Late on Sunday, March 21, the House voted 220 - 211 to enact new penalties on businesses that try to avoid paying taxes by entering into transactions that lack underlying “economic substance” as a revenue provision of the Health Care and Education Affordability Reconciliation Act of 2010 (H.R. 4872) (the “Reconciliation Act”). The Reconciliation Act was released by House Democratic leaders on March 18, 2010 and was intended to bridge their differences with the Patient Protection and Affordable Care Act (H.R. 3590), passed by the Senate on December 24, 2009. Earlier Sunday night, the House voted 219 - 212 to pass H.R. 3590. The Senate will begin debate on the reconciliation measure this week, with a contentious process expected to unfold between Democrats and Republicans over the fate of the provisions in the measure. Two weeks ago, the Senate voted to codify the “economic substance” doctrine, along with a series of other tax provisions to partially pay for a one year extension of more than 40 individual and business tax breaks that expired at the end of 2009. Because the reconciliation measure contains identical tax provisions to the those included in the earlier tax extenders legislation (H.R. 4213), the extenders bill will need to be rewritten to identify new revenue provisions to to pay for the one year extension of the 40 individual and business tax breaks that expired at the end of 2009.
The "economic substance" doctrine is a common law doctrine that has been applied by courts to deny tax benefits arising from transactions that do not result in a meaningful change to the taxpayer's economic position other than a purported reduction in Federal income tax, even though the purported activity actually occurred. Courts also apply related doctrines including the "business purpose," "sham transaction," "substance over form" and "step-transaction" doctrines. There is a lack of uniformity regarding the proper tests to use when applying the "economic substance" doctrine. Some courts apply a conjunctive test that requires a taxpayer to establish the presence of both economic substance and business purpose in order for the transaction to survive judicial scrutiny. A narrower approach used by some courts is to conclude that either a business purpose or economic substance is sufficient to respect the transaction.
The Reconciliation Act provides that: "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." In the case of an individual, the economic substance doctrine shall apply only to transactions entered into in connection with a trade or business or an activity engaged in for the production of income. The determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this provision had never been enacted.
Although the codification of the economic substance doctrine does make standard the conjunctive test, it is the addition of the failure to satisfy the economic substance doctrine to the list of transactions subject to the imposition of accuracy related penalties on underpayments under section 6662 that is expected to raise significant revenue. The Joint Committee on Taxation estimates this provision would raise $4.5 billion through 2019. Amended section 6662 will provide that there shall be added to the tax an amount equal to 20 percent of "any disallowance of claimed tax benefits by reason of a transaction lacking economic substance ... or failing to meet the requirements of any similar rule of law." Thus, not only transactions that are determined to fail to satisfy the economic substance doctrine, but also transactions that are found to be subject to related doctrines including the "business purpose," "sham transaction," "substance over form" and "step-transaction" doctrines may be subject to the 20 percent accuracy related penalty on underpayments of tax. In addition, the penalty rate will increase from 20 percent to 40 percent in the case of any portion of an underpayment which is attributable to one or more nondisclosed noneconomic substance transactions. The term "nondisclosed noneconomic substance transaction" means any portion of a transaction lacking economic substance ... or failing to meet the requirements of any similar rule of law with respect to which relevant facts affecting the tax treatment are not adequately disclosed in the return nor in a statement attached to the return.
The codification of the economic substance doctrine and the imposition of accuracy related penalties on underpayments shall apply to transactions entered into after the date of enactment of the Reconciliation Act.