Economic Substance Doctrine Research Articles

Economic Substance Doctrine: How Codification Changes Decided Cases

Health care reform mesmerized the nation last spring and created strong rhetoric on all sides. In climatic fashion, on March 25, 2010, Congress passed H.R. 4872, the Health Care and Education Reconciliation Act of 2010 (the Reconciliation Act). This legislation modified legislation that was signed into law several days earlier in H.R. 3590, the Patient Protection and Affordable Care Act (P.L. 111-148). President Obama stated that the passage of these bills represents a major accomplishment for his administration.Although this legislation will be remembered in the popular press for starting a new chapter in the country’s health care system, the passage of the Reconciliation Act also starts an important new chapter in the nation’s tax jurisprudence. In this regard, section 1409 of the Reconciliation Act adds a new section 7701(o) to the Internal Revenue Code. This provision seeks to codify and clarify the judicially-created economic substance doctrine. From its inception, the economic substance doctrine has been used to prevent taxpayers from subverting the purpose of the tax code by engaging in transactions that are fictitious or lack economic reality simply to reap a tax benefit. In this respect, the economic substance doctrine is similar to other common law canons of construction that are employed in circumstances where the literal terms of a statute can undermine the ultimate purpose of the statute. Congress had debated for years whether to codify the judicially created economic substance and business purpose doctrines, and now that debate is over.

Economics and Economic Substance

The economic substance doctrine has no basis in economics. The fact that a transaction has an after-tax profit but not a pretax profit is not an indication of inefficient resource allocation. Nor does economic analysis suggest that denying tax benefits to arrangements lacking economic substance will reduce the deadweight loss of taxation. Because a pretax profit requirement has no economic foundation, it is irrelevant whether the calculation of pretax profit takes account of implicit taxes. Both the conventional definition of economic substance based on pretax profit and competing formulations that give less or no weight to pretax profit appear to be based on reverse engineering to isolate features that unappealing transactions in high-profile litigation have shared. All these formulations fail to answer the critical questions surrounding the economic substance doctrine: why lack of economic substance is intrinsically bad, and why intrinsically bad transactions are more likely to lack economic substance. Some supporters of the doctrine concede its lack of economic logic but defend it based on its practical effectiveness. This line of defense is generally based on anecdotes unconnected to the actual content of the doctrine and fails to explain why a pretax profit test should be a relatively effective means of targeting objectionable transactions

A Study on the Development of the Economic Substance Doctrine in the U.S. - From Gregory to IRC Section 7701(o) -

A Study on the Development of the Economic Substance Doctrine in the U.S. - From Gregory to IRC Section 7701(o) -

Apple's Cost Sharing Arrangement: Frankenstein's Monster

This paper performs a forensic analysis of Apple's transfer pricing cost sharing arrangement based on facts and documents that were disclosed in hearings before the U.S. Senate Permanent Subcommittee on Investigations in May 2013 and an investigation of Apple's transfer pricing arrangements by the European Commission between 2013 and 2016 as part of its State Aid investigation, related court filings in Europe and other sources. The paper finds that Apple provided conflicting information to these different investigations and that, when combined, documents from both investigations, when combined with additional research reveal that Apple appears to have violated U.S. transfer pricing laws in 2009 and later years, that should have invalidated its cost sharing arrangement but were apparently not detected by the IRS. These tax violations resulted in U.S. federal tax underpayments that we estimate to be greater than $84 billion. Apple's reserves for Uncertain Tax Positions were $16.5 billion as of September 2020, much less than this amount. The proposed adjustments under the cost sharing periodic adjustment regulations are not limited by any statute of limitations, and appear to be accompoanied by additiional tax violations, including violations of the economic substance doctrine, and the regulations governing the taxation of effectively connected income.

A Comparison of the US Economic Substance Doctrine with Italy’s New Abuse of Law Rules: Gravitation towards Similar Outcomes?

This article compares the general anti-avoidance rules (GAARs) in Italy and the United States, considers whether the two GAARs are on convergent paths and suggests improvements that could be made to the US GAAR.

