1. Overview of U.S. Anti­Abuse Rules
General Anti­Avoidance Tax Rule International Seminar
Sponsored by Secretariat of the Federal Revenue of Brazil
5 October, 2010, 5:00 P.M.
Presented By:
John D. McDonald
1­312­861­8917
john.mcdonald@bakermckenzie.com
Baker & McKenzie International is a Swiss Verein with member law firms around the world. In accordance with the common terminology used
in professional service organizations, reference to a “partner” means a person who is a partner, or equivalent, in such a law firm. Similarly,
reference to an “office” means an office of any such law firm.

2. Agenda
– Overview of U.S. Anti­Abuse Rules and Common Law
Doctrines
– Overview of Section 7701(o)
– How the U.S.’s Experience Highlights Issues to Consider
when Crafting Brazil’s Anti­Abuse Rule
– Questions / Answers
2

3. Overview of U.S.
Anti­Abuse Rules
and Doctrines
3

4. Which U.S. Anti­Abuse Rule?
4

5. Numerous “Sources” of Anti­Abuse Rules
– Treaties
– Limitations on Benefits Provisions Contained In Almost All U.S. Treaties
– The Internal Revenue Code of 1986, as amended (the “Code”)
– Sections 269, 382, 383, and 384 (targeting loss trafficking).
– Sections 355(e) (anti­Morris Trust rules); 707(a)(2)(B) (disguised sale provisions); 1059 (abuse of the
dividends received deduction).
– Regulations Issued Pursuant to the Code
– Treas. Reg. §1.701­2 (partnership anti­abuse rules).
– Treas. Reg. §1.881­3 (anti­conduit regulations).
– Treas. Reg. §§1.1502­13(h)(1); 1.1502­35(g)(6) and 1.1502­36(g)(1).
– If a taxpayer acts with a view to avoid the purposes of the section, or use the section to avoid
another provision of law, appropriate adjustments will be made.
– CAUTION: If the rule is too broad, courts are reluctant to apply. Countryside Limited Partnership, et. al.
v. Commissioner, TC Memo 2008­3.
– Other administrative guidance (e.g., rulings and notices)
– Notice 2010­41, 2010­22 I.R.B. 715 (May 14, 2010) (IRS stated that it would treat certain domestic
partnerships owned by foreign corporations as foreign for the limited purpose of the U.S. anti­deferral
rules).
– NOTE(1): All of the foregoing tend to be very problem­specific.
5

6. No Overarching Anti­Abuse Rule
– Until very recently, there was no general, overarching, Code­
based anti­abuse rule. The closest examples we had were
sections such as:
– Section 446 (giving the authorities broad powers to ensure
the “clear reflection of income” within a single company);
and
– Section 482 (giving the authorities broad powers to ensure
the “clear reflection of income” between related companies).
– Instead, the U.S. has had a long­history of common law (i.e.,
judge­made law) that has filled the gap and constrained tax­
motivated transactions.
– These cases, over time, developed into various “doctrines” . . ..
6

7. Common Law Doctrines – Substance Over Form
– Substance Over Form
– Transactions are taxed in accord with their underlying economic results, and not their mere
form. See Gregory v. Helvering, 293 U.S. 465 (1935); and Higgins v. Smith, 308 U.S. 473,
476­77 (1940) (“transactions, which do not alter the flow of economic benefits, are to be
dismissed from consideration…”)
– Examples would include:
– Various corporate reorganization rulings such as Rev. Ruls. 67­274, 1967­2 C.B. 141
(stock­for­stock exchange followed by liquidation treated as asset reorganization); and
2001­46, 2001­2 C.B. 321 (target’s merger into subsidiary of parent, followed by
upstream merger into parent, treated as direct merger into parent).
– Circular cash flows ignored in Rev. Rul. 83­142, 1983­2 C.B. 68.
– Tax Ownership is determined by reference to the person that possesses the benefits and
burdens of the underlying asset, and not mere legal title. See Grodt & McKay Realty Inc.
v. Commissioner, 77 T.C. 1221 (1977).
– The imputation of income and deductions of an agent to its principal. See Commissioner
v. Bollinger, 485 U.S. 340 (1988) (real estate losses were imputed from corporation, to
its shareholder, a partnership).
– Sale­leaseback arrangements. A’s sale of property to B, followed by B’s lease of the
property back to A for substantially all of the property’s useful life considered a secured
loan. See generally, Rev. Proc. 2001­28, 2001­19 I.R.B. 1156.
7

