For this last guest post, I decided to eschew IP (well, to some degree, see below) and focus on a recent article of mine and Leandra Lederman—Enforcement as Substance in Tax Compliance—that (in my biased opinion) deserves more press. (Though, to be certain, Leandra would strongly disagree with my catchy title—see more on that below.)
In the article, we argue that the failure of the tax authorities to perfectly enforce the tax laws in effect can alter the substance of the tax laws, at least to the extent that taxpayers know the penalties for non-compliance and can reasonably predict how often the tax authorities conduct audits for certain classes of taxpayers.
This claim is quite different from the one that audit rates merely affect the propensity of taxpayers to “cheat.” Rather, the effective tax rate can be intentionally adjusted downward (and not just to zero) by the taxing authorities from the nominal tax rate, in effect, yielding an entirely new substantive law.
For instance, suppose there is a sales tax of 5% and that given current audit strategies, the effective tax rate is 4% in all industries, because 20% of the taxes go unpaid in each industry. Based upon the elasticity characteristics of the products in a given industry—in other words, the propensity of purchasers to continue buying as the price of a good increases—under certain circumstances, the tax authority can adjust its audit rates in one industry relative to another to change the compliance by taxpayers in each industry. This adjustment, in turn, can change the effective tax rates paid by a given industry. For instance, the tax authority might audit more heavily in an industry selling luxury cars than in one selling textbooks, yielding effective tax rates of 4.5% in the luxury car industry and 3.5% in the textbook industry.
The ability of the tax authority to generate different effective tax rates from the same nominal tax rate is an example of what we call “enforcement as substance,” namely the ability of differential enforcement strategies to effectively change the substantive law. A broader (and much less studied) question is whether “enforcement as substance” can be intentionally harnessed to improve social welfare.
Drawing upon work of mine in IP and others that shows that imperfect enforcement can decrease deadweight losses stemming from the issuance of patent rights, we show in our article that a “measured enforcement” policy (i.e., a conscious strategy to differentiate enforcement among different legal actors) can improve social welfare. In the tax context, measured enforcement can similarly be used to decrease deadweight losses caused by taxation, specifically by placing more of an onus on those industries with lower elasticities. Additionally, tax authorities can implement a quasi-Pigouvian tax on activities otherwise imposing negative externalities by upping enforcement of taxes on those activities.
Importantly, we show that under a variety of conditions, measured enforcement can yield welfare benefits while maintaining or even increasing the government’s total tax revenue. Some of these conditions are that the taxpayers be sophisticated and informed and respond rationally to incentives provided by the tax authority’s publicizing of its enforcement strategy. Generally, we believe large, sophisticated corporations—at least as an initial matter—would fit this bill.
Additionally, contrary to the title of this post—such a system should not be billed as one promoting “cheating.” Rather, like prosecutorial discretion in the criminal law context, here the tax authority would use its on-the-ground enforcement discretion to achieve optimal deterrence—namely, the use of its resources in those areas that most need it not solely to increase the public fisc, but to improve overall social welfare. Such allocation of resources of course is not tantamount to promoting cheating in the conventional sense (hence, the quotes around “cheat” in the title of this post).
One potential concern with such an approach is the possibility of abuse on the part of the taxing authority—adjusting enforcement not to benefit society, but as a means of political reward and punishment. Yet, our proposal yields no more room for abuse than under the current system. Indeed, under our framework, the taxing authority would publish its audit rates (otherwise, how could taxpayers adjust their behavior?), making its audit scheme much more transparent than it is now.
Of course, other potential concerns arise in such a scheme, such as separation of powers and horizontal equity (“treating like taxpayers alike”). We address these and other potential issues in detail in the article, concluding (of course) that none are fatal.
On a final note, thanks again to Gordon Smith to letting me guest blog the last few weeks—now, it’s back to the run-of-the-mill life as a law professor in the summer: writing law review articles (most of the time spent on the footnotes), lamenting the decline in law school enrollment, and enjoying the World Cup, Wimbledon, and the occasional barbeque.
Those familiar with US corporate law are well aware that, in this field, a single small jurisdiction looms very large. The state of Delaware is today the legal home to more than half of US public companies and about 64% of the Fortune 500. It’s widely understood that no other US state even comes close, and there’s a substantial US corporate legal literature exploring the contours of, and seeking to explain, Delaware’s domestic dominance. As I’ve ventured into the field of cross-border finance, however, I’ve been struck by the fact that Delaware isn’t really unique. Taking a broad view of the regulatory fields relevant to cross-border corporate and financial services, there’s a set of small jurisdictions that are not merely successful in their respective fields of specialization, but are in fact globally dominant in those fields.
In a current working paper I’ve selected a handful of these jurisdictions that I find particularly interesting; assessed whether extant theoretical paradigms can shed much light on their successes; and proposed an alternative approach that I think better captures their salient characteristics and competitive strategies – the so-called “market-dominant small jurisdiction,” or MDSJ. The jurisdictions studied include Bermuda, well-established among the world’s preeminent insurance markets; Singapore, a rising power in wealth management; Switzerland, the long-standing global leader in private banking; and Delaware, the predominant jurisdiction of incorporation for US public companies and a global competitor in the organization of various forms of business entities.
The interesting question, of course, is why these small jurisdictions have been able to achieve global dominance in their respective specialties – and the paper includes an extended treatment of various theoretical lenses to which one might turn for an explanation. None, however, can account for the range of jurisdictions that I identify. Notably, while taxation (or lack thereof) certainly looms large as a competitive strategy in each case, the “tax haven” literature can’t explain the global dominance of these particular jurisdictions. Simply put, it’s implausible that a new entrant could meaningfully challenge the competitive position of any of these jurisdictions simply by copying their tax codes, or any other component of their regulatory structures for that matter. Each has a substantive domain of service-based expertise providing a source of real competitive advantage beyond the jurisdiction’s black-letter law – and this renders it effectively impossible to compete with these jurisdictions simply by copying and pasting their laws into one’s own books.
The“offshore financial center” literature looks beyond tax, emphasizing cross-border services as such, yet encounters its own problems. This literature has been heavily preoccupied with recent entrants, reflecting strong preoccupation with the global acceleration of cross-border finance since the late 1960s – an inclination that’s tended to distract this literature from the commonalities with early movers like Delaware and Switzerland, which rose to prominence in the early 20th Century. In this light, it’s critical to observe that some of the most successful of the small jurisdictions active in cross-border finance aren’t actually “offshore” at all – again, including Delaware and Switzerland. I argue that the onshore/offshore distinction has obscured more than it illuminates; it simultaneously fails to provide a comprehensive account of what’s truly distinctive about the range of successful small jurisdictions, and overstates the distinction between “us” (onshore) and “them” (offshore) – particularly in terms of involvement in problematic practices, which occur in both settings (of which more below). The rhetorical function of this distinction is largely to paint small jurisdictions’ activities as uniquely and exclusively problematic, obscuring both small-market positives and big-market negatives.
