United States: Wisconsin Amends Economic Substance Requirement To Conform To Federal Law

On March 1, 2016, Wisconsin enacted legislation that amends the existing economic substance requirement that applies to corporate income tax and personal income tax to conform to the economic substance requirement provided by Internal Revenue Code (IRC) Section 7701(o).1 Wisconsin's prior economic substance requirement was broader than the federal requirement that was subsequently adopted. This legislation is effective for tax years beginning on or after January 1, 2016.2

Wisconsin Economic Substance Requirement

Wisconsin enacted its own economic substance requirement in 2009.3 If any person, directly or indirectly, engages in a transaction or series of transactions without economic substance to create a loss or to reduce taxable income or to increase credits allowed in determining Wisconsin tax, the Wisconsin Department of Revenue will determine the amount of taxable income or tax so that it reflects what would have been the taxable income or tax if not for the transaction or transactions without economic substance causing the reduction in taxable income or tax.4 Transactions between members of a controlled group5 are presumed not to have economic substance and the taxpayer must prove economic substance through clear and convincing evidence.6

Prior Standard

Under the original standard, effective for tax years beginning on or after January 1, 2009 and prior to January 1, 2016, a transaction has economic substance only if the taxpayer shows both of the following:

  • The transaction changes the taxpayer's economic position in a meaningful way, apart from federal, state, local, and foreign tax effects; and
  • The taxpayer has a substantial nontax purpose for entering into the transaction and the transaction is a reasonable means of accomplishing the substantial nontax purpose. A transaction has a substantial nontax purpose if it has substantial potential for profit, disregarding tax effects.7

New Standard

As amended, for tax years beginning on or after January 1, 2016, a transaction has economic substance only if the transaction is treated as having economic substance as determined under IRC Section 7701(o), except that the tax effect is determined using federal, state, local or foreign taxes, rather than only the federal income tax effect.8 Under IRC Section 7701(o), in the case of any transaction to which the economic substance doctrine is relevant,9 the transaction is treated as having economic substance only if: (i) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer's economic position; and (ii) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into the transaction.10 For purposes of this standard, any state or local income tax effect which is related to a federal income tax effect must be treated in the same manner as a federal income tax effect.11 While the potential of the transaction to produce profit can be evidence of economic substance, the federal statute provides that the profit potential standard is met only if the present value of the "reasonable expected pre-tax profit" from the transaction is "substantial" in relation to the present value of the expected "net tax benefits" that would be obtained if the transaction were respected.12

Commentary

In 2009, Wisconsin codified an economic substance requirement in advance of an economic substance standard added to the IRC a year later. At the time that Wisconsin enacted the requirement, there was some concern in the tax community that the standard was too broad. For example, the language used in the statute appeared to be so broad that even charitable contributions made by a taxpayer could conceivably be disallowed. Also, some of the language in the statute arguably was ambiguous. If challenged, taxpayers could have had difficulty in showing that a transaction was a "reasonable means" of accomplishing the substantial nontax purpose. Furthermore, separate from the economic substance standard, the Department has the statutory ability to exercise discretionary authority to distribute, apportion or allocate gross income, deductions, credits or allowances between related entities if necessary to prevent evasion of taxes or to clearly reflect income.13 Therefore, the need for a separate statutory economic substance standard was debatable.

In our experience, since the enactment of the Wisconsin economic substance standard, we have not seen the economic substance standard publicly utilized as a defense by the Department. However, the economic substance issue has arisen in Wisconsin litigation concerning periods prior to 2009. For example, the Wisconsin Tax Appeals Commission upheld the denial of deductions for royalties paid to a related entity based on the fact that the primary purpose for the creation of the affiliate and payment of royalties was tax avoidance, and that payment of the royalties otherwise had no economic substance or business purpose.14

The legislature's decision to replace Wisconsin's economic substance standard with the federal standard should benefit taxpayers in that the federal standard is somewhat easier to interpret and not as broad. Although Wisconsin now adopts the standard from IRC Section 7701(o), it makes a notable change to the standard. Rather than only considering the federal income tax effect, the Wisconsin standard also considers the effect on state, local or foreign taxes. Thus, similar to the prior Wisconsin standard, the new standard addresses transactions that have no federal tax effect but have a state or local tax effect.

Footnotes

1 Act 218 (S.B. 503), Laws 2016.

2 Act 218 (S.B. 503), § 11.

3 Act 2 (S.B. 62), Laws 2009, adding WIS. STAT. §§ 71.10(1m); 71.30(2m); 71.80(1m).

4 WIS. STAT. §§ 71.10(1m)(a); 71.30(2m)(a); 71.80(1m)(a).

5 As defined in IRC § 267(f)(1).

6 WIS. STAT. §§ 71.10(1m)(c); 71.30(2m)(c); 71.80(1m)(c).

7 Prior WIS. STAT. §§ 71.10(1m)(b); 71.30(2m)(b); 71.80(1m)(b).

8 WIS. STAT. §§ 71.10(1m)(b); 71.30(2m)(b); 71.80(1m)(b).

9 "Economic substance doctrine" means the common law doctrine under which the tax benefits for a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose. IRC § 7701(o)(5).

10 IRC § 7701(o)(1). Note that this federal economic substance provision was enacted on March 30, 2010, as part of the Health Care and Education Reconciliation Act of 2010 (P.L. 111-152). In general, the economic substance provisions apply to transactions entered into after March 30, 2010.

11 IRC § 7701(o)(3).

12 IRC § 7701(o)(2)(A).

13 WIS. STAT. §§ 71.10(1); 71.30(2); 71.80(1). These are similar to the powers provided under IRC § 482.

14 Hormel Foods Corp. v. Department of Revenue, Wisconsin Tax Appeals Commission, No. 7-I-17, Mar. 29, 2010.

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