Copyright © 1998 Robert L. Sommers, all rights reserved.
The following judicial doctrines have been developed by the courts to analyze the economic substance of a transaction and then determine its tax consequences.
Unfortunately, the terms "tax evasion" and "tax avoidance" are often used interchangeably.
Tax evasion involves fraudulent or criminal behavior, conduct involving deception, concealment, or destruction of records.
Tax avoidance generally denotes non-criminal modes of conduct by the taxpayer which minimize or avoid tax liability, but that he is prepared to disclose fully to the IRS. If a transaction does not establish a tax liability in the first place, the taxpayer’s motive to avoid tax is irrelevant.
The classic description of tax avoidance was written by Judge Learned Hand in Helvering v. Gregory, 69 F. 2d 809, 810 (2nd Cir, 1934), aff’d 293 U.S. 465 (1935).
[A] transaction, otherwise within an exception of the tax law, does not lose its immunity, because it is actuated by a desire to avoid, or, if one choose, to evade, taxation. Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; here is not even a patriotic duty to increase one’s taxes.
In contrast, tax evasion occurs when the taxpayer fraudulently or criminally avoids the payment of taxes otherwise due and owing under the tax laws. There are many tax crimes under the Internal Revenue Code. In that regard, in Spies v. U.S. 317 U.S. 492, 497 (1943) the Supreme Court observed:
…singly or in combination [in income tax crimes] were calculated [by Congress] to induce prompt and forthright fulfillment of every duty under the income tax law and to provide a penalty suitable to every degree of delinquency.
The criminal violations cover the same territory as the civil fraud penalties, although the government has a higher burden of proof in the criminal cases. The criminal cases, however, reach a far greater spectrum of potential defendants. Unlike the civil penalties which target only the taxpayer, the criminal penalties reach anyone engaging in the defined offense, including employees, accountants, lawyers and tax preparers. For example, in Tinkoff v. U.S., 86 F. 2d 868 (7th Cir., 1936), an accountant who prepared fraudulent returns for clients was convicted of tax evasion.
Under IRC Sec. 7206(2), a person is guilty of a crime if he willfully:
aids or assists in or procures, counsels, or advises the preparation or presentation … of a return, affidavit, claim or other document, which is fraudulent or is false as to any material matter, whether or not such falsity or fraud is with the knowledge or consent of the person authorized or required to present such return, affidavit, claim or documents.
In applying the income tax laws, with few exceptions, the substance of the transaction, rather than its form, determines the tax consequences. U.S. v. Phellis, 257 U.S. 156, 168 (1921); Weinert’s Est. v. CIR, 294 F. 2d 750, 755 (5th Cir. 1961).
The "form" of a transaction is generally the label the parties attach to their arrangement; for instance, they might call an arrangement a compensation agreement, a loan, a lease or a sale. There might be documents that support the form, but the courts are not concerned with these labels or documents that purport to govern the transaction — the courts focus on the substance of the transaction, regardless of the labels used by the parties.
According to Bittker and Lokken, Federal Taxation of Income, Estates and Gifts, 2 Ed. (Hereafter "Bittker and Lokken"), the substance over form analysis is often used to dissect transactions between related parties, including loans to family members and transactions between related corporations and their shareholders:
The substance-over-form doctrine is invoked by the government with greatest success with respect to transactions between related persons, since in these circumstances the form used often has minimal, if any non-tax consequences and is often chosen solely to reduce taxes. Id. at 4-36.
Loans to members of the lender’s family are also grist for the substance-over form mill…The same can be said of loans by controlling shareholders to their own corporations and, conversely, of loans by their corporations to them, especially if the advances are proportionate to stock ownership. Id. at 4-37.
Transactions between parent and subsidiary corporations and among other members of an affiliated corporate group provide another set of tempting targets for legislative, administrative, and judicial marksmen armed with the substance-over-form weapon. Id. at 4-37.
