In the latter article, I argue that there really is not a strong division between the "shelter bar" and the regular bar--every practitioner is at times more aggressive in interpretations, and customized tax deals share many of the same problems that exist in shelter deals. At the heart of the problem, I argue, is the tax minimization norm that is so thoroughly accepted and based in a view of tax lawyers as "zealous advocates" for their clients with no room for paying attention to the integrity of the tax system. The professionalism of the bar is not sufficient to counteract the tax minimization norm--tax professionals may, through bar association committees, provide useful insights and proposals on a broad array of matters, but they still stretch the limits in particular instances on behalf of long-term clients and tend to lobby against broad anti-abuse proposals (such as codification of the economic substance doctrine or, in the FASIT regime discussions, the anti-abuse rule that required FASITs to have a business purpose of providing a genuine securitization). Schizer admits, for example, that "only a small cohort of trained experts can truly tell whether [a] shelter is being shut down, and these experts have developed their expertise in the service of taxpayers. ... [I]t is tempting for self-interested political actors to propose half-measures that are not fully effective." id. at 16. Furthermore, though writing collectively may shield some practitioners from client hostility for revealing too much about taxpayer avoidance strategies, he acknowledges that it would be naive to view "bar associations as vehicles to help the government ... since they sometimes serve as interest groups to champion the interests of lawyers and their clients." Id. at 28-29. I would add that the professional activities of tax practitioners through the bar associations may even free them to feel more comfortable in aggressively pursuing client interests in particular deals, because they can readily think of themselves as being a part of the professional bar rather than a part of the negatively perceived shelter bar.
Schizer writes against this background of extensive commentary in his discussion of two institutional mismatches in the tax system--an underfunded, underpaid, underexperienced and understaffed tax administration and a private bar that faces market pressures and professional norms that push it towards serving client interests and neglecting any role in improving tax compliance and enforcement. He considers ways to bring more resources to the service of government without the politically unpalatable option of substantial across-the-board increases in funding for the IRS, its staff, and its programs; and he asks whether it is possible to align tax practitioners' incentives to support their clients' interests with the government's need for more effective tax administration.
His proposals are interesting, but ultimately I think will have little impact if not coupled with legislative action along the lines that I have recommended to cause taxpayers and tax advisers to view tax reporting as an effort to reportcorrectly rather than an effort to use every tool at hand--including audit lottery, low reporting standards, and aggressive interpretations--to lower tax liabilities.
Underfunding tax administration is, after all, as Schizer admits, an "under-the-radar tax cut--appreciated by those who benefit from it--that purports not to be a tax cut at all, but an effort to cut 'fat' from an unpopular federal bureaucracy." Enlisting the Tax Bar, at 5. In fact, he later notes that "some might opt for poor enforcement as a second-best means of cutting a tax that can't be cut more directly." Id. at 15. I'd add that the unpopularity of the IRS is actively encouraged by some of those who benefit most from this indirect tax cut and not something that is true across the board, in spite of the willingness of many to assume a generic distrust and dislike of the IRS by US taxpayers. I've found anecdotally that many ordinary taxpayers fill out their tax forms each year with some pride of patriotic duty and even make a point of utilizing the standard deduction rather than spending vast amounts of time (and money) to ferret out every possible itemized deduction, because they believe that supporting the country is a good idea. Yes--I have really talked to a number of people who describe themselves and their rendezvous with IRS forms in this way, including young people who view their first tax return as a badge of honor. Regrettably, the more the IRS is labeled by radical anti-tax activists as an evil arm of the federal government taking individual citizens' hard-earned property, the more readily that image comes to mind and displaces the idea of a citizen's duty to support the important functioning of our democratic government.
But because of the general view of the IRS as representing government bureaucracy at its worst, Schizer acknowledges the political difficulty in open provision of substantial resources to support adequate audits, skilled staff for litigation, and generally effective enforcement. His alternative suggestions to upgrade the IRS's expertise include:
(1) recruit retired tax partners who will likely be willing to accept the low government pay (since they already have millions), may enjoy the opportunity to serve the public interest, and can effectively mentor junior lawyers that the IRS can afford to hire in larger numbers;
(2) hire and train a larger corps of junior lawyers fresh out of law school with the carrot of loan forgiveness programs;
(3) increase the pay scale for "a small cohort of top people" to provide expertise as a "first-response team", id. at 25;
(4) actively seek the help of tax academics who are "significantly underutilized" and can advise without client conflicts and gain valuable practical experience to add depth to their own scholarship and teaching; and
(5) retain elite private practitioners for discrete projects, including litigation of high-profile cases and initial drafting of regulatory or statutory projects.
I suspect item (3) suffers from the same impracticality as general increases in resources for the IRS and Treasury. Item (5) seems even less realistic. Taxpayers may well shun tax practitioners who take on highly visible litigation as private litigators working on behalf of the government, especially if that litigation tends over time to narrow the potential for tax avoidance planning beneficial to them. What if, for example, a private tax litigator successfully won (for the government) several cases involving expansion and reinforcement of judicial doctrines? There might well come to be a distinct schism, much like the division between labor lawyers and management lawyers, between the tax bar serving private clients and the tax bar willing to work for the government (with, odds are, the less capable falling into the latter group). Giving private tax practitioners the power of the first draft over regulations and statutes (as well as strategies in litigation) could be equivalent to providing the fox the key to the henhouse--it would certainly be tempting for drafters to squirrel away incipient loopholes to be exploited in the future to the benefit of the drafters' clients. If the reason for using private practitioners to substitute for government labor is because of lack of sufficient expertise and just bodies to do the government's work directly, how can these projects work? They will inevitably lack the kind of reasonable oversight to ensure that the government's interest remains paramount. Privacy concerns, as in the case of private tax collectors substituting for government employees, are also significant in this context. Schizer acknowledges these difficulties in passing, without suggesting what remedies would prevent their becoming the predominant mode of private bar participation in government functions.
Yet in spite of these potential drawbacks, at least some of Schizer's proposals for bringing the expertise of the private bar into the government (as a reciprocal to the current revolving door that takes government expertise into the ranks of tax firms for clients' benefit) merit attention and should be considered by the government as it continues its effort to roll back the lax enforcement since the 1998 "taxpayer friendly" legislation.
