by Walter A. Pickhardt
Walter A. Pickhardt is a partner with Faegre & Benson
LLP, Minneapolis. He represented the taxpayer in HMN
Financial v. Commissioner of Revenue.
I. Introduction
It is sadly the case that the economic substance
and business purpose doctrines,1 which have frequently appeared in federal court decisions in recent
years,2 have increasingly been appearing in state
court decisions.3 The courts tend to invoke these
1
These terms frequently are used interchangeably in court
decisions. They are also sometimes referred to collectively as
the sham transaction doctrine. For purposes of this article, I
will use the term ‘‘economic substance’’ to refer to a judgemade rule under which a tax statute can be overridden if the
taxpayer is motivated to participate in a transaction to reduce
its tax liability. The term has been accorded other meanings,
but taxpayer motive is usually considered relevant to the
definition.
2
See, e.g., Coltec Indus., Inc. v. United States, 454 F.3d
1340 (Fed. Cir. 2006); ACM Partnership v. Commissioner, 157
F.3d 231 (3rd Cir. 1998); and Rice’s Toyota World v. Commissioner, 752 F.2d 89 (4th Cir. 1985). A list of federal decisions
can be found in Jasper L. Cummings Jr., The Supreme Court’s
Federal Tax Jurisprudence 481-491 (2010); see also ‘‘PricewaterhouseCoopers Summarizes Economic Substance Case
Law,’’ July 19, 2010.
3
See, e.g., Syms Corp. v. Commissioner of Revenue, 765
N.E.2d 758 (Mass. 2002) (the transfer and license back of
intangibles by a retailer to a holding company ‘‘had no
practical economic effect on Syms other than the creation of
tax benefits,’’ and ‘‘tax avoidance was the clear motivating
factor and its only business purpose’’); TD Banknorth, N.A. v.
Dept. of Taxes, 967 A.2d 1148 (Vt. 2008) (transfer of intangible
income producing assets by bank to holding company held to
lack economic substance ‘‘under any formulation of this
doctrine, whether the focus is on the taxpayer’s motivation in
creating the holding companies, the objective economic activity of the holding companies, or both’’); Baisch v. Department
of Revenue, 850 P.2d 1109 (Ore. 1993) (real estate saleleaseback held to lack economic substance because there was
no reasonable expectation of profit, and business purpose
because intent was tax avoidance). Two cases involving the
‘‘concepts interchangeably to attack transactions
that they [do] not like.’’4 In other words, they apply
the proverbial smell test.
The Minnesota Supreme Court, in
HMN Financial, Inc. v.
Commissioner of Revenue,
repudiated the use of the
economic substance doctrine to
override statutory law.
Anyone who has represented the taxpayer in an
economic substance case knows the drill. The government’s lawyers attempt to concoct a witch’s brew
of evil intent — that is, a purpose to lower one’s tax
liability — by obtaining through discovery the files
of the taxpayer and especially those of its tax advisers. Inevitably, there will be e-mails between the
tax advisers and the taxpayer suggesting a strong
focus on reducing taxes — which of course is precisely why the taxpayer engaged the tax advisers.
same taxpayer reached opposite results. Cf. SherwinWilliams Co. v. Tax Appeals Tribunal, 784 NYS 2d 178 (App.
Div. 3d Dep’t 2004) (parent and intangible holding subsidiaries could be compelled to file combined returns because
distortion was presumed from significant intercompany licensing transactions, and taxpayer did not rebut the presumption given the lack of economic substance and business
purpose) with The Sherwin-Williams v. Commissioner of
Revenue, 778 N.E.2d 504 (Mass. 2002) (transactions with
intangible holding subsidiaries were respected because there
was no evidence of tax avoidance motive, subsidiaries did not
immediately return royalties as dividends, subsidiaries paid
their own expenses, and there were licenses with third
parties). (For the decision in Syms, see Doc 2002-8734 or 2002
STT 71-23; for the Massachusetts Sherwin-Williams decision,
see Doc 2002-24629 or 2002 STT 213-20; for the New York
Sherwin-Williams Co. decision, see Doc 2004-21199 or 2004
STT 215-11; for the decision in TD Banknorth, see Doc
2008-20199 or 2008 STT 185-22.)
4
Peter L. Faber, ‘‘Business Purpose and Economic Substance in State Taxation,’’ State Tax Notes, Feb. 1, 2010, p.
331, Doc 2010-373, or 2010 STT 20-7.
(Footnote continued in next column.)
State Tax Notes, November 1, 2010
329
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HMN Financial and the Codification
Of Economic Substance
Special Report
Too often courts are susceptible to that strategy.
In the federal courts, it may be too late to stop the
spread of the smell test, especially now that Congress has codified the economic substance doctrine
by enacting section 7701(o) of the Internal Revenue
Code.7 But it is not too late in the state courts.
Indeed, the Minnesota Supreme Court, in HMN
Financial, Inc. v. Commissioner of Revenue,8 recently repudiated the use of the economic substance
doctrine to override statutory law. One hopes that
other state courts will follow Minnesota’s lead, yet
one fears that codification at the federal level will
5
Shakespeare, Henry IV, Falstaff, Act III, Scene 5.
The above is not intended as an indictment of government
lawyers, who can hardly be blamed for arguing the smell test
when so many courts have found it attractive. Moreover, there
are situations (although fewer in number) in which the
taxpayers’ lawyers argue the smell test. Sometimes the tax
law is ‘‘too good to be true’’; other times it is ‘‘too bad to be
true.’’ See N. Jerold Cohen, ‘‘Too Good to Be True and Too Bad
to Be True,’’ Tax Notes, Dec. 12, 2005, p. 1437. Courts should
resist the invitations of both sides to override statutory law.
7
Health Care and Education Reconciliation Act of 2010,
P.L. 111-152, 124 Stat. 1029, section 1409 (2010).
8
782 N.W.2d 558 (Minn. 2010). (For the decision, see Doc
2010-11300 or 2010 STT 98-12.)
6
330
lead to codification at the state level, and that the
smell test will be with us for years to come.
II. U.S. Supreme Court Cases
It is especially unfortunate that this sort of interpretation should now be infecting the state courts
because when one looks at U.S. Supreme Court
precedent as opposed to the decisions of some lower
federal courts, it is emphatically not the case that
the taxpayer’s motive to reduce taxes means that tax
statutes should be disregarded in deference to judicial whim.
A. Gregory v. Helvering
The economic substance doctrine is frequently
said to have originated in Gregory v. Helvering.9
Mrs. Gregory owned all the stock of UMC, which in
turn owned 1,000 shares of the stock of MSC, an
appreciated asset. Mrs. Gregory wanted the MSC
stock sold, and she wanted to pocket the proceeds
personally at the lowest tax cost. If UMC sold the
MSC stock and distributed the proceeds to her, UMC
would be taxed on the gain and Mrs. Gregory would
be taxed on the receipt of a dividend. To avoid that
result, she caused UMC to form a subsidiary, Averill.
UMC transferred the MSC stock to Averill, which
simultaneously issued all its shares to Mrs. Gregory.
She then liquidated Averill and sold the UMC stock.
She claimed that she received the UMC stock ‘‘in the
pursuance of a plan of reorganization’’ under IRC
section 112, and that accordingly she recognized no
gain on the distribution (although she acknowledged
gain on the sale).