Rozwój koncepcji treści ekonomicznej (substance) w Stanach Zjednoczonych

Do istotnych wyzwań współczesnego prawa podatkowego należy skuteczne przeciwdziałanie unikaniu opodatkowania. Jednym ze sposobów walki z tym negatywnym zjawiskiem jest poszukiwanie i badanie w działaniach podatników elementu treści ekonomicznej (ang. substance). Na szczególną uwagę zasługują tu zwłaszcza amerykańskie doktryny orzecznicze, a mianowicie doktryna economic substance oraz doktryna business purpose. Analiza tych doktryn wskazuje, że pojęcie treści ekonomicznej (substance) powinno być rozumiane w kontekście zmiany (poprawy) sytuacji ekonomicznej, finansowej, gospodarczej podatnika, wynikającej z czegoś więcej niż tylko z uzyskanej korzyści podatkowej. Owa zmiana (poprawa) może być przy tym analizowana z dwóch perspektyw – obiektywnej lub subiektywnej. Z perspektywy obiektywnej chodzi o rzeczywistą zmianę (poprawę), mającą odzwierciedlenie w zyskach generowanych przez podatnika. Natomiast z perspektywy subiektywnej chodzi o przekonanie podatnika, że podejmowane działania były nakierowane na realizację konkretnego zamierzenia gospodarczego (osiągnięcie zysku). Kryterium obiektywne, jako niewymagające dokonywania ocen motywów działania podatnika, wydaje się przy tym bardziej mierzalne, a tym samym łatwiejsze do zastosowania w praktyce.

Grappling with the Tax Me If You Cann Era: Configuring a Micro Level Objective Economic Substance Inquiry

The Economic Substance Doctrine has been perennially placed at the fulcrum of the IRS’s fight against rising tax shelter activity. The doctrine presupposes that transactions must have economic substance, as the phrasing itself insinuates and should not only be geared at generating tax savings. The Economic Substance inquiry generally involves a two prong test which asks two questions - (i) did the tax payer have a business purpose for engaging in the suspect transaction other than getting tax benefits? (Subjective motivation test), and (ii) did the transaction have economic substance other than tax savings? (Objective analysis test). Most Courts are at par that the two prongs are entirely different standards for economic substance analysis. However, there is still some uncertainty among the Courts as to what each prong really means as different Courts have approached each individual prong differently. Further, there is still ambiguity among the Circuits as at to how the two prong test is to be applied which are evident in the variation in the Circuits’ decisions. Some Courts have said that it is a disjunctive test while others have held that it is a conjunctive test. Elsewhere, there is a simmering revolution that is treating the economic substance inquiry as a unitary analysis which asserts that the two prongs are informed by the same rationale. Practically there are no differences between the unitary analysis and the conjunctive test. A modern species of the Economic Substance Doctrine was evinced in the 1998 decision of ACM Partnership v. Commissioner. In that case it was stated that the objective and subjective motivation tests of the doctrine were not discrete prongs of a rigid “two step analysis” but related factors both of which informed the analysis as to the economic substance of a transaction. It is apt to realize that corporate tax payers desire to do their tax planning under a system of objective rules that espouses certainty and places less emphasis on subjective overtones especially taking into account the factual complexity of day-to-day business transactions. Traversing through literature on the doctrine reveals an area of law that is still riddled with uncertainties which have ultimately been an Achilles heel for its applicability. The recent cases of Black & Decker v. United States and Coltec Industries v. United States have re-invigorated a movement towards an objective economic substance doctrine which incorporates a micro-level analysis such that a transaction is separated into different levels to find out whether each level distinctly had economic substance. This thesis argues that the use of a micro-level objective economic substance analysis which takes into account implicit taxes is a most viable solution to effectively formulating a sturdy objective economic substance inquiry for the coming years. The implication here is that by adopting a micro-level objective economic substance analysis the tax payer will only be denied tax benefits for the distinct levels of a transaction that lacked economic substance and not for the entire transaction. This would bring the IRS and the tax payer to a win-win result and makes more practical and economic sense

Tax Shelters or Efficient Tax Planning? A Theory of the Firm Perspective on the Economic Substance Doctrine

Courts have articulated a number of legal tests to distinguish corporate transactions that have a legitimate business or economic purpose from those carried out largely, if not solely, for favorable tax treatment. We outline an approach to analyzing the economic substance of corporate transactions based on the property rights theory of the firm and describe its application in two recent tax cases.