Schizer's comments about enlisting the private bar more directly, in spite of the current professional norms of intense loyalty to clients and acceptance of an adverse view of government, seem less promising and possibly even counterproductive (i.e., not so different from the proposal to use the private bar to conduct government litigation or draft regulations). He looks for ways that the government could use the lawyer's loyalty to her client to also assist the government--i.e., contexts in which a lawyer might play a role in enhancing enforcement while also assisting her client.
First, he suggests that taxpayers won't mind when their attorneys help squash an aggressive tax deal that they've rejected but their competitors have done. Of course, this already exists, in the brown paper envelopes received by the IRS, and some of that is done by taxpayers snitching directly on their competitors. Is there really any room for increased snitching with even more open encouragement, such as Schizer's suggestion of bounties to informants or direct questioning during audits of competitors' aggressive tax practices? Are there ethical consequences to paying bounties to attorneys for sharing with the government information about likely illegal tax strategies, when attorneys might be expected to do so without such monetary incentives under their obligations as officers of the court?
Second, Schizer suggests that the government should make more use of the bar's willingness to help it find ways to ameliorate the harm from anti-abuse rules that inadvertently impose harsh tax consequences on ordinary business transactions. Again, I doubt that there is any current laxness in carrying out this task. Arguments that a proposed rule will prevent taxpayers from getting tax treatment they deserve for routine transactions inevitably appear whenever Congress proposes anti-abuse or corrective legislation. To the extent the concern is genuine, alerting the government to problem results of rules is a service, and is readily provided because of the benefit to attorneys' practices and their clients' tax bottom line. Efforts to encourage such responses even more may be counterproductive. Attorneys clearly serve their clients' interests as well if they can convince the government to substitute a more lenient rule less likely to result in tax liabilities or penalties for tax motivated transactions that would not occur in the ordinary course of business. If there are methods of structuring transactions very close to the edge that would not be done but for the possibility of avoiding tax liabilities, it is not a social good to encourage that type of structuring--it merely reinforces the overly aggressive tax minimization norm. Finally, paying too much attention to encouraging attorneys to ensure that the government sifts out some harmful effects on a deal that a tax practitioner says might be otherwise doable without the proposed rule may result in filtering in additional possibilities for tax arbitrage. As Schizer notes, there is always a "risk that the bar will propose language that spares not only the meritorious transaction, but also an abusive one," requiring that the tax bar's advice be taken with the proverbial grain of salt. Id. at 39. That may well be the case, for example, with the bar's resistance to using tax indemnities as a trigger for the corporate tax shelter regulations. All in all, the idea of using attorneys' loyalty to their clients' tax avoidance desires to help with tax administration doesn't appear likely to be genuinely productive of a better tax system.
The United States reaches Thanksgiving in the midst of another disputed partnership case, this one involving G-I Holdings Inc., the successor to GAF corporation, on whose return the transaction was reported. Darryll Jones briefly described the transaction, in Black Letter Subchapter K, 113 Tax notes 785 (Nov. 20, 2006). He also discussed the issues involved in reaching a preliminary decision on whether the IRS could challenge a 1990 purported partnership contribution as a disguised sale or whether instead the staute of limitations had run. The IRS's notice of deficiency clearly was not within the three year statute of limitations that ordinarily applies, so the IRS claims a six-year limitations period under section 6501(e), which applies when a taxpayer omits more than 25% of its gross income on its return and inadequately discloses the omission. GAF claimed that it provided adequate disclosure, and, in the alternative, that the omission is less than 25% of its gross income.
I want to discuss two things here: 1) the evidence revealed in the government's brief in opposition to a request to bifurcate the trial, in terms of what it shows about the way the tax minimization standard dominates tax advisers' thinking and 2) the court's approach to the adequate disclosure issue of the limitations question, in terms of what it shows about the way the tax minimization standard appears to justify efforts to obfuscate aggressive tax transactions by embedding them within larger and apparently unnoteworthy business transactions. You can read the case or Darryll's discussion for a better understanding of the gross income prong of the limitations inquiry.
Before getting into these issues, however, a brief description of the transactions. GAF had appreciated assets worth about $480 million that it wanted to sell to Rhone-Poulenc S.A. (RP) without having to pay tax on the substantial appreciation. The 1990 deal was done with a structure similar to one described by Nelson in a 1989 article. GAF transferred the apppreciated assets to a partnership (via intermediary trusts) and then transferred the 49% Class A partnership interests to a grantor trust. A bank also transferred a small amount of cash to the partnership and received a 1% Class A limited partnership interest, which was also contributed to the trust. RP owned, directly or indirectly, the rest of the partnership interests. The trust then borrowed about $460 million from a bank secured by the partnership interests and distributed the proceeds of the nonrecourse loan out to the partners. Money from the partnership would pay the interest on the loan. RP essentially guaranteed the partnership's ability to make the necessary payments to the trust to repay the loan. GAF thus got $450 million cash from the nonrecourse loan, with RP funding all the interest payments and ultimately the repayment of the loan principal amount. GAF got what it would have gotten if it had sold the assets directly (with a remote chance of a downside potential of 26.3 million), minus the tax liability that would have applied to an outright sale rather than a disguised sale through a partnership.
1. The Bifurcation Brief
GAF asked the judge to bifurcate the trial, to decide the limitations issue separately from the substantive issue. The government argued, in its brief in opposition to the motion for a bifurcated trial on adequate disclosure (available on the federal courts' PACER system), that the bifucation strategy was an attempt to disadvantage the government in fully exploring the taxpayer's tax avoidance strategy. That brief provides interesting evidence of the taxpayer's (and its advisers--McKee and Nelson) willingness to present positions inconsistently to different audiences and to portray transactional elements as designed specifically to be viewed as one thing for IRS purposes even though the context shows the parties viewed it differently for substantive purposes. In other words, tax minimization as a goal appears to justify whatever level of twisting of information is necessary.
