[Lyric] The Economic Substance Doctrine (Joseph Bankman)

For more than fifty years, courts have interpreted and applied the tax
Law with the aid of various “common law” doctrines, such as substance
Over form, step transaction, business purpose, sham transaction, and
Economic substance. Notwithstanding this long lineage, the application of
The doctrines has always been controversial. Over the years, a wide swath
Of leading academics and practitioners have debated the wisdom of the
Doctrines, either in articles or in public fora. The intensity and frequency of
This debate has tended to fluctuate over time, with what, for want of a better
Term, might be called the “tax landscape.” In one period, economic and
Legal conditions encourage aggressive taxpayer positions, the government
Challenges those positions with common law doctrines, and the debate over
The use of the doctrines waxes. The law changes, economic conditions
Change, taxpayers have less incentive to take aggressive positions, and the
Common law doctrines fall into relative desuetude
The recent phenomenon of corporate tax shelters has produced a
Resurgence in the use of common law doctrines. The Treasury has
Responded to shelters by stuffing “anti-abuse” provisions into all significant
Regulations; the anti-abuse provisions are, at core, codifications of common
Law doctrines

The Treasury and other lawmakers have proposed statutory
Cures for the tax shelter problem; the cures, like the regulations, are built
Ralph M. Parsons Professor of Law and Business, Stanford Law School; member of the
University of Southern California Law School faculty, 1984–1989
1. See, e.g., Treas. Reg. §§ 1.701, 1.1374-4, -9 (2000).6 SOUTHERN CALIFORNIA LAW REVIEW [Vol. 74:5
Around common law doctrines

And in a series of significant cases, courts
Have accepted the government’s arguments and used common law
Doctrines to deny tax benefits to shelter participants. The common law
Doctrines are closely related to one another, and no single doctrine has done all the work. That said, the economic substance doctrine has played a particularly important role in the government’s fight against corporate tax
Shelters. Proposed legislation incorporates the doctrine, or portions of the
Doctrine; the same is true of recently adopted regulations. And in a handful
Of cases decided within the past year, the economic substance doctrine has
Been used to deny tax benefits aggregating to many billions of dollars
These developments have spawned a new debate (or renewed a
Somewhat dormant debate) over the use of common law doctrines in
General, and the use of the economic substance doctrine in particular. As
Might be expected, those moved to write or speak on the subject have had
Strong views and ambitious agendas. This does not detract from the merits
Of their contributions. The literature on these related topics is full of smart
Observations, as are public presentations. The somewhat partisan nature of
The discourse, however, leaves unresolved some basic questions as to the
Nature of the economic substance and other common law doctrines
This article tries to fill a void in the literature by providing an
Overview of the economic substance doctrine. The article is primarily
Descriptive. The goal is to provide as straightforward an explication of the
Doctrine as is possible; to explore the doctrine’s ambiguities, and to predict
As much as possible, how the doctrine would apply in various real-world
Situations
Inevitably, description turns into prescription. The article will from
Time to time take the position that a particular ambiguity is “best” resolved
In one way or another, or that a particular reading of the doctrine is “most
Reasonable” or “most consistent with underlying intent.” To that limited
Extent, this article is normative. It can be thought of as a guide for
Administrators deciding whether to invoke the doctrine or for judges forced
To interpret the doctrine
This article does not take a position on broader questions involving the
Use of common law doctrines in general, or the economic substance
2. See Abusive Tax Shelter Shutdown Act of 1999, H.R. 2255, 106th Cong. § 3 (1999)
[Hereinafter Tax Shelter Act of 1999] (definition of “noneconomic tax attribute” disallowed under the
Act based upon economic substance doctrine); U.S. TREASURY DEP’T, THE PROBLEM OF CORPORATE
TAX SHELTERS: DISCUSSION, ANALYSIS AND LEGISLATIVE PROPOSALS, JULY 1, 1999, at 95
[Hereinafter TREASURY PROPOSALS] (incorporation of the economic substance doctrine into definition
Of “tax avoidance transaction” in Administration’s proposals).2000] ECONOMIC SUBSTANCE DOCTRINE 7
Doctrine in particular. It does not, for example, compare the doctrines to
Other proposed cures for the problem of tax shelters or statutory ambiguity
Nor does this paper address in any detail a related, though broader and
More diffuse, debate over statutory interpretation in tax. It does not, for
Example, take a position as to whether statutes ought to be read in the
“practical” manner suggested by Michael Livingston, or the “purposive”
Manner suggested by Robert Thornton Smith
3
The article assumes that, at
Least for the near future, the economic substance doctrine will be part of the
Tax landscape, and discusses how that doctrine is likely to be, and ought to
Be, interpreted.
I. A BRIEF HISTORY AND OVERVIEW OF THE ECONOMIC
SUBSTANCE DOCTRINE

The economic substance doctrine has its origin in, and incorporates
Language from, cases such as Frank Lyon Co. v. United States, Knetsch v
3. See generally Michael Livingston, Practical Reason, “Purposivism,” and the Interpretation
Of Tax Statutes, 51 TAX L. REV. 677 (1996) [hereinafter Livingston, Practical Reason]; Robert
Thornton Smith, Business Purpose: The Assault upon the Citadel, 53 TAX LAW. 1 (1999) [hereinafter
Smith, Business Purpose]; Robert Thornton Smith, Interpreting the Internal Revenue Code: A Tax
Jurisprudence, 72 TAXES 527 (1994). Not surprisingly, interpretive theories in tax are related to and in
Part derived from a more general literature on statutory interpretation. Livingston’s interpretive
Position is based on the pragmatic, practical approach associated with Eskridge and Frickey. Under that
Approach, the mode of interpretation will vary from case to case, depending on the age of the statute, the
Legislative history, the policy issues involved, and so on. See WILLIAM N. ESKRIDGE, JR. & PHILIP P
FRICKEY, CASES AND MATERIALS ON LEGISLATION 603–04 (2d ed. 1995); William N. Eskridge, Jr. &
Philip P. Frickey, Statutory Interpretation As Practical Reasoning, 42 STAN. L. REV. 321 (1990);
Livingston, Practical Reason, supra. Smith, on the other hand, espouses a purposivist approach
Inspired by, or at least most often associated with, Ronald Dworkin, whom Smith frequently cites. In
Passages cited by Smith and others, Dworkin argues that the judge may be properly viewed as an author
Of the statute she is interpreting, albeit an author who owes special deference to the original drafters as
Coauthors. See Smith, Business Purpose, supra, at 16–19. Other tax scholars who have written on this
Topic include, notably, Deborah Geier and Lawrence Zelenak. See Deborah A. Geier, Interpreting Tax
Legislation: The Role of Purpose, 2 FLA. TAX REV. 492 (1995); Deborah A. Geier, Textualism and Tax
Cases, 66 TEMP. L. REV. 445 (1993); Lawrence Zelenak, Thinking About Nonliteral Interpretation of
The Internal Revenue Code, 64 N.C. L. REV. 623 (1986). Interpretive approaches to tax statutes are
Discussed throughout this article. See infra Part II.A (discussing relationship between economic
Substance doctrine and interpretive theory). For the most part, however, the doctrine is described
Without specific reference to interpretive theory. This is because, at least among those who invoke the
Doctrine, the link between interpretive approach and doctrinal application is not obvious. Those falling
Anywhere along the spectrum between intentionalist and purposivist, or varying between those points
Are apt to apply some elements of the doctrine in quite similar ways. E.g., infra Part III.B.2 (noting that
The exception for ordinary course of business operations is apt to appeal to those holding a wide range
Of interpretive positions). The same is true for the limited prescriptive comments in this paper. For
Example, the argument that the presence of tax benefits, however massive, should not threaten the tax
Treatment of an investment with an otherwise acceptable before-tax rate of return will (hopefully) be
Attractive to those with a wide range of interpretive positions.8 SOUTHERN CALIFORNIA LAW REVIEW [Vol. 74:5
United States, Gregory v. Helvering, and Goldstein v. Commissioner

