Tax Patents: At the Crossroads of Tax and Patent Law
Linda M. Beale*
(WORK IN PROGRESS – LAST UPDATED 04/16/08)
In the United States today, the tax practitioner community has belatedly become fully aware of the availability of patents for business method processes and financial transactions—including computer-driven processes that have tax-minimizing possibilities and even tax-advantageous methods of structuring transactions. The United States Patent and Trademark Office (the Patent Office) has been granting business method patents for a number of years.[1] State Street, a seminal case for business method patents, was perhaps one of the earliest tax-related patent decisions: the Federal Circuit held that a computerized system for managing mutual funds’ pooling of investments through a tax partnership was patentable subject matter.[2] In the decade since State Street, a number of business method patents with tax implications have been granted, and even more business method tax patent applications are pending.[3]
Needless to say, the availability of patents for tax planning methods has come under significant scrutiny within the tax bar and accountancy organizations, as well as the Treasury Department and Internal Revenue Service (the Service).[4] That consideration began with a rude awakening to the new crossroads between tax and patent law at a tax section meeting of the American Bar Association (ABA) at which an estate planning method using a grantor retained annuity trust was discussed.[5] Many of the participants were shocked later to receive a letter indicating that the method under discussion had been patented—the SOGRAT patent—and that taxpayers who had set up such an entity would have to pay a royalty or face suits for patent infringement.[6]
In the aftermath of the meeting, as the existence of tax strategy patents became better known, tax practitioners expressed deep concerns about the novel idea of tax planning patents.[7] Understandably, those concerns reflect typical worries of any profession in connection with fundamental changes to the nature of the professional practices, and accompanying worries about the costs and the ability to adjust appropriately to new considerations in developing planning ideas for clients and the new costs associated with tax planning in a world of tax strategy patents.[8] Changes might include the need to conduct due diligence research on the existence of patents for similar tax planning methods to those being proposed and the possibility of having to consider filing patent applications to protect intellectual property developed at considerable effort separately from client representations. The ethical implications of tax patents are not clear. This is a special concern in the context of recent changes to the tax provisions governing penalties and reporting standards[9] and of substantial revisions to the rules governing practice before the Service, commonly known as “Circular 230.”[10] In an effort to combat marketing of tax shelters, the Circular 230 rules were modified to include strict requirements for tax opinions that are considered “covered opinions.”[11] Patent licensing agreements, or perhaps even tax planning patents themselves, might come within those rules.[12]
More significantly, the tax bar generally found it contrary to their understanding of the tax laws that it should be possible to grant a patent on a tax planning method developed in accordance with those laws.[13] Tax planning methods are most often specific steps for creating or eliminating entities, and moving client assets into or out of those entities, or for creating new financial instruments.[14] The goal is to establish business structures or issue financial products that merit beneficial tax treatment as provided by specific provisions of the tax laws (e.g., a tax-free reorganization under Section 368, a real estate mortgage investment conduit (REMIC) under Sections 860A through 860G, or a debt instrument eligible for an interest deduction under Section 163). These concerns thus extend well beyond new difficulties in working with clients or the worry that tax strategy patents would likely be granted indiscriminately by a Patent Office unfamiliar with tax law, inexperienced with tax planning and without access to critical resources available to expert tax lawyers in developing tax planning strategies to a recognition of the broad implications of the granting of tax strategy patents for the understanding of the tax laws, for tax compliance and for tax administrability. Further, tax avoidance transactions have been a significant focus for two decades,[15] and patents on tax planning methods could exacerbate that problem. In essence, patents on tax planning methods appear inherently problematic, given the fundamental differences between innovations in tax and, for example, innovations in designing a better manufacturing product such as a motorcycle helmet.
Furthermore, many practitioners considered it irrational—even assuming arguendo that it might be appropriate to grant patents on some tax planning methods—that a patent could be granted on claims such as the one in the SOGRAT patent that appeared patently obvious to most competent tax attorneys in the financial products and estate planning area.[16] Most such attorneys were well aware of the possibilities of using trusts for various client assets, including stock options. Nevertheless, litigation in connection with the SOGRAT patent was settled out of court a year ago based on a presumption of validity (although the settlement order stipulated that there were facts whereby a trier of fact might have found the patent to be invalid).[17] It is generally understood that various users of the method ultimately paid significant royalties to the patent holder, even though they may have developed the method independently.
In the wake of these many concerns about tax strategy patents, the ABA Tax Section established a task force whose objective was to consider the implication of tax strategy patents for tax practitioners, provide information to practitioners and respond to developments in the field.[18] In addition, various ABA Tax Section meeting sessions over the last two years have addressed a number of vexing issues in connection with tax strategy patents, including the applicability of the ethics rules, the Circular 230 rules for practice before the Service, the reportable transaction rules promulgated under Section 6011 of the Internal Revenue Code (the Code), the Patent Office’s methods of assessing patent applications, and the appropriateness of tax planning methods as subject matter for patents.[19] Similar discussions have taken place among various state bar and accountancy associations.[20]
Perhaps not so obvious is the intense interest of the intellectual property (IP) bar in tax-strategy patents and the “deep divide” between the IP and tax bars on the subject,[21] as illustrated by the two companion articles in this volume.[22] Anecdotally, their response to the concerns of tax lawyers is almost uniformly along the lines of what an IP colleague said to me early on when I objected to the granting of patents on tax planning methods: “Get over it!” Tax practitioners’ admonitions about the inadequacy of Patent Office staff to the task of comprehending complex tax laws that generally require substantial study and “real-world” practice to develop expertise are countered with an almost naïve optimism that examiners can be trained through a few focused workshops to deal with tax in the same way that they have acquired greater expertise in the much less technical area of general business methods.[23] IP lawyers frequently take an avuncular pose, comparing tax strategy patents to other new frontiers in patent law and insisting that tax lawyers merely need to understand the patent system better[24] so that they can pass from aversion to adaptation to the new demands at the crossroads of tax and patent law, just as those dealing in computer software, communications technology or other issues have done, leading to beneficial new innovations and economic growth.[25]
The IP perspective, although not monolithic, tends to two broad conclusions. First, it suggests that the various hurdles in the patent law that must be overcome before a tax strategy claim would be eligible to be patented are significant and will likely prevent patentability of many claims currently under consideration.[26] Second, assuming that some tax strategies will nonetheless be eligible for patents, the IP perspective suggests that tax strategy patents provide appropriate and needed economic incentives for valuable tax innovation that implements the underlying policy of patent law to incentivize innovation for the public good and that the tax bar’s concerns do not distinguish tax from other areas.[27]
This article responds to those two main threads of IP commentary. This Part serves as an introduction to the problem. Part II briefly reviews patent law requirements and the history of the issuance of tax strategy patents as a subclass of business method patents. Part III addresses recent developments in the last year—and especially in the last seven months—that point to potential resolutions of the issue as Congress, the courts and the Patent Office work to more carefully delineate the subject matter requirement for patentability and other requirements that are directly relevant to tax strategy patents. It also addresses the effort by the Internal Revenue Service to create a new category of required disclosure for transactions that involve patented tax planning methods. Part IV considers the issues that are most worrisome from a tax perspective if, in spite of these developments, tax strategy patents continue to be issued. Different issues arise in respect to more aggressive tax strategies compared to ordinary tax minimization planning strategies, but each demands a similar solution to prevent the balkanization of the tax system. Part V concludes that the fundamentally different purposes of the tax and patent laws suggest that the conflict must be resolved, one way or another, through prohibition of patents on tax strategies.
