Creating failures in the market for tax planning.

A corporation can deduct the interest it pays when it borrows money, but it is typically taxed when it earns income, including interest, on its investments. However, some investments generate tax-free income. The concern is that a corporation will use tax-deductible borrowing to earn tax-free income. A variety of statutes and regulations in fact prohibit this and related practices. But the regulatory scheme serves largely as a trap for the unwary. There are mechanical rules to be used to connect a loan with its proceeds so that the proceeds can be "traced" to the borrowing. But these rules can easily be circumvented. A leading casebook notes that: "the tracing approach of the regulations contains tax savings opportunities for those who plan their transactions carefully and tax increases or, more likely, random tax consequences for the unknown or unwary and people with better ways to spend their time." (31)

3. Discussion

The foregoing are examples in which the government has decided to let people structure their affairs so that they pay less tax than they otherwise might. Our account provides an argument about why and when it might behave in this manner--that is, when the returns to search are high because there are many additional tax planning methods to be found and the revenue cost of the ones being employed is within an acceptable range. An interesting area to consider in this regard involves multinational corporations arranging their transactions and, indeed, engaging in transactions to minimize their overall tax burden. (32) Here, too, the existence of the techniques is well known. The techniques are allowed to continue and, arguably, flourish given the increasing mobility of assets and operations.

B. Viewing Recent Regulatory Initiatives as Attempts at Disruption: Amendments to Circular 230, the Thompson (now McNulty) Memo, and Sarbanes Oxley

1. Amendments to Circular 230 (33)

Tax planning methods used to effectively come with "insurance." If a law firm could give an opinion that the method passed muster (usually, that the tax position taken was "more likely than not" to prevail (34)) the client using the method could avoid penalties; in effect, the worst thing that could happen is that the client would have to pay the taxes he was trying to avoid, with interest. As amended, Circular 230 provides that clients can avoid the imposition of penalties only if the opinion they receive considers and discusses a great many items in detail. Many matters lawyers had previously dealt with by making assumptions now have to be thoroughly investigated. The lawyers may risk liability themselves if the firm gives an unsupported opinion; they may face monetary penalties and the loss of their ability to practice before the Service. (35) The firm and its lawyers also may face greater reputational costs. Moreover, for transactions identified by the Service as highly suspect, transactions in which the client agrees to maintain the confidentiality of the tax advice, or transactions in which the practitioner's pay is contingent on the promised tax savings, any opinion must be of this elaborate form, even if the client is willing to forego any protection against penalties. Some tax practitioners have advised their clients that issuing opinions that protect the clients from penalties will now be much more expensive; (36) indeed, such an effect is surely among those that the Service desired, and perhaps even expressly intended. It is not yet resolved whether the lawyer's analysis in providing the opinion--the very detailed analysis Circular 230 as amended now requires in many instances--is available to the government. If it is, the government will be able to get free of charge information that it presumably will find quite valuable in formulating its arguments against the tax planning method at issue and rebutting contrary arguments, as well as detecting other methods that presently exist or are in the process of being developed. (37)

It should be noted at this juncture that while the amendments to the Circular were principally aimed at tax shelters, not tax planning, the amended Circular's reach is quite broad--something that is not surprising given the lack of consensus as to what constitutes a shelter. We have thus far largely assumed away the distinction between tax shelters and tax planning; we turn shortly to a consideration of this issue.

2. The Thompson/McNulty Memo

The Thompson Memo, released in 2003, (38) set forth Principles of Federal Prosecution of Business Organizations. The Memo became quite controversial. (39) Among its most controversial provisions were those indicating that in charging a corporation, prosecutors should take into account whether the corporation had been cooperative, where cooperativeness was determined in part by the corporation's (a) waiving attorney-client privilege and work product protection and (b) refusing to pay its employees' legal bills. (40) The Thompson Memo was in force as KPMG was pursued by the government for its tax shelter activities. In the KPMG trial, (41) Judge Kaplan ruled that the Memo's prohibitions on paying employees' legal bills violated their Sixth Amendment right to counsel and their Fifth Amendment substantive due process right to "to obtain and use in order to prepare a defense with resources lawfully available to [the defendants], free of knowing and reckless government interference." (42)

Not surprisingly, in the McNulty Memo, (43) which superseded the Thompson Memo, the government retrenched. In pertinent part, the Memo states, as to the waiver of attorney-client privilege and work product protections:

The attorney-client privilege is one of the oldest and most sacrosanct

privileges under U.S. law.... The work product doctrine also serves

similarly important interests.

Waiver of attorney-client and work product protections is not a

prerequisite to a finding that a company has cooperated in the

government's investigation. However, a company's disclosure of

privileged information may permit the government to expedite its

investigation. In addition, the disclosure of privileged information

may be critical in enabling the government to evaluate the accuracy

and completeness of the company's voluntary disclosure. Prosecutors

may only request waiver of attorney-client or work product protections

when there is a legitimate need for the privileged information to

fulfill their law enforcement obligations. A legitimate need for the

information is not established by concluding it is merely desirable or

convenient to obtain privileged information. The test requires a

careful balancing of important policy considerations underlying the

attorney-client privilege and work product doctrine and the law

enforcement needs of the government's investigation. (44)

On the payment of expenses for officers and employees, the Memo states:

Prosecutors generally should not take into account whether a

corporation is advancing attorneys' fees to employees or agents under

investigation and indictment. Many state indemnification statutes

grant corporations the power to advance the legal fees of officers

under investigation prior to a formal determination of guilt. As a

consequence, many corporations enter into contractual obligations to

advance attorneys' fees through provisions contained in their

corporate charters, bylaws or employment agreements. Therefore, a

corporation's compliance with governing state law and its contractual

obligations cannot be considered a failure to cooperate. (45)

3. Sections 302 and 906 of Sarbanes Oxley

The Sarbanes Oxley Act of 2002, enacted in response to Enron, WorldCom, and other big corporate scandals, requires that a company's top officers provide personal certifications as to the company's filings. (46) Such certifications might conceivably encompass tax planning activity. An argument could be made that an officer providing such a certification might in effect be certifying that she has, after some investigation, no knowledge that the company is engaging in aggressive tax planning activities that could be disallowed and as to which significant penalties could be imposed. A knowingly false certification could be grounds for personal liability, including the imposition of criminal penalties.

4. Discussion

The foregoing suggests that the government, too, is thinking along the lines of focusing on individuals: it is going after individuals' ability to defend themselves or be insulated by their corporations and, in the case of tax professionals, their ability to practice before the Service. (47) Individuals are not well able to diversify against risks of this type. In requiring the types of legal opinions that it does under Circular 230, the government is also perhaps creating a means by which it can appropriate costly research done by people who are almost certainly highly motivated and highly intelligent to assist it in its efforts. Effectively, it is free riding off the efforts of others.