Code Section 7701

Code Section	Effective Date	Name of Act	Name of Provision	10yr Revenue Estimate ($millions)
6662,6662A, 6664, 6676, and 7701	*3/30/2010	Health Care and Education Reconciliation Act of 2010	Codification of Economic Substance Doctrine and Imposition of Penalties	4,545

*Notes on Effective Date

The provision applies to transactions entered into after the date of enactment and to underpayments, understatements, and refunds and credits attributable to transactions entered into after the date of enactment of the Act (March 30, 2010).

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Codification of Economic Substance Doctrine and Imposition of Penalties

Explanation of Provision

1. Conjunctive analysis
2. Non-Federal-income-tax business purpose
3. Profit potential
4. Personal transactions of individuals
5. Other rules
6. Penalty for underpayments and understatements attributable to transactions lacking economic substance

The provision clarifies and enhances the application of the economic substance doctrine. Under the provision, new section 7701(o) provides that in the case of any transaction ¹⁰³³ to which the economic substance doctrine is relevant, such transaction is 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 such transaction. The provision provides a uniform definition of economic substance, but does not alter the flexibility of the courts in other respects.

The determination of whether the economic substance doctrine is relevant to a transaction is made in the same manner as if the provision had never been enacted. Thus, the provision does not change present law standards in determining when to utilize an economic substance analysis. ¹⁰³⁴

The provision is not intended to alter the tax treatment of certain basic business transactions that, under longstanding judicial and administrative practice are respected, merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages. Among ¹⁰³⁵ these basic transactions are (1) the choice between capitalizing a business enterprise with debt or equity; ¹⁰³⁶ (2) a U.S. person’s choice between utilizing a foreign corporation or a domestic corporation to make a foreign investment; ^{, 1037} (3) the choice to enter a transaction or series of transactions that constitute a corporate organization or reorganization under subchapter C; ¹⁰³⁸ and (4) the choice to utilize a related-party entity in a transaction, provided that the arm’s length standard of section 482 and other applicable concepts are satisfied.¹⁰³⁹ Leasing transactions, like all other types of transactions, will continue to be analyzed in light of all the facts and circumstances. ¹⁰⁴⁰ As under present law, whether a particular transaction meets the requirements for specific treatment under any of these provisions is a question of facts and circumstances. Also, the fact that a transaction meets the requirements for specific treatment under any provision of the Code is not determinative of whether a transaction or series of transactions of which it is a part has economic substance.¹⁰⁴¹

The provision does not alter the court’s ability to aggregate, disaggregate, or otherwise recharacterize a transaction when applying the doctrine. For example, the provision reiterates the present law ability of the courts to bifurcate a transaction in which independent activities with non-tax objectives are combined with an unrelated item having only tax-avoidance objectives in order to disallow those tax-motivated benefits.¹⁰⁴²

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1. Conjunctive analysis

The provision clarifies that the economic substance doctrine involves a conjunctive analysis—there must be an inquiry regarding the objective effects of the transaction on the taxpayer’s economic position as well as an inquiry regarding the taxpayer’s subjective motives for engaging in the transaction. Under the provision, a transaction must satisfy both tests, i.e., the transaction must change in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position and the taxpayer must have a substantial non-Federal-income-tax purpose for entering into such transaction, in order for a transaction to be treated as having economic substance. This clarification eliminates the disparity that exists among the Federal circuit courts regarding the application of the doctrine, and modifies its application in those circuits in which either a change in economic position or a non-tax business purpose (without having both) is sufficient to satisfy the economic substance doctrine.¹⁰⁴³

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2. Non-Federal-income-tax business purpose

