Tuesday, January 19, 2010

More on Legal Uncertainty and, More Importantly, the Subjective Prong of the Economic Substance Test (1/19/10)

I have previously discussed here the economic substance instruction that Judge Kaplan gave in the skinnied down KPMG trial that resulted convicted three defendants of multiple tax evasion crimes and is currently on appeal to the Second Circuit. I blogged about the Government’s outsized brief filed last Friday (see the brief here). My topic of focus was the effect of legal uncertainty in the law.

Today, I carry that discussion further in the context of the Government’s claims about the role of the economic substance doctrine in a criminal tax case. To set the stage, there clearly is some uncertainty in the civil cases about the economic substance doctrine. Two tests have been developed, which the Government calls (Br. 55) and most practitioners call a subjective prong and an objective prong. The subjective prong is whether the taxpayer engaging in the transaction had a nontax profit or business objective. Under this test, tax can be a consideration but the taxpayer must have an actual business or profit object or intent; further, there is no requirement that the taxpayer's objective be reasonable. The objective prong is whether the transaction has some – perhaps limited to some reasonable – possibility of profit. The major uncertainty from the civil cases is whether the tests are in the conjunctive or disjunctive. That is, whether a taxpayer desiring to sustain his claim of tax benefits must prove (i) both that he had the profit objective (however unreasonable) and that it was a reasonable profit or business objective or (ii) either of those prongs. (For tax coneheads (among whom I number myself), this objective / subjective inquiry, if indeed conjunctive, may be analogized to the relief from the substantial understatement penalty for tax shelter transactions if the taxpayer had a belief that the transaction will more likely prevail and the belief is objectively reasonable.) The courts in the civil cases are split on that conjunctive / disjunctive issue for the economic substance test.

To state the obvious, criminal cases are not civil cases and different policies are implicated that requires some role reversal. The criminal case asks whether the Government has proved beyond a reasonable doubt that the civil tax result is certain and was willfully violated. Accordingly, in instructing the jury, as he should in a criminal case, Judge Kaplan adopted the most defendant friendly version of the split – that is, he advised the jury that the Government had to both that there was no taxpayer profit or business objective and no reasonable profit or business objective. I have doubts about turning over the economic substance test under either formulation to a jury in a criminal case, but if it must be turned over (and Second Circuit authority says it must), I think Judge Kaplan made the right choice by requiring the conjunctive application of the test. (It is important at this stage to note that the Government argued to Judge Kaplan that the jury should be instructed in the disjunctive – i.e., the jury can convict if either (i) under the subjective prong, the Government proved beyond a reasonable doubt that the taxpayers involved had no profit or business motive, or (ii) under the objective prong, the Government proved beyond a reasonable doubt that there was no possibility – or, in the Government’s mind reasonable possibility -- of profit; that notion is just goofy in a criminal case, but I won't digress further here.)

I want to return shortly to the subjective prong that, in my view, was transformed in this case to an objective inquiry (although I will continue to call it the subjective prong in order to differentiate it from the subpart of the economic substance test that really is supposed to be objective). As to the objective prong, the parties dispute at length in their brief as to whether the possibility of profit is limited by the adjective “reasonable.” I think much of this discussion is semantics echoing Bill Clinton’s famous line – “It depends on what the meaning of the word 'is' is.” (In this semantical game, the Government easily sets up a strawman only to knock it down.) I don’t want to enter that fray right now, but I want to return and address the so-called subjective prong of the economic substance test as it played out in the case.

Let’s go back to the test. It is supposedly an inquiry into the subjective thinking of the taxpayer(s) involved. And, the test as formulated is not an objective test; so long as the taxpayer(s) involved had a subjective profit motive, regardless of how unreasonable it may have been, the tax shelter passes this leg of the economic substance test in a civil case.  Transforming this test to a criminal setting, the Government would have to prove that the taxpayer(s) involved in the counts of conviction had no actual intent -- even if the intent were unreasonable.

As I shall note, at best at least for the absent, nontestifying taxpayers in the counts of conviction, all the Government may have proved beyond a reasonable doubt was that it may have been unreasonable for them to have a profit or business motive, but that is not the same as prove beyond a reasonable doubt that they did not have the motive.

I have asked before how the Government can make that stringent level of proof, at least as to taxpayers as to whom there was no evidence other than the fact that they claimed benefits alleged in the counts of convictions. These taxpayers did not testify and the Government introduced no evidence going to their actual intent. Judge Kaplan and the jury were left to infer that the taxpayers had no such intent solely from the objective evidence of their involvement and the further proof that Government had proved objectively that the shelters could not produce a profit (or at least a reasonable prospect of producing a reasonable profit). The net result is that, in my mind, the court and the jury just conflated two separate tests and turned them into a single objective test -- if the shelter transaction is objectively unreasonable, the presumption is that the taxpayers acted as reasonable persons and thus did not have the intent. This was virtually an irrebutable presumption becuase the taxpayers had no practical ability to prove what the taxpayers might have intended or to otherwise attack the presumption thus raised by the Government in meeting the objective prong of the test.

