Codification of Economic Substance and the New Strict Liability Penalty

Codification of Economic Substance and the New Strict Liability Penalty

The recently passed 2010 Revenue Reconciliation Act contains new tax law provisions that "codify" the economic substance doctrine and impose new penalties on transactions without economic substance. Importantly, the new penalty has no reasonable cause exception. The penalty is 20 percent if the transaction is disclosed and 40 percent if the transaction is not disclosed. The new provisions are effective for transactions entered into after March 30, 2010.

Economic Substance and Business Purpose

The doctrines of "economic substance" and "business purpose" have been applied by the courts for many years to deny tax benefits from certain tax-motivated transactions. The application of these doctrines in the courts, however, has not been uniform. Congress hopes that the codification of economic substance in new Section 7701(o) will provide consistency in applying the doctrines, but many unresolved areas will remain.

Under new Section 7701(o), the economic substance doctrine will be applied using a "conjunctive" test. That is, the transaction will be respected as having economic substance only if both the following two tests are met:

    * there has been a meaningful change in the taxpayer's economic position (apart from federal income tax effects), and

    * the taxpayer has a substantial non-federal tax purpose for entering into the transaction.

In evaluating the taxpayer's business purpose, any state tax benefits or financial accounting benefits that are related to a federal income tax effect cannot be considered. Moreover, profit potential can only be taken into account 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. For this purpose, it is expected that regulations will provide that foreign taxes will be treated as an expense.

Unresolved Areas:

The new law leaves many unresolved areas open to interpretation. For example, Section 7701(o) only applies when the doctrine of economic substance is "relevant" to a transaction but does not specify when economic substance is relevant. Moreover, the new law does not explain when a non-tax business purpose for a transaction will be "substantial" or when a change in a taxpayer's economic position is "meaningful."

Some Relief:

The Joint Committee Report includes a critical exclusion from the codification. In a footnote, the Joint Committee states that if the realization of tax benefits in the transaction is consistent with congressional purpose, the doctrine of economic substance will not be relevant.1 Some situations in which economic substance would not be relevant include: claiming tax credits, such as the low-income housing credit and energy credits; choosing to capitalize a business with debt instead of equity; using a foreign corporation instead of a domestic corporation for a foreign investment; entering into a tax-free reorganization; and using a related party transaction that complies with arm's-length standards.

Strict Liability Penalty for Non-Economic Substance Transactions

A particularly harsh aspect of the new law is the strict liability penalty. The new law applies a 20 percent penalty to underpayments that are attributable to a transaction lacking economic substance under Section 7701(o) or failing to meet the requirements of any similar rule of law. The penalty is 40 percent if the transaction is not disclosed.

Importantly, there is no reasonable cause exception to the penalty. As a result, an opinion of counsel or in-house tax analysis will not protect a taxpayer from the penalty. The penalty provision also applies to claims for refund that are excessive due to lack of economic substance.

Pepper Perspective

While the new law purports to lend some uniformity to the application of the doctrine of economic substance, in practice many issues are open to interpretation, and taxpayers have little guidance as to how the IRS will respond to the codification. Congress and the IRS have asserted that this provision merely codifies the existing judicial doctrine of economic substance and is not intended to expand the scope of transactions subject to the rule. Nevertheless, taxpayers may need to reassess the comfort level for prior transactions and for future transactions; taxpayers should consider implications of the new rules. Some practitioners believe that IRS agents may attempt to expand the meaning of "economic substance." In light of the large penalty, some practitioners may choose to seek IRS rulings on more common transactions to protect themselves.

Taxpayers will also need to take appropriate steps to mitigate the effects of the harsh new penalty regime. With no reasonable cause exception to the penalty, taxpayers can no longer rely upon opinions of counsel for the avoidance of penalties. Moreover, the 40 percent penalty for nondisclosed transactions raises the stakes for aggressive tax planning transactions. As a result, taxpayers will likely consider disclosure as a means to reducing potential penalty exposure.


1 See JCX-18-10 at Footnote 344.

The material in this publication is based on laws, court decisions, administrative rulings, and congressional materials, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship. Internal Revenue Service rules require that we advise you that the tax advice, if any, contained in this publication was not intended or written to be used by you, and cannot be used by you, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

This article is republished with permission of Pepper Hamilton, LLP. Further duplication without the permission of Pepper Hamilton, LLP is prohibited. All rights reserved.