United States: Economic Substance: A Machine Learning Perspective On The Multi-Factorial Analysis

Last Updated: June 4 2019
Article by Chris Yan

Economic substance is part of a series of U.S. anti-abuse doctrines designed to combat tax shelters which comply with the letter of the rules contained in the Internal Revenue Code (IRC) but violate the spirit of the Code. At its core, the economic substance doctrine stands for the principle that the tax authorities are not obligated to respect the tax effects that flow from transactions that lack economic substance.

Partly in response to uncertainty surrounding the application of the test at common law, the economic substance doctrine was codified with the addition of § 7701(o) of the IRC. However, economic substance remains a frequently litigated issue with persisting grey areas that necessitate interpretation.

In this article, we examine three recent economic substance cases to illustrate how Blue J Legal's machine learning technology can help practitioners validate their tax positions. These cases are: Austin v. Commissioner (T.C., 2017); Gregg v. Department of Revenue (Or. Tax, 2017); and DTDV, LLC v. Commissioner (T.C., 2018).

Codification of Economic Substance

While the judicial roots of the economic substance doctrine can be traced back to the seminal Supreme Court decision in Gregory v. Helvering, 293 U.S. 465 (1935), the doctrine was only codified in 2010 with the addition of § 7701(o) of the IRC. § 7701(o) provides that a transaction shall be treated as having economic substance only if:

  1. the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position, and
  2. the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.

The statute also introduces a substantial penalty for underpayment that ranges from 20% to 40% (§ 6662(b)(6);(i)(1-2)).

Prior to the introduction of § 7701(o), there was a substantial degree of judicial divergence in applying the economic substance test. Some circuit courts applied the two-pronged test, while some relied on either one of the prongs, and others resisted a rigid two-step analysis altogether. Although the statute attempted to clarify the application of the test, the doctrine's application has remained inconsistent.

Persistent Ambiguity in Application of Test

To begin, the statute provides no guidance on what constitutes a "meaningful" economic change or a "substantial" business purpose. Moreover, § 7701(o)(5)(C) specifically provides that codification does not alter the determination of the doctrine's applicability at common law. In Notice 2010-62, the IRS has also confirmed that it would continue to rely on relevant common law cases in applying the test set out in § 7701(o).

For practitioners, this means that the uncertainty within this legal area continues to persist despite statutory enactment. This trend is supported by the fact that the doctrine continues to be frequently litigated; Blue J Legal's database reveals that judgment on economic substance has been rendered in over 60 decisions since 2011. The complexity can be illustrated in three recent decisions where the Court elected to frame the economic substance analysis using the common law test instead of the statutory formulation.

In Austin, which involved the creation of multiple entities and the sale and repurchase of stock, the Court applied the doctrine by characterizing the taxpayer's activity as four separate transactions. Although the Court conducted its analysis using the common law test articulated in Frank Lyon Co. v. United States, 435 U.S. 561 (1978) and Rice's Toyota World Inc. v. Commissioner, 81 T.C. 194 (1983), the Court nonetheless arrived at conclusions in line with Blue J Legal's machine learning and algorithmic predictions in all four instances.

Similarly, the Court in Gregg sought to answer the question of whether two individuals' venture was considered a business, and whether that venture lacked true economic substance. Instead of applying the conjunctive test articulated in §7701(o), the Court applied the Frank Lyon test at common law. The Court held that the venture lacked economic substance based on findings that the primary investment motivation was tax savings, and that the transaction lacked any reasonable possibility of profit. Although the Court conducted the analysis using the common-law factors, Blue J's machine learning algorithm was able to predict results consistent with the Court's application by using principles that underlie the statutory analysis.

Most recently, in DTDV, which concerned an examination of the legitimacy of a partnership interest, the Court engaged in the same economic substance doctrine analysis as above, without any regard to the statutory formulation. The Court went through a six-part fact-driven analysis using the common-law factors and ultimately held that the economic substance doctrine did not justify disregarding the transaction. The machine learning algorithm was also able to handle the common-law application and validate the Court's decision.

Dynamic Multi-Factor Prediction using Machine Learning

To be comprehensive, the two-part test needs to be expanded to a five-factor analysis that informs the origin, structure, economic impacts, and non-profit effects of the transaction, as well as the taxpayer's risk level. Blue J Legal's machine learning analysis incorporates up to two dozen fact-driven considerations commonly cited in leading cases and applied by the IRS. Each of these considerations are weighted differently depending on the unique circumstances of the case.

By leveraging machine learning technology, our multi-factor algorithm is able to predict case outcomes accurately and the analysis remains robust in the face of inconsistent judicial application of the test. Machine learning is particularly well-suited to complex multi-factor analysis because it processes raw factual data while remaining impartial to varying formulations of a legal test that capture the same principles.

If you're interested in learning more about how machine learning can help practitioners navigate the complexity of the economic substance analysis to validate a tax prediction, watch our Economic Substance: Influential Factors Webinar on demand.

Thank you to Monica Layarda, Legal Research Analyst for assisting in the publication of this article.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Events from this Firm
21 Aug 2019, Webinar, Unknown, United States

Register for this webinar, here.

It is tempting to cite the benefits of being the early bird when it comes to innovation – but some firms fear they may be burned by being too quick to adopt new technology.

 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions