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    TAX LAW UPDATE: Codification of the "Economic Substance Doctrine"

    Posted by Gale Burns on Mon, Aug 13, 2012 @ 16:08 PM

    August 1, 2012

    Brad Pettit, Senior Attorney, National Legal Research Group

    As part of the Health Care and Education Reconciliation Act of 2010, Congress codified the long‑standing common‑law doctrine of "economic substance," which is applied in federal income tax cases to prevent taxpayers from trying to claim tax benefits from transactions that have no bona fide nontax purpose.  Pub. L. No. 111‑152, § 1409(a), 124 Stat. 1029, 1067‑68 (effective with respect to transactions entered into on or after March 31, 2010) (adding subsection (o) to 26 U.S.C. § 7701 and redesignating former subsection (o) as subsection (p)).  The Internal Revenue Code now expressly provides that

    [i]n the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if—

    (A)       the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position, and

    (B)       the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.

    26 U.S.C. § 7701(o)(1) (Westlaw current through P.L. 112‑90 approved 1‑3‑12).  Section 7701(o) goes on to explain that the term "economic substance doctrine" means the common‑law doctrine under which income tax benefits with respect to a transaction are not allowable if the transaction or series of transactions do not have "economic substance or lack[] a business purpose."  Id. § 7701(o)(5)(A), (D).  It is critical to note that under § 7701(o), there is an "[e]xception for personal transactions of individuals" because Congress expressly provided that the economic substance doctrine is applicable "only to transactions entered into in connection with a trade or business or an activity engaged in for the production of income."  Id. § 7701(o)(5)(B).

    The Code also makes it clear that a taxpayer can be subjected to "accuracy‑related penalties" if he or she tries to claim tax benefits from a transaction or series of transactions that lack economic substance.  Id. § 6662(b)(6) (subsection (6) added to § 6662(b) by Pub. L. No. 111‑152, § 1409(b)(1), 124 Stat. at 1069).  Specifically, the Code now expressly provides that accuracy‑related penalties

    apply to the portion of any underpayment which is attributable to . . . :

     . . . .

    (6)        Any disallowance of claimed tax benefits by reason of a transaction lacking economic substance (within the meaning of section 7701(o)) or failing to meet the requirements of any similar rule of law.

    Id.

    On at least three occasions, the U.S. Tax Court has noted that the above‑described provisions of § 7701(o) essentially represent the adoption by Congress of the common‑law doctrine of economic substance as articulated by the U.S. Court of Appeals for the Third Circuit in the case of ACM Partnership v. Commissioner, 157 F.3d 231, 247‑48 (3d Cir. 1998), cert. denied, 526 U.S. 1017 (1999).  Crispin v. Comm'r, T.C. Memo. 2012‑70, T.C.M. (RIA) ¶ 2012‑070, 2012 WL 858406, at *6 n.14; Blum v. Comm'r, T.C. Memo. 2012‑16, T.C.M. (RIA) ¶ 2012‑016, 2012 WL 129801, at *17 n.21; Rovakat, LLC v. Comm'r, T.C. Memo. 2011‑225, T.C.M. (RIA) ¶ 2011‑225, 2011 WL 4374589, at *27 n.11. 

    The Internal Revenue Service ("IRS") has issued two administrative rulings regarding the codification of the economic substance doctrine that are worth noting.  In I.R.S. Chief Counsel Notice ("C.C.N.") CC‑2012‑008 (Apr. 3, 2012), the IRS established coordination procedures for the economic substance doctrine and related penalties.  Specifically, C.C.N. CC‑2012‑008 provides (1) instructions regarding the role of counsel during an examination that involves the application of the economic substance doctrine under the common law or § 7701(o) ("codified economic substance doctrine"), including any penalties related to the codified economic substance doctrine under §§ 6662, 6662A, or 6676; (2) instructions for reviewing a statutory notice of deficiency or a notice of final partnership administrative adjustment if a Business Operating Division concludes that a transaction lacks economic substance; and (3) coordination procedures for litigating the common‑law economic substance doctrine or the codified economic substance doctrine and a related penalty.

    The IRS also published interim guidance as to the codification of the economic substance doctrine and related provisions in the Health Care and Education Reconciliation Act of 2010.  I.R.S. Notice 2010‑62, 2010‑40 I.R.B. 411.  In Notice 2010‑62, the IRS explained how it applies the new statutory economic substance rules:

    For transactions entered into on or after March 31, 2010, to which the economic substance doctrine is relevant, section 7701(o)(1) mandates the use of a conjunctive two‑prong test to determine whether a transaction shall be treated as having economic substance. The first prong, found in section 7701(o)(1)(A), requires that the transaction change in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position. The second prong, found in section 7701(o)(1)(B), requires that the taxpayer have a substantial purpose (apart from Federal income tax effects) for entering into the transaction.

    The IRS will continue to rely on relevant case law under the common‑law economic substance doctrine in applying [each part of] the two‑prong conjunctive test in section 7701(o)(1). . . .

    The IRS will challenge taxpayers who seek to rely on prior case law under the common‑law economic substance doctrine for the proposition that a transaction will be treated as having economic substance merely because it satisfies either section 7701(o)(1)(A) (or its common‑law corollary) or section 7701(o)(1)(B) (or its common‑law corollary). For all transactions subject to section 1409 of the Act that otherwise would have been subject to a common‑law economic substance analysis that treated a transaction as having economic substance merely because it satisfies either section 7701(o)(1)(A) (or its common‑law corollary) or section 7701(o)(1)(B) (or its common‑law corollary) the IRS will apply a two‑prong conjunctive test consistent with section 7701(o).

     Id.  

    In sum, the most important thing to remember with respect to the statutory economic substance doctrine is that § 7701(o) calls for the application of a two‑part conjunctive test that must be satisfied before a transaction or series of trade or business transactions can be treated as having "economic substance" for federal income tax purposes: (1) the transaction(s) must have changed in a meaningful way, apart from its federal income tax effects, the taxpayer's economic position, and (2) the taxpayer had a substantial purpose, apart from federal income tax benefits, for entering into the transaction(s).  See WFC Holdings Corp. v. United States, 108 A.F.T.R.2d  (RIA) 2011‑6531, 2011 WL 4583817, at *33 n.5 (D. Minn. 2011) ("Congress has recently mandated the application of the two‑prong test, which will require taxpayers to prove that the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position, and . . . the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction." (emphasis omitted) (internal quotation marks omitted)).  For a transaction or series of transactions that were entered into on or after March 31, 2010, both prongs of the two‑part test must be satisfied.  It is also critical to note that preexisting common law is still relevant when determining whether each prong of the statutory two‑part test is met in a particular case.  In the coming months, it will be interesting to follow how the courts and the IRS actually construe and apply new Code § 7701(o).

    Topics: legal research, Brad Pettit, tax law, economic substance doctrine, no tax benefits for transaction having no business, 26 U.S.C. § 7701(o)

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