Tax Insurance Gets IRS Seal of Approval for Facilitating Complex Transactions By, Nemo Perera A merger or reorganization is one of the most significant events in the life of a company, and the tax treatment of these transactions is highly complex. Because of this inherent complexity, the taxable aspect often has an indeterminate outcome. Tax insurance, a specialized form of transactional risk insurance, was developed to facilitate extraordinary transactions by providing certainty for the expected tax treatment or benefits. In addition to mergers, acquisitions, and 355 (tax-free) spinoffs, tax insurance also has application in situations involving NOL (net operating loss) absorption, recognition of goodwill, Section 29 alternative fuel credits, and other legitimate yet somewhat ambiguous circumstances. However, some tax advisors became alarmed when the IRS issued revised Temporary Regulations 1.6011-4T earlier this year. The Temporary Regulation would require disclosure of "transactions with contractual protection" as a possible tax shelter. For all disclosed transactions, the taxpayer would have a duty to maintain every document material to an understanding of the transaction's expected tax treatment. Tax insurance would, in and of itself, trigger the disclosure and maintenance requirements. Concerned about this IRS Red Flag reporting requirement, several taxpayers and other interested parties submitted written comments urging that the scope of "transactions with contractual protection" should be clarified and that tax insurance alone should not trigger any additional disclosure and retention requirements. When the IRS and Treasury officials conducted a hearing in Washington on the issue in January, an industry expert testified about the uses and benefits of tax insurance in facilitating extraordinary transactions. This tax attorney stated that insurance is not provided for tax shelters and demonstrated the need for certainty of tax treatment in connection with extraordinary transactions. More importantly, he focused on the impossibility of the IRS being able to provide "real time" guidance and assurance in business transactions. This is becoming increasingly apparent as the service continues to eliminate the routine issuance of Private Letter Rulings [for example, as of August 8, 2003, refusing to issue advance rulings on Section 355 business purpose, plan, or device (Revenue Procedure 2003-48, released June 24, 2003)]. Tax insurers are the only non-governmental entity motivated to judge tax positions conservatively. Tax insurers are not paid for providing artful opinions or for promoting creative transactions, but are, instead, compensated only for prudently assessing the correctness of a tax position. The attorney argued that the IRS should view tax insurance as a badge of propriety because it shows that a conservative insurance underwriter was willing to risk its own capital and that of its reinsurers on the validity of the tax position insured. At the hearing's conclusion, William O'Shea, a Deputy Associate Chief Counsel of the IRS, concurred, stating: There are a lot of legitimate reasons for having the tax insurance. Really it is more like a green flag. On April 11, 2003, in Treasury Decision 9046 (Tax Shelter Regulations), the IRS issued Final Regulations regarding Section 6011 transactions with contractual protection. The regs were made effective as of February 28, 2003. Recognizing that it would be inappropriate to require the reporting of every transaction for which the taxpayer obtains tax insurance, and that doing so would require the reporting of numerous nonabusive types of transactions, the IRS and Treasury Department changed the focus of the contractual protection issue to bear on whether fees are refundable or contingent. The government now defines a transaction with contractual protection as a transaction for which the taxpayer or a 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 also is a transaction for which fees are contingent on the taxpayer's realization of tax benefits from the transaction. In legitimate applications of tax insurance, a one-time premium is paid to cover risk, and this premium is not refundable or contingent. These tax indemnity transactions are therefore not reportable under the Final Regulations. << Back