Respect for "form" as "substance" in U.S. taxation of international trusts.

• Author: Kozusko, Donald D.
• Position: The Rise of the International Trust

1. RESPECT FOR "FORM"

   It would be difficult to imagine how the federal tax system of the United States could function without the "substance-overform" principle. Every analysis of the tax treatment of a transaction or transfer must, explicitly or implicitly, address the question: "Will the tax law treat this as what it appears to be? The question of whether the tax rules will be applied according to the "form" or the "substance" of the transaction or transfer has taken on a variety of formulations in the judicial decisions.

   1. Is this in Fact a "Sham"?

      First, there is the category of cases where the taxpayer's version of events is documented but inconsistent with what actually occurred. The documents were not respected. A change in title was recorded in the name of the new owner but control over and enjoyment of the property never changed hands. Income and expense were recorded on the books of a trust but the trustee served in fact as a mere nominee. Property was leased, but only on paper. The transaction or transfer was a "fake." In effect, the form was not respected by the taxpayer.

   2. Is this a "Sham" in Substance?

      The next category of cases is much more difficult to categorize. That is unfortunate because they represent the core learning and experience in the application of "substance" over form. While there are a variety of formulations of the appropriate test in these cases, the inquiry always focuses on the lack of an economic dimension to the taxpayer's position. For example, in the leading case of Knetsch v. United States,(1) dealing with a tax shelter investment, the transaction (a leveraged investment in deferred income bonds) was treated as a "sham" because "there was-nothing of substance to be realized by Knetsch from this transaction beyond a tax deduction." On the Court's reading of the facts, the', taxpayer had no credible chance for an economic profit from the investment measured on a pre-tax basis. Some of these cases blend over into the first category: the steps on which the taxpayer relies actually occurred, but the events involve other steps that limit or offset the resulting economic consequences, so that the taxpayer's change in economic position is not meaningful.(2) If a taxpayer claims that his transfer of property to a trust for the benefit of his child is not a gift but a sale, is there any difference between the case where the taxpayer never intended to collect the purchase price (a sham in fact) and the case where the taxpayer loaned the purchase money to the trust on terms that evidenced it would never be paid back (a sham in substance)?(3)

   3. Was this what Congress Intended?

      The Court may also conclude that the actual events are outside the Congressional intent of the Internal Revenue Code (Code) provision on which the taxpayer relies. In the leading case of Gregory v. Helvering,(4) Justice Sutherland conceded that the taxpayer was legally entitled "to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits." However, he concluded that the real question was "whether what was done, apart from the tax motive, was the thing which the statute intended," and decided the case against the taxpayer.(5) Indeed, it should be inevitable that questions of "substance" over "form" require an analysis of statutory intent whenever the transaction or transfer is not a sham in fact (not a "fake"), and the challenge is made on the ground that the taxpayer's position has no substance apart from tax consequences. Assuming that a particular transaction or investment has some economic substance apart from tax consequences (e.g., the pre-tax profit potential is not de minimus), then it has a non-tax purpose and the question of statutory intent should become paramount. Otherwise, the substance over form doctrine would greatly circumscribe the Congressional prerogative to allow transactions to be taxed according to their form, and to encourage the form to be deliberately structured to take advantage of a tax incentive.(6)

      More specifically, in applying "substance over form" to bona fide transactions or transfers (not a "sham" in fact), the perplexing but critical question is "how much substance is enough?" That question cannot be answered without an examination of legislative intent. The relevance of Congressional intent is obvious in "tax shelter" cases where Congress created an incentive and the taxpayer is allegedly "abusing" that privilege.(7) Those cases have generally concluded that, in addition to meeting the literal requirements of the statute, Congress must have assumed that the taxpayer's activity, such as borrowing money, also had some economic purpose apart from tax consequences.(8) This approach actually developed initially outside of the tax shelter context. Most notably, in Gregory v. Commissioner,(9) the Tax Court began by concluding that the "meticulously drafted" statutory provision on corporate reorganizations left no room for a judicial gloss. However, the Second Circuit and the Supreme Court concluded quite the opposite: that a transaction lacking a "business purpose" could not have been intended by Congress as a "corporate reorganization." Though the results of this analysis vary from case to case, and from opinion to opinion, the important point is that this formulation of the doctrine claims Congressional intent as its rationale. Thus, the courts should recognize that its application should adapt to the particular statutory question involved.

