INTRODUCTION
Tax avoidance, by its definition, is an oxymoron. Often times, there is an indicia of illegal overtone, albeit, legal. Tax avoidance is the reduction of tax liability by legal means. It often has pejorative overtones, where for example it is used to describe avoidance achieved by artificial arrangements of personal or business affairs to take advantage of loopholes, anomalies or other deficiencies of tax law. Rules introduced into the law to prevent or circumvent certain types of avoidance which are disapproved of by the legislature may be described as “anti-avoidance provisions” or “provisions against legal avoidance.”1 In contrast with avoidance, tax evasion is the reduction of tax by illegal means. It is this grey area between avoidance and evasion that creates divergence in legal approaches to curb the problem and the ensuing legislative interventions.
Codifying the Economic Substance Doctrine is not a legislative groundbreaking because the doctrine has been applied time and again, within the judicial domain. The implication of codifying the doctrine might be far reaching and polarizing when it comes to business transactions – – particularly, cross-border transactions. Far reaching because of the power it conferred to a single agency – – the Internal Revenue Services, and polarizing because of the glaring burden placed on business transactions, especially, cross-border transactions. Economic substance doctrine was an invention of judicial interpretation which posited that tax benefits from a transaction may be denied if the transaction does not result in a meaningful change to the taxpayer’s economic position other than reducing federal income taxes.2 Judicial analysis of Economic Substance Doctrine takes different forms – – such as step-transaction analysis, sham doctrine, the business purpose test, and the substance over form doctrine – – but the conclusion, often times, is the same. These various judicial analyses point to an effort by the courts to curb tax avoidance and abusive tax planning. Application of Economic Substance Doctrine differs from jurisdictions to jurisdictions and as result, various governmental bodies have tried to harmonize the application of the doctrine to tax law by codifying Economic Substance Doctrine.3 In the United States, Congress, in an effort to address the problem of abusive tax shelters and to bring uniformity and certainty to the analysis of economic substance in transaction, codify “Economic Substance” doctrine4.
Although, the code does not seek to supplant the existing common law precedent, the strict liability imposed by the code certainly begs the question. The Courts would still review the doctrine as codified. The question then becomes what roles would the court play in the implementation of the code? As indicated earlier that under the common law, the doctrine enjoyed neither uniformity nor consistency in the definition of economic substance in business transactions. This makes the terrain very treacherous to navigate, and likewise creates uncertainty in law.5In the past, the role assumed by various courts dictates the path of judicial analysis. Some courts viewed its role, simply as a strict constructionist which often results in a narrow and more constrict interpretations. Others viewed its role as purely interpreting broadly the provision with reference to the object and spirit of the law which also results in a broader and benevolent conclusion. Under the common law, this dichotomy of interpretation of economic substance was very glaring. In lieu of these dichotomies, the courts’ view of Economic Substance Doctrine as codified may ultimately answer the larger question of whether the codification of economic substance would be the catalyst that torpedo business transactions, particularly, cross-border transactions that might ordinarily withstand legal scrutiny. Therefore, the issues in furtherance of the discussion are: 1) whether the court would view its role as strict constructionist that would give tax authorities broad power; 2) whether the court would interpret the code more broadly in accordance with the object and spirit of the law, allowing a more balance adjudication.
