Wednesday, March 17, 2010

More on Economic Substance in Criminal Tax Cases - the Coplan Instructions.(3/17/10)

I have previously blogged on the application of the economic substance doctrine in criminal cases. I offer in this blog the application of the economic substance doctrine in the jury instructions in United States v. Coplan (SD NY No. (S1) 07 Cr. 453 (SHS)). Coplan was the E&Y-related criminal case and, in respect to economic substance, involved the same range of issues and problems as the KPMG-related criminal case on which I have previously blogged. (The entire set of jury instructions here; I shall quote the parts I believe most relevant below.)

The economic substance instruction in Coplan came as a subset of the instruction on the Tax Due element for tax evasion. The Court instructed the jury that the Government was required to prove that there was "a substantial amount of due." (Instr. p. 42.) This is a pretty straight-forward instruction.

Before moving to economic substance, I comment briefly on the task the jury is asked to perform in determining tax due in complex tax cases, including tax shelter cases. These shelters are usually very complex. When they are litigated in a civil context by the taxpayer who actually may owe the taxes, the litigation usually produces a lengthy opinion from a trained judge making many findings of fact and applying sometimes arcane principles of tax law in coming to a conclusion that the shelter works or doesn't work (usually doesn't work in this type of aggressive shelter). The jury by its general verdict of guilt or innocence just cuts to the chase on that issue (and the other elements of the crime(s) charged) without having to be bothered with a detailed analysis to support the conclusion. At least with detailed findings of fact and conclusions of law, the judge has been forced to go through the rigorous steps from a to z and appellate courts and the public can determine whether the conclusion is good. With general verdicts of guilty or not guilty, we cannot test the jury's rationale. But that is the nature of the general jury verdict, so I move on.

The Court then treated the economic substance doctrine as being the central determinant of whether there was a tax due and owing. In other words, most of these shelters had other, more tax-geeky problems that were potentially fatal, but the trial centered around the alleged economic substance defect and that was the instruction that was given. I quote now the relevant instructions (pp. 43 - 48).
The government contends with respect to Counts Two and Three that there was a tax due and owing because losses claimed as a result of the CDS Add-On tax shelter were not properly deductible under the tax laws, and thus that the clients understated the taxes they owed when those losses were reported on their tax returns as deductions that offset taxable income or gains. The government’s position is that the CDS Add-On shelter lacked economic substance.

This means that you must decide whether or not the CDS Add-On tax shelters implemented in Counts Two and Three lacked economic substance, and thus whether any of the relevant taxpayers claiming deductions from the shelter owed more federal income tax than was reflected on their individual tax returns.

* * * *

I will now instruct you on how to determine whether economic substance exists with respect to each relevant taxpayer.

Under our system of tax laws, a loss produced through a financial transaction that lacks economic substance cannot enter into a taxpayer’s tax computations. Any [*45] deduction claimed for a tax loss sustained in such a transaction cannot properly be claimed on a tax return. Thus, if you find that the tax losses from the CDS Add-On shelter were not properly deducted, you may conclude that the taxpayers owed more in taxes than was reported on their income tax returns, and proceed to decide whether that amount was substantial.

In order to establish that a transaction lacks economic substance, the government must prove two elements beyond a reasonable doubt:

The first element is that there was no reasonable possibility that the transaction would result in a “profit.”

The second element is that the relevant taxpayer had no business purpose for engaging in the transaction in question apart from the creation of the tax deduction.

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

First the definition. The word “profit” in this context means a return in excess of all the fees and costs incurred by the client in connection with entering into the tax shelter, disregarding entirely the value of any tax benefits.

