"Le plus ça change, le plus c'est la même 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]
A. 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]
B. 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 manner 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]
C. 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]
A. 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 section 7701(o). In conjunction with confirming that no "angel list' will be published, the Notice also announces that the IRS will not issue any private letter rulings or determination letters on whether economic substance is "relevant." Consequently, there will be no government guidance on when economic substance is "relevant," and taxpayers must make their own determination under the peril of the strict liability penalties.
2. Application of Existing Case Law
Notice 2010-62 provides that existing case law will apply to determine if a transaction has economic substance and business purpose. Whether economic substance applies is made in the same manner as under prior case law. The Notice makes clear, however, that a taxpayer may not rely on prior case law that applies a disjunctive test. The IRS will challenge a taxpayer that relies on prior disjunctive test case law.
3. Relevance
Section 7701(o) is "relevant" only if the economic substance doctrine is relevant. If prior case law held that economic substance was not relevant, the IRS will continue to take that position. The Notice provides, however, that the IRS anticipates that the case law pertaining to when economic substance is relevant will "continue to develop."
4. Net Present Value Calculations
The Notice states that the IRS will apply existing relevant case law and other published guidance for purposes of evaluating a taxpayer 's profit motive, but does not identify specific any published guidance. Presumably, the reference to "published guidance" is to Notice 98-5, even though it was withdrawn in 2004.[23]
The IRS may also intend to issue regulations or other guidance that will provide such guidance.
5. Treatment Of Foreign Taxes as Expenses
Notice 2010-62 announces that the IRS intends to issue regulations under section 7701(o)(2)(B). Furthermore, the Notice states that, "in the interim," the new statute does not restrict the ability of the courts to consider the proper treatment of foreign taxes in economic substance cases.
This later statement seemingly contradicts the statement in the Technical Explanation, which does not restrict a court's ability to consider the appropriate treatment of foreign taxes to the period until the IRS issues regulations. Inasmuch as section 7701(o) does not require foreign taxes to be treated as expenses for a profit test (unlike previously proposed legislation[24]) and limits its mandate to the government to provide regulations in "appropriate cases," the Notice seemingly stakes out an aggressive position. Although the IRS has taken issue with the Fifth and Eighth Circuits in their respective treatment of foreign taxes as taxes and not expenses, the Government did not seek certiorari in the Compaq and IES cases and, therefore, those cases remain good law in those circuits and possibly in other circuits as well. Moreover, that prior versions of economic substance legislative proposals required foreign taxes to be treated as expenses arguably confirms that foreign taxes should not be treated as expenses in all cases.[25]
The position taken by the IRS in Notice 2010-62 concerning foreign taxes takes on greater significance in light of the recent Mayo Foundation decision, which could make it more difficult to challenge a regulation as contrary to the statute it interprets. Challenging a regulation is always an uphill battle, but the Mayo Foundation decision makes such a challenge extremely difficult. Consequently, the initial position taken by the IRS in proposed regulations will be very important.
6. Accuracy-Related Penalties and Reporting
The most helpful portion of the Notice is the guidance on how to meet the adequate disclosure requirements under section 6662(i), which will be satisfied by filing Form 8275 or 8275-R. Furthermore, disclosure under Rev. Proc. 94-69 will be "taken into account," although no guidance was provided on whether "taken into account" will permit a taxpayer to fully satisfy the adequate disclosure requirement under Rev. Proc. 94-69. Finally, the Notice requests comments on the interplay between Rev. Proc. 94-69, Schedule UTP, and the CAP program. Obviously, a CAP program taxpayer will have advance knowledge of the IRS's reaction to a particular transaction and will be in a position to revise or abandon such a transaction. [25A]
When Is Economic Substance Relevant?
Is economic substance relevant when a transaction has no economic purpose other than tax savings? If so, section 7701(o) inquires whether there is economic substance and business purpose. Consequently, under section 7701(o), a transaction is tested for economic substance only when it has no economic purpose other than tax benefits, which obviously is circular.