4
More recent antecedents of the doctrine include cases such as Lerman v
Commissioner, Horn v. Commissioner, Kirchman v. Commissioner, Rose v
Commissioner, and Rice’s Toyota World, Inc. v. Commissioner

5
For the
Purposes of this article, it will be useful, if arbitrary, to date the current
Version of the doctrine from the Third Circuit decision in ACM Partnership
V. Commissioner

6
ACM involved a contingent installment sale (CINS) shelter purchased
By Colgate-Palmolive from Merrill Lynch. The shelter, greatly simplified
Worked as follows. Colgate-Palmolive and a zero-bracket taxpayer entered
Into a partnership; the zero-bracket taxpayer was allocated over 80% of all
Items of gain and loss. The partnership deposited $175 million in interestbearing accounts and a short while later purchased Citicorp debt for $175 million. Less than a month after the purchase of the Citicorp debt, the
Partnership sold the debt for $140 million cash and six-year notes pegged
To the London Interbank Offering Rate (LIBOR) with a fair market value of
Approximately $35 million. The transaction was reported under the
Installment method. The “correct” tax treatment of the transaction would
Have been (and would be) to reduce the LIBOR notes to their fair value of
$35 million, generate a so-called “gain ratio” under the installment method
Of 0%, and apply that ratio to each payment of principal. The regulations
Then in effect, however, established a “default rule” that forced the taxpayer
To recover basis in equal amounts over the period of contingent payments

7
Here, this resulted in the recovery of only one-sixth of the basis in the first
Year. The default rule produced gain of approximately $110 million in the
First year—$140 million received less $30 million basis recovered
Pursuant to the partnership agreement, over 80% of this gain was allocated
4. Frank Lyon Co. v. United States, 435 U.S. 561 (1978); Knetsch v. United States, 364 U.S
361 (1960); Gregory v. Helvering, 293 U.S. 465 (1935); Goldstein v. Comm’r, 364 F.2d 734 (2d Cir
1966). Gregory is widely seen as a precursor to ACM Partnership v. Commissioner and other recent
Cases in large part because it offered a (relatively) reasoned support for nonliteral interpretation of the
Tax law. The other cases cited above apply a nonliteralist approach to shelter-like transactions

5. Lerman v. Comm’r, 939 F.2d 44 (3d Cir. 1991); Horn v. Comm’r, 968 F.2d 1229 (D.C. Cir
1992); Kirchman v. Comm’r, 862 F.2d 1486 (11th Cir. 1989); Rose v. Comm’r, 88 T.C. 386 (1987)
Aff’d, 868 F.2d 851 (6th Cir. 1989); Rice’s Toyota World, Inc. v. Comm’r, 81 T.C. 184 (1983), aff’d in
Part and rev’d in part, 752 F.2d 89 (4th Cir. 1985). The court in Rice’s Toyota World separately
Analyzed the business purpose and objective economic substance of the transaction but did not describe
The former as a part of the economic substance test; Rose concludes that an approach emphasizing
Objective factors is preferable in tax shelter cases, but enfolds some consideration of subjective intent in
Its economic substance test; Kirchman and Lerman develop the “objective” economic substance test

6. 157 F.3d 231 (3d Cir. 1998)

7. Taxpayers were allowed to petition out of the default rule; this, of course, Colgate-Palmolive
Declined to do.2000] ECONOMIC SUBSTANCE DOCTRINE 9
To the zero-bracket taxpayer. The remaining five-sixths of basis
Approximately $145 million, was left in the $35 million of LIBOR notes
This left a “built-in loss” of $110 million in the LIBOR notes. Had the
Zero-bracket taxpayer remained in the partnership, it would have recovered
More than 80% of this loss, offsetting the income it recognized in the year
Of sale. Similarly, the capital account of the zero-bracket partner, increased
By its share of the $110 million gain in year one, would have decreased by
Its share of the $110 million loss. In fact, after absorbing the majority of
Income, the zero-bracket taxpayer was redeemed by the partnership for an
Accommodation fee, leaving Colgate-Palmolive to recognize all of the
Built-in loss

After engaging in the above transaction, the partnership used the
Proceeds from the Citicorp sale to repurchase long-term debt ColgatePalmolive had issued some years earlier
The court in ACM scrutinized the transaction under the economic
Substance test, which it described as containing separate, but interrelated
Inquiries:

The inquiry into whether the taxpayer’s transactions [have] sufficient
Economic substance to be respected for tax purposes turns on both the
“objective economic substance of the transactions” and the “subjective
Business motivation” behind them. However, 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
8
The court defined the objective test as asking “whether the transaction
Has any practical economic effects other than the creation of income tax
Losses.”
9
The court compared the purchase of Citicorp debt for $175
Million and sale of the debt for $140 million and $35 million in LIBOR
Notes to leaving the entire $175 million in interest-bearing accounts for an
Additional few weeks and then simply purchasing equivalent LIBOR notes
The court noted that the transitory purchase and sale of Citicorp debt
Produced only an additional $3,500 in interest income, an amount that was
“obliterated” by transaction costs associated with the purchase
10
The subjective leg of the economic substance test looks to business
Purpose. Colgate-Palmolive argued the investment offered a “realistic
8. ACM, 157 F.3d at 247 (citations omitted)
9. Id. at 248 (quoting Jacobson v. Comm’r, 915 F.2d 832, 837 (2d Cir. 1990))
10. Id. at 249–51.10 SOUTHERN CALIFORNIA LAW REVIEW [Vol. 74:5
Prospect” of pretax profit; the facts of the case gave the court little pause in
Rejecting that argument. Colgate-Palmolive also argued that the investment
Served a nontax purpose, albeit in an indirect way. The purpose of all the
Transactions, according to the taxpayer, was to repurchase long-term
Colgate-Palmolive debt through the partnership
11
The Citicorp transaction
Served as an interim investment by the partnership until Colgate-Palmolive
Could effect that purpose and repurchase its long-term debt. The ACM
Court rejected that argument, holding that the Citicorp debt was unrelated to
The subsequent repurchase of the taxpayer’s debt
12
A nearly identical shelter sold by Merrill Lynch to Brunswick
Corporation led to the same result under the same rationale in a more recent
Tax Court case, Saba Partnership v. Commissioner
13
The explication of
The economic substance doctrine in Saba differs from that in ACM only in
One slight respect: Judge Nims’ decision in Saba is marginally more
Explicit as to the relationship between pretax profit and objective economic
Substance
14
In other recent cases, the economic substance doctrine has been used
To deny interest deductions on corporate-owned life insurance (COLI) to
Winn-Dixie Stores, to deny foreign tax credits to Compaq Computer, and
To reallocate income to the United Parcel Service and away from a related
Foreign corporation
15
11. According to the taxpayer, it had decided that interest rates were to fall, making its long-term
Debt an expensive method of financing. The debt was to be repurchased through the partnership
Because such a purchase could remain hidden from public view. Colgate-Palmolive argued that if its
Purchase of long-term debt were known to “the market,” the company would become vulnerable to
Hostile takeover
12. The ACM court also noted that the Citicorp transaction was inconsistent with the ostensible
Rationale for the partnership. As noted supra in text and note 11, the partnership was to repurchase the
Taxpayer’s long-term debt primarily because the taxpayer had concluded interest rates were to fall. But
The LIBOR notes were effectively interest-only notes (on a notional sum) and would decline in value as
Interest fell