The term ‘‘reorganization’’ was defined by IRC
section 112(i) to mean ‘‘a transfer by a corporation of
all or a part of its assets to another corporation if
immediately after the transfer the transferor or its
stockholders or both are in control of the corporation
to which the assets are transferred.’’ One can readily
understand how Mrs. Gregory could construe that
language as encompassing her transaction. However, the statutory language was not crystal clear
and allowed another interpretation, which the U.S.
Supreme Court adopted. It noted that when the
statute ‘‘speaks of a transfer of assets by one corporation to another, it means a transfer made ‘in
pursuance of a plan of reorganization’ . . . of corporate business; and not a transfer of assets by one
corporation to another in pursuance of a plan having
no relation to the business of either.’’10 Thus, the
Court was not prescribing a method for overriding
tax statutes; the Court was merely doing what
courts are supposed to do — it was interpreting a tax
statute.
9
293 U.S. 465 (1935).
293 U.S. at 469.
10
State Tax Notes, November 1, 2010
(C) Tax Analysts 2010. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
There will be much less discussion regarding the
nontax business reasons for the transaction, which
is what one would expect since the taxpayer typically knows its business better than the advisers do.
However, the advisers may tell the taxpayer that the
transaction should have a business purpose, and if
they do, that will be taken by the government’s
lawyers first as an admission that business purpose
actually is a legal requirement and second as evidence that the business purpose was so weak that
the taxpayer had to be reminded to find one. The
advisers may provide the taxpayer with documentation from prior deals involving taxpayers in the
same line of business in which similar or identical
business purposes will be mentioned. To the government’s lawyers, that will be construed as pattern
evidence of a cookie-cutter transaction. Why that
should matter is a bit of a mystery — many taxneutral business deals are cookie-cutter transactions — but apparently it does. Some of the advisers’
e-mails may also suggest to the government lawyers
that the taxpayer attempted to hide the transaction.
Even if the transaction is otherwise clearly presented in the financial reports, the tax returns, and
elsewhere in the taxpayer’s records, the alleged
‘‘hiding’’ e-mails will be added to the mephitic brew.
At trial, the government’s lawyers will present the
court with ‘‘the rankest compound of villainous
smell that ever offended nostril,’’5 and they will tell
the court that to protect the public fisc, the economic
substance doctrine must trump the statute.6
Special Report
B. Knetsch v. United States
Knetsch v. United States13 is another U.S. Supreme Court case that is frequently cited by taxing
authorities in economic substance attacks. In
Knetsch, the taxpayer acquired annuity savings
bonds that earned 2.5 percent interest in exchange
for a nonrecourse note. The note, secured by the
bonds, required that he pay 3.5 percent interest. He
11
Id. at 469-470 (emphasis added).
The irrelevance of motive, and the significance of legislative intent, is evident in the Supreme Court’s oft-quoted
framing of the issue: ‘‘The legal right of a taxpayer to decrease
the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot
be doubted. But the question for determination is whether
what was done, apart from the tax motive, was the thing
which the statute intended.’’ Id. at 469 (citations omitted).
13
364 U.S. 361 (1960).
12
State Tax Notes, November 1, 2010
paid most of the interest due on the note by borrowing against the increase in cash value of the savings
bonds (at 2.5 percent), so that the cash value never
materially increased. Borrowing at 3.5 percent to
earn 2.5 percent made no sense, except for the
interest deductions.
The very case that may have
coined the phrase ‘business
purpose’ simultaneously
recognized the existence of a
general rule excluding
consideration of tax avoidance
motive.
The trial court denied the deduction because the
taxpayer’s ‘‘only motive . . . was to attempt to secure
an interest deduction,’’ but the Supreme Court expressly rejected taxpayer motive as a ground for
decision. It put aside that finding of the district
court and cited Gregory for the proposition that the
‘‘question for determination is whether what was
done, apart from the tax motive, was the thing
which the statute intended.’’14 For there to be a
deduction for interest, IRC section 163 (section 23
for the years in Knetsch) requires that there be an
indebtedness. The Court found that there was no
real indebtedness because Knetsch’s transactions
‘‘did not appreciably affect his beneficial interest
except to reduce tax.’’15 Again, the Court made its
decision by interpreting a statute, not by overriding
a statute.
C. Frank Lyon v. United States
Frank Lyon v. United States,16 another frequently
cited case, involved the sale-leaseback of an office
building. The issue was whether the lessor or the
lessee was the owner of the building entitled to take
depreciation deductions under IRC section 167. The
Supreme Court, saying that the ‘‘refinements of
title’’ were not controlling, applied a traditional
‘‘benefits and burdens of ownership’’ analysis in
which ‘‘the objective economic realities’’ were controlling.17 In summing up, the Court stated:
In short, we hold that where, as here, there is
a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is
imbued with tax-independent considerations,
and is not shaped solely by tax-avoidance features that have meaningless labels attached,
14
Id. at 365.
Id. at 366.
435 U.S. 561 (1978)
17
Id. at 573.
15
16
331
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It is ironic that a case so frequently cited for the
proposition that taxpayers’ transactions must have
a subjective business purpose actually says exactly
the opposite. The Court emphatically rejected the
relevance of taxpayer motive:
Putting aside, then, the question of motive in
respect of taxation altogether, and fixing the
character of the proceeding by what actually
occurred, what do we find? Simply an operation
having no business or corporate purpose — a
mere device which put on the form of a corporate reorganization as a disguise for concealing
its real character, and the sole object and
accomplishment of which was the consummation of a preconceived plan, not to reorganize a
business or any part of a business, but to
transfer a parcel of corporate shares to the
petitioner. . . .
The whole undertaking . . . was in fact an
elaborate and devious form of conveyance masquerading as a corporate reorganization, and
nothing else. The rule which excludes from
consideration the motive of tax avoidance is not
pertinent to the situation, because the transaction upon its face lies outside the plain intent of
the statute. To hold otherwise would be to exalt
artifice above reality and to deprive the statutory provision in question of all serious purpose.11
Thus, the very case that may have coined the
phrase ‘‘business purpose’’ simultaneously recognized the existence of a general rule excluding
consideration of tax avoidance motive. The taxpayer’s (Mrs. Gregory’s) motive was irrelevant.
What mattered was that the term ‘‘reorganization’’
contemplated a reorganization of a business, and
since the transfer of assets in Gregory was not
germane to the business, it was not a reorganization.12
Special Report
Although the Court said that a transaction having ‘‘economic substance’’ (a term it left undefined)
should be respected, it did not say that courts are
empowered to overthrow statutes if a taxpayer has a
motive to avoid taxation. To the contrary, the Court
observed:
The fact that favorable tax consequences were
taken into account by Lyon on entering into the
transaction is no reason for disallowing those
consequences. We cannot ignore the reality
that the tax laws affect the shape of nearly
every business transaction. See Commissioner
v. Brown, 380 U.S. 563, 579-580 (1965) (Harlan, J., concurring).19
D. Commissioner v. Brown
Commissioner v. Brown,20 which the Supreme
Court cited in Frank Lyon, involved a tax-motivated
transaction whereby the shareholders of a lumber
company sold their stock to a tax-exempt foundation, for which they received a small down payment
and a nonrecourse promissory note. The foundation
liquidated the company and then leased the assets
to a new company (formed by the seller’s attorneys)
for a five-year term. The new company (which was
run by the same personnel) paid 80 percent of its
profits to the foundation as rent. The foundation
paid 90 percent of the rent to the former shareholders in satisfaction of the terms of the promissory
note. At issue was whether the former shareholders
had really sold their stock and should report their
proceeds as capital gain, or whether those proceeds
were ordinary income.
