The Economic Substance Doctrine: Legal Analysis of Proposed Legislation

The Economic Substance Doctrine:
Legal Analysis of Proposed Legislation
Carol A. Pettit
Legislative Attorney
American Law Division
Summary
The economic substance doctrine was judicially developed. A number of bills^th
introduced in the 110 Congress would codify the definition of “economic substance,”
provide a strict liability penalty for underpayments resulting from disallowed
transactions that lack economic substance, and prohibit deduction of interest on those
underpayments. The proposals would not codify the doctrine, itself, nor provide
standards for a court’s determination that the doctrine was relevant to a particular case.
Codification has been dubbed a “revenue raiser,” though there is disagreement as to both
the amount that would be raised and the way in which codification would increase
revenue.
Proposed Legislation
The economic substance doctrine is a judicial rather than statutory tax doctrine that
has been used by the Internal Revenue Service (IRS) and applied by the courts for many
years to disallow, for tax purposes, transactions that technically comply with the Internal
Revenue Code (the Code), but produce tax benefits outside of what Congress intended.¹
Throughout the years it has remained a matter of judicial interpretation and case law.
There have been, however, suggestions that the doctrine should be codified to produce
uniformity among the courts in applying the doctrine. Generally, proposals would codify
the definition of “economic substance” rather than codifying the doctrine. This
codification has been proposed in several bills during the 110^th Congress. Although the
language in each proposal has been similar, the overall subject matter for the bills has
been diverse. A section entitled “Clarification of Economic Substance Doctrine” has been
included in the Abusive Tax Shelter Shutdown and Taxpayer Accountability Act of 2007,²

¹ Helvering v. Gregory, 69 F.2d 809 (2d Cir. 1934), aff’d 293 U.S. 465 (1935), established the
doctrine. For more information, see CRS Report RS22586, The Economic Substance Doctrine:
Recent Significant Legal Decisions, by Erika Lunder.
² H.R. 2345, Title I, 110^th Congress.

the Stop Tax Haven Abuse Act,³ the Responsible Fatherhood and Healthy Families Act
of 2007,⁴ the Export Products Not Jobs Act,⁵ and the Food and Energy Security Act of
2007.⁶ Other bills have contained a similar provision entitled “Codification of Economic
Substance Doctrine.”⁷
Thus far, only one bill containing a provision to define “economic substance” in the
Internal Revenue Code has been passed by either body of Congress. The Senate passed
version of H.R. 2419 contains a section clarifying economic substance. This report
analyzes the proposal as contained in the Senate amendment. Unless otherwise noted, all
further references to “the Farm Bill,” “H.R. 2419,”or “the current proposal” will be
referring to the bill as passed by the Senate.
Clarifying the Economic Substance Doctrine — Amending 26 U.S.C. §
7701. H.R. 2419 adds a subsection to section 7701 of the Internal Revenue Code.⁸ It
attempts to define the situations in which a court may find that a transaction has
economic substance.⁹ These are limited to those transactions in which the taxpayer’s¹⁰
economic position is changed in a meaningful way and “the taxpayer has a substantial
purpose (other than a Federal tax purpose) for entering into such transaction.”¹¹ When a
potential for profit is the basis of the taxpayer’s position that a transaction has economic
substance, the expectation of profit must be reasonable. Even when it is deemed
reasonable, the present value of the expected profit must be compared to the present value
of the expected net Federal tax benefit. The profit potential must be considered¹²
“substantial” when compared to the tax benefit. Further, if the only “substantial purpose
(other than Federal tax purposes)” is a reduction in non-Federal taxes, there is no
economic substance if similarities between Federal tax law and the other tax law result
in a corresponding reduction in Federal taxes that at least equals the reduction in non-

