BY GeOrGe G. jONeS ANd MArk A. LuSCOMBe
Codification of economic
substance: ready or not
The ball is
now in the
IRS’s court,
to release
guidance
that either
narrows or
broadens
the reach of
new Code
Section
7701(o).
“
”
Codification of the economic sub- stance doctrine by the Health Care and Education Reconciliation Act
of 2010 has produced a palpable level of
anxiety among many tax practitioners over
how the new law will be applied to a variety
of tax strategies.
Ironically, the prediction that codifying
economic substance would “clarify and enhance” its application may prove premature,
at least until the Treasury and the Internal
Revenue Service can rein in some of the uncertainties created under the new law.
the economic substance requirements personal transactions by individuals (but not
their business or investment dealings).
Finally, the new law assures taxpayers
that the determination of whether the eco-
nomic substance doctrine is “relevant” for
purposes of triggering the Code Section
7701(o)( 1) (A) “meaningful change” and (B)
“substantial purpose” tests will be made “in
the same manner as if this subsection had
never been enacted.”
The Joint Committee on Taxation elaborat-
ed on this “doctrine-as-usual” provision. In
its JCX- 18-10 report, it explained that, while
codification of the economic substance doc-
trine is designed to provide a uniform defini-
tion for all cases to which it applies, it is not
designed to alter the flexibility of the courts
in other respects.
It further explained that those “other respects” include a court’s ability to aggregate,
disaggregate or otherwise recharacterize a
transaction when applying the doctrine. The
freedom given to courts under the codification may in fact thwart Congress’ goal of
having a unified application of the economic
substance doctrine nationwide.
Future course: The language in new Code
Sec. 7701(o) raises a host of definitional issues. What standards are used to determine
whether the economic substance doctrine is
“relevant” to a transaction? What measurements are appropriate to compare the benefits from pre-tax profits to net tax benefits?
What constitutes change in a “meaningful
way?” When is a purpose “substantial?”
When is expected pre-tax profit “substantial
in relation to the present value of the expected net tax benefits?” What breadth did Congress intend to give to Code Sec. 7701(o)( 5),
which explains that, “The term ‘transaction’
includes a series of transactions?”
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA,
is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.
NEW CODE SECTION 7701(O)
The common law economic substance
doctrine provides that the tax benefits of a
transaction are not allowed if the transac-
tion does not have economic substance or
lacks a business purpose. Application of
that doctrine has now been codified in Code
Section 7701(o), “Clarification of Economic
Substance Doctrine.” New Code Section
7701(o)( 1) requires that, “In the case of any
transaction to which the economic substance
doctrine is relevant, such transaction shall be
treated as having economic substance only if
(A) the transaction changes in a meaningful
way (apart from federal income tax effects)
the taxpayer’s economic position, and (B)
the taxpayer has a substantial purpose (apart
from federal income tax effects) for entering
into such transaction.”
This codified standard clarifies that the
economic substance doctrine involves a con-
junctive analysis that requires inspection of
the objective effects of the transaction on the
taxpayer’s economic position, as well as the
taxpayer’s subjective motives for engaging
in the transaction. By requiring a two-prong
test, the new law eliminates the split among
the federal circuit courts concerning applica-
tion of the doctrine … and does so decidedly
in the IRS’s favor.
New Code Section 7701(o), among its
other provisions, further provides a special
rule under which taxpayers showing profit
potential to satisfy the requirements of (A)
and (B) must show a “substantial” profit exclusive of tax benefits. It also exempts from
NEW PENALTY REGIME
Under new Code Sec. 6662(b)( 6), a 20 percent
penalty will be imposed for an underpayment
attributable to any disallowance of claimed
tax benefits by reason of a transaction lacking
economic substance, as defined in new Code
Section 7701(o), or failing to meet the require-
ments of any similar rule of law. Under new
Code Sec. 6662(i)( 1), the penalty is increased
to 40 percent for an underpayment attrib-
utable to a “non-disclosed non-economic
substance transaction.” A “non-disclosed
non-economic substance transaction” is de-
fined as any portion of a transaction lacking
economic substance with respect to which
the relevant facts affecting the tax treatment
are not adequately disclosed in the return or
in a statement attached to the return.
See STRATEGy on 18
