Risk, return, and objective economic substance.

While an inquiry into pre-tax profit potential protects against denying deductions for genuine losses, it also provides taxpayers with the opportunity to present multiple accounts of the transaction and to build in remote contingencies or small profit amounts. (32) For example, a complex transaction essentially guaranteed to generate a loss might integrate a bet about the direction of a particular interest rate or value of a financial asset. In court, the taxpayer will argue that such a bet saves the entire transaction from failing objective economic substance. (33) Government litigators will, of course, be on the watch for such ancillary profit-potential hooks and will argue that the court should disregard them. Some courts have, however, been drawn in by such profit-potential hooks, particularly when the taxpayer has emphasized elements of market risk. For example, in Compaq Computer Corp. v. Commissioner, discussed in greater detail in Part V.A, the Fifth Circuit gave some weight to the fact that part of the disputed transaction occurred through the New York Stock Exchange. (34) The court reasoned that this made the transaction more genuine since the setting meant that someone could have stepped into the middle of the transaction and altered its outcome. (35)

Closely related to the problem of taxpayer-engineered, profit-potential hooks is the question of how much profit potential is required in order to imbue a transaction with economic substance. Taxpayers will argue that the presence of an actual pre-tax profit, however nominal, conclusively demonstrates the objective reasonableness of their subjective profit expectation. (36) Various courts and other government actors have made an effort to limit the degree of speculation taxpayers may engage in about profit potential and to quantify the amount of profit potential required. Two interrelated approaches to these problems have been proposed.

The first approach is to require that the expected pre-tax profit bear a reasonable relationship to the expected tax benefits (37). The Tax Court, for example, refused to give weight to a profit potential that it considered "infinitesimally nominal and vastly insignificant when considered in comparison with the claimed deductions."(38) The second approach is to require that the reasonably anticipated pre-tax profit exceed some minimum amount - generally, the rate on no- or low-risk investments. (39) Setting the minimum profit potential to a low- or no-risk return is akin to using a comparables approach. The underlying rationale is that if the suspect transaction has no more profit potential than a risk-free investment, the taxpayer must have entered into the suspect transaction to gain a tax arbitrage advantage. Otherwise, the taxpayer would have simply invested directly in the risk-free asset. (40)

These approaches do restrict the range of possible alternate configurations available to a taxpayer and provide some guidance as to the amount of required pre-tax profit potential. Yet these approaches have inherent weaknesses apart from their failure to account for implicit taxes and the formation of tax clienteles. (41) First, the comparison of pre-tax profit to tax benefits introduces a new avenue for speculation - expected net tax benefits. While the actual tax benefits would likely serve as strong evidence of the anticipated tax benefits, tax payers could be afforded some opportunity to argue that they reasonably anticipated much lower tax benefits. Second, reasonable expectation tests appear susceptible to becoming inextricably linked to the taxpayer's subjective motive, which may further dispose a court to allow speculation about contingencies - perhaps to ensure a fair result given the implication of criminality or moral turpitude attaching to the taxpayer's conduct when the tax shelter (42) label is applied. (43)

Finally, requiring a specific level of return will likely trigger arguments asserting that such a requirement in effect gives the government power to direct taxpayer investment and that the minimum return requirement could cause taxpayers inefficiently to take on extra risk in order to ensure that the return on a transaction clears the minimum profit potential hurdle. (44) Of course, there have also been some subtle (and not-so-subtle) suggestions that sophisticated taxpayers would still find it easy to add pre-tax profit to a particular transaction (45) and "then hedge out of the associated risks in ways that could not readily be identified." (46) While it may be overly optimistic to imagine that taxpayers and their attorneys would ever--even grudgingly--agree to a particular formulation of economic substance, it does not follow that such criticisms should be automatically dismissed.