The Economic Substance Doctrine and China’s Power to Tax Income from Indirect Equity Transfers by Non-Resident Enterprises

The indirect transfer of equity in a Chinese resident corporation by a foreign investor that is a non-resident enterprise through transferring shares in an intermediate holding company is a common technique used in cross-border capital flows. According to the Corporate Income Tax Law of China, the place where a company is located (i.e., registered) determines the location of transfers of equity in that company and which country has the power to tax that transfer, which also gives rise to the problem of the legal scope of this taxing power. The State Administration of Taxation has issued relevant documents to establish the economic substance doctrine, adopting a “look-through approach” to negate the existence of an intermediate holding company and accordingly claim jurisdiction to tax in order to deal with the growing problem of base erosion and profit shifting. The taxing power on indirect transfers does not apply, however, to a transfer which has reasonable commercial purposes or meets the special provisions in tax treaties. China should develop rules through legislation to clarify the specific circumstances relating to such “reasonable commercial purposes”, to provide specific exemption from tax for cross-border internal restructuring-related indirect equity transfers, to introduce an advance ruling system, and to perfect the mechanisms for monitoring revenue sources.

It's Time for the Supreme Court to Review the Economic Substance Doctrine (Amicus Brief)

In United States v. Woods, this writer submitted an amicus brief arguing that the Supreme Court should reserve its judgment about the economic substance doctrine, which the district court had applied below. The Supreme Court agreed with that argument, expressly leaving its opinion about the proper application of the economic substance doctrine to a future case.That future case has arrived. This amicus brief, supporting the taxpayer’s petition in WFC Holdings v. United States, explains why this case presents the perfect opportunity for the Court to explain what weight, if any, legislative enactments enjoy in deciding economic substance cases. Although this brief is directed to the Justices, it should appeal to anyone who follows developments related to the economic substance doctrine.

Codification of the Economic Substance Doctrine and the Gregory Case

ABSTRACT Gregory v. Helvering is a landmark case in the area of corporate reorganizations. The concepts that evolved from Gregory include the business purpose test, continuity of business, the taxpayer's right to minimize tax liability, step transaction doctrine, and the economic substance doctrine. The Treasury Department sought a codification of the economic substance doctrine as a necessary weapon to curb the growth of corporate tax shelters. While the doctrine had been part of the fabric of our tax system since Gregory, it had been eroded by some confusing and conflicting case law. In 2010 (the 75th anniversary of Gregory), Congress codified the economic substance rules. In order to understand this new legislation it is necessary to explore the long and grand history of the Gregory case as a backdrop for consideration of the merits and demerits of the codification of the economic substance doctrine.

Penalties: Unintended Consequences of the Economic Substance Penalty

In 2010, Congress codified the economic substance doctrine and created a strict liability penalty for understatements attributable to transactions that did not have economic substance. Recent court decisions have refused to invalidate transactions based on economic substance and have focused instead on other doctrines such as sham transaction and substance over form. This may have implications for the strict liability penalty incorporated into the economic substance doctrine.

Tax Shelters or Efficient Tax Planning? A Theory of the Firm Perspective on the Economic Substance Doctrine

Courts have articulated a number of legal tests to distinguish corporate transactions that have a legitimate business or economic purpose from those carried out largely, if not solely, for favorable tax treatment. We outline an approach to analyzing the economic substance of corporate transactions based on the property rights theory of the firm, and describe its application in two recent tax cases.

