Economic Substance
INSTITUTE OF INTERNATIONAL
BANKERS
ANNUAL TAX SEMINAR
JUNE 18-19 2007
David H. Brockway
McKee Nelson LLP
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I. Case Law Developments
Origins of Economic Substance Doctrine
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Gregory v. Helvering, 293 U.S. 465 (1935).
"The legal right of a taxpayer to decrease the amount of what otherwise would be
his taxes, or altogether to avoid them, by means which the law permits, cannot be
doubted. But the question for determination is whether what was done, apart from
the tax motive, was the thing that the statute intended." Id. at 469 (citations
omitted).
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Frank Lyon Co. v. U.S., 435 U.S. 561, 583-584 (1978) (in order for form of
transaction to be respected, transaction must have “economic substance
which is compelled or encouraged by business or regulatory realities, is
imbued with tax-independent considerations, and is not shaped solely by taxavoidance features that have meaningless labels attached… .”).
Knetsch v. U.S., 364 U.S. 361 (1960) (interest expense deductions disallowed
because only thing of substance to be realized in transaction was tax
deduction).
Goldstein v. Commissioner, 364 F.2d 734 (2d Cir. 1966) (unprofitable,
leveraged acquisition of Treasury bills (at 2% yield), and accompanying
prepaid interest deduction (at 4% rate), disregarded as a purposeless activity
-- other than tax avoidance -- lacking economic substance).
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Interpretation of Tax Laws to Carryout
Underlying Purpose
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Economic substance and similar doctrines reflect view that tax laws should be interpreted
in manner designed to carry out underlying purpose and produce results that are rational
in context, and the more radically the intended tax benefits from a transaction depart from
what might reasonably be viewed to be the intended purpose of the provisions subject to
interpretation, and the more highly structured, contrived or artificial the transactions
appear, the more likely these common law doctrines will be invoked to deny the tax
benefit.
“The economic substance doctrine represents a judicial effort to enforce the statutory
purpose of the tax code. From its inception, the economic substance doctrine has been
used to prevent taxpayers from subverting the legislative purpose of the tax code by
engaging in transactions that are fictitious or lack economic reality simply to reap a tax
benefit. In this regard, the economic substance doctrine is not unlike other canons of
construction that are employed in circumstances where the literal terms of a statute can
undermine the ultimate purpose of the statute.” Coltec Industries, Inc. v. United States,
454 F.3d 1340, at 1353-54 (Fed. Cir. 2006).
Conversely, where the tax benefit sought is clearly consistent with the purpose of the
statutory provisions, challenge on the basis of economic substance is less likely. See,
e.g., Sacks v. Commissioner, 69 F. 3d 982, 991 (9th Cir. 1995) (concluding that a saleleaseback of solar water heaters had economic substance notwithstanding the fact that
the transaction may have been unprofitable on a pre-tax basis, holding that the “[a]bsence
of pre-tax profitability does not show whether the transaction had economic substance
beyond the creation of tax benefits where Congress has purposefully used tax incentives
to change investors’ conduct.” Internal quotations and citations omitted.).
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Objective Effect/Subjective Purpose
• In general, consequence of determination that transaction lacks
economic substance is to disregard the transaction for U.S. tax
purposes.
• Economic substance generally analyzed on basis of two tests:
– Did the transaction have objective economic effect, and/or
– Did the taxpayer have a subjective non-tax business purpose of entering
into the transaction?
• Economic effect has to be purposive – See, e.g., Goldstein where the
debts generating the interest expense were real obligations to banks
that expected to be repaid, but the deductions were disallowed
because there was no purpose for incurring the indebtedness other
than to generate tax deductions. Lee v. Commissioner, 155 F.3d 584,
587 (2d Cir. 1998).
• Courts will scrutinize the taxpayer’s asserted subjective purpose to
ascertain whether it is meaningful in context. See, e.g., H.J. Heinz Co.
v. U.S. (2007), 2007 U.S. Claims LEXIS 155 (Fed. Cl. May 25, 2007).