I ask this simple question: would the proof adduced at trial as to the absent taxpayers have alone sufficed in criminal prosecution of those taxpayers to prove beyond a reasonable doubt that they had no profit or business motive? Does that evidence prove beyond a doubt that the taxpayers could not have been mistaken? In a criminal prosecution of the taxpayers themselves, the Government would have proved a host of facts about the individual taxpayers (education, business savvy, etc.) that would have offered some basis to reasonably infer whether the taxpayers had the actual intent, however unreasonable, or not. At best, all the evidence proves -- perhaps even proves beyond a reasonable doubt -- is that a reasonable taxpayer would have had no such subjective profit motive. The test, however, is not a reasonable one but a subjective one testing whether the taxpayer actually had such intent regardless of whether it was reasonable or not.  (Certainly a diversion to my main point, but the even more startling thing here is that a necesssary conclusion from the Government's arguments is that it in fact proved beyond a reasonable doubt that they taxpayers themselves committed tax evasion, even though they were given no opportunity to defend themselves.)

Sure, Judge Kaplan mouthed the right words – the test is the intent of the taxpayers without qualifying whether it should be reasonable intent, but in the final analysis the jury had no specific evidence of the taxpayers’ intent and were left to conclude only that the taxpayers must not have had the intent because no reasonable taxpayer could have had such an intent. That is an objective test in the guise of a subjective one.

And, of course, the Government knows that it skirted the subjective nature of the subjective prong (that second subjective is not redundant here). I won’t pull out all the points in the brief where the Government fudges on this issue. But you can clearly see the bootstrap with reference to the Gibson Dunn memo. Gibson Dunn, a law firm, was engaged or more taxpayers to opine about the transaction. Gibson Dunn had some doubts and evidenced those doubts in a memo that the defendants were aware of contemporaneously. Notwithstanding Gibson Dunn’s concerns in the memo, some of the Gibson Dunn clients allegedly invested. The Government cites (br. 41-42) that memo as proof that the taxpayers’ “lack of a nontax motive was unquestionable.” I fail to see the logical connection there. I don’t think that the Government ever proved that each of the absent taxpayers in the counts of conviction ever read the memo. But even more breathtaking in its gall, is the Government’s claim that it is entitled to send people to jail on the assumption that the clients have to subjectively believe the same thing as a lawyer whose advice they did not follow. That is not the stuff, in my mind, of criminal tax cases.

The tragedy of all this, in my mind, is that, if these defendants were guilty of some conduct for which criminal penalties are appropriate, the Government had plenty of tools to do it. Tax perjury, aiding and assisting, tax obstruction and even the Klein defraud conspiracy (oops, that's right the jury acquitted on that charge). According to the Government's claims in the briefs, the transactions were laced with lies and pretenses which could have easily been the proper fulcrum into one or more of the other tax crimes with penalties that would have produce ample incarceration periods for the gravity of the claimed misconduct, but the Government chose to make multiple evasion claims that, in my judgment, are seriously questionable.

That is the thread of my argument. Maybe I’ll write more on it in another forum, but it tests the limits of what I imagine is appropriate for a blog.


  1. Well Mr. Townsend, while you are correct in your analysis and I would never quibble with your legal analysis I know a thing or two about the financial markets. Anyone who suggests the taxpayers in BLIPs could “not” have made a profit or that the taxpayers regardless of their presumed intent would not have accepted any such profits is a bald faced liar. While the odds of making such profit were very low, a chance still existed and the real question is were the Forward contracts fairly priced (but even that is a legal question of a dubious nature). What is most appalling is that no Bank on the planet would have entered into the Forward contracts without appropriate margin, as you know, in BLIPs the only Margin taxpayers put up was the BLIPs loan proceeds, thus the loan had a purpose, most banks at the time required a 10 % to 20% margin account (i.e., the taxpayers in BLIPs actually got a better economic deal vis a vi margin under BLIPs than the customary financing required for forward contracts). But what I find most appalling regarding this whole mess is in the second circuit, up until this case, Ingredient Technologies and Atkins where the seminal cases in determining whether criminal economic substance existed, cases where the purchase of sugar as inventory and the purchase of securities never actually happened, not a case like the one described here were the trades actually happened and the bank was at risk, in fact both Atkins and Ingredient required there be no chance of any profit or risk period and even the scumbag Makov admitted a remote chance of profit existed. I would also appreciate someone pointing out where in the law it suggests tax opinion fees are appropriately allocated against potential profits as of 2001 especially given Compaq and IES especially in the criminal context.

  2. Mr. Townsend, I would like to make one more point with your indulgence as I know the legal types find me distasteful but after perusing the DOJ brief a few other points are relevant pertaining to willfulness. If these fine gentleman knew ahead of time that it was a crime to violate the civil economic substance test (which no matter how much the DOJ equivocates was the final jury instruction) under the construct that a tax is due and owing (not whether the position was non frivolous); that such test would be analyzed based on negative inferences by a jury which has no context from which to understand finance or tax law; that violation of such test could be supported by taxpayers recanting their representations at the behest of the DOJ (while the IRS gives such taxpayers favorable settlements); that the government witness Makov (who was hired to imbue the transaction with profitability) would be told by the government he can either risk a life of ass raping and lose all his money or pay a fine of $10 million (after making over $50 million) and serve no jail time for DOJ favorable testimony (make no mistake Makov is a liar); that the criminal economic substance test heretofore would not be the jury instruction; I suggest these gentleman never would have touched any investment/tax advantaged strategy as who in their right mind would.

