ABUSE OF STRUCTURED FINANCIAL PRODUCTS- Misusing Basket Options to Avoid Taxes and Leverage Limits MAJORITY AND MINORITY STAFF REPORT

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over form doctrine is that the tax results of an arrangement are better determined based on the
underlying substance rather than an evaluation of the mere formal steps by which the
arrangement was undertaken.” 80
The substance over form judicial doctrine permits the IRS to re-characterize a transaction
according to its actual substance. 81 According to a leading tax expert, “to permit the true nature
of a transaction to be disguised by mere formalisms which exist solely to alter tax liabilities
would seriously impair the effective administration of the tax policies of Congress.” 82 Under
rulings of the Supreme Court, the substance over form doctrine allows the IRS and the courts to
look holistically at a transaction to understand its nature and bypass any titles or formalities used
to disguise the transaction for tax purposes. 83 For example, the IRS may apply the substance
over form doctrine in analyzing whether a derivative, such as an option, should more properly be
analyzed as a direct investment in the underlying or referenced assets through the use of “a
disguised agency arrangement” with a counterparty, since the derivative can be used to achieve
economic returns indistinguishable from the direct investment in the underlying physical
security. 84
Step Transaction Doctrine. The step transaction doctrine is a corollary of the substance
over form doctrine. It treats a series of separate transactions as a single transaction if the
separate transactions were, in substance, steps that were intended to be “integrated” and
“focused” toward a result to avoid taxation. 85 According to the Joint Committee on Taxation:
“In determining whether to invoke the step transaction doctrine, the courts have looked to two
primary factors: (1) the intent of the taxpayer, and (2) the temporal proximity of the separate
steps.” 86 Courts have held that the doctrine should not apply if the taxpayer can show that at the
time the first of a series of steps was undertaken, the taxpayer did not intend to affect the other
steps. 87 Courts have also held that the step transaction doctrine may apply even if a taxpayer can
identify a valid business purpose. As one appeals court stated: “‘[A] legitimate business goal
does not grant [a] taxpayer carte blanche to subvert Congressionally mandated tax patterns.’” 88
80 Id. at 18.
81 Id. at 19.
82 J. Bruce Donaldson, “When Substance-over-Form Argument is Available to the Taxpayer,” 48 Marq. L. Rev. 41,
41 (1964).
83 See Comm’r of Internal Revenue v. Court Holding Co., 324 U.S. 331, 334 (1945).
84 3/4/2008 “Present Law and Analysis Relating to the Tax Treatment of Derivatives,” prepared by the Joint
Committee on Taxation, JCX-21-08, at 13-14, https://www.jct.gov/publications.html?func=startdown&id=1319.
85 11/10/1999 “Description and Analysis of Present-Law Tax Rules and Recent Proposals Relating to Corporate Tax
Shelters,” prepared by the Joint Committee on Taxation, JCX-84-99, at 19-20,
https://www.jct.gov/publications.html?func=showdown&id=2846 (citing Penrod v. Comm’r, 88 T.C. 1415, 1428
(1987)).
86 Id. at 20.
87 Id. (citing McDonalds Restaurants of Ill. v. Comm’r, 688 F.2d 520 (7th Cir. 1982)).
88 AeroQuip-Vickers, Inc. v. Comm’r, 347 F.3d 173 (6 th Cir. 2003) (citing Associated Wholesale Grocers, Inc. v.
U.S., 927 F.2d 1517, 1526 (10 th Cir. 1991) and quoting Kuper v. Comm’r, 533 F.2d 152, 158 (5 th Cir. 1976)). See
also Jacobs Eng’g Grp., Inc. v. U.S., No. CV 96-2662, 1997 WL 314167 (C.D. Cal. Mar. 5, 1997) (aff’d, without
public opinion, No. 97-55647, 1999 WL 89057 (9th Cir. 1999) (ruling against the taxpayer, the court found that
twelve short-term loans from CFC really functioned as a long-term loan lasting over two years)).