A Tax Rule of Substance

In the early days of the 2008 financial crisis, then-Treasury Secretary Hank Paulson remarked that if you have a bazooka in your pocket, you probably won't need to use it. Just carrying it around is enough to change people's behavior.

He eventually found that, for his particular bazooka--the power to seize Fannie Mae and Freddie Mac--no one took it seriously until he used it.

It may be that the U.S. Treasury Department has been sitting on a tax bazooka for over a decade. It's been hidden for so long, most act as though it doesn't exist. Will the department need to use it for folks to take notice, or will some bazooka-rattling do the trick?

I'm referring to the economic substance doctrine, the 90-year-old legal concept created by the Supreme Court, and codified into law in 2010 by the Affordable Care Act.

It means pretty much what it sounds like--if a taxpayer's transaction or arrangement is meant only to avoid or reduce taxes, and has no justifiable business purpose, the Internal Revenue Service can disregard it and levy taxes as if it didn't exist.

On its face, it seems like a powerful rule. A non-tax person would probably be baffled that the Internal Revenue Service allows so many clear tax havens and shelters to exist, when the plain language of the law gives it the power to simply sweep them away.

In practice, though, it’s been a lot trickier to apply. Just how do you define a business purpose? Is it just to make a profit? Lots of tax-motivated maneuvers do that. And how do you identify when transactions are entered into purely for tax reasons? The law isn’t meant to invalidate merely tax-motivated transactions–that would be absurd, and often run against Congress’ intent when enacting tax incentives. (You’re supposed to change your behavior in response to those.) Years of case law have whittled the doctrine down to limited circumstances, and its use requires extensive analysis of both taxpayer and Congressional intent. Those subjective determinations have made the doctrine a tricky and unpredictable tool for enforcement.

Peter Blessing, associate chief counsel for international at the IRS, hinted that the agency may begin to use economic substance arguments more in legal cases, during an American Bar Association conference last week.

“We'll bring up economic substance doctrine to a greater extent than in the past, perhaps,” Blessing said during a “fireside chat” with tax accountants and lawyers. “You read the statute, it's a very broad statute, it's essentially a business purpose statute.”

Blessing added that his office was “reminded by the people who oversee us” that they should consider using this doctrine, but that they only would if they were sure it was appropriate.

When I first learned about the economic substance doctrine, something about it seemed almost downright un-American to me. You mean you can outsmart the tax laws fair and square, and yet somehow the government still wins?

As Judge Learned Hand famously wrote, “any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes.”

He wrote this as an appeals court judge in the case of Gregory v. Commissioner, which would go on to become the Supreme Court case that established the doctrine of economic substance. The case arose as Evelyn Gregory, owner of United Mortgage, pulled (by tax planning standards) a rather simple switcheroo to reduce income taxes on proceeds from the sale of her company.

Confusingly, Judge Hand was actually ruling in favor of the IRS and its position to disregard Gregory’s corporate reorganization when he wrote that passage defending a taxpayer’s right to arrange his affairs to reduce taxes.

“It does not follow that Congress meant to cover such a transaction, not even though the facts answer the dictionary definitions of each term used in the statutory definition,” he added. “The meaning of a sentence may be more than that of the separate words, as a melody is more than the notes, and no degree of particularity can ever obviate recourse to the setting in which all appear, and which all collectively create.”

Note that this case involves both the taxpayer intent–why did she enter into this transaction–and Congressional intent–why did Congress enact that law? This eventually grew into a two-pronged test, which scholars have noted often conflict or override each other.

It’s one thing to determine the intent of a murderer or money launderer, but how to evaluate intent of a corporate taxpayer? Or of a transaction itself? One example I like–a tax official at manufacturing giant Caterpillar Inc., during a deposition from a whistleblower case, seemed to admit that a transaction had no business purpose other than to recharacterize income and avoid tax through deferral. (See page 72 of this Senate report.) Even this, apparently, wasn’t enough evidence for an economic substance case. Caterpillar recently announced it had settled the long-simmering case with the IRS, for no penalties.

And Congressional intent is murkier still. Former Treasury Secretary William Simon once said, “the nation should have a tax system that looks like someone designed it on purpose.” Maybe he’d say today’s system meets that goal, but likely not. With tax laws more than 100 years old, enacted through compromises with legislators long since dead, interacting in ways they never could have foreseen–what intent can be gleaned from the law’s words?

Codification may have added some clarity to the economic substance rule, but it likely raised as many questions. The new legal language in Section 7701(o), in the “Definitions” section of the Internal Revenue Code, is infuriatingly circular, likely due to Congress’ desire to maintain the status quo with its application. When the economic substance doctrine is “relevant,” a transaction will be considered compliant with the doctrine if “the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and…the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.”

When is the doctrine “relevant,” as some separate question from the two-part test the law lays out? That’s a key, though by no means only, issue that could hamper enforcement.

The recent trend in taxation, especially international corporate taxation, has been against broad, principles-based rules like economic substance, and towards more hard-and-fast anti-abuse rules. The Organization for Economic Cooperation and Development created new standards for evaluating risk-based allocations of income involving hard-to-value intangible assets–think, pure cash boxes–in its 2015 Base Erosion and Profit Shifting project, but they haven’t received nearly as much attention as its formula-based global minimum tax agreement. That avoids angels-on-a-pin-type debates about intent or purpose, or at least tries to, by looking at easily quantifiable factors like payroll and tangible assets.

Formulas can be gamed, but at least they can’t be argued to death in the courtroom. Both taxpayers and tax administrators can benefit from that kind of certainty.

But even as the OECD and Treasury make progress in tackling global tax avoidance, public and political pressure for more results remains, and the Biden administration may be looking to see what secret weapons have been hiding in plain sight in the tax code. Blessing’s comments coincide with speculation–which Treasury has attempted to cool–that they may look to rewrite the crucial check-the-box rules.

There’s some precedent. The Obama administration, faced with continuing high-profile corporate inversions and an obstinate Congress, unveiled controversial Section 385 rules to restrict deductions for intercompany debt. The rules were a straightforward and intuitive use of the legal language–but they went against decades of prior precedent and practice, and were questioned by tax experts across the ideological divide. Yet they still remain in effect, albeit greatly reduced in scope by the Trump administration.

The Internal Revenue Code is filled with passages like these, that have simple language with far-reaching implications. The language authorizing transfer pricing, in Section 482, seems like it’s giving Treasury broad authority to go after tax avoidance–although it’s restricted not only by court precedent but treaties as well. It's just one example of an area where officials could, theoretically, get creative.

With judges applying increasingly harsh scrutiny on Treasury regulations, buttressing them with economic substance claims, or other new statutory interpretations, could put some iron in the glove and encourage taxpayers to back off. (That's what Treasury recently did in U.S. vs. Liberty Global, which Blessing noted.)

On the other hand, the current Supreme Court has shown no reticence to strip fundamental executive branch authority–could a controversial new reading of the law be inviting their ax?

That’s another problem with using a bazooka–you can never be totally sure it will shoot straight.

DISCLAIMER: These views are the author's own, and do not reflect those of his current employer or any of its clients. Alex Parker is not an attorney or accountant, and none of this should be construed as tax advice.

LITTLE CAESARS: NEWS BITES FROM THE PAST WEEK

The Centre for International Corporate Tax Accountability and Research, a research and advocacy organization linked with tax justice movements, released a report on Oct. 12 highlighting Microsoft Corp’s global tax practices. The CICTAR claims the software giant “uses a web of shell companies to potentially dodge billions in tax,” which seems to relate to a corporate residency enabled by Ireland’s infamous “Double Irish” rules, which were finally eliminated in 2020. It’s a little unclear how relevant this is in the post-Double Irish world, but this report is likely to receive more political attention on both sides of the Atlantic.

Treasury must release “immediate guidance” to help taxpayers deal with the new corporate alternative minimum tax, the Association of International Certified Professional Accountants said in an Oct. 14 open comment letter. The association listed a host of problems companies are already confronting, including several in the international sphere. Those include how to reconcile the rules with tax treaties, how to recognize a common parent organization, and income adjustments to prevent potential double-counting. The Inflation Reduction Act gives the department wide latitude in implementing the CAMT, and there’s not even a published legislative history to help guide them. So don’t expect much of a break before the fireworks.

Nigeria, one of the few countries which refused to sign onto the OECD’s Two-Pillar Solution, is pushing for the United Nations to step up on global tax matters, presumably to one day replace the OECD as the world’s tax rules-setting body. This is an old debate that likely isn’t going to change soon, but with so much of the international tax system in flux, it’s still something to keep an eye on.

Friend of Things of Caesar (and one of our first subscribers) Daniel Bunn was appointed to be the new chief executive officer of the Tax Foundation, replacing long-time head Scott Hodge. Congrats to Daniel! He’s one of the top experts following international tax and the OECD negotiations, hopefully we’ll continue to see his excellent work in this area.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Dan Hastings, created by Clem Gretter in 1937 for Star Comics #1. An Interplanetary Police officer, based on Earth, who fights space threats armed with rocket boots and a ray gun, although he can resort to his fists when necessary. According to the Public Domain Super Heroes database, Hastings was an early Flash Gordon copy, used by many different companies.