After the Flood: Has Codification Changed Economic Substance?

By Jonathan Prokup

The passage of President Obama’s health-care legislation will no doubt have long-lasting consequences for the economy in general and the health-care industry in particular.  Less noticed by the general public, but central in the minds of tax professionals, has been a single provision in the accompanying reconciliation bill that codifies the so-called “economic substance” doctrine.  Having often been introduced in bills that eventually died in the catacombs of the legislative process, many practitioners were beginning to believe that codification was a cousin of Bigfoot and the Loch Ness Monster – often spotted, but never confirmed.

So, now that Code section 7701(o) is “the law,” so to speak, has anything changed?  The new law provides that a 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.

At a glance, this provision seems to endorse the so-called “two-prong” test for economic substance first articulated in Rice’s Toyota World, Inc. v. Comm’r, 81 T.C. 184 (1983), aff’d in part, rev’d in part, and rem’d, 752 F.2d 89 (4th Cir. 1984), while requiring that a transaction have both “economic substance” and a “business purpose” to be respected for tax purposes.  (To be sure, the new statute broadens the standard for “economic substance” by replacing the traditional profit-based test with a broader economic-change test.  To the extent that codification makes sense at all, this broadening is the most sensible provision, as it recognizes that taxpayers often undertake transactions, especially those directly related to their core businesses, that don’t produce discrete profits, but are nonetheless beneficial to the taxpayer’s economic position.)

Irrespective of how the statute defines “economic substance,” the statute leaves a number of ambiguities that will likely need to be sorted out by the courts.  As other commentators have noted, for example, the law doesn’t define what is meant by “chang[ing] in a meaningful way… the taxpayer’s economic position.”  Likewise, the statute does not provide any guidance as to the scope of the “transaction” to which the provision is to be applied.  As David Hariton recently illustrated in his article “The Frame Game: How Defining the ‘Transaction’ Decides the Case,” the answer to this issue is a critical part of applying the economic substance doctrine, codified or not.

However, an equally troubling issue is determining when the newly codified doctrine is to be invoked in the first place.  The law itself says that a transaction may be treated as not having economic substance, but prefaces that treatment as applying to “any transaction to which the economic substance doctrine is relevant.”  What does it mean for the economic substance doctrine to be “relevant”?  Indeed, this is likely to be an (if not the most) important area of contention between taxpayers and the IRS, considering the consequences of the answer.

Surely, taxpayers can identify clear situations in which the economic substance doctrine is likely to be relevant.  Think of the quintessential tax shelter cases, such as Knetsch, Shriver, and ACM, which shared a common characteristic in that each was “full of sound and fury, signifying nothing.”  But what about a related-party loan that has real economic effects, but whose sole purpose is to shift income into a low-tax jurisdiction?  Is this a situation in which the economic substance doctrine is relevant? Most taxpayers would likely say, “no,”  given that a loan clearly has the kind of “economic reality” (to borrow a line from Coltec Indus., Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006)) that the economic substance doctrine is intended to ensure.  Yet, in an increasing number of examinations, revenue agents appear to be taking the opposite position, demanding to know the business purposes for related-party loans and other financial transactions.

If the revenue agents are correct, and the economic substance doctrine is “relevant” to such transactions, then the two-prong test discussed above would seem to apply.  And for taxpayers who are unable to satisfy the two criteria, the new strict-liability penalty for ostensibly non-economic transactions will apply.  This position, however, runs counter to the recent public statement of William Alexander, IRS associate chief counsel (corporate), who was recently cited in Tax Notes as saying that “while the code may demand that the Service ask whether something actually happened (an economic substance inquiry), it doesn’t always require that a transaction have a good business purpose.”  Amy S. Elliott, Alexander Downplays Likely Effect of Economic Substance Codification,” 2010 TNT 45-2 (Mar. 9, 2010).

Call me cynical, but I can’t escape the suspicion that these ambiguities are intentional.  As it was, the law of economic substance was a tangled mess of incoherence long before Congress ever thought to get involved.  So why would Congress write a putatively clarifying provision that allows many of the thorniest questions to remain?  I believe the answer lies in the new strict-liability penalty for transactions that fail the statutory test.

To discourage taxpayers from entering into potentially abusive transactions, Congress decided to impose a strict-liability penalty that would increase the risks associated with such transactions.  To justify imposing this new penalty, Congress needed to define what a non-economic transaction is.  However, by leaving open these various questions, Congress was able to leave open the possibility that the new penalty could apply to virtually any transaction, thereby ensuring that the maximum number of transactions would be affected and, therefore, discouraged.

Perhaps, as it seems intended to do, this new provision will reduce aggressive tax planning and increase tax collections.  By the same token, though, the provision also creates serious risks that the IRS will be emboldened to attack run-of-the-mill business transactions.  If anything is clear, it is not this new law.