13. 78 T.C.M. (CCH) 684 (1999)

14. See id. at 720–21

15. Winn-Dixie Stores, Inc. v. Comm’r, 113 T.C. 254, 294 (1999); Compaq Computer Corp. v
Comm’r, 113 T.C. 214, 225 (1999); UPS of Am., Inc. v. Comm’r, 78 T.C.M. (CCH) 262 (1999).2000] ECONOMIC SUBSTANCE DOCTRINE 11
II. JURISPRUDENTIAL OVERVIEW
A. RELATIONSHIP BETWEEN ECONOMIC SUBSTANCE DOCTRINE AND
STATUTORY INTERPRETATION
The federal income tax is, and always has been, based on statute. The
Economic substance doctrine, like the other common law tax doctrines, can
Thus perhaps best be thought of as a method of statutory interpretation. A
Related, though somewhat stronger, claim is that the legislature assumes
That long-standing common law doctrines such as economic substance will
Be used to interpret the statutes it enacts. Under this claim, the doctrines
Have been implicitly adopted as part of the statute—at least where the
Statute does not indicate otherwise
It is in one sense odd to think of the economic substance doctrine as
An interpretive method. This is because the doctrine is only loosely
Connected to more conventional interpretive techniques or approaches
Decisions in which the doctrine is discussed or invoked often contain a
Separate discussion in which text, intent, and purpose are applied to the
Issue at hand. The doctrine itself, however, is discussed and applied
Without significant discussion of text, intent, and purpose. The doctrine fits
Most comfortably, of course, with a purposivist approach to statutory
Interpretation. But the doctrine, like its predecessor and related doctrines
In some respects resembles a substantive canon of interpretation; it has
Been part of the tax law for so long that it is accepted by jurists who would
Otherwise hew more closely to a textual reading of the applicable statute
16
Precisely because the doctrine can be applied without formal
Discussion of text, intent, or purpose, its application is usually accompanied
By, or entwined with, interpretation of the statute using those conventional
Tools. A transaction attacked through the economic substance doctrine will
Invariably be defended on the grounds that the transaction is supported by
The statute’s text, and generally by some combination of intent and purpose
As well. Litigation involving the economic substance doctrine involves
Related, but in some sense distinct, litigation over the text, intent, and
Purpose of the statute. The precise relationship between the economic
Substance doctrine and conventional statutory interpretation is ambiguous
However, it seems clear that a transaction that is clearly supported by the
16. See generally ESKRIDGE & FRICKEY, supra note 3, at 513–631 (role and use of substantive
Interpretive canons); Cass R. Sunstein, Interpreting Statutes in the Regulatory State, 103 HARV. L. REV
405 (1989) (expansive view of substantive canons). Some substantive doctrines, at least, find favor
Even among textualist jurists. ESKRIDGE & FRICKEY, supra note 3, at 655.12 SOUTHERN CALIFORNIA LAW REVIEW [Vol. 74:5
Text, intent, and purpose (or whatever combination that comports with the
Judge’s interpretive stance) will withstand judicial scrutiny regardless of
Whether it otherwise meets the economic substance test
B. RELATIONSHIP BETWEEN THE ECONOMIC SUBSTANCE DOCTRINE AND
OTHER COMMON LAW DOCTRINES
As noted throughout this article, the economic substance doctrine is
Closely related to common law doctrines of sham transaction, substance
Over form, business purpose, economic profit, and step transaction
Detailed discussion of these other doctrines is beyond the scope of this
Article. However, two comments about the relationship between the
Economic substance doctrine and other common law doctrines may be
Useful
First, the economic substance doctrine to some extent incorporates
Other common law doctrines. This is most apparent in the “subjective” leg
Of the doctrine, which explicitly incorporates the business purpose doctrine
The business purpose doctrine has been criticized for focusing on motives
Underlying a transaction, rather than effects of a transaction. The economic
Substance doctrine blunts this criticism by explicitly tying consideration of
Motives (the subjective leg of the doctrine) to effect (the objective leg of
The doctrine)
17
The objective leg of the doctrine to some extent
Incorporates sham transaction, economic profit, and substance over form
Doctrines
Second, the differences between the doctrines are apt to be smaller
Than first imagined. As noted above, the doctrines are limited by the
Constraint, so to speak, of conventional statutory interpretation. Equally
Important, the doctrines are all, in crucial respects, ambiguous or
Incomplete. Sensible administration requires a set of rules—for want of a
Better term, “application rules”to resolve ambiguities and fill in missing
Elements of the doctrine. The application rules of the economic substance
Doctrine are, in one sense, the subject of this article. In general, the rules of
Application are apt to be quite similar for all of the doctrines
III. OBJECTIVE ECONOMIC SUBSTANCE
The objective leg of the economic substance test requires that a
Transaction have some nontax effect. This leads to the obvious question—
How much effect is enough? It may seem sensible to begin with this
17. See discussion infra Part IV.A.2000] ECONOMIC SUBSTANCE DOCTRINE 13
Question, and then explore other dimensions of this leg of the test. Before
Grappling with this question, however, it will be useful to set forth some
Additional rules that limit the doctrine
A. EXCLUSION FOR LEGISLATIVELY “INTENDED” TAX BENEFITS
1. Generally
The primary limitation on the objective economic substance doctrine
Has been adverted to above: The doctrine cannot apply where a sensible
Reading of text, legislative intent, and purpose suggest it should not apply
Consider, for example, a decision by a corporate taxpayer to invest in
Housing subject to low-income tax credit. The tax credit was enacted to
Stimulate investment in low-income housing. A taxpayer who, at the
Margin, makes the investment solely because of tax reasons is presumably
Doing just what the lawmakers who enacted the legislation would have
Wished. (Legislation influences investment only by changing behavior of
Taxpayers at the margin). Yet the investment is necessarily one that does
Not have a favorable before-tax return
As is perhaps obvious, the above example can be generalized to apply
To nearly any investment. Cost-recovery rules vary wildly among various
Assets and natural resources. An investment in an asset subject to favorable
Cost recovery may be just profitable enough to undertake on an after-tax
Basis but provide a negative return on a before-tax basis. The same can be
Said for investments in industries (e.g., life insurance) that may be subject
To favorable tax rules. Applying the economic substance test, in a
Straightforward way, to these sorts of investments would be insupportable
Some tax rules favor certain investment vehicles rather than
Investments. Partnerships and S corporations are taxed more favorably
Than C corporations. Taxpayers who qualify for all three forms of business
Organization can chose one form over another solely for tax reasons
2. Interpreting Text, Intent, and Purpose
The preceding discussion assumed that text, intent, and purpose are
Easy to decipher and congruous. That, of course, will not always or even
Generally be the case. Text may point in a different direction than does
Purpose or intent, and judges or policymakers may have an interpretive
Theory or practice that favors one over the other
18
A particular approach
18. See supra note 5.14 SOUTHERN CALIFORNIA LAW REVIEW [Vol. 74:5
Even if agreed upon, may not yield an obvious answer. One might interpret
A statute according to legislative intent and then be faced with the task of
Collecting shards of conflicting evidence into a single intent;
19
A modernday variant of that approach might further pose the counterfactual question
Of what an enacting legislature that did not think of the issue at hand would
Have intended had they thought of that issue
20
Similar ambiguities beset
The textualist
It is easy to come up with tax-shelter-related examples in which intent
And purpose, and perhaps even text, do not point in any obvious direction
Consider, for example, the following variant on the so-called “basis
Stuffing” shelter. Parent is a Fortune 500 company with a wholly-owned
Subsidiary. Subsidiary engages an investment bank to help raise 100x
Through issuance of conventional debt. The investment bank instead
Convinces Subsidiary to accept 15x cash from Parent and securities worth
