United States: IRS Amends Anti-Tax Shelter Regulations; Narrows Definition of Confidential Transactions

On December 29, 2003, the Internal Revenue Service released amendments (the "Amendments") to its package of anti-tax shelter regulations (the "Regulations") that were originally adopted at the end of February, 2003. The Amendments, which are effective immediately, significantly limit the scope of the category of "reportable transactions" known as "confidential transactions," but do not make any other material changes to the Regulations. The Amendments will automatically apply for purposes of the recently enacted California tax shelter rules unless the California Franchise Tax Board takes affirmative action to adopt differing rules.

The Regulations as they existed before the Amendments are discussed in more detail in our Tax-Legal Update dated 2/28/03 entitled "IRS Finalizes Anti-Tax Shelter Regulations."

Taxpayer reporting obligations. Under the Regulations, a transaction can become a "reportable transaction" merely because it is confidential, without any other indicia of tax benefits or tax motivation associated with the transaction. Prior to the Amendments, a transaction was considered confidential if a principal’s disclosure of the tax treatment or the tax structure of a transaction was limited in any manner for the benefit of any person who made a statement to the principal as to potential tax consequences. Under this broad definition, standard confidentiality provisions in an agreement between the principals to a routine business transaction could cause the transaction to be classified as a reportable transaction.

"Investor List" Maintenance Obligations. In addition to the taxpayer reporting obligations, the Regulations also require any "material advisor" to maintain an "investor list" (including detailed information and records) with respect to any party that engages in (1) a "listed transaction, (2) a transaction that the material advisor knows is (or reasonably expects will become) a "reportable transaction," or (3) a transaction required to be registered as a tax shelter under Section 6111 of the Internal Revenue Code. A "material advisor" is any advisor, which could include an accountant, attorney or investment banker (and could potentially include a principal to a transaction that also acts as an advisor for a fee), who (A) receives at least a "minimum fee," and (B) who provides a "tax statement" to persons involved in the transaction. The fees that cause the threshold to be met need not relate to the tax statement that is made.

Model language in Regulations. Prior to the Amendments, the Regulations contained certain model language that provided a "safe harbor" from classification as a confidential transaction for certain types of merger and acquisition transactions and also provided a "favorable presumption" of non-confidential status for other types of transactions.

Practices Regarding Potential Confidential Transactions. Prior to the Amendments, many taxpayers participating in transactions, and many professional advisors to those transactions, adopted policies designed to minimize inadvertent classification of transactions as confidential transactions. In general, these policies included a general practice of including in confidentiality agreements language that tracked the model "safe harbor" and "favorable presumption" language in the Regulations. However, in cases where confidentiality was an important non-tax business objective of a transaction, the breadth of the model language provided for in the Regulations often posed difficult choices for the parties.

Definition of confidential transaction. Under the Amendments, a transaction can still become a reportable transaction solely because it is confidential. However, under the Amendments, a confidential transaction is defined much more narrowly, i.e., a transaction that is offered to a taxpayer under conditions of confidentiality and for which the taxpayer has paid an advisor a "minimum fee."¹ Further, a transaction will be considered to be offered to a taxpayer under conditions of confidentiality only if the advisor who is paid the minimum fee places a limitation on disclosure by the taxpayer of the tax treatment or tax structure of the transaction and the limitation on disclosure protects the confidentiality of that advisor’s tax strategies. A transaction is treated as confidential even if the conditions of confidentiality are not legally binding on the taxpayer. However, a claim that a transaction is proprietary or exclusive is not treated as a limitation on disclosure if the advisor confirms to the taxpayer that there is no limitation on disclosure of the tax treatment or tax structure of the transaction. The Amendments do not contain any model language for such a confirmation by the advisor. Further, the Amendments delete the prior mergers and acquisitions safe harbor and the favorable presumption and remove the related model language.

Protection for principal acting in its capacity as a principal. The preamble to the Amendments indicates that the change to the definition of confidential transaction is based on the belief of the IRS that confidential transaction status should not apply to transactions in which confidentiality is imposed by a party to the transaction acting in such capacity; instead confidential transaction status should be limited to situations in which an advisor is paid a large fee and imposes a limitation on disclosure that protects the confidentiality of the advisor’s tax strategies. The Amendments specifically provide that a fee does not include amounts paid to a person, including an advisor, in that person's capacity as a party to the transaction. For example, a fee does not include reasonable charges for the use of capital or the sale or use of property.