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Disjunctive Test
• In some circuits, doctrine has been applied by
requiring that, for transaction to be disregarded, it
must lack both (i) objective economic effect and (ii)
subjective non-tax business purpose:
– Rice’s Toyota World v. Commissioner, 752 F. 2d 89 (4th
Cir. 1985); Black & Decker, 436 F. 3d 431 (4th Cir. 2006);
Hines v. U.S., 912 F.2d 736, 739 (“while it is important to
examine both the subjective motivations of the taxpayer
and the objective reasonableness of the investment, in
both instances our inquiry is directed to the same
question: whether the transaction contained economic
substance aside from the tax consequences.”).
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Conjunctive Test
• In other circuits, failure to satisfy either the
objective economic effect or the subjective
non-tax purpose test sufficient to support
IRS challenge disregarding transaction:
– Coltec, 454 F.3d at 1355-56.
– Dow Chemical Co. v. United States, 435 F.3d
594, 599 (6th Cir. 2006).
– United Parcel Service of America, Inc. v.
Commissioner, 253 F. 3d 1014 (11th Cir.
2001).
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Objective Effect/Subjective Purpose
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Blended inquiry.--Most cases, however, do not take a paint-by-the-numbers
approach and consider both factors as relevant to the economic substance
inquiry and afford them such weight as the consider appropriate in the
context.
– ACM Partnership v. Commissioner, 157 F.3d 231 (3rd Cir. 1998) ("These distinct
aspects of the economic sham inquiry do not constitute discrete prongs of a 'rigid
two-step analysis,' but rather represent related factors both of which inform the
analysis of whether the transaction had sufficient substance, apart from its tax
consequences, to be respected for tax purposes.").
– Casebeer v. Commissioner, 909 F.2d 1360, 1363 (9th Cir. 1990); Sacks v.
Commissioner, 69 F.3d 982, 988 (9th Cir. 1995) (“the consideration of business
purpose and economic substance are simply more precise factors to consider …
We have repeatedly and carefully noted that this formulation cannot be used as a
‘rigid two-step analysis’”) (citations omitted).
– James v. Commissioner, 899 F.2d 905, 908-909 ((10th Cir. 1990) (“consideration of
business purpose and economic substance are simply more precise factors to
consider in the determination of whether the transaction had any practical
economic effects other than the creation of tax losses.” Citations omitted.); Keeler
v. Commissioner, 243 F.2d 212 (10th Cir. 2001).
– Compare Horn v. Commissioner, 968 F.2d 1229, 1238 (D.C. Cir. 1992) (applying
disjunctive test) with Boca Investerings Partnership v. United States, 314 F. 3d 625
(D.C. Cir. 2003) (holding “the absence of a nontax business purpose is fatal”).
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Reality is, there are very few situations where the outcome is dependent
upon which variation of the doctrine is applied.
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Action Generating Tax Benefit Must
Have Economic Substance
• Coltec, 454 F.3d at 1358-60 (“the transaction to be analyzed is the one that gave
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rise to the alleged tax benefit”).
– The court concluded that (i) the asserted business objectives flowed from
establishing a subsidiary to manage the taxpayer’s asbestos liabilities, not from
the subsidiary’s assumption of those liabilities in exchange for a note (the
element generating the tax loss), and (ii) the taxpayer had failed to demonstrate
any business purpose to be served by linking the assumption to the
centralization of litigation management.
Black & Decker, 436 F.3d at 441-442 (in case involving transfer of $561 million
to controlled subsidiary in exchange for stock and subsidiary’s assumption of $560
million of contingent liabilities, followed by the sale of the subsidiary stock for $1
million to a trust for a former executive, the court stated that “the Rice’s Toyota test
… focuses not on the general business activities of a corporation, but on the
specific transaction whose tax consequences are in dispute.”) .