85x from a foreign taxpayer. The foreign taxpayer is located in a tax
Jurisdiction that does not tax gains on securities or allow deductions for
Losses on securities. The securities have a basis in the zero-bracket
Taxpayer’s hands of 200x. The parties take the position that the transfers
Qualify under § 351, so that Subsidiary receives a substituted basis of 200x
In the securities
21
Subsidiary sells the securities and takes a loss of 115x
The zero-bracket taxpayer is compensated for the tax value of its
Contribution by receiving 90x of Subsidiary stock, 5x more than the
Securities are worth absent tax considerations
The shelter, if blessed, could quickly erode corporate tax revenues
All high-basis, low-value property would migrate to domestic corporations
One can imagine a decision that sensibly rules the hoped-for tax
Consequences are inconsistent with the statute’s purpose, perhaps with its
Intent
22
And perhaps even with the text
23
19. See OTTO HETZEL, MICHAEL LIBONATA & ROBERT WILLIAMS, LEGISLATIVE LAW AND
PROCESS 438 (2d ed. 1993) (listing twenty indicia of legislative intent, including floor debate
Conference committee reports, actions taken, and reports, hearings, and debates on prior related
Legislation)
20. This “imaginative reconstruction” is associated with Roscoe Pound and to some extent with
Richard Posner
21. I.R.C. § 362(a) (1994). This transaction is discussed in somewhat more detail in Joseph
Bankman, The New Market in Corporate Tax Shelters, 83 TAX NOTES 1775, 1777 (1999)
22. Intent for this purpose would presumably be defined, imaginatively, as the intent the
Legislature would have had toward the transaction had it thought of the transaction
23. This would be the case under the (doubtful) rationale that the transaction did not comply with
The ordinary meaning of contribution but was instead a sale.2000] ECONOMIC SUBSTANCE DOCTRINE 15
On the other hand, appreciated property contributed by low-bracket
Taxpayers to high-bracket corporations in § 351 transfers is taxed at the
High corporate rate when sold by the corporation. That is simply the way
The statute operates. Perhaps it is most sensible to assume the statute
Should, and was intended to, operate symmetrically. The problem of
Contributions of property designed to produce losses at the corporate level
Is addressed in various statutes, including the liquidation provisions under
§ 336. Should we assume that in enacting these provisions Congress
Intended to bless other forms of producing the sale result?
In theory, the “exception” for benefits that comport with text, intent
And purpose might render the economic substance doctrine useless. In
Practice, that has not proven to be the case. The current wave of tax
Shelters fail the economic substance test but do not find much support
Under intent- and purpose-based examinations of the underlying statute
And, in some cases, do not survive even a careful text-based reading of the
Statute
B. DEFINITION OF THE TRANSACTION: TRANSACTIONS LINKED TO
ORDINARY BUSINESS OPERATIONS
1. Generally
The economic substance doctrine requires that the events giving rise
To a particular tax position must have objective economic substance, but
Does not tell us which of many interrelated events ought to be lumped
Together and measured for economic substance. In general, the greater the
Number of events lumped together, the greater the likelihood that a tax
Position will reflect changes in nontax attributes
24
In theory, by expanding
Or contracting the number of related events, a decisionmaker could reach
Virtually any result it wanted under the doctrine. In practice, some tax
Positions will seem to correspond naturally with a discrete number of
Events or transactions. Moreover, courts have already put some flesh on
This part of the doctrine by showing a willingness to lump together
Transactions connected to a taxpayer’s ordinary business operations, but
Treat as discrete each element in tax shelters
Some idea of the issues involved, and the courts’ treatment of those
Issues, can be gleaned from the role Cottage Savings Ass’n v
24. This will obviously not be the case where a taxpayer has entered into a hedge, so that one
Transaction offsets another.16 SOUTHERN CALIFORNIA LAW REVIEW [Vol. 74:5
Commissioner has played in recent case law
25
As readers of this article no
Doubt recall (or at least once knew), the taxpayer in Cottage Savings had
Written mortgages that (due to a rise in interest rates) had fallen in value
The taxpayer could not sell its mortgages without reporting a loss for
Accounting purposes; such a loss would have threatened its ability to
Operate under then-current banking regulations. However, the taxpayer
Was allowed, under banking regulations, to swap its mortgages without
Recognizing an accounting loss and subsequent regulatory closure. The
Taxpayer swapped its mortgages for mortgages of equivalent value and
Claimed a loss for tax purposes. The individual mortgages received were
“different” from those swapped; that is, they secured indebtedness from
Different individuals secured by different property. But the basket of
Mortgages received was as an economic matter identical in every relevant
Respect to the basket of mortgages swapped. The government argued that
The swap should not be treated as a realization event because it lacked
Economic substance. The Court held that the mortgages, though as a basket
Economically similar, were materially different because they embodied
Legally distinct entitlements, and upheld the loss
The taxpayer in ACM argued that its losses on the sale of the Citicorp
Debt ought to be allowed for the same reason the losses in Cottage Savings
Were allowed: The Citicorp debt embodied legally distinct entitlements
From the combination of cash and LIBOR notes received in exchange. The
Court in ACM responded to the argument as follows:
The distinctions between the exchange at issue in this case and the
Exchange before the Court in Cottage Savings predominate over any
Superficial similarities between the two transactions. The taxpayer in
Cottage Savings had an economically substantive investment in assets
Which it had acquired a number of years earlier in the course of its
Ordinary business operations and which had declined in actual economic
Value by over $2 million .
While the dispositions in Cottage Savings and in this case appear
Similar in that the taxpayer exchanged the assets for other assets with the
Same net present value, beneath this similarity lies the more fundamental
Distinction that the disposition in Cottage Savings precipitated the
Realization of actual economic losses arising from a longterm
Economically significant investment, while the disposition in this case
Was without economic effect as it merely terminated a fleeting and
Economically inconsequential investment .
26
25. 499 U.S. 554 (1991)
26. ACM, 157 F.3d at 251.2000] ECONOMIC SUBSTANCE DOCTRINE 17
Thus, the swap in Cottage Savings, while economically insignificant
In itself, was tied to ordinary business operations, and what was measured
For substantial economic effect was not just the swap, but the business
Operations to which it was tied. The sale of Citicorp debt was not tied to
Ordinary business operations, and so it was considered in isolation for the
Purposes of determining economic effect
27
Cottage Savings was raised by
The taxpayer, and distinguished by the court, in much the same way later in
Saba
28
2. Down the Slippery Slope
The treatment of Cottage Savings by the ACM and Saba courts
Suggest that transactions tied to ordinary business operations will be
Favorably treated under the economic substance doctrine. The favorable
Treatment for tax-motivated transactions tied to ordinary business
Operations (the “ordinary business exception”) raises obvious line-drawing
Questions, to wit: How closely must the tax-motivated transaction be tied in
Order to qualify for such treatment, and what constitutes ordinary business
Operations? Consider, for example, the following variant of the CINS
Transaction. Colgate-Palmolive finds itself in a joint venture with a
Corporation with otherwise unusable net operating losses. The principal
Business of the venture is sold. The sale price includes contingent
Payments and the contingent installment sales regulations in effect at the
Time of the original transaction are still in effect. Neither the joint venture
The decision to sell the principal business, nor the decision to sell for
Contingent payments is tax motivated. The default provisions in the
Contingent installment sale regulations will produce a noneconomic tax
