U.S. 125 (1972).
• The court determined that Coltecs basis in the
  Garrison stock that was sold to Nationsbank and
  First Union should not be reduced by the amount
  of the contingent asbestos liabilities
  transferred to the subsidiary.

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Recent Tax Shelter CasesColtec Industries, Inc.
v. United StatesOutcome

• The court held that contingent liabilities are
  not liabilities for purposes of reducing basis
  under section 358(d).
• The court stated that even if section 358(d)
  applied to the liabilities, section 357(c)(3)
  would preclude the liabilities from reducing
  basis because they would give rise to a
  deduction. The court relied upon the analysis
  of section 357(c)(3) in Black Decker, which
  concluded that there was no authority to limit
  the application of section 357(c)(3) only to
  situations where the liabilities would give rise
  to a deduction to the transferee (as opposed to
  the transferor).
• The court also held that section 357(b) did not
  apply to reduce Coltecs basis in the Garrison
  stock, because there was a valid business purpose
  for the assumption of the liabilities. In
  determining that there was a valid business
  purpose, the court relied upon the testimony of
  Coltec employees as to the non-tax purposes of
  the transaction.

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Recent Tax Shelter Cases TIFD-III-E, Inc.
(Castle Harbour) v. United States Facts

• In the early 1990s, General Electric Capital
  Corporation (GECC) sought to reduce the risk
  associated with its aircraft leasing business.
• GECC formed a limited liability company (LLC),
  Summer Street, that was owned by three of its
  subsidiaries, TIFD III-E, TIFD III-M, and GE
  Capital AG. GECC, through the subsidiaries,
  contributed the following to Summer Street
  aircraft worth 530 million, subject to 258
  million nonrecourse debt (net 272 million) 22
  million in receivables 296 million in cash and
  100 of the stock of another of its subsidiaries,
  TIFD VI (valued at 0).
• TIFD III-E, TIFD III-M, and GE Capital AG sold
  interests in Summer Street worth 50 million to
  two foreign banks, ING Bank and Rabo Merchant
  Bank (collectively, the Banks). This sale
  constituted a sale of 100 of GE Capital AGs
  interest in Summer Street. The Banks contributed
  an additional 67.5 million to Summer Street,
  bringing their total investment to 117.5
  million.

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Recent Tax Shelter Cases TIFD-III-E, Inc.
(Castle Harbour) v. United States Facts
(continued)

• Summer Streets name was then changed to Castle
  Harbour - I LLC (Castle Harbour).
• As a result of these transactions, TIFD III-E and
  TIFD III-M owned a combined interest in Castle
  Harbour of approximately 82 percent, and the
  Banks owned a combined interest of approximately
  18 percent.
• Under the terms of the partnership agreement, 98
  percent of the operating income of the
  partnership was allocated to the Banks.
  Operating income was comprised of income less
  expenses. Depreciation of the airplanes and
  certain guaranteed payments to the GE entities
  were treated as expenses that reduced operating
  income repayments of principal on the airplane
  debt were not. Since the aircraft owned by Castle
  Harbour had already been fully depreciated for
  tax purposes prior to their contribution to the
  partnership, only book depreciation
  significantly reduced operating income.

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Recent Tax Shelter Cases TIFD-III-E, Inc.
(Castle Harbour) v. United States Facts
(continued)

• Disposition gains and losses from sales or
  distributions of assets were allocated as
  follows (1) they offset prior disposition
  losses/gains and/or prior operating income/loss
  (2) 90 percent of the remainder of any gain or
  loss was allocated to the Banks, subject to a
  specified limit of approximately 3 million and
  (3) if the limit was reached, then 99 percent of
  the balance was allocated to the GE entities, and
  one percent was allocated to the Banks.
• In each year, a substantial part of the income
  received by the Banks was used to buy down
  portions of the Banks interests, thus decreasing
  their capital accounts. The goal of GE and the
  Banks was to liquidate the Banks interests in
  Castle Harbour over eight-years.
• The expectation of the parties was that the Banks
  would earn an internal rate of return of just
  over 9.
• The partnership allocations reduced GECCs tax
  liability with respect to operating income by
  62.2 million over the life of the partnership.

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Recent Tax Shelter Cases TIFD-III-E, Inc.
(Castle Harbour) v. United States Arguments

• The government argued that the allocation of
  Castle Harbours income to the Banks should be
  disallowed on three grounds (1) the overall
  transaction lacked economic substance (2) the
  Banks should be treated as lenders, not partners,
  for tax purposes and, therefore, partnership
  income could not be allocated to them and (3)
  the manner in which the partnership income was
  allocated violated the overall tax effect rule
  of section 704(b).
• GECC maintained that Castle Harbour was a real
  partnership, established for legitimate, non-tax
  business reasons.

