New Code Provision on the Economic Substance Doctrine
Very difficult to apply, but necessary to understand in light of the strict liability penalties associated with the new provision.
June 21, 2010
On March 30, 2010, the Health Care and Education Reconciliation Act of 2010, H.R. 4872 (the “Health Care Reconciliation Act”) was signed by President Obama. Section 1409 of the Health Care Reconciliation Act “codified” the economic substance doctrine by adding new subsection 7701(o) to the Code. It also added a new strict liability penalty to the Code for transactions that lack economic substance. The statute applies generally to transactions entered into after the date of enactment — March 30, 2010.
The most thorough official review of the economic substance doctrine and the proposals to codify it are in JCS-3-09, Joint Committee Staff Description of Business Tax Revenue Provisions in the President’s Fiscal Year 2010 Budget Proposal (September 2009). The Joint Committee of Taxation explanation was refashioned as various bills were introduced, ultimately resulting in JCX-18-10 (March 21, 2010) with the final bill. The Joint Committee of Taxation’s report is not officially the legislative history of the bill; however, there is no House or Senate Report on the enacted version of the codification of economic substance. It will be important to review JCS-3-09 and JCX-18-10 in deciding whether it applies and how to interpret it because of the wording of Section 7701(o).
Strict Penalty Provision
The strict penalty provision is a critical aspect of the legislation. The purpose of the penalty regime is to make taxpayers give economic substance factors greater weight in their decision-making prior to entering transactions and prior to reporting transactions for tax purposes. By making the penalty provision so onerous when economic substance is found to be lacking, the purpose of the codification and penalty regime is “to change the taxpayer’s cost-benefit analysis and deter some aggressive taxpayer behavior.” JCS-3-09.
Since the penalty provision is so important, it will be discussed first. New Code Section 6662(b)(6) makes Section 6662 (20% accuracy-related penalty) applicable to a transaction lacking economic substance (within the meaning of section 7701(o)) or failing to meet the requirements of any similar rule of law. New Code Section 6662(i) increases the penalty to 40 percent for “nondisclosed noneconomic substance transactions.” A “nondisclosed noneconomic substance transaction” is defined to be any portion of a transaction described in (b)(6) with respect to which the relevant facts affecting the tax treatment are not adequately disclosed in the return nor in a statement attached to the return. I.R.C. 6662(i)(2). The penalty is a strict liability penalty because of new Sections 6664(c)(2) and (d)(2). There is no reasonable cause exception to the application of the penalty, e.g., an opinion from an outside tax advisor does not provide protection.
New Code Section 7701(o) states that it will apply only if the economic substance doctrine is relevant to the transaction. Code Section 7701(o)(5)(C) provides that the determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if Section 7701(o) had never been enacted. Section 7701(o)(5)(A) defines “economic substance doctrine” to be “the common law doctrine under which tax benefits under Subtitle A with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose.” Section 7701(o)(5)(B) provides that the economic substance doctrine will not apply to individual transactions that are not entered into in connection with a trade or business or an activity engaged in for the production of income.
In applying Section 7701(o), the first question to ask is whether the “economic substance doctrine” is relevant to the transaction. If it is not relevant, then Code Section 7701(o) has no application. Examples in which the economic substance doctrine should not be considered relevant are found in JCX-18-10 and JCS-3-09. Footnote 344 in JCX-18-10 states that “if the realization of the tax benefits of a transaction is consistent with the Congressional purpose or plan that the tax benefits were designated by Congress to effectuate, it is not intended that such tax benefits be disallowed.” The examples given to illustrate this concept are the various tax credit provisions enacted to encourage certain activities. In effect, this statement provides a “safe harbor” to the taxpayer in that it defines the economic substance doctrine as applying to tax benefits that the IRS perceives as not consistent with the purposes of the particular Code provision that the taxpayer is relying upon for tax benefits. In addition, JCX-18-10 and JCS-3-09 state that Section 7701(o) is not intended to alter the tax treatment of certain basic business transactions that, under longstanding judicial and administrative practice are respected, merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages. Both reports list the following four transactions as examples:
I.R.C. § 7701(o)
Assuming that the economic substance doctrine is relevant to the transaction, such transaction will be treated as having economic substance only if both an objective requirement and a subjective requirement are met. The “objective requirement” is met only if the transaction changes the taxpayer’s economic position in a meaningful way (apart from Federal income tax effects). I.R.C. § 7701(o)(1)(A). The “subjective requirement” is met only if the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into the transaction. I.R.C. § 7701(o)(1)(B). Neither “meaningful” nor “substantial” is defined. State and local tax benefits that are related to federal tax benefits are treated in the same way as the Federal income tax benefits, i.e., ignored. I.R.C. § 7701(o)(3). The purpose of achieving a favorable accounting treatment for financial reporting purposes is not taken into account as a non-Federal-income-tax purpose if the origin of the financial accounting benefit is a reduction of Federal income tax. I.R.C. § 7701(o)(4).
If a taxpayer relies on a profit potential to establish economic substance, the present value of the reasonably expected pretax profit from the transaction must be substantial in relation to the present value of the expected net-tax benefits that would be allowed if the transaction were respected. I.R.C. § 7701(o)(2)(A). Neither “reasonably expected” nor “substantial” are defined. No rule on computing present value is given. Fees and transaction expenses must be counted in determining net pre-tax profit. I.R.C. § 7701(o)(2)(B). Regulations must be issued regarding when foreign taxes are to be treated as expenses in determining pretax profit. A taxpayer may rely on factors other than profit potential to demonstrate compliance with Code Section 7701(o)(1). JCX-18-10 & JCS-3-09.
As the above discussion shows, application of Code Section 7701(o) will be difficult. It is vague regarding when it will be applicable and in the event it is applicable, it lacks clarity on its application. Regardless of the difficulty in applying the statute, however, economic substance must be considered because of the strict liability penalties associated with failure of a transaction to have economic substance.
Janice Eiseman, JD, LLM, is a principal at Cummings & Lockwood in Stamford, Conn. office where she focuses on the taxation of closely held businesses and tax planning for owners and investors. Eiseman has broad-based experience counseling clients on the formation, ownership and structuring of various business entities, as well as drafting and negotiating tax-based and transactional documentation for both individual and business clients. She has also done controversy work before the Internal Revenue Service and the New York State Department of Taxation and Finance. Prior to joining Cummings & Lockwood, she served as senior tax and benefits counsel at the New York City-based law firm Morrison & Cohen LLP.