GAF obviously argues, for tax purposes, that there is a bona fide partnership and that it had a genuine investment in the partnership represented by its transfer of $480 million in assets as a contribution to capital, subject to the entrepreneurial risks and rewards of the enterprise. Yet it is well aware of the potential for recharacterization. The government's brief notes that a King & Spalding memorandum provided to GAF in 1990 (and made available through discovery in the trial proceedings) outlined "potent way[s] that the Internal Revenue Service could attack" GAF's tax strategy as a sale of assets. Brief at 10.
What is interesting is GAF's description of its tax deal when it was defending itself in litigation with its erstwhile partner RP, which wanted to terminate the deal in 1993 as provided under the agreement's terms, even though US tax law had changed to extend the period during which a disguised sale could be found by three years. In its discussions with RP, GAF officials "repeatedly insisted that GAF's investment in [the partnership] was only $30,000,000--not $480,000,000 as GAF now claims--and that [the partnership] had been structured so that GAF had no upside potential and no downside risk with respect to its $30,000,000 investment." Brief at 15. In fact, the government brief reveals RP notes indicating that a GAF official wanted "no gain or loss", was concerned that "they weren't supposed to lose any part of the 30 million," that the "basic agreement ... held GAF harmless" and that it provided "no extra for RP--no downside for GAF." Brief at 16-17.
But GAF went further--it made clear to its partners that the 30 million that appeared to be an equity investment was "part of risk for IRS only." So a major multinational corporation was structuring a purported partnership deal to get almost all of its proceeds in exchange for appreciated assets out immediately (450 of 480 million) and leaving the additional 30 million in the deal but in a way that was "not at risk" and was "for IRS purposes only." In other words, just to make it look good for the tax analysis, though all the parties knew that there was no such thing as an equity investment, no gain to be earned, no loss to be suffered--no risk to be borne.
They went even further. They structured the way the partnership worked as a complicated transaction just to make sure the IRS couldn't discover its economic substance. The government's brief notes a Coopers & Lybrand memorandum that describes the partnership allocations as being "intentionally complicated so as to steer the IRS away from this unequitable risk of loss" and acknowledging that the value of the assets would remain fixed for the limited life (intended three years) of the partnership. Brief at 18. As the IRS notes, these appear to be clear statements that GAF considered itself a seller rather than a partner.
Interestingly, GAF was upset that its partner RP revealed the fact that the parties considered the deal really a sale of property on tax-free terms. In the course of its litigation with RP, it argued that an affidavit by RP to that effect justified its seeking deferral of the termination of the structure. RP's actions in making clear the tax characterization of the transaction were seen by GAF, that is, as a betrayal of sorts in bringing GAF's intent to the light of day and the possible attention of the IRS. Brief at 22 (quoting from GAF's settlement lproposal in the Texas litigation). The litigation concluded in a tax matters agreement requiring RP to indemnify GAF for its taxes if RP did not adhere to GAF's characterization of the deal as a partnership contribution rather than a sale.
Do we need to worry about these kinds of tax insurance contracts, by the way? Why would someone have to get an indemnity agreement from a partner about how a deal will be characterized? Clearly, it would be when the counterparty thinks the deal is really something else, but acting in conformity with that characterization will have important tax consequences for the other party. It would be interesting to do an empirical study of tax indemnities to determine to what extent those agreements are connected with aggressive tax shelter transactions.
2. The Adequate Disclosure Prong
Adequate disclosure is a key element for deciding whether taxpayers and advisors satisfy the statutory and ethical standards in connection with decisions about tax reporting, so the GAF court's treatment of the adequate disclosure prong for the limitations question is especially interesting. In a Sept. 8 2006 decision in which it granted partial summary judgment on that issue to the United States. See G-I Holdings, Inc. 2006 WL 2595264, 98 AFTR2d 2006-6642 (D. NJ Sept. 8. 2006), the Court concluded that GAF did not provide adequate disclosure about the transaction. The following are excerpts from the court's opinion rejecting the idea that providing "mere clues" to the possible existence of a tax avoidance transaction constitutes adequate disclosure.
This standard does not require Debtors to have disclosed every exact element of the 1990 Transaction viewed from the United States's perspective or theory of the case. It does, however, require that the tax return reveal more than obscure, disconnected marks on a treasure map which the IRS was expected to decipher at its peril. ***
Debtors contend that disclosures in the 1990 GAF Return demonstrate that Debtors made a significant investment in a partnership, had large amounts of flow-through income from the partnership, had incurred a large amount of nonrecourse indebtedness, and had reported no income from the partnership contribution or the borrowing. ***
[T]he United States contends that the 1990 GAF Return is lacking "clues" to several key facts of the 1990 Transaction. Specifically, the 1990 GAF Return contains no connection between the formation of [the partnership] and the Credit Suisse loan, both of which occurred simultaneously on February 12, 1990, or that [the partnership] was structured to make fixed monthly cash distributions to Debtors by way of Class A Priority Returns. Likewise, the 1990 Return makes no mention of Debtors' formation of several trusts used in the transaction. ***
Debtors' $450 million share of the Credit Suisse Loan appears nowhere as a separately itemized entry on the balance sheet in the 1990 GAF Return. Debtors argue that the IRS should have been able to determine the large amount of indebtedness by the size of their reported interest payments, and that their share of the loan was included in the amount of total debt reported. Surely the interest expense coupled with Debtors' significant amount of indebtedness listed in Schedule L, Statement 118 informed the IRS that Debtors had significant long-term debt. These disclosures, however, are not adequate to apprise the government that $450,000,000 of that debt (the identical amount of assets contributed to the "Surfactants Partnership" on Schedule L, Statement 87) occurred in concert with the formation of [the partnership] and the "donation" of GAF's surfactant assets.
The court's refusal to accept the embedding of the transaction details in large, generic categories as adequate disclosure is heartening. As taxpayers and advisers alike become more accustomed to the increased disclosure requirements under the shelter regulations, Schedule M-3, and Circular 230, they should bear in mind that adequate disclosure requires more than "mere clues" --the Gaf court clearly requires that taxpayers describe transaction elements in a way that reasonable IRS agents can make sense out of the transactions and the source of the purported tax benefits.