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Recent Tax Shelter Cases TIFD-III-E, Inc.
(Castle Harbour) v. United StatesOutcome

• The United States District Court for the District
  of Connecticut granted judgment in favor of the
  taxpayer for 62.2 million.
• The court held in favor of the taxpayer on each
  of the arguments raised by the government,
  concluding that although the transaction
  sheltered a great deal of income from taxes it
  was legally permissible.
• The court found that the formation of the
  partnership had economic substance under the
  Second Circuit Court of Appeals sham transaction
  standard, because it had real non-tax economic
  effects and a non-tax business purpose.
• The court held that GECC had a legitimate
  business purpose for the transaction -- to raise
  additional capital, and to demonstrate to
  investors, rating agencies, and GECC senior
  management that it could raise capital on its
  aging aircraft.

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Recent Tax Shelter Cases TIFD-III-E, Inc.
(Castle Harbour) v. United StatesOutcome
(continued)

• The Banks contributed substantial amounts of cash
  to the partnership, which was used to purchase
  aircraft and retire debt, thus establishing a
  real economic effect to the transaction.
• The court declined to decide whether to apply the
  economic substance test advanced by the taxpayer,
  i.e. that if the transaction had either a
  subjective business purpose or an objective
  economic effect, the transaction should be
  respected for tax purposes, or the test advocated
  by the government, i.e. a flexible standard
  where both factors should be considered but
  neither factor is dispositive. Instead, the
  court determined that the transaction had both a
  non-tax economic effect and a non-tax business
  motivation and so would pass the economic sham
  test under either approach.

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Recent Tax Shelter Cases TIFD-III-E, Inc.
(Castle Harbour) v. United StatesEvidence of
Economic Substance

• Castle Harbour received an economically real,
  up-front payment of 117 million from the Banks
  
• The Banks participated in the economically real
  upside potential of the aircraft leasing
  business, despite provisions in the operating
  agreement that apparently guaranteed them a
  certain minimum level of return on their
  investment
• The arrangement allowed GECC to retire some of
  its commercial paper, thus reducing its
  debt-to-equity ratio.

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Recent Tax Shelter CasesSanta Monica Pictures
v. CommissionerFacts

• After Metro-Goldwyn Mayer (MGM) was sold to the
  highest bidder, two individuals and their related
  entities (collectively, the Ackerman Group)
  attempted to acquire MGMs parent company, Santa
  Monica Holding Corporation (SMHC), which was
  owned by the creditors of MGM, the Credit
  Lyonnais group (CL Group).
• SMHC had no valuable assets, and owed
  approximately 1 billion to the CL Group. CL
  Group also owned stock in SMHC. CL Groups tax
  basis in the SMHC debt was approximately 1
  billion, and its basis in the SMHC stock was
  approximately 665 million.
• The Ackerman Group (AG) formed an LLC, SMP. The
  CL Group contributed the SMHC debt and the SMHC
  stock to SMP in exchange for preferred interests
  in SMP and 5 million cash. The CL Group
  acquired a put right, exercisable within five
  years, with respect to its SMP interests. The
  put required the AG to purchase the CL Groups
  interest for 5 million, and the parties entered
  into a deposit account agreement that required
  the 5 million purchase price to be placed in a
  blocked account to be released when the put was
  exercised.

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Recent Tax Shelter CasesSanta Monica Pictures
v. CommissionerFacts (continued)

• At the earliest opportunity, i.e., just three
  weeks after the CL Group made its contribution to
  SMP, the CL Group exercised its put rights and
  received 5 million from the AG for its interest
  in SMP.
• Under the partnership rules, the AG claimed a 1
  billion basis in the SMHC debt held by SMP, and
  claimed a basis of 665 million in the SMHC
  stock.
• In 1997, SMP sold 150 million of the almost 1
  billion debt it held to TroMetro, an LLC formed
  by a long-time associate of one of the
  individuals who controlled the AG, for
  approximately 2.5 million. SMP claimed a loss
  of approximately 147.5 million on the sale on
  its 1997 return.
• In 1998, SMP sold another 81 million of the debt
  it held to TroMetro for 1.4 million (i.e., cash
  of 150,000 and a TroMetro note). SMP claimed a
  loss of approximately 80 million on the sale on
  its 1998 tax return.

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Recent Tax Shelter CasesSanta Monica Pictures
v. CommissionerFacts (continued)

• TroMetro and SMHC entered into a distribution
  agreement with respect to the film library held
  by SMHC. SMHC reported no income from this
  arrangement.
• One of the individuals who controlled the AG was
  on the board of directors of Imperial Bank
  (Imperial). In 1997, Imperial realized
  significant capital gains from the sale of two of
  its financial services companies it was looking
  for losses to offset these gains.
• In November of 1997 the AG formed Corona Film
  Finance Fund, LLC (Corona). SMP contributed
  250,000 cash and a 79 million receivable in
  exchange for a 99 interest in Corona.
• On December 15, 1997, Imperial purchased a 79
  interest in Corona from SMP for 1.25 million,
  and Imperials agreement to pay SMP a fee of 20
  of the tax losses received from Corona. SMP
  claimed a capital loss of 62 million on the sale
  of the Corona interest to Imperial on its 1997
  tax return.

