Lack of Economic Substance Guidance May Chill Legitimate Planning, Organizations Warn

The AICPA and the American Bar Association (ABA) Tax Section jointly issued a comprehensive set of recommendations to the IRS to encourage the Service to quickly establish guidance for applying the economic substance doctrine.

In the absence of specific guidance, the organizations warn in a 65-page report released January 18 that “revenue agents may see it as their responsibility to consider application [of the doctrine] in connection with every issue raised in an examination” and that such broad assertions could have “a significant chilling effect on a wide range of business transactions.”

The economic substance doctrine was codified in the health care reform law last year and, as codified, applies to transactions entered into after March 30, 2010. New Sec. 7701(o) stipulates that a transaction that is subject to the doctrine will be treated as having economic substance only if (1) it changes the taxpayer’s economic position in a meaningful way (apart from federal income tax effects) and (2) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering the transaction.

As taxpayers now face up to a 40% strict-liability penalty for violations (reduced to 20% if the transaction is disclosed by the taxpayer), the AICPA and ABA Tax Section are asking the Service to adopt a framework to help taxpayers determine whether the doctrine is relevant to a transaction.

Uncertainty surrounding the application of the doctrine and terms such as “business purpose” is nothing new. Courts have often reached different conclusions about when a transaction is subject to the doctrine or whether the taxpayer was motivated by profit or tax avoidance. But unlike under prior law, taxpayers now face, in addition to the tax benefit loss, a stiff strict-liability penalty. The AICPA and the ABA Tax Section are therefore urging guidance on terms such as “economic position,” “meaningful way” and “substantial purpose” that are not defined by the law. Without guidance, they caution, “these terms create a great deal of uncertainty.”

The organizations recommend that the guidance be issued as binding regulations with full opportunity for comment, but note that, at a minimum, the Service should provide detailed directives for revenue agents and field counsel that are publicly available. To further protect taxpayers, the groups also recommend that the IRS expand its expedited private letter ruling procedures to cover a broader range of transactions and issues to help taxpayers know prospectively if a planned transaction will fall under the economic substance doctrine. And, given the rigid nature of the penalty, the AICPA and ABA Tax Section are calling on the IRS to add safeguards such as an expanded approval process and a conference of right before the penalty can be asserted.

Their final recommendation is the creation of an advisory panel (modeled on ones established in Canada and Australia) that would include public and private sector tax professionals to advise the IRS on applying the economic substance and strict liability provisions of the Code.