Is A New Round Of International Tax Regulation Coming?

Over the last few years, large corporation's tax bills have come into more and more public focus.  Both Google and Apple have been called in front of Congress to explain their low rate and the overall tax plan of both corporations has become public knowledge.  These revelations are occurring at a time when the global tax base is being eroded as companies are shifting more and more of their income and assets to low-tax countries.  As a result, the OECD has issued a report titled, "Action Plan on Base Erosion and Profit Shifting." 

Let's first look at a brief history of the OECD-tax haven conflict to provide historical perspective, starting with this question: why are the tax rates in tax havens so low?  There are two inter-related answers: they have a tiny geography and small population.  The Cayman Islands is a mere 264 square km in size with a population of 53,737.  Looking at these two inter-related factors from a governing perspective, there is little need for a massive infrastructure system or social safety net programs and hence, little to no need to tax.  The exact opposite is true for OECD countries, who have large land masses and large populations.

Compounding this difference between large, populous countries and small less populated island nations is that businesses which require far more paper-work than physical product are easily moved to tax havens.  The first and most obvious example of this is financial services, an industry dominated by ledgers and accounts, not physical products.  The digital age has exacerbated this phenomena as web pages replace physical storefronts, thus enabling transactions to occur in cyberspace which can be located on a computer server rather than a bricks and mortar locale.  We can also place non-physical assets such as intellectual property into corporations located in these offshore jurisdictions and establish an intra-company payment system where a company will pay its offshore subdivision for usage of the company's intellectual property.  As a result of all these developments, more and more actual economic activity can be moved to these low-tax jurisdictions, thereby eroding the tax base of larger countries.

The OECD started to target offshore activity in the late 1990s with the issuance of the report "Harmful Tax Competition: An Emerging Global Issue."  In effect, the report argued the combination of banking secrecy and low taxes was eroding the OECD's tax base, leading the group to begin a lobbying campaign with these jurisdictions to both lift the secrecy veil and raise their taxes.  Little happened on this front until 9/11, which added further strength to the OECDs anti-secrecy arguments.  Now, more and more offshore jurisdiction are signing "mutual assistance" treaties which allow coordination of tax prosecutions with treaty signatories in certain situations.  From a macro perspective, these developments are leading to a slow end to the age of banking secrecy, which will probably disappear for the most part by the end of my lifetime.  

However, the issue of offshore tax arbitrage is still alive and well, hence the talk of a new global crackdown:

Finance ministers from the Group of 20 leading nations plan to launch a new phase of the international crackdown on corporate tax avoidance this week even as UK business leaders are warning their government to resist “radical new solutions” to profit shifting by multinationals.

Britain has taken a lead in pressing for reform of the international tax rules after a wave of public anger over the low tax bills paid by some large multinationals. An action plan on tackling base erosion and profit shifting is due to be presented to the G20 by the Paris-based Organisation for Economic Co-operation and Development on Friday.

We have no idea where this will end -- or if it will get anywhere in the first place.  However, I do think with the heightened spotlight on low multi-national  tax bills and increasing number of cross-border tax arrangements, this might have legs.

     

What Does a Tax Scam Look Like?

Planners have offered questionable ways to "minimize" tax since the implementation of the tax code.  Attesting to this are the first assignment of income cases which tested the validity and strength of the grantor trust rules when first established (see code sections 671-679).  In fact, a thorough reading of anti-avoidance case law shows there were several important periods in tax scams: the 1950s brought attempts to create phantom "interest" deductions, the 1970s and early 1980s brought limited partnership plans and the 1990s saw the creation of an entire industry encompassing the accounting, legal and financial professional industry.  

But while the long history of this industry could lead to the impression there is a vast difference regarding these plans, there is in fact a remarkable amount of similarity to the way they were structured.  What follows are some of the more common elements.

A hyper-technical reading of the tax code: this is probably one of the most common traits of tax shelters across the time periods listed above.  While the ability to comprehend particular sections of the tax code is obviously a prime requirement for a tax attorney, that knowledge has to be placed in the context of the legislative intent of the code in general.  For example, a common tax shelter in the 1990s involved the contingent liability section of the tax code, which would shift the gains of a transaction to a tax neutral participant (a party for whom income was immaterial) while it shifted the losses to a party that was trying to offset capital gains (usually a US taxpayer).  While these transactions complied with the technical aspects of the contingent liability section of the code, they had no substance, meaning there was no meaningful business purpose for the transaction, save sheltering taxable income.

Ground up tax planning: Most legitimate tax planning starts with a company approaching their attorney with one of four basic needs: the need to increase income (such as expanding into a new market), the need to lower expenses (combining subsidiaries; lowering taxes alone is not a legitimate reason), the need to raise capital or the need to lower risk.  But all four of these transactions starts at a high level and are motivated by a legitimate business need.  In contrast, most tax shelters are transactions in search of a client -- that is, a tax promoter will develop a transaction (usually involving a hyper-technical reading of the tax code) and then sell it to a client, one who is usually looking to offset income or capital gain.  When a transaction starts at a low level it has a difficult time establishing business purpose.  For a further explanation of this issue, see the Senate's Report on tax shelters.

Multiple, pre-planned steps: most transactions are actually very simple: company X buys company Y; company X forms an accounts receivable sub-division; company X divests itself of a subsidiary; company X issues stock, etc...   In contrast, most tax shelters use multiple, pre-planned steps to arrive at a particular destination.  For example, company X and company Y form an offshore partnership.  After 30 days, they purchase short-term notes.  After 35 days, they sell notes to received a contingent liability note.  After 12 months, company Y leaves the partnership ... you get the idea.  Pre-planned steps are a big warning sign that something is probably amiss.