Calculation of Minimum Fee. Note that the definition of confidential transaction is phrased in terms of the minimum fee being paid by the "taxpayer" to the "advisor" who imposes the relevant disclosure limitation on the taxpayer. For purposes of defining both "taxpayer" and "advisor," persons that bear certain relationships to each other (as specified in Internal Revenue Code Section 267(b) or 707(b)) are treated as a single person. So, for example, fees paid by members of an affiliated group would be aggregated in determining whether an advisor had received a minimum fee, as would fees paid to members of the affiliated group of which the advisor is a member. However, in a simple case, fees paid by multiple, unrelated principals to a single advisor would not be aggregated, and minimum fee status would be determined separately as to each principal based on the fees paid by each principal to the advisor.

Effective date of Amendments. The Amendments apply to transactions entered into on or after December 29, 2003. However, taxpayers may rely on the new rules for transactions entered into on or after January 1, 2003, which was the original effective date of the old, broader definition of confidential transaction. Thus, any transaction completed since the Regulations originally became effective can obtain the benefit of the new, narrower definition of confidentiality.

No change to Internal Revenue Code Section 6111 regulations. The Amendments affect only the Regulations under Code Sections 6011 (taxpayer reporting of reportable transactions, including confidential transactions) and 6112 (requirement to maintain investor lists). The Amendments did not change the definition of confidentiality for purposes of the tax shelter registration rules that apply to so-called "confidential corporate tax shelters" under Internal Revenue Code Section 6111(d). As a result, for confidential corporate tax shelters, the Regulations retain the same definition of confidentiality, including the mergers and acquisitions exception, the favorable presumption, and the related model language, as applied prior to the Amendments. A confidential corporate tax shelter is defined as a transaction: (A) a significant purpose of the structure of which is the avoidance or evasion of Federal income tax for a direct or indirect participant which is a corporation, (B) which is offered to any potential participant under conditions of confidentiality, and (C) for which the tax shelter promoters may receive fees in excess of $ 100,000 in the aggregate.

No change to list maintenance rules. While the Amendments narrow the definition of confidential transactions, they do not change the definition of material advisor. (The Amendments do make one change that may assist principals to transactions in avoiding "material advisor" classification as to their own transactions, by clarifying that, in calculating fees received by an advisor, a fee does not include amounts--such as reasonable charges for use of capital or the sale or use of property--paid to a person in that person’s capacity as a party to the transaction.) Note that, although the term "minimum fee" is used both in the reportable transaction rules and the list maintenance rules, and the specified minimum amounts are generally the same, the list maintenance rules look to the aggregate fees received by the material advisor regardless of who is paying the fees. Further, the Amendments do not change the fact that, in appropriate circumstances, a principal to a transaction might be a material advisor with respect to a transaction in which it is also acting as an advisor for a fee.

Implications of continued use of old model language. The Amendments are intended to, and should, reduce significantly the number of transactions classified as confidential transactions under the reportable transaction rules. However, for a combination of reasons, it may not be advisable to simply abandon use of the old model language for all transactions. First, use of the old model language is not harmful from a tax standpoint. Indeed, the old model language should still operate to negate confidential transaction status despite having been deleted from the Amendments. Thus, where the parties are comfortable with the old model language, there is no tax reason why they need to cease using it. Second, a case-by-case analysis may be required to determine whether the old model language can safely be dispensed with in particular transactions. Continued use of the old model language may avoid the necessity for such case-by-case analysis. Third, for transactions that may be potentially be considered "confidential corporate tax shelters," the old model language still applies to negate confidentiality for purposes of those rules. Accordingly, a more conservative strategy may be to continue using the old model language unless a significant non-tax motivation exists for dropping it and until a review has been undertaken of the potential application of the tax shelter rules to the particular type of transaction involved. A few examples of transactions that may require a more case-by-case approach include offerings of complex debt and equity securities (as opposed to common stock, straight debt or plain-vanilla convertible debt) and offerings of partnership and LLC interests.

Confidentiality agreements between principals. In general, for most routine confidentiality agreements (whether a standalone agreement or part of a larger agreement) between the principals to a transaction, it should no longer be necessary to include the model language for the mergers and acquisition "safe harbor" or the model language for the "favorable presumption" or any other special language designed to address the confidential transaction portion of the reportable transaction regulations. For example, customary documentation for routine mergers and acquisition transactions should not require any tax shelter-related carve-outs to confidentiality provisions.