II. A Brief History of Business Method and Tax Strategy Patents
Tax practitioners have become painfully familiar with the chronology of the development of the patent law governing business method patents and, in particular, tax strategy patents. The relevant provision of the Patent Act limits eligibility for patent protection to claims whose subject matter is a “process, machine, manufacture, or composition of matter, or any new and useful improvement thereof”.[28] Patent claims must also satisfy additional conditions to be patented, three of which—utility, novelty and nonobviousness—are often thought of as key requirements in the analysis.[29] Utility merely requires that the patented invention be “useful.”[30] Novelty is defeated by the existence of prior art either before the date of the invention or before one year prior to the time the invention was filed.[31] A patent claim that satisfies the nonobviousness requirement would not be considered obvious by someone of ordinary skill in the field who has complete knowledge of prior art.[32] Each of these hurdles to patentability is important in assessing tax strategy patents.
The subject matter of patents represents a threshold eligibility requirement to patentability. Business method (and tax strategy) patent claims are typically set out as process claims, although some computerized algorithmic applications may appear as machine claims.[33] Although certain types of business methods that were clearly technological inventions were patented early in the development of the country,[34] the courts and the Patent Office had traditionally considered there to be a “business method” exception to patentability for any business method claims that were neither scientific nor technological.[35] The Supreme Court, however, construed the subject matter requirement in a series of important cases in the late 1970s and 1980s that laid the way for the current state of business method patentability. Although it had reiterated in Chakrabarty that “laws of nature, natural phenomena and abstract ideas” are not eligible subject matter,[36] the Court nonetheless permitted the patenting of computerized applications of mathematical algorithms in the 1981 Diehr case.[37] Interpreting the Diehr precedent in Allapat, the Court of Appeals for the Federal Circuit finally permitted patenting of computer programs: it differentiated between ineligible disembodied abstract concepts and eligible machines or processes by looking to whether the claim produced a “useful, concrete, and tangible result.”[38] Finally, in State Street, the Federal Circuit opened the floodgates to new patent applications by holding business methods subject to the same patentability requirements (novelty, nonobviousness, utility, etc.) that apply to consideration of any other process or method.[39]
Some commentators have interpreted State Street to rely on the utility assessment to redefine the scope of the threshold subject matter requirement.[40] There is thus a clear line of expansion in scope of patent subject matter from the Supreme Court’s decision in Chakrabarty permitting patentability of life forms,[41] through the Federal Circuit’s decision in State Street permitting patentability of a computerized accounting process business method,[42] and culminating in the Supreme Court’s rejection of review in Metabolite Labs, a case that could have provided an opportunity to pull back from overly generous subject matter review.[43]
The immediate result of State Street was approval of a business method/financial accounting patent that possibly might force any business embarking on a multi-tiered partnership portfolio investment structure to use the newly patented accounting system.[44] An even more significant result was the priming of the patent machinery to grant additional business method and tax patents, some of which may not include any technological component.[45] In the 2004 Lundgren decision, the Board of Patent Appeals & Interferences (BPAI) ruled that the “technological arts” test that had been followed to distinguish patentable subject matter from non-patentable concepts was not a separate and distinct test for statutory subject matter.[46] Understandably, commentators read this as generally eliminating a “technology” requirement for tax strategy patents.[47]
At about the same time, Patent Office Commissioner Godici acknowledged at a Senate Finance Committee hearing on the tax gap that the Patent Office considered tax strategies to be types of business methods that are potentially patentable.[48] In 2006, the Patent Office extended its business method classification (Class 705) by adding a new subclass (36T) to cover tax planning methods.[49] The Joint Committee on Taxation reported in mid-July 2006 on tax patents, noting a potential concern with tax strategy patents that do not involve computerized application.[50] One recent study examined five tax-related patents that are not computer implemented and concluded that the strategies either should have failed the patentability requirements for nonobviousness or lack of novelty or were so clearly ill-conceived as tax products that they would not produce the tax benefits claimed.[51] Yet as recently as May 2007, the Patent Office explicitly asserted that “patents will play a role in the tax strategy industry” and “[p]atents for tax planning strategies will remain a part of the patent landscape for some time to come.”[52] The very fact that tax planning to assist businesses in properly structuring their business activities could appropriately be considered a “tax strategy industry” by the Patent Office rings warning bells harking to the tax shelter industry that mushroomed through the 1990s with the aid of tax shelter promoters.[53]
III. Recent Developments Affecting Tax Strategy Patents
Although the number of published tax-related patent applications is still quite small compared to the overall number of patent applications and the number of pure strategy patents is apparently even more limited,[54] the potential for future issuance of large numbers of patents covering tax aspects of major categories of financial and business transactions remains a significant worry.[55] Three recent developments, however, suggest some possibility of relief. Congress has begun seriously to consider enactment of legislation to ban tax planning patents. At the same time, the federal courts in recent decisions have pulled back from the broad approach to the subject matter, utility, and nonobviousness requirements that appeared to pave the way for unfettered patentability of tax strategy patents. The Service has also promulgated regulations to require disclosure of tax strategy patent applications.
A. Legislation banning tax strategy patents
The concerns of the tax bar echoed in mainstream media, as journalists reported on the “hot button” issue of patent-eligible tax strategies.[56] The tax concerns augmented more widespread perceptions of patent abuses and stifling of innovation in an overweaning patent system that now appears to favor patent holders at the expense of the general public.[57] The tax practitioners’ concerns about tax strategy patents were therefore soon brought into the several years’ long congressional consideration of major patent law reforms. In its 2007 consideration of patent reforms, the House Judiciary Committee paid attention to the calls for banning tax strategy patents.[58] The House Ways and Means Committee held hearings that covered the complex issues in depth.[59] A major patent reform bill (the Patent Reform Act), similar to bills considered in prior years, was introduced in both the House and Senate.[60] In September 2007, the House passed an amended version of the bill, which prohibits patenting of tax planning methods;[61] but Senate action remains uncertain.[62]
The overall patent reform package is clearly controversial in itself.[63] The tax strategy patent prohibition component of that package may prove too controversial to pass in spite of the considerable support it apparently has at this point. The IP bar objects to special legislation prohibiting tax strategy patents, claiming that it “would run counter to the unitary nature of the U.S. patent system, which generally applies the same rules and standards in a technology-neutral manner.”[64] In addition to widespread opposition from the IP bar to any ban, prohibition of tax strategy patents faces the same descriptive difficulties that beset most tax anti-abuse proposals—how to draw lines between acceptable business behavior and behavior that constitutes abusive tax practices.[65] Even opponents of tax strategy patents agree that there are accounting or computerized data manipulation techniques with tax components that should be patentable (e.g., Turbo Tax or other tax preparation software), but they are adamant that tax planning strategies that represent the abstract ideas of tax planners applying interpretations of tax law to proposed transaction structures should not be.[66] Some of those may be abusive of the tax laws (e.g., a highly technical derivative financial product with computerized accounting requirements that is intended to achieve an illicit interest deduction for a profit stream considered an equity return for tax purposes), but many may simply be undesirable as patented strategies because they are nothing more than abstract interpretations of particular tax provisions (e.g., a computerized method of allocating cost-recovery reductions in a limited partnership). Most commentators do not object to tax preparation software or even to the patenting of software that provides a method for making necessary tax determinations that are required as basic steps in computing tax liabilities in respect of a transaction.[67] The difficulty lies in adopting language that clearly prohibits “pure” tax strategy patent claims that are conceptual business structuring strategies, even though they may be cast as requiring computerized application. Thus, there will undoubtedly continue to be consultation and development in respect of these ideas as the major reform package reaches a final decision, perhaps later in 2008.
