Monday, March 22, 2010

Economic Substance Jury Instruction in Larson/Pfaff/Ruble (3/22/10)

I previously attached deep in a blog Judge Kaplan’s economic substance charge to the jury in United States v. Larson (S.D. N.Y. No. 05 CR 888 (LAK)), dated 12/11/08, pp. 5225- 5232.  I have decided that, because of the ongoing discussion I should lift it up into a separate blog for those who might have missed it.
In order to prove that element in this case, we focus on the doctrine of economic substance. In this case, the government contends that the taxpayers whose tax returns are the subject of each count of tax evasion, owed more federal income tax then they reported on the returns for one reason only, in each case the taxpayer took a deduction from his taxable income due to a loss that the tax return attributed to one of the four tax strategies at issue in this case. You remember them, FLIP, OPIS, BLIPS and SOS.

The government argues that every one of those tax strategies lacked economic substance. That the tax deduction each one of those taxpayers took was improper, for that reason, and, therefore, that each taxpayer owed more federal income tax than was declared on the tax return. The defendants dispute that. They contend, among other things, that the tax strategies did not lack economic substance, that the deductions were proper, and that the tax returns, therefore, accurately stated the amounts of tax that were due and owing.

This means that your task here, with respect to the first element, is to decide for each count, whether the tax strategy that gave rise to the loss claimed as a deduction on that tax return, lacked economic substance in order to decide whether the relevant taxpayer owed more federal tax, income tax, than was shown that was due on the tax return. So I am now going to instruct you with respect to your consideration of the economic substance issue.

A transaction that lacks economic substance cannot enter into tax computations. Any deduction claimed for a tax loss that allegedly was sustained in such a transaction, therefore, is not properly claimed on a tax return.

In order to establish that a transaction lacks economic substance, the government must prove beyond a reasonable doubt both of two factors. The first factor is that the relevant taxpayer had no business purpose for engaging in the transaction apart from creating the tax deduction.

The second factor is that there was no reasonable possibility that the transaction would result in a profit.

Now, let me define one term and say a few things about each one of these factors.

First the definition. The word profit, as I use it in this context, means a return in excess of the cost of the investment, disregarding entirely any tax benefits. Let me give you an example. If somebody puts a million dollars into a deal, he would have to get a return of more than a million dollars without considering any tax benefits in order for the transaction to be profitable. Common sense. A return of $750,000 on a million dollar investment results in a loss of $250,000, not a profit. That's what I mean by profit. Forget the tax benefits, look at the investment and the return.

Now, let me discuss the first element that I mentioned, whether the taxpayer had any business purpose for entering into the deal. In deciding that question, you, of course, may consider any direct evidence of the taxpayer's motive. But you are not limited to direct evidence in deciding why a taxpayer did a transaction. You can consider circumstantial evidence as well.

I am going to talk to you later about what circumstantial evidence means. But for purposes of the present, think of it just as common sense, and then I will explain it later on.

For example, you may consider the manner in which the transaction was sold to the taxpayer. In other words, you are entitled to consider whether and to what extent it was sold to the taxpayer as a way to create a tax deduction to offset other taxable income, and/or as a way to generate a return, a profit, exclusive of tax benefits on the investment. You are entitled to consider that.

You may consider also whether a reasonable taxpayer would have paid the fees necessary to do the transaction in order to gain the chance of whatever profit potential existed if the transaction did not also carry with it tax benefits.

Now, let me try to put this into plain English. What helped me think about it, maybe it will help you, I am going to give you a couple of examples, so bear with me on the examples. Let's take an example in which a taxpayer has to put up $2 million to enter into some deal or strategy. Suppose further that the strategy in question offers a five percent chance, that's one chance out of 20, resulting in a payout, when all is said and done of $2,050,000. In other words, it's a one in 20 chance of making $50,000 on a $2 million investment.

Assume also that the taxpayer has a huge amount of income, and that there is a very big tax benefit to the strategy, maybe a $10 million tax loss or deduction.

Now, common sense will tell you that few, if any, people, no matter how rich they are, would put up $2 million for a five percent chance, a one out of 20 chance, of making $50,000. So on those facts you might conclude that there must have been only one reason for the taxpayer to have paid the $2 million. And that the $10 million tax loss or deduction probably was the only reason.

Let me give you another example, also an example in which the same taxpayer has to put up the same $2 million.

What's different in this example is this, assume there is a 33 percent chance, now it's one out of three we are talking about, of getting a payout of $3 million. And thus a profit of a million dollars within a year. Now, a 33 percent chance, a one out of three chance of making a profit, is not bad odds, it's pretty good odds. And a million dollars is nothing to sneeze at, even if you are very rich.

In this second example, the high likelihood, relatively high likelihood, and the large size of the potential profit, would be circumstances that might tend to show that the taxpayer had a nontax reason for doing the deal.

Many people might consider it a very good investment opportunity, without regard whether there was any tax benefit.

In the end, what you would do, is to consider all the evidence, direct, if there is any, and circumstantial, to decide whether the government had proved that the tax benefits were the only reason for doing the deal.

Those are my examples.