8. Common Law Doctrines – Substance Over Form
– Substance Over Form (Cont’d)
– Should be distinguished from other types of anti­abuse
rules:
– Both taxpayers and the tax authorities can rely on the
substance over form doctrine.
– Application of the doctrine does not necessarily lead to
more tax. It can, in certain circumstances, lead to less
tax, or a deferral of the taxing event.
8

9. FORM: Taxable Sale from U.S.
perspective.
USCO USCO
2
1 UK1 Distributes
UK1 sells its assets to USCO Note to USCO
for a Note
UK1 UK1 3
UK1 “stricken off” and ultimately
lidquidated.
SUBSTANCE: Tax­Deferred from U.S.
perspective.
USCO
Assets
Distributed
in Liquidation
UK1
9

10. Common Law Doctrines – Anti­Abuse
– Business Purpose
– Established by the Supreme Court in 1935 in Gregory v. Helvering, 293
U.S. 465 (1935).
– At least two (2) competing interpretations:
– To be respected, every transaction needs to be motivated by a non­
tax rationale (“higher standard”).
OR
– To be respected, a transaction must not violate the purpose of the
Code section the taxpayer is trying to avail himself or herself of
(“lower standard”). See UPS v. Commissioner, 254 F.3d 1014 (11 th
Cir. 2001) (insuring risks through offshore related company to achieve
better tax answer was permissible).
10

11. Common Law Doctrines – Anti­Abuse
– Business Purpose
– What constitutes a valid business purpose?
– In the U.S., any non­U.S. federal tax purpose is valid. Even the
reduction of state tax or the reduction of foreign tax is valid if the state
or foreign tax reduction is not simply correlative to a U.S. federal tax
benefit (e.g., the fact that a 100 reduction in federal income results in
a corresponding reduction in state income is not a valid business
purpose).
– This is not the case in many other countries (e.g., in France, a motive
to reduce non­French tax is still an impermissible tax motivation).
– What if the tax reduction itself furthers a non­tax rationale:
– Financing transactions that are designed to reduce U.S. withholding
tax?
– Repatriation transactions that enable a U.S. based multinational to
reduce its unrelated party borrowing costs?
11

12. Common Law Doctrines – Anti­Abuse
– Business Purpose
– Do we have to weigh the business purpose with the tax­
motivation? Does the business purpose need to outweigh
the tax­motivation?
– If the business purpose does not need to outweigh the tax­
motivation, is there some minimum threshold of non­tax
benefit that has to be shown? How should it be shown?
12

13. Common Law Doctrines – Anti­Abuse
– Sham
– Factual Sham vs. Economic Sham vs. Sham Entity
– Factual Sham:
– The tax authorities assert that the transaction reported
by the taxpayer on the taxpayer’s return never actually
occurred. See e.g., Julien v. Commissioner, 82 T.C.
492 (1984) (taxpayer failed to prove that underlying
assets were actually purchased or that loans giving rise
to interest deductions were actually made).
– Often invoked simultaneously with allegations of
taxpayer “fraud”.
13

14. Common Law Doctrines – Anti­Abuse
– Sham
– Factual Sham vs. Economic Sham vs. Sham Entity
– Economic Sham or “Sham in Substance”:
– Underlying transactions actually did occur, but they had
no meaningful economic effect on the taxpayer.
Knetsch v. U.S., 364 U.S. 361 (1960) (economic sham
where taxpayer borrowed money at 3.5% from an
insurance company to purchase 30­year maturity
annuities which bore interest at 2.5%, yielding a net out
of pocket cost of $91,570 and interest deductions of
$290,570).
14

