The Obama administration and Congressman Rangel have promised to “codify the economic substance doctrine,” and thereby decrease the deficit by almost $5 billion over 10 years. Because this is thought to be a “revenue raiser,” it is likely to receive serious consideration in the upcoming budget bill negotiations. Instead of pursuing such an amendment to the code, the Treasury might more usefully publish more guidance to clarify the law aside from the “economic substance doctrine.”
The Rangel Bill
In 2007, Chairman Rangel proposed to “clarify” one aspect of the doctrine. The Rangel bill proposal had these elements:
- It did not purport to determine when the “economic substance doctrine” should be applied;
- It did not affect other “common law doctrines”;
- It did not apply to personal transactions;
- It defined economic substance as a transaction that both changes in a meaningful way the taxpayer’s economic position and has a substantial non-federal-tax purpose;
- It asserts that, if the taxpayer relies on profit potential to satisfy the dual tests, then (a) the present value of the (b) reasonably expected (c) pre-tax profit must be (d) substantial in comparison to the tax benefits, (e) taking into account all fees and expenses, (f) giving no non-tax credit to state tax savings “related” to the federal tax savings and (g) ignoring financial accounting benefits (this being a reference to the Enron practice of doing deals for accounting purposes).
The Pros and Cons of “Clarification”
If the proposal cleanly presented a question of clarification of uncertain law or not, then the pros of “clarification” would prevail. It, though, does not. As shown above, many uncertainties would remain if the Rangel proposal were enacted.
In addition, the ability of the “clarification” to raise $5 billion over 10 years is called into question by the fact that the tax shelter wave of the late 1990s, from which the revenue estimate probably was calculated, has run its course. Also, the near-universal precondition to sheltering—income that must be shielded by creating or accelerating deductions and credits—will be in short supply for some time to come due to the losses of many businesses that have arisen since 2007, which seem to extend as far as the eye can see. Finally, the appetite of taxpayers and tax advisors for sheltering has reduced due to multiple events since 2000 that were designed to reduce them, including (a) enhanced financial auditing standards, (b) enhanced tax advisor penalties and standards, (c) enhanced reporting standards in the tax law and (d) accelerated “listing” of transactions for tax purposes.
Not a Supreme Court Doctrine
The “economic substance doctrine” is not the best path to the proper interpretation and application of the federal tax laws. It is not a “doctrine” adopted by the U.S. Supreme Court. Its judicial lineage is highly suspect, and mostly attributable to self-referential cites of lower courts. As “clarified” by the proposal, it is contrary to most recent Supreme Court authority. It crowds out traditional fact finding and statutory construction and weakens the ability of both the IRS Chief Counsel and the courts (not to speak of taxpayers) to know what the tax law is.
The United States Supreme Court has never established or articulated an “economic substance doctrine” to apply to all aspects of the federal tax laws. To put it bluntly, substance does not generally control form in the federal tax law. The whole taxing system runs on the ability to rely on form.
A review of the usual suspects easily proves this assertion. Gregory v. Helvering construed the meaning of the statutory words, “in pursuance of a reorganization,” to mean a business-motivated reorganization of a corporation. It did not state that all transactions described in the code require a business purpose. Higgins v. Smith affirmed a jury finding that a corporation did not actually conduct a business activity, thus failing to satisfy the yet-to-be-announced rule of Moline Properties, Inc. Frank Lyon similarly found as a fact that a lease was a lease, without stating any “rule” but identifying a number of factual considerations relevant to the tax-specific concept of property ownership. The Supreme Court had already decided in F&R Lazarus Co. that ownership determination is not limited to record title. Knetsch similarly found as a fact that the taxpayer did not owe a debt, in the similarly tax-specific concept that indebtedness is not proved by the form of an instrument.
In these and many other decisions, the Supreme Court has used standard judicial tools of fact finding and statutory interpretation to reach results that are both legally supportable and protect the fisc. In so doing, the Court has developed tax-specific concepts for a limited number of fact cluster issues, including the definition of income, the timing of income recognition, the identification of indebtedness, the determination of property ownership, the threshold for regarding and disregarding entities, and—most importantly—assignment of income, which infuses almost all related party tax law. We would be far better off recognizing and using these tax-specific rules in these transactional clusters than dumping that measured approach in favor of meta-rules like the “economic substance doctrine.”
The mortgage participation for mortgage participation swap at issue in Cottage Savings neither had a non-tax purpose nor any substantial non-tax economic effect on the taxpayer. It would flunk the standard in the “clarification.” Nevertheless, the Supreme Court allowed the taxpayer to recognize its losses on the exchange.
Presumably the proponents of the legislation would explain this result by saying that the doctrine is not applicable to it because the taxpayer actually changed its legal relationship to property, and Congress intended that losses be allowed in such circumstances. That is what the Supreme Court thought, and that will suit tax shelter planners very well because they usually can manage to involve an actual legal movement of title to property. Such an understanding of Cottage Savings shows that the “clarification” would itself be a sham.
Taxpayers should be wary of codification of the “economic substance doctrine,” but not for the usual reasons. Its main problem is that it assumes a doctrine exists that the Supreme Court has never mandated, without taking on the heavy lifting of actually stating what the doctrine is.