Economic substance really ties the room together
Two similar examples where taxpayers successfully argued IRS overreached
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This blog post is educational and mentions the Economic Substance Doctrine (ESD), but is in no way investment, tax, or legal advice. The point of this post is to complement an investor's or adviser’s diligence process, but it does not replace personalized guidance from a licensed adviser or attorney in any shape or form.
Economic substance really ties the room together
What I’m reading…
Economic Substance
The Tax Adviser: Memo removes IRS procedural requirements for economic substance arguments (memo provided below, double-check it is current)
IRC §7701(o) Clarification of Economic Substance Doctrine (it is short and worth a read). Note that the common law Economic Substance Doctrine existed long before Congress made it official in §7701(o) in 2010 (see the cases below as examples)
Tax Notes (2001): Compaq Argues ADR Arbitrage Had Economic Substance (taxpayer was successful)
Journal of Accountancy (2001): What constitutes a “sham transaction” for tax purposes? “Under the objective economic substance test, the court tries to measure a transaction’s profit potential apart from tax benefits.”
Legal Standards for “Sham Transactions”: U.S. courts determine if a transaction is a sham using two key tests: Subjective Business Purpose Test: Examines the taxpayer’s intent and how thoroughly they investigated the transaction. Objective Economic Substance Test: Determines if the transaction offers profit potential independent of tax benefits.
Nail-biter case study… Case Study: IES Industries vs. IRS (2001)
The Strategy IES Industries purchased American Depository Receipts (ADRs… similar to the Compaq ADR case above) with upcoming dividends at an inflated price (market value + 85% of expected dividend) and sold them immediately after the dividend payout at market value. Financial Result: The sale generated a capital loss (used to offset other gains), but the transaction yielded an overall profit because the dividends received exceeded those losses. IRS Argument: The IRS denied the associated foreign tax credits and capital losses, labeling the trade a “sham.” They argued IES only bought rights to net dividends and, under that calculation, there was no profit. The District Court initially agreed.
The Ruling (Eighth Circuit Court of Appeals) The Appeals Court reversed the decision in favor of IES Industries, establishing two critical points: Economic Substance: Profitability must be measured using the gross dividend (pre-tax), not the net. Under this measure, the transaction was profitable and had substance. Business Purpose: Citing Gregory v. Helvering (The Supreme Court ruled against Gregory. While she had followed the letter of the law perfectly, the Court held that she had violated the intent of the law. The transaction had no legitimate business purpose other than tax avoidance. See analysis), the court affirmed that tax avoidance is a legal right. A transaction may be respected even if primarily tax-motivated, provided it possesses genuine economic substance.
ARQ: A Brief Guide to Pricing and Taxation of Variable Prepaid Forwards
The Tax Adviser: Estate of McKelvey highlights potential tax pitfalls of variable prepaid forward contracts
Morningstar: Investors have allocated more money to active ETFs on a cumulative basis than to active mutual funds
DCA Family Office: Introduction to Private Markets: Essentials of Investing in Private Equity, Private Credit, and Real Assets
F/m Investments seeks SEC approval to tokenize Treasury bill ETF shares
Recent coverage…
🥳 If you made it this far, today is my 40th birthday.
I'm in wine country with my wife fondly, and vividly, remembering the 1990s.
Let’s hope nobody micturates on economic substance in this fair city😁
Happy Birthday, Brent! Have a great time in wine country 🥳