The Economic Substance Doctrine (Portfolio 508)


William Chip

Senior Counselor to the Secretary of Homeland Security

U.S. Department of Homeland Security

At a glance

I. Introduction and Scope of Portfolio
II. History
III. Judicial Anti-Abuse Doctrines in General
IV. Economic Substance
V. The Profit Requirement
VI. Economic Substance of an Entity
VII. Integration or Bifurcation of a Series of Transactions
VIII. Legislative Proposals to Codify the Economic Substance Doctrine
IX. Cases on Economic Substance by Topic
X. Conclusions and Observations


Bloomberg Tax Portfolio, The Economic Substance Doctrine, No. 508, analyzes the “economic substance doctrine” as codified in §7701(o) of the Internal Revenue Code. Section 7701(o) defines the “economic substance doctrine” as the “common law” developed by the courts to disallow tax benefits for tax-motivated transactions that had no “business purpose” or no “economic substance.” The “business purpose” test looks to the taxpayer's motives for entering into the transaction, while the “economic substance” test looks to the reality of the transaction. Prior to codification, the presence of either “business purpose” or “economic substance” was sufficient in some circuits to sustain a transaction's tax benefits (the “disjunctive” test); in other circuits both needed to be present (the “conjunctive test”).

Section 7701(o) codified the “conjunctive” test by disallowing the federal tax benefits of any transaction for which the courts have found either “business purpose” or “economic substance” to be “relevant” unless, apart from federal tax benefits, there is both a “substantial purpose” for entering into the transaction and a “meaningful change” in the taxpayer's “economic position.” Section 7701(o) also clarifies how the “profit potential” of a transaction may be used to demonstrate economic substance.

Of even greater importance to post-codification tax planning is the 20% penalty on §7701(o) adjustments that are imposed by §6662(a) of the Internal Revenue Code (increased to 40% if the transaction is not “adequately disclosed” on the return). The penalty applies without regard to whether the taxpayer had a professional advisor's tax opinion or any other “reasonable basis” for believing the transaction at issue had economic substance.

This Portfolio may be cited as Chip, 508 T.M., The Economic Substance Doctrine.

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