In developing my alternative – this “market-dominant small jurisdiction” (MDSJ) concept – I draw upon these and other literatures while endeavoring to avoid their limitations. I argue that, notwithstanding substantial differences, these jurisdictions do exhibit fundamental commonalities in their contextual features and economic development strategies:
MDSJs are small and poorly endowed in natural resources, limiting their economic development options. This creates a strong incentive to innovate in law and finance, while rendering credible their long-term commitment to the innovations undertaken. These jurisdictions substantially depend on their legal and financial structures, and the market knows it.
They possess legislative autonomy – the critical resource for such innovation. This is obvious for sovereigns like Singapore and Switzerland, yet full-blown sovereignty isn’t required. Delaware possesses sufficient room to maneuver under the internal affairs doctrine, and Bermuda – a British overseas territory – benefits from an express delegation of legislative authority.
MDSJs tend to be culturally proximate to major economic powers, and favorably situated geographically vis-à-vis those powers. These ties can arise in various ways – through colonialism, common histories, and/or geography. But in each case, their identification with – and capacity to interact closely with – multiple powers positions them to perform important regional and global “bridging” functions in cross-border finance.
- Bermuda has long bridged the Atlantic, maintaining strong ties with the UK and North America alike. They benefit from the substantial ballast of association with the British legal system and insurance market (i.e. Lloyds) on one side, and proximity to the massive US economy and insurance market on the other.
- Singapore has long bridged East and West, having been established as a British colony to maintain an East Asian trade route. Their location allowed them to contribute to the creation of a 24-hour global securities trading system – in the morning taking the baton from US markets that just closed, and in the afternoon handing the baton to European markets that just opened. Since the 2000s Singapore has developed a two-way wealth management strategy, serving as the entry point for Western money into East Asia, and the entry point for rapidly accumulating East Asian money into the West – a strategy facilitated by a highly educated, bilingual (Mandarin-English) working population.
- Switzerland, located in the heart of Europe, borders on and transacts in the native languages of each of the surrounding economic powers. German, French, and Italian are all official languages, and English-language proficiency is widespread as well.
- Delaware plays an under-explored bridging function in the US political economy, standing between and interacting with both the finance capital (New York) and the political capital (DC) – a geographic feature touted in corporate marketing materials.
In addition to these contextual commonalities, MDSJs exhibit similar economic development strategies. Notably, they’ve heavily invested in human capital, professional networks, and related institutional structures. The aim is to foster a community of financial professionals with the incentives and capacity to develop high value-added niche specializations – a project eased by the fact that these are small places. In each case the relevant public and private stakeholders often know one another personally, facilitating consensus and responsiveness to evolving markets. Additionally, these public and private constituencies share largely homogenous interests – they all prosper if finance prospers.
Finally, MDSJs consciously seek to balance close collaboration with, and robust oversight of, the relevant professional communities – the aim being to at once convey flexibility, stability, and credibility. Essentially these jurisdictions seek to avoid over-regulation frowned upon by the market, while at the same time avoiding under-regulation frowned upon by regulators in other jurisdictions. In so doing, they generally try to bring private-sector experience to bear upon the regulatory design process, seeking to maintain cutting-edge regulatory regimes while at the same time conveying stability and credibility to global markets and their foreign regulatory counterparts. In each case this dual aim is reinforced by additional confidence-enhancing features – notably, low levels of perceived public corruption, and multi-party support for the development of financial services capacity.
The paper explores the embodiment of these characteristics in some depth, and ultimately suggests that examining such jurisdictions through this lens could offer tangible benefits as we continue to assess their costs and benefits in cross-border finance. While potential abuse of the structures available in each of these jurisdictions is acknowledged – including money laundering and tax evasion – these problems are not unique to so-called “offshore” jurisdictions. Notwithstanding Delaware’s extraordinary contribution to the development of substantive corporate law – principally attributable to their expert bench and bar – the state has been roundly criticized for creating some of the world’s most opaque shell companies. At the same time, US calls for greater tax transparency are undercut by the fact that we ourselves don’t tax interest income on – and accordingly don’t require 1099s for – non-resident alien accounts. In this light, to avoid charges of a regulatory double standard, US policymakers seeking greater financial and tax transparency – efforts I broadly support – may have to start by cleaning up their own backyards.
I'm very grateful to Gordon for inviting me to post on the Conglomorate about the Hobby Lobby and Conestoga Wood cases--in particular, to summarize some of the arguments I've made about the cases over on Balkinization and SCOTUSblog. Links to my posts about various different aspects of the cases, and to some posts of others, are collected here. As for the issues of particular interest to Conglomorate readers . . . well, I'm afraid I think there's less there than meets the eye as to several of them.1. For example, it is widely believed that the central issue in the cases is whether corporations, or for-profit corporations in particular, can exercise religion, or have religious "consciences." But I don't think the Court needs to, or should, consider that broad question in the abstract. As I explained in one post, even if for-profit corporations can exercise religion in certain contexts, the particular religious claims in Hobby Lobby and Conestoga Wood cannot be asserted by the corporations themselves:
The Hobby Lobby and Conestoga Wood cases do not require the Court to decide, once and for all, whether and under what circumstances for-profit corporations can ever have religious beliefs or consciences; whether they can exercise religion; or whether they can be “persons” under RFRA.
Those formulations pitch the question at far too broad a level of generality, and one untethered from the facts of these particular cases. The issue in these cases is much narrower than that.
This is not a case about whether a particular corporation can "advance" a religious agenda, take steps to further a religious mission (such as by selling religious books), or promulgate religious doctrine; indeed, it's not a case in which the state is alleged to be preventing a corporation from doing anything at all. Therefore it bears no resemblance to, say, a law restricting for-profit religious bookstores from selling certain books. The particular burden being alleged here is that the HHS Preventive Services Rule allegedly coerces a violation of religious duties--thatis to say, rather than restricting a religious practice, HHS is alleged to be focring someone to act in a manner contrary to religiously inspired limitations. The federal government allegedly is putting someone to a choice between compliance with a civil obligation and adherence to a restrictive religious injunction (roughly speaking: “Thou Shalt Not Cooperate With Evil”).
If there is such a burden on religious exercise here, it is not one that is imposed on the corporations—on Hobby Lobby Stores, Inc., Mardel, Inc. (in the Hobby Lobby litigation) or on Conestoga Wood Specialties Corp. That's not because those corporations don’t have “consciences”—neither do churches—or because they cannot advance religious objectives (perhaps they can), but because they don’t have religious obligations. I’m not aware of any religion that imposes duties or injunctions on for-profit corporations. And, more to the point, the complaints in these cases make countless allegations about religious duties and how the government allegedly is compelling certain parties to violate those duties, but they nowhere allege that any of the three corporations here are subject to any religious obligations.
2. A conclusion that the HHS Rule does not substantially burden any religious exercise of these corporate plaintiffs, however, hardly resolves the cases. As you will see if you begin to peruse the plaintiffs' complaints and briefs, the crux of the alleged burden in these cases is not on the corporations’ alleged exercise of religion, but instead on the purported religious exercise of the individual plaintiffs—five members of the Green family in Hobby Lobby, and five members of the Hahn family in Conestoga Wood.