In an earlier posting, here, I discussed the taxpayer's petition for certiorari in the Coltec contingent liability case. One of the important questions is whether the taxpayer had a legitimate business purpose for shifting asbestos liabilities into a subsidiary without related business assets. The taxpayer claimed that it hoped to avoid "piercing the veil" by putting the liabilities in a separate subsidiary. I noted a strong doubt whether there would be any legal protection from the liabilities as a result of that shift, since fraudulent transfers of responsibilities to entitites that are not equipped with the financial resources that may be necessary to satisfy demands upon them are always subject to review, under the tax law and under corporate theories.
One reader reminded me of a further reason why this purported business purpose appears particularly flimsy in the Coltec case. Given the clear evidence from existing litigation that sufferers from asbestos exposure are and will be willing to pursue claims against companies through which they were exposed, one could expect that litigation expenses would be fairly significant in connection with the attempt to avoid liability by shifting the asbestos claims off to a subsidiary. In other words, a reasonable present value determination of expected transaction costs from defending asbestos claims in connection with the shift of asbestos liabilities would undoubtedly dwarf any potential non-tax business gains from the shift (which were already difficult to ascertain). What starts out looking like it had some potential as a genuine business purpose--better management of asbestos claims--becomes much less so when the ongoing transaction costs of the new structure are taken into consideration. The structure just adds one more (expensive) headache that must be dealt with in litigation.
IRS Commissioner Everson reported on this year's enforcement statistics. See IRS News Release. He reports that enforcement efforts have "rebounded" since the low point of the 1998 tax "restructuring and reform" act that focused more on service to taxpayers than on the primary role of the IRS as the collector of revenues. In 2005, enforcement revenues reached $47.3 billion, and in 2006 $48.7 billion.
Everson pointed out increases in individual audits, including an increase in face-to-face exams rather than just correspondence exams (which many--including this blogger--consider less rigorous and less likely to discover aggressive tax avoidance strategies). Everson notes that overall audits were up 6%, but field exams--the more rigorous reviews that had been slighted in recent years--rebounded somewhat with a 23% increase over 2005.
Yet when one looks at the actual statistics, available here, it is clear that IRS enforcement efforts are still significantly below where they were back in 1997. In 1997, there were 803,628 correspondence audits of individual tax returns and 715,615 field examinations of individual returns. Compare 2006, when there were only 302,959 field examinations of individual returns, and 990,722 correspondence audits. The proportion is now 3 correspondence for each field exam, whereas in 1997 it was closer to 50-50. And there are fewer overall audits (counting both field and correspondence) in 2006 compared to 2007, though the number of taxpayers has increased significantly.
After years of targeting low-income taxpayers with audits (especially, audits of the Earned Income Tax Credit), Everson also noted an increase in IRS focus on a more appropriate target--high income taxpayers. Audits of millionaires increased 33%--a good but still not sufficient rate of audit, considering how low the audit rate has been for several years. Even with the increase, only about 1 in 16 millionaires faced an audit last year. That number should be at least 1 out of every 5 millionaires annually. The IRS is still targeting people with incomes just over $100,000, increasing these by 18% last year. Why most of that staff time isn't devoted to those with at least half a million or more is hard to see.
It's noteworthy that there are no statistics on IRS audits of millionaires prior to 2004, so any increase is against whatever low rates were in place in 2004. In 2004 there were almost 6000 field examinations of millionaires' returns and about 4000 correspondence exams. In 2006, slightly more than 9000 field exams compared to almost 8000 correspondence exams. So the number has increase (though still too small, as noted), but the split between field and correspondence has shifted slightly towards correspondence exams, in the case of the ultra wealthy (not a good trend).
There is no breakdown to show how the low-income returns have fared--the breakdown provided by the IRS is only millionaires, $100,000 and more, and less than $100,000. Without more complete data (such as TRAC used to analyze), it is hard to know exactly where enforcement efforts are focusing.
Partnerships and S Corporations got more audits, but closely held corporations (where there is lots of post hoc changing of tax numbers, at least from the anecdotal evidence I've seen) stayed steady at best and audits of the really big players--large publicly held corporations--actually decreased by 2.2%. That is hard to understand, given the track record of participation in tax shelters. Openly marketed tax strategies may be on the wane, but corporations are still engaging in aggressive, customized tax minimization transactions that merit considerable scrutiny. If the IRS reduces its focus on aggressive tax planning for even one year, odds are the corporate tax departments will once again start ginning out deals instead of acting as the gatekeepers they ought to be.
Those business audit numbers are all still far too low, especially in comparison with 1997. Look at the extraordinarily low audit rates for businesses in 2006 compared to their already-too-low rates in 1997 (based on statistics document at 5).
Small Corps:1997 2.22%20060.80%
Finally, the IRS focused on tax-exempt organizations including hospitals, retirement plans and governmental entities. Everson didn't mention religious organizations, but we know that the tax-exempt status of a number of religious organizations was reviewed after the 2004 election and the topic was one of interest to Congress in connection with the 2006 mid-term elections just past. Still, the record is similarly disheartening. Back in 1997, more than 10,000 tax exempt organizations were subject to audit. This year, with the proclaimed significant increase, fewer than 8000 organizations were audited. A dismal decline throughout the first 5 years of the Bush administration is beginning to be reversed, but there is a long way to go to decent audit levels.
The improving but still low audit rates are obvious from the U-shaped curves comparing audit rates for these different groups, presented in chart format by the IRS, here.
One thing obvious from the information provided is that the IRS lacks sufficient enforcement staffing. In 1997, the IRS had 25,215 enforcement officers (revenue officers, revenue agents and special agents) and in 2006, only 21,185. It is time for Congress to fund the IRS to do its collection work, instead of okaying private collection efforts that fill the pockets of private businesses doing work that the IRS can do better and that the government should do because of privacy and other concerns about aggressive private debt collectors doing the government's business for it. See Nina Olson's latest comment on private debt collection here.
