Codification of the economic substance doctrine.

• Author: Beavers, James

Reviving an idea that has come and gone several times since 1999, the House and Senate have included similar proposals for the codification of the economic substance doctrine in recent proposed legislation. According to statements by a Treasury official and a Senate Finance Committee staff member at an ABA Tax Section meeting on January 19, a codification proposal will pass in 2008. This item takes a brief look at the common law economic substance doctrine and the proposals to codify it.

The Common Law Economic Substance Doctrine

The economic substance doctrine states that a transaction's tax benefits will not be allowed if the transaction does not have economic substance. The common law doctrine is an effort by the courts to enforce Congress's statutory intent in situations in which a literal reading of the Code would allow a taxpayer to circumvent this intent. While there is agreement among the courts about the general definition of the doctrine and its purpose, the same cannot be said about a test to determine when a transaction has economic substance. Some courts use a single-element test and some use a two-element test. Under the single-element test, a transaction has economic substance if, viewed objectively, there is a nontax business purpose for the transaction. The taxpayer's subjective intentions regarding the transaction are not taken into account (Coltec Industries, 454 F3d 1340 (Fed. Cir. 2006)). Under the two-element test, a transaction has economic substance if (1) the transaction, viewed objectively, has economic substance and (2) the taxpayer has a subjective business purpose for the transaction. Adding to the confusion, courts that have adopted the two-element test for economic substance have not been consistent in applying it, in some cases requiring that both the elements be satisfied, in others requiring that either one of the two elements be satisfied, and in others only taking both elements into consideration as part of the determination of whether a transaction has economic effects other than those derived from its tax benefits (Pasternak, 990 F2d 893 (6th Cir. 1993); Rice's Toyota World, 752 F2d 90 (4th Cir. 1985); IES Industries, 253 F3d 350 (8th Cir. 2001); ACM Partnership, 157 F3d 231 (3d Cir. 1998); James, 899 F2d 905 (10th Cir.); Sacks, 69 F3d 982 (9th Cir. 1995)).

Reasons for Codifying the Economic Doctrine

In the 1990s, lawyers and accountants began to develop and aggressively market sophisticated tax shelter...