³ H.R. 2136, § 401; S. 681, § 401, 110^th Congress.
⁴ H.R. 3395, § 204; S. 1626, § 204, 110^th Congress.
⁵ S. 96, § 201, 110th Congress.
⁶ H.R. 2419, § 12521, 110^th Congress (Engrossed Amendment as Accepted by the Senate). Many
provisions in the amendment, including the portions regarding the economic substance doctrine,^th
were included in the Heartland, Habitat, Harvest, and Horticulture Act of 2007, S. 2242, 110
Congress.
⁷ E.g., The AMT Relief Act of 2007, H.R. 4351, § 211, 110^th Congress; the Tax Reduction and
Reform Act of 2007, H.R. 3970, § 3501, 110^th Congress.
⁸ Section 7701 provides definitions of terms used under title 26. H.R. 2419 proposes making
current subsection (p), subsection (q) and inserting a new subsection (p) between subsections (o)
and (q).
⁹ Section 12521 (creating new subsection (p)(1)(A)).
¹⁰ Section 12521 (creating new subsection (p)(1)(B)(i)(I)). Federal tax effects are not considered
to result in a meaningful change in economic position. Id.
¹¹ Section 12521 (creating new subsection (p)(1)(B)(i)(II)).
¹² Section 12521 (creating new subsection (p)(1)(B)(ii)). “Substantial” is not defined.

Federal taxes.¹³ When the purpose of the transaction is a financial accounting benefit, that
will not be considered a “substantial purpose (other than Federal tax purposes)” if the
financial accounting benefit stems from a reduction in Federal taxes.¹⁴
Penalizing Noneconomic Substance Transactions — Adding 26 U.S.C.
§ 6662B. In addition to clarifying economic substance, the bill would establish a penalty
for transactions found lacking in economic substance. This penalty would be 30% of the
understatement in tax that resulted from disallowance of the transaction.¹⁵ The penalty
would be reduced to 20% in cases where the facts relevant to the tax treatment of the
disallowed transaction are “adequately disclosed in the return on a statement attached to¹⁶
the return.” In contrast to most penalties provided for in the Code, the proposed penalty
is calculated on the tax understatement rather than on the underpayment,¹⁷ so a taxpayer
may be liable for a penalty even if that taxpayer does not have an outstanding tax balance.
The penalty can only be imposed by the Chief Counsel of the IRS or by an Office of
Chief Counsel branch chief to whom the Chief Counsel has delegated such authority¹⁸
(hereinafter “Chief Counsel or delegate”). The authority to compromise all or part of
the penalty is similarly limited.¹⁹ Compromise of the penalty is also limited to situations
in which the understatement from the noneconomic substance transaction has been
reduced.²⁰
The bill requires the individual asserting the penalty to first notify the taxpayer of the²¹
intent to assert the penalty. The taxpayer must also have the opportunity to respond in
writing.²² While the penalty may be imposed following litigation in which a court finds
that the economic substance doctrine is relevant and that the transaction lacked economic
substance, such litigation is not required for assertion of the penalty. The Chief Counsel
or delegate may determine that the economic substance doctrine is relevant and assert the
penalty after finding that a transaction lacked economic substance.²³ The penalty must be

¹³ Section 12521 (creating new subsection (p)(1)(B)(iii)(II)).
¹⁴ Section 12521 (creating new subsection (p)(1)(B)(iii)(I)).
¹⁵ Section 12522 (creating new section 6662B).
¹⁶ Section 12522 (creating new subsection 6662B(b)).
¹⁷ E.g., 26 U.S.C. §§ 6651, 6656, 6662 (calculating the penalty based on the outstanding tax
balance); but see 26 U.S.C. § 6662A (calculating the penalty on understatement for reportable
transactions).
¹⁸ Section 12522 (creating new subsection 6662B(d)(1)).
¹⁹ Id.
²⁰ Section 12522 (creating new § 6662B(d)(2)(B)).
²¹ Section 12522 (creating new § 6662B(d)(2)(A)(i)).
²² Section 12522 (creating new § 6662B(d)(2)(A)(ii)).
²³ Section 12522 (creating new § 6662B(d)(3)(A)).

