The ABA Tax Section issued a report this month supplementing its 2003 comments on the proposal to codify the economic substance doctrine. See this link. The comments were approved by the Tax Section's Council and "represent the views of the Section" but certainly not of all attorneys (such as me) who may be a member of the Section and have had no opportunity to comment on the report before its filing. It is one of those things that I sometimes resent about the way the ABA (and NYSBA, for that matter) function: executive committees of people who have been invested in the organization for a long time decide the position that the Tax Section will adopt, without plenary sessions or other means of gathering a sense of the members on the issue.
The ABA Tax Section report essentially argues for a limited approach to any codification--one that would merely "clarify" how a court should apply the doctrine in two rather narrow ways. The claim is that anything more would disrupt "legitimate business transactions" and harm "tax planning."
“[W]e continue to believe that any codification of this judicial doctrine should be limited to clarifying that when a court determines that the economic substance doctrine does apply, (i) the taxpayer must establish that the non-tax considerations in the transaction were substantial in relation to the potential tax benefits; and (ii) in evaluating the potential economic profit from the transaction, all costs associated with the transaction (including fees paid to promoters and advisers) should be taken into account.” Id.
The second item is clearly necessary to the adequate functioning of economic substance as an anti-abuse doctrine. If the promoter fees and other amounts necessary to smooth the transaction (getting a bank to go to the trouble of treating a regular financing as though it were a partnership equity interest, for example) were not taken into account, a transaction might appear to have had a potential for a pre-tax profit even when it was actually a losing business.
The first item is more troubling. Saying that non-tax "considerations" must be "substantial" in relation to tax considerations is at most providing a vague notion that some economic substance might be lurking somewhere in the transaction. "Substantial" is far less than a "principal purpose" test. It doesn't even measure up to "must predominate" as a test. In fact, it may be nothing more than a statement that non-tax "considerations" were not "de minimis" in the deal. Should that be enough to legitimize twisting of statutory provisions to provide a tax benefit that was never contemplated by the drafters and that clearly pushes the boundary of permissible use of the Code to generate lower tax liabilities? I'm not so sure. That test seems rather self-serving for tax professionals, to me.
The ABA Tax Section expresses its particular concern with the requirement that the transaction be a "reasonable means" of accomplishing the taxpayer's stated business purpose. Does the ABA Tax Section Council really think that taxpayers should be able to use unreasonable means of accomplishing their business purpose in order to get tax benefits that it would otherwise not be entitled to? The section's objections are couched in terms of the importance of avoiding uncertainty. Again, I am not so sure that certainty merits elevation to the pedestal on which the ABA Tax Section Council places it. If there is some area of uncertainty regarding the degree of aggressiveness permitted, taxpayers are likely to be somewhat more cautious than they would otherwise be. That's not a bad outcome. I've used the analogy before of the yellow strip next to the subway in New York City. Stepping there is not a per se death decision, but it surely places one in considerably more jeopardy than the safe position back of the strip. Why not encourage taxpayers to stay in the safe zone when they are determining how to shape and report their business transactions? Is it really necessary for "legitimate business" that we encourage "tax planning" that steps right up to (and therefore inevitably sometimes over) the line?
Similarly, the ABA Tax Section Council argues that a 40% strict liability for transactions lacking economic substance is "overly harsh". What that means is that tax practitioners know such a penalty would do even more to discourage those borderline transactions. Again, why not? There is little, if any, social merit in encouraging aggressive tax planning transactions. If a high penalty would actually encourage taxpayers to try to get it right, that is an argument for the penalty, not an argument against it. The report argues that increased penalties under recent legislation (in particular, the (misnamed) 2004 "American Jobs Creation Act") are all that's needed. But clearly those penalties remain much too low to be effective in most cases. Given the extremely low audit rates and the extremely low chances of detection of errors on audits, you might need penalties in the1500% range before one could truly hope a rational tax avoider would pay attention to the penalty possibilities. Heftier strict liability penalties are a reasonable tool against the aggressive tax avoidance planning that still goes on, from the "family limited partnerships" used to retain control of assets while ostensibly creating "valuation discounts" that let those assets escape the estate tax to the disguised financings using the flexbility of partnership allocations to give the lending bank a slightly higher interest rate in return for acting as an accommodation party to the deal.
Now, I am not saying that I support economic substance codification, especially in the weak form that the Senate bill proposes. I think it is absolutely appropriate for courts to apply judicial doctrines in the federal common law area of tax law--without that, taxpayers would always be able to distort the statute and stay a step ahead of the government. The courts should continue what they can indeed do very well--looking to statutory purpose, the coherent interpretation of the statute in context, whether a transaction is germane to the taxpayer's business, and other issues tied in to the "substance over form", step transaction, business purpose, sham and economic substance judicial doctrines in their various manifestations in the courts. Courts should apply these doctrines judiciously, but they should not excuse aggressive transactions merely because there is a business purpose if there is no reasonable expectation of a pre-tax profit (and they should treat foreign taxes as expenses in making those determinations).
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