Offshore: first of all, about 30% of my practice involves international tax planning, so I'm obviously not against the practice.  However, tax shelter promoters typically use an offshore jurisdiction for one reason: secrecy, a trait shared by many offshore jurisdictions (although this practice is changing).  This has obvious benefits if the participants are attempting to lower their tax burden in a questionable manner. 

Business Entities with a short life span: how long should a business enterprise exist?  Ideally in perpetuity -- which is one of the primary advantages of the corporate form.  And while businesses do go bankrupt or are sold, thereby ending their corporate life, most business owners want their business to exists for as long as possible as this indicates the company is a viable, ongoing concern.  In contrast, short duration corporations or partnerships are common in tax shelters, some of which contain entities with a life span of no more than 18 months.  While some could argue that joint ventures are an exception to the rule, most of these short-term combinations still have expected corporate an life expectancy of multiple years.

The above points cover most of the basic problems seen in tax shelters.  If you can think of others, please post them in the comments section.

  

How Reality Severely Limits My Vast Legal Super-Powers

The highly skilled lawyer who saves the protagonist from certain impending legal doom is one of the most iconic images in popular media.  Perry Mason of course stands out as one of the first characters that fit this bill, although others such as the cast of LA Law (a college favorite), The Practice and Law and Order stand out as well.  Real life examples include Clarence Darrow (who was portrayed wonderfully by Spencer Tracey in Inherit the Wind) and Johnny Cochran ("If the glove does not fit, you must acquit!").  These real and fictional individuals have given the public the impression that lawyers are super men who can always overcome disadvantageous odds to secure victory.

Sadly, realty often intrudes into real life expectations.  For while I would love to tell clients that I am one of these supermen of yore, I am in fact greatly hampered by three elements: the facts and circumstances of a particular case, the law as it is (not as we want it to be) and the legal code of ethics.  Let me explain each of these in more detail.

Hypothetically, suppose I'm a defense attorney, called in to defend an accused murderer.   On the other side of the court sits the prosecution who has four witnesses, all of whom are nuns with 20/20 vision and perfect recall memory, none of whom were more than 10 feet from the incident when it occurred.  Three video tapes of the crime also exist (all of which can be substantiated at trial), all with a good angle to witness the event.  While the TV or movie lawyer would be able to overcome these facts, the real attorney would merely be trying to keep his client out of the execution chamber (assuming the state had the death penalty).  Although these facts are deliberately extreme, they illustrate a key point: we are always limited by the facts and circumstances of the case we are given.  On a far more mundane (and far more realistic) note, consider a potential client who wants to form a captive insurance company, but who is also in the middle of a lawsuit.  Under the Uniform Fraudulent Transfer Act, I can't do anything because this transaction could easily be construed as an attempt to "hinder, delay or defraud" a potential creditor.  As these illustrations highlight, the facts and circumstances of a particular fact pattern can severely limit my legal options.

The law as it exists (not how we theoretically want it to be) is another element that can provide a fair amount of constraint for legal representation.  Suppose a client wants to transfer money to an offshore jurisdiction that has very tight secrecy laws with the intent of not paying US income taxes.  The clients states this is his goal.  At this point, I have to advise him that 1.) going offshore to hide money is illegal, 2.) he will have to file an informational return to comply with US law, regardless of what he wants to do, and 3.) as the US has a world wide taxation regime, he'll have to pay taxes on his offshore funds.  The preceding three statements highlight the law as it is, so, as an attorney, I would have to tell the client that his motivation runs afoul of the law.  It also means I probably won't be representing this client.

As a first corollary to the preceding point, it's also important to note that I can't fix your behavior after it occurs so that it complies with the law.  Like most people, potential clients regularly "shoot first and ask questions later."  And while I don't expect to be consulted on mundane issues, being aware of a bigger decision before it's made to discuss its legal ramifications helps to prevent bigger problems from developing.  Regrettably, attorneys are usually the last people consulted on decisions.

Finally, there is the legal code of ethics, with the biggest prohibition I face as an attorney:

(a) A lawyer shall not knowingly:

(1) make a false statement of fact or law to a tribunal or fail to correct a false statement of material fact or law previously made to the tribunal by the lawyer;

.....

(3) offer evidence that the lawyer knows to be false. If a lawyer, the lawyer’s client, or a witness called by the lawyer, has offered material evidence and the lawyer comes to know of its falsity, the lawyer shall take reasonable remedial measures, including, if necessary, disclosure to the tribunal. A lawyer may refuse to offer evidence, other than the testimony of a defendant in a criminal matter, that the lawyer reasonably believes is false.

I realize it may sound like a joke that an attorney can't lie, nor can he coach others to lie.  But there it is, plain as day in the model code of conduct.  And it's something that I and other lawyers whom I know take very seriously.  There is also new formal guidance for attorneys regarding representation and its relationship to money laundering -- rules which are very similar to the "know your client" rules.

So, what exactly can I do?  Within the confines of the above stated concepts, a great deal.  First, I can develop and implement a strategy that is compliant with the law as it exists.  Unlike the impression given by such services as Legal Zoom, the law is not merely a series of interlocking forms; each element of a form has legal ramifications and is derived from a substantive area of law that must be understood.  Second, I can keep this plan compliant with the law at it develops.  Remember, the law is always changing, sometimes in substantive ways.   Third, I can keep you out of trouble so long as you consult me on big decisions.     

So, the above three points are really my vast legal super powers as they exist in the real world.