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No shelter from the storm

Investors may soon join the U.S. government's crusade against corporate tax shelters.

In the long-running battle between corporations and tax collectors, the government has finally gained the upper hand. That's in no small part because of the wave of corporate scandals that has hit the country in the past few years. Investigations into Enron Corp.'s collapse, for instance revealed the company's reliance on complex transactions that served little purpose other than to shield income from taxes. These probes also spotlighted how bankers, accountants and lawyers have long marketed similar shelters to a wide swath of corporate America. Now there is growing support in Congress for making corporations pay their fair share in taxes.

In fact, the feds are taking the fight to companies like never before. In August, for example, accounting firm KPMG settled U.S. Department of Justice charges that it helped clients improperly avoid $2.5 billion in taxes between 1996 and 2002. It paid $456 million in fines and agreed to have its tax practice monitored by former Securities and Exchange Commission chairman Richard Breeden.

Rulemaking is also part of the effort. In 20, 03 the IRS beefed up rules that force companies to disclose shelters in their tax returns. It also required accountants and other shelter promoters to register strategies they market to clients and provide lists of the companies that use them. The deals that must be disclosed fall into two categories: "listed transactions" (specifically designated by the IRS as abusive) and "reportable transactions" (a wider array of arrangements that cut taxable income). These can include everything from complex leases to investments designed to yield losses. Congress in 2004 imposed stiff legal penalties for companies that don't comply with the IRS rules. And in July 2005 the Public Company Accounting Oversight Board formally prohibited auditing firms from selling shelters to clients.

As a consequence, sales of shelters appears to have plummeted. Statistics are difficult to come by, but people who work in the once-burgeoning shelter industry say activity has slowed -- a lot. "The atmosphere has changed dramatically," says one veteran corporate tax lawyer. "No big company these days is entering into a listed transaction or anything that might soon become listed."

The fight may yet broaden. The Financial Accounting Standards Board in July proposed a rule that would require companies to more accurately account for shelters and their impact on earnings. If adopted in the first quarter of 2006, as expected, the measure will force companies and auditors to determine whether tax-saving deals have a better than 50 percent chance of standing up to an IRS audit. Shelters that don't meet this standard will have to be reversed. Companies will be forced to recognize the impact in earnings statements and disclose the reasons to investors.

The FASB plan would effect a dramatic change. Currently, shelters are hidden from investors, who can only guess whether companies employ them by looking at fluctuations in their tax rates. Given the upwards of $18 billion that the IRS estimates shelters may cost the U.S. government annually, the hits to earnings from reversing even a fraction of them could be substantial.

"It's going to be a bloodbath if this interpretation gets implemented," predicts Lehman Brothers tax and accounting analyst Robert Willens.

The extent of the damage could depend on how auditors react. Willens and others expect them to be conservative in testing the legitimacy of shelters, given all the scrutiny. If adopted during the first quarter, the standard could become effective by year-end.

Companies, predictably, have fought FASB's plan. They have succeeded in lowering the feasibility hurdle from 70 percent to 50 percent, a level from which the rulemaker is unlikely to budge. Companies that suffer a significant earnings hit under that standard are likely too aggressive with tax strategies, suggests Donald Thomas, project manager for the FASB interpretation: "If I were an investor, I would want to know about that."

Gimme shelters

U.S. corporations increased their use of tax shelters dramatically in the 1990s, the most recent period for which Internal Revenue Service data is available. The figures below show low and high estimates for the amount of tax revenue lost to abusive shelters.

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