W(h)ither Economic Substance?

• Author: Leandra Lederman
• Position: William W. Oliver Professor of Tax Law, Indiana University Maurer School of Law- Bloomington.
• Pages: 01

Page 391

I Introduction

Transactions that claim inappropriate tax benefits are a perennial problem. To distinguish abusive transactions from legitimate ones, courts typically apply the judicially developed "economic substance" doctrine. That doctrine is generally understood to have two prongs: (1) whether the taxpayer had a business purpose for the transaction, and (2) whether the transaction objectively had economic substance (essentially a prospect of profit before taxes).¹ Courts do not apply the doctrine consistently, however, so the prospect of codifying the doctrine, which President Obama supports, has been on the table for a while.²

Courts certainly need to distinguish abusive transactions-whether or not they constitute "tax shelters," however defined³-from appropriate ones. Unfortunately, the economic substance doctrine is a terrible tool for that endeavor. The doctrine is so disconnected from the inquiry of whether a Page 392 transaction was abusive that one judge has called it a "smell test."⁴ Moreover, given the doctrine's focus on the taxpayer's purpose and whether there was a prospect of pre-tax profit, taxpayers can easily manipulate it. This Article therefore argues that courts should abandon the current economic substance doctrine. Instead, courts should consider whether the claimed tax result is consistent with the intent of the applicable provisions.

To be clear, the Article does not focus on how to incorporate into tax disputes an inquiry into congressional intent; others have addressed that issue from a variety of perspectives.⁵ Rather, this Article examines why courts generally do not perform this vital inquiry today, even when claimed tax benefits do not comport with the underlying economics of the transaction, and explains why they should do so.

In developing this argument, this Article makes several connected points. First, identifying abusive transactions is so difficult largely because some tax provisions merely try to measure income while others try to provide an incentive for particular behavior.⁶ A tax-avoidance motive on the Page 393 part of the taxpayer undermines the measurement function, but not the incentive function. In fact, provisions that incentivize behavior by providing tax benefits affirmatively rely on taxpayers' desire to minimize their taxes. Thus, the presence of a tax-avoidance purpose is not a reliable barometer of an abusive transaction.

Second, the business purpose requirement dates to the landmark case of Gregory v. Helvering, but in that case, the U.S. Supreme Court and the Second Circuit merely interpreted the governing statute as implicitly requiring a business purpose.⁷ As explained below, the fact that the courts reached that interpretation in the context of a corporate reorganization-a transaction specific to corporations-is not coincidental. Over the years, the business purpose requirement has been distorted, resulting in analyses that make little sense.⁸

Third, case law and commentary suggest that so long as a transaction has economic substance or a business purpose (or perhaps both), the taxpayer can choose the form in which to carry it out. However, that notion is misleading. Much of the analysis of how a transaction should be treated for tax purposes depends on whether the chosen form really is consistent with that substance. As discussed below, cases such as Gregory, in which the taxpayer had an underlying non-tax purpose (to sell a block of shares), illustrate that a non-tax motive for the transaction is not necessarily sufficient for a court to uphold the tax consequences arising from the chosen form. A corollary to this principle, as this Article demonstrates, is that courts should not respect a transaction, even one closely connected with the taxpayer's business, simply because the taxpayer is conducting a business.

The remainder of this Article proceeds in three parts. Part II first identifies the two principal goals of federal income tax statutes: to measure income and to induce desired behavior. These goals are very different from each other because tax-motivated behavior is inconsistent with the former but is the aim of the latter. Identifying which goal is operative in a particular Page 394 provision requires ascertaining Congress's intent. This Part also explains why the focus on whether a transaction constitutes a "tax shelter" is unhelpful.

Part III of the Article examines the case law that gave rise to the economic substance doctrine. It shows that the doctrine evolved from one focused on congressional intent to an entirely different doctrine in Frank Lyon Co. v. United States⁹-a case in which the Supreme Court did not seem to understand the economics of the transaction in question. The result is a misdirected doctrine that taxpayers can easily manipulate.

Part IV of the Article critiques each of the prongs of the economic substance doctrine, arguing that both the subjective business purpose and objective economic substance elements of the doctrine are misguided and can give rise to nonsensical results. It shows how the courts developed the business purpose prong in a context peculiar to corporate transactions, but extended it to circumstances in which it plays no appropriate role. It further argues that, in some cases, courts have inappropriately found a business purpose simply because the transaction was integrated into the taxpayer's business. This Part also explains that, like the business purpose prong, the economic substance prong can be applied to uphold abusive tax arbitrage simply because it is bundled with other activity.

The Article concludes that the economic substance doctrine is so deeply flawed that it must be abandoned and replaced with a direct inquiry into whether the transaction achieves results that are inconsistent with the intent of the tax laws. That inquiry, akin to Judge Learned Hand's analysis in Gregory, would consider the applicable statutory or regulatory framework in order to determine whether the claimed tax results are consistent with its purposes.

II Identifying Tax Abuse

A Two (Contradictory) Functions Of The Federal Income Tax

A fundamental difficulty the federal tax system poses is how to identify which transactions are abusive and which are legitimate. The core reason for this difficulty is that there are different kinds of tax provisions.¹⁰ Many federal income tax provisions are designed simply to measure the taxpayer's Page 395 economic income and impose tax on that income at specified rates.¹¹ Of course, imposing a tax on any behavior may result in less of that behavior. For example, taxing wages may reduce the amount of time a taxpayer works.¹² If market forces resulted in an optimal amount of the activity before tax was imposed, the reduction in that activity resulting from taxation gives rise to deadweight loss.¹³ Accordingly, taxation of activities for which taxpayers can substitute other activities often produces inefficiencies.¹⁴Assuming perfectly efficient markets before taxes were imposed, the most efficient tax would therefore be one that did not alter taxpayers' behavior at all.¹⁵

If measuring income without altering taxpayer behavior were the only thing Congress sought to accomplish with the federal income tax system, then, in theory, any tax-motivated action could be considered inconsistent with the goal of the tax system, and the claimed benefits disallowed as yielding deadweight loss-though such a tax system would be impossible to administer. In that hypothetical circumstance, the taxpayer's subjective intent would be critical because tax results would depend on it.

However, it is well known that the federal income tax system does not try only to measure taxpayers' taxable income. It also contains provisions expressly designed to alter taxpayers' behavior. These latter provisions intentionally mismeasure income in order to induce more of a particular activity. For example, the individual retirement account provisions encourage people to save money for their retirement.¹⁶ More generally, certain transactions may only be profitable after taxes and may thus be Page 396 undertaken because of the tax subsidy the government offers.¹⁷ Taking the government up on proffered tax benefits is, by definition, not abusive.¹⁸Accordingly, the fact that Congress intentionally provides some tax subsidies is a large part of what makes identifying abusive transactions so difficult.

The question thus becomes what distinguishes tax-influenced transactions that simply accept government incentives from those that exploit the law (whether or not they constitute tax shelters).¹⁹ The dividing line is whether Congress intended to provide the claimed benefit or not.²⁰ Page 397

While not necessarily an easy question to answer, it is the question that distinguishes abusive transactions from appropriate ones. Any other test is simply a proxy for that inquiry. The results of this inquiry can be diagramed as follows:

Congress intended the tax result	Congress did not intend the tax result
Allow claimed tax results to stand.	Disallow claimed tax results.

Note that, as this diagram suggests, unless the tax law provides otherwise,²¹ the taxpayer's intent is irrelevant to whether the transaction is abusive. For example, a taxpayer may decide...