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Recent Tax Shelter CasesSanta Monica Pictures
v. CommissionerFacts (continued)

• On December 23, 1997, Imperial purchased an
  additional 14.65 interest in Corona from SMP for
  approximately 200,000. SMP claimed a capital
  loss of 11.6 million on the sale of the second
  Corona interest to Imperial on its 1997 tax
  return.
• Also in December of 1997, Corona sold the 79
  million receivable contributed by SMP to TroMetro
  for 1.1 million (i.e., 120,000 cash and a
  note). Corona reported a loss of 78 million on
  its return for 1997. Approximately 74 million
  of this loss flowed through to Imperial 4
  million flowed through to SMP and its owners.
• In accordance with the original agreement between
  Imperial and SMP and as a result of the 74
  million loss realized by Imperial, Imperial
  contributed 14.5 million cash (i.e.,
  approximately 25 of the amount of the tax loss)
  to Corona SMP then received the cash.

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Recent Tax Shelter CasesSanta Monica Pictures
v. CommissionerArguments

• The government argued that under substance over
  form principles, i.e. the economic substance and
  the step transaction doctrines, the transactions
  should be recast as direct sales of the high
  basis, low value assets (i.e., the receivables
  and the SMHC stock) by the CL Group to the AG,
  resulting in no transfer of built-in losses to
  SMP and no flow-through of those losses to the
  Ackerman Group.
• The government argued in the alternative that, if
  the form of the transaction was respected, the
  capital losses would still be disallowed because
  SMPs tax basis in the SMHC receivables was zero,
  because the receivables were worthless at the
  time they were contributed to SMP by the CL
  Group.
• The government did not challenge the status of
  SMP and Corona as bona fide partnerships.
• The taxpayer argued that SMP succeeded to the CL
  Groups high bases in the receivables and the
  SMHC stock when those assets were contributed to
  SMP, and that subsequent transfers of the
  receivables generated real losses. The taxpayer
  argued that the form of the transactions should
  be respected, because the parties had valid,
  non-tax business reasons for engaging in the
  transactions.

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Recent Tax Shelter CasesSanta Monica Pictures
v. CommissionerOutcome

• The Tax Court disallowed the capital losses
  claimed on the sales of receivables, holding that
  SMP and Corona never had any basis in the
  receivables. The court concluded that (1) the
  contribution to SMP of receivables and SMHC stock
  by the CL Group lacked economic substance and
  cannot be respected for tax purposes (2) SMP
  obtained no basis in the receivables contributed
  by the CL Group because the receivables were
  worthless or did not represent bona fide
  indebtedness and (3) the Corona transaction
  lacked economic substance.
• The court concluded that the exclusive purpose
  for the formation of SMP was to transfer to the
  AG enormous tax attributes associated with the
  high-basis, low value receivables and SMHC stock.
  

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Recent Tax Shelter CasesSanta Monica Pictures
v. CommissionerOutcome (continued)

• The court concluded, based on economic
  realities, that the CL Group entities did not
  become partners in SMP, but sold their
  high-basis, low value assets to the AG for 10
  million.
• In analyzing the objective economic substance of
  the transaction, the court found that the put
  right the CL Group obtained, and the CL Groups
  exercise of that right on the earliest date
  possible, negated any economic significance that
  might otherwise have attached to the CL Groups
  joining SMP.
• In analyzing the objective economic substance of
  the transaction, the court found that the AGs
  up-front payment of 5 million to the CL Group
  for its contribution of assets (i.e., receivables
  and SMHC stock) to SMP and the additional 5
  million promised upon exercise of the put option
  far exceeded the value of the contributed assets,
  and that the AG had no reasonable expectation of
  recouping the 10 million.

35
Recent Tax Shelter CasesSanta Monica Pictures
v. CommissionerOutcome (continued)

• The court assigned minimal value to the SMHC
  stock contributed by the CL Group, concluded that
  certain securities owned by SMHC (the Carolco
  securities) had no value and concluded that
  unused net operating losses of SMHC had little or
  no value.
• With respect to the governments step transaction
  arguments under the end result and
  interdependence tests, the court stated
  whether this contention is viewed as an
  alternative argument, or merely as a
  particularization of the governments substance
  over form argument, the results are identical We
  disregard the CL Groups purported contribution
  to SMP. Nonetheless, for the sake of
  completeness, the court went through a step
  transaction analysis and concluded that the CL
  Groups contributions of SMHC receivables and
  SMHC stock to SMP and the AGs purchase of the CL
  Groups interest in SMP three weeks later should
  be recast as (1) direct sales of the SMHC
  receivables and SMHC stock from the CL Group to
  the AG, followed by (2) the AGs contribution of
  the SMHC assets to SMP.

