Tax Planning According to Judge Learned Hand

Does the current debate over what is 'acceptable' tax planning make Judge Learned Hand's famous opinion on the right of a tax payer "to arrange his affairs so that his taxes shall be as low as possible" obsolete?

Tove Maria Ryding, Policy and Advocacy Manager for Tax Justice at the European Network on Debt and Development (Eurodad)

The current debate is not over what ‘acceptable’ tax planning is. It is about how to create a level playing field between all tax payers and all countries – or, if you like, tax justice.

Today’s average tax payer does not have a multinational network of legal structures and bank accounts. Whether he is an employee, an independent or perhaps an owner of a small enterprise, he earns his income and pays his taxes in the country where he lives. This tax payer not only has the right to optimise his own tax payments, he also has a democratic right to demand fairness of the tax system of which he is part, and to object towards obvious injustice in the system. And it is this right that tax payers around the world are now exercising.

When multinational enterprises shift around their profits to drive down their tax rate to extremely low levels, or wealth is tucked away from tax authorities in secret bank accounts, it’s not a matter of ‘arranging’ tax affairs. Whether legal or illegal, it is a matter of circumventing domestic legislation and violating the spirit of our tax laws.

Another misconception is the idea that tax payments are a modern type of corporate charity. Like individuals, multinational enterprises need the public services of our societies - infrastructure, law and order, an educated, healthy work force, and so forth. We see – particularly in developing countries – how it is the levels of development and the availability of public services that often determine whether investors are attracted or not. However, when some multinational enterprises choose to use the mismatches and loopholes of domestic tax laws to free-ride and dodge taxation, the consequences fall on the rest of society. The average tax payer will have to accept higher tax payments, lower public services, and rising inequality. Domestic enterprises will have to accept distorted competition from multinational enterprises that can avoid taxation. For some, this will lead to bankruptcy and loss of jobs. At the global level, the missing tax payments severely undermines the fight against poverty and the efforts to protect global public goods. In the longer run, we risk seeing societies with increasing levels of inequality, instability, weak governance and rising levels of civil unrest. This is not in anyone’s interest.

Historic views can still provide important inputs to this debate. In a situation where the many pay the price when the few abuse cross-boundary structures to circumvent tax laws, the following statement by Judge Learned Hand seems ever relevant:

“Right knows no boundaries and justice no frontiers; the brotherhood of man is not a domestic institution”.

Daniel J Mitchell, Cato Institute

Corporations, particularly those with global operations, are being viciously harangued by left-wing interest groups because they take legal steps to minimise their tax burdens.

Politicians in several nations have joined the campaign, demonising the businesses that ostensibly don’t pay enough money to government.

And the Organisation for Economic Cooperation and Development has now broadened its anti-tax competition project with a “Base Erosion and Profit Shifting” initiative targeting legal tax avoidance by firms.

The common theme is that governments and statist NGOs are seeking to create a toxic political climate for firms that engage in traditional tax optimisation strategies.

Needless to say, this runs counter to the legal principle expressed back in the 1930s by Judge Learned Hand, who famously opined:

“Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one's taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.”

But legal principles may not seem to offer much protection if you are a senior officer for Google, Starbucks, Apple, General Electric, or some other multinational firm that has been castigated in either the UK Parliament or the US Congress.

And it is a public relations headache if left-wing pressure groups are marching outside your stores because you haven’t “paid enough” or (in at least one American case) because you are thinking of re-domiciling in a jurisdiction with better tax law.

The actions of politicians and left-wing groups are logical. They want bigger government and that means they need more money. So it makes sense for them to demonise multinational firms.

The mystery is why companies are so passive and apologetic. Where is the CEO who goes on CNBC or Fox Business and boldly proclaims “It is my fiduciary duty to legally minimise our tax burden. It is much better for our workers, consumers, and shareholders if we keep the money we earn rather than turning it over to the government.”

The answer is that companies somehow think that it an unpopular position, even though all their consumers doubtlessly take advantage of any credits, deductions, exclusions, exemptions, allowances, and other preferences that they can find in the tax code.

In the short run, it may make sense to adopt a defensive posture. But as the welfare state begins to run out of money, particularly because of aging populations, there will be ever-more pressure to extract more money from ‘rich people’ and ‘big corporations’.

At that point, having refused to fight on principle today, they will find it that much harder to protect themselves from political predation in the future.”

Philip Marcovici, Offices of Philip Marcovici, Hong Kong

What Judge Learned Hand clearly meant was that taxpayers have the right to arrange their affairs such as to legally and properly pay a minimum of tax. In today’s increasingly transparent world, and one where issues in and around wealth and income inequality are at the forefront, Judge Learned Hand’s opinion is more important than ever.