Gain in the year of sale, and a noneconomic tax loss in later years. ColgatePalmolive is about to petition for relief from that provision under the
Regulations when it realizes that it can turn the rules to its advantage—but
Only if it redeems the interest of its joint venturer after the joint venturer
Has “absorbed” a share of the noneconomic gain in the first year
Presumably, the company can redeem the joint venturer and claim the loss
Unimpeded by the economic substance doctrine
Suppose now that the facts are the same as above except that the
Decision to require some form of contingent payment in the sale, as well as
The decision to redeem out the joint venturer, is tax motivated. Will the
27. Cottage Savings could be distinguished from ACM for other reasons as well. One key
Difference—that Cottage Savings involved realization whereas ACM involved loss generation—is
Discussed in Part III.C infra
28. See Saba, 78 T.C.M. (CCH) at 715–17.18 SOUTHERN CALIFORNIA LAW REVIEW [Vol. 74:5
Events still be compressed into a single event (operation and disposition of
A business), and so meet the economic substance doctrine? What if the sale
Itself is tax motivated? If Colgate-Palmolive stuffs new assets (or cash
With which to purchase assets) in an existing joint venture, for the primary
Purpose of selling the assets in a manner that takes advantage of the
Regulations?
In the preceding examples, the taxpayer has an ordinary business to
Which, perhaps, tax-motivated transactions may be tied. Suppose, though
That the tax-motivated transaction is part of an investment, unconnected to
Any business. Is the exception for ordinary business operations
Unavailable? Or is the investment treated as a separate business, so that the
Question turns on how closely the tax-motivated transaction is tied to the
Rest of the investment? There is obviously no single right answer to that
Question. As a predictive matter, one would expect courts to be more apt to
Link transactions that arise out of regular business operations, more
Suspicious of tax-motivated transactions carried out in separate
Investments, and less likely to link transactions that comprise such
Investments
3. Evaluation
The above analysis suggests that the same transactions, considered in
Isolation, will be treated differently. An aggressive play on the contingent
Sales regulations, for example, works if it is discovered “accidentally” in
The course of ordinary business operations but does not work if it is part of
A prearranged plan that is unrelated to business operations. This produces
Results that are in one respect arbitrary. These results, however, may be
Justified on pragmatic grounds
A rule that allows taxpayers to take advantage of loopholes that
Naturally present themselves in the course of business operations will be
Expensive to the federal coffers, but that cost will be limited to the number
Of “naturally present” loopholes. A rule that allows taxpayers not only to
Take advantage of loopholes but to manufacture circumstances in which
They arise would be ruinous to the fisc
Under that latter case, one might expect the creation of a tax-shelter
Industry devoted to discovering and marketing loopholes. The tax-shelter
Industry would be able to amortize costs over many taxpayers, thus greatly
Reducing the per-taxpayer cost of locating shelters, finding zero-bracket
Parties with which to take advantage of shelters, limiting economic risks
Associated with shelters, and so on. In theory, a single shelter, developed2000] ECONOMIC SUBSTANCE DOCTRINE 19
And marketed by a promoter, could eliminate a substantial portion of
Corporate income
As readers of this article are no doubt aware, to some extent all of this
Has already occurred. Tax shelters have been a growth industry for
Financial intermediaries; these intermediaries have dramatically expanded
Shelter opportunities for corporate taxpayers; and while corporate tax
Revenues have risen with the booming economy, shelters have removed
Billions from government coffers. The economic substance doctrine, with
Its implicit exception for tax-motivated transactions closely tied to ordinary
Course of business operations, and supplemented by more effective
Enforcement, higher penalties, or both, would substantially limit shelter
Use. Taxpayers would still be allowed to exploit unintended snafus in the
Law and regulations, but that exploitation would be limited to those flaws
That arise in the ordinary course of business
A related argument for the ordinary course of business exception
Centers around political-process concerns. The tax rules are not selfexecuting; that is, the rules do not provide a single, apparent result for
Every economic transaction. Given that reality, it would be desirable
Perhaps, if taxpayers could select the rule that reduces their tax burden
Without worrying about whether the rule best comports with underlying
Intent or a multi-faced common law doctrine. So long as rules cannot be
Exploited in mass-marketed shelters, it will be economically feasible to
Give taxpayers that choice. Ambiguities and snafus in regulations and
Statutes can be addressed by amending the relevant statutes or regulations
Without retroactive effective dates. The advent of marketed shelters
Changes that calculus
The ordinary course of business exception can also be defended on
Efficiency grounds. The welfare loss from shelters is not simply derived
From the reduced tax revenue and cost of replacing that revenue but also
Includes the resources devoted to the shelter industry. Companies pay high
Fees to promoters and high transaction costs to manufacture circumstances
Required by shelters. Shelters also eat up internal corporate resources that
Are not easily monetized, such as employee time. These costs are avoided
If taxpayers are allowed to exploit only those drafting errors that come up
In the ordinary course of business. For these and other reasons, one
Suspects that the ordinary course of business exception will appeal to most
Of those who apply the economic substance doctrine, regardless of their
More general interpretive stance or their position on other elements of the
Doctrine.20 SOUTHERN CALIFORNIA LAW REVIEW [Vol. 74:5
The sanguine view of the ordinary course of business exception is
Subject to one important caveat: It assumes that it is impossible or at least
Extremely difficult for taxpayers to change behavior and manufacture
Shelter opportunities and still stay within the boundaries of their ordinary
Course of business. This would be the case if there were a clear-cut divide
Between manufactured shelters and the ordinary course of business, and if
Taxpayers were interested only in shelters that were shorn of business risks
Suppose, instead, that the definition of ordinary course of business is
Ambiguous, but not so ambiguous as to include marketed shelters. A
Company may now be tempted to change its actual business operations and
The costs of that change may be greater than the costs of purchasing a
“ready-made” shelter from a financial intermediary. Consider, for
Example, a variant of the CINS shelter discussed in subsection 1, above:
Colgate-Palmolive has an operating joint venture with a zero-bracket
Taxpayer when it “discovers” a flaw in the contingent sales regulations
Colgate-Palmolive exploits the flaw by selling the venture for a contingent
Amount and redeeming the joint venturer out in the year following the sale
It is quite possible that the social waste entailed in selling an operating
Business would be greater than the waste entailed in the Merrill Lynch
Shelter Colgate-Palmolive actually purchased. The ability to manufacture
Shelter opportunities while staying within (but just barely within) the
Ordinary course of business would also limit the fiscal benefits of the
Ordinary course of business exception. And at least one leading
Practitioner has claimed that a company that correctly manages its business
Operations, tax-wise, need never purchase a marketed shelter to offset
Realized gain
At present, the dynamics of corporate tax planning seem to support the
Positive view, expressed above, of the ordinary course of business
Exception. Companies are willing to take aggressive tax positions on
Transactions done for nontax reasons; companies are also increasingly
Willing to pay for shelters that do not involve business risk. Companies do
Not, however, like to engage in risky enterprises that offer tax benefits as a
Primary return. The ordinary course of business exception, if enforced in a
Strict fashion, and buttressed by effective enforcement and penalties, would
Significantly limit revenue loss to the federal coffers. It also seems likely
