Business-purpose and economic-substance tests. (Corporations & Shareholders).

When determining if a transaction is legitimate for tax purposes or is a sham, the courts and the IRS typically apply a business-purpose test and an economic-substance test. In general, the business-purpose test questions whether the transaction has an identifiable economic purpose independent of tax considerations. The economic-substance test requires that the transaction have real potential for profit.

Although the standards that courts use in determining whether to respect a transaction seem relatively straightforward, the analysis is fraught with the difficulties inherent in applying subjective standards to the facts. IES Industries, Inc., 8th Cir., 6/14/01, provides taxpayers with additional guidance in determining whether their tax-beneficial transactions meet the Eight Circuit's standard for business purpose and economic substance. IES Industries is a particularly interesting case, because the court held that the company satisfied the business-purpose and economic-substance tests in a transaction that closely resembled the stock purchase/ sale transaction that the Tax Court rejected in Compaq Computer Corp., 113 TC 214 (1999).

In Compaq Computer, the IRS challenged a transaction that involved the carefully planned purchase and sale of American depository receipts (ADRs). Compaq purchased ADRs "cum dividend" (i.e., Compaq was entitled to the declared dividend), followed by an immediate sale of the ADRs "ex dividend" (i.e., the purchaser was not entitled to the declared dividend). Compaq was seeking (under prior law) to realize the benefits from the ADRs' foreign tax credits (FTCs), while offsetting a previously recognized capital gain with a capital loss on the ADR sale. In holding that the ADR transaction was a sham, the Tax Court concluded that it had no economic substance or business purpose other than the realization of the tax benefits.

In Compaq, the Tax Court opined that economic substance is supported by evidence of a transaction's potential to produce a profit for a taxpayer and the existence of market risk. In finding that Compaq's ADR transaction would result in an economic loss prior to the use of the FTCs, the court concluded that the transaction lacked the profit potential necessary for economic substance. Further, no economic substance existed, because the carefully planned ADR transaction eliminated virtually all of the market risk associated with the transaction.

In Compaq, the court stated that a transaction satisfies the business-purpose requirement when it has a nontax purpose. On review of the facts surrounding Compaq's ADR transaction, the court concluded that Compaq had no business purpose other than obtaining a Federal tax benefit. As evidence, it cited Compaq's minimal due diligence (a single one-hour meeting with an investment adviser), the absence of a standard cashflow analysis, a single reference call and a one-day period for analyzing and agreeing to the transaction.

In IES Industries, the Eighth Circuit had the opportunity to review the business-purpose and economic-substance issues discussed in Compaq. In addition to the similarity of issues, IES Industries also involved the use of an ADR transaction to obtain tax benefits through the use of FTCs. Moreover, the same investment firm that arranged Compaq's ADR transaction proposed IES's transaction.

In reversing the district court, the Court of Appeals held that IES's ADR transaction satisfied the business-purpose and economic-substance tests, and that the transaction should be respected for U.S. tax purposes. As to the requirement that the transaction have potential for economic profit, the court in IES Industries found that the gross dividend paid, not the net dividend as decided by the court in Compaq, provided the necessary profit potential.

Perhaps the most noteworthy aspect of the IES Industries decision concerns the level of risk (or lack thereof) that must be involved in a transaction for it to be respected for tax purposes. Although the court in Compaq "shammed" the ADR transactions (because Compaq eliminated virtually all market risk), the IES Industries court actually noted that the carefully orchestrated elimination of market risk was evidence of IES Industries' intent to treat the ADR transactions as moneymaking.

Although the ruling in IES Industries might appear at first to be a dramatic liberalization of the economic-substance and business-purpose thresholds, given the similarities in IES'S ADR purchase/sale transactions with those of Compaq, a careful reading of IES Industries results in a somewhat more modest conclusion. In the Tax Court's view, IES Industries, unlike Compaq, spent a considerable amount of time analyzing the transaction, meeting with advisers and performing due diligence. These activities were sufficient for the court to conclude that the IES Industries transaction was legitimate. IES Industries is thus significant, because it helps taxpayers identify the types of activities that the courts consider important in satisfying the economic-substance and business-purpose tests.

However, the transactions entered into by Compaq and IES are no longer permitted under current law. Sec. 901(k)(1) reduces or eliminates the perceived abuses associated with ADR-type transactions. Specifically, under Sec. 901(k)(1), stock must be held for at least 16 days of the prescribed 30-day period, including the dividend record date, to obtain an FTC on foreign taxes withheld at the time of the dividend distribution. This provision is effective for dividends paid or accrued after Sept. 5, 1997. Sec. 901(k)(1) effectively eliminates the desired tax benefits for Compaq and IES ADR-type transactions. Despite this change in the law, from a practical tax-planning standpoint, IES Industries still provides taxpayers with valuable insight into the court's current thinking, because it identifies the criteria the courts deem critical in satisfying the economic-substance and business-purpose tests.

The Service has also recently weighed in on the issue of business purpose and economic substance for the deductibility of a taxpayer's insurance premium payments to a captive insurer. FSAs 200125009 and 200125005 specifically discuss whether insurance premiums paid by a U.S. subsidiary of a foreign parent to a "brother-sister" captive insurer, wholly owned by the foreign parent, are deductible for U.S. tax purposes.

In determining the deductibility of insurance premiums paid to a captive insurer, these FSAs acknowledge that the courts have never fully accepted the "economic family" doctrine, which the Service has relied on to deny interest deductions for certain payments to captive insurers. The courts have held that payments to a captive insurer by a sibling subsidiary were deductible as insurance premiums, provided that the captive insurer or the insurance transaction itself was not a sham.

On review of the FSAs' facts, the Service officially conceded that taxpayers that made insurance payments to a brother-sister captive insurance company should not be denied a deduction, because neither the captive insurer nor the transaction lacked the requisite economic substance or business purpose.

As in IES Industries, FSAs 200125009 and 200125005 are important, because they represent wins for taxpayers in the areas of economic substance and business purpose. The practical value of the FSAs is the IRS's identification of the facts that should be analyzed to determine whether a captive-insurance relationship is a sham transaction that lacks sufficient economic substance or business purpose. Weak Facts for taxpayers engaged in captive-insurance arrangements include parent guarantees, a thinly capitalized captive insurer, an absence of real hazards faced by the insured, noncommercial rates for premiums and commingling of the captive's business assets with the assets of related entities.

FROM JEFFREY A. WEISS, CPA, AND GREGG T. LARSON, J.D., NEWYORK, NY