I write here about fairness and the importance of equitable distribution of resources, so it seems worthwhile to point out the interesting research that has been conducted with other primates on this issue. This research was highlighted in Science writer Sharon Begley's reports, in the November 10th Wall St. Journal, "Animals Seem to Have an Inherent Sense of Fairness and Justice".
Back in June 2005, the New York Times ran an article by Dubner and Levitt titled Keith Chen's Monkey Research. It was about capuchin monkeys, those cute little furry creatures that we know most often from seeing them dance and collect coins in a hat, accompanying a clownish organ grinder. Economist Keith Chen found that the monkeys displayed very similar economic behavior to humans. Given a chance to gamble where they might lose one of two grapes they possessed, they were not very eager. Given a chance to gamble and double the number of grapes from one to two, they were. The relative aversion to loss was statistically about the same as for humans. Classical economic theory tells us the odds are the same, so whether its a gamble to win or a gamble to lose we should rationally have no preference. But most monkeys, and humans, are "irrational" in this situation. Chen taught the capuchins how to use money--a flat silver disk with a hole in the center was tradable for various food items that capuchins crave. They apparently "got it" and then behaved much like humans.
"When taught to use money, a group of capuchin monkeys responded quite rationally to simple incentives; responded irrationally to risky gambles; failed to save; stole when they could; used money for food and, on occasion, sex. In other words, they behaved a good bit like the creature that most of Chen's more traditional colleagues study: Homo sapiens. " Id.
Perhaps the most interesting part of the capuchin story is their innate sense of fairness and rejection of unequal treatment. Various researchers at the Yerkes Primate Research Center at Emory have conducted studies of these traits. See the Center's website and this 2003 article, Monkeys Reject Unequal Pay, by Sarah F. Brosnan and Frans F. de Waal. A capuchin monkey will toss a cucumber to the ground if she is offered the inferior item at the same time that her partner is unfairly favored with a more delectable grape. The experimenters concluded that aversion to inequities is probably innate not only to humans but to other species.
[T]he brown capuchin monkey (Cebus apella) responds negatively to unequal reward distribution in exchanges with a human experimenter. Monkeys refused to participate if they witnessed a conspecific obtain a more attractive reward for equal effort, an effect amplified if the partner received such a reward without any effort at all. These reactions support an early evolutionary origin of inequity aversion. ...
People judge fairness based both on the distribution of gains and on the possible alternatives to a given outcome. Capuchin monkeys, too, seem to measure reward in relative terms, comparing their own rewards with those available, and their own efforts with those of others. They respond negatively to previously acceptable rewards if a partner gets a better deal.
[i]f the partner is kin it does not matter if the food is clumped or dispersed: cooperativeness is high in both partners. If the partner is unrelated and dominant, however, food monopolizability becomes an issue, and cooperative tendency dwindles.
So what does this have to do with my tax blog? The research showing that a sense of fairness is innate not only to humans but to primates generally makes fairness even more important in policy decisions. It is deeply rooted in our psyches and our sense of appropriate human conduct. A key component of fairness, as illustrated by the capuchins' response to unfair allocations, is equitable distribution of resources. Our policy decisions about taxes should take that into account: fairness, in other words, may well trump efficiency in evaluating a tax system. This is especially true, since fairness seems to be a necessary component for institutions that encourage cooperation and community building, in monkeys and in humans.
Coltec Industries is a corporation that executed the contingent liability tax shelter made famous in the Enron case and by reason of Arthur Andersen's promotion, revealed in the Enron investigative reports. Coltec is a former subsidiary of Goodrich, which is the company that would ultimately owe the tax liability for the shelter, if the current litigation over Coltec's participation results in an IRS victory. Goodrich notes that it has "fully reserved" for the $50 million tax liability. See Goodrich website.
In the contingent liability shelter, contingent liabilities are transferred, with some cash but without the other assets of the business that generated the liabilities, in a purported section 351. The transaction is claimed to have a non-tax business purpose--in Coltec's case, to isolate contingent liabilities related to asbestos exposure because of the corporation's fear of piercing of the veil.
Aside: The idea of having a single subsidiary manage asbestos liabilities in a way that avoids tarring the transferor with the mess created by the contingent liabilities sounds at first blush like a genuine business purpose. But there are considerable doubts that shifting such liabilities, without related business assets, off into a subsidiary and then selling the stock would suffice to avoid recharacterization of the relationship between the transferor and the subsidiary and allocation of those liabilities back to the transferor. In other words, the contingent liability shelter may have been very poorly designed to accomplish its purported primary business purpose, though very clearly designed to accomplish its tax avoidance purpose. Should that weigh in the question of whether there was a genuine business purpose for the transaction (as opposed to a genuine business purpose for the liability shift, which seems much less viable). The parallel of Coltec's shelter to Arthur Andersen's promotion of tax shelters to Enron is interesting, since there Andersen initially suggested that the business purpose be isolation of contingent environmental liabilities, but when Enron didn't have any, all the planners were quite content to isolate, instead, Enron's contingent employee-related obligations.
The main value of the contingent liabilities section 351 transaction is creation of a purported high basis, low value stock whose planned immediate sale results in a loss that is available to offset unrelated gains that would otherwise have been subject to tax. The loss effectively accelerates (and duplicates) a deduction that would eventually be available to the transferor on the payment of the contingent liabilities. That is, the transferor of the liabilities has manufactured a present benefit that would otherwise have been denied it under the relevant Code provisions.
The Black and Decker and Coltec cases at the trial courts and at the appellate courts were poorly reasoned and, in my view, unsound interpretations of the relevant statutes that unnecessarily shifted the burden of upholding the tax laws to the economic substance doctrine. I have always considered that you must read these areas of the Code with a view towards finding structural coherence. First, the section 357(c)(3) deductible liability rule should probably be interpreted, with the aide of legislative history, as applying only in cases where contingent liabilities are transferred in the context of the business that gave rise to the liabilities. The question is whether an incorporation transaction that purports to separate liabilities from the obligor in ways that are unlikely to be upheld for legal purposes and with supplemental provisions for ensuring that the obligor will be responsible for the ultimate payment (even if the liabilities exceed the current present value determination of their amount) should be viewed as a genuine incorporation transaction. That question is easily answered no if no other factual changes accompany the transfer--as in the Enron case, where the same activities continued to be done by the same human resource personnel, and there was a clear plan to repurchase the stock, with a tidy profit (equals fee) payment to those who purchased it. A circular flow of cash that results in no new assets actually lodging in the corporation to pay the liabilities also argues for nonrecognition of the incorporation transaction as a valid incorporation. (That is essentially a no-net-value transaction.) It is less easily answered if there are other factual changes that suggest a real, though limited, business to be conducted by the subsidiary with real, though limited, assets. That may have been the case in Coltec, where management of the liabilities could have provided some profit motive.
