Similar to the sham transaction analysis, the so-called “substance over form doctrine” maintains that the “substance,” rather than the form, of a transaction is what governs the tax consequences of a transaction. Generally, the effect of the application of the doctrine is to produce a tax result that differs from the tax result that its form would otherwise demand.
A typical example involves the “debt vs. equity” distinction. One’s contribution to a corporation could be viewed either as a loan (debt) to the business (in which case the corporation may take a deduction for interest it pays on the loan) or as an investment (equity) in the business. If the investor really has equity but the business said it was debt, then the court will re-characterize (for tax purposes) the debt as equity—thus preventing the business from taking a deduction for the alleged “interest” payable on the debt. It is case law, not the Treasury Department that determines whether an instrument is debt or equity. In the early 1980s, Treasury issued regulations on this under Section 385, but due to the controversial nature of their drafting, they were withdrawn. Presently, the courts consider various factors for the determination.
The substance over form doctrine arose from the Supreme Court case Gregory v. Helvering, 293 U.S. 465 (1935), where the Court announced that, “as a general rule, the incident of taxation depends on the substance rather than form of the transaction.” Since that 1935 case, various courts have disallowed a tax benefit associated with a transaction that has a form that differs from its substance. Historically, this doctrine has been utilized by the government to target schemes where taxpayers have purposely mischaracterized a transaction in order to derive beneficial tax treatment.
a. Can taxpayers use the substance over form doctrine for their own benefit?
Usually, no. The substance over form doctrine is typically a “one-sided sword” used for the IRS’s benefit. This is because, usually, the IRS is able to prevent taxpayers from disavowing the form of their chosen transactions: taxpayers cannot disrobe a transaction’s form when it suits their books that its substance is better. And the courts have more often than not supported this notion over the years: they allow the IRS to assert substance-over-form claims, but also require the taxpayer to bear the burden of the form of the transaction they chose. In this sense, the doctrine is one-sided.
b. What is the relationship between the substance over form doctrine and other, similar doctrines?
As mentioned, the Supreme Court announced the substance over form doctrine back in the 1930s. However, since that time the doctrine has taken on different forms. Accordingly, the doctrine is sometimes viewed as the genius of two other species of doctrine—the “economic substance/sham transaction doctrine” and the “step transaction doctrine.” These other doctrines are discussed elsewhere on this website.
c. Does the substance over form doctrine sometimes apply to corporate acquisitions?
Yes, it can. A substance over form analysis can be particularly complex in the corporate acquisition context. Often times many forms achieve the same basic economic consequence.
The doctrine is often used to attack the eligibility of an acquiring corporation to step up the assets of a target corporation to fair market value. For background, Section 338(h)(10) allows the taxpayer to receive a step up in basis of target entity’s assets in a qualifying stock purchase. Essentially, the transaction is treated as if the target corporation sold all of its assets to the buyer and then liquidated; and it results in one level of tax, and an inside basis step up of target corporation’s assets.
However, if the substance over form doctrine were to apply, then this analysis would differ. It would require that the acquiring corporation is not the true purchaser of the target corporation, or that the acquisition was not a qualified stock purchase. Tax wise, this would have the effect of preventing the acquiring corporation from making a valid step-up election on the acquired assets (losing a tax benefit).