Related party transactions provide fertile territory for self-dealing and the form of the transaction is often secondary to achieving a tax result. In contrast, arm’s length transactions with independent third parties are far less vulnerable to substance over form attack. Independent third parties usually express their transaction in writing and are concerned about the non-tax ramifications of the transactions; consequently, the form of the transaction usually embodies the actual substance as well.
The sham transaction concept embodies two separate theories:
A sham in substance occurs when the taxpayer draws up papers to characterize a transaction contrary to the objective economic realities and which have no economic significance beyond the expected tax benefits. Falsetti v. Cm, 85, TC 332 (1985).
A transaction is considered a sham in substance if it effects no real change in each party’s economic position. For example, a sale that fails to transfer beneficial ownership of property — in which the payments circulate among various parties in ways that cancel themselves out — would be considered a sham in substance.
In Rice’s Toyota World, Inc. v. Cm. 752 F. 2d 89, 91 (4th Cir, 1985), the Court of Appeals described the sham-in-substance rule as follows:
To treat a transaction as a sham, the court must find that the taxpayer was motivated by no business purpose other than obtaining tax benefits in entering the transaction, and that the transaction has no economic substance because no reasonable possibility of profits exists.
In Jacobson v. CM, 915 F. 2d 832 (2nd Cir, 1990), the Court of Appeals confirmed the Tax Court’s description of the sham transaction doctrine:
The Tax Court summarized the sham doctrine as follows:
Transactions that are entered into solely for the purpose of obtaining tax benefits and that are without economic substance are considered shams for Federal income tax purposes and purported indebtedness associated therewith will not be recognized…. [A] sham transaction [is] a transaction that is lacking in objective economic reality and that has no economic significance beyond expected tax benefits.
In deciding whether transactions lack economic substance, we consider such factors as the lack of arm’s-length negotiations, inflated purchase prices, the structure of the financing of the transactions, and the degree of adherence to contractual terms.
Courts will not recognize a transaction that lacks any business or corporate purpose, but is a mere device for dodging the taxpayer’s taxes. Helvering v. Gregory, 69 F. 2d 809, 811 (2d Cir. 1934); Gregory v. Helvering, 293 U.S. 465, 469 (1935); CIR v. Transport Trading & Terminal Corp., 176 F. 2d 570, 572 (2d Cir. 1949), cert. Denied, 338 U.S. 955 (1950).
In Helvering v Gregory, the taxpayer, a sole shareholder, wanted to receive marketable securities from her corporation, but a direct distribution would have constituted a dividend (taxed as ordinary income) to her.
The taxpayer formed another corporation, transferred the marketable securities to the new corporation, then promptly liquidated the new corporation, receiving the marketable securities in the process as a liquidating distribution of property from the newly-formed corporation (thus receiving favorable capital gains treatment on the liquidation). The transaction literally conformed to the liquidating distribution provisions of the tax code. In other words, instead of receiving a dividend of marketable securities from her original corporation, she received the same securities tax-free by forming a second corporation, transferring the securities to that corporation, then liquidating the second corporation.
The Supreme Court decided that the transaction lacked any business purpose and violated the tax laws, notwithstanding the fact that it literally complied with the liquidation provisions:
Putting aside … the question of motive in respect of taxation altogether, and fixing the character of the proceeding by what actually occurred, what do we find? Simply an operation having no business or corporate purpose — a mere device which put on the form of a corporate reorganization as a disguise for concealing its real character, and the sole object and accomplishment of which was the consummation of the preconceived plan, not to reorganize a business or any part of a business, but to transfer a parcel of corporate shares to the petitioner [taxpayer].
Judge Learned Hand, in Cm v. Transport Trading & Terminal Corp., 176 F. 2d 570, 572 (2nd Cir, 1949), cert. denied, 338 U.S. 955 (1950) summarized the business purpose doctrine as follows:
The doctrine of Gregory v. Helvering … means that in construing words of a tax statute which describes commercial or industrial transactions we are to understand them to refer to transactions entered upon for commercial or industrial purposes and not to include transactions entered upon for no other motive but to escape taxation.
