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Economic Substance Doctrine – Clarification or Mere Codification?
On 30 March 2010, President Obama signed into law the Health Care and Education Reconciliation Act which included the codification of the economic substance doctrine. The doctrine, having had a common law application since 1935, seeks to prohibit tax transactions that may technically meet statutory requirements but lack any economic substance or purpose. Taxand US examines the new law and what tax directors need to be thinking about to help minimise the impact on taxpayers.
The Internal Revenue Code, in codifying economic substance, has adopted a two-part test:
- the transaction must change the taxpayer's economic position in a meaningful way
- the taxpayer must also have a substantial purpose for entering into the transaction
In addition to creating a test for economic substance, the legislation provides penalties for underpayments attributable to transactions lacking economic substance. The new statute will apply to transactions entered into after the date of enactment, 30 March 2010.
The codification of the economic substance doctrine seems to have muddied the waters. Tax directors need to be involved in predicting the future economic benefit of significant transactions and should expect that these forecasts will be subject to IRS scrutiny.
Given that there is no exception, including reasonable cause, to the penalty, taxpayers will likely come to the IRS for more rulings on transactions and for transactions for which they would have not previously requested such a ruling. Thus, this burden will act as a deterrent for taxpayers from entering into otherwise economically viable transactions.
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