Severe Tax Penalties to be Imposed for Violation of Newly Codified Economic Substance Doctrine
The realm of tax law has been significantly changed by the recent codification of the economic substance doctrine in the Health Care and Education Reconciliation Act of 2010(i) supplementing the Patient Protection and Affordable Care Act(ii), signed into law on March 30, 2010 (together, herein, as the “Act”). The new provision takes a judicially created doctrine that has existed for decades and turns it into a statutory weapon for the Internal Revenue Service (IRS) to use. With this codification, taxpayers need to pay attention and beware.
There are several judicially created tax law doctrines, including the business purpose, sham transaction, and step transaction doctrines. However, the Acts inclusion of the economic substance doctrine represents the first codification of a judicially created doctrine. The new provision provides for the imposition of severe penalties for violations of the economic substance doctrine.
History of the Economic Substance Doctrine
The substance over form doctrine provides that even though the form of a taxpayers transaction may have met the literal requirements of a statute or regulation, the court can still look to whether the transactions substance was consistent with its form.(iii) The purpose of the substance over form doctrine being that a transaction that lacks such substance should not be given the tax benefit prescribed for the form of the transaction. In other words, a taxpayer is usually bound to the form it has chosen, however, the government may dispute that form on the basis that the form does not reflect the actual substance of the transaction.
The economic substance doctrine is a subcategory of the substance over from doctrine. The economic substance doctrine, a judicially created principle, has been treated by courts as a principle of statutory interpretation to construe the text of the Internal Revenue Code (IRC). This doctrine allows the government to reclassify a transaction in a way that reflects its substance when the transaction has no economic substance other than its tax consequences. The IRS and courts have used the economic substance doctrine as a primary tool in challenging questionable tax shelters.
The doctrine is universally recognized and applied by the courts. However, the doctrine has not been consistently applied in the U.S. Circuit Courts of Appeal. The Fourth and D.C. Circuits have adopted a two-prong conjunctive test. In order to disregard a transaction for federal income tax purposes under this test, the court must conclude the transaction fails two requirements: 1) subjective business purpose, and 2) objective profit potential. The Sixth, Eleventh, and Federal Circuits adopted the same test but in a disjunctive fashion. Under the disjunctive version of the test, if the transaction fails either of the two prongs, the transaction at issue may be disregarded. Finally, the Third, Ninth, and Tenth Circuits, adopted a unitary test in which the subjective business purpose and the objective profit potential combined shape the analysis of the transactions substance in relation to the tax consequences.
The Acts Codification of the Doctrine
The Act provides that the economic substance doctrine will be applied in any situation in which the courts would have applied it in the past. Therefore, there is no definition as to when the doctrine should be applied. The law codifies the conjunctive test previously applied by some jurisdictions, requiring that the taxpayer show that the transaction: 1) changes in a meaningful way (apart from federal income tax effects) the taxpayers economic position, and 2) that the taxpayer has a substantial non-tax purpose for entering into the transaction.(iv)
For a taxpayer to justify a transaction using potential economic profit, the taxpayer must demonstrate that the pre-tax profit is substantial in relation to the present value of the expected tax benefits. The taxpayer may take into consideration fees expenses, and foreign taxes when determining pre-tax profit but state tax and financial accounting benefits do not count if the benefits are related to the federal tax treatment.
A noteworthy aspect of this provision is that the IRS may dissect any transaction or series of transaction if it claims that specific parts of the transaction fail the economic substance test even if, overall, the transaction is driven by non-tax economic reasons.(v)
With the enactment of this new law, Congress has indicated that it does not intend to alter the tax treatment of specific business transactions, like choosing to capitalize a business enterprise with debt or equity, engaging in corporate reorganization or choosing a foreign or domestic entity to make a foreign investment.
The penalties dictated by this provision are a major facet of which taxpayers and tax professionals need to be aware. A penalty equal to 20% of the tax is assessed if the transaction fails the two-prong test. The penalty jumps to 40% of the tax if the IRS finds that the transaction was not sufficiently disclosed. Moreover, taxpayer does not get to show that it had reasonable cause for its position regarding the transaction at issue. If the taxpayer loses, the 20% or 40% penalty is automatic.
The new law, along with the resulting penalties, is already in effect. All transactions that occur after March 30, 2010 are subject to the rule.
With the codification of the economic substance doctrine in the Act, Congress has provided the IRS with a serious weapon to utilize in its examinations. The effects will likely be seen from the IRS, taxpayer, and tax practitioner perspectives. Tax professionals may be less apt to push the boundaries with innovative tax planning and structuring transactions. Additionally, IRS agents conducting examinations will likely be quick to use this new power instilled by the codification of the doctrine. Ultimately, because the government has provided no guidance in the law and because the previous case law concerning this doctrine is so inconsistent, taxpayers must act at their own risk when entering into tax-benefitting transactions now that the economic substance doctrine has been codified.
(ii) Pub. L. No. 111-148 (2010).
(iii) See Gregory v. Helvering, 293 U.S. 465 (1935).
(iv) See Health Care and Education Reconciliation Act of 2010 Pub. L. No. 111-152, § 1409 (2010).