The recent health-care legislation (H.R. 4872) will be partly paid by a tax increase associated with an unclear tax provision aimed at tax shelters, but which could be used by the Internal Revenue Service (IRS) for much broader tax assessments. Taxpayers are now subject to a 40% penalty on tax underpayments related to transactions that lack “economic substance”. The penalty will be reduced to 20% if the tax treatment is disclosed in the tax return.
The penalty is a strict liability determination. There is no reasonable-cause defense. A taxpayer who engages in a transaction that lacks economic substance will be subject to these penalties even if the taxpayer acted reasonably and in good faith. Opinions of outside counsel or in-house tax analyses will not protect a taxpayer from imposition of the penalty.
The economic substance test is a common law doctrine that denies tax deductions when the underlying transaction lacks an underlying economic purpose. Similar tests are called “business purpose,” “sham transaction,” “substance over form” and “step-transaction” doctrines. However, the courts have not applied the doctrine uniformly. The new law applies the stricter so-called “conjunctive test” that requires the taxpayer to demonstrate both business purpose and economic substance.
The new Section 7701(o) of the Internal Revenue Code entitled “Clarification of Economic Substance.” includes:
‘‘(1) APPLICATION OF DOCTRINE.—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.”
The existence of economic substance will be evaluated based on the transaction’s potential for pre-tax profit. The new law states:
“The potential for profit of a transaction shall be taken into account in determining whether the requirements of subparagraphs (A) and (B) of paragraph (1) are met with respect to the transaction only if the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected.”
The term “substantial” is obviously unclear. Absent regulations defining the law, there is no minimum return that will satisfy the pre-tax profit-potential test.
The new law does not specify the transactions to which the economic-substance doctrine applies. The IRS, and ultimately the courts, will get to determine whether the above-quoted relevancy precondition is met. However, the Joint Committee on Taxation explanation accompanying the statute provides general guidance on the inapplicability of Section 7701(o) to certain tax-motivated transactions. Specifically:
“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. Among these basic transactions are (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. Leasing transactions, like all other types of transactions, will continue to be analyzed in light of all the facts and circumstances. As under present law, whether a particular transaction meets the requirements for specific treatment under any of these provisions is a question of facts and circumstances.[Footnotes omitted]”
The Joint Committee on Taxation similarly provides a second statement that the new law is not intended to undo other tax laws specifically authorized by Congress, as follows:
“If the realization of the tax benefits of a transaction is consistent with the Congressional purpose or plan that the tax benefits were designed by Congress to effectuate, it is not intended that such tax benefits be disallowed…. Thus, for example, it is not intended that a tax credit (e.g., section 42 (low-income housing credit), section 45 (production tax credit), section 45D (new markets tax credit), section 47 (rehabilitation credit), section 48 (energy credit), etc.) 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.”
Despite these assurances, the vagueness of the law means that normal-course business transactions could be considered to lack economic substance. Facts and circumstances pertaining to the specific transaction at issue will determine whether a particular transaction meets the economic substance requirements. Additional IRS guidance would be helpful, but the IRS is not yet committed to providing any specific guidance. Without additional guidance, taxpayers will face uncertainty as to whether transactions that include tax motivations will be subject to IRS challenge under the economic substance doctrine.
These tax changes will have the following practical impacts:
- Financial statement auditors will focus more on the economic substance doctrine and related penalties. Companies should be prepared to present a more thorough analysis before the tax benefits of transactions can be recognized on their financial statements.
- The new penalties create much larger risks for entering into tax-motivated transactions. Because the new penalties are substantial and perhaps out of proportion to whatever technical concerns the IRS might have, expect the IRS to use the economic substance doctrine to a greater extent. The IRS is further aided because the stricter conjunctive test that was previously applicable in only certain circuits now applies nationally. Because there is a strict liability test preventing the avoidance of penalties, companies should perform rigorous testing of tax motivated transactions before proceeding.
For individuals, new section 7701(o) applies only to transactions entered into in connection with activities engaged in for the production of income. The new economic-substance test does not apply to routine charitable giving and estate planning gifts.
The Joint Committee on Taxation estimates the new penalties will collect $4.5 billion through 2019. These new rules apply to transactions entered into after March 30, 2010.