Substance-over-form doctrine in multistate taxation.

The realm of multistate taxation is diverse. There are estimated to be more than 7,500 state and local taxing jurisdictions, making it very likely that a practitioner is going to be asked to interpret how an unfamiliar state or local tax affects a client's business. This is particularly true when a client has a complex operating structure (e.g., multistate operations, and multiple, special-purpose or disregarded entities) or engages in complex transactions.

Interpreting tax provisions can be difficult, particularly those a practitioner has never encountered before. When interpreting tax statutes that are in dispute, courts often rely on "canons of construction," which are general legal principles, rather than strict rules. There are many legal canons, and knowing when a court might use them is never certain. However, in the last century, a doctrine used consistently to interpret tax provisions emerged, called the "substance over form" doctrine. While not replacing canons of construction or other rules of legal interpretation, this doctrine provides the overriding view courts have taken when examining tax provisions.

The Supreme Court, in F. & R. Lazarus & Co., 308 US 252 (1939), summarized the doctrine as follows:

In the field of taxation, administrators of the laws and the courts are concerned with substance and realities, and formal written documents are not rigidly binding.

Application to State Income Taxes

Many of the cases used to develop the substance-over-form doctrine originally related to Federal income tax. Accordingly, as states began enacting their own income taxes and adopting substantial portions of the Internal Revenue Code, the doctrine became a guiding principle in state income tax cases.

California: State reliance on this principle was explicitly noted in a case dealing with whether a transaction qualified as a reorganization; see In the Matter of the Appeal of Rosenberg Bros. & Co., Inc., CA State Bd. of Equal., No. 60-SBE-001 (4/4/60). In that case, the taxpayer argued that its purchase and immediate liquidation of a company should be viewed as two separate transactions. The court disagreed, stating that both steps were preconceived parts of a single liquidation plan:

In such a situation we feel compelled to follow the United States courts which, in applying similar Federal statutes, have adopted the view that substance not form controls tax liability and have held that such a transaction is a purchase of property and not a reorganization.

Ohio: Similarly, a taxpayer sought to take a more literal reading of a provision that granted a deduction for certain dividends; see McGraw-Hill, Inc. v. Joanne Limbach, Tax Comm'r of Ohio, OH Bd. of Tax Apps., No. 85-D-221 (6/30/89). It argued it could also exclude the gain on the sale of the same subsidiary that generated the dividends. The court declined to accept this interpretation, which would have treated a capital gain to a parent differently from the same capital gain to a nonparent:

The substance-over-form doctrine provides that the legal formalities of a transaction may be overlooked when the true substance of the transaction is determinative of the incidence of taxation. While this doctrine has been applied to the benefit of taxing authorities and taxpayers alike, the philosophy ... is to prevent taxpayers from subverting the taxing statutes by disguising their transactions with mere legal formalisms. The doctrine only applies where the form chosen by the parties to a transaction is a fiction. The doctrine does not apply where a taxpayer later seeks to recast a completed transaction to obtain a tax advantage.

New York: Although the doctrine is pervasive in interpreting state income taxes, there are exceptions. A petitioner argued that a law requiring it to add back interest payments made to a related entity did not apply; see In the Matter of the Petition of Mod Maid Imports, Inc., NY Div. of Tax Apps., Admin. Law Judge (ALJ) Unit, DTA No. 809148 (3/18/93). The taxpayer was able to provide evidence of the law's legislative intent. In rejecting the taxpayer's position, the ALJ noted:

[T]he Legislature intended that the form rather than the substance of a transaction should govern its tax consequences ... petitioner's "form over substance" argument must fail herein.

Accordingly, while the substance of a transaction will generally be scrutinized, the form cannot always be ignored.

Application to Transaction Taxes

The presumptive use of the substance-over-form doctrine in income taxes does not apply to other types of taxes, particularly transaction taxes. Such taxes (such as sales and use taxes) differ from income taxes in that they are designed so that every step or transaction is determined on its own to be taxable or nontaxable.

