Statutory Economic Substance Test Introduces Harsh New
Penalties
The revenue raising measures in the Health Care
and Education Reconciliation Act of 2010 (the "Act"), contain
a codification�though labeled a "clarification"�of the
economic substance doctrine. The Act introduces new
strict liability penalties for transactions failing the
economic substance test. The Act provides that the
applicability of economic substance doctrine to a transaction
is analyzed as if the Act had never been enacted. The
Act does not give any guidance as to when the doctrine
applies. So, economic substance analysis during tax
planning remains the same as it was before implementation of
the Act. However, the Act's harsh new penalty provisions
impose a larger risk on transactions that could potentially
fail the economic substance test. Taxpayers and their
advisers should take this new level of risk into account when
planning transactions. Further guidance from the
Treasury explaining the applicability of the statutory
economic substance test would be helpful.
The Act was enacted on March 30, 2010, and applies to all
transactions entered into after that date. The Joint
Committee on Taxation estimates the economic substance
provisions will increase revenue by $4.5 billion over the next
ten years.
Overview of the Economic Substance Doctrine
The economic substance doctrine is a common law rule that
denies tax benefits for transactions which lack economic
substance. The doctrine is used to invalidate
transactions which, though compliant with the statutory
provisions of the Code, have been entered into for the sole
purpose of avoiding taxes. It is generally expressed as
a two-prong test requiring (1) that the transaction change the
taxpayers economic position and (2) that the taxpayer has a
legitimate non-tax business purpose for entering into the
transaction. The Supreme Court's decision in Frank
Lyon Co. v. U.S., has been interpreted to require this
two-prong analysis. Though the Lyon decision did
not expressly state a two-prong test, later lower court
decisions have expressed the doctrine in that manner.
The first prong is an objective standard, while the second
prong is subjective and depends on the taxpayer's state of
mind. Some courts have applied the prongs conjunctively
(an "and" test) while other courts have applied the prongs
disjunctively (an "or" test).
Overview of The Economic Substance Provisions of the
Act
The Act codifies the economic substance doctrine in its
conjunctive form, requiring both a meaningful change (apart
from federal income tax effects) to the taxpayer's economic
position and a substantial purpose (apart from federal income
tax effects) for entering into a given transaction. The
Act provides for new strict liability penalties relating to
any transaction found to violate the new statutory economic
substance test or any similar rule of law. These
penalties are the section 6662 percent penalty for
underpayment and the section 6676 penalty for unreasonable and
erroneous claims for refund.[1] The Act also removes the
reasonable cause defense to the penalties of sections 6662 and
6662A for all transactions which lack economic substance.
Over the past decade, several proposals have been put forth
to codify the economic substance doctrine.
Applicability of the Codified Economic Substance
Doctrine
The Act does not explain when the economic substance
doctrine applies. In fact, the Act specifically provides
that that determination of whether the economic substance
doctrine is relevant to a transaction shall be made in the
same manner as if the Act had never been enacted. So,
the Act leaves the applicability of the economic substance
doctrine to the discretion of the courts. Essentially,
the Act leaves the applicability of the economic substance
doctrine unchanged, while specifying use of the conjunctive
test.
Because applicability of the economic substance doctrine to
a particular transaction is not always easy to determine, the
Act's silence on this issue leaves open a difficult
interpretation problem. The House Report provides some
comfort in stating that the Act is not intended to alter the
tax treatment of 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 House
Report provides the following examples of such basic business
transactions: (1) the choice between capitalizing a business
enterprise with debt or equity; (2) a U.S. person's choice
between utilizing a foreign corporation or a domestic
corporation to make a foreign investment; (3) the choice to
enter a transaction or series of transactions that constitute
a corporate organization or reorganization under subchapter C;
and (4) the choice to utilize a related-party entity in a
transaction, provided that the arm's length standard of
section 482 and other applicable concepts are satisfied.
Many transactions will fall outside the list of elemental
transactions provided in the House Report. Treasury
Department personnel are reluctant to issue formal guidance
expanding this list, however, due to the difficulty of
creating an all inclusive list. The House Report further
states that so long as the tax benefits of a given transaction
are clearly consistent with all applicable provisions of the
Code and the purposes of such provisions, it is not intended
that such benefits be disallowed. So, to determine
whether section 7701(o) is applicable to a given transaction,
taxpayers and their advisers will need to analyze their
transaction under existing case law. So long as the tax
benefits of a given transaction are consistent with Congress's
purpose in enacting the beneficial provision, there should not
be an economic substance concern.
Generally speaking, taxpayers are allowed to arrange their
affairs so as to minimize their tax liability. However,
the economic substance doctrine denies a taxpayer beneficial
tax treatment for transactions entered into for the sole
purpose of avoiding taxes.
Under the conjunctive test codified in section 7701(o), a
taxpayer must show both an objective change in the taxpayer's
economic position and a subjective non-tax purpose for
entering into the transaction. The objective prong of
the test should be satisfied so long as the transaction
changes the taxpayer's financial position. The
subjective prong of the test depends on the intention of the
taxpayer but is usually proven by showing that the taxpayer
had a profit motive for entering into a transaction.
Business Purpose and Profit Potential
A taxpayer can satisfy the subjective prong of the test by
showing a profit motive for entering into the
transaction. Section 7701(o)(2) requires a reasonable
expectation of pre-tax profit which is substantial in relation
to the present value of the net tax benefits. Under the
Act, taxpayers can not rely on a de minimis amount of
profit. This rule is stricter than existing case law,
which simply required a reasonable possibility of
profit. Thus, transactions which simultaneously offer a
reasonable non-tax profit potential and a large tax benefit
may run afoul of section 7701(o), even though such
transactions would not have been invalidated under the common
law economic substance doctrine. This change in the
applicable standard for profit motive makes it more difficult
for taxpayers to assess the risk that a transaction will fail
the economic substance test. Further, since the Act
provides no guidance as to what constitutes a "substantial"
expectation of profit, it may be difficult for taxpayers to
evaluate whether the profit motive test is met in transactions
that offer significant tax benefits. More guidance from
the Treasury as to how to apply section 7701(o)(2) would be
helpful. Unfortunately, the Treasury has indicated that
the only guidance it is planning on issuing for the Act is in
regards to taking foreign income taxes into account for
purposes of determining pretax profit.
A profit motive may not necessarily be required to satisfy
the subjective prong of the test. However, there is not
much developed case law on what non-tax considerations besides
profit motive are legitimate. The Federal Circuit
recently reversed a Court of Federal Claims decision that a
desire to isolate liabilities is a valid non-tax motive.
Section 7701(o) implicitly acknowledges that a profit motive
is not essential to economic substance by stating a special
rule for taxpayers relying on profit potential.
Unfortunately, the statute does not provide any further
guidance as to what alternative considerations are
valid.
Transaction Costs and State Taxes
The Act also specifies that fees and other transaction
expenses are taken into account as expenses in determining
pre-tax profit, and that the Secretary shall issue regulations
requiring foreign taxes to be treated as expenses in
determining pre-tax profit in appropriate cases. So,
taxpayers wishing to prove a profit motive must be able to
document a substantial profit expectation net of transaction
costs. Further, any state or local income tax effect
which is related to a federal income tax effect is treated in
the same manner as a federal income tax effect. Thus,
state and local income tax effects need to be aggregated with
the federal tax effect in determining substantiality.
The Act does not explain when a state income tax effect is
considered to be "related" to a federal income tax
effect. Additionally, the achievement of a financial
accounting benefit is not 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.
Thus, transactions entered into for the purpose of reducing
state or local taxes, or for the purpose of receiving a
tax-beneficial accounting adjustment are not legitimate
transactions under the Act.
The Act is somewhat less stringent than certain prior
proposals to codify the economic substance doctrine. For
example, the economic substance provisions proposed in the
Senate's Tax Relief Act of 2005 required that a transaction be
a "reasonable means" of accomplishing its stated non-tax
purpose and that the reasonably expected pre-tax profit from a
transaction exceed a risk-free rate of return. The
proposed 2005 statute also contained special rules for
lending, basis adjustments, and income shifting between a
taxpayer and a tax-indifferent party. Finally, the
proposed 2005 statute provided that a lessor could not rely on
depreciation or tax credits when determining profit
potential. The Act does not contain these
rules. The Act is expected to generate
significantly less revenue than the proposed 2005 statute,
$4.5 billion compared to $15.9 billion over ten years.
However, the House Report explains that, in evaluating
economic substance, both the utility of the stated purpose and
the rationality of the means chosen to effectuate it must be
evaluated. The House Report goes on to quote ACM
Partnership v. Commissioner: "a rational relationship
between purpose and means ordinarily will not be found unless
there was a reasonable expectation that the nontax benefits
would be at least commensurate with the transaction
costs."
What Transactions Will Be Subject to the Economic
Substance Doctrine?
The economic substance doctrine has traditionally been
applied to transactions perceived to be "tax shelters."
