Tax practice responsibilities: codification of economic substance affects all tax practitioners.

• Author: Fowler, Gregory M.

Under the judicial economic substance doctrine, courts disregard an otherwise valid transaction and its related tax benefits when the transaction serves no economic purpose other than tax savings. Congress codified the economic substance doctrine and a related strict liability penalty under Sees. 7701 (o) and 6662(i), respectively, in the Health Care and Education Reconciliation Act of 2010, P.L. 111-152, for transactions entered into after March 30, 2010. This column discusses uncertainty surrounding the codification of the economic substance doctrine and explores selected areas of impact on CPAs' professional obligations and practice. It also demonstrates that the doctrine must be understood by all practitioners, not simply those who work with, for instance, multinational companies.

Introduction to Sees. 7701 (o) and 6662(i)

Courts have applied the economic substance doctrine when there was no meaningful change to the taxpayer's economic position other than a purported reduction in federal income tax, despite technical compliance with the Code. However, there have been multiple common law tests for determining economic substance and business purpose. The Sec. 7701 (o) two-prong test creates a uniform standard.

The test provides that where the economic substance doctrine is determined to be relevant, a transaction and its associated tax benefits will be respected only if (1) the taxpayer's economic position changes in a meaningful way and (2) there is substantial business purpose. "Relevance," "meaningful," and "substantial" are not defined. In addition, federal, state, and local income tax benefits cannot be used to demonstrate a change in economic position or business purpose. The Joint Committee on Taxation's (JCT) unofficial report states that this exclusion does not apply to tax provisions enacted to induce behavior (e.g., rehabilitation credits) (JCT, Technical Explanation of the Revenue Provisions of the "Reconciliation Act of 2010," as Amended, in Combination with the "Patient Protection and Affordable Care Act" (JCX-18-10), p. 152 (March 21, 2010)).

The new Sec. 6662(b)(6) strict liability penalty applies to any transaction lacking economic substance under Sec. 7701 (o) and "any similar rule of law." There is no reasonable cause exception, and the penalty is a striking 40% if the transaction is undisclosed (Sec. 6662(i)) and 20% if adequately disclosed on Form 8275, Disclosure Statement, Form 8275-R, Regulation Disclosure Statement, or Schedule UTP, Uncertain Tax Position Statement, with additional requirements for reportable transactions.

"Similar rule of law" is also ambiguous. For instance, does this include the substance-over-form and step-transaction doctrines? The substance-over-form doctrine recharacterizes the tax treatment to reflect the transaction's substance. Similarly, the step-transaction doctrine merges a series of formally separate steps into a single transaction and recharacterizes the transaction's tax treatment. Conversely, when the Sec. 770l (o) test is not satisfied, the transaction is disregarded and tax benefits are disallowed. Despite these differences, the Sec. 6662(b) penalty may apply.

The IRS does not intend to provide substantive guidance on the codified economic substance doctrine (see Notice 2010-62). The JCT provided the following illustrative, nonexhaustive examples of where it is not relevant:

(1) the choice between capitalizing a business enterprise with debt or equity; (2) a U.S. person's choice between utilizing a foreign corporation or a domestic corporation to make a foreign investment; (3) the choice to enter a transaction or series of transactions that constitute a corporate organization or reorganization under subchapter C; (4) the choice to utilize a related-party entity in a transaction, provided that the arm's length standard ... [is] satisfied. [JCT, Technical Explanation at 152-53] Professional Obligations Prepare Obligations Under Sec. 6694

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