For starters, the federal legal obligations in these cases run against the corporations themselves, and/or their insurance plans, not against the shareholders. So the shareholders are not directly burdened by federal law. The question, then, is whether shareholders nevertheless can obtain relief for injuries that they allegedly suffer derivatively, by virtue of the state's regulation of the corporation, notwithstanding the black-letter law that corporations and their shareholders are distinct entities for purposes of liability and benefits.
Individuals typically form a corporation so that they will not be personally liable for any claims against the corporation--indeed, that's one of the principal reasons state law creates the corporate form. Does it follow that shareholders cannot complain about injuries they suffer derivatively when other actors, including the government, take action against the corporation? By accepting the “sweet” (limited liability), must shareholders also accept the “bitter,” in the form of abandonment of rights they otherwise might have had to recover for injuries they suffer by virtue of their ownership of the corporate shares? As Judge Matheson put the question in his separate concurrence in Hobby Lobby, should “[t]he structural barriers of corporate law give [one] pause about whether the plaintiffs can have their corporate veil and pierce it too”?
In response to this question, Professor Bainbridge published an article suggesting that the Court should make use of a corporate law doctrine called "insider reverse veil piercing" in order to allow the Greens and the Hahns to assert RFRA claims as shareholders notwithstanding the fact that they are generally immune from liability for any wrongs committed by their corporations--i.e., to allow them to reap the sweet and also avoid the bitter.
Subsequently, a group of 44 corporate and criminal law professors filed an amicus brief arguing that "reverse veil piercing" would be inappropriate here, and that the Court should not allow the plaintiffs to sue as shareholders.
Professor Bainbridge has now responded with a follow-up article critiquing the corporate law professors' brief. He argues again that the Court should use "insider reverse veil piercing," or "RVP-I," "to allow . . . shareholder standing to sue if the [C]ourt is unwilling to allow the corporation to do so."
What (if anything) should the Court make of this corporate law dispute about RVP-I?
a. First of all, it's not clear that these cases are even about injuries to the individuals in their capacities as shareholders. Indeed, it appears that the individual plaintiffs in Hobby Lobby, members of the Green family, are not shareholders of Hobby Lobby and Mardel, the two corporate plaintiffs in that case; they are, instead, trustees of a management trust that owns the companies. The Greens do not allege that they own the companies; and unless I've missed something, their complaint does not allege any way in which their funds would be used to "pay for" contraception. As I explained in a recent post, Hobby Lobby's brief confirms that the case is not fundamentally about coercing the Greens to pay forcontraception, or about the Greens' religious exercise in their capacity as shareholders. The Greens' fundamental complaint, instead, is that federal law coerces them to violate a religious obligation in their capacities as corporate directors, i.e., decision-makers. "[T]he precise religious [religious] exercise at issue here," the brief explains, is that "the Greens cannot in good conscience direct their corporations to provide insurance coverage for the four drugs and devices at issue because doing so would 'facilitat[e] harms against human beings.'”
A decision by the Court limited to shareholder rights, therefore, would not resolve Hobby Lobby.
That leaves the Conestoga Wood case. The individual plaintiffs in that case, members of the Hahn family, also primarily complain about federal law burdening them in their capacity as corporate directors, or decision-makers. In addition, however, paragraph 11 of their complaint alleges that the Hahns are collectively the “principal” owners of the shares of Conestoga Wood. So perhaps the RVP-I question does arise vis-a-vis the Hahns, whose shareholder funds presumably would be used, not to pay for contraception reimbursement directly, but instead to pay for part of the overall premiums to the plan insurance carrier. (Remarkably, the Conestoga Wood complaint does not specify whether CW has a self-insured employee health insurance plan or a plan issued through an independent insurer. But in its Supreme Court brief, it refers to its (unidentified) "issuer" as having "inserted coverage of the contraceptives into its plan over Petitioners’ objection" after the district court denied a preliminary injunction.) So, in some very attenuated sense, the Hahns' shareholder funds are subsidizing the plan's reimbursement for employees' use of contraception . . . and the complaint might be read to suggest that this use of the Hahns' funds would make the Hahns complicit in their employees' use of so-called "abortifacients" in the rare case (if any) in which use of certain contraceptive methods prevented a fertilized egg from implanting in the uterine wall.
b. But even if the "shareholders' complicity" issue is teed up in Conestoga Wood . . . Honestly?
Can it really be the case that the Supreme Court of the United States ought to decide Conestoga Wood based upon the assumption that the corporate law "RVP-I doctrine" would apply in this unprecedented context? This is a state law question, the answer to which depends upon the legal relationship between a corporation and its principal shareholders . . . presumably under Pennsylvania law.
Professor Bainbridge cites as his primary authorities two 30-year-old state-law cases--one from Minnesota, the other from Michigan--both involving questions far-flung from the RFRA context in Conestoga Wood. To be sure, he also cites one Pennsylvania case--Barium Steel Corp. v. Wiley, 108 A.2d 336(1954). But in that case, which was decided 60 years ago, the Pennsylvania Supreme Court split 3-3 on what we (well, what corporations law professors) would today apparently call an "insider reverse veil piercing" theory, in a case that has almost nothing in common with Conestoga Wood. And the three Pennsylvania Justices who would not have recognized the RVP-I in Barium Steel wrote this: "The decisions in this State will be searched in vain for a single instance where a piercing of the corporate veil has been judicially sanctioned in order to confer a benefit upon the ones responsible for the presence of the veil. Certainly, the opinion for this court in the instant case cites no such decision."
That exhausts my knowledge of how Pennsylvania law treats insider reverse veil-piercing. Perhaps Professor Bainbridge is right that Pennsylvania (and other state) courts would or should "reverse-pierce" the veil in this RFRA context, in which a federal statute is implicated. Perhaps he's wrong. But how should the Supreme Court of the United States resolve that question?
Bainbridge argues that courts have historically "pierced the corporate veil" in 13.41% of RVP cases, and that the Court should decide whether Conestoga Wood should be among that number based upon the simple test of whether piercing here would advance a "significant public policy." But he does not cite any other Pennsylvania authority in support of this view, or any case at all involving RVP and RFRA, or RVP and shareholders' religious exercise more broadly, from any jurisdiction.
This absence of precedent ought to be a serious problem for his RVP-I argument, particularly in light of the principal case cited in the corporate professors' brief (and in the government's brief), Domino's Pizza, Inc. v. McDonald, 546 U.S. 470 (2006).
McDonald was the sole shareholder of a Nevada corporation. He alleged that Domino's had broken contracts with that corporation because of racial animus toward him, in violation of 42 U.S.C. § 1981. The Court held that section 1981 offers relief to a plaintiff when racial discrimination impairs an existing contractual relationship, so long as the plaintiff himself has or would have rights under the existing or proposed contractual relationship. Of course, the contracts themselves, between corporations, did not afford McDonald any rights, because he was merely a shareholder. Citing some of the same Minnesota cases Professor Bainbridge cites, however, McDonald argued that "under state law shareholders are at times permitted to disregard the existence of the intermediate corporate entity where failing to do so would impair full enforcement of important . . . statutes." Resp. Br at 32 n.34.