The Court noted that the transaction was structured to avoid the foundation’s being subject to tax
on unrelated business income under IRC section 511
(as it existed before its amendment in 1970). Under
the structure: (1) the profits realized by the new
company were mostly offset by deductions for rent
paid to the foundation; (2) the rents were received
tax free by the foundation; and (3) the selling shareholders received most of those profits, against which
they subtracted their basis and reported the excess
proceeds as capital gain. Thus, most of the profits
were not subject to tax and the selling shareholders
were redeemed faster than would have occurred had
they sold their stock to a taxable buyer.
In today’s world, the IRS would be quick to label
this a listed transaction with a tax-indifferent party.
But in those halcyon days, tax planning was still a
respectable activity. A tax avoidance motive did not
18
Id. at 583-584.
Id. at 580.
20
380 U.S. 563 (1965).
19
332
repulse the Supreme Court, as it does some lower
courts today.21 The Court construed the term ‘‘sale’’
in IRC section 1222(3) as encompassing bootstrap
transactions in which the buyer had no risk of loss.
Justice John Harlan, concurring, made the following
observation:
Were it not for the tax laws, the respondents’
transaction . . . would make no sense. . . . However, the tax laws exist as an economic reality
in the businessman’s world, much like the
existence of a competitor. Businessmen plan
their affairs around both, and a tax dollar is
just as real as one derived from any other
source. . . . If such sales are considered a serious abuse, ineffective judicial correctives will
only postpone the day when Congress is moved
to deal with the problem comprehensively.22
As Justice Harlan predicted, Congress later did
pass legislation to discourage Brown-inspired transactions by taxing income from debt-financed property that was unrelated to an organization’s exempt
function.23
E. Conclusion
A recent study of federal case law concludes:
As a rule that the taxpayer loses even though it
wins under standard legal interpretation
(showing that the law is on the taxpayer’s side)
and standard fact finding (showing that the
transactions actually occurred as the taxpayer
said they did), the [economic substance doctrine] has no proper origin in the Supreme
Court opinions. It derives entirely from lower
federal court opinions and quite recent ones
. . . . From 1988 through 2008 the Tax Court
used the [economic substance doctrine] by
name 18 times and the other federal courts
used it 44 times; the Supreme Court has never
used it, has never stated it as a general ‘‘doctrine,’’ and has never ruled against a taxpayer
in a case that might even conceivably be
viewed as involving the doctrine since Knetsch
in 1960; indeed, Knetsch and Frank Lyon
(which ruled for the taxpayer based on its form)
are commonly (improperly) cited as the
21
See, e.g., Wells Fargo & Co. v. United States, 91 Fed Cl.
35 (Cl. Ct. 2010), quoting Hoosier Energy Rural Electric
Cooperative, Inc. v. John Hancock Life Insurance Co., 588
F.Supp.2d 919 (S.D. Ind. 2008), aff’d, 582 F.3d 721 (7th Cir.
2009) (sale-in, lease out transaction described as a ‘‘blatantly
abusive tax shelter’’ that is ‘‘rotten to the core’’).
22
380 U.S. at 579-580.
23
Tax Reform Act of 1969, P.L. 91-172, section 121(d), 83
Stat. 487, 543-548. Congress cited Brown as one of the
reasons for amending the statute. S. Rep. No. 552, 91st Cong.,
1st Sess. 62-63, reprinted in 1969 U.S.C.C.A.N. 2027, 20912092; H.R. Rep. No. 413, 91st Cong., 1st Sess. 44-46, reprinted
in 1969 U.S.C.C.A.N. 1645, 1690-1691.
State Tax Notes, November 1, 2010
(C) Tax Analysts 2010. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
the Government should honor the allocation of
rights and duties effectuated by the parties.18
Special Report
In short, the economic substance doctrine is a
recent creation of lower federal courts and is not
supported by U.S. Supreme Court precedent.25
III. State Courts and Economic Substance
Even though the U.S. Supreme Court has repeatedly rejected the relevance of taxpayer motive and
has never recognized the economic substance doctrine, some state courts have relied on Supreme
Court precedent when adopting the economic substance doctrine as a matter of state common law.
A. Massachusetts: Syms and Sherwin-Williams
In Syms Corp. v. Commissioner of Revenue,26 a
retailer formed a Delaware subsidiary to hold its
trademarks. The subsidiary had one employee (an
accountant) and rented office space (which was
shared with hundreds of other corporations) from
the company’s accounting firm in Delaware. The
retailer paid royalties to the subsidiary, which held
the payments for a few weeks and then returned
them to the parent as dividends. The business
operations of Syms did not change after the transfer
and license-back of the marks.
The economic substance doctrine
is a recent creation of lower
federal courts and is not
supported by U.S. Supreme Court
precedent.
The Massachusetts Supreme Judicial Court said
that the commissioner of revenue had the authority,
under the sham transaction doctrine, ‘‘to disregard,
for taxing purposes, transactions that have no economic substance or business purpose other than tax
avoidance.’’27 The court said that the doctrine dated
back ‘‘to the seminal case of Gregory v. Helvering,’’
and it observed that transactions could be invalidated if they were motivated only by the taxpayer’s
desire to avoid tax and structured to avoid com-
24
Cummings, supra note 2, at 199-205.
See also Allen D. Madison, ‘‘Textualism vs. SubstanceOver-Form in Tax Law,’’ Tax Notes, Aug. 25, 2004 (concluding
that it is doubtful that the Supreme Court would allow the
sham transaction doctrine, the business purpose doctrine, the
economic substance doctrine, or the step transaction doctrine
to stand); and Grewal, ‘‘Economic Substance and the Supreme
Court,’’ Tax Notes, Sept. 11, 2007 (concluding that a freefloating economic substance doctrine cannot be reconciled
with Supreme Court precedent).
26
765 N.E.2d 758 (Mass. 2002).
27
Id. at 762.
25
State Tax Notes, November 1, 2010
pletely economic risk.28 The court then applied the
sham transaction doctrine after upholding the findings of the Appellate Tax Board ‘‘that the transfer
and license back transaction had no practical economic effect on Syms other than the creation of tax
benefits, and that tax avoidance was the clear motivating factor and its only business purpose.’’29
The Massachusetts Supreme Judicial Court addressed a similar royalty-company structure, but
took a more nuanced approach and reached a different result, in The Sherwin-Williams Co. v. Commissioner of Revenue.30 The taxpayer, SherwinWilliams, formed two subsidiaries to hold its
trademarks. The subsidiaries rented shared office
space and had one employee (a finance professor).
Sherwin-Williams deducted royalties paid to the
subsidiaries.
The Supreme Judicial Court, after noting that
taxpayers have a legal right to reduce their taxes,
stated: ‘‘Our tax system is a rule-based system,
objective in nature, that places principal importance
on what taxpayers do and the economic consequences attached to those actions, not on what may
have subjectively motivated them to act in the first
place.’’ The court observed that ‘‘Sherwin-Williams,
on initially going into business, could have organized itself in such a way that its intangible assets
(e.g., its marks) were held in a corporation separate
from the corporations holding its production facilities and sales operations; the corporation owning the
marks could have licensed those marks to its sister
corporations,’’ even if the arrangement were solely
tax-motivated.31 The court then asked whether the
rule should be different in the case of a later reorganization. It concluded that the same rule should
apply. The court rejected those federal authorities
that use a two-prong economic substance test32 and
instead relied on other federal authorities holding
28
Id. at 763.