Concern that the larger controversies involved in passage of major patent-reform legislation may derail the provisions banning tax strategy patents has led to introduction in the Senate and House of various stand-alone bills intended to prohibit tax strategy patents.[68] Senators Baucus and Grassley, and Senators Durbin, Coleman and Obama have introduced two different stand-alone bills in the Senate.[69] Representatives Doggett and Boucher have sponsored different stand-alone bills in the House.[70] Again, the language in the existing bills is generally quite broad. The Baucus bill, for example, prohibits patenting of inventions that are “designed to reduce, minimize, avoid, or defer or has, when implemented, the effect of reducing, minimizing, avoiding, or deferring a taxpayer’s tax liability or is designed to facilitate compliance with tax laws . . . .”[71] It is expected that the provision prohibiting tax strategy patents will be offered as an amendment to the overall patent reform bill when it comes to the Senate floor.[72]
In the aggregate, this legislative activity suggests that there is considerable interest in Congress in enacting some kind of a prohibition on the patenting of tax strategies. Even the White House has stated its understanding of the “concerns surrounding patent protection for tax planning methods” and its willingness to “work with Congress to address those concerns.”[73] The context of a large and controversial patent reform bill makes it more difficult, however, to predict the final legislative outcome.
B. Court Cases on the Determination of Subject-Matter Eligibility and Nonobviousness for Business Method Patents
Another series of important recent developments has taken place in the courthouse. The first is a more nuanced understanding of the obviousness test for patentability, briefly addressed in Part III.B.1 (and discussed further in the context of Patent Office competence to analyze tax strategy patents for obviousness, in Part IV.B.1). The second is the apparent narrowing of subject matter standards under recent Federal Circuit decisions, addressed in Part III.B.2.
1. KSR and the Obviousness Test
A major objection to the SOGRAT patent was tax practitioners’ sense that the patented planning structure—combining nonqualified stock options with a grantor retained annuity trust—did not represent an innovative development that competent estate tax planners could not achieve in the ordinary course of business.[74] In fact, most of the tax bar considers the SOGRAT structure an example of typical planning activity undertaken by estate planners in considering possible combinations of the various tax vehicles available (e.g., partnerships, grantor retained annuity trusts, grantor trusts) with the various types of assets held by their clients. This is basically an objection to the Patent Office’s inadequate understanding of obviousness in consideration of patent applications for tax planning methods.
In April 2007, the Supreme Court decided KSR,[75] a case dealing with the patentability requirement of nonobviousness. The Court held that a test employed by the Federal Circuit for combining prior references—called the “teaching, suggestion, or motivation” test for combining prior art—was too “rigid”: the test provided insight but was inadequate to determine nonobviousness in the case of a patent claim for attaching a sensor to an accelerator pedal.[76] Instead, the Court noted the importance of recognizing the role of market pressures in pushing inventors to adapt and combine existing technologies.[77]
As various IP commentators have recognized, the KSR decision represents an important step for claims in respect of tax strategies by establishing parameters that “will make it easier to find an invention obvious and thus unpatentable.”[78] Thus, one patent commentator describes the impact of KSR upon tax-related claims such as the SOGRAT patent in the following terms:
Before the KSR decision, many courts would have required a specific statement in either Law #1 [grantor retained annuity trusts] or Law #2 [change in Rule 16b-3 permitting transferability of nonqualified stock options], such as a statement in the legislative history of Law #2 that the amendment will permit stock options to be transferred to trusts, to provide a motivation to combine Law #1 and Law #2. Absent such a statement in the prior art itself, many courts would have ruled that there was no motivation to combine the references. Under KSR, in contrast, one might demonstrate a motivation to combine the laws through literature or testimony demonstrating a market demand to minimize tax consequences relating to the stock options affected by the change in Law #2.[79]
Accordingly, if Patent Office examiners are able to apply KSR’s stricter nonobviousness analysis appropriately, it should have a positive impact on future assessments of tax-related patent claims. The Patent Office has already issued new guidelines for determining obviousness in view of KSR, [80] but it remains to be seen whether examiners will be successful in making appropriate obviousness determinations in tax strategy applications. Under the new guidelines, examiners should be less willing to find nonobviousness based on a very narrow concept of, and limited search for, prior art rather than a broad assessment of existing analogous planning strategies and changes in the market or interests of clients that could have led ordinary tax planners to develop the new technique.
2. Comiskey and the Threshold Statutory Subject Matter Requirement
Another judicial development is the Federal Circuit’s harder look at the threshold statutory subject matter requirement for process claims in the Comiskey case, involving a patent application for a process of mandatory arbitration.[81] James Toupin, General Counsel of the Patent Office, had filed a supplemental letter brief in Comiskey on behalf of the Patent Office. [82] The brief specifically asked the court to consider the subject matter issue and noted the Patent Office’s concerns that patenting of a mandatory arbitration process would result in an “invention that depends for utility on positive law, rather than laws of nature,” and therefore may not be patentable subject matter.[83] Although the BPAI had rejected the patent claims on obviousness grounds, the Federal Circuit went further: it held that at least some of the claims were not even eligible subject matter.[84] Emphasizing that “[t]he very cases of this court that recognized the patentability of some business methods have reaffirmed that abstract ideas are not patentable,” the Comiskey court stated that “an algorithm or abstract idea can state statutory subject matter only if, as employed in the process, it is embodied in, operates on, transforms, or otherwise involves another class of statutory subject matter, i.e., a machine, manufacture, or composition of matter.”[85] Comiskey thus appears to move the subject matter doctrine back towards a requirement of some type of technological intervention, not unlike the earlier “technological arts” test that had been so roundly rejected in Lundgren.[86]
Following the September 2007 Comiskey decision and a similar decision in Nuijten that same month that rejected a business method process claim that appeared to involve only abstract ideas, the Federal Circuit took a further step that may potentially lead towards at least a partial course reversal on business method patents.[87] It decided in favor of an en banc rehearing of Bilski, a case involving a process claim for a business method for hedging energy risk.[88] The BPAI had determined that the Bilski claims were both non-transformational and merely a “disembodied abstract idea” and therefore non-patentable.[89] Much of the immediate blog commentary suggested that the decision represented a tug of war between judges who had won in the precedential Lundgren decision and the losers in that split decision who were on the Bilski panel, with the result that the unsettled law was “flipping” between those positions.[90] The May 8, 2008 Bilski rehearing will directly address the issue of subject matter eligibility for business method claims: the rehearing order specifically requests amicus briefing on the issue of whether the court should overrule State Street.[91]
In light of these court decisions, the Patent Office has indicated that it expects to issue new guidance on the patentability of tax strategy patents.[92] Although no timing has been indicated, it is likely that the Patent Office guidance will await the release of the Federal Circuit’s opinion following the rehearing in Bilski. Whether the guidance will clearly prohibit patents on business and tax strategies, or merely set out a more restrictive test for providing such patents, remains unclear.