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Recent Tax Shelter CasesSanta Monica Pictures
v. CommissionerOutcome (continued)

• The court addressed the governments alternative
  argument that SMP had a zero basis in the SMHC
  receivables contributed by the CL Group because
  those receivables were worthless, and held that
  the receivables were worthless and, thus, did not
  constitute a contribution of property to SMP.
• The court addressed the governments alternative
  argument that SMP had a zero basis in one of the
  SMHC receivables contributed by the CL group
  because that receivable did not arise out of a
  bona fide debtor/creditor relationship, and
  concluded that the debt was not bona fide debt.
• The court concluded that, in light of the fact
  that SMP had a zero basis in the SMHC assets, the
  contribution of those assets to Corona was
  devoid of business purpose and economic
  substance.
• The court rejected the governments argument that
  the sales of receivables to TroMetro should be
  recast as sales by SMP of an option to receive an
  equity interest in SMHC. However, the court
  noted that this conclusion did not ultimately
  affect its decision because the court had
  already reached the conclusion (on other grounds)
  that SMP had no basis in the SMHC receivables.

37
Recent Tax Shelter CasesSanta Monica Pictures
v. CommissionerEvidence of Lack of Business
Purpose

• The CL Group had no intention of
  producing/distributing films with the AG the AG
  had no experience in running a film distribution
  business the CL Group contributed the film
  assets to SMHC and knew they were of little
  value and the parties did not actively negotiate
  over the particulars re the film business.
• The AG was clearly interested in the tax
  attributes the CL Group had in the MGM companies,
  and its due diligence activities were focused
  almost entirely on obtaining assurances regarding
  the CL Groups high basis in the receivables and
  the SMHC stock.
• The AG faxed a Wall Street Journal article to its
  counsel that described a transaction similar to
  the proposed transaction, with a note that the
  article gives good support for our business
  purpose for doing the deal.

38
Recent Tax Shelter CasesSanta Monica Pictures
v. CommissionerMisstatement and Negligence
Penalties

• The court sustained the section 6662(h) penalty
  for gross valuation misstatements, based on its
  determination that SMP had a zero basis in the
  receivables contributed by the CL Group,
  concluding that SMPs and Coronas claimed basis
  was infinitely more than 400 percent of the
  amount that the court determined to be the
  correct basis in the receivables.
• The court also sustained the section 6662(a)(1)
  negligence penalty, observing that the principal
  of the AG who personally engineered the plan to
  transfer built-in losses was a highly educated,
  sophisticated tax attorney who had worked at a
  major law firm, at the Tax Court, and at Treasury.

39
Recent Tax Shelter CasesSanta Monica Pictures
v. CommissionerSubstantial Understatement Penalty

• The court sustained the section 6662(a)(2)
  substantial understatement penalty, holding that
  the taxpayer cited no substantial authority for
  its position.
• The court held that the transaction at issue was
  a tax shelter for purposes of section
  6662(d)(2)(C)(iii) since it concluded that the
  transaction between the CL Group and the AG
  lacked economic substance and, thus, that the
  taxpayer must demonstrate reasonable belief to
  prevail.
• The court concluded that none of the opinions
  purportedly relied upon by the taxpayer reached a
  more likely than not conclusion, and that the
  taxpayer did not reasonably rely on such opinions.

40
Recent Tax Shelter CasesSanta Monica Pictures
v. CommissionerSubstantial Understatement Penalty

• The court analyzed separately each piece of
  advice the taxpayer claimed to have relied upon,
  which included eight legal and accounting
  memoranda, and determined that none of the
  memoranda provided reasonable cause.
• The courts complaints with the opinions were
  that they
• misrepresented the facts of the actual
  transactions
• assumed certain incorrect facts, e.g. that there
  was a business purpose for the transactions, that
  the taxpayer knew were untrue
• were based on dubious appraisals of assets and
• analyzed legal issues that were irrelevant to the
  case.

41

• WHAT TAXPAYERS AND THEIR ADVISORS NEED TO KNOW
  ABOUT THE AMERICAN JOBS CREATION ACT (AJCA)

42
American Jobs Creation Act (AJCA) Disclosure
Penalties Section 6707A

• New section 6707A imposes a penalty for failing
  to disclose a tax shelter transaction.
• The amount of the penalty is 10,000 for
  individuals, and 50,000 for all other taxpayers
  for reportable transactions and 100,000 for
  individuals and 200,000 all other taxpayers for
  listed transactions.
• Treasury has the authority to define reportable
  and listed transactions in regulations under
  section 6011.
• The penalty applies to any taxpayer who
  participates in a reportable transaction. A
  taxpayer is a participant in a reportable
  transaction if his tax return reflects the tax
  benefit of the reportable transaction.
• The section 6707A penalty applies regardless of
  whether the reportable transaction results in an
  understatement of tax.