Nicole Rose Corp. v. Commissioner, 329 F.3d 282, 284 (2d Cir. 2002) (“The
relevant inquiry is whether the transaction that generated the claimed deductions –
the lease transfer – had economic substance.”).
H.J. Heinz Co. (“That other steps in the overall transaction here, or the transaction
as a whole, may have had legitimate business reasons does not alter this result.”).
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Restructuring Existing Operations
• UPS involved situation where company shifted business of insuring
customer lost parcel risks offshore in order to avoid tax on insurance
profits.
• Tax court treated income as UPS’s because business realities were
identical before and after restructuring and contemporary documents
showed that sole motivation was tax avoidance.
• Eleventh Circuit reversed (254 F.3d 1014).
– Creation of genuine obligations enforceable by unrelated parties were
substantial “economic effects”.
– Although no change in how business operated at customer level, transaction
had “business purpose” because it figured in a bona fide, profit-seeking
business. (“This concept of ‘business purpose’ is a necessary corollary to
the venerable axiom that tax-planning is permissible.” Id. at 1019, citing
Gregory.)
– There may be no tax-independent reason for choosing between two ways of
achieving business objective, but does not mean no “business purpose” in
adopting one versus the other.
– UPS transaction “simply altered the form of an existing, bona fide business”
and therefore had adequate business purpose.
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Economic Effect Should Be Meaningful
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Judicial support for IRS view that potential profit must be more than nominal or
insubstantial relative to tax benefits.
– ACM, 157 F.3d at 250 (transactions lacked economic substance because they “had
only nominal, incidental effects on ACM’s net economic position.”).
– Goldstein, 364 F. 2d at 739-40 (deduction disallowed even though taxpayer had the
opportunity of a small gain or loss by owning the Treasury bills).
– Sheldon v. Commissioner, 94 T.C. 738, 768 (1990) (potential for gain “infinitesimally
nominal and vastly insignificant when considered in comparison with the claimed
deductions.”). (Note, Sheldon was decided by a highly divided court (9-7 decision) and
settled by IRS prior to appeal because it believed the Tax Court’s expansion of
Goldstein law might not be sustained. FSA 1993 WL 1468092.)
– Salina Partnership LP v. Commissioner, T.C. Memo 2000-352 (2000) (“Modest profits
relative to substantial tax benefits are insufficient to imbue an otherwise dubious
transaction with economic substance.”).
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Likelihood of pretax profit to be determined at the time the transactions are
entered into, not on the basis of hindsight. Moreover, high likelihood of pretax
profit not necessary as long as magnitude of potential profit commensurate with
risk. Jacobson v. Commissioner, 915 F.2d 832 (2d Cir. 1990); Bryant v.
Commissioner, 928 F.2d 745, 749 (6th Cir. 1991)
To extent demonstrating genuineness of substance by establishing that
transaction involves assumption of risks, degree of risk actually assumed will be
scrutinized. See, e.g., ASA Investerings Partnership v. Commissioner, 201 F. 3d
505, 514-15 (D.C. Cir. 2000), and ACM Partnership, 157 F.3d at 252, n. 39; but
cf., Compaq at 787-88.
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Foreign Taxes
• One notable exception to the generally pro-IRS trend of case law
interpreting and applying economic substance doctrine in recent years
has been the treatment of foreign income taxes.
• In the two cases that have addressed the issue to date, the courts have
rejected IRS arguments that foreign income taxes should be treated as
an expense in the analysis of whether a transaction had an adequate
profit potential.
– Compaq Computer Corp. v. Commissioner, 277 F.3d 778 (5th Cir. 2001).
– IES Industries v. U.S., 253 F.3d 350 (8th Cir. 2001).
• Some indications that IRS is intent on continuing to litigate issue in
other circuits.
• As speeches of IRS officials and preamble to noncompulsory payment
regulations indicate, it also appears that IRS intends to challenge
cross-border foreign tax arbitrage transactions on the basis of
economic substance arguments beyond simply arguing that foreign
income taxes should be treated as an expense in the pre-tax profit
analysis.
