NEW TAX REGULATIONS ACCURACY - RELATED PENALTIES
By:
Robert D. Whoriskey
New York
Final regulations (the "Regulations") relating to accuracy-related penalties under Section 6662 of the Internal Revenue Code (the "Code") have been released, effective in most situations on September 1, 1995. The Regulations, which are awkwardly drafted, implement changes to the accuracy-related penalty enacted by the Omnibus Budget Reconciliation Act of 1993 (OBRA) and the Uruguay Round of the General Agreement on Tariffs and Trade (GATT).
Those penalties can be a substantial liability in the international tax area, especially for transfer pricing arrangements between affiliated parties under Section 482 of the Code. The basic penalty is 20% of the portion of any underpayment of tax to which it relates. That penalty increases to 40% for any gross valuation misstatement.
The term "accuracy-related penalties" is a misnomer. Section 6662 gathers many types of diverse penalties that were previously set forth under separate sections of the Code. Some of its relevant provisions cover: (1) negligence, or disregard of rules or regulations; (2) any substantial underpayment of income tax; or (3) any substantial valuation misstatement.
The term "substantial valuation misstatement" in turn encompasses a series of different penalty situations: (1) where the value, or adjusted basis, of any property reported on a tax return is 200% or more of the correct amount; (2) where the price for any property or services reported on a tax return is either 200% or more (or 50% or less) of the correct amount determined under Section 482 of the Code; and (3) where the net Section 482 price adjustment for the taxable year exceeds the lesser of $5,000,000 or 10% of gross receipts.
Under the Regulations, the accuracy-related penalty for disregard of the rules or regulations and for substantial understatement of income tax may be avoided by adequately disclosing certain information on IRS Forms 8275 or 8275R, or by showing that the reasonable cause and good faith exceptions to the penalty apply. The penalties for negligence or for a substantial (or gross) valuation misstatement may not be avoided by disclosure.
OBRA also raised the disclosure standard for penalties for disregard of the rules or regulations or substantial underpayment of income tax from "not frivolous" to a "reasonable basis." The Regulations confirm that standard. They do not provide a specific definition of "reasonable basis" for taking a position on a tax return (that topic is "reserved"), but the preamble to the Regulations anticipates that further guidance will be issued on this point.
Under Section 6664(c) of the Code, there is no accuracy-related penalty applicable to any portion of an underpayment of tax, if it is shown that there was reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion. Under the accuracy-related penalties, a taxpayer's reasonable cause and good faith reliance on the advice of a professional tax advisor will be taken into account to determine whether there was reasonable cause and good faith reliance. In most situations, a taxpayer can conclude that an attorney, accountant, or enrolled agent is qualified to give advice on Federal tax law under the Regulations. Such advice, however, must be based on all pertinent facts and circumstances and the tax law as it relates to those facts and circumstances. Under the Regulations, the IRS also will consider a taxpayer's reasons for structuring a transaction in a particular manner in determining whether the taxpayer acted in good faith in its tax return treatment of items from the transaction.
The changes made by GATT to the accuracy-related penalty, effective after December 8, 1994, eliminated exceptions in Section 6662(d)(2) to the substantial understatement penalty regarding tax shelter items for which a corporation had legal justification because (i) it had substantial authority or (ii) there was adequate disclosure and a reasonable belief as to the proper tax treatment. A "tax shelter" is defined as (a) a corporation, trust or partnership, (b) an arrangement, or (c) a plan, if the principal purpose of the entity, arrangement or plan is to avoid or evade Federal income tax.
Under the Regulations, disclosure is no longer effective to avoid the penalty. Whether a corporation is deemed to have acted in good faith and with reasonable cause in its treatment of tax shelter items is an important, although not necessarily dispositive factor for purposes of applying the substantial understatement of tax type of accuracy-related penalty. However, the legal justification for a tax shelter transaction by a corporation may not be adequate if the corporation's participation in the tax shelter lacked sufficient business purpose, or if the corporation claimed tax benefits that were unreasonable in comparison to its investment in the tax shelter, or if the corporation agreed with the promoter that it would protect the confidentiality of the tax aspects of the tax shelter.
Where there is an underpayment of tax by a corporation as to a tax shelter item, the penalty for understatement of tax will apply unless the reasonable cause and good faith tests are satisfied. Whether those tests are satisfied for a tax shelter item for a corporation depends on whether there was substantial authority for proper tax treatment of the item and whether there was reasonable belief that it was more likely than not that the treatment of the tax item was correct.
The Regulations, it should be noted, do not address the three categories of substantial valuation misstatement penalties, which means that those penalties on their face are formula driven and inflexible in their application.