rescinded, however, if a court determines, in a final order, that the economic substance
doctrine was not relevant to the transaction.²⁴
Interest on Noneconomic Substance Underpayments not Deductible —
Amending 26 U.S.C. § 163(m). When taxpayers underpay their taxes, they must pay
interest on the amount that was underpaid. This is true even when the underpayment is
created by a determination that a position taken on a tax return is not allowed for tax
purposes — resulting in an assertion of additional tax liability. Section 163(m) of the
Internal Revenue Code prohibits deduction of interest on understatements due to
reportable transactions²⁵ that were not properly disclosed. The bill would add language
to also prohibit deduction of interest on underpayments due to a transaction that lacked
economic substance.²⁶ There is no exception to allow deduction of the interest if the facts
relevant to the transaction had been disclosed on the tax return.
Analysis of Proposed Legislation
Clarifying the Economic Substance Doctrine. The proposed bill provides
a definition of “economic substance” for courts to use when they find that the economic
substance doctrine is relevant. It makes no claim to clarify when the doctrine is relevant.
Instead it codifies a definition that settles some differences between courts in terms of
what is required to find that a transaction has economic substance.²⁷
The rationale provided by the Court of Federal Claims in Coltec Industries v. United²⁸
States suggests an additional justification for codifying the definition of economic
substance (if not the doctrine itself). The court said that, in determining their tax
liabilities, taxpayers “must be able to rely on clear and understandable rules established
by Congress. If federal tax laws are applied in an unpredictable and arbitrary manner,
albeit by federal judges for the ‘right’ reasons . . . , public confidence in the Code and tax
enforcement system surely will be further eroded.”²⁹
Codifying the definition of economic substance arguably could provide a “clear and
understandable rule.” There are, however, phrases and concepts in the proposed
definition that may be less than clear. If so, they may cause uncertainty rather than

²⁴ Section 12522 (creating new § 6662B(d)(3)(B)).
²⁵ Defined in 26 U.S.C. § 6662A(b).
²⁶ Section 12523 (adding § 163(m)(2)).
²⁷ These differences include whether the two-pronged test was conjunctive (requiring both
economic substance and a business purpose), whether nominal profit potential was sufficient, and
whether a financial accounting benefit is a non-tax business purpose if it results from federal tax
savings. See S. R^EP^T. 110-206, nn. 113-123 and accompanying text (2007).
²⁸ 62 Fed. Cl. 716, 752-56 (2004) rev’d 454F.3d 1340 (Fed. Cir. 2006).
²⁹ Coltec, 62 Fed. Cl. at 755.

providing clarification.³⁰ Some of these are “changes in a meaningful way,”³¹ “substantial
purpose,”³² and substantial profit (in comparison to tax benefit).³³ Additionally, since the
courts are left to determine when the economic substance doctrine is relevant, there may
still be room to apply the codified definition “in an unpredictable and arbitrary manner.”
The Strict Liability Penalty. The current bill proposes a 30% penalty on the
understatement resulting from transactions that lack economic substance if the transaction
was not disclosed. Some other proposals have set the penalty at 40%.³⁴ If the transaction
is disclosed, the penalty would be reduced to 20%. However, in either case, there is no
provision for abating the penalty based on reasonable cause. The penalty is one of strict
liability. Taxpayer reliance on advice from tax professionals is irrelevant even when that
advice is based on substantial authority. Arguably, taxpayers have some protection from
the penalty because it can only be imposed by the Chief Counsel or delegate. However,
since it is left to the courts to determine whether the economic substance doctrine is
relevant, taxpayers are placed in a situation in which they may need professional guidance
as to whether the doctrine is applicable, but cannot rely on that guidance to avoid a
substantial penalty if a court determines that the doctrine applies and the transaction
lacked economic substance. Further complicating taxpayers’ quandary is the assertion by
the Joint Committee on Taxation that
If the tax benefits are clearly consistent with all applicable provisions of the Code and
the purposes of such provisions, it is not intended that such tax benefits be disallowed
if the only reason for such disallowance it that the transaction fails the economic³⁵
substance doctrine as defined in this provision.
Thus, taxpayers, tax professionals, and the courts will still be in the position of trying to
determine Congress’s purpose for various provisions of the tax code. In some cases, there
is sufficient legislative history to determine the purpose, but in other cases there is not.
As a result, taxpayers might avoid legitimate business transactions out of fear of a
potential penalty.³⁶ This could reduce risk-taking and innovation in business and,
possibly, lead to a decline in productivity and profitability. Some, however, believe that
the penalty’s results will be positive “caus[ing] taxpayers to forego entering into
noneconomic, tax-motivated transactions that Congress never intended.”³⁷

