H. 1265, 111th Cong. 1st Sess., Stop Tax Haven Abuse Act, introduced March 3, 2009, referred to Committee on Courts and Competition Policy, Title IV entitled Clarification of Economic Substance Doctrine.
The bill aims to resolve or inform two, and only two, uncertainties that Congress believes the courts encounter when applying what the bill calls the “economic substance doctrine” to federal income tax disputes. The uncertainties are how to compute economic substance and whether economic substance has both an objective and a subjective component.
The proposed resolutions are:
- to establish a necessary but not sufficient test for “economic substance” that requires finding both a meaningful objective economic effect for the taxpayer and a substantial non-federal tax purpose;
- to impose a separate test for “economic substance” in the case where a taxpayer relies solely on a transaction’s profit potential, which requires present valuing, taking account of fees and expenses and a finding of “substantiality”; and
- to exclude from the qualifying purposes one based on financial accounting benefits (which derives from positions taken by Enron) and one based on non-federal tax reductions that are equal to or less than federal tax reductions (which is similar to rules applicable to tax-free spin-offs, which require a business purpose).
Two important facts about the bill are clear from the foregoing summary:
- It does not undertake to either impose or define an “economic substance doctrine” requirement in the income tax; and
- It assumes that taxpayers undertake business transactions for reasons other than profit potential and economic effect.
These two facts themselves suggest uncertainties that are just the beginning of the new uncertainties that will be created by the bill. Of course, failing to answer all possible questions is not a reason to reject a “half a loaf” piece of legislation. However, when the loaf size is considerably less than half, and the unresolved issues are core issues of the income tax, particular care should be taken to avoid causing more problems than are solved.
For example, the incremental approach has not been particularly successful for Congress in the area of tax-free spinoffs. Congress has substantively amended section 355 seven times since the Tax Reform Act of 1986, mostly to try to curb “abuses.” Despite this, it remains the go-to tax reduction provision for corporations, a position that was exacerbated by the 1986 repeal of the “General Utilities Doctrine,” which had provided corporations another route to distribute property without tax. The 1986 repeal illustrates the unintended consequences that often accompany well-meaning tax law changes.
The unanswered questions, and hence future disputes built into the bill, include the following:
- Is there an economic substance doctrine that applies in income tax cases at all, and what exactly is it?
- The section is headed “clarification of economic substance doctrine”; is not Congress interested in what that doctrine might be generally and when it should apply? Does the word “clarification” mean that the Congress adopts it?
- Does any such doctrine apply in estate and gift tax cases, excise tax cases, employment tax cases, etc.?
- Is the application of the legislation limited to courts, or is the IRS supposed to apply it? Or, rather, is the IRS supposed to estimate how the courts will apply it?
- What if a court concludes that economic substance is a subset of “substance over form” and concludes that “substance over form” does not apply?
- Is the bill really telling courts how to find facts? Is that a proper subject of legislation?
- What are the sorts of non-profit-making business purposes that the bill contemplates? Employee morale boosters? Loss leaders?
- What does a taxpayer have to do to “rely on profit potential”? If a taxpayer says it did not rely on profit potential, does that part of the test fall out?
- Are not the taxpayer purpose and the economic substance really the same thing when it’s a matter of profit potential and, when it is not, exactly what sort of purpose is the bill looking for?
- How much is a “substantial” profit potential? How does this term relate to the “substantial part” used in testing the business purpose of a spin-off or the “principal purpose” used in section 269?
- Do the bill’s tests apply at the macro level of an integrated transaction only? (They appear to, which means intervening steps can lack business purpose?)
- Would not this statute overrule the Supreme Court’s decision in Cottage Savings Assn. v. CIR, 499 U.S. 554 (1991), which allowed S&Ls to recognize losses by swapping interests in economically identical mortgage pools that left them in the identical economic positions after the swaps as before, and that were done solely to generate loss recognition and save taxes?
- What does the bill mean when it refers to a “common law doctrine”? Does this mean Congress promotes every line of case law into “common law”?
- The bill uses the term “federal tax purpose”; presumably this means purpose of reducing federal taxes—does the bill leave no room for a tax reduction transaction that Congress clearly intended? Does the bill count on some other “common law” doctrine to trump it in these cases? Is it wise to pull at one end of this ball of string?
Something like this bill is likely to be enacted this year. It will change the playing field for analysis of the likelihood of tax outcomes, but exactly how may still be unclear even after enactment.