Vol. 2, No. 2

Each edition of Tax Matters consists of free-flowing responses by three tax practitioners to a question regarding a current issue in tax law and policy. Tax Matters commentaries provide insightful perspectives on a broad range of topics, making important contributions to the dialogue within the tax bar about cutting-edge issues. Although the commentaries are certainly of interest to the academic community, they are primarily directed toward tax professionals and their clients.

Codification of the Economic Substance Doctrine in 2010 – after years of controversy about whether codification was actually desirable – has generated a very substantial body of professional commentary, chiefly aimed at determining what the effect of the new provision is likely to be. Does the new Code section, section 7701(o), narrow the scope of traditional “tax planning” or do the planning maneuvers relied on in the past continue to be fully reliable? The question gains urgency from the addition of a penalty provision that is automatic in application and that tops out at 40% of understated income where the understatement is the consequence of an ESD infraction. Reactions by practitioners appear below.

Marvin A. Chirelstein, Professor Emeritus of Law, Columbia Law School

Thoughts on the Economic Substance Doctrine | Michael Schler

Has Codification Changed the Economic Substance Doctrine? | David Hariton

Codified Economic Substance Doctrine | Peter H. Blessing

Thoughts on the Economic Substance Doctrine
Michael Schler
Partner, Cravath, Swaine & Moore LLP. All views expressed herein are solely those of the author.
I do not believe that codification of the economic substance doctrine (ESD) resulted in significant change to substantive law. Codification assured that the Supreme Court would not reject the existence of ESD based on a literal reading of the Code, but such rejection was unlikely. Codification also adopted various pro-government judicial interpretations of ESD, but court decisions were tending in this direction anyway, and taxpayers had not won many (if any) ESD cases solely because a court applied a test weaker than the codified test.

The principal substantive change made by codification is the no-fault penalty. Even there, the 40% “headline” penalty rate can be reduced to 20% by adequate disclosure. The taxpayer will normally know that ESD is an issue when it files its tax return. Therefore, the 40% rate only applies to a taxpayer trying to hide a questionable transaction from the IRS by not disclosing.

Many commentators have raised concerns that the risk of the no-fault penalty will discourage both “normal” tax planning and normal commercial transactions. This is reminiscent of concerns that a “nuclear winter” would result from the adoption of the partnership anti-abuse rule in 1994. In my experience, codification has had no adverse effect on normal commercial transactions, and has had a chilling effect only on transactions that were already very questionable. This is consistent with the experience after adoption of the partnership anti-abuse rule and with repeated recent statements by government officials that if a business transaction worked before ESD codification, it still works now.

ESD clearly prevents transactions that solely generate noneconomic tax losses. The result is less clear when a transaction allows the recognition of loss in depreciated assets without materially changing the taxpayer’s economic interest in the assets, as in the Shell Petroleum case.

The most significant issue, however, arises when the overall transaction clearly has economic substance, but tax benefits arise from steps that, standing alone, do not. An example is Gregory v. Helvering, where the underlying transaction was a taxable sale of assets, but an initial spinoff was done solely to reduce tax on the disposition. If ESD does not prevent transactions such as this, it would be almost useless in preventing abusive transactions.

Codification clearly contemplates, consistent with prior case law, that ESD can apply to disallow tax benefits arising from individual steps in a larger transaction. Yet applying ESD separately to each step of every transaction would go too far. For example, in Dover, the taxpayer obtained a tax benefit by making a check-the-box tax election. There was no economic substance to the election, yet the Tax Court upheld the transaction. Most tax lawyers, including myself, believe that the Dover transaction does not violate ESD either before or after codification.

So how can you tell whether a particular step in a transaction is Dover-style “legitimate tax planning” orGregory-style “abusive tax avoidance”? I believe the key is the sentence in the legislative history of codification stating that ESD does not apply if the tax result was clearly intended by Congress. Courts in substance also applied this test before codification. The test obviously does not provide definitive answers, but it focuses on the correct question. The answer is ultimately a matter of judgment, but I believe most tax lawyers have a good sense of where to draw the line, and would reach similar conclusions concerning most transactions. The uncertainties arise largely in heavily tax-structured transactions.

The government has indicated that it will only provide very limited guidance on ESD, despite numerous requests. This is understandable from the government’s perspective. Taxpayers could potentially exploit safe harbors or other pro-taxpayer rules in ways not intended by the government, and a presumption against bifurcation of transactions (as some have requested) would greatly weaken ESD. As a result, ESD could end up weaker than before codification — hardly the intent of Congress. Additional guidance might not even help taxpayers, since it would raise its own interpretative issues, and favorable rules would likely be so narrow (for the reason stated above) that they could create negative implications for transactions not squarely covered.

