A bill has been introduced in Olympia to codify economic substance as the prevailing theory in reviewing potentially abusive tax avoidance transactions. This bill would substantially change Washington tax law.

Under the proposed bill, the Department of Revenue "must disregard, for tax purposes, abusive tax avoidance transactions."

An "abusive tax avoidance transaction means the avoidance of any tax collected by the department under the provisions of this chapter by means of a transaction, plan, or arrangement that lacks economic substance." (Our emphasis.)

A transaction, plan or arrangement will be considered as having economic substance only if:

  • the transaction, plan or arrangement changes in a meaningful way, apart from its tax effect, the taxpayer's economic position;
  • the taxpayer has a substantial nontax purpose for entering into the transaction, plan or arrangement; and
  • the transaction, plan or arrangement is an objectively reasonable means of accomplishing the substantial nontax purpose.

"A transaction, plan, or arrangement that carries some risk of loss and profit potential may nevertheless be found to lack economic substance if the economic risks and profit potential are so insignificant when compared to the tax benefits that a reasonable person would conclude that the taxpayer would not have engaged in the transaction, plan, or arrangement absent its tax effects."

"An objective of achieving favorable financial accounting benefits arising from tax savings is not deemed to be a substantial nontax purpose for entering into a transaction, plan or arrangement."

The burden is on the taxpayer to establish that a transaction, plan or arrangement has economic substance.

In addition, deficiencies resulting from engaging in abusive tax avoidance transaction are to be assessed 35% penalties of the additional tax found due, and there will be no statute of limitations for assessments of additional taxes, penalties, or interests on abusive tax avoidance transactions.

In disregarding an abusive tax avoidance transaction, the Department is empowered to do any of the following:

  • recharacterize the nature of income;
  • disregard the form of a corporate or other entity, even when legal formalities have been observed;
  • treat the tax effects of the transaction, plan or arrangement accordance to its substance rather than form;
  • treat a series of formally separate steps as a single transaction;
  • impute income to a taxpayer that provides services to a related person and the consideration does not reflect FMV; and
  • take any other reasonable steps necessary to deny the tax benefit that would otherwise arise as a result of the abusive tax avoidance transaction.

This bill has been referred to the Washington State House Committee on Finance. Hat tip to Lewis McMurran of the Washington Technology Industry Association. For information on related topics, visit Lew McMurran's Government Affairs blog.