Practitioners have debated the parameters of the economic substance doctrine for decades. A recent district court opinion in Wells Fargo & Co. v. United States, No. 09-CV-2764 (D. Minn. May 24, 2017), addressed and resolved one of the more interesting undecided questions regarding the relationship of the so-called objective and subjective prongs of the doctrine. The ruling rejected a Government argument for disallowance of interest expense deductions under the economic substance doctrine based solely upon a finding that the transaction was undertaken solely for tax-related purposes, notwithstanding a separate jury finding that the transaction had objective pre-tax profit potential.
Since the 1980s, courts have generally made two inquiries in analyzing Service challenges of transactions based upon a lack of economic substance. The objective prong of the analysis considered whether a transaction had a real potential to produce an economic profit after consideration of transaction costs and without consideration of potential tax benefits. The subjective prong of the analysis considered whether the taxpayer had a non-tax business purpose for the transaction.
Practitioners, the Service, and the courts have long debated the relationship between the two prongs of the economic substance doctrine. Some argued for application of the prongs disjunctively; a transaction would pass muster if it satisfied either the subjective or the objective prong. Others argued for application of the prongs conjunctively; a transaction would survive scrutiny only if it satisfied both the objective and the subjective prongs. When Congress codified the economic substance doctrine in 2010, it adopted a conjunctive formulation—denying tax benefits to a transaction if it failed to satisfy either prong.
The courts, probably recognizing that few transactions lacking a reasonable prospect of economic profit are motivated by non-tax business purposes, have generally viewed the subjective and objective prongs as part of a single unified inquiry. Indeed, most (if not nearly all) of the reported decisions have concluded that the disputed transaction either satisfied or failed both prongs of the analysis. As noted by the Wells Fargodecision, “there is a gap between what courts say and what courts do: Although courts may say that a subjective non-tax business purpose is essential, courts in fact have been reluctant to disregard economically substantive transactions solely on the basis of the taxpayer’s subjective motives.”
The unique procedural posture of Wells Fargo required the court to confront directly the question that the courts had been avoiding. The case involved a jury trial concerning a STARS foreign tax credit generator transaction with two components—a trust structure which produced disputed foreign tax credits and a loan structure which generated disputed interest deductions. In response to jury interrogatories, the jury found that the trust structure and loan structure were separate, independent transactions and that the trust transaction failed both the objective and subjective prongs of the economic substance analysis. With respect to the loan transaction, however, the jury found that the transaction passed the objective prong by providing a reasonable possibility of a pre-tax profit, but that the taxpayer entered into the transaction “solely for tax-related reasons.”
With this background, the court turned to the question of whether a transaction with objective profit potential will fail the economic substance doctrine if the taxpayer undertook the transaction solely for tax purposes. The Wells Fargo court concluded that interest deductions from the loan transaction passed muster under the economic substance doctrine notwithstanding the jury’s finding that Wells Fargo entered into the transaction solely for tax reasons, adopting what it described as a flexible approach in applying the economic substance doctrine. It distinguished between examination of the taxpayer’s “actual subjective motivation” and examination of what a reasonable taxpayer’s purpose would be in view of the objective features of the transaction—employing the latter approach in its analysis. Refusing to be influenced by evidence concerning the taxpayer’s actual motivation, the court observed that it would be an “absurd result” if two identical transactions were treated differently for tax purposes based solely on the subjective motivations of the participating taxpayers. Similarly, the court was not persuaded by the government’s characterization of the transaction as a “sham” and its argument that the transaction was the type of economically unproductive activity which should be discouraged.
The Wells Fargo decision leads this blogger to several observations. First, the ruling appears to be correct; the tax law ought to be based upon the objective facts concerning a taxpayer’s transactions, not a nebulous effort to determine the taxpayer’s “real” motives. Second, the ruling suggests largely eliminating the subjective prong of the economic substance doctrine; an examination of the taxpayer’s purpose is superfluous if it is based upon determination of what a reasonable taxpayer’s purposes would be under the objective facts. Third, the subjective prong of the statutory economic substance doctrine is susceptible to a similar approach; the statutory language does not explicitly mandate an examination of factual evidence concerning the taxpayer’s “real” motives and courts might reasonably focus upon evaluation of a reasonable taxpayer’s purposes under the objective facts. Fourth, one would expect relatively little change in the results of cases applying the economic substance doctrine; very few (if any) cases have ever been decided based upon judicial or jury findings that only one prong of the economic substance doctrine had been satisfied and the Wells Fargo decision does not encourage future courts to make comparable findings.
Finally, the ruling may signal the death knell for several lines of cases employing a separate “business purpose” rule. Employing the rule, the Service has, in several different contexts, challenged transactions under an amorphous business purpose rule which disallowed tax benefits from transactions which lacked a sufficient non-tax business purpose. However, the Government has almost never prevailed solely under the business purpose rule in cases where an economic substance challenge would not have resulted in a comparable conclusion. Perhaps, it is time to finally jettison allusions to the existence of a separate business purpose rule and to focus analysis where it belongs—the objective prospect of a pre-tax economic profit.
On May 23, I wrote a post about a fully stipulated collection due process case, Low v. Commissioner, in which the Court remanded the case because the stipulation was incomplete. Counsel for the petitioner commented on the case and has provided access to certain documents in that case for those with further interest. The first stipulation of facts, the briefs, and the briefs in a related case are available through these links.
On May 18, Les wrote a post about the statute of limitations where the taxpayer failed to file the correct form with the IRS, May v. United States. We received a lengthy and thoughtful comment about the matter from occasional guest blogger Stu Bassin. For those interested in this case, we recommend reading his comment.
We bring this up occasionally but the people providing comments on the blog post bring up many relevant insights about the matters on which we post. If you are not regularly reading the comments or at least looking for comments on posts of interest to you, you are missing some important information. Thank you again to those of you who take the time to comment for your thoughtful insights on the posts. Please remember if you make a comment that we do request that you identify yourself because we find that self- identification keeps the comments more civil in tone. We hope that you find the blog provides civil discourse about tax procedure issues and that the comments continue that civil discourse about important tax procedure issues.
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