Id. at 763-765. The court held, in the alternative, that
the royalty payments were not deductible, because they were
not an ordinary and necessary business expense. Id. at
764-765. For a more detailed analysis of Syms, see Faber,
‘‘Business Purpose and the Syms Case in Massachusetts —
the Interplay of Federal and State Concepts,’’ State Tax Notes,
May 13, 2002, p. 643, Doc 2002-11453, or 2002 STT 93-15.
30
778 N.E.2d 504 (Mass. 2002).
31
Id. at 514.
32
Id. at 515-516, citing Rice’s Toyota World, Inc. v. Commissioner of Internal Revenue, 752 F.2d 89 (4th Cir. 1985);
Horn v. Commissioner of Internal Revenue, 968 F.2d 1229
(D.C. Cir. 1992); and United States v. Wexler, 31 F.3d 117 (3d
Cir. 1994). One prong is ‘‘objective economic substance.’’ The
other is ‘‘subjective business purpose.’’ The court noted that
some federal courts require the presence of one or the other
(the disjunctive test) whereas other federal courts require the
presence of both (the conjunctive test). The IRS position is
that a conjunctive test applies under IRC section 7701(o). See
Notice 2010-62, 2010-40 IRB 1.
29
333
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‘‘source’’ of the [economic substance doctrine] in
Supreme Court cases.24
Special Report
Taken together, the Gregory and Lyon decisions
suggest that for a business reorganization that
results in tax advantages to be respected for
taxing purposes, the taxpayer must demonstrate that the reorganization is ‘‘real’’ or
‘‘genuine,’’ and not just form without substance. Stated otherwise, the taxpayer must
demonstrate that the reorganization results in
‘‘a viable business entity’’ that is one which is
‘‘formed for a substantial business purpose or
actually engage[s] in substantive business. . . . We embrace the reasoning of courts
that have concluded that tax motivation is
irrelevant where a business reorganization results in the creation of a viable business entity
engaged in substantive business activity
rather than in a ‘‘bald and mischievous fiction.’’33
The court found that the subsidiaries had engaged in substantive business activities. They
owned the marks and licensed them principally to
Sherwin-Williams, but also to third parties. They
invested the proceeds (that is, they did not immediately return the proceeds as dividends to SherwinWilliams). And they paid their own expenses, including invoices from third-party professionals.34
The Supreme Judicial Court relied on Moline
Properties, Inc. v. Commissioner, in which the U.S.
Supreme Court held that the existence of a corporation should be respected for tax purposes if there is
‘‘business activity.’’35 The Massachusetts court also
relied on Northern Ind. Pub. Serv. Co. v. Commissioner, in which the Seventh Circuit stated ‘‘the
principle that a corporation and the form of its
transactions are recognizable for tax purposes, despite any tax-avoidance motive, so long as the corporation engages in bona fide economically-based
business transactions.’’36 Under those decisions, the
‘‘quantum of business activity may be rather minimal.’’37 The business activities in Sherwin-Williams
were ‘‘rather minimal,’’ but they were enough to
satisfy the Supreme Judicial Court.38
Unfortunately, despite the court’s statement that
‘‘tax motivation is irrelevant where a business reorganization results in the creation of a viable business entity engaged in substantive business activity,’’ the Massachusetts Appellate Tax Board
continues to decide appeals based largely on taxpayer purpose. The board has misread SherwinWilliams as holding that ‘‘tax motivation is significant where a business reorganization or transaction
results in a ‘bald and mischievous fiction’ lacking
economic substance.’’39 Moreover, even if the board
feels compelled to recognize a corporate entity under
the Moline Properties rule, it nonetheless may use
tax motivation to disregard ‘‘intercompany transactions designed to manipulate the tax system for the
taxpayer’s benefit.’’40 Thus, in proceedings before
the board, it appears that a motive to reduce tax
may be determinative despite Sherwin-Williams.41
B. Vermont: TD Banknorth
In TD Banknorth, N.A. v. Dept. of Taxes,42 the
Vermont Supreme Court considered three related
banks that formed investment subsidiaries under
Vermont law. The subsidiaries had no office space,
tangible assets, or employees. The banks transferred to the subsidiaries income-producing intangible assets, including asset-backed securities, collateralized mortgage obligations, corporate bonds,
tax-exempt municipal bonds, and restricted stocks.
The banks also transferred 100 percent participation interests in commercial loans, real estate loans,
and consumer loans, which the banks continued to
service.
The banks sought ‘‘to take advantage of favorable
tax treatment under 32 V.S.A. sections 5836(e) and
5837,’’ which limited to $150 the tax on investment
companies ‘‘whose activities are confined to the
maintenance and management of their intangible
investments and the collection and distribution of
the income from such investments or from tangible
property physically located outside this state.’’ The
38
33
Id. at 515, 518, citing Moline Props. v. Commissioner of
Internal Revenue, 319 U.S. 436 (1943); Northern Ind. Pub.
Serv. Co. v. Commissioner of Revenue, 115 F.3d 506 (7th Cir.
1997); Stearns Magnetic Mfg. Co. v. Commissioner of Internal
Revenue, 208 F.2d 849 (7th Cir. 1954); United Parcel Serv. v.
Commissioner of Internal Revenue, 254 F.3d 1014, 1019 (11th
Cir. 2001); and Bass v. Commissioner of Internal Revenue, 50
T.C. 595 (1968).
34
Id. at 517-518.
35
319 U.S. 436, 438-439 (1943).
36
Northern Ind. Pub. Serv. Co. v. Commissioner, 115 F.3d
506, 512 (7th Cir. 1997).
37
Hospital Corp. of Am. v. Commissioner, 81 T.C. 520, 579
(1983).
334
For a more detailed analysis of Sherwin-Williams, see
Faber, ‘‘Use of Intangible Company Upheld as Business
Reorganization: Massachusetts Gets It Right in SherwinWilliams,’’ State Tax Notes, Dec. 9, 2002, p. 671, Doc 200226833, or 2002 STT 236-20.
39
The Talbots Inc. v. Commissioner of Revenue, Docket
Nos. C266698; C271840; C276882 (Mass. App. Tax Bd. 2009).
(For the decision, see Doc 2009-21854 or 2009 STT 190-20.)
40
Fleet Funding, Inc. v. Commissioner of Revenue, Docket
Nos. C271862-63 (Mass. App. Tax Bd. 2008). (For the decision,
see Doc 2008-3942 or 2008 STT 38-18.)
41
Talbots involved tax years ended January 1994 through
January 2001. Effective March 5, 2003, Massachusetts
adopted a statutory economic substance and business purpose
requirement. See Mass. Gen. L. ch. 62C, section 3A.
42
967 A.2d 1148 (Vt. 2008).
State Tax Notes, November 1, 2010
(C) Tax Analysts 2010. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
that new corporate entities should be respected if
formed for a business purpose or if they engage in
substantive business activity:
Special Report
Although the requirements of the statute were
satisfied, the court held the commissioner properly
disregarded the subsidiaries under the economic
substance doctrine, which it erroneously claimed
originated in Gregory v. Helvering:
While never yet applied in Vermont, the economic substance doctrine has a long history in
federal case law. The origin of this doctrine is
the United States Supreme Court’s decision in
Gregory v. Helvering, 293 U.S. 465 (1935).44
The court also asserted that ‘‘the most succinct
statement of the economic substance doctrine by the
United States Supreme Court’’ occurred in Frank
Lyon, and it held that the doctrine applied in Vermont.45 The court applied the doctrine because the
taxpayers were motivated to reduce tax, the investment subsidiaries had insufficient independent
business activities, and the subsidiaries also had no
economic risk.46
When taxpayers structure their
operations to take advantage of a
state tax incentive, of course they
are motivated to reduce their
taxes.
