The Financial Substance Doctrine: A U.S. Anti-Abuse Rule – Tax Authorities

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This article discusses the economic substance doctrine.

Major corporate transactions typically reflect at least two

separate elements. One is the business arrangement agreed to by the

parties. The other is tax planning that is designed to minimize

taxes while allowing the business arrangement to be consummated. In

order to strike the appropriate balance, advisors must consider the

potential impact of the economic substance doctrine. This doctrine

constitutes a major tool for the I.R.S. to counter tax abusive

transactions, because a transaction that has no economic substance

will not be respected for income tax purposes in the U.S.

For an additional discussion, see Lexis, Tax Considerations for

Taxpayers Applying the Economic Substance Doctrine.

When the tax plan follows the business plan, taxpayers have wide

latitude to choose a structure that reduces or defers tax for the

seller. A simple example is that a taxpayer may choose to pursue a

tax-free reorganization as the form of the transaction rather than

a taxable sale of assets. At times however, the tax planning

may go beyond the business deal, or the underlying transaction may

have no purpose other than a reduction of taxes. See, for example,

ACM Partnership v. Commr., and related cases. TC Memo.

1997-115, affd. 157 F.3d 231 (3d Cir. 1998); ASA Inversterings

Partnership v. Commr., T.C. Memo. 1998- 305 affd, 201 F3d 505 (DC

Cir. 2000); Boca Investerings Partnership v. U.S., 314 F.3d 625

(D.C. Cir. 2003), revg. 167 F Supp 2d 298 (D.D.C. 2001); and Saba

Partnership v. Commr. 273 F.3d 1135 (D.C. Cir 2001).

Each involved the creation of an arrangement to produce losses

for a U.S. taxpayer in order for it to reduce an equivalent gain

from an unrelated transaction, and each was created by financial

engineers at a large financial institution. In such cases, the

courts and the I.R.S. have imposed limits on tax planning when a

tax reduction turned out to be the sole driver for a

transaction.

Common Law Evolution

The economic substance doctrine is a common-law creation that

has been part of U.S. tax law for over 85 years.

Its origins can be traced to Gregory v. Helvering, in

which the Supreme Court recognized a taxpayer’s right to

minimize their tax exposure as long as Congress intended those tax

benefits. Gregory v. Helvering, 293 U.S. 465 (1935), citing U.S. v.

Isham, 17 Wall. 496, 506; Bullen v. Wisconsin, 240 U.S. 625,

630.

The legal right of a taxpayer to decrease the amount of what

other taxes, or altogether 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 which the statute intended.

In the case, the taxpayer was the owner of all the stock of

Corporation A, which held appreciated shares of Corporation B. The

taxpayer wanted to sell the Corporation B shares at favorable

capital gains tax rates. She therefore formed Corporation C, which

acquired from Corporation A all the shares it owned in Corporation

B in a tax-free reorganization. Corporation C was immediately

liquidated and distributed the Corporation B shares to the

taxpayer. Under the law in effect at the time, the liquidation of

Corporation C was a tax-free event, much like the reorganization by

which the Corporation B shares were acquired. All steps required by

law were followed. The question was whether the reorganization

should be ignored for tax purposes because the taxpayer never

intended for Corporation C to continue in business. The Supreme

Court answered in the negative and treated the taxpayer as if she

received a taxable dividend from Corporation A, taxed as ordinary

income.

Since this case, courts have sought to differentiate legitimate

tax planning (i.e., that which has substance) from tax abusive

structures, which are compliant with the letter of the law but

contrary to its spirit. The principle has been invoked in different

iterations and has evolved over the years:

The incidence of taxation depends upon the substance of the

transaction and not mere formalism. (Commr. v. Court Holding Co.,

324 U.S. 331, 334 (1945))
Taxation is not so much concerned with refinements of title as

it is with actual command over the property. (Corliss v. Bowers,

281 U.S. 376, 378 (1930); see also Commr. v. P. G. Lake, Inc., 356

U.S. 260 (1958); Helvering v. Clifford, 309 U.S. 331 (1940);

Griffiths v. Commr., 308 U.S. 355 (1939); Sachs v. Commr., 277 F.

2d 879, 882-883 (8th Cir. 1960), affirming 32 T.C. 815 (1959))
A mere transfer in form, without substance, may be disregarded

for tax purposes. (Commr. v. P. G. Lake, Inc., supra; Commr. v.

Court Holding Co., supra; Commr. v. Sunnen, 333 U.S. 591

(1948) Helvering v. Clifford, supra; Corliss v. Bowers,

supra; Richardson v. Smith, 102 F. 2d 697 (2nd Cir. 1939);

Howard Cook v. Commr, 5 T.C. 908 (1945); J. L. McInerney v. Commr.,

29 B.T.A. 1 (1933), affd. 82 F. 2d 665 (6th Cir. 1936)).
A given result at the end of a straight path is not made a

different result because reached by following a devious path.

