In Patel v. Commissioner, the United States Tax Court held on November 12, 2025, that the economic substance doctrine, as codified by § 7701(o) of the Internal Revenue Code, requires a relevancy requirement, noting that “Congress could hardly have been clearer.” The court also provided exposition as to the standards required by the two-part test under the economic substance doctrine. The entire court reviewed the case and agreed unanimously with the decision.
Section 7701(o) codifies a caselaw-based test, whereby a transaction is treated as having economic substance only if it satisfies both prongs. Under the objective test, the transaction must meaningfully change the taxpayer’s economic position apart from federal income tax effects. And under the subjective test, the taxpayer must have a substantial non-tax purpose for entering into the transaction.
In Patel, the taxpayer entered into a captive insurance arrangement, which purported to reinsure a portion of the taxpayer’s risk. The court analyzed the IRS’s application of § 7701(o) to the taxpayer’s transaction. The analysis included the threshold relevancy requirement and the objective and subjective tests in § 7701(o).
At issue was whether there was a threshold relevancy requirement for even applying the economic substance test, based on the statute’s requirement that “[t]he determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection had never been enacted.” Although the district court case Liberty Global is unclear on the subject, the Tax Court “easily” concluded that the statute requires a relevancy determination as “the statute says so, right there, on its face.” It also concluded that the relevancy requirement is not coextensive with the two-part test (the subjective and objective tests).
The court’s approach to statutory interpretation offers additional insight into how the Tax Court may evaluate regulatory challenges in the wake of Loper Bright. In rendering its interpretation, the court started with the text of the statute applying the typical canon of statutory construction; giving effect, if possible, to every clause and word of a statute. Then the court checked its interpretation for consistency with legislative history.
Interestingly, the court discussed the concept of “congressional inducement;” whereby if Congress incentivizes a particular action or transaction, then the economic substance doctrine is irrelevant. Although the court concluded that this did not apply in this case, it leaves open the door for these arguments as a possible avenue for taxpayers to argue relevance.
In determining relevance, the court looked at whether prior case law applied the economic substance doctrine in similar circumstances. The court observed a number of economic substance cases involving captive insurance transactions and found that the economic substance doctrine has been applied to test whether the captive is a sham corporation that is not created for a legitimate business purpose.
After finding the relevance requirement satisfied, the court applied the objective and subjective tests of section 7701(o). The court’s application of the objective and subjective tests is straightforward. The court found that the transaction failed both the objective and subjective tests. The court explained that the objective test looks plainly to a change in economic position, whereby “real dollars” meaningfully changed hands in the transaction. The court focused on the circular flow of funds such that the money paid was returned in determining that the taxpayer failed the objective test.
According to the court (though addressed only in dicta) the subjective test looks simply to whether there is a substantial purpose apart from federal income tax effects. In analyzing the subjective test, the court concentrated on a number of facts:
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