Under the provision, a taxpayer’s non-Federal-income-tax purpose ¹⁰⁴⁴ for entering into a transaction (the second prong in the analysis) must be ‘‘substantial.’’ For purposes of this analysis, any State or local income tax effect which is related to a Federal income tax effect is treated in the same manner as a Federal income tax effect. Also, a purpose of achieving a favorable accounting treatment for financial reporting purposes is not taken into account as a non-Federal-income-tax purpose if the origin of the financial accounting benefit is a reduction of Federal income tax.¹⁰⁴⁵

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3. Profit potential

Under the provision, a taxpayer may rely on factors other than profit potential to demonstrate that a transaction results in a meaningful change in the taxpayer’s economic position or that the taxpayer has a substantial non-Federal-income-tax purpose for entering into such transaction. The provision does not require or establish a minimum return that will satisfy the profit potential test. However, if a taxpayer relies on a profit potential, 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 that would be allowed if the transaction were respected.¹⁰⁴⁶ Fees and other transaction expenses are taken into account as expenses in determining pre-tax profit. In addition, the Secretary is to issue regulations requiring foreign taxes to be treated as expenses in determining pre-tax profit in appropriate cases.¹⁰⁴⁷

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4. Personal transactions of individuals

In the case of an individual, the provision applies only to transactions entered into in connection with a trade or business or an activity engaged in for the production of income.

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5. Other rules

No inference is intended as to the proper application of the economic substance doctrine under present law. The provision is not intended to alter or supplant any other rule of law, including any common-law doctrine or provision of the Code or regulations or other guidance thereunder; and it is intended the provision be construed as being additive to any such other rule of law.

As with other provisions in the Code, the Secretary has general authority to prescribe rules and regulations necessary for the enforcement of the provision.¹⁰⁴⁸

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6. Penalty for underpayments and understatements attributable to transactions lacking economic substance

The provision imposes a new strict liability penalty under section 6662 for an underpayment attributable to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance, as defined in new section 7701(o), or failing to meet the requirements of any similar rule of law.¹⁰⁴⁹ The penalty rate is 20 percent (increased to 40 percent if the taxpayer does not adequately disclose the relevant facts affecting the tax treatment in the return or a statement attached to the return). An amended return or supplement to a return is not taken into account if filed after the taxpayer has been contacted for audit or such other date as is specified by the Secretary. No exceptions (including the reasonable cause rules) to the penalty are available. Thus, under the provision, outside opinions or in-house analysis would not protect a taxpayer from imposition of a penalty if it is determined that the transaction lacks economic substance or fails to meet the requirements of any similar rule of law. Similarly, a claim for refund or credit that is excessive under section 6676 due to a claim that is lacking in economic substance or failing to meet the requirements of any similar rule of law is subject to the 20 percent penalty under that section, and the reasonable basis exception is not available.

The penalty does not apply to any portion of an underpayment on which a fraud penalty is imposed.¹⁰⁵⁰ The new 40-percent penalty for nondisclosed transactions is added to the penalties to which section 6662A will not also apply.¹⁰⁵¹

As described above, under the provision, the reasonable cause and good faith exception of present law section 6664(c)(1) does not apply to any portion of an underpayment which is attributable to a transaction lacking economic substance, as defined in section 7701(o), or failing to meet the requirements of any similar rule of law. Likewise, the reasonable cause and good faith exception of present law section 6664(d)(1) does not apply to any portion of a reportable transaction understatement which is attributable to a transaction lacking economic substance, as defined in section 7701(o), or failing to meet the requirements of any similar rule of law.