Second, even if some version of the business-context requirement is not adopted, a coherent reading section 357(b) (which applies when the principal purpose for the assumption of liabilities is tax avoidance, as it clearly was in both the Black and Decker and Coltec cases) requires that it be viewed as overriding any results that would otherwise occur under section 357(c). Section 357(b) treats the total amount of liabitities as "money received" on the exchange. Thus the liabilities are boot for section 351(b) purposes, and they are also "money received" under section 358(d)(1) for purposes of the basis rule in section 358(a)(1). Accordingly, the shed liabilities decrease basis. The exception for contingent liabilities is inapplicable in the section 357(b) context, because section 357(c)(2) indicates that section 357(c)(1) does not apply where section 357(b) applies. Since 357(c)(1) does not apply, then section 357(c)(3) cannot apply, because it applies by its language only "for purposes of paragraph (1)". Since section 357(c)(1) ensures that section 357(c)(3) cannot apply, then section 358(d)(2), which applies only to the amount of any liability excluded under section 357(c)(3), cannot apply to change the result and provide the higher basis without the reduction for the contingent liabilities. Liabilities, even contingent liabilities, are therefore to be treated as money received and hence to reduce basis in the formula provided in section 358(d).
The Coltec appellate court (the Federal Circuit, July 12, 2006 opinion available here), agreed with the trial court (Court of Federal Claims, Oct. 29, 2004 opinion available here) that the "any liability excluded under section 357(c)(3)" language was ambiguous. The language could be read to refer to liabilities that are in fact excluded by application of section 357(c)(3) or to those that are merely of the type that may be excluded by that section (but are not because of the operation of section 357(b)). That ambiguity exists if the text is pushed, but the demand for structural coherence argues strongly against the latter interpretation. The Coltec appellate court's interpretation means that section 357(c)(3) becomes, in the section 357(b) context, merely a descriptor that "applies" for purposes of kicking the liabilities out into a special basis rule --section 358(d)(2)--even when it does not actually apply to determine the tax consequences of the liability assumption. That result is contrary to good tax logic--the special basis rule applied in that context would produce a result that is contrary to the general conservation of basis principle that is expressed throughout the Code. Instead of consulting the general way Code provisions are constructed in this area of the Code, the Coltec court even looked at a dictionary meaning of "under" to support its broad, 'descriptor' approach to the section 358(d)(2) reference to section 357(c)(3). It suggested that Congress needed to include additional language ("unless the assumption involved a prohibited purpose described in section 357(b)") to accomplish what the clear intent of the provisions already accomplished without the language. While that might have been a nice clarifying statement, it should not have been necessary given the way the provisions work together in contexts not involving contingent liabilities.
Based on this statutory analysis, the Coltec appellate court held that, even in a case where the anti-abuse provision in section 357(b) applies, the taxpayer can avail itself of the basis reduction provision in section 358(d)(2) merely because its liabilities (that were assumed, though not actually shifted to the assuming corporation, for tax avoidance purposes) were a type of contingent liability, rather than determining its basis under section 358(d)(1) as appears necessary for these provisions to be interpreted with structural coherence. As Karen Burke noted in her article on the Black and Decker decision discussing the 1939 amendments that provided for the basis reduction in the 357(b) context, in 106 Tax Notes 577, 588 (Jan. 31, 2005),
"[W]hether or not an assumption of liabilities was treated as money under the tax avoidance rule for purposes of gain recognition, the transferor's basis was reduced by the amount of liabilities assumed. From that perspective, it makes no sense--contrary to the theory espoused by B&D in support of its motion for summary judgment--to treat an assumption as money under section 357(b) for purposes of gain recognition but not to reduce basis by the amount of the liability assumed. That treatment would create a disjunction between the gain recognition and basis provisions, contrary to the clear intent of the 1939 amendments."
As Burke noted in her 2005 Tax Notes article, "courts should focus pragmatically on 'whether the consequences of getting the accounting wrong are tolerable."
The Coltec trial court (i.e., the Federal Claims court) refused to apply the economic substance doctrine, claiming that it was unconstitutional under a separation of powers analysis. The Federal Circuit rightly rebuked it for disregarding binding Supreme Court precedent. But the trial court also went on to consider the doctrine's applicability and held it inapplicable here. The Federal Circuit reviewed that finding as well, noting that its review of the trial court decision on this issue is a review of a legal conclusion and therefore is conducted "without deference" (i.e., de novo). The appellate court concluded that the assumption of the liabilities had no business purpose, either to help in their management (others were managed without being assumed) or to protect against veil piercing (there was no evidence that the assumption indeed protected against this problem).
whether the appelate court's review of economic substance decisions should be de novo or for clear error and
whether the taxpayer's good faith business judgment can be reviewed as lacking objective economic benefits
I believe that the Court should reject this appeal. If it does review the case, the Court should find against the taxpayer on both issues. First, whether the petitioner demonstrated its burden of proof of economic substance does not call for the deferential "clear error" standard of review proposed by the petitioners. That standard of review is applicable to pure questions of fact, which a trial court is treated as having an advantage in reviewing because of its participation in the case at trial. The determination of the scope of the judicial doctrine of economic substance to include, or not, a transfer of contingent liabilities to a subsidiary in order to generate a significant loss in the immediate sale of some of the subsidiary stock is a matter of law that merits a de novo standard of review.
