The theory of the firm and tax

Courts in many countries have articulated any number of legal tests that they use to supposedly distinguish between corporate transactions that have a legitimate business or economic purpose and those carried out largely, if not solely, to avoid paying tax. In a couple of recent US cases the modern theory of the firm has been applied to try and make this distinction and the basic reasoning seems sound. But I can't help thinking that the most sensible way to handle such problems is to simplify the tax code so that firms don't have the incentive to avoid tax in the first place.

But given that the tax code is unlikely to be simplified any time soon, How are we to make a sensible distinction between legitimate and illegitimate corporate transactions? A new NBER working paper looks at this question and applies the property rights approach to the firm to answering it. The paper explains,

Policy makers have long faced challenges in designing and implementing tax legislation that provides the intended benefits while at the same time avoiding abuse. This tension is well illustrated in a long and diverse series of United States tax shelter cases in which parties disagree over nature of tax-advantaged transactions: corporations, or taxpayers, argue that the terms of the transaction comply with the tax code while the government argues that e transaction violates the spirit of that law. In order to address challenges associated with interpreting complex provisions of the tax code, the Courts have established an economic substance test that is based on evaluating whether a taxpayer would have undertaken the actions at hand absent their tax consequences.

Traditionally some sort of discounted cash flow analysis is used to evaluate the economic substance of tax-motivated transactions. Such an analysis compares the incremental, risk-adjusted benefits of the activities with the incremental risk-adjusted costs, ignoring taxes. The purpose is to determine whether the taxpayer could reasonably expect to realize a profit absent the disputed tax benefits. Discounted cash flow analyses are based on principles of corporate finance that are widely accepted in both business and academic settings. However, a serious shortcoming of such analyses is that they can be very sensitive to long-term financial projections and estimates of discount rates that are developed in the context of litigation, sometimes many years after the fact.

The argument put forward here – consistent with those made in recent court cases – is that additional principles of economics and corporate finance, based on the modern theory of the firm, can be helpful in evaluating the economic substance of corporate reorganizations. In particular, according to the property rights theory of the firm, a key difference between an arm’s length transaction and a transaction inside an organization concerns who has residual control rights, that is, who has the right to determine what happens in events not covered by explicit contractual terms. The possession of residual control rights can have important efficiency consequences in a world where contracts are incomplete. Among other things, to motivate individuals it may not be enough to offer them high-powered incentives; it may be necessary also to allocate them ownership or residual control rights.

In many transactions leading to the creation or reorganization of corporate entities no meaningful transfer of residual control rights actually occurs. These transactions are structured in such a way that both before and after the transaction the company initiating the transaction has complete control. This suggests that the same benefits could have been achieved in-house: that is, such reorganizations or creations of a new entity lack economic substance and should not be respected for tax purposes.

Basically if the same people face the same incentives to make the same (uncontracted for) decisions both before and after the reorganisation then the reorganisation will not change any decision and thus serves no economic purpose.