³⁰ Kolb Solidly Opposed to Codification of Economic Substance Doctrine, F^ED.T^AXD^AY, #I.5
(Feb. 15, 2007) (comments by Fred Greenwood, III). Available at [http://tax.cchgroup.com/].
³¹ Section 12521 (adding § 7701(p)(1)(B)(i)(I)).
³² Section 12521 (adding § 7701(p)(1)(B)(i)(II)).
³³ Section 12521 (adding § 7701(p)(1)(B)(ii)).
³⁴ E.g., S. 1151, 110^th Congress; H.R. 4351, 110^th Congress.
³⁵ J. Comm. on Taxation Release: Economic Substance Doctrine (October 5, 2007).
³⁶ See Jeremiah Coder and Lee A. Sheppard, Officials Predict Economic Substance Codification
in 2008, T^AXN^OTES, 468, 469 (2008); Senate Finance Committee to Consider Tax Reform,
Economic Substance Doctrine, F^ED.T^AXD^AY, #M.3 (February 14, 2008) (available at
[http://tax.cchgr oup.com/]).
³⁷ 153 Cong. Rec. S. 13979 (daily ed. November 6, 2007) (statement of Sen. Grassley).

Two Sides to the Issue. Clarifying the economic substance doctrine through
codification has been a persistent provision in legislative proposals in recent Congresses.³⁸
Though the revenue projections of the current proposal vary, the proposal is viewed as
providing increased revenue for the “pay-go” budget procedures.³⁹ It may also reduce
government costs by eliminating some abusive tax shelter schemes, thus reducing the
resources needed to pursue both the promoters and participants in abusive tax shelters.
Others oppose codification of even a definition of economic substance, in part⁴⁰
because it may provide “the seeds of the next tax shelter problem.” It is the business of
tax professionals to examine the Code closely to determine how it can best be used to
result in the least amount of tax owed. New laws aimed at clarifying current law, both
statutory and case law, are apt to be viewed as challenges. It seems likely that someone
will devise a transaction that a court might, in the past, have found to lack economic
substance but which meets the criteria for having economic substance under the proposed
bill. In this case, some may argue that codification of the definition may hinder rather
than help actions against abusive tax shelters.
There is also some question about both the cost saving and revenue raising prospects
for the proposal. IRS Chief Counsel Donald L. Korb has questioned whether the strict
liability penalty would ever be asserted by the IRS and has indicated that it would make⁴¹

litigation more complex and eliminate taxpayers’ incentive to cooperate with the IRS.
³⁸ See Ways and Means Legislative Counsel Explains Proposed Corporate Tax Reduction, F^ED.
T^AXD^AY, #M.1 (December 4, 2007) (available at [http://tax.cchgroup.com/]).
³⁹ 153 Cong. Rec. S. 13978 (daily ed. November 6, 2007) (statement of Sen. Grassley). For
information on the “pay-go” budget procedures, see CRS Report RL34300, Pay-As-You-Go
Procedures for Budget Enforcement, by Robert Keith.
⁴⁰ Korb Solidly Opposed to Codification of Economic Substance Doctrine, F^ED.T^AXD^AY, #I.5
(February 15, 2008). Available at [http://tax.cchgroup.com/].
⁴¹ Id.