When President Obama signed the Health Care and Education Affordability Reconciliation Act of 2010 back in March, most of the attention was focused on the country’s new health care laws. But tax professionals and scholars were also tuned into a lesser-known portion of the act: a provision that codified in the Internal Revenue Code the judicially developed economic substance doctrine.
University of Florida Levin College of Law Stephen C. O’Connell Professor Martin J. McMahon Jr. was one of those scholars who took note of the newly codified doctrine and he published an article in the Aug. 16 edition of Tax Notes – “Living with the Codified Economic Substance Doctrine” – which examines the new legislation and its significance.
Before exploring McMahon’s analysis, a quick history lesson is in order.
Over the years, taxpayers and tax lawyers have found ways of gaining tax benefits by engaging in transactions that were very different than the types of business-motivated transactions the authors of the Internal Revenue Code intended them to be applied, McMahon said.
“What the economic substance doctrine has come to mean is that a tax benefit, such as a claimed loss, will be denied if there is no business purpose for the transaction and the transaction does not have economic substance,” McMahon said.
“Very smart tax lawyers read the Internal Revenue Code and regulations and figured out how to invent transactions that produce a fictional loss on the tax return that’s not matched by any true economic loss to try to shelter income,” McMahon said.
The courts have concluded that these types of transactions – while not necessarily fraudulent – are abusive, and the new legislation is basically saying to taxpayers, “You should know better.”
The new legislation McMahon examines in his article is intended to clarify the economic substance doctrine, with the intent of disallowing tax benefits from the types of questionable tax shelter transactions that became increasingly common throughout the ‘80s and ‘90s.
The new legislation also seeks to create more concrete guidelines within the economic substance doctrine. Now, transactions that are subject to the economic substance doctrine must pass a two-prong test: one objective test and one subjective test, McMahon said.
The objective test requires that a transaction change the taxpayer’s economic position in a meaningful way outside of tax purposes. The subjective test requires that the taxpayer have a “substantial nontax purpose for entering into the transaction,” McMahon said.
Has the tax world been turned upside down by the new provisions? Are lives ruined and fortunes destroyed by this?
Not exactly, McMahon said.
“It’s just old wine in a new bottle,” he said. “The sky is not falling; the substantive law hasn’t changed but marginally.”
Congress has been moving toward the clarification of the doctrine for about a decade, McMahon said, so it wasn’t a big surprise to anyone. And lawmakers have been applying various interpretive doctrines to these types of situations for about 60 years.
“But what Congress did add that was very significant is a strict-liability penalty if a transaction is held by the courts to not have economic substance,” he said.
Even if the taxpayer has an opinion from a tax lawyer that the expected tax benefits will be allowed, if the tax benefits are disallowed, it will now result in a strict-liability penalty of 20 percent of the tax deficiency resulting from the transaction for those who still try to slide by with transactions. And the penalty is increased to a hefty 40 percent if the transaction was not fully disclosed on the tax return.
Even if the clarifications weren’t earth shattering, the changes caused a number of tax practitioners to look to the IRS and the Treasury Department to publish an “angel list,” which would be a list of transactions that would be immunized in advance from the rules of the economic substance doctrine, McMahon said.
McMahon argued in his article that such a list should not be published because the Treasury and the IRS simply cannot anticipate the new transactions that would be devised by the army of hardworking tax mavens who will plumb the depths of the angel list searching for anomalies around which new tax shelters can be designed. In September, the IRS and the Treasury agreed, announcing they would not be publishing an angel list, he said.
Although the newly codified economic substance doctrine is far from radical, McMahon said it will raise the bar for tax compliance.
“What this statute will do is bring the mentality of tax advisers back to what it was 40 years ago, when the standards were higher,” he said.