Print Page
News & Press: TaxTalk

The ‘New’ Economic Substance Doctrine

04 March 2011   (0 Comments)
Posted by: Author: Terrence H Fraser
Share |

The ‘New’ Economic Substance Doctrine

The Three Cs: Consistency, Clarification and Claws

Terrence H Fraser, JD, LLM, is an estate tax attorney for the United States Department of the Treasury and member of the United States Tax Court. He is a JSD (candidate) International Tax at Thomas Jefferson School of Law.This article is solely the work of the author in his individual capacity.The information in this article does not represent any position taken by, or presented on behalf of, the Government of the United States.  

Over its long and controversial history,courts have interpreted and applied the tax law with the aid of various common law doctrines, such as step transaction, sham transactions, business purpose, substance over form and economic substance. These doctrines go as far back as 1921 when the Supreme Court treated the superiority of substance over form of the transaction in United States v. Phellis and in 1935 when the Supreme Court in Gregory v. Helvering, employed the substance-over-form doctrine and business purpose doctrine to invalidate an alleged reorganisation plan which on its face, as will be discussed below, had no economic or business related purpose other than diminution of taxes.

The judicially created doctrines mentioned in the beginning are all subcategories of the substance over-form doctrine which provides that where the form of a taxpayer’s transaction may satisfy the literal requirement of the relevant statutory or regulatory language, a court can still examine whether the substance of that transaction was consistent with its form, for the simple reason that a transaction lacking such substance should not be accorded the tax treatment prescribed for the form of the transaction.  The economic substance doctrine is the substance-over-form inquiry most particularly adapted to transactions devoid of substance.To put it another way, the economic substance doctrine is a common law doctrine that has been applied by courts to deny tax benefits arising from transactions that do not result in a meaningful change to the taxpayer’s economic position other than a purported reduction in federal income tax, even though the purported activity actually occurred.These judicial doctrines not only apply locally, but also could be applied globally in cross-border transactions where tax-benefit is the primary purpose for entering into certain commercial or financial arrangements outbound. For example, these doctrines could be used to "restrict the use of offshore tax havens and abusive tax shelters to inappropriately avoid federal taxation”.

The purpose of this article is not to provide a detailed analysis of the economic substance doctrine. Rather, it is to discuss briefly the history of the doctrine(s), examples of how the doctrine(s) has been applied to certain transactions, and the purpose and effect of codification. Finally, I will share my thoughts.

Brief case law development of the judicial doctrines 

In 1935,about 14 years after Phellis, supra, the Supreme Court in Gregory v. Helvering scrutinised the facts and circumstances and explained the substance-over-form doctrine and the business purpose doctrine.Summary of the pertinent facts:Evelyn Gregory (the Petitioner) in 1928 was the sole shareholder of all the stocks of a company which assets included, among other property,  1 000 shares of marketable securities of another company. Petitioner wanted these shares to be distributed to her for her own individual profit but this would have been characterised as a dividend which would have been taxed (at a higher rate) as ordinary income. To reduce the amount of income tax, Petitioner sought to bring about a reorganisation plan under the applicable statute. Accordingly, the Petitioner established a new corporation and transferred the marketable securities to the new corporation, then quickly liquidated the new corporation, while at the same time receiving the marketable securities as a liquidating distribution of property from the newly formed corporation, thus receiving favorable capital gains (lower-tax) treatment on the liquidation.

The Commissioner of Internal Revenue determined that the reorganisation attempted was without substance and must be disregarded,and held that the Petitioner was liable for a tax as though the marketable securities were paid to her as a dividend. 

The legal question before the court was whether the reorganisation attempted,apart from the tax motive, was done the way that the statute intended. Apparently the court analysed the applicable statute to ascertain Congresses’ intent behind the legislation and to determine whether her actions here fell within the parameters of the statute’s purpose.

Here,the court said that under the statute,the term ‘reorganisation’ meant a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transfer or or its stockholders or both are in control of the corporation to which the assets are transferred.Based on this definition,the Petitioner argued that since the transaction as laid out above literally satisfied every element required by the statute,the statutory reorganisation was effective.And so long as the reorganisation was not unlawful or illegal,she contended that her motive to escape or diminish the payment of taxes was irrelevant.

The court agreed that a taxpayer has the legal right to decrease the amount of taxes owed, or altogether avoid them, by means which the law permits.However, when the statute speaks of a transfer of assets by one corporation to another,it means a transfer made ‘in pursuance of a plan of reorganisation of corporate business; and not a transfer of assets by one corporation to another in pursuance of a plan having no relation to the business of either. In examining the facts and circumstances, what the court found was an operation having no business or corporate purpose whatsoever.The court, in straightforward terms, said that the plan engineered by the Petitioner was a mere device which was put in the form of a corporate reorganisation as a disguise for concealing its real character, and the sole object and accomplishment of which was the consummation of a preconceived plan,not to reorganise a business or any part of a business, but to transfer a parcel of corporate shares to the Petitioner. The court added that the new corporation was brought into existence for no other purpose; it performed, as it was intended from the beginning it should perform, no other function and when that limited function had been exercised, the new corporation was immediately put to death.  In conclusion, the Supreme Court upheld the Commissioner’s determination.

