The Substantive Canons of Tax Law.

Author:Choi, Jonathan H.

Table of Contents Introduction I. Problems with the Status Quo A. Inconsistency B. Tension with Textualism II. The Substantive Canon Framework A. What Are Substantive Canons? B. Anti-Abuse Doctrines as Substantive Canons C. Applying the Framework 1. Historic Boardwalk Hall 2. Gitlitz 3. Benenson and Summa Holdings D. Codified Canons: Section 7701(o) III. The Case for Substantive Tax Canons A. Substantive Canons Serve as Background Norms B. Substantive Canons Make Statutes More Flexible and Intuitive C. Substantive Canons Complement Purposivism D. The Evolution of Substantive Tax Canons Conclusion Appendix: Catalog of Substantive Tax Canons Introduction

The Internal Revenue Code (1) is notoriously complicated, but life is even more so. Congress cannot anticipate every possible application of its tax legislation, and taxpayers inevitably combine disparate provisions of the Code to produce unforeseen shelters and loopholes. Courts have articulated a variety of doctrines to combat this threat, such as the doctrine that transactions lacking economic substance should be disregarded, (2) and the doctrine barring taxpayers from taking two tax deductions from a single transaction. (3) These doctrines (the "anti-abuse" doctrines (4)) have conventionally been articulated as straightforward rules that do not involve statutory text or purpose. (5) The economic substance doctrine, for example, is a two-factor test that turns solely on the economic effect of (6) and business justification for (7) a transaction, regardless of the tax statute at issue.

The conventional treatment encounters two major problems. First, many judges decline to apply the anti-abuse doctrines in a manner too contradictory to the underlying statute--for example, most courts do not apply the economic substance doctrine to deny incentive tax credits (such as renewable energy credits), even when the incentive tax credits fail its two-factor test. (8) But because there is no consistent theory to weigh mushy statutory purpose against a rigid common law rule, judges strike a haphazard balance between the two in their quest for sensible results. (9) Sometimes courts tweak the doctrines in nonsensical ways, and sometimes they reject the doctrines altogether. (10) This has created confusion and inconsistency as to how and when the anti-abuse doctrines apply. (11)

Second, the anti-abuse doctrines have come under attack in an increasingly textualist world. (12) The rise of modern textualism (13) has inspired accusations that the anti-abuse doctrines violate separation of powers principles and are generally illegitimate. (14) This, in turn, has encouraged opportunistic taxpayers to undertake questionable transactions in the hope that the doctrines may not apply. (15)

This Article addresses both of these problems by integrating the anti-abuse doctrines into a framework already well known to legislation scholars. (16) It argues that these doctrines should be understood as substantive canons of construction, used by judges as rebuttable presumptions of meaning in interpreting the Code. (17) Reconceptualizing the anti-abuse doctrines as presumptions resolves the apparent arbitrariness in their application (18) by allowing courts to integrate them with considerations of statutory text and purpose. (19)

This Article further argues that these substantive tax canons are justifiable as background norms familiar to drafters of statutes (especially the staff experts actually responsible for the bulk of the drafting (20)), regulators, courts, and practitioners, and that the anti-abuse doctrines therefore underlie the best reading of the Code. Substantive canons that serve as background norms are inherently neither textualist nor purposivist (21) and have been accepted by theorists of many different methodological stripes. (22) Moreover, by providing an objective criterion for validity (widespread acceptance as a background norm), the framework adjudicates among the many rules that have been proposed as anti-abuse doctrines. (23) The substantive tax canons discussed in this Article can be investigated by conducting surveys as to common knowledge of disputed canons, or by conducting historical research into their longevity and prevalence. Reconsidering anti-abuse doctrines as substantive canons also provides flexibility in interpretation, rather than forcing Congress to avoid absurdities by hard-coding statutory exceptions to the doctrines. This helps the anti-abuse doctrines to serve their ideal role as intuitive guidelines in unforeseen fact patterns. (24)

Ironically, many of the anti-abuse doctrines were initially understood as tools of statutory interpretation, arising as courts strove to interpret ambiguous (25) early tax statutes. (26) But as the anti-abuse doctrines were formalized and transformed from broad intuitions into specific multifactor tests, their original spirit was lost. (27) Judges and regulators given multifactor rules tend to apply those factors mechanically, to the exclusion of statutory context that might dictate an alternative result. (28) While this can sometimes laudably increase taxpayer certainty, here it has expunged critical nuance in the doctrines' application.

Part I of this Article describes the history of the anti-abuse doctrines and problems with the status quo. Part II explains substantive canons in general and applies the framework to the anti-abuse doctrines. Part III normatively defends substantive canons as background norms, explaining how they are flexible and intuitive guidelines useful both to textualists and purposivists. The Appendix provides additional evidence for the anti-abuse doctrines' status as background norms, based on a review of relevant tax cases. It serves as a catalog of substantive canons in tax law, illustrating the development of the canons and providing an additional resource for readers.

I. Problems with the Status Quo

Criticisms of the anti-abuse doctrines generally fall into two categories: first, that the doctrines are inconsistently applied; second, and more recently, that the doctrines inappropriately contravene statutory text. This Part summarizes both of these claims in turn.

  1. Inconsistency

    Courts have long struggled to reconcile the anti-abuse doctrines with statutory context and have often enforced them inconsistently as a result. This is most apparent with the three most famous anti-abuse doctrines, familiar to virtually all tax practitioners and scholars: (1) the substance-over-form doctrine (requiring that transactions be taxed in accordance with their substance rather than their form); (29) (2) the step transaction doctrine ("requir[ing] that the interrelated steps of an integrated transaction be analyzed as a whole rather than treated separately"); (30) and (3) the economic substance doctrine. (31) Each one aptly illustrates the courts' struggle to balance judge-made rules against statutory meaning.

    The substance-over-form doctrine has frequently been criticized as inconsistently applied. The Code contains a number of provisions that are solely a matter of form, including the various elections that permit taxpayers to choose between cash or accrual methods of accounting, (32) accelerated or straight-line depreciation, (33) and the fiscal or calendar year. (34) And there are circumstances where courts have concluded that form actually trumps substance: Section 71(c) of the Code, for instance, has been interpreted to require taxpayers to specifically "earmark" child support payments for which they wish to receive a tax exemption, meaning that substantive qualification for the tax exemption is insufficient. (35) In their leading textbook, Boris Bittker and Lawrence Lokken complain that "it is almost impossible to distill useful generalizations from the welter of substance-over-form cases" (36) -as indeed it is, if we take these cases as reflecting a static legal rule not dependent on nuances of the underlying statutes.

    Likewise, courts and the Internal Revenue Service (IRS) have been uneven in their application of the step transaction doctrine, apparently out of deference to congressional intent. (37) For example, the Code does not tax shareholders on the contribution of assets to a corporation in exchange for stock if certain conditions are met, (38) including that the transferring shareholders must be in "control" of the corporation after the exchange. (39) Under the step transaction doctrine, control is usually lost (and tax is therefore imposed) if the shareholders dispose of their stock in the corporation after the transfer pursuant to a pre-existing plan. (40) But the IRS has sometimes declined to apply the doctrine in this way when it has perceived a conflict with statutory purpose (to reduce tax frictions). (41) Commentators have agreed with the outcome but questioned the IRS's rationale, describing it as "a new layer of confusion" in the step transaction doctrine. (42)

    Finally, the economic substance doctrine may illustrate the inconsistency issue best of all. The doctrine has two prongs that must both be met for a transaction to be respected. One requires that "the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into such transaction." (43) The problem is that many tax provisions invite taxpayers to participate in transactions solely for tax reasons--historic rehabilitation credits attract investors with no interest in historic rehabilitation, (44) renewable energy credits attract investors with no interest in renewable energy, (45) and so on. To apply the economic substance doctrine here would be poor policy, since the subsidy ought to expand the pool of investors and therefore bid down the returns demanded to fund such projects. If investors that invest solely to obtain a tax credit were ineligible, then the credit would effectively serve as a windfall to existing investors rather than spurring new investment.

    Courts have skirted...

To continue reading