In 1934, a distinguished American jurist, Judge Learned Hand, famously opined that “one may so arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes.” In light of recent developments in tax planning, government enforcement, and domestic and global politics, a serious question exists as to whether this remains the case.
This article will discuss the mounting pressure on tax planners, who increasingly face the delicate and sensitive task of determining whether a contemplated tax reduction strategy is “going too far.”
Avoidance v Evasion
The distinction between legal tax avoidance and illegal tax evasion is, at a high level, well-ploughed turf. In general, legal avoidance becomes illegal evasion if the structure involves some kind of deception, fraud, false statement or sham in fact. Some cases are obvious – a wilful misrepresentation or concealment of fact on a return or series of returns, such as underreporting income on a tax return or misrepresenting a transaction as having occurred when it did not.
Others involve what US authorities call a “Klein conspiracy”, named after a landmark 1950s’ criminal case, where the government alleges a concerted effort to impair, impede and obstruct IRS tax enforcement, such as through mischaracterised transactions, false book entries or other documents or even false statements made during tax examinations.
To some, US authorities pushed the edge of the avoidance versus evasion issue in prosecuting tax practitioners beginning early in the last decade for structuring, marketing, and opining on large tax shelter transactions that with a few signatures, wiped away vast amounts of income.
While defence lawyers urged that the transactions were a series of legal steps that were properly documented, federal prosecutors argued that the architects of these shelters wilfully lied about their purpose. In one line of cases, judges and juries were persuaded that what some practitioners might have characterised as investing in certain foreign currency options and hedges was, in fact, purely a well-papered ruse to generate massive and sham tax losses. The wilful mischaracterisation of a transaction’s business purpose (though sometimes accompanied by other badges of fraud or ill-conceived emails) was deemed a criminal act of evasion, not an honest disagreement over a tax avoidance strategy. Practitioners went to jail, and taxpayers paid heavy penalties.
Legal Avoidance v Abusive Avoidance
Of course fact patterns can be complicated and distinguishable, and fitting a transaction into legal ‘tax avoidance’ is, like most tax work, best analysed on a case by case basis. However, if a deal fits this label, it is ‘legal’ because every aspect of the transaction literally complies with the text of the law. Such tax planning at the corporate level can obviously increase earnings and enhance shareholder value.
But the analysis does not stop with the notion that each aspect – dare we say ‘step’ – of a transaction is ‘legal’. Various judicial and legislative anti-abuse doctrines can nonetheless undermine whether such a transaction ‘works’ for tax purposes. Such concepts are generally well known in the US, where courts apply the ‘step transaction doctrine’, ‘economic substance’, ‘sham in substance’, and other markers to draw lines between those deals that work from those that do not. These analytical tools are largely objective, but the outcome of applying such tools nonetheless often turns on whether a transaction was solely for tax avoidance or whether it held a non-tax purpose, and courts are increasingly less tolerant of taxpayer arguments..
Until recently, tax planners looked almost entirely to these doctrines as providing sufficiently reliable and objective guideposts in drawing the line between acceptable and unacceptable tax . But decisions under such anti-abuse doctrines are beginning to venture into a normative and legal judgment that planners generally should not engage in tax reduction strategies solely for that purpose, even if the structure is legally sound, and a transaction increasingly has become ‘abusive’ because the taxing authority decrees it. The language in court decisions is beginning to reflectadded considerations having little to do with the finer points of statutes, regulations or cases.
Enter Morals and Politics
Even arguably legal tax avoidance transactions may now be viewed as too ‘aggressive’ based on a perceived violation of some larger and more diffuse set of values. For example, in the 2013 case of Salem Financial, Inc v United States, a complex, but legal, loan and trust transaction – commonly known as the ‘STARS transaction’ – was struck down by the Court of Federal Claims as “economically meaningless” under the economic substance doctrine. But the court also voiced a strong moral basis for its decision against the taxpayer and all parties involved in the scheme by calling their conduct “nothing short of reprehensible”. And more recently, the media and the political establishment are applying yet another test – one based, contrary to Judge Hand’s pronouncement, on patriotism and a more absolute and moralistic view of corporate behavior under the tax code.
One clear example arises from the debate over corporate inversions, which is a transaction in which a US-based multinational corporation replaces its US parent with a foreign parent through a restructuring merger, effectively becoming domiciled in the new foreign parent’s jurisdiction of incorporation (usually with a lower corporate income tax rate than the US). The transaction ‘works’ unless the inverted corporation fails to meet certain ownership-related criteria laid out in the Internal Revenue Code, in which case the entity will still be treated as US for US tax purposes.
Whatever other reasons there may be for an inversion, the most important is obvious to any shareholder - the post-inversion foreign-corporation would no longer be subject to the uniquely harsh 35 per cent US corporate income tax rate and the inclusion of certain foreign-sourced earnings of the corporation into the corporation’s pot of US taxable income. The US Treasury acknowledges that ‘genuine’ cross-border mergers, based on non-tax reasons such as increased access to foreign markets and reduction of manufacturing costs, may strengthen the US economy by enabling overseas investment of US companies and attracting foreign investment into the US. However, it also takes the view that inversions driven solely by a desire to avoid US taxes are improper, implying that a tax-motivated inversion is not ‘genuine’, even if technically within the law.
