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The Patentability of Tax Advice – Tax Strategies

The patenting of tax advice and tax strategies raises a number of difficult policy and practical issues. While the payment of taxes is mandatory, taxpayers are free to arrange their affairs within the bounds of the law in a manner that minimizes their legal liability for taxes.[1]  It is not sound policy to force taxpayers to choose between paying either more tax than they are legally obligated to pay or paying royalties to a third party who has patented a tax strategy.

In addition to this basic policy concern, on account of the manner in which tax strategies are developed, the confidential nature of tax returns and the relationships between tax practitioners and their clients applying patent law to tax strategies poses serious administrative problems and burdens. These problems include difficulties in establishing and challenging the originality and obviousness of tax strategies, as well as issues in identifying what types of behavior constitute infringement. Allowing tax strategies to be patented may interfere with the duties that tax practitioners owe to their clients, as well as the free exchange of ideas among tax practitioners and between tax practitioners and government officials, resulting in adverse effects not only with respect to taxpayers and tax practitioners, but, ultimately with respect to the development of sound tax policy.

Nature of Tax Strategies

In order to address the impact of granting patent protection for tax strategies, it is important to consider the types of strategies that are developed and employed by taxpayers and their advisors.  Tax strategies range from benign structures that are clearly consistent with the tax law, to mildly aggressive transactions of uncertain validity, to flagrantly abusive transactions that arguably comply with the technical requirements of the tax law but produce results that clearly were never intended by Congress.  [FLA Law Review – Audit Lotto]

Policy Issues Raised by Patents of Tax Strategies

Permitting patents for tax strategies potentially inhibits the ability of taxpayers to minimize their tax liabilities within the limits of the law. At the very least, a taxpayer would have to pay a royalty to the patent holder. Moreover, a patent holder could simply refuse to license her strategy, forcing the taxpayer to pay more in tax than is legally required.[2]  In theory, it is possible that allowing patent protection for tax strategies could result in net savings to taxpayers if such strategies would not have been developed or made available absent patent protection. Experience dictates, however, that tax advisors do not need patent law protection to develop tax strategies or to comply with their obligations to represent the interests of their clients.  Experience also suggests that creative, sound tax planning ideas are generally available and widely discussed among practitioners and in tax literature.[3]

The patenting of ideas or strategies relating to areas involving legal issues raises difficult issues not limited to the tax area. The tax laws, however, are perhaps unique in that they impose universal affirmative obligations of compliance on U.S. citizens and residents. The entrepreneur that wishes to set up a new business requiring some patented technology to operate always has the choice to pay the royalty or not to engage in the business in question, and will weigh the costs against the expected profits.  But when the same entrepreneur enters into even the simplest transaction — for example, incorporating his or her sole proprietorship — he or she has no choice but to seek tax advice, if for no other reason than to report the transaction correctly on his or her tax return. The patenting of tax strategies would invariably increase the cost to taxpayers of complying with their tax obligations, an indefensible result as a policy matter. For this reason, tax strategies and tax ideas should be generally available to all taxpayers.  The tax law should be an open road, not a toll road.

A distinction can perhaps be drawn between tax advice relating to transactions that would occur without regard to their tax consequences (such as a business combination), and tax advice relating to transactions that would not take place, or would take place in a different form, but for tax considerations (such as a transfer to a trust for estate tax planning reasons).  It is clearly undesirable to permit patent protection for even the most novel and creative tax analysis of a transaction that would occur without regard to the tax consequences. Once a transaction has occurred, a taxpayer is legally required to report and pay the proper amount of tax due.

A more plausible case could perhaps be made for permitting patent protection for structuring transactions that would take place in a different form or would not take place at all, but for tax considerations.  Nonetheless, it is not appropriate to impose a toll charge in the form of a royalty on a taxpayer’s exercise of his or her right to arrange his or her affairs so as to avoid paying more tax than legally required.  In the case of tax strategies that embody behavior that the tax law specifically intends to encourage, permitting patent protection could frustrate Congressional intent. In addition, patent protection for certain strategies, such as those involving transfers of assets to trusts which incorporate certain tax-motivated provisions, would unduly restrict taxpayers’ right to dispose of their property as they see fit and could be viewed as a restraint on alienability.