ECONOMIC SUBSTANCE DOCTRINE: COMMON LAW AND THE CODE
The Substance and form rule is primarily used in countries such as the United Kingdom, United States, and Canada while civil law jurisdictions such as France, Germany and other European nations used the concept of the abuse of Law (Fraus legis). While the substance and form principle is frequently invoked to curtail alleged tax avoidance, the approach taken by the US and UK courts has been deferent. The reason for the divergence is the role assumed by these Courts.6 It is a well-established principle that “the legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted.”7 Similarly, “every man is entitled if he can, to order his affairs so that the tax attracting under the appropriate Acts is less than it would otherwise be.” To the extent that these two views are similar in regards to the rights of taxpayers, the approaches taken in the analysis of economic substance doctrine by these jurisdictions are completely diverse. The approach taken by the US courts is that the substance of a transaction, and not the form, controls when it comes to judicial review of Tax law. What this approach does is brings uncertainty to the purview of business transactions. In Gregory, the court made it clear that, while the form of a transaction might conform to the statutory provision, the substance of the transaction, when examined and does not have business or economic purpose, such transaction shall be disregarded.8
In Frank Lyon Co v US, 435 US 561 (1978) the Supreme Court held that agreements which were intended to have economic substance as opposed to mere tax avoidance should be given effect for tax purposes when determining whether the form or substance of an agreement should govern. Similarly, in Knetsch’s case, the Supreme Court maintained its position that economic substance of a transaction would always control in the analysis of the tax avoidance. This case involved an annuity insurance purchased by the taxpayer and the loan taken against the annuity. The taxpayer then attempted to deduct the interest paid on the loan. Although, the court accepted the “form” of the transaction, it rejected the “substance”9 because the transaction had no business or economic purpose.10 In Justice Brennan’s opinion, “the arrangement was a fiction, because Knetsch’s transaction with the insurance company did “not appreciably affect his beneficial interest except to reduce his tax . . . there was nothing of substance to be realized by Knetsch from this transaction beyond a tax deduction.”11 In the dissenting opinion, however, Justice Douglas raised a very significant point, that is, the legal validity of the transaction should not be ignored. He stated that “It is true that in this transaction the taxpayer was bound to lose if the annuity contract is taken by itself. At least the taxpayer showed by his conduct that he never intended to come out ahead on that investment apart from this income tax deduction . . . Tax avoidance is a dominating motive behind scores of transactions. It is plainly present here. Will the Service that calls this transaction a “sham” today not press for collection of taxes * arising [**138] out of the surrender of the annuity contract? I think it should, for I do not believe any part of the transaction was a “sham.” To disallow the “interest” deduction because the annuity device was [***17] devoid of commercial substance is to draw a line which will affect a host of situations not now before us and which, with all deference, I do not think we can maintain when other cases reach here.” Justice Douglas then concluded that “as long as the transaction itself is not hocus-pocus, the interest charges incident to completing it would seem to be deductible under the Internal Revenue Code as respects annuity contracts made prior to March 1, 1954.”12 In the judicial construct of the economic substance doctrine, two-prong test emerged which is: 1) taxpayer should have a commercial reason for entering into a transaction; 2) the purpose of the transaction or scheme should not merely to avoid tax.13 This two-prong test also constitute the requirement in the economic substance doctrine code which would be discussed later.
The U.S. courts take the position of a strict constructionist, and doing so over steps the basic tenet of legal validity of business transactions. On the other hands, this principle of legal validity forms the basis of legal analysis of economic substance doctrine from other jurisdictions. In UK, as well as in Canada, the analysis focused on the character of the transaction. In Snook case, Lord Diplock expressed the opposite approach to economic substance doctrine. “ . . . for acts or documents to be a “sham,” with whatever legal consequences follow from this, all the parties thereto must have a common intention that the acts or documents are not to create the legal rights and obligations which they give the appearance of creating . . . to enable the court to hold that a transaction was intended to mask a loan, it must find that both parties to the transaction so intended.”14 The substance of a transaction is subjective thus, “. . . the form of the transaction by which [Adam] acquired the right . . . may bear very materially on the question of the capital or revenue character of the outlay made to acquire it.”15 Lord Wilberforce, in his ruling, made it clear that the form of a transaction cannot be ignored simply for lack of economic substance provided the transaction has legal validity.16 Either “form over substance” or “substance over form”, the uncertainty of the law in the economic substance doctrine analysis, facilitates the legislative intervention but unless the U.S. courts scale down its longstanding position, and given the strict language of the code, tax authority would certainly rewrite the contractual obligations with the overwhelming power accorded it by the code.
