Formally legal, probably wrong: corporate tax shelters, practical reason and the New Textualism.

• Author: Walsh, Alexandra M.

INTRODUCTION

In the record-breaking boom of the 1990s, corporate earnings rose sharply. As a result, corporate tax revenues also increased. Interestingly, the increase in tax revenue did not keep pace with the rise in pre-tax income. Between 1988 and 1998, pre-tax corporate income increased by more than 127 percent, from $292.5 billion to $666.4 billion. During the same ten year period, corporate income tax collections increased by only 99 percent, from $94.5 billion to $188.7 billion.(1) Experts in both the government and private sectors believe that the recent increase in the use of corporate tax shelters accounts for much of this discrepancy.(2) It appears that as corporations began to earn more, they worked harder to turn less over to the government. They accomplish this feat by engaging in complex sheltering transactions--devised and sold to them by sophisticated, well-paid tax lawyers--that do not actually affect their economic position but generate artificial losses that, according to a strict interpretation of the tax code, can be claimed as deductions.(3) Subtracted from revenue, these "losses" offset income earned through the corporation's substantive activities, thereby reducing total taxable income below actual economic income.

Before considering how the use of tax shelters might be prevented, it is worth asking whether this practice is even a cause for concern. Currently, the nation is experiencing its first budget surplus in more than 30 years.(4) As politicians debate how to allocate this newfound wealth,(5) worry about erosion of the corporate tax base may seem unnecessary, even alarmist. Consider, though, that the Treasury Department estimates that as much as $10 billion of tax revenue is lost(6) through sheltering activity every year.(7) And then imagine the possibilities if the IRS collected this revenue. Taxpayers might enjoy a tax reduction that is larger and more evenly distributed than the one effected through use of tax shelters. And, of course, the surplus situation is not guaranteed to last. If, and more likely when, it ends, the reduction in revenue caused by tax shelters will no longer seem so insignificant. As additional tax revenue is needed, the continued use of shelters will likely lead to increased tax rates for both individuals and corporations.(8)

Sheltering activity may be undesirable for reasons unrelated to concerns about insufficient tax revenue. First, the money corporations spend to develop, engage in, and defend sheltering transactions does not generate wealth; it merely alters its distribution, shifting it from government to corporations. Though some may believe that corporations should keep more of their income, the means by which shelter participants achieve this distribution--devoting significant resources to economically purposeless transactions--is an inefficient use of societal resources that might otherwise be spent on economically productive activities. Second, tax shelters raise equity concerns. Currently, corporate taxpayers that do not engage in sheltering activity pay higher effective tax rates than otherwise similarly situated taxpayers that do shelter income, a situation that undermines the tax system's attempt to achieve horizontal equity.(9) Finally, many worry that failure to stop sheltering activity will further undermine the public's confidence in, and respect for, our system of taxation, a development which could lead to continued efforts to avoid and evade taxation.(10)

Though armed with an array of policy arguments against sheltering activity, opponents of this practice are on less solid ground when trying to attack it as a violation of the law. Despite the intuition, shared by many, that sheltering activity is somehow wrong, the illegality of this practice is not at all clear-cut. Suppose, for example, that a corporate taxpayer leases property from a foreign entity, immediately prepays all of the rent due under the lease, and then subleases the property back to the foreign entity. It takes a large tax deduction for this rental payment. The foreign entity pays the rent it owes (equal to the amount it received under the primary lease) in periodic installments extended over the term of the sublease. The taxpayer must recognize these payments as income. However, the present value of the tax it pays as it recognizes this income is far less than the present value of the deduction for the rental payment.(11) The Department of the Treasury estimates that this particular sheltering transaction reduces tax revenue by hundreds of millions of dollars per year.(12)

Though we might want to prevent further use of this shelter, we should recognize that claiming a deduction for prepaid rent, which is plainly permissible under the tax code, is different than, for example, a contractor's failure to report self-employment income or a lawyer's deduction of a dinner with friends as a business expense. The latter two actions directly violate the text of the tax code. The former seemingly does not. And, when challenged by the IRS, shelter participants can, and do, defend their deductions as straightforward applications of particular provisions of the tax code. That corporate tax shelters cannot be unequivocally labeled illegal obviously does not defeat the policy arguments I sketched above. Recognizing this does, however, reveal the difficulty of challenging sheltering activity.