Second, the taxpayers argue that a transaction can be disregarded as an economic sham only if it both lacks economic substance and is motivated solely by tax avoidance purpose, in accordance with the Fourth Circuit's highly restrictive Rice's Toyota World test. The Court should reject that overly narrow test. Taxpayers have relied too long on Learned Hand's statement about tax planning as a justification for tax-driven deals. They need to be reminded that tax planning is merely prudent arrangement of pre-existing plans to enter into business-driven transactions and should not be a driver of transactions. A sham transaction exists where there is insufficient substance, apart from tax consequences, for a transaction to be respected for tax purposes. If a transaction has no purpose other than tax avoidance, it should not be entitled to the tax benefits sought. The taxpayer's reliance on a "tax business judgment rule" to avoid close scrutiny of its tax avoidance transactions should not hold sway.
Another Aside: For IRS Commissioner Korb's views on the economic substance doctrine, see his January 2005 speech to the University of Southern California Tax Institute. For a discussion of the likelihood that even codifying some sort of economic substance doctrine won't lead courts to apply it in appropriate circumstances to halt abusive transactions, see Zelenak and Chirelstein, A Note on Tax Shelters. They also discuss the contingent liability shelters. They suggest a general noneconomic loss disallowance rule.
Further, the taxpayer's argument that the court must always look at an "entire transaction" is worrisome. Clearly the scope of the transaction will have much to do with substance-over-form analysis. Whether "the transaction" is a sham and whether it has a business purpose or economic substance will at least frequently depend on the scope of the transaction examined. On the one hand, the scope of the transaction must be broad enough so that courts can see circular flows of cash, offsetting arrangements and similar components that cause an overall transaction to lack economic substance. On the other hand, the scope of the transaction should be able to be focused on the specific transaction that generates an artificial or unmerited tax benefit. If taxpayers can essentially manipulate scope by embedding tax avoidance transactions within larger transactions, it would make it difficult for abuses to be ended. A rule forbidding a court to look at the specific transaction that gives rise to an abuse would therefore be too limiting. Transaction scope, like the economic substance doctrine itself, needs to be flexible enough to allow a court to grasp the overall context and the particulars of the abuse, and set the scope of the transaction to be analyzed for abuse accordingly. After all, if a transaction is really a valid business transaction, there should be reasonable business reasons for each of the material economic steps undertaken. As a prominent law firm noted in discussing the Coltec appellate decision,
This significant decision underscores the importance of ensuring the economic reality of each significant step of complex, tax-advantaged business transactions, and supporting each such step by valid business purposes. Morgan Lewis website (July 19, 2006).
Another worrisome element of Coltec's petition for cert is the taxpayer's language assailing courts' use of common-law power to deny tax benefits claimed to be "conferred in the tax code." This combination of literalism (the Federal Circuit's acceptance of the taxpayer's analysis of 357(b) and 358(d)(2) provides a good example) with a claim that the taxpayer is entitled to the claimed tax benefits by "the plain terms of the Code", id. at 28, in a situation in which the taxpayer's interpretation demands that the court honor the least context-appropriate of two contested meanings (as though there were no ambiguity and as though the bulk of the argument were not against the taxpayer's interpretation), together with an openly hostile view of the court's exercise of its proper role in ensuring regard for the congressional purpose evinced in the structural coherence of the Code is both ironic and troubling. The petitioner here describes the Federal Circuit's economic substance analysis as "impermissible judicial freewheeling that nullifies petitioner's statutory rights", id. at 2, and as illustrating the "perils of the standardless common-law power that some federal courts are now wielding to deny taxpayers benefits that Congress has conferred in the tax code". Id. at 25. In fact, it is taxpayers who are pushing the envelope on hyper-literal statutory interpretation to derive tax benefits not intended to be conferred by the Code sections who are, at least some of the time, engaging in "impermissible... freewheeling."
The taxpayer's cries of uncertain tax treatment of purportedly bona fide business transactions because of the uncertainty of the application of the economic substance doctrine must also be heard with some measure of skepticism. There are situations where uncertainty is not troublesome and in fact welcome. I've analogized the economic substance doctrine to the narrow yellow rubber strip on New York Subways--you can walk there when no train is present and survive, but it is a dangerous area to be in, prudence demands that you not go there, and no one will be worse off for your avoiding that area. Some flexibility and uncertainty in the likely application of the doctrine is actually a good thing, since the sheltering activity that is protected by taxpayers knowing that the doctrine cannot apply is of no societal benefit. Too much certainty in the tax shelter area would mean that taxpayers could engage in innovative abusive transactions at will, subject to the IRS's ability to play catch up and the Congress's notoriously slow ability to respond with appropriate statutory provisions. Those anti abuse provisions are necessitated only because of the abusers who insist on advantageous hyper-literalist interpretations of the Code, yet they add immensely to the complexity of the Code.
In particular, every taxpayer that undertook these contingent liability shelters was aware at the time of their undertaking the promoted deals that the IRS would object to the shelters; that the shelters were based on a reading of the statute, including the applicability of section 357(c)(3) and the interrelationship of section 357(b) and section 358(d), that was not in accord with the common view of the way the statutory provisions worked as a part of a coherent structure determining tax attributes for incorporation transactions; and that the taxpayers were using the transaction to achieve a tax objective--ostensibly splitting off contingent liabilities that would actually remain within the consolidated group and still be payable by the taxpayer, to create a current loss to accelerate (and duplicate) the deduction of liabilities not to be paid until some time in the future--that was not intended to be provided by the Code provisions. The extreme tax minimization norm that the petitioners put forward as something to be protected by the Court should be rejected.
The IRS just announced that $92.2 million in refund checks have been returned to it because more than 95,000 taxpayer-owners cannot be located. IR-2006-178. Taxpayers can correct the situation either by going to "Where's My Refund?" on the IRS website or by filing Form 8822 to register a change of address with the IRS. If unable to download and print the form from the link above or on the IRS website, taxpayers can call 1-800-829-3676.