The court cases generally do not pose the question whether the economic substance doctrine is relevant to a transaction, but rather place the burden on the taxpayer to demonstrate that the transaction under review has economic substance.[26] Consequently, case law has not developed criteria to determine when economic substance doctrine is "relevant," but has rather discussed whether a transaction was motivated by a profit potential and a non-tax business purpose.
The analysis becomes tautological, resulting in the possible application of the economic substance doctrine to every transaction with no threshold limitation of "relevance."
When Is Economic Substance Met?
Clearly, a transaction will have economic substance when a court agrees with a taxpayer that the transaction does indeed have economic substance.[26] It is possible that an Appeals officer might also agree with a taxpayer. A taxpayer, however, must on its own come to a meaningful conclusion whether a particular transaction meets the requirements of section 7701(o).[26A]
Some useful questions to determine whether a transaction has economic substance are as follows.
- Is the outcome of the transaction consistent with all applicable Code provisions?[27]
- Does tax result rely on the interaction of highly technical tax law provisions?[28]
- Is the outcome consistent with the purposes of those applicable Code provisions?
- Is the transaction a "real" transaction arising out of business needs or was it created in order to create a tax benefit?[29]
As a practical matter, every transaction should be evaluated under the economic substance doctrine. And, as noted by Notice 2010-62, the case law will continue to evolve, requiring further analysis under new case law. Currently, there are too many economic substance cases to count and they would not include those situations in which the IRS raised an economic substance argument on audit, which was settled at audit or Appeals. Because transactions may be aggregated, disaggregated, or recharacterized, economic substance analysis requires multiple inquiries concerning the same transaction. Thus, each step, various combinations of steps, and the transaction in its entirety potentially must be considered, in addition to all possible recharacterizations. A thorough analysis will be time-consuming as a result. Financial auditors will undoubtedly require such an analysis routinely.
A. Meaningful Change in Economic Position
A number of judicial decisions consider whether a transaction meaningfully changes a taxpayer 's economic position and clearly will at least initially provide guidance to a taxpayer.[30] Under this more general, subjective approach, the treatment of foreign taxes is not necessarily a factor. When is there no meaningful change in economic position? Many courts do not require a minimum return in order to satisfy the "meaningful change" standard.
One way to approach the analysis is to compare the costs of the transaction to the potential for economic gain from the transaction. This was the approach of the Fourth Circuit in Rice's Toyota World, Inc. v. Commissioner,[31] in which the court determined that the transaction lacked economic substance. In that case, assets with limited residual value were subject to a sale/leaseback transaction. Under the facts of that case, the taxpayer could easily walk away from the transaction from an economic perspective because the taxpayer paid more than fair market value for the assets so that the taxpayer had no equity in the assets. Because the assets had minimal residual value, the transaction could not be profitable. That economically the taxpayer could abandon the assets was a factor taken into account by the Fourth Circuit in determining that the transaction lacked economic substance.
Additional factors to consider are whether circular cash flow transactions or other circular asset transfers are present, the taxpayer 's protection from risk, and whether cash or assets will be returned to the original party (or its related party) when the transaction is complete.
B. Application of For-Profit Test
Although a taxpayer is not required to apply the for-profit test under section 7701(o)(2)(B), it is an objective test that may in some respects be easier to apply simply because it is a numeric calculation. It will be interesting to see if, when a taxpayer declines to invoke the objective for-profit test, whether the IRS will nonetheless provide its own analysis whether the taxpayer meets the test. One can envision the situation where the taxpayer relies on the more general "meaningful change in economic position" test and the IRS challenges the taxpayer not only on the basis of that test, but also on the basis that the more objective for-profit test is not met.
Under the for-profit test of section 7701(o)(2), the present value of the reasonably expected pre-tax profit from the transaction must be "substantial" in relation to the present value of the expected net tax benefits. Fees and other transaction expenses must be taken into account to determine pre-tax profit. Regulations are to be issued that treat foreign taxes as expenses in determining pre-tax profit in "appropriate cases."