43
American Jobs Creation Act (AJCA) Disclosure
Penalties Section 6707A (continued)

• The section 6707A penalty, effective for returns
  and statements the due date for which is after
  October 22, 2004, applies in addition to any
  accuracy-related penalties.
• The section 6707A penalty cannot be waived for
  failing to report a listed transaction, but
  the taxpayer can argue that the transaction was
  not a substantially similar transaction.
• However, Notice 2005-11 grants the IRS authority
  to rescind the penalty for failing to disclose a
  reportable transaction (other than a listed
  transaction) based upon (1) Whether the taxpayer
  has a history of complying with the tax laws (2)
  Whether the violation is due to an unintentional
  mistake of fact and (3) Whether imposing the
  penalty would be against equity and good
  conscience
• There is no judicial review of the Commissioners
  determination whether to rescind the section
  6707A penalty.

44
American Jobs Creation Act (AJCA) Disclosure
Penalties Section 6707A (continued)

• Certain taxpayers have to disclose the payment of
  certain penalties to the Securities and Exchange
  Commission (SEC).
• The penalties which trigger this new reporting
  obligation are the section 6707A penalty for
  failure to disclose, the section 6662A penalty
  for an understatement attributable to an
  undisclosed listed transaction or undisclosed
  reportable avoidance transaction, and the 40
  percent penalty under section 6662 for gross
  valuation misstatements if the 30 percent penalty
  under section 6662A would have applied.
• Note that the failure to make the disclosure to
  the SEC as just described is itself treated as a
  failure to include information with respect to a
  listed transaction for which the penalty under
  section 6707A applies.

45
American Jobs Creation Act (AJCA) Disclosure
Penalties Section 6707A (continued)

• Reportable transactions include six different
  types of transactions.
• Listed Transactions
• Confidential Transactions for which the taxpayer
  has paid an advisor a minimum fee (i.e., 250,000
  for corporations, and 50,000 for other
  taxpayers)
• Transactions with Contractual Protection
• Loss Transactions - A transaction that results in
  a loss of 10 million or more in a single taxable
  year for corporations, or 20 million or more in
  multiple years
• Transactions with a Significant Book-Tax
  Difference - Transactions with a book-tax
  difference of more than 10 million on a gross
  basis in any taxable year are considered
  significant for these purposes and
• Transactions Involving a Brief Asset Holding
  Period - Transactions are reportable if there is
  a tax credit claimed that exceeds 250,000, and
  the asset giving rise to the credit is held for
  45 days or less.

46
American Jobs Creation Act (AJCA) Disclosure
Penalties Section 6707A (continued)

• The two types of reportable transactions that
  most large corporations will face are loss
  transactions and transactions involving
  significant book-tax differences.
• For tax years ending on or after December 31,
  2004, if a corporate taxpayer is required to file
  the new Schedule M-3, the reporting of book-tax
  differences is deemed to be satisfied by the
  filing of that completed schedule.
• If the Schedule M-3 is filed with the return, it
  does not also have to be filed with OTSA.
• If, however, the transaction has significant
  book-tax differences and falls within another
  category of reportable transactions (for example,
  it is substantially similar to a listed
  transaction or involves a substantial loss), then
  it would not only be reported on Schedule M-3,
  but would have to be reported on a Form 8886
  filed with the return. A copy of the Form 8886
  would then have to be filed with OTSA.

47
American Jobs Creation Act (AJCA) Accuracy-
Related Penalties Section 6662A

• In general, section 6662A provides that a
  20-percent accuracy-related penalty may be
  imposed on any reportable transaction
  understatement.
• A reportable transaction understatement means
• The amount of the increase in taxable income
  which results from a difference between the
  proper tax treatment of an item and the
  taxpayers treatment of such item (as shown on
  the taxpayers return), multiplied by the highest
  rate of tax imposed by section 1 (section 11 for
  corporations) plus
• The amount of decrease in the aggregate amount of
  credits determined under subtitle A which results
  from a difference between the taxpayers
  treatment of an item to which section 6662A
  applies (as shown on the taxpayers return) and
  the proper tax treatment of such item.

48
American Jobs Creation Act (AJCA) Accuracy-
Related Penalties Section 6662A (continued)

• Section 6662A applies to any listed transaction
  and any reportable transaction (other than a
  listed transaction) if a significant purpose of
  such transaction is the avoidance or evasion of
  Federal income tax.
• The section 6662A penalty applies to any increase
  in taxable income resulting from certain
  reportable transactions regardless of the amount
  of the unreported tax liability. This means that
  it applies even if the taxpayer is in a net
  operating loss position.
• The amount of the section 6662A penalty is 30
  percent, rather than 20 percent, if the taxpayer
  does not adequately disclose the relevant facts
  affecting the tax treatment of the item giving
  rise to the understatement.