The step transaction doctrine, especially pronounced in the corporate-shareholder area, requires that interrelated steps of a transaction may be analyzed as a whole if they in substance are interdependent and focused on a particular end result. Bittker and Lokken at 4-47 states the rule as follows:
If the parties have agreed to a series of steps, no one of which will be legally effective unless all are consummated, application of the doctrine is ordinarily assured.
In Manhattan Bldg. Co. v. CIR, 27 TC 1032, 1042 (1957), citing American Bantam Car Co. v. CIR, 11 TC 397 (1948), aff’d per curium,, 177 F. 2d 513 (3d Cir. 1949), cert. denied, 339 U.S. 920 (1950), the court stated the step transaction doctrine as follows:
The test is, were the steps taken so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series?
The Supreme Court, in Minnesota Tea Co. v. Helvering, 302 U.S. 609, 613 (1938), observed that:
A given result at the end of a straight path is not made a different result because reached by following a devious path.
When the step transaction doctrine is used to eliminate transitory steps, it overlaps with the business purpose doctrine (the step is disregarded because lacking in business purpose) and the substance-over-form principle (the step is disregarded as a formality that obscures the substance of the transaction).
The "assignment of income" doctrine states that income is taxed to the one who earns it — a taxpayer cannot avoid tax by assigning his income to another party or entity. Gross income derived from property must be included in the income of the person who beneficially owns it. Blair v. Cm., 300 U.S. 5 (1937); Lucas v. Earl, 281 U.S. 111 (1930). The assignment of income doctrine is judicial in its origin and adds to IRC Sec. 61 (the definition of gross income) an implicit requirement that gross income must be included in the return of the appropriate taxpayer.
A corporation is acting as an agent of its shareholder when a taxpayer’s income is assigned to the corporation, unless the corporation conducts substantial business activities. Cm v. State-Adams Corp, 283 F. 2d 395 (2nd Cir, 1960), cert denied, 365 U.S. 844 (1961). In Parish-Watson & Co. v. Cm, 2 BTA 851 (1925), the court held that income from property held by a corporation as agent of its sole shareholder was included in the shareholder’s gross income.
This doctrine becomes relevant when a taxpayer attempts to deflect income to another entity, such as by assigning an installment obligation or compensation earned by him, to his wholly-owned corporation.
The courts have often found a constructive dividend when a corporation transfers money or other property, without an expectation of reimbursement, to or for the benefit of one or more of its shareholders, and the transaction is not characterized or reported as a dividend. The transfer must be made with respect to the corporation’s stock. It is not necessary that either the corporation or the shareholder intend a dividend distribution for constructive dividend treatment to result. Crosby v. U.S., 496 F. 2d 1384 (5th Cir, 1974). Actually, in almost every case, the constructive dividend was improperly characterized as a loan, business expense or consideration for the purchase of an asset.
The basic inquiry regarding the true nature of the corporate transfer is whether there is an actual loan, business expense or asset purchase to support the transfer to the shareholder. A transfer to a shareholder from the corporation for a purpose other than to satisfy its corporate obligations or to acquire a corporate asset is usually a dividend. For example, in King’s Court Mobile Home v. Cm, 98 TC 511 (1992) funds diverted by the shareholder were constructive dividends, not wages, when the transfer was characterized as wages long after the diversion occurred and there was no evidence that the purported compensation was reasonable in amount.
To be characterized as a constructive dividend, the distribution or transfer by the corporation must also primarily benefit the shareholder. Loftin & Woodward v. U.S., 577 F. 2d 1206 (5th Cir. 1978). The benefit may be conveyed through a distribution by a corporation to a third party for the benefit of a shareholder, to satisfy the shareholder’s purpose, or through a distribution of corporate earnings or assets for the private purpose of the shareholder. Dean v. Cm, 57 TC 32 (1971); Sparks Nugget, Inc. v. Cm, TC Memo 1970-74, affirmed, 458 F. 2d 631 (9th Cir, 1972).
In cases where there are distributions to the controlling shareholder, the IRS usually issues a Notice of Deficiency, treating the distributions as constructive dividends. Given the IRS’s presumption of correctness in most cases, the burden of proof usually falls to the taxpayer to show by a preponderance of the evidence that the distribution was made in connection with a valid corporate purpose.
