Economic Substance Principle
The Internal Revenue Service uses an economic substance test, often referred to as the economic substance principle, to identify sham transactions that exist solely to reduce or eliminate taxes. In addition, the courts use this same doctrine to rule on the legitimacy of activity between two or more parties.
This term ‘economic substance doctrine’ has other names including:
* Substance over Form Doctrine
* Sham Transaction(s)
* Sham in Substance Doctrine
The goal of this doctrine is to prevent taxpayers from subverting the legislative purposes of the Internal Revenue Code. Readers should understand that federal district and circuit courts define this doctrine slightly differently; but the underlying definition is straight forward. This doctrine typically affects income taxation, speciality taxes and relationships between partners/members in a partnership/membership.
This article is designed to introduce the meaning of a legitimate economic transaction along with court definitions. A separate section will cite examples of fraudulent transactions and the court’s interpretation of this rule.
For the reader, the goal is to understand the economic substance doctrine; how it is applied by the IRS; and of course, how the legal system interprets this principle and applies it to justice.
Economic Substance Doctrine – Principles and Definitions
The 16th Amendment implemented income taxation. Within 10 years, taxpayers had already begun to look for ways to circumvent taxation. The most common tool is to generate false losses that are technically legal in form. The very first big case was decided by the Supreme Court.
In effect the Supreme Court establishes the primary purpose of this doctrine. The taxpayer must prove that the underlying economic transaction was not concocted to avoid or reduce tax liability. In the Gregory Vs. Helvering case, the Supreme Court actually uses the word ‘sham’.
Over a period of 80 years the federal court system has developed a two part test to prevent subverting the legislative purpose of the tax code. One leg of the test addresses the subjective intent, that is, whether the taxpayer had a non-tax business goal for the transaction. The other leg focuses in on the objective intent, i.e. a reasonable possibility of profit. The next two subsections explain these two legs in more detail.
The subjective test looks at the taxpayer’s motivation for entering into the transaction. This motivation must also take into consideration the long held tenet that taxpayers are free to arrange their financial affairs to minimize overall taxation. This stems from the Revolutionary War era belief that no citizen is obligated to pay more than the law demands. Tax aversion is not illegal, tax evasion is.
(2) The 9th Circuit Court provided some guidance in MaGuire by setting up four criteria for identifying subjective intent.
1) Experience of the Taxpayer – There is a higher standard of care required for sophisticated entrepreneurs over novice businessmen. Sophistication is established with any one of these backgrounds – A) formal education in business including college; B) certification in a specialty such as real estate, stocks etc.; C) length in business, in general any full time duration of more than five years (the 10,000 hour guideline) demonstrates experience; and/or D) special knowledge of subject matter that relates to the transaction such as financial background, actuarial science or law.
2) Extent of Research into the Transaction – A common characteristic of many of these failed attempts is the swiftness of setting up the deal and signing the agreements. Subjective intent is demonstrated with extensive research of the issue at hand, the documentation of the multiple variations and the impact of each alternative. This process demonstrates or traces the thinking and goal of the transaction.
3) Use of Advisors and their Background Work on the Transaction – As with many economic transactions, especially complex negotiations outside consulting is engaged. This includes lawyers, accountants, bankers, brokers, insurance agents and specialists. Each of their respective inputs into the transaction is documented and their perspective is considered in determining the intent of the transaction.
4) Actual Motivation to Enter into the Transaction – The fourth criteria to consider is actual motivation, the primary objective, of entering into this transaction. Business decisions are usually made for the following reasons:
a) Profit Motive
b) Improvement of Business Position (Market Share)
d) Risk Reduction
The overall assumption is that the taxpayer is “acting like a prudent economic actor” in generating or conducting this transaction. The courts look at the above four criteria to identify true subjective intent of the taxpayer. To invalidate the motivation the courts looks at “a conspicuous lack of concern over the particulars of the transaction by the taxpayer”.