Now let me say a few words about your determination whether there was a reasonable possibility that the shelter would result in a profit. This element requires you to reach an objective judgment about whether the government has proved that there was no reasonable possibility that the shelter would result in a profit. In other words, this does not depend upon what the taxpayer believed about the profit potential. It requires you to consider all of the evidence and reach a conclusion about whether the government has proved beyond a reasonable doubt that there was no reasonable possibility of a profit on the tax shelter after the fees and other costs were paid. If you find that the government [*46] has proved beyond a reasonable doubt that there was no reasonable possibility of a profit, then you move on to the second element, whether the relevant taxpayer had no business purpose for engaging in the tax shelter. If you find that the government has not proved the lack of a reasonable possibility of a profit, then you must reject the government’s theory and find the defendants not guilty.

Now let me discuss the second element that I mentioned—whether the taxpayer had any business purpose, that is, a non-tax reason, for participating in the shelter. In deciding that question, you may consider any direct evidence of the taxpayer’s motive. For instance, you may consider testimony or other statements by the taxpayer as to his or her reason or reasons for participating in the shelter.

But you are not limited to direct evidence in deciding why a taxpayer participated in the shelter. You may consider circumstantial evidence as well. For example, you may consider the manner in which the shelter was marketed or sold to the taxpayer. Thus, for instance, you are entitled to consider whether and to what it extent the shelter was advertised as a tax savings device, a means of obtaining a profit, and so forth. You may also consider the likelihood of a significant profit in relation to the amount of fees that clients were required to pay to participate in the tax shelter. Common sense tells you that if the client pays large fees to enter into a transaction with a large intended tax benefit and a very small likelihood of profit, that fact might tend to show that the client did not have a non-tax reason for doing the shelter. Conversely, if there is a significant possibility that the transaction will return a profit greater than all fees and costs, such a fact might tend to show that the client did have a non-tax reason for doing the transaction.

Taking into account both direct and circumstantial evidence of the relevant taxpayer’s intent, you must determine whether the government has proved beyond a reasonable doubt that the relevant taxpayer had no business or non-tax reason for doing the tax shelter in order to conclude that it lacked economic substance.

If you unanimously find with respect to at least one relevant taxpayer in each of Counts Two and Three that the government has proved beyond a reasonable doubt both prongs of the economic substance test—that is, losses were claimed on an individual tax return as a result of a tax shelter for which there was no reasonable possibility of making a profit and where the relevant taxpayer had no business purpose for engaging in the shelter—you may find that the requirement of additional tax due and owing is satisfied with respect to the count you are considering. * * * *

However, if you do not find that both elements of the economic substance test have been proven beyond a reasonable doubt as to losses claimed by any relevant taxpayer in a given count, then the government will not have proved that additional tax was due and owing as to that count, and you must find the defendants not guilty of the tax evasion count you are considering.
Well, that's it. The court invites the jury to consider indirect evidence as to the "relevant taxpayer's" purpose in participating in the shelter. This is a wholly subjective inquiry as to the relevant taxpayers. Since, I speculate here, these taxpayers made representations that they had such an independent profit motive, the jury must have concluded that those "relevant taxpayers" lied in making the representation and, therefore, that they too were guilty of tax evasion. Now tax evasion in such circumstances in criminal trials against the taxpayers is usually proved by circumstantial evidence since the taxpayer usually does not testify and, in any event, there is no direct proof of the mental state of mind required. But, I suspect that in these cases, the criminal jury is sorely tempted to conflate the two economic substance prongs -- we the jury find that there is no reasonable possibility of profit and therefore the taxpayer cannot have reasonably had a profit motive and therefore he or she did not have a profit motive. I just wonder if the jury actually has enough evidence to make the latter conclusion without the erroneous intervening logical step. In other words, there is no requirement in the economic substance test that the taxpayer's profit motive be reasonable or correct; just that the taxpayer have the profit motive. To give the jury the tools / record to get properly to the conclusion, the Government would have had to prove up a separate evasion case against each of the "relevant taxpayers." My suspicion / speculation is that the Government did not do that and left the jury to speculate that the taxpayers did not have the required profit motive because, in the jury's collective mind, no reasonable taxpayer could have the required profit motive.

And this does not even address what a reasonable profit motive even is.

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