Under IRC Sec. 301 (c) (3) and 316 (a), dividends are taxable to the shareholders as ordinary income to the extent of the earnings and profits of the corporation, and any amount received in excess is considered as a nontaxable return of capital to the shareholder’s basis in the stock. Any amount received in excess of the corporation’s earnings and profits and the shareholder’s basis in his stock is considered gain from the sale or exchange of property (usually capital gain). Truesdell v. CM, 89 TC 1280 (1987).
In DiZenzo v. Cm, 348 F. 2d 122, 127 (2nd Cir, 1965), reversing in part and remanding TC Memo 1964-121, the court held that the burden of proof is generally on "taxpayers to establish that the corporation did NOT have earnings and profits equal to the funds diverted" with respect to deficiencies (emphasis in original). Taxpayers must then establish that the corporation did not have earnings or profits; otherwise, distributions to shareholders will be considered dividends and taxed as ordinary income. DeLeo v. CM, 96 TC 42 (1991).
In U.S. v. Mews, 91-1 U.S.TC Para. 50,044 (7th Cir, 1991), Judge Richard Posner summarized the law regarding constructive dividends:
By "constructive dividend" the law means simply a corporate disbursement that is a dividend in the contemplation of law though not called such by the corporation making the disbursement… Every disbursement that is not an expenditure for the corporation’s benefit — that is not a purchase, a loan … the repayment of a debt, an ordinary and necessary business expense, etc. — must be a dividend, for if it does not benefit the corporation it must benefit the shareholders. It need not be paid to the shareholders any more than it need be called a dividend. Just as you cannot escape income tax by assigning the right to receive your income to somebody else … so a shareholder cannot, by directing his corporation to pay to X rather than to himself what corporation law deems a dividend to him, avoid having to report it as income.
In Mews, the court found that intercorporate transfers:
…were not disbursements made in pursuit of corporate goals or opportunities or pursuant to corporate duties. So they had to be dividends. The fact that Mews [the taxpayer], the one and only shareholder, did not put the monies in his pocket but instead had them paid directly to a legal fiction [another corporation] wholly owned by himself did not change their character as dividends.
Under IRC Sec. 482, the IRS may reallocate income, deductions, allowances, or credits among two or more U.S. or foreign businesses that are controlled or owned by the same interests. The term "controlled" includes direct or indirect control, whether or not legally enforceable and however exercisable. Commonly controlled taxpayers include parents and their subsidiaries that are ultimately controlled by the same interests as well as brother-sister corporations directly controlled by their parent. Control can be found in the family setting when a child runs a company, but his parent is the one in actual control, since the definition of control is not limited to legally enforceable control.
IRC Sec. 482 places a controlled taxpayer in an equal position with an uncontrolled taxpayer, by determining the true taxable income from the property and business of a controlled taxpayer. It uses the standard of an uncontrolled taxpayer dealing at arm's length with another uncontrolled taxpayer. Those who command a group of controlled taxpayers are assumed to have complete power to cause each taxpayer to reflect the actual taxable income from its property and business.
If an individual taxpayer and a controlled corporation are recognized as separate entities, Reg. §1.482-1(i)(2) states that the individual’s employment for compensation constitutes a separate trade or business from the employer company. In such cases, the IRS has the power to make reallocations without obtaining proof of a tax-avoidance motive on the taxpayer’s part.
The IRS's authority to determine true taxable income extends to any case in which the taxable income of a controlled taxpayer is different than it would have been if the taxpayer had been dealing at arm's length with an uncontrolled taxpayer (Reg. §1.482-1(f)(1)). The IRS need not show an intent to evade or avoid taxes.
Under IRC Sec. 6038A and 6038C, foreign corporations which are engaged in a trade or business in the U.S. must file annual information returns, listing any 25% foreign shareholders. This requirement includes any direct 25% foreign shareholders and ultimate indirect 25% foreign shareholders, such as individual shareholders. The form used to report this information is Form 5472.