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1033- The term ‘‘transaction’’ includes a series of transactions.
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1034- If the realization of the tax benefits of a transaction is consistent with the Congressional purpose or plan that the tax benefits were designed by Congress to effectuate, it is not intended that such tax benefits be disallowed. See, e.g., Treas. Reg. sec. 1.269–2, stating that characteristic of circumstances in which an amount otherwise constituting a deduction, credit, or other allowance is not available are those in which the effect of the deduction, credit, or other allowance would be to distort the liability of the particular taxpayer when the essential nature of the transaction or situation is examined in the light of the basic purpose or plan which the deduction, credit, or other allowance was designed by the Congress to effectuate. Thus, for example, it is not intended that a tax credit (e.g., section 42 (low-income housing credit), section 45 (production tax credit), section 45D (new markets tax credit), section 47 (rehabilitation credit), section 48 (energy credit), etc.) be disallowed in a transaction pursuant to which, in form and substance, a taxpayer makes the type of investment or undertakes the type of activity that the credit was intended to encourage.
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1035- The examples are illustrative and not exclusive.
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1036- See, e.g., John Kelley Co. v. Commissioner, 326 U.S. 521 (1946) (respecting debt characterization in one case and not in the other, based on all the facts and circumstances).
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1037- See, e.g., Sam Siegel v. Commissioner, 45. T.C. 566 (1966), acq. 1966–2 C.B. 3. But see Commissioner v. Bollinger, 485 U.S. 340 (1988) (agency principles applied to title-holding corporation under the facts and circumstances).
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1038- See, e.g., Rev. Proc. 2010–3 2010–1 I.R.B. 110, Secs. 3.01(38), (39), (40), and (42) (IRS will not rule on certain matters relating to incorporations or reorganizations unless there is a ‘‘significant issue’’); compare Gregory v. Helvering. 293 U.S. 465 (1935).
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1039- See, e.g., National Carbide v. Commissioner, 336 U.S. 422 (1949), Moline Properties v. Commissioner, 319 U.S. 435 (1943); compare, e.g. Aiken Industries, Inc. v. Commissioner, 56 T.C. 925 (1971), acq., 1972–2 C.B. 1; Commissioner v. Bollinger, 485 U.S. 340 (1988); see also sec. 7701(l).
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1040- See, e.g., Frank Lyon Co. v. Commissioner, 435 U.S. 561 (1978); Hilton v. Commissioner, 74 T.C. 305, aff’d, 671 F. 2d 316 (9th Cir. 1982), cert. denied, 459 U.S. 907 (1982); Coltec Industries v. United States, 454 F.3d 1340 (Fed. Cir. 2006), cert. denied, 127 S. Ct. 1261 (Mem) (2007); BB&T Corporation v. United States, 2007–1 USTC P 50,130 (M.D.N.C. 2007), aff’d, 523 F.3d 461 (4th Cir. 2008); Wells Fargo & Company v. United States, No. 06–628T, 2010 WL 94544, at *60 (Fed. Cl. Jan. 8, 2010) (distinguishing leasing case Consolidated Edison Company of New York, No. 06–305T, 2009 WL 3418533 (Fed. Cl. Oct. 21, 2009) by observing that ‘‘considerations of economic substance are factually specific to the transaction involved’’).
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1041- As examples of cases in which courts have found that a transaction does not meet the requirements for the treatment claimed by the taxpayer under the Code, or does not have economic substance, See, e.g., BB&T Corporation v. United States, 2007–1 USTC P 50,130 (M.D.N.C. 2007) aff’d, 523 F.3d 461 (4th Cir. 2008); Tribune Company and Subsidiaries v. Commissioner, 125 T.C. 110 (2005); H.J. Heinz Company and Subsidiaries v. United States, 76 Fed. Cl. 570 (2007); Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006), cert. denied 127 S. Ct. 1261 (Mem.) (2007); Long Term Capital Holdings LP v. United States, 330 F. Supp. 2d 122 (D. Conn. 2004), aff’d, 150 Fed. Appx. 40 (2d Cir. 2005); Klamath Strategic Investment Fund, LLC v. United States, 472 F. Supp. 2d 885 (E.D. Texas 2007); aff’d, 568 F. 3d 537
(5th Cir. 2009); Santa Monica Pictures LLC v. Commissioner, 89 T.C.M. 1157 (2005).
