|* Partner, Sullivan & Cromwell LLP. All views expressed herein are solely those of the author.
Section 7701(o) expressly provides: “The determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection has never been enacted.” But that is the only significant determination that the court ever makes; therefore codification has almost no substantive effect.
More specifically, Section 7701(o) defines the economic substance doctrine (ESD) 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.” If, however, the transaction in question is defined to include only the structures or steps that were designed to give rise to the relevant tax benefits, then the transaction lacks business purpose and economic substance by definition. If a court thinks the claimed tax results are unconscionable, it generally defines the transaction narrowly and concludes both that the doctrine is relevant and that the transaction lacks business purpose and economic substance. If the court thinks the claimed tax results are within the realm of legitimate tax planning, however, the court defines the transaction to include the taxpayer’s broader business objectives and concludes that the transaction has both business purpose and economic substance and that the doctrine isn’t relevant anyway. Whether the court finds the tax results unconscionable turns on many factors, including of course whether the court perceives them to be inconsistent with the general structure of the relevant rules (as Judge Learned Hand put it in Gregory v. Helvering, “not what Congress intended”). This also includes such factors as how the court views the taxpayer and whether the transaction has been “promoted.”
In other words, ESD, at least as currently applied by the courts, is primarily a subjective anti-abuse rule the application of which is objective in name only. I can’t recall a single case that found, for example, that the relevant transaction had no business purpose but had economic substance (or had no economic substance but did have a business purpose) and held for the taxpayer on that basis.
It appears, therefore, that the only real change is the 40% strict liability penalty. This does not mean, however, that the change is not significant. At the margin, the penalty is likely to discourage aggressive tax planning, as taxpayers will — or at least should — fear that if a judge doesn’t like the results, he or she will define the transaction narrowly to include only the tax planning steps and find that the economic substance doctrine was relevant. In such a case, the strict liability penalty will indeed apply, and it will be 40% if the position has not been disclosed.
Nor does this mean that Treasury should not bother promulgating regulations under Section 7701(o). To the contrary, codification strikes me as a golden opportunity for Treasury to give taxpayers a better sense of what it does not like and why. I don’t think Treasury need fear that taxpayers will use such regulations against it by complying with their letter (but not their spirit) and then offering up evidence of such compliance to the court. Any judge that would have found against the taxpayer to begin with would not be deterred by such self-serving formalism. Moreover, Treasury can fill the regulations with disclaimers such as, “This is just what we mean, by way of example, in order to give better guidance regarding what sorts of things you should not be trying to do. It cannot be taken as pro-active authority or used as a shield, etc.”
To place these points in sharper focus, I take you take you back to Cottage Savings Ass’n v. Commissioner, where two savings and loan associations exchanged economically identical mortgage portfolios solely to accelerate the timing of a loss realization for tax purposes. The exchange itself obviously lacked both business purpose (it was concededly done solely to realize a tax loss) and economic substance (the exchange had so little effect on the taxpayers’ economic positions that it was not a cognizable event for regulatory or accounting purposes, which is why it was so attractive). Nevertheless, the Supreme Court held for the taxpayer, reversing the court below. What bearing does the codification of the economic substance doctrine have on whether taxpayers will prevail in a case like this? Absolutely none. But surely it would be helpful for taxpayers to have a better sense of when tax planning of this sort is acceptable and when it isn’t. Nor does it matter that whatever guidance Treasury provided on this point would only be prescriptive. As the Bible says, it is better to light even a single candle than to curse the darkness.