Many things have been happening to help move the world into transparency, and the corporate and personal tax landscapes have been changing fast and in a very public way. Whistleblowers, increased use of technology and closer cooperation between governments is bringing to light serious problems with how taxes are imposed and enforced cross-border. Recent developments have highlighted both the misuse of secrecy rules and the reality that tax evasion is a global problem. The current debate on what is ‘acceptable’ tax planning is appropriate, provoked by the realities in and around abuse and unfairness. But there remains a clear difference between illegal tax evasion and legal tax avoidance.

Undeclared funds are a global problem, and measurement of the amounts involved is very difficult. The Tax Justice Network has reported the figures involved to be as high as over US$30 trillion. Oxfam has estimated that if taxes were properly paid by those earning the income involved, global poverty would be eliminated twice over. In the corporate tax world, funds may not be undeclared, but aggressive transfer pricing planning and the use of entities lacking requisite substance are improperly reducing the tax revenues of countries to which income and profits should more properly be allocated.

But does this mean that taxpayers should voluntarily pay more tax than they are legally and properly required to under the tax laws that have application to them? Or does transparency and responsibility require more of a focus on what laws do apply, and how they apply? Should governments be tasked with simplifying and clarifying their tax rules rather than trying to impose a subjective ‘moral’ set of requirements in addition to the objective rules that laws provide for? Is it not a reality that tax laws are not keeping up with technology, cross-border activity and the reality that simplicity, certainty and fairness can do more for tax collections than short term populist moves to create more complexity and uncertainty?

That a taxpayer, on understanding their position, cannot make business and personal decisions on where they live, where they carry on business and otherwise, at least in part with an eye to tax minimisation, is simply wrong.

In a transparent world, and one where, hopefully, taxpayers are responsible business and wealth managers and owners, it is critical for tax laws to be clear, fair, and the basis on which taxpayers can choose how to structure their affairs with a view to being fully tax compliant while paying the minimum taxes that they are legally responsible to pay.

David Neufeld, Law Office of David Neufeld, Princeton, New Jersey

“The first thing we do, let’s kill all the lawyers.”¹ When people recall this quote by Dick the Butcher, a conspirator in Henry VI, Part 2, they envision it as some rallying cry against that contemptible breed. In fact it is part of a scene where the self-styled revolutionary Jack Cade is scheming on ways to steal the crown. In this context ridding the realm of lawyers would facilitate his villainy, a somewhat different spin than many believe. Such is the world of quotes out of context.

So too has Judge Learned Hand’s oft-quoted permission for tax planning been misquoted by taking it out of context. And by doing so he seemed to bless even extreme planning ideas by planners, specifically those that swoop down upon gaps in the statutes to feast like ravenous seagulls hungrily devouring newly hatched sea turtles in a feeding frenzy.

One must be cognizant of the Helvering v Gregory case,² the source of Judge Hand’s quote, to fully appreciate what he meant when he said “[a]nyone may so arrange his affairs that his taxes shall be as low as possible. . . .”³ In that case Judge Hand, later affirmed by the Supreme Court, held against the taxpayer, who had swooped down upon a gap in the statute by structuring a corporate reorganization that complied with all the written rules set forth in the Code.

A pedantic reading of the law would have yielded a win for the taxpayer. But, according to Judge Hand, in what should have been a more memorable quote, “the meaning of a sentence may be more than that of the separate words, as a melody is more than the notes, and no degree of particularity can ever obviate recourse to the setting in which all appear, and which all collectively create.”

In other words, one must adhere to the spirit, the intent, of the law and not just a literal interpretation that does violence to it. “To dodge the shareholders’ taxes,” said the judge, “is not one of the transactions contemplated as corporate ‘reorganizations’.” In fact, what his more famous quote was addressing was the idea that one may do all that one is allowed within the law, both letter and spirit, regardless of his desire to avoid tax.

With that as background, can one say that the attitude towards tax planning has changed in the current environment when compared with what was acceptable in 1928 when Mr Gregory did his dastardly deed, in 1934 when Judge Hand handed down his decision and the quote that has long outlived him, Mr Gregory and Commissioner Helvering, or at the turn of the 21^st century? Well, no. If tax planning involves taking affirmative actions in structuring one’s life, business and transactions in a way that minimizes one’s taxes, so long as it complies with both the letter and the spirit of the law, that seems no more impermissible today than it had at any time in the past, including the day Judge Hand penned his learned opinion. It’s when tax lawyers stray too far that popular opinion is in accord with Dick the Butcher’s own famous misquote.

