An Inquiry Into the Legitimacy of Offshore Planning: Establishing Business Purpose

I have previously referred to US anti-avoidance law as a "conceptual briar patch."  In learning about this law, the practitioner is first faced with a fundamental question of just how many US doctrines exist.   He could easily come to the conclusion there were five, which are

1. Substance over form
2. Sham Transaction
3. Business Purpose
4. Economic Substance 
5. Step Transaction Doctrine

At the same time, he could reasonably conclude the sham transaction and economic substance doctrine are the same concept (both have an objective and subjective component) with sham transaction terminology used from the late 1950s to the late 1970s/early 1980s and the economic substance doctrine used thereafter. Or he could conclude the sham transaction is used in simpler transactions (such as interest deduction manipulations) whereas economic substance is used in more complex transactions (such as the tax evasion plans promulgated during the 1990s).  And is the business purpose doctrine a separate doctrine or one of the factors of the shame transaction/economic substance doctrine?  A reading of the case law supports both views.  And just to make matters that much more confusing, aren't they all really just branches of the substance over form doctrine?  

The preceding discussion highlights the overall complexity of this area of US tax law.  I will admit to treating the business purpose doctrine as one of the factors of the economic substance doctrine for a number of years, largely based on the BNA Tax Portfolio asserting this argument. However, I have come to the conclusion that business purpose is a separate doctrine for two reasons.   The first is the Frank Lyon Supreme Court Decision Frank Lyon Co. v. United States, 435 U.S. 561 (1978).  Any doctrine outlined in a Supreme Court case should rise of the level of black letter law, largely based of the precedential weight afforded the deciding body.  But just as importantly, this case provides a positive set of factors with which the practitioner must comply.  This is in sharp contrast to the vast majority of anti-avoidance cases which contain only negative suggestions: most cases essentially state don't do this, but offer no affirmative guidance. 

The facts in the case are straightforward.  Worthen bank in Arkansas wanted to build a new headquarters.  However, "[a]s a bank chartered under Arkansas law, Worthen legally could not pay more interest on any debentures it might issue than that then specified by Arkansas law. But the proposed obligations would not be marketable at that rate."  To avoid this problem, the bank structured a sale-leaseback transaction, selling the building and underlying property to the Frank Lyon company (Frank Lyon sat on the bank's board), who in turn leased the building back to the bank.  New York Life also provided financing.  The service determined that for tax purposes Lyon did not own the building, so the deductions claimed as a result of property ownership were not allowed.  While the lower court sided with Lyon, the appellate court ruled for the service.

Sale-leaseback transactions are hardly a revolutionary concept.  In fact, I believe one could argue they are part and parcel of corporate transactional practice -- a reality recognized by the court:

The present case, in contrast, involves three parties, Worthen, Lyon, and the finance agency. The usual simple two-party arrangement was legally unavailable to Worthen. Independent investors were interested in participating in the alternative available to Worthen, and Lyon itself (also independent from Worthen) won the privilege. Despite Frank Lyon's presence on Worthen's board of directors, the transaction, as it ultimately developed, was not a familial one arranged by Worthen, but one compelled by the realities of the restrictions imposed upon the bank. Had Lyon not appeared, another interested investor would have been selected.  The ultimate solution would have been essentially the same. Thus, the presence of the third party, in our view, significantly distinguishes this case from Lazarus and removes the latter as controlling authority (Lyon at 576-576).

By noting the taxpayer had a legitimate business reason to structure the transaction in this manner, the court outlined several factors that must be present in all business transactions to demonstrate business purpose:

1. there is a genuine multiple-party transaction 
2. with economic substance that is 
3. compelled or encouraged by business or regulatory realities, 
4. that is imbued with tax-independent considerations, and 
5. that is not shaped solely by tax-avoidance features to which meaningless labels are attached.  (Lyon at 583-584)

Now that we've outlined business purpose factors, the question logically turns to proving a transaction complies with them.  As I've previously noted, one commentator has correctly observed that business transactions fall into three categories: increasing revenue, lowering expenses, raising financing or some combination of the three (Peter C. Canellos, Business Purpose, Economic Substance and Corporate Tax Shelters, 54 SMU L. Rev. 47, 52-53, (2001)).  I would add that lowering a risk profile is also a valid business purpose.  This is one of the fundamental reasons corporations divide themselves into divisions and a primary motivator for incorporation in the first place.  Successfully showing that a transaction falls into one or more of these categories would demonstrate substance.  The process of making this determination requires the lawyer to look at the transaction at the company level, making an exhaustive inquiry one that is similar to those engaged in by courts implementing an economic substance doctrine investigation.  Only after the practitioner develops the facts of the case should he begin developing a transactional strategy that incorporates various elements of law such as business entities, tax, securities and insurance.