Accordingly, it is possible that the courts and the Patent Office will soon effectively ban tax strategy patents through a new understanding of the subject matter requirement for tax patents. One drawback, of course, is the possibility for further reversals of position on the issue. Different judges and new situations could lead the trial courts and Federal Circuit to retreat to a laxer variant of the State Street position, unless the Supreme Court sets out clear guidance.[93]
Whether this undercurrent of change will be sufficiently vigorous to lead the Patent Office to refuse to patent tax planning methods that are not necessarily carried out by computer technology is uncertain. Even if only tax planning methods with computerized implementation are ultimately patentable, there are still significant concerns stemming from the ubiquitous role of computers in ordinary business processes and the potential inability of the Patent Office examiners to distinguish tax-related applications on the borderline that are truly technological from those that are not.[94]
C. Proposed Reportable Transaction Regulations Governing Patented Transactions
In 1999, the Federal Circuit also decided another case that casts a long shadow over the patenting of tax planning strategies. In the now (in)famous Juicy Whip decision, the Federal Circuit held that the utility threshold requirement is not high, and it is satisfied if there is “some identifiable benefit.”[95] Accordingly, the Patent Office does not assess the utility of patent claims, such as tax planning strategies, in terms of their usefulness in providing a public benefit or in furthering public policies. Rather, it leaves such determinations to other federal agencies that are directly involved in setting and enforcing those policies.[96] As a result, the Patent Office can issue patents on devices—such as drag racing cheating devices[97]—that may be illegal to use within some jurisdictions.[98]
The Service and the Patent Office thus each operate within their own jurisdictions to make appropriate determinations.[99] That territoriality creates a potential for both misperceptions about validity of tax planning patent claims, as noted by various commentators,[100] and abuse of the patent process to promote abusive tax shelter transactions.[101]
Although tax strategy claims that are designed to further abusive tax sheltering transactions could receive patent approval, there is no clear evidence that they have been used, to date, to further abusive tax planning transaction methods, as the IP bar readily points out.[102] Patent applications are generally publicized after the initial 18-month period, but it is possible for applications to remain confidential throughout the application review process if there is no intent to file for similar protection abroad.[103] Thus, there may be applications in the pipeline that are abusive, but that would not be known at this point.
The grant of a patent does not assure the licensee of a patented planning method that the tax consequences of the method as set out in the patent are correct. The fact that a government agency has approved a patent for the tax-saving method may, however, be seen by both tax practitioners and taxpayers as certifying that the patented planning method provides the tax benefits claimed. This is a particular problem for the tax system, because taxpayers are obligated to report the tax consequences of each of their transactions and activities in accordance with the tax law. Any perceived government sanction of an illegal or ineffective method of reporting tax liabilities would have a strong ability to mislead or confuse taxpayers in carrying out this duty. That is quite different from an individual citizen’s choice to purchase a licensed device for conducting illegal activities, when they are clearly under no obligation to take part in such activities. This voluntary compliance aspect of the tax system and the universal applicability of the tax laws distinguish tax from other areas of law and make the granting of tax strategy patents especially worrisome. Furthermore, a required disclaimer for promotions of patented transactions that the granting of a patent does not confirm that the planning method provides the tax benefits claimed might not alleviate the confusion caused by the apparent stamp of governmental approval. Similar disclaimers required under the new Circular 230 written opinion requirements are appended to so many materials that tax practitioners question whether they may well be disregarded and ignored by most readers.[104]
The Service has responded to these additional concerns—both the potential that taxpayers could be misled by the existence of a patent to consider the patented strategy necessarily valid and the possibility that tax planning method patents could be used to promote abusive tax avoidance transactions—by promulgating proposed regulations that require disclosure for patented transactions under the Service’s reportable transaction rules.[105] This is an important step, though one that complicates the reportable transaction regime and may ultimately create a considerable volume of material that the Service, with its currently restricted resources, may be unable to process efficiently.[106]
In brief, the reportable transaction regulations were developed over the last decade as a means of providing greater transparency and more timely information about tax planning to the Service, so that it can better assess the validity of innovative tax planning methods based on aggressive interpretations of the Code that have a potential for tax avoidance and undertake timely audits of participating taxpayers.[107] Not every transaction is required to be reported; instead, the regulations promulgated under Code Section 6011 establish a small number of filters to identify for special disclosure those transaction types that are most likely to involve aggressive tax planning. The filters include listed transactions, confidential transactions, transactions with contractual protection, loss transactions and transactions involving a brief asset holding period.[108] Listed transactions are transactions that the Service has identified as abusive tax avoidance transactions through notice or other published guidance.[109] Additional regulations promulgated under Code Sections 6111 and 6112 govern reporting and list maintenance by material advisors.
In 2006, the Treasury Department amended the reportable transaction regulations and issued proposed and temporary regulations adding a category of reportable transaction called “transactions of interest.”[110] In the commentary on the proposed regulation, the Service and Treasury Department noted that tax strategy patents might be interpreted as approval by the government for the patented transaction and expressed concern that such patents could impede tax administration.[111] They asked for comments on the potential creation of a new category of reportable transactions to cover patented tax strategies. After receiving various comments, including from the ABA Task Force,[112] suggesting that there be some method of disclosure for patented tax strategies, the Service and Treasury Department released a notice of proposed rulemaking with proposed regulations treating patented transactions as reportable transactions.[113]
The proposed regulations with respect to tax strategy patents expand the categories of transactions that must be reported by adding a category of “patented transactions” to the reportable transaction filters and by treating most patent holders as material advisors.[114] There are two subparts for the definition of patented transactions that are designed to require disclosure by both patent users and patent holders or their agents. Thus, patented transactions are transactions (i) for which a patent user pays a fee for the legal right to use a patented tax planning method, and (ii) for which a patent holder (or patent holder’s agent) has the right to payment for another person’s use of a patented tax planning method.[115] Reporting is triggered by inclusion of a patented transaction item (including deduction of payments to the Patent Office to apply for a patent) on a tax return.[116]
The definition of the critical term, “tax planning method,” is quite broad, but does provide an exemption for tax preparation software:
[T]he term tax planning method means any plan, strategy, technique, or structure designed to affect Federal income, estate, gift, generation skipping transfer, employment, or excise taxes. A patent issued solely for tax preparation software or other tools used to perform or model mathematical calculations or to provide mechanical assistance in the preparation of tax or information returns is not a tax planning method.[117]
For patent users, the definition of patented transactions requires knowledge or reason to know that the planning method is the subject of a patent.[118] Fees include any form of consideration, but do not include settlement of, or payment of damages in, an infringement suit.[119] Thus, persons from whom the Service could not be expected to receive valuable information in a timely fashion, such as a person who uses a patented tax strategy without knowing about the patent or an infringer, are not subject to the disclosure requirement.
The ABA Task Force has commented on the proposed regulations, noting the importance of requiring reporting at the time of application for tax strategy patents as a means of allowing tax administrators a timely opportunity to assess covered transactions and determine whether some further action, either within the agency or in Congress, is necessary.[120] For example, a tax method claim for which a patent is sought may be clearly erroneous as a matter of law under existing authorities. In that case, the Service could perhaps issue a notice or some other published guidance that describes the components of the transaction and sets out the settled interpretation of the law under which the patent claims fail. If the Service can issue such guidance expeditiously, such a notice should not be viewed by the Patent Office as irrelevant merely because it is issued after the patent application is made available to the Service. The Service’s statements of settled law, demonstrating that the tax planning method does not achieve the claimed tax benefits, should guide the Patent Office in its understanding of the prior art relevant to the patent claim and permit the Patent Office to reject the application on the basis of lack of utility.
Patent claims that present non-novel or obvious extensions of current law that would have been accessible to ordinary tax practitioners may also present an opportunity for the Service to assist the Patent Office in deciphering prior art. Attorneys within the Office of Chief Counsel could review such applications and submit prior art references to the Patent Office. Those references, again, should lead the Patent Office to conclude that persons having ordinary skill in the art could have developed the tax planning method presented in the patent claim and thus to reject the patent application.
