Much has been written about the theoretical interpretation of the complex laws governing the taxation in the United States of financial activity. Littler has been written about the practical aspects of a taxpayer managing its tax risk in the finance arena — knowing which are the “danger” issues, advocating before governmental bodies to change the laws, and dealing with an audit as it looms before a taxpayer. Tax is a culture, and to practice effectively, the tax practitioner must understand the major institutions creating, interpreting and enforcing the laws. This article explores some of the cultural perspectives of financial product law.
This article pays attention to ways to avoid audit risk in connection with a company’s financial activities, and will describe effective methods for dealing with the Internal Revenue Service (IRS) when it begin examining financial transactions. Sometimes conflicts with the IRS can be prevented or curtailed through effective communications with the other institutions involved in the tax universe. With this in mind, this article will shed light on the workings of the IRS, the relationship between the IRS Chief Counsel, the Office of Tax Policy at the Department of the Treasury and various Congressional bodies creating the tax law. Throughout, the discussion will be kept as current as possible, recognizing that financial activity of even non-financial firms has been targeted by the IRS as one of the areas of highest scrutiny.
2. Why should the Tax Department of a Company Be Concerned about Financial Transactions?
2.1 Changes at the IRS
Mr. Donald Korb, IRS Chief Counsel, has stated publicly that he has made financial transactions a priority for the IRS and says that he “wants to get on top” of financial products much faster. He frequently reminds audiences of the many successes he has had in litigating tax cases involving financial transactions (such as Chicago Tribune, Castle Harbour, and Coltec), and has indicated that he will use the tool of litigation more extensively in the future. Mr. Korb has also established a new branch within the Financial Institutions and Products section of Chief Counsel that is directed to focus only on new financial products. This group is expected to be available for discussions with taxpayers with regard to transactions they are contemplating or having issues with and is authorized to issue timely guidance in various forms.
Consistent with this, the IRS has established a new form of guidance, namely the generic legal advice memorandum (GLAM). The purpose of such advice is to give agents a framework to understand the legal issues in a situation. The advice is public and is intended to be published soon after it is requested. The GLAM format was designed in response to the use by taxpayers of technical advice memoranda (TAMs) as a sward against the government, rather than as was intended by the IRS, i.e. as a mechanism for resolving a case to pre-empt litigation.
2.2 Aggressive tax shelter stance for derivatives
The IRS and Treasury view derivatives and financial engineering as an exceptionally productive tool in the development of tax shelter transactions. Because derivative contracts are so flexible, there are an unlimited number of possible economic outcomes that can be obtained using derivatives. In contrast, tax outcomes are limited by the “pigeonhole approach” the law has adopted for determining the tax treatment of a transaction. The principles of economic substance and business purpose do provide some boundaries on the possible tax manipulation that is possible, but there is still risk to Treasury when taxpayers engage in financial engineering to minimize their tax liability.
While many of the tax shelter notices issues in the past several years have been targeted at derivative transactions, the one that has caused particular trouble for taxpayers is described in Notice 2002-35 and Notice 2006-16. In these Notices, the transaction described could include almost every swap in the marketplace, as well as other plain-vanilla transactions. This outcome is unavoidable in the finance arena because an abstract description of one abusive transaction can be understood to apply to a wide range of benign transactions. The tax rules for derivatives are generally unconnected to the underlying economics of the transaction, and so the cause of the abuse is usually the application of the tax rules, rather than some characteristic of the transaction. Hence the difficulty the government has in describing “bad” derivatives. The difficulty the IRS has in distinguishing abusive from non-abusive transactions, as well as the difficulty in understanding financial transactions makes the IRS especially wary of any transaction that contains elements of financial engineering.