Expert Insight: Codification of Economic Substance—The “Apple” of States’ Eyes?

The recent congressional hearings regarding Apple’s tax planning strategies highlighted some of the methods the company is using to reduce its federal tax burden.  Last year, a story in the New York Times focused on the company’s strategy for avoiding taxes in California and several other states. 

Some lawmakers have suggested that the first step toward significant tax reform ought to begin with eliminating tax planning strategies that exploit tax loopholes.

Achieving this by adopting a codified definition of “economic substance” is not a new idea. Tucked away in the provisions of the 2010 Revenue Reconciliation Act or so-called “Obamacare” legislation in 2010 was a provision aimed at codifying the common-law doctrine of economic substance. The resulting provision establishes a two-part test for determining when a transaction has economic substance, and it carries substantial new penalties for transactions that fail to meet the test. 

Upon enactment, it was unclear what impact the federal codification of economic substance might have on the states, which vary widely in applying the doctrine to combat certain corporate structures that have resulted in tax benefits. But now it appears that more states are following the federal government’s example by codifying their own economic substance tests.

A recent case in Massachusetts illustrates the potential pitfalls of adopting a state tax planning strategy that can fall prey to a state sham transaction common law doctrine or statute. In Massachusetts Appellate Board case, Allied Domecq v. Comm. of Rev.,No. C282807 ( the parent company of a subsidiary located in Massachusetts attempted to establish nexus in the state so that its subsidiary could share in its corporate losses. However,The Board labeled this a “sham,” finding no economic substance to the transaction.

We asked Brett Carter, a partner in the Nashville office of Bradley Arant Boult Cummings LLP, about the issues surrounding state codification of economic substance policy.

BBNA:  Which states have codified their economic substance policy?

Carter: Wisconsin, Ohio, California, New Hampshire, Massachusetts, Washington and North Carolina. Some states, such as South Carolina and Colorado  have adopted federal income tax principles and will now be able to rely on the codification of the federal economic substance doctrine..

BBNA: Have these states adopted a relatively uniform test for economic substance or do their approaches vary?

Carter: No. The codification of the economic substance doctrine varies depending on the types of transactions subject to the doctrine, the factors used to determine whether a transaction has adequate substance, which party will bear the burden of proof to establish whether the applicable economic substance standard has been met, and what the burden of proof is (i.e. clear and convincing or preponderance).

BBNA: Have any states adopted an approach that the federal government might learn from?

 Carter: I’m not sure that the Federal government can learn from any of the state statutes, except that certainty in definitions is important. With respect to the federal statutes’ use of the term “substantial,” there should be some attention paid to that by Congress, as that term invites uncertainty to a statute that should be clarifying the standard. In the end, economic substance is inherently a slippery slope, so it is not surprising that the federal codification does not answer all the questions that taxpayers have.

BBNA: What are some advantages or disadvantages to operating in a state that has codified its economic substance policy?

Carter: Economic substance is, at some level, fraught with peril because there are so many variants of the doctrine – whether a business purpose is enough or whether you need only show a profit in a transaction. Under the common law, taxing authorities will use the variation of the doctrine that is most favorable to the state, and that may or may not have been the variation of the doctrine that was used by the taxpayer in vetting the transaction on the front end. Thus, a codified economic substance doctrine allows taxpayers to have some level of certainty of what they have to prove to defend a transaction or structure.

BBNA: Do you believe that federal legislation is necessary to ensure that the states adhere to a uniform standard for determining economic substance?

Carter: If the adoption of economic substance statutes was more widespread among the states, federal legislation to address uniformity and burden of proof would be helpful for taxpayers. However, most states have not codified the economic substance doctrine. Thus, federal legislation may only encourage states to rely on this doctrine more often.

BBNA: How will codification of economic substance policy affect the planning and litigation of such so-called “sham” transactions, in which a company manipulates economic substance to achieve a tax benefit?

Carter: The real challenge for taxpayers in the codification of economic substance is the burden of proof. The standards vary but that has been the case under the common law economic substance doctrine. With the heightened burden of proof in some states, this makes it even more challenging for taxpayers with legitimate and thoughtfully structured transactions. Going to court is difficult enough without having to prove the case by “clear and convincing evidence.”

By Melissa Fernley and Steven Roll

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