American Jobs Creation Act (2004) Enacts New Penalties

Editor: Last month, Larry Bell, CA, cautioned that the American Jobs Creation Act of 2004 could impact Canada's deferred compensation plans. This month, Tom Earle, CA, describes some of the new penalties (including securities Exchange Commission disclosures) introduced by this legislation to enforce compliance with the reportable transaction regulations.

Signed by US President George Bush on October 22, 2004, the new American Jobs Creation Act of 2004 (Jobs Act) made significant business tax changes to US tax legislation. In an effort to crack down on abusive tax shelters, the Jobs Act introduced new penalties and made significant changes to the existing penalties relating to reportable transactions. Tax practitioners and taxpayers who conduct a US trade or business should familiarize themselves with these transactions to avoid the new penalties.

During the past seven years, tax shelters and reportable transactions have been an increasing concern to the US Congress and the Internal Revenue Service (IRS). Since 2002, all large and mid-sized corporate examinations have included the mandatory issuance of a tax shelter information document request (IDR) by the IRS. The purpose of the IDR is to assist IRS agents in identifying and developing tax shelter issues relating to certain "listed transactions."

For US federal income tax returns filed after February 28, 2000, the IRS has issued regulations that require taxpayers to disclose information relating to each "reportable transaction" in which they participate. There are currently six categories of reportable transactions:

1. Listed transactions - Any transaction that is the same, or substantially similar to, a transaction that is specified by the IRS as a tax avoidance transaction and identified by notice, regulation, or other form of published guidance.

2. Confidential transactions - Any transaction that is offered to a taxpayer under conditions of confidentiality and for which the taxpayer has paid an advisor a minimum fee. A transaction is considered to be offered to a taxpayer under conditions of confidentiality if: a) the advisor who is paid the minimum fee places a limitation on the taxpayer's disclosure of the tax treatment or of the transaction's tax structure; and b) 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 on the taxpayer are not legally binding. 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 the transaction's tax structure.

3. Transactions with contractual protection - A transaction with contractual protection is a transaction for which the taxpayer or a certain related party has the right to a full or partial refund of fees if all or part of the intended tax consequences from the transaction are not sustained. A transaction with contractual protection is also one for which fees are contingent on the taxpayer's realization of tax benefits from the said transaction.

4. Loss transactions - Generally, a loss transaction is any transaction that results in the taxpayer claiming a loss under Internal Revenue Code (IRC) section 165 in the amount of: 1) $10 million (all dollar amounts herein are in US dollars) in any single tax year or $20 million in any combination of tax years for a corporation or for a partnership with corporate partners; 2) $2 million in any single tax year or $4 million in any combination of tax years for a partnership, individual, "S" corporation, or trust; or 3) $50,000 in any tax year for individuals or trusts if the loss arises with respect to certain foreign currency transactions.

5. Transactions with significant book-tax differences - A transaction with a significant book-tax difference is a transaction in which the amount for tax purposes of an item of gross income, gain, expense, or loss differs by more than $10 million from the amount for book purposes. Generally, the reporting requirement for a significant book-tax difference only applies to sec registrants or certain other business entities meeting certain asset thresholds.

6. Transactions involving brief holding periods - A transaction involving a brief holding period is one that results in a tax credit exceeding $250,000 if the underlying asset giving rise to such credit is held for 45 days or less.

Prior to the Jobs Act there was no penalty for failing to disclose reportable transactions; however, failure to disclose a reportable transaction was a strong indication that the taxpayer had not acted in good faith-in effect, barring the relief of any accuracyrelated penalty that might otherwise have been attributable to the undisclosed transaction.

"Failure to disclose" penalty

The Jobs Act imposes a strict penalty on taxpayers who do not disclose the required information concerning reportable transactions. If the taxpayer is an individual, the penalty is $10,000 ($100,000 in the case of an unreported listed transaction). The penalty increases to $50,000 for other types of taxpayers ($200,000 in the case of an unreported listed transaction). No judicial appeal is allowed, and the penalty may only be abated if the violation is not a listed transaction and if the IRS commissioner finds that abatement would promote compliance and effective administration.

Separate accuracy-related penalty for reportable transactions

The Jobs Act creates a new penalty that applies at a rate of 20% to any understatement of tax attributable to a reportable transaction if a significant purpose of this transaction is tax avoidance or evasion. The penalty is increased to 30% for non-disclosed listed transactions and other tax avoidance transactions. The penalty may not apply if it can be shown that there was reasonable cause and that the taxpayer acted in good faith. The reasonable cause exception requires that: a) the relevant facts affecting the item's tax treatment are adequately disclosed; b) there is substantial authority for the treatment; and c) the taxpayer believed such treatment was "more likely than not" proper. In determining whether the treatment is "more likely than not" proper, the taxpayer may not rely on certain disqualified opinions or on opinions prepared by certain disqualified tax advisors.

SEC disclosure

An SEC reporting entity, or an entity required to be consolidated with another entity for purposes of reporting to the SEC, must report to the SEC any penalty incurred for the failure to disclose a listed transaction; and/or the 30% accuracy-related penalty for non-disclosed reportable avoidance transaction understatements; and/or the penalty for gross valuation misstatements that are attributable to non-disclosed listed or non-disclosed reportable avoidance transactions. A failure to report these penalties to the SEC may result in an additional penalty of $200,000.

Extending the statute of limitations for tax assessment

Prior to the Jobs Act, some taxpayers did not report listed transactions in hopes that the statute of limitations would expire before the IRS could detect them. The Jobs Act combats this by extending the statute of limitations to one year after the earlier of: 1) the date at which the information is adequately disclosed by the taxpayer; or 2) the date at which the material advisor satisfies their tax shelter list maintenance requirements with respect to an IRS request.

Provision relating to material advisors

The Jobs Act requires all material advisors to file information returns disclosing any reportable transactions to which material aid, assistance, or advice is provided after October 22, 2004. A "material advisor" is a person who: a) provides material aid, assistance, or advice with respect to organizing, managing, promoting, selling, implementing, insuring, or carrying out any reportable transaction; and b) receives a fee in excess of a threshold amount for that assistance or advice. The threshold amount is $50,000 for reportable transactions in which substantially all the benefits are provided to an individual, and $250,000 in any other circumstance.

IRS Notice 2005-26 provides guidance to material advisors on how to file Form 8264 to meet the new reporting requirements.

What this means for us

In summary, the Jobs Act has created significant penalties with respect to reportable transactions. Practitioners and taxpayers must familiarize themselves with the reportable transactions rules and review past and current transactions for compliance to avoid what are, in my opinion, draconian penalties.

[Sidebar]

Did you know?

Taxpayers must disclose information relating to each "reportable transaction"

[Author Affiliation]

By Tom Earle, CA

[Author Affiliation]

Tom Earle, CA, specializes in US Tax Services with Deloitte & Touche LLP in Vancouver. For his input, Tom thanks Michael Blanton, a director with Deloitte & Touche LLP in Vancouver.