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July 31, 2012

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, is frequently invoked by tax authorities to frame the interpretation of a contractual arrangement whose meaning is called into question. Under this doctrine, the tax authorities generally ignore the labels or formats used by the contracting parties and instead make their own determination of the content by analyzing the meaning and actual effect of the arrangement. 

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 characterization, characterization 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 insight offered in this edition of Tax Advisor Weekly is intended to remind tax departments about the importance of staying ahead of the curve and educating others within an organization about the value of reserving a seat for tax at the table where important decisions are made. 

The Disavowal Doctrine
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 rationalize 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.

Having Cake and Eating It Too
What is quite clear is that the Service and the courts have no problem with taxpayers suffering the tax consequences of their own decisions. This principle was espoused by the Supreme Court in Comr. v. National Alfalfa Dehydrating & Milling Co.:

While a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not, and may not enjoy the benefit of some other route he might have chosen to follow but did not.

So the prevailing wisdom is that the tax "form" chosen by contracting parties is binding on a taxpayer unless the Service finds that the agreed-upon form is inappropriate. If the form is not acceptable to the Service, it could use its authority to disavow the form of a transaction by invoking well-known doctrines such as substance over form, step transaction, sham transaction and economic substance (now codified). On the flip side, for taxpayers seeking to disavow a particular form, the Service could choose to hold taxpayers to their agreed-upon form using other judicial standards that have developed as a byproduct of the Disavowal Doctrine.

Does this all mean that it is a one-way street, no matter the circumstances? Well, not quite. Although the lopsided powers of the government in this area are supported by plenty of authority, not all is settled. The courts are clearly divided over the degree of proof required by taxpayers to disavow form, something that has leveled the playing field a bit. This has left the door open for some taxpayers to subsequently clarify the substance and/or intention of an arrangement, while others are left to stew in the form of their arrangements.

Different Strokes for Different Folks  Uncertainty in Doctrine Application
There are two competing standards that are commonly applied in situations involving a taxpayer's attempt to disavow form: the "strong proof" standard and the "Danielson" standard. The courts are clearly divided over which standard would enable a taxpayer to disavow its own form. The Tax Court and some appellate circuits generally follow the "strong proof" standard. Other appellate circuits and the federal circuits have adopted the more stringent "Danielson" standard, while others have adopted a narrower view of Danielson or no particular standard at all.

The "strong proof" standard was best espoused by the Tax Court in Coleman v. Comr., where the court addressed the tax ownership of equipment in cross-border related-party leasing transactions. The court ruled that the taxpayer could disavow its form only by showing somewhat more than a preponderance of the evidence (slightly more than 50 percent) that both parties actually intended differently than was evidenced in the agreement. Thus, this rule requires a taxpayer to provide strong proof that "a contract does not reflect actual intentions of the contracting parties" and that there is "some independent basis in fact or some arguable relationship with business reality." If the taxpayer is unable to provide strong proof, the taxpayer may not attack its form even if the substance is different than the form.

The Danielson standard, a slightly more rigorous approach, originated from the Third Circuit's ruling in Comr. v. Danielson. The case involved a contractual purchase price allocation issue among assets having different income tax characteristics. The Danielson court ruled that a taxpayer cannot challenge the form of a transaction unless it adduces proof that would be sufficient to change the construction or to show its unenforceability because of mistake, undue influence, fraud, duress or other grounds, in an action between the contracting parties.

Both disavowal standards have been used in a variety of contexts including purchase price allocations, sales versus lease characterizations and attempts at aggregating separate legal transactions into one. The principal difference between the two standards is that the strong proof standard allows a taxpayer to make substantive arguments to support the claim that the substance of the transaction differs from its form, whereas the Danielson standard does not allow substantive arguments to be made by the taxpayer, and instead looks for arguments that the contract is unenforceable due to mistake, undue influence, fraud, duress, etc. (essentially similar to the "parole evidence rule" under state contract law). 

Illustrative Disavowal Cases  Purchase Price Allocations
The Danielson standard again took center stage in the recent case of Peco Foods, Inc. & Subsidiaries v. Comr. In this case, the Tax Court held that the taxpayer could not disavow asset purchase price allocations that were agreed to by the contracting parties. Whether intended or not, the agreements were very specific in how the purchase price was to be allocated among the assets and further stated that such allocations were "for all purposes (including financial accounting and tax purposes)". 

