codification of economic substance doctrine

Codification” of the economic substance doctrine—much ado about nothing?
Author: By Richard M. Lipton
RICHARD M. LIPTON is a partner in the Chicago office of the law firm of Baker & McKenzie LLP, and is a past chair of the ABA Tax Section.
Copyright © 2010, Richard M. Lipton.

As part of the Health Care and Education Reconciliation Act of 2010, Congress enacted new Code Sec. 7701(o) , which provides for the “codification” of the economic substance doctrine and the addition of substantial penalties for transactions that are found to lack economic substance. The question that tax practitioners will need to ask is: “Does this change in the law really change anything?” It is likely that most traditional tax planning will be unaffected by this new legislation. This Practice Alert, which is excerpted from a more extensive article in the June 2010 issue of the Journal of Taxation , discusses the recent codification of the economic substance doctrine.

“Strict liability” penalty. In many respects, the most important aspect of the new legislation is not the substantive law concerning the definition of economic substance but rather the penalty that is imposed on transactions that lack economic substance.

Under the new legislation, Code Sec. 6662 is amended to impose a penalty equal to 20% of the portion of any underpayment of tax attributable, under Code Sec. 6662(b)(6) , to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance or failing to meet the requirements of any similar rule of law. In determining whether this penalty is applicable, Code Sec. 6662(i)(2) provides that amendments or supplements to an already-filed return are not taken into account if the amendment or supplement is filed after the date the taxpayer is first contacted by IRS regarding the examination of the return (or such earlier date as specified by regs).

Perhaps most important, Code Sec. 6664(c)(2) provides that the “reasonable cause” exception that generally applies to other penalties is not applicable with respect to an understatement attributable to the lack of economic substance in a transaction. In other words, the penalty is a “strict liability” or “no fault” penalty—no matter the facts and circumstances surrounding the transaction, if a court determines that the transaction lacked economic substance, the 20% penalty applies.

As if this 20% strict liability penalty weren't severe enough, Code Sec. 6662(i)(1) provides that the 20% penalty is increased to 40% with respect to any portion of any underpayment attributable to a transaction that is found to lack economic substance and with respect to which the relevant facts affecting the tax treatment of the transaction are not adequately disclosed in the return or in a statement attached to the return.

Impact of codification. What is the impact of this “codification” of the economic substance doctrine? There will be lots of commentaries, but the question is whether or not this represents a fundamental change in the law. Has Congress changed the way courts will treat transactions that generate substantial tax benefits? Will taxpayers need to alter their behavior in order to comply with this new rule? Should taxpayers be disclosing virtually every transaction that they enter into in order to reduce the risk of an additional 20% strict liability penalty?

What Code Sec. 7701(o) doesn't do. It may be more important to consider, first, what Code Sec. 7701(o) doesn't do. It doesn't:

... alter the manner in which the economic substance doctrine has been applied except in those jurisdictions that did not use the conjunctive test;
... affect individual estate and trust tax planning;
... alter the application of the “substance over form,” “step transaction,” or other judicial doctrines; or
... create new theories or rules that practitioners have to learn.
Elimination of “disjunctive” test. An argument can be made that the most significant impact of the new legislation is to eliminate the “disjunctive” test used in some circuits, where it was possible to claim that either the presence of a business purpose or a change in economic position was sufficient to legitimize the tax consequences of a transaction entered into for tax-avoidance purposes. If Code Sec. 7701(o) does nothing else, it confirms that the conjunctive test requiring both a change in economic position and a substantial business purpose for a transaction is the law.

This will be an important change in the circuits that appeared to have adopted the most clear-cut disjunctive rule. In the circuits in which a taxpayer needed either an objective or subjective business purpose but not both, transactions will henceforth need to be judged applying both aspects of the test, including particularly that the taxpayer's business purpose is “substantial” in comparison to the tax benefits to be obtained from the transaction. The new legislation also clarifies that when a taxpayer is relying on a profit potential to justify its claimed tax benefits, such profit potential must be substantial.

Transactions before and after codification. To what extent, if any, did the enactment of Code Sec. 7701(o) alter prior law? If a transaction “worked” before Code Sec. 7701(o) to provide tax benefits (assuming that there was only a conjunctive test), does it still work now? Can tax practitioners continue to advise taxpayers to engage in transactions that will generate significant tax savings if structuring the transaction in a different manner would have resulted in less-favorable tax consequences?