Currently, there is no guidance on what is "substantial" or what rate of return is required, or what discount rate must be applied for present value. Moreover, there is no guidance on what the term "net tax benefits" means. Additionally, there is no guidance on whether fees and other expenses must be directly related to the tested transaction, although presumably that would be the case.
Lessons Learned from Taxes Cases Taxpayers Won
By studying the various economic substance cases, it is possible to discern when a court may decline to disallow a transaction on the basis that the transaction lacks economic substance. This is certainly the message provided by the government.[32] Furthermore, a taxpayer should anticipate that Appeals and courts will do the same to determine whether a particular transaction has economic substance. The following discussion examines a number of cases won by taxpayers and the basis on which the courts concluded that the transactions met the economic substance test.
The general themes that emerge from the following cases are that the transactions were undertaken as an integral part of the taxpayer 's business, even if the transaction was designed to achieve a tax benefit, and real economic change occurred. Even in the case where a foreign tax-indifferent party recognizes gain while the U.S. taxpayer recognizes a loss, this fact is not enough to defeat the economic substance of the transaction.
A. United Parcel Service of America, Inc. v. Commissioner [33]
In United Parcel Service, UPS undertook a reinsurance transaction that was consistent with its business and, in fact, continued its existing insurance business that was tangential (but important) to its primary shipping business. Essentially, UPS reinsured its insurance business to a non-controlled foreign corporation. The result of this restructuring was the deferral of the premiums that previously had been included in UPS's income in the year of receipt.
The Eleventh Circuit in holding that the transaction had economic substance made some important observations. First, choosing one business form over another solely for tax purposes still satisfied the business purpose test. The Eleventh Circuit compared such a choice to a choice between debt or equity capitalization, which of course is similar to the Technical Explanation statement discussed above. Finally, the transaction only altered the form of an existing business.
B. Countryside Limited Partnership v. Commissioner [34]
This case involved the deferral of income recognition from the liquidation of the interests of several partners in a real estate investment partnership. While the case involved several tiered partnerships, essentially the issue for economic substance purposes was whether the distribution by the lower-tier partnership of notes purchased with contributed funds from the upper-tier partnership and borrowed funds from a third party bank were used to purchase notes that were neither listed nor traded on an established financial market was solely tax-motivated. As a result, the notes were treated by the court as non-marketable securities and not equivalent to cash, which resulted in non-recognition of gain under section 731(c).
The lower-tier partnership interest was distributed to two of the partners in liquidation of their partnership interests. The liquidated partners did not report any gain from the transaction and conceded that the transaction was structured to prevent the recognition of any gain. The IRS argued that the transaction could not generate a profit after taking into account expenses.
The Tax Court based its holding that the transaction had economic substance on the transaction's accomplishing the legitimate business purpose of converting equity into promissory notes and the resulting change in the economic position of the liquidating partners. The key here was that the partnership owned and operated a 448-unit residential property for approximately seven years before the liquidating distribution to the retiring partners. Another point was that the exit strategy from the partnership involved an unrelated party, i.e., the bank that lent the funds to the lower- and upper-tier partnerships.
C. Granite Trust Co. v. United States [35]
Although the Granite Trust case is not strictly an international case, it is relevant to U.S. multinational corporations because it concerns the application of the corporate liquidation provisions, which frequently are important in restructuring the organization of a company's subsidiaries. In Granite Trust, the court upheld a loss recognized as a result of a section 331 liquidation that was preceded by the sale of 21 percent of the stock of the subsidiary so that section 332 would not apply to deny recognition of the loss. In this case, the tax loss reflected a real economic loss; arguably, the transaction affected only the timing of the recognition of the loss. An IRS official has confirmed that codification of economic substance would not change this result.[36]
D. Caruth Corp. v. United States [37]
The Caruth case, like Granite Trust, does not involve a strictly international issue (nor does it even involve a public corporation). The case is noteworthy, however, because it addresses the application of economic substance in the context of a section 351 transaction, also an important tool for restructuring. In this case, the majority taxpayer of a closely held corporation contributed nonvoting common stock of the existing corporation to a newly organized corporation wholly owned by the majority shareholder before the payment of a large dividend by the existing corporation. Thereafter, the taxpayer contributed preferred shares of the existing company to a local charity after the declaration of a large dividend. Several days later, on the dividend record date, the charity received the dividend from the preferred shares. Two months later, the taxpayer repurchased the shares from the charity. No prior agreement for repurchase had been made.