A 2005 report by the Joint Committee on Taxation and the
decision in Rose v. Commissioner provide some guidance
as to what characteristics are usually present in transactions
found to fail the economic substance test. In the 2005
Report, the Joint Committee on Taxation proposed a
codification of the economic substance doctrine but limited
its applicability to transactions involving one or more of six
enumerated criteria. The six forms of applicable
transactions were: (1) transactions in which (a) the taxpayer
holds offsetting positions which substantially reduce the risk
of loss, and (b) tax benefits would result from differing tax
treatment of the positions; (2) transactions structured to
result in a disparity between basis and fair market value
which create or increase losses or reduce gains; (3)
transactions structured to create or increase gain in an asset
any portion of which would not be recognized for federal
income tax purposes if the asset were sold at fair market
value by the taxpayer (or a related person); (4) transactions
structured to result in income for federal income tax purposes
to a tax-indifferent party for any period which is materially
in excess of any economic income to such party with respect to
the transaction for such period; (5) transactions in which a
taxpayer disposes of property (other than inventory,
receivables, or stock or securities regularly traded on an
established securities market) which the taxpayer held for a
period less than 45 days; (6) transactions structured to
result in deductions or losses otherwise allowable under the
Code and which are not allowed for financial reporting
purposes.
In Rose, the court stated that transactions failing
the subjective prong of the economic substance test usually
share one or more of the following five characteristics: (1)
tax benefits were the focus of promotional materials; (2) the
investors accepted the terms of purchase without price
negotiation; (3) the assets in question consist of packages of
purported rights, difficult to value in the abstract and
substantially overvalued in relation to tangible property
included as part of the package; (4) the tangible assets were
acquired or created at a relatively small cost shortly prior
to the transactions in question; and (5) the bulk of the
consideration was deferred by promissory notes, nonrecourse in
form or in substance. On appeal, the Sixth Circuit
affirmed the Tax Court's decision. Although the Sixth
Circuit did not explicitly adopt the factors listed by the Tax
Court, it held that the Tax Court's analysis was consistent
with the two-prong economic substance test.
The Act does not contain a list of factors to be used to
determine whether the economic substance doctrine should
apply�nor does the Act limit itself to "tax shelters."
Nonetheless, the factors in the Joint Committee on Taxation's
2005 Report and in the Rose decision can serve as
guideposts in evaluating whether a transaction gives rise to
economic substance concerns. Transactions with these
characteristics are more likely to be perceived as tax
shelters and are therefore more likely to be singled out for
review under the economic substance doctrine.
The Act provides that the term transaction includes a
series of transactions. Courts have combined separate
transactions where there is an overall scheme to generate tax
benefits. Similarly, where a tax-motivated
transaction is coupled to unrelated substantive transactions,
courts may isolate the tax-motivated transaction. So,
when entering into a series of transactions, taxpayers should
evaluate whether the series as a whole has economic substance
and whether each transaction, separately, has economic
substance.
Because the outcomes of cases dealing with the economic
substance depend heavily on the facts, pertinent case law
analyzing economic substance will likely be unavailable for
many types of transactions. This lack of authority will
create uncertainty in determining whether section 7701(o)
applies to a given transaction. This uncertainty, in and
of itself, would not be so meaningful if the Act did not also
change the penalty provisions of section 6662. While
taxpayers have long been exposed to the risk of
recharacterization for lack of economic substance, the new
penalty provisions magnify the risks associated with the
economic substance doctrine, as discussed in the next
section.
Effect of the New Penalties Under Sections 6662 and
6676
Section 6662 provides penalties for taxpayers who underpay
their taxes. The section 6662 penalty is applicable to
underpayments that are attributable to negligence or disregard
of the rules or regulations, substantial understatements of
income tax, substantial valuation misstatements, substantial
overstatements of pension liabilities, and substantial estate
or gift tax valuation understatements. The penalty is 20
percent of the portion of the underpayment to which section
6662 applies. Section 6676 imposes a penalty for claims
for excessive refunds made without a reasonable basis.
The penalty is 20 percent of the excessive amount of refund
claimed. The Act extends the penalties of sections 6662
and 6676 to transactions lacking economic substance.
The Act's most considerable effect is its imposition of
strict liability penalties for underpayments and requests for
refunds relating to transactions failing the economic
substance test. The new section 6662(b)(6) extends
section 6662 penalties to underpayments resulting from
transactions that fail the statutory economic substance test
of section 7701(o) or any similar rule of law. Further,
the Act provides for increased penalties for any nondisclosed
noneconomic transactions. Under section 6662(i), the
penalty of section 6662(a) is increased from 20 percent to 40
percent for any transaction described in section 6662(b)(6)
for which the taxpayer does not provide adequate
disclosure. The Act also removes the reasonable cause
defense to the penalties of sections 6662 and 6662A for any
transaction described in section 6662(b)(6). Finally,
the Act imposes penalties under section 6676 for any request
for refund relating to a transaction described in section
6662(b)(6). The Act states that requests for refunds
relating to section 6662(b)(6) are treated as not having a
reasonable basis for purposes of section 6676.
Absent a change in the penalty rules, the Act's effect on
tax planning would have to be much smaller than it is.