So let me come back to this case. If you find that the government has proved that the tax benefits were the only reason for doing the deal involved in any particular count, you will go on to consider the second part of the economic substance test that I gave you a moment ago. And that I am going to talk about more in a minute.

If you find, however, that the government has not proved that the tax benefits were the only reason for doing the deal, you must reject the government's economic substance argument. And you, therefore, must reject its contention that there was additional tax due and owing. That in turn would require you to find the defendant or defendants in question, not guilty on the particular tax evasion count that related to the particular taxpayer and year in question.

Now, let me say a word about the second fact in the economic substance test, which is whether there was a reasonable possibility that the strategy involved on the count you are considering would result in a profit.

Now, at one level this is largely self-explanatory, but I want to emphasize to you that this factor requires you to come to an objective judgment about whether the government has proved that there was no reasonable possibility that the strategy would result in a profit. In other words, this doesn't depend on what the taxpayer believed about the tax potential -- excuse me, the profit potential -- it requires you to consider all the evidence that you have, and reach a conclusion about whether the government has proved beyond a reasonable doubt, that there was no reasonable possibility of a profit.

In doing this, you are going to have to consider the evidence concerning investment aspects of each of the four tax strategies at issue in this case. For example, the transactions involving the Argentine peso and the Hong Kong dollar that were involved in the BLIPS strategy, and the foreign currency options that were involved in the SOS strategy. Of course, you have to consider the particulars of the other two strategies, as well, I mentioned those because they come immediately to mind.

Now, in considering whether the government has met its burden on the second factor, you should take into account whether the taxpayer, considering all the aspects of the strategy, had any reasonable chance of making a profit or suffering a loss as a result of changes in the market.

To take one example, if you are considering a BLIPS deal, you should consider whether the taxpayer had any reasonable chance of making a profit or suffering a loss as a result of changes in the value of the Argentine peso and the Hong Kong dollar, given the terms of the deal. If you find that the government has proved beyond a reasonable doubt both prongs of the economic substance test, in other words, both that the taxpayer had no nontax reason for doing the deals on the count in question, and that there was no reasonable possibility of making a profit, you may find that the requirement of additional tax due and owing will have been satisfied, and you will go on to consider whether the government has proved that the additional tax due and owing was substantial.

1 comment:

  1. Uh oh now I am really confused. The House just codified economic substance in the Health Care reconciliation package, if the Senate passes it will become the law of the land.

    The law essentially states that if you rely on profit potential, potential profit must be substantial in relation to the tax benefits. Potential profit is computed by determining the net present value of the reasonably expected profit less transaction costs including foreign taxes (the law still does not explicitly include tax opinion fees).

    How does one even determine reasonably expected profit? If I buy a lottery ticket for $1 dollar with a chance of winning $100 million is that my profit or do I have to multiply $100 million by the probability of winning?

    The Government would suggest you multiply $100 million potential profit by the probability of winning to determine reasonably expected profit not withstanding this defies all norms of accepted financial analysis.

    Black/Scholes purports to value options such that a fair price is paid for an option based on the potential profit from the option. Thus if I paid $1 for an option valued under Balck/Scholes that had a pay out potential of $20 with a stochastic probability of 5% chance of hitting, how do I determine if the transaction has economic substance?

    Do I multiply, $20 (the potential payout) times 5% (the probability of hitting the payout) to yield a potential reasonably expected payout of $1? Of course this yields a zero profit since the option cost $1 and a tax benefit of 40 cents which under the law means the transaction lacks economic substance.

    Does this mean anyone who trades options or makes investments for that matter and deducts their losses will be a criminal?
    Of course the correct analysis which most financial gurus engage would provide that the $1 paid for the option is reasonable in relation to the potential profits of $19 ($20 less $1) and $19 is considered the reasonably expected profits and the transaction would have economic substance.

    Which method is it?

    When Wells Fargo bought Wachovia and Hank Paulson then Secretary of the Treasury specifically exempted Wells from Section 382 limitations at the request of Steele the CEO of Wachovia (and former employee of Paulson at the Treasury), Wells agreed to buy Wachovia since it would obtain tens of billions in tax benefits from all of Wachovia’s built in losses and net operating losses, clearly this type of transaction (as are most of the bank acquisitions) lacks economic substance under the codified standard. How am I wrong?

    In fact, many are serving substantial jail sentences right now because of how the economic substance test was applied. As a general example, the BLIPs guys effectively bought an option for $1 million that had a potential payout of $30 million as determined under Black/Scholes.

    Does anyone who does not meet the economic substance test (and no one trading options or other financial instruments would) need to go to jail if they deduct their losses?

    One last question, the new economic substance law excepts several transactions form its application especially in the reorganization area. The prosecutors in the Stein case are on record stating to the courts over and over that the “tax law” only applies to any transaction after it is determined that the economic substance law has been met. Of course anyone who knows anything about taxes knows such a statement is patently false but what does it mean now that such false statements are clearly shown to be false under the new law? In fact, the often referred SCT case "Gregory" considered by many to be the progeny of the economic substance law was a case involving a reorganization which is now apparently specifically exempted form application of the economic substance rules under the new law.

    How confusing.


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