  3. Anonymous has posted two fine comments. Thanks.

    I have not had time to consider and comment substantively on the comments. It does appear, however, that hyperbole is not confined to Government claims.

    And, I think readers should know Anonymous' perspective. Anonymous obviously desires to be anonymous, but his comments over time has indicated an unusual amount of interest in and knowledge of the prosecution of the KPMG related defendants. I surmise that Anonymous is not a neutral observer. But, of course, neither am I. Readers should thus take anything we say with appropriate caution.

    Having said that, I do want to state my opinion that Anonymous makes excellent comments that are worthy of consideration.


  4. I am gonna stop but in reviewing the DOJ brief the DOJ suggests it would be “ludicrous” to apply the Ingredient Technology jury instruction of no market risk or no chance of profit because then all tax shelters which had a theoretical chance of profit would be viable. Huh? One of the most often cited cases, ACM at the time these investments were being made held the transaction ACM entered into involving repos and interest rates lacked economic substance because in the last ten years (or so) from when the case was decided interest rates had never moved enough to render the subject transactions profitable. Interestingly, in BLIPs, within two years of the original transactions, the Argentinean peg broke and would have rendered most of the BLIPs transactions profitable. The DOJ goes on to incredibly argue in its brief that even in Ingredient Technology some risk existed because the “secret” side agreement eliminating all risk and potential for profit may not have been honored. Huh? The secret side agreement was the reason the dudes in Ingredient got convicted because it was apparently believed by the jury that no risk or profit potential existed. Huh? There was no secret side agreement in BLIPs, no agreement with the banks that in the event the Peso peg broke the bank would not have to pay and not even an agreement that if the Peg moved such that more margin would be required under conventional financing such margin would have to be provided, true risk to the bank. “Ludicrous”, I would submit the whole Code is ludicrous or that the IRS would force Helmer, a farmer, to pay tax on option proceeds under an arcane interpretation of the tax law is ludicrous or that the DOJ would allow Ted Turner in Fulcrum to obtain an $80 million tax deduction from a repo transaction that by its very terms had no potential for profit is ludicrous……Ludicrous?

  5. I know nobody wants to hear this but the government is arguing in its appeal brief that if a transaction does not have a reasonable possibility of profit after all costs (apparently including tax opinion fees) and a taxpayer (or advisor) knows it, tax fraud necessarily results. (Of course, I would have thought James has a direct bearing on this issue since no one knows what “reasonable possibility of profit means” and that is why heretofore the criminal standard had been no possibility of profit or no market risk). In fact, most civil cases define when economic substance is lacking based on a particular set of facts but provide no definition of what a reasonable possibility of profit is or define such term vis a vi probabilities,

    The government and the Judge then conflate this issue by effectively defining reasonable possibility of profit based on statistical probabilities of success and seem to believe a non financially sophisticated jury can make such a determination.

    The end result is most public and private options lack economic substance and any one who takes deductions resulting from losses on such options is a criminal since such options clearly lack economic substance (and most certainly do not have a 33% chance of success as described in the jury instructions for a probability that may be reasonable). It may be time to start making some citizens arrests.

    Of course this is ridiculous since under Balck/Scholes the main drivers in pricing options is volatility (essential the stochastic probability of price movement which is usually around 10% to 15%) and time value of money. Forward contract pricing essentially works the same way, at least the type at issue here.

    What is somewhat perplexing is the Judge in this case seemed to understand that these types of contracts were priced under Black/Scholes when asking a question of one of the prosecutors. The Judge asked the prosecutor if options could have a value prior to expiration because under the Balck/Scholes formula the price obtained rarely corresponds to the eventual market price over time (the Judge even said that he understood that people trade and make money off of this asymmetry (or something to that effect)). The prosecutor responded that the prosecutor had no idea how Black/ Scholes worked but that the options were worthless (something that empirically was clearly not the case).

    How can a criminal case where men are being deprived of their liberty and likely being tortured in a U.S. prison be decided based on the definition of a reasonable possibility of profit (a term for which no definition exists) and where the jury instruction by their very terms and definition provides none of the subject transactions had a reasonable possibility of profit purely based on how the options or forward contracts are priced under Black/Scholes?

    Of course in the real world, it is not the probability of whether the options hit that traders take into account but the price paid for such options based on the probability of them hitting that is analyzed in determining whether to make the trade. In fact, a probability of 1% could be wholly reasonable depending on the option price. Further, make no mistake, many traders trade on a basis entirely different than pricing under Black/Scholes; under the Elliot Wave theory (and its many variations), Japanese Candlesticks and many other charting type indicators to determine the appropriate probability for success on any trade.


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