When is the Economic Substance Doctrine Applied?

Tax Professionals' Resource
April 5, 2013 — 1,715 views  
Become a Bronze Member for monthly eNewsletter, articles, and white papers.

In 2010, the Economic Substance Doctrine came to be part of tax law in the U.S. The US government adopted this doctrine along with the 2010 Patient Protection and Affordable Care Act. President Obama signed into this act on March 30, 2010. According to the Economic Substance Doctrine, any transaction must display economic value apart from reduced tax liability. Only if this condition is met, will the transaction be considered valid. As part of US tax law, the objective of the Economic Substance Doctrine is to put up a fight against tax-driven transactions. When applied, this doctrine refuses to recognize tax benefits accrued by only tax-motivated transactions.

Economic Substance Doctrine – An Overview

While the Economic Substance Doctrine was adopted only in 2010, its history dates back to the Gregory vs. Helvering landmark judgment of 1935. While this case did not legally secure a place for this doctrine, the first symptoms could be seen in Commissioner of Internal Revenue Mr. Guy Helvering's argument with respect to economic substance. In this case, the Supreme Court emphasized on the fact that there had been a lack of business purpose in carrying out the transaction in question.

The doctrine is essentially anti-abuse in nature and is intended to control transactions that take place only because of tax benefits. While the Supreme Court assesses the economic relevance of a transaction through this doctrine, the criteria for relevance are not stated clearly.

Applying Economic Substance Doctrine

The Frank Lyon Company case of 1978 was another milestone event in terms of getting the Economic Substance Doctrine in place. It was only after this judgment that the government seriously began to formulate its two-prong method to prove economic substance of form. The two-prong method observes two components – the objective component where it has to be assessed whether a transaction has economic substance and the subjective component where it has to be evaluated if there is a non-tax motive to carry out the transaction.

In reality, however, courts have struggled to apply this doctrine to business transactions. And that has been mostly because they have been artificial transactions with little or no connection with the business. As a result, some courts have taken a conjunctive approach to the doctrine – demanding that taxpayers prove both the components of the two-prong method – while others have adopted a disjunctive approach, demanding only one component to be satisfied. Courts have also laid down different rules when it comes to taxpayers satisfying either prong of the test. The codification of the doctrine under new IRC § 7701(o), however, is expected to resolve the issue of inconsistency.


The Economic Substance Doctrine as part of IRC § 7701(o) comes with a harsh penalty. If the lack of economic substance has to do with underpayments, the taxpayer is charged a penalty of 20%. In case the taxpayer does not disclose the details of a transaction, he has to pay 40%. In terms of transaction disclosures, there is no exception. A penalty of 20% is also applicable to refund claims under the new law.

Tax Professionals' Resource