While the government has for the most part successfully attacked tax products or tax-motivated strategies that were in vogue in the late 1990s and in the 2000s, there were many cases that the Service did not get the chance to audit and thereby escaped unscathed by passage of the statute of limitations and there were also some instances where the Service suffered a judicial defeat.
Frequently, the client investing in a particular tax solution or tax-motivated transaction, was primarily driven by tax savings and, in the event the strategy was audited and successfully challenged by the IRS, to still avoid penalties by obtaining a "more likely than not" standard tax opinion from a reputable law firm or accounting firm . The tax opinion, in the eyes of the Service and some skeptical commentators on the tax law, was nothing more than a purchase of insurance acquired by the investor to avoid a 20% (or higher) penalty. Owing back taxes and interest for the use of the money until the taxes were repaid from a "flaky" deal was not enough "skin in the game" for the taxpayer to be adverse to investing in the tax solution in the first place.
In an effort to provide uniformity to the tax law, Congress enacted section 7701(o) codifying the economic substance doctrine. The Congress adopted the Service’s approach, i.e., a two part conjunctive test which requires both (objective) economic substance and (subjective) substantial business purpose. The legislative history notes that the codification was not intended to replace or surplant existing precedent. Under the economic substance doctrine, first the transaction under evaluation must result in a meaningful change in the taxpayer's nonfederal-income-tax economic position and, second, the transaction must also have a substantial nonfederal-income-tax purpose. Both prongs must be satisfied based on the taxpayer’s generally required burden of proving its position by a preponderance of the evidence. The taxpayer is not required, per se, to establish a pretax profit to establish economic substance but can use this standard to meet the statutory requirement by demonstrating that the present value of the anticipated pretax profit is substantial in relation to the present value of the expected net tax benefits that would be allowed from the transaction. Presumably guidance will be issued by the Service on examining the pretax profit test and how to compute the pretax profit, etc. Under section 7701(o)(4), accounting benefits cannot be taken into account in testing for whether the transaction has a substantial nonfederal-income-tax effect where the origin of the financial accounting benefit is a reduction in federal income tax. The reason for this rule is straightforward: If reduction of federal tax was the origin of the accounting treatment and the accounting treatment could be relied on in applying the conjunctive test, the test would become circular and cease to have meaning. Beyond this simple case, however, the circumstances in which the origin of the accounting benefit is federal tax reduction should be specified by Treasury and the IRS in future guidance. Foreign taxes are not treated as expenses per se under the pretax profit test subject to further guidance to be issue by the Service.
The term "transaction" is defined in section 7701(o)(5)(E) as including a series of transactions, i.e., see Treas. Reg. §1.6011-4(b)(1) "transaction includes all of the factual elements relevant to the expected tax treatment of any investment, entity, plan, or arrangement, and includes any series of steps carried out as part of a plan."
As far as the second prong, i.e., the taxpayer’s non-tax purpose for entering into the transaction, the purpose must be "substantial" and a "reasonable means" of satisfying such purpose. This requires that the transaction have a reasonable nexus to the taxpayer’s normal business operations or investment activities.
Congress has definitely imposed a "skin in the game" requirement for taxpayers that fail to meet the economic substance test. New section 6662(b)(6) imposes a strict liability penalty without an out for reasonable cause or good faith. The penalty is imposed on an "underpayment", per §6664(a) and is based on the amount of tax due were the transaction reported correctly. The penalty is 20% of the underpayment for disclosed transactions and 40% for undisclosed transactions.
Guidance will be forthcoming on this "new world" of section 7701(o) of statutory economic substance. Perhaps the Service will reduce the anxiety level of tax practitioners and there clients by publishing an "angel list" of transactions or parts of larger transactions that will not be challenged by the Service under section 7701(o).
President Obama signed into law on March 30, 2010, the HIRE Act. Section 1409 of the Act sets adopts long-standing principle of the federal income tax law, that of the doctrine of economic substance, and not only codified the rule, which itself is controversial, but imposes a new strict liability penalty for its violation.
There are several judicial doctrines which are used to test the efficacy and purpose of the particular transactions being reviewed as well as sorting out those transactions that are primarily or solely motivated by tax savings from those transactions which have a substantial business purpose or economic motive that requires that the taxpayer changes position or risk with respect to the transaction viewed on a "before the transaction" and "after the transaction" basis. Several of the noted doctrines resorted to by the courts as aides are the "step transaction doctrine", the "sham transaction" doctrine" and the "business purpose doctrine". A fourth judicial overlay is that of the "economic substance" doctrine. Over the past ten years or so the courts have invoked the underlying calculus of each of these doctrines, which frequently overlap or are applied in an inconsistent manner, in determining whether or not to deny the tax benefits designed to flow from tax-motivated transactions.
The legal standard for applying the economic substance doctrine has been approached differently by various circuit courts of appeals. Some have required that the transaction have either economic substance (from an objective standpoint) or a substantial business purpose (from a subjective standpoint). Other courts have required both prongs be present, i.e., both economic substance and substantial business purpose. Yet other courts have applied an overall approach drawing upon both business purpose and economic substance in evaluating the transaction as a whole.
The courts also did not always apply the same reasoning on the type of nontax economic benefit a taxpayer must establish to satisfy the economic substance requirement. Some courts denied tax benefits where a perceived business benefit was not in fact obtained. Other courts denied tax benefits on the judicial view that the transaction lacked profit potential. Still other courts disallowed tax benefits in instances where the transaction had a profit motive and the taxpayer was exposed to risk but the economic risks and profit potential were insignificant compared with the size of the tax benefits derived from the transaction.