In response to the allegation that business activities were insufficient, the taxpayers argued that the
Vermont statute ‘‘specifically authorizes and, in fact,
encourages the creation of such empty-shell holding
companies.’’ That was a powerful argument. When
taxpayers structure their operations to take advantage of a state tax incentive, of course they are
motivated to reduce their taxes — the whole point of
a tax incentive is to channel the desire to reduce
taxes in a specific direction. The incentive in question required the taxpayers to limit their business
activities to the maintenance and management of
investments and the collection and distribution of
investment income. However, the court refused to
consider that argument because it was raised for the
first time at oral argument.
43
Id. at 1151. The banks reduced their own taxes through
the transfer of the income-producing assets, and the holding
companies paid ‘‘virtually no tax.’’ Id.
44
Id. at 1155.
45
Id. at 1156-1157.
46
Id. at 1158-1159.
State Tax Notes, November 1, 2010
C. Wisconsin: Hormel Foods
In Hormel Foods Corp. v. Wisconsin Department
of Revenue,47 the Wisconsin Tax Appeals Commission considered a royalty company situation similar
to those at issue in Syms and Sherwin-Williams.
Hormel established a two-tier structure: a first-tier
holding company (International) and a second-tier
subsidiary (Foods LLC) that acquired intellectual
property from Hormel.48 Hormel licensed the intellectual property from Foods LLC. It paid royalties
that were set at arm’s length based on a study
prepared by its accounting firm. The commission
made extensive fact findings regarding Hormel’s tax
planning and interactions with the accounting firm,
which had provided substantial assistance in establishing the structure.
Wisconsin has a statute that is almost identical to
IRC section 482 and that permits the commissioner
to ‘‘distribute, apportion or allocate gross income,
deductions, credits or allowances between or among’’
related entities ‘‘in order to prevent evasion of taxes
or clearly to reflect the income’’ of such entities.49
The commission said that the courts had not
‘‘squarely addressed’’ the scope of the statute, and
then ignored the statute for the remainder of the
opinion. Instead, the commission relied on the sham
transaction doctrine, under which ‘‘transactions will
only be recognized for tax purposes if they have
economic substance and a valid business purpose
other than avoiding taxes.’’ The commission said:
While not yet openly applied in Wisconsin, the
economic substance doctrine has a long history
in federal case law. The origin of this doctrine is
the United States Supreme Court’s decision in
Gregory v. Helvering. . . . The Court [there]
stated that while taxpayers have a legal right
to act in a way that will diminish their tax
burden, they may not do so by creating a
business entity with no other business or corporate purpose, but whose ‘‘sole object and
accomplishment [is] . . . the consummation of a
preconceived plan’’ to avoid taxation.
The commission, like the courts in Syms and T.D.
Banknorth, mischaracterized the holding in Gregory
v. Helvering.
47
Docket No. 07-I-17 (Wisc. Tax App. Comm. 2010). (For
the decision, see Doc 2010-7482 or 2010 STT 66-20.)
48
Hormel had another subsidiary (HFSC) that owned
financial assets and provided intercompany cash management and other financial services. Although ‘‘setting up HFSC
created tax benefits to Hormel’’ because it did not have nexus
with Wisconsin, those tax benefits apparently were not challenged by the state.
49
Wis. Stat. section 71.30(2).
335
(C) Tax Analysts 2010. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
General Assembly passed that provision as a tax
incentive ‘‘to expand the financial management industry in Vermont.’’43
Special Report
IV. Minnesota’s Rejection of the Economic
Substance Doctrine
The most recent state tax case to address the
economic substance doctrine is HMN Financial.51
The Minnesota Supreme Court there emphatically
rejected the relevance of taxpayer motive and held
that when the language of the statute is clear, courts
have no authority to override it.
A. Facts
HMN Financial (HMN), a bank holding company,
owned Home Federal Savings Bank (HF Bank), a
bank doing business in Minnesota and Iowa. KPMG
approached HMN with a plan to reorganize its
business for the purpose of reducing its Minnesota
tax liability.52 HMN engaged KPMG and the plan
was implemented. HF Bank formed Home Federal
REIT Inc. (HF REIT), which qualified as a real
estate investment trust under federal and Minnesota tax law. It also formed Home Federal Holding
Inc. (HF Holding) as a holding company to own all
the common stock and 90 percent of the preferred
stock of HF REIT. Employees of HF Bank owned the
remaining 10 percent of the preferred stock.
HF Bank initially contributed, and later sold, 100
percent participation interests in mortgage loans to
HF REIT. HF Bank retained the servicing rights on
loans that it had originated; a third party retained
the servicing rights on other loans. From the vantage point of the mortgage borrowers, the structure
was invisible. HF REIT earned interest on the loans.
It paid its expenses and distributed its entire net
income as a dividend to HF Holding. HF Holding in
turn paid its expenses and distributed its entire net
income to HF Bank.
The Minnesota Supreme Court said, correctly,
that HMN ‘‘essentially paid corporate franchise tax
on only 20 percent of its income from the loan
interests it transferred from HF Bank to HF
REIT.’’53 The reason the structure worked had to do
with Minnesota’s foreign operating company (FOC)
rules as in effect during the 2002 through 2004 years
at issue in the case.
Minnesota is a water’s-edge combined reporting
state. The income of a unitary business conducted by
affiliated corporations must, as a general rule, be
included on a combined report.54 However, some
corporations, including foreign corporations and
FOCs, are excluded from the combined report.55
Foreign corporations, assuming they have nexus
with Minnesota, are required to file on a separate
return basis.56 FOCs, however, are exempt from the
requirement of filing a Minnesota tax return (that
is, they are not subject to tax).57
An FOC was defined, during the years in issue, to
be a domestic corporation engaged in a unitary
business with a corporation taxable in Minnesota, if
the average of the percentages of its tangible property and payroll assigned to locations inside the
United States is 20 percent or less.58 HF Holding
qualified as an FOC because it was incorporated in
Minnesota and had all its property and payroll in
the Cayman Islands.
Although an FOC pays no Minnesota tax on its
income, the quid pro quo is that its adjusted net
income is deemed to be paid as a dividend on the last
day of its tax year to its shareholders.59 FOC shareholders are entitled to claim an 80 percent dividends
received deduction.60 Dividends actually paid by an
FOC are eliminated on the combined report.61
50
At the end of its opinion, the commission stated that
Hormel failed to prove that the deductions were ‘‘ordinary
and necessary.’’ Wisconsin incorporates IRC section 162. It is
possible to read Hormel as disallowing a deduction under that
section, rather than as overriding statutory law based on
economic substance.
51
782 N.W.2d 558 (Minn. 2010).
52
At trial, HMN acknowledged that one of the purposes
was to reduce Minnesota tax, but it also introduced evidence
that there were nontax business purposes for the structure
(even though such purposes were not required). The Minnesota Tax Court found that tax reduction was the only purpose.
HMN Financial, Inc. v. Commissioner of Revenue, 2009 Minn.
