August 15, 2011 The Tax Lawyer

Why Common Law Calculus Failed: An Analysis of the Economic Substance Doctrine in Klamath Strategic Investment Fund v. United States

Vol. 64, No. 2 - Winter 2011

Brea E. L’Heureux

Abstract

    In Klamath Strategic Investment Fund ex rel. St. Croix Ventures v. United States, the U.S. Court of Appeals for the Fifth Circuit held that a transaction lacking economic substance must be disregarded for tax purposes, regardless of the taxpayer’s stated motives. Notwithstanding the transaction’s literal compliance with the Code, the court affirmed the district court’s decision to disallow claimed losses generated by a tax shelter whose sole purpose was to avoid tax liability. Despite finding the transaction lacked economic substance, however, the court did not penalize either taxpayer for underreporting.

    Klamath is now one of many decisions that comprise an incongruent body of judicial law called the economic substance doctrine, and illustrates the logic of Congress’s recent decision to codify the law. “An injudicious tax offers a great temptation to smuggling,” and loopholes present in the tax system create incentives for taxpayers to engage in aggressive, often abusive, tax avoidance behavior. The economic substance doctrine evolved to address these gaps and deny tax benefits for transactions that lack economic legitimacy. However, the courts’ inconsistent application of determinative standards and disjointed application of related penalties degraded the doctrine’s efficacy at deterring abusive tax avoidance behavior, prompting legislative intervention to codify the doctrine.

    Part II of this Note describes the evolution of economic substance doctrine—paying particular attention to its purpose and the bases for the recent codification of the law. Part III describes the transaction at issue in Klamath and outlines the Fifth Circuit’s economic substance analysis, using Klamath as context to illuminate the deficiencies of economic substance under the common law. Part IV argues that Klamath demonstrates the need to recalibrate the cost-benefit calculus of engaging in abusive tax shelters and asserts that the codification of the economic substance doctrine is a step toward that end. Part V concludes that the codified framework provides clarity and uniformity needed to enhance the efficacy of the doctrine, and was a necessary step to combating abusive tax shelters.

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