Formally Legal, Probably Wrong: Corporate Tax Shelters, Practical Reason and the New Textualism

By Walsh, Alexandra M. | Stanford Law Review, July 2001 | Go to article overview

Formally Legal, Probably Wrong: Corporate Tax Shelters, Practical Reason and the New Textualism


Walsh, Alexandra M., Stanford Law Review


INTRODUCTION

In the record-breaking boom of the 1990s, corporate earnings rose sharply. As a result, corporate tax revenues also increased. Interestingly, the increase in tax revenue did not keep pace with the rise in pre-tax income. Between 1988 and 1998, pre-tax corporate income increased by more than 127 percent, from $292.5 billion to $666.4 billion. During the same ten year period, corporate income tax collections increased by only 99 percent, from $94.5 billion to $188.7 billion.(1) Experts in both the government and private sectors believe that the recent increase in the use of corporate tax shelters accounts for much of this discrepancy.(2) It appears that as corporations began to earn more, they worked harder to turn less over to the government. They accomplish this feat by engaging in complex sheltering transactions--devised and sold to them by sophisticated, well-paid tax lawyers--that do not actually affect their economic position but generate artificial losses that, according to a strict interpretation of the tax code, can be claimed as deductions.(3) Subtracted from revenue, these "losses" offset income earned through the corporation's substantive activities, thereby reducing total taxable income below actual economic income.

Before considering how the use of tax shelters might be prevented, it is worth asking whether this practice is even a cause for concern. Currently, the nation is experiencing its first budget surplus in more than 30 years.(4) As politicians debate how to allocate this newfound wealth,(5) worry about erosion of the corporate tax base may seem unnecessary, even alarmist. Consider, though, that the Treasury Department estimates that as much as $10 billion of tax revenue is lost(6) through sheltering activity every year.(7) And then imagine the possibilities if the IRS collected this revenue. Taxpayers might enjoy a tax reduction that is larger and more evenly distributed than the one effected through use of tax shelters. And, of course, the surplus situation is not guaranteed to last. If, and more likely when, it ends, the reduction in revenue caused by tax shelters will no longer seem so insignificant. As additional tax revenue is needed, the continued use of shelters will likely lead to increased tax rates for both individuals and corporations.(8)

Sheltering activity may be undesirable for reasons unrelated to concerns about insufficient tax revenue. First, the money corporations spend to develop, engage in, and defend sheltering transactions does not generate wealth; it merely alters its distribution, shifting it from government to corporations. Though some may believe that corporations should keep more of their income, the means by which shelter participants achieve this distribution--devoting significant resources to economically purposeless transactions--is an inefficient use of societal resources that might otherwise be spent on economically productive activities. Second, tax shelters raise equity concerns. Currently, corporate taxpayers that do not engage in sheltering activity pay higher effective tax rates than otherwise similarly situated taxpayers that do shelter income, a situation that undermines the tax system's attempt to achieve horizontal equity.(9) Finally, many worry that failure to stop sheltering activity will further undermine the public's confidence in, and respect for, our system of taxation, a development which could lead to continued efforts to avoid and evade taxation.(10)

Though armed with an array of policy arguments against sheltering activity, opponents of this practice are on less solid ground when trying to attack it as a violation of the law. Despite the intuition, shared by many, that sheltering activity is somehow wrong, the illegality of this practice is not at all clear-cut. Suppose, for example, that a corporate taxpayer leases property from a foreign entity, immediately prepays all of the rent due under the lease, and then subleases the property back to the foreign entity. …

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