Notwithstanding the IRS's sham transaction challenge, the court held that the transaction resulted in a change in the economic position of the taxpayer because the taxpayer 's remaining shares in the dividend-paying corporation were worth less as a result of the large dividend payout. Moreover, the transaction had a legitimate business purpose, which was in part to induce the minority shareholders to sell out to the taxpayer. The majority taxpayer had thought that the large dividend would entice them to sell because a stock sale would be taxed at capital gains rates rather than ordinary rates and so scheduled a lag between the dividend announcement date and the dividend record date.
E. Flextronics America, LLC v. Commissioner [38]
This case involved a sale of U.S. assets between two Canadian parties, one of which was Nortel. Although the case involved a tax indifferent party that recognized gain on the transaction that was not taxable by the United States, the asset sale occurred within a business context that would have occurred in any event. By purchasing the inventory assets separately from the other business assets and subsequently pledging the inventory as security to the lenders, the purchaser recognized a loss as a result of contributing the pledged inventory assets to a new corporation under section 351. As a result of the section 351 contribution, the pledged inventory assets received an increase in basis under former sections
357(c) and 362(a). When the inventory assets were sold, the sale produced a loss because of the high basis relative to the inventory's fair market value.
The Tax Court found that the transactions had business purpose and economic substance because the inventory transactions provided inventory needed in the business of the purchaser and provided security for the bank loans that were needed and used to purchase the rest of the business. The inventory transactions occurred in the context of a purchase of a business complementary to the purchaser 's business and would have occurred in any event. That the purchaser structured the transaction to receive a tax benefit was not sufficient for the Tax Court to deny the loss deduction under the economic substance or step transaction doctrine.
Lessons Learned from Cases Taxpayers Lost
The number of cases that taxpayers lost dwarfs the number of cases won, which reflects the nature of the transactions in those cases lost. Many transactions viewed by the various courts as having no economic substance are now statutorily barred by recent amendments to the Code (because the cases were deemed to be "tax shelters"). It is still instructive to review the lost cases, however, in order to understand the principles enunciated by the courts that led to a determination that the transactions had no economic substance. Because of the number of cases, this article does not discuss cases individually, but rather summarizes the principles provided by those cases.
A. Transactions Unrelated to Business Activity of the Taxpayer and Not in the Ordinary Course of Business
Such transactions, because they are not a part of a taxpayer 's ordinary business activity, are suspect from the courts' perspective. As can be seen from the discussion of the cases in which the taxpayer prevailed, transactions undertaken as a part of the taxpayer 's business are clearly given more credence by the courts.
B. Transactions Not In Accordance with Commercial Practices in the Relevant Industry
Transactions that are consistent with business practices of the taxpayer 's industry fare better than those that are unusual or out of the ordinary for an industry.
C. Economic Risks and Profit Potential of the Transaction Are Insignificant Compared to the Tax Benefits
Transactions that limit risk excessively and have little profit potential have received greater judicial scrutiny and usually are not treated by the courts as having economic substance. Similar to such transactions, circular cash flow and other transactions where the taxpayer ends up in the same economic position following the transaction have not withstood economic substance scrutiny.
D. No Genuine Obligation with an Unrelated Party
A number of cases have scrutinized the relationship and obligations of the parties to the transaction, even where one of the parties is unrelated to the taxpayer. Included in this category would be cases where a bank or other finance partner is not treated as a partner.
