Economic Substance in Criminal Cases - Is It About the Lie? (5/19/09)

THIS BLOG WAS UPDATED AS OF 5/25/2009; IN REVISED LANGUAGE, I ATTEMPT TO CLARIFY MY ASSERTION THAT, IN APPLYING THE ECONOMIC SUBSTANCE DOTRINE IN CRIMINAL TAX SHELTER CASES, THE "OR" TEST MUST APPLY AND REQUIRES THAT THE GOVERNMENT PROVE FOR CONVICTION THAT (1) EACH OF THE TAX SHELER INVESTORS -- THE TAXPAYERS -- LIED (WHICH IS DIFFERENT THAN MERELY PROVING THAT A HYPOTHETICAL REASONABLE TAXPAYER COULD NOT HAVE MADE THE REPRESENTATION TRUTHFULLY) AND THAT (2) THE SHELTER ENABLERS MUST HAVE KNOWN THAT THE TAX SHELTER INVESTORS -- THE TAXPAYERS -- ACTUALLY LIED.

Yesterday, I blogged here about the decision in Klamath. In that case, the Fifth Circuit faced the conflict among the courts in the appolication of the economic substance doctrine in civil cases and held that the taxpayer must have both (i) objective economic sustance and (ii) a nontax business or profit motive. (Actually, the Fifth Circuit stated these two-prong requirements as three-prong requirements, but I conflate the second and third here.) I noted in that blog that the Government also trots out the economic substance doctrine issue in criminal cases involving tax shelters. On a related note, I previously blogged here about the claim by a federal prosecutor prominent in such criminal prosecutions that criminal tax shelter cases are about the lie. In this blog, I address these related themes.

In the criminal case from the monster indictment of 19 KPMG-related individuals, 13 of the original 19 defendants were dismissed for prosecutorial misconduct. Only six of the original 19 thus were left. Two of those pled. The Government tried the remaining 4 defendants in late 2008. As to the BLIPS shelter (the same type of shelter involved in Klamath), the Government claimed in the case that the defendants criminally crossed the line established by the economic substance doctrine. Recognizing that there is a conflict among the courts as to the interpretation of the economic substance doctrine and that a criminal tax violation requires a clearly defined line that must be crossed, Judge Kaplan submitted the most defendant-friendly iteration of the economic substance doctrine to the jury. After charging the jury on Cheek willfulness, Judge Kaplan instructed as follows (United States v. Ruble, 2009 U.S. Dist. LEXIS 34908 (S.D.N.Y. 2009)):

[Y]ou may find that a defendant acted willfully in this respect only if the government has persuaded you beyond a reasonable doubt that the defendant, first of all, knew that the relevant taxpayer was motivated by no business purpose apart from the creation of a tax deduction. Secondly, knew that the strategy in question had no reasonable possibility of making a profit, in excess of the costs incurred without regard to tax benefits. And, thirdly, knew that the tax due and owing absent the deduction attributable to the strategy in question, would have been substantially greater than the tax reported on the taxpayer's tax return.

Note that, as presented to the jury, the jury could and should have acquitted if either of the key elements -- no nontax business purpose or no reasonable possibility of profit (a variation on objective economic substance) -- was not proven beyond a reasonable doubt. In other words, for purposes of the criminal case, the test is in the disjunctive rather than the conjunctive. The failure to prove either element would cause the criminal case to fail. And this is as it should be given the fact that there is some remaining uncertainty, even after Klamath, as to whether the test is conjunctive or disjunctive in civil cases. So, Judge Kaplan presented the most defendant-friendly application of the test, as he should do given the fact that a clear line is required both for Cheek willfulness and the rule of lenity. The jury then convicted the defendants for the BLIPS shelters.