An Assessment of Anti-Tax Avoidance Doctrines in the United States and the European Union

This article analyzes the main anti-tax avoidance doctrines in the US and the EU. Part II considers the economic substance doctrine in the context of common law doctrines developed at federal level in the US to deny taxpayers expected tax benefits, namely “economic substance”, “substance over form”, “step transaction”, “business purpose” and “sham transaction”. Whilst this paper focuses on the economic substance doctrine, it is nevertheless relevant to review the other doctrines mentioned above, since it is the lack of a unique and simple interpretation which has led to the recent codification. The origin of the present economic substance doctrine derives from an analysis of Gregory v. Helvering and its subsequent implications in the US and overseas. In general, the doctrine has been applied to transactions where a taxpayer undertakes a transaction or a series of transactions which are technically within the legislative and regulatory framework but which produce some form of tax benefit which is unlikely to have been intended by Congress or the regulators. One of the main issues related to interpretation of the doctrine has been that two different approaches have been taken regarding its application. Certain US courts have applied a “conjunctive test” which requires the taxpayer to establish the presence of both “economic substance” and “business purpose” in order for the transaction to survive judicial scrutiny. Others have used a “disjunctive test”, in which a business purpose or economic substance is sufficient for purpose, and it is precisely this contradictory approach which highlights the lack of a single interpretation of the economic substance doctrine.Part III briefly analyzes the new sections of the Internal Revenue Code (§) 1409 (hereinafter, IRC) which incorporates §7701(o). § 7701(o) is reviewed together with the Joint Committee on Taxation’s (JCT) Technical Explanation of the new codification. It also covers the proposed “angel list” of approved transactions which did not succeed in going forward.Part IV considers one of the most criticized aspects of the codification, namely the penalty provisions applied to transactions deemed to be lacking economic substance under the code, including some possible adverse consequences of the imposition of such penalties.Part VI reviews the EU perspective of the “Wholly Artificial Arrangement” doctrine applied by the European Court of Justice (ECJ) to curb abusive transactions compared with the application of the economic substance doctrine in the US. Part VI also considers how EU coordination is constrained by voting unanimity and how the legislation affects anti-abuse regulations, since EU Directives on one hand contain anti-abuse provisions directly applicable to Member States and on the other member states have domestic anti-abuse provisions which can be limited by EU law.This Wholly Artificial Arrangement doctrine has never been stated as a doctrine itself. Part VI sets out to establish an understanding of, and common requirements of, this doctrine based on EU law and ECJ decisions.

An Assessment of the Anti-Tax Avoidance Doctrines in the United States and the European Union

The codification of the economic substance doctrine in the United States has given rise to controversy there and in countries with investments in the United States. This article analyses the origin of this doctrine and the consequences of its codification. It also considers EU anti-tax avoidance legislation and court cases.

Codification of the Economic Substance Doctrine or how Congress Commemorated the Seventy-Fifth Anniversary of the Gregory Case

The year 2010 marks the 75th anniversary of Gregory v. Helvering, 293 U.S. 465 (1935), a landmark case in the area of corporate reorganizations. Gregory journeyed through the Board of Tax Appeals, the Second Circuit Court of Appeals, and eventually the Supreme Court in 1935. The concepts that evolved from the Gregory case include the business purpose test, continuity of business, the taxpayer’s right to minimize tax liability, step transaction doctrine, and the economic substance doctrine. As of November 30, 2010 the Gregory case had been cited 3,432 times, indicating that Gregory has passed the test of time. Earlier in this decade, the Treasury Department sought a codification of the economic substance doctrine, which had its origin in the Gregory case, as a necessary weapon to curb the growth of corporate tax shelters. While the doctrine had been part of the fabric of our tax system since Gregory, it had been eroded by some confusing and conflicting case law. On March 30, 2010 Congress granted this wish by codifying the economic substance rules as part of P.L. 111-152 entitled Healthcare and Education Reconciliation Act of 2010 Section 7701(o) of the Internal Revenue Code now reads: In the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if -- (A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position, and (B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction. In order to understand this new legislation it is necessary to explore the long and grand history of the Gregory case. In addition this paper will consider the merits and demerits of the codification of the economic substance doctrine.

