Codification of the economic substance doctrine in A.B. 1601 and S.B. 614: August 29, 2003.

• Position: California

On August 29, 2003, Tax Executives Institute sent the following letter to the California Senate's and Assembly's Committees on Appropriation. The letter highlights TEI's concerns in respect of codification of the economic substance doctrine and extreme penalties. The letter was prepared under the aegis of the Institute's State and Local Tax Committee, whose chair is Barbara Barton of Electronic Data Systems Corp. TEI's letter to Congress regarding the same issues-at the federal level-was enclosed; this letter is reprinted beginning on page 398 of this issue.

As president of Tax Executives Institute, I am writing to commend the recent decision to significantly modify provisions relating to codification of the economic substance doctrine in A.B. 1601 and S.B. 614. (1) TEI is the preeminent organization of business tax professionals, and our members--including more than 600 in California--had grave concerns about the initial proposals, which were modeled after pending federal legislation. While we are heartened by recent changes to sharpen the focus of the legislation, TEI continues to oppose the penalty provisions that remain in the bills.

As initially proposed, the provision in each bill codifying economic substance presented the same difficulties as the federal proposal:

* The proposal was too broad in scope, ensnaring many wholly legitimate transactions.

* Taxpayers cannot adequately define "meaningful" changes to economic position, "substantial" nontax purpose, or "reasonable" means of accomplishing such purpose.

* Current law permits taxpayers to enter transactions lacking economic substance if the resulting tax benefits were intended by Congress. The proposal seemingly made all tax benefits from transactions that lack economic substance open to challenge even where taxpayers are engaging primarily in the behavior Congress intended.

* Granting regulatory authority to clarify the above issues would only postpone the difficult decisions, would likely make tax administration more complicated, and raise troublesome tax policy issues.

* In sum, the proposal would create intolerable uncertainty that would substantially impair the ability of taxpayers to conduct ordinary business transactions.

The amended provisions, relying on current case law and adjudication of business purpose and disregarded entities, ameliorate some of these difficulties. Still troubling, however, is the draconian penalty regime in relation to tax shelter transactions...