As the IP bar has suggested, if a tax method claim in a patent application is abusive, the Service could issue a notice identifying the tax planning technique as a listed transaction, thus alerting taxpayers and tax advisors that the Service does not consider the method a valid interpretation of the tax laws.[121] Although the listing process generally takes some time and each potential listed transaction requires extensive review within the Service, that process is considerably more responsive than legislative changes, which often require several congressional terms to achieve.[122] The listing process should eventually provide a means of discouraging use of an abusive method patent. Practitioners are wary of recommending listed transactions to their clients, so that merely requiring reporting with respect to a transaction structure has been successful in discouraging its use.[123] It is therefore likely that the Service’s notice listing a patented transaction as abusive would discourage taxpayers from participating in the transaction if a patent were granted and would similarly discourage promoters from developing similar transactions.
To facilitate discovery of abusive transactions, the reportable transaction regulations already require reporting of confidential transactions, as noted above. Those rules may be avoided by taxpayers and advisers intending to take their chances with the audit lottery, however, by eliminating any contractual requirements for confidentiality while maintaining confidentiality “in fact.”[124] Patents could also facilitate promoters in maintaining secrecy about the use of a tax strategy: although the patent would be published upon issuance, there is no patent provision requiring disclosure of licensing agreements.[125] Required reporting by licensed users of patented transactions and by patent holders as material advisors under the proposed reportable transaction regulations will therefore more likely ensure that potentially abusive transactions are disclosed to the Service and bring full scrutiny to those who use such transactions.
Several commentators have objected to the reportable transaction mechanism as too burdensome for patent holders and licensees and have urged that the Service defer to congressional action instead.[126] Similar objections were voiced when the Service first proposed the reportable transaction regulations for other types of transactions,[127] yet that regime has been in operation for some time without the strong negative repercussions that critics projected. The reportable transaction regime permits a speedier response to abusive transactions than would otherwise be available. Without the regulations, the Service would not learn about abusive patented transactions until the patent issued. Some issued patents for tax shelter transactions might avoid close scrutiny by the Service due to their classification or manner of stating claims or other means.[128] Even for those that the Service does scrutinize, the Service would require some time to assess fully the patented transaction, and in that time transactions would have the opportunity to go forward. The Service could also develop legislative proposals to address abuses that exploit a perceived loophole in the current tax provisions, but there would likely be a considerable time lag before Congress could or would take action. A particular tax shelter is typically undertaken by relatively few taxpayers only in the period before the tax administration becomes aware of it, so delayed Congressional action to obsolete the transaction would not provide a sufficient hurdle. Thus, a patent on a tax shelter transaction would likely have considerably more value if there is not some mechanism such as the reportable transaction regulations to provide information to the Service at the time of the patent application.
If the proposed regulations are finalized substantially in their current form, they will provide an important tool in the arsenal of the tax administration to deal with tax shelter transactions. It would be difficult to exploit the patenting process to avoid the restraints on confidential tax advice that promotes abusive transactions. The additional transparency provided by requiring reporting to the Service by the patent applicant at the time of fee payments in connection with the patent application should give tax administrators a timely opportunity to evaluate the validity of the transaction under current interpretations of the tax laws.[129] That evaluation could result in listing the transaction set forth in the underlying patent claims and thus act as a significant deterrent to use of the abusive transaction method.[130]
The reportable transaction regulations will not, however, resolve all of the concerns of the tax bar and tax administration with the issuance of patents for tax strategies.[131] A number of difficult issues remain, in particular for those patented transactions that would not result in identification as listed transactions. These issues are addressed in Part IV.
IV. Why Tax Strategy Patents Matter
A patent is a grant of a monopoly in the patented technology for the life of the patent.[132] Benefits from holding a patent therefore include the ability to charge a fee or royalty for others to use the patented technology or, if the holder chooses, the ability to exclude others from using the technology covered. If a tax strategy patent is valid, taxpayers who do not arrange a license with the patent holder (and pay the related royalty) to use the tax-structuring technique covered by the claims of the patent would face the possibility of a patent infringement suit (assuming their use of the patented method becomes known to the patent holder).[133] Even if a tax strategy patent is not valid and could be overturned through litigation, many or even most taxpayers will likely not be able to engage in the patented tax-structuring technique without paying a royalty, because of the high costs of challenging a patent once it has been granted by the Patent Office.[134] A patent provides these exclusionary rights for twenty years from the date of filing.[135]
This Part IV restates the primary objections to tax strategy patents granting these exclusionary rights if, in spite of the hopeful signs outlined in the prior Parts, tax strategy patents continue to be issued. The intent is to provide a better grounding of the rationales, which have been addressed by a number of tax commentators, in the foundational principles of the tax system and the institutional role of tax in our democracy. Part IV.A considers the impact of these exclusionary rights in the case of patented tax claims that provide a strategy for an abusive tax shelter transaction. Part IV.B. addresses their impact in the case of legitimate tax planning strategies.
A. Patenting of Abusive Tax Planning Strategies
The ability of any person to receive royalties for licensing use of a patent on an abusive tax avoidance strategy would be particularly offensive. To the extent that such patents avoided the Service’s scrutiny and were successfully promoted to select groups of users, the Patent Office would have become an enabler of promoters of tax shelters, at the same time that the Service continues to expend considerable resources in fighting such shelter promotions.[136] The Service’s reportable transaction rules have provided greater transparency to make it harder to profit from tax shelters, and Congress’s recent strengthening of penalty provisions has encouraged greater compliance.[137] Although the Service is still hindered by insufficient resources for enforcement, it has made enforcing its tax shelter rules a priority. Anecdotal reports suggest that the anti-tax shelter focus has gained some traction in the struggle against the shelter industry: tax chiefs at public corporations are paying attention and avoiding tax shelter promotions.[138] Congress has continued the trend by changing the tax return preparer provision to force tax advisers to balance their tax minimization planning with a proper regard for the integrity of the tax laws, requiring a confidence level of more likely than not for tax return preparers’ work.[139]
Patenting tax shelter strategies is fundamentally inconsistent with this effort to squelch tax shelter promotion. If patent applications are not available for review by the Service (either through the reportable transaction regime or some other mechanism for opening applications for Service review), shelter promoters could develop new shelter transactions and apply for patents, without publishing the application (to avoid Service scrutiny). Assuming a patent issued, the holder could reap substantial economic benefits from the promotional value of the patent, prior to any action by the Service to list or challenge the transaction. Consider, for example, the various provisions enacted by Congress to end inappropriate deductions for equity-like returns that are legally in the form of interest on debt.[140] An inventive investment banker may create a new financial derivative product that applies a hyper-literal interpretation to the Code to claim success in again characterizing an equity-like payment as interest eligible for an interest deduction. The Service’s determinations regarding claimed tax benefits of derivatives historically require considerable time and internal review. The patent holder might well reap substantial profits before the Service determines that the product is not taxable as claimed. Even if those deals can be challenged through audits and litigation, the anti-shelter enforcement drive suffers and, with it, the federal fisc.
