United States: IRS Issues Proposed Regulations That Modify The Rules On The Disclosure Of Reportable Transactions, Material Advisor Disclosure Rules And List Maintenance Requirements

On November 2, 2006, the IRS issued proposed regulations (the "Proposed Regulations") that propose to modify and clarify the rules relating to: (i) the disclosure of reportable transactions under Section 6011 of the Internal Revenue Code of 1986, as amended (the "Code"), (ii) material advisors responsible for disclosing reportable transactions under Section 6111 of the Code, and (iii) material advisors responsible for keeping lists under Section 6112 of the Code. These rules are contained in regulations that were finalized on December 29, 2003 (the "Reportable Transactions Regulations"). The Proposed Regulations were issued due to revisions to Sections 6111 and 6112 of the Code, which were enacted as part of the American Jobs Creation Act of 2004 (the "AJCA"), and in response to various comments and questions regarding the Reportable Transactions Regulations. The Reportable Transactions Regulations are described in an earlier legal update dated February 4, 2004, entitled IRS Amends Anti-Tax Shelter Regulations; Narrows Definition of Confidential Transactions. The reportable transactions disclosure provisions of the AJCA are described in an earlier legal update dated November 3, 2004, entitled Anti-Tax Shelter Provisions of American Jobs Creation Act of 2004 Expand Reporting Rules for Taxpayers and Advisors, Substantially Increase Penalties for Non-Compliance and Provide IRS with Additional Sanction Authority.

Under the Reportable Transactions Regulations, a taxpayer must disclose its participation in a "Reportable Transaction" on IRS Form 8886, which is to be attached to the taxpayer's federal income tax return for each year affected by the transaction, and which is also to be specially filed with the IRS Office of Tax Shelter Analysis ("OTSA") for the first affected year. There are six categories of Reportable Transactions: (i) transactions that are the same as or substantially similar to transactions that have been specifically identified by the IRS as tax-avoidance transactions ("Listed Transactions"); (ii) "confidential transactions"; (iii) transactions with "contractual protection"; (iv) certain loss transactions; (v) transactions with a significant book-tax difference; and (vi) certain transactions involving a brief asset holding period.

In accordance with previous interim guidance provided by the IRS in Notice 2006-6, 2006-5 I.R.B. 385, the Proposed Regulations eliminate the category of transactions with a significant book-tax difference from the categories of Reportable Transactions. The removal of the book-tax difference category applies to transactions that otherwise would have to have been disclosed on or after January 6, 2006 (regardless of when the transaction was entered into).

The Proposed Regulations add "transactions of interest" as a new category of Reportable Transactions. A transaction of interest is a transaction that is the same as or substantially similar to one of the types of transactions that the IRS has identified by notice, regulation, or other form of published guidance as a "transaction of interest." These are intended to cover transactions that the IRS believes have a potential for tax avoidance or evasion, but for which the IRS lacks enough information to determine whether the transaction should be identified specifically as a tax avoidance transaction. When the IRS has gathered enough information to make an informed decision as to whether a transaction of interest is a tax avoidance type of transaction, the IRS may take one or more actions, including removing the transaction from the transactions of interest category in published guidance, designating the transaction as a Listed Transaction, or providing a new category of Reportable Transactions. In addition, the Proposed Regulations provide generally that if a transaction becomes a transaction of interest after the filing of a taxpayer’s tax return (including an amended return) reflecting the taxpayer’s participation in the transaction of interest and before the end of the statute of limitations period with respect to any taxable year in which the taxpayer participated in the transaction of interest, then a disclosure statement must be filed.

It is anticipated that, upon finalization of the Proposed Regulations, the transactions of interest category of Reportable Transactions will apply to transactions entered into on or after November 2, 2006.

The "transaction of interest" category gives the IRS a powerful new tool to gain intelligence about market developments. Previously, disclosure was only required for Listed Transactions and transactions that met one of the other five filters. A Listed Transaction was one that the IRS had already concluded was a tax avoidance transaction. The other five filters were objective. Transactions of interest on the other hand are ones which the IRS suspects, but is not sure, have the potential for tax avoidance. This is a significantly lower threshold for disclosure than had been the case previously. Also, taxpayers previously had some comfort that they could determine in advance whether a transaction was required to be disclosed. The new "transaction of interest" category will make it much tougher for taxpayers to make such a determination. Thus, under the Proposed Regulations, if it does not want to do a "reportable transaction," a taxpayer would have to be comfortable that the IRS will never declare the transaction a "transaction of interest" sometime during the period before the statute of limitations closes on the taxable years during which the transaction was in existence.

