The Economic Substance Doctrine: Coming To A State Near You?

By Jonathan Prokup

Pennsylvania may soon join the other states that have challenged the use of the so-called Delaware Loophole, according to our colleagues at the State and Local Tax Blawg.  The legislation, contained in Pa. House Bill 2150, would disallow deductions that a parent operating corporation claims for royalty payments made to a “Delaware Holding Company.”

The new limitation would not apply where the transaction is related to “a valid business purpose.”  In this regard, the legislation defines a valid business purpose as, “[a] purpose, other than the avoidance or reduction of taxation, which alone or in combination with other purposes constitute the primary motivation for a business activity or transaction which changes in a meaningful way, apart from a reduction of taxation, the economic position of the taxpayer.”

Our readers will recognize that the legislation defines “business purpose” in a manner that is remarkably similar to the codified “economic substance” doctrine of section 7701(o) of the Internal Revenue Code.  For example, compare the language of the Pennsylvania legislation, which requires that a transaction “change[] in a meaningful way, apart from a reduction of taxation, the economic position of the taxpayer,” with the language of section 7701(o)(1), which requires that a transaction “change[] in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position.”

Notwithstanding this similarity, the Pennsylvania legislation diverges from the Federal doctrine in two key respects.  First, the legislation’s business purpose test is a permissive rule that applies only in defined circumstances.  It serves as an exception to the limitation on royalty payments to a Delaware Holding Company.  In this regard, the legislation is much narrower than the Federal economic substance doctrine, which can apply to a indefinite number of transactions to which the doctrine may be considered “relevant.”  Second, the legislation applies a stricter business purpose test than Federal doctrine, requiring that purposes “other than the avoidance or reduction of taxation” be the “primary motivation for a business activity or transaction.”  Section 7701(o)(1) requires only that a taxpayer’s business purpose be “substantial.”

Over more than a decade, Congress took many attempts at codifying the economic substance doctrine before finally succeeding in 2010.  Given the increasing pressure on state legislators to find revenue, it is unlikely that Pennsylvania will take nearly as long to enact this provision.

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