Transactions Require Both Economic Substance And A Nontax Business Motive To Be Valid For Tax Purposes

5th Circuit Joins Georgia's 11th Circuit and the majority view in holding transactions require both economic substance and a nontax business motive to be valid for tax purpose.

The U.S. Court of Appeals for the Fifth Circuit held in Klamath Strategic Investment Fund, et al. v. United States, No. 07-40861 (5th Cir. May 15, 2009), that “a lack of economic substance is sufficient to invalidate [a] transaction regardless of whether the taxpayer has motives other than tax avoidance.” Finding that the taxpayer’s Bond Linked Issue Premium Structure (BLIPS) transaction lacked economic substance, the Klamath panel affirmed the lower court’s ruling that the transaction should be disregarded for tax purposes. The panel also affirmed the lower court’s ruling that no penalties applied.

‘Conjunctive’ v. ‘disjunctive’ test

The Fifth Circuit’s opinion adopts the majority appellate view (following the Third, Tenth, Eleventh, and Federal Circuits) that a transaction will be respected for tax purposes only if it has economic substance and a nontax business purpose. This is often referred to as the “conjunctive” test.

By contrast, in the Fourth Circuit a transaction will be respected if it has economic substance or there is a nontax business purpose. This is often referred to as the “disjunctive” test. (See Rice’s Toyota World, Inc. v. Commissioner, 752 F.2d 89, 91-92 (4th Cir. 1985).)

Codification proposals take ‘conjunctive’ approach

The proposals to codify the economic substance doctrine contained in recent bills – for example, the Heartland, Habitat, Harvest, and Horticulture Act of 2007 (S. 2242) – and in President Obama’s FY 2010 budget follow the majority-view “conjunctive” test, and provide that a transaction will have economic substance only if: (1) the transaction changes the taxpayer’s economic position “in a meaningful way” apart from federal tax effects, and (2) the taxpayer has a “substantial purpose” other than a federal tax purpose for entering into the transaction.

For More Information Contact The Atlanta, Georgia Law Offices Of AttorneyBritt:

AttorneyBritt
Gary L. Britt, CPA, J.D.
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Atlanta, Georgia 30328

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IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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