Though less certain, that this leg of the doctrine would reduce social waste
C. ABSURDITY OF RESULT
It is commonsensical to think that the application of the doctrine will
Depend in part on how much, if at all, the taxpayer’s position seems to2000] ECONOMIC SUBSTANCE DOCTRINE 21
Conflict with the “correct” tax treatment of a particular transaction. All else
Being equal, positions that seem absurd on their face are more likely to fail
The economic substance test. If, and to the extent, this surmise is correct, it
Is interesting to speculate on whether realization-related shelters, which
Generally provide deferral of economic and otherwise taxable gain, will be
More leniently treated than shelters that provide a tax loss on an
Economically break-even transaction—the so-called “loss generators.”
For the most part, realization is wholly elective: Taxpayers can choose
Whether and when to recognize gain or loss on an asset simply by timing
The sale of the asset. Occasionally taxpayers find themselves wishing to
Retain ownership of an asset for economic or regulatory purposes yet still
Recognize a loss for tax purposes (as in Cottage Savings), or to disinvest in
An asset for economic or regulatory purposes and defer gain. There are of
Course rules designed to prevent this sort of result
29
But suppose a
Taxpayer negotiates around these rules. The realization doctrine is
Inherently arbitrary, and commonly manipulated by taxpayers, in aboveboard fashion. Does that mean that any application of a multi-faceted
Standard such as economic substance is inappropriate?
The answer to this question is probably no. The economic substance
Doctrine will play a role in some realization-related cases. But the fact that
The result in those cases is apt to appear less egregious than the result in
Loss generator cases is likely to influence the application of the doctrine
An example of the differential treatment of the realization-related tax
Positions might be the treatment of Cottage Savings, both by the Supreme
Court in deciding the case and by more recent courts in distinguishing the
Case. As noted above, the court in ACM distinguished the facts in ACM
From the facts in Cottage Savings by invoking what this article has termed
The ordinary course of business exception. The mortgages swapped in
Cottage Savings were tied to mortgages written in the ordinary course of
Business, and so the economic substance test is applied to the writing, as
Well as the swap, of the mortgages. Cottage Savings’ swap thus meets the
Economic substance test through the aggregation of linked events
The Court in Cottage Savings gave a different rationale for the
Decision: that the exchanges qualified under the literal language of the
Statute. The government’s claim that the exchanges lacked economic
Substance was dismissed without significant discussion. Here, the fact that
The taxpayer took a somewhat reasonable position in an area in which the
29. See, e.g., I.R.C. § 1091 (1994) (wash sales rules); I.R.C. § 1259 (West Supp. 2000)
(constructive sales rules).22 SOUTHERN CALIFORNIA LAW REVIEW [Vol. 74:5
Law is arbitrary led the Court simply to reject the application of the
Economic substance doctrine
D. LOST TAX REVENUE AND OTHER INTANGIBLE COSTS
An economic substance case that involves a publicly marketed shelter
And a billion dollar price tag is hard to defend as taxpayer’s counsel—on
That most tax lawyers would agree. This predictive statement can be
Explained on a number of grounds. A taxpayer will generally have a harder
Time establishing a business purpose for a marketed shelter than for a
Nonmarketed shelter. A marketed shelter will stick out from a taxpayer’s
Ordinary business operations, so the economic effect of the shelter is likely
To be judged in isolation, rather than together with linked business
Transactions. At the core, however, one suspects that courts (and certainly)
Administrators will treat marketed shelters worse on pragmatic grounds
Marketed shelters pose a greater threat to the federal coffers. Such shelters
Can impose intangible costs as well. The shelters of the early 1980s were
Thought to erode confidence in, and compliance with, the tax law. The
Same can be said, perhaps, of today’s corporate tax shelters
E. FINANCING TRANSACTIONS
Many recent and current tax shelters are financing-related. Step-down
Preferred, for example, enabled taxpayers effectively to deduct not only the
Interest on debt, but the principal as well;
30
The basis-stuffing shelter
Described in Part III.C gives taxpayers capital as well as a loss; the same
Can be said for the so-called § 357(c) shelters
31
In general, the economic
Substance is not an effective tool with which to challenge these forms of
30. Step-down preferred is described in Bankman, supra note 21, at 1779
31. In these shelters, a domestic corporation would accept a contribution of property from a
Foreign person not subject to U.S. tax jurisdiction. The property would be subject to a lien in security
For debt incurred by the contributor; in accepting the property, the corporation would become
Secondarily liable on the debt secured in part by the lien. The amount of the debt would typically be
Many times the value of the property. For example, the property might be worth $1 million and the debt
$30 million. The debt would be fully secured by other property still held by the contributor and the
Contributor itself would be creditworthy. The parties would take the position that the contribution was
Governed by § 351. In accordance with a revenue ruling, the parties would further take the position that
The contributor recognized gain for tax purposes equal to the entire amount of debt now guaranteed by
The corporation—even though the contributor remained primarily liable for the debt and the debt was
Fully secured by other property of the contributor. The recognition of gain would be of no event to the
Contributor who, as noted above, was not subject to U.S. tax. But, based on that hypothetical
Realization, the parties would take the position that the corporation ought to get a step up in basis to
Reflect gain recognized on transfer. The net result in this example would be a $30 million basis for
Property worth $1 million.2000] ECONOMIC SUBSTANCE DOCTRINE 23
Shelters. The reason for this is that financing is naturally linked to the use
Of proceeds from the financing, and that the latter provides sufficient
Business purpose. It is for this reason that statutory approaches to the taxshelter problem that adopt some variant of the economic substance doctrine
Generally provide other tests for financing arrangements
32
F. HOW MUCH PROFIT IS ENOUGH?
1. Generally
Having discussed some of the application rules of the objective
Economic substance doctrine, it now seems appropriate to address the
Question raised at the start of this section: How much substance is enough?
If substance is measured by pretax rate of return, what rate of return is high
Enough to give a transaction substance?
Unfortunately, there is no clear answer to this question under existing
Doctrine. This is not because courts have come out differently on the issue;
Rather, it is because no tax shelter case has yet involved any positive return
Once transaction costs are taken into account
33
What should the answer to this question be? One plausible rule would
Be to require only the bare minimum present value expected return required
By similarly situated taxpayers for investments with similar risk
Characteristics. The rule could be made less ambiguous by eliminating the
32. See Tax Shelter Act of 1999, supra note 2, § 3; TREASURY PROPOSALS, supra note 2, at 96
33. The “how-much-is-enough” issue is discussed at greatest length by the court in Saba. There
The court concluded:
Relatively modest profits are insufficient, standing alone, to clothe the disputed CINS
Transactions with economic substance. In particular, even assuming for the sake of argument
That the partnership reasonably could have expected profits of up to $10,800,000 on a 5-year
Investment in the LIBOR notes, such profits would be inconsequential when compared with
The capital losses of approximately $170,000,000 that the CINS transactions were designed to
Generate for Brunswick
Saba, 78 T.C.M. (CCH) at 721. This passage suggests that the court favored an approach that
Compared tax benefits to pretax profits—an approach consistent with the Treasury Department’s shelter
Proposals but inconsistent with most case law on point
Immediately after offering the “benefits-to-pretax-profits” approach, the court in Saba took a
Different approach:
