INSIGHTS AND RESOURCES

Court of Appeals rejects IRS' substance over form argument

TAX ALERT  | 

Authored by RSM US LLP


Introduction – substance over form

Article I of the Constitution gives Congress the authority to lay and collect taxes. This concept seems simple, but may be complicated by courts’ interpretations of the laws Congress has enacted. The judicially-created substance over form doctrine is an excellent example of this type of complication. 

If a transaction’s substance varies from its form, the substance over form doctrine may deny tax benefits that would otherwise be allowed based on the transaction’s form. The June 2021 Ninth Circuit Court of Appeals decision explains a key limitation of the substance over form doctrine. Mazzei v. Commissioner, No. 18-72451 (9th Cir. 2021). 

Congress may provide tax rules expressly based on form 

The substance over form doctrine is a well settled principle that federal courts apply when interpreting tax rules, as the Court of Appeals acknowledged in Mazzei. However, Congress may authorize or prohibit attaining tax benefits based on the form of a transaction without regard to the transaction’s substance. The Ninth Circuit denied the IRS’ assertion of substance over form in Mazzei, holding that when Congress expressly departs from substance-over-form principles, the IRS may not invoke those principles in a way that would directly reverse that congressional judgment.

Congress expressly based FSC tax benefits on form

The Tax Code’s foreign sales corporation (FSC) rules formerly provided a U.S. federal tax benefit to taxpayers exporting goods from the U.S.1 The taxpayers in Mazzei owned stock of a FSC through their Roth IRAs (individual retirement accounts). The FSC's after-tax income was returned to the Mazzeis as dividends distributed to the taxpayers’ Roth IRAs. The IRS did not think it was appropriate that the Roth IRAs would pay no tax on the receipt of these dividends, with the Mazzeis later paying no tax upon receipt of qualified withdrawals from the Roth IRAs. 

The Ninth Circuit observed that the case would be an easy one to apply substance over form principles to if it involved ordinary business entities. The court pointed out that “[t]he taxpayers used what is essentially a shell corporation to engage in arbitrarily priced, self-dealing transactions that lacked economic substance and then funneled those proceeds as “dividends” to a tax-free Roth IRA.” It then considered the extent to which the FSC provisions should override substance over form principles. 

While the IRS had argued at the Tax Court that the taxpayers’ entire FSC arrangement should be essentially disregarded under the substance over form doctrine and treated as a device for making Roth IRA contributions. The Tax Court did not go that far, but held that the Roth IRAs purchase of the FSC stock for nominal consideration should be disregarded under substance over form principles. In the Tax Court’s view, the FSC would be respected, but the Roth IRAs ownership of the FSC would not. Under the Tax Court’s approach, export activity-based benefits would still be allowed, but the FSCs’ dividends would be taxable to the Mazzeis.  

On appeal, the Ninth Circuit held that the Tax Court erred by invoking substance-over-form doctrine to forbid what the Tax Court plainly allowed. The Tax Court had emphasized that the Roth IRAs were not exposed to any significant risk with respect to their FSC ownership. The Court of Appeals noted that the Tax Code itself eliminated business risk from the FSC by “explicitly authoriz[ing] the establishment of a FSC that will not conduct any operations itself, and… generates value only by virtue of the reduced rate of taxation that is paid on moneys that are funneled through it in accordance with strict statutory formulas.”

Conclusion

Even though the FSC provisions were repealed over 20 years ago, the principle the Ninth Circuit adhered to in Mazzei remains valid. If Congress has plainly authorized a transaction, it is not up to the courts to save the IRS from the resulting consequences, even if it perceives authorization of the tax result as unwise. While this principle provides an important limitation to the substance over form doctrine’s scope, that doctrine remains broadly applicable. Taxpayer considering transactions that have forms that could be viewed as inconsistent with their substance should consult their tax advisors.

 

1Congress repealed the FSC rules in 2000, after the WTO (World Trade Organization) found that the FSC regime was an impermissible subsidy. 

Let's Talk!

Call us at +1 213.873.1700, email us at solutions@vasquezcpa.com or fill out the form below and we'll contact you to discuss your specific situation.

  • Topic Name:
  • Should be Empty:

This article was written by Stefan Gottschalk, Nate Meyers and originally appeared on 2021-06-07.
2020 RSM US LLP. All rights reserved.
https://rsmus.com/what-we-do/services/tax/federal-tax/tax-mergers-and-acquisitions/court-of-appeals-rejects-irs-substance-over-form-argument.html

The information contained herein is general in nature and based on authorities that are subject to change. RSM US LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. RSM US LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.

RSM US Alliance provides its members with access to resources of RSM US LLP. RSM US Alliance member firms are separate and independent businesses and legal entities that are responsible for their own acts and omissions, and each is separate and independent from RSM US LLP. RSM US LLP is the U.S. member firm of RSM International, a global network of independent audit, tax, and consulting firms. Members of RSM US Alliance have access to RSM International resources through RSM US LLP but are not member firms of RSM International. Visit rsmus.com/about us for more information regarding RSM US LLP and RSM International. The RSM logo is used under license by RSM US LLP. RSM US Alliance products and services are proprietary to RSM US LLP.

​Vasquez & Company LLP is a proud member of the RSM US Alliance, a premier affiliation of independent accounting and consulting firms in the United States. RSM US Alliance provides our firm with access to resources of RSM US LLP, the leading provider of audit, tax and consulting services focused on the middle market. RSM US LLP is a licensed CPA firm and the U.S. member of RSM International, a global network of independent audit, tax and consulting firms with more than 43,000 people in over 120 countries.

Our membership in RSM US Alliance has elevated our capabilities in the marketplace, helping to differentiate our firm from the competition while allowing us to maintain our independence and entrepreneurial culture. We have access to a valuable peer network of like-sized firms as well as a broad range of tools, expertise and technical resources.

For more information on how ​Vasquez & Company LLP can assist you, please call +1 213.873.1700.

Subscribe to receive important updates from our Insights and Resources.

  • Should be Empty: