The Dbriefs Federal Tax series presents:

Codification of the
Economic Substance
Doctrine: What Does It
Mean for Your Company?
Harrison Cohen, Deloitte Tax LLP
Phillip Gall, Deloitte Tax LLP
Irwin Panitch, Deloitte Tax LLP

April 27, 2010

Agenda

• Codification of the Economic Substance Doctrine:

New Section 7701(o)
• Potential Framework for Analyzing Transactions
Under New Section 7701(o)
• Question & Answer

Copyright © 2010 Deloitte Development LLC. All rights reserved.

Codification of the Economic
Substance Doctrine: New
Section 7701(o)
Poll question #1

Under new section 7701(o), in the case of any transaction to

which the economic substance doctrine is relevant, a
transaction is treated as having economic substance only if:

• It changes in a meaningful way the taxpayer’s economic

position
• The taxpayer has a substantial non-tax purpose for
entering into the transaction
• Either (a) or (b)
• Both (a) and (b)

Copyright © 2010 Deloitte Development LLC. All rights reserved.

Codification of economic substance
doctrine
• On March 30, 2010, the President signed the Health Care and
Education Reconciliation Act of 2010 (the “Act”).
• The Act added new section 7701(o), which “clarifies and enhances”
the application of the common law economic substance doctrine,
according to section 7701(o)’s primary legislative history, a March
21 pamphlet by the staff of the Joint Committee on Taxation (JCX-
18-10) (the “JCT pamphlet”).
– The JCT pamphlet states that new section 7701(o) does not change
prior law standards in determining when to utilize an economic
substance analysis.
– New section 7701(o) defines the term “economic substance doctrine” to
mean the common law doctrine under which tax benefits under Code
sections 1 through 1563 with respect to a transaction are not allowable
if the transaction does not have economic substance or lacks a
business purpose.
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Codification of economic substance
doctrine (cont.)
• Under new section 7701(o), in the case of any
transaction to which the economic substance doctrine is
relevant, a transaction is treated as having economic
substance only if:
– It changes in a meaningful way (apart from federal income tax
effects) the taxpayer’s economic position, and
– The taxpayer has a substantial purpose (apart from federal
income tax effects) for entering into the transaction.
• The provision is effective for transactions entered into
after March 30, 2010.

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Satisfying the two prongs of the economic
substance doctrine
• A taxpayer may rely on profit potential to satisfy both prongs of the
economic substance doctrine. However, profit potential will be taken into
account only if the present value of the reasonably expected pre-tax profit
from the transaction is substantial in relation to the present value of the
expected net tax benefits that would be allowed if the transaction were
respected.
– Fees and other transaction expenses are taken into account as expenses in
determining pre-tax profit.
– The Treasury is instructed to issue regulations requiring foreign taxes to be
treated as expenses in determining pre-tax profit “in appropriate cases.” The
JCT pamphlet states that there is no intention to restrict the ability of the
courts to consider the appropriate treatment of foreign taxes in particular
cases.
• The JCT pamphlet states that a taxpayer may rely on factors other than
profit potential to demonstrate that a transaction results in a meaningful
change in the taxpayer’s economic position or that the taxpayer has a
substantial non-federal-income-tax purpose.
3 Copyright © 2010 Deloitte Development LLC. All rights reserved.
Satisfying the two prongs of the economic
substance doctrine (cont.)
• Any state or local income tax effect that is related to a
federal income tax effect is treated in the same manner
as a federal income tax effect.
• Achieving a financial accounting benefit is not taken into
account as a non-federal tax purpose for entering into a
transaction if the origin of such financial accounting
benefit is a reduction of federal income tax.

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Poll question #2

Which of the following is an example of a basic business

transaction that falls on the “Angel List”?

• The choice between capitalizing a business enterprise

with debt or equity
• A U.S. person’s choice between utilizing a foreign
corporation or a domestic corporation to make a foreign
investment
• The choice to enter into a transaction or series of
transactions that constitute a corporate organization or
reorganization under subchapter C
• All of the above

Copyright © 2010 Deloitte Development LLC. All rights reserved.

Is the economic substance doctrine
relevant to a transaction?
• New section 7701(o) provides that the determination of whether
the economic substance doctrine is relevant to a transaction is
made in the same manner as if the provision had never been
enacted.
• The JCT pamphlet states that if “the realization of the tax benefits
of a transaction is consistent with the Congressional purpose or
plan that the tax benefits were designed by Congress to
effectuate, it is not intended that such benefits be disallowed.”
• In this regard, the JCT pamphlet further provides that for example,
it is not intended that certain tax credits (e.g., sections 42, 45D,
47, 48, etc.) be disallowed in a transaction pursuant to which, in
form and substance, a taxpayer makes the type of investment or
undertakes the type of activity that the credit was intended to
encourage.