The rule of Helvering means that a transaction will not be respected where it lacks any business purpose and economic substance and where it is a mere subterfuge for escaping tax obligations. In CIR v. Transport Trading & Terminal Corporation,Judge Learned Hand said, "The doctrine of Gregory v. Helvering is not limited to cases of corporate reorganisations.It has a much wider scope;it means that in construing words of a tax statute which describe commercial or industrial transactions we are to understand them to refer to transactions entered upon for commercial or industrial purposes and not to include transactions entered upon for no other motive but to escape taxation.” Inferring from Judge Learned Hand’s statement and has already been stated above, the economic substance doctrine and business purpose doctrine, therefore, could apply to international, cross-border transactions where the ulterior purpose for entering into the transaction is tax benefits.

The next doctrine I will touch on briefly is the so-called ‘step transaction’ doctrine. The step transaction doctrine is in effect another rule of substance over form; it treats a series of formally separate steps as a single transaction if such steps are in substance integrated, interdependent, and focused towards a particular result. The step transaction doctrine is a corollary of the general tax principle that the incidence of taxation depends upon the substance of a transaction rather than its form. Thus, again, the step transaction doctrine represents something that naturally follows the substance over form principle.In Minnesota Tea Co. v. Helvering, the step transaction doctrine was discussed and applied. 

Summary of the pertinent facts:

After a corporation (the Petitioner) was created in 1928, its stock was immediately distributed to its stockholders. Soon thereafter, the corporation acquired shares and cash of another company. The cash was immediately transferred to the corporation’s stockholders in pursuance of a plan of reorganisation that required the stockholders to assume the corporation’s debts. Petitioner claimed that this was a distribution under the relevant statute and thus the distribution was not a taxable gain. The Commissioner disagreed.The issue before the court was whether the passing of the funds to the stockholders who pursuant to a plan, agreed to use such funds to pay off and, in fact, did pay off, the Petitioner’s debts was a distribution to the stockholders? If so, no taxable gain to Petitioner would be realised. If not, Petitioner would be liable for income taxes to the extent of any taxable gain. 

Utilising the end result, binding commitment tests, the Supreme Court held that putting the money received by Petitioner into the hands of its stockholders for the express purpose of paying off corporate debts was clearly not, in accordance with the applicable statute, a distribution for the stockholders benefit but was a fund, the equivalent of which they were bound to pass on to creditors. 

By that roundabout process,the Petitioner "received the same benefit as though it had retained that amount from distribution and applied it to the payment of such indebtedness”.The court added that the preliminary distribution to the stockholders was "a meaningless and unnecessary incident in the transmission of the fund to the creditors, all along intended to come to their hands, so transparency artificial that further discussion would be a needless waste of time”. Further, the court mentioned that the controlling principle will be found in Gregory v. Helvering. Once again,the Commissioner’s determination was affirmed.The end result test, interdependent test, or binding commitment test discussed in Minnesota Tea, supra, will not be addressed here,in any detail, except to say that such tests are normally invoked in connection with the application of the step transaction doctrine.This is merely to inform the reader of this article of the existence of these tests and their significance to the step transaction doctrine.

In addition, there is a distinction between the above two cases.In Gregory the new corporation was formed and then used as the device to accomplish the reduction of tax obligations.In Minnesota Tea Co.,the stockholders were used as the device to achieve the tax benefits.In other words, different conduits and different strategies were utilised to accomplish the same end result. 

As noted above,courts at times have given these judicial doctrines (as transactions lacking in economic substance) various labels.Whether the transaction is called a sham transaction, step transaction,business purpose, substance over form or economic substance, in my view, makes no difference – they all mean the same thing. And they were created by courts to do one thing, that is, to invalidate transactions where the primary purpose is to achieve some tax advantage that is contrary to congressional intent.For simplicity sake,I will refer to the doctrines as the ‘economic substance doctrine’.

Source: By Terrence H Fraser (TaxTALK)



Section 240A of the Tax Administration Act, 2011 (as amended) requires that all tax practitioners register with a recognized controlling body before 1 July 2013. It is a criminal offense to not register with both a recognized controlling body and SARS.

  • Tax Practitioner Registration Requirements & FAQ's
  • Rate Our Service

    Membership Management Software Powered by YourMembership  ::  Legal