High Volatility, Negative Correlation, Roth IRA Conversions, and the Codified Economic Substance Doctrine

This paper describes and analyzes an investment strategy that, when combined with simple Roth IRA conversion planning, can substantially reduce the tax costs of Roth conversions. The strategy leverages, through the combination of volatily and negative correlation, the put option feature inherent in Roth IRA recharacterizations. The only significant risk to taxpayers who execute the strategy is that the IRS might assert that the recently codified economic substance doctrine (and its strict liability penalty) applies to disallow the tax benefit. However, the doctrine appears not to be relevant in this context, where Congress has given taxpayers an explicit election to recharacterize Roth IRA conversions. Even if the doctrine were to apply, it would not likely increase current year tax liability.

Living with (and Dying by) the Codified Economic Substance Doctrine

This article examines recently enacted section 7701(o), codifying clarifications to the judicial economic substance doctrine, and the associated new strict liability penalty regime applicable to transactions that are found to lack economic substance. Section 7701(o) provides that for a transaction to satisfy the economic substance doctrine it must meet a conjunctive test requiring, first, that the transaction change the taxpayer’s economic position in a meaningful way apart from Federal income tax consequences, and, second, both that the taxpayer have a substantial nontax purpose for entering into such transaction. The article traces the origins of these requirements to various judicial applications of the economic substance doctrine, or one of the various other judicial anti-abuse doctrines, beginning with Gregory and going all the way up to the recent decisions of the Court of Appeals for the Fifth Circuit in Klamath Strategic Investment Fund v. United States. The article examines each of the subsections of § 7701(o) to put each of them in the context of prior case law, and where possible to make some assessment of the future impact of the various provisions. In this context the article compares various cases the outcome of which likely would not have been affected, or likely would have been affected, had section 7701(o) been in effect at the time of the transactions, ranging from Cottage Savings to the recent ConEd case. The article considers transactions that the legislative history suggests should be insulated from application of the economic substance doctrine and discusses practitioner suggestions that an “angel list” should be promulgated. Unlike most prior analysis, the article suggests that the Treasury’s hesitancy to promulgate an angel list is well founded.

Strictly Wrong as a Tax Policy: The Strict Liability Penalty Standard in Noneconomic Substance Transactions

This Note analyzes the propriety of using a strict liability standard to assess tax penalties for transactions lacking economic substance. Non-economic substance transactions lack legitimate business objectives and exist only to produce tax benefits. Under current law, the Internal Revenue Service can disallow the tax benefit claimed by the taxpayer and then assess a penalty for the taxpayer’s understatement of tax liability. In response, the taxpayer can assert a reasonable cause exception, which can serve as a defense to the penalty should the taxpayer demonstrate that he had reasonable basis for his tax position. In the last decade, numerous legislative proposals sought to eliminate the reasonable cause exception and replace it with a strict liability standard. This Note examines the conflict created by this potential change in the tax law. This Note begins by defining the economic substance doctrine, as used in the U.S. courts of appeals, to determine whether a transaction lacks economic substance. This Note then explains the accuracy-related penalty assessed for non-economic substance transactions, as well as the reasonable cause exception to the penalty. Two cases illustrate the interaction of the economic substance analysis, the tax penalty, and the reasonable cause exception. Next, this Note summarizes legislative proposals spanning from 1999 to 2009, which would codify the economic substance doctrine and adopt a strict liability penalty standard. The strict liability standard is then analyzed at length, as this Note discusses the arguments for and against it. Ultimately, this Note concludes that on balance, the strict liability standard should not be adopted, but regardless of whether the current penalty regime is retained or alternative solutions are developed, the reasonable cause exception should remain a feature of the standard by which to penalize non-economic substance transactions.

A Daddy-Daughter Chat About Economic Substance

Economic substance - the concept that a transaction should actually move money around - is one of a short list of doctrines designed to back stop the tax system. It is possible, indeed, the aim of not a few tax practitioners, to create transactions that meet the requirements of the Code - the letter of the law - but violate what some might say to be the intent of the Code - the spirit of the law. Proposals to codify the economic substance doctrine have been and will continue to be debated and rational minds differ about when, or if, the doctrine should be applied. This paper is an irreverent treatment of the doctrine.