Tax LEXIS 13, *68-69 (Minn. Tax Ct. 2009). HMN did not
contest that finding in its appeal to the Minnesota Supreme
Court.
336
53
782 N.W.2d at 562-563.
Minn. Stat. section 290.17, subd. 4(j).
55
Minn. Stat. section 290.17, subd. 4(f) and (h); see Manpower, Inc. v. Commissioner of Revenue, 724 N.W.2d 526
(Minn. 2006) (French SARL held to be a foreign eligible entity
whose income and factors were excludable from a combined
report). (For the decision, see Doc 2006-24651 and 2006 STT
238-12.)
56
Minn. Stat. section 290.17, subd. 4(f).
57
Minn. Stat. section 289A.08, subd. 3.
58
Minn. Stat. section 290.01, subd. 6b.
59
Minn. Stat. section 290.17, subd. 4(g).
60
Minn. Stat. section 290.21, subd. 4.
61
Minn. Stat. section 290.17, subd. 4(g).
54
State Tax Notes, November 1, 2010
(C) Tax Analysts 2010. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
The commission next discussed the varying standards under federal and state law, including Syms
and Sherwin-Williams, and concluded (without
adopting any particular test) that it would analyze
the facts based ‘‘on economic substance, business
purpose, and a showing that the transaction was not
shaped solely by tax-avoidance features.’’ The commission said that ‘‘reducing taxes is a perfectly
legitimate business goal so long as it is not the
primary purpose for a transaction.’’ Because
Hormel’s primary purpose was determined to be tax
reduction, the commission held that there was no
economic substance or business purpose. Hormel
was denied a deduction for the royalties it paid to
Foods LLC.50
Special Report
May the intercompany transactions between
the bank (‘‘HF Bank’’), the REIT (‘‘HF REIT’’)
and the holding company (‘‘HF Holding’’) be
disregarded by the Commissioner for income
tax purposes, if the transactions were lacking
economic substance or business purpose and
the relevant entities were created solely to
avoid Minnesota taxes?63
The Tax Court agreed that the transactions
should be disregarded for lack of economic substance
and business purpose (although it did not define
those concepts).64
Oddly enough, however, neither the commissioner
nor the Tax Court actually disregarded the intercompany transactions. To the contrary, the tax court
made fact findings that the transactions occurred
and were accounted for consistent with generally
accepted accounting principles. It also gave them
effect for tax purposes. The court found that HF
REIT acquired participation interests and that it
bore any losses associated with them. It found that
HF REIT received principal and interest as a result
62
IRC sections 561(a), 857(b)(2)(B); Minn. Stat. section
290.01, subd. 19(3).
63
2009 Minn. Tax LEXIS at *40.
64
Id. at *39.
State Tax Notes, November 1, 2010
of holding those interests. It found that HF REIT
reported the interest income on its tax returns, and
made no changes to HF REIT’s return. It found that
HF REIT paid dividends to its common and preferred shareholders (HF Holding and more than 100
other shareholders). And it found that HF Holding
received the dividends paid by HF REIT in its bank
accounts and paid dividends to HF Bank. In short,
the tax court found that there were no factual
shams, and it respected the fact that HF REIT
earned the interest.65
So given that the commissioner did not disregard
transactions, what did he do under his purported
economic substance/business purpose authority? He
did two things: He subtracted the FOC deemed
dividend from the HF Bank’s income, and he added
the identical amount to the income of HF Bank —
that is, he added the net income of HF Holding to the
income of HF Bank (but not as a deemed dividend).
Those additions and subtractions were, on their
face, offsetting entries. However, they generated tax
because the deemed dividend (which was subtracted) qualified for the dividends received deduction, whereas net income of HF Holding (which was
added) did not qualify.
There are two ways to characterize the adjustments. One way to look at it is that the commissioner treated an FOC (HF Holding) as if it were a
non-FOC, meaning that its income was includable
on the HMN combined report. However, Minnesota
law says that an FOC’s income must not be included
on the combined report.66 A second way to look at it
is that the commissioner respected HF Holding as
an FOC paying a deemed dividend to HF Bank, but
that he denied the dividends received deduction. But
Minnesota law says that deemed dividends from
FOCs are 80 percent deductible.67
So either way one looks at it, the commissioner’s
position was that he had the authority to override
Minnesota statutory law. He claimed that his authority derived from the statute as well as the
common law (that is, business purpose). The Minnesota Supreme Court analyzed and rejected both
arguments.
B. Rejection of Statutory Arguments
The commissioner argued that there was a statutory basis for the authority to override substantive
tax law, but his arguments were strained, to say the
least. First, the commissioner cited a statute giving
him ‘‘the authority to make determinations, corrections, and assessments with respect to state taxes.’’
He argued that this provided him the power to
65
Id. at *2-39.
Minn. Stat. section 290.17, subd. 4(f) and (h).
Minn. Stat. section 290.17, subd. 4(g), and section
290.21, subd. 4.
66
67
337
(C) Tax Analysts 2010. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
The structure worked as follows. HF REIT earned
interest income on the mortgages. It was allowed a
dividends paid deduction for both federal and Minnesota income tax purposes.62 Thus, although HF
REIT was included on HMN’s combined report, its
interest income was completely offset by the dividends paid deduction. HF Holding had income (that
is, the dividends it received from HF REIT), but it
was not required to report that income on a Minnesota tax return. Its income was deemed paid as a
dividend to HF Bank, which included the income on
the combined report filed by HMN. However, HF
Bank was entitled to an 80 percent dividends received deduction, so only 20 percent was subject to
tax.
Although HMN’s tax reporting was consistent
with the letter of Minnesota law, the commissioner
of revenue issued an order assessing tax. The order
stated that HF Holding ‘‘does not have any net
income under Minn. Stat. section 290.17, subd. 4(g)
and thus it does not have a ‘deemed dividend’ nor
eligibility for a dividends received deduction’’ because ‘‘the arrangements that transferred the income on the portion of Home Federal Bank’s loan
portfolio to HF REIT and then to HF Holding lacked
economic substance and are ignored for purposes of
determining the taxable income of their combined
group.’’
HMN petitioned the order to the Minnesota Tax
Court, which framed the issue as follows:
Special Report
The commissioner argued that
there was a statutory basis for the
authority to override substantive
tax law, but his arguments were
strained, to say the least.
The commissioner next cited a statute authorizing him to impose a new accounting method on a
taxpayer whose existing method ‘‘does not clearly or
fairly reflect income.’’70 The court held that this
statute was inapplicable because the commissioner
was not challenging an accounting method.71 Similarly, the commissioner cited a statute empowering
him to require the use of an alternative apportionment method if the taxpayer’s method did not fairly
reflect net income.72 That statute was inapplicable
because the commissioner had no complaint about
apportionment.73
The commissioner also claimed statutory authority to ‘‘require such combined report as, in the
commissioner’s opinion, is necessary in order to
determine the taxable net income of any one of the
affiliated or related corporations.’’74 But HMN had
already filed a combined report: What the commissioner wanted was a different combined report on
which the tax was computed in a manner not authorized by the statute. The authority to require a
combined report did not mean that the commissioner could make up new rules for reporting income.75
Finally, the commissioner cited a complex statute
that is roughly comparable to IRC section 482.76 The
commissioner argued that this statute authorized
the adjustments he made. The tax court agreed,
68
Minn. Stat. section 289A.35.