In general the federal courts hold that a lack of objective economic substance is sufficient by itself to disqualify a transaction. In addition, a transaction can also be disregarded as an economic sham if the sole subjective motivation is tax avoidance even if there is economic substance.
The basic question to answer is ‘Can the transaction generate a reasonable possibility of profit?’, the Fourth Circuit Court.
The key word is ‘reasonable’. Is there a reasonable expectation of profit, not a mere potential. If the goal is tax reduction then there is no beneficial interest for the taxpayer to support the transaction. The objective standard is that of a ‘rational’ or ‘prudent’ business person. This standard is simply whether or not the transaction has a realistic financial benefit to the taxpayer. The end result of profit must be exclusive of tax benefits.
The courts go further by raising the bar for the test by stating that a sophisticated business entrepreneur especially those with tax experience must demonstrate tax intent. The standard forces the burden of proof on the taxpayer that the transaction was intended for a profit.
Since many of these transactions involve multiple layers to complete the transaction, the courts turn to the step-transaction doctrine to determine whether a profit was the true intention. There are several tests of the step-transaction doctrine to prove a sound economic objective.
By the time these transactions are challenged by the IRS, the end result is either assured or established. The typical end result of most business transactions are earnings in excess of costs associated with those earnings, i.e. a profit. Sometimes the motivating business purpose may have little profit but achieve other business purposes such as:
* Lower Interest Rates on Debt – A debt restructuring can often reduce the effective costs of capital which is an acceptable business objective.
* Risk Reduction – Reducing risk of loss is considered an acceptable business purpose. However, the courts can use the substitution principle with insurance to also reduce risk exposure. The net result is if alternative methods of risk reduction exist, are their costs lower than the actual transaction? If true, then the transaction may be considered a sham as any prudent business person will always seek the least expensive alternative.
* Increased Control – If a transaction increases control over assets or overall operations it is considered a reasonable objective.
* Improves Legal Relations – Many transactions generate significant early losses (thus the significant tax savings) but have long term benefits including legal rights or position. This is very common in the purchase of intangible assets.
This particular test looks at the relationship of the parties before and after the transaction. Most sham transactions involve related parties whether family members or ownership by a single or few individuals of all companies participating. The more ‘arms-length’ the transaction and negotiations the more likely there is substance. This concept is even used in the field of agency. Look at this case’s basic relationship.
In this case the IRS collapsed this conduit mechanism to the point whereby the seller sold its assets of the company to the buyer and forced recognition of all gains. Since the agent was a related party, the IRS eliminated the middleman. The courts concurred.
The binding commitment test looks at the series of steps taken in the transaction to see if one step binds the business to the next step. In general, a series of transactions over several years is treated as economically sound whereas a short time span to complete the series of steps is more indicative of a sham. The courts use Fletcher, Cyclopedia of the Law of Private Corporations §6970.145, . This particular test has been rejected by the Supreme Court because the stair stepping nature of successive transactions culminating into a single transaction is tantamount to reaching.
(4) There are many factors to consider when looking at the profit analysis. As to historical context of the transactions, the courts are looking at the whole picture and not the details. What is the real economic goal of the transaction? Replacement of high interest debt with lower interest rates is an acceptable economic transaction, but a sale of assets to restructure debt to minimize taxation is the economic equivalent of a traditional sale with taxable implications (recognizing gains). Consideration is given to:
A) Control over the assets
B) Payments in substance
C) Timing of the transaction
D) Contribution of assets and loan transactions, are they integrated and interlocking?