8 thoughts on “After the Flood: Has Codification Changed Economic Substance?

  1. In addition to the strict liability provision for transactions that lack economic substance, the increased penalty for nondisclosure is a key component of this change. Because the penalty is now 40% for nondisclosure, double the penalty for disclosure, tax practitioners may decide this 40% penalty is too much to risk. The language of the statute, coupled with this increased penalty for nondisclosure, will likely either (a) reduce aggressive tax planning, or (b) result in practitioners disclosing too much and handing the Service a road map for these transactions.

  2. [re-post]

    Although 7701(o)’s “relevance” language is depressingly vague, there might be a silver lining to this cloud. Courts will now have to interpret the word “relevant” and explain just when the economic substance doctrine applies. One circuit might interpret “relevant” one way and another circuit, another way. This type of split in the circuits is the exact type of thing that the Supreme Court actually grants cert on from time to time.

    The government has, at times, argued that there is no meaningful split and that any differences in the circuits’ approaches are largely cosmetic. Given the internally inconsistent, ambiguous, and oftentimes conclusory language found in many of the relevant opinions, it might in fact be difficult to draw sharp lines between the various courts’ approaches. But now the courts will not be able to resort to nebulous invocations of “Congressional purpose” in justifying their application of the doctrine. Instead, if they take their jobs seriously, they will actually have to interpret the word “relevant” and explain what it means. (Alas, each circuit might simply announce that a “facts and circumstances” test applies, which would leave us exactly where we are.)

    I think that by rooting the application of the doctrine in statutory language, rather than circuit precedents, a clear circuit split is more likely to develop. And, we might thus finally get the Supreme Court guidance on how the economic substance doctrine applies — the Court may be more likely to join the fray if the Question Presented relates to a specific ambiguity in 7701(o)’s language.

    This is perhaps a topic for another day, but I think it will be interesting to see how the Supreme Court articulates when the doctrine is “relevant.” I’ve argued previously that the doctrine has never been relevant to the Supreme Court. But, section 7701(o) clearly indicates that Congress wants the doctrine to apply in certain (unspecified) circumstances. The statutory interpretation issues raised by codification will be fascinating.

  3. Mr. Prokup writes that “as it was, the law of economic substance was a tangled mess of incoherence long before Congress ever thought to get involved” by enacting new section 7701(o).

    I confess to missing the point. Terming the law of economic substance “a tangled mess of incoherence” may be a useful marketing tagline for those in the private tax bar who are looking for work to do, but it is an inapt description of the post-ACM (or post-Knetsch or post-Frank Lyon) work that judges actually do in deciding tax shelter cases. A careful reading of the case law over the last 50 or 35 or 15 years ought to reveal meaningful convergence in judicial views on economic substance in tax cases.

    1. Mr. Jacobus,

      My favored definition of the term “incoherence” is in the manner contemplated by Deborah Paul, The Sources of Tax Complexity: How Much Simplicity Can Fundamental Tax Reform Achieve, 76 N.C. L. Rev. 151,161 (1997) (“A coherent tax regime forms a logical whole. An incoherent regime expresses inconsistent purposes or no purpose at all.”). I think this definition fairly sums up the history of the “sham transaction,” or “economic substance,” doctrine. Although some courts have converged around factors that are considered in the analysis, there is certainly no general agreement among the circuit courts as to what factors should be considered in applying the doctrine; and that disagreement almost certainly reflects different conceptions of what the doctrine is intended to accomplish.

      Moreover, even to the extent that there has been such convergence, that trend does not mean that the converged-upon doctrine itself “forms a logical whole.” Even after codification (which, if I interpret your comment correctly, you believe to reflect a coherent interpretation of the doctrine), many questions remain about how the doctrine is to be applied, thus creating the risk that it will be inconsistently applied and will merely perpetuate an incoherent regime.

      Finally, flippant commentary notwithstanding, concerns over the development of the economic substance doctrine are not unique to members of the tax bar, but are shared by academic writers and courts as well. See, e.g., Alexandra M. Walsh, Formally Legal, Probably Wrong: Corporate Tax Shelters, Practical Reason and the New Textualism, 53 Stan. L. Rev. 1541, 1545 (2001) (citing Peat Oil & Gas Assoc. v. Comm’r, 100 T.C. 271 (1993) (Swift, J., concurring); Collins v. Comm’r, 857 F.2d 1383, 1386 (9th Cir. 1988)).

      1. Mr. Prokup,

        You misinterpret my comment.

        Adjectives like “coherent” or “incoherent” are a poor substitute for hard logic and careful attention to facts.

        Many thanks,


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