In the post-Enron era, the Treasury Department has spent considerable time and attention on the topic of identifying tax shelters. The task for the Treasury has been to craft a definition of tax shelter that is neither overbroad nor easily avoided by clever designers of tax-motivated transactions. In new regulations issued at the end of 2003, the Treasury Department cut back significantly on one of the most controversial definitions of tax shelters: transactions offered under conditions of confidentiality. This definition, which had been written last February to capture virtually all confidential transactions, has now been revised to permit many confidential transactions to proceed with their confidentiality requirements intact, without causing such transactions to become reportable tax shelters. In our Commentaries issued last spring, we explained the market responses to the February 2003 regulations. In this Commentaries, we explain the Treasury's response to the firestorm of criticism over those regulations, the new rules, and the likely market responses to these new rules.
Since last February, language waiving tax aspects of confidentiality protections has been routinely included in numerous forms of transaction documents in order to ensure that the transactions did not qualify as tax shelters subject to reporting and other requirements under applicable Treasury regulations. These regulations were seen by Jones Day and by many other interested market participants as grossly overinclusive. On December 29, 2003, Treasury and the IRS issued new regulations that essentially rewrite the reportable transaction rules contained in Treas. Reg. Sec. 1.6011-4 as they relate to confidential transactions. The IRS and Treasury have now decided that the mere fact that disclosure relating to a transaction is subject to limitations imposed by the parties to the transaction is not indicative of tax shelter intent. Instead, the focus is now on whether the requirement that the transaction be kept confidential comes from an adviser (such as a promoter, lawyer, accountant, banker, etc.) rather than from a party to the transaction. Accordingly, the new regulations provide that the confidentiality rules that can cause a participant in a transaction to be report the transaction as a tax shelter will be limited to situations in which an adviser who is paid a large fee (generally $250,000 if the party paying the fee is a corporation and $50,000 for all others with special rules for partnerships and trusts) imposes a limitation on disclosure that protects the confidentiality of the adviser’s tax strategies. The IRS and Treasury now believe that the confidentiality definition of tax shelter status should not apply to transactions in which confidentiality is imposed by a party to the transaction, acting in that capacity.
Certain exceptions (i.e., regarding the timing of the confidentiality waivers in M&A transactions and disclosure limitations arising out of securities law) and the presumptive safe harbor that had been contained in the February 2003 regulations have now been removed from the regulations because the IRS and Treasury have determined that they are no longer necessary under the new rules. The new regulations apply to transactions entered into on or after December 29, 2003. However, taxpayers may rely on these new rules retroactively for transactions entered into on or after January 1, 2003, and before December 29, 2003.
The new rules thus substantially narrow the scope of the confidential transaction definition of tax shelter status so that, as a general matter, typical M&A transactions, leases, litigation settlements, loan agreements, license agreements, and the like, in which the parties themselves impose a confidentiality obligation upon one another, do not fall within the scope of the new rules. In addition, the presumption language (i.e., the tax-based confidentiality waivers) that we had advised should be inserted into relevant transaction documents (e.g., confidentiality agreements, engagement letters, offering memoranda, definitive purchase agreements, etc.) is no longer required in order to keep the parties from having to treat the transaction as a reportable tax shelter. Nevertheless, the new rules still must be kept in mind in reviewing confidentiality and other similar agreements, especially where one of the participants may be acting in more than one capacity (such as in a case where an adviser also participates in a transaction as a principal). In addition, the new changes to the tax shelter regulations apply only to the rules defining confidential transactions as tax shelters and do not amend any of the other rules that describe other characteristics that may cause a transaction to be classified as a reportable tax shelter.
The market is now considering the impact of these new regulations. On January 6, 2004, the Loan Syndications and Trading Association announced that it was retracting its recommendation that documentation for most ordinary non-tax-motivated lending transactions and all secondary loan market transactions contain tax confidentiality waivers. This sort of market reaction is positive, and we trust that other market participants will react in similar fashion. Nonetheless, certain regulations that relate to obligations imposed on tax shelter organizers were not amended by Treasury and still retain a definition of tax shelter that broadly includes transactions offered under conditions of confidentiality. Accordingly, many transaction organizers, promoters, underwriters, and other intermediaries and advisers are still contemplating whether, and how, they will operate under the new Treasury regulations if the principals to the transaction no longer include tax-based confidentiality waivers. It is likely that some organizers, advisers, promoters, and other transaction intermediaries will continue to insist that tax-based confidentiality waivers still be used in order for such intermediaries to avoid the more inclusive tax shelter definition applicable to them.
We will continue to monitor and advise on market reactions to these new regulations but, for the meantime, the inclusion of tax-based confidentiality waivers is not generally required in order for principals in confidential transactions to avoid having to treat their transactions as tax shelters.
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