E. Transactions Conducted With Tax-Indifferent Parties
Transactions with tax-indifferent parties have historically been suspect and, in several prior versions of economic substance legislation, that factor was singled out for special treatment. Significantly, section 7701(o) does not contain any such special provisions. However, as was discussed above in the Flextronics case, the presence of a tax-indifferent party is not always fatal.
F. Tax Losses Not Reflected Economically
This factor seems to be crucial for courts. For example, in the cases involving artificially increased basis of an asset followed by a sale of the asset at the lower fair market value, the courts have had little trouble in concluding that such a transaction does not have economic substance because the tax loss resulted from the inflated tax basis and not from an economic loss.
What's Next?
A. IRS Application
Despite the very real concerns about the strict liability penalty, there are some restrictions on imposing the penalty. An LB&I Directive (9/14/2010) requires the approval of the Director of Field Operations for assertion of the section 6662(b)(6) economic substance penalty to ensure uniform application of the strict liability penalty. Although Chief Counsel review of a proposed penalty is likely, no formal announcement requiring such review has been made to date. IRS officials have also announced that an LB&I Directive, which will provide internal guidance for auditors, is currently under development, but it is unlikely that guidance will be made public. What the IRS has said is that auditors will be advised to apply traditional examination techniques to determine if a tax benefit meets tax law requirements.
B. Questions Remain
- Will the required review of a proposed assertion of a section 6662(b)(6) penalty "chill" assertion?
- Before the enactment of section 7701(o), the IRS frequently relied upon economic substance as a basis to deny a tax benefit. If any penalty that is asserted now must be reviewed, what will be the effect? Will the IRS continue to frequently challenge transactions as not having economic substance?
- How will the potential assertion of the penalty affect audits? Will auditors "threaten" the application to gain leverage? Other consequences might there be?
- Will auditors who assert the penalty be required to develop more detailed reasons for its application?
- Will prior cases be the only guide for application?
- Will the IRS find new ways to apply economic substance in unanticipated situations?
- What will be the effect of such an unanticipated application on the penalty, i.e., will the IRS be as likely to prevail at Appeals or in court?
Practical Issues
A. Financial Reporting
The biggest immediate issue is how to address economic substance in the context of financial reporting. Auditors will begin economic substance review for 2010 transactions that occurred after March 31. Undoubtedly, transactions will be scrutinized under economic substance doctrine. Such scrutiny will require consideration of all the permutations and combinations of a transaction because of the aggregation/disaggregation rule. Moreover, all potential recharacterizations will need to be considered in order to assess the viability of the transaction. An opinion of counsel may have some relevance in this context.
B. Tax reporting/Disclosure
Another issue is whether to disclose a particular transaction to protect against the 40-percent penalty. The IRS has already an- nounced that the CAP program will be expanded. For taxpayers who qualify for this program, this may become the best way in which to protect a corporation from the strict liability penalty because an IRS determination may be received before the return being filed.
Summary
Although economic substance doctrine is not new, the strict liability penalty should get your attention. Disclosing every transaction to limit penalties to 20 percent is not practical. Development of internal procedures for review of prospective transactions would be helpful in determining whether the transaction needs to be revised to limit exposure and when disclosure is appropriate. It is a new era.
Carol P. Tello is a partner resident in the Washington office of Sutherland Asbill & Brennan LLP. She received her B.A. degree from the College of William and Mary, her J.D. degree from the University of Maryland School of Law, and her M.L.T. degree from Georgetown University. She previously worked in the Office of the Associate Chief Counsel (International) of the Internal Revenue Service, where she participated in income tax treaty negotiations, several Tax Court cases on international tax issues, and on various regulations and other guidance. Her practice includes a broad range of cross-border tax planning and IRS controversy matters for both business entities and individuals. This article is adapted from a presentation to the New York Chapter of Tax Executives Institute on December 8, 2010. Ms. Tello can be contacted at Carol.Tello@sutherland.com.