   4. Are We Seeing the Whole Picture (the "Step Transaction" Doctrine)?

      Though conceptualized as a separate doctrine, the "step transaction" doctrine largely overlaps with the "substance over form" doctrine. It might be considered, in large part, a variation on "substance over form" in that it deals with whether the form of the taxpayer's ordering of events will be respected. Will steps be added to or subtracted from the course of events described by the taxpayer, or will the steps be reordered, to show the "true picture?" Courts have used the step transaction doctrine to link prearranged or contemplated steps, despite a party's lack of a legal obligation or financial compulsion to complete all the steps in the transaction.(10) Should every step be respected, however transitory or lacking in substance? The step transaction doctrine has been employed to eliminate transitory or unnecessary steps where the steps taken were "so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series."(11)

2. "FORM" AS "SUBSTANCE"

   Against this persistent belief in the sanctity of substance lies the reality that the operation of the tax law is dependent upon form. Taxpayers often choose among forms based on tax consequences, because different forms are treated differently by the tax law. Moreover, different forms are rarely completely identical in substance. Consequently, questions of degree arise in deciding whether the two forms are "similar enough" to be taxed the same way. For these reasons, form becomes substance in many cases. A Code provision contemplates a form of transaction or transfer and treats it a certain way by reason of a certain legislative policy on such matters. If a particular form then seems to vary from the norm, the question arises: "Is this what Congress intended?" A decision must be made as to whether the variance in form is material or immaterial in view of the substitutive purpose. How often this question arises depends on the ingenuity of taxpayers, the context involved, and most importantly, how closely the form contemplated by the Code provision matches the legislative purpose.

   1. Taxation of Gratuitous Transfers by Nonresidents of the United States

      The importance of form is readily illustrated in the field of U.S. taxation of international trusts and their settlors and beneficiaries. The tax rules for nonresidents of the United States depend heavily on distinctions based on form. A simple example will illustrate this reliance on form, and how form reflects substance. This example deals with transfer taxation of nonresidents. While the estate, gift and generation-skipping tax impose taxation based on legal rights to property, which are naturally matters of form, the following discussion will consider how even simple rules of form might be open to challenge in cases where another result seems to have a more substantive foundation. Even so, the simple rules of form generally prevail.

      Although the U.S. estate and gift tax is imposed on gratuitous transfers by U.S. citizens and residents regardless of the location of the property, such transfers by a non-resident citizen (NRA) are not subject to tax if the property is considered situated outside the United States.(12) Accordingly, it has become standard practice for NRAs who are purchasing U.S. situs property to effect the purchase through a non-U.S. corporation.(13) Is there reason to doubt the logical integrity of a system in which the U.S. estate tax applies upon the death of a non-U.S. investor to direct stockholdings in the U.S. equity market but not to the same stocks that are the sole asset of a non-U.S. company wholly owned by the same investor? It is not necessary to challenge this structure in order to defend the integrity of the system, if respect for form is an important principle that promotes consistency and ease of application both for the investor and the U.S. tax authorities.

      Congress has acknowledged the viability of avoiding U.S. estate tax by the use of a non-U.S. investment company. The legislative history of the Foreign Investors Tax Act of 1966 contains this instructive passage describing the opportunity for a newly-minted NRA, having lost U.S. citizenship and residency, to avoid U.S. estate tax on U.S. situs property:

      In determining the value of the gross estate of such an expatriate (as in the case of nonresident aliens...