E) Objective of an exchange of assets
As an example, many businesses will sell a major asset and then lease this asset back from the buyer with an option to buy it back at the end of the lease. In this case the leasing company is trying to garner tax advantages by depreciating the asset using accelerated depreciation. The IRS is effectively saying that this structure is merely a loan to the original owner of the asset. In AWG Leasing Trust V. United States (5) the court keyed in on the residual value at the end of the lease. The greater the residual value the more likely the transaction will pass the economic substance objective test. If little or no residual value or a true title transfer of the asset, the more likely the taxpayer will fail the objective standard of economic gain. Title transfer is defined as possessing the “benefits and binders” of ownership. Title of ownership allows the taxpayer to depreciate the asset and amortize financial costs for tax purposes.
Case Studies Involving Economic Substance Doctrine
Almost every single case involves taxpayers using creative mechanisms to reduce or take advantage of the tax code. The IRS challenges the taxpayer by using this doctrine. All of these cases involve millions of dollars of taxes and from the readings, the taxpayers honestly believe their actions were justifiable beyond the tax savings. In every case, the courts held in favor of the Internal Revenue Service.
The following are examples of tools used.
Arbitrage under the economic substance doctrine is simply tax attribute shifting. Some entities enjoy tax benefits, credits or lower/zero rates of taxation. Arbitrage is the process of transferring those tax attributes to a taxable entity reducing the receiver’s overall tax obligation.
One of the methods used is a tax indifferent entity (non-profits, governmental authority, utility, REITs etc.) selling their assets to the tax paying entity. Legally the title passes to the buyer. The taxpayer (buyer) turns around and leases the assets back to the same entity. The taxpayer takes depreciation and interest (financing) expense deductions thus reducing their tax obligation.
The courts look for non-legitimate attributes to disqualify the transaction including:
A) No secondary markets for the asset
B) Critical assets are leased back to the lessee
C) Unreliable appraisals
D) Dissimilar tax attributes/benefits between the two parties
E) Use of debit defeasance accounts (money set aside from the sale to make lease payments)
A sale-leaseback is very similar to tax arbitrage except both entities have similar tax attributes. In this situation the taxpayer is trying to take advantage of accelerated depreciation to reduce tax obligations early on and defer the tax obligation to later years. This works extremely well when the seller of the asset has loss carry-forwards that need utilizing immediately.
The most famous case cited by the courts is Rice’s Toyota World, Inc. V. Commissioner of the Revenue (6).
In this case the taxpayer buys an older used model computer and leases it back to the seller claiming title ownership of the computer. The taxpayer wanted to take advantage of the double-declining balance depreciation method available in those years and lower its taxable income. Here the courts looked at the residual value of the asset and the forms of respective notes, recourse and nonrecourse to evaluate the economic objective.
In this case the court’s decision that the residual value and the associated risk assumed was unreasonable given the duration of the lease. However, the court did allow the interest deduction as assigned in the recourse debt stating that if a part of the deal has economic substance then the associated benefits pass.
This is probably the more common form of tax avoidance. The idea is to disguise a transaction as a loan to take advantage of the interest deduction for tax purposes. The key is that traditional loans are not taxable income. Sham loans look like a loan but in reality are some form of constructive dividend or distribution.
In Schering-Plough V. Unitied States (7) a foreign subsidiary lent money to its U.S. based parent company. Under the tax code, a domestic corporation is taxed on dividends received from its foreign subsidiary. In this case the loan was a mask to constructive receipt of dividends. The key here is that the court stated that since the parties are related it is easy to contrive a fictional transaction.
Another alternative is to fake a loan as a sale. When a company has extensive loss carry-forwards and needs to take advantage of them they try to fake a sale. A sale of assets generates significant taxable gains due to prior depreciation taken. In MAPCO, Inc. V. United States (8) the courts held that a sale of future income (similar to an annuity) for a single lump sum payment is economically a loan and not a sale of an asset.
Notable Court Positions
What is interesting is how the various circuits interpret the two prong test. Most of the courts require both a business purpose and a profit motive. The Fourth Circuit will accept passing either test to satisfy economic substance. Whereas the Third Circuit requires as a minimum of a relationship between the two tests. The one court a taxpayer must get past is the Tax Court. The Tax Court looks for the profit motive as the standard to meet legal muster.
