The Disavowal Doctrine - Does Substance Matter?
It is widely held that the reality of a transaction should ultimately govern when interpreting the meaning of a contractual arrangement. The "substance over form" doctrine, which originated under the Supreme Court's ruling in Gregory v. Helvering 1, is frequently invoked by tax authorities to frame the interpretation of a contractual arrangement whose meaning is called into question. Under this doctrine, tax authorities generally ignore the labels or formats used by the contracting parties and instead make their own determination of the content by analysing the meaning and actual effect of the arrangement. Taxand US looks at the definition and application of this doctrine in more detail.
A taxpayer's ability to invoke the substance over form argument is limited and not openly embraced by the tax authorities. Using what is referred to as the "Disavowal Doctrine," the authorities have held the taxpayer to the chosen form of a transaction (e.g., labels, nontax legal structure, intentions as to legal characterisation, characterisation on original tax return) and prohibited the taxpayer from attacking its own form, sometimes even where the transaction lacks sufficient substance to withstand an attack by the Internal Revenue Service (Service). This lack of flexibility has the potential to paint an unwary taxpayer into a corner. To counter this contingency, best practices suggest that strategically integrating the tax function with other departments that influence key decisions is crucial.
However, this remains one of the many challenges faced by tax departments, even as the impact of taxes in today's environment is fraught with increased uncertainty and complexity.
The policy reasons behind the Disavowal Doctrine seem clear on the surface - the government could not effectively and efficiently administer the tax law if taxpayers had an unfettered ability to alter the interpretation of an arrangement, particularly where there is no ambiguity. Not having some parameters could potentially cause the Service to litigate the contracting parties for every transaction that occurs, because the Service could not accept the arrangement at face value. Further, this could whipsaw the Service, in that transacting parties would file tax returns based on unilateral positions that are most beneficial to them, perhaps at the expense of another party. Thus, one could rationalise the need for limitations on taxpayers, but what about situations that do not disturb the government's interests or those of another taxpayer (the "no harm, no foul" situation)? The answer to this question remains unclear, largely because the scope of the application of the Disavowal Doctrine is uncertain.