Revenue Procedure 91-55, 1991-2 CB 784 illustrates the reporting requirements for a direct 25% foreign shareholder and an ultimate indirect 25% foreign shareholder. In the example, two individuals own 100% of a Swiss holding company (Sh 1 owns 80% and Sh 2 owns 20%). The Swiss corporation owns 100% of an Italian corporation which, in turn, owns 100% of a U.S. corporation. Both the Italian corporation and Sh 1 must be identified on the Form 5472 since the Italian corporation is a direct 25% foreign shareholder and Sh1 is the ultimate indirect 25% shareholder.
Even if there was some compensation for services involved, any payments over the amount considered "reasonable compensation" under IRC Sec. 162(a) would have been treated as a constructive dividend. The regulations state that reasonable compensation is made with reference to the fair market value of similar services performed. IRC Reg. 1.162-7(a) states:
(a) There may be included among the ordinary and necessary expenses paid or incurred in carrying on any trade or business a reasonable allowance for salaries or other compensation for personal services actually rendered. The test of deductibility in the case of compensation payments is whether they are reasonable and are in fact payments purely for services. [emphasis added]
IRC Reg. 1.162-2(a)(3) states:
(3) In any event the allowance for the compensation paid may not exceed what is reasonable under all the circumstances. It is, in general, just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances. The circumstances to be taken into consideration are those existing at the date when the contract for services was made, not those existing at the date when the contract is questioned. [emphasis added]
IRC Sec. 862(a)(3) states that compensation for personal services performed outside the U.S. by a non-resident alien is foreign-source income and is not taxable by the U.S. IRC Sec. 862(a)(3), however, has never been applied to allow a non-resident shareholder of a U.S. corporation to bail-out corporate earnings through a compensation agreement. The typical case under this section permits foreign employees (who are not owners of their companies) who work part of the year in the U.S. to exclude the work performed outside the country.
In P. Stemkowski, 82-2 USTC Para. 9589 (2nd Cir, 1982) the court apportioned the salary of a Canadian hockey player, who worked under a one-year contract with a club located in the United States, to sources within and without the United States on the basis of the number of days in the regular season of play plus the number of days spent in training camp and the number of days spent in the playoffs. In Stemkowski, taxpayer worked for a U.S. company and had no control over the number of days he worked in the U.S. and Canada. Also, Stemkowski did not involve the payment of earnings from a corporation he controlled, it was a straight employment situation.
Under IRC Sec. 864(b), a taxpayer who performs personal services at any time within the U.S. is engaged in a trade or business in the U.S. IRC Reg. 1.864-2(a). The income generated from these services is generally treated as income effectively connected with a trade or business within the U.S. under IRC Sec. 864(c)(2) or IRC Sec 864(c)(6). Thus, a foreign taxpayer engaged in personal services is taxed at regular rates and is entitled to deduct applicable expenses.
Foreign taxpayers do not have to engage in much activity within the U.S. to be considered engaged in a trade or business. In Johansson v. U.S. , 336 F. 2d 809 (5th Cir, 1964), Johansson (formerly world heavy-weight boxing champion) was engaged in a trade or business when he fought in 3 fights over a 2-year period. In Ingram v. Bowers, 57 F. 2d 65 (2nd Cir, 1932), an opera singer who recorded music in the U.S. was held to be engaged in a trade or business.
Under IRC Sec. 864(c)(3), if a foreign person is engaged in a trade or business at any time during a taxable year, all the foreign person’s U.S.-source income is treated as effectively connected with a U.S. trade or business. This would include all payments for compensation received for those personal services which are effectively connected income. IRC Reg. 1.864-4(c)(6)(ii). Also, under the business activities test, such services would be treated as effectively connected income (i.e. the trade or business of performing services in the U.S.), and would be considered a material factor in the realization of that income.
Any gains or losses from the sale or exchange of capital assets which are directly related to the taxpayer’s trade or business are considered effectively connected to the trade or business. For example, a transfer of stock in a U.S. corporation to ensure the performance of personal service renders all dividends, gains and losses from that stock as effectively connected income, gain or loss. IRC Reg. 1.864-4(c)(6)(i).