49
American Jobs Creation Act (AJCA) Accuracy-
Related Penalties Section 6662A (continued)

• The reasonable cause and good faith defense is
  not available with respect to the 30-percent
  penalty.
• Tax treatment on an amended return or a
  supplement to a return is not taken into account
  if the amended return or the supplement is filed
  after the earlier of the date the taxpayer is
  first contacted by the IRS regarding an
  examination of the return, or any other date
  specified by the Secretary.
• In general, the section 6662A accuracy-related
  penalty does not apply to any portion of a
  reportable transaction understatement if,
  pursuant to section 6664(d), it is shown that
  there was reasonable cause and the taxpayer acted
  in good faith.

50
American Jobs Creation Act (AJCA) Accuracy-
Related Penalties Section 6662A (continued)

• The reasonable cause and good faith exception
  does not apply unless
• The relevant facts affecting the tax treatment of
  the item are adequately disclosed
• There is or was substantial authority for such
  treatment and
• The taxpayer reasonably believed that such
  treatment was more likely than not the proper
  treatment. Section 6664(d)(2).
• Under section 6664(d)(2), the requirement to
  disclose adequately under section 6011 will be
  treated as satisfied even if the taxpayer did not
  in fact disclose if the section 6707A penalty is
  rescinded.

51
American Jobs Creation Act (AJCA) Accuracy-
Related Penalties Section 6662A (continued)

• The opinion of a tax advisor may not be relied
  upon to establish reasonable belief if either the
  tax advisor or the opinion is disqualified.
• A tax advisor is a disqualified tax advisor if
• The advisor is a material advisor and
  participates in the organization, management,
  promotion, or sale of the transaction, or is
  related to any person who so participates
• The advisor is compensated directly or indirectly
  by a material advisor with respect to the
  transaction
• The advisor has a fee arrangement with respect to
  the transaction which is contingent on the
  intended tax benefits from the transaction being
  sustained or
• By regulations, the advisor has a disqualifying
  financial interest in the transaction.

52
American Jobs Creation Act (AJCA) Accuracy-
Related Penalties Section 6662A (continued)

• An opinion is a disqualified opinion if
• The opinion is based on unreasonable factual or
  legal assumptions (including assumptions about
  future events)
• The opinion unreasonably relies on
  representations, statements, findings, or
  agreements of the taxpayer or any other person
• The opinion does not identify and consider all
  relevant facts or
• The opinion fails to meet other requirements
  prescribed by the Secretary.

53
American Jobs Creation Act (AJCA) Accuracy-
Related Penalties Notice 2005-12

• Notice 2005-12 provides interim guidance on
  implementing section 6662A and the revisions to
  sections 6662 and 6664.
• For purposes of determining whether the 30
  percent penalty applies, the taxpayer will be
  treated as disclosing the relevant facts
  affecting the tax treatment of the item under
  section 6011 if the taxpayer filed a disclosure
  statement under Treas. Reg. 1.6011-4(d), is
  deemed to have satisfied its disclosure
  obligation under Rev. Proc. 2004-45, 2004-31
  I.R.B. 140, or satisfies the requirements set
  forth in any other published guidance regarding
  disclosure under section 6011.
• For purposes of determining the amount of any
  reportable transaction understatement, the IRS
  will not take into account amended returns filed
  after the dates specified in Treas. Reg.
  1.6664-2(c)(3) and Notice 2004-38, 2004-21
  I.R.B. 949, which are dates after which a
  taxpayer may not file a qualified amended
  return.

54
American Jobs Creation Act (AJCA) Accuracy-
Related Penalties Notice 2005-12 (continued)

• Notice 2005-12 also provides interim guidance on
  when a material advisor is a disqualified tax
  advisor.
• A material advisor participates in the
  organization of a transaction if the advisor
  devises, creates, investigates, or initiates the
  transaction or tax strategy devises the business
  or financial plans for the transaction or tax
  strategy carries out those plans through
  negotiations or transactions with others or
  performs acts related to the development or
  establishment of the transaction.
• A material advisor participates in the
  management of a transaction if the material
  advisor is involved in the decision-making
  process regarding any business activity with
  respect to the transaction.
• A material advisor participates in the promotion
  or sale of a transaction if the material advisor
  is involved in the marketing of the transaction,
  including soliciting taxpayers to enter into a
  transaction or tax strategy placing an
  advertisement for the transaction or instructing
  or advising others in the marketing of the
  transaction.

55
American Jobs Creation Act (AJCA) Accuracy-
Related Penalties Notice 2005-12 (continued)

• Notice 2005-12 provides that a tax advisor,
  including a material advisor, will not be treated
  as participating in the organization, management,
  promotion, or sale of a transaction if the
  advisors only involvement in the transaction is
  rendering an opinion regarding the tax
  consequences of the transaction.
• Notice 2005-12 also defines when a tax advisor
  will have a disqualified compensation
  arrangement. Until further guidance, a tax
  advisor is treated as a disqualified tax advisor
  if the tax advisor has a referral fee or
  fee-sharing arrangement by which the advisor is
  compensated directly or indirectly by a material
  advisor. This rule applies regardless of whether
  or not the tax advisor is a material advisor.
• An arrangement is a disqualified compensation
  arrangement if there is an agreement or
  understanding (oral or written) with a material
  advisor of a reportable transaction pursuant to
  which the tax advisor is expected to render a
  favorable opinion regarding the tax treatment of
  the transaction to any person referred by the
  material advisor.

