Charlene D. Luke (Florida State) presents Risk, Return and Economic Substance at Florida today as part of its Faculty Colloquia Series.  Here is the abstract:

The economic substance doctrine is a judicial method used to assess transactions suspected of being nothing more than elaborate (and illicit) tax avoidance. Courts vary in their formulation of the doctrine. Generally, the test consists of (1) a subjective inquiry into the taxpayer’s motivations for entering the suspect transaction and (2) an objective inquiry into whether the transaction accomplished anything beyond tax effects. Both inquiries frequently revolve around the profit potential of the suspect transaction. In making an objective inquiry into profit, courts focus on the profit potential exclusive of taxes — the pre-tax landscape. This Article suggests that although a pre-tax inquiry has intuitive appeal, use of the pre-tax viewpoint is flawed first because it may foster overly imaginative speculation about alternate endings for the transaction. Second, the pre-tax viewpoint does not sufficiently account for the difficulty in separating the economics of a transaction from its tax consequences. In particular, the pre-tax viewpoint fails to account for implicit taxes and tax clienteles.

This Article argues for a shift from the pre-tax to a post-tax viewpoint for the objective inquiry into profit, and it proposes a two-step method for making such a shift. First, the taxpayer’s after-tax return on the suspect transaction would be compared to after-tax returns available on comparable market transactions. The suspect transaction would be presumed to fail the objective profit inquiry if its after-tax return is substantially outside the return range for the comparables. Second, the taxpayer would be able to rebut this presumption only by providing evidence that the non-standard return more likely than not resulted from unique economic conditions rather than from tax manipulation.