(Minnesota Tea Co. v. Helvering, 302 U.S. 609, 613 (1938))
Where a taxpayer embarks on a series of transactions that are

in substance a single, unitary, or indivisible transaction, the

courts have disregarded the intermediary steps and have given

credence only to the completed transaction. (Redwing Carriers, Inc.

v. Tomlinson, 399 F. 2d 652, 654 (5th Cir. 1968); May Broadcasting

Co. v. U.S., 200 F. 2d 852 (8th Cir. 1953); Whitney Corporation v.

Commr., 105 F. 2d 438 (8th Cir. 1939), affirming 38 B.T.A. 224

(1938); Commr. v. Ashland Oil & R. Co., 99 F. 2d 588 (6th Cir.

1938), reversing sub nom. Swiss Oil Corporation v. Commr.,

32 B.T.A. 777 (1935), certiorari denied 306 U.S. 661 (1939); Kuper

v. Commr., 61 T.C. 624 (1974); KimbellDiamond Milling Co. v.

Commr., 14 T.C. 74 (1950), affirmed per curiam 187 F. 2d 718 (5th

Cir. 1951), certiorari denied 342 U.S. 827 (1951)).
Transactions that are challenged as intermediary steps of an

integrated transaction are disregarded when found to be so

interdependent that the legal relations created by one transaction

would have been fruitless without the completion of the series.

(American Bantam Car Co. v. Commr., 11 T.C. 397, 405 (1948), affd

177 F. 2d 513 (3rd Cir, 1949), certiorari denied 339 U.S.

920 (1950); see Scientific Instrument Co. v. Commr., 17 T.C. 1253

(1952), affd per curiam 202 F. 2d 155 (6th Cir.,

1953))
The doctrine of economic substance becomes applicable, and a

judicial remedy is warranted, where a taxpayer seeks to claim tax

benefits, unintended by Congress, by means of transactions that

serve no economic purpose other than tax savings.
Whether we respect a taxpayer’s characterization of a

transaction depends upon whether the characterization represents

and is supported by a bona fide transaction with economic

substance, compelled or encouraged by business or regulatory

realities, and not shaped solely or primarily by tax avoidance

features that have meaningless labels attached. (Frank Lyon Co.

v. U.S., supra at 583-584; Winn-Dixie Stores, Inc. v.

Commr., supra; Nicole Rose Corp. v. Commr., 117 T.C. 328

(2001), affd 320 F3d 282 (2nd Cir. 2002)).

At times, the economic substance doctrine has been used in

conjunction with the business purpose doctrine. The latter, a

subjective doctrine, entails analyzing the purpose of the

transaction to determine whether the taxpayer intended the

transaction to serve some useful non-tax purpose. Joint Committee

on Taxation, Technical Explanation of the Revenue Provisions of

the “Reconciliation Act of 2010,” as amended, in

Combination with the “Patient Protection and Affordable Care

Act,” JCX-18-10,

March 21, 2010, p. 143. Herein, referred to as the “Technical

Explanation to the 2010 Act.”

Some degree of uncertainty arose through different applications

of the economic substance doctrine by various courts. One of the

most cited inconsistencies was that certain courts would

examine both the economic substance and the business purpose of a

transaction in order to determine a given transaction’s

economic substance (the “conjunctive test”), while

other courts determined that the presence of either economic

substance or business purpose was enough in reaching a conclusion

(the “disjunctive test”).

This uncertainty and lack of uniformity led to the codification

of the economic substance doctrine in 2010.

Codification of the Economic Substance Doctrine

The standards by which the economic substance doctrine is

applied were clarified by I.R.C. §7701(o). Thus, the term

“economic substance doctrine” is defined as the common

law doctrine under which income tax benefits with respect to a

transaction are not allowable if the transaction does not have

economic substance or lacks a business purpose.

In determining whether a given transaction has economic

substance, I.R.C. §7701(o) continues to rely on case law. In

determining whether a transaction meets the economic substance

doctrine, the following points must be considered:

The economic substance doctrine must be relevant to the

transaction.
Additionally, the following conjunctive two-prong test must be

met:
- The transaction changes the taxpayer’s economic position
  
  in a meaningful way (apart from Federal income tax effects) (the
  
  “economic substance test”).
- The taxpayer has a substantial purpose (apart from Federal
  
  income tax effects) for entering into the transaction (the
  
  “business purpose test”).

I.R.C. §§ 7701(o)(1) and 7701(o)(5)(D). In determining

whether the taxpayer meets the conjunctive two-prong test, the

transaction’s potential for profit is taken into account only

if the expected pre-tax profits substantially exceed the expected

net tax benefits that would be allowed if the transaction were

respected (the “profit potential test”). I.R.C.

