Academic journal article Missouri Law Review

One Prong, Two Prong, Many Prongs: A Look into the Economic Substance Doctrine

Academic journal article Missouri Law Review

One Prong, Two Prong, Many Prongs: A Look into the Economic Substance Doctrine

Article excerpt

Klamath Strategic Investment Fund ex rel. St. Croix Ventures v. United States, 568 F.3d 537 (5th Cir. 2009).


Almost every federal circuit, as well as Congress, has weighed in on the economic substance doctrine and attempted to clarify its boundaries. The economic substance doctrine deals with transactions that, although technically in accord with the Internal Revenue Code (the Code or I.R.C.), were originally structured solely for tax avoidance purposes. (1) The Internal Revenue Service and courts dislike these transactions because they thwart the general intent of Congress in enacting certain tax-saving Code provisions. (2) Until recent amendments to the I.R.C., the federal circuits were split between two different approaches to tax avoidance transactions, yet the application of the two approaches was slightly unique in each circuit. (3) There were many, albeit unsuccessful, attempts to codify the economic substance doctrine in the past ten years. (4) Although there were several proposed bills, (5) the language in each proffered version was largely the same--effectively the same language that appears in the newly codified economic substance doctrine. The pertinent portion reads:

   (o) clarification of economic substance DOCTRINE.--(1) APPLICATION
   OF DOCTRINE.--In the case of any transaction to which the economic
   substance doctrine is relevant, such transaction shall be treated
   as having economic substance only if--(A) the transaction changes
   in a meaningful way (apart from Federal income tax effects) the
   taxpayer's economic position, and (B) the taxpayer has a
   substantial purpose (apart from Federal income tax effects) for
   entering into such transaction. (6)

These proposed bills, and now the newly codified doctrine, specify certain factors to be considered (such as profit potential) (7) and the requirements needed to find economic substance. (8)

Although there was a majority forming as to which test to use, the circuit split was creating unrest among the lower courts. At times, even knowing which test a specific circuit used was not particularly helpful in guiding a taxpayer. In addition, if a taxpayer planned incorrectly, he or she may have faced severe tax penalties. (9) Moreover, the different standards applied at the appellate level made it difficult for the tax and district courts to assess particular transactions because the test applied by the court changed depending on where the appeal was heard. (10) Thus, the economic substance issue created uncertainty for both taxpayers and courts and most recently surfaced in the U.S. Court of Appeals for the Fifth Circuit case Klamath Strategic Investment Fund ex rel. St. Croix Ventures v. United States. (11)


Klamath Strategic Investment Fund involved two partners who "represented the State of Texas in litigation against the tobacco industry." (12) The outcome of this litigation provided the two partners, Cary Patterson and Harold Nix, with a substantial increase in income--approximately thirty million dollars each. (13) Because of this influx of income, Nix and Patterson looked into potential investment opportunities. (14) Nix had previously developed an interest in investing in foreign currency transactions that were both high risk and high reward investments. (15) Patterson also became interested in these foreign currency transactions and sought the counsel of a highly experienced businessman, Ed Cox, who frequently dealt with these types of complex investment strategies. (16) "Thereafter, Nix and Patterson jointly decided to pursue ... foreign currency" investments. (17) Their primary motivation in these transactions was to earn a profit. (18) The district court made note of Nix and Patterson's delay in getting into these foreign investment strategies. (19) The court felt that if their primary motivation had been tax avoidance only, then Nix and Patterson would have begun their investments in 1999, when they recognized the first of their substantial increases in income from the tobacco litigation, instead of in 2000, when they actually began these transactions. …

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