When Supreme Court Chief Justice John Roberts cast the deciding vote to uphold the constitutionality of the Affordable Care Act, he justified his decision by applying the legal principle of substance over form.
Substance over form? It is a principle that is commonly accepted as a theoretical concept, but one that is not always followed in practice. Many of the loopholes that are enshrined in American tax legislation, in fact, actually embrace form over substance.
Nevertheless, Justice Roberts relied on the principle in order to affirm the Court’s acceptance of the Act. Thus, before deciding whether to agree with his decision, it may be helpful to assess whether it was appropriate for him to apply the principle.
Gifts vs. Wages
The definition of the theory of substance over form is a simple one; namely, government officials should focus on a transaction’s underlying economic reality, as opposed to its superficial legal structure, when establishing its regulatory practices.
For instance, let’s consider an employee who earns $1,000 per week by providing services to an employer. Can the parties avoid paying payroll taxes by structuring each weekly payment as a “thank you” gift instead of a wage?
Of course not; the federal government would never allow them to do so. Even if a legal contract is structured in a manner that superficially refers to such payments as “gifts,” the economic substance of each payment would nevertheless represent a wage for tax purposes.
In other words, the tax burden would be determined by the transaction’s substance and not its form.
Double Irish and Dutch Sandwiches
On the other hand, in practice, many American corporations exploit loopholes that emphasize legal form over economic substance.
Consider, for instance, the issue of royalty payments. If a company must pay royalties to another firm, those payments would represent tax deductions to the company and taxable revenue to the other firm. If the company owned its own patents, though, it would not be required to pay royalty payments to itself.
But let’s assume that a company that owns its patents creates a wholly owned subsidiary in a tax jurisdiction with no (i.e. a zero percent) corporate income tax. Let’s also assume that it transfers ownership of the patents to the subsidiary, which then charges royalty payments to the parent company. The corporate parent would enjoy the benefit of treating the payments as tax deductions. Of course, the subsidiary would need to declare the royalty income in its own tax jurisdiction, but it would not pay any taxes on that income if its tax rate is zero!
Most companies have no economic need to make payments to wholly owned subsidiaries. And yet many have created complex royalty strategies, such as Apple’s infamous Double Irish with a Dutch Sandwich, that emphasize form over substance.
Penalties vs. Taxes
How can we apply the concept of substance over form to the Affordable Care Act? Well, by 2016, all Americans will be required to purchase health insurance policies, and will be required to pay fiscal penalties of 2.5% of taxable income if they fail to do so.
President Obama, having promised during the election campaign to avoid raising taxes on middle class Americans, has insisted that the penalties should not be considered taxes. Thus, the Act itself refers to these payments as “penalties” or “fines” and not as higher taxes. In other words, the U.S. Congress has structured the “penalties” in a manner that avoids the legal structure of “taxes.”
And yet Justice Roberts clearly considers the economic substance of the payments to be more relevant than the legal form. After all, he reasoned, any citizen who purchases insurance will enjoy a lower tax burden than one who opts to pay the penalty.
So he concluded that the Act’s penalty provision simply represents a tax break to subsidize the cost of procuring health insurance policies. Like the home mortgage interest deduction and the higher education tuition deduction, Roberts decided that the economic substance of the law deserved to be treated as a matter of taxation policy.
The Cain Train!
Now that Justice Roberts has struck a blow in support of economic substance over form, will the Court reconsider the legality of tax loopholes? Will the justices prohibit such byzantine corporate structures?
The American public, after all, continues to support proposals for eliminating tax deductions and instituting “flat taxes” in place of the current system of taxation. Radio talk show host Herman Cain, for instance, briefly became the Republican Party front-runner for President of the United States on the strength of his 9-9-9 flat tax proposal.
As long as corporate lobbying activities promote the development of new loopholes, it is difficult to foresee their eventual elimination. Nevertheless, if you believe that economic substance should outweigh legal form in matters involving taxation, you may agree with the decision made by Justice Roberts regarding the Affordable Care Act.