Notice & Comment

The Solicitor General’s Curious Defense of the Economic Substance Doctrine

The taxpayers in Tucker v. Commissioner recently filed a petition for certiorari with the Supreme Court, asking it to review whether their complex transaction generated benefits under the federal tax code. The Fifth Circuit held that compliance with federal tax statutes was not enough, and that the judge-made economic substance doctrine “empowers the federal courts to disregard the claimed tax benefits of a transaction—even a transaction that formally complies with the black-letter provisions of the Code.” 766 F. App’x 132, 137 (5th Cir. 2019) (cleaned up). Under that doctrine, the district and appellate courts have frequently stated that taxpayers must meet subjective and objective tests in order for their transactions to earn tax benefits, even if no statute imposes those tests.[FN1] In their petition for certiorari, the taxpayers argue that this extrastatutory approach finds no basis in the Supreme Court’s decisions.

The Department of Justice’s Office of the Solicitor General has, in the past, denied that lower courts disregard tax statutes in favor of judge-made tests. In Winn Dixie Stores v. Commissioner, 254 F.3d 1313 (11th Cir. 2001), for example, the taxpayer-petitioner argued that the lower court had improperly characterized and employed the economic substance doctrine as a “threshold hurdle that must be overcome before the court analyzes particular code provisions.” See Petition for Certiorari, 2002 WL 32135968, *14-*15. But the Solicitor General argued that the court “did not hold that the [economic substance] doctrine applies independent of the Code.” See Brief in Opposition, 2002 WL 32135972, *14. This, along with other factors, led the Solicitor General to oppose the taxpayer’s petition.

The Solicitor General’s characterization of Winn-Dixie and other cases does not comport with the views commonly accepted elsewhere. Time and again, lower courts have expressly stated that the judge-made economic substance doctrine applies independently of and can override federal statutes. See generally Amandeep S. Grewal, Economic Substance and the Supreme Court, 116 Tax Notes 969 (2007) (contrasting lower courts’ extrastatutory approach with the Supreme Court’s statute-based approach). Additionally, at the trial and appellate levels, the government does not deny that the economic substance doctrine and occasionally other doctrines apply apart from legislative enactments. The IRS Chief Counsel and the Department of Justice routinely argue that taxpayers must satisfy judge-made tests even if they have complied with all relevant statutes and regulations. But the Office of the Solicitor General, across administrations, has resisted this common understanding.

At last, in Tucker, the Solicitor General’s office has unequivocally abandoned its peculiar view.[FN2] The government’s brief in opposition candidly acknowledges that the “economic-substance doctrine is not a canon for construing ambiguous statutory terms,” and that it applies “even if the transactions technically comply with the statutory and regulatory provisions that authorize such benefits.” See Brief in Opposition, Tucker v. Commissioner, pp. 10-11 (emphasis in original). The evolution in the Solicitor General’s position should provide a strong reason to grant certiorari. After all, both taxpayers and the government now agree that lower courts have applied judge-made doctrines rather than federal statutes. This presents a major separation of powers issue that the Court should resolve. Cf. also United States v. Woods, 571 U.S. 31, 37 n.1 (2013) (declining to express any view on the economic substance doctrine, as applied by the lower court).

However, the Solicitor General’s belated admissions may be harmless. The government argues that when Congress codified the economic substance doctrine in 2010, it “confirmed that the economic substance doctrine encompasses sham tax-avoidance transactions that otherwise comply with the Code.” See id. at p.13. Under new Section 7701(o), whenever the economic substance doctrine is “relevant,” a taxpayer must satisfy a statutory two-part test in order to establish its right to claimed tax benefits. See Section 7701(o)(1)(A) & (B). The Solicitor General believes that Section 7701(o) thus blesses, and in fact codifies, the principle that transactions must satisfy requirements “apart from compliance with the Code.” See id. at p.14 (emphasis in original).

We should all welcome clarity from Congress about the economic substance doctrine, but Section 7701(o) does not provide it. The statute defines the doctrine but says that it applies only when it is “relevant.” This returns us to square one: Under what circumstances may courts disregard federal statutes in favor of judge-made tests? See Brief of Amicus Curiae Professor Amandeep S. Grewal, WFC Holdings v. United States, pp. 25-26 (S. Ct. 13-1037). It is impossible to tell without Supreme Court guidance. And, critically, the “relevance” issue has nothing to do with whether the Court decides a case before or after Congress enacted the new statute. Under Section 7701(o)(5)(C), “whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if [Section 7701(o)] had never been enacted.”  As the IRS itself acknowledges, Section 7701(o) does “not affect the ongoing development of authorities” on when the economic substance doctrine applies. IRS Notice 2010-62, at 5 (Oct. 4, 2010).[FN3]

The Tucker petition thus presents a strong case for certiorari. The Supreme Court should provide guidance on when, if ever, courts may use the economic substance doctrine to override federal tax statutes. Case law under Section 7701(o) cannot develop coherently unless the Court resolves that threshold issue. Additionally, extrastatutory doctrines remain highly controversial, with one court even comparing the IRS’s practices to Caligula’s. See Summa Holdings, Inc. v. Commissioner, 848 F.3d 779, 781 (6th Cir. 2017) (Sutton, J.). One hopes that the Court provides guidance on these significant issues soon, whether in Tucker or another case.

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Comments welcome. This post may be updated.


FN1:  Judicial formulations have varied greatly, but in assessing whether a transaction has economic substance, courts have generally examined whether the taxpayer had any purpose for the transaction other than tax avoidance (the subjective test), and have also examined whether the transaction had any meaningful effect on the taxpayer’s economic position, aside from any potential tax reduction (the objective test).

FN2: The shift from Winn-Dixie to Tucker seems to have been gradual. In WFC Holdings v. United States, for example, the Solicitor General’s brief in opposition described the economic substance doctrine in common-law terms, but did not use language quite as forceful as that found in the Tucker opposition brief.

FN3: The Solicitor General thus errs when he asserts that Section 7701(o) necessarily blesses the extrastatutory approach adopted by most lower courts. Rather, it remains undetermined whether courts should apply the two factors listed in the statute in every single case, or instead only when an operative statute could be plausibly interpreted to embrace those two factors. See Brief of Amicus Curiae Professor Amandeep S. Grewal, Woods v. United States, pp. 18-20 (S. Ct. 12-562). For example, because Section 162 refers to deductions paid or incurred while “carrying on any trade or business,” courts have often applied economic substance principles to that section. The quoted language, after all, likely contemplates deductions made in connection with legitimate business activities, not deductions made solely to avoid taxes. But courts had split on how economic substance principles applied to statutes like Section 162.  Section 7701(o) now establishes a uniform approach. See Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 111th Congress, JCS-2-11 No. 19, 2011 WL 940385, *16 (Section 7701(o) “clarifies that the economic substance doctrine involves a conjunctive analysis” and “eliminates the disparity that exists among the Federal circuit courts regarding the application of the doctrine”).

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