Possible tax angle to the Supreme Court appointment

Amid reports that President Bush may well choose a woman to fill Justice O’Connor’s Supreme Court slot, the New York Times today says that Judges Edith H. Jones and Edith Brown Clement, both of the United States Court of Appeals for the Fifth Circuit, are considered the two leading prospects among women. The Times further says that Jones is a prominent abortion foe, while Clement’s views on abortion are considered uncertain in White House and conservative circles. Gee, I wonder which of the two this leaves out in front, if this particular tea leaf is indeed the right one to examine.

While tax jurisprudence is hardly the most important issue raised by the appointment, those in the tax field may be interested to recall that Jones was the author of an egregious opinion upholding a corporate tax shelter that the Tax Court had struck down. The case was Compaq v. Commissioner, involving the purchase and immediate, pre-arranged resale of a foreign company’s stock, at a huge loss pre-U.S. tax, as a way of in effect purchasing foreign tax credits (from foreigners who could not use them) to offset other U.S. income tax liability. University of Chicago law prof David Weisbach and I criticized Judge Jones’ decision in a short piece, “The Fifth Circuit Gets It Wrong in Compaq v. Commissioner,” published at 94 Tax Notes 511 (January 28, 2002).

Views about how best to respond to corporate tax shelters may reasonably differ, and I know some good tax lawyers who are anti-shelter and yet who thought the government should have lost in Compaq under the set of arguments that it made. But Jones’ opinion was noteworthy for its misinterpreting (or, less charitably, misrepresenting) the factual record of the case, which clearly showed how completely “pre-wired” the deal was, and for its taking an extremely crabbed view of the economic substance doctrine in income tax law (a key IRS tool in combating new shelters). For example, Jones’ opinion seemed to take the view that economic substance is demonstrated whenever taxpayers either (1) bear economic risk in a deal, or (2) arrange not to bear economic risk in a deal. That doesn’t leave a whole lot of room for ever finding a lack of economic substance.

In light of the unspoken attitudes that Jones’ Compaq opinion suggests, appointing her to the Supreme Court would probably mean that there were at least three votes (with Scalia and Thomas) for scrapping the entire economic substance doctrine, which has been a central and widely accepted part of the common law of income taxation since the 1930s. Rehnquist, or his replacement if he retires, might make four, and my sense in Supreme Court tax cases is that, if a few Justices feel strongly about an issue, one or two others may be inclined to go along, as they do not care so much.

A Jones appointment would therefore seem to raise the odds of a major victory for tax shelter promoters, albeit one that Congress could call off (at least prospectively) by passing a statute endorsing the economic substance doctrine. That, by the way, would have its own ironic twist. Once the Supreme Court had changed the revenue estimators' baseline by eliminating the economic substance doctrine, Congress might be able to credit itself with billions of dollars of revenue-raising by simply restoring the prior status quo. This, in turn, might be used to “pay” for new tax breaks of some kind. A true happy ending.

UPDATE: Speculating in complete ignorance now that it's Roberts, the fact that he appears to be an establishment type rather than a bombthrower would seem to me to reduce the likelihood that he would want to throw 70 years of settled tax law into disarray.

Did Bush blink on this one, considering his usual rage-filled drive to create maximum distress? Lucky for the rest of us if he did.