ECONOMIC SUBSTANCE: WHAT IT IS, INTERPRETATION AND EXAMPLES - ARTE - 2025

The economic substance is a doctrine in US tax law, according to which a transaction to be considered valid must have both a substantial purpose, in addition to reducing tax obligations, as an additional economic effect to the tax effect.

This doctrine is used by the Internal Revenue Service (IRS) to determine if with tax shelters, which are the strategies used to reduce tax obligations, tax laws are being abused.

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For a transaction to be honored, it must change the taxpayer's economic situation and position itself in a significant way, apart from the effect on the tax. Also, the taxpayer must have had a substantial purpose to participate in the transaction, other than the effect on the tax.

The doctrine of economic substance has long been part of tax law. Although it was only codified in the Internal Revenue Code in 2010, the IRS and the courts have used the doctrine for years to ignore transactions that do not meet established requirements.

What is the economic substance?

The genesis of the economic substance doctrine is a common law doctrine that rejected the tax benefits associated with a transaction, if the transaction was deemed to lack economic substance or commercial purpose.

The term economic substance represents the actual activity and effective role that a business plays in the broader context of an internationally operating organization.

For example, is a company located in Switzerland or some other country really necessary, from an economic perspective, in the overall corporate structure of an organization?

Tax planning companies

A considerable number of international tax planning structures, such as finance companies, holding companies, and trading companies, have been established around the world.

This is done to benefit from the tax laws of other foreign jurisdictions. It is also done to take advantage of the favorable conditions of the double taxation treaties signed between two countries.

For example, this may be the case when country A has not signed a double tax treaty with country B. Therefore, an additional company is filed in country C, with which both country A and country B have signed beneficial double tax treaties.

The sole objective of the corporate entity inserted in country C is to benefit from the favorable conditions applicable to the double taxation treaties. However, due to no economic need, this type of intervening structure often lacks genuine economic activity.

Therefore, foreign entities are often established for financial and / or tax reasons, but not so much because they are really "economically" necessary in the company's worldwide operating activities.

Interpretation

The economic substance doctrine is a judicial doctrine of law that does not allow the tax benefits of a transaction if it lacks an economic substance or a commercial purpose.

This doctrine was codified in 2010, in section 7701 (o), which defines that a transaction has economic substance only if:

- The transaction significantly changes the economic position of the taxpayer, apart from its tax effects.

- The taxpayer has a substantial purpose to carry out the transaction, apart from those tax effects.

The Internal Revenue Service establishes that, in order to determine whether or not the doctrine of economic substance applies to a transaction, it must include all the relevant factual elements of a normal tax treatment for any investment, plan or agreement.

Inclusion of plan steps

The transaction must also include each of the steps that are carried out as part of a plan. The facts and circumstances will determine whether or not the steps in the plan will serve to define the transaction.

When a plan generated a tax benefit and has interconnected steps with a common goal, the IRS will define it as a transaction if all the steps are included together.

Each step will be considered when analyzing whether the overall transaction lacks economic substance. If a sequence of steps contains a single step that is tax-motivated, and that is not necessary to achieve a non-tax objective, the IRS will penalize the transaction.

These rules apply to transactions made after March 30, 2010. This is the date that section 7701 (o) was promulgated.

Examples

Structures to improve the shareholder base

It is essentially a series of transactions conducted with the purpose of increasing the corporate share base. This is to reduce any capital gains from the sale of shares.

Adjustable rate debt structure

They are transactions that involve a loss with the exchange of currencies. They serve to offset the profits from the sale of a business that is not related to that exchange.

Leveraged bases of investment exchange

It involves a highly complex series of connected transactions. It involves the sale by a subsidiary company of practically all its assets, with a considerable profit. It then follows up with a series of purchases and sales of digital foreign currency options.

Then the subsidiary forms with these options a company of which it is fully owner. At the same time, this company buys shares of corporations that are not on the stock market.

Later, when this company liquidates the shares of the subsidiary to have its own shareholding base, it will generate a loss when it sells the shares. Thus, it compensates for the gain obtained from the previous sale of the assets of the subsidiary.

Debt transactions

They are transactions of debts defaulted. In this case, a bankrupt retailer surrenders its bad debt, related to its bankruptcy.

They are delivered to a limited liability company (SRL), whose specific function is the collection of accounts receivable. In return, he receives a majority stake in this company.

Subsequently, the retailer exchanges his interests in the LLC for cash. Delivers to the LLC a portion of those accounts receivable for majority interests in other newly created LLCs.

Investors then sell their shares in these LLCs through an additional layer of LLC companies, which function as holding companies.

The set of related LLCs request a transfer of accounts receivable, based on their nominal value. Write off those accounts receivable as bad debt, generating losses for investors.

Finally, the original top-level SRL announces losses on the subsequent sale of the shares to the later holding LLCs.

References

1. Wikipedia, the free encyclopedia (2018). Economic substance. Taken from: en.wikipedia.org.
2. Economic-Substance (2018). What is economic substance? Taken from: economic-substance.com.
3. Sally P. Schreiber (2014). Notice defines terms for economic substance doctrine. Journal of Accountancy. Taken from: journalofaccountancy.com.
4. David Klasing (2014). What is the Economic Substance Doctrine? Klasing Associates. Taken from: klasing-associates.com.
5. Peter H. Blessing (2018). Codified Economic Substance Doctrine. Columbia Journal of Tax Law. Taken from: taxlawjournal.columbia.edu.