782 N.W.2d at 566.
70
Minn. Stat. section 290.07, subd. 2; cf. IRC section
446(b).
71
Id.
72
Minn. Stat. section 290.20.
73
Id. at 567.
74
Minn. Stat. section 290.34, subd. 2.
75
The Minnesota Supreme Court noted that ‘‘the Commissioner essentially argues that the four provisions, taken
together, add up to a broad grant of authority to close
statutory tax loopholes.’’ However, it rejected this claimed
‘‘amorphous authority’’ that would allow the commissioner ‘‘to
ignore HMN’s statutory compliance’’ under the guise of attacking tax loopholes. 782 N.W.2d at 567.
76
Minn. Stat. section 290.34, subd. 1.
69
338
noting that HF Holding had received the benefit of
‘‘routine free service from HF Bank employees.’’ This
triggered the statute and, apparently, permitted the
commissioner to do whatever he thought necessary
to make things right. That was a startling holding,
especially because the court found as a fact that HF
Holding had ‘‘little activity’’ and that the services in
question were de minimis. Thus, the smallest mispricing would, under the tax court’s analysis, empower the commissioner to throw out statutory law
and impose his own rules.
The Minnesota Supreme Court agreed with the
commissioner that the statute applied, because even
if the services were minimal, they had ‘‘some value
greater than zero.’’77 However, the court said that
the commissioner’s remedy under the law was to
require a fair price — that is, reduce HF Bank’s
compensation deduction by a minimal amount. The
law’s remedy provisions did not permit the commissioner to disregard ‘‘HMN’s captive REIT structure
altogether.’’ Similarly, if the participation interests
in the mortgages were transferred at an unfair
price, the remedy was to correct the pricing.78 The
supreme court concluded:
Nothing in section 290.34, subdivision 1 or any
of the other statutes under which the Commissioner claims authority for his action, expressly
gives the Commissioner the authority to override other statutes. Indeed, the Commissioner
does not cite any authority addressing the
issue of whether the Commissioner can tax
according to substance rather than form when
a taxpayer has structured its business to be in
full compliance with the relevant tax statutes. . . . During the tax years at issue, foreign
operating corporations received beneficial tax
treatment under Minnesota statutes. The
Commissioner clearly dislikes the tax consequences that occur under the relevant statutes,
but it is for the legislature, not the Commissioner, to change the law that creates such
consequences.79
The court next examined the commissioner’s
claimed authority under the common law.
C. Rejection of Economic Substance
Argument
In Hutchinson Technology, Inc. v. Commissioner
of Revenue, the Minnesota Supreme Court said,
‘‘There is nothing to prevent any FOC from being an
empty shell entity, existing solely to provide tax
exemptions.’’80 Most taxpayers understood that to be
a broad statement supporting a business’s right to
77
698 N.W.2d 1, 16 (Minn. 2005).
Id. at 568-569.
Id. at 570.
80
698 N.W.2d 1, 16 (Minn. 2005).
78
79
State Tax Notes, November 1, 2010
(C) Tax Analysts 2010. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
determine ‘‘tax upon any theory [he] might entertain.’’68 The Minnesota Supreme Court found that
argument preposterous. If it were true, there would
be no room left for judicial review. The statute
merely allowed the commissioner to make tax computations, not to make tax law.69
Special Report
The Commissioner cites a number of our cases
for the proposition that he has the broad authority to tax according to substance rather
than form. But none of these cases embraces
81
St. Paul & C. Ry. Co. v. McDonald, 25 N.W. 453 (Minn.
1885); cf. Helvering v. F. & R. Lazarus & Co., 308 U.S. 252
(1939) (person having burdens and benefits of ownership
entitled to depreciation).
82
Midwest Federal Sav. & Loan Ass’n v. Commissioner of
Revenue, 259 N.W.2d 596 (Minn. 1977); Transport Leasing
Corp. v. State, 199 N.W.2d 817 (Minn. 1972).
83
In re Marshall’s Estate, 228 N.W. 920 (Minn. 1930) (gift
held completed; donor’s intent to reduce tax irrelevant).
84
Bond v. Commissioner of Revenue, 691 N.W.2d 831
(Minn. 2005) (rejecting tax protester’s claim that Social
Security Administration held assets in a trust for his benefit).
85
Anderson v. Commissioner of Taxation, 93 N.W.2d 523
(Minn. 1958).
State Tax Notes, November 1, 2010
the radical position that the Commissioner
may disregard statutes that allow certain business structures favorable tax treatment.
Rather, those cases emphasize the proper role
of our court to construe the relevant statutes to
determine if a taxpayer is in compliance with
those statutes. If Minnesota statutes allow a
favorable tax treatment, neither our court nor
the Commissioner has the power to disregard
those statutes and impose a different tax treatment. And, if we conclude a taxpayer has
complied with the relevant statutes, that ends
our analysis. . . . We hold that neither Minnesota statutes nor case law grants the Commissioner the power to disregard HMN’s business
structure in assessing HMN’s taxes. When a
business complies with all of the relevant tax
statutes, that business is subject to tax in
accordance with those statutes.86
In Sherwin-Williams, the Massachusetts Supreme Judicial Court opined that the state’s ‘‘tax
system is a rule-based system, objective in nature,
that places principal importance on what taxpayers
do and the economic consequences attached to those
actions, not on what may have subjectively motivated them to act in the first place.’’87 It endorsed a
textualist approach — a process involving the application of statutory language to objective facts in
which subjective motive has no part to play.88 The
Minnesota Supreme Court’s holding in HMN Financial is, if anything, an even more forceful endorsement of textualism and rejection of the economic
substance doctrine.
V. Federal Codification of Economic
Substance: Does It Reverse HMN Financial?
In March 2010, shortly before the decision in
HMN Financial, Congress adopted IRC section
7701(o).89 IRC section 7701(o)(5)(A) states that the
term ‘‘economic substance doctrine’’ refers to the
federal common-law doctrine under which income
tax benefits with respect to a transaction are not
allowable if the transaction does not have economic
substance or lacks a business purpose. IRC section
7701(o)(1) provides that in the case of any transaction to which the economic substance doctrine is
relevant — a condition whose meaning is far from
clear — the transaction shall be treated as having
economic substance only if (i) the transaction
changes in a meaningful way (apart from federal
income tax effects) the taxpayer’s economic position,
86
782 N.W.2d at 571.
778 N.E.2d at 514.
88
Obviously, there would be an exception if the statute
called for an examination of taxpayer motive. See, e.g., IRC
sections 265(a) and 269(a).
89
See supra note 7.
87
339
(C) Tax Analysts 2010. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
structure its operations to obtain the tax benefits
provided by the FOC statutes, but the tax court
didn’t see it that way. It asserted that HMN’s
position was contrary to ‘‘70 years of Minnesota law
disallowing sham transactions.’’ The commissioner
claimed to find over 100 years of authority in his
supreme court brief.
In reality, the Minnesota Supreme Court had
never before held that the commissioner was authorized to override statutory law under the economic
substance doctrine (or under any other theory). Most
of the cases the commissioner relied on involved fact
settings that required the court to characterize
something for tax purposes in a way that might be
different from its characterization for other purposes. In one case, for example, a railroad owned
bare legal title to property; the burdens and benefits
of ownership were held by a construction company.
