Sorting Out the Tangle of Economic Substance
David P. Hariton
Sullivan & Cromwell
Tax Lawyer, Vol. 52, No. 2, Winter 1999
This article is written in response to Judge McKee's dissent from the Third Circuit affirmence of the Tax Court's decision for the Commissioner ACM v. Commissioner. "I can't help bus suspect," Judge McKee said, That the majority's conclusion to the contrary is, in its essence, something akin to a "small test." If the scheme in question smells bad, the intent to avoid taxes defines the result as we do not want the taxpayer to "put one over." ... The fact that ACM may have "put one over" in crafting these transactions ought not to influence our inquiry. Our inquiry is cerebral, not visceral. To the extent that the Commissioner is offended by these transactions he should address Congress and or the rulemaking process, and not the courts.
I disagree, and I endeavor below to shed light on both the proper role and the proper operation of the economic substance doctrine. My analysis is based on the language of relevant decisions that have been handed down over the past sixty-five years. In brief, the conclusions I reach are as follows:
First, the economic substance doctrine is not just a small test, because it only applies to transactions which lack economic substance. The doctrine permits taxpayers to retain even the most egregious tax benefits if they arise from transactions with meaningful economic consequences. Colgate would not have lost under the economic substance doctrine if, for example, it had purchased an office building, rather than an AA- rated note, and sold it the following year for cash plus contingent payments (unless the sales price had been locked in).
Second, tax benefits will not be disallowed merely because they arise from transactions which lack economic substance, Rather, if the transactions lack economic substance, then the court may overturn the formalistic results. The court may still decide, however, that the formalistic results are not disturbing enough to be overturned. After all, form, not substance, determines tax liabilities under a realization-based income tax.
Third, economic substance is not about profit potential. Any transactions with significant net equity will produce a significant profit. A transaction only has economic substance, however, if it alters the taxpayer's economic position in a meaningful way (apart from its tax consequences). A complicated way of investing cash lacks economic substance - even though it obviously produces profit - if it leaves the taxpayer in substantially the same position as if the cash had been left in the bank. Taking a naked position in commodities has economic substance, however, even if it is likely to produce a loss. Economic substance must be judged in relation, however, to the size of relevant tax benefits.
Finally, a more complex, tax-advantaged way of executing a transaction should not lack economic substance if the transaction itself has economic substance. A court must distinguish, however, between real and merely purported relationships in this regard. For example, there was no meaningful economic difference between using several "mirror" subsidiaries and using just one subsidiary to acquire a target corporation in the 1980s. The mirror subsidiaries were a way of effecting an acquisition, however, in the sense that if they were eliminated, what remained would not have been a more direct acquisition, but rather no acquisition at all. By contrast, Colgate argued that its contingent installment sale ("CINSI") transaction was merely a tax-advantaged way of repurchasing outstanding Colgate debt. If one eliminated the CINS transaction, however, the subsequent repurchase of Colgate debt would not have been affected (and conversely, after the CINS transaction was completed, the outstanding Colgate debt still had to be repurchased). Moreover, the relevant tax benefit (a large capital loss) bore no relation to the repurchase of outstanding debt. In fact, the CINS transaction was just a complex way of investing cash which lacked economic substance.
Accepted Paper Series
Date posted: July 5, 2001
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