If a taxpayer is engaged in a trade or business at any time during the year, IRC Sec 864(c)(3) applies to treat all U.S.- source income, other than income under IRC Sec. 871(a)(1) (generally, rents, interest, dividends and compensation from non-U.S. sources), portfolio interest and capital gains as effectively connected income, even if the taxpayer realizes the income at a time before he began the business or after he ceased to do business in the U.S.
In WC Johnson, 25 TC 920 (1955), a Canadian citizen and resident was treated as engaged in a U.S. trade or business by virtue of being a partner of a partnership that made an oral agreement with another partnership regarding a U.S. cattle business. Since the Canadian partnership, through its agreement, was engaged in a U.S. trade or business through a fixed place of business, Mr. Johnson, as a partner of the Canadian partnership, was also engaged in a U.S. trade or business.
Persons who are not residents of a foreign country cannot take advantage of that country’s tax treaties directly; therefore, taxpayers have formed corporations in the treaty country in an attempt to come within its favorable treaty provisions. This a called "treaty shopping" and is a major concern of the U.S. government, since the most favorable treaty countries encourage taxpayers to form companies within their jurisdictions to avoid taxation. Most of the treaty shopping cases involve "conduit financing," a scheme where a company interposes a corporation in a treaty country with favorable provisions on the taxation of interest payments, then routes the interest payments on loans through the conduit.
The leading case on treaty shopping is Aiken Industries, 56 TC 925 (1971). In Aiken Industries, a U.S. corporation ("U.S. Corp") borrowed money from its Bahamian parent corporation ("Foreign I") and signed several promissory notes. Foreign I then assigned the promissory notes to its newly formed Honduran subsidiary ("Foreign II") which collected the interest on the notes. Foreign II signed identical notes in favor of Foreign I for the assignment of U.S. Corp’s note. Foreign II conducted no business other than to collect interest on these notes. There was a double-tax treaty in effect between the U.S. and Honduras, and the U.S. Corp claimed an exemption from withholding on its interest payments under the treaty.
The Tax Court held that the treaty did not apply since the interest payments were not "received by" Foreign II and its role in the transaction could be disregarded. Receipt of funds under the treaty meant more than temporary physical possession; the recipient had to have complete dominion and control over the funds. The court stated that Foreign II lacked any business purpose except to take advantage of a treaty provision and there was a complete matching between the interest income it received and what it paid to Foreign I. Foreign II was merely a collection agent and conduit. Therefore, the funds paid by U.S. Corp were received directly by Foreign I without the intervention of the treaty.
In another treaty shopping case, Johansson v. U.S., 336 F. 2d 809 (5th Cir, 1964), Johansson, a Swedish citizen and former boxing heavy-weight champion, devised a plan to avoid being taxed in the U.S. He allegedly became a resident of Switzerland, formed a Switzerland corporation and then became employed by his Swiss company. He then claimed treaty benefits for commercial travelers under the U.S.-Swiss treaty (certain employees of Swiss corporations in the U.S. for less than 184 days were not taxed under this exception). The court held the tax plan was merely a device to divert personal income on a temporary basis, that Johansson was not really a Swiss resident and that his paper Swiss company did not really hire him as an employee. He was denied the benefits under the Swiss treaty.
In the area of treaty shopping with corporations acting as conduits to obtain favorable tax treatment on the payment of interest, the IRS has issued a series of revenue rulings. In Revenue Ruling 84-152, 1984-2 CB 381, the IRS held that a loan from a Swiss parent corporation to its U.S. subsidiary which was channeled through an Antilles subsidiary was a direct loan from the Swiss parent to the U.S. subsidiary. The Antilles company was disregarded as a mere conduit and the payments it received were not "derived by" it within the context of the Antilles treaty. The IRS stated the primary reason for involving the Antilles corporation was an attempt to receive reduced withholding under the treaty.
