Codification of the economic substance doctrine by the Health Care and Education Reconciliation Act of 2010 has produced a palpable level of anxiety among many tax practitioners over how the new law will be applied to a variety of tax strategies.
Ironically, the prediction that codifying economic substance would "clarify and enhance" its application may prove premature, at least until the Treasury and the Internal Revenue Service can rein in some of the uncertainties created under the new law.
NEW CODE SECTION 7701(O)
The common law economic substance doctrine provides that the tax benefits of a transaction are not allowed if the transaction does not have economic substance or lacks a business purpose. Application of that doctrine has now been codified in Code Section 7701(o), "Clarification of Economic Substance Doctrine." New Code Section 7701(o)(1) requires that, "In the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if (A) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer's economic position, and (B) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into such transaction."
This codified standard clarifies that the economic substance doctrine involves a conjunctive analysis that requires inspection of the objective effects of the transaction on the taxpayer's economic position, as well as the taxpayer's subjective motives for engaging in the transaction. By requiring a two-prong test, the new law eliminates the split among the federal circuit courts concerning application of the doctrine ... and does so decidedly in the IRS's favor.
New Code Section 7701(o), among its other provisions, further provides a special rule under which taxpayers showing profit potential to satisfy the requirements of (A) and (B) must show a "substantial" profit exclusive of tax benefits. It also exempts from the economic substance requirements personal transactions by individuals (but not their business or investment dealings).
Finally, the new law assures taxpayers that the determination of whether the economic substance doctrine is "relevant" for purposes of triggering the Code Section 7701(o)(1) (A) "meaningful change" and (B) "substantial purpose" tests will be made "in the same manner as if this subsection had never been enacted."
The Joint Committee on Taxation elaborated on this "doctrine-as-usual" provision. In its JCX-18-10 report, it explained that, while codification of the economic substance doctrine is designed to provide a uniform definition for all cases to which it applies, it is not designed to alter the flexibility of the courts in other respects.
It further explained that those "other respects" include a court's ability to aggregate, disaggregate or otherwise recharacterize a transaction when applying the doctrine. The freedom given to courts under the codification may in fact thwart Congress' goal of having a unified application of the economic substance doctrine nationwide.
* Future course: The language in new Code Sec. 7701(o) raises a host of definitional issues. What standards are used to determine whether the economic substance doctrine is "relevant" to a transaction? What measurements are appropriate to compare the benefits from pre-tax profits to net tax benefits? What constitutes change in a "meaningful way?" When is a purpose "substantial?" When is expected pre-tax profit "substantial in relation to the present value of the expected net tax benefits?" What breadth did Congress intend to give to Code Sec. 7701(o)(5), which explains that, "The term 'transaction' includes a series of transactions?"
NEW PENALTY REGIME
Under new Code Sec. 6662(b)(6), a 20 percent penalty will be imposed for an underpayment attributable to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance, as defined in new Code Section 7701(o), or failing to meet the requirements of any similar rule of law. Under new Code Sec. 6662(i)(1), the penalty is increased to 40 percent for an underpayment attributable to a "non-disclosed non-economic substance transaction." A "non-disclosed non-economic substance transaction" is defined as any portion of a transaction lacking economic substance with respect to which the relevant facts affecting the tax treatment are not adequately disclosed in the return or in a statement attached to the return.
The kicker to the new economic substance penalty, of course, is that it is a strict-liability penalty. No exceptions, including the reasonable-cause exception, are available to the imposition of the penalty for any underpayment, or reportable transaction understatement, attributable to a transaction lacking economic substance. Outside opinions or in-house analysis will not, therefore, protect a taxpayer from imposition of a penalty if it is determined that the transaction lacks economic substance or fails to meet the requirements of any similar rule of law.
Further, there are no second chances. The determination of whether a position is a non-disclosed non-economic substance transaction will generally be based on the return as originally filed or as amended by the taxpayer prior to being contacted by the IRS (or at such other date that "the Treasury Secretary may specify").
* Future course: One prediction for the new strict-liability 40 percent penalty is that courts will be more willing to see some economic substance in situations in which relatively hapless taxpayers face a 40 percent penalty because of good-faith reliance on their advisors. Another prediction is that the IRS may be flooded with protective disclosures. Those disclosures will tend to overwhelm existing agency resources that, in turn, will give cover to those disclosures otherwise worth a closer look by the government. Another view is that those likely to be subject to the 40 percent penalty will decide to play the all-or-nothing audit lottery and not place any spotlight on the transaction through disclosure.
The legislative history, but not the statute itself, took pains to emphasize that Code Section 7701(o) and its penalty enforcement mechanism were "not intended to alter the tax treatment of certain basic business transactions that, under long-standing judicial and administration practice, are respected, merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages."
The committee report followed that observation with a non-exclusive "angel list" of basic transactions that will not trigger use of the economic substance doctrine, including: debt or equity capitalization; choice of a foreign or domestic corporation to make a foreign investment; decisions regarding corporation organization or re-organization; and use of related parties compliant with Section 382.
Needless to say, practitioners are putting pressure on the Treasury and the IRS to expand the angel list and to place it into regulations in order to carry the force of law. Also of concern within the present angel list are questions over whether certain optional steps taken within the "basis business transactions" described in the committee reports are also protected.
The need for guidance is immediate. Both codification and its accompanying penalty regime became effective for transactions entered into after March 30, 2010. Not surprisingly, even the effective date itself carries its own issue: There is concern over how broadly the term "transaction" will be interpreted for purposes of the effective date, especially if a post-March 30 transaction that claimed the tax benefit is part of a comprehensive, multi-step business plan that began prior to the effective date.
A host of issues need to be addressed. The ball is now in the IRS's court, to release guidance that either broadens or narrows the reach of new Code Section 7701(o), and to make certain that whatever guidelines are issued are consistently followed by IRS agents.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.
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