The following article is adapted and reprinted from the M&A Tax Report, Vol. 11, No. 10, May 2003, Panel Publishers, New York, NY.


By Robert W. Wood, San Francisco

Our tax writers are struggling with myriad concepts in this war-torn economy. Little wonder that along with so many other tax topics, efforts to improve and/or even codify the economic substance doctrine continue to be discussed. Introduced last year, proposals to codify the economic substance doctrine have engendered a fair amount of concern and criticism, both from the office buildings of private practice, the halls of academia, and even the maze of governmental practice. On the one hand, the administration seems to want to put a tight rein on the admittedly flexible (and perhaps even amorphous) economic substance doctrine. On the other hand, some Treasury officials think that codification of the economic substance doctrine may leave it too inflexible to deal with abusive transactions that can most effectively be dealt with on a case by case basis.

Of course, before one can effectively debate whether a codification of economic substance would be a good thing or a bad thing (or might be a little of both depending upon the way in which the way the law is written), there's a minor detail. One would need to know just what we mean by economic substance! That, it turns out, is no mean feat.

A Rose by Any Other Name?

In fact, the economic substance doctrine seems to focus primarily on whether the transaction is real (not necessarily adequately documented, but "real" in some more tangible sense). It is hard to get tax lawyers talking about the economic substance doctrine without having the phrases "business purpose" and "step transaction doctrine" uttered in the same breath, or at least the same paragraph. And, in my experience, this is true regardless of whether the tax lawyer speaks on behalf of the government or for a private client.

What then is this amorphous swirl of non-Code doctrine all about? I think it is possible to differentiate each of these separate (though admittedly related) tax doctrines. First, it is obvious that these rules are all creatures of case law. That makes any attempt by Congress to legislate the economic substance doctrine into the Code fairly radical on its face. The very nature of these doctrines is fluid. At the same time, statutory powers do not necessarily have to be circumscribed.

A good example is Section 269 of the Code, which generally empowers the Internal Revenue Service to disallow losses, deductions, etc., in cases of tax avoidance. Few would argue that this Code section is capable of a cut and dried application. As it happens, few would probably argue that this Code section has been effective for the Service. Indeed, by my count, the Service has lost far more cases arising under Section 269 than it has won. It has been a blunt weapon for the IRS.

Differentiating Doctrines: Shams, Economic Substance, and Step Transactions

While these three concepts are often confused, I think one of them (at least) can be segregated, and is truly a horse of a different color. The step transaction doctrine is procedural in nature, something that does not seek to examine whether a transaction makes sense, as the economic substance doctrine does (more about that later). Rather, the step transaction doctrine seeks to determine &mda regardless of the purpose of the overall series of items — whether ostensibly separate transactions ought to be integrated or stepped together, thus disregarding the overall form of the transaction for its quintessential result.

The step transaction doctrine, to a far greater extent than the economic substance doctrine and the sham transaction doctrine, is capable of close definition. Much of the case law, the commentary, and even pronouncements from the Internal Revenue Service, suggest that there are three independent bases for evaluating the application of the step transaction doctrine:

As much as I believe it is possible to carve off the step transaction doctrine as separate and distinct from both the economic substance and sham transaction doctrines, it is nevertheless true that the step transaction doctrine often invokes at least a brief side trip into these related fields. Indeed, in a recent IRS legal memorandum, ILM 200224007, Tax Analysts Doc. No. 2002-14217, 2002 TNT 116-26, the IRS reviewed step transaction authority and found that it applied. Still, unable to rest alone on that doctrine, the IRS said that even if the step transaction doctrine did not apply, the substance over form principle independently yielded a victory for the government. For discussion, see Wood, "More Step Transaction Authority," Vol. 11, No. 1, The M&A Tax Report (August 2002), p. 1.

Shams and Lack of Substance

The economic substance doctrine, even if one dismisses step transaction authority as something entirely different, is indisputably related to the sham transaction doctrine. This doctrine (or pair of doctrines) can come up in a variety of contexts. Even so, it most classically occurs where losses have been triggered. After all, a loss is allowable for federal income tax purposes only if it is bona fide, reflecting actual economic consequences.

