Risk-based rules are the tax system's primary response to aggressive tax planning. They usually grant benefits only to those taxpayers who accept risk of changes in market prices (market risk) or business opportunities (business risk). Attempts to circumvent these rules by hedging, contractual safeguards, and diversification are well understood. The same cannot be said about a very different type of tax planning. Instead of reducing risk directly, some taxpayers change the nature of risk. They enter into informal, legally unenforceable agreements with contractual counterparties that are designed to eliminate market or business risk entirely. The new uncertainty these tax planners inevitably accept, however, is the risk that the counterparties will violate the implicit agreements and betray taxpayers' trust (counterparty risk). A deliberate substitution of counterparty risk for market or business risk is what this Article calls relational tax planning. The Article offers an economic analysis of different risks and considers two responses to the relational tax planning problem. The analysis suggests that from a welfarist perspective, business risk is a superior deterrent compared to both market and counterparty risks. Counterparty risk is the most complex of the three. In addition to producing risk-bearing losses like all other risks, it leads to reduced transaction costs in future exchanges between relational tax planners, but only if they manage to overcome bargaining obstacles caused by opportunism and asymmetric information. These insights suggest two very different responses, a sweeping reform will allow--and even encourage--taxpayers to engage in relational tax planning, but it will also ensure that counterparty risk they incur is sufficiently high. If only incremental improvements are pursued, courts should increase their scrutiny of relational tax planning involving extensive dyadic business relationships and interactions based on social norms.
INTRODUCTION I. WHY BOTHER WITH IMPROVING RISK-BASED RULES? II. UNDERSTANDING DIFFERENT TYPES OF RISK A. Market Risk B. Business Risk C. Counterparty Risk D. Multilateral Counterparty Risk III. THE PROBLEM OF RELATIONAL TAX PLANNING A. What Is the Problem? B. How Serious Is the Problem? IV. EVALUATING WELFARE CONSEQUENCES OF DIFFERENT TYPES OF RISK A. Market Risk B. Business Risk C. Counterparty Risk 1. Private Benefits of Cooperation 2. Private Costs and Benefits of Defection 3. Additional Private Costs of Relational Tax Planning D. Multilateral Counterparty Risk E. Comparing Risks V. ANTICIPATING RELATIONAL TAX PLANNING: A SWEEPING REFORM A. Incorporating Relational Tax Planning into Risk-Based Rules B. Excessive Market Risk or More Cooperation? C. Assessing the Recalibrated Risk-Based Rules VI. RATIONALIZING EXISTING RISK-BASED RULES: INCREMENTAL IMPROVEMENTS A. Comparing Market, Business, and Counterparty Risks B. Evaluating Counterparty Risk in Different Settings CONCLUSION INTRODUCTION
Contrary to popular belief, death and taxes have little in common. While death is indeed certain, taxpayers have plenty of ways to escape (some of) their tax obligations. But they must pay a price: work less than they would have liked, save less than they would have preferred, or do a number of other things they would rather not do. This Article is about one unpleasant consequence that taxpayers must often accept as a price of lowering their tax bills--risk.
Tax law is full of risk-based rules--provisions that grant tax benefits only to those who accept a certain amount of risk. (1) Yet courts and scholars have failed to recognize that not all risks are the same. As a result, the government's efforts to protect the tax base by relying on risk-based rules have been even less successful than is commonly acknowledged.
The multitude of risk-based rules that pervade all areas of tax law are deceptively similar. They all appear to bestow benefits only on those who accept risk of changes in market prices (market risk) or business opportunities (business risk). Because many taxpayers dislike risk, random market forces deter them from engaging in undesirable tax planning--or so the government hopes. Virtually all commentary regarding risk-based rules has focused on market risk. (2)
Yet taxpayers often face a very different kind of uncertainty. They attempt to reduce their taxes by relying on assistance from contractual partners without obtaining a legally enforceable right to compel these partners to act as the parties agreed. These tax planners assume the risk that their counterparties will not perform as promised (counterparty risk). Factors affecting this type of uncertainty--such as asymmetric information and opportunistic behavior--are fundamentally different from those that underlie market and business risks.