To counter this is the Eighth Circuit’s stance:
(9). For the reader the main idea is that to qualify; the transaction must have both a business purpose (other than tax savings) and an economic objective.
The result of all this is passing Treasury Regulation §1.701-2 of Chapter 26.
The Supreme Court carved out exceptions to this rule. In Lyon (10) a bank was precluded from building its own building by federal and state regulations. A member of its Board of Trustees, Frank Lyon, competed for and won the right to construct the building and lease the building back to the bank for upwards of 40 years with several opportunities for the bank to buy the building for the balance of the third party financing. Mr. Lyon had to front $500,000 of his own capital to complete construction. The Internal Revenue Service collapsed this leaseback deal as a sham because economic title was held by the bank.
The Supreme Court deemed this transaction as having economic substance for the following five reasons:
1) The bank was precluded to build the building by federal regulations; AND
2) The taxpayer was independent of the bank and financing sources; AND
3) The taxpayer was liable for the construction loan and mortgage note; AND
4) The accounting method matched the economic transaction; AND
5) The taxpayer risked $500,000 as a part of constructing the building.
One of the key elements in this case was the risk shifting. Mr. Lyon exposed himself to real and substantial risk. This includes the bank going out of business, merger with another bank, economic collapse and the real possibility the bank would move out and not renew the lease. In addition, Mr. Lyon used up some of his borrowing capacity and therefore reduced his business opportunities in other arenas of business.
Summary – Economic Substance Principle
Taxpayers have historically tried to beat taxation through technical trickery. The Internal Revenue Service uses Regulation 1.701-2, the economic substance doctrine, as its trump card to assess taxation. This doctrine forces the taxpayer to comply with the spirit of the Internal Revenue Code.
Simply put, the doctrine states that absent the tax benefits, the transaction must affect the taxpayer’s financial position in a positive way.
The taxpayer must prove two elements or tests to meet the standards as set by the federal courts. The first prong is a subjective business purpose test. This test focuses on the motivation of the transaction. This motivation is analyzed based on the experience of the taxpayer, the extent of research involved, the use of advisers and the underlying reasons motivating the taxpayer.
The second prong of the two elements is the objective test. This test focuses in on profit and other objective standards (measurable) found in business. The key is a reasonable expectation of profit as is customarily used by a rational or prudent businessman. Is there a realistic chance of a good profit to be made from the deal?
The Supreme Court has carved out some exceptions to these standards including transactions culminating from regulatory restrictions, true arms-length negotiations, risk shifting and liability. Use this doctrine as a guide towards researching the specifics of your transaction. ACT ON KNOWLEDGE.
(1) Evelyn F. Gregory Vs. Guy T. Helvering, Commissioner of the Internal Revenue [T9 L. ED 596], (293 U.S. 465-470) U.S. Supreme Court Decided January 7, 1935
(2) MaGuire Partners – Master Investments, LLC V. United States 9th Circuit Court, No. CV 06-07371-JFW (RZx), Lexis 8361
(3) Enbridge Energy Co. V. United States, 553 F. Supp. 2d 716 March 31, 2008
(4) United States V. G-I Holdings Inc.
(5) AWG Leasing Trust V. United States, 592 F. Supp. 2d 953 May 28, 2008
(6) Rice’s Toyota World, Inc. V. Commissioner of the Revenue, 752 F. 2d 89; 1985 U.S. Appeals Court
(7) Schering-Plough V. United States, 651 F. Supp. 2d 219
(8) MAPCO Inc. V. United States, 556 F. 2d 1107, 214 Court of Claims 389
(9) WFC Holdings Corp. V. United States, 728 F. 3d 736
(10) Frank Lyon Co. V. United States, 435 U.S. 561, 55 L. ED 2d 550, 98 S. CT. 1291 Decided April 18, 1978
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