Economic substance: a view from the Tax Court.

• Author: Laro, David

I thank you for the opportunity to speak with you about issues and perspectives that are of importance to us all. At the outset, I note that my remarks are my own and they may or may not be harmonious with those of my colleagues on the U.S. Tax Court for whom I do not speak.

I would like to talk with you today about taxes, the United States Tax Court, and the judicial doctrines of business purpose and economic substance.

There is no doubt about the importance of taxes in our society. Taxes permeate almost every aspect of the law and our dally lives. The Supreme Court recognized this early on when it said that the power to tax is the power to destroy.(1) Because of this immense power, we need an independent judiciary to adjudicate tax controversies between the government and its citizens. Thus, the Tax Court was established. The U.S. Tax Court is a federal court of law located in Washington, D.C. The court has 19 judges, each of whom is appointed by the President and confirmed by the Senate. The judges have national jurisdiction which means that they may near cases anywhere in the United States.

Each year the court gets about 20,000 new cases. The cases arise when taxpayers are audited and are unable to settle their controversies by administrative procedures. Taxpayers, whether corporate or individual, trust or partnership, all have the right to go to court to resolve their issues. Although there are three courts from which taxpayers may choose -- namely, the U.S. District Courts, the U.S. Court of Federal Claims, and the U.S. Tax Court -- most taxpayers, in fact about 95 percent of all taxpayers who litigate, choose to do so in the U.S. Tax Court. Some cases involve modest amounts while others may involve more than a billion dollars. The total dollar amount in controversy aggregating all cases currently before the court is about $26 billion. The importance of the cases, however, is measured aside from the dollar amount in controversy. In many instances, the cases are precedent forming and thus serve to provide future guidance in the tax law. Some Tax Court opinions can be long, more than 100 pages, and take months for the judge to review the evidentiary record before the opinion is written.

We travel frequently to various cities to hear cases. We have courtrooms in about 35 cities and we borrow courtrooms from the federal district courts in other cities where we hear cases. I am often asked about how it is that one judge may go to one city and another goes to a different city. It works like this: Each session, the clerk of the court determines where the cases will be heard based upon the petitions filed by taxpayers. A calendar is then passed around to the judges who then will choose the city to which they want to go. If there is a conflict, the judge with the highest seniority will prevail unless that judge has already been to the selected city. So, for the most part but certainly not always, the cases a judge has depends on the session attended. In other instances, cases are assigned to a particular judge because of that judge's familiarity with the subject matter or for other valid reasons. In the instance of ACM,(2) the case was assigned to me.

Now, let us turn our attention to a discussion of the doctrine of economic substance. It seems highly appropriate that we do this for several reasons. First, the doctrine of economic substance is the legal analysis which the Tax Court has used in some recent high-profile cases including ACM,(3) Compaq,(4) andWinn-Dixie Stores.(5) Secondly, the Treasury's White Paper(6) uses the doctrine of economic substance as its standard for testing whether a corporate transaction was entered into for the purpose of tax avoidance. Finally, while it is difficult to estimate the federal government's revenue loss from corporate tax shelter transactions, it has been suggested that the figures indicate that the amount in controversy from ACM, Compaq, and Winn-Dixie, together with cases factually similar to them, is approximately $10 billion in taxes.(7) So, it does seem appropriate that we should focus on this judicial doctrine.

Recently, I heard a case involving economic substance. It was the case of ACM.(8) After ACM was released, Lee Sheppard wrote an article analyzing the case and used the headline, "Hero of the Day: Laro Saves the Corporate Tax."(9) It seems clear that the author was correctly emphasizing the importance of the case in our jurisprudence. Indeed, ACM has refocused the thinking with respect to corporate tax planning.

After ACM was decided by the Tax Court, the Third Circuit affirmed the main issues dealing with economic substance and the Supreme Court has declined to review the decision. So, it is now ethical and reasonably safe for me to discuss some of its aspects with you. While I will use ACM as a backdrop to discuss corporate tax-advantaged products with you, I do not intend to parse the details of ACM. Much has been written about it and I leave you to examine the case with the perspective of the scholarly articles that address it.

In ACM, the government argued that the partnership's transactions should be denied favorable tax treatment for each of the following three reasons:

1. There was no economic substance and no real business purpose.

2. The foreign bank was really a lender rather than a partner.

3. Economic reality under section 704(b) required that the income and loss be reallocated.

The court held for the government on the issue of economic substance, and thus it was not necessary to resolve the other two issues. After ACM, in a similar case, ASA Investerings,(10) the court held for the government on the second issue, namely, that the foreign bank was really a lender and not a partner.

Certainly, the government has a number of Code sections and judicial doctrines upon which it can rely to attack corporate shelters besides the judicial...