At oral argument, Justice Kennedy identified this claim as "kind of an inverse corporate veil piercing," and asked: "[A]re there any cases where we pierced the corporate veil in order to help the shareholder?" (The answer, of course, is that the Court has never done so.)
Not surprisingly, the Court unanimously rejected McDonald's inverse veil piercing claim. Justice Scalia's opinion for the Court explained that "it is fundamental corporation and agency law—indeed, it can be said to be the whole purpose of corporation and agency law—that the shareholder and contracting officer of a corporation has no rights and is exposed to no liability under the corporation's contracts."
The Court presumably was able to issue such a categorical interpretation of state law because it had been offered no examples, in any jurisdiction, of reverse veil piercing to vindicate shareholder contract rights. To be sure, Conestoga Wood does not involve shareholders' contract rights, so McDonald does not directly resolve the RVP-I question here. But the Hahns have the burden to show a RFRA burden, and neither they nor Professor Bainbridge have cited any case, from Pennsylvania or elsewhere, in which shareholders have been permitted to use RVP-I to allege harms to their religious exercise, under a state or local RFRA, resulting from a law that has an impact on corporate funds. The Court presumably should, therefore, treat the RVP-I argument here the way in which it treated the equally unsupported and unprecedented argument in Domino's--i.e., summarily reject it.
Domino's appears to be the one and only occasion in which the Supreme Court has specifically considered the relationship between the "RVP" doctrine and a federal statute. You'd think, therefore, that Professor Bainbridge would devote serious attention to the case. His analysis of Domino's is relegated to a footnote, however. And his efforts to distinguish the holding in that case are unpersuasive. For example, he notes that the shareholder in Domino's raised "only" contractual and statutory rights. ButConestoga Wood's claim here (the only claim with any traction, anyway) is based on a federal statute (RFRA), just as McDonald's was. Bainbridge's suggestion that the federal statutory right established by RFRA is more "fundamental" than the federal statutory right against race discrimination established by section 1981--indeed, so much more "fundamental" that it ought to result in an about-face on the Court's RVP-I holding--is so implausible that it doesn't warrant a response.
His principal argument fares no better. He insists that Domino's is a "weak precedential reed" because the Court in that case "made no effort to analyze the issues raised by RVP, but simply dismissed it out of hand," without addressing "any of the points made [by Prof. Bainbridge] in defense of the doctrine." In other words, Bainbridge thinks that the Court should ignore its unanimous holding in Domino's because the Court did not do its homework in that case, even after Justice Kennedy had specifically teed up the question as whether the Court should recognize a claim of "inverse corporate veil piercing." Suffice it to say that that argument is unlikely to have any traction with the Court. Moreover, it misses the point: The Court rejected the RVP-I claim in Domino's because the plaintiff there gave the Court absolutely no basis for concluding that state law would recognize such an exception to the default "fundamental corporation and agency law" principle that a corporate shareholder has no rights and is exposed to no liability under the corporation's contracts. The same thing is true in this case: Neither the Hahns nor Professor Bainbridge has offered the Court any authority at all in support of the proposition that the Pennsylvania Supreme Court -- or other state courts, for that matter -- would recognize an RVP-I claim in a case involving RFRA.
Moreover, even if the Court were somehow able to answer the RVP-I question as a matter of Pennsylvania law (after certifying it to the Pennsylvania Supreme Court, perhaps?), that state-law-based judgment would not govern similar cases arising in the other 49 states and the District of Columbia, and therefore would hardly be a satisfactory resolution of the question on which the Court granted certiorari in Conestoga Wood. (And it wouldn't have any impact on a non-shareholder case such as Hobby Lobby.)
* * * *
In the absence of any indication that Pennsylvania law would allow RVP-I in this novel context, the more appropriate approach for the Court would be to follow its example in Domino's, and simply move on from a shareholder-injury inquiry to address the principal question raised both in Conestoga Wood and in Hobby Lobby--namely, whether federal law coerces the individual plaintiffs (the Hahns and the Greens) to violate religious injunctions in their capacities as decision-makers, or directors, of the three corporations in question in these two cases. In an earlier post, I discuss why I think the plaintiffs have failed to adequately plead facts to support such a claim.
4. Finally, and most importantly, in posts at both SCOTUSblog and Balkinization, I've tried to explain that, wholly apart from the questions regarding corporations and shareholders, a broad ruling in favor of Hobby Lobby and Conestoga Wood could mark a sea-change in the way the Court has traditionally resolved claims for religious exemptions in the commercial sector, with potentially dramatic ramifications for an array of laws involving taxes, wages and hours, antidiscrimination norms, etc. This is so because, when it comes to regulation of commercial activities, the Supreme Court—and virtually every other court and legislature, for that matter—has consistently construed the Free Exercise Clause and religious accommodation statutes not to require religious exemptions from generally applicable regulations. The Supreme Court, in particular, has rejected such claims in at least nine cases, from 1944 through 1990--and has almost always done so without a dissenting vote.
This long line of consistent denials of exemptions to actors in the commercial sphere reflects the view of Justice Jackson in the first such case (Prince v. Massachusetts), in which he wrote in his concurrence that “money-raising activities on a public scale are, I think, Caesar's affairs, and may be regulated by the state so long as it does not discriminate against one because he is doing them for a religious purpose and the regulation is not arbitrary and capricious, in violation of other provisions of the Constitution.”
A unanimous Court put the point this way in U.S. v. Lee, in 1982: “When followers of a particular sect enter into commercial activity as a matter of choice, the limits they accept on their own conduct as a matter of conscience and faith are not to be superimposed on the statutory schemes which are binding on others in that activity,” at least where “[g]ranting an exemption . . . to an employer operates to impose the employer’s religious faith on the employees.”
Whether or not this was a stand-alone “holding” in Lee, there is no doubt that the statement did—and continues to—fairly reflect the Court’s unbroken line of decisions over many decades. (The singular exception to the rule is Hosanna-Tabor, which, unlike Hobby Lobby, involved the right of nonprofit, specifically religious organizations to determine the “ministers” who speak on their behalf.)
And the Lee statement further points to the principal reason for this uniform treatment of religious exemption claims in the commercial sphere—namely, that in such cases it is virtually always the case that conferral of an exemption would require third parties (customers, employees, competitors) to bear significant burdens in the service of another’s religion, something the Court has understandably been loath to sanction. As I wrote on SCOTUSblog,
Contrary to the views of some, I think it overstates matters to say that such a significant third-party burden invariably renders a permissive religious accommodation unconstitutional. The Court’s jurisprudence in the area of permissive accommodations is not so unequivocal. But this much is clear: Such a significant third-party burden at a minimum raises profound constitutional concerns. For that reason, as Chip Lupu and Bob Tuttle explain, the Court has regularly construed permissive accommodation statutes – using the avoidance canon either expressly or implicitly – to recognize a compelling government interest in avoiding the imposition of significant third-party harms.