Much of the current battle against corporate tax shelters is being waged in federal tax and appellate courts.(13) In these forums, the corporate taxpayer contests deficiencies asserted by the government by arguing that the disputed transaction plainly meets the requirements of a particular provision, and that it therefore has a legal right to the deduction the provision allows. The government responds by pointing out that the transaction has no economic substance and, despite the apparent applicability of the invoked provision, the taxpayer should not be allowed to the use the "loss" it generates to reduce its tax liability.(14) In recent cases, courts have consistently sided with the government, rejecting the taxpayer's textualist position by applying the common law economic substance doctrine. Roughly, this doctrine holds that if a transaction has no "practicable economic effects other than the creation of tax losses" and was engaged in merely to create such losses, the court will not respect it for tax purposes (i.e., the disputed deduction will not be allowed).(15) In a sense, the doctrine acts as a substantive canon of statutory interpretation. The court refuses to interpret the text of the code, however clear, in a way that allows the taxpayer to benefit from tax-motivated, economically meaningless sheltering activity. As discussed more thoroughly below, this interpretive stance exemplifies what court watchers call judicial practical reasoning.

Though it has successfully defeated corporate tax shelters in recent cases, use of the economic substance doctrine is by no means unproblematic or uncontroversial. This flexible, standard-driven doctrine arguably vests too much discretion in judges, and thus raises the typical concerns about judicial activism and bias, lack of predictability, and the potential for judgments inconsistent with the will of Congress. Moreover, by leaving so much up to the judge, the doctrine does nothing to guarantee that decisions will continue to be "correct" as a policy matter. Though judges thus far have used the economic substance doctrine to reject the shelter participant's position, it is questionable whether the doctrine actually requires this result. For example, to date, no court or academic has laid out an objectively clear, agreed-upon test for determining whether a transaction has "substance."(16) Perhaps most importantly, if we believe that sheltering activity is socially undesirable, reliance on the economic substance doctrine to combat tax shelters is risky given the growing judicial support, particularly in the United States Supreme Court, for textual interpretation of statutory law.(17) Given the weight of precedent carried by the economic substance doctrine,(18) it is unlikely that even the current Court would reject the government's position in a corporate tax shelter case. However, if faced with such a case, the Court is likely to pay close attention to the taxpayer's textualist argument and to expect the government to provide a meaningful answer to it.

In this paper, I assess the potential for a textually based challenge to corporate tax shelters. Specifically, I ask whether this practice could be prevented either by legislative amendment of the tax code or by an argument that the text of the code, as currently written and properly interpreted, already prohibits sheltering activity. After describing each of these possibilities, I ask whether a textually based attack that could comprehensively address this problem would actually provide a more principled means of adjudicating these disputes. After all, textualists do not like text merely for text's sake. Rather, they endorse their interpretive method because they believe it promotes predictability, properly constrains judicial decisionmaking, and ensures that legislation is applied as Congress intended. If there is no weapon (textual or otherwise) that both effectively defeats shelters and promotes these values, we may be left in the quandary of living with socially undesirable sheltering activity or accepting judges' discretionary--and potentially unprincipled-resolution of these disputes.

The paper is divided into four parts. In Part I, I briefly present the shelter participant's textualist argument. I explain how this argument is different from, and stronger than, the arguments used in other tax avoidance disputes. Part II describes the practical reason approach to statutory interpretation, that is, the method courts often use to defeat arguments that, like the shelter...