Economic substance is an anti-abuse doctrine that analyzes suspect business transactions for a motive other than the obtaining of a tax advantage. Certain strategies involving, for example, corporate reorganizations, acquisitions or sales, financings, partnership structures, loans and deductions, or various tax shelter arrangements may offend the purpose underlying sections in the Internal Revenue Code (IRC) that minimize tax liability.1
While some transactions technically comply with the rules that lead to a tax benefit, they violate the spirit in which those benefits are offered. When this happens, the Internal Revenue Service (IRS) is not obligated to respect the transaction or the tax effects that would flow from it, because such a transaction has no "economic substance." Factors such as the origin, structure, and economic effects of the transaction; effects of the transaction besides profit; and the risk level undertaken by the taxpayer have been considered by the courts to be relevant when determining economic substance.
The result of such a finding can be severe. A taxpayer responsible for transactions lacking economic substance will be subject to a general penalty of 20% of the disallowed tax benefits related to the transaction.2 If there was inadequate disclosure of relevant facts about the non-economic substance transaction, the penalty increases to 40%.3 Taxpayers are precluded from relying on "reasonable cause" defences if subjected to either of these penalties.4
Footnotes
1 Christopher Yan, Economic Substance: A Machine Learning Perspective on the Multi-Factorial Analysis, Lexology (Jul. 11, 2019), https://www.lexology.com/library/detail.aspx?g=281977be-06e5-4e77-a57f-fe0caa4defc7.
2 IRC §§ 6662(a) and (b)(6); § 6676(a).
3 IRC §§ 6662(i)(1) and (2).
4 IRC § 6676(c).
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