Economic Substance Codification and Multinational Cross-Border Transactions

Economic Substance Codification and Multinational Cross-Border Transactions

U.S. multinationals need to focus on the codification of the Economic Substance Doctrine in the recently enacted Health Care and Education Reconciliation Act of 2010, P.L. 111-152 (H.R. 4872)...  U.S. multinationals with contemplated or pending transactions [need] to act quickly to put in place a practical cross-border risk-management plan.

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The new law provides no guidance with respect to determining the relevance of economic substance to a particular transaction. Instead, it relies on the current subjective common law determination based on the overall consistency between a transaction's tax benefits and business results. The court retains significant latitude in determining whether the doctrine may be relevant and may combine, dissect or otherwise typify a transaction.

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New 26 USC 7701(o)(2)(A) introduces the so-called Profit Test, which looks at the ratio of pre-tax profit to tax benefit that would be allowed if the transaction were respected. This test is intended to create an objective measure of economic impact with respect to all or part of a given transaction by comparing the present value of the reasonably expected pre-tax profit from the transaction to the present value of the net tax benefits that would be allowed if the transaction were respected. If the pre-tax profit is "substantial" compared to the net tax benefits, the transaction would be deemed to pass the Profit Test... The term "substantial" is not defined and there is no precedent or other available indicator as to what ratio would suffice. Further, in applying the Profit Test, transaction fees and costs - including foreign taxes - are treated as expenses in determining pre-tax profits. [The IRS is to issue accompanying regulations that require that foreign taxes be treated as expenses in calculating pre-tax profits where appropriate.]

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Given the immediate implications of the new law - applicable for transactions entered into after March 30, 2010 - management and in-house and outside counsel must...

  • Capture Transaction-Related Communications. Remember that the most damning evidence against the taxpayer in the case of Schering-Plough Corp. v. United States, 651 F. Supp. 2d 219 (D.N.J. 2009), came directly from the taxpayer's own internal emails and memoranda...
  • Analyze and Document Contemporaneously. While taxpayers cannot prevent the IRS from using economic substance to challenge a transaction, they can take steps to close off the government's arguments through systematic and comprehensive analysis and documentation. Veritas Software Corp. v. Comm'r, 2009 U.S. Tax Ct. LEXIS 34 (T.C. Dec. 10, 2009).
  • Report Proactively. For those transactions that may not be specifically listed or recognized as explicitly reportable, counsel should work closely with the taxpayer to determine if disclosing the transaction is appropriate as a proactive measure... [and] to ensure that appropriate reporting of uncertain tax positions under Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes... reflects the rule changes with respect to a transaction whose economic substance may be relevant.

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Comments

Anonymous
Anonymous
  • 06-10-2011

I am currently searching the information re. penalties in the case if the lack of economic substance, unfortunately tehe article is silent in this respecr ...