Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
THE TAX SHELTER GAME
Contemporary Chinese Art Specialist, Phillips de Pury & Company, New York, New York; Columbia University, B.A., 1999; Georgetown University Law Center, J.D., 2006. The author is grateful to Professor Ethan Yale for his valuable guidance and insight in supervising her paper.
Uncertainty underlies both substantive issues and practical enforcement in the tax shelter industry. Proposed general antiabuse provisions are criticized for their lack of certainty. 1 Nonstatutory doctrines, such as economic substance and business purpose, are disparaged in favor of statutory and regulatory measures such as disclosure and penalties. 2 Likewise, the results of enforcement efforts to stem the tide of abusive tax shelters are speculative at best in the secretive, elastic, and innovative world of the tax shelter industry.
The legal literature on uncertainty in response to tax shelters has largely addressed substantive uncertainty in general antiabuse standards versus that of rules based approaches. Decisions arising from standards based principles, such as tax avoidance motives, have been criticized as “arbitrary and nontransparent.” 3 Yet, as David Weisbach points out, uncertainty is neither intrinsically good nor bad, and a position on either side must be supported by examining the actual consequences. 4 George Yin notes that while rules are the most efficient way of addressing common transactions by promoting certainty, standards are more efficient in addressing uncommon transactions like tax shelters. 5 Accordingly, instead of regarding uncertainty as a negative attribute of the tax system, it is worth considering whether uncertainty may be a positive characteristic that can be manipulated to discourage abusive tax shelters.
This Article addresses uncertainty in enforcement. It does not take up the substantive standards-versus-rules debate, except where the debate is relevant to the parties’ decision making. The practical application of uncertainty in the strategic process of combating tax shelters has received limited consideration to date. In this context, game theory provides a framework for understanding how current legal rules, such as disclosure and penalty rules, sort different types of information and influence the Service and tax shelter users’ strategic decision making. A game theoretical analysis of tax shelters demonstrates that the current disclosure regime and its attendant penalties are not being effectively employed to deter or screen out abusive tax shelters and that a long-term strategy of litigation rather than settlement is more likely to deter tax sheltering in the long run. The analysis below identifies the uncertainty in the players’ probability and payoffs and draws on behavioral decision theory findings on uncertainty to suggest how the Service can manipulate uncertainty to deter shelter participation.