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Tax Law: Economic Substance Test Enacted as Part of Health Care Law

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Ronald Feuerstein
BKK Business Law Newsletter
May 2010

Many of our clients may be surprised to learn that as part of the new health care law, there are numerous non-health care related revenue raising tax provisions. One of the most far-reaching is new Internal Revenue Code section 7701(o), which codifies the "economic substance" doctrine and enacts new companion penalty provisions. Under new code section 7701(o), in the case of any transaction to which the economic substance doctrine is relevant, the transaction will be treated as having economic substance only if:

  1. the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position, and
  2. the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into such transaction.

Thus, the new economic substance rule requires a conjunctive analysis. As such, it requires an inquiry regarding the objective effects of the transaction on the taxpayer’s economic position, as well as an inquiry concerning the taxpayer’s subjective motives for entering into the transaction. Under the new provision, a taxpayer must satisfy both tests.

In analyzing the first prong of the economic benefit test, a taxpayer may rely on factors other than profit potential to demonstrate that a transaction results in a meaningful change in the taxpayer’s economic position or that the taxpayer has a substantial non-Federal income tax purpose for entering into such transaction. The provision does not require or establish a minimum return in order to satisfy the profit potential test. However, if a taxpayer relies on profit potential, the present value of the reasonably expected pretax profit must be substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected.

Under the second prong of the test, a taxpayer’s non-federal income tax purpose for entering into a transaction must be "substantial." In making such analysis, any state or local income tax effect that is related to a federal income tax effect is treated in the same manner as a federal income tax effect. Furthermore, a purpose of achieving a favorable accounting treatment for financial reporting purposes is not taken into account as a non-federal income tax purpose if the origin of the financial accounting benefit is a reduction of federal income tax.

A most significant aspect of the new provision is its special penalty regime. Under code section 6662, there is imposed a new strict liability penalty for an underpayment attributable to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance as defined in Code section 7701(o) or failing to meet the requirements of any similar rule of law. The penalty rate is 20 percent (increased to 40 percent if the taxpayer does not adequately disclose the relevant facts affecting the tax treatment in the return or a statement attached to the return).

It is important to note that no exceptions (including for reasonable cause) to these new penalties are available. Moreover, outside opinions or in-house analysis will not protect a taxpayer against the penalty. The same 20 percent penalty (without any reasonable cause exception) will be applied to claims for refund or credit deemed excessive under code section 6676(b).