Document Type


Publication Date

Fall 2011


Under the economic substance doctrine as codified in 26 U.S.C. § 7701(o), legislatively unintended tax benefits may be disallowed if a transaction lacks a substantial business purpose or fails to accomplish a meaningful change in the taxpayer's economic position. In a recent article on framing the “transaction” in economic substance cases, David Hariton makes three interrelated points. First, he observes that even though the judicial outcome may depend largely on how the relevant transaction is framed, few courts have explicitly focused on the framing issue. Second, he proposes that courts should presumptively frame the underlying transaction broadly by focusing on the entirety of the taxpayer's undertaking, rather than disaggregating particular tax-motivated steps or structures. Finally, he believes that the principal target of the economic substance doctrine should be “tax shelters” whose defining hallmark is that they are “extraneous to the taxpayer's business rather than merely an aspect of it.”

In considering framing explicitly, Hariton focuses on what is arguably the most difficult issue that courts are likely to face in applying the economic substances doctrine--namely, whether to disallow tax benefits by disaggregating tax-motivated steps (which, standing alone, clearly lack economic substance) from a purported larger transaction. While Hariton understandably seeks to establish an outer boundary for Coltec's disaggregation approach, his proposed presumption against bifurcation would deprive the economic substance doctrine of much of its essential flexibility. In enacting section 7701, Congress expressly approved of the disaggregation approach and gave courts broad discretion in framing the relevant transaction. Although such flexibility inevitably gives rise to uncertainty, the central question under the codified version of economic substance (as under prior law) is whether the overall result of a multi-step transaction is consistent with Congressional intent. If the tax benefits are clearly contemplated--as arguably was the case in UPS--the taxpayer should win. By contrast, transactions that seek to exploit unintended technical gaps deserve to fail. Perhaps ironically, codification may encourage taxpayers to argue that such transactions do not work technically, in the hope of avoiding strict liability penalties under section 7701.

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