1. 562 U.S. (2011), Slip Opinion No. 09-837 (hereinafter "Slip Op.").
Under the Mayo Foundation decision, however, Chevron will apply "with full force in the tax context." This means that a challenged tax regulation, whether a legislative or an interpretative regulation, only needs to satisfy a "reasonable interpretation" standard; thus, if the regulation is a reasonable interpretation of the statutory provision that it is interpreting, the regulation will be valid. In the context of the 20- or 40-percent strict liability penalty, Chevron deference increases the stakes if, in fact, before Mayo Foundation, any regulations issued under section 7701(o) would not have been considered to be legislative regulations and, hence, would have been subject to less deference under National Muffler Dealers Association v. United States, 440 U.S. 472(1979),
2. Pub. L. No. 111-152, § 1409, 124 Stat. 1029 (2010). This bill was enacted in combination with the Patient Protection and Affordable Care Act. Pub. L. No. 111-148, 124 Stat. 121 (2010).
3. Technical Explanation of the Revenue Provisions of the "Reconciliation Act of 2010," as amended in Combination with the "Patient Protection and Affordable Care Act," Joint Committee on Taxation, JCX-
18-10 (Mar. 21, 2010) ("Technical Explanation"), at 144.
4. See Codification of Economic Substance Should Have Minimal Effect on Practice, IRS Official Says, Tax aNalysTs, 2010 TNT 90-2 (May 11,
2010); IRS Could Consider Challenging Previously Approved Transactions Following Economic Substance Codification, Alexander Says, Tax Analysts, 2010 TNT 193-2 (Oct. 6, 2010).
5. For example, H.R. Rep. No. 111-443 was prepared for a 2009 proposal that contained penalty provisions ultimately not adopted. It remains uncertain whether the discussion concerning economic substance would be considered valid legislative history.
6. I.R.C. § 7701(o)(5)(C).
7. I.R.C. § 7701(o)(5)(A).
8. I.R.C. § 7701(o)(1).
9. I.R.C. §§ 7701(o)(1) and (2). See also Technical Explanation, at 154 ("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 . . . ."); Section C of Notice 2010-62, 2010-40 I.R.B. 411.
10. I.R.C. § 7701(o)(2)(A).
11. I.R.C. § 7701(o)(2)(B).
12. Id. The Joint Committee has said the regulations will not restrict the ability of courts to consider the treatment of foreign taxes. See Technical Explanation, at 155 n.357. The treatment of foreign taxes as expenses to determine pretax profit would overrule the Fifth and Eighth Circuit decisions in the Compaq and IES decisions, respectively. See Compaq Computer Corp. v. Commissioner, 277 F.3d 778, 785–86 (5th Cir. 2001); IES Industries v. United States, 253 F.3d 350, 354 (8th Cir. 2001).
13. I.R.C. § 7701(o)(4).
14. I.R.C. § 7701(o)(3). An example of this may be similar to Example 7 of Treas. Reg. § 1.355-2(b)(5), in which a state has in effect for state income tax purposes a similar regime to that of Subchapter S. Treas. Reg. § 1.355-2 (b)(1). The example concludes that the purpose of reducing state income taxes is not a corporate business purpose.
15. I.R.C. § 7701(o)(5)(D).
16. Technical Explanation, at 153.
17. 454 F.3d 1340 (Fed Cir. 2006), cert denied, 127 S. Ct. 1261 (2007), which is cited by the Technical Explanation, at n.352.
18. I.R.C. § 6662(i)(3). This restriction on timeliness of adequate disclosure is the same as the provision applicable to reportable transactions under section 6662A(e)(3).
19. I.R.C. § 6676(c).
20. I.R.C. 6664(c)(2).
21. I.R.C. § 6676(c).
22. Temp. Reg. §301.6707A-1T(d)(3) provides the factors that would be ap- plied to determine whether rescission would be granted in a specific case.