In Revenue Ruling 84-153, 1984-2 CB 383, a U.S. corporation formed an Antilles subsidiary which then issued bonds outside the U.S. and lent the proceeds to the U.S. parent. The IRS ruled the Antilles company to be a conduit for financing purposes only, and its primary purpose was to avoid the withholding requirements on interest paid by the U.S. corporation through the Antilles treaty.
Revenue Ruling 87-89, 1987-2 CB 195, held that a foreign corporation from a non-treaty country which deposited funds with a bank located in a treaty jurisdiction that exempted federal income tax on interest payments, which, in turn, lent the funds to the foreign corporation’s U.S. subsidiary, was a direct loan from the foreign parent to the U.S. subsidiary. The use of a bank to re-lend the funds was disregarded.
The Tax Court rejected a conduit financing scheme involving a U.S. corporation and its Netherlands Antilles subsidiary in Morgan Pacific Corp, TCM 1995-418 (1995). In this case, the U.S. corporation was required to withhold 30% on payments to its NA subsidiary, which then paid the funds to a foreign corporation. The taxpayer conceded that Aiken Industries applied and that the transfers were not exempt under the treaty, but contended that it merely made bookkeeping entries recorded in its corporate accounts and never actually "paid" interest to the subsidiary.
The taxpayer also claimed the foreign corporation had an equity interest in the taxpayer and the transfers were really non-taxable distributions in respect to stock, rather than payments of interest. The Tax Court rejected both these arguments and held interest was paid directly to the foreign corporation. The taxpayer was charged with negligence and failure to deposit penalties, in addition to the 30% withholding tax.
In 1995, The IRS released the "conduit financing" regulations in their final form under IRC Sec. 7701(l). These regulations are consistent with the prior case law and revenue rulings cited above. Congress indicated its approval of these revenue rulings in the legislative history by stating the rulings "appropriately ignore conduit entities and properly recharacterized the transactions described therein." S Prt 103-37, 103d Cong. 1st Sess 206 (Comm. Print. 1993).
Although "ignorance of the law is not an excuse," ignorance or mistake of law is a defense in support of which a defendant may produce evidence that the defendant lacked the requisite state of mind required in tax crimes. "An actual bona fide misconception of the law, regardless of the presumption that the taxpayer knows the law, will not result in criminal liability." Battjes v. United States, 172 F. 2d 1,4 (6th Cir. 1949). The Model Penal Code provides in Section 2.04: "Ignorance or mistake as to a matter of fact or law is a defense if - (a) the ignorance or mistake negatives the purpose, knowledge, belief, recklessness or negligence required to establish a material element of the offense." While most courts say that the defendant’s mistake need not be objectively reasonable, other courts authorize a "willful blindness" instruction that permits the jury to impute knowledge to the defendant if the jury finds, beyond a reasonable doubt, that the defendant deliberately closed his eyes to the obvious. United States v. MacKenzie, 777 F. 2d 811 (2d Cir. 1985).
When a defendant claims good faith reliance on, and a shift of responsibility to, the defendant’s counsel or tax adviser, the defense will fail if the defendant has withheld material facts from the adviser. United States v. McCormick. The prosecution need not show that the defendant ordered that the return be falsified. The prosecution’s response can be evidence that the defendant (1) was aware of the contents of the return and (2) knew that the reportable income significantly exceeded the amount reported on the return. United States v. Chesson, 933 F. 2d 298 (5th Cir. 1991). Further, to escape tax penalties, a taxpayer must show that the advisor reached his decision independently after being fully apprised of the facts. Leonard v. IRS, 414 F. 2d 749, 750 (5th Cir, 1969).
Full disclosure of the material facts to the adviser is an element of the defense. Therefore, reliance on the advice of the tax adviser will fail as a defense if the defendant has withheld material facts from the adviser. See U.S. v. McCormick, 67 F. 2d 867 (2nd Cir). In U.S. v. Raub, 177 F. 2d 312 (7th Cir, 1949) a taxpayer who failed to supply an accountant with all material information to prepare a return could not use the defense that he relied on his accountant’s advice.
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