Academic journal article Brigham Young University Law Review

Per Se Economic Substance

Academic journal article Brigham Young University Law Review

Per Se Economic Substance

Article excerpt

I. INTRODUCTION

I know that these monsters are the result of fabulous industry and ingenuity, plugging up this hole and casting out that net, against all possible evasion; yet at times I cannot help recalling a saying of William James about certain passages of Hegel: that they were no doubt written with a passion of rationality; but that one cannot help wondering whether to the reader they have any significance save that the words are strung together with syntactical correctness.

-Judge Learned Hand1

Almost no one likes to pay taxes;2 almost everyone does whatever they can legally (and cost effectively) to avoid taxes;3 and almost no one likes a tax cheat.4 Thus, while most are comfortable with others paying only their "fair share," certain tax avoiders are consistently scrutinized by the public for their elaborate tax planning-most commonly politicians and large businesses.5

The IRS and courts have been granted the task of distinguishing the tax cheat from the tax avoider - a task that has proven difficult since the inception of the tax code.6 When accomplished "by means which the law permits," tax avoidance is an indubitable "legal right."7 Yet, "the law" is not limited to the code itself. Recognizing that "[e]ven the smartest drafters of legislation and regulation cannot be expected to anticipate every [tax evasive] device"8 and that "[a] strictly rule-based tax system cannot efficiently prescribe the appropriate outcome of every conceivable transaction that might be devised and is, as a result, incapable of preventing all unintended consequences,"9 courts have developed multiple tools to detect sham transactions used for no other purpose than tax evasion.10 The economic substance doctrine (ESD) is one of the most prominent of these tools.11

Generally, the ESD is used by courts to revoke statutorily compliant tax benefits arising from transactions that, beyond such tax benefits, have no subjective business purpose and no objective economic effect.12 Courts and scholars disagree over the details of the ESD, generally forming four areas of debate. First, when should the ESD be applied?13 Second, how should the objective economic effects of a transaction be determined?14 Third, what constitutes a sufficient subjective business purpose for entering a transaction?15 And fourth, should the objective and subjective prongs of the ESD be applied disjunctively, conjunctively, or balanced as factors in an overall inquiry into the economic substance of the transaction?16 Given the highly debated nature of each of these questions, it is easy to see how a code that is focused on precision and clarity can quickly become unwieldy.

In this Comment, i address the second debate: how should courts assess whether a transaction has an objective economic effect beyond its tax benefit? often, courts use the pre-tax profit test to make this assessment.17 Yet disagreement persists over how pre-tax profit should be measured.18 For example, circuit courts have recently split on how foreign tax expenses should be included in this calculation.19 Likewise, courts and scholars dispute the boundaries of a suspect transaction as well as how much pre-tax profit is sufficient to demonstrate an objective economic effect.20 The unsettled nature of these disputes entails taxpayer uncertainty and accusations of reverse-engineered decisions.21

On a more theoretical level, scholars often question the underlying assumption of the pre-tax profit test, namely that "the economics of a transaction are readily separable from its tax components," and have demonstrated that this assumption can often lead to inaccurate results.22 Thus, variations on, and alternatives to, the pre-tax profit test have been proposed by various scholars in this field.

The leading two alternatives are Michael Knoll's variation on the pre-tax profit test that takes into account implicit taxes23 and Charlene Luke's proposal to look beyond the pre-tax profit calculation and assess the objective economic substance of a suspect transaction by examining its risk and after-tax return in comparison to other transactions. …

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