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 requirements.
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 such transaction.
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 test.
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.”