Canada: U.S. Tax Law Economic Substance Doctrine Codified - With Potentially Broad Consequences for Transaction Planning

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.

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