15. Common Law Doctrines – Anti­Abuse
– Sham
– Factual Sham vs. Economic Sham vs. Sham Entity
– Sham Entity
– Entities (partnerships, trusts, corporations, etc…) will
be respected as separate and distinct entities from
other persons (even related persons, like shareholders
and partners) so long as there is some rationale for
forming the entity apart from tax purposes, and the
entity conducts business activity. See Moline
Properties v. U.S., 319 U.S. 436 (1943); and Rogers v.
Commissioner, 34 T.C.M. 1254 (1975) (interpreting
Moline as requiring a subjective and objective test).
15

16. Common Law Doctrines – Anti­Abuse
– Analogous Concepts in Brazil:
– Absolute Sham: the transaction really did not occur or will
never occur. It can be compared to the factual sham for US
purposes.
– Relative Sham: the transaction did occur but it is only
apparent, the real transaction is hidden. (can be compared to
the economic sham for US purposes).
16

17. Common Law Doctrines – Anti­Abuse
– Economic Substance
– In Frank Lyon v. U.S., 435 U.S. 561 (1978) the Supreme Court
established a two­prong analysis that evolved into the “economic
substance” doctrine:
– Subjective Test: taxpayer must be motivated by a legitimate non­tax
business purpose.
– Objective Test: the transaction must put the parties in a different
economic position than they were in before.
– Overlaps in many respects with “business purpose” and “economic
sham” doctrines.
– Prior to enactment of section 7701(o), some courts of appeal required
satisfaction of both prongs, some required satisfaction of either
prong, and some courts were simply less clear about how they were
applying the test. 17

18. Common Law Doctrines – Anti­Abuse
– Step­Transaction
– The tax authorities can “collapse” a series of steps to
prevent the taxpayer from achieving a tax benefit.
Step One Step Two Public Shareholders
Individual A Individual A Individual A Shares
USCO PublicCo
Branch
Step Three
USCO merges
Branch
up into PublicCo
USCO
Branch
Assume that Individual A wants to transfer his business to PublicCo for PublicCo shares, but
knows that this would be taxable . . . so, he engages in a three­step transaction. Compare West Coast Marketing
Corp. v. Commissioner, 46 T.C. 32 (1966) with Weikel v. Commissioner, T.C. Memo 1986­58. 18

19. Common Law Doctrines – Anti­Abuse
– Step­Transaction (Cont’d)
– When should the doctrine be applied?
– Binding Commitment Test – Each step is contractually required to
occur at inception?
– Mutual Interdependence Test – Would one step be fruitless if the
subsequent steps did not occur?
– End Result Test – Did the taxpayer “intend” all of the steps to reach a
single end result from inception?
– Can the authorities merely “reorder” steps instead of collapse them?
– Compare Edgar S. Idol v. Commissioner, 319 F.2d 647 (1963) with
th
Esmark v. Commissioner, 886 F.2d 1318 (7 Cir. 1989).
– When counting steps . . . what constitutes a “step”? Does an extra
board resolution constitute an extra step?
– Can the authorities create steps that did not occur (i.e., a direct
contribution by Individual A into PublicCo)? 19

20. Common Law Doctrines – Anti­Abuse
– Conduit
– You cannot simply “route” a sale of assets, or interest, or
royalties etc… through a company in order to get a better
tax answer.
– Court Holding Co. v. Commissioner, 324 U.S. 331 (1945)
(corporation negotiated sale of its assets to third party, then
subsequently, called off the sale, liquidated, and then the
shareholders sold the exact same assets to the exact same
third party, thereby achieving a better tax answer under the
law at the time).
– Del Commercial Properties, Inc. v. Commissioner, 251 F.3d
210 (D.C. Cir. 2001) (applying conduit principles.
20

21. Common Law Doctrines – Anti­Abuse
– Assignment of Income
– You cannot separate income from the underlying asset to
achieve a better tax answer.
– Helvering v. Horst, 311 U.S. 112 (1940) (father gave
interest coupons with respect to bond, but not the bond
itself, to son, but the court held that father was taxed on the
interest).
21