The Court’s decision in Hobby Lobby is likely to have a profound effect upon how other courts treat state and federal RFRA claims in the commercial sector going forward. If the Court were to hold that RFRA requires an exemption in these cases—and were to hold, in particular, in the case brought by a very large for-profit employer, that the law substantially burdens plaintiffs’ religious exercise and that the government lacks a compelling interest in denying religious exemptions—that would be a groundbreaking departure from the judiciary’s (and Congress’s) historical practice, one that could pave the way for claims for “myriad exceptions flowing from a wide variety of religious beliefs” (Lee) by commercial enterprises with respect to many other statutes, including nondiscrimination requirements, zoning regulations, taxes, and so on.
Thanks, Usha, for the introduction. Let Us rule!
I am delighted to join The Conglomerate for a brief stint. I am an enthusiastic follower of the blog and an occasional commenter, so I am thrilled to have the microphone for the next two weeks.
I have some specific topics I plan to post about but I would like to start off the discussion with a meta question. I have been writing about securities law and going to conferences for a few years, inlcuding those of the law & economics variety. At these events, I often cross paths with tax professors, and I have noticed one curious difference between tax and corporate & securities folk: tax professors like tax collectors. Overwhelmingly so. They recognize that the IRS is not perfect, but when in doubt, they generally side with the IRS, not taxpayers.
Not so for corporate and securities professors. At every milestone anniversary of the creation of the SEC someone proposes that the Commission be abolished. So I am wondering why? It could be that my samples are biased. Or it could be that both sets of people like regulators, but corporate & securities people are just grumpier and less likely to express nice things about securities regulators. Or perhaps the difference is real.
Whatever the reason, I am going to reveal my personal bias here: I like securities regulators. That does not imply that I love every idea that comes out of the SEC. But as between the regulated entities and the SEC, my default is to side with the securities regulator. What is yours?
The late Larry Ribstein coined the phrase "the Apple Rule" when Apple seemed to be the only corporation engaged in options back-dating that got a pass from regulators and prosecutors. Now, it seems that the Apple Rule applies to corporate income taxes as well.
Here is Glommer Emeritus Vic Fleischer's very funny take on Apple's hearing in front of the U.S. Senate two days ago (or "the ghost of Steve Jobs Goes to Washington").
Here is Vic's more detailed explication of Apple's global tax maneuvers.
There are several ways that a company can lower its global tax bill by separating an otherwise integrated business model into components located in various subsidiaries in various taxing jurisdictions. To oversimplify things, a global operation can attempt to have subsidiaries in high tax jurisdiction bear costs (whether from paying high interest rates on intercompany loans or bearing the brunt of mark-ups for various inputs or fees for use of intellectual property) and have subs in low or zero tax jurisdictions recognize profits. This is easier for companies with very important intellectual property, but has been used by bricks-and-mortar companies like Starbucks (all green coffee is sold through a Swiss Starbucks and roasted by a Netherlands company and the markup paid to those entities; royalties for the "Starbucks experience" are paid to the Netherlands entity as well).
Apple's CEO assures us that Apple does not use "tax gimmicks." Instead, it has two subsidiaries that are incorporated in Ireland but managed from the U.S., which means that they are considered under Irish taxing authority by the U.S. and considered under the U.S. taxing authority by the Irish. They pay zero taxes. Apple also has two Irish subsidiaries that do pay taxes to Ireland, but they are very, very low taxes. And, a lot of profits are recognized by these four subs.
Apple's CEO also reminds us that Apple pays a lot of taxes to the U.S., about $6 billion in 2012, $3.4 billion in 2011, so we should feel pretty lucky. (See above for Vic's response.)
This is not the place to go for careful consideration of tax policy, but we do know something here about business regulation more generally, so an observation and a reference with regard to the IRS investigation of tea party groups and their 501(c)(4) status:
- I assume that the decision to investigate the tea party applicants by the agency was an exercise of enforcement discretion; as such, it should be unreviewable by the courts under the principle that agencies cannot be reviewed for their decision to bring enforcement actions on one set of guys as opposed to another set of guys (the idea is that reviewing those sorts of decisions would enmesh the courts too much in the work of the agency). The denial of an application for 501(c)(4) status, oddly enough, would be plainly reviewable as a matter of administrative law. But doesn't appear to be what happened here. Of course, the mere fact that you can't go to court doesn't make it right, and what is happening here is supervision (pretty angry supervision, too) by the other branches of government, rather than by the judiciary. Moreover, this is tax, and tax is different; there may be special review provisions at stake in the tax code I'm not aware of.
- Kristin Hickman is your source for the administrative procedures adopted by the IRS, and one of the themes of her work, fwiw, is that the IRS rarely complies with some of the basic principles of administrative law. See, e.g., here and here and here.
I hate to admit this, but my highly time-leveraged life seems to only work because of Amazon Prime. If someone needs a book, a math compass, a birthday present, even diapers, it has sometimes made sense for me to merely order the merchandise from Amazon, get free shipping and no tax. Yes, sometimes that's easier than driving the 20 minutes to Target. If I'm willing to pay $3.99, then I get it the next day. For a $20 item, it's seems like a wash. This may change.
On Monday, the Senate will vote (and probably pass) The Marketplace Fairness Act of 2013. (It has its own website, here.) This bill would require online retailers to collect and remit sales taxes based on the delivery location of goods purchased. If there is no delivery location, for example in the case of a download, then the tax will be based on the billing address. For those of us living in Illinois, this difference between ordering on Amazon now and in the future could be almost 10%. (Chicago's general merchandise tax is a total of 9.25%, down from 9.5% last year.) For those of you who live in the five states without a sales tax, keep on living in tax-free bliss.
The winners here are the bricks-and-mortar stores who have to charge tax. Apparently, "showrooming" is a thing -- customers shop in stores where they can see and try on merchandise, then order online and skip the tax. Ouch. This Act should take that incentive away. Even big stores like Gap and Best Buy charge tax online because they have a physical presence in most/all states. Of course, online retailers have had a good run, and that run may have been enough to kill many many competitors, including big ones like Borders.
Interestingly, Amazon, which has been the obvious beneficiary of tax-free online retailing, is supportive of the legislation. After years of fighting states that have tried to force Amazon to pay sales tax, (blog post here), the online giant is a cheerleader for the Act. Perhaps this is because Amazon has recently entered into voluntary arrangements with nine states, including large markets such as California, New York and Texas. Building warehouses in these states where it is already taxed has allowed Amazon to ship merchandise cheaper and even faster. And, Amazon may have established such a loyal fanbase of customers addicted to its convenience and fast shipping that it doesn’t fear losing customers over price.
What about downloads, you ask? Most states don't include digital downloads in definitions of taxable goods. In the states that do, you are probably already paying tax on downloads from Apple (which has physical stores), but not Amazon. Now, you will. And, the Marketplace Fairness Act may enbolden states to redefine general merchandise tax rates or use tax rates to include digital downloads.
So, who is against Internet sales tax equity? Online-only retailers that aren’t nearly as big as Amazon and the portal that serves them: eBay. Though the act exempts small businesses with no more than $1 million in revenue, that threshold leaves medium businesses with a price disadvantage and new compliance costs. Therefore, some groups argue that the $1 million threshold could be raised to $10 million without states losing much revenue, while giving needed relief to small-to-medium enterprises. And, of course, the Heritage Foundation and anti-tax watchdogs oppose the Act as just another tax increase that will hurt consumers.
