One of the IRS's most commonly invoked arguments in the corporate context is the economic substance doctrine. Under this doctrine, tax benefits are denied if the transactions giving rise to the claimed tax benefits lack "economic substance" apart from tax considerations.
Of course, this begs the question: when does a transaction with favorable tax consequences have "economic substance" apart from the tax benefits?
As every good tax attorney knows, the answer is always a resounding, "it depends."
Over the years, different courts have formulated varying approaches for evaluating the economic substance (or lack thereof) of a transaction. Some courts have adopted a two-prong test requiring corporate taxpayers to establish: (1) economic substance; and (2) a business purpose. See e.g., Pasternak v. Commissioner, 990 F.2d 893, 898 (6th Cir. 1993). Other courts have adopted a disjunctive approach requiring corporate taxpayers to establish either: (1) economic substance; or (2) a business purpose. See e.g., Black & Decker Corp. v. U.S., 436 F.3d 431 (4th Cir. 2006). Still, other courts have considered all relevant factors in evaluating questionable transactions, with economic substance and business purpose constituting non-determinative factors to be considered. See e.g., ACM Partnership v. Commissioner, 157 F.3d 231 (3d. Cir. 1998); Sacks v. Commissioner, 69 F.3d. 982, 985 (9th Cir. 1995).
In an effort to clarify the law on this point, Congress added Section 7701(o) to the Internal Revenue Code last year. Pursuant to Section 7701(o)(1), a transaction has "economic substance" if: (1) it changes the taxpayer's economic position in a meaningful way (apart from Federal income tax effects); and (2) the taxpayer has a substantial non-tax purpose for entering into the transaction.
Still, this begs the question: what types of non-tax benefits must a corporate taxpayer establish to demonstrate a "meaningful" non-tax change in economic position and what type of purpose must a corporate taxpayer have to establish a "substantial" non-tax purpose?
Because the Tax Code does not provide any guidance in this regard, it is necessary to look to court decisions.
PRONG 1: ECONOMIC SUBSTANCE. The most widely used formulation is an objective assessment of whether a "reasonable possibility of profit" exists. See Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89, 91 (4th Cir. 1985). Significantly, the "possibility of profit" inquiry is an objective one. This means that the relevant question is not whether the corporate taxpayer under evaluation saw a possibility for profit, but rather whether a reasonable corporate taxpayer would have seen a possibility for profit.So perhaps a transaction changes a taxpayer's economic position in a "meaningful" way so long as a "reasonable possibility of profit" exists. This is something that will be clarified by post-2010 cases that implicate the economic substance doctrine.
PRONG 2: BUSINESS PURPOSE. A transaction lacks business purpose if it would not have been consummated but for the tax consequences. See Helvering v. Gregory, 69 F.2d 809 (2d Cir. 1934). Or conversely, a valid business purpose exists if the transaction was consummated in spite of (rather than because of) the resulting tax consequences.Given the lack of case law evaluating the newly enacted Section 7701(o) of the Tax Code, it is difficult to articulate a bright-line standard as to what types of transactions have economic substance and valid business purposes apart from the beneficial tax effects. In the end, individual cases will turn on the specific facts and circumstances of the transaction under evaluation. In this regard, it is helpful to remember that, in tax law, substance is exalted over form. E.g., Commissioner v. Court Holding Co., 324 U.S. 331,334 (1945). Thus, the substance of the transaction will ultimately determine whether the tax benefits will be allowed, not the technical compliance with the Tax Code .
SOURCES:
- Pasternak v. Commissioner, 990 F.2d 893, 898 (6th Cir. 1993)
- Black & Decker Corp. v. U.S., 436 F.3d 431 (4th Cir. 2006)
- ACM Partnership v. Commissioner, 157 F.3d 231 (3d. Cir. 1998)
- Sacks v. Commissioner, 69 F.3d. 982, 985 (9th Cir. 1995)
- I.R.C. s. 7701(o)
- Helvering v. Gregory, 69 F.2d 809 (2d Cir. 1934)
- Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89, 91 (4th Cir. 1985)
- Commissioner v. Court Holding Co., 324 U.S. 331,334 (1945)
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