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Inherently Subjective Standard
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Very difficult to reconcile the case law so as to state a coherent set of rules that
will consistently be applied.
– Tests imprecise and inherently subjective.
– To certain extent, the principles being applied are in conflict.
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Ultimately a judgment call based on entire context, relative magnitude of tax
benefit compared to nontax considerations, extent to which tax benefit might
reasonably be viewed as “abusive”, etc.
Only thing that is clear is that recent trend in case law involving economic
substance and similar common law doctrines has been very favorable for IRS.
– A number of significant cases where circuit courts reversed taxpayer victories at trial
court: Black & Decker; Coltec; Castle Harbour (TIFD III-E, Inc.) v. U.S., 459 F.3d 220
(2d Cir. 2006); Dow Chemical Co. v. U.S., 435 F.3d 594 (6th Cir. 2006).
– A number of significant trial court cases strongly supporting IRS position: Heinz; Long
Term Capital Holdings v. United States, 330 F. Supp. 2d 122 (D. Conn. 2004), aff’d,
150 Fed. Appx. 40 (2d Cir. 2005); BB&T Corp. v. United States, 233 F.R.D. 447
(M.D.N.C. 2006).
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As a general proposition, in light of developing case law, it is advisable for
planning purposes to take a generally conservative approach to applying the
economic substance and similar doctrines, particularly in the context
transactions that might reasonably be viewed as abusive by the IRS and the
courts. In particular, it is probably advisable to satisfy both objective economic
effect and subjective nontax purpose tests, regardless of circuit.
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II. Possible Enactment of Economic
Substance Doctrine.
• Various proposals have been made.
• If legislation is adopted, likely to depart to
some extent from various legislative
proposals that have been made to date.
• Discussion here based on 2005 draft
conference report to accompany H.R. 4297
(provisions which were ultimately dropped
from legislation).
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Purportedly Enacting Current Law
Standard
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New rules would only apply to cases in which a court determines economic
substance to be relevant.
– Somewhat circular.
– Does rule only mean that those situations (like low-income housing credit) where
economic substance requirement not applied under current law will continue not to
be subject to requirement?
• Conf. Rpt. Note 365: “If the tax benefits are clearly contemplated and expected by the
language and purpose of the relevant authority, it is not intended that such tax benefits be
disallowed if the only reason for such disallowance is the fact that the transaction fails the
economic substance doctrine as defined in this provision.”
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Although Conf. Rpt. explicitly states (p. 233) that legislation does not change
current law standards used by courts to determine when to apply economic
substance analysis, it clearly makes certain modifications to standards as
applied in case law.
– Cites section 269 regulations for current law standard – odd, since section 269
involves a separate statutory basis.
– Where new statutory language explicitly modifies standard in existing case law
(e.g., minimum pretax profit rules), new rules will clearly apply to situations not
subject to challenge under current law.
– No clear indication that taxpayers would be entitled to rely on existing case law
regarding economic substance.
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Conjunctive Test
• A transaction must satisfy both an objective
economic effect test and a subjective
purpose test.
– Objective Test.--The transaction must change
the taxpayer’s economic position “in a
meaningful way (apart from Federal tax
effects).”
– Subjective Test.--The taxpayer must have a
“substantial non-tax purpose” for undertaking
the transaction, and the transaction must be
“a reasonable means of accomplishing
such purpose.”
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New “Reasonable Means” Test
As written, “reasonable means” could be interpreted to be a significant
departure from existing case law.
– Does not appear that new standard intended to involve the weighing by IRS
or courts whether approach taken by taxpayer to achieve its business
objective was the most reasonable without regard to taxes.