Before the Act's enactment, taxpayers and their advisers had
to consider the risk of whether a transaction would be
recharacterized for failing the common law economic substance
doctrine. The new sections 6662(b)(6) and 6662(i),
however, greatly increase the risks associated with failing to
comply with economic substance doctrine. This will
impact both taxpayers and their advisers.
Taxpayers and their advisers should now carefully consider
whether a transaction meets the economic substance doctrine in
order to avoid the accuracy-related penalties of section
6662. In order to escape the harsh 40 percent penalty of
section 6662(i), taxpayers may want to disclose all
transactions having the slightest chance of violating the
economic substance doctrine. As discussed above,
determining whether a transaction violates the economic
substance test of section 7701(o) is not an easy task.
Because the common law economic substance test is very
fact-dependent and because the Act does not define what
transactions the section 7701(o) test applies to, it will be
difficult for taxpayers to assess their risks under the new
section 6662(b)(6). These risks are further aggravated
because taxpayers cannot rely on reasonable cause as a defense
to penalties arising from section 6662(b)(6). Likewise,
because of the new penalty in section 6676(c), taxpayers
considering filing a claim for refund will want to carefully
evaluate whether the transaction at issue raises any economic
substance concerns. Further, the strict liability nature
of the section 6676(c) penalty means that taxpayers cannot use
a refund request as a method for testing uncertain tax
positions.
Violations of Any Similar Rule of Law
The extended penalty regime is not limited to the statutory
economic substance test of section 7701(o). The Act
imposes the accuracy-related penalties for violating the
economic substance doctrine or any similar rule of law.
The Act does not define what is a similar rule of law for
these purposes. The JCT Technical Explanation states
that similar rule of law term is intended to apply the section
6662 penalty to transactions the tax benefits of which are
disallowed as a result of the application of the similar
factors and analysis that is required under the provision for
an economic substance analysis, even if a different term is
used to describe the doctrine. So, it may be that the
similar rule of law provision merely extends the statutory
test to jurisdictions that use a different name to describe
the economic substance doctrine. However, a broader
interpretation of the term "similar rule of law" is
possible. A similar rule of law could conceivably be
interpreted to mean other common law doctrines used to
recharacterize transactions, such as the step transaction
doctrine or the substance over form doctrine. A similar
rule of law might also be interpreted to mean any statutory
anti-abuse rule intended to prevent the distortion of economic
realities.
While the JCT's explanation applies a narrower meaning to
similar rule of law, it is possible that courts or the IRS
would use a broad definition of similar rule of law in
determining penalties under the new section 6662(b)(6).
Potentially, a taxpayer must now worry not only about section
6662 penalties for failing the statutory economic substance
test provided by the Act, but also about potential section
6662 penalties for failing the common law economic substance
doctrine as applied in the taxpayer's jurisdiction or any
other similar doctrine. Further clarification of what a
similar rule of law is for purposes of the new section
6662(b)(6) would be helpful.
The section 6662(b)(6) and section 6662(i) penalties may
also increase IRS motivation to pursue challenges based on the
economic substance doctrine. Up to the present, the IRS
has used the economic substance doctrine as a kind of backstop
to the Code. That is, if the IRS was unable to
successfully challenge a transaction on technical statutory
grounds, it might appeal to the court to recharacterize the
transaction under the economic substance doctrine. The
Act does not require a transaction to be analyzed under
applicable statutory rules before applying an economic
substance analysis. While some courts have only turned
to economic substance after a detailed statutory analysis,
other courts have proceeded directly to economic
substance.
Sections 6662(b)(6) and 6662(i) provide penalties for
violations of the economic substance doctrine which are not
necessarily available for violations of technical statutory
provisions. So, where a transaction might be challenged
either for lack of economic substance or for a technical
violation, the IRS will now be incentivized to pursue the
economic substance argument first in order to collect the
section 6662 penalties. In turn, these new incentives to
the IRS may create more economic substance risk for
taxpayers.
Conclusion
The Act codifies the standard used in applying the economic
substance doctrine without any guidance as to when that
doctrine is applicable. Until further guidance on the
applicability of the doctrine is issued, a fact-specific
analysis of a given transaction is required to determine
whether the transaction poses economic substance
concerns. Because of the increased penalty provisions
provided by the Act, taxpayers may now wish to be more
cautious in entering transactions that have a potential for
being recharacterized for lack of economic substance.
For more information, please contact:
Peter
J. Connors
Partner, Tax
212-506-5120
Paul
J. Sax
Senior Counsel, Tax
415-773-5949
George G.
Wolf
Partner, Tax
415-773-5988
Wolfram
Pohl
Associate, Tax
415-773-4252
[1] All section references are to
the Internal Revenue Code, unless otherwise noted.
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