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.