§7701(o)(2)(A).

For the purpose of computing profit potential, fees and other

transaction expenses are to be taken into account as expenses in

determining pre-tax profit. In addition, the I.R.S. is authorized

to adopt regulations under which foreign taxes will be treated as

expenses in determining pre-tax profit in appropriate cases. Note

that factors other than profit potential may demonstrate that a

transaction results in a meaningful change in the

taxpayer’s economic position or that the taxpayer has a

substantial non-Federal tax purpose for entering into such

transaction. The provision does not require or establish a

specified minimum return that will satisfy the profit potential

test.

Certain benefits that stem from reducing Federal taxable income

can no longer be used as a business purpose. Thus, for example,

reductions in state or local income taxes – which are

typically counted as deductions when computing taxable income for

Federal purposes – are treated in the same manner as a

reduction in Federal income taxes if the transaction at issue

affects the computation of taxable income for Federal tax purposes

in addition to state tax purposes. In addition, entering into a

transaction to achieve a financial accounting benefit will not be

treated as a valid business purpose for entering into the

transaction if the origin of the financial accounting benefit is a

reduction of Federal income tax.

The provision does not alter the tax treatment of certain basic

business transactions that, under longstanding judicial and

administrative practice, are respected merely because the choice

between meaningful economic alternatives is largely or entirely

based on comparative tax advantages.15 Technical Explanation to the

2010 Act, JCX-18-10,

p. 152. Among these basic decisions are:

The choice between capitalizing a business enterprise with debt

or equity,
The choice between foreign corporations and domestic

corporations,
the treatment of a transaction or series of transactions as a

corporate organization or reorganization, and
The ability to respect a transaction between related parties,

provided that the arm’s length standard of I.R.C. § 482

is satisfied.

Nonetheless, I.R.C. §7701(o) does not alter a court’s

ability to aggregate, disaggregate, or otherwise recharacterize a

transaction when applying the economic substance doctrine. Thus,

the court decisions, referenced above, regarding economic substance

continue as valid law.

IRS Application of I.R.C. §7701(o)

Application of the Conjunctive Test

In applying the conjunctive two-prong test, the IRS will rely on

relevant case law under the common-law economic substance doctrine

and the business purpose doctrine. I.R.S. Notice 2010-62. Notice

2010-62 was issued by the I.R.S. to provide interim guidance

regarding the codification of the economic substance doctrine and

related provisions in the Health Care and Education Reconciliation

Act of 2010.In this regard, the I.R.S. will rely on

pre-codification authorities and post-codification authorities.17

Notice 2010-62, B. The I.R.S. will not issue general administrative

guidance regarding the types of transactions to which the economic

substance doctrine applies or does not apply, or issue private

letter rulings or determination letters on whether a transaction

meets the requirements of I.R.C. § 7701(o). Id; Notice

2010-62, Effect on Other Documents.

Definition of “Transaction”

As explained earlier, the economic substance doctrine applies to

a transaction or a series of transactions. In I.R.S. Notice

2014-58, the I.R.S. refers to Treas. Reg. § 1.60114(b)(1) to

define a “transaction.” Generally, the term includes

all the factual elements relevant to the expected tax treatment of

any investment, entity, plan, or arrangement. It also includes any

or all of the steps that are carried out as part of a plan. Facts

and circumstances determine whether a plan’s steps are

aggregated or disaggregated when defining a transaction.

Generally, all steps are taken into consideration (i.e., an

aggregated approach is applied) when all such steps are

interconnected with a single objective. However, when certain steps

are taken for tax purposes only, such steps may be isolated, and a

disaggregated approach may be applied. I.R.S. Notice 2014-58

provided the following disaggregated approach example:

If transfers of multiple assets and liabilities occur and the

transfer of a specific asset or assumption of a specific liability

was tax-motivated and unnecessary to accomplish a non-tax

objective, then the economic substance doctrine may be applied

solely to the transfer or assumption of that specific asset or

liability. Separable activities may take many forms including, for

example, the use of an intermediary employed for tax benefits and

whose actions or involvement was unnecessary to accomplish an

overarching non-tax objective. These situations are merely examples

intended to illustrate the potential application of the

disaggregation approach and are not exhaustive or

comprehensive.

I.R.S. Notice 2014-58, A.

Analysis of Relevancy

In I.R.S. Notice 2010-62, the I.R.S. provided guidance as to how

it would determine relevancy of the economic substance

doctrine to a particular transaction. It stated, in relevant part,

that:

The IRS will continue to analyze when the economic substance

doctrine will apply in the same fashion as it did prior to the

enactment of section 7701(o). If authorities, prior to the

enactment of section 7701(o), provided that the economic substance

doctrine was not relevant to whether certain tax benefits are

allowable, the IRS will continue to take the position that the

economic substance doctrine is not relevant to whether those tax

benefits are allowable.

