Risk, return, and objective economic substance.

TABLE OF CONTENTS I. INTRODUCTION 784 II. OBJECTIVE ECONOMIC SUBSTANCE 786 III. PRE-TAX PROFIT 793

A. Weighing Potentialities 793

B. After-Tax World 798 IV. Proposed Objective Economic Substance Inquiry 803

A. Comparables Test 804

1. Overview 804

2. Fact-Finding Tasks 806

a. Transaction Boundaries 806

b. After-Tax Calculation 807

c. Market Comparables 809

B. Factor Based Indquiries 810

1. Rebutting the Presumption Triggered by

Comparables Test Failure 810

2. Lack of Suitable Comparable 811

C.Framework Effects 812

1. After-Tax Approach 812

2. Taxpapyer Sophistication 814

3. Adoption of Framework 815 V. Case Studies 816

A. Compaq v. Commissioner 816

1. Transaction Deatails 816

a. Purchase of AADRs 818

b. Re-sale of ADRs 819

c. Dividend 820

d. Fees 820

2. Pre -Tax, Post-Tax 821

B. Black & Decker v. United States 825

1. Transaction 825

2. After-Tax Inquiry 828

a. Black & Decker Contingent Liabilities

Transaction 828

b. Generic Contingent Liabilities Shelter 830 VI. CONCLUSION 831

I. Introduction

The economic substance doctrine is a judicial method used to evaluate transactions suspected of being nothing more than elaborate (and illicit) tax avoidance. The doctrine was developed in the court system, and its precise requirements are continually evolving. Generally, the test consists of a subjective inquiry into whether a taxpayer had a nontax purpose for entering the suspect transaction and an objective inquiry into whether the transaction accomplished anything beyond tax effects. (1) These inquiries frequently focus on the economic profit available in the transaction because taxpayers often assert a profit motive as their nontax reason for entering the suspect transaction. Economic profit is determined by looking to the pre-tax landscape.

The use of pre-tax analysis reflects the idea that a genuine economic transaction will yield a higher return before taxes than after taxes. This article suggests that although this idea has intuitive appeal and provides some indication of economic substance, exclusive use of the pre-tax viewpoint is fundamentally flawed. This article reviews the problems associated with the pre-tax viewpoint and proposes an alternative framework for testing objective economic substance. (2)

Under the proposed framework, the after-tax return on the suspect transaction would be compared to the return available on an economically equivalent market transaction. If the after-tax return on the suspect transaction were substantially similar to the return available on a comparable transaction, the taxpayer would satisfy the objective economic substance inquiry. If, however, the taxpayer's after-tax return on the suspect transaction were substantially higher than the return on economically comparable market transactions, the suspect transaction would be presumed to fail the objective economic substance inquiry.

When a transaction fails the comparables inquiry, the taxpayer would still be able to rebut the presumption that the transaction lacks economic substance by demonstrating that the additional return more likely than not arose because she was part of a naturally occurring tax clientele for the transaction. A "tax clientele" is a group whose members have a preference for a particular asset or transaction because their tax bracket affords them an extra return that the investor setting the price of the asset is unable to attain. This rebuttal takes the form of the taxpayer demonstrating membership in a natural tax clientele because Congress presumably sanctions (and even encourages) the formation of broad tax clienteles through the progressive rate system. For example, in the case of tax-exempt bonds, high tax bracket taxpayers will be able to earn a higher return than on a comparable taxable bond if the price on both assets is set by a taxpayer in a lower bracket. (3)

If the comparables test could not be performed because of the absence of a suitable comparable, the court would turn to a factor-based inquiry into whether the after-tax result more likely than not resulted from economic opportunity other than tax arbitrage. (4) Relevant factors in this determination would include analysis of any imperfect comparables, the ease with which other taxpayers could have entered into the transaction, the presence or absence of a known tax-shelter promoter, the dependence of the after-tax return on particular tax attributes of the taxpayer or counterparty, the timing and circumstances surrounding the creation of those tax attributes, and the extent of risk and pre-tax profit. (5)

This article will review the problems associated with the pre-tax viewpoint and propose an alternative method for testing objective economic substance. In particular, Part II will provide an overview of the economic substance doctrine and discuss the assumptions about this doctrine that underlie the proposed method. Part III will critique the current pre-tax approach to an objective inquiry into profit. Part IV will detail the proposed objective economic substance framework. Part V will consider how the proposed framework might have been applied to two cases--Compaq Computer Corp. v. Commissioner and Black & Decker Corp. v. United States. Part VI states the article's conclusion.

II. OBJECTIVE ECONOMIC SUBSTANCE

This Part will briefly describe the economic substance doctrine and also outline the background assumptions regarding when the doctrine should be applied and what work the objective prong of the doctrine should perform. These assumptions are working assumptions; an in-depth defense of them is beyond the scope of this article.

In general, the economic substance doctrine is applied to transactions when a taxpayer has technically met statutory and regulatory requirements but has met these requirements in such a way that the specific result of the transaction or series of transactions is unlikely to have been foreseen by Congress or regulators. The precise structure of the economic substance doctrine is not settled, and enumeration of the doctrine's many variations is beyond the scope of this article. (6) Generally, however, the doctrine consists of both a subjective and an objective prong. The subjective prong is satisfied if the taxpayer had a nontax business or investment purpose for entering into the transaction. (7) The objective prong looks to whether the transaction accomplished anything beyond generating the claimed tax benefits. (8) This article focuses on the objective prong of the economic substance doctrine.

The objective and subjective inquiries of the economic substance doctrine often dovetail. Thus, for example, a taxpayer who asserts that she entered a suspect transaction in order to earn a pre-tax profit would satisfy the objective prong by demonstrating the reasonableness of attaining that goal. (9) The courts have not reached a consensus as to the weight each prong should be given. Some courts require taxpayers to satisfy both prongs, whereas in other courts taxpayers need only satisfy one prong in order for the transaction to survive scrutiny. (10) This article does not take a position as to the weight the courts should give the two prongs.

The economic substance doctrine is only one of several tests developed in the courts for the purpose of scrutinizing claimed tax benefits. Each of these tests fills a slightly different--though occasionally overlapping--niche in the world of tax litigation. Although the subjective and objective prongs together form the economic substance doctrine, these two prongs fill distinct roles. The objective economic substance prong is closely related to the sham transaction doctrine and to the more generalized "substance-over-form" approach. These two tests inform this article's working assumptions about the boundaries and content of the objective economic substance test.