Research On The Application Of Economic Substance Doctrine

Tax avoidance is a kind of activity which takes advantage of the loophole in tax laws and regulations. It doesn’t violate the literal meaning of tax laws and regulations but is against the intent of legislature. So it is impossible to prevent tax avoidance by strictly implementing the literal meaning of tax laws and regulations. The authorities have to resort to some obscure terms in tax laws. The general anti-avoidance rule (GAAR) in China’s tax laws is a type of such obscure terms. It entitles the tax authorities some discretion to deal with tax avoidance activities. However, infinite discretion wiil result in too much uncertainty in dealing with tax avoidance cases. The same case may be decided differently if it is presented to different officers in tax authorities. Thus, in my opinion, there should be more concrete standards when implementing the GAAR, which will restrict the discretion of tax authorities. In order to sort out the concrete standards, the author has done some detailed research in American case laws in the field of tax avoidance. Although there is no GAAR in the U.S. tax laws, the economic substance doctrine actually plays the role of GAAR in anti-avoidance activities. So a study in American case laws and the economic substance doctrine is helpful for China’s anti-avoidance practice.The job of judges when dealing with tax avoidance cases can be divided into two parts. Firstly, the judge needs to make judgments about whether the transactions in the case are tax avoidance activities. Secondly, the judge needs to re-characterize the transactions and their tax treatment if they are identified as tax avoidance transactions. This paper will focus on the first part. The majority of the U.S. courts of appeals will identify a transaction as a tax avoidance activity if it lacks reasonable business purpose or economic substance. Actually, there is not much difference in the concept of reasonable business purpose and economic substance. So in this paper, we will only consider if a transaction has economic substance. If it lacks economic substance, it will be identified as tax avoidance activities. Transactions with economic substance are those with reasonable prospect of significant non-tax profit. And the author will further discuss three related questions about whether a transaction is with a reasonable prospect of significant non-tax profit. Firstly, how to ascertain if a transaction is with a prospect of profit, from evidence about the motive, transaction process or results? Secondly, to what extent should the quantity of non-tax profit be in order to be regarded as significant non-tax profit? Thirdly, how should the authorities react in the situation where taxpayers successfully avoid the application of economic substance doctrine?By analyzing the case laws in the field of tax avoidance, the author has summarized three conclusions about the concrete standards in applying economic substance doctrine. Firstly, the evidence about the motive of the transaction is the primary factor in considering whether a transaction is with a reasonable prospect of non-tax profit. Secondly, a transaction shall not be treated as having economic substance by reason of having a potential for profit unless-(I) the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected, and (Ⅱ) the reasonably expected pre-tax profit from the transaction exceeds a risk-free rate of return. Thirdly, in the situation where taxpayers successfully avoid the application of economic substance doctrine by exploit some loopholes in tax laws and regulations, courts of appeals will not regard these transactions as tax avoidance activities but the Congress will amend the loopholes to prevent similar tax avoidance transactions thereafter. The author suggests China’s tax authorities and courts employing those concrete standards and introducing case laws in their anti-avoidance practice.