Taxpayers' efforts to engage in what I call traditional tax planning--reducing market and business risks by hedging, contractual safeguards, and diversification--have drawn plenty of interest from policymakers and academics alike. At the same time, taxpayers have learned to substitute counterparty risk for market and business risks and engage in what I refer to as relational tax planning without too much unwanted attention. The disparity is understandable. Traditional tax planning is often easy to define and detect because it involves reliance on express, written contracts. These contracts may be long, complex, and seemingly unrelated to transactions that give rise to the underlying risk, but often they are clear, readily observable, and verifiable. In contrast, relational tax planning is much harder for the government to counter. It depends on tacit understandings and implicit agreements that are difficult to define, identify, and prove in court.
For example, a risk-based wash sale rule attempts to foreclose tax-motivated loss harvesting by denying a deduction to taxpayers who sell securities at a loss and repurchase identical securities within thirty days. (3) Tax planners may try to circumvent this rule by selling the security and immediately buying a thirty-one-day option to purchase an identical security for the same price. (4) Discovering this option is not particularly challenging for the government, nor is deciding whether the waiting period should be suspended if such option is acquired. (5) But what if instead of buying an option, the taxpayer sells the security to a friend or a business associate, with an understanding (unwritten and unenforceable) that the taxpayer will repurchase the security for the same price in just over a month? Administering a system that takes informal arrangements like this into account is much more difficult. It is hardly surprising that the government has not had much success in combating relational planning. Commentators have done little to assist policymakers in developing alternative approaches. (6)
This Article reverses the trend. It highlights the challenge of relational tax planning, offers an economic analysis of market, business, and counterparty risks, and evaluates two alternative reforms. The three risks differ in their deterrent effects and social welfare consequences. Business risk is a particularly attractive policy instrument. Tax planners who accept it not only incur a risk-bearing loss (a private and social cost similar for all risks), but also sustain an expected loss from resolution of future business contingencies (a private cost that has no effect on the overall social welfare). The latter feature makes business risk a more efficient deterrent than market risk.
The two unique characteristics of counterparty risk are the cooperation gain and the bargaining cost. The cooperation gain exists because, by relying on contractual partners, taxpayers and their counterparties build (or reinforce) mutual trust. Stronger trust reduces transaction costs, not just in the tax-motivated exchange that produced it, but in all other interactions between the two transactors as well. This is clearly beneficial to relational tax planners. Whether society benefits as well is a much more difficult question. The bargaining cost arises because relational tax planning requires cooperation. Contract scholars and organizational theorists learned long ago that whenever bargaining is required, people occasionally fail to capture available gains from trade. (7) Opportunistic behavior and asymmetric information get in the way. While bargaining failures of commercial actors generally reduce social welfare (valuable goods and services are underproduced), no such reduction occurs when contracting is tax motivated (fewer tax shelters go forward). Therefore, the bargaining cost acts as an additional deterrent without increasing the social cost of counterparty risk.
These insights allow us to evaluate two responses to the relational tax planning problem: a sweeping reform and a set of incremental improvements. The former alternative is a complete reversal of the current approach. Rather than designing risk-based rules with market risk in mind and then struggling to protect them from taxpayers' attempts to switch to counterparty risk, the government may deliberately allow taxpayers to make the substitution. The key point is that this concession will produce no windfall to relational tax planners as long as the amount of risk they must incur to obtain the desired tax benefits is sufficiently high, assuming the market-risk-to-counterparty-risk conversion. Continuing with the wash sale example, if a thirty-day waiting period is too short, assuming the wash seller has an informal arrangement to repurchase the security, a longer waiting period may restore the balance. Whether it will take two months, three months, or even longer, at some point the private cost of a possible counterparty defection may become roughly as great as the private cost of incurring market risk produced by the current thirty-day waiting period.
This approach has two...