Year in Review - Tax shelters and the economic substance doctrine

The Court of Appeals overturned various lower court opinions and the Federal Circuit created yet another legal standard as to the economic substance. In Black & Decker Corp. v. United States, 436 F.3d 431 (4th Cir. 2006), which involved a transfer of stock in exchange, in part, for contingent liabilities, the Fourth Circuit remanded the case back to the lower court for consideration of the economic doctrine test under Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89, 91 (4th Cir. 1985). In TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006), overturned the lower court decision based on “the totality-of-the-circumstances”. The 2d circuit cited as authority Commissioner v. Culbertson, 337 U.S. 733, 742 (1949), which is an assignment of income case. But by far the most important case was Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006). In Coltec Industries, the Federal Circuit Court created a new standard for economic substance.

The Court of Appeals overturned various lower court opinions and the Federal Circuit created yet another legal standard as to the economic substance. In Black & Decker Corp. v. United States, 436 F.3d 431 (4th Cir. 2006), which involved a transfer of stock in exchange, in part, for contingent liabilities, the Fourth Circuit remanded the case back to the lower court for consideration of the economic doctrine test under Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89, 91 (4th Cir. 1985). In TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006), overturned the lower court decision based on “the totality-of-the-circumstances”. The 2d circuit cited as authority Commissioner v. Culbertson, 337 U.S. 733, 742 (1949), which is an assignment of income case. But by far the most important case was Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006). In Coltec Industries, the Federal Circuit Court created a new standard for economic substance. The standard consists of the following:

  1. A transfer of assets will be disregard if it lacks a business purpose other than reduce taxes. A lack of economic substance is sufficient to disqualify the transaction without proof that the taxpayer’s sole motive is tax avoidance. 
  2. The taxpayer bears the burden of proving that the transaction has economic substance. 
  3. The economic substance of the transaction must be viewed objectively rather than subjectively. 
  4. The transaction to be analyzed for economic substance is the transaction that gives rise to the alleged tax benefit not the legitimate transactions at the end of the line.  
      1. Arrangements with subsidiaries, i.e. related parties, that do not affect the economic interest of independent third parties deserve particularly close scrutiny.

For a thorough analysis of Coltec, see Dawson, COLTEC: A New Standard for Economic Substance, Business Entities (WG&L) (Nov./Dec. 2006)

On November 8, 2006, Coltec filed a Writ of Certiorari citing to the fact that there is a split amongst the Circuits as to proper applicable standard for the economic substance test and that the Coltec test is in conflict with those judicial standards.

Whether the Supreme Court accepts the case for review will be worth following, after all Congress has continuously been considering whether to adopt a uniform definition for economic substance and has postponed making a decision. The Supreme Court may view the definition of economic substance as a matter for Congress and therefore not accept the case.

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