Treasury Secretary Lawrence H. Summers on Monday set new rules on corporations and their tax advisors in an effort to curb a boom in abusive tax shelters that he said is costing the government up to $10 billion a year.
The rules come at a time when individuals are paying higher taxes, relative to their incomes, but taxes are claiming a smaller share of corporate profits than they did in the past.
Although it’s impossible to know just how much corporate profit is disappearing into complex shelter arrangements, Summers said the difference between the amount of income that corporations are reporting to their shareholders and the amount they report to the Internal Revenue Service has more than doubled since 1990.
At $90 billion, he said, the gap between corporate “book” income and taxable income is wider than at any time since the mid-1980s.
“Although some of this gap can be attributed to other causes, there is no doubt that there has been a striking growth in abusive tax shelters,” Summers told a meeting of the Federal Bar Assn. here.
The current wave of tax shelters is largely confined to the corporate sector, experts say. It is fueled by tax lawyers, accountants and other financial services providers who have discovered they can command seven-figure fees by devising impenetrably complex financial instruments in which large companies can hide their taxable earnings.
In this new environment, "$100 million is not a large deal,” said Paul J. Sax, a San Francisco tax lawyer who heads the American Bar Assn.'s taxation section. “There are $1-billion deals.”
Typically, promoters sell the new shelters on the pitch that the competition is already doing the same thing, Sax said. “Corporate America is under greater pressure to produce earnings. The odds favor you getting away with this so dramatically that [executives think] you should do it.”
Critics in government and private tax practice worry that the situation will cause widespread cynicism--with consequences that could eventually affect the federal budget.
“Even if [the missing money] is $10 billion a year, that’s not the problem,” Sax said. “When the individual taxpayers hear this is going on, they will be angry, and they will go home and invest in their own tax shelters. We know that the individual taxpayer is very wily when angered.”
And because personal income tax receipts outnumber corporate taxes by about 6 to 1 in America, a revival of small-time tax cheating could significantly affect government revenue flows. Sax recalled that after President Richard Nixon resigned, severely denting confidence in the integrity of the U.S. government, taxes became harder than usual to collect.
“We fear that if headlines [say] that corporate America didn’t pay in 2000, and Congress went along, it would be very bad for the tax system,” Sax said.
Summers warned that one corporate tax shelter in particular, the so-called debt straddle, would no longer be allowed. In a debt straddle, a corporation sets up two debt instruments whose interest rates offset each other under changing economic conditions. The instruments serve no business purpose but generate artificial losses for tax purposes.
Summers also described three regulations that he said would go into effect immediately but might be subject to revision. The rules set new reporting requirements, and attempt to clear up ambiguous language in the tax code that corporate tax advisors have been using to their advantage.
In the future, Summers said, a corporation that engages in a transaction that looks like a tax shelter must attach a separate statement to its tax return, describing the investment. In addition, tax shelter promoters will be required to report any transactions that have the “significant purpose” of avoiding taxes, that are offered to corporations under “confidential” conditions, and that command fees of more than $100,000.
Until now, promoters had to report only investments offered to clients “under conditions of confidentiality.” This meant few tax shelters were reported; corporations and their advisors agreed informally not to talk about the deals, but didn’t make them “confidential” as a matter of law.
Under a third new rule, tax shelter promoters must keep lists of all investors and corporations to whom they have offered assistance for the last seven years, and to open these lists to the IRS when asked. The records will help IRS officials who spot an abusive tax shelter at one corporation to identify all other companies the arrangement was promoted to, Summers said.
Summers said the new rules were not meant to discourage responsible corporations from legally cutting their taxes.
“We have no quarrel with the natural desire of companies and individuals to minimize their tax burden by legitimate means,” he said. “We must, however, draw the line at the pursuit of engineered transactions that are devoid of economic substance.”