B. Patenting of Legitimate Tax Planning Strategies
Tax practitioner concerns with tax strategy patents extend over a range of issues that have been addressed repeatedly in a number of published articles and commentary.[141] This article will not reiterate all of the many arguments that have been made. It will, rather, focus on several broad points. As a threshold matter, the tax bar concern that the Patent Office is not equipped to apply the nonobviousness standards and other patentability requirements to sophisticated tax transactions is not an insubstantial concern that can be lightly dismissed: the Patent Office has not hired, and will not be able to hire, sufficient tax attorneys with the breadth and depth of expertise necessary to assess sophisticated tax planning techniques. Second, the tax bar is concerned about a variety of interrelated problems that are encompassed within the concept of private appropriation of the tax laws. These rest in the fundamental conflict between the tax law’s goal of collecting revenues through a voluntary compliance system that depends on a system of laws that fairly demand sacrifice of the nation’s residents to fund important governmental goals and the patent law’s goal of providing temporary monopolies to private parties to incentivize beneficial innovations. Three particular manifestations of this fundamental conflict will be addressed here: fairness issues, institutional concerns, and professional concerns.
1. Patent Office competence to assess tax strategies
Even if abusive transactions can be addressed through means such as the reportable transaction regulations, there remain substantial concerns about the competence of patent examiners—who are frequently scientists and engineers or, at best, economists or business specialists by training—to make appropriate patent eligibility determinations in the case of tax planning method patents.[142] The IP bar tends to understate these concerns and express unbounded optimism in the Patent Office’s ability to adapt to this new challenge.[143] The tax bar is considerably less optimistic.[144] Sophisticated applications of tax law may be present in tax-related patent claims with respect to exotic financial derivatives or similar planning strategies. Engineers’ ability to expand their repertoire to cover the data processing aspects of financial transactions and software is of little similarity to the need for the Patent Office to acquire sufficient tax expertise to assess tax planning methods. Fields like banking, real estate analysis, sales and business consulting simply do not have a foundational legal system as immense or as challenging as the Code and regulations and other authorities applicable to tax planning. Many tax partners in firms deal primarily with one or another area of the tax code—partnerships or corporations or trusts or financial products or individual taxation issues. It is challenging to acquire that in-depth expertise across all fields and generally requires years of experience, constant exposure to new transactions, and continuing education on relevant statutory and administrative authority changes. Consider the divisions within the Service itself, where some deal with financial products, others with corporate tax, and still others with partnerships and other tax conduits.[145] Furthermore, practitioners that leave commercial practice to become academics, journalists or government officials face further difficulties. It is difficult, if not impossible, for them to stay in touch with current transactions and the new, aggressive techniques being developed, particularly with each of the many changes in the tax law, unless they also maintain a practice that continues to expose them to new developments.[146] Simply hiring a few patent examiners with backgrounds in tax, or holding special training sessions or presentations for those examiners, as suggested by the IP bar,[147] will not suffice; nonetheless, the Patent Office has in the past asserted that they consider themselves already competent to assess tax strategies.[148] This is an area frequently misunderstood by the IP bar, members of which tend to assume that the lack of an adequate database can be remedied as easily it has been for very different categories like software, by simply encouraging more submissions of prior art or other relatively simple steps.[149]
Finally, it may be especially difficult for Patent Office examiners to determine whether a particular tax-related claim merely implements statutory objectives (and therefore is obvious) or rather creatively extends the statutory provision to a novel structure that could only be understood to be comprehended within the statutory scope in hindsight. I have argued that the tax laws require a coherence-reinforcing interpretive approach that attempts to fit each provision into a structurally coherent system, to the extent possible and consistent with the purpose for the particular provision.[150] This coherence-reinforcing interpretation is necessary to understand the capacity of the Code for governing new transaction structures that have not been explicitly considered during enactment. For example, some statutory provisions may apply only to very specific types of transactions. To take a simple case, the reorganization provision in Section 368(a)(1)(A) applies only to reorganizations that are effectuated under a valid merger or consolidation statute. An extraordinary amount of discussion has taken place over the years since the enactment of the provision to determine what mergers are actually covered by the provision.[151] Multistep transactions may be integrated and recast as “A” reorganizations. The tax bar and Service continues to discuss these issues, so it is clear that the Patent Office would struggle to make obviousness determinations about these complex transaction structures.
2. Private monopolies on interpretations of the tax laws
In its comments on the patented transaction proposed regulations, the ABA Task Force expressed its concern about the potential for tax strategy patents effectively to privatize provisions of the tax law by permitting the holder to exercise monopoly control over a legal interpretation as it applies to a novel financial transaction or structure.[152] The proposed regulations may provide notice to the Service that a patented tax strategy may effectively privatize an area of the tax law’s application; however, it is not clear how the Service could respond to remedy the situation since it is endemic to the nature of the monopoly right granted by the issuance of a patent.
IP commentators argue that privatization of the tax laws on such a broad scale is not possible, “because the prior art embodied in the law itself (including the draft legislation) would either anticipate or render obvious all or most of the explicitly intended applications of the law” or that “patenting one method will not preclude other strategies involving the same assets or vehicles.”[153] The problem is that while a number of strategies may have been foreseen when a statute was enacted and specifically contemplated by the drafters, the statute also clearly should be considered, from a coherence-reinforcing interpretive perspective, as intended to govern wholly new types of transactions that nonetheless come within its bounds. Are all of those “obvious” even though the development of a particular viable structure requires considerable work by investment bankers and tax planners and analysis by tax attorneys? I suspect that most tax lawyers would agree that some structures that do indeed implement statutory objectives are not obvious, even within the more rigorous KSR standard for obviousness. Thus, the SOGRAT strategy appeared obvious to most tax practitioners because it required only a simple extension of a known tax vehicle (the trust) and a known type of assets (stock options). The creation of guaranteed maturity classes for REMICs was not obvious, however, because it required a considerable stretch in application of the relevant rules (regarding the meaning of credit enhacement contracts and the contexts for permissible purchases of mortgage loans out of a REMIC vehicle) to accelerate payment to a specific date not determined by the maturity dates of the purchased mortgage loans. The ability to design such structures is the hallmark of an exceptional tax guru. Those innovations that fit within this group, though difficult to identify, would likely be considered a patentable “invention.”
Recognition of the special attributes of the tax system argues against granting patents to inventors of tax reduction strategies who may either restrict or capture an interpretation regarding the applicability of a particular area of the law. The tax system exists to raise revenues appropriately from all citizens and residents to fund important government functions. To accomplish that purpose, the tax system requires compliance under a self-assessment system that is often referred to as voluntary compliance: taxpayers report their tax items, determine their own tax liabilities and make payment to the government in accordance with that determination, subject to the possibility of an audit by tax administrators.[154] The tax system is universal, in that each and every taxpayer is required to determine their tax liabilities in accordance with all of the tax provisions that apply to the ordinary business, investment, and personal endeavors that the taxpayer has undertaken. Because it is a centrally important function of a democratic government, the tax system is grounded in fairness norms, including the ideal that taxpayers perceive the system as treating them fairly in comparison with other taxpayers (often referred to as a “horizontal equity” mandate that each taxpayer be treated the same as other taxpayers that are similarly situated).[155] The tax laws are enacted by Congress in complex packages, including various measures intended to act efficiently to stimulate activities in some areas or to discourage particular kinds of activities in other areas. These characteristics of the tax system are all interrelated: a taxpayer may be less compliant than otherwise expected because of perceived unfairness or may not report in accordance with the tax laws because of misunderstood opportunities for avoiding taxation.
