IRS concludes transaction may lack economic substance

Tax Hot Topics - Transactions lacking substanceIn a chief counsel advice memorandum (CCA 201515020) released April 10, the IRS concluded that it may disregard a taxpayer’s participation in a transaction under the common law economic substance doctrine (ESD).

Under the facts of the CCA, a taxpayer entered into a transaction with a broker that consisted of two legs: (i) a loan and (ii) a prepaid forward contract.

The loan was made by the broker, as a lender, to the taxpayer as the borrower. The loan had a stated principal amount and provided for 64 quarterly installments of interest and principal over a 20-year period. The proceeds of the loan were used by the taxpayer to purchase a prepaid forward contract from the broker.

The contract obligated the broker to deliver a certain amount of bonds or their cash equivalent to the taxpayer and required the broker to make payments corresponding with the payment schedule of the loan over a 20-year period. The loan and the contract were designed to create offsetting rights and obligations over the same 20-year period.

Both the loan and the contract were marketed to the taxpayer by a promoter as a way to currently deduct interest expense on the loan and recognize long-term capital gain on the contract.

Applicable case law related to the ESD analyzes two factors in determining whether a transaction lacks economic substance: (i) whether the transaction changes the taxpayer’s objective economic position apart from tax benefits and (ii) whether the taxpayer has a subjective nontax purpose for entering into the transaction. The IRS concluded that it may disregard the taxpayer’s participation in the loan and the contract because the participation would fail either prong of the ESD.

Andy Cordonnier
+1 202 521 1502

Jeff Borghino
+1 202 521 1532

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