56
American Jobs Creation Act (AJCA) Material
Advisor Rules - Changes

• The AJCA made the following changes to the rules
  applicable to material advisors
• Section 6111(a) was amended to require each
  material advisor with respect to a reportable
  transaction to make a return (in such form as the
  Secretary may prescribe) setting forth
  information identifying and describing the
  transaction information describing any potential
  tax benefits expected to result from the
  transaction and such other information as the
  Secretary may prescribe.
• Section 6111(b) 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 (or such other
  amount as may be prescribed by the Secretary) for
  such advice or assistance. (The threshold
  amounts are 50,000 in the case of a reportable
  transaction substantially all of the tax benefits
  from which are provided to natural persons, and
  250,000 in any other case).

57
American Jobs Creation Act (AJCA) Material
Advisor Rules

• Section 6111(c) confers authority to issue
  regulations which provide
• That only one person shall be required to satisfy
  the section 6111 requirements in cases in which
  two or more persons would otherwise be required
  to meet such requirements
• Exemptions from the requirements of the section
  and
• Such rules as may be necessary or appropriate to
  carry out the purposes of the section.
• Section 6112 provides that each material advisor
  with respect to any reportable transaction is
  required to maintain a list identifying each
  person with respect to whom such advisor acted as
  a material advisor with respect to such
  transaction and containing such other
  information as the Secretary may by regulations
  require.
• Section 6708 provides a penalty of 10,000 per
  day, which is applicable to a material advisor
  who fails to provide the list that is required to
  be maintained under section 6112 within the
  prescribed time frame.

58
American Jobs Creation Act (AJCA) Material
Advisor Rules - Guidance

• Notice 2004-80 provides interim guidance
  regarding disclosures by a material advisor and
  the maintenance of lists by material advisors.
• Notice 2005-17 provides an extension of the
  transition relief outlined in Notice 2004-80.
• Notice 2005-22 provides additional interim
  guidance to material advisors, including advice
  regarding, among other things
• How to complete IRS Form 8264, and when it must
  be filed and
• Determining the point at which an advisor becomes
  a material advisor.

59
American Jobs Creation Act (AJCA) Section
6501(c)(10)

• New section 6501(c)(10) changes the statute of
  limitations for listed transactions by providing
  that if a taxpayer fails to include on any return
  or statement for any taxable year any information
  with respect to a listed transaction which is
  required under section 6011, the time for
  assessment of any tax imposed with respect to
  such transaction shall not expire before the date
  which is 1 year after the earlier of
• the date on which the taxpayer furnishes the
  required information to the Secretary, or
• the date that a material advisor provides
  required information relating to such transaction
  with respect to such taxpayer.
• New section 6501(c)(10) focuses on disclosure.
  The statute of limitations is only extended if
  (1) the taxpayer has not disclosed the
  transaction under section 6011 and (2) the
  material advisor has failed to fulfill its
  disclosure obligation.
• Revenue Procedure 2005-26 provides additional
  guidance on section 6501(c)(10).

60
American Jobs Creation Act (AJCA) Section 6404(g)

• The AJCA amended the circumstances under which
  interest which otherwise would have been
  suspended by operation of section 6404(g) is not
  suspended.
• In general, section 6404(g) provides that, in
  certain circumstances, where the Secretary does
  not provide a notice to the taxpayer specifically
  stating the taxpayers liability and the basis
  for the liability before the close of the 18
  month period beginning on the later of the date
  on which the return is filed or the due date of
  the return without regard to extensions, the
  Secretary suspends the imposition of interest
  (and other additional amounts) related to the
  suspension period.
• Prior to the changes in the AJCA, interest would
  be suspended on certain listed transactions if
  they were not otherwise in a category defined in
  section 6404(g)(2).

61
American Jobs Creation Act (AJCA) Section
6404(g) (continued)

• The AJCA provides that, under section
  6404(g)(2)(D) and (E), any interest, penalty,
  addition to tax, or additional amount will not be
  suspended for amounts
• with respect to any gross misstatement
• with respect to any reportable transaction where
  section 6664(d)(2)(A) is not met and
• with respect to any listed transaction (as
  defined in section 6707A(c)).