A transaction has economic substance when it is the kind of transaction that some people
Enter into without a tax motive, even though the people fighting to defend the tax advantages
Of the transaction might not or would not have undertaken it but for the prospect of such
Advantages—may indeed have had no other interest in the transaction
Id. at 722 (quoting Yosha v. Comm’r, 861 F.2d 494, 499 (7th Cir. 1988)). The reference to “people
Without a tax motive” in the quote is unclear. One possibility—that a transaction must offer a return
Sufficient to attract a zero-bracket taxpayer in order to pass muster—is discussed infra in text following
This note.24 SOUTHERN CALIFORNIA LAW REVIEW [Vol. 74:5
“similarly situated” requirement. In that case, a taxpayer could justify its
Position so long as it could show that some taxpayers, somewhere, would
Have found the pretax return it had received to be attractive
A significant drawback to the “comparison-with-other-investment”
Rule outlined above is hinted at in Part III.A, above. Tax rates vary across
Asset types and investment vehicles. If tax benefits are fully embedded in
Asset price, then, at the margin, investments in all tax-favored assets should
Provide a subpar and perhaps even negative pretax return. To illustrate
Suppose that a taxpayer justified a shelter purchase that provided a negative
Before-tax return on the grounds that similarly situated taxpayers had made
Investments in low-income housing that provided an equivalent negative
Return
One could of course distinguish the low-income housing investment
On the grounds that low-income housing is legislatively favored while the
Taxpayer’s investment presumably is not. But that form of distinction
Becomes more problematic as the tax-favored treatment of the comparison
Investment becomes less a matter of explicit legislative intent. May the
Taxpayer offer investments in depreciable machinery as the comparison
Investment? A remainder interest in a safe income stream? The problem is
Compounded by the difficulty of determining the actual return. A interestbearing checking account, for example, might be taken as an example of a
Non-tax-favored asset that might be used as a comparison investment
However, as is by now well known, checking accounts offer tax-free return
In the form of checking and other services. The return on a checking
Account is thus tax favored
The problem of comparisons with tax-favored assets could be avoided
By requiring comparison with a fully taxed asset; one might then require a
Pretax return equal to the lowest plausible return an investor would require
From a fully taxed asset. The same result could be obtained by using as a
Comparison the lowest return sufficient to attract investment from a zerobracket taxpayer. The downside to this approach is that it assumes the
Comparison asset is fully taxed, when, in fact, the investment the taxpayer
Would have made had it not purchased a shelter might well have been tax
Favored
A conservative, but perhaps workable, approach would be to specify a
Relatively low (and admittedly arbitrary) rate as a hurdle rate for
Transactions subject to challenge under the economic substance test. For
Example, one might establish a safe harbor for investments that provide an
Expected pretax return equal to some percentage (less than 100%) of the2000] ECONOMIC SUBSTANCE DOCTRINE 25
Tax-exempt rate
34
This would be a taxpayer-friendly rule: It would the
Give the taxpayer the benefit of comparison with a safe, tax-favored asset
Another attractive approach, discussed below, is to look at the return
Provided by other (nonshelter) investments of the taxpayer
The analysis thus far has assumed that a taxpayer has actually made an
Investment in an asset; that is, that the taxpayer has placed some of its
Money at risk. In many of the shelters thus far litigated, however, that has
Not been the case. Not only were the returns, after transaction costs
Negative, but the taxpayer had hedged away the possibility of any upside or
Downside. If a negative expected return has no economic substance, then
Perforce, the same is true for a negative expected risk-free return
Suppose, though, that a taxpayer produces a positive expected riskfree return. Suppose, in the ACM case, Colgate-Palmolive had held the
Citicorp debt for two years and held the LIBOR notes received in exchange
For the debt for a like period. Assume, however, that Colgate-Palmolive
Had a history of investments in Treasury bills and notes, and had hedged
Out most or all of the risk associated with holding the Citicorp debt and
LIBOR notes. Assume finally that the interest on the debt instruments
Exceeded transaction costs and produced a return sufficient to meet the low
Hurdle rate suggested above. Now the investment in Citicorp debt that
Gives rise to the loss may lack economic substance not because the pretax
Return is too low, but because the taxpayer has not actually made that
Investment
A court in that situation could reach the same bottom-line result by
Adopting Treasury bills and notes as establishing the required pretax rate of
Return. Here, the decision to use a combination of Citicorp debt, LIBOR
Notes, and hedges to obtain the return and risk characteristics offered by
Government debt serves no business purpose: The taxpayer could have
Gotten that same return with lower transaction costs had it simply continued
Its prior practice of investment in government debt
Existing investments might be adopted as the natural comparison
Investments even in situations in which the taxpayer does not hedge out the
Risk of the shelter. In situations in which the taxpayer has a consistent
Pattern of nonshelter investments, those nonshelter investments offer a
Natural hurdle rate against which to measure the economic return from
Shelter investments
35
34. One could use the same rates as provided for in I.R.C. § 382(f)
35. The court in ACM implicitly adopted this approach in comparing the return on the Citicorp
Transaction from the return available through its prior investment.26 SOUTHERN CALIFORNIA LAW REVIEW [Vol. 74:5
The Treasury has included a variant of the economic substance test in
Its proposed legislation. Under that variant, tax benefits would be
Measured against pretax profit
36
One suspects that any intelligent
Application of the economic substance test requires some consideration of
The relationship between tax benefits and nontax benefits. But basing a test
Primarily on the relationship between the benefits raises problems of its
Own. Suppose, for example, that a transaction offers a healthy pretax rate
Of return but even greater tax benefits. Ought the transaction to be at risk
Under the economic substance test? The better view is that a transaction
That produces a substantial pretax return is immune from challenge on
Economic substance grounds
Some investments are intended to produce intangible business
Benefits. For example, an investment might be designed to discourage a
Hostile takeover, or increase customer goodwill. These benefits, no less
Than any other benefits, must be taken into account when determining
Whether a transaction has economic substance
IV. SUBJECTIVE LEG OF THE ECONOMIC SUBSTANCE
DOCTRINE
A. RELATIONSHIP BETWEEN THE SUBJECTIVE AND OBJECTIVE TESTS
As noted in Part II, above, the economic substance doctrine has both
An objective and subjective leg. Courts have without exception insisted
That the two legs are interrelated;
37
However, courts have also stated that a
Transaction that has objective economic substance will be respected for tax
Purposes, regardless of the taxpayer’s motivation
38
Courts are split as to
Whether a transaction that has subjective but not objective economic
Substance should be respected for tax purposes
39
In practical terms, then
The tests are interrelated in those cases in which evidence as to objective
36. The Treasury’s approach is discussed and defended in TREASURY PROPOSALS, supra note 2
At 162–65. Robert Thornton Smith has also suggested a comparison test. Under this test, the tax-rateadjusted pretax yield would be compared to the full after-tax yield. Smith, Business Purpose, supra
Note 3, at 25. The critique of the Treasury approach—that an investment with an acceptable economic
Return should be upheld notwithstanding tax benefits—applies to Smith’s approach as well
37. ACM P’ship v. Comm’r, 157 F.3d 231, 247 (3d Cir. 1998); Saba P’ship v. Comm’r, 78
T.C.M. (CCH) 684, 713–15 (1999); UPS of Am., Inc. v. Comm’r, 78 T.C.M. (CCH) 262, 270 (1999)
38. ACM, 157 F.3d at 248
39. Saba, 78 T.C.M. (CCH) at 713–15 (comparing Horn v. Comm’r, 968 F.2d 1229, 1237 (D.C
