TaxProf Blog

Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Thursday, May 31, 2007

Luke Presents Risk, Return, and Economic Substance Today at Florida State

Charlene Luke (Florida State) presents Risk, Return, and Economic Substance today at Florida State as part of its Faculty Enrichment Speaker Series. The project focuses on a relatively narrow aspect of the court-created economic substance doctrine - the objective inquiry into profit or risk - and explores shifting this inquiry from a pre-tax to a post-tax perspective. Here is the abstract:

The economic substance doctrine is used by courts to assess the claims made by taxpayers who have designed complicated, non-intuitive paths to tax benefits — paths unforeseen by government authorities but which nonetheless technically satisfy various statutory and regulatory checkpoints. While courts have not settled on a uniform framing of the doctrine, the doctrine converges around the question of whether a taxpayer earned (or could reasonably have expected to earn) a pre-tax profit on the suspect transaction. This pre-tax inquiry remains controversial. First, the use of pre-tax profit test fails to deal adequately with implicit taxes. Second, the pre-tax profit test as applied by several courts has come to focus on whether the taxpayer undertook market risk or not in a particular transaction. As a result, the test ignores the possibility of risk-free returns and may cause taxpayers to take on risk unnecessarily. Finally, the amount of pre-tax profit required (whether in absolute or relative terms) has never been established. This raises the possibility that taxpayers will be able to pass scrutiny by taking an insignificant amount of market risk or by inserting extraneous low or no risk profit generators into a transaction.

This project (still at a preliminary stage) raises the possibility that an initial inquiry into economic substance should focus on whether a taxpayer’s after-tax return is substantially commensurate with the riskiness of the transaction, assessed objectively and with the benefit of hindsight. Such a viewpoint shift should resolve the problem of implicit taxes and ties the amount of profit to an objectively determinable position. The possibility would remain that taxpayers could object on the ground of having to take on unnecessary risk. For example, if the after-tax return is large relative to the risk involved, a taxpayer may assert that the transaction was simply a golden economic opportunity and that it should not be penalized for taking it.

Should the taxpayer raise this or similar explanations for a return that appears non-standard relative to the risk, a taxpayer would have the opportunity to bring forward evidence indicative of a realistic and subjective expectation of such a non-standard return. Pre-tax profit claims could be used by the taxpayer to demonstrate this intent. Such claims should, however, remain anchored to the post-tax return and to actual results. That is, the pre-tax and post-tax positions should bear a standard relationship to each other. For example, if the taxpayer claims a windfall transaction, one would expect the pre-tax profit to be larger than the post-tax return.

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