For example, in the case of a "manufacturer" selling to a "wholesaler" selling to a "retailer," selling to a "consumer," each step must be reviewed (and audited) separately for sales and use tax consequences. If the wholesaler is audited, it must demonstrate that it paid (collected) sales tax or has an exemption for (from) the transaction, with the manufacturer (retailer). Similarly, if the retailer is audited, it must demonstrate that it paid (collected) sales tax or has an exemption for (from) its transaction with the wholesaler (consumer). Each transaction stands on its own; the chain of transactions would never be "collapsed" to infer that in substance, a sale between the manufacturer (first party) and the consumer (last party) occurred.

Transaction taxes are designed to tax and give significance to individual transactions; income taxes are supposed to tax increases to wealth, with less reliance on the details as to how such wealth was obtained. The difference between the two is also reflected in how the substance-over-form doctrine is applied. In transaction tax matters, it is not uncommon to see the doctrine reversed to emphasize "form over substance."

Texas: For example, a retailer in a sales tax audit challenged how the taxability changed when it altered the notation on its invoice from "postage" to "postage and handling." In holding for the state, the court emphasized the significance of the stated language; see Spencer Gifts, Inc. v. Bob Bullock, Comptroller of Pub. Accts., 766 SW2d 593 (TX Ct.Apps. 1989):

Spencer's brief extensively discusses its business reasons for labeling and calculating its postage and handling charges in the way that it does. Spencer has a solution--change the wording on its order form. That it has made a business decision that it will have better customer relations by obscuring exactly what is included in "postage and handling" cannot be binding on the Texas tax system. (Emphasis added.)

Tennessee: A bank that could have avoided successor liability by simply repossessing property was held liable when it elected to purchase the debtor's equity interest. The bank took over the business without formally foreclosing, by negotiating to buy the debtor's remaining equity in the property. However, by purchasing the debtor's interest in the business in lieu of a foreclosure, the bank qualified under the statute as an "owner" and was liable for the debtor's prior, unpaid taxes; see Bank of Commerce v. Woods, 585 SW2d 577 (TN Sup. Cr. 1979).

Illinois: Similarly, an aircraft owner wished to exchange existing aircraft for new. In lieu of directly exchanging the aircraft with the seller, a third-party intermediary was used. According to the state, the owner was not entitled to receive credit for its old aircraft as a "trade-in" to reduce the new one's tax base. Although the owner demonstrated that the transaction had accomplished the identical result from its perspective, the court was not willing to overlook that a "trade-in," as explicitly stated in the law, had not occurred; see Dep't of Rev. of the State of Ill. v. Dauntless Tenpin and 8-Ball Co., Taxpayer, IL Admin. Hearing, No. LIT 02-1, IL Dep't of Rev. (1/1/02):

[A]ssuming that taxpayer's version of the substance of the transaction is economically sound, it still does not carry the day. The statute clearly looks to title transfer and negates the application of the "substance over form" doctrine to transactions involving the ROTA and the UTA [sales and use tax].

New York: Just as there are exceptions in income tax dealing with the presumption of substance over form, there are exceptions in transaction taxes dealing with form over substance. In New York, in In the Matter of Burger King v. State Tax Comm'n, 416 NE2d 1024 (NY Ct. Apps. 1980), the Tax Commission assessed a restaurant sales tax on purchases of packaging material. The assessment was based on the fact that the restaurant did not charge its customers a line item on the receipt for packaging. Based on this, the state argued, the packaging was not being "resold" as required for exemption from sales tax. In ruling for the restaurant, the court overlooked the form of the transaction (i.e., the absence of a line item for packaging on the customer receipt) and looked to the substance to determine if a resale had occurred:

[T]he packaging material is as much a part of the final price as is the food or drink item itself. It would be exalting form over substance, therefore, to hold that a resale of these paper products does not take place merely because Burger King does not list a separate price.

For transaction taxes, the transaction's form will more likely than not have significance. However, courts have not been willing to look blindly at form when it would obscure the tax's purpose.

Conclusion

The varying reliance on substance or form in interpreting state and local taxes makes it important for practitioners to consider all taxes involved in a transaction. A business structure that produces a desirable and anticipated result for one state or local tax may turn out to be problematic for another, simply due to interpretation.

FROM THOMAS E. BOWEN, ESQ., CPA, BENNETT THRASHER P.C., ATLANTA, GA