Congress continues to focus on tax-shelter activity.

• Author: Prysock, Mark
• Position: Washington insights

Based on a recent spurt of legislative activity, Congressional Democrats believe that corporations and wealthy individuals are sheltering taxable income from the federal government at an alarming rate. Despite evidence that tax-shelter activity is down significantly over the past decade, many Congressional leaders perceive an ongoing problem. Congress is now eyeing legislative proposals to codify the "economic substance" doctrine, and to punish companies with subsidiaries engaging in business activities in "tax haven" countries.

The economic substance doctrine is not new. U.S. tax courts have long understood the importance of evaluating whether businesses are engaging in business transactions for sound economic reasons rather than to lower their tax bills. To help do this, the courts created--and subsequently developed--both an "economic substance" test and a "business purpose" test.

Congressional leaders believe these judicially created tests are too narrow, and have embraced more comprehensive--and vaguely worded--legislative language. As passed by the Senate Finance Committee, the economic substance provision would establish a two-part test on economic substance. The taxpayer must establish that (1) the transaction changes in a meaningful way the taxpayer's economic position; and (2) the taxpayer has a substantial non-federal tax purpose for entering into the transaction.

The proposal is problematic for several reasons. First, it would impose a strict liability underpayment penalty of 30 percent on transactions lacking economic substance. Given that economic substance and business purpose are inherently imprecise, subjective determinations, the penalties are overly harsh. Second, the proposal requires demonstration that the transaction be a reasonable means of accomplishing the taxpayer's non-tax purpose--but there are no guidelines on how this requirement should be interpreted and applied.

Similarly, several legislative proposals have been introduced this year to address perceived abuses involving "tax haven" countries, whose usage, proponents contend, reduces federal revenues by approximately $100 billion. To this end, Sen. Byron Dorgan (D-N.D.) has introduced a bill (S. 396) to treat certain controlled foreign corporations located in specified tax haven countries as domestic corporations for federal tax purposes.

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Moreover, Sen. Carl Levin (D-Mich.) has introduced legislation (S. 681) to establish...