But whatever the legalities, political figures, including congressional leaders and President Obama, have denounced inversions as unpatriotic. Companies contemplating perfectly sensible inversions are subject to political and moral pressure to refrain from tax-motivated expatriation after having operated as a US company for many years and derived large benefits from the US markets and infrastructure. Last year Walgreens, a major US drugstore company, terminated its inversion plans to merge with Alliance Boots, a European retailer, because of the potential for customer backlash, loss of government contracts, and a likely protracted legal dispute with the IRS.
Thus, US tax planners are increasingly forced to look far beyond the ‘legal’ risks that a tax plan entails and to consider political and reputational risks in reviewing a given transaction. Such an analysis requires not just the ordinary tools of the tax trade, such as detailed code and regulatory analysis and professional advice and outside opinions, but the input even of media consultants and corporate lobbyists.
To complicate the matter yet further, in the international arena, the dividing line between sustainable and non-sustainable deals is even more ambiguous, due to the lack of a coherent ’international tax system’ where all constituents abide by one single agreed upon legal doctrine that is effectively enforced by a centralised authority. The existence of different sets of domestic law, with a complex network of tax treaties and other international agreements, provide a fertile environment to engage in tax avoidance transactions. But such ‘anarchy’ also leads to difficulty in generating a formal doctrine to police international tax planning transactions in general, as each country has its own ‘anti-abuse’ rules that may or may not apply in a given case. The lack of a unified legal regime for labelling certain transactions as inappropriate has caused further confusion and created inefficiencies in international business operations. Companies must face the risk that even if their ‘legal’ tax avoidance transactions may work in one country, another affected tax authority may challenge and reject it after implementation. To the extent that such a review will now embody any notion of ‘morality’, one can only imagine the legal and cross-cultural complexities.
One recent example of a tax avoidance structure that the international community has condemned as ‘immoral’ is known as the Double Irish Dutch Sandwich technique – a structure that many large multinational corporations, including Google and Apple, have utilised. The transaction involves funneling profits through an Irish company, then to a Dutch company, and finally to a second Irish company that is headquartered in a low-tax jurisdiction. By in effect arbitraging the differing tax residency rules under Irish and Dutch domestic law, the EU free trade regime forbidding withholding tax on inter-EU transactions, and the income tax treaty between Ireland and the Netherlands allowing taxation of royalties only in the country of residence, a corporation is ultimately able to achieve a dramatic reduction in its tax liabilities. And this complex structure can be meticulously planned so that it violates none of the numerous anti-abuse doctrines and is thus ‘legal’.
Yet, enter the concept of morality. Critics argue that companies embarking on this approach are exploiting unintended gaps in the crisscrossing web of different laws and reducing their effective global tax rates to single digit figures, despite the fact that they generate billions of profits around the world. This is viewed as ‘unfair’ in that the corporate taxpayers are shirking their social responsibility to contribute to the society in the form of tax dollars in exchange for their shareholders’ profiting from the social infrastructure, markets, and economic activities in various jurisdictions. From a political perspective, this argument resonates strongly not just in the media, but with many ordinary businesses and taxpayers who do not have the means to engage in such complex global tax structuring and must pay a substantially higher rate of tax.
One could view the launching of the recent OECD BEPS project, which aims to curb tax practices that result in base erosion and profit shifting, as an attempt to construct a relatively unified legal front against such aggressive tax avoidance structures and certain illegitimate tax avoidance behaviours to prevent corporate profits from escaping tax. BEPS has gained momentum, in part because of a great increase in public awareness and scrutiny of tax avoidance transactions – for instance, the protests against, and boycotting of, Starbucks by the UK public, and the controversy resulting from leaked documents out of Luxembourg. And recently, the EU announced that it may expand its push toward making tax rulings transparent among member governments on a quarterly basis to include disclosure of such developments retroactive for the past ten years. Corporations must now worry about brands becoming tainted as immoral and unethical because of an attempted tax strategy even a decade ago.
What to Do?
Taxpayers and their advisors who must navigate the currently murky international waters between tax avoidance and tax evasion would be well advised to ensure, at a minimum, that the tax planning process is procedurally and ethically sound – by seeking professional advice of tax experts, making full disclosure of all pertinent facts relevant to the tax plan, and ensuring that the actual tax avoidance transaction as carried out conforms to the transaction as planned and documented. But planners now likely must develop methods to buffer allegations of ‘immorality’ or a ‘lack of patriotism’, perhaps by engaging with tax authorities in advance, developing messaging strategies to defend the increase in shareholder value, and preparing for what appears to be an eventual push toward greater transparency, even to the public, of tax rulings and determinations.
For instance, it may become routine practice for tax planners to engage strategic public relations or political consultants to gauge and evaluate the non-legal, ie, reputational, repercussions that a seemingly ‘aggressive’ tax avoidance structure may bring about, such as a drop in company share value, short-term and long-term loss of revenue, and negative impact to the corporate brand. Lobbyists might be engaged to interface with politicians; media talking points may be required. Indeed, advertisers and litigators have for years made presentations before mock sample audiences under confidentiality arrangements to gauge possible reactions. It is not too far fetched to imagine this practice coming even to the tax planning world soon.
The practice of tax has always been intellectually challenging, and lawfully reducing one’s tax liability as much as possible was, consistent with Judge Hand’s view, what many tax practitioners signed up to do for their clients and employers. The world has changed, however, and planners must take note that there are larger, global and more serious undercurrents having little to do with the merits of a tax issue to challenge this long held view.