Such criticisms may indicate a failure to balance properly certainty and uncertainty in the current mix of pre-tax profit proposals. The desirability of a particular mix of certainty (rules) and uncertainty (standards) has generated a substantial body of scholarship. (47) A short, simplified version will suffice here: too much certainty and narrowness, and taxpayers might simply be able to work around the new rule or even find ways to use the rule to bootstrap a new shelter; (48) too much uncertainty and breadth, and taxpayers may decide to treat the new standard as meaningless. (49) The balance between certainty and uncertainty will also have ramifications at the government level. Flexibility in the tools used to combat tax shelters is critical, yet government actors should be able to deploy such tools more efficiently if they can better predict outcomes.

The persistence and volume of the complaints about the economic substance doctrine and codification proposals suggest that the balance of rules and standards is not quite right in current formulations of the doctrine. A frequent taxpayer criticism of attempts to codify economic substance is that the doctrine over-deters and creates uncertainty because of its potential to jeopardize congressionally intended benefits. Use of the pre-tax viewpoint may, however, create a setting in which taxpayer obfuscation flourishes and government actors feel compelled to try economic substance in case it works. The proposed alternate framework for determining objective economic substance shifts initial inquiries into profit and risk to a more rule-oriented test. The comparables method also helps sidestep the problem of the government requiring a specific, expected profit amount while still using risk to restrain tax shelters. (50) Although the proposed framework begins with a brighter-line approach, it then moves to an approach that is more open-ended and factor-based. (51)

B. After-Tax World

A more fundamental problem with the pre-tax landscape is the assumption that the economics of a transaction are readily separable from its tax components. The initial appeal of quantifying pre-tax profit seems to stem from the idea that an individual who is engaging in a genuine economic transaction should be focused on its pre-tax profit possibility. (52) Acceptance of this idea leads to the intuition that financial assets and transactions are priced without regard to individual tax consequences and that, therefore, pre-tax profit is a good indicator of economic profit and the genuineness of a transaction. This intuition, however, runs counter to principles of tax capitalization and efficient markets.

The terms "implicit tax" and "tax capitalization" are used to denote price changes that occur as the market takes explicit tax rates into account. (53) Implicit taxes (or implicit tax subsidies) arise in response to a tax benefit (or tax detriment) (54) conferred by Congress on a particular type of transaction or investment product. An implicit tax is not paid directly to Congress but is instead captured by another party to the transaction. (55) Tax clienteles then form as some investors are able to earn inframarginal returns on implicitly taxed transactions and assets. (56)

Tax-exempt municipal bonds provide the paradigmatic case of implicit tax and tax clienteles. (57) Assume that a city wants to raise $10 million by issuing tax-exempt bonds. To simplify the example further, assume that a taxable bond with the same level of risk as the tax-exempt bond offers a fixed 10% return. (58) Taxpayers in the 35% bracket will be indifferent as between the tax-exempt bonds and risk-adjusted taxable bonds only if the return on the tax-exempt bonds is at least 6.5%. (59) 35% bracket taxpayers may not, however, be the investors setting the price (i.e., not the marginal investors). For example, the city may need to set the rate at 7% in order to raise the entire $10 million. At that interest rate, the 30% bracket taxpayers would be the investors at the margin because they will be indifferent as between the taxable bonds and the tax-exempt bonds. (60) The difference between the interest payable on the taxable bond and the tax-exempt bonds is the implicit tax. (61)

The implicit tax will be the same for all taxpayers. In contrast, explicit tax rates vary across rate brackets. This rate-bracket difference will create preferences (tax clienteles) for particular investments. (62) In the previous example, 35% bracket taxpayers will prefer the tax-exempt bonds to the risk-adjusted taxable bonds. Even after taking into account the implicit tax on the tax-exempt bonds, these taxpayers will still come out ahead by choosing the tax-exempt bonds over the risk-adjusted taxable bonds. The 35% bracket taxpayers are the tax clientele for the tax-exempt bonds; in other words, they are inframarginal rather than marginal investors with respect to the bonds.