Dealing with codified economic substance in the context of international issues: self-help, the only game in town.

• Author: Tello, Carol P.

Le plus ca change, le plus c'est la meme chose

This French proverb makes the ironic observation that change does not always end in change or, the more things change, the more you are back where you started. What is the relevance of the ironic proverb to the recent codification of the economic substance doctrine (ESD) in section 7701(o) of the Internal Revenue Code? The answer is that since Congress acted, government officials have sought to reassure taxpayers that the ESD did not change. Maybe that ultimately will be the result.

But at this point something has changed--namely, that, if the government applies economic substance, a strict liability penalty will be imposed on the understatement (20 percent if there is disclosure of the transaction and 40 percent if no disclosure occurs) with no reasonable cause exception and no protection provided by an opinion of counsel. Thus, the penalty provisions applicable to understatements attributable to transactions without economic substance are treated more harshly than reportable transactions. Consequently, the stakes for taxpayers involved--the importance of getting it right--have increased dramatically, even without taking into account the Supreme Court's January 2011 decision in Mayo Foundation v. United States, which addresses the level of deference the courts should provide to regulations issued by the Internal Revenue Service. (1) This article explores how to deal with section 7701(o) in the international arena.

Background

Section 7701(o) was enacted as a "pay-for" as part of H.R. 4872, the Health Care and Education Reconciliation Act of 2010 in March 2010. (2) Section 7701(o) is effective for transactions entered into on or after March 31, 2010, which means that any transaction that occurred in the last three quarters of 2010 is potentially subject to section 7701(o) and its sanctions. The codified economic substance test requires a conjunctive test for determining whether a transaction has economic substance, whereas not every circuit applied a conjunctive test under the common law test. This was one reason given for codifying economic substance doctrine, i.e., to ensure uniform application of the doctrine. (3)

1. Legislative History

   There is no "official" legislative history for section 7701(o), i.e., no House Ways and Means Committee, Senate Finance Committee, or Conference Committee Report except to the extent that the contemporaneous Technical Explanation prepared by the staff of the Joint Committee on Taxation would be so treated. Although the Technical Explanation may not be considered formal "legislative history," it does provide some insight and background on section 7701(o).

   For instance, the Technical Explanation provides that section 7701(o) is not intended to alter the tax treatment of basic business transactions that have been respected by longstanding judicial decisions and administrative practice merely because the choice between meaningful economic alternatives is largely or entirely based upon comparative tax advantages. The Technical Explanation lists the following transactions as being among such transactions.

   * The choice between debt or equity to capitalize a corporation;

   * The choice between a foreign or a U.S. corporation to make a foreign investment;

   * Entering tax-free corporate reorganizations; or

   * The use of a related party entity (assuming section 482 is met).

   Although government officials have not endorsed the Technical Explanation's list of approved transactions, government officials have informally suggested that principles of the Granite Trust and Cottage Savings cases remain good law. (4) Granite Trust is consistent with the choice of a tax-free organization cited by the Technical Explanation even though the company in that case (Granite Trust) chose not to enter into a taxable transaction.

   Before the enactment of section 7701(o) in 2010, many legislative proposals were offered concerning the economic substance doctrine. Although the proposals vary from the final enacted version, the question remains whether the committee reports from the unenacted proposals will have any vitality in interpreting section 7701(o), particularly in light of the lack of actual legislative history under section 7701(o). (5)

2. Statutory Provisions

   Under section 7701(o), the economic substance doctrine applies to a transaction if it is "relevant," which is determined as if the law had never been enacted. (6) "Economic substance" means the common law doctrine under which income tax benefits under subtitle A (the income tax provisions of the Internal Revenue Code) with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose. (7)

   A transaction is treated as having economic substance if:

   * The transaction changes in a meaningful way the taxpayer's economic position (not including federal, state, or local tax effects), and

   * The taxpayer has a substantial business purpose for the transaction. (8)

