Doctrines Of Substance Over Form, Economic Substance, Economic Reality, Business Purpose And Sham Transactions

The tax doctrine of substance over form is a judicial creation. It is often invoked by the courts in cases in which a taxpayer has constructed a scheme of transactional relationships in documents and has a view on tax advantages that flow from tax reporting based on their effect. But tax law requires that there be a relationship between a desired tax benefit [such as a tax deduction, deferral or characterization of income] and an objective that relates to a purpose of business or a profit motive. In one case it was said that the tax motive must be the mortar but not the bricks of the structure.

If tax motivation is seen to outweigh business purpose and/or profit objective on the evidence evaluated [documents and factual inferences from analysis of the documents as well as from the actions of the parties to the documents], the courts will more than likely decide that the taxpayer's efforts of "form" do not reflect the "substance" of the undertaking in economic terms. On that basis the intended tax benefits will be denied. Words such as "masquerade," "a fiction," and similar epithets are often used by the courts to epitomize all manner of complex undertakings which, in the effort to secure valuable tax benefits, failed in operation to reflect a true economic purpose apart from obtaining the tax benefits.

It is also true that the motive of tax avoidance will not be pertinent to analysis of an undertaking carried out in a manner consistent with documents and actions of the taxpayer(s) if the undertaking is seen to have economic reality in terms of business purpose and a true expectation of profits. In such situations, the ulterior purpose of tax avoidance is disregarded. The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted. So, the question for determination is whether the law permits a taxpayer to set up artificial arrangements and devices of form to conceal their real character, which is the accomplishment of a preconceived plan solely to obtain tax benefits. It does not. Courts will not generally uphold tax-advantaged transactions unless the transactions had economic substance and the taxpayers incurred real economic risk. If it were otherwise, taxpayers would be able with impunity to exalt artifice above reality and to deprive tax provisions in question of all serious purpose.

Often, when the intent of the statute is seen by the courts to have been subverted by an artificial arrangement that is solely tax-motivated it will refer to the arrangement as a "sham." There is really little difference in terms between "lack of economic substance," "lack of economic reality," or "sham." The outcome is the same irrespective of the term used to characterize what the tax law proscribes.