– Conf. report at 223 describes standard to be that “the non-tax purpose for
the transaction must bear a reasonable relationship to the taxpayer’s normal
business operations or investment activities,” citing for authority a quote from
tax court in ACM Partnership:
“Key to the determination of whether a transaction has economic substance is that
the transaction must be rationally related to a useful nontax purpose that is
plausible in light of the taxpayer’s conduct and useful in light of the taxpayer’s
economic situation and intentions. Both the utility of the stated purpose and the
rationality of the means chosen to effectuate it must be evaluated in accordance
with commercial practice in the relevant industry. A rational relationship between
purpose and means ordinarily will not be found unless there was a reasonable
expectation that the nontax benefits would be at least commensurate with the
transactional costs.”
– Citing the circuit court opinion in ACM Partnership, the Conf. Rpt. at 224
states that, by requiring “reasonable means”, the provision reiterates the
present-law ability of the courts to bifurcate a transaction in which
independent activities with non-tax objectives are combined with an
unrelated item having only tax-avoidance objectives in order to disallow the
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tax benefits of the overall transaction.
Purpose Test
• Conf. Rpt. at p. 224 explicit that economic substance can
be established without regard to profit potential by
relying on factors such as regulatory considerations.
• Cf. Frank Lyon; Horn v. Commissioner, 968 F.2d 1229,
1238 (D.C. Cir. 1992) (differentiating “between those
business actions which are likely to generate additional
net revenues and those that are taken for nonrevenue
purposes;” stating that “a transaction will not be
considered a sham if it is undertaken for profit or for
other legitimate nontax business purposes”).
• Accounting benefits do not, however, qualify as a
substantial non-tax purpose “if the origin of such financial
accounting benefit is a reduction of income tax.”
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Minimum Profit Potential
• In order to satisfy objective economic effect test on basis of
having a profit potential the present value of the pre-tax
profit is substantial in comparison to the net tax benefits.
– “Thus, a ‘reasonable possibility of profit’ will not be sufficient to
establish that a transaction has economic substance.” Conf. Rpt. n.
373.
• In addition, the reasonably expected pre-tax profit must
exceed a “risk-free” rate of return. A clear departure from
current law.
• Fees, other transaction expenses, and foreign taxes are
taken into account in determining pre-tax profit.
• For lessors of tangible property, net tax benefits do not
include the benefits of deprecation, any tax credit or any
other deduction as provided in Treasury guidance.
• By introducing this special rule only for the objective
economic effect test, does than mean lesser profit might
satisfy purpose test?
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Tax Indifferent Parties
• Certain transactions involving “tax indifferent parties” are disregarded. A
tax indifferent party is any person:
– not subject to federal income taxation, or
– whose tax liability would not be substantially impacted by the tax items taken
into account with respect to the transaction.
• Other than US branch operations, foreign affiliates of foreign controlled
groups would ordinarily be “tax indifferent parties”.
• Financing transactions with tax indifferent parties are disregarded if the
present value of deductions claimed with respect to the transaction is
“substantially in excess” of the present value of anticipated economic
returns of the lender/investor.
– Applies to transactions that are “in substance the borrowing of money or the
acquisition of financial capital directly or indirectly from a tax indifferent party.”
– Includes public offerings if at least 50% of the offering is reasonably expected
to be placed with tax-indifferent parties.
• Also disregarded are transactions that (1) allocate taxable income or gain
to a tax-indifferent party in excess of it’s “economic income or gain” or (2)
results in a “basis adjustment or shifting of basis on account of overstating
the income or gain of the tax-indifferent party.”
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New Penalties
• Would impose a penalty of 40% of the amount of
an understatement resulting from a
“noneconomic substance transaction”.
• Penalty would be reduced to 20% if relevant facts
are adequately disclosed in the taxpayer’s return.
• Strict liability, no out for reasonable cause and
requires Commissioner consent to drop.
• A “noneconomic substance transaction” is one
that:
– (1) lacks economic substance, or
– (2) fails to “meet the requirements of any
similar rule of law.” Very open-ended.
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