Document Type

Working Paper

Publication Date

2007

Center/Program

The Charles Evans Gerber Transactional Studies Center

Center/Program

Center for Contract and Economic Organization

Abstract

Risk-based rules are the tax system's primary response to aggressive tax planning. They usually grant benefits only to those taxpayers who accept risk of changes in market prices (market risk) or business opportunities (business risk). Attempts to circumvent these rules by hedging, contractual safeguards, and diversification are well-understood. The same cannot be said about a very different type of tax planning. Instead of reducing risk directly, some taxpayers change the nature of risk. They enter into informal, legally unenforceable agreements with contractual counterparties that are designed to eliminate market or business risk entirely. The new uncertainty these tax planners inevitably accept, however, is the risk (counterparty risk) that the counterparties will violate the implicit agreements and betray taxpayers' trust. A deliberate substitution of counterparty risk for market or business risk is what this Article calls relational tax planning. The Article offers an economic analysis of different risks and considers two responses to the relational tax planning problem. The analysis suggests that business risk is superior to both market and counterparty risks. Counterparty risk is the most complex of the three. In addition to risk-bearing losses produced by all risks, it reduces transaction costs of future exchanges between relational tax planners, but only if they manage to overcome bargaining obstacles caused by opportunism and asymmetric information. These insights suggest two very different responses. A sweeping reform will allow - and even encourage - taxpayers to engage in relational tax planning, but will also ensure that counterparty risk they incur is sufficiently high. If only incremental improvements are pursued, courts should increase their scrutiny of relational tax planning involving extensive dyadic business relationships and interactions based on social norms.

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