Corporate Tax Avoidance: The Case of Abusive Tax Shelters

‘if we could measure it, we could tax it.’
Comment of a tax official on measuring tax avoidance

In my continuous search to find interesting links and discussions to TALK TAX readers, I refer today to the discussion surrounding tax shelters. In the last few months, I have dedicated some of my available time to study issues surrounding some recent developments on corporate tax avoidance, such as the discussion on relationship between domestic anti-abuse rules and tax treaties (see for example the post on a recent Canadian Court decision), the discussion surrounding international tax arbitrage (see recent post) and the particular issue of abusive tax shelters. This short note is ultimately designed to address that the so-called tax shelters, which although predominantly a US issue are a growing concern also in other tax systems and internationally.

There is a perplexing number of tax planning techniques that even to a well-trained tax specialist are difficult to grasp. Some of them may in fact rise to the level of being qualified as tax shelters, but others are simply part of acceptable tax planning techniques, which have become a commonplace in a global economy. So the first question is what are tax shelters? and the second is were to draw the line?

Professor Michael Graetz (Yale) once amusingly defined a tax shelter as "a deal done by very smart people that, absent tax considerations, would be very stupid." This entertaining definition already provides some ideas of what is a tax shelter. Basically, one may attempt to further define a tax shelter as a transaction undertaken to secure a tax benefit that may seem, at first sight, acceptable under a literal interpretation of the law, but which the legislator did not envisages and also there is little or no business substance supporting the said transaction.

Although this definition is still far from perfect, there is in it more that meets the eye. For example, the fact that most existing tax shelters are usually “marketed” complex transactions with almost no substance, which involve an indifferent third party, already provides some additional criteria into the discussion. In fact, according to the US Internal Revenue Service, corporate tax shelters have the following characteristics: (i) lack of meaningful economic risk of loss or potential for gain; (ii) inconsistent financial and accounting treatment; (iii) presence of tax-indifferent parties; (iv) complexity; (v) unnecessary steps or novel investments; (vi) promotion or marketing; (vii) confidentiality; (viii) high transaction costs; (ix) risk reduction arrangements.

There is a lot of material available in the IRS website to understand through concrete cases what are tax shelters. For example, the listed abusive tax shelters page provides a possible start for the non-US tax lawyers attempting to enter these dangerous waters. I personally suggest another route and that is to take an example of a very complex tax shelter called Bond Linked Issue Premium Structure (BLIPS), which involves investors taking out bank loans and then shifting them to partnerships to claim tax losses. These transactions (and others) were widely discussed and even subject to an investigation by the US Senate Permanent Subcommittee on 2003, which you may recall focused on the involvement of one of the big four. Instead of reading those endless pages, I would suggest reading an interesting (and shorter) court decision on the BLIPS. In Klamath Streategic investment Fund, LLC v. United States, several interesting issues are discussed, namely: (i) the goal of the transactions; (ii) the involvement of tax advisors; (iii) the (lack of) substance issues; and (iv) the justification of the application of further penalties apart from disregarding the tax implications of the transactions. Another suggestion is listening and reading a brief description of US tax shelters.

As European, my interest is more on how fast some of these “fashions” cross the Atlantic. For example, following the US Regulations on Abusive Tax Shelters and Transactions, the UK introduced in 2004 its own disclosure rules covering tax arrangements concerning employment or certain financial products. These rules were recently (2006) widened to the whole corporate tax. Other countries are probably following with great interest the UK attempt of establishing an efficient reporting regime for tax planning arrangements. I am aware at least of (unsuccessful) attempts to introduce in France a similar regime and an ongoing discussion in Portugal. Apart from the complex regulatory and professional privilege issues that these type of rules involve, there is, I would say, a clear temptation to simply follow the American/UK model (disclose and then we see) without stopping to think what are type of transactions we want to tackle and more importantly whether there are other means more adequate to tackle them (e.g. special anti-abuse rules).

It is interesting to note that the discussion around tax shelters is also turning rather quickly into an international topic of itself. For example, the OECD Seoul Declaration of September 2006 where high ranked tax officials confronted the issue of non-compliance with the tax laws in an international context. Amongst the four areas in which the OECD Countries will intensify work we find: (i) Further developing the directory of aggressive tax planning schemes so as to identify trends and measures to counter such schemes. (ii) Examining the role of tax intermediaries (e.g. law and accounting firms, other tax advisors and financial institutions) in relation to non-compliance and the promotion of unacceptable tax minimization arrangements with a view to completing a study by the end of 2007.

This efforts already lead to the development of a Joint International Tax Shelter Information Centre (JITSIC). The JITSIC was established in 2004 by the tax administrations of four countries, Australia, Canada, the United Kingdom and the United States, to supplement the ongoing work of each of the countries in identifying and curbing abusive tax schemes.

In another front, States are also exploring additional ideas and forms to tackle the issue of tax avoidance, such as through bilateral information exchange agreements based on the OECD Model. It is important to recall that in 2002, the OECD released a model agreement for effective exchange of information in tax matters. The model agreement itself grew out of the work on curbing harmful tax practices, which identified “the lack of effective exchange of information” as one of the key criteria in determining harmful tax practices (see the OECD progress reports issued in 2000, 2001, 2004 and 2006). According to the OECD, a total of, 33 jurisdictions are committed to improve transparency and to establish effective information exchange for tax purposes. As such, it is no surprise to see the OECD congratulating Antigua and Barbuda and Australia for having signed a Tax Information and Exchange Agreement.

All these interesting developments make a life of an international tax lawyer interesting…

Don’t you agree?