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Is the economic substance doctrine
relevant to a transaction? (cont.)
• The JCT pamphlet states that the provision “is not intended to alter
the tax treatment of certain basic business transactions that, under
longstanding judicial and administrative practice are respected,
merely because the choice between meaningful economic
alternatives is largely or entirely based on comparative tax
advantages.”
• It then provides four non-exclusive examples of basic business
transactions:
– The choice between capitalizing a business enterprise with debt or equity;
– A U.S. person’s choice between utilizing a foreign corporation or a domestic
corporation to make a foreign investment;
– The choice to enter into a transaction or series of transactions that constitute a
corporate organization or reorganization under subchapter C; and
– The choice to utilize a related-party entity in a transaction, provided that the
arm’s length standard of section 482 and other applicable concepts are
satisfied.
6 Copyright © 2010 Deloitte Development LLC. All rights reserved.
Is the economic substance doctrine
relevant to a transaction? (cont.)
• Citing Coltec, ACM, and Minnesota Tea Co. v.
Helvering, the JCT pamphlet also states that the
provision does not alter the court’s ability to aggregate,
disaggregate, or otherwise recharacterize a transaction
when applying the doctrine.
– Courts continue to have the ability to bifurcate a transaction in
which independent activities with non-tax objectives are
combined with an unrelated item having only tax-avoidance
objectives in order to disallow those tax-motivated benefits.
– A transaction is defined to include a series of transactions.

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New penalty provisions

• The Act imposes a strict liability penalty if a transaction lacks

economic substance or fails to meet the requirements of any
similar rule of law.
– What is a similar rule of law? The JCT pamphlet states: “It is intended
that the penalty would apply to a transaction the tax benefits of which
are disallowed as a result of the application of the similar factors and
analysis that is required under the provision for an economic
substance analysis, even if a different term is used to describe the
doctrine.”
• The penalty rate is 20% of the underpayment, but is
increased to 40% if the taxpayer does not disclose the
relevant facts on the tax return.
• No exceptions to the penalty, including the reasonable cause
exception, are available. Thus, outside opinions or in-house
analysis would not protect the taxpayer from the penalty.
8 Copyright © 2010 Deloitte Development LLC. All rights reserved.
Potential areas impacted by codification of
economic substance doctrine
• Because of the strict liability penalty, the implications of
new section 7701(o) must be considered for purposes of:
– Tax planning
• Additional consideration of advance IRS rulings?
– Financial Accounting Standards Board (FASB) Interpretation No.
48, Accounting for Uncertainty in Income Taxes (now codified in
FASB’s Accounting Standard Codification in Topic 740, Income
Taxes)
– Merger and acquisition transactions (e.g., buyer’s due diligence)
– Corporate governance

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Poll question #3

Outside opinions or in-house analysis will protect the

taxpayer from the strict liability penalty if a transaction lacks
economic substance or fails to meet the requirements of any
similar rule of law.

• True
• False

Copyright © 2010 Deloitte Development LLC. All rights reserved.

Potential Framework for
Analyzing Transactions Under
New Section 7701(o)
Framework for analyzing economic
substance
1.Does the economic substance doctrine apply to a
particular transaction?

2.If the economic substance doctrine applies, does the

transaction meet the tests set forth in new section
7701(o)?

10 Copyright © 2010 Deloitte Development LLC. All rights reserved.

Potential factors to consider in
determining if the economic substance
doctrine applies
• Whether the transaction appears on the “Angel List”
• The nature of the tax benefit
– Economic vs. noneconomic loss
– Timing vs. permanent
– Gain recognition
• Whether there is precedent in the courts or from the IRS
not asserting or applying the economic substance
doctrine to analogous facts
• Internal vs. third-party transactions
• Whether the tax benefit is consistent with a statute or
clear congressional intent

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Potential factors to consider in the
application of the economic substance
doctrine
• What is considered “substantial” in regards to the non-
tax business purpose?
• How much of a change is “meaningful”?
• Who is the taxpayer that is supposed to have the
meaningful change (e.g., consolidated group, related
parties, etc.)?

12 Copyright © 2010 Deloitte Development LLC. All rights reserved.

Poll question #4

What impact will the enactment have on evaluating

transactions?

• Significant
• Moderate
• None
• Unsure

Copyright © 2010 Deloitte Development LLC. All rights reserved.

Question and Answer
Join the Federal Tax series on
May 19th as we present:

M&A, Tax, and the

Economic Upswing:
Should You Change Your
Game Plan?
Thank you for joining
today’s webcast.

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Contact info

Harrison Cohen
202-378-5227
harrisoncohen@deloitte.com

Phillip Gall
212-492-2871
phillipgall@deloitte.com

Irwin Panitch
202-378-5231
ipanitch@deloitte.com

Copyright © 2010 Deloitte Development LLC. All rights reserved.

This presentation contains general information only and is based on the experiences and
research of Deloitte practitioners. Deloitte is not, by means of this presentation, rendering
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Copyright © 2010 Deloitte Development LLC. All rights reserved.

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