As part of the Health Care and Education Reconciliation Act of 2010 (the Act), U.S. Congress enacted into law new Internal Revenue Code (IRC) Section 7701(o), which provides for the codification of the “economic substance doctrine”. In addition, the health care reform legislation added stiff new penalties for transactions that are determined to lack economic substance. These new rules and penalties apply to transactions entered into after March 30, 2010, the date of enactment of the new law.
The “economic substance doctrine” is common law doctrine in the tax law of the United States under which transactions must have an economic purpose aside from the reduction of tax liability (i.e., tax benefits) in order to be considered valid. The U.S. courts have developed the doctrine over many years to enforce the statutory intent of Congress in cases where the literal reading of the requirements of the statutory or regulating authority of the tax law would allow a taxpayer to circumvent this intent. Thus, in situations where there is no substance to a transaction other than the creation of unintended tax benefits, the courts have applied the economic substance doctrine to deny those tax benefits to taxpayers.
In recent years, calls from the House and Senate for codification of the economic substance doctrine have resulted primarily from the rise in the use of sophisticated tax shelter programs that have targeted technical defects in the Internal Revenue Code and regulations to generate tax benefits for taxpayers, but did not appreciably benefit or increase a taxpayer’s economic position. Taxpayer use of these tax shelters has been viewed by the IRS and Congress to be abusive and an illegal effort to subvert the intent of Congress with respect to tax laws. The IRS’s primary and most successful weapon in fighting the use of these abusive tax shelters has been to deem that these tax shelters violate the common law economic substance doctrine.
Supporters of codification of the economic substance doctrine claim that, in addition to providing improved IRS enforcement against tax shelters, codifying the doctrine will result in greater clarity and uniformity in application of the tax law and will encourage more responsible tax planning by taxpayers, practitioners and promoters.
Although, generally, the U.S. courts agree on the definition and purpose of the doctrine, they have not agreed on a single test to determine whether a transaction has economic substance. Some courts apply a two-prong test to determine whether a transaction has economic substance. Under the two-prong test, a transaction has economic substance if: (1) the transaction, viewed objectively, has economic substance; and (2) the taxpayer has a subjective business purpose for the transaction. Some courts require that both elements be satisfied (referred to as the “conjunctive test”); others require that either one of the two elements be satisfied (the disjunctive test).
The newly enacted statute resolves the split among the U.S. Circuit Courts of Appeals by providing that the two-part economic substance standard will be applied on the conjunctive basis (and not disjunctive). Thus, a transaction subject to the economic substance standard must lead to a non-tax change in economic position, and the taxpayer must have a non-tax business purpose for entering the transaction.
Section 1409 of the Act adds new IRC Section 7701(o), titled Clarification of Economic Substance Doctrine, to provide that a transaction will only have economic substance if:
1) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position, and
2) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into such transaction.
Thus, as previously noted, the new codified standard adopts the two-prong “conjunctive” economic substance test and requires a taxpayer to satisfy both an objective and a subjective component for a transaction to be respected for tax purposes. In order to satisfy the objective component, a taxpayer must demonstrate that the transaction resulted in a meaningful and appreciable enhancement in the net economic position of the taxpayers (other than reduction in taxes). One measure of this component is a legitimate potential or a realistic possibility for a pre-tax profit. In order to satisfy the subjective component, a taxpayer must demonstrate that the taxpayer was motivated by the opportunity to profit from the transaction, or at least had a valid business reason for entering into the transaction other than tax savings (the business purpose test).
New IRC Section 7701(o) also provides that the profit potential of a transaction will be considered in applying the economic substance test, and a taxpayer will prevail only if the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected.
The Joint Committee on Taxation (JCT) explanation of the Act clarifies that a taxpayer is not required to use the profit potential test, and that if it does, there is no mandatory minimum return required. However, the lack of guidance as to what “substantial” may mean may result in more transactions falling within the scope of the economic substance codification, if such transactions result in significant federal income tax benefits.
The Act imposes harsh new strict liability penalty standards and increased penalties on transactions that fail the new economic substance test.
Specifically, the Act amends Section 6664(c) and (d) of the IRC to prohibit application of the “reasonable cause exception” to a substantial understatement penalty attributable to any transaction that fails the economic substance test. Thus, no exceptions are available for the imposition of the penalty for any underpayment or reportable transaction understatement.
In addition, by an amendment to IRC Section 6662, the understatement penalty increases from 20 percent to 40 percent to the extent the understatement is attributable to any portion of a transaction that lacks economic substance and is not adequately disclosed in a return or statement attached to the return. Lack of adequate disclosure in an original return cannot be cured by amendment or supplemental disclosure after notice of IRS examination of the relevant return or some other date the IRS might specify. Also, IRC Section 6676 is amended to hold that a claim for refund for an amount attributable to a transaction lacking economic substance will not be treated as having a reasonable basis and will therefore be subject to a 20 percent penalty on such amount.
The new law will have a significant effect on future tax planning as taxpayers sort out their potential exposure to the 20 and 40 percent strict liability penalties. Accordingly, the ultimate effect of the codification of the economic substance doctrine might be that risk-averse businesses will forgo bona fide business transactions where there is a risk of IRS challenge. Codification may be the IRS’s tool that discourages taxpayers from adopting aggressive tax planning techniques in the future, thus increasing tax revenues. In addition, an aggressive imposition of a strict liability penalty standard by the IRS will force taxpayers and their advisors to pay more attention to the doctrine even for ordinary-course commercial and investment transactions. Even typical related-party transactions between a corporation and its controlling shareholders may come under scrutiny of the new law.
Summary and Conclusions
Supporters of the codification of the economic substance doctrine argue that it provides for a consistent test for the courts to apply in assessing whether the substance of a transaction should be respected for federal tax purposes. Some detractors argue that codification does not result in a uniform standard, but is merely a way to raise federal revenues. There are concerns that the administration will turn to increased administrative enforcement actions to challenge legitimate tax planning techniques and commercial business or investment transactions in order to raise revenues and impose penalties.
The codification provision was designed to raise $4.5 billion in revenues for funding health care reform. At the present time, it is not clear whether this increased revenue will be due to an increase in penalties or a broader application of the doctrine. Only time will tell whether the new law and penalties will be applied on a broader basis to raise significant revenues for the Treasury.
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