|* Partner, Shearman & Sterling LLP. All views expressed herein are solely those of the author.
The question of how the codified economic substance doctrine (“ESD”) may be considered to change the way we practice has two aspects: (i) is there reduced reliability of tax planning based on the expectation of disallowed transactions that would have been upheld previously, and (ii) how is practice affected by the greater downside from the automatic penalty?
The case law leading up to the codification of the ESD contained a variety of strains of a general anti-abuse principle, including the ESD. Section 7701(o) focuses on this particular formulation of the various doctrines and (under my reading) asks practitioners to isolate those cases in which courts use this two-prong formulation as opposed to denying the taxpayer’s claim under other doctrines, such as substance over form, business purpose as used in various corporate transactions, step transaction, and so forth.
The argument that the codified ESD should be narrowly construed in this way is based on the legislative history relating to the statute’s “relevance” concept, statements of Treasury and IRS officials, and the fact that the salient point of the codification is the automatic penalty associated with it under Section 6662(b)(6). Whether a transaction should be upheld or not, is not the issue; rather, the issue is whether the transaction merits an automatic penalty. Only where the doctrine otherwise is “relevant” do the statute’s two substantive elaborations of the doctrine — the requirement that the transaction always have both business purpose and substance and if these are purported to be met based on profit, that present value and substantiality concepts be applied — come into play.
So what kinds of transactions are covered? And are any of these ones that would be surprising, given that various courts already applied the two-part test and present value and substantiality concepts? A major target is highly tax-engineered and/or promoter marketed tax avoidance transactions. In cases where the two-prong test was applied, courts increasingly found both prongs were met, where necessary by isolating the tax avoidance part of a larger transaction or deeming certain cash flows to be circular. Transactions of this ilk never were for the faint of heart, and many practitioners and firms never even advised on them. Even those that did often applied present value and substantiality concepts to some extent.
In my experience, such transactions were no longer being done by public companies even precodification due to the scrutiny imposed by auditors before recording a tax benefit for a transaction for financial statement purposes. Hence, the parties engaged in such transactions are generally limited to private companies, investment partnerships, and individuals — and even their participation has precipitously declined. As to these obviously targeted transactions, codification occurred only after the IRS largely had won the war in the courts. Certain types of transactions (e.g., involving foreign tax credits), however, remain in question, and as to them the penalty may be a deterrent.
What about “normal” commercial transactions — leaving aside the four categories expressly blessed in the legislative history — are those affected? This depends in part on one’s confidence level that doctrines such as substance over form are not implicated, and that a purely tax-motivated transaction is not for that reason alone implicated. E.g., the merger of two subsidiaries to avoid limitation on the use of losses under the consolidated return separate return year limitation (SRLY) rules should not be vulnerable to the ESD penalty even if it lacks business purpose, nor should a “repo” transaction if it fails because the buyer is considered the economic owner.
The closest to relatively conventional transactions that have raised questions under the codified ESD are traditional leasing and project financing transactions that meet pre-codification IRS leasing guidelines and case law, excluding sale in lease out transactions (SILOs). Cases over the years have analyzed leasing transactions as subject to the ESD and allowed them to pass muster if there was sufficient profit and they lacked abusive elements such as risk-insulation.
Although the pretax profit test in Section 7701(o) is not the exclusive means of showing business purpose, for a leasing transaction pretax profit is the only possible business purpose of a lessor buying property to lease. The problem in applying the pretax profit test to leasing is the present value concept. Common sense would say that, as Congress showed its desire to apply a present value concept in measuring pretax profit, it would be very odd if that test were intended to be passed generally purely on the basis of inflation — i.e., that pre-tax profit could be found even if discounting cash flows by a risk-free tax discount rate would result in a loss.
But doing precisely that would mean that many conventional leasing and project financing structures, which are premised on a 2 to 4% internal rate of return (and assume no or minimal allocable financing costs) being sufficient, would not pass the test. This raises the question whether Congress intended to eliminate the viability of those transactions. If not — and nothing indicates that — should the net present value test be construed generally so as to accommodate these transactions (by determining “profit” using undiscounted flows and discounting such “profit” but only to assess substantiality)? Should instead a more lenient test be applied specifically to these transactions? Or should the IRS simply pronounce that Congress did not intend that these conventional transactions be subject to the codified ESD?
My feeling is that project tax advisors will find enough comfort in the contorted language of the pre-tax profit test, the legislative history, and the absence of any indication that the test for conventional leasing prepaid loans was intended to be changed.
Finally, I do believe the in terrorem effect of the penalty will be a substantial additional factor in discouraging participation in certain aggressive transactions that garnered “should” level opinions in years past.