THE CODE
If absolute power corrupts absolutely, the codified Economic Substance Doctrine would certainly corrupt the tax authorities. In 2010, Congress enacted the Patient Protection and Affordable Care Act and among other things, the new legislation codified the judicially doctored economic substance doctrine and applies to transactions entered into after March 30, 2010.17 The new code adds new section to the Internal Revenue Code which provides that in the case of any transaction “to which the economic substance doctrine is relevant” the transaction shall be treated as having economic substance only if 1) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position and 2) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into such transaction. The new statute also indicates that “[t]he determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if [the legislation] had never been enacted”18 which signaled that the doctrine shall be reviewed using the common law approach. The 2010 Act also proscribes a strict liability of 20 percent on underpayments resulting from transactions found to lack economic substance or failed to meet the requirements of any similar rule of law and 40 percent for undisclosed transactions.19 To create an objective review in regards to all or parts of business transaction, the new code includes the “Profit test.”20
MORE QUESTIONS THAN ANSWERS
If the purpose for the codified economic substance doctrine is to create certainty in the review of business transactions as it relates to tax avoidance, the purpose has failed thus far because the code raised more questions than it provides answers for uniformity and/or certainty. To begin with the threshold question under § 7701(o)(1)- – “relevant”. What transaction would economic substance doctrine be relevant? Would it be relevant to only debt v. equity transaction or transaction of foreign or domestic entity? Or would the “relevant” only applies to organizations or reorganizations under Sub-chapter C, and/or related party transactions satisfying § 482? The code merely states that the determination of whether the economic substance doctrine is “relevant” to a particular transaction will be made in the same manner as if the new statutory economic substance provision had not been enacted.21Unfortunately, neither the existing authorities clearly define the types of transactions that are subject to the economic substance doctrine. Accordingly, taxpayers are left with substantial uncertainty as to the circumstances in which this new statute would be applied. What constitutes “the transaction”? Section 7701(o)(5)(D) of the code only states that the term “transaction” includes a series of transactions. Unless the court defines this term broadly to include all factual elements relevant to a course of action, taxpayers would only be left with high degree of uncertainty.
The code also states that the taxpayer’s economic position has changed in a “meaningful way” aside from Federal income tax effects in § 7701(o)(1)(A). What constitutes a “meaningful way” is a million-dollar question that needs to be answered. Similarly, when does a taxpayer have a “substantial purpose” aside from Federal income tax benefits as required under § 7701(o)(1)(B)? And when is state and local tax effects sufficiently “related” to Federal tax effects such that state tax planning cannot constitute a substantial purpose under § 7701(o)(3)? These are critical issues to implementation of the new code, and if the court takes the role of strict constructionist, as in the past, the legal terrain in this area would further remain uncertain. As part of its efforts to implement the new legislation, an LB&I Directive was issued relating to the codification of the economic substance doctrine in the 2010 Act. The directive sought to ensure consistent administration of the strict liability penalty related to the application of the doctrine, any proposal to impose the doctrine, and thus, the penalty. The managers and examiners must seek approval from the appropriate Director of Field Operations (DFO), once determined that economic substance doctrine applies to any transaction or series of transactions. The LB&I Directive has four steps: 1) an examiner should evaluate whether the circumstances in the case are those under which application of the economic substance doctrine to a transaction is likely not appropriate; 2) an examiner should evaluate whether the circumstances in the case are those under which application of the doctrine to the transaction may be appropriate; 3) if an examiner determines that the application of the doctrine may be appropriate, the guidance provides a series of inquiries an examiner must make before seeking approval to apply the doctrine; and 4) if an examiner and his or her manager and territory manager determine that application of the economic substance doctrine is merited, guidance is provided on how to request DFO approval.22 The application of economic substance doctrine as codified is subjective, and this directive does nothing to alleviate the subjectivity.