Associate Professor Stephen Phua, NUS School of Law, Singapore

Where a taxpayer qualifies for an explicit tax-preference designed to discriminate between specific objects or subjects, no question of tax avoidance arises. The right to exercise a choice to comply with that differentia is intended rather than proscribed. However, to the extent that Judge Learned Hand was thought to have prescribed an unfettered right to choose, that can only be a false choice. No language is free from ambiguity and no tax statute is without its structural weaknesses. Therein lies the role of a general anti-avoidance rule (GAAR) – to safeguard the integrity of a tax system by circumscribing the incentive for human ingenuity to abuse such weaknesses.

The legitimacy of any plan to optimise tax incidence is to be derived from a proper construction of the relevant tax statute. Mere formalistic compliance rightly offers no immunity against the GAAR. A desire to advance commercial expediency alone is no licence to permit legal form to trump true substance. This much is uncontroversial.

Indeed, it is the need to frame the limits of tax planning in more controversial circumstances that the role of GAAR is placed on a stronger footing. It reserves a broad power to counteract unintended tax benefits that would otherwise have accrued to transactions executed to advance the disingenuous and inordinate choices of taxpayers. The potency of GAAR to curb the seduction of such choices lies in the creation of a contingency over the security of the desired tax benefit. Contrary to popular misgivings, the application of GAAR to prefer substance over form does not result in an ex ante loss of certainty of law but merely an ex post facto erosion of transactional finality. As a statutory tool, such a response is not alien to the administration of justice.

Judge Learned Hand’s response is another; and it is one that is increasingly untenable today. There is no single response that can immunise or imperil the gumption and guile of self-interest. The desire to avoid or minimise a compulsory exaction will outlive any debate on the hallmarks of what is right or what is left of acceptable tax planning. The proper balance in any particular case lies with the judiciary but history shall be the final judge.

Alex Cobham, Director of Research, Tax Justice Network

Far from being obsolete, Judge Learned Hand’s opinion – when read fully – may never have been as relevant as it is today.

The opinion was handed down in the depths of the Great Depression, with US unemployment peaking above 20 per cent. Public anger was directed towards financial market players and regulators, and elites seen as dodging their fair tax contributions in a time of austerity (see, eg, the trial of Andrew Mellon). Sound familiar?

In considering the merits of a corporate reorganisation designed to reduce the owner’s tax liability, Judge Learned Hand delivered his famous quotation – and then found against the taxpayer, in what is often seen as an important turning point in the movement of US taxation towards substance over form.

A taxpayer has the right to organise their affairs in substance so that their “taxes shall be as low as possible”, but no right to abuse inappropriate form so as to deceive as to the substance.

Now fast forward to today. In the continuing painful aftermath of the financial crisis, there is great public attention on both financial misdemeanours and economic inequality. These issues come together in the waves of anger that greet each further tax revelation – whether in relation to extremes of corporate profit-shifting, to individual tax evasion or the scale of undeclared offshore wealth.

Public outrage has not necessarily been greatest in relation to the acts of clearest criminality. Perhaps for this reason, tax professionals can frequently be heard to lament that tax is complex (which it often is), and the public do not understand the detail (which we often don’t).

But that doesn’t make the public wrong, or to be ignored. Aside from genuine misunderstandings, much anger stems from a sense that tax has not followed substance.

That regardless of the appropriate application of the arm’s length principle for transfer pricing, for example, too many multinational companies are simply not paying their fair share of tax in the places where their economic activity actually takes place. Or that regardless of the legal existence of the UK’s non-domicile rule, long-term residents availing themselves of it do not make an equivalent contribution to society.

The problem is not one that a purposive interpretation of tax law can solve alone, since clearly the non-domicile rule – for example – intends this use. Some tax law is itself unjust. And hence the amount of public criticism of the rule in the UK over the last few weeks, as its use by a number of those with undeclared Swiss bank accounts has emerged.

The current debate over what type of tax ‘planning’ is acceptable confirms the central point of Judge Learned Hand’s opinion that substance matters.

As long as some professionals are willing to market schemes that exploit the divergence between substance and form, such revelations will continue to prompt anger. And so too will laws that have the same ultimate effect.

As Wendell Holmes said, tax is the price we pay for civilisation. Tax justice is the simple demand that this price be fairly shared – in substance.

1.  Shakespeare, Henry VI, part 2, Act IV, Scene 2.
2. 69 F.2d 809 (2d Cir. 1934)
3.  69 F.2d at 810-811