The must justifiable objection to codification is to the no-fault 20% penalty that arises even with disclosure. Aside from revenue considerations, Congress may have believed an in terrorem penalty for highly tax-motivated transactions is justified. On balance, the penalty seems unfair. Also, it might discourage courts from applying ESD to questionable transactions, could put taxpayers in the peculiar position of arguing that if their transaction does not work, it is for reasons other than ESD, and could require courts to decide on the applicability of ESD even after disallowing the claimed tax benefits for another reason.

Finally, as noted, ESD does not apply if the tax results are clearly intended by Congress. So ESD, like other anti-abuse rules, stops transactions with tax results not intended by Congress, but only if the transactions also happen to violate ESD. The Code and regulations contain innumerable anti-abuse rules, each applying only if specified conditions are satisfied.

Every such rule raises numerous questions about its scope, and causes much tax planning to avoid it. More fundamentally, if a transaction provides a tax benefit not intended by Congress, its success should not logically depend upon whether it happens to be covered by a specific anti-abuse rule.

To avoid these results, Congress could adopt a general anti-abuse rule for the whole Code (as many other countries have done). The sole issue would then be whether the tax result of any transaction was intended by the Code and regulations. This would be a much more logical and consistent approach to tax avoidance transactions.


Has Codification Changed the Economic Substance Doctrine?
David Hariton
Partner, Sullivan & Cromwell LLP. All views expressed herein are solely those of the author.
Section 7701(o) expressly provides: “The determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection has never been enacted.” But that is the only significant determination that the court ever makes; therefore codification has almost no substantive effect.

More specifically, Section 7701(o) defines the economic substance doctrine (ESD) as “the common law doctrine under which tax benefits under subtitle A with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose.” If, however, the transaction in question is defined to include only the structures or steps that were designed to give rise to the relevant tax benefits, then the transaction lacks business purpose and economic substance by definition. If a court thinks the claimed tax results are unconscionable, it generally defines the transaction narrowly and concludes both that the doctrine is relevant and that the transaction lacks business purpose and economic substance. If the court thinks the claimed tax results are within the realm of legitimate tax planning, however, the court defines the transaction to include the taxpayer’s broader business objectives and concludes that the transaction has both business purpose and economic substance and that the doctrine isn’t relevant anyway. Whether the court finds the tax results unconscionable turns on many factors, including of course whether the court perceives them to be inconsistent with the general structure of the relevant rules (as Judge Learned Hand put it inGregory v. Helvering, “not what Congress intended”). This also includes such factors as how the court views the taxpayer and whether the transaction has been “promoted.”

In other words, ESD, at least as currently applied by the courts, is primarily a subjective anti-abuse rule the application of which is objective in name only. I can’t recall a single case that found, for example, that the relevant transaction had no business purpose but had economic substance (or had no economic substance but did have a business purpose) and held for the taxpayer on that basis.

It appears, therefore, that the only real change is the 40% strict liability penalty. This does not mean, however, that the change is not significant. At the margin, the penalty is likely to discourage aggressive tax planning, as taxpayers will — or at least should — fear that if a judge doesn’t like the results, he or she will define the transaction narrowly to include only the tax planning steps and find that the economic substance doctrine was relevant. In such a case, the strict liability penalty will indeed apply, and it will be 40% if the position has not been disclosed.

Nor does this mean that Treasury should not bother promulgating regulations under Section 7701(o). To the contrary, codification strikes me as a golden opportunity for Treasury to give taxpayers a better sense of what it does not like and why. I don’t think Treasury need fear that taxpayers will use such regulations against it by complying with their letter (but not their spirit) and then offering up evidence of such compliance to the court. Any judge that would have found against the taxpayer to begin with would not be deterred by such self-serving formalism. Moreover, Treasury can fill the regulations with disclaimers such as, “This is just what we mean, by way of example, in order to give better guidance regarding what sorts of things you should not be trying to do. It cannot be taken as pro-active authority or used as a shield, etc.”

To place these points in sharper focus, I take you take you back to Cottage Savings Ass’n v. Commissioner, where two savings and loan associations exchanged economically identical mortgage portfolios solely to accelerate the timing of a loss realization for tax purposes. The exchange itself obviously lacked both business purpose (it was concededly done solely to realize a tax loss) and economic substance (the exchange had so little effect on the taxpayers’ economic positions that it was not a cognizable event for regulatory or accounting purposes, which is why it was so attractive). Nevertheless, the Supreme Court held for the taxpayer, reversing the court below. What bearing does the codification of the economic substance doctrine have on whether taxpayers will prevail in a case like this? Absolutely none. But surely it would be helpful for taxpayers to have a better sense of when tax planning of this sort is acceptable and when it isn’t. Nor does it matter that whatever guidance Treasury provided on this point would only be prescriptive. As the Bible says, it is better to light even a single candle than to curse the darkness.


Codified Economic Substance Doctrine
Peter H. Blessing
Partner, Shearman & Sterling LLP. All views expressed herein are solely those of the author.
The question of how the codified economic substance doctrine (“ESD”) may be considered to change the way we practice has two aspects: (i) is there reduced reliability of tax planning based on the expectation of disallowed transactions that would have been upheld previously, and (ii) how is practice affected by the greater downside from the automatic penalty?

The case law leading up to the codification of the ESD contained a variety of strains of a general anti-abuse principle, including the ESD. Section 7701(o) focuses on this particular formulation of the various doctrines and (under my reading) asks practitioners to isolate those cases in which courts use this two-prong formulation as opposed to denying the taxpayer’s claim under other doctrines, such as substance over form, business purpose as used in various corporate transactions, step transaction, and so forth.

The argument that the codified ESD should be narrowly construed in this way is based on the legislative history relating to the statute’s “relevance” concept, statements of Treasury and IRS officials, and the fact that the salient point of the codification is the automatic penalty associated with it under Section 6662(b)(6). Whether a transaction should be upheld or not, is not the issue; rather, the issue is whether the transaction merits an automatic penalty. Only where the doctrine otherwise is “relevant” do the statute’s two substantive elaborations of the doctrine — the requirement that the transaction always have both business purpose and substance and if these are purported to be met based on profit, that present value and substantiality concepts be applied — come into play.

So what kinds of transactions are covered? And are any of these ones that would be surprising, given that various courts already applied the two-part test and present value and substantiality concepts? A major target is highly tax-engineered and/or promoter marketed tax avoidance transactions. In cases where the two-prong test was applied, courts increasingly found both prongs were met, where necessary by isolating the tax avoidance part of a larger transaction or deeming certain cash flows to be circular. Transactions of this ilk never were for the faint of heart, and many practitioners and firms never even advised on them. Even those that did often applied present value and substantiality concepts to some extent.

In my experience, such transactions were no longer being done by public companies even precodification due to the scrutiny imposed by auditors before recording a tax benefit for a transaction for financial statement purposes. Hence, the parties engaged in such transactions are generally limited to private companies, investment partnerships, and individuals — and even their participation has precipitously declined. As to these obviously targeted transactions, codification occurred only after the IRS largely had won the war in the courts. Certain types of transactions (e.g., involving foreign tax credits), however, remain in question, and as to them the penalty may be a deterrent.

What about “normal” commercial transactions — leaving aside the four categories expressly blessed in the legislative history — are those affected? This depends in part on one’s confidence level that doctrines such as substance over form are not implicated, and that a purely tax-motivated transaction is not for that reason alone implicated. E.g., the merger of two subsidiaries to avoid limitation on the use of losses under the consolidated return separate return year limitation (SRLY) rules should not be vulnerable to the ESD penalty even if it lacks business purpose, nor should a “repo” transaction if it fails because the buyer is considered the economic owner.

The closest to relatively conventional transactions that have raised questions under the codified ESD are traditional leasing and project financing transactions that meet pre-codification IRS leasing guidelines and case law, excluding sale in lease out transactions (SILOs). Cases over the years have analyzed leasing transactions as subject to the ESD and allowed them to pass muster if there was sufficient profit and they lacked abusive elements such as risk-insulation.

Although the pretax profit test in Section 7701(o) is not the exclusive means of showing business purpose, for a leasing transaction pretax profit is the only possible business purpose of a lessor buying property to lease. The problem in applying the pretax profit test to leasing is the present value concept. Common sense would say that, as Congress showed its desire to apply a present value concept in measuring pretax profit, it would be very odd if that test were intended to be passed generally purely on the basis of inflation — i.e., that pre-tax profit could be found even if discounting cash flows by a risk-free tax discount rate would result in a loss.

But doing precisely that would mean that many conventional leasing and project financing structures, which are premised on a 2 to 4% internal rate of return (and assume no or minimal allocable financing costs) being sufficient, would not pass the test. This raises the question whether Congress intended to eliminate the viability of those transactions. If not — and nothing indicates that — should the net present value test be construed generally so as to accommodate these transactions (by determining “profit” using undiscounted flows and discounting such “profit” but only to assess substantiality)? Should instead a more lenient test be applied specifically to these transactions? Or should the IRS simply pronounce that Congress did not intend that these conventional transactions be subject to the codified ESD?

My feeling is that project tax advisors will find enough comfort in the contorted language of the pre-tax profit test, the legislative history, and the absence of any indication that the test for conventional leasing prepaid loans was intended to be changed.

Finally, I do believe the in terrorem effect of the penalty will be a substantial additional factor in discouraging participation in certain aggressive transactions that garnered “should” level opinions in years past.