SHIFTING INCOME FROM ONE TIME PERIOD TO
ANOTHER
If tax rates are constant or declining over time, taxpayers prefer to delay
recognizing income until it can be taxed at as low of a rate as possible. It is also
desirable to defer paying taxes as long as interest is not being charged on the tax
liability. If tax rates are increasing over time, it pays to accelerate recognizing income
unless interest rates are very high. For example, if tax rates are 28% today and
expected to be 33% in 1 year, it makes sense to accelerate paying the tax unless the
taxpayer can invest 28 cents today to return more than 33 cents after tax in 1 year.
Such an investment would have to yield nearly 18% after tax in 1 year to warrant
postponing paying the tax. Of course, nontax factors (such as financing current
consumption) might also figure importantly in the taxpayer’s decision of whether or not
to defer income recognition.
The U.S. income tax system, as in most income tax systems around the world,
taxes income based on a realization principle. That is, income is not typically taxed
until certain types of exchanges take place. For example, income from the appreciation
of most assets is not taxed until the assets are sold and, even then, the income might
not be taxed until cash is received from the sale (for example, the seller may accept a
note receivable or promissory note from the buyer delaying the receipt of cash to the
seller—an installment sale). This relief feature of the tax law (deferral of taxation until
gains/losses are realized) is motivated by a desire by Congress to avoid forcing
taxpayers to liquidate assets or borrow money to pay their accrued tax liabilities (i.e.,
to make sure taxpayers have the wherewithal to pay the tax). Such relief would be
unnecessary if it were costless to liquidate assets or to borrow money—that is, if there
were no market frictions. But in many circumstances, such frictions are very important,
and without the relief provisions, taxpayers would be forced to engage in economically
wasteful transactions to meet their tax liabilities. Alternatively, they might choose to
forego socially desirable activities (such as the sale of an asset with a note to a buyer
that can better utilize the asset) in anticipation of possible problems with making tax
payments. Conversely, the granting of tax relief of this sort has drawbacks as well.
Such relief offers tremendous potential for abuse, especially when the cost to liquidate
certain assets is low. Although it may be socially inefficient for them to do so, taxpayers
can and do incur real costs in timing their asset sales to shift income from one period
to another.
Restrictions on Taxpayer Behavior
The tax authority has the ability to impose broad legal restrictions on taxpayer
behavior, essentially giving the taxing authority the right to ask whether transactions
“pass the smell test.” Let us take a closer look at some of the broad restrictions that
are involved.
Economic Substance, Business Purpose, and Substance over From
Among the most powerful tools at the IRS’s disposal to discipline aggressive tax
planners are the closely related doctrines of economic substance, business purpose,
and substance over form.8 These doctrines were generally judicially developed and
are not entirely separable, and their application by the courts has not always been
consistent. Generally, the economic-substance doctrine is applied where a taxpayer
attempts to claim tax benefits unintended by Congress via transactions that the taxing
authorities claim have no economic purpose other than tax savings. On March 30,
2010, the Health Care and Educational Reconciliation Act of 2010 (the Act) was signed
into law. The Act added Section 7701(o) to the U.S. Tax Code, which codifies the
economic-substance doctrine in the sense that it provides a definition of economic
substance; whether economic substance is a relevant doctrine for a transaction is
determined the same as before the Act.9 The Section provides that the tax benefits of
a transaction are “not allowable if the transaction does not have economic substance
or lacks a business purpose” (subpart [5]). Further, the Act imposes significant
penalties for engaging in transactions that fail the economic substance doctrine and
for underreporting of facts related to such transactions.
The business-purpose doctrine disallows tax benefits in transactions where there
is not a substantial motivation or purpose for the transaction other than saving taxes
(tax avoidance).10 Whether or not a tax-advantaged transaction has a valid business
purpose is often the focus of the dispute between a taxpayer and the IRS. If a taxpayer
engages in a set of transactions deemed by a court to have no valid business purpose
other than tax avoidance, the tax benefits sought in the transactions are disallowed
(and penalties may be levied). And if there is some business purpose to the
transactions, the taxing authority may assert that the business purpose is insufficient.
The courts play an important role in interpreting these concepts and in allowing their
definition to evolve over time as the socioeconomic environment changes. The
substance-over-form doctrine allows the IRS to look through the legal form of
transactions to their economic substance. The landmark case of Gregory (a taxpayer)
v. Helvering (an IRS commissioner) illustrates these doctrines, particularly the
business-purpose doctrine. In that case the taxpayer tried to transform a dividend into
a capital gain as follows: Gregory (1) split the corporation in two in a tax-free
reorganization and (2) liquidated one of the two new corporations. Prior to the 1986
Tax Act, the complete liquidation of a U.S. corporation (whose balance sheet included
no inventories or depreciable assets) was a nontaxable event at the corporate level.
The liquidation gave rise to a capital gain to shareholders, taxed at well below ordinary
income tax rates, and much of the sale proceeds was received by shareholders as a
nontaxable return of capital. The court viewed the economic substance of Gregory’s
two transactions as equivalent to a dividend, which at the time were taxed at much
higher rates than long-term capital gains. Moreover, because it saw no business
purpose for the two transactions other than tax avoidance, it ruled that the less
favorable dividend treatment be applied for tax purposes.
Of course, there are ways to transfer property out of a corporation and into the
hands of shareholders at capital gains rates, or as a nontaxable return of capital,
without liquidating. The simplest way is to repurchase shares of stock in the open
market. If share repurchases are proportional to shareholder interests, however, the
share repurchases will be considered to be an ordinary dividend. This is an example
of the substance-over-form doctrine. If the repurchase is proportional, it is effectively
a dividend, and can be recharacterized as a dividend, even if the transaction is
technically accomplished as a repurchase of shares. The IRS has also tried (often
unsuccessfully) to use the substance-over-form argument when taxpayers essentially
manufacture riskless assets from portfolios of risky assets. Whereas the returns on
risky assets are generally taxable at capital gains rates, the returns on riskless assets
are taxable (or tax deductible) at ordinary income tax rates. Consider the possibilities
when capital gains tax rates are below ordinary tax rates. Suppose that taxpayers
could borrow at the riskless interest rate, take an ordinary tax deduction for the interest,
and then use the proceeds to purchase a portfolio of risky assets that, together, are
not risky. If the portfolio of risky assets earns the riskless interest rate before tax but is
taxed at favorable capital gains tax rates, such taxpayers could wipe out their tax bills.
We expand on this tax arbitrage notion in Chapter 5. The substance-over-form and
business-purpose doctrines have also been codified in several parts of the Internal
Revenue Code (IRC). By codified, we mean that Congress has passed tax bills
transforming the judicial support for these doctrines into statutes or laws. IRC Section
482 has been used most extensively by the IRS in cases involving international
transfer pricing (for example, interest rates on loans, or sales prices on transfers of
goods or services between parent and subsidiary corporations operating in different
countries). The motivation for playing games with transfer prices is that the parent and
subsidiary may face very different tax rates. Section 482 has also been applied to a
variety of transactions among related individuals who are taxed at different rates within
the same tax jurisdiction (such as parents and children).
