October 31, 2006
Patenting tax strategies
Posted by Victor Fleischer

Paul Caron links to today's NYT editorial on patenting tax strategies.  There were two great presentations on the topic at last Friday's conference on the future of tax shelters:  the first by Dan Burk and Brett McDonnell (with wonderfully clear commentary by Brant Hellwig) and the second by Phillip Curry, Claire Hill and Francesco Parisi (with insightful comments from David Weisbach). 

The New York Times takes the position that patenting tax strategies is bad policy.  I'm sure most of us share that intuition.  But there are some strange dynamics going on that make the problem more complicated than it seems. 

1.  Patenting of Tax Strategies May Be Inevitable.  As Brett explained, anything that we call a tax strategy could easily be re-labeled as a financial planning strategy or a business method. There is no realistic hope, it seems, of getting rid of business method patents.  And so it might be difficult to ask the patent office to weed out tax strategies from everything else.  If the IRS lacks the resources to weed out tax shelters, can we expect the patent office to do better?

2.  Or maybe not.  There is something unique, I think, about patenting legal advice; a practitioner (backed eloquently by Larry Solan) pointed out that there are unique ethical problems raised with patenting legal compliance strategies.  Perhaps we could say, as a matter of policy, that legal compliance is constructively obvious, even when it is not.  But I can't say that I know all of the patent policy implications of such a rule. 

3.  The lobbying option.  The fact that tax strategies succeed or fail based on the interpretation of laws and regulations makes them fundamentally different from other kinds of patents.  The law can change.  The laws of science are fixed.  But if your competitor patents a tax strategy, you have three options:  (1) find a substitute strategy, (2) pay the license, or (3) lobby Congress or the IRS to change the rules.  This lobbying option may make patenting tax strategies (or any other regulatory strategy) less of a valuable business than it might seem at first glance.

4.  We can turn market failure into our friend. Weisbach emphasized this point in his commentary.  Think about all the papers you've read talking about problems with the patent system -- that patents create too much monopoly power, that patent portfolios decrease innovation, the tragedy of the anti-commons ... in the context of tax planning, these are good things.  We don't need tax shelter innovation in the same way that we need health care innovation.  Tax planning is wasteful activity that serves no socially useful purpose.  And so if patents create monopolies, like other monopolies, it will tend to lead to an underproduction of the commodity in question (in this case, effective tax planning strategies).  (Alternatively, it could just drive up the cost of tax planning by forcing taxpayers to use inferior products with higher transaction costs and deadweight loss.) 

5.  Perhaps we can enlist the tax bar.  If we don't want tax strategies to be patented as a matter of social policy, perhaps we could set up a nonprofit (advised by taxprofs and practitioners) who create new tax strategies and patent them first.  The nonprofit could refuse to license out the strategy, thereby reducing wasteful planning behavior.  One problem with this is that there are often close substitutes available for planning strategies, so it would be difficult for the nonprofit to stay ahead of the planners (just as the IRS has difficulty). 

6.  Patenting Patent Strategies.  Brett made an offhand comment that a side benefit of allowing patents on tax strategies is that at least the licensing revenue itself gets taxed, returning some revenue to the tax system.  The problem is that any tax planning firm aggressive enough to patent strategies will get creative with its patents ... contributing the IP to a Cayman Islands LP and licensing back the patents, thereby shifting the income from the tax advice offshore, where it could be sheltered indefinitely offshore with some careful Subpart F planning.  Hmm.  I'd better apply for a patent on that "Offshore Tax Patent Income Shelter Strategy" before anyone else does.

It will be interesting to see how this all develops.  Stay tuned. 

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