This post is another general introduction post that will serve as an anchor for future posts on economic substance. It is not all that interesting by itself, but for those not familiar with the tax law’s economic substance doctrine, it can serve as a primer.
Analysis under the economic substance doctrine should generally precede analysis under substance over form doctrines such as tax ownership, step-transaction, debt versus equity, etc. It’s somewhat axiomatic that substance over form analysis is not particularly relevant when the transaction had no substance in the first place.
In short, the economic substance doctrine requires that the transaction must not have been done solely for tax reasons; that there must be some other independent business purpose for the transaction. In applying the economic substance doctrine, I generally walk through a three-part analysis (which is not all that original).
- Determine if the tax benefit obtained/sought is outside the scope of the doctrine.
- Define the scope of the transaction that you are testing.
- Apply the economic substance doctrine to the transaction as defined in the last step.
- Determine if the tax benefit obtained/sought is outside the scope of the doctrine.
There are obviously all sorts of tax benefits that were implemented by Congress to incentivize taxpayers to engage in certain activities. To deny those tax benefits on economic substance grounds would clearly undermine the intent of Congress.
Some of those tax benefits seem obvious, such as the low income housing tax credits, energy production credits, etc. However, some benefits that are intended are the subject of continuing controversy, such as foreign tax credits. Foreign tax credits generally exist to relieve US taxpayers from being taxed twice on foreign source income (once by a foreign country and then a second time by the US). While that seems simple enough, there are several structured transactions where US taxpayers may have gone beyond the intent of the provision in an attempt to secure a benefit beyond relief from double taxation. Therefore, merely because a benefit is intended by Congress, it does not necessarily qualify for a blanket exemption from the application of the economic substance doctrine simply because it meets the statutory requirements. In those cases, courts will scrutinize a transaction to determine if the taxpayer secured a tax benefit beyond the intent of the provision.
In addition to being exempt because it is an intended benefit, certain provisions may also contain their own anti-abuse provisions that make the economic substance doctrine irrelevant. In particular, they may have a tighter standard than the economic substance doctrine. For example, IRC 269 applies to certain acquisitions where the “principal purpose” of the acquisition was evasion or avoidance of Federal income tax. Because this requires only a “principal purpose” of tax evasion/avoidance as opposed to a sole purpose, you’d typically think the economic substance doctrine was irrelevant where 269 was applied. However, due to the application of penalties under the new codified economic substance doctrine in IRC 7701(o), this may no longer be true.
- Define the scope of the transaction.
After determining that the tax benefit isn’t immune to the application of the economic substance doctrine, the next thing to do is define the scope of the transaction being analyzed. This seems like it should be a fairly easy task but it really isn’t and there isn’t a lot of guidance on how to do it.
Here’s what the IRS had to say about the scope of the transaction Notice 2014–58 (“Additional Guidance Under the Codified Economic Substance Doctrine and Related Penalties”):
“transaction” generally includes all the factual elements relevant to the expected tax treatment of any investment, entity, plan, or arrangement; and any or all of the steps that are carried out as part of a plan. Facts and circumstances determine whether a plan’s steps are aggregated or disaggregated when defining a transaction.
Generally, when a plan that generated a tax benefit involves a series of interconnected steps with a common objective, the “transaction” includes all of the steps taken together – an aggregation approach. This means that every step in the series will be considered when analyzing whether the “transaction” as a whole lacks economic substance. However, when a series of steps includes a tax-motivated step that is not necessary to achieve a non-tax objective, an aggregation approach may not be appropriate. In that case, the “transaction” may include only the tax-motivated steps that are not necessary to accomplish the non-tax goals – a disaggregation approach.
This amounts to a lot of confusing babble where it seems that the IRS will apply economic substance to all of the aggregate steps in the transaction except in cases where they won’t. It’s not entirely the wild wild west though, as the IRS does establish its own standard for disaggregating a step: the transaction will generally be reviewed as a whole except that a tax-motivated step that is “not necessary” to achieve a non-tax objective.
This seems like a very tight standard since a “tax-motivated step” can be helpful for achieving an objective even if it falls short of being necessary. Moreover, even if a tax-motivated step is not even helpful, it can be a fairly integrated (if not integral) part of the overall strategy.
Defining a transaction can be a crucial step in determining whether the transaction is considered tax-motivated or not. For example, let’s take a simple transaction where a non-US taxpayer purchased a dividend paying US stock. Upon realizing that the dividend would be subject to a US withholding tax rate of 30%, the non-US taxpayer decided to switch from a holding the US stock directly to a swap that references that same stock. Assume also that we know that the only reason the non-US taxpayer switched was for tax reasons (i.e., if not for the tax advantage the taxpayer otherwise hates swaps).
If you define the transaction as the switch from stock-to-swap not inclusive of the original investment decision, then based on my assumption, this transaction is clearly solely tax motivated and would likely fail under the economic substance doctrine. If you viewed the transaction as including the non-US taxpayer’s original decision to purchase the stock and the switch from stock-to-swap, then the transaction likely has economic substance since the non-US taxpayer’s original investment decision to buy the stock surely had non-tax motivation.
While it may seem tempting to say that, of course, the switch from stock-to-swap must be viewed in isolation, consider two taxpayers: one who entered into a swap in the first place (and therefore should clearly satisfy the economic substance doctrine in choosing swap over stock), and the other who switched from stock-to-swap only after realizing their error. In my mind, it seems rather silly to claim that the first taxpayer should be treated differently from the second taxpayer. Of course, maybe it’s justifiable under the general rule that smart taxpayers deserve better treatment that stupid ones, but arriving at that result under the auspices of economic substance doctrine seems weird.
That said, the definition of the transaction can be the one place where the economic substance doctrine can be clawed or de-clawed in ways that seem almost arbitrary.
- Analyze the transaction using the subjective and/or objective test:
Once the transaction has been defined, now it’s time to apply the core of the economic substance doctrine. Under common law, the economic substance doctrine had a subjective and an objective component whose theoretical (if not practical) application varied from jurisdiction to jurisdiction.
The subjective component of the doctrine is the mens rea part of the test. That is, it depended on the intent of the person engaging in the transaction. Was the person engaging in the transaction solely for tax purposes? Because the test is “subjective”, it depended only on the state of the mind of the person engaged in the transaction.
The objective component of the transaction requires that the transaction change the taxpayer’s economic position in a meaningful away (apart from Federal income tax effects). For this test, the taxpayer’s state of mind is irrelevant; it requires that some real observable change in the taxpayer’s economic position take place.
As mentioned above, the above two tests were not applied consistently across all jurisdictions. Some of the ways they have been applied include:
- Subjective test applied only with facts and circumstances (I view this as applying the objective test to determine the credibility of the taxpayer’s subjective state of mind).
- Taxpayer must satisfy both the subjective and objective test.
- Taxpayer must satisfy the subjective or the objective test.
Because of the confusion and the disparate treatment of the various jurisdictions (and a lust for vengeance), Congress codified the economic substance doctrine in March 2010 in IRC 7701, requiring that the taxpayer pass both the subjective and the objective test. In addition to requiring both the subjective and the objective test to be satisfied, Congress also provided that if the potential for pre-tax profit is used to satisfy the subjective/objective test, the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits.
Lastly, Congress also instituted a penalty for when a transaction failed due to the application of the economic substance doctrine: 40% if not disclosed and 20% if disclosed.
These new twists added by Congress clean up some of the ambiguity that existed under case law (e.g., subjective and/or objective tests) but add some new ones to the mix (what is “substantial”?).