UK: Tax Shelters and Economic Substance

At a time when the offshore industry is facing adverse policies and an increasing scrutiny I thought it best to revisit the doctrine of economic substance in the context of tax shelters. This article is intended to provide some guidelines to people using offshore vehicles to conduct their trades and/or preserve their wealth. We do not intend to provide a picture of all the situations as wealth management and international trade require more and more sophisticated vehicles. Tax planning is in constant evolution with the legislator trying to catch up with clever advisers. On the other hand economic substance is not the only tool the IRS (and other tax administrations) has to combat aggressive tax planning: treaty shopping, sham transactions in facts or in substance are some of them…

In a nutshell the economic substance is a legal doctrine that comes into play when the court has to decide whether a transaction is purely tax driven or has some business motives. From the response will depend the taxation or not of the event. The idea was first judicially embodied in the US Supreme court, although the doctrine was already toying with it, in 1937 in Gregory vs Helvering where it was held that "the transactions were simply an operation having no business or corporate purpose" where the whole operation consisted in extracting dividends through reorganisation of a company in a tax efficient manner. This doctrine have been now enacted in the CARE Act (April 9^th, 2003), section 701, the effects of which will start to be felt from February 15^th, 2004. The Act reads that to satisfy the Economic Substance a conjunctive test would have to be met: an objective inquiry regarding the effects of the transaction on the taxpayer’s economic position and a subjective inquiry regarding the motives for engaging in the transaction. The transaction must satisfy both tests! This departs from judicial precedents where courts were adopting either one or the other test. The enactment of the doctrine was received with mixed feelings and some reservations, including within the US Treasury Department.

The offshore industry which is active on the borders of aggressive tax planning has not been very concerned by this theory until the IRS decided to launch its offshore compliance programme requiring full disclosure and actively pursued tax shelters promoters and their clients. Probably it escaped her attention that the Joint Committee on Taxation published in 2002 recommendations as to how they will deal with tax shelters without substance. There was an incentive for tax payers, in the form of a 20% penalty (instead of 40%), who come clean or in good faith. The debate was focusing on the tax competition issue and disingenuously used Gregory vs Helvering famous dictum that "anyone may so arrange his affairs that his taxes shall be as low as possible…here’s not even a patriotic duty to increase one’s taxes".

Because the tangible effects of tax laws are to hit the wallet, everyone is made to believe that it concerns only the fruit of a transaction and that hiding monetary values into an offshore shelter/vault will relieve them from taxation. Unfortunately this is not so. Taxation is not concerned by monetary sums but by the legal instruments/operations which produce this economic result. A famous tax expert and scholar coined the term "tax ectopia" or "displacement" to describe this phenomenon. To make the point clearer when one buys a car under a lease agreement this operation could be requalified as a sale on credit albeit the economic substance (instalments paid, price of car) has not changed in monetary terms…The only departure from this theory would be the lump sum taxation that Switzerland uses to attract sportsmen/artists. Hence the important words in Gregory were "arrange his affairs" which clearly envisioned a legal operation.

On the other hand one would wrongly assume, from that dictum, that the legal form of the operation would prevent them from a tax enquiry or taxation. First of all because tax laws are also concerned with incomes; they are intertwined. As the dictum suggests the effect of the authorisation to organise one’s affairs as one wished is nevertheless the collection of an amount of taxes. The intention of the legislator must be factored in any tax planning activity. Some would probably say that it creates uncertainty and divinatory powers. Divination is not left only to the intention of the legislator but also concerns the motives of the taxpayers. Therefore one has the option to objectively consider that one must adheres to the words of the statute/tax laws, one has to be taxed or not according to the arrangement one has made, or to subjectively import in the debate the motivation of the taxpayer and of the legislator alike. This dilemma is shown in the debate on whether the tax law should allow for some flexibility and for the taxpayers to exploit the law inherent imperfections or minimise such exploitation by a general anti-avoidance rule.

The Economic Substance theory is a powerful tool to force the legislator into action and to curb harmful tax planning practice and tax laws balance between flexibility and rigid negation of certain operations.

For companies, reaching finance performance through cost reductions and restructuring is as meaningful as reaching the same through tax management and tax reduction. That is where the economic substance theory comes into play to prevent unintended tax advantages. Clearly the taxpayer may organise his affairs as he wishes but the motives will be scrutinized. If there is no business purpose the intended tax consequence might be denied. However the "existence of a tax benefit resulting from a transaction does not automatically make it a sham as long as the transaction is imbued with tax independent considerations" in Holladay vs commissioner.

The uniform products sold by offshore services providers and some tax planners may lack the "tax independent consideration" as they are designed to offer a tax advantage. Some recent cases have put them to the test. Therefore it is important to provide evidence that there is a business purpose.

Although there is no clear cut, we can suggest the following points :

• Cost of the transaction,
• Pursuit of objective.
• Existence of (financial) intermediary.
• Existence of a ( market) risk.

As one author said " a tax shelter is a deal done by very smart people that absent tax considerations would be very stupid". The mirror image would be now a "tax shelter is a deal done by very smart people that absent any business purpose is very stupid". This can be find in the recommendation of the Treasury that defines a tax shelter as "any entity, plan or arrangement in which a direct or indirect participant attempts to obtain a tax benefit in a "tax avoidance" transaction"!

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• John Prebble – Australian Tax Teachers Association 14^th annual conference. "Fictions of income Tax"
• The Hon David Laro "Economic Substance : a view from the Tax Court"
• Robert L. Sommers – The Tax Hound- "Judicial doctrines relevant to tax fraud schemes"
• Berg Kapro Lewis – Dissertation on tax avoidance.
• Philadelphia Bar Association – "Evaluating aggressive Tax Strategies – a methodology in light of new court cases"
• UCLA School of law – Samuel C. Thomson Jr and Robert Allen Clary II – "Coming in from the Cold . the case for ESD Codification"
• Compaq vs Commissioner of Internal Revenue – United States Court of Appeal for the fifth circuit.
• Jay A Soled – "Use of judicial doctrines in resolving transfer tax controversy"