62
American Jobs Creation Act (AJCA) Section 163(m)

• Effective for taxable years ending after October
  22, 2004, newly-enacted section 163(m) disallows
  a deduction for any interest payable on an
  underpayment attributable to a reportable
  transaction as defined by section 6662A(b) if the
  requirements of section 6664(d)(2)(A) are not
  met.
• Thus, no interest would be deductible on that
  part of an underpayment attributable to a listed
  transaction or a reportable tax avoidance
  transaction unless reasonable cause can be
  proved.
• Reasonable cause for this purpose requires all
  relevant facts to have been disclosed in
  accordance with the regulations under section
  6011, that there be substantial authority for the
  treatment of the transaction, and that the
  taxpayer reasonably believes that the treatment
  was more likely than not proper.
• This disallowance covers interest on the
  deficiency, interest on any interest payable, and
  interest on any penalty.

63
American Jobs Creation Act (AJCA)Changes to
Section 7525

• The AJCA limits the scope of the section 7525 tax
  practitioner-client privilege for communications
  regarding tax shelters.
• In general, the change in the AJCA broadens the
  scope of the limitation in section 7525(b) from
  communications between a federally authorized tax
  practitioner and a director, shareholder,
  officer, or employee, agent, or representative of
  a corporation (emphasis added) to (A) any
  person, (B), any director, officer, employee,
  agent or representative of that person, or (C)
  any other person holding a capital or profits
  interest in the person where the communication
  is in connection with the promotion of the direct
  or indirect participation of the person in any
  tax shelter (as defined in section
  6662(d)(2)(C)(ii)).

64

• REVISIONS TO
• CIRCULAR 230

65
Revisions to Circular 230Background

• On December 17, 2004, the U.S. Department of the
  Treasury (Treasury) and the IRS published final
  regulations amending Circular 230. These
  regulations were promulgated, in large part, with
  the purpose of curbing the promotion of abusive
  tax shelters. The regulations were revised on
  May 18, 2005, to respond to certain comments by
  practitioners. 70 Fed. Reg. 28,824 (May 19,
  2005). The regulations provide ethical standards
  applicable to practitioners (i.e. attorneys,
  certified public accountants, enrolled agents,
  and enrolled actuaries) who provide written tax
  advice concerning one or more federal tax issues.
  A practitioners failure to comply with these
  regulations could result in the imposition of
  sanctions, which may include censure (public
  reprimand), suspension, disbarment, and/or
  monetary penalties.

66
Revisions to Circular 230Applicability

• The new regulations govern all written tax
  advice, including electronic communications,
  concerning one or more federal tax issues.
  Written tax advice means written advice
  concerning one or more federal tax issues. A
  federal tax issue is a question concerning the
  federal tax treatment of an item of income, gain,
  loss, deduction, or credit, the existence or
  absence of a taxable transfer of property, or the
  value of property for federal tax purposes.
• Written tax advice is subject to one of two sets
  of rules -- the covered opinion rules contained
  in section 10.35, or the other written advice
  rules contained in section 10.37. The rules
  applicable to covered opinions are more
  stringent than the rules applicable to other
  written advice.

67
Revisions to Circular 230Overview of Provisions

• Best Practices - Broadly drafted aspirational
  standards.
• Covered Opinions - Detailed rules applicable to
  written tax advice on one or more federal tax
  issues arising from (1) a listed transaction
  (2) a plan or arrangement the principal purpose
  of which is the avoidance or evasion of federal
  tax or (3) a plan or arrangement a significant
  purpose of which is the avoidance or evasion of
  federal tax, if the written advice is (a) a
  reliance opinion (with a more likely than not, or
  stronger, conclusion) (b) a marketed opinion
  (c) subject to conditions of confidentiality or
  (d) subject to contractual protection (emphasis
  added).
• Other Written Advice - Rules applicable to
  written advice that does not qualify as a
  covered opinion.

68
Revisions to Circular 230Best Practices (Section
10.33)

• The Best Practices standards are aspirational in
  nature. Best practices include the following
• Complying with the standards of practice provided
  in other sections of Circular 230.
• Communicating clearly with the client regarding
  the terms of the engagement, including the form
  and scope of the advice to be rendered.
• Establishing the facts, determining which facts
  are relevant, evaluating the reasonableness of
  any assumptions or representations, relating the
  applicable law (including potentially applicable
  judicial doctrines) to the relevant facts, and
  arriving at a conclusion supported by the law and
  the facts.
• Advising the client regarding the import of the
  conclusions reached, including, for example,
  whether a taxpayer may avoid accuracy-related
  penalties under the Code if a taxpayer acts in
  reliance on the advice.
• Acting fairly and with integrity in practice
  before the IRS.
• Tax advisors in supervisory roles within a tax
  practice are encouraged to take reasonable steps
  to ensure that the tax practices procedures are
  consistent with these best practices.

69
Revisions to Circular 230 Covered Opinions
(Section 10.35)

• The standards of 10.35 apply to Covered
  Opinions. Under the regulations, a covered
  opinion is written advice, including electronic
  communications, concerning one or more federal
  tax issues arising from
• A transaction that is a listed transaction (or
  a transaction that is substantially similar to
  a listed transaction) at the time the advice is
  rendered.
• A partnership or other entity, investment plan or
  arrangement, or any other plan or arrangement the