The onus is on business entities or taxpayers to now show that any transaction entered into, regardless of its legal validity, satisfies the two-prong requirements of the new code. This position runs contrary to the position of any other jurisdictions with anti-avoidance code that has the economic substance doctrine provision as in the United States. General Anti-Avoidance Rules (GAAR) in Canada comes to mind. GAAR was introduced in 1988 to curb abusive tax avoidance. In pertinent part, section 245 of Canada GAAR states: a) transactions that are part of a series of transactions, commencing before the day of Royal Assent and completed before 1989 (and for this purpose a series of transactions does not include any related transactions or events completed in contemplation of the series), or (b) any one or more transactions, one of which was entered into before April 13, 1988, that were entered into by a taxpayer in the course of an arrangement and in respect of which the taxpayer received from the Department of National Revenue, before April 13, 1988 a confirmation or opinion in writing with respect to the tax consequences thereof; b) subsection 245(2) states that where a transaction is an avoidance transaction, the tax consequences to a person shall be determined as is reasonable in the circumstances in order to deny a tax benefit that would result from that transaction or from a series of transactions that includes that transaction. An avoidance transaction is defined in subsection 245(3) as a single transaction or one that is a part of a series of transactions where the single transaction or the series results directly or indirectly in a tax benefit, unless the transaction is carried out primarily for bona fide purposes other than to obtain the tax benefit. “Tax benefit” is defined to mean a reduction, avoidance or deferral of tax or other amount payable or an increase in a refund of tax or other amount under the Act; and subsection 245(4) provides that the rule in subsection (2) does not apply to a transaction where it may reasonably be considered that the transaction would not result directly or indirectly in a misuse of the provisions of the Act or an abuse having regard to the pro visions of the Act read as a whole.23 The application of the GAAR involves three steps. It must be determined: 1) whether there is a tax benefit arising from a transaction or series of transactions within the meaning of section 245(1)(2) of the Income Tax Act; 2) whether the transaction is an avoidance transaction under section 245(3), in the sense of not being “arranged primarily for bona fide purposes other than to obtain the tax benefit”; and 3) whether there was abusive tax avoidance under section 254(4), in the sense that it cannot be reasonably concluded that a tax benefit would be consistent with the object, spirit or purpose of the provisions relied upon by the taxpayer. The burden is on the taxpayer to refute points (1) and (2), and on [*3] the Minister to establish point (3).24 Under GAAR, it is not enough to show that the scheme or series of schemes lacks economic substance, there must also be a showing of abusive tax avoidance. The analysis of the third steps requires a two-part inquiry under section 245(4) of GAAR.25If the new economic substance doctrine legislation receive such scrutiny as in Canada, the enormous power conferred to the IRS by code would be in check.
IMPACTS OF THE CODE TO BUSINESSES
With the new legislation comes the new power that may shake business transactions, locally and cross-border to the core. The penalty is severe if transaction or series of transactions is not reported. (a 40% hit.) If reported and the IRS determines that the code applies, the taxpayers is subject a 20% penalty. Taxpayers in both scenarios are in a no-win situation. The new statutory economic substance provision greatly complicates tax planning. The provision is quite broad, ambiguous, and many legitimate business transactions, if tested for economic substance, could fail the statutory test. Although, the code may not apply to certain common transactions, particularly, transactions where other judicial doctrines – – such as sham doctrine, step transaction doctrine, and perhaps, the substance over form doctrine – – apply but there would be other situations where the taxpayers reasonably expect the doctrine not to be relevant which the code would apply. Such uncertainty would cause severe paralytic effects on businesses. The profit test is nebulous at best, and taken together with the strict liability penalty provision of the Act, taxpayers would be subjected to an increased tax burden.
CONCLUSION
The Court has maintained its position that when it comes to collection of taxes, substance would always take precedent over form. The recent decision on the Health Care and Education Reconciliation Act of 2010 (“HIRE Act”) certainly tolls that same line; and judging the behavior of the Court, which “gives great deference to regulatory agencies’ interpretation of the law and facts,”26 the IRS might have just been equipped with overwhelming power by this legislation. Economic Substance Doctrine code is overbroad, vague and laden with numerous ambiguities, and to implement the statute would be arbitrary and capricious and concentrate too much power in one agency. The Court can use it’s checks and balances power to curtail this excessiveness. If the Court must do this, it must look within and take a step back from its position. Step-transaction doctrine, with more emphasis on legal validity of transactions, could be the start towards judicial sanity. The code cannot stand on its own merit because the very purpose to wit: certainty of law, uniformity of purpose, upon which the code was based, failed by the widest imagination conceivable. The Statute instead creates uncertainty. The Court must take the high road otherwise; the power conferred by the Statute may ultimately be the power that corrupts the Internal Revenue Services (IRS) absolutely.
1The IBFD International Tax Glossary defines avoidance.
