Cut Abusive Tax Shelters

The economy continues to do well, companies are reporting record profits, and U.S. Treasury coffers are overflowing with tax revenue few had anticipated three or four years ago. So why are U.S. companies paying less and less in taxes? The answer in large part is corporate tax shelters. With a disturbing frequency, companies aided by specialists at law firms, investment banks and accounting firms are stretching the limits of the complex tax code to shelter earnings from the Internal Revenue Service.

Clearly, the 40,000-plus pages of the U.S. tax code offer taxpayers ample room to find a crack or two. But when companies engage in business activities that have no economic reason other than dodging taxes, they have gone too far. The U.S. Treasury Department has responded with rules requiring companies to disclose aggressive tax-avoidance transactions and has asked Congress to pass legislation to stiffen punishment for such practices. Clearly, greater transparency in corporate tax returns is necessary if Washington intends to keep up with ever more creative corporate accounting.

Shady tax shelters that accountants offered to wealthy individuals were all the rage in the 1980s. They took the form of cookie-cutter schemes, such as accelerated depreciation, and were easy to spot. Corporate tax shelters of the 1990s are a different species. They are often impenetrable transactions devised by the brightest tax brains on Wall Street and peddled to companies for millions of dollars. The Treasury considers illegal various accounting schemes aimed solely at either hiding revenue from the government or creating paper losses. Unlike shelters that serve a greater public good, such as building low-income housing, the Treasury is targeting shelters that serve no policy goals; they merely exploit quirks of the tax code.

Treasury Secretary Larry Summers was right last month when he said the proliferation of tax shelters is corrosive to the economy, for instance depriving the government of at least $10 billion a year in revenue. An even more damaging consequence is that companies are, in effect, forced to use tax shelters if their competitors do so. The tax dodging spiral is undermining the country’s voluntary tax system.

To combat these practices, the Treasury Department has issued rules to require companies to disclose in their tax filings any transactions designed to significantly reduce their tax liability. They would have to tell the government if they paid more than $100,000 to promoters of tax shelters or had taken out insurance against tax benefits that might not materialize. Acting independently, the Securities and Exchange Commission has proposed rules that would require companies to keep reserves against iffy tax claims or disclose the possibility of a tax liability in their financial statements.

In addition, the Treasury has asked Congress to enact a law that would bar companies from benefiting from transactions whose only purpose is to avoid paying taxes--the so-called “economic substance” test--and to penalize practices that don’t meet it. The House has before it a bill introduced by Lloyd Doggett (D-Texas), and on the Senate side, Finance Committee Chairman William Roth (R-Del.) has already held hearings. Both houses should act now.

The measures that the Treasury has taken would not prevent companies from using the tax code to minimize their tax burden. But they would open the corporate tax practices to greater scrutiny and discourage illegitimate transactions. Surely, the test that corporate transactions should have economic purpose should not be difficult to meet.