The Economic Substance Doctrine: A U.S. Anti-Abuse Rule

• Published date: 05 May 2022
• Subject Matter: Tax, Income Tax, Tax Authorities
• Law Firm: Ruchelman PLLC
• Author: Mr Stanley Ruchelman and Neha Rastogi

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....