2Gregory v. Helvering, 293 U.S. 465
3Canada –General Anti-Avoidance Rule Section 245(1),(2) of the Income Tax Act; Belgium –ITC92 Article 344(1)(Amended in 1993); France – Law of Finance 1974 Art 14; Germany – Section 42 Abgabenordnung 1977, §6(1); and Netherlands under “Frau Legis”.
4The Health Care and Education Affordability Reconciliation Act of 2010, Section 1409.
5Cross-border application of Economic Substance Doctrine varies. Some jurisdictions prefer substance over form in their analysis -United States; and others prefer form over substance– which refers to as the “legal validity of transaction” – – Canada, UK, Belgium.
6Gregory v Helvering 293 U.S. 465 (1935); Duke of Westminster v. IRC (1936) 19 TC 490. The difference in the opinions of these two early cases set the stage for the divergence of approaches developed in the economic substance doctrine analysis.
7Gregory, supra note 5, at page 469; Duke of Westminster, Supra note 5 at 520; Lord Diplock observation that “there may be different ways of carrying out [business or commercial] … transactions. They will not be struck down if the method chosen for carrying them out involves the payment of less tax than would be payable if another method was followed” in Europa Oil (NZ) Ltd v CIR, Privy Council in 76 ATC 6001 (1976) 1 ALL ER 503, is also germane to the discussion of the Economic Substance Doctrine.
9“Form” means the true legal character of a transaction and “Substance” means the economic consequences of a transaction.
10Knetsch et ux. v. United States, 346 U.S. 361 (1960) at page 367.
13Gregory, supra note 6. The Supreme Court in Frank Lyon, laid down the two factors required in economic substance analysis as established in Gregory. “The first factor inquires whether there is a legitimate non-tax business reason for the form; in other words, were the parties motivated at least in part by reasons unrelated to taxes? . . . The second . . . factor requires that the agreement have non-tax “economic substance.” . . . We have construed that factor to require a “change in the economic interests of the relevant parties.”
14Snook v. London and West Riding Investments Ltd, [1967] 1 All ER 518. Although, this is a non-tax case, it nonetheless, helps explain the legal character analysis of economic substance doctrine; see also, Yorkshire Railway Wagon Co. v. Maclure, 21 Ch. D. 309; and Stoneleigh Finance Ltd. v. Phillips, 2 Q.B. 537.
15IR Comrs v Adam (1928) 14 TC 34.
16W. T. Ramsay v. IRC, (1981) 54 TC 101 at page 186; He stated that: “Given that a document or a transaction is genuine, the court cannot go behind it to some supposed underlying substance…. This is a cardinal principle but it must not be overstated or overextended. Whilst obliging the court to accept documents or transactions, found to be genuine, as such, it does not compel the court to look at a document or a transaction in blinkers, isolated from any context to which it properly belongs. If it can be seen that a document or transaction was intended to have effect as part of nexus or series of transactions, or as an ingredient of a wider transaction intended as a whole, there is nothing in the doctrine to prevent it being so regarded; to do so is not to prefer form to substance, or substance to form. “
1726 U.S.C. §1409; Health Care and Education Affordability Reconciliation Act of 2010.
22IRS Notice –LMSB-20-0910-024, September 14, 2010.
23IC88-2 – – General Anti-Avoidance Rule – Section 245 of the Income Tax Act.
24Queen v. Canada Trustco Mortgage Co., LEXIS (2005) SCC 54 at page 58.
25Id. Supra note 24 at page 66; First, the courts must conduct a unified textual, contextual and purposive analysis of the provisions giving rise to the tax benefit in order to determine why they were put in place and why the benefit was conferred. The goal is to arrive at a purposive interpretation that is harmonious with the provisions of the Act that confer the tax benefit, read in the context of the whole Act. Second, the court must examine the factual context of the case in order to determine whether the avoidance transaction defeated or frustrated the object, spirit or purpose of the provisions in issue.
26Chevron USA Inc, v. Natural Resources defense Council, Inc, 467 U.S. 837(1984) – – the deference analysis has two-prong test: 1) whether Congress directly address the issue in dispute in the statute, therefore, the statutory language prevails; 2) whether the statute is silent or ambiguous – – is the agency interpretation reasonable? If so, Court upheld, even if the Court would have interpreted the law differently. (Doctrine of Stare Decisis).
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