   A "meaningful change" in a taxpayer's economic position is not required to be measured by profit potential. (9) If a taxpayer relies on profit potential, however, the present value of the reasonably expected pre-tax profit must be "substantial" in relation to the present value of the expected net tax benefits. (10) Fees and other transaction expenses will be taken into account to determine pre-tax profit. (11) Regulations are to be issued that require foreign taxes to be treated as expenses in "appropriate cases." (12)

   For purposes of determining whether a taxpayer has a substantial business purpose, a financial accounting benefit is not a qualifying purpose if the origin of the benefit is a reduction of federal income tax. (13) Moreover, any state or local income tax effect that is related to a federal income tax effect is treated in the same mariner as a federal income tax. (14)

   The term "transaction" includes a series of transactions. (15) The Technical Explanation further explains that section 7701(o) does not affect a court's ability to aggregate, disaggregate, or otherwise recharacterize a transaction. (16) This provision and the Technical Explanation obviously reflect Coltec Industries v. United States. (17)

3. Monetary Penalties Applicable To Noneconomic Transactions

   In addition to codifying the economic substance doctrine, new section 6662(b)(6) applies the accuracy-related 20-percent penalty to underpayments attributable to 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. The statute does not provide any definition or description of the phrase "any similar rule of law." The Technical Explanation, however, explains that the penalty is intended to apply to a transaction the tax benefits of which are disallowed as a result of the application of factors and analysis similar to that required under the provision for an economic substance analysis, even if a different term is used to describe the doctrine. Presumably, this phrase could include step transaction, substance over form, business purpose, alter ego, and sham doctrines (among others), but there is no limitation on what other rules of law may be invoked. The inclusion of this phrase in the penalty provision likely enlarges the reach of section 7701(o).

   Under section 6662(i), a noneconomic substance transaction for which the relevant facts are not adequately disclosed in the return or in a statement attached to the return results in a 40-percent penalty. Moreover, disclosure by amended return is not effective if the amended return is filed after the taxpayer has been contacted for audit or such other date specified by regulations. (18) The IRS has provided guidance on what constitutes "adequate disclosure" in Notice 2010-62.

   Additionally, a taxpayer that files an erroneous claim for refund or credit for an excessive amount, which is attributable to a noneconomic substance transaction, is treated as not having a reasonable basis, the result of which is a penalty equal to 20 percent of the excessive amount. (19)

   Strict Liability Penalty

   The reasonable cause exception provided by section 6664(c) is not available for any portion of an underpayment attributable to a transaction without economic substance. (20) Consequently, an opinion of counsel (including outside counsel) does not mitigate the penalty, regardless of the level of the opinion (e.g., more likely than not, should, or will). Additionally, an excess amount attributable to an erroneous claim made with respect to a noneconomic substance transaction is not treated as having a reasonable basis (21) and, therefore, the 20-percent penalty imposed under section 6676(a) is a strict liability penalty for such transactions.

   The penalty regime applicable to a transaction found not to have economic substance is harsh, particularly compared to the regime applicable to listed or reportable transactions, which provides reasonable cause relief where adequate disclosure is made on a timely return that identifies characteristics of the transaction. Furthermore, for a nondisclosed listed or reportable transaction, the penalty is increased to only 30 percent as compared to the 40-percent penalty for an undisclosed noneconomic substance transaction. Nondisclosed corporate reportable transactions, however, are subject to a $50,000 penalty under section 6707A, which may be abated (but not for a listed transaction) by the IRS if it would promote compliance with the tax laws and effective tax administration. (22)

1. Notice 2010-62

   1. No IRS Guidance Will Be Provided

      On September 13, 2010, the IRS issued Notice 2010-62, which provides limited guidance relating to the application of section 7701(o). Significantly, Notice 2010-62 confirmed that the IRS will not issue an "angel list" of transactions that would not be subject to scrutiny under...