The Sham Transaction Doctrine
“Sham transactions” are either “shams in fact” or “shams in
substance.” A sham in fact is a transaction where the economic activity purportedly
giving rise to the desired tax benefit took place on paper, but in reality
never occurred. Transactions may also be
deemed shams in fact if clearly “performed in violation of some background
assumptions of commercial dealing, for example arms-length dealing at fair
market values.” For these reasons, a
transaction deemed a sham in fact would result in the disallowance of any tax
benefits intended to be derived from the transaction. Shams in substance, on
the other hand, are transactions that actually occurred, but which are devoid
of economic substance beyond the creation of the intended tax benefits. A sham in substance is potentially more difficult
to identify than a sham in fact, therefore this discussion primarily focuses on
shams in substance. An example of a sham in substance is a transaction entered
into by a taxpayer to produce a loss, but where the risk of loss is artificial
due to a third party guarantee eliminating the risk. Under such circumstances any loss deduction
would likely be disallowed as an impermissible sham in substance.