Business-purpose and economic-substance tests.

• Author: Tapajna, Joseph J.
• Position: Corporations & Shareholders

When determining if a transaction is legitimate for tax purposes or is a sham, the courts and the IRS typically apply a business-purpose test and an economic-substance test. In general, the business-purpose test questions whether the transaction has an identifiable economic purpose independent of tax considerations. The economic-substance test requires that the transaction have real potential for profit.

Although the standards that courts use in determining whether to respect a transaction seem relatively straightforward, the analysis is fraught with the difficulties inherent in applying subjective standards to the facts. IES Industries, Inc., 8th Cir., 6/14/01, provides taxpayers with additional guidance in determining whether their tax-beneficial transactions meet the Eight Circuit's standard for business purpose and economic substance. IES Industries is a particularly interesting case, because the court held that the company satisfied the business-purpose and economic-substance tests in a transaction that closely resembled the stock purchase/ sale transaction that the Tax Court rejected in Compaq Computer Corp., 113 TC 214 (1999).

In Compaq Computer, the IRS challenged a transaction that involved the carefully planned purchase and sale of American depository receipts (ADRs). Compaq purchased ADRs "cum dividend" (i.e., Compaq was entitled to the declared dividend), followed by an immediate sale of the ADRs "ex dividend" (i.e., the purchaser was not entitled to the declared dividend). Compaq was seeking (under prior law) to realize the benefits from the ADRs' foreign tax credits (FTCs), while offsetting a previously recognized capital gain with a capital loss on the ADR sale. In holding that the ADR transaction was a sham, the Tax Court concluded that it had no economic substance or business purpose other than the realization of the tax benefits.

In Compaq, the Tax Court opined that economic substance is supported by evidence of a transaction's potential to produce a profit for a taxpayer and the existence of market risk. In finding that Compaq's ADR transaction would result in an economic loss prior to the use of the FTCs, the court concluded that the transaction lacked the profit potential necessary for economic substance. Further, no economic substance existed, because the carefully planned ADR transaction eliminated virtually all of the market risk associated with the transaction.

In Compaq, the court stated that a transaction...