The Many Faces of the Economic Substance's Two-Prong Test: Time for Reconciliation?
The fall of 2004 saw the occurrence of several important developments in relation to the ongoing debate on the application of the economic substance doctrine. It started with the issuance of the opinion in Long Term Capital Holding v. United States in the end of August, a case in which a District Court held that a transaction involving the contribution of stock with a built-in loss to a partnership lacked economic substance and had been entered into without any business purpose other than tax avoidance. The court upheld penalties assessed by the IRS despite the taxpayer’s argument that it obtained and relied on two "should" level opinions supporting its position. During the fall, the Jobs Act of 2004 was finalized and finally signed by the president on October 22, 2004, leaving out the proposed codification of the economic substance doctrine. Subsequent to the Government’s victory in Long Term Capital Holding v. United States, three District Courts have held for the taxpayers in cases involving an economic substance analysis. First, in Black & Decker Corp. v. United States a U.S. District Court has granted Black & Decker Corp.'s motion for summary judgment in its refund suit for over $ 57 million in federal taxes arising from a contingent liability transaction, on the grounds that the transaction had economic substance. Second, in TIFD III-E Inc. v. United States a U.S. District Court (in the Second Circuit) has ordered the IRS to refund $ 62 million to TIFD, the tax matters partner of Castle Harbour-I LLC, applying the economic substance doctrine and finding that the LLC's creation was not a sham designed solely to avoid taxes) Finally, in Coltec Industries Inc. v. United States a U.S. Court of Federal Claims has ordered the IRS to refund to Coltec Industries Inc. $ 82.8 million in federal taxes arising from a contingent liability transaction, almost similar to the one in Black & Decker, on the grounds that the transaction satisfied the statutory language and requirements and, only as a backstop, applying the economic substance doctrine to conclude that the transaction had both business purpose and economic substance. These events have emphasized the controversial application of the doctrine, and how divided are courts, the Government and taxpayers in their interpretation of the doctrine. In a previous article, this author has explored the profit potential issue, an ongoing debatable issue in relation to the doctrine. This article focuses on another unsettled issue, namely the application of the two-prong test. Frank Lyon v. United States has been construed to establish a two-prong standard for examining if a transaction lacks economic substance. Under the general two-prong test described in greater detail herein, the economic substance doctrine is based on an objective and subjective determination of whether a transaction has real, nontax economic benefit. Nevertheless, since Frank Lyon v. United States, the United States Supreme Court has not issued an important decision involving economic substance analysis, and interpretations of the doctrine subsequent to Frank Lyon v. United States was left to the circuits. As a result, circuits and courts are divided with respect to the application of the two-prong test, and several variations have emerged, each of which may result in a different way. This article presents the competing views regarding the application of the two prong test, and suggest a practical solution to reconcile these differences. The conclusions advanced are that the two-prong test ought to be collapsed into a single objective test, which would generally consist of the current objective prong.
Date of this Version
Yoram Keinan, "The Many Faces of the Economic Substance's Two-Prong Test: Time for Reconciliation?" (November 26, 2004). bepress Legal Series. bepress Legal Series.Working Paper 431.