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Economic Substance

INSTITUTE OF INTERNATIONAL BANKERS

ANNUAL TAX SEMINAR

JUNE 18-19 2007

David H. BrockwayMcKee Nelson LLP

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I. Case Law Developments Origins of Economic Substance Doctrine

• 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).  

• 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 tax-avoidance 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

• 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 sale-leaseback 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• 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”).

• 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 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• 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.”).

• 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• 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.

• 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).

• 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

• 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.”

• 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” TestAs 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 tax benefits of the overall transaction.

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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.