The legality of offshore planning: an introduction

By F Hale Stewart, JD, LLM, CAM, CWM, CTEP

The Law Office of Hale Stewart


Apple's tax plan — and subsequent appearance before Congress defending their plan — has again drawn attention to the idea of offshore planning. The overall debate has fallen into the fairly predictable pattern of the political right saying Apple is 100 percent allowed to do whatever they can to lower their taxes, while the political left has decried the practice as a deliberate evasion of taxes.

What both sides have failed to do is place the idea of offshore planning in the context of U.S. anti-avoidance law in order to determine if the structure would indeed stand-up to scrutiny in the event it was challenged in court. While the analysis that follows will hardly be an in-depth treatment, it should serve to highlight some of the legal issues involved with complex international tax planning of this nature.

By way of introduction, there are two core concepts of U.S. anti-avoidance law, both of which are derived from the same case, Gregory v. Helvering. The concept which is by far most cited is that taxpayers are allowed to structure their affairs to minimize taxation. However, just as important — but not cited with nearly the same frequency — is that all transactions must have substance; merely complying with the technical requirements of the code is insufficient.

In Gregory, the taxpayer performed a corporate formation and liquidation over a three-day period. The court ruled this short duration indicated the corporation was not meant to be used for a legitimate business purpose, but was instead a technical shell game used to minimize taxes. In ruling against the taxpayer, the court forever added an additional layer to tax planning — the need to demonstrate transactional "substance."

Further complicating our analysis are two issues. The first is that "legal substance" is an ephemeral and ill-defined concept. Little to no scholarship has been performed on the idea. The vast majority of courts dealing with this issue gloss over it, usually stating the act of formation is sufficient in and of itself to demonstrate a legitimate enterprise.

However, this is exactly what the taxpayer did in Gregory only to have the court rule against her. Perhaps the best list of factors for practitioners to use to demonstrate substance (or at lease corporate separateness) comes from veil piercing law, where many courts have a list of factors to determine if a company is in fact an "alter ego" of the person incorporating the company.

A strong argument could also be made that the material participation standards of 26 U.S.C. 469 could provide some much needed parameters for comparison. However, no court decision that I'm aware of has formally applied these commonly used and understood concepts to the area of corporate substance.
The best explanation I have found for "substance" is from a law review article titled "Business Purpose, Economic Substance and Corporate Tax Shelters" by Peter C. Canellos (54 SMU L. Rev. 47) where he notes that the vast majority of legitimate business transactions (which would therefore survive a substance over form challenge) have at their core, one of three purposes: increasing profit, lowering expenses or acquiring/raising financing. However, it should be noted that only lowering a tax expense is insufficient.

Unfortunately from a practicing perspective, whether or not a transaction falls into one of the three categories usually falls under the, "I know it when I see it" column.

The second problem complicating an analysis of the transaction is that substance over form law is itself a conceptual briar patch. Despite it's importance to tax law, no case law book has ever been written on this topic.

Shepherdizing the Gregory case returns over 1,000 cases, law review articles, CLE materials and practitioner's guides. Courts routinely use various substance over form terms interchangeably and incorrectly, and return conflicting decisions on the same or similar facts. While five actual anti-avoidance law concepts have been cited and developed in the case law (substance over form, the sham transaction, business purpose, the economic substance doctrine and the step transaction doctrine), legitimate scholarly debate could support the contention that there is only one, or three, four and five doctrines.

Going forward, I'm going to look at offshore from three perspectives: substance over form, economic substance and business purpose. Substance over form will use the concepts outlined above ("material participation" and the factors in "alter ego" analysis will be used. There will also be an explanation of legislative intent). I will make the assumption that the economic substance doctrine is a latter day version of the sham transaction doctrine ("sham transaction" language was used primarily in the 1950s-1970s, while "economic substance" language was used from the late 1980s/early 1990s onward; both contain an objective and subjective component). The business purpose doctrine will use the factors outlined in the Frank Lyon case. As the step transaction doctrine is most often used in corporate reorganizations or shorter duration transactions, it will not be used.