On March 30, President Obama signed the Health Care and
Education Reconciliation Act of 2010 (the "Act"),
enacting certain changes to the recently completed health care
overhaul. Included as a revenue raiser is a codification of the
"economic substance doctrine" as new Section 7701(o) of
the U.S. Internal Revenue Code, which applies to transactions
entered into after March 30, 2010. Similar provisions had been
proposed numerous times over the past several years with little
support from the tax community.
New Code Section 7701(o) applies to "any transaction to which
the economic substance doctrine is relevant". Generally,
courts have applied the economic substance doctrine in transactions
that are specifically structured to achieve a particular tax result
without meaningfully changing the taxpayer's economic position.
Courts have used the doctrine to treat the taxpayer as if it had
not entered into the transaction for tax purposes.
Different courts have applied the doctrine differently in deciding
when and how to apply it. For example, in a recent case, a court
used the doctrine to ignore particular steps in a transaction even
though the overall transaction clearly changed the taxpayer's
economic position. Courts have used different standards in
determining how to decide whether a transaction should be
considered to have "economic substance". Courts have also
not applied the doctrine in certain transactions, such as tax-free
reorganizations, where the court considered that the Code clearly
contemplates allowing the taxpayer to enter into the transaction in
order to achieve the tax results specified by the relevant Code
provision.
Whenever the economic substance doctrine is applied, Section
7701(o) specifies that a transaction will be considered to have
economic substance only when the following two requirements are
met:
- The transaction changes the taxpayers' non-tax economic position "in a meaningful way".
- The taxpayers have a "substantial" non-tax related purpose for entering into the transaction.
Courts have previously differed on whether this was the correct
formulation of how to apply the doctrine and whether both of these
requirements - a significant economic change, and
a significant non-tax purpose - were necessary. The Act makes it
clear that both requirements need to be present for a transaction,
and potentially steps within a larger transaction, to be respected
for tax purposes. The resulting two-prong test is significantly
broader in concept than similar anti-avoidance rules in other
countries, such as, Canada - where, for instance, meeting the first
requirement would typically be sufficient.
Statements in the legislative history assert that the Act is not
intended to change when the doctrine is applied and that it was not
intended that Section 7701(o) would apply to certain decisions
that, although tax-motivated, have historically been left, within
limits, to taxpayers' discretion - such as the decision to
capitalize an entity with debt or equity, the choice whether to use
a U.S. or foreign entity to make an investment, the decision to
engage in a corporate reorganization, and the decision to involve a
related party in a transaction. Legislative history is not binding
on courts, however, and Section 7701(o) itself only states that the
provision will apply to "any transaction" to which the
doctrine is "relevant", and that "the determination
of whether the economic substance doctrine is relevant to a
transaction (or series of transactions) shall be made in the same
manner as if this subsection had never been enacted". Given
that the U.S. Internal Revenue Service (the "Service")
has the authority to issue interpretive regulations under the Code,
it is possible that the Service could decide to issue regulations
under Section 7701(o) that broaden, potentially significantly, the
range of situations where the economic substance doctrine will be
applied.
The Act also increases the penalty for substantial understatements
of tax attributable to transactions lacking economic substance to
40% of the amount of the tax. The penalty can be reduced to 20% if
the transaction is disclosed on the taxpayer's return.
The development of the economic substance doctrine in the wake of
the enactment of new Section 7701(o), including any pronouncements
or proposed regulations issued by the Service, will need to be
closely monitored to determine how taxpayers need to structure (or
avoid) and analyze transactions, including parts of transactions
that might be separately tested, in order to avoid the ambit of
this potentially amorphous doctrine. While courts have struck down
regulations considered to exceed the scope of the related Code
rule, it is quite possible that the IRS will successfully implement
a broad application of Section 7701(o). One clear consequence is
that it will become even more critical to evaluate the desired
structure when an investment or business transaction is first
consummated to take into account all future circumstances and tax
goals, as it will become increasingly difficult to make
tax-motivated changes once the structure for the investment or
business arrangement is established.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
