Codification of the Economic Substance Doctrine

Reviving an idea that has come and gone several times since 1999, the House and Senate have included similar proposals for the codification of the economic substance doctrine in recent proposed legislation. According to statements by a Treasury official and a Senate Finance Committee staff member at an ABA Tax Section meeting on January 19, a codification proposal will pass in 2008. This item takes a brief look at the common law economic substance doctrine and the proposals to codify it.

The Common Law Economic Substance Doctrine

The economic substance doctrine states that a transaction’s tax benefits will not be allowed if the transaction does not have economic substance. The common law doctrine is an effort by the courts to enforce Congress’s statutory intent in situations in which a literal reading of the Code would allow a taxpayer to circumvent this intent.

While there is agreement among the courts about the general definition of the doctrine and its purpose, the same cannot be said about a test to determine when a transaction has economic substance. Some courts use a single-element test and some use a two-element test. Under the single-element test, a transaction has economic substance if, viewed objectively, there is a nontax business purpose for the transaction. The taxpayer’s subjective intentions regarding the transaction are not taken into account (Coltec Industries, 454 F3d 1340 (Fed. Cir. 2006)). Under the two-element test, a transaction has economic substance if (1) the transaction, viewed objectively, has economic substance and (2) the taxpayer has a subjective business purpose for the transaction. Adding to the confusion, courts that have adopted the two-element test for economic substance have not been consistent in applying it, in some cases requiring that both the elements be satisfied, in others requiring that either one of the two elements be satisfied, and in others only taking both elements into consideration as part of the determination of whether a transaction has economic effects other than those derived from its tax benefits (Pasternak, 990 F2d 893 (6th Cir. 1993); Rice’s Toyota World, 752 F2d 90 (4th Cir. 1985); IES Industries, 253 F3d 350 (8th Cir. 2001); ACM Partnership, 157 F3d 231 (3d Cir. 1998); James, 899 F2d 905 (10th Cir.); Sacks, 69 F3d 982 (9th Cir. 1995)).

Reasons for Codifying the Economic Doctrine

In the 1990s, lawyers and accountants began to develop and aggressively market sophisticated tax shelter ideas that used technical defects in the Code and regulations to generate tax benefits for taxpayers through complicated multi-part transactions that did not appreciably change the taxpayers’ economic position. The IRS and nearly everyone else (other than their promoters and users) viewed these shelter transactions as abusive and illegal efforts to subvert Congress’s intent. However, due to aggressive marketing by shelter promoters and the lure of large tax savings for a low cost, the use of these shelters increased dramatically throughout the 1990s. In litigation over these transactions, one of the IRS’s primary (and most successful) arguments against them has been that they violate the common law economic substance doctrine.

However, the use of the doctrine has been hampered by the fact that, as noted above, there is a split in opinion in the circuit courts over its proper application. This lack of uniformity in the application of the doctrine came to be viewed by some people, including some members of Congress, as a serious impediment to the IRS’s enforcement efforts against abusive tax shelters. This led, beginning in 1999, to repeated attempts by members of Congress to pass legislation that would create a single test for determining whether a transaction has economic substance that would apply to taxpayers all over the country.

Current Proposals

The AMT Relief Act of 2007 (H.R. 4351), which was passed by the House on December 12, 2007, includes Subtitle B, Codification of Economic Substance Doctrine. This bill would add a new subsection to Sec. 7701 that would make the test for economic substance a two-element test in which both elements must be satisfied (see the exhibit). The Senate has attached similar proposed legislation to the Food and Energy Security Act of 2007 (H.R. 2419).

In addition to clarifying how the economic substance doctrine is to be applied, both the House and Senate codification proposals include provisions for new disclosure requirements and strict-liability penalties for transactions that lack economic substance. The penalty under the House version is 20% of an underpayment attributable to a transaction lacking economic substance, while under the Senate version the penalty is 30% of the understatement attributable to such a transaction. Under both proposals, the penalty percentage is increased by 10% if the underlying transaction was not disclosed under the new disclosure rules.

Probable Effects of Codification

Supporters and critics of codifying the economic substance doctrine have widely diverging opinions on what the effects of codification would be. Supporters claim that codifying the doctrine will result in greater clarity and uniformity of the law, leading to a fairer application of the doctrine among taxpayers in different areas of the country and a better environment for responsible tax planning. They also see this greater clarity and uniformity in the law as leading to improved IRS enforcement against tax shelters by reducing the effort IRS personnel currently must expend to learn the nuances of the law as it is applied in different federal circuits. Because the codification proposals include new disclosure requirements and strict liability penalties for transactions lacking economic substance, supporters believe that codification will be a powerful deterrent to participating in such transactions.

Critics do not envision such a rosy future if the doctrine is codified. They look at the vague language of the codification proposals (e.g., “changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position”), the uncertainty of existing precedent after codification, and the likely lack of reliable IRS guidance and conclude that the law will be less clear after codification. This, they predict, will confound IRS enforcement efforts and taxpayers’ and practitioners’ legitimate planning efforts. In addition, because of the uncertainty in the law, its possible application to areas not previously subject to the doctrine, and the new strict liability penalties for transactions that do not satisfy the doctrine, critics claim that taxpayers are likely to forgo some legitimate transactions for fear of incurring a huge penalty. Further, critics predict that having the law set down in a statute will limit the doctrine’s flexibility, making it more difficult for the IRS and the courts to adapt the doctrine to new types of transactions that appear in the future and easier for taxpayers and practitioners to devise new ways to circumvent the doctrine.

In March 2007, the AICPA sent a letter to the House Ways and Means Committee and the Senate Finance Committee expressing the AICPA’s strong opposition to an attempt to codify the economic substance doctrine because of the potential adverse effects of codification.

Reflections

The actual effects of codifying the economic substance doctrine are hard to predict. The codified doctrine may, as supporters suggest, aid the IRS in its enforcement efforts against abusive tax shelters. However, it is questionable how great a difference it will make because the IRS is already having considerable success combating these shelters using the common law economic substance and sham transaction doctrines. Whether or not codification has an effect on types of transactions that are currently considered legitimate depends largely on the Service’s ability to exercise restraint in choosing when to apply the codified doctrine. However, given the IRS’s known propensity for aggressively using any statutory enforcement tool it is given, taxpayers and practitioners have good reason to fear that codification will result in the economic substance doctrine being applied to many more transactions than it has been in the past.

Subtitle B, H.R. 4351, AMT Relief Act of 2007; Part II, H.R. 2419, Food and Energy Security Act of 2007