Cir. 1992), with Kirchman v. Comm’r, 862 F.2d 1486, 1492 (11th Cir. 1989)). Robert Thornton Smith
Would uphold a transaction that meets the subjective but not objective leg of the economic substance
Test. Smith, Business Purpose, supra note 3, at 26–27.2000] ECONOMIC SUBSTANCE DOCTRINE 27
Intent is inconclusive. In such cases, strong but not dispositive evidence of
Objective substance can offset weak evidence of subjective substance, and
Vice versa
B. DEFINITION OF SUBJECTIVE ECONOMIC SUBSTANCE
The subjective leg of the economic substance doctrine looks to the
Taxpayer’s expectations and motives: The leg is similar, if not identical, to
The “business purpose” doctrine, and is sometimes simply referred to as the
Business purpose requirement. As explained by the court in Compaq
Computer, “[t]o satisfy the business purpose requirement of the economic
Substance inquiry, ‘the transaction must be rationally related to a useful
Nontax purpose that is plausible in light of the taxpayer’s conduct and
Economic situation.’”
40
How significant must the nontax purpose be? That question is left
Unanswered by the courts, for the same reason that the cognate question in
The objective leg of the economic substance test is left unanswered: The
Transactions thus far challenged by the government have served no
Plausible nontax purpose
41
Perhaps the most reasonable rule would be to peg the required
Expectations to the required return or business purpose in the objective leg
Of the doctrine. Thus, if in a particular case, a 3% riskless pretax return is
Thought required to imbue a transaction with objective economic substance
An expectation of the same return would meet the subjective leg of the
Doctrine
C. CRITIQUE
It is, of course, impossible to know a taxpayer’s (or anyone else’s)
Actual subjective intent. The subjective intent or business purpose doctrine
Must inevitably look to objective indicia of intent: contemporaneous
Documents, evidence of meetings, and the like. These indicia may be
Subject to manipulation. A primary criticism of the business purpose test is
That it leads to the creation of false or misleading documents that evidence
Nontax motives. Promoters supply corporations with reams of paper on the
40. Compaq Computer Corp. v. Comm’r, 113 T.C. 214, 224 (1999) (quoting ACM P’ship v
Comm’r, 73 T.C.M. (CCH) 2189, 2217 (1997))
41. Taxpayers in decided cases have argued that the transactions ought to be tied to other
Transactions with nontax purpose and effect. The conclusion in the text—that the transactions had no
Nontax purpose—implicitly adopts the courts’ determinations that the transactions were appropriately
Viewed in isolation. See “scope-of-transaction” discussion supra Part III.B.28 SOUTHERN CALIFORNIA LAW REVIEW [Vol. 74:5
Ostensible business benefits of a particular shelter; the corporation approves
The purchase in meetings whose notes stress such benefits—all for a shelter
That in truth is purchased only for its tax benefits
What is astounding, thus far, is how few steps shelter-participants in
Litigated cases took to establish nontax motives for their investment. Far
From creating a false record of due diligence and expectations of pretax
Profit, participants left a paper trail that virtually ruled out any inference of
Nontax motives. It may be that the first set of shelter-participants simply
Did not anticipate courts would reach consensus around the economic
Substance doctrine and reject their position in part for lack of business
Purpose. If that is the case, the criticism of the subjective economic effect
Doctrine is left intact. The next generation of shelter-participants will leave
A paper trial that establishes nontax reasons for their investments
It may be, however, that the creation of a false paper trial is harder
Than it sounds. Administrators and courts are properly skeptical of
Documentary records written and controlled by taxpayers and shelter
Promoters. It may be difficult to generate a plausible paper record to
Support a transaction that on its face offers only tax benefits. In addition
Most shelters are purchased by large corporations, and require the approval
And input of a number of employees and officers. As noted throughout this
Article, corporate purchasers generally will not purchase a shelter if it
Carries with it any significant business risk. It may be difficult for a
Promoter to sell a shelter to a corporate officer if it is accompanied by
Written materials that emphasize nontax benefits and risks; difficult for a
Corporate officer who favors the shelter to sell the shelter to her colleagues
If it is so accompanied by such written materials; and so on. It is possible
Of course, that corporate officers would orally describe a shelter as having
Little or no business upside or downside in internal meetings but create a
Written record to the contrary. No doubt some of this occurs; there
Generally will be a common understanding of the shelter that is not
Reflected in written records. But this mild form of deception or dissembling
Will be assumed by administrators and courts and for that reason will not be
Particularly useful. Corporate officials will be reluctant to go beyond this
For example, if a shelter with little nontax purpose is honestly discussed in
A corporate meeting, an employee taking notes or minutes of that meeting
May describe the decision in a way that highlights that nontax purpose, but
May not be willing to write further that tax benefits played no role in the
Decision to purchase the shelter. Many corporate officials are comfortable
Taking very aggressive tax positions, but very few are willing to lie outright
In support of those positions. Most corporate officials realize that false2000] ECONOMIC SUBSTANCE DOCTRINE 29
Records may be challenged in court, in which case they will be in the
Position of either admitting the falsity of those records or risking perjury
V. CONCLUSION
The economic substance test is dizzyingly complex, as readers who
Have gotten this far will no doubt attest. This complexity arises from a
Number of interrelated factors. First, the test is best seen as a technique of
Statutory interpretation, which poses open-ended and unanswerable
Questions. Second, the test must be applied to a near-infinite variety of
Economic activities and transactions. Third, the present treatment of capital
Is inconsistent and to some extent incoherent. Taxpayers can exploit this
Incoherence by structuring transactions that produce tax benefits out of thin
Air. And conflicting rules make it difficult, sometimes, to determine the
“correct” treatment of a particular transaction. Finally, only a few cases
Have been decided under the economic substance test, leaving open
Multiple interpretations of the doctrine
It is virtually certain that more cases will be decided under the test
And that courts will fill in some of the lacunae and resolve some of the
Ambiguities. The other sources of complexity will remain. In the end, the
Utility of the doctrine will depend upon the nature of shelter activity. As
Discussed throughout this paper, shelters that combine tax benefits with any
Real economic investment have historically been hard to sell. In the past, at
Least, “conservative” shelters, structured to include real investment, have
Generally been “cleansed” of that investment, and its corresponding risk
Before finding corporate purchasers. The shelters decided in existing cases
Show no net investment and expected and realized negative rates of return
Once transaction costs are taken into account. As long as the next
Generation of shelters is similarly barren of real investment, the economic
Substance test will work well. The test—or a similar method of statutory
Interpretation—may be necessary to prevent significant erosion of the
Corporate tax, and the tax now paid by individuals with substantial income
From capital
42
Should purchasers of shelters change their position and
Accept tax products that combine current-style shelters with significant
Economic investment, the economic test will break down. At that point
Congress may have no choice but to engage in substantive law reform
Some shelter activity will take place under even the most utopian tax
42. This sanguine view assumes that the test will be intelligently applied by tax administrators—
For example, that it will not be applied to tax-motivated transactions clearly supported by legislative
Intent, and so forth.30 SOUTHERN CALIFORNIA LAW REVIEW [Vol. 74:5
Structure. However, the current tax treatment of capital needlessly
Multiplies shelter opportunities and provides a fertile breeding ground for
Shelter development