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2010 Budget Tax Proposal

Codify "Economic Substance" Doctrine

Legislative efforts to address the problem of abusive tax shelters have centered on whether to codify, or write into law, an “economic substance” rule or doctrine. The economic substance doctrine says that a transaction must have a meaningful economic purpose or investor risk to be legitimate. The president proposes to clarify such a doctrine, impose a new 30 percent penalty on understatement of tax for transactions that lack economic substance, and deny deductions for interest attributable to any understatement of tax arising a transaction that lacks economic substance.  A transaction would meet the "economic substance" doctrine only if it changes in a meaningful way (apart from any federal tax effect) the taxpayer's economic position and the taxpayer has a substantial purpose (other than a federal tax purpose) for undertaking the transaction.

In recent years, courts have consistently rejected a variety of tax shelters because the transactions lacked economic substance. They have, however, articulated different standards for determining the presence of economic substance. Advocates of defining economic substance in the Internal Revenue Code believe this would lead to greater certainty and uniformity in the definition of allowable transactions than current common law interpretations and thereby more effectively constrain tax-sheltering behavior. Courts would still, however, have to interpret when a transaction falls within the intent of the statutory language.  The estimated revenue gain is probably based on the assumption that the increase in penalties when a transaction lacks economic substance, as defined in the provision, will deter aggressive behavior and not on the assumption that the legislative language will make the IRS more successful in the courts.

Taxpayer representatives fear that rigid application of a statutory economic substance doctrine will lead to the denial of certain tax benefits that are currently permitted. Others, such as former IRS Chief Counsel Donald Korb, oppose a legislated definition because it may add little to what the courts are already doing and could provide a roadmap for taxpayers to design transactions that satisfy the doctrine. They believe that today’s various court interpretations constrain tax shelters more effectively than a more uniform statutory rule.

Additional Resources
Description of Revenue Provisions Contained in the President’s Fiscal Year 2010 Budget Proposal; Part Two: Business Tax Provisions (JCS-3-09), Joint Committee on Taxation, September 2009, pp 34-71