What Is The Economic Substance Doctrine?

The Court of Federal Claims has upheld the IRS’s determination that a taxpayer’s Son-of-BOSS transaction lacked economic substance. The court found that potential for profit does not in and of itself establish economic substance, especially where the profit potential is dwarfed by tax benefits.
The new codified standard requires a two-part analysis. First, consideration is given to the objective effects of the transaction on the taxpayer’s economic position. Second, the taxpayer’s subjective motives for engaging in the transaction are considered. In this case, the taxpayer had entered into the disputed transaction before March 30, 2010, which is the effective date of the act.
Case law set forth five principles incorporated in the economic substance doctrine:
The transaction to be analyzed is the one that gave rise to the alleged tax benefit;
The transaction cannot lack economic reality;
The taxpayer bears the burden of proving that the transaction has economic substance by a preponderance of the evidence;
The economic substance of a transaction must be viewed objectively;
Arrangements with subsidiaries that do not affect the economic interests of independent third parties deserve particularly close scrutiny.
Here, the court found that the transaction lacked economic substance. The taxpayer could not show by a preponderance of the evidence that the partnership was formed as a legitimate investment vehicle. Moreover, the transactions did not reflect economic reality as the taxpayer experienced merely fictional tax losses, the court found.