As a corollary, an artificial loss which lacks economic substance, such as a loss created for tax purposes, will generally be disallowed by the IRS and the courts. Perhaps my favorite all-time example of the artificial loss transaction is one that has no prospect of a pre-tax profit, a transaction that makes economic sense and may potentially be profitable only when considering tax benefits. The tax shelter transactions (which we thought we were rid of in the 1980s) probably represent the best (or worst?) example of this kind of purely tax-motivated transaction. Apart from non-statutory economic substance and sham transaction authorities, the IRS arsenal against such transactions includes some statutory all-time favorites too, including Section 469 with its passive loss regime, and Section 465 and its at-risk rules.

Instead of doctors, dentists, lawyers, etc., who engaged in tax shelters in years gone by, today the largest corporations have their own brand of tax shelter activities that have generated the recent spate of concern over abusive transactions.

The way in which the economic substance and sham transaction doctrines intersect is well-illustrated by one of the classic cases in this genre, Cottage Savings Association v. Commissioner, 499 U.S. 554 (1991). In that case, the taxpayer made reciprocal sales and purchases of mortgage participations with several unrelated savings and loan institutions. The sole purpose of these reciprocal sales and purchases was to obtain a tax loss with respect to the taxpayer's portfolio of fixed rate mortgages. The portfolio had substantially depreciated in value, and the savings and loan association wanted to sell the portfolio in order to realize the deductible loss.

Of course, the savings and loan was unwilling to part with the mortgage participations lock, stock and barrel, as it did not want to report a loss for regulatory accounting purposes. The applicable savings and loan regulations allowed savings and loans to exchange mortgage pools and not to report a loss, as long as a number of specified conditions were met. These conditions were designed to insure that the mortgages received were economically equivalent to the mortgages given up. The idea was for Cottage Savings to swap out of one pile of mortgages and swap into another pile of mortgages, effecting a regulatory status quo. Yet, from a tax perspective, Cottage Savings sought a large tax loss.

Real vs. Paper Loss

The matter went all the way to the U.S. Supreme Court, where the court held that an exchange of property constitutes a disposition of the property only if the properties exchanged are materially different. The Court here found that although this savings and loan taxpayer did end up with other similar mortgages, the tax loss was appropriately available, since Cottage Savings did in fact dispose of those mortgages. In response to the IRS arguments that the mortgages given up and those received in exchange were not materially different, the Supreme Court found that the underlying properties were materially different. The respective possessors of the property enjoyed legal entitlements that were different in kind and/or extent.

Perhaps the most dangerous (dangerous for taxpayers, that is) argument the IRS made was that the two mortgage pools were not materially different. The IRS argued that the two mortgage pools should not be considered materially different because they were economic substitutes. According to the Supreme Court, this "economic substitutes" notion was insidious, and would lead to a finding that there are material differences between two items only when the parties, the relevant market, and/or the relevant regulatory body would consider them so.

Here, the Supreme Court found that there were different mortgages, different obligors and different security, so that getting out of one set of mortgages and into another set had to be treated as the realization of a loss.

Tax Savings Only

One of the reasons the Cottage Savings decision continues to be cited with some degree of reverence even today relates to calling a spade a spade. Indeed, with plainspoken simplicity, the Supreme Court acknowledged that the only motivation for the transaction in question was saving taxes. Nonetheless, the Supreme Court gave these transactions their intended effect. There was no non-tax business purpose whatsoever.

There is a certain brutal honesty in saying that a transaction was entered into solely for tax reasons. Recall that Learned Hand (and others in his wake) is often cited for the proposition that there is nothing wrong with arranging one's affairs so as to pay as little tax as possible. That kind of sentiment may seem out of style in the 21st century. In Cottage Savings, the Supreme Court found that, notwithstanding the patent tax saving motivations, there was economic effect to the transaction. The mortgages were in fact different, even though they were ostensibly the same, and treated as the same kinds of obligations for regulatory purposes.

Of course, as nice as it would be to say that Cottage Savings established the law of the land, paving the way for realization events even where the taxpayer craftily creates a transaction that triggers only tax losses but no losses of any other kind, that has not been so. A set of regulations was promulgated in 1996 to shortstop the Cottage Savings decision. In large part, these regulations provide guidance for determining when a modification to the terms of a debt instrument will be considered an exchange of properties that differs materially under Section 1001 of the Code, thus triggering the realization of gain or loss. See Reg. §1.1001-3, T.D. 8675, 61 Fed.Reg. 32926 (June 26, 1996).

Economic Substance: Who and Why?, Vol. 11, No. 10, The M&A Tax Report (May 2003), p. 1.