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