Penalties and Additional Guidance

When a taxpayer enters into a transaction that does not meet the

economic substance standard and the transaction reduces tax, the

portion of the taxpayer’s reduction in tax that is

attributable to the transaction is subject to a 40% penalty. If the

transaction is disclosed in the tax return, the penalty is reduced

to 20%. Disclosure is effected using Form 8275, Disclosure

Statement. I.R.C. § 6662(b)(6). The penalty does not

apply to any portion of an underpayment on which a fraud penalty is

imposed. I.R.C. § 6664(b).

The penalty is a strict liability penalty (i.e., the taxpayer

cannot benefit from a reasonable cause exception). I.R.C. §

6664(c)(2). Because there is no reasonable cause defense available

to taxpayers, any proposal to impose an I.R.C. § 6662(b)(6)

penalty at the examination level must be reviewed and approved by

the appropriate Director of Field Operations (D.F.O.). LB&I,

Codification of Economic Substance Doctrine and Related

Penalties, LMSB-20-0910- 024, September 14, 2010. This

directive is effective for transactions entered into on or after

March 31, 2010. Also see Office of

Chief Counsel, CC-2012-008, “Coordination Procedures for the

Economic Substance Doctrine and Related Penalties”.

The I.R.S. Large Business and International (LB&I) Division

has issued internal guidelines for determining when it is

appropriate to apply the codified economic substance doctrine.

While the Treasury Department has cautioned taxpayers not to rely

too heavily on these guidelines, examiners are instructed to carry

out the following four-step inquiry prior to asking a D.F.O. to

assert the penalty:

First, an examiner should evaluate whether the circumstances in

the case are those under which application of the economic

substance doctrine to a transaction is likely not appropriate.
Second, an examiner should evaluate whether the circumstances

in the case are those under which application of the doctrine to

the transaction may be appropriate.
Third, if an examiner determines that the application of the

doctrine may be appropriate, the examiner must make a series of

inquiries, provided in the guidance, before seeking approval to

apply the doctrine.
Fourth, if an examiner and his or her manager and territory

manager determine that application of the economic substance

doctrine is merited, guidance is provided on how to request D.F.O.

approval.

The LB&I guidelines provide examples for every step. These

examples are relevant not only for purposes of the penalty regime

but also with respect to I.R.S. application of the economic

substance doctrine. For example, transactions to which the

application of the economic substance doctrine is generally not

appropriate include the following ones:

The transaction is not promoted/developed/administered by a tax

department or outside advisors.
The transaction is not highly structured.
The transaction contains no unnecessary steps.
The transaction generates targeted tax incentives that are

consistent with Congressional intent in providing the

incentives.
The transaction is at arm’s length with unrelated third

parties.
The transaction creates a meaningful economic change on a

present value basis (pre-tax).
The taxpayer’s potential for gain or loss is not

artificially limited.
The transaction does not accelerate a loss or duplicate a

deduction.
The transaction does not generate a deduction that is not

matched by an equivalent economic loss or expense (including

artificial creation or increase in basis of an asset).
The taxpayer does not hold offsetting positions that largely

reduce or eliminate the economic risk of the transaction.
The transaction does not involve a tax-indifferent counterparty

that recognizes substantial income.
The transaction does not result in the separation of income

recognition from a related deduction either between different

taxpayers or between the same taxpayer in different tax years.
The transaction has credible business purpose apart from

federal tax benefits.
The transaction has meaningful potential for profit apart from

tax benefits.
The transaction has significant risk of loss.
The tax benefit is not artificially generated by the

transaction.
The transaction is not pre-packaged.
The transaction is not outside the taxpayer’s ordinary

business operations.

In the

LB&I guidelines, the I.R.S. refers to the four transactions

that are not deemed relevant by the Technical Explanation to the

2010 Act, by stating that “it is likely not appropriate to

raise the economic substance doctrine if the transaction being

considered is related to” these transactions.

Conclusion

While the economic substance doctrine has certainly been

introduced into the Internal Revenue Code by I.R.C. § 7701(o),

it has not been entirely codified. It is a constantly evolving

concept and one that makes abusive tax planning extremely costly

through the applicable penalty regime. The likelihood of disclosure

of a transaction without economic substance will likely be low for

taxpayers that are neither audited under U.S. G.A.A.P. nor subject

to analysis by the auditors in accordance with FIN 48, which deals

with uncertain tax positions. Without the overview provided in an

audit of financial statements under U.S. G.A.A.P., taxpayers may

not have a system to report and disclose the transaction. In

comparison, if a U.S. G.A.A.P. audit is performed and a reserve is

taken with regard to an uncertain tax position, Schedule UTP must

be filed with the tax return for the year in which the reserve is

established, and the taxpayer’s assets exceed the $10 million

threshold provided in the instructions.