Tax Lawyer's Blog

The economic substance doctrine (PDF) is a doctrine which holds that a transaction must have an economic purpose aside from reduction of tax liability in order to be considered valid.

Tax-News.Com reports that House Democrats have proposed language to be included its healthcare legislation that will codify the standards to be used by the IRS and the Courts in applying the doctrine:

Under the provision, the economic substance doctrine would be satisfied only if: the transaction changes in a meaningful way (apart from federal income tax consequences) the taxpayer’s economic position, and; the taxpayer has a substantial non-federal tax purpose for entering into such transaction.

The provision also imposes a 20% penalty on understatements attributable to a transaction lacking economic substance. This penalty increases to 40% in the case of transactions in which the relevant facts affecting the tax treatment of the transaction are not adequately disclosed.

It is estimated that codifying the economic substance doctrine would raise USD3.6bn in additional tax revenues over 10 years.

Efforts have been made in the past to codify ESD, but have failed.

Here is what attorney/CPA James Beavers said about codification in an article he wrote in 2008 for the AICPA’s The Tax Advisor:

The actual effects of codifying the economic substance doctrine are hard to predict. The codified doctrine may, as supporters suggest, aid the IRS in its enforcement efforts against abusive tax shelters. However, it is questionable how great a difference it will make because the IRS is already having considerable success combating these shelters using the common law economic substance and sham transaction doctrines.

Whether or not codification has an effect on types of transactions that are currently considered legitimate depends largely on the Service’s ability to exercise restraint in choosing when to apply the codified doctrine. However, given the IRS’s known propensity for aggressively using any statutory enforcement tool it is given, taxpayers and practitioners have good reason to fear that codification will result in the economic substance doctrine being applied to many more transactions than it has been in the past. (Emphases Added)

IRS restraint?

Good luck with that.

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