The benefits put in place by the Health Care and Reconciliation Act had to be paid for somehow and the idea of codifying the economic substance doctrine had been floating around for some time. Practitioners had expressed deep concern that the doctrine was too vague to be codified and that — to the extent it was capable of definition — it was already part of the common law, so that its codification would achieve nothing. Once the economic substance provision got scored as a revenue raiser at $4.5 billion through 2019, however, Congress grabbed it and there was no letting go.

So now we have new law that provides that taxpayers are subject to a 40-percent penalty on underpayments of tax attributable to transactions that lack economic substance. The penalty is reduced to 20 percent when there is disclosure on the taxpayer’s return. Here’s the hammer: There is no reasonable cause defense. If a transaction is determined to lack economic substance, the penalty will apply even if the taxpayer acted reasonably and in good faith and regardless of disclosure. Having a tax opinion at any level of confidence or preparing extensive supporting in-house analysis does not provide protection from imposition of the penalty.

Section 7701(o), entitled “Clarification of Economic Substance Doctrine” provides that a transaction will be treated as having economic substance only if both:

• The transaction changes the taxpayer’s economic position (apart from federal income tax benefits) in a meaningful way and
• The taxpayer has a substantial purpose, apart from federal income tax effects, for entering into the transaction.

The statute provides that these rules apply only to transactions to which the economic substance doctrine is “relevant.” Relevancy is not defined. Section 7701(o)(5)(C), however, provides that the determination of relevancy should be made in the same manner as if the provision “had never been enacted.”

The Internal Revenue Service (IRS) now has to figure out what guidance it can provide in the application of the new provision and practitioners have to figure out whether their opinions must change on transactions they previously viewed as not being exposed to penalties.

Undoubtedly many ink cartridges will be emptied exploring the uncertain parameters of economic substance and the fine-points of its application. What will be most helpful to CPA practitioners at this point, however, is identification of “clean” transactions or an “angel list.” If we can first clear out the underbrush of the transactions that are recognized to be outside the crosshairs of the concept, many concerns might disappear and the closer cases can be left to resolution in the fullness of time.

Recall that, when the IRS promulgated Subchapter K — anti-abuse regulations under Section 701 — it was the set of examples of specific transactions that would not be considered to be abusive that helped to calm the hysteria. The IRS provided the examples with the caveat that addition or deletion of any facts might alter the outcome but the examples still provided great comfort.

Until regulations come out, are there any transactions that we can feel comfortable that are unlikely to be subject to attack under the new economic substance rule? Here are a few:

Section 7701(o) states that, in the case of individuals, the provision only applies to transactions entered — into in connection with a trade or business or activities engaged in — for the production of income. Therefore:

• Routine charitable giving and estate planning that does not occur in the context of a trade or business should not be subject to the economic substance test.
  

The committee reports state that the new law is not intended to disallow tax benefits that are consistent with the congressional purpose or plan that the benefits were designed by Congress to effectuate. The committee reports go on to state: “Thus, for example, it is not intended that the following tax credits be disallowed in a transaction pursuant to which, in form and substance, a taxpayer makes the type of investment or undertakes the type of activity that the credit was intended to encourage:

• Section 42 (low-income housing tax credit),
• Section 45 (production tax credit),
• Section 45D (new markets tax credit),
• Section 47 (rehabilitation credit),
• Section 48 (energy credit),
• Etc.”

One could view “Etc.” optimistically as a signal of approval of other credit-related transactions. Notable in its absence, however, is the foreign tax credit.

The committee reports also state that the provision 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. The committee reports to the legislation set out four categories of transactions that the legislation is not intended to attack:

• The choice between capitalizing a business enterprise with debt or equity,
• A U.S. person’s choice between using a foreign corporation or a domestic corporation to make a foreign investment,
• The choice to enter into a transaction or series of transactions that constitute a corporate organization or reorganization and
• The choice to utilize a related-party entity in a transaction, if the arm’s length standard of Section 482 and “other applicable concepts” are satisfied.

Apart from the items above that were referenced in the committee reports, here are some other transactions that may be possible candidates for an “angel list:”

• Sales to trigger an economic loss.
• Sales to accelerate a gain to use an expiring loss.
• Consolidating or deconsolidating and combining or separating affiliates to net profitable operations against nonprofitable ones.
• Elections. An election is not, in and of itself, a “transaction” but an election is, almost always solely based on tax considerations. Could regulations offer a presumption that an election, standing alone, will not be a “relevant transaction?”

Conclusion

There is not and probably never will be a clear-cut and universally accepted interpretation of the meaning of economic substance. Nevertheless, if the IRS can identify base-case transactions that are — barring factual deviations — presumed not to be “relevant,” it will go a long way toward making our lives easier. Hopefully, an “angel list” will be proposed that includes the above transactions and many more — a host of angels.

Barbara de Marigny, JD/LLM, is a partner in Gardere’s Tax Practice Group. She focuses her practice on federal income taxation, partnership taxation, limited liability companies (LLCs), domestic and international joint ventures and tax planning for business transactions. She also has specific expertise in mergers and acquisitions of public and private companies in taxable and tax-free acquisitions of stock, LLC interests and partnership interests. Prior to joining Gardere, de Marigny was a partner at the law firm of Oppenheimer, Blend, Harrison & Tate, Inc. de Marigny served from 1981 to 1999 as an attorney at Baker & McKenzie. She was a partner at the firm from 1989 until her departure in 1999.