Is it a new tax? Not really. It's the same old state sales tax, just with more enforcement. Though sales taxes are an obligation imposed on the consumer, retailers are supposed to collect and remit the tax. However, retailers with no physical presence in a state can’t be compelled to collect these taxes. Funnily enough, we were all supposed to be sending in the tax we aren't charged on our Amazon purchases. Who knew? Well, I hope I get some sort of Internet shopping amnesty.
To catch-up: In 2001 and 2003, Congress instituted a number of tax rate reductions that were set to expire at various times in the last decade. Extended before, these reductions are again set to expire on December 31. The media has focused on the impact on individual tax rates, which will increase. More markedly, however, the rates for both capital gains and dividends will rise dramatically. Specifically, dividend income would automatically be taxed as ordinary income, at the possibly new maximum income tax rate of 39.6%, instead of the rate for the past decade of 15%. Plus, the ACA surtax on high earners will kick in for many investors, bringing the maximum dividend rate to 43.4%, almost three times as much as the rate now.
So, how will this change corporate behavior in the coming months? Any estate tax planner will tell you (if they have time to talk at all) that for the next 2.5 months all they are doing is revising estate plans to address a possible change from the $5 million/person exemption to $1 million. But are corporations scrambling as well?
This article seems to suggest no. Corporations are not changing scheduled January dividends to December dividends, even though it would save their investors millions of dollars. Even though corporations did make switches in the shadow of previous 2010 deadline. So, do corporations know something we don't? Do these big corporations, like Wal-Mart, have eyes and ears (and dollars) in Washington that tell them not to worry about the tax cliff? Could Congress be ready to extend the rates after the election or even retroactively after the deadline? Corporations don't have a deduction for paying out dividends, so corporations should be neutral, unless the higher rates increase their cost of capital.
Scholars could have years of projects out of observing behavior prior to these rate cut expirations. Should investors change their behavior? Perhaps investors should sell shares on December 31 in anticipation of a January dividend, hoping that the share price would reflect the high probability of the dividend. Then, investors would pay the lower 15% on any capital gain, a rate that may also automatically increase to 28% on January 1.
OK, so first of all I have to apologize to my son, who asked me if there was prize money in the Olympics. I pooh-poohed the thought of tainting the Olympics with prize money. But, apparently there is -- $25,000 for a gold medal; $15,000 for silver; $10,000 for bronze. Sorry. I was wrongish.
OK, so second, there is a firestorm in the blogosphere right now about the absolute unfairness of taxing Olympians -- yes, Olympians! -- on their winnings. So, of course the numbers going around are that the tax on a gold medal is $8,750 and that Missy Franklin (as of yesterday) would owe $14,000 for one gold and one silver. (She now has two golds and a silver as of Wednesday night, but let's stick with the $14k number.)
Now, obviously the Weekly Standard and all those who would lower taxes chose Missy as their poster child because she is young, freshfaced and adored by all (including me, who can't stop watching that Call Me Maybe video). But, I think the numbers are wrong, which are based on a 35% effective tax rate. Missy may not be in the 35% tax bracket. Before her race last night, I'm going to guess that her income for this year (2012) was whatever she got at the Olympics and nothing else. She is an amateur and wants to have no endorsements so she can swim for her high school, Regis Jesuit. (See why we love her!?!). So, as of yesterday at lunch, I'm guessing her total earnings were $40k. Because she earned under $53,500, her tax would be $3,315 plus 28% of $17,900, for a total of $8,327. Not $14k. And, if she took the standard deduction and the personal exemption, her taxes could be $5,597. And, Missy might decide to itemize to deduct a lot of things related to training and travel, reducing her bill even more, but I leave that to the individual tax specialists. (For amateur athletes, I'm guessing the Olympics is an "activity not engaged in for profit," but maybe not for professional athletes, but that's beyond the purpose of this blog post.) So, I would think the maximum she would pay would be closer to $5k than $14k for two medals. (Now she has earnings of $65k, so the bill will be higher.)
Leaving tax accuracy aside, the bigger philosophical question is whether those who bring home the gold should face a tax bill. There aren't a lot of great reasons to exempt the honoraria from tax besides symbolism. Yes, Olympians work extremely hard and most live with very little income while training. Yes, some have lucrative endorsements, like Phelps and Lochte, but most have zilch. But, lots of people work very, very hard, and they pay tax on their income. If I took the next four years off to write a book or invent something or go to medical school, I would have to pay taxes should the book or investion sell or I became a surgeon. The drive and determination of Olympians is very inspiring, but a lot of folks who pay taxes have impressive drive and determination also.
However, Senator Rubio has proposed legislation to exempt the winnings from taxation because taxing Olympic prizes "punishes success" and "punishes excellence." This reporter thinks Olympians shouldn't be taxed, just like military personnel who are deployed in a combat zone. Wow. Are the Olympics really akin to a combat zone? Are U.S. Olympians more like U.S. soldiers in a combat zone than U.S. soldiers who aren't in a combat zone and still pay taxes? Astronauts pay taxes. Listen, nobody loves the Olympics more than me or cries more when they play the National Anthem, but I'm not buying it.
As an analogy, Nobel Prize winners are taxed on their very large ($1.5M) prize. And, many Nobel Prize winners are plain old professors and researchers who have toiled away for years waiting for recognition. And, Nobel Prize winners make great, lasting contributions to society. But, since 1986, we've taxed them.
Yesterday I told my Corporate Tax class that we could teach a whole course on the tax implications of the Facebook IPO. I wasn't kidding. Here are a few of the interesting issues that highlight current debates in the taxation of corporations and their shareholders. (Gregg Polsky has also covered some of these on The Faculty Lounge.)
Mark Zuckerberg's stock: CEO Zuckerberg holds almost 414 million shares of stock. At the time of the IPO, he owes no taxes on that stock until a recognition event, such as sale. When and how did he acquire this stock? Most likely, much of it is "founder's stock." This is friend of the Glom Vic Fleischer's territory (See Taxing Founder's Stock). Zuckerberg probably contributed the algorithms and code for Facebook in return for stock as a nontaxable event either as a contribution to a corporation by a control group or (as Vic explains), making an election to have the stock distribution a taxable event, with the valuation of the stock as equal to the contribution. Even though the stock is more accurately described as consideration for Zuckerberg's labor, it will be taxed at some point as capital gains, which is now 15% and considerably less than the ordinary income rate. Gregg argues that this isn't that bad because the corporation doesn't get a deduction for it, so no deduction plus 15% is better than 35% deduction and 35% taxation, if you look at it from the point of view of the public fisc. I think Vic is looking at it from the point of view of regular folks who contribute labor for stock versus founders. Interesting debate.
