Courts Adopt Coherent Framework for Analyzing

Lehman Brothers tax expert Robert Willens explains how the courts have developed a standard for determining "sham" transactions.
Robert WillensJuly 3, 2001

Recently, two U.S. Circuit Courts of Appeal considered decisions that had been rendered by the U.S. District Court and the U.S. Tax Court, respectively, with respect to transactions that can be characterized as “tax shelters.”

In each case, the lower court had ruled against the taxpayer; in I.E.S. Industries v. United States, the District Court’s decision was reversed by the Eighth Circuit whereas, in Winn-Dixie Stores, Inc. v. Commissioner, the 11th Circuit affirmed the Tax Court’s holding. In each case, the Court of Appeals was asked to evaluate whether the transactions under scrutiny were properly characterized as shams such that the hoped-for tax benefits, to be derived from the shelters, would be denied.

The cases, taken together, are important, not only for their outcomes, but also because the courts seem to have embraced a relatively objective standard—the economic substance approach—for resolving what is inherently a subjective question; whether a transaction is a sham.

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In the I.E.S. case, the taxpayer engaged in a “dividend stripping” transaction. It purchased ADRs, “cum” dividends (after the dividend had been declared), and promptly, sold such ADRs “ex”-dividend [(but at a point in time at which I.E.S. would be regarded as the record owner of the security and, hence, for tax purposes, the party “entitled” to the dividend (See Rev. Rul. 82-11)].

The overriding objective of the trade was to “convert” capital gains into tax-favored dividend income. Such conversion would occur through the offsetting of the capital loss on the sale of the ADRs against unrelated capital gain income. Such capital gains would be “replaced” by dividend income which, in this case, carried with it foreign tax credits that could be used to offset the U.S. tax otherwise imposed on such dividends.

The District Court held that the transaction was a sham and, thus, the hoped-for foreign tax credit was properly denied. However, the Eighth Circuit reversed the lower court and found that a transaction is only a sham if it is bereft of economic substance and that there is a lack of economic substance only in cases where the transaction is devoid of profit potential.

That was not the case here because the economic benefit to I.E.S. was the gross dividend (and not, as the I.R.S. asserted, the net—after withholding taxes were assessed—dividend). On this basis, the transaction, in fact, yielded a profit and, thus, possessed economic substance which meant, in the final analysis, that it was not a sham.

In Winn-Dixie, the taxpayer entered into a COLI (Corporate-Owned Life Insurance) program. It would purchase life-insurance policies, insuring the lives of its employees, and would then, as part of the plan, borrow against the policies.

The interest and fees with respect to the arrangement outweighed the cash surrender value and benefits paid on the policies with the result that the program yielded a pre-tax loss but, if the interest was properly deductible for tax purposes, a post-tax benefit. The I.R.S. sought to set aside the interest deduction—the sine qua non of the trade—by arguing that the arrangement was a sham; the Tax Court upheld the I.R.S.’s argument.

The 11th Circuit agreed with the Tax Court. This was so even though the taxpayer argued that, here, there was no room for the sham doctrine because the loans fell within the so-called “four of seven” exception then found in Sec. 264(c): Compliance with this exception, the taxpayer argued, strongly suggested that its interest deductions had received Congressional approval.

The court, however, citing a Supreme Court decision, Knetsch v. United States, that, at least in the 11th Circuit, retains vitality, stated that the sham doctrine does apply to indebtedness even if the accompanying interest deduction is not prohibited by Sec. 264. That crucial (and questionable) holding–that case law has not been rendered obsolete by a seemingly permissive statutory provision–led, inevitably, to the court’s conclusion that the transaction was a sham.

The court stated that a transaction is not entitled to “respect” if it lacks economic substance. The instant transaction was so lacking because the COLI program, as indicated, could never generate a pre-tax profit. Accordingly, the interest deduction was properly disallowed.

More importantly, perhaps, the courts seem to agree on the framework for analyzing exactly when a transaction does or does not possess the requisite degree of economic substance. Apparently, if the transaction is capable of producing a pre-tax profit (and if, in fact, it does so produce such a profit so much the better) it will be regarded as imbued with economic substance and will not be set aside as a sham.

Adding this degree of objectivity to what has historically been a rather subjective process, will enable taxpayers to more accurately evaluate the various tax shelter schemes that are constantly “in the market” and, if the pre-tax profit road to economic substance is now the universally accepted guideline, such taxpayers will also be in a position to assess the likelihood that the shelter will withstand judicial scrutiny.

Robert Willens is a Managing Director and Tax & Accounting Analyst at Lehman Brothers.