23. Notice 2004-19, 2004-11 I.R.B. 606.
24. See Jobs and Growth Reconciliation Tax Act of 2003, H.R. 2, 108th
Cong. § 301 (S. Amend.) (2003); AMT Relief Act of 2007, H.R. 4351,
110th Cong. § 211 (2007); Affordable Health Care for America Act of
2009, H.R. 3962, 111th Cong. § 562 (2009).
25. E.g., H.R. 4351 (2007) and Senate Amendment to H.R. 2 (2003).
25A. The IRS announced on March 31, 2011, that the CAP program will be expanded and made permanent. IR-2011-32. Details about the program have been added to the Internal Revenue Manual.
26. See ACM Partnership v. Commissioner, 73 T.C.M. (CCH) 2189, at *36 ("The doctrine of economic substance becomes applicable, and a judicial remedy is warranted, where a taxpayer seeks to claim tax benefits, unintended by Congress, by means of transactions that serve no economic purpose other than tax savings."). See also Coltec Industries, 454
F. 3d 1340, 1357 (Fed. Cir. 2006), cert denied, 127 S. Ct. 1261 (2007), and Long-Term Capital Holdings v. United States, 330 F. Supp.2d 122, 165, 171 (D. Conn. 2004).
26A. Some practitioners have argued that a private letter ruling will provide protection even if economic substance is not mentioned. That remains to be seen. The IRS has already issued PLRs that contain a caveat concerning economic substance. See, e.g., PLR 201105002 (Feb. 4, 2011).
27. Technical Explanation, at 153 ("[T]he 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.")
28. For example, Treas. Reg. § 1.269-2 disallows tax benefits when the effect of the benefit would be to distort the liability of the taxpayer when the essential nature of the transaction is examined in light of the basic purpose of the benefit. See Technical Explanation, at 152 (further explaining that it is not intended that a tax credit such as section 42 (low-income housing credit), section § 45 (production tax credit), section 45D (new markets tax credit), section 47 (rehabilitation credit), or section 48 (energy credit) be disallowed where a taxpayer makes the type of investment or undertakes the type of activity that the credit was intended to encourage).
29. See Coltec Industries v. United States, 454 F.3d 1340, 1357 (Fed. Cir. 2006), cert denied, 127 S. Ct. 1261 (2007) ("[T]here is a material difference between structuring a real transaction in a particular way to provide a tax benefit (which is legitimate), and creating a transaction, without a business purpose, in order to create a tax benefit (which is illegitimate).").
30. See e.g., Rice's Toyota World v. Commissioner, 752 F.2d 89, 94–95 (4th Cir.
1985); Goldstein v. Commissioner, 364 F.2d 734, 740–42 (2d Cir. 1966);
Knetsch v. Commissioner, 364 U.S. 361, 365–66 (1960).
31. 752 F.2d 89 (4th Cir. 1985).
32. At the University of Chicago 63rd Annual Federal Tax Conference, William Alexander, Associate Chief Counsel (Corporate), suggested that taxpayers "mine" case law to extract principles to be applied. See Year in Review: Economic Substance Codification Raises Guidance Questions, Tax aNalysTs, 2011 TNT 1-8 (Jan. 3. 2011).
33. 254 F.3d 1014 (11th Cir. 2001).
34. T.C. Memo 2008-3 (2008) (case continues).
35. 238 F.2d 670 (1st Cir. 1956).
36. Remarks of Marie Milnes-Vasquez, Branch 4, Senior Technical Review, IRS Associate Chief Counsel (Corporate) at the ABA Section of Taxation meeting on May 7, 2010. Tax aNalysTs Doc. 2010-10221.
37. 688 F. Supp. 1129 (N.D. Tex. 1987).
38. T.C. Memo. 2010-245 (Nov. 8, 2010).
Appendix
Important Economic Substance Cases for Multinational Corporations