Baucus said on November 14th, according to BNA, that he hopes to push through a full "extenders" package in the lame-duck session of the Congress. That would include the following:
making permanent the research and development credit,
a state sales tax deduction,
work opportunity and welfare-to-work credits,
a college tuition deduction,
deductions for out-of-pocket teacher expenses,
increased small business expensing limits,
tax incentives for investment in the District of Columbia,
a Native American employment tax credit,
accelerated leasehold improvement recovery,
accelerated depreciation for business property on tribal reservations,
brownfield remediation expensing,
an enhanced deduction for corporate contributions of computer equipment for educational purposes, and
qualified zone academy bonds. (source BNA).
Baucus should not put his energy into these "extenders" and should forget about any provisions for cutting the billionaire's estate tax. The R&D credit should be left as it is. Companies need to do R&D to stay in business, so providing a credit instead of a deduction merely cuts their taxes. Increased small business expensing and state sales tax deductions are likewise not needed at this time. The tax writing committees should leave the Code alone and provide some time for too-infrequent deliberation about policy choices.
Abhijit Banerjee, Roland Benabou and Dilip Mookherjee edited "Understanding Poverty", a 2006 Oxford Press book that brings together an impressive collection of work by economists on poverty, described by the editors as "one of the central problems of economics." About one fifth of the world's people--1 billion people--live in poverty (defined as less than $1 a day). The poor are "cold, and hungry," "illiterate, prone to sickness, unemployment, alcoholism and depression," "excluded from many markets and social groups" and "vulnerable to natural disasters and predation by organized crime and rapacious officials." They are often unaware of their rights and unable to access legal institutions to protect them. Ultimately, "[p]overty is a tragedy not only for the individuals concerned but also for the world at large, being intimately linked with some of the most pressing social and political problems of our time." Introduction, at xiii.
The book brings together essays on diferent aspects of the problem of poverty that have been learned in the last twenty years. In particular, the essays address market failues that keep the poor from making the kind of investments they need to escape poverty and government failures that allow elites to capture government institutions. The first four essays provide a sense of the issues addressed throughout the book.
Deaton considers how we measure poverty. Purportedlyl scientific measurement--how many calories it takes to satisfy a minimal standard of eating--was apparently the basic measure of the "poverty line" in most countries, but Deaton notes that in the US the amount was "adjusted" to coincide with the value already in use by the administration of the time. Id. at 6. Deaton notes that the calculation of the poverty line is generally just "food rhetoric." Arguably the line should be revised upward, but no one wants to admit there are really more poor people who should be the beneficiaries of redistributive legislation. Furthermore, there is little reason for drawing an arbitrary line and then treating everyone above the line as being capable of caring for themselves while those below the arbitrary line receive transfers.
Acemoglu et al looks at historical data from European colonies in the US and slave plantations in the Caribbean, to conclude that institutions that enforced property rights and constrained elites produced the best post-colonization per capital outcomes, whereas extractive institutions caused relatively rich places to get poor over time.
Engerman et al look at the role of inequality in the long-term development of colonial countries, and find that extreme inequality in wealth and human capital led to societies that ultimately prove less successful in the long run. They argue that greater equality led to "more democratic political insitutions, to more investmentin public goods and infrastructure, and to institutions that offered relatively broad access to property rights and economic opportunnities. In contrast, where there was extreme inequality, political institutions were less democratic, investments in public goods and infrastructure were far more limited, and the institutions that evolved, tended to provide highly unbalanced (favoring elites) access to property rights and economic opportunities. The resulting differences in access to opportunities may be important in accounting for the disparate records of long-term growth." Id. at 41. The study also note that successful countries like the U.S. began with local governments with progressive patterns of expenditures on schools, roads and other infrastructure that provide broadly distributed social goods, and heavy reliance on property and inheritance taxes that placed relatively more of the tax burden on those with wealth. The U.S. 1862 Homestead Act, providing free land to those who worked it, was another egalitarian policy that supported productive economic growth.
Thomas Piketty examines the Kuznet curve hypothesis, which suggests that inequality should rise with industrialization and then decline as more workers join high productivity sectors of the economy. In the US, the curve is viewed as having "doubled back on itself" with falling inequality giving way to sharply rising inequality since the 1970s. Piketty suggests that decline in inequality during the twentieth century was due to upheavals caused by two world wars and the Great Depression, which led to a decline in the concentration of capital incomes, while wage incomes remained relatively stable. Since WWII, the increase in inequality has been limited by progressive taxation of income and wealth. His statement here is worth quoting in full.
"[T]he rise of progressive income and estate taxation probably explains (at least in part) why top capital incomes were not able to fully recover from the 1914-1945 shocks and why capital concentration never returned to its prewar level. That is, progressive taxation can have a substantial long-run impact on pretax income inequality, via its effects on future capital concentration. Although this view was fairly common early in the twentieth century, it has been overly neglected during recent decades. Cutting back on progressivity can have important long-run consequences on wealth inequality and the resurgence of rentiers, both in poor countries and in developed economies." Id. at 67. (emphasis added).
And these progressive policies, he concludes, did not harm growth. In fact, they may have supported growth by widening access to human capital and entrepreneurial finance.
"[P]er capital growth rates have been substantially higher in the postwar period than during the nineteenth century and all the more so in countries such as France and Germany, where the shocks incurred by capital owners were particularly severe. This is consistent with the theory of capital market imperfections: in the presence of credit constraints, excessive wealthy inequality entails megative consequences for social mobility and growth. There are good reasons to believe that the 1914-1945 shocks allowed new generations of talented entrepreneurs to replace old-style capitalist dynasties at a faster pace than would otherwise have been the case." Id. at 67.
Piketty attributes today's increased inequality to a variety of factors, such as: "slowdown in the rate of growth of educational attainment," changes in the minimum wage, "dramatic rise of very top wages in the United States" and "changing social norms and attitudes toward inequality." He concludes that "[t]here is today in many parts of the world a wider acceptance of inequality than was the case a few decades ago, and this probably has a strong impact on actual inequality."
These studies are worth reading and pondering. In spite of the many fiscal constraints on our economy, we are a wealthy country that has the ability to take more significant action to alleviate poverty. We should not ignore the likely negative impact of increasing inequality on the most vulnerable among us or on the democratic institutions through which we govern ourselves.