22. Section 7701(o)
22

23. Section 7701(o) – U.S. Codifies Economic
Substance
– On March 29, 2010, President Obama signed the Health care and
Education Reconciliation Act of 2010 (H.R. 4872) (the “Act”). Section 1409
of the Act codifies the “economic substance” doctrine.
– Under the Act, the first task is to determine whether the doctrine is
“relevant”. Section 7701(o)(5)(C) provides that the determination as to
whether the doctrine is relevant is made in the same manner as under the
common law before the Act was promulgated.
– The legislative history also exempts certain basic transactions from the
doctrine: (i) capitalizing with debt or equity; (ii) choosing a domestic or
foreign corporation; (iii) choosing to use a related party entity in a
transaction; and (iv) engaging in any corporate organization or tax­deferred
reorganization. H.R. Rep. No. 111­443 at 296 (Mar. 17, 2010). 23

24. Section 7701(o) – U.S. Codifies Economic
Substance
– If the doctrine applies, the taxpayer must be able to demonstrate the
transaction:
– Changes in a meaningful way (apart from U.S. tax effects) the taxpayer’s
economic position; and
– The taxpayer has a “substantial” purpose (apart from U.S. tax effects) for
entering into the transaction.
– Makes it clear that there is a threshold level of business purpose that
must be achieved, although business purpose need not “outweigh”
tax motivation.
– Makes it clear that no state, foreign or financial statement benefit will
be considered if it simply results from the U.S. federal tax benefit.
24

25. Section 7701(o) – U.S. Codifies Economic
Substance
– The Act does not resolve the longstanding issue as to what
constitutes a “transaction”:
– Does each and every step in an overall transaction have to
possess an independent non­tax rationale?
– Or is it sufficient if the overall end result is motivated by a
non­tax rationale?
25

26. Section 7701(o) – U.S. Codifies Economic
Substance
– The Act adds two “strict liability” penalties in the event: (i) the doctrine
applies; and (ii) the taxpayer cannot satisfy the two­prong test:
– 20% of the tax if there is “adequate disclosure”; and
– 40% if there is not “adequate disclosure”.
– Initially unclear what constituted “adequate disclosure”. The IRS recently
issued Notice 2010­62.
– Generally, taxpayer cannot rely on generic disclosures (e.g., the
disclosures under Treas. Reg. §1.368­3).
– Instead, subject to certain exceptions, taxpayer must file a specific
disclosure on Form 8275 or 8275­R, creating a “red flag” for the auditors.
26

27. Relevant Aspects
of the U.S.
Experience 27

28. Underlying Principles
– Transactions should change the economic positions of the parties involved:
– Should related party transactions be subject to more scrutiny than others?
– Transactions should be motivated by a non­tax rationale:
– Does state/local/municipal tax reduction count?
– Does foreign tax reduction count?
– What about altered financial presentation?
– What if the tax reduction itself generates a true non­tax benefit:
– Financing transactions that reduce withholding tax rates but lower the after­
tax cost of borrowing?
– Repatriation transactions which allow a company to reduce its unrelated
party borrowing?
– How significant does the non­tax rationale need to be?
– Is weighing required?
– Do you analyze each and every step in a transaction for business purpose or
just the overall end­result? Or do you just analyze the single step that
generates the tax benefit?
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29. Questions???
29

30. * * *
Pursuant to requirements relating to practice before the Internal Revenue
Service, any tax advice in this communication (including any attachments) is
not intended to be used, and cannot be used, for the purpose of (i) avoiding
penalties imposed under the United States Internal Revenue Code, or (ii)
promoting, marketing or recommending to another person any tax related
matter.
Baker & McKenzie International is a Swiss Verein with member law firms around the world. In accordance with the common terminology used
in professional service organizations, reference to a “partner” means a person who is a partner, or equivalent, in such a law firm. Similarly,
reference to an “office” means an office of any such law firm.