The Service disagreed with Peco's attempt to rely on a post-transaction cost-segregation study (an analysis that is viewed as acceptable tax planning) to claim more accelerated depreciation deductions. The Service believed, and the Tax Court concurred, that the specific contractual terms to describe the types of assets acquired in the transaction were unambiguous and should be construed at face value. As a result, the contractual classifications were binding on both parties.

We suspect that the Peco decision was a surprise for many and that taxpayers will take away important lessons that will affect the manner in which agreed-upon allocations are reflected in contracts. The good news is that the holding was more about upholding contractual meaning than the efficacy of cost segregation studies in tax planning. Also noteworthy is that the Tax Court's opinion cited the House Report that accompanied the purchase price allocations rules under Section 1060(a). The cited House Report clearly refers to the Danielson standard for instances where the parties attempt to refute a contractually agreed-upon purchase price allocation. As the Peco case occurred within the 11th Circuit (which has similarly adopted the Danielson standard), it remains to be seen whether a similar case adjudicated by the Tax Court in a non-Danielson circuit would come to the same conclusion.

However, it does not end there. In an earlier purchase price allocation case, we have also learned that what you do not explicitly include in the agreement may cause problems for you later. In Lane Bryant, Inc. v. United States, the taxpayer, a publicly traded company, entered into an agreement to recover its stock from hostile corporate raiders. The agreement did not explicitly allocate any repurchase premiums paid as part of the agreement between the stock and "non-stock" items. As a result, the court held that the taxpayer could not claim any portion of the premiums paid as a business expense (either currently or through amortization deductions).

The taxpayer attempted to disavow the form and argue that the substance should prevail, all of which was buttressed by the intent of the parties. However, the Federal Circuit Court of Appeals held that since no consideration had been allocated to the non-stock items, there was nothing for the taxpayer to deduct or amortize. The court acknowledged the taxpayer's argument that the premium was intended as payment for the non-stock items, but concluded that in the "absence of a specific allocation for the non-stock items, the 'intent' of the contracting parties is irrelevant."

More Food for Thought  What Does This Mean for Me?
With so much uncertainty regarding the application of the Disavowal Doctrine to many types of transactions and the difficulty in framing it into easily determinate consequences, there are several important takeaways that should be kept in mind:

  • Try to get tax representation at the table. Give yourself sufficient time to perform due diligence as well as analyze potential tax consequences and opportunities or alternatives. There could be too much at stake.
  • Words have consequences. The inclusion or omission of words in a legal agreement could mean a world of a difference. You may be locked into whatever was signed unless you can clear either the hurdle(s) of the "strong proof" standard or the Danielson standard (whichever is applicable).
  • Unambiguous written agreements are generally binding for tax purposes. Therefore, agreements need to strike a balance between being specific enough so as not to be ambiguous and not being so specific that you paint yourself into a corner.
  • There are inherent uncertainties as to how the tax authorities will view a taxpayer's attempt to disavow its own form, as the courts are divided over the degree of proof required. The disavowal standards vary among the different courts and create more difficulty for management to accurately assess its FIN 48 (ASC 740-10) reserves.

Alvarez & Marsal Taxand Says:
It is unlikely that the "form versus substance" debate will go away anytime soon. In fact, it has arguably become embedded in the fabric of our tax system. Nonetheless, like the old adage, "say what you mean and mean what you say," it is prudent that any written agreement reflects the true form of the transaction intended by all parties.

While it is not feasible to perform many types of in-depth analysis to model all tax permutations and consequences of a transaction before it occurs, it is important to engage the right internal and external resources (including tax) at the forefront of the decision-making process. This way, one will not have unforeseen future repercussions, or miss potential tax planning strategies. This will help level the playing field for a contest where the authorities hold almost all of the cards. 


  • Gregory v. Helvering, 293 U.S. 465 (1935).
  • Commissioner v. National Alfalfa Dehydrating & Milling Co., 417 U.S. 134 (1974).
  • Coleman v. Commissioner, 87 T.C. 178 (1986).
  • Ullman v. Commissioner, 264 F.2d 305 (2d Cir. 1959).
  • Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967).
  • Peco Foods, Inc. v. Commissioner, T.C. Memo. 2012-18.
  • Id.
  • Lane Bryant, Inc. v. United States, 35 F.3d 1570.
  • Id.

As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.   The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of chaneging laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.

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