The tax system also is the major tool available to Congress to shape and guide the economy. The tax laws affect taxpayer choices about lifestyles, careers, and investments. These public-oriented characteristics of the tax system are at the bottom of the worry about tax strategy patents that is summed up in the statement that tax patents “improperly grant[] private persons ownership of the public tax laws.”[156] Privatising portions of the tax law weakens the usefulness of tax for accomplishing policy goals.
a. The Innovation Fallacy
Because of the requirement that everyone comply with the tax laws, this issue tends to be described by the IP bar as a failure of the tax bar to understand the way patented inventions serve the public good by providing a suitable means to comply with legal requirements.[157] This is an expression of what I call the “innovation fallacy” of the IP approach to patenting of legal strategies: if there is a private monopoly of the tax law, IP commentators say, it is necessarily fair because the benefit of innovation is the purpose of the patent law.[158]
An example of the way that the patent law’s encouragement of innovation works to further legal goals provides an instructive contrast with the tax laws. Consider the fact that some jurisdictions require all motorcycle riders to wear appropriate protective headgear.[159] As IP commentators point out, the fact that headgear is required to comply with the law does not support prohibition of patents on motorcycle helmets.[160] To the contrary, a patent on a new type of motorcycle helmet that is more protective than earlier types saves lives and allows those who purchase that patented invention to enjoy a new level of protection. Everyone is better off, even those who cannot afford the protection. Patent protection incentivized the discovery of a better helmet by encouraging researchers to spend more than they might otherwise have spent to develop the new protection. Once the patent expires, the new protection should be available to all without the added licensing cost. And because the patent is published, smart inventors will be able to use that discovery as a springboard to other discoveries. Even those who do not want to pay the royalty to use the invention are not unable to comply with the law—they are free to find another means of complying.
The tax bar, on the other hand, finds the IP perspective off base because the public good is not served by patenting tax avoidance. The law in the example relates to a choice that someone may or may not make—to ride a motorcycle. The public through its representatives has decided that the activity is sufficiently dangerous for participants to require certain protections. Everything that encourages the development of better protection, including patent protection for inventors, reinforces the underlying purpose of the law by providing better means of complying to ensure that the law’s protective purpose is satisfied. Similar arguments apply in the case of patents on pollution control devices on smokestacks, which reinforce environmental laws even though they may initially prevent some from carrying out their manufacturing objectives if they cannot afford the appropriate devices.
In contrast, the complex and extensive tax laws include a limited affirmative mandate—that taxpayers report their taxable items appropriately, within the limits of the procedural requirements and confidence levels, and pay the corresponding tax liabilities. This is discussed extensively in an earlier article, as follows.
[U]nlike other legal regimes, tax is a set of rules that characterize the results of taxpayer transactions for purposes of determining appropriate assessment. It is not a set of prohibitory rules that are intended to ensure that a person’s transactions stay on the legal side of a fixed line between legal and illegal conduct. Other legal regimes set out strict requirements that regulated entities must follow to avoid sanction for committing a proscribed act (such as insider trading under the securities laws) or for failing appropriately to implement a required act (such as maintenance of reserve funds for banking institutions or appropriate sanitation in hospital operating rooms). For these regimes, violators are subject to punishment.... In contrast, the Code neither proscribes nor mandates that taxpayers conduct their activities by means of particular transactions. ... The choice as to mode of arranging affairs is the taxpayer’s business, but the decision as to how those arrangements will be taxed is the government’s business. Congress has legislated rules that are intended to be adequate to the taxpayer’s self-assessment task of determining the tax consequences adhering to actions undertaken for non-Code reasons.
There are only two coercive elements in the Code enforced through the audit process and penalty sanctions — tax reporting and tax payments. … This [is a] regime of rules that characterize and assess rather than label and punish.[161]
The tax law applies to everyone and every-wealth producing activity. The tax system has hundreds of provisions that are intended to ensure that taxpayers can determine their tax obligations appropriately, whatever activities they undertake. The tax laws do not require taxpayers to undertake any particular transaction or deny taxpayers the right to undertake tax-disadvantaged transactions. Thus, the patenting of tax preparation software to help individuals report their tax liabilities is the best analogy for the tax regime to the role of motorcycle helmets in respect of a headgear law. Such software smoothes the way for complying with taxpayers’ reporting and payment obligations.
In contrast, tax planning is an attempt to develop a means of achieving a particular business or financial transaction in a way that will result in the least taxes possible, without claiming a tax benefit that is not allowable under the tax laws that apply to the transaction. Tax planning is neither good nor bad in itself, but the tax bar is under considerable market pressure from clients to push tax planning beyond its reasonable boundaries, creating an aggressive approach to tax planning that I have addressed extensively in prior articles—the “tax minimization norm”—which is appropriately discouraged by tax administrators.[162] In brief, the tax minimization approach to the tax adviser’s role is not illegal, as the oft-quoted phrase from Learned Hand makes clear,[163] but the tax minimization norm does not further the underlying purpose of the tax laws to provide revenues for the federal fisc. Market demands press lawyers towards more aggressive tax planning methods, leading them to adopt hyper-literal interpretations of particular Code provisions or to twist the interpretation of Code provisions to yield the needed outcome, literally “finding (or manufacturing) loopholes.”[164] The result is often the grafting of unnecessary and complex structures on ordinary business transactions in order to achieve tax savings objectives. There is no reason whatsoever to incentivize tax planning strategies among tax practitioners or taxpayers. In fact, there is strong reason to discourage tax minimization planning as a deadweight loss to society: it is inefficient and wasteful because it expends resources on devising complicated structures to slip through the interstices of tax categories in order to claim a more advantageous treatment than a straightforward transaction would have merited, at a considerable cost to the federal fisc.[165] The direct intent of tax minimization is to limit the ability of the government to collect taxes from the taxpayer’s activities, not to reinforce that ability. Thus, incentivizing innovation in this area does not reinforce the proper functioning of the tax laws, but runs counter to it.
b. Inappropriate Capture.
In addition to asserting that innovation in tax planning must be a good that should be encouraged, if tax planning is permissible at all, the IP bar also insists that the patent laws would not damage the coherence of the tax system by permitting patent trolls to monopolize areas of the law.[166] Let’s consider some ways that capture might occur in a harmful way. If a planning strategy relates to a type of entity created by tax laws, then it may effectively capture an area of the law such that any taxpayer undertaking a particular transaction structure in order to come within an explicit tax-advantaged provision must pay a royalty to the holder of the patent (or may be refused a license to do the transaction). This would be true even when Congress enacted the provision to encourage such transactions by making it possible for taxpayers to receive that benefit. Partnerships, REMICs, real estate investment conduits, grantor trusts, and other tax-created vehicles might potentially be captured in this way.
Many patent applications for such strategies would likely be considered non-novel and obvious and would be appropriately rejected as ineligible for a patent, [167] but some of these methods, however, would likely survive the novelty and obviousness tests. There are innumerable bright minds in the tax departments of corporations, investment banks and law firms, many of whom have come up with new ideas in the financial derivatives and securitizations areas that interpret the tax laws to govern combinations of known structures in non-obvious ways.[168] A strategy most often will create transactions that require the application of a number of different Code provisions, and any one new provision may be relevant to a number of different structural transactions. Drafters may have publicly discussed a particular application of a new Code provision to a particular kind of transaction, but the types of transactions that are likely to be patented may be quite different from those specifically contemplated by the drafters, even though they may at the same time lead to useful results not unlike the uses the drafters did contemplate. Examples might include the invention of TruPS, a beneficial interest in a grantor trust that holds certain junior subordinated debt interests and is paid a preferred return out of the cash flows of the trust, so that it is considered an “equity-flavored interest” by credit agencies (although it is classed as debt for tax purposes),[169] or the invention of “guaranteed maturity classes” of REMIC regular interests, which permitted REMIC sponsors to issue REMIC debt with set maturities (unlike prior analysis of the REMIC provisions).[170] The holder of a patent on the process for developing the instruments would have acquired private control over an area of the tax laws (certain REMICs; certain grantor trusts). The value of the patent would increase to the extent that taxpayers are limited to transactions encompassed within the patent or others held by the same patent holder on related transactions.