Regarding tax shelters, on a policy level, the issue of patentability does not bear any significant relationship to problems associated with tax shelters. It is unclear whether granting patent protection for abusive tax strategies would result in an increase in tax shelter activity as a result of incentivizing the development of tax shelters or whether it would result in a reduction in such activity by reason of increasing taxpayers’ cost of using such strategies. On balance, it is not clear that tax advisors would not seek to patent aggressive tax strategies, given that the patent application is a public document. To the extent that the disclosure and reporting rules for reportable transactions under Treas. Reg. § 1.6011-4 and IRC Sections 6111 and 6112 work as intended, patentability should not have a material effect on disclosure.  Any implication that receipt of a patent evidences a governmental imprimatur for an abusive strategy can be avoided by the IRS issuing rules requiring disclosure that patent approval does not evidence validity as a matter of tax law.[4]

Difficulties in Establishing Obviousness (or Lack Thereof)

One requirement for patentability of an invention is that the invention not be “obvious.” Many tax strategies that may not be obvious to others are obvious to seasoned tax practitioners.  In the case of a particular tax strategy, it is difficult or impossible to determine whether a skilled practitioner would be able independently to come up with the strategy without having heard about it from another practitioner or in the course of doing transactions. Especially in the case of strategies developed in response to changes in the tax law, a practitioner may be the first to devise a strategy which may not be at all apparent to a layperson or even to an average practitioner, but which other skilled practitioners will come up with on their own within a reasonably short period of time — or would if the first practitioner did not describe the strategy in an article or a patent application.  For the most part, strategies developed to assist clients with structuring non-tax motivated transactions in a tax-efficient manner are more likely to be discovered independently by multiple practitioners — and are in that sense more “obvious” — than are strategies designed by practitioners or promoters out of “whole cloth” to present to clients who have no particular objective other than their desire to not pay taxes.

Many tax strategies are widely discussed among practitioners.  While these types of strategies would be obvious, unless they are widely publicized in writing, they are not easily discoverable in the patent application process. Similarly, many tax strategies are so widely employed or generally known that they have never been reduced to writing, and appear only on taxpayer’s tax returns in the form of numbers on a page. As tax returns are privileged, no patent examiner would ever be able to review them.  For these and other reasons, even highly skilled and trained patent examiners and IRS personnel may, in many cases, be unable to determine whether a tax idea is obvious.[5]  A good example is the GRAT patent, the idea for which was widely discussed many years before the patent was applied for, but was not implemented due to non-tax law restrictions in effect at that time. When those restrictions were relaxed, the technique became practicable.

Difficulties in Establishing or Challenging Originality of Tax Strategies

The practical difficulties of establishing or disputing the originality of tax strategies strongly militates against giving them patent protection. The circumstances in which tax strategies are developed in many cases make it difficult if not impossible to resolve issues as to whether such strategies are sufficiently original to merit patent protection. In many cases, strategies adopted by taxpayers are not publicly disclosed. A tax strategy may be embodied only on the taxpayer’s return and/or advice provided by a practitioner. Tax returns are confidential, and tax advice is typically protected under the attorney-client privilege or the practitioner privilege provided by IRC Section 7525. [6] Although a tax strategy may be embodied in a document that is not strictly speaking confidential or privileged, the document may not be readily discoverable by a third party.

Suppose, for example, Practitioner X develops a tax strategy involving a trust, and uses that strategy on behalf of several of his or her clients. If Practitioner Y subsequently applies for patent protection of the strategy, Practitioner X’s prior clients likely have no incentive to challenge the patent. In fact, the clients may have good reason to not publicly disclose that they employed the strategy, including concerns about possibly attracting an IRS audit as well as general concerns about the privacy of their financial affairs. Practitioner X may very well wish to challenge the patent in order to preserve the ability to employ the strategy on behalf of future clients without having to get permission from or pay royalties to Practitioner Y. However, it would be difficult if not impossible for Practitioner X to establish prior use of the strategy without violating his or her obligations of confidentiality owed to his or her former clients.

Issues as to What Constitutes Infringement

Granting patent protection for tax strategies possess substantial difficulties in determining what constitutes infringing conduct.[7]

Suppose, for example, that a taxpayer, based upon advice from a tax practitioner, employs a patented strategy without permission from the patent holder, and that the tax effect of the strategy is reflected on a return prepared by a tax preparer.

In theory, some or all of the following actions could constitute infringement:

  1. The tax practitioner’s advice to engage in the patented strategy (the “Practitioner’s Advice”);
  2. The taxpayer’s engaging in the transaction (the “Underlying Transaction”);
  3. The tax preparer’s preparation of the return reflecting the effect of the strategy (the “Return Preparation”); or
  4. The Taxpayer’s filing of the return (the “Return Filing”).

It is not clear how treating the Return Preparation or the Return Filing as constituting infringement in and of itself can possibly be viewed as good policy. Once a taxpayer has engaged in a transaction, the taxpayer is legally obligated to properly reflect the impact of the transaction on the return, which the taxpayer needs the preparer to prepare.  Compliance with legal obligations should not constitute patent infringement.

