As with most of the more sophisticated bullshit tax shelter, the facts are mind-numbingly complex to disguise the odor. So, I won't get into the details. Readers interested can read the case and the pundits who will claim that the world is coming to an end because taxpayers can't get their way.
I do address a burden of proof question that the Court address, but which ultimately was not outcome determinative. For some reason, in the notice of deficiency and in the answer, the IRS did not raise the economic substance basis for disallowing the claims; instead the IRS raised it for the first time in a pretrial memorandum. The Tax Court assigned the burden of proof to the IRS on that issue. The IRS had timely asserted the related concept of substance over form, so the normal taxpayer burden of proof applied to that issue.
After exhaustive analysis of the proof, the court held that the IRS had not met its burden of proof with respect to lack of economic substance. The Court seems to have been particularly piqued at the IRS' principal expert and his lack of a net present value calculation. The Court formulated its bottom line conclusions on failure to meet burden of proof as follows:
Respondent has failed to demonstrate that John Hancock had no realistic expectation of profit when it entered into the test transactions. Though John Hancock's ABC reports lack a net present value analysis and are therefore inconclusive, respondent bore the burden of proof on this issue. Respondent has failed to meet his burden of proof, and we are therefore not persuaded that the test transactions fail the objective economic substance inquiry.
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Respondent has failed to meet his burden of proving that the test transactions fail either the objective or subjective test under the economic substance doctrine. Therefore, we do not find that the test transactions lack economic substance.To clarify the jargon, burden of proof in the context used by the court is the burden of ultimate persuasion which the trier of fact applies when in a state of equipoise as to a fact. When in a state of equipoise, the trier holds against the party bearing the burden of persuasion as to the fact. As did the Court in John Hancock, when I use burden of proof in this blog entry, I am referring to the burden of persuasion.
It is a truism recognized by courts and litigators that, although burden of proof is much discussed in the cases, burden of proof rarely in fact affects the outcome of the cases. Burden of proof affects the outcome only if the trier is in equipoise as to a fact. Most observers feel that it is a rare case where the trier is in a true state of equipoise so that the case is determined by the assignment of the burden of proof (meaning persuasion in this context). See Cigaran v. Heston, 159 F.3d 355, 357 (8th Cir. 1998) (“The shifting of an evidentiary burden of preponderance is of practical consequence only in the rare event of an evidentiary tie . . . .”); see also Polack v. Commissioner, 366 F.3d 608, 613 (8th Cir. 2003) (citing the Cigaran case) Blodgett v. Commissioner, 394 F.3d 1030, 1039 (8th Cir. 2004); and Knudsen v. Commissioner, 131 T.C. 185, 188 (2008).
Burden of proof is often described as proof by a preponderance of the evidence -- i.e., the existence or nonexistence of the fact is more likely than not. Since litigators like to illustrate legal concepts, particularly burdens of proof, with numbers, it is often said that, in the usual civil litigation, the bearer of the burden of proof must assure that the evidence before the trier will permit / compel the trier to find that the existence of the fact is at least 50+%. If the existence of the fact is 49%, then the trier is persuaded as to the nonexistence of the fact and the party bearing the burden of proof loses, not because of the assignment of the burden of proof but because the trier is affirmatively persuaded that the nonexistence of the fact is more likely than not. (This is why courts, such as the Tax Court, will often state the burden of proof rule but then state that assignment of the burden is irrelevant because the court affirmatively finds the existence or nonexistence of the fact.) The burden of proof means something only if the trier is in a true state of equipoise -- illustrated as 50% without being able to find either 49% or 51%.
It would appear that, in the % metaphor to illustrate burden of proof, the Tax Court judge was in the 50% as to the existence or nonexistence of the objective and subjective inquiries for economic substance. Perhaps this is the rare case where that phenomenon of equipoise actually exists. However, the economic substance holding -- whether correct or not -- was not outcome determinative because the taxpayer lost in any event for other reasons.
Finally, students should see that, if the issue had been outcome determinative, the resolution of the case would be based upon the allocation of the burden of proof (repeat, the burden of persuasion). The taxpayer would have prevailed on its bogus claims from the bullshit shelter because the Tax Court judge pronounced himself to be in a state of equipoise. Yet, from my reading of the case, the evidence was exhaustive even while, in some respects, it was incomplete / could have been more complete. But triers of act decide cases all the time on the basis of an imperfect record. That is the role of inferences that, in all aspects of life, we must make for important decisions. Maybe, if the issue had been outcome determinative, the judge would have spent the extra time and energy so that a decision for or against the taxpayer would have been an affirmative one rather than punting.
Addendum 8/7/13 9:15pm:
Tax Notes had the following article: Amy S. Elliott, Jaime Arora, Matthew R. Madara and Andrew Velarde, Tax Court Strikes Down John Hancock's LILO/SILO Transactions, 2013 TNT 151-1 (8/6/13). I don't have a link to the article, but the following are excerpts:
Mark Allison of Caplin & Drysdale said that given that other courts have systematically rejected LILO/SILO transactions, the Tax Court's decision was not surprising. He said he thought it was interesting that the Tax Court primarily relied on the substance-over-form doctrine rather than the economic substance doctrine.
Allison said the Tax Court gave the taxpayer a moral victory when it concluded that the government failed to establish that the test transactions lacked economic substance. However, that victory was short-lived after the Tax Court examined whether the transactions' substance followed their form, he said.
Monte Jackel of Monte A. Jackel Federal Tax Advisory Services LLC said he was skeptical that any general conclusions could be drawn from the decision because it drew so heavily from the facts of the taxpayer's transactions. The Tax Court also demonstrated that it will thoroughly analyze these transactions in the future, he said.
Jackel said he was surprised that the Tax Court rejected the government's economic substance argument. Based on the facts presented by the Tax Court, it appeared as if the taxpayer structured an uneconomic deal when it entered the transactions, he said.
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"What remains open in this decision and the others which the government has won in recent years is how the tax system can reconcile these decisions with tax-motivated transactions that have been around and accepted for years," said David J. Shakow of Chamberlain, Hrdlicka, White, Williams & Aughtry.
"Unless Congress decides that it will not use the tax system to encourage taxpayers to engage in specific economic activities, the line between improper tax-motivated transactions and ones that are acceptable will be murky. The courts currently may find comfort in the fact that the transactions presented to them often show large tax benefits for relatively small out-of-pocket investments, but it is not clear that the analytical tools that courts are using will ultimately allow them to distinguish acceptable transactions from ones that are not," Shakow said.