Managing Principal T. Christopher Borek and Academic Affiliate Oliver Hart Publish on Distinguishing Tax Shelters from Efficient Tax Planning

April 24, 2015

Assessments of the economic substance of tax shelters involving corporate reorganizations can benefit from the application of additional principles of economics and corporate finance. In a recent article, "Tax Shelters or Efficient Tax Planning? A Theory of the Firm Perspective on the Economic Substance Doctrine" (Journal of Law and Economics, November 2014), Managing Principal T. Christopher Borek, Analysis Group academic affiliate Professor Oliver Hart of Harvard University, and Angelo Frattarelli of the US Department of Justice describe how the property rights theory (PRT) of the firm, which distinguishes between transactions according to "residual control rights - that is, who has the right to determine what happens in events not covered by explicit contractual terms," can be useful in tax cases. PRT argues that the allocation of residual control rights can have important efficiency consequences in a world where contracts are incomplete. The authors suggest that the PRT approach can be "simpler, and, importantly, more directly captures the economic substance associated with ownership" than other approaches adopted by courts, such as discounted cash-flow analyses.

The authors demonstrate the applicability of PRT in the cases in which "there was no meaningful change in control and so, according to PRT, no economic substance." For example, the authors describe a contingent-liability tax dispute involving Wells Fargo. In this matter, WFC Holdings Corporation v. United States of America, the US District Court for the District of Minnesota disallowed a tax refund to WFC Holdings Corporation (Wells Fargo) because the circumstances surrounding Wells Fargo's claimed $423 million in capital losses associated with a corporate reorganization lacked business purpose and economic substance. Analysis Group supported the US Department of Justice in the dispute, in which Wells Fargo sought a tax refund of at least $82,313,366 for the tax year ending December 31, 1996. The DOJ countered that Wells Fargo's refund demand was based on capital losses accruing from a series of transactions that were intended to create a tax shelter. Professor Hart, serving as an expert witness on behalf of the United States, described how the transaction at issue did not facilitate any meaningful business objectives that could not have otherwise been implemented given that the transaction did not influence or limit the control Wells Fargo had over the associated corporate entities. US District Judge John R. Tunheim concluded, "The Court cannot isolate one part, or even a few parts, of one step of a large, complex transaction and find that its profit potential imbues the entire transaction with substance which is otherwise lacking … WFC has not shown that the [lease restructuring transaction], viewed as a whole, had economic substance or a real purpose other than tax avoidance."

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