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1042- See, e.g., Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006), cert. denied 127 S. Ct. 1261 (Mem.) (2007) (‘‘the first asserted business purpose focuses on the wrong transaction—the creation of Garrison as a separate subsidiary to manage asbestos liabilities. . . . [W]e must focus on the transaction that gave the taxpayer a high basis in the stock and thus gave rise to the alleged benefit upon sale’’) 454 F.3d 1340, 1358 (Fed. Cir. 2006). See also ACM Partnership v. Commissioner, 157 F.3d at 256 n.48; Minnesota Tea Co. v. Helvering, 302 U.S. 609, 613 (1938) (‘‘A given result at the end of a straight path is not made a different result because reached by following a devious path.’’).
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1043- The provision defines ‘‘economic substance doctrine’’ as the common law doctrine under which tax benefits under subtitle A with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose. Thus, the definition includes any doctrine that denies tax benefits for lack of economic substance, for lack of business purpose, or for lack of both.
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1044- See, e.g., Treas. Reg. sec. 1.269–2(b) (stating that a distortion of tax liability indicating the principal purpose of tax evasion or avoidance might be evidenced by the fact that ‘‘the transaction was not undertaken for reasons germane to the conduct of the business of the taxpayer’’). Similarly, in ACM Partnership v. Commissioner, 73 T.C.M. (CCH) 2189 (1997), the court stated: Key to [the determination of whether a transaction has economic substance] is that the transaction must be rationally related to a useful nontax purpose that is plausible in light of the taxpayer’s conduct and useful in light of the taxpayer’s economic situation and intentions. Both the utility of the stated purpose and the rationality of the means chosen to effectuate it must be evaluated in accordance with commercial practices in the relevant industry. A rational relationship between purpose and means ordinarily will not be found unless there was a reasonable expectation that the nontax benefits would be at least commensurate with the transaction costs.
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1045- Claiming that a financial accounting benefit constitutes a substantial non-tax purpose fails to consider the origin of the accounting benefit (i.e., reduction of taxes) and significantly diminishes the purpose for having a substantial non-tax purpose requirement. See, e.g., American Electric Power, Inc. v. United States, 136 F. Supp. 2d 762, 791–92 (S.D. Ohio 2001) (‘‘AEP’s intended use of the cash flows generated by the [corporate-owned life insurance] plan is irrelevant to the subjective prong of the economic substance analysis. If a legitimate business purpose for the use of the tax savings ’were sufficient to breathe substance into a transaction whose only purpose was to reduce taxes, [then] every sham tax-shelter device might succeed,’’’) (citing Winn-Dixie v. Commissioner, 113 T.C. 254, 287 (1999)); aff’d, 326 F3d 737 (6th Cir. 2003).
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1046- See, e.g., Rice’s Toyota World v. Commissioner, 752 F.2d at 94 (the economic substance inquiry requires an objective determination of whether a reasonable possibility of profit from the transaction existed apart from tax benefits); Compaq Computer Corp. v. Commissioner, 277 F.3d at 781 (applied the same test, citing Rice’s Toyota World); IES Industries v. United States, 253 F.3d at 354 (the application of the objective economic substance test involves determining whether there was a ‘‘reasonable possibility of profit . . . apart from tax benefits.’’).
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1047- There is no intention to restrict the ability of the courts to consider the appropriate treatment of foreign taxes in particular cases, as under present law.
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1048- Sec. 7805(a).
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1049- It is intended that the penalty would apply to a transaction the tax benefits of which are disallowed as a result of the application of the similar factors and analysis that is required under the provision for an economic substance analysis, even if a different term is used to describe the doctrine.
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1050- As under present law, the penalties under section 6662 (including the new penalty) do not apply to any portion of an underpayment on which a fraud penalty is imposed.
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1051- As revised by the provision, new section 6662A(e)(2)(b) provides that section 6662A will not apply to any portion of an understatement due to gross valuation misstatement under section 6662(h) or nondisclosed noneconomic substance transactions under new section 6662(i).
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