The court held that the construction company was
the real owner. The decision simply expressed the
universal principle that, for tax purposes, the owner
of property is not necessarily the one who possesses
legal title.81 The commissioner also relied on cases in
which the supreme court said that a transaction
structured as a lease could be treated as a sale if
that was the substance of the transaction.82 He also
cited a case holding that a transfer in trust may not
be a completed gift if the transferer retains significant rights to enjoy the property until his death,83
and another holding that an alleged trust might not
be a real trust.84 And he cited another case holding
that a ‘‘liquidation’’ may really be a ‘‘reorganization’’
if the shareholders reincorporate the liquidated
company under substantially the same ownership.85
HMN Financial was the first case in which the
Minnesota Supreme Court had to decide whether
there was a common-law economic substance doctrine allowing the commissioner to override statutory law. The court emphatically rejected the commissioner’s ‘‘radical’’ argument:
Special Report
IRC section 7701 is a definitional provision. The
only section in the code to use the new definition of
economic substance is section 6662, a penalty provision under Chapter 68 of the code. It provides for a
20 percent penalty for an underpayment attributable to a transaction lacking economic substance.
The penalty is increased to 40 percent if the taxpayer fails to disclose the relevant facts on its tax
return.90
IRC section 7701(o) does not
reverse the result in HMN
Financial.
Section 7701(o) does not reverse the result in
HMN Financial. Minnesota has, since 1987, defined
the term ‘‘net income’’ by reference to federal taxable
income, as defined in IRC section 63, with some
Minnesota modifications.91 The definition of economic substance in IRC section 7701(o) does not
affect the determination of federal taxable income in
IRC section 63, and therefore does not affect Minnesota net income.92 It is, of course, possible that the
federal courts will modify their common-law approaches to economic substance in light of the defi-
90
See IRC section 6662(b)(6) and (i); see also Notice 201062, 2010-40 IRB 1. IRC section 6664 does not refer to
economic substance per se but was amended to state that the
reasonable cause exception shall not apply to any IRC section
6662(b)(6) transaction. See IRC section 6664(c)(2) and (d)(2).
See also IRC section 6676(c), relating to erroneous claims for
refund or credit.
91
1987 Minn. Laws ch. 268, art. 1, section 11; see Minn.
Stat. section 290.01, subd. 19. Minnesota has not yet conformed to federal 2010 law changes, but it is expected to do so
in 2011.
92
The definition of economic substance in the code is
relevant for federal penalties, but Minnesota does not conform its penalties to federal penalties. See Minn. Stat. section
289A.60. Moreover, Minnesota has its own set of definitions
that do not consistently incorporate federal definitions contained in section 7701. Minn. Stat. section 290.01. See generally Chris Whitney and Ferdinand Hogroian, ‘‘The State Tax
Impact of the Federal Economic Substance Doctrine,’’ State
Tax Notes, Aug. 9, 2010, p. 391, Doc-2010-15379, or 2010 STT
152-3 (noting that states do not automatically conform to the
penalty provisions in the code); and Craig B. Fields, Richard
C. Call, and W. Justin Hill, ‘‘State Conformity to the Codification of the Economic Substance Doctrine,’’ State Tax Notes,
Aug. 30, 2010, p. 587, Doc 2010-18748, or 2010 STT 167-2
(noting that states in many cases have their own penalty
rules).
340
nition in IRC section 7701(o),93 but that should be
irrelevant for Minnesota tax purposes because HMN
Financial holds there is no common-law economic
substance doctrine in Minnesota.
The greater concern is that the Minnesota Legislature will react to the HMN Financial decision by
adopting its own economic substance test.94 Bills
have been introduced each year since 2005 to codify
economic substance, but none have been enacted
into law. It seems probable, especially in view of the
federal enactment of IRC section 7701(o), that similar legislation will be introduced in 2011. And this
time around, legislators will have more ammunition
because the Minnesota Supreme Court, instead of
saving the Legislature from itself, actually enforced
the laws the Legislature wrote.
VI. Conclusion
HMN Financial represents the clearest endorsement to date in support of a textualist approach to
the interpretation of state tax law. The question to
be resolved is whether HMN Financial will be
textualism’s last gasp? Textualist courts are deferential to the will of the legislature as expressed in
the language of the law, but what if the legislature
throws up its hands and concedes that it is incapable
of drafting tax statutes in a manner that produces
intended results? That, in essence, is what Congress
did by enacting section 7701(o), a provision that is
supposed to apply only in situations in which ‘‘the
economic substance doctrine is relevant.’’95 The
problem is that no one knows what that means.96
Although one can predict that the IRS will view the
economic substance doctrine as relevant to some
transactions (such as listed transactions), one cannot predict how the IRS will view many other
93
The IRS position appears to be that IRC section 7701(o)
does modify the federal common law by adopting a conjunctive test. It has announced that it will challenge taxpayers
who rely on prior case law that favored a disjunctive test. See
Notice 2010-62, 2010-40 IRB 1.
94
There is precedent in Massachusetts. The year after
Sherwin-Williams was decided, Massachusetts responded by
codifying the sham transaction doctrine. See supra note 41.
Several other states also have codified the economic substance doctrine. See Whitney and Hogroian, supra note 92; see
also Giles Sutton, Jamie C. Yesnowitz, and Chuck Jones, ‘‘The
State Implications of the Codification of Economic Substance,’’ State Tax Notes, July 12, 2010, p. 87, Doc 2010-12646,
or 2010 STT 132-2; and Jeffrey C. Glickman and Clark R.
Calhoun, ‘‘The Economic Substance Doctrine in State Tax
Practice,’’ State Tax Notes, Sept. 6, 2010, p. 655, Doc 201018783, or 2010 STT 172-3.
95
IRC section 7701(o)(1).
96
See Notice 2010-62, 2010-40 IRB 1; see also Amy S.
Elliott, ‘‘Practitioners Blast Economic Substance Guidance
With No Angel List,’’ Tax Notes, Sept. 20, 2010.
State Tax Notes, November 1, 2010
(C) Tax Analysts 2010. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
and (ii) the taxpayer has a substantial purpose
(apart from federal income tax effects) for entering
into the transaction. Economic substance requires
that both conditions be met: meaningful nontax
change in economic position plus nontax business
purpose.
Special Report
State legislatures should not
follow the lead of Congress in
codifying economic substance.
Tax law is highly technical. Traditionally, taxpayers planning transactions have relied on objec-
97
Arguably, the economic substance doctrine should never
be relevant when a tax incentive provision is involved, which
was the situation in HMN Financial and T.D. Banknorth. See
Arthur R. Rosen, ‘‘Business Purpose, Economic Substance
Don’t Apply to Intended Tax Benefits,’’ State Tax Notes, June
14, 2010, p. 905, Doc 2010-12135, or 2010 STT 113-2.
State Tax Notes, November 1, 2010
tive indicia of what the tax law is. Obviously, as in
any other area of the law, tax law has gray areas.
Judicial doctrines, such as the step transaction
doctrine, have arisen to characterize ambiguous sets
of facts or to interpret statutes. However, the economic substance doctrine is different — when it is
applied, courts override statutory law. That introduces tremendous subjectivity into the system. The
rule of law is replaced by the whim of tax administrators and judges, and it becomes exceedingly difficult for taxpayers to plan.
One hopes that state courts will follow the lead of
the Minnesota Supreme Court in its HMN Financial
decision. One also hopes that state legislatures will
not follow the lead of Congress in codifying economic
substance.
✰
341
(C) Tax Analysts 2010. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
transactions, particularly novel transactions that
have tax benefits associated with them.97