Although the "transaction of interest" category is effective as of November 2, 2006, the IRS did not issue a list of "transactions of interest" along with the Proposed Regulations. It is unclear whether the IRS will issue such a list while the regulation is still in proposed form. Taxpayers will be watching carefully to determine the type of transactions that appear on the first list of "transactions of interest." This may give some indication of how broadly the IRS intends to use this new power.

The Proposed Regulations eliminate the special exclusion from the Reportable Transactions disclosure rules for lease transactions. Under the Reportable Transactions Regulations, this special exclusion rule provides that certain customary commercial leases of tangible personal property ¹ are excluded from all of the Reportable Transactions categories, except Listed Transactions. Because the confidential transactions category has been narrowed and the significant book-tax difference transactions category is being removed, the IRS believes that leasing transactions should be subject to the same Reportable Transactions disclosure rules as other transactions. However, the IRS also believes that most customary commercial leasing transactions will not fall into any of the Reportable Transactions categories and will not be subject to disclosure. The IRS intends to obsolete Notice 2001-18 when the Proposed Regulations are finalized.

Under the Reportable Transactions Regulations, a transaction involving a brief asset holding period is any transaction resulting in the taxpayer claiming a tax credit, including a foreign tax credit, exceeding $250,000 if the underlying asset giving rise to the credit is held by the taxpayer for 45 days or less. However, the Code already has existing provisions addressing the availability of claiming foreign tax credits in transactions involving brief asset holdings periods. Under Section 901(k) of the Code, foreign tax credits for foreign withholding taxes imposed on dividends are disallowed if the taxpayer does not meet a minimum holding period. In addition, Section 901(l) of the Code, added as part of the AJCA, disallows foreign tax credits for foreign withholding taxes imposed on other income or gain with respect to property if the taxpayer does not meet a minimum holding period. Accordingly, the Proposed Regulations modify the brief asset holding period category of Reportable Transactions to exclude transactions resulting in a claimed foreign tax credit.

Under the Reportable Transactions Regulations, taxpayers that were unsure whether a transaction should be disclosed pursuant to the Reportable Transactions disclosure rules under Section 6011 have been disclosing such transactions on a protective basis. However, the IRS has found that these protective disclosures may fail to provide all of the information requested under Section 6011. Due to the uncertainty of the nature and scope of these protective disclosures, the Proposed Regulations add clarifying language that allows protective disclosures to be filed in situations where a taxpayer is unsure of whether the transaction should be disclosed pursuant to the Reportable Transactions disclosure rules under Section 6011 if the taxpayer complies with the rules of the Reportable Transactions Regulations as if the transaction is subject to disclosure, and the person furnishes to the IRS the information requested under these regulations. Accordingly, under the Proposed Regulations, a protective disclosure must fully comply with all of the disclosure rules pursuant to Reportable Transactions Regulations, and the taxpayer must provide to the IRS all information requested under these rules, for the protective disclosure to be effective.

In certain situations, partners, shareholders, and beneficiaries may file their federal tax returns before receiving Schedule K-1s from the partnership, S corporation or trust that participated in a Reportable Transaction. The Proposed Regulations address this problem by providing that if a taxpayer in a partnership, S corporation, or trust receives a timely Schedule K-1 less than 10 calendar days before the due date of the taxpayer’s return (including extensions) and, based on receipt of the timely Schedule K-1, the taxpayer determines that it participated in a Reportable Transaction, the disclosure statement will not be considered late if the taxpayer discloses the Reportable Transaction by filing a disclosure statement with OTSA within 45 calendar days after the due date of the taxpayer’s return (including extensions). This provision is proposed to be applicable for transactions entered into on or after the date the Proposed Regulations are published as final regulations in the Federal Register. However, taxpayers currently may rely on this provision in the Proposed Regulations.

The treatment of patented tax advice and tax strategies is under study by the IRS. In particular, the IRS is exploring ways in which the patenting of tax advice or tax strategies could be addressed, including through the creation of a new category of Reportable Transactions.

