Friday, June 28, 2013

Economic substance doctring

Economic Substance Doctrine

Economic substance analysis begins with Gregory v. Helvering, 293 U.S. 465 [14 AFTR 1191] (1935), “the Supreme Court's foundational exposition of economic substance principles under the Internal Revenue Code.” ACM P'ship v. Comm'r, 157 F.3d 231, 246 [82 AFTR 2d 98-6682] (3d Cir. 1998).

 In Gregory, the taxpayer engaged in a series of transactions which were technically consistent with the Internal Revenue Code but which lacked any real economic substance and defeated the purpose of the Code provisions. 293 U.S. at 467–70. The taxpayer attempted to avoid paying taxable dividends on stock transfers from her wholly-owned corporation by first creating a new corporation to which she transferred the stock, and then liquidating the new corporation and transferring the stock to herself. Id. at 467–68. She claimed that the transaction did not create taxable dividends because she had received the stock ““in pursuance of a plan of reorganization”” within the meaning of the Internal Revenue Code. Id. at 468–69 (citation omitted). Although the transactions technically fell within the definition of a corporate reorganization, which normally would have meant that the transfers were exempt from taxation, the Court held that the IRS could collect tax on the dividends. Id. at 469–70. The Court explained that “[t]he whole undertaking, though conducted according to the terms [of the statute], was in fact an elaborate and devious form of conveyance masquerading as a corporate reorganization” and as such it defeated the “plain intent” of the Internal Revenue Code. Id. at 470. Therefore, pursuant to the cours will look to determine whether a claimed deduction “exalt[s] artifice above reality,” or “look beyond the form of [a] transaction” to determine whether it has the “economic substance that its form represents,”CM P'ship , 157 F.3d at 247 (citation and alteration omitted); accord Freytag v. Comm'r, 904 F.2d 1011, 1015 [66 AFTR 2d 90-5322] (5th Cir. 1990) (“The fundamental premise underlying the Internal Revenue Code is that taxation is based upon a transaction's substance rather than its form. Thus sham transactions are not recognized for tax purposes, and losses allegedly generated by such transactions are not deductible.”), aff'd on other grounds, 501 U.S. 868 [68 AFTR 2d 91-5025] (1991).

The Supreme Court has explained that a “natural conclusion” of its holding in Gregory was that transactions that “do not vary control or change the flow of economic benefits[ ] are to be dismissed from consideration.” Higgins v. Smith, 308 U.S. 473, 476 [23 AFTR 800] (1940); accord Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1355 [98 AFTR 2d 2006-5249] (Fed. Cir. 2006). This Court, the Federal Circuit, and other Courts of Appeals have followed a similar approach. See Klamath, 568 F.3d at 543. 36

A lack of economic substance is sufficient to invalidate the transaction regardless of whether the taxpayer has motives other than tax avoidance.as noted by theSupreme Court's prescript in Frank Lyon Co. v. United States, 435 U.S. 561 [41 AFTR 2d 78-1142] (1978), which addressed the factors courts should consider when assessing whether a transaction lacks economic substance.

Frank Lyon generateda “multi-factor test for when a transaction must be honored as legitimate for tax purposes,” including whether the transaction: “(1) has economic substance compelled by business or regulatory realities, (2) is imbued with tax-independent considerations, and (3) is not shaped totally by tax-avoidance features.  The transaction must exhibit objective economic reality, a subjectively genuine business purpose, and some motivation other than tax avoidance.” Southgate Master Fund, LLC ex rel. Montgomery Capital Advisors, LLC v. United States, 659 F.3d 466, 480 [108 AFTR 2d 2011-6488] (5th Cir. 2011).

Importantly, these factors are phrased in the conjunctive, meaning that the absence of any one of them will render the transaction void for tax purposes. Thus, if a transaction lacks economic substance compelled by business or regulatory realities, the transaction must be disregarded even if the taxpayers profess a genuine business purpose without tax-avoidance motivations..


When applying the economic substance doctrine, the proper focus is on the particular transaction that gives rise to the tax benefit, not collateral transactions that do not produce tax benefits.  Transactions lack objective economic reality if they “do not vary, control, or change the flow of economic benefits.””Southgate , 659 F.3d at 481 (citation and alteration omitted). “The objective economic substance inquiry asks whether the transaction affected the taxpayer's financial position in any way.” Id. at 481 n.41 (citation, quotation marks, and alterations omitted). “This is an objective inquiry into whether the transaction either caused real dollars to meaningfully change hands or created a realistic possibility that they would do so[,]” meaning ““a reasonable possibility of profit from the transaction existed apart from tax benefits.”” Id. at 481 & n.43 (citation and other footnote omitted). “That inquiry must be “conducted from the vantage point of the taxpayer at the time the transactions occurred, rather than with the benefit of hindsight.”” Id. at 481 (citation omitted).


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