Section 1409 of the Health Care and Educational ReconciliationActof2010 (P.L. No. 111-152), titled “Codification of Economic Substance Doctrine and Penalties," sets out a statutoryeconomic substance doctrine and significantly alters the contours of the penalty structure with respect to transaction that are treated as lacking economic substance.
The changes set out in section 1409 -- both the substantive changes to the economic substance doctrine and the penalty provisions - are generally effective with respect to transactions entered after March 30, 2010.
2. The Economic Substance Doctrine.
TheEconomic Substance Doctrine is a strand of the tax law of the United States under which a transaction must have an economic purpose aside from reduction of tax liability in order to be considered valid. This doctrine is used to determine whether tax shelters, or strategies used to reduce tax liability, are considered "abusive" by the Internal Revenue Service. The following case squib illustrates the application of the Economic Substance Doctrine to a structured transaction / tax shelter that created a $60 million paper loss causing the Taxpayer to show an adjusted gross income of $26,381.00.
* * * * *
CARLOS E. SALA; TINA ZANOLINI-SALA, Plaintiffs - Appellees, v. UNITED STATES OF AMERICA, Defendant - Appellant.
UNITED STATES COURT OF APPEALS FOR THE TENTH CIRCUIT
2010 U.S. App. LEXIS 26910; 106 A.F.T.R.2d (RIA) 5488
November 19, 2010, Filed
PRIOR HISTORY: [*1]
APPEAL FROM THE UNITED STATES DISTRICT COURT FOR THE DISTRICT OF COLORADO. (D.C. NO. 1:05-cv-00636-LTB-KLM). Sala v. United States, 613 F.3d 1249, 2010 U.S. App. LEXIS 15232 (10th Cir. Colo., 2010)
PROCEDURAL POSTURE: Appellant, the United States, sought review of a judgment by the United States District Court for the District of Colorado in favor of appellee taxpayers, holding that the Internal Revenue Service improperly disallowed a refund to the taxpayers. The court found in favor of the government, and the taxpayers filed a petition for rehearing and suggestion for rehearing en banc.
OVERVIEW: The district court found that the entire foreign currency investment program was to be reviewed as a single transaction and concluded that each phase of the investment strategy had economic substance. On review, the court reversed, finding that the taxpayer's participation in the program lacked economic substance under 26 U.S.C.S. § 732(b). The court considered only the tax loss for the tax year at issue in that the pre-determined liquidation of the partnership was at the end of that tax year. The transaction was designed primarily to create a reportable tax loss that would almost entirely offset the taxpayer's income for that year with little actual economic risk. The court concluded that the pre-determined nature of the liquidation indicated a lack of economic substance. The existence of some potential profit was insufficient to impute substance into an otherwise sham transaction where a commonsense examination of the evidence as a whole indicated the transaction lacked economic substance. Indeed, rather than suffering any actual financial loss through the partnership and investment program, the taxpayer actually profited from the transaction.
OUTCOME: The court granted in part the implicit request for a panel rehearing and issued an amended opinion nunc pro tunc to the original filing date. The court reversed the judgment and remanded to the district court with instructions to vacate its judgment and to enter judgment in favor of the government. The court also denied the en banc suggestion.
3. New Section 7701(o).
Section 1409 enacts new § 7701(o) of the Code, which purports to clarify the application of the economic substance doctrine:
7701 (o) CLARIFICATION OF ECONOMIC SUBSTANCE DOCTRINE. --
(1) APPLICATION OF DOCTRINE. -- In the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if -- (A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position, and (B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.
(2) SPECIAL RULE WHERE TAXPAYER RELIES ON PROFIT POTENTIAL. --
(A) IN GENERAL. -- The potential for profit of a transaction shall be taken into account in determining whether the requirements of subparagraphs (A) and (B) of paragraph (1) are met with respect to the transaction only if the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected.
(B) TREATMENT OF FEES AND FOREIGN TAXES. -- Fees and other transaction expenses shall be taken into account as expenses in determining pre-tax profit under subparagraph (A). The Secretary shall issue regulations requiring foreign taxes to be treated as expenses in determining pre-tax profit in appropriate cases.
(3) STATE AND LOCAL TAX BENEFITS. -- For purposes of paragraph (1), any State or local income tax effect which is related to a Federal income tax effect shall be treated in the same manner as a Federal income tax effect.
(4) FINANCIAL ACCOUNTING BENEFITS. -- For purposes of paragraph (1)(B), achieving a financial accounting benefit shall not be taken into account as a purpose for entering into a transaction if the origin of such financial accounting benefit is a reduction of Federal income tax.
(5) DEFINITIONS AND SPECIAL RULES. -- For purposes of this subsection --
(A) ECONOMIC SUBSTANCE DOCTRINE. -- The term “economic substance doctrine" means 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.
(B) EXCEPTION FOR PERSONAL TRANSACTIONS OF INDIVIDUALS. -- In the case of an individual, paragraph (1) shall apply only to transactions entered into in connection with a trade or business or an activity engaged in for the production of income.
(C) DETERMINATION OF APPLICATION OF DOCTRINE NOT AFFECTED. -- The determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection had never been enacted.
(D) TRANSACTION. -- The term “transaction" includes a series of transactions.
3. Complimentary Changes to the Penalty Regime a. A New Component of the Accuracy Penalty
New subsection (b)(6) of section 6662, provides a 20% penalty for “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." However, it is unclear what is meant by “a similar rule of law." Sham transaction? Form over substance? Too good to be true? The smell test? I can say it with a straight face so it must be Kosher?
b. A New 40% Penalty
New subsection (i) of section 6662 provides for a 40% penalty in the case of “nondisclosed economic substance transactions." § 6662(i)(1). The phrase “nondisclosed economic substance transactions" means “any portion of a transaction described in subsection (b)(6) [i.e. transactions lacking economic substance] with respect to which the relevant facts affecting the tax treatment are not adequately disclosed in the return nor in a statement attached to the return." § 6662(i)(2).
c. No “Reasonable Cause" Defense
New subsection 6664(c)(2) provides that the “reasonable cause and good faith" defense to penalties set out in § 6664(c)(1) “shall not apply to any portion of an underpayment which is attributable to one or more transactions described in section 6662(b)(6) [i.e. transactions lacking economic substance]."
d. Transactions Lacking Economic Substance
Refund claims which lack a “reasonable basis" are subject to a 20% penalty. § 6676. New § 6676(c) provides that an excessive [refund claim] which is attributable to any transaction described in section 6662(b)(6) [i.e. transactions lacking economic substance] shall not be treated as having a reasonable basis." Accordingly, transactions which may fail on the basis of “economic substance" cannot be litigated in a refund forum (e.g. Federal Court of Claims) without the possibility that the government will assert a 20% penalty.