Zuckerberg's and others stock options: From reports in the media, it seems that the stock options that Zuckerberg holds (and probably others) are nonqualifying stock options. The S-1 describes a 2005 stock option plan that issued incentive stock options, but stock options issued before then or under a different plan don't seem to be qualifying options. Should holders of nonqualifying stock options exercise those options at or after the IPO, they will encounter a taxable event regardless of whether they sell the stock. Zuckerberg has over 120 million stock options giving as compensation, which he plans to exercise. His exercise price is 6 cents. So, at something like $30/share,that's about $3.6 billion (say it like Mike Myers) of taxable ordinary income (the spread between exercise price and price at conversion). Zuckerberg's tax bill (federal and California) may well be one of the biggest tax bills ever. Apparently, he plans to sell enough shares to pay his taxes, which may reach $2 billion. Other holders will also face the same dilemma of having a tax bill even if they don't have any additional cash on hand. Those who exercise qualifying ISOs will not have a current tax liability if they do not sell. (I have now wandered away from things I know about, so I will stop.)
But, for each option that is exercised that is taxable as compensation, Facebook gets a deduction, even though no cash is (or has ever) gone out of the company for that expense. So, Facebook calculates that it will have tax refunds for awhile given the billions of dollars in compensation expense it will enjoy.
Restricted Stock Units: Starting in 2008, Facebook began granting service providers RSUs instead ot stock options, probably to avoid the 500 shareholder threshold for registration under 12(g) of the Securities Exchange Act. These RSUs are scheduled to vest six months after the IPO. The recipients will be taxed at ordinary rates for the difference between the FMV of the stock at the time and the price paid for the grant (if any). (Though, recipients could make an 83(b) election at the time of the grant when valuation is both less and less clear, but this may be a risky move.) Finally, Facebook has to withhold cash for that. Facebook has listed this as a risk factor in its S-1:
We anticipate that we will expend substantial funds in connection with the tax liabilities that arise upon the initial settlement of RSUs following our initial public offering and the manner in which we fund that expenditure may have an adverse effect.
Whew. That's enough.
While charitable contributions and taxes are sometimes portrayed as substitutes, we think of charitable giving as "generous" and we think of paying taxes as a necessary cost of living in a civil society. Thus, Learned Hand aptly described our attitude toward the payment of taxes: "any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes." Helvering v. Gregory, 69 F.2d 809, 810-11 (2d Cir. 1934).
Despite this widespread view toward the payment of taxes, Romney is still criticized for not paying (or wanting to pay) more taxes. In a WaPo piece from earlier today, for example, Rabbi Sharon Brous of Los Angeles observes, "On one hand, I really admire his sense of obligation to his immediate community, but I would offer that perhaps he might adopt a more expansive notion of what community is." This, despite the fact that Romney was not using the most tax-advantageous method of making his charitable contributions. (Thanks, Miranda.)
Rather than blaming Romney for paying too little in taxes, perhaps we should encourage more charitable giving. Again from the WaPo story:
Overall, Americans give between 2 and 3 percent of their income to charity, according to the Philanthropy Roundtable, but in the first few years of the recession, that number dropped, too. Newt Gingrich gave just $81,000 — 2.58 percent of his $3.1 million income and a fraction of his 2005-06 tab at Tiffany’s — to charity in 2010....
The more individuals and corporations give, the less the government has to. Giving, and giving until it hurts, forces you to recognize that, like a parent, you’re responsible for other people — whether in your own community or around the world. When you lay down your money, you say, “This (church sanctuary, child, environmental hazard) is my problem.” Providing a sense of interconnected obligation is traditionally what religious communities have done best, and it is no surprise that the religious groups that are growing fastest in America — Mormons, Pentecostals, certain sects of Jews — are those that make demands on their members' time and money.
Because I'm teaching Corporate Tax this semester, I'm probably poring over the "How Much Tax Does Romney Pay?" discussions. Yesterday, my friend and former colleague Miranda Fleischer was quoted in an article not about the passive income rates that drive down Mitt Romney's (and others) effective tax rate, but about his charitable deductions. Miranda has written extensively about the whys and wherefores of the charitable tax deduction. Her latest is Equality of Opportunity and the Charitable Tax Subsidies, 91 B.U. L. Rev. 601 (2011).
The candidates' tax returns have revived discussion about carried interest and the 15% tax rate of dividends and capital gains (see the other Professor Fleischer), but at least Romney's tax profile reminds me of some of the foundational questions of why we have the charitable tax deduction. Romney and his wife are very generous with their charitable contributions (they gave 16.4% of gross income, more than other filers with similar income). Newt Gingrich, on the other hand, donated less money as a percentage of income than even the average taxpayer, even though his AGI was over $3 million.
One of the questions surrounding the charitable tax deduction is why should the government subsidize charitable giving. If we believe that the deduction prompts taxpayers to give 30% more or something like that than they would otherwise give, the government is generally giving a partial match to taxpayers's pet charities. Miranda has in a series of articles fleshed out the philosophical reasons why government subsidization is probably a good idea. But I wonder whether it's necessary. Without the deduction, would taxpayers generally be less generous by 30% or so? Would we still donate to our religious institutions, alma maters, food banks, women's shelters and legal aid clinics without it?
I think the answer for the Romneys is yes. They probably donate to their church out of a mixture of duty and love for their church, and a deduction wouldn't change that. According to Miranda, the Romneys also aren't giving charitable donations in the most tax-advantaged way, so lowering their tax bill does not seem to be a goal of their generosity. Of course, you can say that with the Romneys' wealth, the marginal utility of the deduction may not be the same as for the rest of us. So, what about the middle class (or the other 99%, depending on your choice of rhetoric). Do we give or give more generously because of the tax deduction?
I think business law can provide insight here. Look at Kiva. If you make a "loan" to an entrepreneur through Kiva (which it makes through its foreign partners), you do not receive interest, but even that foregone interest is not tax-deductible. Neither is the principal amount, even if you do not cash out after being repaid but re-loan instead. (See Sarah Lawsky's Money for Nothing: Charitable Deductions for Microfinance Lenders, 61 SMU L. Rev. 1525 (2008). But, Kiva was pretty successful in attracting what were essentialy non-deductible charitable donations. Now, Kiva invites patrons to make either loans or tax-deductible donations for administrative expenses of Kiva. An interesting question is whether the addition of the tax-deductible option lessened the amount received as loans and what the resulting ratio between them is. Kickstarter, a crowdsourcing site for artists to fund new projects, raises money without the promise of a tax deduction (though some of its artists do have 501(c)(3) organizations). Do the tax-deductible projects get funded quicker and more fully? Are there other perks that donors prefer? Production credit? Special access or invitations?
Mitt Romney disclosed today that his his effective tax rate is "probably closer to the 15% rate than anything."
Are you surprised? I'm not, for two reasons.
First, most of his income comes from investments, the gains from which are taxed at the capital gains rate of 15% ... or less.
Second, he has substantial deductions, including (I assume) charitable deductions in excess of 10% of his income. After all, Mormons tithe. And we typically make contributions to the poor and to other causes on top of that 10% contribution. If you would like to lower your taxes in this way, start here.
Both the capital gains rate and the possibility of a cap on charitable deductions have been on the table in recent efforts at tax reform, and I suspect Romney's tax return will light a fire under both issues during the election.
