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The passage of President Obama's health-care legislation will no doubt have long-lasting consequences for the economy in general and the health-care industry in particular. Less noticed by the general public, but central in the minds of tax professionals, has been a single provision in the accompanying reconciliation bill that codifies the so-called "economic substance" doctrine. Having often been introduced in bills that eventually died in the catacombs of the legislative process, many practitioners were beginning to believe that codification was a cousin of Bigfoot and the Loch Ness Monster - often spotted, but never confirmed.
So, now that Code section 7701(o) is "the law," so to speak, has anything changed? The new law provides that a 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.
At a glance, this provision seems to endorse the so-called "two-prong" test for economic substance first articulated in Rice's Toyota World, Inc. v. Comm'r, 81 T.C. 184 (1983), aff'd in part, rev'd in part, and rem'd, 752 F.2d 89 (4th Cir. 1984), while requiring that a transaction have both "economic substance" and a "business purpose" to be respected for tax purposes. (To be sure, the new statute broadens the standard for "economic substance" by replacing the traditional profit-based test with a broader economic-change test. To the extent that codification makes sense at all, this broadening is the most sensible provision, as it recognizes that taxpayers often undertake transactions, especially those directly related to their core businesses, that don't produce discrete profits, but are nonetheless beneficial to the taxpayer's economic position.)
Irrespective of how the statute defines "economic substance," the statute leaves a number of ambiguities that will likely need to be sorted out by the courts. As other commentators have noted, for example, the law doesn't define what is meant by "chang[ing] in a meaningful way... the taxpayer's economic position." Likewise, the statute does not provide any guidance as to the scope of the "transaction" to which the provision is to be applied. As David Hariton recently illustrated in his article "The Frame Game: How Defining the 'Transaction' Decides the Case," the answer to this issue is a critical part of applying the economic substance doctrine, codified or not.
However, an equally troubling issue is determining when the newly codified doctrine is to be invoked in the first place. The law itself says that a transaction may be treated as not having economic substance, but prefaces that treatment as applying to "any transaction to which the economic substance doctrine is relevant." What does it mean for the economic substance doctrine to be "relevant"? Indeed, this is likely to be an (if not the most) important area of contention between taxpayers and the IRS, considering the consequences of the answer.
Surely, taxpayers can identify clear situations in which the economic substance doctrine is likely to be relevant. Think of the quintessential tax shelter cases, such as Knetsch, Shriver, and ACM, which shared a common characteristic in that each was "full of sound and fury, signifying nothing." But what about a related-party loan that has real economic effects, but whose sole purpose is to shift income into a low-tax jurisdiction? Is this a situation in which the economic substance doctrine is relevant? Most taxpayers would likely say, "no," given that a loan clearly has the kind of "economic reality" (to borrow a line from Coltec Indus., Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006)) that the economic substance doctrine is intended to ensure. Yet, in an increasing number of examinations, revenue agents appear to be taking the opposite position, demanding to know the business purposes for related-party loans and other financial transactions.
If the revenue agents are correct, and the economic substance doctrine is "relevant" to such transactions, then the two-prong test discussed above would seem to apply. And for taxpayers who are unable to satisfy the two criteria, the new strict-liability penalty for ostensibly non-economic transactions will apply. This position, however, runs counter to the recent public statement of William Alexander, IRS associate chief counsel (corporate), who was recently cited in Tax Notes as saying that "while the code may demand that the Service ask whether something actually happened (an economic substance inquiry), it doesn't always require that a transaction have a good business purpose." Amy S. Elliott, Alexander Downplays Likely Effect of Economic Substance Codification," 2010 TNT 45-2 (Mar. 9, 2010).
Call me cynical, but I can't escape the suspicion that these ambiguities are intentional. As it was, the law of economic substance was a tangled mess of incoherence long before Congress ever thought to get involved. So why would Congress write a putatively clarifying provision that allows many of the thorniest questions to remain? I believe the answer lies in the new strict-liability penalty for transactions that fail the statutory test.
To discourage taxpayers from entering into potentially abusive transactions, Congress decided to impose a strict-liability penalty that would increase the risks associated with such transactions. To justify imposing this new penalty, Congress needed to define what a non-economic transaction is. However, by leaving open these various questions, Congress was able to leave open the possibility that the new penalty could apply to virtually any transaction, thereby ensuring that the maximum number of transactions would be affected and, therefore, discouraged.
Perhaps, as it seems intended to do, this new provision will reduce aggressive tax planning and increase tax collections. By the same token, though, the provision also creates serious risks that the IRS will be emboldened to attack run-of-the-mill business transactions. If anything is clear, it is not this new law.