Section 6111 of the Code requires each "material advisor" with respect to any Reportable Transaction to make a return setting forth information identifying and describing the transaction and any potential tax benefits expected to result from the transaction no later than the date specified by the IRS. Notice 2004-80, 2004-2 C.B. 963, provided interim guidance on the definitions of material advisor for the purposes of the material advisor disclosure requirements under Section 6111 of the Code, which apply until further guidance is issued. The interim guidance is described in an earlier legal update dated November 23, 2004, entitled IRS Issues Interim Rules Implementing Anti-Tax Shelter Provisions of American Jobs Creation Act of 2004.

Under the Proposed Regulations, each material advisor with respect to any Reportable Transaction (as described above) must file a return by the date prescribed in the regulations. For this purpose, a person is a material advisor with respect to a transaction if: (i) the person makes or provides a tax statement to or for the benefit of certain persons (or other types or classes of persons identified by the IRS as material advisors in published guidance); (ii) the person directly or indirectly derives gross income in excess of certain threshold amounts; and (iii) the Reportable Transaction is entered into by the taxpayer. For "transactions of interest," the IRS may identify reduced threshold amounts in published guidance.

The material advisor disclosure statement must be filed by the last day of the month that follows the end of the calendar quarter in which the advisor became a material advisor with respect to the Reportable Transaction. Form 8918, "Material Advisor Disclosure Statement," will be published for use by material advisors to disclose reportable transactions and will supersede Form 8264 which is currently being used for material advisor disclosures. The IRS will issue a "reportable transaction number" to material advisors who file Form 8918. Material advisors must provide this number to persons to whom the material advisor makes or provides tax statements with respect to the transaction.

In general, transactions in which a taxpayer obtains "tax result protection" (or "tax insurance") are not included in the categories of Reportable Transactions. However, the Proposed Regulations provide that although a transaction is not a Reportable Transaction simply because there is tax insurance for the transaction, a "tax statement" for purposes of the material advisor rules includes providing tax insurance that insures some or all of the tax benefits of a Reportable Transaction, which may cause the third party insurer to become subject to the material advisor disclosure rules under Section 6111 of the Code.

The Reportable Transactions Regulations currently provide an exception from the material advisor rules for tax statements made with respect to a transaction in which the tax benefits are reflected on an already filed tax return with the IRS. However, the Proposed Regulations provide that the exception will not apply to a person who makes a tax statement with respect to the transaction if it is expected that the taxpayer will file a supplemental or amended return reflecting additional tax benefits from the transaction.

Section 6111 of the Code requires each material advisor (as defined above) with respect to any Reportable Transaction is required to maintain a list identifying each person with respect to whom the advisor acted as a material advisor with respect to the transaction. Notice 2004-80, 2004-2 C.B. 963, provided interim guidance on the definitions of material advisor for the purposes of the material advisor list maintenance requirements under Section 6112 of the Code, which apply until further guidance is issued. The interim guidance is described in an earlier legal update dated November 23, 2004, entitled IRS Issues Interim Rules Implementing Anti-Tax Shelter Provisions of American Jobs Creation Act of 2004.

The Proposed Regulations clarify the information to be included in the list, such as the name of each other material advisor to the transaction, if known by the material advisor, and any designation agreement to which the material advisor is a party. Furthermore, the Proposed Regulations specifically clarify that the list must consist of three separate components: (i) an itemized statement of information; (ii) a detailed description of the transaction; and (iii) copies of documents relating to the transaction. The itemized statement of information must contain all of the requested information in a form that is easy to understand, such as a list, spreadsheet, or table. Under the Proposed Regulations, the Secretary of the Treasury, in published guidance, may provide a form or method for maintaining and/or furnishing a list.

The Proposed Regulations remove the provision detailing how a privilege is claimed with regard to certain information on the list. The Proposed Regulations continue to require that, if a claim of privilege is made, the material advisor must continue to maintain the list in accordance with the regulations.

Generally, for the Reportable Transactions disclosure rules, the Proposed Regulations will apply to transactions entered into on or after the date the Proposed Regulations are published as final regulations in the Federal Register. However, upon publication, the final regulations will apply to transactions of interest entered into on or after November 2, 2006.

For the material advisor reporting and list maintenance rules, the Proposed Regulations will apply to transactions with respect to which a material advisor makes a tax statement on or after the date the Proposed Regulations are published as final regulations in the Federal Register. However, upon publication, the final regulations will apply to transactions of interest entered into on or after November 2, 2006 with respect to which a material advisor makes a tax statement on or after November 2, 2006.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved