An Economic-Like Substance

Gregory v. Helvering, the 1935 Supreme Court decision which established the economic substance doctrine, involved a remarkably simple transaction in which Evelyn Gregory created a shell entity to sell shares in her company, creating a loss to mitigate the capital gains created by the sale.

Project Soy–the structure of intercompany transactions which the U.S. District Court last year ruled lacked economic substance in Liberty Global Inc. v. United States–was a mind-numbingly complex maneuver “designed to leverage the different effective dates between two different provisions enacted in the Tax Cuts and Jobs Act,” according to a Holland Knight analysis.

In both cases, the Supreme Court ruled that the transactions could be ignored by the Internal Revenue Service, because they did not reflect economic reality, but were purely tax-motivated.

The difference in complexity in the two cases is maybe analogous to the economic substance doctrine itself, which began as a simple and intuitive principle and developed, over decades of case law and a Congressional Act, into a complex and difficult application. So complex and difficult, in fact, that the IRS has rarely used it, preferring to use tried-and-true statutes such as those allowing pricing adjustments under the arm’s-length standard.

But that is likely changing. Back in 2022 I wrote about comments from a government official suggesting that the IRS might be looking to use the doctrine more aggressively in the future. Since then, the U.S. District Court may have opened the floodgates with the Liberty Global case, arguably throwing aside the case history of the economic substance doctrine in favor of a broad reading of the statutory language.

This could affect all areas of law, but it’s especially pertinent in international taxes–where the structures can become exceptionally complex and suspicions continue that they are largely or entirely tax-motivated. It may be years before the effects from this can be seen, but it could have dramatic effects on multinational tax planning. On the one hand, it could allow the IRS to finally crack alleged tax avoidance structures which have proven to be remarkably persistent.

On the other hand, the potentially subjective determinations behind this new broad understanding of statutory language could make an already-precarious international tax landscape even more unpredictable.

Because this is a newsletter and not a legal paper, I’m going to gloss over the details of the Liberty Global case and try to get to the central issue. After some of the U.S. Treasury Department’s TCJA regulations were thrown out for not complying with the Administrative Procedure Act, the IRS claimed that Liberty Global’s structure could be disregarded anyway, due to the economic substance doctrine. The case came down over conflicting interpretations of the doctrine, including its case history as well as its statutory language.

While the doctrine itself was created by the Supreme Court 90 years ago, it wasn’t codified into law until Congress passed the Affordable Care Act in 2010. The idea of codifying the doctrine had been bouncing around Washington for years, but lawmakers picked it up here as they were looking for any source of revenue to cover the ACA’s costs, and codification gave them a slight boost.

Taking pains to retain the status quo in its application, Congress ultimately enacted language which is arguably circular and rather confusing. It lays out a two-pronged test to apply “in the case of any transaction to which the economic substance doctrine is relevant.” For that sentence, the “economic substance doctrine” is defined as the “common law doctrine” in which tax benefits are not allowable if “if the transaction does not have economic substance or lacks a business purpose.”

For the tests, the law states that a relevant transaction “shall be treated as having economic substance” if it “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.”

No one can seem to agree on why the section prefaces with the condition that the economic substance doctrine be “relevant”--does that mean that the two-pronged test is a refinement of the pre-existing doctrine, or an expansion of it? (The House report for the ACA states that it “clarifies and enhances” the doctrine, and otherwise isn’t much help.) Liberty Global argued that the IRS couldn’t apply the two-pronged test until it proved that the doctrine was relevant to the transactions at issue, based on the more nuanced and complex distinctions drawn from decades of case law.

The Court, however, ultimately agreed with the government that the statute itself was all that was needed. If a transaction lacked economic substance, based on that definition, then of course the economic substance doctrine would apply. (That makes the whole preface unnecessary and redundant, Liberty Global noted.)

“At the risk of tautology, I proceed with the conclusion that the economic substance doctrine applies when a transaction lacks economic substance,” wrote Judge R. Brooke Jackson in the U.S. District Court ruling. “There is no ‘threshold’ inquiry separate from the statutory factors.”

That could mean that any transaction which does not change the taxpayer’s economic position, or does not have a substantial purpose could be targeted by the IRS to be disregarded under the doctrine. Those potentially subjective and intention-based determinations could throw many common structures under suspicion. An evaluation of Congressional intent behind a certain tax law, a key element of the economic substance doctrine historically, is also notably absent. (Corporations are supposed to engage in tax-motivated behavior when it comes to some incentives, for instance.)

“The interests of businesses, consumers and the government are best served when the economic substance doctrine is interpreted as a principled, predictable and administrable judicial doctrine that aligns with Congressional intent rather than an in terrorem measure that gives substantial power to the IRS and courts to take away tax benefits that would otherwise accrue under the plain text of the Code and its regulations,” the U.S. Chamber of Commerce wrote in an amicus brief supporting Liberty Global’s appeal of the District Court opinion.

As I wrote back in 2022, a layperson might wonder why the IRS allows so many complex international structures at all, given this powerful tool allowing the agency to disregard them. Isn't that just common sense? The truth is that years of case law have slowly whittled it down to a very narrow application for clear and typically novel transactions.

But now, perhaps the more intuitive and powerful use is open.

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.

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This isn't directly related to the newsletter but I just thought I should let you all know, this week I'm leaving my day job at Capitol Counsel. My plan is to continue with the newsletter--which should be unaffected by the switch--along with other work related to international taxes. Thanks again to all of you for making this project a success. If you want to support the newsletter, keep reading and consider upgrading to a paid subscription.

LITTLE CAESARS: NEWS BITES FROM THE PAST WEEK

• Following the Group of 20 coalition of nations’ finance ministers meeting in Brazil last week, the organization issued a “Ministerial Declaration on International Tax Cooperation”--a first-ever outlining of tax principles and goals from the world’s largest economies. It doesn’t break a lot of new ground, however–mostly, it expresses support for initiatives which already began at the Organization for Economic Cooperation and Development or elsewhere. It also expresses mild support for the United Nations’ recent ad hoc tax committee–which is currently debating “terms of reference” for negotiations over a new platform on international tax issues–while also cautioning against “duplication of efforts” (i.e. usurping the OECD) on global tax matters. There are other tea leaves to be read, including its strong language on the importance of “all taxpayers, including ultra-high-net-worth individuals, to contribute their fair share in taxes.” As a general document indicating directions and trends, it’s very interesting to peruse.
• As is customary, the OECD submitted a report on taxation to the G-20 at its finance ministers meeting, including updates on the Two-Pillar project as well as its other initiatives on Base Erosion and Profit Shifting. On Pillar One, which the OECD has yet to announce a final agreement on despite its self-imposed June 30 deadline, the report states that there is “near full consensus” on Amount A and “very broad support” for the Amount B framework, with “some remaining issues for a small number of members to be resolved.” So, same as before. The OECD also issued several new publications on a wide array of international tax issues, including the reporting of beneficial ownership, taxing cryptocurrencies, tax and real estate, and inequality. So, lots of beach reading for those hot August afternoons!
• Speaking of clamping down on individual tax evasion, Senate Finance Committee Chairman Ron Wyden, D-Ore., is continuing his investigations into alleged tax dodging and Swiss banks, writing a letter to the CEO of UBS Group AG demanding information related to an account-holder recently indicted for alleged tax evasion. On the one hand this relates to the seemingly never-ending saga of bank secrecy and Switzerland, but what’s interesting here is that the defendant here is a military contractor. Those contracts usually include some extra protections against this kind of thing, so we’ll see where this leads.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Every week, a new character from the Golden Age of Superheroes who's fallen out of use.

Golden Girl, first appearing in Golden Lad #5 in 1946. A crimefighting partner of Golden Lad--who, if you've forgotten, became a superhero after receiving superpowers from an ancient Aztec artifact he found in his grandfather's antique shop. Like her partner she can fly and has super-strength (as well as some bad-ass armored gloves).

Contact the author at amparkerdc@gmail.com.