Significant recent corporate developments.

• Author: Hayes, Brandon L.

This article summarizes selected recent developments in federal income taxation of corporations and shareholders. Congress was especially active in 2010, driven by a need to generate additional revenue. Consequently, it enacted a number of provisions affecting corporate taxpayers, including the codification of the economic substance doctrine, and various other corporate tax reform proposals are currently included in bills drafted by the House and the Senate.

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At present, the enacted proposals affect U.S. domestic corporations primarily with respect to changes in the taxation of international operations--namely, how corporate taxpayers may utilize foreign tax credits generated by such operations. However, several proposals still under consideration in Congress would have much broader application to domestic corporations and their shareholders. In addition, the IRS and Treasury have provided additional guidance on certain subchapter C transactional issues in the form of new final and temporary regulations.

Legislative Update

In 2009, the White House and Treasury published a detailed explanation of the administration's budget proposals for the 2010 fiscal year. (1) This Green Book detailed several new proposals, including one for the codification of the economic substance doctrine and another to repeal the "boot-within-gain" limitation of Sec. 356(a)(1) in certain cross-border reorganizations. As discussed below, in March President Barack Obama signed into law a new provision of the Code, Sec. 7701(o), which codifies the economic substance doctrine. In addition, Congress is considering a revised version of proposed changes to the boot-within-gain limitation that is broader in scope and impact than the proposal originally outlined in the Green Book. Finally, Congress has also proposed a change to the treatment of securities issued by a controlled corporation to its distributing corporation parent in connection with a divisive Sec. 355 distribution.

Codification of the Economic Substance Doctrine

Included in the Health Care and Education Reconciliation Act of 2010, (2) new Sec. 7701 (o) codifies the common law economic substance doctrine, providing specific rules for applying it to any transaction for which the economic substance doctrine is determined to be relevant. As codified, Sec. 7701(o)(l) provides that in the case of any transaction to which the economic substance doctrine is relevant, that transaction will be treated as having economic substance only if (1) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer's economic position and (2) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into the transaction.

Based on this construction, the first question for taxpayers is deciding when the doctrine might be relevant to a particular transaction. If the economic substance doctrine is determined to be relevant to a transaction, taxpayers must satisfy a two-pronged conjunctive test in order to avoid the imposition of a strict liability penalty, the amount of which varies depending on whether the taxpayers have satisfied certain reporting requirements.

Determining Relevance

As the statute is drafted, Congress has provided taxpayers with almost no way to determine whether the economic substance doctrine is relevant to a transaction. The only guidance provided in the statute is in Sec. 7701(o)(5), which states, "The determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection [Sec. 7701 (o)] had never been enacted." Consequently, taxpayers are left with practically no way to predict how the new statute is to be applied.

Despite requests from tax practitioners, the IRS and Treasury have steadfastly refused to issue an "angel list" of certain nonabusive transactions for which the economic substance doctrine is not relevant. (3) Although IRS officials have made public statements that certain transactions, such as sales of subsidiary stock in a Granite Trust transaction, (4) should not be subject to the economic substance doctrine, (5) taxpayers and their advisers remain uncertain about the economic substance doctrine's scope.

Presumably Sec. 7701(a)(5) stands for the proposition that taxpayers must look to the common law developed by the courts in order to determine whether the economic substance doctrine is relevant to a transaction. However, although there are several cases that identify when the economic substance doctrine is relevant to a particular type of transaction, the converse is not true: There is little or no common law guidance that taxpayers may apply to affirmatively conclude that the economic substance doctrine is not relevant to a particular type of transaction. Therefore, in the absence of the publication of an angel list or similar guidance, it should be expected that taxpayers will be overly conservative in their economic substance doctrine analysis, at least until the courts have the opportunity to apply the new statute.

Conjunctive Test

Assuming that the economic substance doctrine is relevant to a transaction, the taxpayer must then determine whether it satisfies the economic substance requirements of Sees. 7701(o)(1)(A) and (B). Under the common law, courts have traditionally applied an analysis focused on two factors. First, did the transaction change the taxpayer's economic position in a meaningful way (notwithstanding the federal income tax result)? Second, did the taxpayer have a business purpose for the transaction (apart from federal income tax planning)? Prior to the adoption of the statute, the courts were split as to whether the economic substance doctrine required taxpayers to satisfy a disjunctive or conjunctive test (i.e., some courts required only one of the two factors to be satisfied, while others required the satisfaction of both). Sec. 7701 (o) resolves the conflict in favor of a conjunctive approach. Now, in order to satisfy the economic substance doctrine, Sec. 7701(o)(l) requires taxpayers to show 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 the transaction.

Obviously this two-pronged test is less favorable to taxpayers who might previously have fallen under the jurisdiction of a court that applied a disjunctive test.

With respect to the first prong, taxpayers...