April 9, 2010
On March 30, 2010, President Obama signed the Health Care and Education
Affordability Reconciliation Act of 2010 (the “Act”).
Section 1409 of the Act codifies the economic substance doctrine and applies
to transactions entered into after March 30, 2010.
The economic substance doctrine is a judicially-developed doctrine under
which the anticipated tax benefits from a transaction may be denied if the
transaction does not result in a meaningful change to the taxpayer’s economic
position other than reducing federal income taxes. This result can occur even if
the transaction otherwise satisfies all statutory and administrative
The Act adds new section 7701(o) to the Internal Revenue Code which provides
that in the case of any transaction “to which the economic substance doctrine
is relevant” the transaction shall be treated as having economic substance only
if (1) the transaction changes in a meaningful way (apart from federal income
tax effects) the taxpayer’s economic position and (2) the taxpayer has a
substantial purpose (apart from federal income tax effects) for entering into
While the new statute specifies the test that must be met in order to have
economic substance, it does not specify when that test must be applied. It
merely states that the determination of whether the economic substance doctrine
is relevant to a particular transaction will be made in the same manner as if
the new statutory economic substance provision had not been enacted.
Unfortunately, existing authorities do not clearly define the types of
transactions that are subject to the economic substance doctrine. Accordingly,
taxpayers are left with substantial uncertainty as to the circumstances in which
this new statute will be applied.
The Act includes a new 40% strict liability penalty that will be imposed on
underpayments resulting from transactions found to lack economic substance or
failing to meet the requirements “of any similar rule of law.” The penalty is
reduced to 20% of the underpayment if the transaction is disclosed by the
taxpayer. If it is determined that the doctrine applies to a transaction and the
test is not met, this harsh penalty will apply, regardless of the reasonableness
of a taxpayer’s belief that the economic substance doctrine is not relevant to a
transaction or that the transaction satisfies the statutory economic substance
The new statutory economic substance provision will greatly complicate tax
planning. The provision is quite broad, and many legitimate business
transactions, if tested for economic substance, could fail the statutory test.
This will not matter for certain common transactions to which the doctrine
clearly is not relevant. There will be other situations, however, in which
taxpayers might reasonably expect the doctrine not to be relevant but are unable
to be certain. There will also be situations in which the doctrine is or may be
relevant, and in which it is not clear whether the statutory test is satisfied.
For these reasons and because of the related strict liability penalty, taxpayers
must accept increased tax risk with respect to some transactions and, in all
likelihood, will be deterred from engaging in other transactions that otherwise
would have been undertaken.
For a more detailed and technical discussion of the new statutory economic
substance doctrine and its possible applications, see the article “Codification
of the Economic Substance Doctrine by the Health Care and Education
Affordability Reconciliation Act of 2010.”