Now, what has that got to do with the lie which, as noted in the previous post, is asserted to be the bedrock of criminal cases in the tax shelter area? In the BLIPS tax shelter, the Government claimed and the proof suggested, that the investment strategy independent of the "borrowing" transaction giving rise to the tax play had only a highly speculative possiblity of returning proceeds in excess of the all-in costs of the combined transaction (those costs consisting principally upon the promoters fees based ad valorem on the touted tax benefits alleged to be derived). (I note that the instructions did not surgically separate the investment play from the borrowing play which gave rise to the tax benefit, as the court did in Klamath but which the court did not do in Sala which is currently on appeal to the Tenth Circuit.) Hence, when the investors made the obligatory nontax profit motive representation to KPMG and to Ruble, given the marginality of the possibility of profit on the invesment play, they lied. Although it is impossible to know precisely why a jury convicts, at least the notion or speculation would be that the jury believed the taxpayers lied in making that key representation and that the defendant-enablers who received and relied upon that "representation" knew that the taxpayers were lieing. This would mean that the taxpayer-friendly application of the economic substance doctrine would deny the taxpayers the benefit they claimed on their returns and the defendants thus would be guilty because the taxpayers' taxes then would have been underpaid.

That may be a bit confusing, so let's approach it another way. Focusing on the taxpayers (i.e., the shelter investors), at least for criminal purposes, they could have underpaid their taxes (a requirement for anyone to be convicted of tax evasion) only if, under the most taxpayer-friendly application of the economic substance doctrine, their taxes were actually underpaid. Under a taxpayer friendly version of the economic substance doctrine, the taxpayer does not underpay the tax if either the transaction has objective economic substance or the taxpayer had a profit motive. (The Court in Klamath, discussed here, said that expressly in adopting the majority approach to require both economic substance and a taxpayer nontax business or profit motive ("This particular situation highlights the logic of following the majority approach to the economic substance doctrine, because the minority approach would allow tax benefits to flow from transactions totally lacking in economic substance as long as the taxpayers offered some conceivable profit motive,")) But, all the courts have not adopted the "both" test approved in Klamath, and thus whether the test is both or or is still uncertain as to its ultimate resolution in the federal courts. Certainty in the law is required for criminal prosecution (a la James, Garber, Dahlstrom, Pirro), so the taxes should be deemed due for criminal purposes only under the more lenient "or" test. Assuming arguendo that the transaction has no objective economic substance, the tax is due for criminal purposes only if the taxpayer had no nontax business or profit purpose. But, the taxpayers represented that they did have a nontax business or profit purpose. So, correct instructions would require that the jury find that the taxpayers actually lied as to profit motive (a subjective determination as to what was in their minds) and that the defendant-enablers must have known they were lieing.

But, wait a minute, you might say, did the Government really prove in the case that each of the taxpayers involved in the counts of conviction lied (And, you might ask, if those taxpayers were lieing, why were they not also indicted?) While I did not attend the trial, I did review the daily transcripts. I don't think the Government made any serious attempt to prove beyond a reasonable doubt that each of those taxpayers lied other than from an inference that no reasonable taxpayer could have made the representation. That inference turns a subjective test (the taxpayer's profit motive) into an objective test (a reasonable taxpayer's profit motive). The test, however, is not objective, it is subjective. Many of those taxpayers did not even testify, and there was no other real evidence as to their states of mind in making the representation. Maybe at least some of those taxpayers really believed that the investment strategy would produce a profit (and made no attempt to distinguish the loan play from the investment play (see Sala)). In that case, the taxpayers did not lie, regardless of whether some hypothetical reasonable taxpayer might not have reached that same belief under the circumstances. And, if the taxpayers themselves really did not lie, then under the lenient "or" test which must be used for criminal purposes, they did not owe the tax.

In other words, even if the tax shelter enablers knew that no reasonable taxpayer could make the representation, since taxes for criminal purposes would be due only if in fact the taxpayers lied -- i.e., they had no actual profit motive, even an unreasonable one -- the tax due and owing element could not be established without proving the lie for each of the taxpayers involved in the counts of conviction.

I have discussed in a previous blog (see here) the heavy burden of proof on the Government for tax evasion convictions as a result of the required element of proof of tax due and owing by the taxpayer. The issue discussed here is just a variation of that theme, although in an important but different context.

So, are the convictions flawed? We'll see on appeal.