January 12, 2007

TO: Distribution

FROM: Philip Garlett, Dan Burt

RE: Proposed Tax Shelter Disclosure Regulations

The Treasury and IRS issued proposed regulations ("Regs") on November 2, 2006 that when finalized, will significantly modify the tax shelter disclosure regulations. We believe the Regs will have two significant effects: (1) the addition of "transactions of interest" ("TIs") as a disclosure category will, in some cases, require taxpayers to reassess financial statement reporting positions they have previously taken, and (2) although the book-tax disclosure requirement has been removed, we think it that it will reappear in other forms, and that transactions with significant book-tax differences will still be an audit target. Taxpayers must continue to plan transactions with a very carefully considered view of their book-tax effects.

1. Transactions of Interest

The Regs would add a new disclosure requirement for TIs. These are transactions that the IRS believes have the potential for tax avoidance or evasion, but for which the IRS lacks enough information to determine whether the transactions should be identified specifically as tax avoidance transactions. The IRS will identify TIs in public guidance and will require taxpayers to disclose the transactions as well as any "substantially similar" transactions. Based on the information received, the IRS will (i) designate the transaction as a listed transaction, (ii) create a new category of reportable transaction, or (iii) remove the transaction from the TI category altogether. The TI category will not apply to transactions entered into before November 2, 2006, but beyond that limitation, the IRS can require disclosure even for past transactions entered into before their identification as TIs. As a practical matter, once a transaction has been identified, taxpayers may have to reassess whether the tax benefit they took in their financial statements needs to be adjusted under FASB Interpretation No. 48 (“Fin 48”). Where such a reassessment is necessary, taxpayers will know only that the IRS has suspicions about the transaction but not whether the agency will eventually regard it as a tax shelter. This will further complicate the already complicated Fin 48 process.

2. Book/Tax Disclosure

The Regs would also codify the removal of the significant book-tax category of disclosure previously announced in Notice 2006-6. The removal generally applies to transactions after January 6, 2006. The preamble to the Regs claims that the category was made unnecessary because of the creation of IRS Schedule M-3 (a book-tax reconciliation schedule).

The rationale is surprising because the book-tax filter focused on an item-by-item analysis without the possibility of netting while the Schedule M-3 allows netting of transactions in the same category of book-tax differences. Further, Schedule M-3 is not specifically designed to uncover tax shelters. Book-tax differences are a significant hallmark of tax shelters and it is difficult to believe that the IRS is completely abandoning book-tax discrepancies as a filter for discovering tax shelters. IRS auditors will continue to regard such differences as fertile ground for inquiry and taxpayers should assume that book-tax differences will reappear, albeit in more limited form, in disclosure documents -- perhaps in changes to Form 8886 (the disclosure form) or possibly in future changes to Schedule M-3.

Recommendations: The regulations have not been the subject of extensive commentary, probably because on the surface they seem innocuous. The TI category could, however, significantly complicate taxpayers' Fin 48 assessments. Also, taxpayers must remain sensitive to the possibility that significant book-tax differences will attract the attention of IRS auditors. Taxpayers should continue to be attentive to changes in disclosure forms and schedules, as these may be where book-tax disclosures will creep back in.

¹ Philip Garlett joined Burt, Staples & Maner as a partner in October, 2006. Prior to joining the firm, he was the international tax coordinator for the Office of Associate Chief Counsel (International), IRS, and was involved in analyzing arbitrage and shelter transactions, including those presented to JITSIC. Prior to that position, he was the head of the Harmful Tax Practices Unit at the OECD.