UPDATE: The Obamas paid taxes at a rate of 25.3%, and 13.6% of their 2010 income went toward charitable contributions. See here. More on tax rates from that story:
Roughly half of households—mostly lower-income—pay no income tax, although many still pay payroll taxes. The average income-tax rate for the middle slice of households—those making between $34,300 and $50,000—was 3.3% for 2007, according to Congressional Budget Office data based in part on actual returns. That estimate includes the effects of various breaks, such as the per-child credit and the mortgage-interest deduction. Average income-tax rates rose to 14.4% for the top fifth, and to 19% for the top 1%, before dropping slightly for the very highest earners, who tend to have a larger percentage of their income from investments.
Although I teach, write and practiced predominantly in corporate and commercial law, I also have an LL.M. in Tax. Granted, my LL.M. coursework largely focused on business taxation, and therefore falls squarely within my interests. Nonetheless, given that tax and corporate/commercial law are treated as separate legal disciplines, I see tremendous opportunities for comparative and interdisciplinary analysis among tax, corporate and commercial law.
For instance, I find it intriguing that courts employ highly divergent decision-making approaches in these realms. In the tax realm, courts tend to focus on the actual economic arrangement of the parties, in an effort to identify economic substance rather than mere contractual form. Courts presiding over tax cases tend to utilize more expansive and contextual interpretive methodologies, and routinely scrutinize objective and subjective intent and other "facts and circumstances." These approaches stand in contrast to the dominant, textualist interpretive paradigm in corporate and commercial law, which relies almost exclusively upon strict interpretive norms (such as rules of contract interpretation) to construe written agreements.
To be sure, these divergent methodologies reflect the differing goals of tax, corporate and commercial law. While jurisprudence across all three disciplines emphasizes the need for certainty, uniformity and predictability in the law, tax law remains manifestly skeptical of the party autonomy that corporate and commercial law strive to protect. Courts presiding over tax cases are often called upon to examine possible crimes against the public fisc; in contrast, courts presiding over corporate and commercial law cases are generally called upon to manage disputes among sophisticated parties to voluntary, utility-maximizing arrangements.
Yet despite these distinctions, courts are increasingly importing tax doctrine into the corporate and commercial law context. A classic example is the "debt recharacterization doctrine." In the federal income tax realm, considerably high stakes turn on the proper classification as debt or equity of a person's interest in a corporation. Generally speaking, the characterization of the investment as a loan means that payments of interest will be includible in gross income. In contrast, to the extent the investment is deemed to be an equity capital contribution, then the principal amount of the investment must be capitalized into the investor's basis in the corporation's stock. The tax treatment of any repayment will be determined pursuant to rules governing corporate distributions, with any amounts deemed to be a dividend includible in gross income. In light of these differing tax consequences, courts have developed multi-factor, highly facts-intensive and contextual analyses to recharacterize a purported debt instrument into an equity investment, and to reassign tax consequences accordingly.
The debt recharacterization doctrine was subsequently imported into the bankruptcy realm. In that context, if a court determines that an investment is equity rather than debt, then the claim will be treated as an equity ownership interest in respect of which no distribution of corporate assets can be made unless creditor claims are satisfied. Even within the less formalistic realm of bankruptcy, the importation of the debt recharacterization doctrine is a major departure from dominant jurisprudential norms. As a general matter, bankruptcy courts look to state contract law when matters arise under private agreements and there is no statutory law on point. For this reason, although bankruptcy courts have wide latitude to exercise legal and equitable powers, most matters that arise in respect of contracts are construed in accordance with state contract law, including rules of contract interpretation.
Of course, the bankruptcy context, much like the tax realm, may provide inherent justifications for the application of more expansive judicial methodologies. In particular, courts applying the debt recharacterization doctrine in bankruptcy matters are frequently responding to the plight of third party creditors who may recover less due to the crafty maneuvers of shareholders.
More recent cases demonstrate a willingness to import tax doctrine into corporate and commercial law even where the justifications for doing so are less obvious. For instance, in Coughlan v NXP BV, C.A. No. 5110-VCG (Del. Ch. Nov. 4, 2011), the Delaware Court of Chancery applied tax law's "step transaction doctrine" to an action brought by a stockholder representative seeking to construe terms of a merger agreement. In tax law, the step transaction doctrine is applied where parties engage in multiple transfers to circumvent rules that would apply to a more direct transfer. In Coughlan, the merger agreement provided that, in the event of a change in control of NXP or of pertinent corporate assets, the person acquiring NXP or the assets would be required to accelerate certain contingent payments or assume the obligations. The stockholder representative argued that NXP's two-step transfer of assets to a joint venture amounted to a change in control. NXP argued that it engaged in two transfers that were each permitted under the merger agreement. The court applied the step transaction doctrine, finding that the two transfers should be analyzed as a single transaction that ultimately effectuated a change in control.
The court explained that the step transaction doctrine has been imported into the Delaware corporate and transactional context as well as the bankruptcy realm. It cited a 2007 case construing provisions in a partnership agreement, whereby the Court of Chancery defended application of the doctrine: "I see no reason as a matter of law or equity why the step transaction principle should not be applied here. Indeed, partnership agreements in Delaware are treated exactly as they are treated in tax law, as contracts between the parties." Twin Bridges Ltd. P’ship v. Draper, 2007 WL 2744609, at *10 (Del. Ch. Sept. 14, 2007).
To be sure, such a rationale denies fundamental differences in tax, corporate and commercial law. However, in terms of judicial decision-making methodologies, the increased application of tax doctrine to cases in the corporate and commercial law realm may signal a movement away from formalism, and a rising interest in identifying the actual economic arrangement of parties as opposed to merely construing contractual form. Indeed, the Court of Chancery articulates this point in Coughlan, issuing words of caution to parties who rely on the written word in their business planning and legal advocacy: "transactional formalities will not blind the court to what truly occurred." Coughlan, C.A. No. 5110-VCG at 23.
The local paper here last week mentioned in a fairly small article that Amazon had terminated its relationship with Illinois vendors who previously had earned commissions by referring internet customers to Amazon. (Some bloggers earn commissions from Amazon by referring purchasing customers through their websites; the Glom does not.) Why the big "You're Fired"? Well, last week the governor of Illinois, Pat Quinn, signed into law a new tax law that would require Amazon to pay local sales tax on that purchase. Amazon apparently did not think that was a good deal. The state of Illinois has promised to find these abandoned Illinois vendors new commission-earning relationships with other Amazon-like retailers, presumably ones that have physical locations and already collect tax like Sears, Wal-Mart and Best Buy. Some Illinois ex-affiliates are opting instead to take up business in another state, rather than wait for that help to come.
But, apparently, Illinois is not the only state looking for revenue cash left on the table (or under the sofa cushions) by passing an "Amazon tax." (NYT article today here.) And, apparently, Amazon is not that happy at being the biggest undertaxed cash cow in sight. Amazon takes the position that it is required only to collect tax on sales to states where it has a presence, not mere internet affiliates or even warehouses (as in Texas). Though the states are arguing that Amazon should be treated just like any other retailer that has to collect sales tax on its products, Amazon argues that it should be treated just like any other retailer without a brick and mortar presence in that state. Here is a recent SSRN paper by Edward Zelinsky on why Amazon taxes violate federal law, citing a Colorado controversy.
Given the financial straits of many states, I bet this isn't the last we hear of this topic.