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By Brian D. Lepard, Law Alumni Professor of Law
University of Nebraska College of Law, Lincoln, Nebraska
The codification of the economic substance doctrine in §7701(o) of the Internal Revenue Code, enacted in March 2010 under §1409 of the Health Care and Education Reconciliation Act of 2010,1 has raised many questions. Among them is just how this new provision affects transfer pricing and the application of the regulations under §482 of the Code. To date the Treasury Department and the IRS have provided no guidance on these questions.
The Economic Substance Doctrine and §7701(o)
The economic substance doctrine is a long-standing doctrine created by the courts, which holds that transactions will be respected for federal income tax purposes only if they have "economic substance."2 In assessing the economic substance of a transaction, courts have examined both the objective economic substance of the transaction and the subjective business purpose, if any, behind it. Some courts have required only that a transaction satisfy one or the other of these tests; others have insisted that they satisfy both. For years many commentators argued that the economic substance doctrine should be codified as a way to ensure greater consistency in its application (and enhance revenue), and in 2010 Congress succeeded in doing so, enacting §7701(o). The new provision is effective for transactions entered into after March 30, 2010.3
Section 7701(o) defines the "economic substance doctrine" 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."4 The provision purports not to redefine the economic substance doctrine as elaborated by the courts, but to clarify it.5
The centerpiece of §7701(o) is its affirmation that in "the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if – (A) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer's economic position, and (B) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into such transaction."6 The provision thus lays down both an objective and a subjective test for satisfaction of the economic substance doctrine.
The legislation that enacted §7701(o) also amended the penalty provisions of the Code to create strict liability for violations of the economic substance doctrine – perhaps the most worrisome aspect of the new legislation to practitioners.7 Congress provided in particular that in the case of an underpayment attributable to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance within the meaning of §7701(o), a taxpayer does not have the right to rely on the normal "reasonable cause and good faith" exception for underpayments generally provided in §6664(c)(1).8
The Concept of Economic Substance in the §482 Regulations
It remains to be seen how the new statutory provisions will affect the application of the §482 regulations. There is definitely the potential for them to be relevant to transfer pricing disputes because the §482 regulations make a number of references to the "economic substance" of a transaction. For example, the regulations lay down rules for determining when the contractual terms provided in a written contract between controlled taxpayers will be respected for purposes of determining the degree of comparability between the controlled transaction (or taxpayer) and any uncontrolled comparables.9 In particular, the regulations affirm that the "contractual terms, including the consequent allocation of risks, that are agreed to in writing before the transactions are entered into will be respected if such terms are consistent with the economic substance of the underlying transactions."10 The regulations provide that in "evaluating economic substance, greatest weight will be given to the actual conduct of the parties, and the respective legal rights of the parties."11 The regulations note that if "the contractual terms are inconsistent with the economic substance of the underlying transaction, the [IRS] may disregard such terms and impute terms that are consistent with the economic substance of the transaction."12 The regulations affirm, further, that if there is no written agreement, "the [IRS] may impute a contractual agreement between the controlled taxpayers consistent with the economic substance of the transaction."13 Again, in "determining the economic substance of the transaction, greatest weight will be given to the actual conduct of the parties and their respective legal rights."14
The regulations also provide that the IRS "will evaluate the results of a transaction as actually structured by the taxpayer unless its structure lacks economic substance. However, the [IRS] may consider the alternatives available to the taxpayer in determining whether the terms of the controlled transaction would be acceptable to an uncontrolled taxpayer faced with the same alternatives and operating under comparable circumstances."15
The Relationship Between Sections 7701(o) and 482
The relationship between §§7701(o) and 482 is not clear. The Joint Committee on Taxation's explanation of §7701(o) refers to §482 only briefly by affirming that the provision "is not intended to alter the tax treatment of certain basic business transactions that, under long-standing judicial and administrative practice are respected, merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages," including "the choice to utilize a related-party entity in a transaction, provided that the arm's length standard of §482 and other applicable concepts are satisfied."16
This statement is helpful, but of course does not indicate whether and how §7701(o) would apply to a transaction between related parties if the §482 regulatory provisions on the "arm's length standard" are not satisfied. Moreover, those provisions themselves make reference to the IRS's power to disregard or impute contractual terms based on the "economic substance" of the transaction.
One threshold issue is whether a related party transaction covered by the §482 regulations (a "§482 transaction") actually triggers §7701(o). The new provision applies to "any transaction to which the economic substance doctrine is relevant." Is the economic substance doctrine "relevant" to a §482 transaction? On the one hand, it could be argued that it is because the regulatory provisions reviewed above mandate that the IRS consider the "economic substance" of a §482 transaction and disregard or impute contractual terms based on that economic substance. On the other hand, the provisions in question do not authorize the IRS wholly to disregard a §482 transaction, as the economic substance doctrine normally requires. Moreover, the regulations do not refer to the economic substance "doctrine" as such.
IRS guidance to date on §7701(o) has not addressed these issues explicitly. Notice 2010-62,17 issued on September 13, 2010, makes no mention at all of §482. On July 15, 2011 the IRS released the text of a directive from the IRS Commissioner of the Large Business and International Division to examiners and managers on the codified economic substance doctrine and related penalties (the "July 15 directive").18 The directive, drawing on §7701(o)'s legislative history, at least reiterates that "the choice to utilize a related-party entity in a transaction" if "the arm's length standard of §482 and other applicable concepts are satisfied" is a factor tending to show that application of the economic substance doctrine to a transaction is "likely not appropriate." However, this statement contains the ambiguities just mentioned.
One potentially helpful statement in the July 15 directive is that an examiner must answer certain queries before seeking the approval of his or her appropriate Director of Field Operations (DFO) to apply the economic substance doctrine. One of these queries is, "Is the transaction subject to a detailed statutory or regulatory scheme?" If so, the directive states that so long as the transaction complies with this scheme, "the application of the doctrine should not be pursued without specific approval of the examiner's manager in consultation with local counsel." It is possible that the §482 regulations could be viewed as just this type of "detailed statutory or regulatory scheme." This would definitely be the better view, especially because, as we have seen, the Treasury Department already requires an analysis of the "economic substance" of a §482 transaction in those very regulations. It would be helpful if the IRS could clarify whether it agrees with this suggestion.
The determination of whether and how §7701(o) applies to a §482 transaction is also critical because it could affect the penalty regime to which a taxpayer is subject. As noted above, Congress eliminated the "reasonable cause and good faith" exception in the case of any portion of an underpayment attributable to a failure to comply with the economic substance doctrine as codified in §7701(o).19 However, the exception is available in the case of an underpayment attributable to a "net §482 transfer price adjustment" so long as certain requirements regarding transfer pricing methods and taxpayer-maintained documentation are satisfied.20 If §7701(o) applies to a §482 transaction, then, this "strict liability" regime could eliminate any protection otherwise provided by the reasonable cause and good faith exception. This is another important issue meriting guidance from the IRS.
Accordingly, the IRS should, as soon as possible, provide more detailed guidance to practitioners and taxpayers on how §7701(o) and its associated penalty provisions will affect the application of §482 and the §482 regulations.
For more information, in the Tax Management Portfolios, see Keinan, 508 T.M., The Economic Substance Doctrine, Lepard, 551 T.M., Section 482 Allocations: General Principles in the Code and Regulations, Lepard, 552. T.M., Section 482 Allocations: Specific Allocation Methods and Rules in the Code and Regulations, and Lepard, 553 T.M., Section 482 Allocations: Judicial Decisions and IRS Practice and in Tax Practice Series, see ¶3600, Section 482 — Allocations of Income and Deductions Between Related Taxpayers.
1 See P.L. 111-152, §1409, 124 Stat. 1029 (2010).
2 For an example of a case applying the doctrine, see ACM Partnership v. Comr., 157 F.3d 231 (3d Cir. 1998), aff'g T.C. Memo 1997-115 (1997), cert. denied, 526 U.S. 1017 (1999).
3 See P.L. 111-152, §1409(a), 124 Stat. 1029 (2010).
5 See §7701(o)(5)(C).
7 See, e.g., §6662(b)(6), (i), §6664(c)(2).
8 See §6664(c)(2).
9 See Regs. §1.482-1(c)(2), (d)(3)(ii)(A).
10 Regs. §1.482-1(d)(3)(ii)(B)(1).
13 Regs. §1.482-1(d)(3)(ii)(B)(2).
14 Id. For detailed examples of the application of the rules in Regs. §1.482-1(d)(3)(ii) involving contractual terms imputed from economic substance, see Regs. §1.482-1(d)(3)(ii)(C), Examples 3, 4, 5, and 6.
15 Regs. §1.482-1(f)(2)(ii)(A). For other references to economic substance in the regulations, see, e.g., Regs. §1.482-1(d)(3)(iii), -7A(g)(5), -7T(h)(2)(iii)(B), -7T(h)(2)(iii)(C), Examples 1-2, -7T(i)(5), -7T(k)(1)(iv)(A), (B), Examples 1-2, R-9(i)(2)(ii), (3), -9(i)(5), Examples 1-3.
16 Joint Committee on Taxation, Technical Explanation of the Revenue Provisions of the "Reconciliation Act of 2010," as amended, in combination with the "Patient Protection and Affordable Care Act" (JCX-18-10) (3/21/10) (emphasis added).
17 2010-40 I.R.B. 411.
18 See LB&I-4-0711-015 (7/15/11), reproduced as Worksheet 8 in 508 T.M., The Economic Substance Doctrine.
19 See §6664(c)(2).
20 See §6662(e)(3)(D).
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