Principals also acting as an advisor for a minimum fee. Greater caution should be exercised if a principal to a transaction is also acting as an advisor and will be paid at least a "minimum fee" in connection with a transaction. A case-by-case analysis may be required to determine whether a "minimum fee" is being charged. As noted previously, the Amendments provide that a fee does not include amounts paid to a person, including an advisor, in that person's capacity as a party to the transaction and that a fee does not include reasonable charges for the use of capital or the sale or use of property.

• In the typical case, where the only confidentiality obligations are mutual ones imposed with respect to the principals in their capacity as such, it should not be necessary to include any special language in the confidentiality agreement or confidentiality provisions design to address the confidential transaction portion of the reportable transaction regulations.

• If special confidentiality obligations--in addition to those that apply to the principals generally--are imposed upon the other principals for the benefit of the advisor/principal, particularly if there is any question about the status of the advisor/principal as a genuine principal (e.g., a person otherwise acting as an advisor takes on a small participation in a transaction), consideration could be given to either:

• Having the advisor/principal that receives the minimum fee confirm in writing to any payor of a minimum fee that the fee recipient (including any related parties) has not imposed any limitation on disclosure by the payor (including any related parties) of the fee of the tax treatment or tax structure of the transaction under federal, state or local income or franchise tax laws; or

• Having the principals to the transaction specifically state in writing that neither the services provided by the advisor/principal nor the fee being paid to the advisor/principal relate in any manner to any tax advice or tax strategy or to the tax treatment, tax structure or tax consequences of the transaction under federal, state or local income or franchise tax laws.

Confidentiality obligations imposed by third party advisors. Under the Amendments, if an advisor to a transaction (such as an investment banker, accounting firm or law firm), (1) is paid a minimum fee by a principal to the transaction, and (2) imposes a confidentiality obligation on such principal, then the transaction will be a confidential transaction as to the principal, if the confidentiality obligation may be interpreted to place a limitation on the principal’s disclosure of the tax treatment or tax structure of the transaction so as to protect the confidentiality of the advisor’s tax strategies. Confidential transaction status can be avoided if the third party advisor that receives the minimum fee confirms in writing to the payor of the minimum fee that the advisor (and related parties) has not imposed any limitation on disclosure by the payor (and related parties) of the tax treatment or tax structure of the transaction.

Because of the broad definition of "confidential corporate tax shelter" (i.e., transactions structured to produce federal income tax benefits that constitute an important part of the intended results of the transaction), any transaction that could arguably meet the definition of a confidential corporate tax shelter requires special treatment. As a result of an applicable exception, conventional merger and acquisition transactions should not be affected by the confidential corporate tax shelter rules. In cases where the confidential corporate tax shelter rules may apply, the old model language (which continues to exist in the "confidential corporate tax shelter" regulations) should be included in any confidentiality agreement that protects any person that may be considered a promoter of the transaction.

Taxpayers who act as advisors to transactions for a "minimum fee" and provide tax advice, including potentially taxpayers acting in a dual advisor/principal role, will still have concerns about minimizing the potential burden of maintaining investor lists with respect to their transactions. A list maintenance obligation could arise if the advisor or advisor/principal itself imposes a disclosure limitation related to its tax strategies. Even if the advisor or advisor/principal does not impose such a disclosure limitation, it could have a list maintenance obligation if it is aware that another person has imposed such a disclosure limitation on one or more principals to the transaction, or if it is aware that the transaction is another category of reportable transaction or is a Internal Revenue Code Section 6111 registration-required tax shelter. In appropriate circumstances, as a preventive measure, the advisor or advisor/principal could consider obtaining a representation from the principals to the effect that the transaction is not a reportable transaction.

Impact on accuracy-related penalties of failure to report reportable transactions. On December 29, 2003, the IRS released final regulations that specify the impact on liability for so-called "accuracy-related penalties" (negligence, substantial underpayment, and valuation overstatement, understates or misstatements) of a taxpayer’s failure to report a reportable transaction. Under these regulations, if any portion of an underpayment of tax is attributable to a reportable transaction, failure by the taxpayer to disclose the reportable transaction is a strong indication that the taxpayer did not act in good faith with respect to that portion of the underpayment. Thus, failure to report can potentially adversely affect qualification for the good faith/reasonable cause exception to the imposition of accuracy-related penalties.

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.

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