Beginning in 1935 with the United States Supreme Court decision in Gregory v. Helvering, courts have developed and applied common law doctrines to deny tax benefits for transactions that meet literal statutory requirements but seemingly exploit statutory provisions. In Gregory, the Court said to do otherwise would “exalt artifice above reality and to deprive the statutory provision in question of all serious purpose.” Over the years, overlapping theories of (1) substance versus form, (2) sham transaction, (3) business purpose, and (4) economic substance have developed to combat tax motivated transactions that are just too good to be true. To battle the rise of tax shelters, Congress first considered codifying the economic substance doctrine in 1999. After several attempts, Congress has now codified the doctrine in the Health Care and Education Reconciliation Act of 2010, signed into law by President Obama on March 30, 2010.
Highlights of the New Statute
The new Internal Revenue Code Section 7701(o) adopts a two-part test for economic substance:
- First, the transaction must change the taxpayer’s economic position in a meaningful way.
- Second, the taxpayer must also have a substantial purpose for entering into the transaction.
This two-part test clarifies differences in case law in that the taxpayer must meet both an objective test (meaningful change in economic position) and a subjective test (substantial purpose for entering the transaction). Of course, the federal tax benefits of the transaction are not considered in determining whether these tests are met. Likewise, any state or local income tax effect that is related to a federal income tax effect will be treated in the same manner as a federal income tax effect.
In determining whether these two tests are met, the potential for profit will only be considered if the present value of the expected pre-tax profit from the transaction is substantial in relationship to the present value of net expected tax benefits. In determining pre-federal-tax profit, new regulations will determine the extent to which foreign taxes are treated as expenses.
In addition, the financial accounting benefit of the transaction is not to be taken into account as a purpose for entering into a transaction if the origin of such financial accounting benefit is a reduction of federal income tax.
Tough New Penalty Provisions
The legislation provides for penalties for underpayments attributable to transactions lacking economic substance. The legislation imposes a 20 percent penalty for underpayments of tax attributable to transactions lacking economic substance that are disclosed to the IRS. The penalty increases to 40 percent for undisclosed transactions. There is no exception to the penalties, including reasonable cause.
When Will the New Statute Not Apply?
- The new statute only applies to transactions entered into after the date of enactment, March 30, 2010.
- For individuals, the new statute only applies to transactions entered into in connection with a trade or business or an activity engaged in for the production of income.
- The provision does not change current law standards used by courts in determining when to use an economic substance analysis.
- The committee report states that the new provision is not intended to alter the tax treatment of certain basic business transactions that are respected under longstanding judicial and administrative practice merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages.
- The committee report lists the following examples of basic business transactions that are not impacted by the new law: (1) the choice between capitalizing a business enterprise with debt or equity; (2) the choice between foreign corporations and domestic corporations; (3) the treatment of a transaction or series of transactions as a corporate organization or reorganization under Subchapter C; and (4) the ability to respect a transaction between related parties provided that the arm’s length standard of Section 482 is satisfied. Leasing transactions, like all other types of transactions, will continue to be analyzed in light of all the facts and circumstances.
What Is Likely to Change?
Statements from the IRS as to the likely impact of the new provision have been a bit confusing. Last December, IRS Chief Counsel William Wilkins said, “any transaction that accomplishes a tax result by trying to seem like something that it isn’t is going to attract the application of the doctrine...No transaction is immune.” Speaking in general terms, he said he believes putting the doctrine into law could be beneficial and may not require a significant regulatory effort to implement. “It clears up some different approaches in the circuits and clarifies some of the standards...The statute would be self-executing and there may not be a need for extensive guidance.”
More recently, IRS officials said that codification should have a minimal practical impact. William Alexander, IRS associate chief counsel (corporate), said the codification has not changed the economic substance doctrine much. He also pointed out that the type of analysis required by the first prong of the economic substance doctrine, one that considers the specific facts and circumstances of each transaction to determine the real economics, does not lend itself to exempting general types of transactions. Therefore, he does not believe that that the IRS will issue an angel list. Coming under pressure from practitioners to provide guidance, a senior Treasury official has also said that guidance establishing clear, reasonable procedures “is in the best interests of everyone.”
If the impact of codification is minimal, the projected $4.5 billion in receipts through 2019 for this provision are a bit hard to understand.
According to commentators, taxpayers operating in the regions covered by the Courts of Appeal of the Second, Fourth, and Eighth Circuits will be most affected by the health care law’s changes to the way the economic doctrine is applied to their transactions. The requirement to meet both the objective and subjective tests is more stringent than the standards used in those circuits.
However, even more meaningful is that the provision imposes a new strict liability penalty for an underpayment attributable to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance. No exceptions, including the reasonable cause rules, to the penalty are available. Thus, under the provision, outside opinions or in-house analysis would not 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.
What Is Unclear?
Many years of litigation and regulation promulgation will undoubtedly be required to determine the ultimate impact of this new provision. For example:
- Will the IRS issue a safe harbor list of transactions?
- How difficult will it be to obtain a private letter ruling on a transaction to avoid potential penalties?
- Could a public accounting firm that provides initial tax advice on a transaction with penalty exposure run afoul of PCABO Rule 3522(b), which prohibits auditors from directly or indirectly recommending an “aggressive tax position” transaction, and jeopardize auditor independence?
- Will other anti-abuse judicial doctrines such as sham transaction and form versus substance have continuing validity? Or will they be subsumed by the economic substance doctrine?
- Which states will adopt similar approaches for income and other taxes?
Alvarez & Marsal Taxand Says:
The codification of the economic substance doctrine seems to have muddied the waters, because the existing application of the doctrine was predictable, given the large number of rulings and cases. Tax directors need to be involved in predicting the future economic benefit of significant transactions and should expect that these forecasts will be subject to IRS scrutiny. Unfortunately, the IRS usually has the benefit of hindsight when determining whether projected economic benefits materialized.
Given that there is no exception, including reasonable cause, to the penalty, taxpayers will likely come to the IRS for more rulings on transactions and for transactions for which they would have not previously requested such a ruling. Thus, this burden will act as a deterrent for taxpayers from entering into otherwise economically viable transactions.
293 U.S. 465 (1935).
Id. at 470.
Joint Committee on Taxation Report, JCX 84-99 (November 10, 1999).
Pub. L. No. 111-152.
The term “transaction” also includes a series of transactions. IRC § 7701(o)(5)(D).
Joint Committee on Taxation, JCX-27-10 (May 4, 2010).
Statements by IRS Chief Counsel William Wilkins to BNA on December 23, 2009. Daily Tax Rep. (BNA) No. 10, at S-18 (January 19, 2010).
Statement by William Alexander, IRS associate chief counsel (corporate), at the corporate tax session of the American Bar Association Section of Taxation meeting in Washington, DC on May 8, 2010. Tax Analysts, 2010 TNT 90-2 (May 10, 2010).
Statement by Robert J. Crnkovich, senior counsel in Treasury’s Office of Tax Legislative Counsel while speaking at a session of a Practicing Law Institute tax planning seminar on partnerships and other strategic alliances on May 27, 2010. Daily Tax Rep. (BNA) No. 102, at G-1 (May 28, 2010).
Joint Committee on Taxation, JCX-17-10 (March 20, 2010).
T. Mimi Luong, Senior Associate, contributed to this article
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