If the legislative history of Code Sec. 7701(o) as well as the definition of the economic substance doctrine in Code Sec. 7701(o)(5)(A) are given a literal reading, it would seem that little has changed concerning the manner in which the economic substance doctrine will be applied to transactions, including transactions that generate substantial tax benefits. Indeed, the statutory language emphasizes that the economic substance doctrine can be applied only to transactions that would have been subject to attack under the common law, without taking into account the enactment of Code Sec. 7701(o) . Absent further guidance, however, there can be no assurances that IRS will take such a view of the legislation.

Moreover, the stakes may have changed as a result of the penalties that could now be applied. The practical effect of Code Sec. 6662(b)(6) and Code Sec. 6662(i) is that a taxpayer could be subject to a strict liability penalty for 20% of the understatement if IRS concludes that a transaction lacked economic substance, even if the taxpayer believed that the transaction was bona fide and even if the taxpayer had no tax-avoidance intention in entering into the transaction. This penalty would increase to 40% if the transaction was not disclosed, which makes the stakes very substantial indeed.

Disclosure. This leads to the most important question raised by the new legislation—when should taxpayers disclose that a transaction might be viewed as lacking economic substance? On the one hand, given that Code Sec. 7701(o) simply clarified the pre-existing common law, it could be argued that disclosure should only occur in those rare situations in which taxpayers entered into transactions which the taxpayer believed could be challenged under the common law.

On the other hand, any time that a taxpayer enters into a transaction in which a significant tax benefit is obtained, the taxpayer might consider making a disclosure in order to reduce the stakes if IRS decided to challenge the economic substance of the transaction. This could result in taxpayers making a disclosure with respect to any transaction in which a loss is recognized, even if the loss was a real economic loss, unless the transaction involved a sale of assets to unrelated third parties.

A more subtle question is whether making a disclosure will potentially be a self-fulfilling prophecy. If a taxpayer believed that a transaction had economic substance under prior law (ignoring the disjunctive test), a disclosure could be viewed as an “admission” that the taxpayer was concerned about whether the transaction would be respected. Taxpayers may choose not to disclose that transactions might not have economic substance for fear that IRS will otherwise believe that the transaction is suspect.

Moreover, it is not certain that judges will want to impose a 40% penalty with respect to transactions that taxpayers legitimately believed were outside the scope of the economic substance doctrine, even if the court subsequently concludes that the transaction could be within the scope of the doctrine. Therefore, taxpayers may not want to disclose except in situations where the concern about economic substance is substantial.

This leads to an even more important issue, which is whether a court will be required to impose the penalty under Code Sec. 6662(i) if the tax benefits for a transaction also could be disallowed on other grounds. The statutory language indicates that the strict liability penalty applies only where the underpayment is attributable to non-economic-substance transactions. If a taxpayer enters into a transaction that lacks both economic substance and is not respected under the substance-over-form test, can the court conclude that the form of the transaction should not be respected and, therefore, decline to impose the penalty under Code Sec. 6662(i) ? What if there is a “technical” flaw in a transaction that was intended to generate non-economic tax benefits—can the new penalty apply?

For example, several court decisions concluded that a contingent liability had to be treated as a liability for purposes of analyzing Son-of-BOSS transactions, thereby eliminating the claimed tax benefit from the transaction. In those situations, would a court be precluded from applying Code Sec. 6662(i) unless the court also concluded that the transaction lacked economic substance? Could the court even impose the penalty where there was a statutory basis for disallowing the claimed tax benefits, so that the common law doctrine did not need to be applied? It would seem that in such situations the deficiency was not “attributable to” the application of the economic substance doctrine, so the new penalty in Code Sec. 6662(b)(6) and Code Sec. 6662(i) would not apply.

Conclusion. The “codification” of the economic substance doctrine in Code Sec. 7701(o) was opposed by the prior Administration on the grounds that the courts had been adept at disallowing claimed tax benefits in appropriate situations, so that codification of the economic substance doctrine was not necessary. Moreover, the prior Administration was concerned about the potential application of a new statutory provision and the related penalty.

Whatever the concerns were, Code Sec. 7701(o) has been enacted and now taxpayers and their advisors will have to live with it. Only time will tell whether the courts view this change in the law as significant and whether the new penalty will be applied in a manner that generates significant revenue. Likewise, it may be some time before tax practitioners need to make the decision whether to err on the side of disclosing liberally in order to avoid the 40% penalty. Moreover, it is possible that this new legislation will have little effect (other than scoring revenue for purposes of passing the health care bill) and, in hindsight, will simply be viewed as a continuation of the status quo.



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