While a more plausible case might be made that the Practitioner’s Advice and/or the Underlying Transaction could constitute infringement,[8] the argument that the Underlying Transaction constitutes infringement presumably would not be effective in the case of a strategy that consists of a novel analysis of the tax consequences of transaction that would have been undertaken without regard to the tax consequences.  Even where the specific form of the Underlying Transaction is influenced by tax considerations, it is often difficult to determine whether the particular form of a transaction constitutes infringement, given that the form of a particular transaction often will be driven as much by considerations peculiar to the specific business circumstances as by tax considerations.  Furthermore, common forms of transactions tend to evolve over time; thus making it difficult to determine whether a structure for which patent protection is sought is fundamentally different from an earlier structure or whether a new structure infringes upon a similar but distinguishable structure that was previously patented. This ambiguity poses a risk of inhibiting perfectly legitimate business transactions.

To the extent that the Underlying Transaction does not constitute an actionable infringement, the Practitioner’s Advice likewise cannot be treated as infringement. Even if the Underlying Transaction constitutes an infringement, bringing an infringement action against the practitioner would be problematic.[9]  Regardless of whether the taxpayer asks the practitioner about the advisability of the Underlying Transaction or the practitioner suggests that the taxpayer undertake the Underlying Transaction, the Practitioner’s Advice essentially constitutes an analysis of the legal consequences of a transaction. The ability to bring enforcement actions based upon the Practitioner’s Advice would interfere with the practitioner-client relationship and raise serious issues with respect to the practitioner-client privilege.

Effects Upon Practitioners

In addition to the potential for throwing up roadblocks that taxpayers would have to navigate in organizing their own affairs, the patenting of tax strategies may interfere with the advisor’s duties to his or her own clients, and would impose burdens on the tax advisor that are undesirable in the context of a very complex, voluntary tax system.  Tax advisors have ethical obligations to represent their clients’ interests zealously within the bounds of the law. If the advisor is aware of the existence of a patent that may cover advice he or she would otherwise give to his or her client, the advisor would be under a duty to inform his or her client of that fact. The advisor might now also have an ethical obligation to research the patent law looking for patents covering any tax strategies that he or she might be recommending.  The more obvious and well-known the strategy is, the less likely it will be that the advisor would expect it to be patented. Unfortunately, it appears that some tax strategies that have been afforded patent protection cover techniques that are widely known, widely used and obvious. Requiring tax advisors to research patent issues and to advise on the existence of and validity of patents covering proposed strategies could result in substantial additional costs to clients.

Moreover, if patents are permitted for tax strategies, tax practitioners maybe discouraged from freely discussing tax issues with one another. Their interests may be better served by refraining from such discussions, keeping their ideas secret and seeking to patent them.

Open discussions among tax practitioners are beneficial to practitioners, their clients, and the government. This exchange of ideas increases practitioners’ understanding of the law and enables them to better serve their clients.  Such discussions enable groups such as the ABA, the AICPA, and various state and local bar associations to provide recommendations to legislators and tax administrators that ultimately facilitate good tax policy.

[1]  [Cite – L. Hand dissent]

[2]  A similar point was made in testimony by Dennis L. Belcher at the July13 hearing.

[3] Our own publicly-available reports necessarily address a wide variety of tax strategy and planning issues.  Our reports are usually prepared at the request of, and directed to, government officials.  They are intended to provide helpful commentary on the practical or legal aspects of tax proposals under study by various branches of the government. See “Tax Section Reports” under www.nysba.org(sections)).

[4]  For example, it may be possible to require the inclusion on published patent materials of precatory language similar to that used on offering statements filed with the SEC, which generally provide that the SEC has neither approved nor disapproved the securities to be issued under the subject prospectus, and has not made a determination whether the prospectus is accurate or complete.  Under the securities laws, any representation of the contrary is a criminal offense.

[5]  We understand that the Patent Office has a policy of referring tax-related patent applications to the IRS for assistance in determining what is and is not obvious.

[6]  Not all tax strategies are embodied only in confidential documents.  For example, tax strategies relating to publicly offered securities are disclosed in documents filed with the Securities and Exchange Commission.  In addition, tax strategies are often discussed in published articles and seminars.

[7]  Many of the confidentiality-related considerations discussed above with respect to originality also make it difficult to discover whether infringement has occurred.

[8]  The only case of which we are aware that alleges infringement of a patented tax strategy is a currently pending case involving the GRAT Patent.  Wealth Transfer Group v. Rowe, No. 06CV00024 (D. Conn. Filed January 6, 2006).  Based upon the complaint, it appears that the alleged infringement is the defendant’s transfer of an option to a GRAT (i.e., the Underlying Transaction).

[9]  Of course, a practitioner would be responsible for advising a client about the possibility that a proposed transaction could result in patent infringement and presumably could be sued by the client if the practitioner does not provide proper advice on the patent issue.

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