There would even likely be a race to the Patent Office in connection with each revision of the tax laws in that area, in an attempt to corner the patent market on additional innovative transactions using the new provision that were not obviously contemplated by the drafters. Given the complexity of the tax laws, there are likely to be such new uses (in this sense, tax law is like language—always ready to cover the unknown). That behavior could well result in a few major players holding key patents in entire areas of the law, such that any taxpayer engaging in ordinary activities in that area would need to structure their transactions under one of the methods governed by the patents. Unwary tax practitioners and taxpayers who did discover the method independently might find themselves faced with expensive infringement suits.[171] Yet the provisions were intended to provide certainty about tax treatment of any instruments issued by these securitization vehicles that satisfied the requirements for that classification and to benefit any taxpayers that wanted to create such securitization vehicles. The only way to prevent patent holders from cornering the market on new ways to carry out the intent of Code provisions that are not explicitly contemplated (or easily derived by experts from information about ones that are explicitly contemplated) at the time the provisions are drafted appears to be to legislate a ban on tax strategy patents.
The conventional patent wisdom seems to be turned on its head in respect of the tax system. The basic requirements for patentability favor strong patent protection for inventions that are likely to be of broad utility. In our motorcycle helmet case, patents—and the concomitant ability to charge a reasonable royalty—would be desirable even if the new helmet were so advanced that individuals had no practical choice for complying with the headgear requirement other than the new (and expensive) model. But it would be fundamentally contrary to the intent and purposes of the tax system for a patent to grant similar rights to an interpretation of tax laws governing a particular strategy for structuring transactions, so that it cornered that legal interpretation for all those intending to carry out similar transactions.
c. Core Concerns
There are three additional aspects of the private monopoly of tax laws touched upon in this discussion that are cause for particular concern and merit focused consideration.
(1) Fairness Concerns
The tax system is built around normatively important concepts that are essential to its function even though not evident in every practical aspect.[172] I have suggested that these normative concepts must be viewed as including an external distributive justice principle that is “rooted in institutions of a democratic polity based on personal liberty and equal respect.”[173] Contextualized to rate structures and bases, this distributive justice framework supports a concept of fairness that is generally characterized as based on ability to pay. Like-situated taxpayers should bear similar tax burdens (horizontal equity) and better-off taxpayers should bear heavier burdens (vertical equity). Thus, I have argued that customized tax planning in itself threatens distributive justice: aggressive tax planning for those that can afford it reduces their tax burdens and ultimately results in a heavier burden on others.[174]
IP attorneys argue that the fact that some taxpayers may be able to execute licensing agreements with a tax strategy patentee while others will have to forego taking advantage of the tax provisions governing the patented tax strategy because they cannot afford a licensing agreement is little different from the ability of some taxpayers to pay for sophisticated tax advice while others must do without.[175] The distortive effect of tax patents is, however, much more severe than the availability to some taxpayers of hired tax advisers. Whether or not a taxpayer uses sophisticated advisers, the taxpayer may structure its transaction as desired and enjoy the resulting benefits if the transaction falls within tax provisions providing a particular tax benefit. The use of a tax adviser simply makes it more likely that the taxpayer will find tax-advantaged ways to structure the transaction. The differential access may relate to resources or to trade secrets, but it is not enforced by the government nor is it absolute. Unlike the election to use tax planning assistance, however, a tax patent may permit its holder to block all others from undertaking the planning technique governed by the patent—essentially fencing off a way of structuring a transaction based on an interpretation of a provision of law intended to be available and equally applicable to all. Ironically, that right is granted by the very government that sets the rules for determining tax liabilities based on a claim of universal application, and requires every taxpayer to determine their tax payments accordingly.
Further, the voluntary assessment that underlies the federal tax administrative structure depends in large part upon taxpayers’ respect for the tax system and perception that it treats all taxpayers fairly. The existence of tax strategy patents that provide a boon to some from a particular interpretation of the laws that is not accessible to a taxpayer without paying a royalty—even if the taxpayer developed the same interpretation on her own—directly undercuts the perception of fairness necessary for voluntary assessment to work. It undermines the integrity of the tax system.
(2) Institutional Concerns
A tax strategy patent puts an aspect of the tax laws under the control of the patent holder rather than Congress. It makes access to certain tax-advantaged transaction structures more costly (through a toll charge) or it removes access completely if the patent holder determines not to license any other taxpayers to use the strategy. As we’ve seen, IP commentators treat this preemption concern lightly—“To the extent that the law requires filing tax returns for certain business transactions, entities should avoid the transaction if the tax returns will run afoul of a patented strategy.”[176] These key rights under the patent law directly conflict with the congressional role in setting economic and tax policy through legislation and ultimately undermine congressional authority. Patents on tax strategies ultimately gravely undermine congressional authority.
This is perhaps more so today than ever before, as Congress has turned to the tax code as a primary tool in establishing economic and even social policy. Tax provisions are set to discourage some activities (e.g., gambling is discouraged by prohibiting deductions for gambling losses in excess of gambling winnings)[177] and encourages others (e.g., business investment is encouraged by providing cost recovery provisions that accelerate depreciation deductions in comparison with actual economic depreciation).[178] Patented tax strategies could hinder the ability of Congress to legislate economic incentives through the Code, thwarting congressional purpose.
Some might dislike Congress’s tendency to use the tax Code to legislate its economic policies and prefer that Congress would legislate its economic policies and favors for various constituencies separately from the enactment of tax laws. Although such an approach might well be preferable in an ideal legislative system, it does not accord with the practical realities of today’s political context. Adding tax patents to the issues that compromise and complicate the enactment of tax laws and considerations of appropriate economic policies is not advisable.
Even assuming arguendo that licensing arrangements result in no excessive rent extraction in the setting of royalties, the availability of patents undermines a fundamental premise of using the tax laws as a key factor in economic planning. Consider an economic stimulus package that is intended to operate for some period of time. Assume that over time, various patents are granted that capture a significant portion of the potential transactions and thereby limit the availability of the stimulus primarily to those paying a royalty to the patent holder. The existence of tax strategy patents effectively acts to divert a significant portion of the benefit from the stimulus: the patent holder, who is not the intended recipient of the benefit, receives a substantial portion of the benefit in the form of a royalty, and the taxpayers who are the intended recipients lose an equivalent amount.[179] To add insult to injury, diversion of those tax savings from the intended recipients to patent holders is regarded by the patent system as an appropriate reward for the costs of developing innovations to thwart the congressional intent.
Another case illustrating the thwarting of congressional intent is tax legislation that contemplates extraction of higher taxes through provisions that discourage certain conduct. Such provisions have two purposes—raising additional federal revenues and discouraging undesirable activity. Assume, again, that a tax guru develops an innovative tax planning method that circumvents the tax legislation. In this case, the existence of the tax strategy patent acts to privatize the revenue stream intended for the government, without deterring the activity that Congress had determined to be undesirable.
(3) Professional Concerns
Interpreting the numerous yet finite tax provisions to apply to the infinite variety of new activities that humans engage in is not easy, and for that t